Analysis of the SEC Rule 16 b-3 and the SEC Staff Question and Answer #123.16

This article is an analysis of SEC Rule 16 b-3 and the SEC Staff Question and Answer #123.16 regarding exemptions from Section 16(b) of the Securities Act of 1934

 This analysis is an attempt to make clear whether a disposition of issuer shares for tax withholding to the issuer by an insider can be considered a matchable trade for a violation of section 16 (b) of the 1934 Securities Exchange Act.

Below is the entire SEC Rule 16 (b)-3. The most relevant parts for the purpose of this analysis are

(a) General,

(d) Acquisitions from the issuer (1),
(e) Dispositions to the issuer,

and Note (3). The relevant parts are highlighted . -------------------------------------------------- 

                           
§ 240.16b-3 Transactions between an issuer and its officers or directors.

 
(a) General. A transaction between the issuer (including an employee benefit plan sponsored by the issuer) and an officer or director of the issuer that involves issuer equity securities shall be exempt from section 16(b) of the Act if the transaction satisfies the applicable conditions set forth in this section. 

 
(b) Definitions - (1) A Discretionary Transaction shall mean a transaction pursuant to an employee benefit plan that:                                                                             
(i) Is at the volition of a plan participant;
(ii) Is not made in connection with the participant's death, disability, retirement or termination of employment;
(iii) Is not required to be made available to a plan participant pursuant to a provision of the Internal Revenue Code; and
(iv) Results in either an intra-plan transfer involving an issuer equity securities fund, or a cash distribution funded by a volitional disposition of an issuer equity security.

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(2) An Excess Benefit Plan shall mean an employee benefit plan that is operated in conjunction with a Qualified Plan, and provides only the benefits or contributions that would be provided under a Qualified Plan but for any benefit or contribution limitations set forth in the Internal Revenue Code of 1986, or any successor provisions thereof.                                          
(3)
(i) A Non-Employee Director shall mean a director who:
(A) Is not currently an officer (as defined in § 240.16a-1(f)) of the issuer or a parent or subsidiary of the issuer, or otherwise currently employed by the issuer or a parent or subsidiary of the issuer;
(B) Does not receive compensation, either directly or indirectly, from the issuer or a parent or subsidiary of the issuer, for services rendered as a consultant or in any capacity other than as a director, except for an amount that does not exceed the dollar amount for which disclosure would be required pursuant to § 229.404(a) of this chapter; and
(C) Does not possess an interest in any other transaction for which disclosure would be required pursuant to § 229.404(a) of this chapter.
(ii) Notwithstanding paragraph (b)(3)(i) of this section, a Non-Employee Director of a closed-end investment company shall mean a director who is not an "interested person" of the issuer, as that term is defined in Section 2(a)(19) of the Investment Company Act of 1940.                                                                                                
(4) A Qualified Plan shall mean an employee benefit plan that satisfies the coverage and participation requirements of sections 410 and 401(a)(26) of the Internal Revenue Code of 1986, or any successor provisions thereof.                                                                                                                                            
(5) A Stock Purchase Plan shall mean an employee benefit plan that satisfies the coverage and participation requirements of sections 423(b)(3) and 423(b)(5), or section 410, of the Internal Revenue Code of 1986, or any successor provisions thereof.

 
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(c) Tax-conditioned plans. Any transaction (other than a Discretionary Transaction) pursuant to a Qualified Plan, an Excess Benefit Plan, or a Stock Purchase Plan shall be exempt without condition.                                               

(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; or                                                                                              
(3) The issuer equity securities so acquired are held by the officer or director for a period of six months following the date of such acquisition, provided that this condition shall be satisfied with respect to a derivative security if at least six months elapse from the date of acquisition of the derivative security to the date of disposition of the derivative security (other than upon exercise or conversion) or its underlying equity security.

 
(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.

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(f) Discretionary Transactions. A Discretionary Transaction shall be exempt only if effected pursuant to an election made at least six months following the date of the most recent election, with respect to any plan of the issuer, that effected a Discretionary Transaction that was:
(1) An acquisition, if the transaction to be exempted would be a disposition; or
(2) A disposition, if the transaction to be exempted would be an acquisition.

