Recent SEC Enforcement Action Provides Cautionary Guidance for Adopting and Structuring 10b5-1 Plans

We continue to see a strong interest among corporate insiders, including senior executive officers and directors, in adopting Rule 10b5-1 sales plans, despite the current market downturn.  These pre-established plans allow insiders to dispose of a specified number or value of shares over a pre-determined period of time regardless of whether they are aware of material nonpublic information at the actual time of a sale, so long as the insider is not aware of material nonpublic information when the plan is adopted.  Current best practice is to require at least 30 days between the plan’s adoption and the date of the first sale under the plan so as to allow for a “cooling-off period” for the stock to reduce the appearance of any improper insider trading.  With economic uncertainty predicted over the next six to 12 months and the rule’s requirement that an insider not possess undisclosed material information, particularly with regard to known negative trends, a recent SEC enforcement action, In the Matter of Sheng Fu and Ming Xu, should be of note to insiders when adopting and structuring a 10b5-1 plan.

The SEC’s enforcement action provides two important takeaways for corporate insiders: (i) Rule 10b5-1 plans should be adopted during clear open window periods, after careful consideration of yet undisclosed trends, events and uncertainties, and (ii) Rule 10b5-1 plans should provide for a more conservative cooling-off period to avoid the possibility that allegations of improper insider trading may be raised.

The SEC Enforcement Action

In anticipation of cease-and-desist proceedings by the SEC, in September 2022, two Cheetah Mobile executive officers consented to the entry of a cease-and-desist order concerning insider trading in connection with the executives’ joint Rule 10b5-1 plan.  According to the SEC’s Order, during the summer of 2015, Cheetah Mobile, a China-based mobile internet company, was made aware that the company’s largest advertising customer was going to “change its algorithm that determined fees for ad placements, and that, unless Cheetah Mobile improved the quality of its ad placements, the algorithm change could halve the revenues that the Advertising Partner paid to Cheetah Mobile.” While the advertising partner and Cheetah Mobile worked together to improve its ad placements, it became apparent by the end of 2015 that there was no solution to prevent a drop-off in revenues from the advertising partner and Cheetah Mobile’s revenues from the advertising partner began to decline. In May 2016, in its first quarter earnings release, Cheetah Mobile disclosed this revenue decline and advised the market that it did not expect to meet previous revenue and earnings guidance for 2016.  The company’s stock dropped around 18% by the end of the day on which the announcement was made.

The SEC Order found that, during the time the Cheetah Mobile executives were aware of the negative revenue trends presented by the advertising customer’s algorithm change and before the May 2016 announcement to the market, the executives jointly created a 10b5-1 trading plan in March 2016.  Once adopted, they sold 96,000 shares of the company under the plan before the announcement to the market.  The SEC found that the executives avoided more than $300,000 in losses from the earlier sales and, most importantly, that the executives failed to disclose details of the declining revenue trend on Cheetah Mobile’s earnings call in March 2016 and in its 2015 annual report filed in April 2016, and made misleading statements about the trend before its May 2016 disclosure.

Among the many remedies imposed on the Cheetah Mobile executives for violating a number of SEC rules related to fraudulent conduct in connection with the purchase or sale of securities, the SEC required that any future 10b5-1 plans for the executives must have a cooling-off period of 120 days after their plans are adopted before any securities transactions can be executed, and that the executives must affirmatively report all trade activity by e-mail directly to the SEC staff.

Adopting a 10b5-1 Plan in the Current Environment

Insiders planning to adopt a trading plan need to be sensitive to the current uncertainty of the overall market’s impact on a public company’s operating and financial trends. In preparing to enter into a plan, the insider should determine and carefully review with the company what trends, demands, commitments, events or uncertainties are known, both to establish a valid 10b5-1 plan and for proper corporate disclosure in the company’s SEC periodic reports and earnings releases.  Such prospective information in the current environment may include increases in raw material prices, higher energy costs, rising interest rates, excess inventory of goods, erosion of market share or non-renewal or modification of a material contract.  For example, Item 303 of Regulation S-K requires public companies to describe material commitments for capital expenditures. If an executive knows that a material capital expenditure will be required as a result of a known demand, such as to maintain a growth trend, disclosure is required as to the need for those expenditures, whether or not the company has any contractual commitments to make them. Further, if the company’s executives determine not to make those expenditures and an adverse effect on the company from discontinuation of the growth trend is reasonably likely to be material, disclosure is required.     

The SEC’s order makes clear that executives must make these assessments of the future impact of a known trend, event or uncertainty before adopting a 10b5-1 plan.  Simply waiting for the end of a prohibited employee benefit plan blackout period to adopt a plan is not sufficient. 

Structuring a 10b5-1 Plan Cooling-Off Period 

The 120-day cooling-off period in the SEC enforcement action reflects the SEC’s current proposed amendment to Rule 10b5-1 published in December 2021, which remains pending.  Many practitioners believe that this recent enforcement action may signal the SEC’s intent to adopt this 120-day cooling-off period in its final rules, expected in April 2023.  Until these new rules are released, corporate insiders may want to consider a more conservative cooling-off period of at least 60 days, which is in line with the current recommendation of the ABA’s Federal Regulation of Securities Committee.

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