10b5-1 Plan Strategies for Executives

Key Points:

• Understanding Material Nonpublic Information: A 10b5-1 plan must be set up when the executive has no material, nonpublic information about the company.
• Flexibility in Trading: 10b5-1 plans allow executives to trade during blackout periods and set specific rules for the timing and execution of trades.
• Plan Setup Essentials: Setting up a 10b5-1 plan involves company approval, legal counsel consultation, and drafting the plan to meet specific trading goals.
• Tax Issues and Strategies: Executives face tax implications under 10b5-1 plans, which can be managed through strategic planning and long-term sales.
• Maintaining Compliance and Adaptability: Executives must regularly review and update their 10b5-1 plans to ensure alignment with financial objectives and compliance with trading regulations.

Introduction

Managing company stock accumulated over the years for executives with equity-based compensation presents unique challenges. There are many reasons to want to sell stock in the company, including needing liquidity or reducing concentration risk, but the potential for insider trading, whether real or accused, can complicate selling shares without raising suspicion. One powerful solution to navigate these challenges is implementing a 10b5-1 plan.

Named after the Securities and Exchange Commission (SEC) ruling in 2000, 10b5-1 plans are specifically designed to enable insiders to trade their company’s stock in a legally compliant manner. These plans provide a structured and pre-established approach to trading, allowing executives to execute transactions without fearing legal issues due to accusations of using material nonpublic information (sometimes referred to MNPI) for personal gain.

Here, we will delve into the importance of 10b5-1 plans for executives who have amassed substantial company stock through equity-based compensation tools. By understanding these plans’ key features and benefits, executives can gain confidence in managing their stock holdings while adhering to regulatory guidelines.

Material, Nonpublic Information

First, we need to understand what material nonpublic information is. Material, nonpublic information refers to any information about a publicly traded company that could significantly impact the company’s stock price if it were publicly known. In this context, each word, material and nonpublic, has its own definition.

Material information refers to any data or facts about a company that a reasonable investor would likely consider important when making investment decisions. It typically includes information that could influence the market price or value of the company’s securities. Examples of material information may include:

• Financial results: Information about the company’s earnings, revenues, profits, losses, or other financial metrics.
• Business operations: Information about significant contracts, mergers, acquisitions, divestitures, product launches, or changes in business strategy.
• Legal or regulatory matters: Information about ongoing investigations, litigations, or regulatory actions that could significantly impact the company’s operations or financials.
• Industry developments: Information about market trends, competitive dynamics, or changes in industry regulations that could affect the company’s performance.

Nonpublic information is simpler to understand; it refers to information not disseminated to the public through appropriate channels. This information is not accessible to the general public. It is known only to a limited group of individuals, such as company insiders, management, or those with a contractual or fiduciary duty to maintain confidentiality.

It’s essential to note that the determination of what constitutes material, nonpublic information can be subjective and context-specific. The Securities and Exchange Commission (SEC) provides guidance and case law examples to help define and interpret materiality, but ultimately, it may depend on the specific circumstances and facts surrounding the information. It is best to err on the side of caution, but if you need to proceed, carefully research your individual situation or hire a specialist to avoid any potential issues.

The initial step in establishing a compliant 10b5-1 plan involves creating the plan when you do not have any material, nonpublic information—assuming that as a starting point, these plans can be amazingly flexible.

Flexibility

Why set up a 10b5-1 plan? The plan protects the company from accusations of insider trading and benefits the corporate executives by offering trading flexibility, allowing them to navigate trading restrictions and take advantage of favorable market conditions. Each executive can construct their own 10b5-1 plan based on their personal goals. However, the plan usually must be approved by the company’s board of directors. Some companies prescribe the form of the plan that is to be adopted, which can limit flexibility.

