It’s been about 15 years (yikes, already?) since the SEC adopted Rule 10b5-1. For those new to the concept, a 10b5-1 plan may be best explained as a device that allows company insiders to trade in the company’s securities pursuant to a pre-arranged trading plan or instruction. The pre-arranged element is intended to help the insider avoid automatic liability for insider trading and serve as an affirmative defense to claims of insider trading. While there have been many benefits to enacting such trading plans, 10b5-1 plans have not escaped scrutiny from the SEC. I won’t cover that particular scrutiny in today’s blog, but will tackle another unintended downside: the impact of well-intentioned, pre-determined trades on a company’s stock price.
Haven’t We Seen It All?
In recent years we’ve seen the gamete of questionable situations that arise from having a 10b5-1 trading plan. Did the executive really not have material non public information at the time they created the plan? Or, on the flip side, did the executive time that press release to be just before or shortly after the trade already set to occur in his or her 10b5-1 plan? The thing these scenarios have in common are that they raise a question as to whether a specific individual should have indeed been able to trade in the company’s stock, in spite of having a 10b5-1 plan. We could cover a lot of examples of these instances. But today I want to turn to one thing I hadn’t heard of until recently, a circumstance that had nothing to do with the ethics of the trades executed under an individual’s 10b5-1 plan. It appears to be a completely, unintended consequence of the executives and company being well intentioned and yet still generating some ripples about it.
It Started With A Tweet
On February 9, 2015, CNBC’s Jim Cramer sent a memo to the board of social media darling Twitter. The essence? Stop 10b5-1 trades, because the flow of these trades (albeit pre-timed and planned) are hurting the company’s stock price. As CNBC reported, the actual memo said: “Memo to the board of directors of Twitter: Someone suggest that there be a moratorium on selling stock for a bit, maybe six months, maybe a year, to show that you believe in the company… If I were on the board I would simply say, ‘Hey guys, could you give it a break for a while because you are now telling a good narrative about user growth and engagement and you are starting to get people excited again about the company and its stock and your selling makes them feel foolish.’”
The activity that prompted the memo was a series of sales of stock by top executives at Twitter in the weeks and months prior to the memo. Although the trades were done pursuant to 10b5-1 plans, several were executed in close proximity to each other, bringing in millions of dollars to Twitter executives ($8.5 million to its CEO in January and February alone, with a similar amount to its founder and chairman, and $1.8 million to another executive). Although it may be argued that the trades were executed based on long, pre-planned directives, the quantity and dollar value of the shares liquidated seemed to be sending a message that the executives were dumping stock. Not to mention simultaneously releasing thousands of shares into the market.
So what happened? What did the Twitter board do? The company has not commented on the matter, but in a Fortune article citing exclusive information (Exclusive: Twitter execs put stock sales on ice – April 22, 2015), it appears that the memo was received and action taken. Fortune cites having multiple sources who confirm a moratorium on 10b5-1 transactions, save one insider who continues to be permitted to sell stock. Aside from the transactions of that lone insider, no other 10b5-1 transactions have occurred since February 6, 2015. It’s not clear if the company canceled plans or simply did not renew them. Whatever the details, the end results appears to be a moratorium. Since that time, Twitter’s stock price has risen approximately 25% (as of the date of the Fortune article). You be the judge. Did a halt in insider trading activity send a positive message to shareholders, resulting in an increased stock price?
Takeaways
While the Twitter scenario is the first I’ve heard of this type of moratorium, in particular initiated by a party external to the company, it certainly provides food for thought. Social media has given a voice to many – shareholders, customers, media, and others. It’s quite simple to send a message to a company, including its board of directors. And in this case it seems the message was heard. This raises the question – do other companies need to worry about how their 10b5-1 plan trades are perceived by the market? I don’t have a definitive answer on that, but I do have some suggestions.
