Columbia Law Blog written by SKadden Arps attorneys


Columbia Law Blog written by Shadden Arps attorneys

 Analysis of Article by Skadden Arps attorneys regarding Shareholder Enforcement of Section 16 b) of the 1934 Securities Act.

"Skadden Discusses Section 16 Settlements" from Columbia Law School Blog
March 9,2017 linked below: and

By Brian V. Breheny, Neil M. Leff, Erica Schohn, Joseph M. Yaffe and Josh LaGrange of Skadden Arps Highlighted in Black below:

1. The so-called "short-swing profit rule" under Securities Exchange Act Section 16(b) generally prohibits officers and directors as well as 10 percent shareholders of a U.S. public company from profiting from any purchase or sale (or sale and purchase) of the company's equity securities within a period of less than six months.

The above is generally true but Section 16 (b) clearly defines the statue's purpose. It is "For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer,"

2. However, Rule 16b-3 permits a company's board of directors and qualifying board committees to take actions that exempt from the short-swing profit rule most transactions under the company's equity-based compensation programs.

The above is generally true as applied to grants of equity compensation securities as both parties are generally on equal footing as both parties may have inside information and both parties can use the inside information. But SEC Rule 16 (b)(3) can not permit exemptions when "the purpose of the transaction is to use unfairly the information that was obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer". This is clearly the case when the insider can use insider information and the issuer has no discretion but to accept the disposition".

Regardless of what they may claim, some attorneys are promoting the idea that the issuer is allowed to grant options and restricted stock, where the executives can subsequently trade unfairly based on inside information, while trying to exempt the transaction from 16 (b) via SEC Rule 16 b-3(e).

3. For example, many companies take steps so that the common practice often referred to as "net settlement," in which the company withholds a portion of the shares that would otherwise be issuable upon settlement of an equity award in order to satisfy the participant's tax obligations, would be treated as an exempt disposition under Rule 16(b)-3(e).

There are problems with the above statement:

"Net exercise" can be at the discretion of the officer, director or 10% owner with the issuer required to accept the insider's choice or
The "net exercise" can be mandatory where neither the insider or the issuer has discretion, or
The "net exercise" is at the discretion of the issuer

In the case of 1), the transaction is "comprehended to be within the purpose of the statute Section 16 (b)" and no SEC Rule can exempt the transaction

In the case of 2), an exemption is clearly achieved.

In the case of 3) The staff of the SEC in the Q and A 123.16 of May, 2007 says that there is no exemption from 16 (b) since the specificity of approval requirements under 16 b-3(e) is not satisfied when the issuer has discretion.

In summary

a) to be exempted, the transaction must "not be comprehended within the purpose of
section 16 (b)" and satisfy the specificity of approval requirements under Rule 16b-3(e) and Note (3).

b) The tax withholding can only be for a tax liability that occurs after the income calculation is made. Both the income calculation and the tax liability may be deferred past the vesting date of Restricted stock or RSUs or the exercise date for ESOs. IRC 83 C-3 defers the income calculation and tax liability when a sale of shares could cause a violation of Section 16 (b).
And, I have never seen a plan or grant agreement that approves a disposition to the issuer for a tax liability made substantially before the income calculation and the tax liability occurs.

4. Without this exemption, the disposition of those withheld shares would be viewed as a sale and "matched" with any purchases of company equity securities made by the participant in the 12-month period beginning six months before and ending six months after the withholding.

The above sentence is almost correct. The period is 12 months minus four days.

5. If the fair market value of the company equity securities on the date of the withholding exceeded the participant's purchase price in any such sales, the participant would be required to disgorge the excess to the company.

This above paragraph is correct.

6. Recently, however, a prospective litigant (sometimes in cooperation with others) sent numerous companies demand letters claiming that such transactions are outside the scope of that exemption and should be treated as nonexempt sales subject to matching under the short-swing profit rule.

The above paragraph is generally accurate as the Statute 16 (b) allows exemptions only for transactions " not comprehended within the purpose of section 16 (b)".

7. The first wave of these letters sought to compel companies to make recovery of relatively modest short-swing profits supposedly realized by officers who exercised the net settlement rights granted to them by their company equity awards.

Letters were sent to companies by a shareholder seeking recovery of profits earned in violation of section 16 (b), where a matching transaction was the disposition to the issuer for taxes or exercise price. Some of the dispositions were "'comprehended within the purpose of the statute". Some were not approved with the necessary specificity and some were for premature tax liabilities.

8. The primary complainant, who has been identified as a vexatious litigant by the California state courts' Judicial Council on the basis of seemingly unrelated litigation,

Some may claim that the shareholder was a "vexatious litigant" but none can produce any vexatious filings.
9. asserts highly technical claims (in some cases dependent on a "novel" interpretation of Internal Revenue Code Section 83(c)(3) that would change the time at which withholding would occur) that are generally inconsistent with Section 16(b), Rule 16b-3, the related Securities and Exchange Commission (SEC) proposing and adopting releases and the interpretative positions expressed by the SEC's staff.

