The Securities and Exchange Commission recently amended Rules 16b-3 and 16b-7 under the Securities Exchange Act of 1934, to clarify that
- Rule 16b-3 may be relied on to exempt officer and director securities transactions from Section 16(b) short-swing profit recovery, even if the transactions are not compensatory in nature, and
- Rule 16b-7 may be relied on to exempt stock reclassifications, even if they involve securities with different risk characteristics or change the percentage ownership of the holders.
The SEC adopted these amendments in direct response to a decision by the Third Circuit Court of Appeals, Levy v. Sterling Holding Company, LLC, 314 F.3d 106 (3d Cir. 2002), that interpreted these exemptions narrowly, and cast doubt on the availability of Section 16 exemptions for acquisitions and dispositions by directors and officers in many merger and acquisition transactions, as well as in reclassifications.
This Update summarizes the key elements of the amended rules and offers practical guidance.
Amended Rules 16b-3 and 16b-7 Apply Retroactively
Because these amendments clarify conditions for these exemptions under existing rules, the amended rules are retroactively available for transactions that satisfy the applicable conditions from the date the existing rules became effective. Amended Rule 16b-3 is available for any transaction on or after August 15, 1996, and amended Rule 16b-7 is available for any transaction on or after May 1, 1991.
Background on Section 16(b) and Short-Swing Profit
Under Section 16(b) if an officer, director or 10% shareholder of a public company buys and sells, or sells and buys, securities of that company within a six-month period, the company may generally recover profits from the "matching" trades that occurred within the six-month "short-swing" period. SEC rules under Section 16(b) exempt from this general requirement transactions that satisfy specified requirements.
- Rule 16b-3: Transactions Between a Company and Its Officers or Directors. Rule 16b-3 has long exempted many employee benefit plan transactions from Section 16(b) short-swing profit recovery. In 1996 the SEC extended the exemptions under Rule 16b-3 to cover most transactions between officers and directors and their company as long as the transactions are approved by the company's board of directors, a committee of two or more non-employee directors or the company's shareholders.
- Rule 16b-7: Mergers, Reclassifications and Consolidations. Rule 16b-7 exempts corporate transactions, including mergers, consolidations, reorganizations and reincorporations in a different state, from Section 16(b) as long as specified common ownership requirements are met. The SEC views these transactions as not significantly altering the economic investment of an insider.
The Third Circuit's Decision in Levy v. Sterling Holding Company
In Levy the Third Circuit Court of Appeals ruled that neither Rule 16b-3 nor Rule 16b-7 was available to exempt from Section 16(b) the acquisition by two company insiders of securities in a reclassification conducted in preparation for the company's initial public offering. The reclassification involved the conversion of nonconvertible preferred stock (which the insiders had acquired in a noncompensatory transaction) into common stock, and resulted in an increase in the percentage ownership of the company's common stock by the insiders. As nonexempt transactions, the insiders' acquisition of common stock in the conversion could be matched with their sales of common stock less than six months later, and the newly public company would have a right to recover the insiders' short-swing profit.
The Third Circuit in Levy construed Rule 16b-3 to apply only to transactions with the company that have a compensatory purpose, even though the rule contains no language suggesting this interpretation and the SEC in adopting the rule stated that "a transaction need not be pursuant to an employee benefit plan or any compensatory program to be exempt, nor need it specifically have a compensatory element." The court's decision also caused concern that Rule 16b-7 would not be available for a reclassification that involves the acquisition of securities with different risk characteristics from the securities disposed of (the exchange of nonconvertible preferred stock for common stock) or increases the insider's percentage of common stock owned.
Rule 16b-3 and Rule 16b-7 Amendments Reaffirm Broad Exemption
In its release adopting the clarifying amendments, the SEC stated that
the Levy v. Sterling opinion read Rules 16b-3 and 16b-7 to require satisfaction of conditions that were neither contained in the text of the rules nor intended by the Commission. The resulting uncertainty regarding the exemptive scope of these rules has made it difficult for issuers and insiders to plan legitimate transactions, and may discourage participation by officers and directors in issuer stock ownership programs or employee incentive plans. With the clarifying amendments . . . we resolve any doubt as to the meaning and interpretation of these rules . . . .
The SEC amended Rule 16b-3 to confirm that acquisitions from or dispositions to a company by its officers or directors may be exempt from Section 16(b), whether or not intended for a compensatory or other particular purpose, as long as one of the approval conditions is satisfied.
Amended Rule 16b-7 clarifies that reclassifications are to be treated in the same way as mergers and consolidations under the rule, and that the only conditions applicable to the exemption are the common ownership and other conditions specified in the rule. The amended rule does not define "reclassification," in order to preserve flexibility, but the adopting release describes transactions that the SEC considers reclassifications, including transactions in which the terms of the entire class or series are changed, or in which an entire class or series of securities is replaced with a different class or series of securities of the same company.
SEC Also Amended Item 405 of Regulations S-K and S-B
In the adopting release for the amendments to Rules 16b-3 and 16b-7, the SEC also amended Item 405 of Regulations S-K and S-B. Item 405 requires companies to disclose in the proxy statement for their annual shareholders meetings any transactions that were required to be reported, and any reports that were required to be filed, under Section 16(a) that were not reported or filed by their respective filing deadlines. Before this amendment, Item 405 included a presumption (put in place when filings were made in paper and due no earlier than 10 days after the end of the month in which the transaction took place) under which companies could presume that a required filing was timely if the company received a copy within three calendar days after the filing deadline. The SEC amended Item 405 to eliminate this presumption since company insiders are now required to file Section 16 reports electronically on the SEC's electronic filing system (EDGAR), and must do so for most transactions within two business days.
Companies Should Monitor Timeliness of Section 16 Filings. Most companies prepare and file Section 16 reports for their officers and directors, but not for other insiders (who hold 10% or more of a company's stock, but are not officers or directors). Under amended Item 405, companies should review Section 16 reports posted on EDGAR for any insiders for whom the company does not make Section 16 filings to evaluate the timeliness of these reports for purposes of disclosing late filings in the company's proxy statement in connection with its annual shareholders meeting.