Enforcement of Section 16 (b) of the 1934 Securities Exchange Act

 Only shareholders will enforce Section 16(b) of the 1934 Securities Exchange Act against officers or directors. The issuer very rarely enforces it against the insiders.

Below is a copy of Section 16 b of the 1934 Act. The highlighted parts relate to the ability of the SEC to create rules exempting certain type transactions.

"(b) 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, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) or a security-based swap agreement involving any such equity security within any period of less than six months, unless such security or security-based swap agreement was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security or security-based swap agreement purchased or of not repurchasing the security or security-based swap agreement sold for a period exceeding six months.

Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than two years after the date such profit was realized.

This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security or security-based swap agreement or a security-based swap involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection."

 
End of section 16 (b)

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The Third Circuit Explains the extent of SEC exemptions from 16 b via Rule 16 b-3(e)

United States Court of Appeals,Third Circuit.
Mark LEVY, Appellant v. STERLING HOLDING COMPANY, LLC;  National Semiconductor Corporation;  Fairchild Semiconductor International, Inc.No. 07-1849. Decided: October 1, 2008

"According to the statute itself, the purpose of section 16(b) is "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." 15 U.S.C. § 78p(b). The statute authorizes the SEC to promulgate rules and regulations exempting from liability transactions that are "not comprehended within[this] purpose." Id.;  see Levy I, 314 F.3d at 112.   Exercising this authority, the SEC has established a number of section 16(b) exemptions. See 17 C.F.R. §§ 240.16b-1, .16b-3, .16b-5 to .16b-8 (codifying SEC Rules 16b-1, 16b-3, and 16b-5 to 16b-8). "

The statute 16 (b) of the 1934 Act and the paragraph above from the Third Circuit, states the kind of transactions the SEC is allowed to exempt from 16 b.

It is clear than when the officer or director has no discretion and must deliver shares to the issuer for the tax payments or exercise price payments arising from the vesting of RS, RSUs, or the exercise of ESOs or SARS and the issuer is required to accept the delivery, the disposition to the issuer is exempt from 16 (b). This is true since both the insiders and the issuer have equal information and the insiders can not use the inside information to their advantage. Both are on equal footing.

 
The transaction is considered not comprehended within the purpose of 16 (b) and can be exempted by the SEC.

Still the transaction, with no discretion had by the insider or the issuer, must be specifically approved pursuant to SEC Rule 16 b-3(e) to achieve an exemption from Section 16 (b).
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Now for further analysis purposes, let us assume that the officer or director has discretion to use shares or cash for payment of the taxes that arise from the vesting of Restricted Stock, RSUs or the exercise of ESOs or SARS. And now assume that the issuer must accept the officer's or director's decision.

Both the insiders and the issuer have the same inside information. But the insider can use the information when deciding whether to pay cash or deliver shares to the issuer and the issuer must accept the insider's decision. This situation puts the insider on far superior standing to the issuer. In fact the insider has much greater standing to the issuer than the insider would have to a market trader as the issuer has no choice to not buy the shares, whereas the market trader can choose not to buy the shares. And generally the price at which the disposition is made to the issuer would be greater than the price the disposition was made to the market trader.

This equal footing requirement for an exemption was endorsed by the American Bar Association and the NY State Bar Association and the SEC in the Release of August 9, 2005

So this situation, where the insider has a choice, and the issuer has no choice, allows "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,"

And the SEC can not make a Rule which exempts such transactions. So even if some attorneys try to interpret a SEC Rule to exempt such a transaction, claiming that the transaction was authorized by the Board or the Compensation Committee, the transaction is still not exempt from Section 16 (b). Additionally when the insiders have the choice to pay cash or shares,  the specificity of approval requirements under Rule 16b-3(e ) is not satisfied.

So we now turn to the situation where the issuer has the discretion to accept a transaction by the insider or reject it.

When asked a question about issuer discretion, the SEC staff answered the following in the Q and A 123.16 on May, 23, 2007

Question: Would approval of a grant that by its terms provides for automatic reloads 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.
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The same result applies under Rule 16b-3(e) where the automatic feature is a tax- or exercise-withholding right. [May 23, 2007]

End of the Q and A

The SEC staff says that in this case, the discretion by the issuer precludes the satisfaction of the specificity of approval requirements under Rule 16b-3(e).
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The explanation above about the preclusion of the satisfaction of the specificity of approval requirements under Rule 16b-3(e) when the issuer has discretion also applies to discretionary dispositions to the issuer by the insider to pay the exercise prices of ESOs, SARs and Warrants

However designers of the Plans and Grant Agreements seek to allow the officers and directors to maximize the wealth extraction to the top executives. The designers do so in a way to maximize the executive's ability to trade on inside information and by having attorneys trying to interpret Section 16 (b) and the SEC Rules in a manner that allows insider trading by top officers and directors.

And when someone calls their hand, they come together and do their best to stop the person who calls their hand and who tries to enforce section 16 (b).



IRC 83 c-(3)

Another part of this analysis deals with IRC 83 c-(3), which defers the income calculation and the tax liability if a sale of the shares received from the vesting or exercise by the insider could cause a violation of section 16 (b).

In other words if there is a market purchase on Jan 1, 2016 by an insider of 10,000 shares at $50.00 followed by the vesting of 20,000 RSUs 4 months later, May 1, 2016, when the stock is trading at $75, and the insider is still an insider, the income calculation and tax liability is deferred for 2 months.

Since the deference may be for a maximum of 2 months, until August 1, 2016, there is never an approval by the Board or the Compensation Committee, pursuant to Rule 16 b-3(e) for a disposition for a tax to the issuer on the day of vesting or exercise that is 2 months premature.


IRC 83 c-3 was referenced by the Ninth Circuit in Strom v. U.S. and the Judge stated the following verbatim:

BERZON, Circuit Judge:

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).

End of Judge Berzon's words

Of course the attorneys for the defendants try to interpret the Ninth Circuit ruling differently. These attorneys claim that the IRC Bulletin below says otherwise.

Below is the paragraph from an IRS Bulletin of March 17, 2014

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.


Of course the paragraph above describes a situation where the sale of stock could not cause a violation of 16 -b-3(e). Of course, if the highlighted language was changed to "that would give rise to a section 16 (b) liability," the answer would be that Treasury and the IRS do believe that such a non-exempt purchase of shares would defer taxation of the subsequent stock option exercise.

 

Code "F" versus Code "D"

 
Another consideration in this analysis is "why do these insiders report the delivery to the issuer of shares for taxes or exercise prices as a Code "F" transaction in Column 3 of Table I of the SEC Form 4. They later claim the disposition is exempt from 16 (b) pursuant to Rule 16 b-3(e). If that were the case, then they should have entered code "D".

Perhaps the reason they do report an "F" instead of a "D" in Column 3 of Table I of the SEC Form 4 is to try to avoid the operation of Title 18 Section 1001 against them.

Regards:

John Olagues