When you work at a public company, you face a unique conundrum in creating wealth. Much of your pay is in the form of company stock, often acquired via grants of stock options and/or restricted stock units (RSUs). You plan to sell company shares to meet financial goals, yet you don’t want to be accused of insider trading. Fortunately, SEC Rule 10b5-1 can help.
Insider-Trading Risk
When you know what is termed material nonpublic information (MNPI) about a company, whether you’re an executive, employee, or outsider, you cannot trade in that company’s securities until the MNPI is disclosed. MNPI is confidential information about the company that will move the stock price up or down.
When you possess MNPI, regardless of whether or not you factored that information into your buy or sell decision, you’re at risk of being charged with insider trading by the Securities and Exchange Commission (SEC) and criminal prosecutors. To make matters even more challenging, the intervals when company insiders do not possess MNPI, and can sell shares without the risk of insider trading, may be brief and infrequent.
Test your knowledge of the rules: Try the quiz on insider-trading prevention and its interactive answer key at myStockOptions.com, a resource of all aspects of equity compensation.
Rule 10b5-1 To The Rescue
If you’re in this position, how can you regularly sell company stock? You can use what’s called a Rule 10b5-1 trading plan. When properly created, a 10b5-1 plan gives you a way to diversify your stock holdings, sell stock to meet goals under your financial plan, and avoid getting into trouble for insider trading.
Alert: The SEC is focusing on abuses with these plans and has proposed new rules.
myStockOptions.com recently held a webinar on 10b5-1 plans and other SEC rules. A panel of three experts provided key insights on both the legal framework of 10b5-1 plans and the role they can play in financial planning for company insiders.
Basics Of 10b5-1 Plans
A 10b5-1 plan is a prearranged stock-trading plan under SEC Rule 10b5-1 that provides an affirmative defense against charges of insider trading when you later sell or buy stock while you know MNPI about your company. Created when you do not know MNPI, the plan is set up in advance to make automatic, periodic sales and/or purchases of your company’s stock.
The plans need to follow the requirements, as the SEC is starting to bring enforcement actions for abuses. For example, the SEC recently announced (September 21, 2022) that it had settled an enforcement proceeding involving alleged insider trading by Cheetah Mobile’s CEO and its former president; this case and the related SEC Order involved the misuse of a Rule 10b5-1 plan.
The SEC’s statement quotes Joseph G. Sansone, Chief of the SEC Enforcement Division’s Market Abuse Unit, who explains that “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.”
Rule 10b5-1 trading plans have become popular since SEC Rule 10b5-1 was adopted in 2000. “Over 50% of Fortune 500 companies have at least one executive using a 10b5-1 plan,” observed webinar panelist Mike Andresino, a partner in the Boston office of the law firm ArentFox Schiff, in his opening remarks.
Mike went on to outline the basic parameters of 10b5-1 plans. “The insider who establishes the plan cannot be in possession of MNPI when the plan is established,” he asserted. “The person cannot exert any subsequent influence over the implementation of the plan and must have entered into the plan in good faith.”
There are various ways to establish a 10b5-1 plan, he noted. By far the most common is the contract method. “You enter into a binding contract to buy or sell company stock that specifies, or has a formula to determine, the number of shares, the stock price they will be sold at, and the timing. That formula doesn’t have to be precise. You don’t have to specify prices. You can refer to the market; you can refer to extrinsic events.”
Two examples:
Period-sales approach: Sell X number of shares on the first day of every month/quarter, as long as the price is above $Y
Price-only approach: Sell X number of shares at any time during the plan when price reaches $B; sell an additional C number of shares if price gets to $D
Importance Of 10b5-1 Plans
Rule 10b5-1 trading plans can become very important financial tools for executives, employees, and directors who know MNPI about their companies most of the time. While companies have regular open trading windows when you are permitted to trade stock, amid blackout periods when you are not allowed to trade, those window periods may not be helpful for some executives and key employees.
“In reality, for many of them, they may have inside information at any point, whether the window is open or closed,” said webinar panelist Rich Baker, the executive director of Morgan Stanley Executive Financial Services in New York. Whether the MNPI involves a product rollout, M&A, or company litigation, it can keep executives in blackout periods for quarter after quarter. “I’ve seen executives who are unable to sell company stock for two years,” Rich stated.
