On December 14, 2022, the Securities and Exchange Commission (the “SEC”) adopted new rules1 (i) implementing additional conditions for insiders to rely on the affirmative defense for Rule 10b5-1 trading plans (“10b5-1 plans”) under Rule 10b-5 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”); (ii) requiring issuers to provide periodic report and proxy statement disclosures regarding the use of insider 10b5-1 and other trading plans and issuers’ insider trading policies; and (iii) requiring directors and officers to disclose 10b5-1 transactions on SEC Forms 4 and 5. The new rules are intended to deter insider trading, enhance transparency and improve investor protections. This alert highlights the key terms of the new rules and suggests considerations and next steps for issuers.
Effective Date of New Rules
The new rules become effective 60 days following publication of the release in the Federal Register. The rules require issuers to comply with the new disclosure requirements in Exchange Act periodic reports (such as Form 10-Q and Form 10-K) and in proxy or information statements in the first filing that covers the first full fiscal period that begins on or after April 1, 2023 (or on or after October 1, 2023 for smaller reporting companies). The new Form 4 and Form 5 reporting requirements under Section 16 of the Exchange Act for directors and officers subject to Section 16 (“Section 16 officers”) become effective for beneficial ownership reports filed on or after April 1, 2023.
1. New Conditions to the 10b5-1 Plan Affirmative Defense
Section 10(b) and Rule 10b-5 under the Exchange Act prohibit insider trading, that is, the purchase or sale of an issuer’s security on the basis of material nonpublic information (“MNPI”). Currently, Rule 10b5-1(c) provides an affirmative defense to liability under Section 10(b) and Rule 10b-5 by allowing trading in an issuer’s securities, regardless of whether the individual is in possession of MNPI at the time of the trade, so long as the trade is made pursuant to a binding contract or other trading arrangement adopted at a time that the person was not aware of MNPI and other conditions of the rule are met.
The SEC expressed concern that corporate insiders have used 10b5-1 plans to circumvent the objectives of the rule and trade on the basis of MNPI while avoiding liability, for instance, by establishing multiple, overlapping plans and executing trades shortly after the establishment of 10b5-1 plans. The new rules attempt to curb such practices by (i) requiring “cooling off periods” between the date the plan is entered into or amended and the date of the first trade under the plan; (ii) requiring certain representations by the insider regarding 10b5-1 plans; and (iii) imposing new conditions regarding multiple 10b5-1 plans and single trade plans.
A. Cooling Off Periods
The rules impose new conditions on individuals, including directors, Section 16 officers, and certain other individuals. A director or Section 16 officer cannot rely on the affirmative defense unless the 10b5-1 plan prohibits trading until the later of (i) 90 days after the adoption of the plan or (ii) two business days following the disclosure of the issuer’s financial results in a Form 10-Q or Form 10-K for the fiscal quarter in which the plan was adopted. In no event can the cooling off period exceed 120 days following the plan’s adoption. For individuals other than directors or Section 16 officers, the new rules impose a 30-day cooling off period. A new cooling off period will occur when a 10b5-1 plan is modified or changed (whether through a computer program, written formula or otherwise) affecting the amount, price or timing of the purchase or sale of the securities underlying a 10b5-1 plan, because the new rules treat such changes as a simultaneous termination of the original plan and adoption of a new plan.
At this time, the SEC decided not to implement the proposed 30-day cooling off period for issuers for 10b5-1 plan adoptions and modifications.
B. Certifications for Directors and Section 16 Officers
The new rules require directors and Section 16 officers to include a certification in the individual’s 10b5-1 plan that (i) he or she is not aware of MNPI regarding the issuer when adopting or modifying the 10b5-1 plan, and (ii) he or she is adopting the 10b5-1 plan in good faith and not as part of a plan or scheme to evade the prohibitions of the Exchange Act.
