January 5, 2023
The last couple of weeks of 2022 brought several key announcements and developments in the U.S. and UK, and now, with the holidays and celebrations behind us, we have the opportunity to take a deep dive into what this all means and what to do about it.
Looking ahead, it's anyone's guess what the new year will bring. But we are committed to continue to bring you our take on key developments in the financial regulatory space ... starting with some important analysis in today's issue.
So have a good read. Any comments or questions? Just drop me a note here.
Daniel Meade
Editor, Cabinet News and Views
On the first business day of the year, January 3, 2023, the Board of Governors of the Federal Reserve System (“the Fed”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”), the nation’s primary banking regulators, came together to issue a Joint Statement on Crypto-Asset Risks to Banking Organizations. Striking in its tone and issued “given the significant risks highlighted by the recent failures of several large crypto-asset companies,” the purpose of the statement is to ensure that banks do what they can to ensure “that risks to the crypto-asset sector that cannot be mitigated or controlled do not migrate to the banking systems.” While the statement reassures that “banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type,” the message is clear that whenever a bank chooses to engage with a client involved with the business of cryptocurrency, the prudential regulators will be watching closely through supervision protocols to assess whether the bank has put into place “appropriate risk management, including board oversight, policies, procedures, risk assessments, controls, gates and guardrails, and monitoring, to effectively identify and manage risks.”
The statement includes a list of specific risks that banks should be aware of, including: risk of fraud; custodial legal uncertainties; inaccurate or misleading representations by crypto-asset companies; significant volatility of crypto-asset markets and the impact that volatility may have on deposit flows at crypto-asset companies; susceptibility of stablecoin projects to create “potential deposit outflows for banking organizations that hold stablecoin reserves”; contagion risk among the broader crypto-asset sector as a result of things such as opaque lending, investing, funding, service and operational arrangements; a lack of maturity in risk management and governance practices among the crypto-asset sector; and heightened risks with “open, public, and/or decentralized networks” where there is a lack of governance mechanisms to oversee the systems (e.g., because of reliance upon digital asset organizations (DAOs), smart contracts or other artificial intelligence technology) and where there may be an absence of contracts or standards to clearly establish roles, responsibilities and liabilities with respect to such networks.
On the last point, in particular, the joint statement shows the regulators are beginning to reach some conclusions about cryptocurrency networks that are simply too risky. In other words, if the governance of a cryptocurrency network is driven only (or even mostly) by technology, and there is no or very limited ability for humans to intervene, then that network may be deemed too risky for any bank to be involved with. In addition, if the cryptocurrency network lacks clear rules about responsibility for compliance with the law (especially anti-money laundering laws) and what liabilities each party to a transaction may have, then that network may also be deemed too risky.
On December 16, 2022, the Board of Governors of the Federal Reserve System (the “Board”) adopted a final rule (the “Final Rule”) to implement the Adjustable Interest Rate (LIBOR) Act[1] (the “LIBOR Act”). The Final Rule follows the Board’s publication of a proposed rule (the “Proposed Rule”) in July 2022 and invitation for public comment. The Final Rule addresses many of the comments received on the Proposed Rule and sets forth the Board’s final decision on a number of substantive and technical issues related to the planned cessation of USD LIBOR on a representative basis. The Final Rule will become effective 30 days after publication in the Federal Register.
A discussion of the Final Rule is set forth below.
A. Categorization of Legacy Contracts
The Proposed Rule used the terms “covered contract” and “non-covered contract” to describe LIBOR contracts that would be subject to the Proposed Rule and those that generally would not be subject to the Proposed Rule. Several commenters indicated that this bifurcation did not fully align with the LIBOR Act and was confusing. Therefore, the Board did not include these terms in the Final Rule. Instead, in the Final Rule the Board identified three categories of contracts encompassing legacy LIBOR contracts.
The first category of LIBOR contracts includes those contracts that contain fallback provisions identifying a specific benchmark replacement not based in any way on LIBOR values[2] and that do not require the conducting of a poll, survey, or inquiries for quotes to determine the replacement rate. Contracts in this first category are generally expected to transition to the contractually agreed-upon benchmark replacement as provided in their fallback provisions on or before the LIBOR replacement date.[3]
The second category of LIBOR contracts includes (i) contracts that contain no fallback provisions and (ii) contracts that do not identify a determining person[4] and that only (A) identify a benchmark replacement that is based on LIBOR or (B) require the conducting of a poll, survey, or inquiries for quotes to determine the replacement rate. Contracts in this second category are expected to transition on the LIBOR replacement date to the “Board-selected benchmark replacement” for the particular type of LIBOR contracts as described below.
