Demystifying 10b5-1 Plans

Steve Edwards, CFA, Senior Investment Strategist

Patrick Gremban, Investment Strategist

Helen K. Donnelly, Investment Strategist

The authors would like to acknowledge Joshua Shek, CFA and Rich Baker, CEP for their contributions to this report.

The History of 10b5-1 Plans

10b5-1 plans allow corporate executives and other insiders to establish preset trading plans for transacting in company stock holdings. The SEC created this opportunity in 2000, with the introduction of Rule 10b5-1, which clarified that executives who transacted in their company stock while in possession of MNPI would trigger insider-trading rule violations. Moreover, the SEC included guidelines within the Rule that, if followed, would provide an affirmative defense against claims of insider trading.

Benefits for Executives

10b5-1 plans can help executives and other insiders to meet their goals, particularly with regard to potentially diversifying holdings and reducing idiosyncratic risks associated with concentrated positions. As noted above, these plans may provide an affirmative defense against claims of insider trading. Once established, they permit insiders to trade outside of “open windows” (also known as blackout periods). In addition, insiders may exercise employee stock options—and effect the immediate sale of their equity proceeds—during otherwise prohibited periods while protecting against hitting option expiry dates. Given their preset nature, these plans automate insiders’ trading plans, customized to an individual’s particular objectives, down to specific amounts and timing. That feature protects investors against “emotional” selling and mitigates potential negative signaling from liquidating their holdings.

Establishing a 10b5-1 Trading Plan

Executives and other insiders may implement a plan when they are not in possession of material nonpublic information and are acting in good faith with respect to the plan. The plan, including its subsequent trading schedule, may be highly customizable. When establishing a 10b5-1 plan, insiders may consider the following variables: the number of shares to be sold, frequency of sales and the duration of the plan. Inputs can be formula-driven or static.

Exhibit 1. 10b5-1 Plans Broaden Insiders’ Opportunities for Liquidating Concentrated Positions, Potentially Leading to Greater Diversification and Lower Exposure to Idiosyncratic Risks

Executives and other insiders should consider the following steps when adopting 10b5-1 plans, which may extend to multiple types of equity, such as restricted stock units and founder shares, as well as to stock options:

1. Determine diversification objectives. The plan’s goal could include the desired amount of total liquidity to generate, the quantity of shares intended for sale in a given sales period or the amount of company exposure to maintain. Of course, should the insider increase the liquidation amount, he or she will maintain a smaller amount of company exposure.

2. Look beyond assets held in your name. Insiders may consider related entities, including trusts and family members that hold shares, in their diversification strategies, potentially including those shares in any 10b5-1 plan. We recommend working with a financial advisor to develop a holistic strategy for your entire balance sheet.

3. Establish a selling frequency. For 10b5-1 plans, the time between sales is measured typically in months or quarters, based on the timing of individual liquidity needs. Shorter times between sales generate liquidity more frequently and may serve as a method of dollar-cost averaging out of a concentrated position rather than selling at a single point, which may increase vulnerability to price fluctuations.

4. Set the minimum price (“limit price”). This price represents the level at which the investor would be willing to liquidate shares, given the following: Sale information will become publicly available after the trade execution. Other investors will scrutinize Form 144- or Form 4- reported sales in the context of recent valuation points, such as the initial public offering (IPO) price or the price of any secondary offering.

5. Consider including upper-limit prices. These levels, set above the minimum price, indicate the prices at which additional shares may be sold. Upper limits allow clients to account for potential stock appreciation and upside volatility.

6. Determine the plan length. 10b5-1 plans typically have a 12- month duration, and other investors and regulators will pay close attention to any modifications or terminations. Longer plans may become susceptible to modifications or terminations, due to changes in investor or company circumstances. Shorter plans may increase the possibility of the insider being prevented from adopting a subsequent plan in a timely manner given possession of MNPI.