C. Multiple Overlapping 10b5-1 Plans and Single-Trade 10b5-1 Plans
The new rules add new restrictions regarding multiple overlapping 10b5-1 plans and single-trade 10b5-1 plans. For multiple overlapping plans, the affirmative defense may only be available if individuals do not have another outstanding contract, instruction or plan (and may not later enter into any additional such plan) that would qualify for the affirmative defense under the new rules for transactions of any class of securities of the issuer on the open market during the same period.
The new rules provide certain relief to the restriction on multiple overlapping plans. First, the new rules treat contracts with multiple brokers making trades pursuant to the same 10b5-1 plan as one “plan”, so long as the contracts with each broker-dealer (taken together as a whole) meet all of the applicable conditions of the new rule. Notably, individuals can still meet the conditions of the affirmative defense by substituting broker-dealers executing trades pursuant to a single 10b5-1 plan so long as the instructions between the broker-dealers are similar (e.g., with respect to the prices, amounts and dates of securities to be purchased or sold).
Second, individuals may maintain two 10b5-1 plans simultaneously so long as trading under the later commencing plan cannot begin until all trades under the earlier plan are completed or expire without execution. Trades under such plans are also subject to the cooling off period rules, so an insider must wait the additional 30 or 90 days, as applicable, before conducting trades in the new 10b5-1 plan.
Third, insiders will not lose the affirmative defense for transactions under a 10b5-1 plan where insiders instruct their broker-dealer or agent to sell securities in order to satisfy tax withholding obligations when a compensatory equity award (such as restricted stock) vests. This exception applies in situations where an insider has multiple 10b5-1 plans that qualify for the affirmative defense (as mentioned above, this would normally cause the insider to lose the affirmative defense). The exception is only available for taxes related to vesting – as opposed to exercise – of awards, so it is not available for tax withholding related to option exercises.
With respect to single-trade 10b5-1 plans, an individual will not be entitled to the affirmative defense unless: (i) during the prior 12-month period, the individual has not entered into an additional single trade plan, and (ii) such other plan qualified for the affirmative defense. The insider can only rely on the affirmative defense for one single trade plan during any 12-month period.
The SEC also clarified that a good faith obligation applies to the activities of the insider (including the insider’s efforts to direct the activities of others) in order for the affirmative defense to be available.
2. New Issuer and Section 16 Insider Disclosure and Reporting Requirements
Prior to the new rules, there were no mandatory disclosure requirements about the use of issuer or corporate insider 10b5-1 plans or other trading arrangements, and issuers were not required to disclose their insider trading policies or procedures. The new rules impose disclosure requirements related to insider trading plans and transactions under such plans and modify SEC Form 4 and Form 5 reporting requirements related to 10b5-1 plans and gifts by Section 16 insiders.
A. New Item 408(a) of Regulation S-K
Under new Item 408(a) of Regulation S-K, issuers must disclose in a Form 10-Q and Form 10-K, as applicable, (i) whether, during the last fiscal quarter, any director or Section 16 officer adopted or terminated (1) a contract or plan intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) (a “Rule 10b5-1 Trading Arrangement”) and/or (2) any plan or contract that is a “non-Rule 10b5-1 Trading Arrangement”2; and (ii) a description of the material terms of such plans, including the name and title of the director or Section 16 officer, date of adoption or termination, duration of the plan or contract and aggregate number of securities to be sold or purchased under such plan or contract (pricing information need not be disclosed). The issuer must indicate whether the plan is or is not a Rule 10b5-1 Trading Arrangement, as well as disclose any modifications or changes (such as adoption or termination) to a Rule 10b5-1 Trading Arrangement. The SEC opted not to adopt similar disclosure requirements for issuer trading arrangements at this time.
B. New Item 408(b) of Regulation S-K
The SEC also added new Item 408(b) of Regulation S-K, which requires issuers to (i) disclose, on an annual basis, whether or not (and if not, why not) the issuer has adopted insider trading policies and procedures and (ii) provide disclosures of such policies and procedures. Issuers must make these disclosures in their annual reports on Form 10-K and proxy and information statements. The new rules also require issuers to provide a copy of their insider trading policies and procedures as an exhibit to Form 10-K. Issuers may incorporate by reference from a proxy statement the disclosures required under new Item 408(b) so long as it is timely filed. These disclosures will be subject to the certifications required by Section 302 of the Sarbanes-Oxley Act of 2002.
