What Is Rule 10b-5? Definition and Role in Securities Fraud

What Is Rule 10b-5?

Rule 10b-5 is a regulation created under the Securities and Exchange Act of 1934 that targets securities fraud. This rule makes it illegal for anybody to directly or indirectly use any measure to defraud, make false statements, omit relevant information, or otherwise conduct business operations that would deceive another person in the process of conducting transactions involving stock and other securities.

Rule 10b-5 is formally known as the "Employment of Manipulative and Deceptive Practices."

Key Takeaways

  • Rule 10b-5, enacted in 1934 by the Securities and Exchange Commission (SEC), is a rule targeting securities fraud.
  • Two related rules—Rule 10b5-1 and Rule10b5-2—were issued in 2000 to create more current legal perspectives regarding securities fraud.
  • Rule 10b-5 covers "insider trading," which occurs when confidential information is used to manipulate the market in one’s favor.
  • Changes to Rule 10b5-1 outlining ways for insiders to proactively avoid the appearance of insider trading took effect Feb. 27, 2023.

How Rule 10b-5 Works

Rule 10b-5 is the SEC's (SEC) main basis for investigating possible security fraud claims. Violations of the rule include executives making false statements to elevate share prices, a company hiding huge losses or low revenue with creative accounting practices, or actions taken to grant current shareholders a better return on their investments—as long as the deception remains undiscovered. These schemes typically require ongoing, misleading statements to perpetrate fraud.

Rule 10b-5 also covers instances where an executive issues false statements to artificially drive down the price of a company’s stock so they can buy up more shares at a discounted rate. These and other manipulative uses of confidential information are acts of "insider trading."

In addition to making illicit profits or attracting more investors, these schemes can be put in motion as a way of taking over a company by changing the shareholder balance.

Introduction of Rules 10b5-1 and 10b5-2

In 2000, the SEC further defined and clarified a range of issues related to potential securities fraud with ratification of Rule 10b5-1 and Rule 10b5-2. These rules put insider trading into a more modern, legal perspective.

Rule 10b5-1

Rule 10b5-1 says that an individual is trading based on material nonpublic information (MNPI) if that person is aware of the information while engaging in a sale or purchase of securities.

There are, however, exceptions and stipulations of Rule 10b5-1 that let individuals proceed with trading even if they possess such information. They include trades that are parts of plans that were already set in motion through a contract or process that wouldn't be affected by knowledge of the information.

According to Rule 10b5-2, securities fraud can be committed even under nonbusiness circumstances.

Rule 10b5-2

Rule 10b5-2 explains ways that the misappropriation theory—which postulates that a person who uses insider information in trading securities has committed securities fraud against the information source even if that person isn't an insider—can apply even under nonbusiness circumstances.

It further states that an individual who obtains confidential information is obliged to a duty of trust.

How Affirmative Defense Works Under Rule 10b5-1 (c)

In general, an affirmative defense occurs in a legal sense when someone takes precautionary action before an event. For instance, say you had a broken sidewalk slab in front of your house, and you're afraid someone might get hurt by if they trip on the slab and sue you. Until getting it repaired you place some orange hazard cones on the site to warn others that there is a hazard. That constitutes an affirmative defense, meaning you took steps to warn others ahead of someone hurting themselves.

In the securities industry, an affirmative defense is used to apply to securities transactions that could otherwise be interpreted as insider trading or a potentially shady transaction involving MNPI. A 10b5-1 trading plan set up by a company or insider executive spells out the time period covered by the plan, the amount of securities involved, and any price involved in the transaction, as well as the executive involved.

For instance, a 10b5-1 plan might be entered into by a senior executive, in which they intend to sell X-amount of shares by a certain date and at a certain price. Having their 10b5-1 plan in place not only eliminates the perception of any sort of insider trading, but also discloses in public the actual details of the executive's trading plan. All this is intended to keep markets transparent and insider trading visible to everyday investors. The 10b5-1 plan is the "orange safety cone" in the securities markets.

Several adjustments to the use of the affirmative defense doctrine by insiders became effective on Feb. 27, 2023. Insider trading under these rules means there is a plan to sell securities by officers, directors, and others with access to MNPI.

2023 Changes to Trading-Plan Rules

The following are changes put in place in early February 2023 to clarify rules and procedures related to insider trading activities.

Rule 10b5-1 (c)(1)—Mandatory Cooling-Off Period

For directors and "Section 16 officers" wishing to trade their company's stock, there is now a mandatory cooling-off period. Section 16 is a rule within the Securities Exchange Act of 1934 that spells out the regulatory filing responsibilities that directors, officers, and principal stockholders are legally required to adhere to.

