In this letter from SEC Chair Jay Clayton to Representative Brad Sherman following up on a previous conversation, Clayton offers his views and provides some insights and signals on a number of policy issues related to “good corporate hygiene.” The topics include controls and policies designed to prevent insider trading, Rule 10b5-1 plans and the grant of stock options while in possession of material inside information. Apparently, the issues addressed were significant enough that Clayton has asked Corp Fin director Bill Hinman and others on the staff to raise these issues “in upcoming speaking engagements and to remind market participants of these views.”
Importance of a Strong Control Environment. In times of “heightened market volatility and uncertainty,” good corporate hygiene—including controls designed “to prevent not only insider trading but also, ideally, the appearance of impropriety or misalignment of interests”—takes on added importance, especially because “the potential for executives to possess material non-public information increases as we have witnessed during this time of COVID-19-induced economic and market stress.” Although Clayton believes that, in general, public companies have acquitted themselves well during the pandemic with regard to public disclosure and corporate controls, still, market confidence depends on a “universal commitment to compliance and regulatory vigilance.”
Insider Trading Policies for Senior Executives and Board Members. Clayton believes that insider trading policies should prevent trading by senior executives and directors from the time the company comes into possession of material non-public information until the information has been publicly disclosed, even if an individual officer or director does not have personal knowledge of the information. Apparently, there is some legislation in the works on this topic. (Could they be referring to HR 2534, the “Insider Trading Prohibition Act,” which has passed the House and been sent on to the Senate?) In this area, Clayton believes that “the integrity bang for the compliance buck is large.”
Terms and Administration of Rule l0b5-1 Plans. Although well designed and administered 10b5-1 plans that eliminate “any suggestion of impropriety or unfairness” can advance good corporate governance, some practices, even where legal, can “raise questions of interest alignment and fairness,” especially issues surrounding trading/absence of trading in the context of plan implementation, amendment or termination. Clayton contends that inclusion in 10b5-1 plans of “mandatory seasoning”—waiting periods—after adoption, amendment, suspension or termination and before trading can begin or resume is appropriate, demonstrates good faith and bolsters investor confidence in management and the markets. Clayton notes that the staff are working on a report (in response to an appropriations act directive) on the growth in stock buybacks and may also include a discussion of 10b5-1 plans in that report, including the interrelationship of buybacks and 10b5-1 plans. Clayton advises that boards should keep that interrelationship in mind in the context of 10b5-1 plans.
Issuing and Pricing Stock Options. Clayton also recommends that each company “consider carefully the wisdom of issuing stock options to its executives while in possession of material non-public information.” In his view, when a company grants an award based on the trading price of the stock (typically considered FMV) while in possession of positive material inside information, the purpose of the grant to incent performance “is diluted to the extent future increases in company stock value are attributable to the release of positive information rather than future performance.” The grant could also be inconsistent with the terms of the plan approved by shareholders and with existing accounting standards “because, in short, the trading price of its stock is not a good indicator of fair market value.” Boards and comp committees, he advises, should have “policies in place that ensure that plan requirements are satisfied and the awards are priced and accounted for properly.” Clayton signaled that Corp Fin staff will be alert to “this potentially material dynamic” when looking at comp disclosures as part of the review process. (Note that Sherman may be introducing a bill that would prohibit the grant of stock options if the grantor or recipient are in possession of certain material non-public information.)
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