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Refinements to Rule 10b5-1 Insider Trading Regulations Adopted by the SEC

The Securities and Exchange Commission (SEC) took steps on December 14, 2022, to bolster Rule 10b5-1 under the Securities Exchange Act of 1934, better known as the "Exchange Act". These changes were put into place with a vision to intensify the disclosure obligations and safeguard investors from insider trading. As the laws governing insider trading primarily depend on court-established precedents, they can be challenging to comprehend. The revisions to the rule aim to simplify these complexities for market participants.

Since the inception of Rule 10b5-1, courts, analysts, and legislative members have expressed apprehension about the positive defense provision under Rule 10b5-1(c)(1)(i), citing concerns that traders might exploit the rule's protections to carry out strategic trades using undisclosed critical information. Also, certain scholarly examinations of Rule 10b5-1 trading arrangements have indicated that corporate insiders relying on Rule 10b5-1 consistently outperform executives and directors not operating under such arrangements.

The rule modifications emphasize the prerequisites for availing the 10b5-1 affirmative defense. The SEC has put in place a cooling-off period before initiating trading under a Rule 10b5-1 plan and necessitated that all individuals acting under such a plan must demonstrate good faith. In addition, directors and officers are now required to provide attestations within their plans, confirming at the time of adopting a fresh or adjusted Rule 10b5-1 plan that: (i) they do not possess any undisclosed material information about the company or its securities; and (ii) they are initiating the plan in good faith and not to circumvent the restrictions of Rule 10b-5.

Furthermore, the updates prohibit the implementation of multiple concurrent trading plans and restrict the opportunity to invoke the affirmative defense for a single-trade plan to one instance per twelve-month period for everyone except issuers. The modifications also expand disclosure requirements related to a company’s insider trading policies and procedures, including quarterly updates from a company on its usage of Rule 10b5-1 plans and other trading agreements by its directors and officers.

More rigorous disclosures now include details about the procedures concerning option grant timing and the release of confidential material information. The updated regulations necessitate that companies record any option awards starting four business days before submitting a routine or current report on Form 8-K that discloses confidential material information, excluding Form 8-K that reveals a new significant option award grant, and concluding one business day post a triggering event. Insiders filing Forms 4 or 5 will need to mark a checkbox to confirm that a reported transaction is intended to satisfy Rule 10b5-1(c) affirmative defense conditions and disclose the adoption date of the trading plan. Finally, genuine gifts of securities, previously allowed to be reported on Form 5, will now need to be reported on Form 4.

The modified 10b5-1 regulations will come into effect on February 27, 2023. The Section 16 reporting entities will have to adhere to the modifications to Forms 4 and 5 for beneficial ownership reports filed on or post-April 1, 2023. Smaller reporting firms will need to comply with the fresh disclosure and SBRL tagging requirements in Exchange Act periodic reports on Forms 10-Q, 10-K, and 20-F, and in any proxy or information statements in the initial filing covering the first full fiscal period starting on or post-October 1, 2023. All other businesses must follow the new disclosure and tagging requirements in the first submission covering the first full fiscal period beginning on or after April 1, 2023.

Background

Insider trading is forbidden by the general anti-fraud provisions, particularly Section 10(b) of the Exchange Act and Rule 10b-5. Section 10(b) of the Exchange Act declares it illegal for any person to utilize or employ, directly or indirectly, any manipulative or deceptive devices related to the purchase or sale of any security registered on a national securities exchange, any security not so registered, or any securities-based swap agreement, against the rules and regulations the SEC may set as necessary or suitable in public interest or investor protection.

Rule 10b-5 declares it unlawful for any person, directly or indirectly, to: (i) utilize any device, scheme, or deception to defraud; (ii) make any untrue statement of a significant fact or omit to state a significant fact necessary to avoid misleading statements; or (iii) engage in any act, practice, or course of business which functions or would function as a fraud or deceit upon any person.

The SEC introduced Rule 10b5-1 in 2000 to offer more clarity to the general anti-fraud provisions in Section 10(b) and Rule 10b-5. Despite this, the laws governing insider trading continued to be primarily shaped by judicial interpretations. Insider trading is based on three primary theories: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory. Rule 10b5-1(b) defines "on the basis of" for trading on insider information as "subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is 'on the basis of' material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale." Rule 10b5-1(c) offers an affirmative defense to insider trading, including for entities that regularly have access to material nonpublic information, like corporate officers, directors, and issuers.

Revised Rules

The amendments to Rule 10b5-1 modernize the requirements for the affirmative defense, such as the introduction of a cooling-off period before a plan could begin trading, the prohibition of overlapping trading plans, and limiting single-trade plans to one per twelve-month period. The updated rules also require directors and officers to provide written confirmations that they are not in possession of any nonpublic material information when they engage in the plans and extend the existing good faith requirement for trading under Rule 10b5-1 plans.

