Analysis of Exemptions from Section 16 (b) of the Securities Act of 1934 pursuant to SEC rule 16 b-3

Analysis of Exemptions from Section 16 (b ) of the Securities Act of 1934 pursuant to SEC rule 16 b-3

 
As applied to dispositions from officers and directors to the issuers.

Below is Section 16 (b) of the 1934 Act:

"(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)

Section 16 (b) has as its purpose to prevent "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,"

However: "This subsection shall not be construed to cover ........any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection."

So the Commission (i.e. the SEC) can exempt only transactions that are not comprehended within the purpose of the subsection by making rules and regulations that exempt such transactions. And practitioners can not interpret SEC Rules in a manner where exemptions are available for transactions "comprehended within the purpose of the subsection".
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Below is what the Third Circuit Court of Appeals stated about the SEC's ability to exempt transactions from section 16 (b).

First Paragraph of :

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, 2003

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).
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The SEC pursuant to Rule 16 b-3(e) can exempt certain dispositions of issuer equity securities by officers or directors to the issuer when the dispositions are made in transactions between the officers or directors and the issuer that are properly approved by the issuer Board or Compensation Committee, and which are "not comprehended within the purpose of this subsection."

Below is condition 16 b-3(e) of SEC Rue 16 b-3.

(e) Dispositions to the issuer. Any transaction, other than a Discretionary Transaction, involving the disposition to the issuer of issuer equity securities, whether or not intended for a compensatory or other particular purpose, shall be exempt, provided that the terms of such disposition are approved in advance in the manner prescribed by either paragraph (d)(1) or paragraph (d)(2) of this section.

Below is Note (3)

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.
                                              

Below is SEC Rule condition 16 b-3(d)(1) and(2)

(d) Acquisitions from the issuer. Any transaction, other than a Discretionary Transaction, involving an acquisition from the issuer (including without limitation a grant or award), whether or not intended for a compensatory or other particular purpose, shall be exempt if:
(1) The transaction is approved by the board of directors of the issuer, or a committee of the board of directors that is composed solely of two or more Non-Employee Directors;

(2) The transaction is approved or ratified, in compliance with section 14 of the Act, by either: the affirmative votes of the holders of a majority of the securities of the issuer present, or represented, and entitled to vote at a meeting duly held in accordance with the applicable laws of the state or other jurisdiction in which the issuer is incorporated; or the written consent of the holders of a majority of the securities of the issuer entitled to vote; provided that such ratification occurs no later than the date of the next annual meeting of shareholders; ---------------------------------------------------------------

 
So the SEC created Rule 16 b-3 to give exemptions for dispositions to the issuer and acquisitions from officers or directors to the issuer as long as there is proper approval as required by condition 16 b-3(e), and 16 b-3(d) (1) and (2) and Note 3.

Of course Rule 16 b-3 can not be interpreted to exempt transactions that are "comprehended within the purpose of this subsection" and are not between the insiders and the issuer.

 
The American Bar Association in a letter to the SEC on August 16, 2004 page 2 paragraph 3 linked below,

https://www.sec.gov/rules/proposed/s72704/blsaba081604.pdf

regarding what type of dispositions from an officer or director to the issuer should be exempt from section 16 (b) via Rule 16 b-3(e) said:

"Whether the transactions are compensatory in nature should be irrelevant to the purposes of Section 16, because the key consideration of the statute is the absence of the ability to take advantage of the other party on the basis of inside information."

The SEC accepted and adopted the idea that "the key consideration of the statute is the absence of the ability to take advantage of the other party on the basis of inside information" by quoting from the ABA letter the paragraph in the SEC release [RELEASE NOS. 33-8600; 34-52202; 35-28013; IC-27025; File No. S7-27-04] page 11 paragraph 1.
                                            

Below is the link to the SEC Release effective August 9, 2005

https://www.sec.gov/rules/final/33-8600.pdf

In the same Release effective August 9, 2005, the SEC also accepted and adopted the paragraph from a letter of the New York State Bar Association to the SEC on August 9, 2004, which is on page 3 paragraph 2. The New York State Bar Association letter is linked below:

https://www.sec.gov/rules/proposed/s72704/nysba080904.pdf

"Rule 16b-3 is entirely consistent with the intent of Congress in enacting Section 16(b), since it exempts only transactions involving parties on an equal footing from the standpoint of knowledge of inside information"
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So the starting point, in determining whether a disposition of equity securities from the officer or director to the issuer can be exempt from section 16 (b) of the 1934 Act, is to determine whether the officer or director has equal standing with the issuer regarding insider information and its use in making such transactions.
A clear example of an officer making a disposition to the issuer that is "comprehended within the purpose of section 16 (b)" (and can not be exempted) is when the officer has discretion to deliver shares or cash for the payment of a tax liability from vesting of restricted stock units and the issuer must accept the officer's decision. Clearly the officer has superior footing since the officer can use inside information but the issuer can not use the inside information.

Another clear example of an officer making a disposition to the issuer that is "comprehended within the purpose of section 16 (b)." is when the officer has discretion as to the timing of the exercise of Employee Stock Options and the delivery of shares for payment of the exercise price instead of cash. Again, the officer has superior footing over the issuer with regard to the use of inside information relating to the timing of the exercise of the ESOs and the delivery of shares to pay the exercise price.

