SEC Rule 10b5-1 has had a significant impact on how directors, officers and other employees who are subject to “blackout” periods diversify their company stock holdings. Adopted concurrently with Regulation FD in August of 2000 as the Selective Disclosure Rule, 10b5-1 encompassed two major provisions. The first addressed the appropriate standard for insider trading liability under the anti-fraud provisions of the federal securities laws. Prior to the enactment of 10b5-1, the courts were split on whether insider trading liability simply required proof that the person engaging in the securities transaction was in “knowing possession” of material nonpublic information at the time of the trade, or whether it was necessary to prove that material nonpublic information was actually “used” as the basis for the trade. The latter being a much more rigorous standard.
Rule 10b5-1 provides that a person is deemed to have traded based on material nonpublic information if he was simply “aware” of the information when the purchase or sale was made. There is no need to prove that the information was “used”. The second provision of 10b5-1 establishes the basis for an affirmative defense in connection with trades by insiders. This defense is designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision. To satisfy this affirmative defense a person must establish that:
- Before becoming aware of the material nonpublic information, the person had entered into a binding contract to trade, instructed another person to trade or adopted a written plan;
- The contract, instruction or plan either specifies the amount, price, and date of the proposed transaction(s), provides a written formula or mechanism for determining such amounts, prices or dates or does not allow the insider to exercise any subsequent influence over how, when and whether to effect purchases or sales (and that the person who does exercise such influence is not aware of material nonpublic information) and,
- The purchase or sale that occurred was in fact pursuant to the prior contract, instruction, or plan.
Even though the rule was originally promulgated primarily to address ambiguity in the law, from the beginning, the SEC suspected that some plans were adopted as a new way to disguise what is sometimes described as “strategic” trading based on material non-public information. After more than 20 years of observation and several administration changes, a reform-minded SEC updated the rule to address the problem. In the wake of several successfully litigated Rule 10B5-1 related insider trading cases, in December 2022 the SEC adopted additional rules:
There is now a mandated "cooling off" (i.e., waiting) period before trades can start after the plan's adoption or modification:
For directors and officers, the later of (1) 90 days or (2) two business days after the disclosure in SEC Form 10-Q or 10-K of the company's financial results for the fiscal quarter in which the plan was adopted or modified (but not to exceed 120 days). The proposed rules had a 120-day cooling-off period before any trading could start after the plan's adoption or modification.
For people other than directors and officers, 30 days. This is an important difference from the proposed rules, which did not clearly specify a cooling-off period for regular employees and managers.
Plan adopters must certify, in the plan itself, when adopting or modifying it that you are not aware of material nonpublic information about the company. This certification requirement is just for directors and officers.
Overlapping 10b5-1 plans for open-market trades are generally prohibited. One exception would be another plan set up just to allow sales of stock (sell-to-cover trades) for tax withholding when restricted stock/RSUs vest.
Single-trade plans are now limited to one per 12-month period.
Companies must also now annually disclose their insider-trading policies and procedures. This includes the need to check a box on SEC Form 4 and Form 5 when a reported stock transaction is made under a 10b5-1 plan
Under the original rules, affiliates and their financial professionals embraced the rule and began to adopt 10b5-1 compatible plans that I call Structured Diversification Programs (SDPs). Many public companies have implemented optional SDPs for the benefit of the company’s executives. The rule has had a significant impact on the way corporate executives and other employees subject to “blackout” periods, diversify their holdings of company stock. In fact, at some companies these plans have taken the place of blackout period companies to diminish the risk of insiders being the subject of shareholder lawsuits based on allegations of insider trading.
Even under new rules, the parameters of 10b5-1 still allow a wide variety of ways in which an SDP can be designed. Issues that need to be addressed in a typical plan include:
- The number of shares to be transacted or some means by which the number can be derived.
- The selling method.
- The frequency of transactions.
- The duration of the plan specified by a particular contract, instruction, or plan.
Simple plans provide that the broker transact a specified number of shares (e.g. 1000) at the market (or a specified price [limit]) with a set frequency (say, each Wednesday) and duration (perhaps a year). A more sophisticated plan could establish a formula for the determination of the minimum conditions necessary to enact a transaction. Such a formula might provide that the broker sells more shares if the stock is up and fewer if it is down or that the broker “work” a block of stock over a shorter period of time (say, two months) with the objective of maximizing the gross proceeds. If a formula is used, it is important, especially under the updated rules, that the formula not constitute a “device” that allows the insider to exercise plan influence or control.
Executives generally have welcomed the opportunity to delegate the diversification of their holdings, freeing them to concentrate on their day-to-day responsibilities. For an executive who felt it was prudent to sell a set number of shares on a regular basis in order to achieve a specified level of security holdings by a date, an SDP could allow them to meet their objective without the temptation to exploit short-term price fluctuations. Executives who receive large stock option grants may find it much more convenient to use an SDP and be free of limited trading windows to dispose of the shares acquired by those options. Especially as options get closer to expiration the need to avoid the risk of forfeiture makes the systematic nature of an SDP attractive. Whether an SDP is adopted individually by an executive or is part of a model plan adopted by the company, each participant generally must submit the specific plan he adopts for the approval of the company’s compliance officer. Compliance review can assure that plans are consistent in with any company-wide insider transactions policies.
Companies may reserve the right to suspend a plan in certain instances (e.g., an underwriting of additional equity or convertible debt). If the executive is an affiliate for the purposes of Section 16 reporting, the plan will not eliminate the need to comply with the “Short Swing Profit Rule.” Affiliates who are deemed to be a “control person” for purposes of Rule 144 must also comply with the volume and “manner of sale” provisions of that Rule. Unregistered certificate shares that the plan anticipates selling will need to have any restrictive legends lifted prior to the date on which it is anticipated the shares will be sold. This process requires additional paperwork, which may need to be made part of the plan documents. And if the company prepares Form 4 for the affiliate, it may be necessary for there to be a third-party reporting provision in the plan so that the broker can report transaction by the insider promptly to the company in order to facilitate this reporting.
Because it is necessary for the executive adopting an SDP to not be in possession of material nonpublic information at the time she adopts the plan, many companies already require a waiting period after the adoption of the plan before its conditions go into effect. This addresses the potential concern by shareholders that the plan is being adopted to strategically exploit insider information. While, even under the new rules, it is not required, many companies choose to disclose, by means of a press release, the fact of a plan’s implementation to shareholders to send a message that the executive’s sales are part of a prudent effort to diversify his holdings, not a sudden change in the executive’s commitment to ownership.
SDP financial planning strategies will be as varied as the shareholders who adopt them, but some general tactical rules should probably be applied to all plans whose purpose is to reduce, to any significant degree, the executive’s single-security concentration. A well-designed plan should consider:
- Incorporating all the client’s corporate holdings in the pool of diversifiable assets. Be sure to consider the qualified plan’s holdings, previously exercised and unsold shares, and any other vested stock holdings. Using an SDP can ensure compliant tracking and reporting of all form 4-type transactions for both the client and the company. These are often overlooked for qualified plan shares.
- Key price levels for transactions so that the long-term strategic goal is met. Such considerations might include a minimum market price, a key price level that would trigger additional diversification, or a ladder approach that increases the number of shares being sold as the price rises.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful. The return and principal value of stocks fluctuate with changes in market conditions. Shares when sold may be worth more or less than their original cost. A diversified portfolio does not assure a profit or protect against loss in a declining market.