 
Notes to § 240.16B-3

Note(1)                                                                         

The exercise or conversion of a derivative security that does not satisfy the conditions of this section is eligible for exemption from 16 (b) of the Act to the extent that the conditions of 240.16b-6(b) are satisfied

Note (2):                                                                       

Section 16(a) reporting requirements applicable to transactions exempt pursuant to this section are set forth in 240.16a-3(f) and (g) and 240.16a-4.

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.

 
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Note (4):                                                                       
For purposes of determining a director's status under those portions of paragraph (b)(3)(i) that reference § 229.404(a) of this chapter, an issuer may rely on the disclosure provided under § 229.404(a) of this chapter for the issuer's most recent fiscal year contained in the most recent filing in which disclosure required under § 229.404(a) is presented. Where a transaction disclosed in that filing was terminated before the director's proposed service as a Non-Employee Director, that transaction will not bar such service. The issuer must believe in good faith that any current or contemplated transaction in which the director participates will not be required to be disclosed under § 229.404(a) of this chapter, based on information readily available to the issuer and the director at the time such director proposes to act as a Non-Employee Director. At such time as the issuer believes in good faith, based on readily available information, that a current or contemplated transaction with a director will be required to be disclosed under § 229.404(a) in a future filing, the director no longer is eligible to serve as a Non-Employee Director; provided, however, that this determination does not result in retroactive loss of a Rule 16b-3 exemption for a transaction previously approved by the director while serving as a Non-Employee Director consistent with this note. In making the determinations specified in this Note, the issuer may rely on information it obtains from the director, for example, pursuant to a response to an inquiry.
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So the relevant parts of SEC Rule 16 b-3 are below:                                                                                             
(a) General. A transaction between the issuer (including an employee benefit plan sponsored by the issuer) and an officer or director of the issuer that involves issuer equity securities shall be exempt from section 16(b) of the Act if the transaction satisfies the applicable conditions set forth in this section.                                                                                                                                           
(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;                                                                                                                                                          
(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.                                                               
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.

 
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Below is the SEC Question and Answer # 123.16 of May 23, 2007.

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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Analysis of the relevant parts of SEC rule 16b-3(a) General is below:                                                          
"A transaction between the issuer and an officer or director of the issuer that involves issuer equity securities shall be exempt from section 16(b) of the Act if the transaction satisfies the applicable conditions set forth in this section."                                                                 
So for the transaction between the issuer and officer or director to be exempt, it must satisfy the applicable conditions set forth in this section as shown below:                                                                                                 
(d) Acquisitions from the issuer. A disposition of shares to the issuer for taxes is not an acquisition from the issuer. But (d)(1) also applies to a disposition to the issuer for tax withholding as stated in SEC rule 16 b-3(e).

The SEC in an Amicus Curiae  Brief in the Ninth Circuit in the Dreiling v. American Express 2005 case on page 11 stated that SEC Rule 16 b-3(d) applies only where the transaction is between the officer or director and the issuer.                                                                                                                                                              
So for an officer or director to get an exemption from 16 (b) for the disposition of issuer shares for tax withholding, which is a transaction between the insider and the issuer, the necessary requirements are below:                                                                                          
(1) The specific transaction is (must be) 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; and it must be between the officer or director and the issuer.

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 Section 16 b(3)(e) Disposition 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.                                                                                                                                                  
16 b(3)(e) is saying the terms of such specific disposition must be approved in advance for an exemption. If the terms are discretionary, there is no exemption from 16 (b) for the transaction.                                                                   
Note (3) is also required to be satisfied for an exemption to take place as stated below:                                                                                                                            
"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."------------------------------                                                                             
So Note 3 is stating that the approval conditions require the approval of each specific transaction. And are not satisfied by approval of a plan in its entirety unless the terms and conditions of each transaction are fixed in advance. 

Here is a statement by the SEC in an Amicus Curiae  brief:

Dreiling v. American Express Ninth Circuit 2005...Page 25 of the Amicus Curiae brief:                                                                                                                                            
" To that end, Note 3 to the rule requires that each specific transaction be approved to assure that the board focuses on each particular grant or award, and is accountable for authorizing each one. Since the basis for the exemption is that approved grants of securities are likely to be motivated by legitimate corporate objectives, and not by an attempt to profit from inside information, it is important that the board actually consider each specific transaction, and that it evidence "acknowledgment and accountability" a s to what it is doing."               

