SEC Rule 10b5-1

Rule 10b5-1 creates a framework that helps traders avoid insider trading accusations. This rule has become especially important for hedge funds that trade public company stocks. When properly set up and followed, it provides a legal safe harbor within the broader rules that govern how traders can use material non-public information.

The rule establishes what lawyers call an "affirmative defense" to insider trading claims. This means traders can prove their innocence by showing that their trades followed a pre-existing plan. The plan must have been created when they had no access to material non-public information.

This defense recognizes a practical problem: if someone creates a legitimate trading plan in good faith, they shouldn't face insider trading charges later just because they learned sensitive information after making the plan. The rule provides a way to demonstrate that trades were based on the original plan, not on inside information.

Trading plans must meet several basic conditions to qualify for Rule 10b5-1 protection. First, the person must have created the plan when they had no material non-public information. Second, the plan must specify the exact details of future trades—either the precise amounts, prices, and dates, or a written formula or computer program that determines these elements automatically.

Third, and critically, the person cannot influence how trades are executed once the plan begins. The execution must be largely automatic or handled by a broker with very limited discretion. This requirement prevents people from using the plan as cover while actually making trading decisions based on inside information they learn later.

In February 2023, the SEC added mandatory "cooling-off" periods to Rule 10b5-1. These are minimum waiting periods between when someone creates or changes a plan and when trading can begin.

For directors and officers of public companies, the cooling-off period is more complex. They must wait the longer of two timeframes: either 90 days after adopting the plan, or two business days after their company releases quarterly financial results following the plan's adoption. However, this second option cannot exceed 120 days total. For everyone else, the cooling-off period is 30 days.

These waiting periods apply to all plans created or modified after February 2023. They serve as a condition for receiving the legal protection—without the waiting period, the affirmative defense is not available.

The rule also requires that people act in good faith both when creating the plan and throughout its execution. Good faith means not trying to manipulate when their company releases information to make their planned trades more profitable. If a director or officer deliberately influences disclosure timing while knowing material non-public information, they lose their legal protection even if they initially created the plan properly.

When directors and officers of public companies create or modify a Rule 10b5-1 plan, they must include written statements in the plan documents. These certifications confirm two key facts as of the date they adopt the plan: first, that they are not aware of any material non-public information about their company or its securities; and second, that they are creating or changing the plan in good faith, not as part of a scheme to violate insider trading rules.

These written certifications create documentary evidence that the person complied with the rule's basic requirements when they established their plan.

Rule 10b5-1 allows traders to specify their future transactions in several ways. They can provide explicit details like specific numbers of shares, prices, and dates. Alternatively, they can use mathematical formulas or computer programs that determine trading parameters automatically. The key requirement is that plans must be structured so the plan holder cannot make discretionary decisions about individual trades once execution begins.

Most traders cannot have multiple overlapping Rule 10b5-1 plans for the same type of securities during the same time period. There are limited exceptions for plans with different brokerage firms, for sequential plans where the second begins only after the first ends, and for certain arrangements where securities are sold only to cover tax obligations on employee stock awards.

Additionally, people other than the companies themselves can rely on the legal defense for only one single-trade plan within any 12-month period. This prevents abuse of the rule through frequent plan modifications.

Information becomes "material" when a reasonable investor would consider it significantly important for making investment decisions. This includes any information that, if disclosed publicly, could substantially affect the stock price or change how investors view the company. Courts determine materiality by looking at all the circumstances rather than applying a simple formula.

Typically material information includes a company's financial results and operational performance. Examples are earnings announcements, proposed mergers and acquisitions, changes to previously announced earnings forecasts, financial difficulties, dividend changes, major lawsuit developments, and significant management or operational changes.

Materiality can also apply to market-related information, such as details about large buy or sell orders in company securities or information about a fund's portfolio holdings, depending on the context. Even advance information about forthcoming financial media reports may be material in some situations.

Information remains "non-public" until it has been widely distributed to the investment community. Information becomes public through SEC filings, government agency disclosures, established news media, or publications with general circulation. Importantly, sufficient time must pass after public disclosure for the information to spread through the market before it stops being considered non-public.

Insider trading liability typically requires that someone breach a duty when they trade or share information. Courts must examine the nature of the information, where it came from, and what specific duties the trader owes—and these duties don't necessarily have to be owed to the information source itself.

For example, a corporate officer owes various duties to the corporation through their position. An outside contractor might assume confidentiality duties through their contract. Courts have recognized that making false statements can also constitute equivalent duty breaches for insider trading purposes.

When someone with material non-public information (the "tipper") shares that information with another person (the "tippee"), the legal analysis changes. The tippee can face liability if the tipper disclosed the information in exchange for a personal benefit.

Determining personal benefit depends heavily on specific facts and context. Courts have found that personal benefit can be inferred when material non-public information is shared with close friends or family members. In these cases, the personal relationship itself can constitute the benefit the tipper received.

Rule 10b5-1 plans serve particularly important functions for hedge funds, especially when fund personnel serve on portfolio companyCompanies in which a fund has made an investment, typically through equity or debt securities. boards or when the fund regularly accesses material non-public information through its investments. This application becomes especially relevant for activist investingInvestment approaches where funds buy significant stakes in companies to push for operational, financial, or strategic changes through direct engagement with management or proxy contests. strategies.

In activist investing, managers become actively involved in directing a public company's management. This involvement may give them access to sensitive non-public information or create fiduciary obligationsLegal obligation to act in the best interests of another party, requiring utmost good faith and loyalty. to the company's shareholders. These positions can severely restrict the manager's ability to trade the company's securities.

Pre-established Rule 10b5-1 plans provide valuable tools for managing liquidity needs while operating within these legal constraints. They allow managers to continue trading according to predetermined plans even after they gain access to inside information through their activist roles.

Hedge funds must carefully structure these plans to ensure they meet Rule 10b5-1's requirements without creating additional compliance problems. Plans must be specific enough and lack sufficient discretion to qualify for the legal defense. They must also integrate with the fund's broader compliance systems for handling material non-public information and preventing insider trading violations.

Any change to a plan's terms—including modifications to amounts, prices, timing, or algorithmic formulas—legally ends the original plan and creates a new one. This triggers a new cooling-off period before trading can begin. Fund management should work closely with compliance staff to ensure that plan adoptions, modifications, and terminations are properly documented and timed to maintain access to the legal protection.