Enforcement Risks Relating to Section 10b5-1 Plans

The US Securities and Exchange Commission (“SEC”) and the Department of Justice (“DOJ”) have recently taken actions that highlight their increased scrutiny on insider trading through the alleged misuse of Rule 10b5-1 Plans. This Legal Update discusses the increased enforcement related to Rule 10b5-1 Plans and the need for companies to ensure the adequacy of their insider trading policies, procedures and compliance programs, along with the risk individual traders face and steps that might mitigate these risks.

Background

Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 promulgated thereunder prohibit purchases or sales of a security while in possession of Material Non-Public Information (“MNPI”) regarding the security or issuer, in breach of a duty owed to such issuer. This prohibited conduct is more commonly referred to as “insider trading.” Rule 10b5-1 under the Exchange Act of 1934 provides an affirmative defense to insider trading liability for trades undertaken pursuant to a binding contract, an instruction to another person to execute the trade for the instructing person’s account or a written plan (collectively, a “Rule 10b5-1 Plan”). The affirmative defense applies only if, among other things, the trader was not in possession of MNPI when the Rule 10b5-1 Plan was adopted and the Rule 10b5-1 Plan was entered into in good faith and not as part of a scheme to evade the prohibitions of the federal securities laws.

As discussed in our recent update, on December 14, 2022, the SEC adopted amendments to Rule 10b5-1 to both (a) add new conditions to the availability of the affirmative defense to insider trading liability; and (b) enhance public disclosure by issuers and insiders of trading plans designed to comply with Rule 10b5-1. The amendments are designed to address concerns about the rule’s potential for abuse. The centerpiece of the SEC’s new rules is a required “cooling-off” period in order for a trader to benefit from the affirmative defense. More specifically, under the SEC’s new rules, as a necessary, but not sufficient, condition to qualify for the affirmative defense provided by Rule 10b5-1:

• Trading under a Rule 10b5-1 Plan adopted or modified by a director or “officer,” as defined in Rule 16a-1(f) of the Exchange Act, must not begin until the later of: (a) 90 days following plan adoption or modification; or (b) two business days following disclosure of the issuer’s financial results for the fiscal quarter in which the plan was adopted or modified (but not to exceed 120 days following plan adoption or modification); and
• Trading under a Rule 10b5-1 Plan for persons other than directors and officers (which includes non-officer employees who enter into Rule 10b5-1 Plans) must not begin until 30 days following plan adoption or modification.

For purposes of the director and officer cooling-off period, the amendments provide that an issuer is considered to have disclosed its financial results at the time it files a Form 10-Q or Form 10-K, or, in the case of foreign private issuers, when such foreign issuer files a Form 20-F or furnishes a Form 6-K disclosing financial results.

In addition, and relevant for enforcement actions discussed in this Legal Update, the SEC’s new rules also prohibit overlapping Rule 10b5-1 Plans for purchases and sales of an issuer’s securities in the open market, subject to limited exceptions. Moreover, at the time a Rule 10b5-1 Plan is adopted (or modified), directors and officers are required to include a representation in the Rule 10b5-1 Plan certifying they (a) are not aware of MNPI about the issuer or its securities and (b) are adopting (or modifying) the 10b5-1 Plan in good faith and not as part of a scheme to evade the prohibitions of the Exchange Act’s Section 10(b) or Rule 10b-5. Rule 10b5-1 previously required 10b5-1 Plans be entered into in good faith and not as part of a plan or scheme to evade the insider trading rules. In order to clarify that cancellations or modifications of a Rule 10b5-1 Plan may not be conducted in a manner to benefit from MNPI, the amendments require Rule 10b5-1 Plans be entered into in good faith and the person who has entered into the plan must act in good faith throughout the duration of the trading arrangement. Finally, the SEC’s new rules require (a) officers and directors filing a Form 4 or Form 5 pursuant to Section 16 under the Exchange Act to indicate whether a reported transaction was executed pursuant to a plan intended to satisfy the affirmative defense conditions of Rule 10b5-1; and (b) issuers filing periodic reports pursuant to Section 13(a) or 15(d) of the Exchange Act using the domestic forms (e.g., Forms 10-K and 10-Q) must disclose when their officers and directors adopt or terminate Rule 10b5-1 Plans and other trading arrangements as well as the material terms of such arrangements. This is not a complete summary of the SEC’s recent amendments—Mayer Brown more fully summarized these changes to Rule 10b5-1 and the new disclosure obligations for public companies and their insiders in a December Legal Update.

Recent DOJ and SEC Investigations

The SEC’s rule changes come in the midst of increased enforcement scrutiny. On March 1, 2023, the DOJ announced an indictment for an alleged insider trading scheme involving the fraudulent use of Rule 10b5-1 Plans. The indictment alleges that the CEO and chairman of the board of directors of Ontrak Inc. was in possession of MNPI that the company’s then-largest customer planned to terminate its contract when he entered into two Rule 10b5-1 Plans. The Ontrak CEO is alleged to have sold nearly $20 million in Ontrak shares pursuant to the two Rule 10b5-1 Plans to avoid approximately $12.5 million in losses. On both occasions, he allegedly sold his shares the day after entering into the Rule 10b5-1 Plan.

