Insider Trading and 10b5-1 Plans

First published on The Conference Board’s ESG blog.

The swift deceleration in economic activity that accompanied the outbreak of COVID-19 has resulted in stock market volatility levels not seen since the 2008 financial crisis. In this environment, where corporate insiders are regularly informed of material non-public information, many believe that insider trading within pre-defined trading programs will grow. In fact, the SEC said as much in a statement it issued on March 23rd.

With this in mind, executives and corporate board directors should take a fresh look at insider trading compliance and governance programs and if they do not currently have a 10b5-1 plan in place, now may be the right time to implement one. Should an executive or director come under scrutiny for perceived insider trading, a company must be prepared to communicate its policies and how it is ensuring appropriate measures to prevent illegal trading activity.

Recent allegations made against some U.S. Senators for insider trading have prompted a review of the use of 10b5-1 plans, which were established to protect the owner of the plan by creating an arms-length transaction between the owner of securities and their actions. However, investors continue to question if 10b5-1 plans are in fact achieving that goal and whether there is sufficient oversight of them. It is estimated that 50% of S&P 500 companies had established 10b5-1 plans in 2019.

What is a 10b5-1 Plan?

The SEC originally created language under section 10b5 in the 1940s to prohibit fraud or deceit in connection with the purchase or sale of any security. And while for many decades it was understood that trading in securities when material non-public information (MNPI) was available was illegal, there was no hard rule to define this action. Over time, court rulings and other factors further complicated the issue of whether the presence of insider trading occurred.

In 2000, after the stock market crashed, the SEC instituted a formal framework for defining violations from insider trading. Under 10b5-1(b), a person could be liable for insider trading simply by possessing inside information regarding a given security, breaching a fiduciary duty to the source of the information, and then trading it with a self-serving intent, even if he or she would have made the trade anyway. Possession of information became the operative factor.

A 10b5-1 plan can only be established when MNPI is not present and the executive directs the 3rd party on the type of sales (or purchases), the dates, and the amounts in advance. Trade execution, therefore, occurs automatically without interference from the executive.

Disclosure

No formal disclosure requirements exist when establishing a 10b5-1 plan, although many companies announce the plans’ formation via 8K filings, press releases or both. Executive trades, however, must be disclosed under a Form 4 filing two business days after the trade is executed. Form 4 filings are closely followed by investors to gauge changes to insider ownership as significant changes to holdings could signal a material change to the company’s strategy or performance.

Why set up a 10b5-1 plan?

The 10b5-1 rule provides a defense for insiders from trading when there is material non-public information about the company. Since the plan is established and executed by a third party who has been given trading instructions in advance of any MNPI, the executive can use the plan as part of his or her defense if allegations of insider trading are made.

Watch out for….

There have been abuses in the use of these plans. Best practices for 10b5-1 plans, which can be helpful in the defense of executives’ actions, include the following:

  • Establishing one plan, not multiple plans;
  • Selecting a timeframe that is not too short-term oriented;
  • Announcing the establishment of a plan via an 8K filing;
  • Acknowledging that securities covered may include fixed income as well as equities;
  • Avoiding amendments to the plan; and
  • Exercising an interim “cooling off” period before a plan is implemented or after a plan is terminated.

In 2009, in one of the most high-profile cases of investor trading, Angelo Mozillo, the CEO of Countrywide Financial, was charged by the SEC and paid the highest settlement at the time. One of the main red flags was that Mozillo had established four different plans and modified one plan, and then started trading immediately.

Conclusion

Establishing a 10b 5-1 trading plan for high-level employees who have access to or may have learned of material non-public information is a practice that every company should consider instituting. Directors also must be satisfied that these plans are established with a best practice approach to avoid any abuse by their executives or fellow board members. Should a company be caught in a situation where insider trading is suspected, the company should be prepared to communicate all the steps it has taken to prevent insider trading. Having 10b5-1 plans in place may be one of the best places to start.

Eileen Cohen is a Sr. Counselor at Abernathy MacGregor. She is also a Fellow at the ESG Center of the Conference Board. Ms. Cohen was previously an investor and head of corporate governance for a large asset management firm. She was inducted in the 2017 NACD Directorship 100. 

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