In both examples above, the officer could choose to pay with stock when the officer had negative inside information about future company announcements, but could pay with cash when the officer had positive inside information about future announcements. In both cases the issuer was required to accept the dispositions. In both cases, the dispositions to the issuer were transactions with the issuer where the officer had superior footing.

In these examples, the officer or director has a more superior footing over the issuer than the officer or director would have over a person merely investing by purchasing shares in the market, since the investing person still has a choice to not buy the stock.
                                                  

Once it is determined that the transaction is "not comprehended within the purpose of the subsection 16 (b).", it is possible to get an exemption if the transaction is approved consistent with the requirements of SEC Rule 16 b-3(e).

Below is a relevant sentence from 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."

The above paragraph says that it is possible to meet the approval requirements of Rule 16 b-3(e) by having approval of a Plan, where the terms and conditions of each transaction are fixed in advance.

What are the requirements to have the terms and conditions of a disposition of shares of stock to the issuer by an officer or director fixed in advance? When the officer has discretion as to the timing or the amount of shares to be disposed or the issuer has discretion as to the timing or the amount of shares to be accepted, the terms and conditions are not fixed in advance to qualify the transaction as exempt to satisfy approval via Plan approval.

So if an exemption is not achieved via Plan approval, there must be "approval of each specific transaction" in advance of the transaction. And that approval must be made by the Compensation Committee or the Board of Directors in advance of each specific transaction.

Note (3) also says:

"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."

What exactly does the paragraph above mean? My understanding is that often the Grant Agreement addresses what the terms are of a possible disposition to the issuer of shares for payment of the exercise price or to pay a tax liability. Most Grant Agreements do not specifically require delivery of shares for the full payment of exercise price payments or tax liabilities. Many Grant Agreements give discretion to the issuer, some give discretion to the officer or director to choose the form of satisfaction of the withholdings. Some allow the issuer to permit the officer or director the right to elect to deliver shares. Some require the officer or director to make share dispositions to the issuer .
                                                 

The SEC staff envisioned that it was possible for the disposition of shares to be automatic for exercise price payments or tax payments with the issuer having discretion to reject the disposition of such shares. These circumstances thereby, according to the SEC staff, made the automatic dispositions for the tax or exercise price not exempt from 16 (b) via SEC Rule 16 b-3(e).

The staff illustrated its view in the Q and A # 123.16 of May 23, 2007 which is below.

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. [May 23, 2007]
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Another consideration in determining whether a disposition of shares to the issuer by an officer or director for a tax liability upon vesting of Restricted Stock, RSUs, Performance shares or the exercise of ESOs is exempt from 16 b, is whether IRC 83 c-3 deferred the income calculation and the tax liability past the vesting date or exercise date.

Below is IRC 83(c)(3).

Sales which may give rise to suit under section 16(b) of the Securities Exchange Act of 1934

So long as the sale of property at a profit could subject a person to suit under section 16(b) of the Securities Exchange Act of 1934, such person's rights in such property are-
subject to a substantial risk of forfeiture, and
not transferable.
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For example if an officer bought 100,000 shares at $20.00 and three months later his RSUs vested when the stock was trading at $25.00 and the officer was still an officer, a non exempt sale of shares would cause a violation of 16 b. Therefore the shares received from vesting were still considered forfeitable and non transferable. Under these conditions, the income calculation and tax liability are deferred until a non exempt sale would not cause a 16(b) violation.

Judge Berzon of the Ninth Circuit Court of Appeals in Strom v. U.S. illustrates in the verbatim quote below, that income calculation and tax liability are deferred when there is a non exempt purchase within 6 months prior to an exercise of ESOs when the stock is trading higher on the day of exercise than it was trading when the non purchase of the stock was made.
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).

Few practitioners understand IRC 83 c-(3) and are confused by the IRS examples.They do not understand the IRS clarification of March 17, 2014 and believe that IRC 83(c) does not apply in any cases.
                                             

Below is the paragraph from the 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.

The phrase "that would not otherwise give rise to section 16(b) liability" means that either:

 
1) The purchase of shares were perhaps more than 6 months earlier than the exercise of a stock option

2) The price of the stock when the exercise of the stock option took place was equal or below the price when shares were purchased.

3) The person who purchased the shares and exercised the options was not an insider at the time of both the purchase of the shares and the exercise of the options

This paragraph from the IRS Bulletin of March 17, 2014, clearly illustrates that the IRS believes that IRC 83 c-3 would defer taxation of the stock option exercised by an insider (i.e. an officer, director or a greater than 10% owner) when a non exempt purchase of stock was made less than 6 months prior to the stock option exercise. In addition, when the stock was purchased, the stock was trading below the stock price on the day the ESOs were exercised.                                     

Summary

To achieve an exemption from 16 b for dispositions to the issuer, the following 3 requirements are necessary.

The transaction must not be comprehended within the purpose of Section 16 b.

The required prior approvals of the terms and conditions of the disposition are met with sufficient specificity by the Board or the Compensation Committee by approval of each specific transaction either in the Plan Document or in the Grant Agreement.

IRC 83 c-3 may defer the tax liability, making it such that all or parts of the dispositions for tax withholdings are not exempt from 16 (b) at the time of the disposition, since no approvals are ever made for a tax withholding that comes premature to the income calculation of the taxes.

John Olagues