Corporate officers and directors sometimes view having a Rule 10b5-1 trading plan as an impenetrable barrier to facing insider-trading charges.  But a recent case announced by the SEC demonstrates that such plans are not bulletproof.[1]  If an executive enters into such a plan while in possession of material nonpublic information, insider-trading charges could ensue.

The facts of this case are relatively straightforward.  In 2015, Cheetah Mobile, Inc., a company focused on developing content-driven products on mobile computers and mobile games, was informed that its largest advertising partner was changing its algorithm, which would halve the revenues Cheetah Mobile would generate unless it improved the quality of its ad placements.  One-third of Cheetah Mobile’s revenue was driven by placing within its applications third-party advertisements provided by its largest advertising partner.

By the end of the year, it was clear that Cheetah Mobile would be unable to implement a solution to prevent a decrease in revenue.  As a result, Cheetah Mobile’s revenue declined 3% in the fourth-quarter of 2015, and 8% in the first quarter of 2016.  This represented a 30% drop in revenue from the largest advertising partner. The CEO omitted to disclose to the company’s investors that the negative trend was created by the advertising partners’ algorithm change, instead chalking the poor revenue numbers up to greater-than-expected “seasonality.”  The CEO similarly omitted to disclose the known negative trend in revenue to the SEC on its Form 20-F for the 2015 fiscal year filed in April 2016.

Cheetah Mobile’s insider-trading policy prohibited employees from trading in Cheetah Mobile securities and from establishing 10b5-1 plans while in possession of MNPI.  In March 2016, the CEO and CTO each stablished a 10b5-1 trading plan for the purpose of selling shares in Cheetah Mobile through a private British Virgin Islands company they had formed.  By selling their shares in March, the CEO and CTO avoided losses of $303,417 ($203,290 and $100,127, respectively).  One month later, in May 2016, the CEO announced that Cheetah Mobile did not expect to meet its 2016 expected earnings due to the downturn in revenue from its largest advertising partner.  The announcement led to an approximately 18% drop in Cheetah Mobile’s shares.

The key takeaways from the case are that:

• 10b5-1 plans  do not supply an ironclad defense in all circumstances.  If the executive or insider does not act in good faith or is aware of the material nonpublic information at the time the 10b5-1 trading plan is created, insider-trading charges could ensue.

• Violations of the sort charged in this action could lead to onerous undertakings, including disclosing all modifications of a 10b5-1 plan to the SEC and to the company’s legal department; waiting for a 120-day cooling-off period to make any trades under a newly enacted 10b5-1 plan; agreeing to additional trading restrictions; and certifying annually to compliance with such undertakings.

[1] SEC Charges Cheetah Mobile’s CEO and its Former President with Insider Trading, available at https://www.sec.gov/news/press-release/2022-169.