| Release No. 34-28869 Release No. 35-25254 Release No. IC-17991 February 8, 1991
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 Table of Contents
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SUPPLEMENTARY INFORMATION:The Commission today announced the adoption of revisions to its rules promulgated under Section 16 1 of the Securities Exchange Act of 1934 (Exchange Act) . 2 Every rule under Section 16 has been amended, deleted, or reorganized except for Rule 16e-1, 3 and several new Section 16 rules have been added. Further, Exchange Act Rule 12h-2 4 has been deleted as obsolete and Rule 30f-1 5 under the Investment Company Act of 1940 (Investment Company Act) 6 has been amended.
In addition, new Item 405 of Regulation S-K 7 and new Form 5 have been adopted, as have changes to Schedule 14A 8 and Forms 10-K, 9 3, 10 4 11 and N-SAR. 12
I. EXECUTIVE SUMMARY
The beneficial ownership reporting and short-swing profit recovery provisions of Section 16 of the Exchange Act apply to every person who is directly or indirectly the beneficial owner of more than ten percent of any class of equity securities that is registered pursuant to Section 12 of the Exchange Act (ten percent holders) , 13 and to every director and officer of an issuer with a class of equity securities so registered. 14 Section 16 of the Exchange Act was designed to provide the public with information on securities transactions and holdings of corporate insiders and to deter insiders from speculative short-swing trading in their corporations securities and from engaging in transactions in their corporations securities while in possession of material, non-public information. Section 16 is but one weapon against insider trading. Unlike other provisions applicable to insider trading, such as Sections 10(b) , 15 14(e) 16 and 21A 17 of the Exchange Act, Section 16 is a strict liability provision under which an insiders short-swing profits can be recovered regardless of whether the insider actually was in possession of material, non-public information.
In response to developments in the trading of derivative securities, the growth of complex and diverse employee benefit plans, and substantial filing delinquencies, the Commission undertook a comprehensive review of the rules and forms under Section 16. Noting that the regulatory framework had resulted in interpretive uncertainty, substantial litigation, and, in some instances, unnecessary regulatory burdens, the Commission proposed to revise the rules to achieve greater clarity, rescind unnecessary requirements, streamline mandated procedures, increase compliance with the reporting provisions of the rules, and enhance consistency with the statutory purposes of Section 16.
The Commission initially proposed comprehensive revisions to the rules promulgated pursuant to Section 16 in December 1988; 271 comment letters were received. 18 In response to comments, the Commission revised the proposed amendments and republished the rules for comment in August 1989; 211 comment letters were submitted in response to the reproposal. 19 For the reasons provided in the Proposing and Reproposing Releases, and as further explained in this release, the Commission today is adopting the proposed regulatory scheme, with a number of modifications in response to comments made on the reproposal.
Rule 16b-3, the employee benefit plan rule, has been modified in several respects from that reproposed. The shareholder approval condition to the exemption, applicable to issuer grant plans and other plans unable to satisfy the conditions of former Rule 16a-8, 20 has been retained. The reproposed extension of the required period of disinterested status for plan administrators to one year following the administration of a plan has not been adopted. In response to comments, Rule 16b-3 has been reorganized to clarify the application of the regulatory framework to transactions under broad-based, non-discriminatory plans and the availability of the intra-plan transaction exemption for elections and transactions within a participant-directed plan. The revisions are intended to facilitate compliance with Rule 16b-3 by Section 401(k) plans 21 and other similar broad-based participant-directed plans.
In addition to the revisions addressing employee benefit plans, revisions have been made to modify the reproposed conditions under which a trust becomes subject to Section 16 where it has an insider trustee; specify the extent of insiders obligations to disclose on the first Form 5 unreported transactions and holdings that should have been reported prior to the effective date of the rules; delete the former exemption for surrenders of options in a merger as unnecessary; provide a reporting as well as a short-swing profit exemption for non-events such as pro rata stock splits, stock dividends, and similar grants; add an exit box to Forms 4 and 5; add a provision deeming a Form 3, 4 or 5 timely filed if delivered to a third party business that guarantees delivery to the Commission no later than the due date; and clarify the application of the rules to specific situations. 22 Comment is solicited on the exit box, as discussed in Section II.C.2 below.
II. SECTION 16(a) REPORTING
A. Who Must Report
1. Officers and Directors
The definition of officer has been adopted without substantive change from the reproposal. It is modeled after the definition of executive officer used elsewhere in the Exchange Act rules, 23 but also specifically includes principal financial officers and principal accounting officers (or controllers where there is no principal accounting officer) , as well as officers of a parent having policy-making functions with respect to the issuer. 24 Thus, persons having policy-making duties, as specified under Rule 3b-7, will be deemed officers for purposes of Section 16. 25 A persons title alone should not determine whether that person is subject to Section 16; the proper focus should be on whether a person is a corporate employee performing important executive duties of such character that he would be likely, in discharging these duties, to obtain confidential information about the companys affairs that would aid him if he engaged in personal market transactions. 26 If title were determinative, persons with executive functions could avoid responsibility by forgoing title; moreover, persons with officer titles but no significant managerial or policy-making duties would be subject to the draconian liability of Section 16(b) . Similarly, in determining whether an advisory, emeritus or honorary director is a director for Section 16 purposes, the persons title is not determinative and no change in current staff interpretation is being made. 27
2. Transactions While not an Officer or Director
Rule 16a-2(a) is adopted substantially as reproposed. Thus, a person will not be required to disclose transactions or be subject to Section 16(b) short-swing profit liability for transactions that occurred within six months prior to the date the individual first became an officer or director, except that an officer or director who becomes subject to Section 16 as a result of the issuers registration of a class of equity securities pursuant to Section 12 of the Exchange Act will be subject to Section 16 with respect to transactions conducted during the six months prior to the first transaction requiring a Form 4 filing. 28
In contrast, consistent with the prior rules, 29 transactions by officers and directors after termination of employment with an issuer are not necessarily exempt from Section 16. In response to commentators concerns, the Rule makes it clear that, as is currently the case, an insider continues to be subject to Section 16 for up to six months following termination. However, a transaction occurring after a person has terminated insider status must be reported only if it occurs within six months of a transaction that took place while the person was an officer or director. 30 As a result, a person is required to file on Form 4 to report non-exempt transactions within six months of the last transaction while the person was an officer or director subject to Section 16. In addition, the person is required to file on Form 5 to report transactions on a deferred basis for that portion of the issuers fiscal year during which the person was an officer or director subject to Section 16, and also is required to report exempt transactions occurring within six months of the last transaction while the person was an officer or director subject to Section 16.
For example, if an insider executes a transaction on April 28 and terminates officer or director status on April 30, any transaction executed on or before October 28 must be reported, since it occurred within six months following the last transaction prior to termination of officer or director status. If, in this example, the insider filed a Form 5 in June to report exempt acquisitions and dispositions in an employee benefit plan, and in September exercised an option previously granted and reported on a Form 5, the insider must file another Form 5 (or an optional Form 4) to report the exercise, since it occurred within six months following the last transaction prior to termination of officer or director status. In addition, the insider should indicate on the Form 4 or 5 reporting the exercise that insider status has terminated. 31 Where all prior transactions, including transactions otherwise reportable on Form 5, have been reported, and the insider has not had any transactions, including transactions exempt from Section 16(b) , in the six months prior to termination, there is no Form 5 filing obligation or other post-termination reporting obligation. In this case, the insider may wish to furnish the issuer with a written representation that no further report on Form 5 is required.