Consider the potential timing of trades when approving 10b5-1 plans. One thing companies should consider, if they haven’t already, is how the future trades may be perceived by shareholders in the best and worst of trading scenarios. If an insider has multiple stock price targets to trigger sales, for example, and all those targets are hit in a short period of time given a rapid rise in stock price, how will those multiple trades be perceived?
Evaluate how many plans have similar triggers. Companies approach evaluating and approving proposed 10b5-1 plans differently. One thing to assess is just how many insiders have plans or propose plans with similar triggers. If five executives want to sell shares when the stock price reaches $50, this could result in a large volume of shares and transactions hitting the market all at one time. I’m not a 10b5-1 expert, but it seems there has to be a way to monitor existing plan terms and match those up against those proposed by new trading plans. If volume of shares and shareholder/market perception is a potential concern, perhaps the company can establish collective limits (as a matter of policy) as to how many shares can be sold at a given price or under a certain trigger. I may get flack for even suggesting this option, but I’m throwing it out there. Should companies, as a matter of policy, restrict the number of shares that can be sold under a trading plan, or, even a limit on shares sold cumulatively – based on the collection of all existing plans? This would certainly have helped Twitter buffer against the influx of shares into the market earlier this year.
This type of unintended aftermath of 10b5-1 trades feels like new territory. I’d love to hear from anyone who has (as a matter of policy) specific limits to prevent an influx of shares into the market, or who has ideas about best practices to help companies avoid a public call-out like Twitter received. Although they haven’t publicly admitted to any action taken, if we are to listen to the “sources” in this matter, kudos is due to Twitter’s board for handling the situation in a constructive way.
My Google alerts have exploded this week with reports of the latest insider trading indictments, leading to more cap feathers in the SEC’s extended effort to uncover insider trading. According to the Wall Street Journal, the crackdown has resulted in 72 convictions out of 80 people charged in the past three years – a pretty impressive result. Most of the charges and convictions did not involve stock plans. However, in the midst of all the attention on outright stock trades, another investigation has been building in the background – the SEC is now turning attention towards probing increasing claims that Rule 10b5-1 plans are fraught with abuse and, ultimately, insider trading. In today’s blog, I explore the issue.
First, A History of 10b5-1 Plans
Rule 10b5-1 was adopted by the SEC in 2000 as an attempt to provide executives and other company insiders with a way to trade shares of stock without risking the error of trading on “inside” information. The concept is that an insider creates a trading plan (which addresses shares to be sold and prices/timing) when he/she is not in possession of material, non public information. Then, the plan is executed over months/years, presumably resulting in trade orders being established long before the actual trade. According to the SEC, the idea behind the plans was to give executives a safe harbor to proceed with these prearranged trades and “give executives regular opportunities to liquidate their stock holdings–to pay their kids’ college tuition, for example–without risk of inadvertently facing an insider trading inquiry.” In the decade plus time since the adoption of Rule 10b5-1, the plans have become a commonplace, routinely implemented by insiders at companies across the nation. Some companies have even extended the use of these plans down within other ranks of the organizations, suggesting the belief that this is a great way to help other non executive insiders avoid trading on inside information.
What’s the Loophole?
In 2006, an accounting professor at Stanford University named Alan Jagolinzer began briefing the SEC on results of research he’d done on 10b5-1 plans. His findings suggested that executives who adopted such plans outperformed their peers that didn’t have a prearranged trading plan. He felt this may be the result of abuse within these programs. What kind of abuse, you ask? It seems that many trades in these plans appear to be “well timed” – perhaps a sale occurs just before bad news is announced. While insiders may have locked themselves into a prearranged trading plan, a loophole seems to have emerged. They may not want or be able to modify the trading plan, but these insiders may certainly have input into the timing of company announcements. So, in a reverse sort of fashion, it’s not the plans that may be causing problems, it’s the fact that insiders can get around their own plans by timing the announcement of good and bad news around their planned stock trades. Of relevance to us as stock professionals is that 10b5-1 plans can include a variety of shares – ranging from stock options, to shares owned outright, to shares previously purchased through the ESPP.