The third category of LIBOR contracts includes contracts that contain fallback provisions authorizing a determining person to determine a benchmark replacement. The application of the LIBOR Act to these contracts will depend on the benchmark replacement selection, if any, made by the determining person. Contracts in this third category are expected to transition to the benchmark replacement selected by the determining person, or to the Board-selected benchmark replacement if no benchmark replacement is selected by the determining person.
The description of these categories in the Board’s commentary provides a helpful roadmap for implementation of the LIBOR Act and the Final Rule.
B. Board-selected Benchmark Replacement
The central feature of the Final Rule is the selection of the “board-selected benchmark replacement” that will be applicable to various types of LIBOR contracts. The Board-selected benchmark replacement identifies what benchmark replacement certain legacy LIBOR contracts will transition to on the LIBOR replacement date, the benchmark replacement that certain contracts with a “determining person” may transition to, and the benchmark replacement that, if used, will receive the benefit of protective provisions in the LIBOR Act, such as a safe harbor. The Board-selected benchmark replacement varies based on the type of LIBOR contract.
The Final Rule sets forth the following benchmark replacements for the following types of contracts:
- Derivatives
- The Final Rule selects the “Fallback Rate (SOFR)” identified in the ISDA 2020 IBOR Fallback Protocol published by ISDA on October 23, 2020 (the “ISDA Protocol”) as the fallback benchmark rate for all derivative transactions. The Fallback Rate (SOFR) is a rate equal to SOFR, compounded in arrears for the applicable tenor, plus the stated spread adjustments for the applicable tenor (which are the same as the statutory spread adjustments specified in the LIBOR Act). This will align derivatives transitioning pursuant to the LIBOR Act with many derivatives that have or will transition pursuant to the ISDA Protocol.
- Consistent with the request of some commenters, the Final Rule addresses some technical amendments to ensure alignment with the ISDA Protocol, including by defining “derivative transaction fallback observation day” in the same way as ISDA.
- Notably, the Board declined requests from some commenters to select a different benchmark replacement for certain derivatives linked to certain cash transactions and transition them to the benchmark replacement used by the relevant underlying transactions. The Board recognized that this may give rise to basis risk for these transactions, but opted instead to emphasize a simple, clear, and manageable benchmark replacement for all derivative transactions consistent with the ISDA Protocol.
- Cash Transactions
- For most cash transactions, with the exceptions set forth below, the Board selected (x) SOFR plus the statutory spread to replace overnight LIBOR and (y) 1-, 3-, 6- and 12-month CME Term SOFR plus the statutory spread to replace the corresponding tenor of LIBOR. These selections are consistent with ARRC recommendations and the Proposed Rule.
- Consumer loans will transition to the same fallback rates as set forth above; however, the spread adjustment will be implemented on a gradual basis over a one-year period after the LIBOR replacement date and will be fully implemented on the first year anniversary of the LIBOR replacement date. The transition spread adjustment[5] is intended to prevent consumer borrowers from experiencing significant shifts in borrower rates on and immediately following the LIBOR replacement date.
- FHFA[6] — FHFA-regulated-entity contracts, other than Federal Home Loan Bank advances, will transition to (x) SOFR plus the statutory spread to replace overnight LIBOR and (y) 30-day Average SOFR[7] to replace 1-, 3-, 6- and 12-month LIBOR. Federal Home Loan Bank advances will transition to Fallback Rate (SOFR).
- FFELP — Under the Final Rules, the Board created a fallback rate specific for certain asset-backed securities in response to comments to the Proposed Rule. A “Federal Family Education Loan Program (FFELP) asset-backed securitization (ABS)” is any asset-backed security for which more than 50 percent of the collateral pool consists of FFELP loans, as reported in the most recent servicer report available on the LIBOR replacement date. Any FFELP asset-backed securitization (ABS) will transition as follows: (i) one-month LIBOR will be replaced with 30-day Average SOFR plus the tenor spread adjustment specified in the LIBOR Act; (ii) three-month LIBOR will be replaced with 90-day Average SOFR plus the tenor spread adjustment specified in the LIBOR Act; and (iii) six- or 12-month LIBOR will be replaced with 30-day Average SOFR plus the statutory tenor spread adjustment for six- or 12-month tenors, respectively.