3. Ten Percent Holder
Section 16, as applied to ten percent holders, is intended to reach those persons who can be presumed to have access to inside information because they can influence or control the issuer as a result of their equity ownership. Section 13(d) of the Exchange Act 32 specifically addresses such relationships. As proposed, the rules adopted today 33 define ten percent holders under Section 16 as persons deemed ten percent holders under Section 13(d) of the Exchange Act and the rules thereunder. The Section 13(d) analysis, such as the exclusion of non-voting securities 34 and counting only those derivative securities exercisable or convertible within 60 days, 35 are imported into the ten percent holder determination for Section 16 purposes. 36 The Section 13(d) definition of beneficial ownership is used only to determine status as a ten percent holder; once status is determined, the reporting and short-swing profit provisions of Section 16 apply only to those securities in which the insider has a pecuniary interest. 37
Under the Rule, adopted as reproposed, shares held by institutions eligible to file beneficial ownership reports on Schedule 13G 38 that are held for clients in a fiduciary capacity in the ordinary course of business are not counted for purposes of determining ten percent holder status (13G exemption) . 39 This is a limited departure from the approach under Section 13(d) . Securities not held in a fiduciary capacity, however, must be counted in determining whether the 13G institution is a ten percent holder. Questions have been raised as to the applicability of the 13G exemption to employee benefit plans and pension funds subject to the Employee Retirement Income Security Act of 1974 (ERISA) . 40 Consistent with current staff interpretation of Section 13(d) , 41 a plan will not be deemed the beneficial owner of shares allocated to plan participants over which participants have voting power. 42
B. What Is Reported--Transactions in Securities in Which Insider has Pecuniary Interest
1. Pecuniary Interest
Section 16(a) reporting obligations and Section 16(b) short-swing profit recovery cover only those securities in which insiders have or share a direct or indirect pecuniary interest. 43 The definition of pecuniary interest is adopted as reproposed, with the following modifications to the application of the indirect pecuniary interest standard.
a. Partnership Holdings
Under the partnership attribution rule, adopted as reproposed, the beneficial ownership of portfolio securities 44 owned by a general or limited partnership is attributed to the general partners in proportion to the greater of their capital account or interest in the profit of the partnership at the time of the transaction. 45 In the event of a short-swing transaction, a general partners share of the partnerships capital account or profits is determined by the partnership agreement in effect at the time of the transaction and the partnerships most recent financial statements.
b. Fee Arrangements
In the Reproposing Release, the Commission proposed that investment adviser or trustee fee arrangements based on the performance of the portfolio would create a pecuniary interest in the portfolio, except where the fee was calculated on an annual or longer basis and the securities of the issuer did not comprise more than ten percent of the portfolio. 46 Commenters expressed concern that the rule inadvertently implied that fees based upon the amount of assets managed would create a pecuniary interest and that advisers and trustees could not be paid until the end of the year. The rules adopted clarify that asset-based fees do not create a pecuniary interest in the securities managed and that advisers or trustees may be paid more than once during the year, as long as the fee is related to performance for a year or more.
c. Corporate Holdings
A non-exclusive safe harbor governing beneficial ownership of portfolio securities held by a corporation or similar entity 47 has been adopted. The Rule adopted today 48 provides a safe harbor from attribution of corporate holdings for shareholders who are not controlling shareholders 49 of the corporation and do not have or share investment control over the corporations portfolio securities. Unlike the reproposal, the safe harbor does not extend to controlling shareholders and, therefore, the rule does not distinguish between public and nonpublic corporations.
2. Broad-based Stock Indices and Baskets
A new provision has been added to make it clear that beneficial ownership of a broad-based, publicly traded market basket or index security or future does not create a beneficial ownership interest in the component stocks. 50 This provision clarifies that in such a case, the pecuniary interest in one component stock is too remote for the stock to be considered beneficially owned. 51
3. Section 13(d) Groups
Questions have been raised concerning the application of the reporting and short-swing profit recovery provisions of Section 16 to Section 13(d) groups. 52 In applying the rules adopted today, only those securities in which a member of a group has a direct or indirect pecuniary interest would be reported and subject to short-swing profit recovery. 53 Thus, while securities holdings of group members may subject the group members to Section 16, if the group member does not have or share a pecuniary interest in securities held by other group members, the transactions of the other group members do not create Section 16 obligations for that member. 54
4. Trusts and Trustees
The trust rule adopted today addresses the application of Section 16 to trust holdings and transactions substantially as reproposed. 55 There are two changes from the reproposal, discussed below, which limit the circumstances under which a trust becomes subject to Section 16 as a result of having an insider trustee.
In addition, the Rule has been reorganized for clarity. 56 The first part of the Rule addresses circumstances under which a trust, trustee, beneficiary or settlor becomes subject to Section 16, 57 while the second part addresses the reporting and short-swing profit obligations of such parties once they are subject to Section 16. 58 The first part of the Rule is based on the Section 13(d) concepts used for determining ten percent holder status generally, 59 while the second part is based on the pecuniary interest concepts used for determining reporting and short-swing profit obligations generally. 60
a. Status Under Section 16
As in the reproposed rules and under current law, the Rule provides that a trust is subject to Section 16 if it holds more than ten percent of a class of equity securities of an issuer registered pursuant to Section 12. Under the new Rule, ten percent ownership by a trust is determined in accordance with the general beneficial ownership rule, Rule 16a-1(a) (1) . 61 Employee benefit plan trusts subject to ERISA thus will exclude from the ten percent calculation securities that are allocated to participants with voting control, a result that carries out the purposes of Section 16 without unduly interfering with the day-to-day operation of pension and employee benefit plans. 62
As proposed, a trust also would have become subject to Section 16 if the trustee was an insider and had investment control over the trusts portfolio securities. The Rule, as adopted, subjects the trust to Section 16 only if an insider trustee has or shares investment control and the trustee, or a member of the trustees immediate family, has a pecuniary interest in the issuers securities held by the trust. 63 This modification recognizes that the potential for abuse is remote where the trustee has little incentive to abuse inside information. Further, the Rule has been modified to state that if a trustee is an institution eligible to file a Schedule 13G, the trustees insider status does not subject that trust to Section 16. 64 Additionally, the service of an officer or director as a trustee of the issuers employee benefit plan does not in itself subject the plan to Section 16, even if the officer or director is a plan participant. 65
The former Rule provided that where the trust was a ten percent holder, each trustee also became subject to Section 16. The result is similar under the Rule as adopted; 66 whether a trustee is deemed to be the beneficial owner of securities held by the trust for status purposes is governed by the general beneficial ownership rule, Rule 16a-1(a) (1) , which focuses on a Section 13(d) analysis. 67 Thus, a trustee having or sharing voting or investment control over securities held by a trust would include these securities in the trustees own ten percent holder calculation. 68 Professional institutional trustees, however, are likely to be able to avail themselves of the 13G exemption provided by Rule 16a-1(a) (1) .
The Rule 16a-1(a) (1) analysis also is applicable to beneficiaries or settlors. Under most circumstances such parties are not expected to have either the requisite voting or investment control over the securities, and thus could exclude the securities from the ten percent holder calculation. Where, however, a settlor has the power to revoke the trust without the consent of another person, the settlor will be deemed a beneficial owner of securities held by the trust for determining status as a ten percent holder. 69
b. Reporting and Short-Swing Profit Obligations
The Rule separately addresses reporting obligations, and the corollary application of short-swing profit recovery provisions, of trusts, trustees, beneficiaries and settlors. 70 Trust holdings and transactions normally are reported only by the trustee on behalf of the trust, 71 and generally would not be matched for Section 16(b) purposes with non-trust transactions of the trustee, beneficiaries and settlors. Four exceptions to this provision are specified in the Rule.
First, just as employee benefit plan securities allocated to employees with voting control are excluded from the trusts ten percent holder calculation, securities held by or transactions conducted in an employee benefit plan are excluded from the trusts reporting obligations if the trustee does not exercise investment control with respect to such holdings or transactions. 72 These transactions instead must be reported by employee participants who are subject to Section 16. The allocation of securities owned by a trust to a participant account is not a trust transaction subject to Section 16, and need not be reported by the trust, but is an acquisition reportable by the insider-participant.
