Approval by the Board of Insider Trading does not get an exemption from Section 16 (b) of the 1934 Securities Exchange Act

Apparently there are Companies that want to allow top executives to maximize the compensation that they receive from the companies.

So the executives and attorneys who are influential in designing equity compensation plans, make provisions in the plans to maximize their equity compensation as an extra expense to the shareholders.

These plans make it such that executives can chose to pay withholding taxes and the exercise prices upon exercise of ESOs either in cash or by delivering shares and require the issuer to accept the executive's choice. Of course allowing the choice of delivering shares to the executive, while the issuer is required to accept the shares, puts the executive in superior standing relative to the issuer.

In fact when the executive is allowed to force delivery of shares to the issuer when the executive has very negative information, the standing of the issuer is far less than a market purchaser.

Giving the executives the choice of paying cash or shares for the exercise price or for withholding taxes which the issuer has no choice but to accept , allows insider to trade on inside information at the expense of the shareholders.

For example if the executive knows there are some bad earning soon to be reported, he/she may exercise his far in-the-money ESOs early and deliver shares to the issuer, which is required to purchase the shares.

This is clearly a violation of Section 16 (b) of the 1934 Securities Exchange Act of 1934.

But certain attorneys who promote the interests of the executives at the expense of the shareholders, will claim that the disposition of the shares was not a violation of 16 (b) since the issuer gave the insiders prior permission to do inside transactions with the issuer.

Of course when the officer or director has news of very positive news in the near future, he can delay the exercise of the ESOs or exercise and pay the issuer for the exercise of the ESOs and the tax in cash.

John Olagues

Below is an article written by a person who advises companies how to avoid the enforcement of section 16 (b).


Practice Pointers

Availability of Rule 16b-3(e) to Exempt Elective Tax Withholding

As discussed in several recent issues of Section 16 Updates, a group of individual shareholders launched an initiative last year in which they are challenging the availability of Rule 16b-3(e) to exempt an officer's or director's disposition of stock to the issuer resulting from the exercise of a tax withholding right if (1) the insider had discretion whether to exercise the right or (2) the issuer had discretion either to exercise the right or to reject the insider's exercise of the right. See the December 2017 issue of Updates at pp. 7-8, the March 2017 issue at p. 13, and the June 2017 issue at pp. 9-11. The shareholders contend that, unless withholding is "automatic," the withholding of shares upon exercise of an option or the vesting of restricted stock (or restricted stock units) must be re-approved by the board of directors or a committee of nonemployee directors at the time of exercise of the right.

The issue the shareholders have raised is whether the board's or a committee's approval of an option or stock award which contains an elective tax withholding right constitutes "specific approval" of the actual withholding, as required by Rule 16b-3(e). Note (3) to Rule 16b-3 provides that, "[w]here the terms of a subsequent transaction (such as the exercise price of an option, or the provision of an exercise or tax withholding right) are provided for in a transaction as initially approved . . . , such subsequent transaction shall not require further specific approval." Issuers and insiders have commonly deemed Note (3)'s reference to a tax withholding right as exempting elective tax withholding.

Entire Note (3):
The approval conditions of paragraphs (d)(1), (d)(2) and (e) of this section require the approval of each specific transaction, and are not satisfied by approval of a plan in its entirety except for the approval of a plan pursuant to which the terms and conditions of each transaction are fixed in advance, such as a formula plan. Where the terms of a subsequent transaction (such as the exercise price of an option, or the provision of an exercise or tax withholding right) are provided for in a transaction as initially approved pursuant to paragraphs (d)(1), (d)(2) or (e), such subsequent transaction shall not require further specific approval.The shareholders, however, contend that the following Compliance and Disclosure Interpretation, (Q. 1234.16 (May 23, 2007), supports their position that withholding must be automatic:

Question: Would approval of a grant that by its terms provides for automatic reloads satisfy the specificity of approval requirements under Rule 16b-3(d) for the reload grants?

Answer: Yes. Approval of a grant that by its terms provides for automatic reloads would satisfy the specificity of approval requirements under Rule 16b-3(d) for the reload grants, unless the automatic reload feature permitted the reload grants to be withheld by the issuer on a discretionary basis. The same result applies under Rule 16b-3(e) where the automatic feature is a tax- or exercise-withholding right.

The shareholders' reading of the CDI is not a total surprise, at least to the extent that the shareholders are arguing that issuer discretion, as opposed to insider discretion, is inconsistent with the exemption. We noted this possible reading of the CDI when it was first issued. See the June 2008 issue of Section 16 Updates at p. 8. We also noted, however, our belief that such an interpretation of Rule 16b-3 would be inappropriate.