C. Expanded Disclosures Regarding Option Grant Practices
The SEC also amended its executive compensation disclosure rules by requiring expanded narrative and tabular disclosures related to option grant practices under new Item 402(x) of Regulation S-K.
Issuers will be required to provide narrative disclosure regarding (i) their policies and practices on the timing of awards of stock options, SARs and/or similar option-like instruments in relation to the disclosure of MNPI; (ii) how the board considers MNPI when determining the timing and terms of an award; and (iii) whether the issuer has timed the disclosure of MNPI for the purpose of affecting executive compensation.
The tabular disclosure requires issuers to disclose awards made in the four business days before the filing of a periodic report or of a current report on Form 8-K that discloses MNPI and ending one business day after a triggering event. (The new rules clarify that Form 8-K does not trigger the disclosure if it only reports the grant of a material new option award under Item 5.02(e).) The information provided must include: (i) the name of the named executive officer under the SEC’s proxy rules; (ii) the grant date of the award; (iii) the number of securities underlying the award; (iv) the per share exercise price; (v) the grant date fair value of each award computed using the same methodology as used or the issuer’s financial statements under generally accepted accounting principles; and (vi) 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 MNPI.
Lastly, the new disclosure requirements require issuers to tag the information specified by new Items 408(a), 408(b), and Item 402(x) in Inline XBRL in accordance with Rule 405 and the EDGAR Filer Manual.
D. 10b5-1 Plan Transactions Disclosed on Forms 4 and 5 and Bona Fide Gifts Disclosed on Form 4
The new rules also add a checkbox on Forms 4 and 5 that requires filers to indicate whether a transaction reported on the form was made pursuant to a plan that is intended to be a 10b5-1 plan. Accompanying the checkbox is text clarifying that the transaction is intended to satisfy the affirmative defense conditions. In addition, Section 16 officers, directors and 10 percent beneficial owners will have to report bona fide gifts of equity securities within two business days of the transaction on Form 4 (rather than on the current delayed basis reporting on Form 5). The SEC clarified that Section 16 officers and directors can still rely on the affirmative defense when making a bona fide gift of equity securities.
Next Steps and Considerations
With the rules becoming effective 60 days following publication in the Federal Register, and with compliance required for the first filing that covers the first full fiscal period that begins on or after April 1, 2023 (October 1, 2023, for smaller reporting companies), issuers and insiders should begin preparing for the impact of the new rules. For instance, issuers should (i) review their current disclosures against the new disclosure requirements and consider potential modifications; (ii) review their insider trading policies and practices for potential updates; (iii) review with their insiders who use 10b5-1 plans the proposed cooling-off periods, certifications and other requirements; (iv) review with their Section 16 officers and directors the modified disclosures for 10b5-1 plan transactions and the new two business day reporting requirement for bona fide gifts of equity securities; and (v) review or consider adopting stock option grant timing policies.
1 See Insider Trading Arrangements and Related Disclosures, at http://www.sec.gov/rules/final/2022/33-11138.pdf.(December 14, 2022).
2 A “non-Rule 10b5-1 Trading Arrangement” is defined as a trading arrangement with a director or Section 16 officer where the director or officer asserts that, at a time when he or she was not aware of MNPI about the issuer or the securities, he or she adopted a written trading arrangement and the trading arrangement (i) specified the amount of securities to be purchased/sold and the price at which and date on which the securities were to be purchased/sold; (ii) included a written formula, algorithm or computer program for determining the amount of securities to be sold and the price at which the securities would be sold; or (iii) did not permit the covered person to exercise any subsequent influence over how, when or whether to effect the purchases/sales (and that any other person who did exercise such influence was not aware of MNPI when doing so).