•  President and principal executive officer;
• Principal financial officer;
• Principal accounting officer or, if none, the controller;
• Any vice president in charge of a principal business unit, division or function (such as sales, administration or finance); and
• Any other officer who performs a policy-making function, or any other person who performs similar policy-making functions for the company, including officers of the company’s parent or subsidiaries.

More Than 10% Beneficial Shareholders. In addition to directors and officers, persons, including entities, who beneficially own more than 10% of a class of a company’s registered securities are subject to Section 16(a) reporting obligations. In determining who is a more than 10% holder, Section 16(a) uses the concept of beneficial ownership rather than legal or record ownership. A person’s voting or investment power over a security is a key factor in determining beneficial ownership. For example, a person with sole or shared voting or investment power over securities will usually beneficially own the securities for Section 16(a) 10% ownership purposes. This is the same test used for determining 5% beneficial ownership for purposes of Schedules 13D and 13G.

What Is the Scope of Section 16?

Equity Securities. Section 16 applies only to equity securities of the company, including the right to acquire equity securities. It does not apply to non-equity securities, such as pure debt securities.

What Do Section 16(a) Insiders Report?

Beneficially Owned Shares. For Section 16(a) insiders, the SEC uses a second beneficial ownership test to determine which holdings and transactions the insider must report. Beneficial ownership for purposes of reporting holdings and transactions to the SEC (and for short-swing profit liability) is based on the insider’s direct or indirect pecuniary interest in the securities. This test is based on an insider’s ability to profit from purchases or sales of securities.

Shares Held by Household Members. An insider is considered to have indirect beneficial ownership of securities held by members of the insider’s immediate family sharing the same household. These immediate family household members include grandparents, grandchildren, siblings and in-laws, as well as the insider’s spouse, children and parents.

Trust Shares. An insider is considered a beneficial owner of shares in a trust for Section 16 purposes if the insider has or shares investment control over the trust securities and the insider is a:

• Trustee, and either the trustee/insider or a member of the trustee/insider’s immediate family (whether or not they share the same household) has a pecuniary interest in the trust securities;
• Beneficiary; or
• Settlor, and the settlor/insider has the power to revoke the power to revoke the trust.

Partnership or Corporation Shares. An insider who has control or a controlling influence over a partnership or corporation will generally have beneficial ownership of the securities held by that partnership or corporation.

Derivative Securities. Section 16(a) applies not only to a company’s common stock but also to derivative securities. Derivative securities include stock options, stock appreciation rights, warrants, convertible securities or similar rights with an exercise or conversion privilege at a price related to an equity security. Derivative securities also include third-party contracts: puts, calls, options or other rights to acquire the company’s securities that an insider enters into with a person other than the company.

How Does an Insider Report Beneficial Ownership?

Initial Report – Form 3. Upon becoming an insider, an insider initially files a Form 3 with the SEC listing all the insider’s holdings of the company’s securities, including derivative securities such as stock options. The insider must file a Form 3 within ten calendar days of the triggering event, for example, within ten days after becoming an officer, director or more than 10% shareholder of a public company. The insider must file a Form 3 even if the insider does not beneficially own any securities of the company at the time of the filing. Insiders of a newly public company file a Form 3 on the date the company becomes a reporting company under the 1934 Act.

Current Report – Form 4. Generally, any change in an insider’s beneficial ownership of the company’s securities is reported on a Form 4. Insiders usually must file a Form 4 within two business days after a change in beneficial ownership. This two-day reporting period begins when a transaction is executed, not when it settles.

The Form 4 two-day filing deadline also applies to any transaction between an insider and the company, including transactions that are exempt from short-swing profit recovery under Rule 16b-3 under the 1934 Act, such as the grant, exercise or conversion of stock options or other derivative securities or the withholding of shares for tax purposes (such as upon vesting of restricted stock units).