C. Synthetic LIBOR
With the recent publication of a proposal by the United Kingdom’s Financial Conduct Authority (“FCA”), the regulator of the ICE Benchmark Administration (“IBA”), LIBOR’s administrator, to require publication of 1-, 3-, and 6-month USD LIBOR settings on a “synthetic” basis through end-September 2024, it appears likely that these tenors of USD LIBOR will continue to exist on a synthetic, or non-representative, basis for some period after June 30, 2023. The Board recognizes that this could have an impact on a number of legacy contracts, including those that contain fallbacks that are not expressly triggered where a benchmark called “LIBOR” is available but is not representative, and has included in the Final Rule a few provisions and clarifications to address this point, while declining to incorporate other suggestions relating to synthetic LIBOR.
- The Proposed Rule requested comment on whether the Final Rule should provide that a LIBOR contract containing fallback provisions that identify a clear and practicable benchmark (e.g., the prime rate) but lack an express non-representative trigger would transition on the LIBOR replacement date notwithstanding such lack of express trigger. The Final Rule incorporates clarifying language regarding certain related provisions of the LIBOR Act, but does not purport to make clarifications about contracts that are outside the scope of the LIBOR Act.
- The Board reiterated in the commentary and in the actual Final Rule, consistent with the LIBOR Act, that any LIBOR contract containing fallback provisions that identify a benchmark replacement not based in any way on any LIBOR value (e.g., the prime rate or federal funds rate) is not subject to automatic transition to the Board-selected benchmark replacement on the LIBOR replacement date. As a result, certain LIBOR contracts that do not contain a non-representativeness trigger but do contain non-LIBOR fallback rates could be required, pursuant to their terms, to utilize applicable synthetic LIBOR tenors. Contract counterparties should carefully analyze provisions in their legacy LIBOR contracts to determine whether a benchmark transition trigger has been implicated.
- The Final Rule also clarifies the treatment of certain contracts with a “determining person” if synthetic LIBOR is published, as described below.
D. Determining Persons
The Final Rule clarifies two potential ambiguities in the interpretation of the term “determining person” raised by commenters to the Proposed Rule.
- The definition of “determining person” was clarified to note that it refers to a person with “sole” authority, right, or obligation to determine a benchmark replacement. This clarifies the treatment of a LIBOR contract whose fallback provisions require the consent or agreement of multiple parties. Multiple parties cannot, collectively, be a “determining person.” As a result, if those parties are unable to reach agreement, and the contract does not contain a specific benchmark (nor, as a result of this clarification, a “sole” determining person), it will be subject to automatic transition to the Board-selected benchmark replacement under Section 104(a)(2) of the LIBOR Act.
- The definition of “determining person” was also clarified to provide that a person would qualify as such even if their authority, right, or obligation to determine a benchmark replacement is contingent (e.g., when the non-representative, synthetic version of LIBOR is not available). Therefore, so long as the applicable LIBOR contract does not contain a fallback provision that identifies a non-LIBOR based benchmark replacement, like the prime rate or effective Federal funds rate, a “determining person” has the statutory authority pursuant to Section 104(c)(1) and (2) of the LIBOR Act to select the Board-selected replacement benchmark by, at the latest, the LIBOR replacement date. If the determining person under any such LIBOR contract does not select a benchmark replacement by the LIBOR replacement date, the applicable Board-selected benchmark replacement will be the benchmark replacement for the LIBOR contract pursuant to section 104(c)(3) of the LIBOR Act.
E. Technical Revisions and Notice Requirements
The Final Rule includes a number of technical changes, including clarification of certain language commonly used in legacy LIBOR contracts. Many legacy LIBOR contracts used the wording “Eurodollar deposit and lending rates” or similar phrases, oftentimes interchangeably with “interbank lending or deposit rates.” The Final Rule clarifies that “Eurodollar deposit and lending rates” are “interbank lending or deposit rates” for purposes of the LIBOR Act and the Final Rule.
In the Proposed Rule, the Board also invited comment as to whether the Final Rule should require a determining person to provide notice regarding the selection of a replacement benchmark. Consistent with the comments received, the Final Rule does not impose any notice requirements.
F. Conforming Changes
The LIBOR Act allows the Board to determine, in its discretion, conforming changes that would address issues affecting the implementation, administration and calculation of the Board-selected benchmark replacement. These conforming changes will become an integral part of any LIBOR contract for which the Board-selected benchmark replacement becomes the benchmark replacement pursuant to the LIBOR Act and the Final Rule. The conforming changes addressed by the Final Rule are as follows:
- Many legacy LIBOR contracts referenced a specific source for LIBOR (such as a particular newspaper, website, or screen). The Final Rule replaces any such specified source with the publication of the Board-selected benchmark replacement (including a spread adjustment, if applicable) by either the relevant benchmark administrator or any third party authorized to publish such rate.
