How To Avoid a 10B5-1 Meltdown

February 3, 2021

Well, if you don’t know what a 10b5-1 plan is yet, you may aspire to be in a place to need one. For some, they are a necessary evil. For others, they are downright mystifying.  But let’s take a look at their origin story, and try to unpack what they are, why they are necessary, and how to operate well when we have one.

SEC Rule 10b5–1 allows company insiders with access to material, non-public information to set up a predetermined plan to sell company stocks in accordance with insider trading laws. The 10b5-1 plan was adopted as a protective measure for executives that are both privy to ‘inside information’ and receive stock from their company. This plan allows executives to diversify their stock holdings (through buying and selling) beyond the stock they earn through their employment agreement while creating protections against insider trading.  The Securities and Exchange Commission (SEC) likes it when people buying and selling stock are making decisions based on information that is available to everyone. Problems arise if people trading on stocks have additional useful information that the rest of the market doesn’t  have access to (you can ask Martha Stewart about this one – she’s probably well versed in the law now).

But it’s not just the small-time insider traders that the SEC worries about. Insider trading can lead to large-scale securities fraud, where significant market moves happen based on privileged information, benefiting only those few with substantial stock holdings (the C-level employees or majority shareholders) while leaving the rest of the market wondering what just happened.  In the spirit of creating fairness in the markets, the US passed the Securities Act of 1933 and the Securities Exchange Act of 1934, which added rules as to when people are allowed to trade their personal cache of company stock and effectively curtail insider trading.

While discouraging illegal trades with these two Acts, the SEC went further in 2000, adding protections for C- and director-level executives that may be privy to exclusive information on their company, through the establishment of Rule 10b5-1.  The 10b5-1 plan sets up parameters for stock trades, agreed upon annually, in advance of any trading. These parameters include date ranges – windows of time where trades will be allowed. These opportunity windows are set so there isn’t any question as to whether the employee knew something in advance, as the windows are set up based on calendar dates outside of earnings calls and other announcements.

In addition to a time-window, there is also a pricing target, giving guidance for a price for the stock as well.  As with the date window, this is to ensure an extra layer of protection against stock pricing manipulation and guard against large market moves. These protective measures set up what lawyers like to call “Affirmative Defense” for the executives.  If there are issues around the timing of a stock trade, the plan can be used as evidence of scheduling and should (in theory) exonerate the executive from accusations of fraud.

Every plan is different.  Trading blackouts (times that investors are not allowed to trade) can be dependent on earnings calls and major product announcements, and may be subject to increased scrutiny if not managed properly.  A great, current example of 10b5-1 planned trading is related to one of the bigtime headlines in everyone’s daily newsfeeds since March 2020:  COVID-19.  The CEO of Pfizer, Albert Bourla, sold $5.6M in stock the same day as the announcement of positive findings in their Phase 3 trial for the COVID-19 vaccine. That said, the sale was part of a structured 10b5-1 Plan, and while the timing seems fishy, it will probably be deemed a coincidence because his plan was already in place long before the announcement about the vaccine. The idea of these plans is to set them once a year, and then forget it.

Trades can be changed and cancelled for sure, but that could weaken the ‘good faith’ defense. These plans are not implemented for their flexibility – they are rigid with good reason – but not unbreakable.  With foresight, plans can be structured with enough room to give the executive options if s/he wants to stop a trade or make a modification. That said, frequent changes are not recommended, and might affect the ”Affirmative Defense” protection that the 10b5-1 plan is intended to introduce. For a comprehensive, technical outline of 10b5-1 plans, Harvard Law has a summary guide here.

That’s the highlight reel of why there are 10b5-1 plans, and why they work.  That said, there’s also the downside.  In my experience, I’ve seen 10b5-1 plans so restrictive you would need mercury in retrograde during a lunar eclipse when the sun was in Leo to even suggest buying or selling stocks.  These frustrations can lead to my own coined term: the 10b5-MELTDOWN! So, let’s talk about how to carve a good path through the plan to create a winning solution for investors before we get into the MELTDOWN.

If you are an executive, and there is reason for you to have a 10b5-1 plan, you may want to consider hiring an investment advisor to help navigate the plan. There are many factors that should be taken into consideration, and keeping everything top of mind can be overwhelming.  How can an investment advisor assist as you implement your 10b5-1 plan?  Let’s start with the most obvious: hiring a third party to execute buying and selling stock provides a big buffer between the C- and director-level executives and the trade. This buffer can help protect the executive from insider trading accusations.

An investment professional can also look at portfolios holistically, without emotion being a large driver. This enables safe rebalancing of a portfolio, keeping an eye on the news, market push, and other environmental concerns to ensure the trades made are timed well (see Pfizer example above).

There is also the question around tax efficiency. We typically advise our clients to create a 12-month plan, but at times longer plans are necessary. With this in mind, an 18-month plan, in theory, could fall into three separate tax years! An investment professional can assess what should be traded in any given tax year, helping reduce the risk of concentrated stock positions while keeping the tax implications in mind.

There are questions you should be asking of your investment services providers when looking at implementing a 10b5-1 plan. First is experience: ask your broker or manager how many plans s/he has implemented. Executives need confidence that their manager is aware of tax implications while complying with the plan. Ask about checks and balances that are in the portfolio that ensures each trade is happening within the parameters outlined in the strategy. What guidance is provided during the process to ensure both adherence to the plan AND sanity for the executive and his/her portfolio.  Keep good records. Request a paper trail for each trade – make sure the integrity of the plan is maintained, while “affirmative defense” has the support of evidence.  And finally, there should be an open line of communication between the investment advisor and the company’s general counsel or compliance department in the event of shifting trading windows, earnings calls, or any unforeseen announcements that may coincide with a trading window.

Ultimately, 10b5-1 plans should be good news – an executive in need of guidance in this instance is both an asset to their company and has (in theory) a respectable portfolio. With the right checks and balances in place, navigating the confusing world of 10b5-1 plans doesn’t need to lead to a MELTDOWN! In fact, it could be the necessary evil you aspire to in 2021.

Sincerely,
Hilary Clark | Associate Relationship Manager and & Client Team Operations Manager
Hilary can be contacted at (425) 283-1607, hilary.clark@coldstream.com, www.coldstream.com