The alleged "novel" interpretation of the Primary Complainant is exactly the interpretation of the Ninth Circuit Court of Appeals

in Strom v. U.S. as below: Nos. 09-35175, 09-35197. Decided: April 06, 2011

BERZON, Circuit Judge stated the following:

Ordinarily, when an employee is compensated with nonstatutory stock options that do not have a readily ascertainable fair market value at the time of the grant, the employee realizes income for tax purposes upon exercising the options.1 See 26 U.S.C. §§ 83(a) & (e)(3)-(e)(4); 26 C.F.R. § 1.83-7(a). The taxpayer is taxed on an amount equal to the fair market value of the stock on the date of exercise minus the option price paid for the stock. See 26 C.F.R. §1.83-1(a)(1); id. §1.83- 7(a)

Internal Revenue Code § 83(c)(3), however, allows taxpayers to defer recognition and valuation of income so long as a profitable sale of the stock acquired through the exercise of the options "could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934." 26 U.S.C. § 83(c)(3).

Section 16(b), in turn, forbids a corporate insider from profiting on a purchase made within six months of a sale (or a sale made within six months of a purchase) of the corporation's stock. See 15 U.S.C. § 78p(b). If a taxpayer is permitted to defer tax consequences under IRC § 83(c)(3), the taxpayer will be later taxed on an amount equal to the fair market value of the stock on the date that § 83(c)(3) no longer applies minus the option price paid for the stock. See 26 U.S.C. § 83(a); 26 C.F.R. § 1.83-1(a)(1).

And the IRS in a paragraph from an IRS Bulletin of March 17, 2014, which I agree with 100%, confirms Judge Berzon

Specifically, practitioners asked whether the purchase of shares in a transaction not exempt from section 16(b) of the Securities Exchange Act of 1934 prior to the exercise of a stock option that would not otherwise give rise to section 16(b) liability would defer taxation of the stock option exercise. Treasury and the IRS do not believe that such a non-exempt purchase of shares would defer taxation of the subsequent stock option exercise. This result is consistent with Example 3 of § 1.83-3(j)(2). In response to these requests for clarification, Treasury and the IRS have revised Example 4 of proposed regulation § 1.83-3(j)(2) to address the situation raised."

10. The complainants appear to be motivated by the possibility of receiving a fee to induce them to refrain from filing suit under Section 16(b) - which shareholders may do in the name of the company - or of receiving a finder's fee in cases where the company does make a recovery from its officer, however baseless the claim.

No claims were ever shown to be baseless in any proceeding under Section 16 (b), asserted by the person that this article refers to. These Skadden Arps article writers are very much aware of the violations of 16 (b) that are regularly made by insiders . But they choose to defend their clients in their obvious unfair inside trading with the issuer, by attempting to twist the meaning of 16 (b) and SEC Rule 16 b-3(e).

11. Until very recently, to our knowledge, these claims had been brought regarding only relatively small amounts that would not ordinarily be viewed as justifying defending against a technical securities claim. Not surprisingly, it appears that in those circumstances, the parties have reached private settlements without any responsive filings.

Mostly correct

12. Companies, mindful of not appearing to circumvent the purpose of Section 16(b) by shielding their officers, have been left in the difficult position of considering whether to make recoveries from officers, notwithstanding the apparent lack of merit in the underlying theories.

If there was apparent lack of merit in the underlying theories, why would the companies be mindful of not appearing to circumvent the purpose of Section 16 (b)?

13. Quite recently, these litigants have brought claims seemingly under the same or similar arguments but relating to larger sums. These larger claims may give rise to judicial resolution, but such determinations may be slow in coming.

The above paragraph is reasonably accurate.

14. Until these theories are addressed by judicial or administrative authority, companies should consider taking steps to enhance their position that the Rule 16b-3 exemption will be available for insiders' dispositions of equity securities in share-withholding transactions on a going-forward basis.

The above is the advice of these attorneys claiming that these "theories" have not been addressed and that the companies should take steps to enhance their achieving exemptions, notwithstanding that the transactions may be "comprehended within the purpose of 16 (b)'.

15. For example, although not alone sufficient to address all the theories raised by these litigants, companies should review their plans, award agreements, resolutions and any other relevant documents to confirm that the board or a qualifying committee has granted to company insiders the right to use share withholding at the insider's election.

Of course neither the board nor the compensation committee can achieve an exemption for a transaction that is "comprehended within the purpose of the statute", since the SEC can not exempt a transaction that is "comprehended within the purpose of the statue". Also if the transaction is "not comprehended within the purpose of the statute", for the transaction to be exempt from 16 (b), it must be approved by the board or the committee in a manner which satisfies the specificity required for approval under SEC Rule 16 b-3(e).

