On September 21, 2022, the Securities & Exchange Commission announced a settled enforcement action against two executives of China-based mobile internet company Cheetah Mobile, Inc. The SEC alleged that Sheng Fu, Cheetah Mobile’s CEO, caused the company’s misleading statements and failure to disclose a materially negative revenue trend, and that he and Ming Xu, Cheetah Mobile’s former president and chief technology officer, after acknowledging the trend became aware, sold securities under an improperly prepared trading plan under Rule 10b5-1 and avoided several hundred thousand dollar losses. This is a rare SEC action resulting from the improper use of a Rule 10b5-1 trading plan, and it may signal a postponement of future SEC enforcement and increased scrutiny of trading under Rule 10b5-1 trading plans.
The central theses
- The SEC scrutinizes Rule 10b5-1 plans closely, and such plans should not be construed as passes for release from prison to avoid insider trading liability.
- Insiders must not be in possession of material non-public information (MNPI) when implementing a plan; otherwise, the Plan cannot serve as a positive defense against insider trading allegations;
- The SEC’s view of information constituting MNPI may be broadened and what is considered material is evaluated with hindsight; and
- The best practice for Rule 10b5-1 plans is a cooling off period between implementing the plan and initiating the planned trades.
facts of the case
Cheetah Mobile made up to a third of its revenue from an advertising partner who placed third-party advertisements on Cheetah Mobile’s mobile platforms. In the summer of 2015, advertising partner Cheetah Mobile announced that it would change its algorithm that determines ad placement fees, and that the algorithm change could reduce the partner’s payments to Cheetah unless Cheetah Mobile improves the quality of its ad placement on Mobile Half. Cheetah Mobile wasn’t able to adapt to the new algorithm, but according to the SEC, as its revenue began to fall, Cheetah Mobile’s CEO offered investors and analysts an essentially misleading statement during a earnings call when he called the revenue decline due to “seasonality” and caused by “some declines at one of our largest third-party advertising platform partners where we are seeing significant sequential moderation in sales.” The SEC claimed that the CEO’s statements about revenue trends and expectations were materially misleading because the CEO failed to disclose that the algorithm change had a cause a negative sales trend and the trend has been persistent and non-seasonal. The company also didn’t disclose this “known trend” in its annual report filed with the SEC, which the CEO signed.
The SEC alleged that Cheetah’s CEO and then-President, while aware of the significant negative trend in the advertiser’s revenues, entered into Rule 10b5-1 trading plans to sell some of their Cheetah Mobile securities. The SEC claimed that executives avoided losses of about $203,290 and $100,127, respectively, by selling before Cheetah Mobile released a lower-than-expected second-quarter guidance.
A new enforcement trend?
This case is unusual for at least a couple of reasons. First, the SEC rarely collects fees from individuals who have traded under Rule 10b5-1 trading plans. Trading plans under Rule 10b5-1 may be particularly useful for persons believed to have non-public information, such as: B. Directors, officers or executives of a company. By confirming that they do not have material non-public information at the time the plan is implemented, they can defend themselves against insider trading allegations, even if they become aware of MNPI after the plan is in place but before the trade is completed. But the existence of a commercial plan under Rule 10b5-1 alone is not sufficient to protect against liability: the plan must be entered into in good faith. While insider trading is not common in connection with Rule 10b5-1 plans, the SEC has shown that trades made while executives were aware of nonpublic information will be reviewed even if a Rule 10b5-1 plan exists.
Second, the SEC’s definition of what information constitutes MNPI could be expanded. While many insider trading cases relate to earnings announcements or potential mergers and acquisitions, in this case the MNPI that executives were hired to trade was an undisclosed negative revenue trend. Interestingly, by the time executives signed the Rule 10b5-1 trading plans, Cheetah Mobile had already announced that it expected its total revenue for the first quarter of 2016 to decrease compared to the immediately preceding quarter. However, the company had not disclosed that the change in its advertising partner’s algorithm had resulted in an allegedly negative trend in sales.
Recommended course of action
On December 15, 2021, the SEC proposed rule 10b5-1 rule changes for trading plans. Although these rules have not yet been enacted, the Cheetah Mobile case signals a growing appetite for increased scrutiny of Rule 10b5-1 plans and subsequent trades. Critics have noted for years that executives and insiders who trade under Rule 10b5-1 plans are more successful than others who do not use those plans, and that the timing of the trade and the set up of the plans appear to “play the system”. . The SEC’s proposed rules — along with the Cheetah Mobile enforcement action — may also demonstrate best practices for those who wish to act under Rule 10b5-1 plans without putting themselves or their companies at risk.
No MNPI when preparing a Rule 10b5-1 plan: Persons wishing to act should ensure that they are not in possession of material non-public information when preparing the plan under Rule 10b5-1. Companies and individuals wishing to trade should also consider carefully what might be considered material for investors; For example, an undisclosed negative sales trend could be material.
Set a time to think: Insiders should also consider a “cooling-off period” between the plan’s effective date and the start of trading under the plan. The SEC has suggested a minimum of 120 days; While no such limitation currently exists, a delay between acceptance of the plan and commencement of trading may help support the argument that the plan was made in good faith. Specifically, as part of the settlement, the CEO of Cheetah Mobile agreed to a 120-day cooling off period for any new Rule 10b5-1 plans it makes for the next five years.
Ensure robust internal controls: Businesses and their advocates should also ensure they have sound internal controls in place. You should take a close look at their insider trading policies, the enforcement of trading windows for the implementation of Rule 10b5-1 plans and the review of changes to Rule 10b5-1 plans. Since the SEC has proposed increased disclosure requirements for planned trades under Rule 10b5-1, companies may also want to consider disclosing executive plans.
Through careful planning, implementing strong internal controls, and thinking critically about what might be considered an MNPI, companies, insiders, and their advocates can reduce risk and stay ahead of a changing compliance landscape.
Learn more about Rule 10b5-1 plans and best practices or listen to the MoFo Perspectives podcast, Above Board: Rule 10b5-1 Plans. For more information on enforcement trends and proposed changes, see our Rule 10b5-1 Plans at 20 alert.