Three transactions are exempt from the two-day filing deadline:

• Gifts;
• Inheritances; and
• Small acquisitions other than from the company that do not exceed in the aggregate $10,000 in market value within a six-month period, provided the insider makes no nonexempt dispositions during the six months thereafter.

The insider must report these transactions at the end of the company’s fiscal year on a Form 5 annual report if they were not voluntarily reported earlier on a Form 4.

Insiders are not required to report on Form 4 or 5 transactions that effect only a mere change in the form of the insider’s beneficial ownership of securities without changing the insider’s pecuniary interest in the securities. For example, a distribution to the insider of securities previously beneficially owned by the insider through an employee benefit plan merely changes the form of the insider’s beneficial ownership (from indirect to direct) and is exempt from Forms 4 and 5 reporting requirements. Likewise, a pro rata distribution of securities from a general partnership to its general partners is a mere change in the form of ownership and exempt from Forms 4 and 5 reporting requirements. This change in form exemption does not apply to:

• The conversion or exercise of a derivative security (this is reported on a Form 4); or
• A transfer of securities to a person whose holdings are attributed to the insider, such as a gift to a minor child or a transfer to a family trust (this is reported on a Form 5 or earlier on a voluntarily filed Form 4).

Even though a mere change in the form of an insider’s beneficial ownership does not in itself trigger a Form 4 or 5 reporting obligation, the insider must reflect the resulting changed ownership in the total direct and indirect beneficial ownership column on the next Form 4 or 5 the insider files.

Acquisitions of company securities in ongoing, tax-conditioned employee benefit plans (e.g., broad-based employee stock purchase plans or 401(k) plans) generally are also exempt from Section 16(a) reporting obligations. But the insider needs to reflect the changes to her current holdings as a result of those acquisitions in the total beneficial ownership column on all subsequent Forms 4 and 5. By contrast, dispositions of securities acquired under employee benefit plans must be reported on Form 4. Transfers into and out of company stock funds in employee benefit plans generally must be reported on Form 4 but, in specific circumstances, the insider may be provided additional time to report.

Annual Report – Form 5. Insiders must file any required Form 5 within 45 calendar days after the end of the company’s fiscal year. Any person who was an insider at any time during the fiscal year must file a Form 5 unless the insider had no reportable transactions during the year or had already filed one or more Forms 4 during the year covering all transactions required to be reported on a Form 4 or 5. A Form 5 must include all reportable transactions that were exempt from Form 4 reporting requirements and not reported earlier and all holdings or transactions that should have been reported on Form 3 or 4 during the fiscal year but were not.

Consequences of Late Filing: Embarrassment, Publicity and Fines

Civil Penalties. Failure to timely file a Form 3, 4 or 5 can result in substantial penalties to the insider. The SEC can seek fines in judicial enforcement actions of up to $9,753 for each violation by an individual and up to $97,523 for each violation by a corporation or other entity. If the violation includes fraud, deceit or deliberate disregard of a regulatory requirement, the fine can be as much as $195,047 for an individual and $975,230 for a corporation. (These amounts are subject to adjustment for inflation.) The SEC can also issue cease-and-desist orders in administrative proceedings against future violations. Failure to file reports also prevents the two-year statute of limitations from running on suits against insiders to recover any profits due to the company under the short-swing profit rules in Section 16(b).

SEC Enforcement. Aided by sophisticated computer algorithms and quantitative data sources, the SEC has made clear that it has the tools and the intention to vigorously investigate and enforce Section 16 reporting violations. In a major enforcement initiative in 2014 specifically targeting Section 16 reporting violations, the SEC recovered significant monetary penalties from individual insiders and companies. More recently the SEC has focused enforcement attention on cases in which an insider committed other, more serious violations of the federal securities laws, but could initiate another sweep based solely on Section 16(a) violations at any time. A company’s agreement to make filings on behalf of insiders is not a valid defense against individual director and officer liability since insiders bear the ultimate responsibility for Section 16 filings.