Furthermore, the modifications necessitate a more detailed disclosure about a company's insider trading policies, procedures, and practices related to option grants and releasing nonpublic material information. Companies will now need to document option awards starting four business days prior to the submission of a routine or current report on Form 8-K disclosing nonpublic material information, and ending one business day after a triggering event, in a tabular format. The new disclosures must be tagged using inline XBRL.

Additionally, Forms 4 and 5 have been updated to include a new checkbox to disclose if a transaction was carried out in accordance with a Rule 10b5-1(c) or another trading plan. Gifts of securities will now have to be reported on Form 4, as opposed to being exempt and reported yearly on Form 5.

Newly Modified Insider Trading Affirmative Defenses

Previously, Rule 10b5-1(c) indicated that a person's trade isn't based on undisclosed, significant information if, prior to becoming aware of such information, they had:

1. Entered into a binding agreement to buy or sell the security, 2. Instructed another to purchase or sell the security on their behalf, or 3. Developed a written plan for trading securities.

The plan should have detailed the number of securities to be bought or sold and their price, date of purchase or sale, or outlined a written formula or algorithm determining these factors. The individual wasn't permitted to subsequently influence how, when, or where to effect purchases or sales. The trade was considered as being pursuant to the contract, plan, or instruction unless the individual altered the contract or plan or entered into or altered a corresponding transaction.

The rule also stated that the defenses only applied if the contract or plan to purchase or sell securities was enacted in good faith and not to avoid the rule's prohibitions.

Revisions to Rule 10b5-1 have added new conditions, such as:

1. Corporate officers and directors must include a cooling-off period in their 10b5-1 trading plans. This means trading cannot commence until either 90 days after the plan's adoption or two business days following the company’s financial results disclosure.
2. Trading plans by non-Section 16 officers or directors should include a 30-day cooling-off period.
3. Any modification to the plan's trading details acts as a plan termination, requiring a new cooling-off period.
4. Officers and directors must certify they're unaware of significant nonpublic information about the company or security when creating a new or modified trading plan.
5. Overlapping Rule 10b5-1 trading plans for open market trades aren't covered by the affirmative defense under Rule 10b5-1(c)(1).
6. Plans to execute a single trade are limited to one every 12 months.
7. Trading plans must be created and operated in good faith.

New Disclosure Obligations

Before, there were no compulsory disclosure requirements for the use of Rule 10b5-1 trading arrangements. The new rules require quarterly disclosure of the use of these arrangements by a company, its directors, and officers. Companies also have to disclose their insider trading policies and procedures annually. Similar requirements apply to foreign private issuers.

Forms 4 and 5 have also been updated to require insiders to identify whether a reported transaction was executed following a trading plan.

New Item 408 requires companies to disclose whether any director or officer created or terminated a Rule 10b5-1 trading arrangement in the last fiscal quarter, along with the plan's key terms. They also have to disclose whether they've adopted insider trading policies and procedures, or explain why not.

Companies also need to provide a narrative and tabular disclosure related to option grants, discussing their policies and practices on the timing of these awards and how the board determines when to grant them. The table should show awards made within a specific time window around the filing of a report that discloses material nonpublic information and include various details about the award.

Continuing the amendments to the Insider Trading Affirmative Defenses:

Item 402(x) also requires companies to offer both narrative and tabular information regarding their policies and practices associated with stock options, SARs (stock appreciation rights), and similar instruments. The company must disclose how the board decides the timing of such awards, whether the board or compensation committee considers material nonpublic information when determining the timing and terms of an award, and whether the company has manipulated the disclosure of material nonpublic information to influence executive compensation value.

The tabular information should detail awards given four days before the filing of a periodic report (Form 10-Q or 10-K) or a current report (Form 8-K) that unveils material nonpublic information. The information must comprise:

1. The executive officer's name.
2. The grant date.
3. The number of securities underlying the award.
4. The per-share exercise price.
5. The grant date fair value.
6. The percentage change in the market price of the underlying securities between the closing market price of the security one trading day prior to and one trading day following the disclosure of material nonpublic information.

This regulatory overhaul is designed to ensure more transparency and accountability in the trading activities of company insiders, thereby helping to prevent insider trading and restore public trust in the securities markets.

To sum up, the modifications to Rule 10b5-1 and the introduction of new disclosure obligations aim to tighten control over insider trading, by enforcing good faith in trading plans, introducing cooling-off periods, limiting the number of trading plans and enforcing stricter disclosure and reporting rules. These changes underscore the importance of careful compliance management for companies and their officers and directors. In the ever-evolving landscape of insider trading regulation, staying abreast of these changes and understanding their implications is crucial for maintaining legal and ethical trading practices.