- Many legacy LIBOR contracts specified a particular time of day (e.g., 11:00 a.m. London time) for sourcing LIBOR. The Final Rule replaces any such time with the standard publication time for the applicable Board-selected benchmark replacement, as established by the relevant benchmark administrator.
- If a LIBOR contract requires the use of a combination of LIBOR values over a period of time that spans the LIBOR replacement date (e.g., an average of LIBOR every month during 2023), such provision would use LIBOR prior to the LIBOR replacement date and the applicable Board-selected benchmark replacement for any date on or after the LIBOR replacement date.
- The Final Rule provides that (with certain exceptions), to the extent that a Board-selected benchmark replacement is not available for a particular day as required in a contract, the most recently available publication of the Board-selected benchmark replacement will apply. This is designed to address concerns about referencing certain defined business days (e.g., London business days) in a LIBOR contract for determining benchmark rates that may not be applicable to the Board-selected benchmark replacement; if the Board-selected benchmark replacement would not be available on such day, the calculation party would look back to the most recent day on which it were available.
The conforming changes listed above are not exclusionary. The Final Rule clarifies that, with respect to any LIBOR contract that is not a consumer loan, a calculating person may make additional technical, administrative, or operational changes, alterations, or modifications that, in that person’s reasonable judgment, would be necessary or appropriate to permit the implementation, administration, and calculation of the Board-selected benchmark replacement without consent from any other person.
The Board has reserved the right to publish, in its discretion, additional conforming changes.
G. Scope of Section 105 of the LIBOR Act
The LIBOR Act provides for certain statutory protections related to the selection and use of the Board-selected benchmark replacement. In response to comments on the Proposed Rule, the Board included a new section in the Final Rule expressly stating that the provisions of Section 105(a)-(d) of the LIBOR Act shall apply to any LIBOR contract for which the Board-selected benchmark replacement becomes the benchmark replacement pursuant to Section 253.3(a) or (c) of the Final Rule.
Under Section 105(a)-(d), the selection of a Board-selected benchmark replacement and implementation of related benchmark conforming changes in the circumstances described below:
- constitute a commercially reasonable replacement for, and a reasonable, comparable, or analogous rate, index, or term for LIBOR and substantial performance relating to or based on LIBOR;
- may not be deemed to impair or affect rights of parties under a contract or have the effect of discharging, excusing performance, giving rise to a termination right, or constituting a breach under a LIBOR contract;
- are provided a safe harbor from any claims, causes of action, requests for equitable relief, or liability from damages for the use of a Board-selected benchmark replacement or the implementation of benchmark replacement conforming changes; and
- are deemed not to be an amendment or modification of a LIBOR contract or prejudice, impair, or affect the rights, interests, or obligations of any person under or with respect to any LIBOR contract.
Sections 253.3(a) and (c) of the Final Rule, which align with Sections 104(a) and 104(c) of the LIBOR Act, address situations where the applicable Board-selected benchmark replacement replaces the existing benchmark (i) automatically as a result of a LIBOR contract containing no fallback language or containing neither a specific benchmark replacement nor a determining person, (ii) automatically as a result of a determining person having not selected a benchmark replacement by the applicable benchmark replacement date, or (iii) as a result of the selection of such rate by the determining person.
The Final Rule also separately provides that nothing in the Final Rule is intended to alter or modify Section 105(e) of the LIBOR Act, which states that subject to certain specific provisions in the LIBOR Act, nothing in the LIBOR Act may be construed to create any negative inference or negative presumption regarding the selection of a benchmark replacement or changes related thereto that is different than the Board-selected benchmark replacement.
[1] Pub. L. 117-103, div. U, codified at 12 U.S.C. 5801 et seq., https://www.congress.gov/117/plaws/publ103/PLAW-117publ103.pdf (pp. 777-786).
[2] This does not include references to LIBOR values used to account for the difference between LIBOR and the selected benchmark replacement.
[3] “LIBOR replacement date” means the first London banking day after June 30, 2023, unless the Board determines that any LIBOR tenor will cease to be published or cease to be representative on a different date.
[4] A “determining person” means, with respect to any LIBOR contract, any person with the sole authority, right, or obligation, including on a temporary basis (as identified by the LIBOR contract or by the governing law of the LIBOR contract, as appropriate) to determine a benchmark replacement, whether or not the person’s authority, right, or obligation is subject to any contingencies specified in the LIBOR contract or by the governing law of the LIBOR contract.