Proxy Statement Disclosure. A public company must disclose by name in its proxy statement any insiders who reported transactions late or failed to file required reports during the fiscal year. In 2019 the SEC adopted amendments changing the caption for proxy statement disclosure from “Section 16(a) Beneficial Ownership Compliance” to “Delinquent Section 16(a) Reports” and encouraged companies to exclude this disclosure and heading if there are no delinquencies to disclose. At the same time, the SEC eliminated the requirement that a company note by checkbox on the cover of its Form 10-K if there is proxy statement disclosure of late Section 16 reports.

Mandatory Electronic Filing and Website Posting of Beneficial Ownership Reports

Electronic Filing. Insiders must file Section 16 reports electronically. The reports are due by 10 p.m. Eastern time on the filing deadline. Although insiders can file reports directly through the SEC’s online filing system (located at www.onlineforms.edgarfiling.sec.gov), it is far more common for companies or third-party service providers to submit Section 16 reports on behalf of insiders, although the insiders remain legally responsible for their individual electronic filing obligations.

Electronic Signatures. Effective December 4, 2020, insiders can elect to sign Section 16 reports electronically by using existing platforms such as DocuSign and Adobe Sign. Previously, people who filed Section 16(a) reports for insiders were required to have in hand a manually signed paper copy with ink signature before submitting the filing. Before utilizing the electronic signature process, the filer must manually sign an attestation agreeing that the filer’s electronic signature will constitute the legal equivalent of a manual signature. The attestation must be furnished to the SEC on request and retained by the company for at least seven years from the date it was last used in connection with an electronically signed filing. 

Website Posting. Section 16 rules mandate that companies post on their corporate websites all Forms 3, 4 and 5 filed by their insiders and 10% beneficial owners by the end of the business day after the date of filing. Companies must keep the reports posted for at least 12 months. Although companies may post the reports directly, most post by linking to third-party service providers or to the EDGAR database. The link must be directly to the forms or a list of the forms, and the link caption must clearly indicate access to insider Section 16 reports.

Section 16(b) – Short-Swing Profit Liability

Section 16(b) of the 1934 Act imposes liability on insiders for profits realized on short-swing trades, that is, for any profits an insider receives from the purchase and sale (or sale and purchase) of registered securities of the company within a period of less than six months in nonexempt transactions. In other words, the insider must be sure that no “matchable” transactions occurred in the six months prior to the planned nonexempt transaction and must avoid any matchable transactions in the following six months. The insider is liable for profits realized in either cash or noncash form (such as securities). Under Section 16(b), the company or a shareholder acting on behalf of the company may bring an action against the insider for disgorgement of the realized profits. Section 16(b) applies to all Section 16(a) insiders (i.e., directors, executive officers and more than 10% beneficial shareholders).

The test for Section 16(b) liability is purely objective: an insider who purchases and sells (or sells and purchases) registered securities in nonexempt transactions within a period of less than six months is liable for the profits received as a result of the transactions. It does not matter whether the insider was aware of confidential information, whether the confidential information was material, whether the insider relied on the information in making the transaction or whether the insider acted in good faith. 

Transactions Exempt from Section 16(b) Liability

Transactions Between the Company and Its Officers or Directors. Transactions between the company and its officers or directors may be exempt from Section 16(b) short-swing liability. For example, a grant of stock options to a director or officer will not be treated as a purchase under Rule 16b-3 if the company’s Board, a committee of nonemployee directors or the shareholders approve the grant or if the director or officer holds the stock options or shares acquired upon exercise of the stock options for at least six months from the stock option grant date. The exercise by the director or officer of the stock options will also be exempt. Similarly, a sale or disposition of securities by the director or officer back to the company generally will not be treated as a sale for purposes of Section 16(b) if the Board or a committee of nonemployee directors pre-approves the sale or disposition.

