Introduction

Rule 10b5-1, established by the Securities and Exchange Commission (SEC) in the year 2000, permits executive officers and directors of publicly traded companies to establish a trading plan for the sale or purchase of company stock and provides these individuals an “affirmative defense” against claims that shares were traded based on material non-public information (MNPI). A typical Rule 10b5-1 plan specifies the sale or purchase of a predetermined number of shares at a specified price (or prices) over the term of the plan.

Companies (i.e., issuers) may also establish Rule 10b5-1 plans for stock buybacks.

It is important to note, neither executive officers and directors nor companies are required to use a Rule 10b5-1 trading plan to execute company stock transactions, and many trades are completed without such plans.

Currently, there are no disclosure requirements when a 10b5-1 trading plan is adopted, modified, or terminated. And, although such plans must be adopted when the participant is not aware of any MNPI, under present rules there is no waiting period before a stock transaction can take place. Thus, it is possible to adopt a trading plan and sell shares on the same day, although in our experience many plans include a 30-day “cooling-off” period before the first stock transaction can be completed.

On December 15, 2021, the SEC released proposed rules that significantly change both the plan provisions and disclosure requirements that must be met for executive officers, directors, and issuers to avail themselves of the affirmative defense afforded such plans. The SEC cites several concerns with the current rules including the potential for abuse and lack of transparency. The proposed rules are currently subject to a 45-day comment period, and public companies and other interested parties are encouraged to offer responses to some, or all of the 72 issues raised by the SEC staff in the release.[1]

Proposed Rules

The SEC’s proposals for Rule 10b5-1 plans are extensive and a major departure from current rules governing such plans. The major changes are divided into two parts: the proposed plan requirements that must be met for the affirmative defense to be available and the proposed disclosure requirements, which are intended to improve transparency.

Proposed Plan Requirements

• Rule 10b5-1 trading plans entered into by executive officers and directors must include a 120-day cooling off period before any trading activity may be executed under the plan;
• Rule 10b5-1 trading plans entered into by issuers must include a 30-day cooling off period before any trading activity may be executed under the plan;
• Officers and directors will be required to personally certify to the issuer that they are not aware of MNPI and that they are adopting the plan in good faith and not trying to circumvent the insider trading rules when adopting a Rule 10b5-1 plan;
• The affirmative defense under Rule 10b5-1(c)(1) will not apply to multiple overlapping Rule 10b5-1 trading plans for open market trades in the same class of securities;
• The affirmative defense under Rule 10b5-1(c)(1) for a single-trade plan will only be available if it is the only trade during any 12-month period; and
• Rule 10b5-1 trading plans must be entered into and operated in good faith.

The SEC indicates that executive officers and directors will likely need to consult with legal counsel before attesting to the issuer that they are not in possession of MNPI. The SEC also expressed concern that an executive officer might influence the release of positive MNPI just before a scheduled trade date or conversely, delay the release of negative MNPI until after the scheduled trade date, which is why they added the “operated in good faith” requirement.

Proposed Disclosure Requirements

• Issuers must disclose in the 10-K whether the company has adopted insider trading policies and procedures, and if not, why. If the issuer has such policies and procedures, the issuer is required to “provide detailed and meaningful information,” including:

         — The process for determining if an insider has MNPI;

          — The process for documenting such a determination and the approval of such requests; and

          — How the issuer ensures compliance.

• Issuers must disclose their stock option (and stock appreciation right [SAR]) grant policies and practices, and how the Board considers MNPI prior to the grant, in the 10-K and Compensation Discussion & Analysis. Issuers also must provide a tabular disclosure of option (and SAR) awards made within 14 days of the release of MNPI as well as the company share price on the trading day before and after the release of such information;
• Issuers must disclose the adoption and termination (including modifications) of all Rule 10b5-1 trading plans in the 10-Q or 10-K. And because the SEC is concerned that trading plans may be established to evade the new reporting requirements, the proposed rules also apply to any non-qualified trading plan or arrangement. The required disclosure for both Rule 10b5-1 eligible and non-eligible trading plans includes:

          — The name and title of the director or officer;

         — The date on which the director or officer adopted or terminated the contract instruction or written plan;

          — The duration of the contract instruction or written plan; and

          — The aggregate number of securities to be sold or purchased pursuant to the contract, instruction or written plan.

• Executive officers and directors must disclose on Forms 4 and 5 whether a reported transaction was executed pursuant to a Rule 10b5-1 trading plan (note, such disclosure is customary, and the SEC will add a check box to Forms 4 and 5 to facilitate this reporting requirement); and
• Executive officers and directors must promptly report anybona fide gifts of company securities on Form 4.[2]

The new rules apply to all domestic and foreign issuers; there is no exemption for small reporting companies or emerging growth companies. In addition, the proposed disclosures required in Forms 10-Q and  -Kwould be subject to the certifications required by Section 302 of the Sarbanes-Oxley Act.

Pay Governance Comments

Some members of Congress and certain courts have commented that the affirmative defense under Rule 10b5-1(c)(1) has allowed corporate insiders to use MNPI to trade company shares on an advantaged basis. Further, several academics (e.g., Alan D. Jagolinzer, M. Todd Henderson, Taylan Mavruk, Artur Hugon and Yen-Jung Lee) have prepared studies attempting to show that executive officers and directors utilizing Rule 10b5-1 plans have outperformed executive officers and directors that did not use a Rule 10b5-1 plan. While the SEC proposal has tried to affirmatively address these concerns, the proposed rules, if finalized in their current form, may also lead to a significant reduction in the use of such plans.