7. Review any tax implications with trusted tax advisors. Given the complexity of equity compensation, we recommend that insiders work closely with tax professionals to optimize the tax implications related to any liquidity or option-exercise strategy. In terms of putting together the plan, there are a variety of common selling strategies to consider, which the plan may incorporate or combine, tailored to an executive’s needs and goals:

• Periodic selling, in which sales have date-based triggers (Example: Sell 5,000 shares on the first of each month)

 

• Limit orders, in which sales are made at or above a specified price (Example: Sell 10,000 shares at $45)

 

• “Accelerated selling”, in which multiple limit orders are used together with increasing amounts of stock at each limit price (example: Sell 5,000 shares at $20; then sell 10,000 shares at $30)

 

• Quantity limits, in which insiders specify the number of shares that can be sold in a designated period (Example: Sell no more than 50,000 shares in a calendar month or target 10% of daily volume)

 

Below, we present a quick case study that compares different trading strategies, with the intention to showcase each one’s advantages and disadvantages. In this case study, our hypothetical client has 500,000 shares in her company and wishes to sell 120,000 shares over a one-year period to help generate liquidity for upcoming expenses.

Recent SEC Amendments to Rule 10b5-1

Although 10b5-1 trading plans offer many benefits, the SEC recently amended the Rule to include additional requirements. Since its adoption in 2000, many commentators have alleged that insiders have abused it—by adopting a plan without any “cooling-off” period, for example. The amendments, partially in response to those allegations, extend to the following:

• Mandatory cooling-off period. Plans must now honor a mandatory cooling-off period, measured from a plan’s execution to the potential start of any trades. A cooling-off period is required for all purchase / sale plans, except for the issuer's own plans. Non-Section 16 officers and directors are subject to a 30-day cooling-off period. For Section 16 officers and directors, the potential start of any trades is determined as the later of a) 90 days after plan adoption or b) two business days following the fi ling of the 10-K/Q or 20-F/6-K for the fiscal quarter of adoption. The cooling-off period is subject to a 120-day maximum, regardless of timing of financial results.

 

• Single trade-plan restriction. Insiders may only adopt one, single trade plan in any 12-month period, with certain exceptions.

 

• Insiders must act in good faith with respect to the plan and no MNPI certification. Section 16 directors and officers must certify in writing that they are not aware of MNPI and are adopting the plan in good faith.

 

• No overlapping sales plans. The amendments restrict the use of multiple, overlapping trading plans.

 

• Disclosure requirements. The amendment includes expanded issuer disclosure requirements, mandating a) quarterly disclosures of whether any director or officer has adopted or terminated a plan and b) a description of the terms of each plan. Material terms include name and title, adoption/termination date, duration and the amount of securities to be sold or purchased. Importantly, issuers are not required to disclose sale or purchase prices.

 

• In addition, any modifications to amount, price or timing of purchases/sales will be treated as a termination and an adoption of a new plan, subject to the applicable cooling off period. Although these requirements may appear daunting at first, 10b5-1 plans remain useful for most corporate executives and other insiders.

 

Not all insiders may benefit from 10b5-1 plans, however. There are also considerations relating to 10b5-1 plans beyond those requirements of the rule itself. For example, insiders should consider company trading policies applicable to 10b5-1 plans as these policies often impose additional requirements on these plans (e.g., company approval of adoptions and terminations, no-sale periods around earnings). In addition, issuers are now required to disclose in public annual 10-K and quarterly 10-Q reports with the SEC when Section 16 directors and officers have adopted a plan, and the material terms of the plan (excluding pricing), as well as plan terminations. Lastly, employees who typically do not encounter MNPI or are not subject to corporate window policies may not require a 10b5-1 plan.

Conclusion

Corporate executives and other insiders may consider using 10b5-1 plans to reach their diversification goals. Tailoring an optimal strategy will depend on the client’s specific circumstances, needs and preferences. Please reach out to your Morgan Stanley Financial Advisor or our 10b5-1 team to see how we can help sort through the details.