Stock Options and Other Derivative Securities: Purchase Occurs at Time of Grant. Shares subject to stock options and other types of derivative securities are deemed to be purchased for Section 16(b) purposes upon the grant of the stock option or other acquisition of the derivative security rather than upon exercise or conversion. This is because a derivative security is treated as the functional equivalent of the underlying security into which it can be exercised or converted. For example, the grant of an option to purchase common stock is treated as the functional equivalent of the insider’s purchase of the common stock. The exercise, conversion or vesting of a derivative security is generally exempt from Section 16(b) liability.

Although exempt from Section 16(b) liability, insiders must report separately the grant and the exercise or conversion of an option or other derivative security on Form 4 within two business days after each transaction.

Calculating Profit Realized in a Short-Swing Transaction

When applying Section 16(b) to a single purchase and single sale of securities within a six-month period, the profit calculation is straightforward: the aggregate purchase price of the securities is subtracted from the aggregate sale price.

For multiple sales and purchases within a six-month period, the profit realized is calculated under the lowest-in, highest-out method. The following example illustrates the application of the rule:

Assume that Director Bertrand Brass purchases 100 shares of his company’s common stock in January for $40 a share, purchases an additional 100 shares in February for $45 a share, sells 100 shares in March for $60 a share, purchases 100 shares in April for $50 a share, sells 100 shares in May for $55 a share and sells 100 shares in June for $80 a share. Under the lowest-in, highest-out approach, the January purchase ($40 per share) would be matched with the June sale ($80 per share), the February purchase ($45 per share) would be matched with the March sale ($60 per share) and the April purchase ($50 per share) would be matched with the May sale ($55 per share). Mr. Brass would be liable for $6,000 in realized profits.

Initial Schedule 13G Report

Within 45 days following the end of the calendar year in which a company completes its IPO, every person (including directors and officers) that beneficially owned more than 5% of the company’s stock at the time of the IPO and as of the last day of the calendar year must report that ownership to the SEC on a short-form Schedule 13G. The term person includes entities. These initial 5% shareholders are referred to as exempt shareholders because their shares were acquired prior to the company’s IPO.

Schedule 13D or 13G Filings Once the Company Is Public

After a company is public, any exempt shareholder who acquires more than 2% of the company’s stock in a 12-month period, or any other shareholder who acquires more than 5% of the company’s stock (following its IPO), may be required to file a Schedule 13D, which is more lengthy than Schedule 13G. Shareholders who are passive investors can initially file or continue to file reports on Schedule 13G, avoiding the more burdensome Schedule 13D. A passive investor is a shareholder who beneficially owns less than 20% of the company’s stock, provided the investor did not acquire the securities for the purpose, or with the effect, of changing or influencing control of the company. A person in a control position – such as a director or executive officer – does not qualify as a passive investor.

In general, an investor must amend Schedule 13G annually to report any changes in the information previously reported, including any change in beneficial ownership. Whenever a passive investor acquires more than 10% of the company’s stock, the investor must amend the Schedule 13G “promptly” after the date of the acquisition. From then on, the passive investor must file an amended Schedule 13G promptly after the date on which its beneficial ownership increases or decreases by more than 5%, until the passive investor has reported beneficial ownership below 10% again. A nonpassive investor must amend its more detailed Schedule 13D promptly to report any material change in the information previously reported, which includes any change of 1% or more in its beneficial ownership.

A passive investor loses Schedule 13G eligibility – and must file a Schedule 13D – if the investor acquires 20% or more of a class of securities or no longer holds the shares with no purpose, or effect, of changing or influencing control of the company. In either case, the investor must file a Schedule 13D within ten days of the acquisition or change in passive investor status. In addition, the investor may not vote its shares or acquire more shares during the period that begins at the time of the acquisition of 20% or more of the company’s shares or loss of passive investor status and ends ten days after the investor files Schedule 13D.

Individuals and entities who fail to file timely and accurate Schedules 13D and 13G can be subject to significant monetary penalties and cease-and-desist orders. The SEC’s enforcement initiative targeting Section 16 beneficial ownership reporting violations (discussed above in the section on Section 16 reporting) has also been directed against Schedule 13D and 13G filers.