Second, an insider trustee with a pecuniary interest in any holding or transaction of the trust 73 must report such holding or transaction on the trustees individual form, as well as on the separate form filed on behalf of the trust. 74 Trust transactions in which the insider trustee has a pecuniary interest can be matched with personal transactions of the trustee, as well as other trust transactions. The Rule sets forth two nonexclusive situations where the trustee is deemed to have a pecuniary interest: the trustee or an immediate family member is a beneficiary of the trust, 75 or a performance fee is received that does not satisfy the proviso of Rule 16a-1(a) (2) (ii) (C) . 76
Third, the Rule addresses insider beneficiaries specifically, recognizing, as did the former rule, that it is inappropriate to require beneficiaries to incur reporting and short-swing profit obligations for transactions beyond their control. Accordingly, although beneficiaries have a pecuniary interest in trust securities to the extent of their pro rata interest in the trust, 77 they ordinarily would not report trust holdings or transactions. In the usual situation where the trustee makes the investment decisions without the prior approval of or consultation with the beneficiary, only the trust reports the transactions, and the transaction is matchable only with other trust transactions. 78 Where the insider beneficiary has investment control over the transaction and the trustee executes the transaction as directed, the beneficiary rather than the trust reports the transaction, which is matchable with other transactions of the beneficiary. 79 Where investment control is shared, including consultation between the trustee and beneficiary, both the trust and the beneficiary must report the transaction and are responsible for any resulting short-swing profits. 80
Finally, the Rule addresses reporting by insider settlors. 81 Just as a settlor who reserves the right to revoke the trust without the consent of another person is deemed to beneficially own the issuers securities held by the trust for purposes of determining ten percent ownership status, such a settlor also is viewed as having a pecuniary interest in the securities, and is responsible for reporting and short-swing profit recovery. However, if such a settlor neither has nor shares investment control, it would be inappropriate to require reporting or profit recovery. In this event, the trust rather than the settlor is responsible for reporting and the trust transactions are not matchable against the settlors transactions, just as for a beneficiary having no investment control.
C. How and When to Report
1. Timing of Reports
As reproposed, option exercises and conversions of derivative securities must be reported on the earlier of the next Form 4 otherwise required or on Form 5. 82 In addition, commenters suggested that reporting earlier on a voluntary basis would facilitate report preparation and Section 16(a) compliance. At their suggestion, the rules, as adopted, have been amended to state explicitly that insiders may report exercises and conversions, as well as any other transactions, on a date earlier than that which is required by the rules. 83
The rules adopted today provide that for purposes of Section 16 a form will be deemed timely filed if it is delivered to a third party business, including the postal service, in sufficient time for it to guarantee delivery of the filing to the Commission no later than the specified due date. 84 Accordingly, the insider will not be deemed delinquent on account of the third partys breach of its guarantee. For example, many mail services currently guarantee overnight delivery or delivery within a specified time. An insider required to file a Form 4 with the Commission by the tenth of the month will be deemed to have timely filed the Form 4 if the insider delivers the Form to a mail service guaranteeing delivery to the Commission by the due date. This provision recognizes the large number of individuals that are subject to the reporting requirements of Section 16(a) , as well as the expectation that forms mailed or delivered by guaranteed delivery services will be filed with the Commission by the specified due date. 85 Insiders must retain a receipt or other writing from the third party evidencing timely receipt by the third party for filing with the Commission by the required date in order to rely on this provision.
2. Revisions to Forms 3, 4, and 5
The annual Form 5 filing requirements have been adopted substantially as proposed, with revisions to facilitate the reporting of securities held in employee benefit plans. A Form 5 must be filed within 45 days of the issuers fiscal year end by every person who was an insider at any time during the fiscal year to report any securities transactions during that period that have not been reported previously on a Form 4, either because of deferred reporting or failure to file required reports. 86 A Form 5 is not required from an insider with no reportable transactions.
In response to comments that information concerning transactions in employee benefit plans and dividend reinvestment plans (DRIPs) may not be available from plan administrators to permit timely reporting on Form 5, as well as concern that the information required would be voluminous and not meaningful, two changes to the reporting requirements have been made. 87 First, insiders are permitted to report exempt acquisitions in thrift and stock purchase plans 88 and DRIPs 89 on an aggregate basis, rather than transaction by transaction. Reportable dispositions may not be aggregated. Second, insiders must report plan transactions on the Form 5 as of the most recent date for which such data is reasonably available to the reporting person. 90 Plan information for the fiscal year not reported on the Form 5 filed for that year would be reportable on the Form 5 for the next fiscal year (or may be filed on a Form 4 or an amended Form 5 promptly after becoming available) .
Commenters were concerned that the Form 5 requirement to report any unreported transactions, including those made prior to the adoption of Form 5, would place insiders at risk of committing reporting violations by failing to report earlier transactions that they in good faith did not recollect. In response to these concerns, the Rule adopted today requires an insider, in completing the first Form 5 or making the first written representation that no Form 5 is required, to report transactions not previously reported for each of the issuers two past fiscal years, rather than for an indefinite period. For calendar year companies this will mean that the Form 5 will include transactions in 1990 and 1991. As another example, an insider of a company with a June 30 fiscal year end would include transactions for the year ending June 30, 1990, and 1991. The Rule also provides that the insider need only have a reasonable good faith belief that all transactions in the period prior to the effective date of the rules have been reported or are reported on the Form 5. 91 The limitation of insider review to the prior two fiscal years is not an amnesty for earlier violations of Section 16(a) . Likewise, late disclosure of any transactions, on any form, does not cure the original violation.
In subsequent years, Form 5 will relate only to transactions during the most recent fiscal year and DRIP and employee benefit plan transactions from the prior fiscal year for which information was not available at the time of the prior report and not previously reported. Insiders will be responsible for determining whether all required reports and transactions during such periods have been reported. 92
In response to commenters concerns, Forms 3, 4, and 5 and related instructions have been revised to simplify the forms and facilitate completion and reporting. 93 General revisions include reformatting the forms (i.e., combining columns and eliminating others as unnecessary) to create additional space for reporting transactions, and changing transaction codes to specify in greater detail the types of transactions reported. Minor changes also have been made to form instructions to clarify reporting obligations.
At the suggestion of commenters, boxes have been added to Forms 4 and 5 that insiders must check to indicate termination of insider status. Completing these boxes will facilitate Commission and investor monitoring of insider reports. Comment is solicited on the usefulness of this approach.
Forms 4 and 5 also have been amended to contain, next to the exit box, a reminder that subsequent reports may be required to be filed by persons who were insiders at any time during the issuers fiscal year. Of course, as discussed above, 94 even after a person ceases to be an officer or director, the person may have subsequent filing obligations (i.e., a Form 4 for post-termination transactions or a Form 5 at the end of the year to reflect option exercises, employee benefit plan transactions, other transactions exempt from Section 16(b) , small acquisitions or other previously unreported transactions) . 95 Insiders who wish to file reports of exempt transactions early, at the time of their ceasing to be officers or directors subject to Section 16, may do so on either a Form 4 or Form 5.
III. DERIVATIVE SECURITIES
A. Conceptual Framework
Given the uncertainty surrounding the application of Section 16 to derivative securities under the former rules and existing case law, the Commission is adopting a comprehensive regulatory framework, in order to effect the purposes of Section 16 and to address the proliferation of derivative securities and the popularity of exchange-traded options. This framework recognizes that holding derivative securities is functionally equivalent to holding the underlying equity securities for purposes of Section 16, since the value of the derivative securities is a function of or related to the value of the underlying equity security. Consequently, both types of securities can be used to engage in the kind of short-swing profit taking that Congress sought to prevent. 96
Section 16 was enacted by Congress to provide a prophylactic measure against insider trading by allowing the corporation to recapture the profit derived by one of its insiders who engages in two transactions in the companys equity securities within a six-month period of time. Just as an insiders opportunity to profit commences when he purchases or sells the issuers common stock, so too the opportunity to profit commences when the insider engages in transactions in options or other derivative securities that provide an opportunity to obtain or dispose of the stock at a fixed price. 97 The holder of a call option not only knows that he will be able to obtain the stock, but also knows the price at which it will be obtained. Thus, whether or not the holder chooses to exercise his right to obtain the stock, the extent of his profit is determinable, when compared with a transaction in the underlying equity security or a derivative security related to that underlying equity security. 98
The functional equivalence of derivative securities and their underlying equity securities for Section 16 purposes requires that the acquisition of the derivative security be deemed the significant event, not the exercise. Failure to recognize that derivative securities are functional equivalents of the underlying securities for Section 16 purposes would permit insiders to evade disgorgement of short-swing profits simply by buying call options and selling the underlying stock, or buying underlying stock and buying put options. Potential abuse with derivative securities is demonstrated by the many enforcement actions involving the purchase of derivative securities, rather than common stock, to misuse inside information. 99
By equating ownership of the derivative security to ownership of the underlying equity security, opportunities for evasion of Section 16 are minimized. Unlike the results under prior Commission rules and case law, under the rules adopted today, transactions in the derivative securities are matchable against transactions in the underlying securities and against each other; short-swing profits obtained through use of derivative securities are recoverable. 100 The rules correspondingly recognize that, for purposes of the abuse addressed by Section 16, the exercise of a derivative security, much like the conversion of a convertible security, essentially changes the form of beneficial ownership from indirect to direct. 101 Since the exercise represents neither the acquisition nor the disposition of a right affording the opportunity to profit, it should not be an event that is matched against another transaction in the equity securities for purposes of Section 16(b) short-swing profit recovery.
