It may seem like just an ordinary matter of insider trading, but there is one difference in this regular SEC enforcement action: According to the SEC, it involved selling under an alleged 10b5-1 trading scheme while in possession of material non-public information. As you probably know, in order to effectively isolate an insider from potential liability for insider trading, the 10b5-1 plan must be set up when the insider is acting in good faith and unaware from MNP. Making the plan when the insider just learned of MNPI, as claimed in this Order, kind of defeats the whole purpose of the rule. That’s not how it should work, and the two executives involved here – the CEO and President/CTO of Cheetah Mobile – found out the hard way, with civil fines of $556,580 and $200,254. The company’s CEO was also accused of playing a role in the company’s misleading statements and failure to disclose around a material negative revenue trend. According to the head of the SEC Enforcement Division’s Market Abuse Division in this press release, “[w]If trading under 10b5-1 plans can protect employees from liability for insider trading under certain circumstances, those executives’ plan failed to comply with the securities laws because they were in possession of material nonpublic information when they entered into it. ”
Background. Company executives, directors and other insiders are constantly exposed to material nonpublic information, making it sometimes difficult for them to sell company stock without the risk of insider trading, or at the very least claims of insider trading. To address this problem, Congress developed the Rule 10b5-1 affirmative defense in 2000. In general, Rule 10b5-1 allows a person, when acting in good faith and unaware of MNPI, to prepare a formal trade contract, instruction or plan specifying predetermined dates or formulas or other mechanisms – which not be subject to the person’s further influence – to determine when the person can sell shares without the risk of insider trading. According to the SEC, people are “aware” of MNPI “if they know, knowingly avoiding knowing or being reckless in not knowing that the information is material and non-public.” In order to be effective, the contract, instruction or plan must also meet the specific requirements set out in the Rule. In effect, the Rule provides an affirmative defense to show that a purchase or sale was not made “on” MNPI. If a 10b5-1 contract, instruction, or plan is well established, it is not a matter of whether the person had MNPI at the time of buying or selling the security; rather, that analysis is performed at the time the instruction, contract or plan is drawn up.
The ample leeway the Rule gives directors to transact under these plans, along with the lack of public information requirements, has long sparked controversy over Rule 10b5-1 plans, and many allegations and allegations have been made. suspicions of wrongdoing of 10b5-1 schemes have emerged in the press (see this PubCo post), in Congress (see this PubCo post), and in academia (see this PubCo post), representing more than 15 years back. Initially, academic studies revealed a statistical relationship between the timing of executive sales under Rule 10b5-1 plans and negative company news, finding that executives using 10b5-1 plans generated significantly better returns than other executives at the same time. company. SEC Enforcement took note and indicated that sales under 10b5-1 plans would then be scrutinized. As reported in the Washington Postin comments made in 2007, then SEC enforcement chief Linda Thomsen expressed concern that “executives are taking advantage of a legal safe haven to sell their stocks and profits before their companies report bad news….[A]academic studies suggest the rule may be a cover for inappropriate activity, Thomsen said. “We’re looking hard at this….If executives are, in fact, insider trading and using a cover plan, they should expect the ‘safe haven’ to provide no defense.’” (See this Cooley News Brief.) Several years later , a study conducted by the WSJ seemed to point to coincidental results of insider trading under 10b5-1 plans that appeared to be the result of more than serendipity. The article identified a number of issues with 10b5-1 plans, including the lack of disclosure about the plan or changes thereto and the lack of rules about how long the plans must be in place before trading under the plans can begin. (See this Cooley News Brief.) These have become familiar themes. Recommendations for addressing potential problems with 10b5-1 plans were also the subject of a regulatory petition from the Council of Institutional Investors in 2013 (see this Cooley News Brief), failed congressional efforts in 2019 and 2021 (see this PubCo post and this PubCo post), as well as recommendations from last year’s SEC Investor Advisory Committee (see this PubCo post). Still, while 10b5-1 plans are widely suspect, there have not really been a string of successful insider trading cases involving misconduct under 10b5-1 plans.