So if the  terms of the subsequent transaction are not provided for in a transaction as initially approved, such transaction shall require specific approval of the transaction.----------

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And the SEC staff on May 23, 2007 clarified SEC Rule 16 b-3 of Aug 9, 2005 with their Q and A # 123.16 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]

 
So if the automatic reload feature permitted the reload grants to be withheld by the issuer on a discretionary basis, the approval would not satisfy the specificity of approval requirements.                                                   

"The same result applies under Rule 16b-3(e) where the automatic feature is a tax- or exercise-withholding right."                                                                                                                                                              This certainly means that when the issuer has discretion as to how the tax withholding is made, there is no satisfaction of the approval requirements and no exemption from Section 16 (b) for the withholding.                                                                                                                                           
So to determine whether a disposition of shares to the issuer for taxes by an officer or director is exempt from section 16 (b), the first thing to do is to determine whether the issuer had discretion to withhold shares or cash. If the issuer had such discretion, there is no exemption from section 16 (b) for the disposition of shares.                                                                                                                                  And there is no court decision that has ruled otherwise nor is there an SEC statement that says otherwise.                                                                                                                                                                                    

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Below are three examples of issuer discretion as to how taxes from gains are to be paid by the grantee, which do not satisfy the requirements for an exemption from Section 16 (b).

13.6 Withholding of Taxes. As a condition to the exercise and/or settlement of any award or the lapse of restrictions on any award or shares, or in connection with any other event that gives rise to a federal or other governmental tax withholding obligation on the part of the Company or a subsidiary with respect to an award, the Company and/or the subsidiary may (a) deduct or withhold (or cause to be deducted or withheld) from any payment or distribution otherwise payable to the award recipient, whether or not such payment or distribution is covered by the Plan, or (b) require the recipient to remit cash (through payroll deduction or otherwise) or make other arrangements permitted by the Company, in each case in an amount or of a nature sufficient in the opinion of the Company to satisfy or provide for the satisfaction of such withholding obligation.

If the event giving rise to the withholding obligation involves a transfer of shares of Common Stock, then, at the sole discretion of the Committee, the recipient may satisfy the withholding obligations associated with such transfer by electing to have the Company withhold shares of Common Stock or by tendering
previously-owned shares of Common Stock, in each case having a fair market value equal to the amount of tax to be withheld...............

8. Tax Liability and Withholding . The Grantee agrees to pay to the Company any applicable federal, state or local income, employment, social security, Medicare or other withholding tax obligation arising in connection with the Award to the Grantee, which the Company shall determine; and the Company shall have the right, without the Grantee's prior approval or direction, to satisfy such withholding tax by withholding all or any part of the shares of Common Stock or cash that would otherwise be paid to the Grantee, with any shares of Common Stock so withheld to be valued at the Fair MarketValue on the date of such withholding. The Grantee, with the consent of the Company, may satisfy such withholding tax by transferring cash or Common Stock to the Company, with any shares so transferred to be valued at the FairMarket Value on the date of such delivery. Income tax withholding shall occur on the date of actual distribution. Notwithstanding the foregoing, the ultimate liability forGrantee's share of all tax withholding is the Grantee's responsibility, and the Company makes no tax-related representations in connection with the grant or vesting of Performance Units or the distribution of Common Stock or cash to the Grantee.

Section 9. Withholding of Taxes. The Company may make such provision as it may deem appropriate to satisfy the withholding of any applicable federal, state or local taxes that it determines it (or a Subsidiary or Affiliated Entity) may be obligated to withhold or pay in connection with the vesting of the Award or the disposition of shares of Common Stock acquired upon vesting of the Award. A Participant may pay the amount of taxes required by law upon the payment of an Award (i) in cash, (ii) by delivering to the Company shares of Common Stock having a Fair Market Value on the date of payment equal to the amount of such required withholding taxes, or (iii) by directing the Company to withhold from the shares of Common Stock to be delivered to the Participant upon payment of the Award shares of Common Stock having a Fair Market Value on the date of payment equal to the amount of such required withholding taxes. If the Participant elects to use the stock withholding option described in subparagraph (iii), the Participant must make the election at the time and in the manner the Company prescribes.

The Committee, in its discretion, may deny the Participant's request to satisfy the tax withholding obligations using a method described under subparagraph (ii) or (iii). In the event the Company determines that the aggregate Fair Market Value of the shares of Common Stock withheld as payment of any tax withholding obligation is insufficient to discharge that tax withholding obligation, then the Participant must pay to the Company, in cash, the amount of that deficiency immediately upon the Company's request.

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John Olagues