On September 21, 2022, the United States Securities and Exchange Commission (“SEC”) indicted the CEO, Sheng Fu, and former President, Ming Xu, of China-based technology company Cheetah Mobile Inc. (“Cheetah Mobile” or the “Company”) ‘) insider trading for the sale of Cheetah Mobile American Depository Shares while in possession of material non-public information. Specifically, the trades in question – sales of a total of 96,000 shares to avoid losses of approximately $203,290 or $100,127 prior to negative disclosure – were made under a Rule 10b5-1 plan jointly prepared by the two executives. However, the SEC found that their plan did not protect them from liability because they entered into the plan only after becoming aware of material nonpublic information — a significant drop in advertising revenue from the company’s largest advertising partner. This case reflects the recent increased scrutiny by executives of trading and possible abuses of Rule 10b5-1 plans by the SEC and underscores the importance of adhering to best practices when entering into such plans.
The results of the SEC
The SEC’s injunction order (the “SEC Order”) against Fu and Xu found that Fu and Xu violated the anti-fraud provisions of the Securities Exchange Act of 1934 (the “Exchange Act”), and that Fu also violated the anti-fraud provisions of the Securities Act of 1933 and was a cause of Cheetah Mobile’s violations of issuer reporting requirements under the Exchange Act.[1] According to the SEC’s order, in 2015 and 2016, Cheetah Mobile “derived up to a third of its revenue from placing third-party advertising in its applications served by its largest advertising partner,” which is a division of a major social Media platform was. In the summer of 2015, the advertising partner informed the company that it was changing its algorithm that determines fees for ad placements, and that the algorithm change could “halve the revenue” if Cheetah Mobile doesn’t improve the quality of its ad placements, which the partner paid to the company. The advertising partner’s revenues then fell by 11% from Q3 2015 to Q4 2015 and by 30% in Q1 2016. However, during Cheetah Mobile’s Q1 2016 earnings call, Fu attributed the “softness” of Q1 earnings to stronger-than-expected “seasonality.” The SEC order went on to say that Fu and Xu announced in late March In 2016, despite being aware of the negative sales trend, they signed their joint 10b5-1 plan. Fu and Xu then sold 96,000 shares under this plan before Cheetah Mobile announced in May 2016 lower than expected second quarter 2016 revenue guidance and that it did not meet previously issued 2016 revenue and earnings guidance. That disclosure caused the company’s stock price to fall 18%, and Fu’s and Xu’s sales ahead of the disclosure allowed them to avoid losses of about $203,290 and $100,127, respectively.
The Settlement and Enterprises of Fu and Xu
Without admitting or denying the SEC’s findings in the SEC order, Fu and Xu agreed to injunctions, certain mandatory filings with the SEC regarding trading and future 10b5-1 plans, and the payment of $556,580 in civil penalties USD and $200,254. respectively. Fu also agreed to restrictions on any future Rule 10b5-1 plans he might make in the future. Specifically, for a five-year period, such plans must be reported to the SEC within 48 hours of execution, including a 120-day “cooling off” period between the date the plan or any amendment becomes effective and the first date of a transaction pursuant to the Scheme and Fu is prohibited from maintaining more than one Rule 10b5-1 Scheme at any given time in respect of Cheetah Mobile securities.[2]
Increased SEC review of Rule 10b5-1 plans and new proposed amendments to Rule 10b5-1
The SEC’s enforcement actions against Cheetah Mobile executives reflect SEC Chairman Gary Gensler’s stated intention to stop trading, particularly by executives, under Rule 10b5-1 plans. Gensler has publicly stated that Rule 10b5-1 plans “have resulted in real cracks in our insider trading regime” and has warned that “if insiders do not act in good faith in using 10b5-1 plans, they will not receive endorsement from those plans.” provide defense.”[3] Joseph G. Sansone, head of the SEC Enforcement Division’s Market Abuse Unit, echoed these comments when announcing the Cheetah Mobile action, stating, “While trading under the 10b5-1 plans protect employees from insider trading liability in certain circumstances can, [the Cheetah Mobile] The executives’ plan did not comply with securities laws because they were in possession of material non-public information when they signed it.”[4]
The restrictions on Fu’s future Rule 10b5-1 plans imposed by the SEC regulation also reflect the SEC’s proposed amendments to Rule 10b5-1 of the Exchange Act, published December 15, 2021, which are summarized in more detail here. For example, under the proposed changes, all 10b5-1 plans held by officers and directors of the Company are subject to a mandatory 120-day “cooling off period” after initial acceptance or modification before trading under the plan can begin. The proposed changes also prohibit overlapping or concurrent 10b5-1 plans for open market transactions in securities of the same issuer and limit 10b5-1 plans from executing a single trade on any plan within a 12-month period.[5] The proposed changes also require expanded disclosures by issuers of Rule 10b5-1 plans that have been entered into by their officers and directors.
The central theses
The Cheetah Mobile case is a stark reminder that the SEC (and particularly its Market Abuse Division’s Analysis and Detection Center) is, and will continue to, scrutinize corporate insider trading, particularly with respect to significant disclosures and the resulting stock price movements. even if these trades are made according to 10b5-1 plans. It is therefore crucial to ensure that any plans under Rule 10b5-1 are entered into during open trading windows, when the insider does not have material non-public information, and in good faith.
[1] “Order to initiate injunctive relief proceedings”, Regarding Sheng Fu and Ming XuFile No. 3-21118 at 9-12 (Sept. 21, 2022) (“SEC Order”), https://www.sec.gov/litigation/admin/2022/33-11104.pdf.
[2] SEC order at 9-12.
[3] Gary Gensler, “Prepared Remarks: CFO Network Summit” (June 7, 2021), https://www.sec.gov/news/speech/gensler-cfo-network-2021-06-07#.
[4] SEC Press Release, “SEC Alleges Cheetah Mobile CEO and Former President of Insider Trading” (September 21, 2022), https://www.sec.gov/news/press-release/2022-169.
[5] SEC Proposed Rule, Rule 10b5-1 and Insider Trading, 17 CFR Parts 229, 232, 240 and 249
[Release No. 33-11013; 34-93782; File No. S7-20-21]https://www.sec.gov/rules/proposed/2022/33-11013.pdf.
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