Here are some examples of trading flexibility that a 10b5-1 plan could provide:

Trading during Blackout Periods

Companies often impose blackout periods during which insiders, including executives, are prohibited from trading company stock. These blackout periods typically occur around significant corporate events, such as earnings releases or mergers and acquisitions. However, a properly structured 10b5-1 plan can provide a mechanism for executives to trade even during blackout periods. Since the trades are predetermined and independent of the executive’s ongoing knowledge, they can proceed as scheduled without violating blackout restrictions.

An example of this would be a plan that stated you would sell 100 shares every month if the price was above $100. If the plan was written this way, even during the blackout period, you could sell 100 shares per month.

Timing Flexibility

A 10b5-1 plan allows executives to establish specific timing parameters for their trades. This flexibility will enable them to align their trading activities with their financial goals and market conditions. For example, an executive may set up the plan to execute trades at regular intervals, such as monthly or quarterly (as in the example above), or at predetermined dates in the future for tax planning or cash flow needs. This flexibility allows executives to adapt their trading strategies to optimize potential market opportunities or address specific cash flow needs.

An example might be if you need to plan for liquidity around your child’s college expenses, you could set up a plan that allows sales around the dates of tuition bills.

Long-Term Trading

A 10b5-1 plan is not limited to short-term or immediate trading activities. Executives can establish plans with a longer duration, extending over months or even years. This long-term approach allows for a systematic and consistent selling or buying of company stock over an extended period. By spreading out their trades, executives can mitigate the potential impact of short-term market volatility and implement their trading strategy gradually to achieve their desired objectives.

Rule-Based Trading

With a 10b5-1 plan, trading decisions are rule-based and predetermined. The plan’s terms must be clearly outlined, encompassing the precise amount, price, and date of the transaction(s). We did exactly that in the first example, outlining an amount, 100 shares, a price, $100, and a date, monthly.

In some cases, the plan may involve a straightforward approach, authorizing trades on specified dates or at predetermined prices. However, it can also become more intricate, incorporating targets tied to the stock’s performance concerning market or industry indices or even selected competitors. It is crucial for the plan to unambiguously identify the calculations for the relevant prices and triggers, leaving no room for the insider’s discretion. However, it can incorporate various trading strategies, providing greater flexibility in executing transactions.

Flexibility to Modify or Terminate the Plan

While it is essential for a 10b5-1 plan to provide structure and consistency, it also allows for flexibility in certain situations. Executives may be able to modify or terminate the plan under specific circumstances, such as financial emergencies, changes in personal circumstances, or shifts in long-term investment strategies. These modifications or terminations must comply with regulatory guidelines and any specific requirements outlined in the plan document. Rule 10b5-1 technically even allows one to terminate his or her plan based on material nonpublic information acquired after the fact. However, as a practical matter, many companies prohibit this in 10b5-1 plans involving their securities.

Options

Executives can exercise stock options as part of their 10b5-1 trading strategy, but it must be done as a cash transaction, not a net transaction. In a cash transaction, the executive pays the exercise price upfront in cash to receive the underlying shares. On the other hand, in a net transaction, the exercise price is paid by surrendering a portion of the received shares. To avoid potential insider trading issues, exercising options as a net transaction is generally not allowed under a 10b5-1 plan.

By offering trading flexibility, a 10b5-1 plan empowers executives to navigate trading restrictions, capture favorable market opportunities, and adapt their trading strategies to their unique financial circumstances and objectives.

Putting Together a 10b5-1 Plan

Okay, so you’re sold on 10b5-1 plans and want to establish one now. How do you do it? Establishing a 10b5-1 plan involves several important steps to ensure compliance and effectiveness. Here’s a breakdown of what needs to be done to put together a 10b5-1 plan:

Company Approval

If you are an executive officer or director, the first thing to do is check with the company’s human resources or compensation committee to see what policies or other rules executives need to follow. The company may have a process that mandates many of the steps below, including the lawyers to use, the time frames allowed, and the maximum number of shares allowed to be traded. Additionally, board approval may be required to help demonstrate good governance practices and safeguards against potential conflicts of interest.

