A recent SEC injunction revealed that two executives of Cheetah Mobile Inc. engaged in illegal insider trading when selling stock under an alleged 10b5-1 trading scheme. The SEC learned they drafted the plan after learning of a significant drop in ad revenue from the company’s largest advertising partner (the AdPartner) that the company had not yet disclosed. They then sold 96,000 American Depository Shares under the plan and avoided losses of approximately $203,290 and $100,127 respectively by making those sales before the trend and its effect were announced.
Rule 10b5-1 can provide an affirmative defense to allegations of insider trading, but only if the plan was prepared in good faith at a time when the individual was unaware of material nonpublic information. Here, the SEC found that the plan did not comply with the requirements of Rule 10b5-1 because the executives were aware of material nonpublic information in preparing the plan. This case underscores the importance of confirming the availability of all elements of the defense — a task that will become more difficult if proposed rule changes are approved.
Background
In 2015 and 2016, the company focused on developing mobile and computer applications, mobile games and other Internet-related products, earning up to one-third of its revenues from serving third-party advertisements delivered by the AdPartner in its applications. In mid-2015, the AdPartner informed the company that it was changing its algorithm that determines ad placement fees and that unless the company improves the quality of ad placements, the new algorithm could cut the AdPartner’s revenue in half.
The company earned $52.1 million in revenue from the AdPartner in the third quarter of 2015, but only $46.4 million in the fourth quarter — down 11%, representing 3% of total revenue in the fourth quarter. quarter, which the SEC deemed “significant.” AdPartner’s revenue declined further to $32.7 million in the first quarter of 2016 — a 30% drop, representing 8% of total revenue in the first quarter.
In a face-to-face meeting with the AdPartner, the CEO expressed concern that the algorithm change would lead to a drop in revenue and cause the company to fall short of its own revenue targets and Wall Street expectations. In emails sent to the AdPartner in late 2015, the then President and Chief Technology Officer (CTO) also expressed concerns about earnings and Wall Street’s potential response in the event of a significant drop in revenue.
Despite this well-known negative trend, during a quarterly conference call with analysts and investors in March 2016, the CEO attributed the “softness” in Q1 2016 revenue expectations primarily to greater-than-expected “seasonality.” The SEC concluded that this explanation was materially misleading because the CEO did not disclose the algorithm change and negative impact on revenue, and did not disclose that the negative trend was persistent and non-seasonal in nature. The company also did not disclose the trend in its annual report on Form 20-F filed in April 2016.
In late March 2016, while aware of the trend, which was material non-public information at the time, the two executives drafted a trading plan to sell some of their shares through a joint entity. Company policy prohibited employees from trading its securities and from making 10b5-1 trading plans while in possession of material nonpublic information. The SEC order also stated that the executives as officers had a duty to refrain from using the confidential information for their own personal gain. In May 2016, the company announced its lower-than-expected revenue guidance for the second quarter of 2016 and did not expect to meet its full-year revenue and profit guidance. After that, the share price fell by 18%. The executives avoided losses totaling $303,417 by selling securities under the plan prior to the May announcement.
Violations, Commitments and Order
The SEC found that both executives have violated Section 10(b) and Rule 10b-5, which prohibit fraudulent conduct in connection with the purchase or sale of securities. In addition, the CEO was found to have violated Sections 17(a)(2) and (3), the anti-fraud provisions of the Securities Act, which do not require a scientist and may be based on a finding of negligence. He was also found to be the cause of the Company’s violations of Section 13(a) and Rules 12b-20 and 13a-1 of the Exchange Act regarding the filing of false reports.
For five years:
- Among other things, both executives are required to notify the SEC of any US brokerage account they hold. They are also required to notify the SEC within 48 hours if they transact in corporate securities, including derivatives, or open a US brokerage account. They are prohibited from trading company securities in accounts other than those disclosed to the SEC.
- The CEO must notify the SEC within 48 hours if he enters into, changes or cancels a 10b5-1 plan related to corporate securities. He is also prohibited from maintaining more than one 10b5-1 plan at any time with respect to corporate securities and must include a cooling-off period of at least 120 days between the date of adoption or amendment of the plan and the execution of trades.
- Both executives are required to certify annually that they are meeting their respective obligations as set forth in the order and to provide written evidence of compliance supported by supporting documents.
The CEO and executives agreed to suspend and cancel orders related to certain securities laws and to pay civil fines of $556,580 and $200,254, respectively.
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