We blogged last summer about Securities and Exchange Commission (SEC) Chair Gary Gensler’s desire to seek amendments to the 10b5-1 rules for insider stock sales, and at the end of last year the SEC adopted proposed regulations to enact the changes Gensler described. This proposal adds new conditions to Rule 10b5-1(c), which provides affirmative defense to insider trading for parties that frequently have access to material nonpublic information, including corporate officers, directors and issuers. It also includes a new regime for disclosure of option grant practices, with a required tabular disclosure when grants are made within 14 days before or after the public disclosure of material nonpublic information by companies.
We believe that this proposal will lead to healthy board-level discussions about how individual 10b5-1 programs should be structured and how plan operations would need to be disclosed in company filings. These plans are tailored to individual needs; however, the company usually selects the vendor to administer plan operations, thereby providing de facto approval of how the plans operate.
A more immediate action step would be to consider the timing of option grants for the 2022 grant cycle (particularly for calendar-year companies), as the added tabular disclosures likely will be required for 2023 proxies, which disclose compensation actions taken during 2022. More on each element of the proposal follows.
Gensler’s speech focused on four areas the SEC was considering beefed-up requirements that must be met so corporate insiders (officers and directors) can assert an affirmative defense to insider trading liability where trades are made by another person subject to a binding written agreement entered into when the trader was not aware of material nonpublic information:
Finally, the SEC also would require insiders to certify in writing both of the following when they adopt or modify a Rule 10b5-1 plan:
The certifications are not filed with the SEC but would need to be retained for 10 years. The proposed regulations contain many more details on precisely when the affirmative defense can be invoked and how the disclosure requirements would be met, all of which should be reviewed with counsel prior to plan implementation.
Companies would be required to disclose policies and practices on the timing of awards of options and stock appreciation rights (SARs) in relation to the disclosure of material nonpublic information.
This part of the proposal came a bit from left field, as none of the current SEC commissioners had suggested in public statements that opportunistic stock option grants, either through accelerating the announcement of bad news before a grant (‘bullet-dodging”) or delaying good news until after a grant (“spring-loading”), were issues of concern. Before this proposal, there were no explicit immediate disclosure requirements when these types of grants are made, although that information could be pieced together from annual report and proxy statement issuances, as reflected in data gathered in numerous academic studies cited by the SEC in its preamble to the new rule.
However, an inkling of this issue’s importance came in November 2021 when the SEC staff issued Staff Accounting Bulletin (SAB) No. 120 instructing companies to properly account for non-routine spring-loaded stock option awards made before announcing market-moving information, such as earnings releases with better-than-expected results, or the disclosure of a significant business transaction. In that SAB, the SEC staff informed companies that when measuring the grant date value of these option grants for accounting purposes, the valuation must account for the impact that the disclosure of material nonpublic information will have on share value upon its release. Although the guidance did not provide an example, we read this as meaning that options with a grant date fair value of $2 (based on an $8 trading price), for example, must consider the impact on that value if the market price then increased to $12 after the release. Perhaps instead, the proper ASC 718 expense for those option grants would be higher than $2 and closer to (or just at) $3.
The proposal expands the information all companies would need to disclose, not just those companies required to add a footnote to their ASC 718 expense disclosures referenced in the above example. The proposal would require all public companies, under new section 402(x), to include a description in their 10-K annual reports of their option/SAR grant policies and practices, how they determine the timing of grants (predetermined dates during the year or not), and the influence of material nonpublic information in their compensation committees’ grant timing and grant valuations. This discussion would also be included in the company’s compensation discussion and analysis, so that shareholders can understand company option grant timing practices when considering say-on-pay votes, when approving executive compensation plans and when electing directors. We expect that these will become garden-variety discussions that all companies will be required to include, unless special circumstances exist.
For companies that make grants to named executive officers within 14 days before or after the release of material nonpublic information on quarterly reports or 8-Ks, the SEC would require additional disclosures so that shareholders understand with complete transparency how the process works. The SEC believes that many companies, after the end of a completed fiscal quarter or annual period, hold meetings with their boards of directors a week or two before issuing the earnings release when they are likely aware of material nonpublic information that could affect the stock price of the company. Rather than propose a facts and circumstances test, the SEC proposed a black letter rule that would mandate disclosure within this time frame.
This tabular disclosure would be required for companies that make awards within 14 calendar days before or after the filing of a periodic report on Form 10-Q or Form 10-K, an issuer share repurchase, or the filing or furnishing of a current report on Form 8-K that discloses material nonpublic information (including earnings information).
Instructions are provided as to how these columns must be populated, with rules substantially similar to those in the current proxy disclosure rules. All public companies must abide by the option disclosure rules, including smaller reporting companies.
We noted earlier that the new disclosure rules regarding option grant practices are likely to be required for the 2023 proxy, so that grants made during early 2022 potentially will trigger the 402(x) tabular disclosure if made within 14 days before or after the disclosure of material nonpublic information. We agree with the SEC that this disclosure will provide additional transparency for shareholders but note that the importance of the information disclosed will increase as share prices change from the grant date to the release of material nonpublic information, and vice versa.
It appears the SEC wants to discourage companies from making option grants during these windows, and it may make sense for companies to think hard about making grants within the 14 days before earnings or other announcements due to the uncertainty of share price volatility. As for grants made after earnings are announced, companies will have the actual share price movements in hand when determining if grants should be made within 14 days after bad news is disclosed.
The new disclosure requirements warrant immediate focus and attention. It is very possible that these rules will be finalized sometime during 2022, and therefore disclosures could be required on the 2023 proxy. As noted, the importance of these grants being made within this window will matter more to shareholders and proxy advisory firms based on where share price has moved, so having to make this disclosure may not be a big deal in some cases. On the other hand, companies should consider if they want to take any risks in making these grants during 2022 if they become reportable. Time is short for companies that would trigger this disclosure to change their practices, but it is worth considering if grant timing can be changed in 2022.
The 10b5-1 issues are largely ministerial in that most companies already have in place an insider trading policy they already disclose. If the regulations are finalized during 2022, it is likely that the SEC will allow companies and insiders some ramp-up time before they must comply with the new restrictions. It would certainly be worthwhile for companies to consult with their stock plan administrators to determine what actions need be taken to meet the new rules. The question of whether it makes sense to adopt the new requirements before they are finalized becomes a legal question that SEC counsel can help determine. If the answer is no, then there is time to get ready for those changes.