Although brokerage firms generally play the primary role in assisting their clients with Rule 144 compliance, as a best practice companies should educate insiders who are subject to Rule 144 regarding the applicable resale limitations and assist with Rule 144 compliance. (See our Practical Tip later in this chapter, which includes our suggestions for compliance with Rule 144.)

Securities Subject to Rule 144

Rule 144 covers two types of securities: restricted securities and control securities.

• Restricted securities result from a purchase directly from the issuer or an affiliate of the issuer in a private offering exempt from Restricted securities typically bear a restrictive notation or legend that states that the securities are not registered and can only be offered or sold in an offering registered with the SEC or under an exemption from registration.

• Control securities are securities owned by any person who directly or indirectly may exercise control over the issuer, either alone or as a member of a control Control securities may be acquired in any manner, including on the open market, from the company through a public offering or upon the exercise of a stock option or vesting of restricted stock units (RSUs). The SEC uses the term affiliate to describe such a control person.

Who Are Affiliates?

Under Rule 144, a company’s affiliates generally include its directors, executive officers and significant shareholders that can influence the company either individually or in concert with others, as well as:

• The spouse or any relative of the affiliate who lives in the same household as the affiliate;
• Certain trusts or estates for which the affiliate (or a member of the affiliate’s family sharing the same household) serves as a trustee, executor or 10% beneficiary;
• Certain corporations, partnerships or other entities in which the affiliate or the affiliate’s family owns a 10% interest; and
• Affiliates of companies acquired in transactions regulated by Rule 145 under the 1934 Act – even if they do not become affiliates of the acquiring company

Determining which persons may be affiliates for purposes of Rule 144 requires a fact-specific inquiry. 

Rule 144 Requirements

General requirements:

• Current Public Information. Requires that adequate public information be available concerning the issuer of the To satisfy this requirement, a company that has been a reporting company for at least 90 days before the date of sale must have filed all SEC-required reports during the 12 months immediately preceding the proposed sale (or such shorter period in which it was required to file), other than current reports on Form 8-K. In addition, the company must have filed electronically and posted on its website, if any, all interactive data files it was required to submit and post during the 12 months immediately preceding the sale (or such shorter period in which it was required to file and post the files). (We discuss interactive data files in Chapter 4.)
• Holding Period for Restricted Securities. A person who acquires restricted securities of a reporting company must hold the restricted securities for at least six In some situations the holder may measure this holding period starting from the date the previous holder acquired the securities (e.g., if the restricted securities are acquired as a gift). The holding period does not begin until the seller has fully paid the purchase price for the securities. For example, if the stock was purchased with a promissory note, the purchase price would not be considered fully paid unless the note is full recourse and secured by collateral, other than the stock, having at least equal value to the shares (and the note must also be paid in full before the stock may be sold). Control securities that are not restricted securities have no holding period.

Three additional requirements of Rule 144 apply only to affiliates:

• Volume Limitations. During any three-month period affiliates may only sell up to a number of shares equal to the greater of 1% of the outstanding securities of the class or the average weekly reported trading volume for the previous four calendar (For most insiders, this limitation does not limit sales.) An alternate volume limitation exists for debt securities, which limits the sale of debt securities to 10% of the outstanding tranche (or class).
• Manner of Sale. Affiliates must sell shares only in unsolicited broker transactions, transactions directly with a market maker or in riskless principal transactions. A riskless principal transaction occurs where, after having received an order to buy (or sell), a broker or dealer buys (or sells) the security as principal in the market to satisfy the order to buy (or sell). The seller may not solicit or arrange for the solicitation of orders to buy the stock or make any payment in connection with the sale of the stock to any person other than ordinary commissions payable to the broker who executes the order to sell the stock. In a broker transaction, the broker must do no more than execute the order to sell the stock and receive no more than the usual and customary broker The broker must neither solicit nor arrange for the solicitation of customers’ orders to buy the stock. (Most national brokerage firms have a Rule 144 sales unit that ensures compliance with this manner-of-sale requirement.) The manner-of-sale restriction does not apply to debt securities.
• Notice of Sale. If an affiliate intends to sell more than 5,000 shares or expects to receive aggregate sale proceeds of over $50,000 in any three-month period, the affiliate must file a Form 144, “Notice of Proposed Sale of Securities,” with the SEC concurrently with either the placing with a broker of an order to execute a sale or the execution directly with a market maker of a sale. The person filing the notice must have a bona fide intention to sell the securities referred to in the notice within a reasonable time after filing the notice. The purpose of the filing is to serve as a nonbinding notice to the public that a significant number of additional shares are likely to enter the market. The Form 144 filing covers sales of the securities referred to in the notice during the three- month period that begins on the filing date. If the seller wishes to sell additional securities, or to sell securities after the end of that three-month period, the seller must file a new Form 144. The seller has the option to submit the Form 144 in paper form by mail to the SEC or electronically on EDGAR or by email. In addition, if the subject securities are traded on any national securities exchange and the seller does not submit the Form 144 on EDGAR, the seller must also mail a copy of the Form 144 to the principal exchange on which such securities are traded.

