The SEC last month adopted new rules and rule amendments intended to enhance investor protections against insider trading. The changes add new conditions to the availability of Rule 10b5-1’s affirmative defense to insider trading liability and create new disclosure requirements for public companies and their executive officers and directors.
The amendments are the first since the SEC established Rule 10b5-1 in 2000 and reflect growing concern by the commission over the potential for company insiders to technically comply with the conditions to Rule 10b5-1’s affirmative defense, while at the same time, in effect, trade on the basis of material non-public information (MNPI) – and potentially escape liability for insider trading.
Rule 10b5-1(c) provides an affirmative defense to an insider trading claim by negating a proposition that a particular trade occurred ‘on the basis of’ MNPI in violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5. Subject to specific conditions, the affirmative defense generally provides that a trade was not made on the basis of MNPI if such trade was made pursuant to a binding contract, an instruction to another person to execute the trade or a written plan adopted at a time when the trader was not aware of the MNPI.
Such plans must be entered into in good faith and not as part of a scheme to evade the prohibitions of the insider trading rules.
AMENDMENTS TO RULE 10B5-1
‘Cooling-off’ periods
The amendments establish new, mandatory ‘cooling-off’ periods for 10b5-1 plans entered into by directors, Section 16 officers and other persons (other than the issuer) for such plans to benefit from the affirmative defense. These cooling-off periods require a delay between the time a 10b5-1 plan is entered into and the first trade is executed. These cooling-off periods are triggered by both the adoption of a new plan and ‘any modification’ of an existing plan as to the amount, price or timing of the purchase or sale of the covered securities – whether or not the changes are material.
Directors and officers adopting a plan under the amended rule may qualify for the affirmative defense only if trading does not begin until the later of: (i) 90 days after plan is adopted or modified; and (ii) two business days following disclosure of the issuer’s financial results for the fiscal quarter (via forms 10Q, 10K, 20F or 6K, as applicable) in which the plan was adopted or modified (but not more than 120 days).
For persons other than the issuer, trading cannot begin until 30 days after the plan is adopted or modified. Issuers have no required cooling-off period.
Director and officer good-faith requirement
Before the amendments, Rule 10b5-1 required that plans were entered into in good faith. This has been strengthened and broadened to require that those entering into a plan act in good faith throughout the duration of the trading arrangements contemplated by the plan. The SEC clarified in its adopting release that the good-faith requirement applies to activities within the insider’s control, but not those outside its control.
Director and officer representations
Directors and officers must include representations in their plans at the time that the plan is adopted or modified that they are: (i) not aware of MNPI about the issuer or its securities; and (ii) adopting or modifying the plan in good faith and not as part of a scheme to evade the prohibitions of Rule 10b5-1.
Prohibition on overlapping plans and ‘single-trade’ plans
Rule 10b5-1 will now prohibit all persons other than the issuer from having multiple overlapping plans for open market trades of an issuer’s securities, subject to a few limited exceptions. The amendments also limit all persons other than the issuer to one ‘single-trade’ plan during any 12-month period.
New disclosure requirements for issuers and insiders
Public companies reporting using domestic forms will be required to provide quarterly disclosure (via Form 10Q or Form 10K) of the adoption or termination of 10b5-1 plans and ‘non-Rule 10b5-1 trading arrangements’ by officers and directors during the related quarter.
These disclosures must include the material terms of the 10b5-1 plan or arrangement (other than price), such as the date the plan was entered into or terminated, the duration of the trading arrangement and the aggregate number of securities to be purchased or sold. Foreign private issuers are not subject to this requirement.
All public companies will be required to disclose annually, on Form 10K or Form 20F, as applicable, whether they have adopted insider trading policies and procedures governing the purchase, sale and/or other dispositions of the company’s securities by directors, officers and employees or the company itself reasonably designed to promote compliance with insider trading laws and include the policies themselves as an exhibit to the filing. If a public company has not adopted such policies, it would need to explain why it has not done so.
