After Charges of Abuses, SEC May Consider Changes to 10b5-1

Executives and board members probably haven't worried much about their 10b5-1 stock trading plans. That's about to change.

In recent months, renewed media and shareholder attention has led to growing scrutiny of the plans, which allow insiders to sell shares on preset days or intervals to avoid accusations of insider trading. The Council of Institutional Investors, an association of pension funds and other large shareholders representing combined assets of $3 trillion, has recently expressed concerns about potential misuse of the plans and urged the Securities and Exchange Commission to consider new rules.

In a letter to the SEC, Jeff Mahoney, CII's general counsel, wrote that “many executives at public companies have adopted practices with respect to Rule 10b5-1 plans that are inconsistent with the spirit, if not the letter, of the rule.” Among CII concerns are that executives are setting up the plans when they are aware of material, non-public information; cancelling or amending them to suit insiders' needs; and setting up trades within days of adopting the plans, rather than with a built-in delay, as most plans are designed.

“The plans are going to get a lot of attention,” says Boris Feldman, a member of law firm Wilson Sonsini Goodrich & Rosati. “Over the next year this is going to be on the agenda for a lot of companies” to examine their 10b5-1 plans, he adds.

“I think it is terribly media driven at this point,” says Bruce Vanyo, co-head of the law firm Katten Muchin Rosenman's securities litigation practice. “We're told there are criminal investigations going on, but obviously it would be too early to tell where those investigations will go. It will be at least months if anything comes of them. Given all this attention, companies need to be particularly sensitive and go back and make sure the programs are tight and proper.”

“Clear guidelines regarding the circumstances in which a Rule 10b-5-1 plan may be adopted, modified, or cancelled, as well as enhanced transparency … would have meaningful benefits for a company, its shareholders, and the investing public,” Mahoney wrote in CII's letter to the SEC. Specifically, CII has asked the SEC to consider interpretive guidance or amendments that would require plans to adopt the following guidelines:

Companies and company insiders should only be permitted to adopt plans during a set trading window,  that commences after the announcement of a quarter's financial results.

Companies and insiders should be prohibited from adopting multiple, overlapping plans.

There should be a mandatory delay (three months or more is suggested) between the adoption of a plan and the first trade.

Companies and insiders should not be allowed to make frequent modifications or cancellations of plans.

According to Mahoney, the SEC is now contacting companies and requesting information about their plans.  Some corporate law firms have also been publicly recommending that their clients adopt some or all of the recommended reforms, he says.

Rule 10b5-1, adopted by the SEC in 2000, allows corporate executives to make prearranged trades when they are not in possession of inside information at specified prices or dates in the future. The idea was to give executives opportunities to diversify through the use of plans without facing the prospect of an insider-trading investigation if the timing of a trade suddenly seems suspicious.

The plans not only provided a shield for executives to protect against insider-trading charges, they also sent a strong signal to those who might be tempted to trade on material non-public information. The message was that executives who didn't use the plans would be subject to greater scrutiny on the timing of their trades.

The plans raised few complaints until 2007, when Linda Chatman Thomsen, former director of the Division of Enforcement at the SEC, raised concerns that some executives could be exploiting the plans. “Recent academic studies suggest that Rule 10b5-1 may be being abused,” she said, explaining that executives who trade within a 10b5-1 plan had outperformed their peers who trade outside of such a plan by nearly 6 percent.

“If you put too many conditions or restrictions on the 10b5-1 plans, insiders may see them as too burdensome.”

—Ronald Mueller,

Partner,

Gibson Dunn

“Presumptively, plan participants should be no more successful on average than those who trade outside a plan,” she said. “The data suggests that executives with plans sell more frequently and more strategically ahead of announcements of bad news. This raises the possibility that plans are being abused essentially to facilitate trading on inside information. So we're looking.” Thomsen said at the time that the SEC was examining potential problems, such as multiple and overlapping 10b5-1 plans and a lack of timely disclosure for modifications or terminations.

The SEC, since that time, has made no changes to how plans are established and disclosed. The issue arose again, however, in 2009 when the Commission initiated an enforcement action against Countrywide CEO Angelo Mozilo for, among other matters, entering into a 10b5-1 plan while in possession of material non-public information. The 2010 settlement, $22.5 million, was the largest ever paid by an executive.

Too Good to Be True?

Ronald Mueller, a partner with the law firm Gibson Dunn, says the concerns about 10b5-1 plans are similar to past concerns over stock option backdating. Those arrangements drew scrutiny when it appeared “some companies had an amazing track record of always granting stock options at the annual low of the stock price.” Although it turned out that there were indeed abuses, there was also, in many cases, only the appearance of impropriety.

