Trading plans are now subject to new limits that can prevent insider trading and help boards prevent C-Suite misconduct.

Insider trading has long been a minefield for directors of U.S. corporations, a complex area of oversight and governance where missteps may result in potential criminal liability for both themselves and the executive management they oversee. Recently, the SEC has taken steps aimed at strengthening safeguards against insider trading. A recent enforcement action, and new rules guidance, illustrates the pitfalls of prior efforts to curb misconduct and new strategies for preventing abuses of corporate trading plans.
 
Most directors are aware that insider trading has long been regulated by the Securities Exchange Act of 1934 and SEC Rule 10b-5, which generally prohibit fraud and deception in connection with the purchase and sale of a security. These rules were clarified with the issuance of Rule 10b5-1 in 2000, in which the SEC explained that a person may violate these rules by purchasing or selling an issuer’s security while aware of material nonpublic information.

The prior rule, however, attempted to balance the competing goals of preventing fraud and allowing corporate directors and insiders some flexibility in transacting in their company’s shares. In issuing Rule 10b-5, the SEC created an affirmative defense for when the insider sales were made pursuant to a prearranged trading plan entered into when the trader was not aware of material nonpublic information. To meet the requirements for this defense, the “10b-5(1) plan” had to specify the amount of securities to be sold, the date and price of the sales, or a formula for determining the amount, date and price and that the plan was “entered in good faith.”
 
No sooner than these 10b-5(1) plans were widely adopted, suspicions arose that they could be easily exploited to mask illegal trades. Critics noted that plans could be created in anticipation of a future, impermissible insider trade to provide cover for conduct that still violated the trading regulations. These worries were most acute in plans with short “cooling-off” periods between the creation or amendment of the plan and the trading window, plans that covered only a single trade and plans adopted in a quarter before corporate earnings are announced for the quarter.

The SEC’s 2022 enforcement action against executives of Cheetah Mobile, a China-based internet mobile company, illustrates how 10b5-1 plans can be abused. Unbeknownst to the investing public, in 2015 and 2016, Cheetah’s revenues were rapidly softening because of a change in the algorithms used by an advertising partner of the company. While in possession of this information, in March of 2016, Cheetah’s CEO and president created a purported 10b5-1 trading plan permitting them to sell some of their holdings of Cheetah equity before a May 2016 announcement relating to weakness in advertising revenues, helping the two executives avoid hundreds of thousands of dollars in losses. The problem was that the executives had material nonpublic information at the time they created the plan and then designed the plan to permit sales just two months later. 

In an effort to combat these abuses, on December 14, 2022, the SEC issued a new set of guidelines implementing a mandatory “cooling-off” period prohibiting the initiation of trades under a 10b5-1 plan until the later of 90 days after adopting the plan or two business days after the release of financial results on Form 10-Q or Form 10-K for the fiscal quarter in which the plan was adopted or 120 days after adopting the plan, whichever is earlier. In the case of the Cheetah executives, their 10b5-1 plan would have been forbidden under either of the new standards. In addition to the “cooling-off” period revisions, the SEC also amended its prior rule to require that any person entering into a 10b5-1 must “act in good faith with respect to the plan,” in addition to the existing requirement that plans be entered into in good faith.  These two provisions taken together amount to a significant further limitation on the use of trading plans, such that even an insider selling pursuant to a plan meeting the new 10b5-1 trading plan requirements could still be denied the affirmative defense if the plan was intended as a ruse to shield unlawful insider trading. 

While there can be no doubt that the SEC’s new regulations represent a challenging new framework for directors and insiders to master, they ultimately give boards more power to prevent corporate conduct likely to draw fire from regulators and investors. Members of corporate boards should be sure to educate themselves on these changes to 10b5-1 trading plan guidelines and enforcement and ensure that trading plans are properly vetted under their insider trading policies. 

Michael Stocker Dark is of counsel in the San Francisco office of Berman Tabacco.

Nathaniel Orenstein is a partner in Berman Tabacco’s Boston office.