[5] Refinitiv Limited will publish and provide rates for consumer loans that sum (i) CME Term SOFR and (ii) the transition spread adjustment.
[6] In response to comments to the Proposed Rule suggesting that the terms “GSE” and “Covered GSE contract” used in the Proposed Rule were too broad, the Final Rule replaced those terms with “FHFA-regulated entity” and “FHFA-regulated-entity contract”.
[7] “30-day Average SOFR” is defined in Section 253.2 of the Final Rule.
In its last regulatory action for 2022, on December 23, the U.S. Commodity Futures Trading Commission (“CFTC”) published its staff no-action letter No. 22-21 (“NAL”) allowing commodity brokers – Futures Commission Merchants (“FCMs”) – to invest their customer funds in investment instruments that contain an adjustable rate of interest that is benchmarked to Secured Overnight Financial Rate (“SOFR”) instead of London Interbank Offered Rate (“LIBOR”). This NAL expanded CFTC’s previous similar relief to also apply to Derivatives Clearing Organizations (“DCOs”) investing customer funds.
The CFTC was compelled to issue this relief because its Regulation 1.25 provides a list of specific instruments where customer funds may be invested by FCMs and DCOs, and has a specific reference to only the LIBOR-linked investments while it does not expressly allow SOFR-linked investments relating to three types of customer derivatives accounts: (1) futures accounts, (2) cleared swaps accounts and (3) foreign futures and options accounts. These investments are significant: according to research from the Futures Industry Association (“FIA”), in 2022 FCMs held approximately $350 billion of customer funds in futures accounts and approximately $152 billion of customer funds in cleared swaps accounts. The CFTC also provides updated customer funds numbers broken down by the FCMs.
The NAL extends relief for FCMs and DCO until December 31, 2024 or the date when the CFTC issues a final rule addressing LIBOR transition issues. CFTC Commissioner Mersinger suggested that instead of issuing no-action relief, the CFTC should have issued a comprehensive SOFR transition rule as well as a comprehensive rule on investment of customer funds as referred to in CFTC’s regulatory agenda for 2022.
Earlier in 2022, on August 12, the CFTC issued final rules updating the set of interest rate swaps that are required to be submitted for clearing under CFTC’s Part 50 regulations to include SOFR-linked swaps and swaps based on other critical risk-free reference rates.
The UK’s Financial Conduct Authority (“FCA”) and Prudential Regulation Authority (“PRA”) have together fined a leading bank a total of £48,650,000 for IT failures that left customers unable to access their accounts. The fine would have been £69,500,000 were it not for a 30% discount for early settlement.
In 2018, the bank undertook a single migration of its entire system to a newly-built platform − the failure of which left personal and business banking customers unable to access their accounts. Investigations by the PRC (responsible for the prudential regulation of the bank) and FCA (responsible for conduct of business regulation) found significant operational risk management and governance failures directly led to significant disruption to business as a result of failures to organize and control this significant outsourcing project. Both regulators pointed to the crucial role of prudent management and governance in ensuring safety and soundness and identified insufficiently robust governance as a key element in the incident. The bank’s approach to risk management was also assessed as deficient; examples included the static nature of the programme risks (the list of 22 risks remained unchanged throughout the project) and a lack of visibility over the supply chain.
While the incident pre-dates the PRA’s specific operational resilience framework for banks (in force in 2021) both regulators pointed to pre-existing principles and rules that had been breached. In the case of the PRA, at heart the failures were a result of breaches of Fundamental Rules 2 (business must be conducted with due care, skill and diligence) and 6 (firms must organize their affairs responsibly and effectively). As we move towards full implementation of UK regulators’ rules on identifying and operating within impact tolerances for operational risks to all important business services, this enforcement action serves as a reminder that the universe of these risks requires comprehensive resilience that includes outsourcing and supply chain relationships.
On 21 December 2022, ESMA published a final report in relation to draft technical standards for cross-border fund management activities and the cross-border marketing of investment funds within the EEA under the UCITS and AIFM directives. This follows a consultation paper ESMA had published on 17 May 2022. The EU Commission is now expected to adopt the draft technical standards within three months from the publication date.
The requirements in the draft technical standards aim at fostering convergence and facilitating cross-border activities within the EU, particularly in relation to the format and procedures relating to the various regulatory notifications and filings that need to be made to national regulators for these purposes. This includes standardizing the content and format of the filings, and specifying what may be required by way of accompanying information that UCITS management companies and AIFMs must submit to the relevant local regulator within the EU. Templates for these filings are attached as appendices to the report.