“In most cases there was nothing suspicious going on, it was just fortuitiveness,” Mueller says, That may well be the case with 10b5-1 plans, with regulators and watchdogs alike needing to distinguish between abuses, innocent good luck, or any combination of both.

Gregory Schick, a partner at law firm Sheppard Mullin Richter & Hampton, said companies should be protected by 10b5-1 plans, but nevertheless need to worry about “the question of appearance.” Adopting CII's recommendations to prove good faith may help companies avoid reputation risks. Going an extra step or two, in line with CII's suggestions, will “give more on an impression that there is, in fact, compliance,” he says.

CII LETTER

The following is a selection from the Council of Institutional Investors' Letter to the Securities and Exchange Commission urging interpretive guidance or amendments to Rule 10b5-1 and the equity trading plans it authorizes.

It appears that many plans adopted by insiders in reliance on Rule 10b5-1 allow trades to occur pursuant to such plans within mere days after the plan has been adopted, which also raises questions about whether such plans were made in good faith and whether the insider could have been in possession of material non-public information at the time that the plans were adopted.

As a leading voice for long-term patient capital, the Council, consistent with our membership-approved policies, strongly believes that clear guidelines regarding the circumstances in which a Rule 10b5-1 plan may be adopted, modified, or cancelled, as well as enhanced transparency regarding the existence of such plans would have meaningful benefits for a company, its shareholders, and the investing public. We also believe that such guidelines, whether in the form of additional interpretive guidance or an amendment to Rule 10b5-1 itself, are essential to restoring public confidence with respect to purchases and sales of a company's securities by its insiders.

More specifically, we would respectfully request that the Securities and Exchange Commission consider pursuing interpretive guidance or amendments to Rule 10b5-1 that would require Rule 10b5-1 plans to adopt the following protocols and guidelines:

Companies and company insiders should only be permitted to adopt Rule 10b5-1 trading plans when they are permitted to buy or sell securities during company-adopted trading windows, which typically open after the announcement of the financial results from a recently completed fiscal quarter and close prior to the close of the next fiscal quarter;

Companies and company insiders should be prohibited from adopting multiple, overlapping Rule 10b5-1 plans;

Rule 10b5-1 plans should be subject to a mandatory delay, preferably of three months or more, between the adoption of a Rule 10b5-1 plan and the execution of the first trade pursuant to such a plan; and

Companies and company insiders should not be allowed to make frequent modifications or cancellations of Rule 10b5-1 plans.

We believe the adoption of the protocols and guidelines outlined above, together with the Council's related membership approved policies, will strengthen our capital markets.

Making boards explicitly responsible for oversight of Rule 10b5-1 plans will make them more responsive to long-term shareowners and more vigilant in their oversight responsibilities, while such oversight also will make insiders more thoughtful about Rule 10b5-1 plans that they adopt.

Source: Council of Institutional Investors.

Among those best practices, Schick says, is to avoid frequently modifying a plan. “One of the fundamental principles is that when you adopt or modify a plan you don't have any inside information,” he says. “That's a requirement for having an effective plan. Frequently amending it would likely cast some doubt.”

Another fundamental piece of advice: Keep it simple. “I know that my clients are going to have a problem with a 10b5-1 plan when they ask me a lot of questions about it,” he says. “What if we do this? What if we do that? After three or four ‘what ifs,' I say, ‘I don't think this is really for you.' If you are going to wake up every morning, as some executives do, worrying because there is a trade today you know will be higher in a month, then they should never adopt one because then they are going to be amending it and changing it. There is too much opportunity to get into trouble.”

“In the past, a company was not required to disclose to the SEC, or the public, that they had implemented a 10b5-1 plan,” Vanyo says. “One of the things that might happen, in a step to require greater transparency, the SEC could take the additional step of requiring companies to file their plans with it and make them publicly available.”

Some are concerned that new restrictions on the plans could cause executives to abandon them. “If you put too many conditions or restrictions on the 10b5-1 plans, insiders may see them as too burdensome,” Mueller says. “The plans already take away flexibility. If you take away even more then you may have people not using them at all, and you have a greater compliance concern.”

New hurdles to selling shares could also “undermine the utility of using equity as compensation,” Mueller says. “I've had clients ask if they should consider starting to use more cash-based compensation. That runs the risk of moving away from aligning compensation with shareholder returns because you are taking out equity.”

“It would be a dramatic change,” he says of CII's proposals to the SEC. “if it is going to be pursued, there really needs to be some hard examples that show the current rules aren't working.”