SEC charges executives with insider trading—10b5-1 plan provided no defense

Cydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes Insider Trading via the Corporation (discussed on the Forum here) by Jesse M. Fried.

It may look like just another run-of-the-mill insider trading case, but there’s one difference in this settled SEC Enforcement action: according to the SEC, it involved sales under a purported 10b5-1 trading plan while in possession of material nonpublic information. As you probably know, to be effective in insulating an insider from potential insider trading liability, the 10b5-1 plan must be established when the insider is acting in good faith and not aware of MNPI. Creating the plan when the insider has just learned of MNPI, as alleged in this Order, well, kinda defeats the whole purpose of the rule. That’s not how it’s supposed to work, and the two executives involved here—the CEO and President/CTO of Cheetah Mobile—found that out the hard way, with civil penalties of $556,580 and $200,254. The company’s CEO was also charged with playing a role in the company’s misleading statements and disclosure failures surrounding a material negative revenue trend. According to the Chief of the SEC Enforcement Division’s Market Abuse Unit in this press release, “[w]hile trading pursuant to 10b5-1 plans can shield employees from insider trading liability under certain circumstances, these executives’ plan did not comply with the securities laws because they were in possession of material nonpublic information when they entered into it.”

Background. Corporate executives, directors and other insiders are constantly exposed to material non-public information, making it sometimes difficult for them to sell company shares without the risk of insider trading, or at least claims of insider trading. To address this issue, in 2000, Congress developed the Rule 10b5-1 affirmative defense. In general, Rule 10b5-1 allows a person, when acting in good faith and not aware of MNPI, to establish a formal trading contract, instruction or plan that specifies pre-established dates or formulas or other mechanisms—that are not subject to the person’s further influence—for determining when the person can sell shares, without the risk of insider trading. According to the SEC, people are “aware” of MNPI “if they know, consciously avoid knowing, or are reckless in not knowing that the information is material and nonpublic.” To be effective, the contract, instruction or plan must also conform to the specific requirements set forth in the Rule. In effect, the Rule provides an affirmative defense designed to demonstrate that a purchase or sale was not made “on the basis of” MNPI. If a 10b5-1 contract, instruction or plan is properly established, the issue is not whether the person had MNPI at the time of the purchase or sale of the security; rather, that analysis is performed at the time the instruction, contract or plan is established.

The wide berth the Rule gives executives to conduct transactions under these plans, together with the absence of public information requirements, has long fueled controversy about Rule 10b5-1 plans, and there have been many allegations and suspicions of 10b5-1 plan misconduct raised in the press (see this PubCo post), in Congress (see this PubCo post) and in academia (see this PubCo post), going back over 15 years. Initially, academic studies uncovered a statistical link between the timing of executive sales under Rule 10b5-1 plans and negative corporate news, finding that executives using 10b5-1 plans generated significantly better returns than other executives at the same company. SEC Enforcement took note, signaling that sales under 10b5-1 plans would then be under scrutiny. As reported in the Washington Post, in remarks delivered in 2007, then-SEC Enforcement Chief Linda Thomsen expressed concern that “executives are taking advantage of a legal safe harbor to sell their stock and profit before their companies report bad news….[A]cademic studies suggest that the rule may be a cover for improper activity, Thomsen said. ‘We’re looking at this hard….If executives are in fact trading on inside information and using a plan for cover, they should expect the ‘safe harbor’ to provide no defense.’” (See this Cooley News Brief.) Several years later, a study conducted by the WSJ seemed to indicate fortuitous results from trading by insiders under 10b5-1 plans that appeared to be the result of more than serendipity. The article identified a number of problems with 10b5-1 plans, including the absence of public disclosure about the plan or changes to it and the absence of rules about how long the plans must be in place before trading under the plans can begin. (See this Cooley News Brief.) These have become familiar themes. Recommendations for addressing potential problems with 10b5-1 plans were also the subject of a rulemaking petition from the Council of Institutional Investors in 2013 (see this Cooley News Brief), unsuccessful Congressional efforts in 2019 and 2021 (see this PubCo post and this PubCo post), as well as recommendations from the SEC Investor Advisory Committee just last year (see this PubCo post). Still, even though 10b5-1 plans are widely suspect, there haven’t exactly been a raft of successful insider trading cases that involve misconduct under 10b5-1 plans.

