On September 21, 2022, the Securities & Exchange Commission announcement a lawsuit settled against two executives of China-based mobile internet company Cheetah Mobile, Inc. The SEC alleged that Sheng Fu, CEO of Cheetah Mobile, caused the company’s misleading statements and failed to disclose a revenue trend significant negative and that, after becoming aware of the trend, he and Ming Xu, the former president and chief technology officer of Cheetah Mobile, sold securities in accordance with an ill-conceived Rule 10b5-1 trading plan and avoided a few hundred thousand dollars in losses. This is a rare SEC action resulting from improper use of a Rule 10b5-1 trading plan, and it may signal a change in future SEC enforcement and increased scrutiny of trading in accordance with the trading plans in Rule 10b5-1.
Key points to remember
- The SEC scrutinizes Rule 10b5-1 plans closely, and such plans should not be viewed as get-out-of-jail cards to avoid insider trading liability;
- Insiders cannot be in possession of material non-public information (MNPI) when implementing a plan; otherwise, the plan cannot serve as an affirmative defense to an allegation of insider trading;
- The SEC’s view of the information that constitutes MNPI may expand and what is considered material will be assessed in hindsight; and
- The best practice for Rule 10b5-1 plans is to have a cooling-off period between setting up the plan and commencing planned trading.
Facts of the case
Cheetah Mobile derived up to one-third of its revenue from an advertising partner who placed third-party advertisements on Cheetah Mobile’s mobile platforms. In the summer of 2015, the ad partner informed Cheetah Mobile that it would be changing its algorithm that determined ad placement fees and that unless Cheetah Mobile improves the quality of its ad placements, the change algorithm could reduce the partner’s payments to Cheetah. Mobile in two. Cheetah Mobile was unable to adapt to the new algorithm but, according to the SEC, when its revenues began to decline, Cheetah Mobile’s CEO offered a materially misleading explanation to investors and analysts during a earnings call when he referred to the decline in revenue as being due to “seasonality” and caused by “some declines at one of our larger third-party ad platform partners, where we are seeing significant sequential moderations in sales there. The SEC alleged that the CEO’s statements about revenue trends and expectations were materially misleading because the CEO failed to disclose that the algorithm change created negative revenue trend and the trend was persistent and not seasonal. The company also failed to disclose this “known trend” in its annual report filed with the SEC which the CEO signed.
The SEC alleged that while aware of the material negative revenue trend of the advertising partner, the CEO and then chairman of Cheetah entered into business plans under the 10b5-1 rule to sell some of their securities Cheetah Mobile. The SEC claimed that because they sold before Cheetah Mobile disclosed lower-than-expected second-quarter guidance, executives avoided losses of about $203,290 and $100,127, respectively.
A new trend in law enforcement?
This case is unusual for at least two reasons. First, the SEC rarely charges people who have traded in accordance with Rule 10b5-1 trading plans. Rule 10b5-1 business plans can be particularly useful for individuals suspected of having nonpublic information, such as directors, officers, or directors of a company. By certifying that they did not possess material nonpublic information at the time they adopted the plan, they can establish an affirmative defense to a charge of insider trading, even if they learned of MNPI after in place of the plan but before the end of the operation. . But the existence of a trading plan under Rule 10b5-1, on its own, is not enough to protect against liability: the plan must be entered into in good faith. While insider trading involving Rule 10b5-1 plans is not common, the SEC has shown that trades made while executives had knowledge of nonpublic information will be reviewed, even if a Rule plan 10b5-1 exists.
Second, the SEC’s definition of what constitutes MNPI information may be expanding. While many insider trading cases relate to earnings announcements or potential mergers and acquisitions, in this case the MNPI the executives were accused of trading on was an undisclosed negative earnings trend. Interestingly, when executives concluded the 10b5-1 rule business plans, Cheetah Mobile had already disclosed that it expected lower overall revenue in the first quarter of 2016 compared to the immediately preceding quarter. But the company had not disclosed that its ad partner’s algorithm change created what the SEC alleged was a negative revenue trend.
Best Practices
On December 15, 2021, the The SEC has proposed changes to the rules for Rule 10b5-1 trading plans. Although these rules have not yet been enacted, the Cheetah Mobile case signals a growing appetite for scrutiny of the plans for Rule 10b5-1 and subsequent transactions. For years, critics noted that executives and insiders who trade in accordance with Rule 10b5-1 plans are more successful than others who do not use such plans and that the timing of trading and drawing up plans appears to be “playing with the system”. The SEC’s proposed rules, along with Cheetah Mobile’s enforcement action, may also identify best practices for those wishing to trade under Rule 10b5-1 plans without exposing themselves or their businesses to risks.
No MNPI when making a plan under Rule 10b5-1: Persons wishing to trade should ensure that they are not in possession of material nonpublic information when establishing the Rule 10b5-1 plan. Companies and individuals wishing to trade should also think carefully about what might be considered important to investors; for example, an undisclosed negative revenue trend could be material.
Institute a period of reflection: Insiders should also consider a “cooling off” period between the enactment of the plan and the start of trading under the plan. The SEC has proposed a period of at least 120 days; although no such restrictions are currently in place, a delay between the adoption of the plan and the start of negotiation may help to support the argument that the plan was drawn up in good faith. Notably, as part of the settlement, the CEO of Cheetah Mobile agreed to a 120-day cooling-off period for any new Rule 10b5-1 plan he establishes for the next five years.
Ensure strong internal controls: Companies and their attorneys also need to make sure they have strong internal controls. They should take a close look at their insider trading policy, enforcement of trading windows for promulgation of Rule 10b5-1 plans, and review of changes to Rule 10b5-1 plans. Since the SEC has proposed increased disclosure requirements for planned transactions under Rule 10b5-1, companies may also consider disclosing executives’ plans.
By planning carefully, adopting strong internal controls, and thinking critically about what might be considered MNPI, companies, insiders, and their advisors can reduce risk and stay ahead of a compliance landscape by evolution.