Although affiliate status generally ceases upon termination of a director’s or officer’s employment or service relationship with a company, brokers may require that a former affiliate continue to sell under Rule 144 until 90 days after the date affiliate status terminates.

Rule 144 and Shell Companies

Generally, sellers may not rely on Rule 144 for the resale of securities initially issued by current or certain former shell companies, other than a business combination–related shell company.

Rule 144 Compliance Chart for Reporting Companies

Penalties

Insider Liability: For Trading. Potential penalties for insider trading violations include imprisonment for up to 20 years, civil fines of up to three times the profit gained or loss avoided by the insider trading and criminal fines of up to $5 million.

Issuer Liability: For Inaction. The company, as well as directors and officers, may be subject to controlling-person liability under federal securities laws. Controlling-person liability may apply if the company or the director or officer knew, or recklessly disregarded, that a person directly or indirectly under the company’s or the responsible person’s control was likely to engage in insider trading and the company or person failed to take appropriate steps to prevent the trading. The penalty for inaction is a civil fine of up to the greater of $2,166,279 (subject to adjustment for inflation) or three times the profit gained or the loss avoided as a result of the insider trading and criminal fines of up to $25 million.

Company Insider Trading Policy

The best way to protect a company and its insiders from potential liability under the insider trading laws is to adopt and enforce a clear policy that defines insider trading and prohibits trading while aware of material nonpublic information. The insider trading policy should apply to all directors, officers, employees and consultants of the company.

Establish Blackout Periods. The insider trading policy should establish trading blackout periods. A trading blackout period is a time period during which the company prohibits Section 16 insiders and other employees and consultants who have access to material nonpublic information about the company from buying and selling the company’s securities. Blackout periods generally begin two to four weeks before the end of the quarter and end after the first or second full business day following the company’s earnings release for that quarter. If a material event occurs (or material information is known) outside a blackout period, the company generally will impose an event-specific blackout period for applicable insiders while the event (or information) remains material and nonpublic.

Require Preclearance. Section 16 insiders and certain other employees and consultants with access to material nonpublic information should be required to notify and seek approval from a company compliance officer for any transactions in company stock by them or their family members at least two business days before the contemplated transaction.

Rule 10b5-1 Trading Plans

Rule 10b5-1 provides an affirmative defense for insiders who sell securities pursuant to a previously established Rule 10b5-1 trading plan, even if the insider is aware of material nonpublic information at the time of the actual trade. (We discuss Rule 10b5-1 trading plans in detail later in this chapter.) A company’s insider trading policy will generally permit an insider to adopt a Rule 10b5-1 trading plan during a period of time outside a blackout period and when the insider is not aware of material nonpublic information, but only if the trading plan is precleared by a compliance officer. The insider trading policy should exclude trades under appropriately established Rule 10b5-1 trading plans from the preclearance policy and blackout periods.

