The Greek epic “Odyssey” recounts, in one episode, precautions taken by the saga’s hero, Ulysses, before sailing by the mythical sirens Scylla and Charybdis. Ulysses asked his shipmates to tie him to the ship’s mast, and to plug their own ears with wax to avoid the sirens’ tempting song, which threatened to entice unwary travelers.
The “Odyssey” may not first come to mind in the securities law context, but Ulysses’ act of risk avoidance is precisely what corporate Rule 10b5-1 trading plans seek to do. These plans tie the hands of corporate insiders (and companies themselves), by “setting and forgetting” plans to trade company stock at some future time before any awareness of material nonpublic information (MNPI).
By removing the discretion to heed the siren song and trade unlawfully, Rule 10b5-1 plans commit corporate insiders to a pre-determined course. Tying them to the “mast” ensures a later trade will not be “on the basis of” MNPI, providing investors an “affirmative defense” to criminal and civil liability.
As discussed below, the Securities and Exchange Commission recently proposed changes to Rule 10b5-1 to create additional hurdles for the affirmative defense to apply. The SEC’s timing is notable, and bookends a year in which “CEOs and corporate leaders including Microsoft’s Satya Nadella, Amazon founder Jeff Bezos and Tesla’s Elon Musk sold a record $69 billion in stock in 2021.”
Indeed, as of Nov. 29, 2021, “sales by insiders were up 30% from 2020 and up 79% against a 10-year average,” according to InsiderScore/Verity.
Rule 10b5-1’s Affirmative Defense
Currently, Rule 10b5-1 establishes an affirmative defense for targets of insider trading investigations if a corporate insider-trader can demonstrate a suspicious trade—even if made when the insider actually possessed MNPI—was the result of a preexisting contract, instruction to a third-party to execute the trade, or a written plan for such a trade.
The contract, instruction, or plan must: (1) specify the security traded, and the price and date of the trade; (2) have a predetermined written formula, algorithm, or program to determine the volume, price, and date of the transaction; and (3) not allow the insider “to exercise any subsequent influence over how, when, or whether to effect purchases or sales.”
Importantly, the affirmative defense is only available “when the contract, instruction, or plan to purchase or sell securities was given or entered into in good faith and not as part of a plan or scheme to evade the prohibitions of this section.” (Companies themselves can invoke the affirmative defense, provided that at the time of the trade, the company already “implemented reasonable policies and procedures” to avoid trading on the basis of MNPI.)
In announcing the proposed rule change, SEC Chairman Gary Gensler noted several loopholes in the current rule.
First, there is no “cooling-off” period between the adoption of a plan and the execution of a trade, so a corporate insider could adopt a plan to execute a trade that permits the trade to occur that very same day.
In one study Gensler cited, 39% of plans commenced trading within 60 days of adoption, 14% within 30 days of adoption, and 1% within one day of adoption. Furthermore, 38% of plans executed trades in the weeks immediately preceding a quarterly earnings announcement.
Additionally, insiders can presently adopt multiple plans, but cancel those deemed unfavorable, leaving for execution only plans the trader finds advantageous. Despite the good faith requirement, these maneuvers have a strong appearance of impropriety, and therefore diminish investor confidence.
Proposed Amendments to Rule 10b5-1
The SEC’s Dec. 15, 2021, publication of proposed amendments to Rule 10b5-1 will—if adopted after public comment—constrain insiders further still, by imposing additional requirements for the affirmative defense to apply.
Specifically, the new rule would affect individuals by: (1) imposing a 120-day “cooling off” period from the adoption of a plan and the first trade (i.e., beyond the next quarterly financial results); (2) requiring insiders to publicly disclose their entry into a 10b5-1 plan; (3) requiring the adoption of only one plan in any particular stock during a 12-month period; (4) requiring insiders to certify they did not possess MNPI when the plan was adopted; and (5) limiting when an insider can donate stock in hopes of getting favorable tax benefits.
Advice for the Wary
The likelihood that the proposed changes will be adopted (in some form) seems high, given that even an SEC commissioner critical of some aspects of the proposal supports it, despite “mixed feelings.”
Thus, companies would do well to reexamine their Rule 10b5-1 plans in anticipation of changes, particularly considering that some major public companies, even if they do require a cooling-off period under their Rule 10b5-1 plans, limit the cooling-off period to a mere 30 days. (For example, see the insider trading policies of General Motors, Hershey’s, and Shake Shake.)
At the same time, insiders would be well advised to heed regulators’ increased appetite for enforcement, which perhaps reflects a sense that insiders’ stock awards are not always exercised fairly. Conservative trading plans, adopted in good faith, heightened caution and, where possible, consultation with counsel, can help to ensure Ulysses remains bound to the mast.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Justin Danilewitz is a partner at Saul Ewing Arnstein & Lehr. Previously, he served as an assistant U.S. attorney in the Department of Justice. He represents companies and individuals in internal investigations and government criminal and civil investigations, including in insider trading, health-care fraud, and contractor fraud investigations.
Zachary Jacobs is a former litigation associate at Saul Ewing Arnstein & Lehr.