In 2021, the SEC released a new proposal to address these concerns by adding conditions to the availability of the Rule 10b5-1 affirmative defense that, according to the press release, “closed critical gaps in the SEC’s insider trading regime.” and by improving disclosure requirements “to help shareholders understand when and how insiders trade in securities” when “they may sometimes have material non-public information.” The conditions include cooling-off periods, certifications, prohibition on overlapping plans and a restriction on single-trade plans. (See this PubCo post.)
The order. According to the Order, Cheetah Mobile, a foreign private mobile communications publisher based in China, was primarily focused on “developing mobile and computer applications, mobile games and other content-driven products,” but earned up to a third of its total revenue from advertising revenues. third parties posted by an advertising department of a major social media platform. In the summer of 2015, Cheetah Mobile was notified by its ad partner of a potential change to its algorithm that, in the absence of improvements to the quality of Cheetah Mobile’s ad placement, would likely increase the revenue that this ad partner paid the company. halve. Attempts to improve the situation only offered a temporary solution, so that by the end of 2015 it became clear that advertising revenues would fall. And that’s what happened. Ad partner revenues declined from $52.1 million in the third quarter of 2015 to approximately $46.4 million in the fourth quarter of 2015, and declined further in the first quarter of 2016 by approximately 30% to approximately $32. 7 million.
During an analyst conference call in March 2016, Cheetah Mobile provided earnings guidance for the first quarter of 2016 that reflected an expected decline in total revenue in the following quarter. While the CEO in explaining the drop “referred to declines in certain partner revenues,” the SEC claimed he emphasized “seasonality.” For example, the SEC quotes the CEO during the call: “I think the softness you can see in the first quarter outlook that indicated a sequential decline for the first time is mainly due to not only seasonality, but some declines in one of our largest third-party ad platform partners, where we see significant sequential sales mitigations there, we don’t see any structural changes in the overall markets or any competitive landscape.” [The CEO] further noted that “if you look at some of the Q1 softness in our guidance, I think, as we mentioned earlier…some of the more-than-expected seasonality or softness comes from one of our biggest … platform partners.” that the CEO’s statements were materially misleading in that he “did not disclose that the algorithm change had caused a negative trend in the ad partner’s revenue, and that this trend was persistent and not seasonal in nature.” Likewise, the SEC claimed that the company had not disclosed that information about the known negative revenue trend in its Form 20-F. When the company’s first-quarter results were finally released in May, the company also released a lower-than-expected second-quarter expectation, which it attributed to, among other things, a “decrease in [a measure of advertising revenues] from some of our third-party advertising platform partners.” Following these announcements in May, the company’s ADS price fell about 18%.
In late March 2016, the CEO and CTO/President, who were both aware of the negative revenue trend, drafted a joint plan, which would be a 10b5-1 plan, which provided advance guidance for the sale of Cheetah Mobile Collateral. According to the SEC, the company’s insider trading policy prohibits “employees from trading company securities and from preparing 10b5-1 trading plans while in possession of material nonpublic information.” In addition, the SEC accused that, as officials of Cheetah Mobile, the CEO and CTO, “Cheetah Mobile and its shareholders had a duty to refrain from using the company’s confidential information for their own personal gain.” Prior to the May announcement, the CEO and CTO sold 96,000 Cheetah Mobile ADS under the plan, avoiding losses totaling $303,417.
The SEC charged that the CEO and CTO “knew or recklessly ignored” that the information about the revenue decline was “material and non-public”, were aware of this MNPI when they created the alleged 10b5-1 plan and knew it was plan was not in accordance with the requirements of Rule 10b5-1. The SEC also charged that they “knew or recklessly disregarded that, by selling Cheetah Mobile’s securities prior to disclosing this material nonpublic information to investors, they each violated the trust duty they owed to Cheetah Mobile and its shareholders.” .”
The CEO and CTO were both charged with violating Section 10(b) of the Exchange Act and related Rule 10b-5, which prohibit fraudulent conduct in connection with the purchase or sale of securities. The CEO was also charged with violations of Sections 17(a)(2) and (3) of the Securities Act, and as causing Cheetah Mobile’s violations of Section 13(a) of the Exchange Act and related Rule 13a-1 and Rule 12b-20. The CEO was ordered to pay a civil fine of $556,580 and the CTO $200,254. Both were also subject to extensive five-year commitments, primarily related to their securities trading and 10b5-1 business.
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