The profit that can be realized on short-swing transactions, whether accomplished through derivative securities, the underlying equity security or a combination of both, depends upon the price of the underlying security. While the amount of the profit may vary given factors such as the time value of money and volatility of the underlying stock evidenced in the option premium, the exercise does not change the opportunity to realize a profit. As the price of the underlying common stock increases, so does the value of a call option 102 or similar derivative security with a fixed exercise or conversion price related to the common stock. 103
When an insider acquires a typical call option, the insider acquires the right to receive the underlying equity security at a fixed price for a fixed duration. 104 When the price of the underlying equity security exceeds sufficiently the price at which the derivative security can be exercised, the profit can be locked in as there is no uncertainty about the insiders ability to realize the profit, whether by selling the derivative security, selling the underlying securities received upon exercise, or selling other holdings of the underlying securities or other derivative securities related to the underlying security. 105 In each case the insider locks in the ability to profit by transactions in derivative securities, but under the former rules the insider could evade disgorgement of the short-swing profit earned by timing the exercise of the call option to occur more than six months after the sale of the underlying security. Some courts have recognized a potential for abuse and have matched a transaction in a derivative security with an offsetting transaction in the underlying security, 106 but many courts have not. 107
The following scenarios, while not exhaustive of all possible combinations of transactions involving derivative securities and the underlying equity security, use actual prices on the specified dates and illustrate an insiders profit potential from short-swing transactions involving derivative securities and the underlying equity securities. The amount of profit differs primarily due to the diminishing value of an option as it approaches expiration and the fact that some of the value of the option premium (or market price) is lost upon exercise. 108
(1) Purchase Stock--Sell Stock. If an insider of IBM purchased 1,000 shares of IBM common stock on February 23, 1990 ($102-5/8 per share NYSE) , he would have paid $102,625. If the insider sold the 1,000 shares on April 16, 1990, for $110,750 ($110-3/4 per share NYSE) , a profit of $8,125 would have been made. 109
(2) Purchase Option--Exercise Option--Sell Stock. Similarly, the same insider could have bought ten IBM call option contracts (covering 1,000 IBM common shares) on February 23, 1990 for $9,875 ($9-7/8 per share) , exercisable on or before October 19, 1990 at $100 per share. If on April 16, 1990, the insider exercised the option and purchased the stock for $100,000 and sold the stock for $100,750 ($110-3/4 per share) , the profit would be $875. 110
(3) Purchase Option--Sell Stock. If the insider purchased the same ten IBM call option contracts (covering 1000 IBM common shares) on February 23, 1990 for $9,875 ($9-7/8 per share) , exercisable on or before October 19, 1990, but, instead of exercising the option and selling the underlying stock, he sold 1,000 shares of IBM common stock otherwise held on April 16, 1990 for $100,750 ($110-3/4 per share) , the insider would lock in the ability to earn a profit of $875. 111
(4) Purchase Option--Sell Option. Suppose the same insider purchased ten IBM call option contracts (covering 1,000 IBM shares) on February 23, 1990 for $9,875 ($9-7/8 per share) exercisable at $100 before October 19. On April 16, 1990, the insider sold the call options for $13,625 ($13-5/8 per share) . The profit would have been $3,750. 112
(5) Purchase Stock--Purchase Put Option. The same insider also could have bought 1,000 shares of IBM stock on February 23, 1990 for $102,625, and on April 16, 1990 bought ten put option contracts (covering 1,000 IBM shares) expiring October 19 with an exercise price of $115, at a price of $7-1/2 per share, or $7,500. By purchasing the put options, the insider locked in the ability to earn a profit of $4,875, when the insider could receive $115,000 for the 1,000 shares under the put options. 113
In each of the five examples there was an acquisition of a beneficial ownership interest in an equity security of IBM followed by a disposition in less than six months, and in each case, the insider profited in a short-swing manner. Under the former rules, the profit would have been recoverable from the insider in examples 1 and 2. However, the outcome was uncertain for examples 3, 4 and 5. The Commissions rules did not specifically address the situations presented in those examples and many courts have had difficulty in concluding that transactions in derivative securities and transactions in underlying securities should be matched to permit short-swing profit recovery. Moreover, the courts have not determined whether Section 16 applies to standardized options under the former rules. 114
Given the growth of trading in derivative securities, increased sophistication in trading practices involving derivative securities, and continued Commission experience with derivative securities and practices, the rules adopted today eliminate this disparity in treatment, which is neither analytically warranted nor consistent with the purposes of Section 16. Derivative securities are susceptible to the type of abuse that Section 16 seeks to eliminate, and should be subject to the short-swing recovery provisions of Section 16 to carry out the purpose of the statute.
The former Commission Section 16 rules and case law, by failing to recognize the functional equivalence of derivative securities and the underlying equity securities, and by therefore focusing on the exercise, rather than the acquisition, of the derivative security, have left open a significant potential for short-swing abuse in trading derivative securities, while permitting recovery in situations that represent long-term investments. For example, an insider with knowledge of a positive material development, to be announced shortly, determines that while he wants to retain his existing equity position, he wants to take advantage of the information, so he purchases issuer warrants. After the public announcement and rise in stock price the insider sells his common stock, obtaining a short-swing profit, knowing that he can replace the shares at a predetermined price since he holds the warrants. Under the former rules, he could simply wait six months and a day to exercise the warrants so the profit would not be subject to Section 16(b) and not recoverable by the company. Ironically, however, an insider who purchased a warrant for investment purposes, exercised the warrant after a year and sold the underlying stock five months later--17 months after the purchase of the warrant, far beyond the six month period the statute defines as short-swing--would be subject to short-swing profit recovery. 115
Given the short-swing profit potential presented by transactions in derivative securities, the Commission has amended the rules to make it clear that ownership of derivative securities constitutes beneficial ownership of the underlying equity securities for purposes of Section 16. Therefore, transactions in options, convertible securities, warrants and similar derivative securities will be matchable with transactions in other derivative securities and in the underlying equity, and the profits recoverable by the corporation.
In realigning the Section 16(b) focus from the exercise of the derivative securities to the acquisition of the derivative securities, the new regulatory framework not only reverses the Commissions own regulatory approach but also differs from a line of cases that, in the absence of rules to the contrary, have held that the exercise of the option (rather than its acquisition) is the Section 16(b) purchase of an equity security. 116 These cases have held that an acquisition of a right is not a purchase of an equity security unless accompanied by an irrevocable liability to pay for the stock, or other indicia of beneficial ownership. A few courts have found a purchase of an equity security to occur at the acquisition of the derivative security, 117 but usually the purchase has been found to occur at exercise. As the most recent judicial decision to address the operation of derivative securities stated:
This judicial rule [treating exercise as a purchase under Section 16(b) ] cannot withstand careful analysis. A person who acquires a call option acquires the right to purchase the underlying stock at a given price. If the price of the stock subsequently rises and the person exercises the option and then sells the stock, the profit he earns represents the swing in the price, not between the date of exercise of the option and later sale of the stock, but rather between the time he originally purchases the option and the time he sells the stock.... The courts have strayed because they have viewed the intervening event--the exercise of the option for stock--as an independent purchase. This is incorrect. Because the option holder already owns the right to purchase the stock at a fixed price, his decision to actually exercise the option does not provide him the ability to earn insider profits and thus does not constitute a §16(b) purchase. 118
The conceptual framework for derivative securities adopted today does not distinguish between standardized options and other options, such as those granted under employee benefit plans. Some have argued that employee stock options should be treated differently from other options, because employees do not pay cash for the options and, therefore, the exercise rather than the grant should be treated as the purchase. Under Section 16, the Commission historically has recognized that a purchase takes place at the time of the grant of employee options or bonus stock and that the consideration for the bonus stock and options is the employees services. 119 Just as with standardized options, the employee option requires further payment at the time of exercise, but the short-swing profit opportunity is set at the time of grant, just as it is with the acquisition of a standardized option. Indeed, not to treat the employee option or bonus stock grant as a purchase for Section 16 purposes would be to provide a significant opportunity for the short-swing transactions Congress wished to eliminate. For example, an insider could sell employer stock in advance of bad news, and obtain a specifically-authorized stock option grant at market after the price drop, without the concern that profit could be recoverable under Section 16.