Ideally, Rich went on, you set up a 10b5-1 plan when you have an open trading window and do not possess MNPI. “There’s a waiting period, a ‘cooling off’ period, before you can start trading,” noted Rich. “Then trading should be allowable from a legal perspective under the plan on an ongoing basis thereafter.”
Rich explained that 10b5-1 plans can confer other benefits beyond just letting corporate insiders trade company stock in good faith and get on with their financial planning. “10b5-1 plans can reduce investor concerns. They let the company facilitate an orderly disposition for all of their executives so that they don’t have lots of optic-concerning trades going on when activity is high at the company.”
“Diversification, selling long shares, is the most commonly thought of use for 10b5-1 plans,” chimed in Mike Andresino. “You can also exercise and sell stock options under a 10b5-1 plan. In combination with restricted stock and restricted stock units, you can use 10b5-1 plans to sell shares to cover taxes at vesting even during a blackout period.”
Best Practices For 10b5-1 Plans
Mike then discussed some of the best practices for 10b5-1 plans that have arisen to help ensure they work as an affirmative defense against insider trading. “The letter of the law doesn’t have a lot of requirements, but over the years a series of practices have developed,” he observed as a prelude to covering the SEC’s proposed rules. One is the “cooling off” period. “Companies often have a period that must elapse between the adoption of the plan and the first trade that takes place under the plan. Sometimes it’s as short as two weeks. The sweet spot is generally 30, 60, or 90 days.”
Terminating the plan early can, Mike noted, put a big dent in any later claim that you entered the plan in good faith. “One thing which indicates to courts and the SEC that you may not have had good faith is adopting a plan and then, when it looks like it may be beneficial to hold the shares, you terminate the plan.” Similarly, Mike said, multiple overlapping plans can also raise questions about good faith. “Companies often impose restrictions on that.”
SEC Proposed Rules
The SEC has proposed new rules for 10b5-1 plans to combat suspected abuses, explained Rich Baker. These rules would codify many of the best practices that have arisen. The amendments add new conditions to the availability of the affirmative defense to insider-trading liability, including:
- 120-day cooling-off period before any trading can start after the plan’s adoption or modification
- Requirement to certify when adopting or modifying the plan that you are not aware of material nonpublic information about the company
- No overlapping 10b5-1 trading arrangements for open-market trades
- A limit on single-trade plans to one per 12-month period
- Plan must be entered into and operated in good faith
The first two SEC rules would apply only to senior officers and directors, though a company could decide under its own rules to impose them on other executives and on employees. The final SEC rules are expected in the spring of 2023.
Financial Planning With 10b5-1 Plans
Webinar panelist Megan Gorman, the founder of Chequers Financial Management in San Francisco and a Forbes.com contributor, spoke about the role a 10b5-1 arrangement can play in financial planning. She presented tips and case studies on how she effectively uses and designs these plans for clients.
When putting together a plan, she explained, you should answer four questions:
- What shares are you selling?
- How long is the plan?
- What is the frequency of sales?
- What is the selling method?
“Monthly selling plans with limits are often a great approach,” she said. She noted that the optimal length of the plan is typically 12 months. “You can also structure the plan to change at different points to meet cash-flow requirements.”
Using what she calls an “elevator design” allows more shares to be sold as the company’s stock price rises, as illustrated in one of her webinar case studies. She asserted that it is also crucial to factor tax planning into your 10b5-1 arrangement, along with future vestings of restricted stock or restricted stock units.
Optics are another key consideration, Megan emphasized, especially for senior executives who can easily stumble into the media spotlight. “Just because you are allowed to do a 10b5-1 plan doesn’t mean you should,” she cautioned. “Even the most innocent actions can look nefarious on the outside.” One test Megan applies is a thought experiment: how would this stock trade look if it were reported on the front page of The Wall Street Journal?
Seek Expert Advice
Starting a Rule 10b5-1 trading plan is not a DIY activity. You need expert legal, financial, and tax advice, to follow both the SEC and your company’s rules. You want to assure you are setting up the plan properly and that it achieves what you want it to without getting you into trouble.
Before you set out, myStockOptions.com has content sections on Rule 10b5-1 trading plans and insider-trading prevention that can help you understand the rules and concepts. In addition, the webinar in which the experts quoted above spoke is available on demand at the myStockOptions Webinar Channel.