| Release No. 34-19756 May 11, 1983 48 F. R. 23173
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 Table of Contents
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I. BACKGROUND
Rule 16b-32 was adopted by the Commission to provide an exemption from the short-swing profit recovery provisions of Section 16(b) of the Exchange Act3 for securities transactions under employee benefit plans not considered within the purposes of Section 16(b). One of the conditions of the rule is that certain types of amendments to a plan must receive the approval of shareholders, including any amendment which would materially increase the benefits accruing to participants under the plan.4
In 1979, the Internal Revenue Service ruled that an employee could deliver already owned stock in payment of the exercise of a stock option without recognizing any taxable gain on the unrealized appreciation of the delivered shares. The tax advantages of this ruling, however, were generally thought to be unavailable to employees who were also officers or directors of a company and subject to Section 16(b) of the Exchange Act, since the stock-for-stock exercise appeared to involve the simultaneous purchase and sale of an equity security subject to the short-swing profit recovery provisions of Section 16(b).
The Commission received a number of requests for exemptive relief from the possible application of Section 16(b) to this new compensation technique. In April 1980, the Commission proposed the amendment of Rule 16b-3 to exempt from Section 16(b) the mechanical transactions of exchange necessary to exercise an option through the delivery of already owned stock.5 In the release proposing the change, the Commission noted that without such an exemption, the legitimate use of certain types of employee compensation plans would be largely frustrated, and that the safeguards inherent in Rule 16b-3 made the opportunities for abuse slight. The Commission also expressed the view that, under the proposal, an amendment to an existing stock option plan allowing the delivery of already owned stock upon exercise of an option would not be a material amendment to the plan requiring stockholder approval, since it would not result in any additional remuneration for directors and officers not already contemplated by the plan.
The release proposing the amendment for comment specifically requested comment with respect to the Commission's view on the materiality of an implementing plan amendment and the need for shareholder approval thereof. The release adopting the proposed amendments stated that virtually all public comment had been favorable, and that every commentator who had addressed the issue of materiality of plan amendments had agreed with the Commission's opinion that such amendments did not materially increase participants benefits and therefore did not necessitate shareholder approval under Rule 16b-3.6 Accordingly, the Commission reaffirmed its view that amendments to existing stock option plans permitting the stock-for-stock exercise of options need not be submitted to shareholders for approval under Rule 16b-3.
II. THE COLEMA DECISION
The Colema case, in brief, involved a shareholder derivative suit alleging that the delivery of already owned stock as payment for an option exercise, and the exercise of that option through a multiple series of exchanges of shares, resulted in short-swing profits for officers that should be returned to the company. The defendants contended, among other things, that the exchange transactions were specifically exempted from Section 16(b) liability by the new, stock-for-stock amendments to Rule 16b-3. The District Court disagreed, indicating that amendments to stock option plans permitting the use of the stock delivery technique conferred material benefits upon plan participants, and thus required shareholder approval in accordance with Rule 16b-3. In Colema, shareholder approval had not been obtained, and the court held that the exemption provided by Rule 16b-3 was not available to the defendants. The court took notice of the Commission's contrary position on the materiality of such amendments for purposes of the rule, but did not find it controlling. The court did find, however, that the defendants had acted in good faith reliance on Commission rules and regulations, and so were immune from liability under Section 23(a) of the Exchange Act.7
III. THE COMMISSION'S VIEWS
The Commission continues to believe that its determination not to require shareholder approval of plan amendments designed to implement stock-for-stock exercise of options was based on cogent reasons, among them the fact that officer and director participants do not receive any additional remuneration by virtue of such arrangements. While rulemaking action with respect to the issue raised by Colema is not being considered at this time, this issue will be included in the Commission's review of its rules under Section 16 which it anticipates conducting later this year. Until such review is completed, the Commission will take the position that stockholder approval is required under Rule 16b-3 of plan amendments allowing the delivery of stock to exercise options.