We encourage companies to review the SEC proposal and consider how the proposed rules might impact the company’s insider trading policies as well as any requirements that executive officers and directors must use Rule 10b5-1 trading plans when buying or selling company stock. The SEC has published a brief Fact Sheet, “Rule 10b5-1 and Insider Trading: Proposed Rules” on its website, which provides a two-page summary of the principal rules and procedures proposed. [2]

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com or Mike Kesner at mike.kesner@paygovernance.com.

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[1] “SEC Proposes Amendments Regarding Rule 10b5-1 Insider Trading Plans and Related Disclosures.” U.S. Securities and Exchange Commission. December 15, 2021. https://www.sec.gov/news/press-release/2021-256

[2] “Rule 10b5-1 and Insider Trading: Proposed Rules.” U.S. Securities and Exchange Commission. December 15, 2021. https://www.sec.gov/files/10b5-1-fact-sheet.pdf

Introduction

From time to time, the Securities and Exchange Commission (SEC) provides interpretative accounting guidance, referred to as staff accounting bulletins (SABs), to public companies. On November 24, 2021, the SEC released SAB 120, which addresses the estimation of the fair value of share grants such as stock options, restricted shares, performance awards, and other equity awards when a company issues an equity award just prior to the release of positive non-public information. This type of equity award is referred to in SAB 120 as a “spring-loaded” award. If the award is spring-loaded, the SEC believes the company may need to value the award for accounting and proxy purposes at an amount greater than the reported share price at the date of grant.

It is important to note that the statements of SEC staff in accounting bulletins are not rules or interpretations of the SEC nor are they published as bearing the SEC’s official approval. Such statements represent interpretations and practices followed by the Division of Corporate Finance and the Office of the Chief Accountant in administering the disclosure requirements of the federal securities laws.

Spring-Loaded Share Awards/Grants

Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Topic 718 (ASC 718) is based on the premise that compensation costs resulting from share-based payment transactions are to be recognized in company financial statements at fair value. ASC 718 specifies the accounting treatment of a wide range of share-based compensation arrangements including stock options, restricted share plans, performance-based awards, stock appreciation rights, and employee stock purchase plans.

The SEC acknowledges that a company generally possesses non-public information when entering share-based transactions. The SEC notes that an observable market price on the grant date is generally a reasonable and supportable estimate of the current price of the underlying share in a share-based payment transaction in the event of “a routine annual grant to employees that is not designed to be spring-loaded.” [1] The SEC further opines, however, that when share-based payment arrangements are entered into in contemplation of or shortly before the planned release of material non-public information, and such information is expected to result in a material increase in share price, the company should consider whether an adjustment in the observable market price is warranted. According to the SEC, “determining whether an adjustment to the observable market price is necessary, and if so, the magnitude of any adjustment, requires significant judgment,”[1] which leaves it up to companies to determine the fair value that should be used for accounting and proxy reporting purposes.

SAB 120 provides an obvious example of a spring-loaded share transaction:

"Facts: Company D is a public company that entered into a material contract with a customer after market close. Subsequent to entering into the contract but before the market opens the next trading day, Company D awards share options to its executives. The share option award is non-routine, and the award is approved by the Board of Directors in contemplation of the material contract. Company D expects the share price to increase significantly once the announcement of the contract is made the next day. Company D’s accounting policy is to consistently use the closing share price on the day of the grant as the current share price in estimating the grant-date fair value of the options.

"[Question:] Should Company D make an adjustment to the closing share price to determine the current price of shares underling [the] share options?

"Interpretative Response : Prior to awarding share options in this fact pattern, the staff [(i.e., SEC)] expects Company D to consider whether such awards are consistent with policies and procedures, including the terms of the compensation plan approved by shareholders, other governance policies, and legal requirements. The staff reminds companies of the importance of strong corporate governance and controls in granting share options, as well as the requirements to maintain effective internal control over financial reporting and disclosure controls and procedures.

“In estimating the grant-date fair value of share options in this fact pattern, absent an adjustment to the closing share price to reflect the impact of Company D’s new material contract with a customer, the staff believes the closing share price would not be a reasonable and supportable estimate and, without an adjustment the valuation of the award would not meet the fair value measurement of FASB ASC Topic 718 because the closing share price would not reflect a price that is unbiased for marketplace participants at the time of the grant.” [1]

Additional Accounting Guidance in SAB 120

In addition to the guidance above pertaining to spring-loaded share awards, SAB 120 provides additional miscellaneous guidance to companies regarding the application of ASC 718. This guidance includes such applications of ASC 718 regarding:

• The transition from non-public to public entity status;
• The financial statement footnote disclosure of valuation methods used for equity awards including assumptions such as expected volatility, expected term, and current price of the underlying share (particularly when valuing spring-loaded awards); and
• The accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, and capitalization of compensation cost related to share share-based payment arrangements.

Closing Remarks

Pay Governance recommends that corporate management ensure members of the Board’s compensation committee be made aware of this latest SEC development — especially if the Company is contemplating making any off-cycle equity grants prior to the close of the fiscal year. We also recommend that the company consult with their legal and accounting advisors to determine if additional documentation is needed to demonstrate that annual and/or off-cycle awards were not made in contemplation of the release of positive non-public information. Because Pay Governance LLC is a management consulting firm, we are prohibited from providing an official opinion regarding accounting, corporate tax, or SEC reporting issues that may be rendered by either qualified legal or tax counsel or a certified public accounting firm.

General questions about this Viewpoint can be directed to John Ellerman at john.ellerman@paygovernance.com or Mike Kesner at mike.kesner@paygovernance.com.

[1] “Staff Accounting Bulletin No. 120: 17 CFR Part 211.” U.S. Securities and Exchange Commission. November 24, 2021. https://www.sec.gov/oca/staff-accounting-bulletin-120