As the DOJ noted, this indictment “represents the first time that the Department of Justice has brought criminal insider trading charges based exclusively on an executive’s use of 10b5-1 trading plans.” In announcing the charges, Assistant Attorney General Kenneth A. Polite, Jr. stated: “Today’s groundbreaking insider trading indictment demonstrates that the Department of Justice, together with our law enforcement partners, will not allow corrupt executives to misuse 10b5-1 plans as a shield for insider trading.” Polite went on to note that, “[a]s this case shows, we have embraced the use of data to proactively identify and investigate fraud as we continue to ensure that ordinary investors are on an equal playing field with corporate insiders.” The DOJ’s press release suggests that some of its data analysis efforts are focused specifically on Rule 10b5-1 Plans, noting “[t]he investigation is part of a data-driven initiative led by the Fraud Section to identify executive abuses of 10b5-1 trading plans.” The SEC filed a parallel enforcement action against the CEO on March 1, 2023.

Some of the SEC’s December 2022 rule changes specifically address the conduct alleged in the DOJ’s recent indictment. For example, the DOJ alleges that, in establishing his Rule 10b5-1 Plans, the CEO refused to include any “cooling-off” period – i.e., a gap in time between when he entered into the Rule 10b5-1 Plan and when the first sale pursuant to the plan occurred – despite warnings from two brokers. Under the SEC’s new rules, as noted above, such a cooling-off period is now required for a trader to benefit from the affirmative defense.

The indictment of the Ontrak CEO follows earlier SEC enforcement actions involving Rule 10b5-1 Plans. For example, in September 2022, the SEC settled an insider trading case against two officers of Cheetah Mobile allegedly possessing MNPI when they set up Rule 10b5-1 Plans. Specifically, the SEC alleged that two senior officers established Rule 10b5-1 Plans after learning about a significant reduction in advertising revenues from the company’s largest advertising partner. The two officers allegedly avoided approximately $300,000 in losses through their trades. The officers settled the charges without admitting or denying the allegations, agreeing to pay civil penalties of approximately $500,000 and $200,000, respectively. In announcing the case, the Chief of the SEC Enforcement Division’s Market Abuse Unit stated: “While trading pursuant to 10b5-1 plans can shield employees from insider trading liability under certain circumstances, these executives’ plan did not comply with the securities laws because they were in possession of material nonpublic information when they entered into it.”

Mitigating Enforcement Risk

While companies that adapt to the SEC’s December 2022 rule changes regarding Rule 10b5-1 Plans will reduce the risk of investigation and enforcement, enforcement scrutiny is not likely to abate any time soon. In recent years, the Financial Industry Regulatory Authority (“FINRA”) has greatly increased its electronic surveillance of unusual trading in temporal proximity to major disclosures from public companies. These inquiries targeting the identification of insider trading now occur automatically upon most material announcements and frequently lead to referrals to the SEC’s enforcement staff. And beyond FINRA and the SEC, as noted above, the DOJ too has embraced the use of data analytics to ferret out abuses of Rule 10b5-1 Plans, along with other violations of the federal securities laws, including spoofing and other forms of market manipulation. Consistent with this trend, a number of companies have announced SEC investigations focused on potential insider trading involving 10b5-1 Plans. Particularly given the government’s increased use of data analysis, companies should be even more vigilant in guarding against executives trading while in possession of MNPI. The SEC’s new disclosure requirements described above bring this point into particular focus. The SEC’s rule changes and the increased focus by the SEC and the DOJ should provide strong incentives for companies to review and tighten their insider trading policies and procedures and compliance programs, particularly as they relate to the creation of, and trading through, Rule 10b5-1 Plans.

Rule 10b5-1 Plans that apply the new required cooling off periods and otherwise comply with the rule will mitigate the risk of enforcement and liability, but not eliminate it. As noted above, the SEC routinely seeks information from issuers intended to identify trading on the basis of MNPI in or around significant public disclosures, without regard to whether there is particularized evidence of insider trading. As with all insider trading investigations, anomalous trading activity is more likely to raise questions and trigger more intense SEC enforcement scrutiny . Insiders who execute similar-sized sales on a relatively routine basis for ordinary-course financial planning purposes—e.g., portfolio diversification or liquidity for making estimated tax payments – may face fewer hurdles in satisfying SEC enforcement staff that the trades were not based on MNPI, absent extenuating circumstances. SEC enforcement staff may be more likely to focus on large trades—e.g., trades involving a significant overall percentage of the individual’s holdings or a significant percentage of the insider’s permissible trading limits imposed by an issuer. Limit orders will often trigger enhanced scrutiny as well . Regardless of the particulars of the trade, traders should consider contemporaneously memorializing the reasons behind the size and structure of the trade—e.g., liquidity needs, financial planning purposes and/or the non-MNPI basis for the size and/or structure of the trade—particularly where there are aspects of the trade that SEC enforcement staff may view as unusual. (For additional practical tips, see our December Legal Update.)

Takeaway

In conclusion, a well-considered 10(b)5-1 plan, implemented while an executive is not in possession of MNPI and that complies with the new rules, including the cooling off period, remains one of the strongest defenses to an SEC insider trading investigations.