The Commission recognizes that issuers with unapproved stock delivery amendments are faced with the problem of devising a method to eliminate liability under Section 16(b) during the interim period between the date of the Colema decision (February 9, 1983) and the date stockholder approval of the amendments is obtained. In the Commission's view, the exemption provided by Rule 16b-3 would be preserved if issuers submit the stock delivery amendments for stockholder approval as soon as practicable (usually at the next meeting of security holders, whether annual or special) and make all transactions occurring under such amendments after the Colema decision contingent on stockholder approval of the amendments and ratification of the interim transactions.8 Accordingly, if such approval and ratification are not forthcoming, the transactions would be rescinded.
The Commission believes it is appropriate to address two other issues indirectly raised by the Colema decision. The first is whether the Rule 16b-3 exemption is lost for all transactions under a plan which contains a stock delivery amendment that has not been approved by stockholders.9 The Commission does not believe such a result is required by the rule or consonant with its intent where stockholder approval of such an amendment was not solicited because of reliance upon the Commission's position on the matter. In the Commission's view, it would be inappropriate to subject plan participants to liability for transactions unrelated to stock delivery amendments under the above circumstances.
The second issue is whether the Coleman decision affects the availability of Rule 16b-3 for the so-called "pyramiding" of shares. The Colema case involved pyramiding, which is a technique under which an optionee requests the issuer to automatically apply the shares received upon the exercise of a portion of a stock option to satisfy the exercise price for additional portions of the option. The effect of pyramiding is to allow a participant to deliver a relatively small number of shares in satisfaction of the exercise price of even the largest option. The Commission believes that the use of pyramiding is within the meaning of Rule 16b-3, so long as the technique yields an optionee no more than the appreciation or "spread" inherent in the very exercise of the option. This position, of course, is based on the assumption that shareholder approval will be obtained, after appropriate disclosure of the pyramiding technique, and that all other applicable conditions of the rule will be satisfied.
List of Subjects in 17 CFR Part 241
Insider Trading, Reporting Requirements, Securities.
Text of Amendment
In accordance with the foregoing, Title 17, Chapter II, of the Code of Federal Regulations is amended as follows:
PART 241 INTERPRETIVE RELEASES RELATING TO THE SECURITIES EXCHANGE ACT OF 1934 AND GENERAL RULES AND REGULATIONS THEREUNDER
* * * * *
1. By adding this Release No. 34-19756 (May 11, 1983) to the list of interpretive releases.
By the Commission.
1 Colema Realty Corp. v. R. D. Bibow, et al, No. H-82-430 (D. Conn. Feb. 9, 1983).
2 Rule 16b-3 is discussed in some detail in Section IV. C. of Release No. 34-18114 (September 23, 1981) [46 FR 48147] (October 1, 1981).
3 Section 16(b) provides in part that any profit realized by an insider as a result of a purchase and sale or sale and purchase of an equity security of his company, made within a six-month period, shall inure to the company.
4 Rule 16b-3(a)(2)(ii)(A).
5 Release No. 34-16770 (April 30, 1980) [45 FR 29853].
6 Release No. 34-17080 (August 21, 1980) [45 FR 57389].
7 Section 23(a) provides in pertinent part that liabilities imposed by the Exchange Act shall not apply to any act done or omitted in good faith in conformity with a rule, regulation or order of the Commission. It is unclear, however, to what extent reliance may be placed on Section 23(a) for transactions under unapproved stock delivery amendments occurring after February 9, 1983, the date of the court's decision.
8 There also would appear to be other measures that similarly would preserve the Rule 16b-3 exemption until stockholder approval could be obtained. For example, an issuer may retain the stock delivery provisions but limit their use to persons who are not officers or directors. This measure is based on the principle, articulated in Release No. 34-13659 (June 2, 1977) [42 FR 33283] (June 30, 1977), that a plan which is bifurcated in its treatment of insiders and non-insiders will be in compliance with Rule 16b-3, so long as the transactions with insiders comply with the applicable requirements of the rule.
9 Of course, if the stock delivery amendment is rescinded until such time as it is approved by stockholders, there clearly would be no issue regarding the availability of Rule 16b-3 for transactions under the plan occurring after the rescission.
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