16. - a provision in a plan that merely authorizes the company to permit share withholding is likely not sufficient for this purpose.

It is true that the approval conditions of SEC Rule 16 b-3 (e) and Note 3 are not satisfied when the plan merely authorizes the company to permit share withholding. According to 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.

17. In addition, although it should not be required in order for the Rule 16b-3 to be available, companies may be able to deprive these litigants of the purported basis for their claims by having the board or a qualifying board committee approve each specific withholding transaction immediately before it occurs,

This is a way to achieve an exemption, assuming that the transaction is "not comprehended within the purpose of section 16 (b)".

18. or by mandating share withholding and the time at which it must occur.

The above seems to be certainly a way to achieve an exemption from 16 (b).

19. In addition, until these claims are addressed, companies should consider alerting their insiders about the risks associated with purchasing shares on the market within six months of net settlements or other dispositions to the company, and vice versa.

The above certainly is a way to avoid a section 16 (b) claim.

20. Although it is unfortunate that the threat of meritless litigation may compel companies to change practices that already satisfy the requirements of Rule 16b-3, these steps, although burdensome and not a guarantee against future demands, may deter future claims or provide for more efficient avenues of defense in the event of litigation.

The conclusion that the claims are meritless has no basis as the claims are supported by Section 16 (b) and court decisions.


Here are two Supreme Court Decision on point:
Below is a U.S. Supreme Court Decision
in Reliance Electric Co. v. Emerson Electric 404 U.S. 418, 92 S. CT 596

The history and purpose of 16 (b) have been exhaustively reviewed by federal courts on several occasions since its enactment in 1934. See, e. g., Smolowe v. Delendo Corp., 136 F.2d 231; Adler v. Klawans, 267 F.2d 840; Blau v. Max Factor & Co., 342 F.2d 304. Those courts have recognized that the only method Congress deemed effective to curb the evils of insider trading was a flat rule taking the profits out of a class of transactions in which the possibility of abuse was believed to be intolerably great. As one court observed:
"In order to achieve its goals, Congress chose a relatively arbitrary rule capable of easy administration. The objective standard of Section 16 (b) imposes strict liability upon substantially all transactions occurring within the statutory time period, regardless of the intent of the insider or the existence of actual speculation. This approach maximized the ability of the rule to eradicate speculative abuses by reducing difficulties in proof. Such arbitrary and sweeping coverage was deemed necessary to insure the optimum prophylactic effect." Bershad v. McDonough, 428 F.2d 693, 696. 

And the
U.S Supreme Court in Gollust v. Mendell 501 U.S. 155 as the quote below illustrates:

1(a) Section 16(b) provides standing of signal breadth, expressly limited only by the conditions that the plaintiff be the "owner of [a] security" of the "issuer" at the time the suit is "instituted." Any "security" - including stock, notes, warrants, bonds, debentures, puts, and calls, 15 U.S.C. 78c(a)(10) - will suffice to confer standing. There is no restriction in terms of the number or percentage of shares, or the value of any other security, that must be held. Nor is the security owner required to have had an interest in the issuer at the time of the short-swing trading. Although the security's "issuer" does not include parent or subsidiary corporations, 15 U.S.C. 78c(a)(8), this requirement is determined at the time the 16(b) action is "instituted." Congress intended to adopt the common understanding of the word "institute" - "inaugurate or commence; as to institute an action," Black's Law Dictionary 985-986 (3d ed. 1933) - which is confirmed by its use of the [501 U.S. 115, 116] same word elsewhere to mean the commencement of an action, see, e.g., 8 U.S.C. 1503(a). Pp. 121-124.
"To enforce this strict liability rule on insider trading, Congress chose to rely solely on the issuers of stock and their security holders. Unlike most of the federal securities laws, 16(b) does not confer enforcement authority on the Securities and Exchange Commission. It is, rather, the security holders of an issuer who have the ultimate authority to sue for enforcement of 16(b)."

"If the issuer declines to bring a 16(b) action within 60 days of a demand by a security holder, or fails to prosecute the action "diligently," 15 U.S.C. 78p(b), then the security holder may "institut[e]" an action to recover insider short-swing profits for the issuer. Ibid.

This post comes from Skadden, Arps, Slate, Meagher & Flom LLP. It is based on the firm's client update, "Executive Compensation and Benefits Alert: Nuisance Plaintiffs Pursue Novel Theories to Exact Section 16 Settlements," dated February 23, 2017, and available here.

The parts in bold are this writers words commenting on the Skadden Arps article..


John Olagues

Edited Sat, Jun 17, 2017 3:07 PM

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