Nor do employee options justify different treatment because, unlike standardized options, they are non-transferable. Their non-transferability does not impair the short-swing profit opportunity provided by the right to acquire stock at a fixed price. The restriction on transferability, a Commission-imposed requirement for an exemption under Rule 16b-3 initially derived from the Internal Revenue Code as a reflection of prior business practice and designed to provide a further safeguard against abuse, should not operate to remove option grants from the scope of Section 16.
Under the rules adopted today, acquisitions of call options from an issuer or third party are deemed purchases for purposes of Section 16 and are matchable with sales of the underlying stock or sales of another call equivalent derivative security relating to the same equity security. The exercise of the option, which does not create a new opportunity for profit, is exempt unless the option is out-of-the-money. 120 Generally, there appears to be little economic justification for an insider to exercise an out-of-the-money option. While it may be possible to view exercises of out-of-the-money options as a similar change from indirect to direct ownership, the rules do not provide such treatment given concerns as to the reasons that an insider would exercise such an option. At-the-money options are treated as in-the-money options under the new rules.
The sale of the stock underlying an option is not exempt and therefore is matchable with a purchase of the same equity security or any call derivative security relating to the same equity security within six months. Thus, to avoid short-swing profit recovery, a grant of an employee stock option by an issuer, absent an exemption, must occur at least six months before or after a sale of the equity security or any derivative security relating to the equity security. While many employee stock option grants may be exempt under Rule 16b-3, that exemption reflects the safeguards imposed on the transaction and not a determination that an option grant is not within the purview of Section 16. 121
Some commenters have questioned the appropriateness of the Commissions exempting the exercise of derivative securities in light of the United States Court of Appeals for the Second Circuit decision in Greene v. Dietz. 122 In that case, the majority of a panel of the Second Circuit criticized a Commission rule that exempted the exercise of employee benefit plan stock options. One district court, in Perlman v. Timberlake, subsequently found the rule invalid, although another district court, in Perlitz v. Continental Oil, upheld the rule. 123 The Commission filed an amicus brief for rehearing in Greene, and an amicus brief before the court in Perlman, both of which were before the court in Perlitz. 124 These briefs set forth the Commissions view that the rule was a proper exercise of its authority. 125
Moreover, there are significant differences between the rules adopted today and the rule challenged in these cases. For example, in contrast to the rules adopted today, the exemption for the exercise considered in Greene was not a corollary of a regulatory scheme that defined derivative securities as holdings of the underlying securities and specifically subjected transactions in derivative securities to Section 16(b) , as transactions matchable against transactions in the underlying equity. The Rule scrutinized in 1957 was adopted without the concomitant application of short-swing liabilities to derivative securities transactions. 126 Now, after 30 years of study and experience with trading in derivative securities, the Commissions rules today recognize what they did not then, 127 that derivative securities are functionally equivalent to underlying equity securities for purposes of Section 16. 128
B. Definitions of Equity Securities of An Issuer and Derivative Security
The definition of equity securities of an issuer has been adopted as proposed. 129 The rule provides that derivative securities written by third parties, so long as they relate to and derive their value from the equity securities of the issuer, are within the definition as functionally equivalent instruments representing beneficial ownership of the underlying securities. To do otherwise would be to countenance the evasion of Section 16(b) liabilities through the trading of standardized or third party options or other rights issued by a third party relating to equity securities of the issuer.
While a few commenters expressed a contrary view, the application of Section 16(b) to third-party derivative securities is consistent with both the statutory purposes of Section 16(b) and its language. Defining an equity security of the issuer to include derivative securities written by third parties is consistent with the language of the statute, both because those securities represent beneficial ownership of the underlying equity and because they are securities relating to that issuer. 130 The Supreme Court stated in Reliance Electric Co. v. Emerson Electric Co., 131 where alternative constructions of the terms of §16(b) are possible, those terms are to be given the construction that best serves the congressional purpose of curbing short-swing speculation by corporate insiders. 132 The prophylactic purpose of Section 16(b) would be vitiated by the reading suggested by commenters who took issue with the approach of the proposed rules.
Derivative securities are defined in the rules to include options and convertible securities, and similar rights whose value depends upon the value of the issuers equity securities. 133 The definition has been clarified to exclude securities without a fixed exercise price. 134 Rights without a fixed exercise price do not provide an insider the same kind of opportunity for short-swing profit since the purchase price is not known in advance. The opportunity to lock in a profit begins when the exercise price is fixed; at that time, the right becomes a derivative security subject to Section 16.
The rules 135 specifically exempt from the definition of derivative security: (1) a pledgees interest in pledged securities, (2) the obligation to receive or surrender securities in a merger, (3) cash-only securities, such as phantom stock, awarded under an employee benefit plan satisfying the provisions of Rule 16b-3(c) or with a fixed date of redemption beyond six months from the date of acquisition, 136 (4) interests in broad-based index options, futures, and baskets, (5) employee benefit plan interests or plan rights of participation, and (6) rights with an exercise or conversion privilege at a price that is not fixed. 137 The first three exclusions from the definition are adopted as proposed. The fourth exclusion from the definition, relating to broad-based index options and futures, has been expanded to include broad-based publicly traded market baskets of underlying equity securities, provided the basket has been approved for trading by the appropriate federal governmental authority. 138 The fifth exclusion has been added to clarify that employee benefit plan interests, or rights to participate in an employee plan, are not derivative securities. 139 The sixth exclusion, as discussed above, makes it clear that a derivative security must have a fixed exercise price.
C. Call and Put Equivalent Positions
Under the rules, transactions in derivative securities are matchable; the rules use the terms call equivalent position and put equivalent position to define those transactions that may be viewed as purchases and sales, respectively, and therefore matchable. The definitions of call equivalent position 140 and put equivalent position 141 are adopted as proposed. Derivative securities have either a call feature, permitting the owner to acquire securities upon exercise, or a put feature, permitting the owner to dispose of securities upon exercise.
A person owning a call option or writing a put option 142 would benefit from an increase in the value of the underlying security, while a person owning a put option or writing a call option would benefit from a decrease in the value of the underlying security.
D. Acquisition of Derivative Securities
When an insider purchases a derivative security in the open market or in a negotiated transaction, or is granted a derivative security by the issuer, the opportunity to realize the short-swing profit begins. Thus the acquisition of a derivative security is a reportable event, whether or not the derivative security is presently exercisable. 143 Acquisitions of call derivative securities are matchable with any disposition of the related underlying security (or other call equivalent position related to the same class of underlying security) for purposes of short-swing profit recovery. 144 Likewise, acquisitions of put equivalent positions are matchable with any acquisition of the related underlying security (or any disposition of a put equivalent position related to the same class of underlying security) .
As noted above, a right to acquire an equity security with an exercise price that is not fixed is not deemed to be an equity security or derivative security subject to Section 16. 145 The rules adopted today clarify that a right with a floating exercise price is not required to be reported and will not be deemed to be acquired or purchased, for Section 16 purposes, until the purchase price of the underlying securities becomes fixed or established, which commonly occurs at exercise. 146 Thus, a right to purchase an equity security is deemed acquired as of the date the exercise or conversion price becomes fixed, and the acquisition, absent an exemption, would be matchable for Section 16(b) purposes with a disposition within six months of the fixing of the price. For example, the acquisition of an option having an exercise price equal to 90 percent of the market price as of the date of exercise would be deemed to be a purchase of the underlying stock as of the date of exercise. 147 The receipt of such an option to purchase shares at a discount from the floating market price does not provide the same kind of opportunity for short-swing profit as a right with a fixed exercise price because the value relationship between the floating option and the underlying stock is a function of the issuer discount or subsidy, rather than capital appreciation. 148
In the case of an option with a floating price that will become fixed as of an event or a specified date prior to exercise, the right is deemed to become a derivative security upon the fixing of the price, and is reportable as the acquisition of a derivative security. The rules have been modified to provide that if the timing of the event fixing the price is outside the control and knowledge of the holder, then the acquisition would be reportable on Form 4 as of the date of the event fixing the price, but would be exempt from Section 16(b) matching with sales occurring before the fixing of the exercise price, but will not be exempt from Section 16(b) matching with sales occurring thereafter. 149 Given the holders lack of control over the timing of the fixing of the acquisition price, it would not be appropriate to put all sales at risk for the entire period, however long, prior to fixing of the price.