The draft technical standards and templates include sensible amendments from those consulted on, particularly now only requiring documentation or information actually be available at the time of filing. Notably, delegation agreements do not now need to be included. Unfortunately, the technical standards still do not address some of the outstanding uncertainties about the regime, especially in relation to the de-registration of closed-ended funds.
On December 22, just before many of us may have started turning to our holiday breaks, the Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”) and Office of the Comptroller of the Currency (“OCC”) issued an extension of the no-action relief they had previously given. The interagency statement reiterates what the agencies have said for the past few years that they “will continue to exercise discretion to not take enforcement action against either an asset manager that is a principal shareholder of a bank, or a bank for which an asset manager is a principal shareholder, with respect to extensions of credit by the bank to the related interests of such asset manager that otherwise would violate Regulation O.”
Regulation O (12 CFR Part 215) places limits and reporting obligations on extensions of credit by insured depository institutions (“IDI”) to executive officers, directors, or principal shareholders of the IDI (“Insiders”) and to companies controlled by such Insiders. As the Interagency Statement points out, the issue that has arisen in recent years is when investment fund complexes acquire more than 10% of banks or their parent bank holding companies. These investment fund complexes often also have 10% of other companies. Thus, companies in which an investment fund complex has a greater than 10% investment would be a “related interest” under Regulation O, and loans to portfolio companies of such investment fund complexes would be subject to the Regulation O limits and upset many existing extensions of credit throughout the economy.
The renewal of this no-action position by the banking agencies until January 1, 2024 continues the relief the agencies have been offering, subject to certain supervisory expectations articulated in the statement that provide more leeway for index funds. The FRB noted that it “continues to actively consider whether to amend Regulation O to address the treatment of extensions of credit to fund complex-controlled portfolio companies under Regulation O.”
On January 13, 2022, the Securities and Exchange Commission (the “SEC”) proposed several rule and form amendments to address potentially abusive practices relating to the use of Rule 10b5-1 plans, grants of options and other similar equity instruments, and gifts of securities (the “Proposed Rules”). After considering numerous comment letters on the Proposed Rules, on December 14, 2022, the SEC adopted amendments to Rule 10b5-1 under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and new disclosure requirements intended to strengthen investor protections regarding insider trading. Unlike the Proposed Rules, the final amendments (the “Final Rules”) do not apply to trading activities of issuers. The Final Rules impose the following additional conditions on the availability of the affirmative defense provided by Rule 10b5-1(c)(1):
- cooling-off periods applicable to directors and “officers” (as defined by Rule 16a-1(f) under the Exchange Act) and other persons except for the issuer;
- a certification condition for directors and officers;
- limitation on the ability of persons other than the issuer to use multiple overlapping Rule 10b5-1 plans;
- limitation on the ability of the Rule 10b5-1(c)(1) affirmative defense for a single-trade plan to one single-trade plan (subject to certain limited exceptions) during any consecutive 12-month period for all persons other than the issuer; and
- a condition that all persons entering into a Rule 10b5-1 plan must act in good faith with respect to that plan.
In addition, the Final Rules impose the following additional disclosure and reporting requirements:
- quarterly disclosure by registrants regarding the use of Rule 10b5-1 plans and certain other trading arrangements by registrant’s directors and officers for the trading of its securities;
- annual disclosure in new Item 408 of Regulation S-K of registrant’s insider trading policies and procedures and corresponding amendments to Forms 10-Q and 10-K;
- a new mandatory Rule 10b5-1(c) checkbox on Forms 4 and 5;
- certain tabular and narrative disclosures regarding awards of options, stock appreciation rights and/or similar option-like instruments granted to corporate insiders shortly before and immediately after the release of material nonpublic information in new paragraph (x) to Item 402 of Regulation S-K;
- requirement that registrants tag the information specified by new Items 402(x), 408(a), and 408(b)(1) in Inline XBRL; and
- requirement to report bona fide gifts of equity securities on Form 4, rather than on Form.
These amendments are discussed below in more detail and are intended to improve investor confidence in the securities markets, and, at the same time, ensure liquidity and flexibility for traders who would like to plan securities transactions in advance when they are not aware of material nonpublic information.
Issuers will be required to comply with the new disclosure and tagging requirements in periodic reports on Forms 10-Q, 10-K and 20-F and in any proxy or information statements that are required to include the Item 408, Item 402(x), and/or Item 16J disclosures in the first filing that covers the first full fiscal period that begins on or after April 1, 2023, provided, that the compliance date for issuers that are “smaller reporting companies” as defined in Rule 405 under the Securities Act of 1933, as amended, and Rule 12b-2 under the Exchange Act, will be October 1, 2023. Section 16 reporting persons will be required to use amended Forms 4 and 5 for beneficial ownership reports starting April 1, 2023.
