SEC’s Heightened Scrutiny of Rule 10b5-1 Plans and Final Rulemaking Focus Is on Insiders Rather than Issuers | Pillsbury Winthrop Shaw Pittman LLP

Rule 10b5-1 plans have gained wide acceptance and compliance. On September 21, 2022, however, the SEC issued a settled order against the Chief Executive Officer (CEO) and the former President and Chief Technology Officer (CTO) of Cheetah Mobile, Inc. (Cheetah or the Company), a China-based mobile internet company traded on the New York Stock Exchange, following insider trading charges against the two executives.

According to the Commission’s press release, the CEO and CTO entered into a purported Rule 10b5-1 plan with respect to Cheetah securities while they were in possession of MNPI, and sold Cheetah shares pursuant to the plan while in possession of MNPI. The CEO and CTO agreed in the Cease and Desist Order (the Order) to pay civil penalties and agreed to undertakings related to future securities transactions.

The Commission does not frequently bring enforcement actions involving Rule 10b5-1 plans. This action, followed closely by the adoption of final rules heightening the requirements to invoke the Rule’s affirmative defense to insider trading, reflects the Commission’s current focus on trades made by company insiders pursuant to plans that purport to comply with Rule 10b5-1. We discuss the final amendments to Rule 10b5-1 in detail here.

The Facts:

Cheetah develops content-driven products, such as mobile phone and computer applications. Like many web-based companies, Cheetah earns a large part (up to one-third) of its revenues from fees generated by the placement of third-party advertisements within its products. In the summer of 2015, Cheetah’s primary advertising partner (Advertising Partner) informed Cheetah that a change the algorithm used to determine these fees might halve the amounts paid over to Cheetah. Cheetah’s efforts to mitigate the effect of the new algorithm failed. As a result, Cheetah experienced significant declines in revenue from the Advertising Partner in the fourth quarter of 2015 and the first quarter of 2016—representing roughly 3% and 8% of its total quarterly revenue, respectively.

Cheetah did not tie the negative trend to the change in Advertising Partner’s algorithm in its March 16, 2016, conference call (held by the CEO), its April 22, 2016, Form 20-F for fiscal year 2015, or its May 19, 2016, Form 6-K for first quarter financial results. Only in a conference call the day of its May 19, 2016, Form 6-K, Cheetah announced that it did not expect to meet its previously issued revenue guidance and earnings for the full year due to “weaknesses in [its] expected mobile revenue growth … cause by a decline in [a measure of advertising revenues] from some of [its] third-party advertising platform partners.” Following these disclosures, the price of Cheetah stock dropped approximately 18%.

On March 29, 2016, the CEO and CTO had established a trading plan in the name of a jointly held British Virgin Islands company (the March Trading Plan), which provided advance directives for the sale of Cheetah securities by the BVI company’s brokerage firm. Between March 29, 2016, and Cheetah’s announcement on May 19, 2016, the BVI company sold 906,000 securities pursuant to the plan, enabling the CEO and CTO to avoid combined losses of $303,417.

The CEO and CTO intended for the March Trading Plan to be a Rule 10b5-1 plan. A Rule 10b5-1 plan, however, must be established in good faith when the person establishing it is not in the possession of MNPI. According to the Order, the CEO and CTO received regular updates on Advertising Partner-derived revenue and knew of the algorithm change and resulting negative revenue trend when the trading plan was adopted. Cheetah’s CEO and CTO therefore were not entitled to invoke the Rule 10b5-1 affirmative defense.

Noteworthy Points

The enforcement action raises several interesting points:

First, the Commission did not bring charges against the Company, itself, for the material misstatements in its April 22, 2016, Form 20-F. Instead, the Order ties the Company’s noncompliant public filings to its CEO, stating that the CEO “was a cause of Cheetah Mobile’s violations of Section 13(a) of the Exchange Act and Rule 13a-1 thereunder … and of Exchange Act Rule 12b-20, which requires an issuer to include in a statement or report filed with the Commission any information necessary to make the required statements in the filing not materially misleading.”

Second, by taking action against the CEO and CTO for adopting a Rule 10b5-1 plan while in possession of MNPI, the SEC cautioned public company insiders (and market participants, generally) that adoption of a Rule 10b5-1 plan provides no protection if the persons establishing the plan are not doing so in good faith, i.e., without possession of MNPI or intent to evade the requirements of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934.

Third, as part of the settlement, the CEO and CTO agreed that for a five-year period, they will take affirmative steps to provide “guardrails” against trading while in possession of MNPI.

With respect to the CEO, certain undertakings in the Order set forth below incorporated aspects of the SEC’s then-proposed amendments to Rule 10b5-1:

i. A requirement to provide notice of the establishment, modification or cancellation of any trading plan that purports to be established pursuant to Rule 10b5-1 to the Chief of the Market Abuse Unit within the SEC’s Division of Enforcement, within 48 hours of such establishment, modification or cancellation;

ii. A 120-day cooling off period before any transactions can be made pursuant to a new or modified Rule 10b5-1 plan with respect to Cheetah securities; and

iii. A prohibition against maintaining, directly or indirectly, more than one Rule 10b5-1 plan at any time with respect to Cheetah securities.

Notably, Cheetah’s own legal department was integrated into the CEO’s undertakings: the Order requires prior approval of Cheetah’s legal department within 48 hours of the CEO entering into any transaction with respect to Cheetah securities other than a transaction pursuant to a Rule 10b5-1 plan.

In addition, with respect to both the CEO and the CTO, the Order establishes significant SEC oversight of their transactions in Cheetah securities or other securities traded on U.S. stock exchanges. The undertakings require the following notices to be given to the Chief of the Market Abuse Unit (i.e., the unit that brought the enforcement action) within the SEC’s Division of Enforcement:

i. Notice, within 48 hours, of any transaction, whether directly or indirectly made, in Cheetah securities;

ii. Notice, within 30 days of the Order, of all brokerage accounts that they own or control, directly or indirectly, which can trade securities on United States securities exchanges (a U.S. Securities Account), along with the identity of the broker-dealer that maintains each account;

iii. Notice, within 48 hours, of the opening of any U.S. Securities Account; and

iv. An annual written certification certifying compliance with their respective undertakings set forth in the Order by identifying the undertakings and providing a narrative description of compliance supported by exhibits sufficient to demonstrate compliance.

The identity of the parties bears mentioning. Cheetah, a Cayman Islands company with its principal place of business in China, is a foreign private issuer under the U.S. securities laws, with securities listed on the New York Stock Exchange. The CTO and CEO are both residents of China.

The SEC has noted the limitations on its ability to oversee compliance with U.S. federal securities laws by Chinese companies and individuals in China, noting, among other things, that Chinese law prohibits any overseas securities regulator from directly conducting investigations or otherwise gathering evidence in China—and largely restricts the ability of Chinese companies and individuals to cooperate in such investigations absent Chinese government approval. The undertakings to which Cheetah’s CEO agreed, which, as noted, mirrored the SEC’s proposals with respect to disclosures surrounding Rule 10b5-1 plans, may provide an alternative mechanism for the SEC to reach inside the compliance processes in Chinese or other non-U.S. companies through individual officers of the companies. It appears that despite its enforcement challenges in China, the SEC has found ways to continue to utilize its resources to track securities trading by persons in China for indications of misconduct.

Risk Mitigation Measures

This enforcement action sheds light on how the Commission envisions the allocation of responsibility in administering Rule 10b5-1 plans. Issuers, insiders and those who administer Rule 10b5-1 plans should take guidance from the undertakings in the Order and ensure their policies and procedures comply with the requirements of Rule 10b5-1, as amended.