Even if your company has a well-established process and the legal team you’re required to use, it is still important to review the steps below so you can understand what is happening and know how it incorporates your goals.

Engage Legal Counsel

It is crucial to consult with legal counsel experienced in securities laws and regulations. The importance of an experienced legal team is why many companies require executives to use their process, as their lawyers have already reviewed it and minimizes company risk. A competent legal team, internal or external, will guide you through the process, ensuring compliance with all applicable rules and regulations and helping draft the necessary documentation.

Determine Trading Objectives

Clearly define your trading objectives for the plan. Consider factors such as the desired timeframe, the number of shares to be bought or sold, and the specific price or formula for executing the trades. Evaluate how the proposed trades align with your broader financial goals. Consider factors such as liquidity needs, diversification strategies, retirement planning, and other investment objectives.

It’s important that the plan you create complements and supports your overall financial plan rather than operating in isolation. Later, we will be looking at some of the tax-saving opportunities. Incorporating the plan with your other sources of income can be a challenging step, as it involves creating a multi-year forecast of income and tax implications. But by coordinating your plan with your overall tax planning strategy, you can help maximize tax efficiency and reduce your overall lifetime tax burden.

Draft the Plan

Now that legal has provided the framework allowed and you have defined your financial goals (along with your financial advisor if you have one), work with legal counsel to draft the written plan document. The plan should outline the specific parameters for trading, including the duration, trading intervals, and pricing mechanism (see the Flexibility section above for more details and examples). It should also address any restrictions or limitations on the ability to modify or cancel the plan. The U.S. Securities and Exchange Commission (SEC) has issued regulations that define many of these limitations and need to be followed for the plan to be in compliance, or it can be disallowed.

File Form 144 and Other Disclosures

If you are an insider selling shares under the plan, comply with the necessary reporting and disclosure requirements. This may include filing a Form 144 with the Securities and Exchange Commission (SEC) and submitting any required disclosures to your company. The legal team you have been working with should be able to file this on your behalf.

Monitor and Update the Plan

Regularly review and monitor the plan’s performance to ensure it aligns with your financial objectives. If adjustments to the plan become necessary due to changes in personal circumstances or market conditions, consult with legal counsel to make appropriate modifications while adhering to regulatory guidelines.

Adhere to Insider Trading Restrictions

While the 10b5-1 plan offers some limited flexibility, it is crucial to adhere strictly to the guidelines outlined in the plan. Avoid making changes or engaging in trading activities while in possession of material nonpublic information to prevent potential insider trading allegations.

Putting together a 10b5-1 plan is a meticulous process requiring careful consideration and regulatory guideline adherence. Executives must seek company approval and engage legal counsel to ensure compliance with securities laws and regulations. By clearly defining their trading objectives and avoiding material nonpublic information, executives can establish a plan that aligns with their broader financial goals while mitigating the risk of insider trading allegations.

Next, we will delve into the tax issues associated with 10b5-1 plans and explore planning strategies to minimize their impact.

Tax Issues & Planning Strategies

Now that we understand how to set up a 10b5-1 plan and available flexibility options, let’s identify some potential tax issues and how we can use the flexibility options to avoid them and reduce our tax burden.

Ordinary Income Tax Rates

One significant tax issue with 10b5-1 plans is that stock sales executed under these plans can be subject to ordinary income tax rates rather than the potentially more favorable capital gains tax rates. The distinction is based on the structure and setup of the plan, particularly the absence of proper structuring around holding periods. To avoid higher tax liabilities, executives must ensure their plan is appropriately designed to adhere to capital gains tax rates whenever possible. Blindly setting up a rule to sell a certain number of shares monthly could set you up to sell shares held for less than one year and, therefore, taxed at short-term rates.