The exemption from Section 16(b) for exercises of options does not apply to the exercise of out-of-the-money options, as discussed above, because there generally is not rational economic reason for such exercises. In response to commenters, however, the Rule provides an exemption for out-of-the-money exercises necessary to satisfy the serial exercise requirement of the Internal Revenue Code, which requires insiders to exercise incentive stock options in the chronological order in which they were granted, even if they are out-of-the-money. 150
E. Disposition of Derivative Securities
Dispositions of derivative securities are reportable events representing changes in beneficial ownership of the underlying securities, as well as in the derivative securities themselves, and are therefore subject to the short-swing profit recovery provisions of Section 16(b) . Dispositions of call derivative securities are matchable with any acquisition of related underlying securities (or other call equivalent position related to the same class of underlying securities) . Likewise, dispositions of put equivalent positions are matchable with any disposition of related underlying securities (or call equivalent positions related to the same class of underlying securities) . However, as under the former rules, the disposition of derivative securities in connection with an exercise or conversion is exempt from Section 16(b) , because it represents only a change in the form of beneficial ownership. 151
1. Expiration of Derivative Securities
Rule 16b-6(d) exempts from Section 16(b) the expiration or cancellation without value of a long derivative security. The Rule has been revised to make it clear that the expiration of short derivative securities positions may yield a profit which is subject to recovery under Section 16(b) . 152
2. Options in a Merger
The exemption for option exercises as a result of a merger, contained in former Rule 16b-6(c) , has been deleted as no longer necessary. The former rule was promulgated in response to concern that profit recovery under such circumstances would negate the accrued value of long-term options. An insider would be required to exercise the option, which was deemed a purchase under the former scheme, before surrendering the underlying securities into the merger. Without an exemption, the combination of the exercise and the surrender of the underlying securities would result automatically in a short-swing transaction subject to Section 16(b) . Under the rules adopted today, the exercise of the option is exempt if it is not out-of-the-money. 153 If the option was held six months before the merger, there would be no short-swing transaction for purposes of Section 16(b) , assuming no matching purchase within six months. 154
3. Determination of Profit
The profit calculation standard for transactions in derivative securities is adopted as reproposed. 155 The Rule provides guidance to the courts and issuers seeking settlements with insiders, but permits consideration of other equitable factors in determining profits. If the same security is purchased and sold, the recovery would be the profit received. For transactions involving different types of equity securities, under the standard adopted today, the maximum short-swing profit recovery is the difference in market value of the underlying security between the date of purchase and the date of sale. If an insider can demonstrate that the amount of profit was less, then a court can order a lesser recovery. 156
IV.EMPLOYEE BENEFIT PLAN TRANSACTIONS
The substantive revisions to Rule 16b-3 157 have been adopted substantially as reproposed, except that the shareholder approval requirement and the one year period of non-participation for disinterested administrators of the former rules have been retained. In addition, the Rule has been reorganized to clarify its application to acquisitions under grant plans and to employee-directed transactions under 401(k) and other thrift and similar plans.
Employee benefit plans, the subject of Rule 16b-3, have been a traditional vehicle through which employers have compensated and provided incentives to their employees. Since many plans provide for grants or awards at least every 12 months, if there were no acquisition exemption, any sale of any equity security by participating officers or directors would necessarily occur within six months before or after an acquisition, and therefore result in short-swing liability. Rule 16b-3 is intended to provide relief from this frustration of the legitimate use of employee benefit plans as a method of executive compensation, where the nature of the transaction and the safeguard imposed by the rule minimize the potential for abuse. 158 Recognizing the interests of companies in providing employee benefit plans for their officers and directors, the Commission historically has sought to establish conditions ... designed to preclude the unfair use of information which may have been obtained by an officer or director by reason of his relationship to the issuer in order to delineate situations in which [an employee benefit plan] transaction [is] not comprehended within the purpose of Section 16(b) . 159
The Rule as adopted divides plan transactions into two principal categories--grant and award transactions and participant-directed transactions. 160 Two conditions apply across-the-board to all plan transactions involving employer securities. 161 First, the transaction must be pursuant to a written plan. Second, the plan or a written agreement must require derivative securities to be non-transferable, with limited exceptions discussed below.
As proposed, the Rule would have deleted the requirement that employee benefit plans and material plan amendments be approved by shareholders as a condition to exemption. The Rule as adopted retains the requirement for those employee benefit plans of the types subject to the shareholder approval requirement under the formal Rule. 162 Thus, shareholder approval continues to apply to most grant and award plans and, as more fully discussed below, to participant-directed plans that would not have been eligible for exemption under former Rule 16a-8.
Additional conditions, which must be met for the transaction to qualify for exemption from Section 16(b) , vary depending on whether the transaction is a grant or award of securities (such as options or bonus stock) to the insider, or an insider-directed transaction, which commonly occurs in thrift or similar plans through payroll deduction.
To be exempt, in addition to satisfying the general conditions for exemption and the shareholder approval requirement, grants or awards of securities to insiders must be made pursuant to a plan in which either a disinterested committee of directors makes all substantive decisions regarding timing, eligibility, pricing and amount of awards, or an automatic formula specifies those terms. 163 These conditions are designed to preclude the insider from influencing the time, terms or amount of the grant of securities, so as to take advantage of inside information. In addition, all grants or awards now are subject to a six month holding period from the time of the grant by the company. Thus, for example, an insider cannot sell bonus stock within six months of its grant, or sell securities received upon exercise of an option within six months of the option grant, without losing the exemption for the acquisition and becoming subject to the short-swing profit recovery provisions of Section 16(b) . 164
The conditions applicable to transactions in plans that permit participants to make investment elections, such as thrift or savings plans 165 (participant-directed transactions) , primarily entail restrictions upon the timing of elections to acquire or dispose of equity securities held in the participants plan account. 166 These restrictions are designed to assure that the transaction is part of a plan that permits only ongoing or other routine transactions, where the opportunity for abuse is limited because elections are not changed on a short-term basis.
Rule 16b-3, as adopted, continues to provide an exemption for cash settlements of stock appreciation rights (SARs) satisfying the conditions of the former Rule, including the requirements of shareholder approval and disinterested administration, and that elections generally be made in specified quarterly window periods. 167 Consistent with the former Rule, the Rule also requires a six month holding period. Further, the exemptions for specified dispositions of plan securities to the issuer, such as cancellations and redemptions, are retained substantially as provided in the former and proposed rules, along with an exemption for dispositions pursuant to qualified domestic relations orders. 168 Finally, consistent with the former rules, the Rule has been revised from the reproposal to exempt all distributions to the participants from a Rule 16b-3 plan. 169
The restructured Rule is discussed in more detail below. 170
A. General Exemptive Conditions of Rule 16b-3
Rule 16b-3 as adopted today establishes two general conditions, a shareholder approval condition, and additional transaction-specific conditions necessary for a transaction pursuant to an employee benefit plan to be exempt from Section 16(b) . 171 The Rule requires that transactions be pursuant to a written plan specifying the basis for determining eligibility and either the price and amount of securities to be awarded or the method by which the price and amount are to be determined. 172 The plan or a written agreement also must provide that derivative securities are not transferable other than by will or the laws of descent and distribution. 173 This latter condition is similar to the condition imposed on incentive stock options under the Internal Revenue Code 174 and has been a condition of the Rule 16b-3 exemption since 1952. 175 At the suggestion of commenters, the Rule adopted today also permits transfers pursuant to qualified domestic relations orders. 176
Upon reconsideration, the Commission has determined to retain the former shareholder approval condition in Rule 16b-3. This requirement was proposed to be deleted in favor of other safeguards against Section 16(b) abuse, but concerned shareholders, commenting on the proposals, urged that shareholders have an interest in not only the level of compensation, but that compensation be designed to enhance the longer term horizons of management. 177 The adopted requirement parallels the former requirement, and thus plans that were not subject to the shareholder approval requirement under the former rules are not subject to shareholder approval under the new rules. There are two types of such plans, both established as trusts. First, plan trusts containing issuer securities where less than 20 percent of the securities are held by insiders are excluded. 178 Second, pension and retirement plan trusts that have broad-based employee participation are excluded. 179 The overall effect of these two exemptions is to carry forward the current scope of the shareholder approval requirement; most grant and award plans will be subject to the shareholder approval requirement, and many participant-directed plans will qualify for exemption from the requirement because of the manner in which they are structured.