Companies reporting using the domestic forms must also comply with new annual executive compensation disclosure requirements. These include both: (i) a narrative disclosure of the company’s policies regarding the timing of option grants and the release of MNPI; and (ii) new tabular disclosures that identify, for each director and named executive officer details of each equity award granted to the person in the period beginning four business days before, and ending one business day after, the filing of a periodic report on Forms 10Q or 10K or the filing or furnishing of a current report on Form 8K that discloses MNPI (other than a current report disclosing the grant under Item 5.02(e)), as well as the percentage change in the closing price of the underlying stock from the trading days before and after the disclosure.
Finally, persons subject to Section 16 reporting (officers, directors and certain holders of 10 percent or more of a class of securities registered under Section 12 of the Exchange Act) will be required – via a new checkbox added to Form 4 and Form 5 – to identify whether the reported transaction was executed pursuant to a plan ‘intended to satisfy the affirmative defense conditions’ of Rule 10b5-1(c).
These persons will also have to report bona fide gifts of securities (whether or not a part of a 10b5-1 plan) on a Form 4 within two business days of the gift, instead of on a Form 5 within 45 days after the issuer’s fiscal year-end.
Rule effectiveness and phase-in periods
The amendments to Rule 10b5-1 are effective from February 27, 2023. They do not affect the availability of the affirmative defense under existing 10b5-1 plans entered into before the effective date, unless modified after that date.
The amendments create phase-in periods for the new public company disclosure requirements. Smaller reporting companies must comply with the new disclosure requirements in periodic reports that cover the first full fiscal period beginning on or after October 1, 2023. For all other issuers, the first report subject to the new requirements will be that covering the first full fiscal period beginning on or after April 1, 2023.
Section 16 reporting persons must comply with the amended Form 4 and Form 5 for reports filed on or after April 1, 2023.
NEXT STEPS FOR BOARDS, INSIDERS AND BROKER/DEALERS
Public company boards and/or general counsel and chief compliance officers can take the following steps now in preparation for the effectiveness of the amendments.
Update or adopt insider trading policies
Boards should carefully review existing insider trading policies and update them as needed to align with the amendments. In particular, boards should consider:
- Codifying within the policy the required cooling-off periods and representations required by the amendments
- Requiring that officers and directors pre-clear entry into, or modification of, 10b5-1 plans or similar trading arrangements to provide a mechanism ensuring such plans are kept track of internally and ultimately disclosed. This can also, if applicable, verify that the required cooling-off period and representations have been included
- Requiring officers and directors to pre-clear gifts of securities to ensure Form 4s are filed on time
- Providing that the issuer itself is covered by the policy. Otherwise, an issuer may be forced to explain why it has no insider trading policy with respect to itself.
Analyze equity award grant timing
In light of the expanded executive compensation disclosure requirements, boards and compensation committees should assess whether adjustments to the timing of grants of equity awards are prudent and consider generally the timing of such grants in proximity to other milestones and material developments for the company that may be perceived as material.
Prepare to make use of the updated Forms 4 and 5
General counsel and/or chief compliance officers should take note that Forms 4 and 5 filed on or after April 1, 2023 are the updated versions including the new checkbox even if the reported transaction is not done under a plan intended to satisfy the conditions to the affirmative defense.
Consider additional steps
In addition, directors and officers should also consider the following as companies transition to comply with the amended rule:
- Take note of the cooling-off periods and make appropriate personal finance arrangements to ensure compliance with the applicable period
- Consider timing when planning to make gifts of securities given the need to file a Form 4 within two business days from the gift.
- Take note of the requirement to act in good faith. This applies throughout the duration of the 10b5-1 plan and it can implicate all activities within the control of the insider – including any efforts by the insider to direct the activities of others. Therefore, not only is an insider prohibited from modifying a planned trade to their benefit, but they would also run afoul of the good-faith requirement by influencing the actions of the issuer in such a way that would affect their trades. This might be, for example, by directly or indirectly causing the issuer to disclose MNPI in a manner that would make the insider’s trades under an existing 10b5-1 plan more or less profitable.
Lastly, brokers/dealers that use standard forms for 10b5-1 plans for their clients should update these in advance of the rule coming into effect. Forms, other than those intended for issuers, should reflect the required cooling-off periods and include the representation and certification required of directors and officers. This may mean creating three different forms: one for directors and officers, one for persons other than directors, officers and issuers and one for issuers.
John Ablan is a partner and Laura Billiter is an associate in the corporate and securities group at Mayer Brown
John Ablan
