Section 16 c of the 1934 Securities Act and SEC Rule 16 c-4

Section 16 (c) is below

(c) It shall be unlawful for any such beneficial owner, director,or officer, directly or indirectly, to sell any equity security of such issuer (other than an exempted security), if the person selling the security or his principal (1) does not own the security sold, or (2) if owning the security, does not deliver it against such sale within twenty days thereafter, or does not within five days after such sale deposit it in the mails or other usual channels of transportation;

but no person shall be deemed to have violated this subsection if he proves that notwithstanding the exercise of good faith he was unable to make such delivery or deposit within such time, or that
to do so would cause undue inconvenience or expense.

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So what does section 16 c make unlawful?

Section 16 c makes short sales of stock by insiders unlawful when the short seller does not own the stock sold or if owning the security, the seller does not deliver it against such sale within twenty days thereafter, or does not within five days after such sale deposit it in the mails or other usual channels of transportation; Beow is a relevant SEC Rule

SEC Rule 16 c-4.

§ 240.16c-4 Derivative securities.

Establishing or increasing a put equivalent position shall be exempt from section 16(c) of the Act, so long as the amount of securities underlying the put equivalent position does not exceed the amount of underlying securities otherwise owned.

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So what exactly does SEC Rule 16 c-4 say? Does it say that a 10 % beneficial owner/insider who owns 2 million shares and the insider writes calls on 3 million shares and buy puts on 1 million shares, has violated Section 16 (c) via SEC Rule 16 c-4? If there is a violation of Rule 16 c-4, are the profits made as a result of the violation subject to forfeiture by the SEC?

Does the SEC enforce such violations? How are the illegal profits calculated?

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With the above Section 16 c and Rule 16 c-4 in mind, are the actions of an insider described below unlawful?

Assume that a 10% beneficial insider has purchased in the market 3 million shares of stock at $4.00 and 9 months later the stock is trading at $15.00.

Knowing that if a sale of the stock is made at $15.00, it would cause a short term capital gain of $33 million, the 10% beneficial owner decides to write-at-the- money calls on 3 million shares and buys at-the-money puts on 3 million shares.

Both the calls and the puts have the same strike prices of $15.00 and the same time to expiration (i.e. 5 months after the transactions are made).  Assume that in 5 months from the time of the call writes and the put purchases, the stock is trading at $8.00.

The puts are exercised on Saturday expiration day with the calls expiring and cancelled on the Friday prior to expiration date.

Are there violations of section 16 c and Rule 16 c-4. Is there a violation of SEC Rule 16 b-6(d).

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A set of transactions very similar to the ones described above actually took place and have been reported to the SEC. There is also a suit under section 16 b via SEC Rule  16 b-6(d) against the violators. 

I will disclose more details as to the name of the insiders and the name of the company over time.

John Olagues