Trouble Ahead?
Since Mr. Jagolinzer first relayed, and subsequently published, his findings, other chatter has emerged from various sources – including a petition to the SEC from the Council of Institutional Investors. Recent press stories have again resurrected the issue, and the SEC seems to be taking note. A recent Harvard Business Review blog suggests that the SEC and other regulators have opened investigations. Could this be the next backdating scandal?
This heightened scrutiny highlights the importance of companies “adopting well-crafted 10b5-1 policies that are designed both to prevent trades based on inside information and to avoid the appearance of impropriety–even when applying 20/20 hindsight.” The Harvard Business Review blog had a few suggestions on how to accomplish this:
Have the first trade under a 10b5-1 plan take place after a reasonable “seasoning period” has passed from the time of adoption of the plan,
Have each executive use only one 10b5-1 plan at a time, and
Minimize terminations and amendments of 10b5-1 plans.
It will be interesting to see how these investigations transpire over the coming months. In the meantime, companies should revisit their 10b5-1 policies and make adjustments that will stand up to the potential microscope and hindsight.
Heading into the new year, many companies will be starting the annual grant process. If your insiders are due for a new grant this year, they may be looking to modify their Rule 10b5-1 Trading Plan or enter into one for the first time. So, now is the time to review your company’s policy and make sure that it’s solid.
Affirmative Defense
Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of any “manipulative and deceptive device” in connection with the purchase or sale of securities. In 2000, the SEC released Rule 10b5-1, clarifying that trading on the basis of material nonpublic information is just such a “device”. Additionally, the Rule states that entering into a trade while aware of material nonpublic information constitutes trading on the basis of that information. Fortunately, paragraph c of Rule 10b5-1 provides an affirmative defense that basically allows an individual to demonstrate that she or he is not trading on the basis of material nonpublic information.
In order to rely on the affirmative defense, an individual must enter into a contract, instruction, or plan to trade at a point in which she or he isn’t in possession of material nonpublic information. And that is the problem. When exactly is an officer of your company not privy to some piece of nonpublic information? When can an insider enter into a Rule 10b5-1 trading plan?
Timing of Plan Creation
In May of last year, the SEC published interpretive guidance on Rule 10b5-1. Question 120.20 really caught my eye. The question is whether or not the Rule 10b5-1 affirmative defense is available if an individual is aware of material nonpublic information at the time the plan is created, but the trade doesn’t take place until that information is made public.
The SEC answered with a single word: no. Just no. What that means is that no length of “cooling off period” is long enough; in order to garner the protection provided by Rule 10b5-1 a person simply must not be in possession of material nonpublic information at the creation of the trading plan.
When is That Even Possible?
So, what does that mean for companies trying to create a solid policy on Rule 10b5-1 trading plans? How is it even possible that insiders can find a period of time when they are not in possession of information that would negate the affirmative defense? To help me with this dilemma, I called on one of our fabulous panelists from the “10b5-1 Plans: Practical Advice and Implementation” session at our 2009 Conference, Michael Andresino of Boston’s Posternak Blankstein & Lund. (If you missed this session, take time to listen to it now!)
First, I still feel very strongly (and Michael agrees) that companies should require at least their Section 16 insiders to trade exclusively through a plan designed to comply with Rule 10b5-1. You have zero chance of relying on the Rule 10b5-1 affirmative defense if there is no plan in place. Second, the most basic precaution to take on the timing of the creation of these plans is to only allow insiders to enter into a plan after the company has made its quarterly financial disclosures; during an open trading window after the quarterly or annual press release (and conference call) is complete. A lot of companies take the position that at that point all material information has been made public.