The new required cooling-off period covers the later of: 90 days before trading under a 10b5-1 plan can be activated or two business days after disclosure in a periodic report of the issuer's financial results for the quarter in which the plan was adopted.

The idea of the cooling-off period is to prevent the appearance of insider trading by having an executive lay out a plan for transactions well in advance of any actual transaction, in this case 90 days before the 10b5-1 plan can be put in action.

For people other than an issuer, director, or Section 16 officer, a 30-day cooling-off period is required between the plan’s adoption and the start of trading under it.

Previously, there was no mandatory cooling-off period, although most issuers and firms observed some form of a "quiet period," most frequently using a 30-day time frame.

Rule 10b5-1 (c)(2)—Restricting Multiple Overlapping Rule 10b5-1 Trading Plans

This rule applies to people with an existing 10b5-1 plan. It prohibits them from establishing an additional 10b5-1 plan covering the same time period defined under 10b5-(c)(1). This regulation is intended to prevent the hedging of an existing 10b5-1 plan with overlapping dates, which may give the 10b5-1 holder an unfair advantage over the general investing public.

Rule 10b5-1 (c)(3)—Restricting Single-Trade Arrangements

This new regulation offers the availability of the affirmative defense for all individuals, other than issuers, to be applied to a single-trade plan during any 12-month period in which the plan calls for the purchase or sale of securities in a single transaction.

The exception to this rule is that no other 10b5-1 plan calling for a single transaction has been enacted in the last 12 months, or would otherwise satisfy Rule 10b5-1(c). As with the overlapping- plan exception, the SEC excluded from this prohibition qualified sell-to-cover transactions, typically made for tax purposes.

Rule 10b5-1 (c)(4)—Officer and Director Certifications

This rule requires directors and Section 16 officers to declare in their 10b5-1 plan that they don't have MNPI and that they are entering the 10b5-1 plan in good faith and not as part of a plan or scheme to evade the prohibitions of Rule 10b-5.

While previously there was no regulation covering certification of a lack of MNPI, most banks and institutions would regularly require such an attestation as part of a 10b-5 plan.

Rule 10b5-1 (c)(5)—Good Faith Condition

All 10b5-1 plans must contain a certification that the plan owner is acting in good faith during the tenure of the plan. This regulation is specifically aimed at the owners of plans (insiders) and the possibility that they might attempt to influence others to make pronouncements or take other actions that would be favorable to the 10b5-1 plan owner. Violation of the Good Faith Rule removes the affirmative defense option, and exposes the plan owner to punishment for insider trading violations.

What Is Rule 10b5?

This rule covers insider trading and lays out various ways in which insiders can manipulate securities in their favor and against the general investing public. It also provides ways for insiders to rightfully transact in their own company's stock, creating a trading plan that serves as an affirmative defense to insider trading rules.

How Can Senior Officers or Directors Sell or Buy Securities Without Violating Insider Trading Rules?

Senior company officers or directors can avoid the appearance of insider trading and use an affirmative defense by establishing a plan in advance (90 days for insiders/30 days for outsiders) to transact (sell or buy) in the insider's firm's securities.

What If I Come Into Possession of MNPI and I Am Not an Employee of the Company Involved?

Anyone who comes into possession of MNPI is under an obligation not to act on that information, as it could still be construed as a form of insider trading lead to prosecution of the person acting on it.

How Long Must a 10b5-1 be in Place Before It Can be Acted Upon?

The SEC has recently declared a 90-day mandatory cooling-off period before a 10b5-1 plan can be implemented. This is to avoid the appearance of potential insider trading and offers the company insider an affirmative defense once they enact their 10b5-1 trading plan.

The Bottom Line

Rule 10b5 sets regulations against insider trading. The rule lays out the types of information considered Material Non Public Information (MPNI), and outlines ways that insiders can violate SEC insider trading regulations and expose themselves to penalties and fines.

Rule 10b5-1 was created to allow senior company officials to transact in the company's stock and avoid insider trading prohibitions. The insider can adopt an affirmative defense for such trading by creating a plan in advance that details what transactions the insider intends to make.

Article Sources
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  1. Code of Federal Regulations. "12 CFR §240.10b-5."

  2. U.S. Securities and Exchange Commission. "Final Rule: Selective Disclosure and Insider Trading."

  3. Code of Federal Regulations. "12 CFR §240.10b5-1."

  4. Code of Federal Regulations. "12 CFR §240.10b5-2."

  5. U.S. Securities and Exchange Commission. "Insider Trading Arrangements and Related Disclosures."

  6. White & Case. "SEC Adopts Amendments to Rule 10b5-1."

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