I. Amendments to Rule 10b5-1
a. Mandatory Cooling-off Period
After consideration of the comments it received, the SEC adopted a modified cooling-off period that will apply to all persons other than the issuer, with directors and officers of issuer subject to a longer cooling-off period than other persons who rely on the affirmative defense provided by Rule 10b5-1(c)(1). A cooling-off period is intended to provide a separation in time between the adoption of the plan and the start of trading under the newly-adopted plan in order to minimize the ability of an insider to benefit from material nonpublic information the insider may have.
A director or officer who adopts or modifies a Rule 10b5-1 plan will not be able to rely on affirmative defense of the plan unless the plan does not allow trading under the plan to begin before the later of (1) 90 days after the adoption of the plan or (2) two business days following the disclosure of the issuer’s financial results in a Form 10-Q or Form 10-K for the fiscal quarter in which the plan was adopted or, in the case of foreign private issuers, in a Form 20-F or Form 6-K that discloses the issuer’s financial results (in each case, subject to a maximum of 120 days after adoption of the plan).
b. Mandatory Director and Officer Certifications for New and Modified Rule 10b5-1 Plans
The final Rule 10b5-1(c)(1)(ii)(C) adopted by the SEC states that, if a director or officer of the issuer of securities establishes or modifies a Rule 10b5-1 plan, the plan will not provide an affirmative defense unless the director or officer includes a representation in the plan certifying that at the time of its adoption or modification (as applicable), the director or officer is not aware of material nonpublic information about the issuer or its securities, and the director or officer is adopting the plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5.
c. Restrictions on Overlapping and Single-Trade Plans
The Final Rules added a condition to the Rule 10b5-1(c)(1) affirmative defense that persons, other than issuers, generally may not at any time have multiple contracts, instructions or plans that would qualify for the Rule 10b5-1 affirmative defense during the same period. In adopting this amendment, the SEC noted that multiple overlapping plans can be used for impermissible hedging or may allow trading on the basis of material nonpublic information by an insider who had otherwise complied with the provisions of Rule 10b5-1. To address received comments, the SEC added several clarifications and exceptions to the single plan requirement.
The first one addresses an insider’s use of multiple broker-dealers to execute trades under a single Rule 10b5-1 plan that covers securities held in different accounts by providing that a series of separate contracts with different broker-dealers or other agents acting on behalf of the insider may be treated as a single “plan” if those contracts, taken together as a whole, meet all applicable conditions of, and remain collectively subject to, the provisions of Rule 10b5-1(c)(1). In addition, a broker-dealer or other agent executing trades on behalf of the insider under a Rule 10b5-1 plan may be substituted by a different broker-dealer or other agent as long as the purchase or sale instructions under the plan do not change.
The second one permits any person (other than the issuer) to maintain two separate Rule 10b5-1 plans if trading under the second plan is authorized to begin only after all trades under the first plan have been completed or expired without execution and the cooling-off period that would be applicable under Rule 10b5-1(c)(1)(ii)(B) to the second plan if it were adopted on the date of termination of the first plan has ended.
The third one provides that an insider will not lose the benefit of the affirmative defense under an otherwise eligible Rule 10b5-1 plan if the insider puts in place another plan that would qualify for the affirmative defense, so long as the additional plan only authorizes qualified sell-to-cover transactions where an agent is only authorized to sell securities as necessary to satisfy tax withholding obligations incident to the vesting of a compensatory award, and the insider does not exercise control over the timing of such sales. This exception, however, is not applicable to sales relating to the exercise of option awards because such exercise occurs at the discretion of the insider, and therefore, may occur when the insider is in possession of material nonpublic information.
Finally, consistent with the restrictions on multiple overlapping plans, the Final Rules provide that if a contract, instruction, or plan adopted by any person other than the issuer is designed to effect an open-market purchase or sale of securities as a single transaction, the affirmative defense will not be available if the person had, during the preceding 12-month period, adopted another single-trade plan that qualified for the affirmative defense under Rule 10b5-1. A plan is “designed to effect” the purchase or sale of securities as a single transaction if it has the practical effect of requiring that result.
d. Amendment to the Good Faith Condition
The Final Rules add a condition that a person who entered into a Rule 10b5-1 plan must act “in good faith with respect to the contract, instruction, or plan.” For example, a corporate insider would not be operating a Rule 10b5-1 plan in good faith if the corporate insider, while aware of material nonpublic information, induces the issuer to publicly disclose that information in a manner that benefits insider’s trades under the plan.