In any case, we believe it is clear that the CDI was not intended to limit Rule 16b-3(e) to automatic withholding, and instead just answered the question asked, which related to automatic transactions. We think our view is supported by this statement in a 1996 staff interpretive letter ,American Bar Association, Q. 4 (Dec. 20, 1996):

the disposition to the issuer that occurs upon cash settlement of stock options, stock appreciation rights and phantom stock rights is eligible for exemption under Rule 16b-3(e). The specific approval standards of Note 3 will be satisfied to exempt these transactions where . . . the derivative securities are issued pursuant to terms that contemplate settlement in cash that is either non-volitional or upon exercise at the holder's discretion within a finite term. (emphasis added)

The ABA letter supports reliance on the exemption where cash settlement occurs at the election of the insider, and we believe that the staff would take a similar position today regarding an insider's election to exercise a tax withholding right. The ABA letter does not address tax withholding that is elective on the part of the issuer, but that issue appears to have been addressed in Jordan v. Flexton, 2017 WL 2590976 (S.D. Tex.). In that case, the compensation committee of the board of directors of Dynegy, Inc. had granted restricted stock units which provided that, upon vesting, the grantee would be obligated to pay the withholding taxes in cash. If the grantee failed to make the required cash payment, "the company" could elect to withhold stock or instead withhold cash compensation otherwise payable to the grantee. Insiders did not deliver cash on the vesting date, and the company withheld shares to satisfy their tax withholding obligations.

The court dismissed the complaint for failure to state a claim, holding in a one-page order that "the transactions in question are compensation related and are designed to be exempt under" Rule 16b-3(e). The court therefore not only rejected the plaintiff's argument that Rule 16b-3 exempts withholding transactions only if they are "automatic," but also upheld reliance on the exemption where the decision to withhold shares was made by the issuer rather than the insider or the compensation committee. The case is currently on appeal to the Fifth Circuit.

Jordan v. Flexton is one of 16 cases of which we are aware in which the shareholder group chose to pursue litigation. Ten of the other complaints have been dismissed voluntarily or by stipulation, and two were dismissed on the ground that a non-lawyer shareholder may not pursue a Section 16(b) claim pro se.

As a matter of policy, the staff will not address an interpretive question that is the subject of pending litigation. For that reason, issuers have been unable to seek guidance from the staff that might be useful in dissuading the shareholder group from continuing to pursue their claims or in providing comfort to issuers that elective tax withholding, by the insider or the issuer, is eligible for exemption under Rule 16b-3(e). If the pending actions are resolved, however, and the plaintiffs do not file additional actions in the meantime, the staff may be willing to provide guidance and eliminate the uncertainty that now surrounds tax withholding.

Making Clear When Insider Status Begins and Ends

The precise moment at which a person becomes, or ceases to be, an officer, director or ten percent owner can be critical to determining whether a transaction by that person is reportable on Form 4 (or Form 5) or is subject to matching under Section 16(b) with an opposite-way transaction occurring within less than six months. Litigated cases have demonstrated, for example, that:

An amendment to a ten percent owner's warrants to reduce the exercise price, which might be deemed to involve a simultaneous purchase and sale, is not subject to matching with prior opposite-way transactions where the amendment occurred 26 minutes after the issuer's issuance of common stock in a private placement, resulting in dilution of the ten percent owner's holdings to less than 10% of the class outstanding (Donoghue v. Corp., 2009 WL 260797 (S.D.N.Y.)).
A shareholder of a company acquired in a stock merger who, under the terms of the merger agreement, becomes a Section 16 officer of the acquirer "immediately after" the effective time of the merger may sell issuer securities within less than six months of the merger because the "purchase" of stock in the merger is exempt under Rule 16a-2 as a "pre-insider" transaction (Gryl v. Shire Pharmaceuticals Group PLC (298 F. 3d 136 (2d. Cir. 2002)).
A shareholder of a company acquired in a stock merger who, under the terms of the merger agreement, becomes an officer or director of the acquirer "simultaneously" with the closing of the merger is an insider at the time of the purchase of stock in the merger and therefore must report the purchase on Form 4, but the acquisition may be exempted under Rule 16b-3 because the shareholder was an officer or director when the purchase occurred (SEC amicus brief in Gryl v. Shire Pharmaceuticals).
Where a ten percent owner writes a call option that will expire in less than six months and purchases a put option having the same expiration date, and the put option is in the money on the expiration date and therefore is deemed by exchange rules to be exercised "immediately prior" to the expiration of the call, the premium the insider received for writing the call option will not be recoverable under Rule 16b-6(d) where the exercise of the put caused the insider to own less than 10% of the common stock outstanding, because Section 16 is not applicable to a transaction that occurs after termination of ten percent owner status (Olagues v. Perceptive Advisors LLC, 2017 WL 3605511 (S.D.N.Y.)).
These cases demonstrate that careful sequencing of events, whether through serial closings or the drafting of documents to provide that events occur simultaneously or in a particular order, can minimize exposure to liability under Section 16(b) or eliminate unnecessary Section 16 reporting obligations. Beneficial ownership ordinarily will be deemed acquired or disposed of when the rights and obligations of the insider become fixed and irrevocable. When an insider's rights and obligations derive solely from a written agreement, drafters should take legitimate advantage of the mechanical application of Section 16 to provide that the insider's transactions occur at times or under circumstances that place them out of the reach of Section 16(b). Similarly, equity award agreements can be worded to provide that forfeiture or accelerated vesting of an award will occur "immediately after" the insider's termination of service, making the forfeiture or vesting non-reportable under Rule 16a-2 as an exempt "post-termination" event.


It is clear that the writer of the above article is willing to twist the meaning of the SEC Rules to help the companies maximize the extraction of wealth from the shareholders.


Edited Tue, Oct 15, 2019 11:27 AM

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