C. Grant or Award Transactions
1. Disinterested Director Provision or Formula
In addition to meeting the general exemptive conditions of Rule 16b-3 and the shareholder approval requirement, grants and awards of equity securities under an employee benefit plan must be made by a committee of two or more disinterested directors 180 or pursuant to a specific formula. 181 As under the reproposal, the disinterested administration requirement has been strengthened by requiring that award decisions be made by directors, who have fiduciary responsibilities to the company and shareholders. Upon reconsideration, the reproposal to extend the prohibition against administrators participating in any plan of the issuer to one year following such service is not deemed necessary and has not been adopted. Instead, the former requirement prohibiting participation for one year prior to serving as an administrator is retained. The Rule adopted today provides that it is a directors actual participation in a plan, rather than the eligibility of a director to participate, that affects his or her disinterested status. 182
Where an insider participating in an employee stock bonus or option plan can exercise discretion in determining either the amount of securities that may be acquired or other material terms of awards to the insider, the award is treated as a volitional acquisition, just like an open market purchase. If such an acquisition is preceded or followed by a matchable sale of a security within the statutory six-month period, any short-swing profit is recoverable. The disinterested administration requirement of Rule 16b-3 is designed to prevent insiders from having, directly or indirectly, any control over the terms of their own awards, and therefore removes the ability of the insiders to time their acquisitions under the plan to take advantage of inside information. It also provides assurance that plan administrators cannot be influenced by their own expectation of awards in plans of the issuer and accordingly shields them from any potential pressure from insiders to act in a less than independent fashion.
As under former Rule 16b-3, where a grant of bonus stock or the award of derivative securities meets the conditions of the new Rule, and thus is not within the control of the insider, that non-volitional transaction is an exempt purchase. Since the substantive decisions concerning the grant are made by disinterested administrators, the grant transaction is not one that the insider can cause in order to take advantage of inside information unfairly to effect a short-swing transaction. Awards of derivative securities meeting the Rule 16b-3 conditions are subject to the same conditions for exemption as grants of bonus stock, since the new rules treat derivative securities as a form of beneficial ownership of the underlying equity securities. 183
In response to comments, the disinterested administration requirement specifies several exceptions consistent with current staff interpretation. The Rule makes it clear that a directors disinterested status is not affected by participation in either a formula plan, automatic in operation, 184 or a broad-based participant-directed plan such as an employee thrift plan. 185 The Rule specifically provides that a director may choose between cash or an equivalent amount of issuer equity securities in lieu of the directors annual retainer fee or meeting fee without affecting the directors disinterested status. 186 Finally, as provided under former Rule 16b-3, a director of the issuer is disinterested for purposes of administering plans that are not open to directors. 187
The Rule provides that a formula may be used as an alternative to disinterested administration, or it may be used in tandem with decisions made by disinterested administrators. 188 Such formulas serve as a substitute for the disinterested administration requirement by automatically establishing the terms of awards. As with the disinterested administration condition, the Rule as adopted strengthens the safeguards associated with use of a formula by requiring greater specificity concerning award terms than is currently required. The amount, price and timing of awards to individuals or classes of employees must be set forth in the plan or automatically determined by the formula.
The Rule, adopted as reproposed, also conditions the exemption for grants or awards of bonus stock and derivative securities under an employee benefit plan on a six month holding period. If an insider fails to adhere to this condition, and sells the securities within the six month period, the Rule 16b-3 exemption for the grant or award of the stock or derivative security is lost and the sale is matchable with the grant or award transaction, or other non-exempt acquisitions, for purposes of Section 16(b) short-swing profit recovery. The six month holding period provides an additional safeguard against short-swing transactions.
A total of six months must elapse between the grant of the derivative securities and the sale of the securities underlying those derivative securities; the timing of the exercise does not affect the six month period. Of course, if the exercise occurs when the option is out-of-the-money, the exercise would not be exempt, and would be matchable with any sales of equity securities within six months before or after the exercise. The out-of-the-money exercise will not affect the exempt status of the grant.
3. Treatment of Restricted Stock and Discount Stock
Under the new Rule, the date of a grant or award is the date of acquisition; if the acquisition is exempt pursuant to Rule 16b-3, it would be reported on a deferred basis on Form 5, or may be reported earlier on Form 4. Consistent with prior interpretation, the acquisition of restricted stock containing vesting or forfeiture provisions likewise is deemed to occur as of the date of grant even if not vested or subject to risk of forfeiture. 189 If the stock is forfeited, the forfeiture would be reported on Form 5 (or earlier, on Form 4, at the option of the insider) as a cancellation without value received. The vesting of the stock or the lapse of a forfeiture provision is not a reportable event for purposes of Section 16. 190
Interpretive questions have been raised concerning the treatment of discount or cheap stock grants. 191 Cheap stock is treated the same as any other right to purchase equity securities. Therefore, awards with a fixed exercise price, such as par value, will be treated as the award of a derivative security. 192 However, grants or awards of cheap stock or rights having a floating exercise price at a discount, such as a price related to a percentage of market value of the underlying equity security on the date of exercise, are deemed to involve acquisitions of neither derivative securities nor equity securities. 193 Thus, a grant of these rights is not a Section 16 event. Commenters, however, were uncertain about the application of the new rules to the exercise of such rights. The Rule, as adopted, clarifies that an insider is deemed to acquire the underlying equity securities, for purposes of Section 16(b) , when the exercise priced of an option or right with a floating exercise price is fixed. 194 In the case of cheap stock with a floating price, or other rights with a floating price, this usually occurs at exercise. Thus, the six month holding period begins at exercise. If the grant of the right satisfied the conditions of the grant or award exemption of the Rule, the acquisition of the underlying equity securities would be treated as an award of an equity security at the time of exercise and would be exempt from Section 16(b) , subject to satisfaction of the holding period.
D. Participant-Directed Transactions
The Rule as reproposed provided four exemptions for transactions in participant-directed plans. These exemptions have been restructured for clarity and modified to address commenters concerns that a literal reading of the conditions as reproposed would render the exemptions unavailable to 401(k) plans and other similar stock purchase plans. In particular, commenters were concerned that the reproposed requirement that the plan be a retirement or pension plan could be read to preclude thrift plans from qualifying because they provide for in-service withdrawals. Concern was also raised that the reproposed requirement that the plan be open to all employees was too restrictive, because there may be separate classes of employees who do not participate in thrift plans, such as union employees who may receive different pension benefits pursuant to a collective bargaining agreement. The Commission did not intend to change the current exempt status of transactions in 401(k) plans or other broad-based thrift plans under Rule 16b-3, and has modified the Rule to avoid such a result.
As adopted, the Rule exempts specified transactions within any participant-directed plan of an issuer, 195 where the plan satisfies the general exemptive conditions of the Rule and has been approved by shareholders, where required, and the participant-directed transaction satisfies one of four additional sets of conditions of the Rule discussed below. Shareholder approval is retained as a condition for those participantdirected plans that were subject to the condition under former Rule 16b-3 because they could not satisfy the conditions of former Rule 16a-8. Those plans would include director plans where the insider can choose periodically between cash and securities in lieu of an annual retainer.
The first two exemptions are available for transactions in any participant-directed plan. 196 If either condition is met and the plan qualifies under Rule 16b-3, the transaction is exempt. First, transactions in such a plan are exempt when the participants election is made at least six months in advance of its effective date, i.e., six months prior to any purchase of the securities under the plan. 197 Second, an exemption is provided for transactions conducted by terminated, retired, or disabled employees, or on behalf of deceased employees, to settle their plan accounts, because the timing of these events is not likely to present the opportunities for abuse that Section 16 addresses. 198 This exemption, as adopted, differs from the reproposal by the inclusion of a death and retirement provision, and by providing that the exempt transaction can occur on the date of termination or retirement rather than being deferred for six months after election.