II. Additional Disclosure Requirements
To address concerns that the absence of mandatory disclosure requirements of Rule 10b5-1 and other trading arrangements of corporate insiders creates an environment in which it is more difficult for investors to assess whether corporate insiders may be misusing their access to material nonpublic information, the SEC included several new disclosure requirements in the Final Rules.
a. Quarterly Reporting of Trading Arrangements
The Final Rules add a new Item 408(a) of Regulation S-K that requires each registrant to disclose in Forms 10-Q and 10-K any adoption or termination by any of its directors or officers of any contract, instruction or written plan for the purchase or sale of securities of the registrant that is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c) and/or any non-Rule 10b5‑1 trading arrangement as defined in Item 408(c) and to provide a description of the material terms of such trading arrangements (other than certain pricing information).
b. Mandatory Disclosure of Insider Trading Policies and Procedures
A new Item 408(b) of Regulation S-K and new Item 16J in Form 20-F, added by the Final Rules, require registrants to disclose in their annual reports on Form 10-K (Item 16J in Form 20-F for foreign private issuers) and proxy and information statements on Schedules 14A and 14C whether they have adopted insider trading policies and procedures.
c. Identification of Transactions Intended to Satisfy Rule 10b5-1(c) on Forms 4 and 5
Section 16(a) of the Exchange Act requires corporate officers, directors, and principal shareholders to disclose changes in their beneficial ownership on Form 4 or 5, which are publicly available. The Final Rule adds the mandatory Rule 10b5-1 checkboxes to Forms 4 and 5 that require the Section 16 reporting person to state that the reported transaction is intended to satisfy the affirmative defense conditions of Rule 10b5-1(c).
III. Mandatory Disclosure of Stock Options and Similar Instruments Granted Close in Time to the Disclosure of Material Nonpublic Information
To address concerns that a registrant may be aware of material nonpublic information at the time its board of directors grants stock options and certain option-like awards, the SEC added a new paragraph to Item 402 of Regulation S-K that would require registrants to discuss their policies and practices on the timing of such awards and provide a tabular disclosure of certain information relating to such instruments if, during the last completed fiscal year, such instruments were awarded to any named executive officer of the registrant within a period starting four business days before the filing of a periodic report on Form 10-Q or Form 10-K, or the filing or furnishing of a current report on Form 8-K that discloses material nonpublic information (other than a current report on Form 8-K disclosing a material new option award grant under Item 5.02(e)), and ending one business day after a triggering event.
IV. New Inline XBRL Data Requirements
Under the Final Rules, registrants are also required to tag the information specified by newly-added Items of Regulation S-K and new Item 16J(a) of Form 20-F in Inline XBRL, in accordance with Rule 405 and the EDGAR Filer Manual.
V. Requirement to Report Gifts of Equity Securities on Form 4
In the Final Rule, the SEC also adopted amendments to Rule 16a-3 that require Section 16 reporting persons to report bona fide gifts of equity securities on Form 4 (rather than Form 5). As a result, such gifts will have to be reported before the end of the second business day following the date of execution of the transaction (instead of within 45 days after the issuer’s fiscal year end). This amendment is intended to address concerns that the delayed reporting of gifts on Form 5 may allow problematic practices involving gifts of equity securities while in possession of material nonpublic information or backdating gifts of equity securities in order to maximize the related tax benefits.
Conclusion
Overall, the adopted amendments are focused on reducing ability of corporate insiders to misuse Rule 10b5-1 safe harbor in order to profit from material non-public information they have access to. The amendments are intended to address concerns about misuse of Rule 10b5-1 expressed by legislators, courts and many commenters who pointed out that corporate insiders trading pursuant to Rule 10b5-1 plans consistently outperform the trading of corporate insiders outside of such plans. Therefore, corporate insiders have to be prepared to comply with the new restrictions and disclosure requirements relating to their use of Rule 10b5-1 plans, while issuers of publicly-traded equity securities should be ready to address additional disclosure requirements relating to the use of such plans. At the same time, the SEC chose not to impose any new restrictions or disclosure requirements on the use of Rule 10b5-1 plans by issuers despite concerns expressed by some commenters. Therefore, issuer share repurchase transactions (including accelerated share repurchase transactions and other structured share repurchases) that are often structured as Rule 10b5-1 plans will not be affected by the adopted amendments.