SEC Stepping Up Enforcement of 10b5-1 Trading Plans

A criticism of the amendments to Rule 10b5-1 that the SEC proposed earlier this year is that the changes are unnecessary, as evidenced by the fact that the SEC has brought few enforcement actions related to inappropriate uses of 10b5-1 trading plans. This may soon change, however. As reported in Bloomberg, the SEC is actively investigating whether 10b5‑1 plans have been used to engage in insider trading (“US Probes Insider Trading in Prearranged Executive Stock Sales”).

The Cheetah Mobile Case

The first such case involves executives of Cheetah Mobile, a China-based mobile internet company. Here are the facts of the case, as described in the SEC Order:

• In the summer of 2015, Cheetah Mobile learned that one of its ad partners would be changing its ad placement algorithm in a way that could materially reduce Cheetah Mobile’s ad revenue.
• In Q4 of 2015 and Q1 of 2016, Cheetah Mobile’s revenue from the advertising partner declined by 11% and 30% respectively.
• During the March earnings announcement, the CEO attributed the reductions in ad revenue to greater-than-expected “seasonality” and failed to disclose the advertising partner’s algorithm change and the affect of this change on ad revenue.
• On March 29, 2016, two Cheetah Mobile executives, its CEO and its President and CTO, entered into Rule 10b5-1 to sell some of their Cheetah Mobile holdings.
• The sales under the plans occurred before the May 2016 Q2 earnings announcement.
• In Q2 2016, ad revenue continued to decline. After the earnings announcement, Cheetah Mobile’s stock price declined 18%.
• By selling before the Q2 earnings announcement, the executives avoided losses of $203,290 and $100,127, respectively.

The SEC charged the executives with violating insider trading laws for the sales that occurred under their trading plans. In the press release announcing the charges, Joseph Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit, provides the following explanation:

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.

The Penalties

Without admitting or denying the SEC’s findings, the CEO and the president and CTO agreed to cease-and-desist orders, undertakings relating to their future securities trading, and to pay civil penalties of $556,580 and $200,254, respectively.

This serves as a reminder that the penalties for insider trading can be severe and can exceed the gain realized or loss avoided by a substantial amount. If you get caught, insider trading is a crime that really doesn’t pay.

A Red Flag

One thing that is interesting to me about this case is that the facts closely align with circumstances that academics have found can be red flags for abusive use of 10b5-1 trading plans.

A study of 10b5-1 plans published in early 2021 found that almost 40% of the studied plans were implemented and had at least one trade execute in the same quarter, before earnings for the quarter were announced. The researchers expressed concern that the executives likely have some idea of how the company is performing for the quarter at the time they entered into the plans and that these plans are merely a means of circumventing blackout periods.

The Cheetah Mobile case seems to justify the researchers’ concerns. This is perhaps one reason the SEC’s proposed new rules for 10b5-1 plans call for a 120-day cooling off period before trades can start under the plans.

More Enforcement to Come

The Bloomberg article reports that the SEC and DOJ are investigating whether executives have been “gaming” these prearranged stock-sale programs set up in defense against insider trading charges. The authors note that government investigators are using “computer algorithms in a sweeping examination” of these plans by C-suite executives.

Bloomberg also quotes anonymous sources who report that “federal officials requested information from executives early this year” and are “now preparing to bring multiple cases.”

Actions to Take Now

A commentary from the law firm Morrison & Foerster discusses this new enforcement trend (“The Rise of Rule 10b5-1 Enforcement and How Companies Can Mitigate Risk of DOJ and SEC Actions”). The authors note that:

The SEC and DOJ are increasingly using data analytics to identify and initiate investigations of suspicious trading under Rule 10b5-1 plans.

The alert reminds us that Rule 10b5-1 plans on their own cannot insulate corporate executives and employees from insider trading liability and that insiders cannot be in possession of material nonpublic information at the time that they enter into a Rule 10b5‑1 plan. Most concerningly, the authors note that “the SEC’s view of information that constitutes MNPI may be expanding,” and that the SEC has the benefit of hindsight when assessing materiality.

The authors offer the following suggestions to protect insiders:

Cooling-Off Period

Require all 10b5-1 plans adopted by executives to include a cooling-off period before trades can begin under the plan. The period should be sufficient to delay trading until after the next quarterly earnings announcement.

Internal Controls

Examine your insider trading policy, require 10b5-1 plans to be adopted during open trading windows, and review modifications to 10b5-1 plans. Start thinking now about the disclosures the SEC has proposed for these plans.

Prohibit Overlapping Plans

Do not allow insiders to adopt multiple 10b5-1 plans that are in operation over the same time period. In the proposed rules for 10b5-1 plans, the SEC expresses concern insiders will implement multiple 10b5-1 plans with the intention of allowing one plan to proceed and cancelling the others once they have sufficient material nonpublic information to make a more informed decision about the trades.