In 2021, the SEC issued a new proposal designed to address these concerns by adding conditions to the availability of the Rule 10b5-1 affirmative defense that would, according to the press release, fill “critical gaps in the SEC’s insider trading regime,” and by enhancing disclosure requirements “to help shareholders understand when and how insiders are trading in securities” when “they may at times have material nonpublic information.” The conditions included, among other things, cooling-off periods, certifications, prohibitions on overlapping plans and a limitation on single-trade plans. (See this PubCo post.)

The Order. According to the Order, Cheetah Mobile, a mobile communications foreign private issuer based in China, was primarily focused on “developing mobile and computer applications, mobile games, and other content-driven products,” but it earned up to one-third of its total revenues from third-party ads placed by an advertising division of a major social media platform. In the summer of 2015, Cheetah Mobile was advised by its advertising partner of a prospective change to its algorithm that, absent improvements to Cheetah Mobile’s ad placement quality, would likely cut in half the revenues paid to the company by this advertising partner. Efforts to ameliorate the situation provided only a temporary fix, so that, by the end of 2015, it became apparent that advertising revenues would fall. And that’s what happened. Revenues from the advertising partner fell from $52.1 million in Q3 2015 to approximately $46.4 million in Q4 2015, declining further in Q1 2016 by about 30% to approximately $32.7 million.

On a March 2016 analyst conference call, Cheetah Mobile provided earnings guidance for Q1 2016 that reflected an expected sequential-quarter decline in overall revenues. Although, in explaining the decline, the CEO “referenced declines in certain partner revenues,” the SEC alleged that he emphasized primarily “seasonality.” For example, the SEC quotes the CEO as saying during the call, “‘I think the softness that you may see in the first quarter guidance which indicated sequential decline for the first time is mainly due to not only seasonality but also some declines in one of our largest third party advertising platform partners, where we see significant sequential moderations in sales there. We don’t see any structural changes in overall markets or any competitive landscape.’ [The CEO] further noted that “if you look at some of the softness in first quarter in our guidance, I think as we mentioned before … some of the greater than expected seasonality or softness coming from one of our largest … platform partners.’” The SEC charged that the CEO’s statements were materially misleading because he “did not disclose that the algorithm change had created a negative trend in revenues from the Advertising Partner, and that this trend was persistent, and not seasonal in nature.” Likewise, the SEC alleged that the company did not disclose that information about the known negative revenue trend in its Form 20-F. When the company’s Q1 results were ultimately announced in May, the company also disclosed lower-than-expected second-quarter guidance, which it attributed to, among other things, a “decline in [a measure of advertising revenues] from some of our third-party advertising platform partners.” Following these May disclosures, the price of the company’s ADS fell by approximately 18%.

At the end of March 2016, the CEO and the CTO/President, both of whom were aware of the negative revenue trend, established a joint plan, which purported to be a 10b5-1 plan, that provided advance directives for the sale of Cheetah Mobile securities. According to the SEC, the company’s insider trading policy, “prohibited employees from trading in Company securities and from establishing 10b5-1 trading plans while in possession of material nonpublic information.” In addition, the SEC charged that, as officers of Cheetah Mobile, the CEO and CTO “owed Cheetah Mobile and its shareholders a duty to refrain from using the Company’s confidential information for their own personal gain.” Prior to the May announcement, the CEO and CTO sold 96,000 Cheetah Mobile ADS under the plan, avoiding losses of an aggregate of $303,417.

The SEC charged that the CEO and CTO “knew or recklessly disregarded” that the information about the revenue decline “was material and nonpublic,” were aware of this MNPI when they created the purported 10b5-1 plan and knew that the plan did not comport with the requirements of Rule 10b5-1. The SEC also charged that they “knew or recklessly disregarded that, by selling Cheetah Mobile securities in advance of the disclosure of this material nonpublic information to investors, they each breached the duty of trust and confidence they owed to Cheetah Mobile and its shareholders.”

The CEO and CTO were both charged with violation of Section 10(b) of the Exchange Act and related Rule 10b-5, which prohibit fraudulent conduct in connection with the purchase or sale of securities. The CEO was also charged with violation of Sections 17(a)(2) and (3) of the Securities Act, and as a cause of Cheetah Mobile’s violations of Section 13(a) of the Exchange Act and related Rule 13a-1 and Rule 12b-20. The CEO was ordered to pay a civil penalty of $556,580 and the CTO of $200,254. Both were also subject to extensive five-year undertakings, primarily in connection with their securities trading and 10b5-1 activity.

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