Loyola University Chicago School of Law, JD 2022
Many of the most valuable companies in the world today began as small start-ups owned by a few visionary entrepreneurs. As those companies become increasingly valuable, so does the stock held by those founders. It is no secret that much of the wealth amassed by the richest people on the planet is tied up in the stock of their companies. When CEOs and other executives sell a large portion of their incredibly valuable stock, how do they avoid accusations of insider trading? The answer: they implement a Rule 10b5-1 plan.
In recent years, investors have seen high profile executives unload valuable stock
Over the past week, Elon Musk has sold roughly $5 billion worth of Tesla stock. Prior to the selling wave, Musk owned 170 million shares. He has since sold 4.5 million shares. Although Musk’s sales this week rank among the largest ever by a chief executive over the course of a few days, this is not the first time investors have watched executives unload their stock. In early November, Adam Aron, the chief executive of AMC Entertainment, sold 1.25 million shares of AMC stock, worth about $53 million. In May, Jeff Bezos sold $1.95 billion worth of Amazon stock over the course of two days.
As you can imagine, transactions of this size conducted by a company’s leader are inherently suspect. Investors often respond by selling their shares as well, assuming that it cannot be a good sign for the future of the company if its chief is cashing in an ownership stake. Similarly, regulators have expressed concern about these transactions due to the high risk of insider trading. So, how are executives able to execute huge sales of their shares without fear of action from regulators? They use a device called a Rule 10b5-1 plan. The transactions by Musk, Aron, and Bezos were all accomplished using a Rule 10b5-1 plan.
Rule 10b5-1 plans are an affirmative defense to insider trading
Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) prohibits the employment of manipulative and deceptive devices in the trading of securities. Rule 10b5‐1 states that the manipulative and deceptive devices prohibited under Section 10(b) and Rule 10b-5 include purchases and sales of securities made “on the basis of” material non-public information about a security or issuer in breach of a duty of trust or confidence that is owed to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material non-public information.
Furthermore, Rule 10b5-1 specifies that a purchase or sale of a security is made on the basis of material non-public information when the person making the purchase or sale was “aware” of material non-public information at the time the purchase or sale was made. Thus, the SEC contends that “possession,” not “use,” of material non-public information is sufficient to establish liability in insider trading cases. Although the rule broadens the scope of illegal trades, it provides relief in the form of an affirmative defense of a Rule 10b5-1 plan, which is available to any person and any entity, including companies with respect to their own securities.
Rule 10b5-1 plans allow major shareholders to sell a predetermined number of shares at a predetermined time. The purpose of such plans is to provide an affirmative defense to insider trader accusations. Because the plan effectively takes the decision of when to sell shares out of the executive’s hands, the Rule 10b5-1 affirmative defense is available even if actual trades made pursuant to the plan are executed at a time when the executive is aware of material non-public information that would otherwise subject the executive to liability. There is no required public disclosure at the time the plan is adopted. Modifications, suspension and termination of Rule 10b5-1 plans are technically all permitted but may weaken the good faith defense. A change is permissible if the participant does not have material non-public information at such time
Regulators are concerned about the potential abuses of Rule 10b5-1 plans
Although there have been no recent SEC enforcement actions concerning Rule 10b5-1 plans, SEC chairman, Gary Gensler, has expressed his desire to revise the rules that govern the plans. In June, Gensler suggested that rule changes are now due. “In my view, these plans have led to real cracks in our insider-trading regime,” he said. In addition, academic studies have asserted that some executives use 10b5-1 plans to engage in opportunistic, large-scale selling of company shares.
Based on comments made by Gensler, it is suspected that an SEC proposal would try to reduce the risk of improper trading by requiring insiders to wait four to six months after a plan’s conception before trading; putting limits on plan cancellations or modifications; disclosing their adoption and any changes; and curbing the number of plans that executives can set up. Despite these concrete recommendations, no such changes have yet been made to Rule 105b-1 plans.