SEC Rule 10b5-1 plans Featured

7:00pm EDT February 24, 2008

So often, executives receive a large portion of their compensation in stock options, restricted stock or performance stock units, tying their overall compensation package back to the growth of the company and the value provided to shareholders. They often seek diversification strategies based upon their risk tolerance and investment objectives. But as insiders, or being perceived as insiders, they’re limited on when they can sell company shares.

Usually, executives can only trade when they are not in possession of material non-public information. This is generally presumed to be during an open trading window, which is set by companies and most often occurs for a short period after earnings release. These windows are narrow and can close unpredictably when the executive insider comes into the possession of material nonpublic information.

The executive is caught in a bit of a conundrum: While stock sales of key executives tend to be negatively perceived, a concentrated position in their company stock exposes them to market-and company-specific risk. As a result of all these factors, the executive’s ability to sell stock in the most optimal manner is quite limited.

“SEC Rule 10b5-1 plans are a potential solution,” explained Richard K. McDonnell Jr., CPA, a senior manager in the tax department at Burr Pilger Mayer. “They also allow for an affirmative defense against potential claims of insider trading.”

Smart Business received more insight into these plans from McDonnell.

How do SEC Rule 10b5-1 plans work?

These plans allow executive insiders to complete an agreement between a broker-dealer and the executive, approved by the issuer’s corporate counsel, to sell shares in a preset manner throughout the year.

Corporate executives can generally use the plans for the sale of actual company shares, to allow for the exercise of their company stock options and the immediate sale of the shares received, as well as the sale of their restricted stock or shares warded through performance share plans.

For example, let’s say that the executive has different lots of stock options at different grant prices and expiration dates. We would review the grants with the executive and complete the planning. The executive’s decisions would then be incorporated by the broker-dealer into a SEC Rule 10b5-1 plan for the executive’s and corporate counsel’s sign off. For example, the executive only has two years to exercise one lot of stock options prior to expiration of 20,000 shares. The grant price is $10 and the market is $40; the executive thinks that the stock should go up to $45 over the year or so. The executive could set up his plan to exercise 3,000 shares a month, as long as the current market is over $40. On the next lot, with approximately the same parameters, the executive could set the exercise price at $45 for the full lot. For a lot that has a few years until expiration, consideration for the exercise price might be at $60 because the executive thinks, and the market shows, that over the next few years the value might reach $60 but not much more than that. If the price hits currently, the executive can capitalize. On the whole, the planning is quite flexible and can be customized to fit both the executive’s needs and selling decisions.

How do the plans apply to restricted stock grants?

These plans are extremely important for use with restricted stock grants, whose restriction may lapse during a blackout window. In that case, the executive would receive the stock and the Form W-2 compensation without the ability to sell the stock until the next open window. This could be detrimental if the stock drops in value between the date of the lapse in restriction when the compensation element is determined and the actual sale of the stock.

So we could set up a plan during an open window that would enable the executive to sell these shares the day the restriction lapses. Once the plan is drawn up with a broker-dealer and approved by corporate counsel, when the restriction lapses, the executive would be able to sell the shares at the current market value, equal to the compensation element.

Are there any other considerations?

Most companies will only allow SEC Rule 10b5-1 plans to be implemented during open window periods and, of course, when the executive does not have knowledge of any material nonpublic information.

The most important item to remember is that the modification or termination of the plan may weaken or lose the benefit of the affirmative defense against insider trading. If the executive completes his or her stock option planning and diversification strategy in conjunction with the SEC Rule 10b5-1 plan, it is very important that he or she stay the course for the length of the particular plan, which typically runs for one year.

RICHARD K. MCDONNELL JR., CPA, is a senior manager in the tax department at Burr Pilger Mayer. Reach him at (650) 855-6880 or