A Regulation BTR blackout period means any period of more than three consecutive business days during which pension plan participants cannot trade in securities held in their individual accounts, but only if this suspension affects at least 50% of the participants in all of the company’s “individual account plans.” A Regulation BTR blackout period does not include:

• Any regularly scheduled trading suspension that the company incorporates into the pension plan’s governing documents and timely discloses to employees before they become participants; or 
• Certain temporary trading suspensions imposed by the pension plan in connection with individuals’ becoming (or ceasing to become) participants in the plan by reason of a corporate merger, acquisition or similar transaction.

A variety of transactions over which directors and executive officers have no control fall outside Regulation BTR. For example, transactions under Rule 10b5-1 trading plans, changes that result from a stock split or dividend and compensatory grants and awards under plans that clearly set out the amount, price and timing of awards or include a formula for determining these items are all exempt.

To satisfy Regulation BTR and notify the directors, executive officers and the public, companies must, within specific time frames:

• Provide their directors and executive officers with a Regulation BTR notice of pension plan blackout periods; and
• File the Regulation BTR notice on Form 8-K.

Rule 10b5-1 begins by clearly stating that anyone trading in a company’s securities while aware of material nonpublic information is engaging in unlawful insider trading. The rule then provides a limited safe harbor (technically, an affirmative defense) that, when closely followed, creates a shield from liability. Rule 10b5-1 allows insiders to adopt, at a time when the insider is not aware of material nonpublic information, a written trading plan that will permit future sales, even when those future sales may occur at times that the insider is aware of material nonpublic information. Rule 10b5-1 trading plans are relatively easy to understand, establish and administer, and court cases have demonstrated the usefulness of properly structured trading plans in defending against charges of insider trading. However, perceived abuses of Rule 10b5-1 trading plans have led to scrutiny in academic studies and by the SEC and the courts. In early 2021 the SEC chair asked the SEC staff to make recommendations to “freshen up” Rule 10b5-1 to incorporate and expand upon best practices.

Benefits to the Company and Its Insiders on Adopting Rule 10b5-1 Trading Plans

In addition to helping establish protection from liability, written Rule 10b5-1 trading plans can:

• Enable insiders to make orderly dispositions of stock for diversification, estate planning or other personal needs and to facilitate stock option exercise and sale programs;
• Reduce the number of times a company faces a decision about whether material nonpublic information exists that requires the company to prohibit trading in its stock by insiders;
• Help market perceptions by bringing transparency and advance disclosure to insiders’ sales of company stock; and
• Protect an insider from the risk of “conduit theory” liability for gifts to charitable organizations or others when the insider knows the donee is likely to sell the gifted securities in the near future.

The Three “Legs” of a Rule 10b5-1 Trading Plan

A successful Rule 10b5-1 trading plan stands on three legs. First, the trading plan must be established when the insider is not aware of material nonpublic information. SEC guidance clarifies that the affirmative defense of a trading plan is not available if an insider establishes the plan while aware of material nonpublic information, even if the plan is structured so that transactions will not begin until after that material information is made public.

Second, the trading plan must be in writing and must:

• Specify the amount (either number of shares or dollar value), price (market price on a particular date, a limit price or a specified dollar price) and dates of the trades (this may be the day on which a market order is to be executed or on which “best execution” begins or on which a limit order is in force); or
• Include a formula, algorithm or computer program for determining the amount, price and dates of the trades to be made; or
• Delegate to another person sole discretion to determine the amount, price and dates of the trades to be made, provided that the person is not aware of material nonpublic information. 

Third, each trade should comply with the trading plan. The insider must not alter or deviate from the trading plan (by changing the amount, price or timing of the trade) or enter into or alter a corresponding or hedging transaction or position with respect to the securities. SEC guidance clarifies that the cancellation of one or more plan transactions represents an alteration of or deviation from the trading plan that may affect the availability of the affirmative defense.