Timing and Market Conditions

Executives should exercise caution and carefully assess the timing of their trades within the 10b5-1 plan. Poorly timed transactions can lead to unintended tax consequences or missed opportunities to maximize tax advantages. Despite all our efforts to align the 10b5-1 plan with the overall tax plan, there might be situations where perfect alignment is not possible, potentially resulting in higher-than-expected tax liabilities due to the structured nature of the plan.

Planning strategies can significantly mitigate the tax impact of 10b5-1 plans for corporate executives. Several approaches can be employed to achieve this goal:

Coordination with Other Financial Planning

We have mentioned this several times, but the best tool we have to maximize the benefits of a 10b5-1 plan is a multi-year detailed tax plan. A rolling five-year detailed plan, including all household sources of income, is ideal. Executives should collaborate closely with their financial advisors to integrate their 10b5-1 plans into broader financial and tax planning objectives. The two main objectives of the plan need to be:

• Filling up tax brackets: If you are in a role where you are now considering a 10b5-1 plan, your career and income are on the rise. Utilize the tax bracket, considering both ordinary income and capital gains brackets you are now in, and fill those up.
• Consider lower income years: If you know your income will be lower in a future year due to perhaps a spouse taking some time off or performing major renovations to a rental property, consider increasing the amount of sales planned for that year.

This coordination ensures that stock sales align with other income or investment strategies, maximizing overall tax efficiency.

Long-Term Sales

One effective strategy is to implement structured sales, allowing executives to spread their stock sales over time, but there is a need to ensure that all of the shares sold qualify for long-term capital gains rates. This should be thought about and incorporated into the plan when structured.

Monitoring Plan Adjustments

Financial goals and plans change constantly, requiring updates. When making changes to their 10b5-1 plans, executives must exercise caution. Any adjustments should be made during open trading windows and without possessing material, nonpublic information. This practice helps to avoid triggering insider trading allegations and maintains the plan’s compliance with regulations.

10b5-1 plans offer a useful solution for corporate executives to manage their stock holdings effectively while navigating potential challenges and regulatory requirements. By providing a structured and pre-established approach to trading, these plans ensure compliance with insider trading regulations and safeguard against accusations of using material nonpublic information for personal gain.

The flexibility of 10b5-1 plans empowers executives to navigate trading restrictions and exploit favorable market conditions. However, it is crucial to carefully plan and align the plan with overall financial goals to optimize tax outcomes. By employing strategies such as coordinating the plan with their overall financial plan, executives can minimize the tax impact of their 10b5-1 plans.

Frequently Asked Questions (FAQ)

Q: What is a 10b5-1 plan and why is it important for executives?

A: A 10b5-1 plan is a pre-established trading plan that allows corporate insiders to trade company stock in compliance with insider trading laws. It’s crucial for executives who accumulate company stock to manage their investments without legal issues related to insider trading.

Q: How does a 10b5-1 plan provide trading flexibility?

A: The plan allows trading during blackout periods, sets specific timing for transactions, and implements rule-based trading strategies. This enables executives to align trading with their financial goals and adapt to market conditions.

Q: What are the critical steps in setting up a 10b5-1 plan?

A: Key steps include obtaining company approval, consulting with legal counsel, defining trading objectives, drafting the plan with specific parameters, and ensuring compliance with SEC regulations.

Q: How can a 10b5-1 plan impact taxes for executives?

A: Sales under a 10b5-1 plan can be subject to ordinary income or capital gains tax rates. Executives need to structure their plan carefully to benefit from lower capital gains tax rates and align transactions with their broader tax planning.

Q: What strategies can be used to minimize the tax impact of a 10b5-1 plan?

A: Executives should integrate their 10b5-1 plans with overall financial and tax planning, considering long-term sales and monitoring plan adjustments to maximize tax efficiency.

If you have any questions about 10b5-1 plans, about corporate compensation in general or want to explore how a Flat-Rate Fee-Only structure can help you achieve your goals, set up a time to talk.

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