Material Nonpublic Information
After that, it’s important to keep in mind that it isn’t just any nonpublic information that creates an issue with the Rule 10b5-1 affirmative defense. The problem is with material nonpublic information. It may be difficult to decide what information is material and what is not. An obvious distinction is that if the information could lead to an event that must be disclosed on a Form 8-K, then it’s reasonable to consider that information to be material. For example, if an individual is aware that your company is in the middle of negotiating a merger or acquisition, then it may be inadvisable for that person enter into a trading plan at that point. On the other hand, if the individual is aware of regular ongoing sales deals or the status of the new widget a company is producing that is part of the normal course of business, these pieces of information may not be considered material.
Situations must be considered on a case-by-case basis. Some companies approach this issue by requiring individuals to disclose to the legal department any nonpublic information that they are aware of at the time they enter into a new plan. This allows the legal department to help insiders determine if that information could be considered material before approving the plan.
How Does Your Policy Measure Up?
Does your company’s insider trading policy address Rule 10b5-1 trading plans? If not, now is the perfect time to have that conversation with your legal team. If you do have a policy, check to see what it says about the timing of the creation of new plans. Confirm that the policy contains components that help ensure that the insider may rely on the Rule 10b5-1 affirmative defense and review those components with your legal team to be sure that everyone is still comfortable that they are adequate.
A class-action lawsuit was recently filed against Novatel by two pension funds that had invested in Novatel stock alleging that several executives engaged in insider trading. Each executive named in the suit claims to have been trading exclusively under a Rule 10b5-1 trading plan, so what went wrong? Although there were Rule 10b5-1 trading plans in place, these plans were allegedly modified to increase the sale of shares prior to a public disclosure of the loss of Novatel’s contract with Sprint (which resulted in a sharp decline in share price).
Sound familiar? Last October, I blogged on Rule 10b5-1 trading plans. I stressed the fact that entering into a Rule 10b5-1 plan does not inherently protect an individual from the risk of prosecution for insider trading. The most prominent illustration of this at the time was the ongoing SEC investigation of Countrywide CEO, Angelo Mozilo, who is also accused of modifying his Rule 10b5-1 trading plan to increase sale amounts prior to a sharp decline in share price.
Remember that Rule 10b5-1 trading plans must be properly administered in order to provide protection to the individual. The top ways Rule 10b5-1 plans may be misused are:
1. Entering into a plan with transactions that take place immediately
2. Cancelling a plan to prevent a transaction from taking place
3. Modifying an existing plan to increase or decrease sales
Take some time now to review your company’s policy on Rule 10b5-1 trading plans.
Getting Shareholder Approval
In other news, the CEO of Keynote Systems, Umang Gupta agreed to cancel his 400,000 share option grant (currently underwater) in exchange for a ‘yes’ vote from shareholders to extend the expiration date for Keynote’s equity incentive plan. In the original appeal to shareholders, Gupta attempted to assuage misgivings stemming from the ISS/RiskMetrics recommendation against the extension. The main concern voiced by ISS/RiskMetrics was the high number of options outstanding. Gupta explained that the reason so many options remain outstanding is that 90% of the grants are currently underwater–and that the company cannot do an option exchange without shareholder approval. Shareholders originally took ISS/RiskMetrics’ advice and rejected the extension. However, after Gupta agreed to relinquish his grant, shareholders voted to extend the equity plan expiration date. Ultimately, the 400,000 share grant wasn’t the only option cancelled by Umang Gupta. He also cancelled an additional grant for 300,000 shares; one that was even more underwater than the negotiated grant. Obtaining this expiration extension from shareholders means that Keynote can continue to offer equity compensation to current (or potential) employees without having to ask for shareholder approval on a completely new plan.
If this down market finds your company courting shareholder approval for a new plan or additional shares under an existing plan, consider what you can do to improve your odds for shareholder approval. Maybe your CEO isn’t ready to cancel his or her outstanding grants, but you can still take steps to help garner shareholder approval. For the top ways to improve your stock plan proposal, check out this article by Compensia.com on the NASPP Practice Alerts, “Five Tips for a Successful Employee Stock Plan Proposal”.