In addition to these three legs, the insider must enter into the trading plan in good faith and not as part of a scheme to evade the prohibitions of Rule 10b5-1. SEC guidance clarifies that in creating a new trading plan after cancelling a prior trading plan, all surrounding facts and circumstances, including the period of time between the cancellation of the old plan and the creation of the new plan, must be evaluated in determining the insider’s good faith intent.

Drafting a Rule 10b5-1 Trading Plan

The legal or compliance department of the insider’s broker usually will take the lead in drafting the insider’s Rule 10b5-1 trading plan. The insider and the company must then closely review and tailor the draft trading plan to ensure that it fits their requirements. The trading plan should first establish the amount, price and dates of the trades, or a method to determine the amount, price and dates. Next, a Rule 10b5-1 trading plan will state explicitly in writing that:

• No Inside Information. When the insider enters into the trading plan, the insider is not aware of material nonpublic information with respect to the company or its securities.
• Waiting Periods. The first transaction under the trading plan will take place only after a waiting period (typically at least 30 days to three months from the date the plan is executed). Similarly, there are typically waiting periods of at least 30 days before trading can be resumed under a modified trading plan and before an insider who has terminated a plan can enter into a new plan. These waiting periods help solidify the insider’s good faith in establishing the trading plan.
• No Hedge. The insider has not entered into or altered a corresponding or hedging transaction with respect to the stock to be traded under the trading plan and agrees not to enter into any of those transactions while the plan is in effect.
• Rule 144. The insider and the broker will take any steps necessary to comply with Rule 144.
• Filings. The insider will be responsible for making all filings, if applicable, under Sections 13(d) and 16 of the 1934 Act, and the broker will supply the insider with all the information necessary for those filings on a timely basis.
• Independent Broker. The insider acknowledges that the insider does not have any authority, influence or control over any actions by the broker and will not attempt to exercise any authority, influence or control, and the broker will not seek advice from the insider with regard to the manner in which the broker acts under the trading plan.
• Purpose. The trading plan will generally set forth a specified purpose, for example, to permit the orderly disposition of a portion of the insider’s holdings or to facilitate the exercise of options and sale of the underlying stock.
• Good Faith. The insider is entering into the trading plan in good faith and not as part of a plan or scheme to evade the provisions of Rule 10b5-1.
• Intent. The trading plan is intended, and will be interpreted, to comply with Rule 10b5-1 and related SEC interpretations.

Review by the Company

A company’s insider trading policy should require insiders to submit Rule 10b5-1 trading plans to the company’s compliance officer for preclearance before adoption. The purpose of preclearance is not for company “approval” of the terms of the trading plan, but to permit the compliance officer to determine that the plan is being adopted outside a trading blackout period and otherwise complies with the company’s insider trading policy. To assist with this review, companies should consider adopting written Rule 10b5-1 guidelines that all insiders must follow in adopting a Rule 10b5-1 trading plan.

Public Disclosure; Filing the Right Forms

If the Rule 10b5-1 trading plan relates to a senior executive and a material number of shares, the company should consider disclosing the establishment of the executive’s trading plan to maximize transparency, preempt market reaction and alleviate shareholder concerns. A company can make the public disclosure through one or some combination of a Form 8-K, Form 10-Q, press release or website posting.

Companies should implement procedures to ensure that insiders timely report Rule 10b5-1 trading plan transactions on Forms 4, 5 and 144 and, as required, on Schedule 13D or 13G. When reporting transactions on Form 144 (initially filed when the first trade under the trading plan is executed or a sell order is placed), the insider must sign the form and indicate in the space provided below the signature line the date on which the insider adopted the trading plan, which actions serve as the insider’s representation that the insider was not aware of material nonpublic information as of the date the plan was adopted (rather than the date the Form 144 was signed). Sales under a trading plan that will occur over a period of more than three months will require multiple filings of Form 144. In the Form 4, filed to report the transaction, insiders should also note that the trade was pursuant to a Rule 10b5-1 trading plan to minimize speculation that the transaction reflected the insider’s current perception of the status of the company.