In contrast to the first two exemptions, the third and fourth exemptions are available only for participant-directed transactions relating to a thrift, pension, retirement, or other ongoing stock purchase plan. 199 These exemptions are provided for transactions undertaken as a result of an election to participate or to change participation levels and for intra-plan transfers.
The third exemption provides that the initial and periodic purchase transactions resulting from an election to participate or an election to change levels of participation 200 under a plan satisfying general exemptive conditions of the Rule and the shareholder approval condition (where applicable) are exempt if four safeguards are met to assure that plan transactions are ongoing and routine.
First, the plan must be broad-based and not discriminate in favor of highly compensated employees. 201 This limits the exemption to routine plans where wide participation and equal treatment of all participating employees limits insiders opportunities to engage in short-swing speculation.
Second, purchases under the plan within six months before an insider participants withdrawal of plan securities (other than pursuant to a qualified domestic relations order, or at death, retirement, disability or termination) will lose their exempt status unless: (i) following withdrawal, the insider ceases purchases of securities under the plan for six months, or (ii) the securities so distributed are held by the participant for six months before disposition. 202 This safeguard imposes a penalty on early withdrawal by insider participants to discourage non-periodic transactions generating short-swing profit and serves to encourage long-term investment strategies. 203
Third, similar to the second safeguard, insider participants electing to cease participation in a plan may not renew participation for six months. 204 This penalty is likewise intended to discourage insiders from using a plan to make purchases on a one-shot or episodic, rather than on an ongoing, routine, basis.
The fourth safeguard is applicable to stock purchase plans, such as Section 423 plans, 205 where the rights have floating exercise prices and there is no obligation to purchase the stock until the date of exercise or purchase. For such plans, the underlying securities must be held six months from the date the exercise or purchase price is determined. 206 Since rights to purchase stock at a price that floats with the market price provide different opportunities for abuse, the six month holding period requirement commencing at the date the price is fixed prevents insiders from profiting in a short-swing manner by selling the underlying stock received from such rights within six months.
The fourth and final participant-directed plan exemption covers acquisitions of employee securities or dispositions of such securities in connection with transfers among funds within a thrift plan, where the intra-plan transactions occur during a quarterly ten-day window period beginning on the third day after release of the issuers quarterly financial information, if the insider has not within the prior six months made an election to effect an intra-plan transaction involving the issuers securities. 207 Thus, an insider could make an intra-plan transfer during one of four window periods as long as there is only one election per six month period, or two window periods in a year. These window periods coincide with the release of the issuers quarterly financial reports, which serves as a safeguard against the insider having material information that the public does not have. The six month period is designed to prevent an insider from electing to purchase issuer securities by participating in an employer securities fund and then electing to sell such securities by transferring out of the fund within six months, or vice versa.
SARs that may be settled only for cash, where either the award satisfied the conditions of Rule 16b-3(c) or the cash-only SAR may be redeemed or exercised only upon a fixed date of redemption at least six months after award, or upon death, retirement, disability or termination of employment, are not deemed to be derivative securities and are exempt from Section 16. 208 In contrast, SARs settled for stock are derivative securities and are accorded the same treatment as options. 209 SARs that can be settled in either cash or stock, but are settled in cash, are treated as an exercise of an option (generally an exempt transaction) and the simultaneous sale of the underlying stock. 210 If the cash settlement satisfies the conditions of the safe harbor, the sale upon the receipt of cash is exempt from Section 16(b) . The Rule continues to impose conditions of shareholder approval, issuer information availability, disinterested administration, exercise of the SAR only during a window period except in specified situations, 211 and a six month holding period from the acquisition of the right to the date of the cash settlement. 212
Apart from traditional SARs, other securities or rights related to the securities have been deemed SARs under current staff interpretation where there is a right to receive cash in return for the surrender of the right or securities. For example, the right to surrender securities to satisfy tax withholding consequences of an option exercise is deemed an SAR equivalent. 213 A right that, by its terms, affords an opportunity to receive cash related to an appreciation in the value of the underlying equity securities will be treated as an SAR, but other derivative securities or underlying equity securities that do not have a cash component will not be so treated. The ability to receive cash in certain circumstances, such as a change of control, creates a cash component similar to a grant of an SAR. The addition of a cash component must satisfy the conditions of Rule 16b-3 for exemption. 214
F. Cancellations, Expirations, and Qualified Domestic Relations Orders
Historically, Rule 16b-3 has provided an exemption for specified dispositions of plan securities, including cancellations and expirations. The proposals provided similar exemptions. The reproposals added a condition for exemption that the cancellation, expiration, or surrender must not be accompanied by the receipt of consideration. Concern was expressed that a cancellation of an option accompanied by a grant of a new option would not be exempt. As a result, the Rule adopted today provides a specific exemption for cancellations attendant on grants of replacement options. 215 Additionally, an exemption for a disposition of plan securities pursuant to a qualified domestic relation order has been added. 216
The Rule adopted today makes it clear that the exemption for distributions applies to participant-directed plans as well as distributions from grant or award plans if the conditions of the Rule are satisfied. 217 Since securities are deemed purchased when acquired under the plan, distributions from a plan simply represent a change from indirect to direct ownership. Thus, it is appropriate to apply the exemption to distributions from either type of plan. 218 The exemption applies only to distributions of equity securities, not cash payments in lieu of the equity security. If, for example, the insider surrenders 500 shares of stocks in his or her account to the issuer for cash, the receipt of cash would be deemed a sale of the 500 shares for purposes of Section 16. 219
A. Pro Rata Rights, Stock Splits and Stock Dividends
In response to comment received, the reproposed rule exempting the pro rata grant of subscription rights has been modified to include an exemption for the acquisition of pro rata grants of rights to all holders of a class of equity securities registered under Section 12 of the Exchange Act. 220 As commenters pointed out, there is no reason under Section 16 to distinguish subscription rights from other rights, such as a repurchase right or poison pill, that are awarded pro rata to all holders of the underlying equity security registered under Section 12, since the opportunity for the abuse addressed by Section 16 is limited where all shareholders are treated equally. When subscription or similar rights are exercised, the transaction is treated as the exercise of a derivative security and is reported accordingly. 221
The rules as proposed would have exempted stock splits and stock dividends from Section 16(b) but would have required the transaction to be reported on Form 5. The Commission has concluded that neither Section 16 reporting nor short-swing liability should apply to stock splits, stock dividends, or grants of rights where the grants are provided pro rata to all security holders, as these are non-discretionary transactions, and do not present the opportunity for abuse intended to be addressed by Section 16. Information regarding stock splits and stock dividends is readily available to the public through issuer press releases and periodic Commission filings. Accordingly, the exemption provides both a reporting and short-swing profit recovery exemption for pro rata awards such as subscription rights or shareholder rights, as well as changes in the number of equity securities owned pursuant to pro rata stock splits and stock dividends. Should the holdings of an insider change as a result of such events, the insider may note the reason for the change in the space provided on the Form 4 or Form 5. 222
The reproposals contained an exemption for reporting persons of Canadian issuers. The Commission has determined not to adopt the exemption at this time. The matter will be considered in connection with the Commissions proposed multijurisdictional disclosure system. 223
C. Owner of Any Security of the Issuer
The Commission continues to believe that a shareholder does not lose standing to sue under Section 16(b) by virtue of the fact that, as a result of a business combination transaction, the shareholder is divested of ownership of shares in the company in whose securities the short-swing profits are alleged to have been made. 224 However, in light of the fact that the Supreme Court has granted certiorari in the case of Mendell v. Gollust, the Commission has determined not to adopt the proposed definition of owner of any security of the issuer 225 at this time.
D. Section 16(d) --Market Makers
The Commission also has determined not to adopt proposed Rule 16d-1 at this time. Prior interpretations and no-action letters under Section 16(d) remain in effect.
In addition, questions have been raised concerning the applicability of Section 16(d) to transactions on a national securities exchange that are incident to over-the-counter market making activities. Persons making a market on a national securities exchange are not eligible for the Section 16(d) exemption. However, Section 16(d) has been interpreted by the staff to exempt purchases and sales of closed-end fund shares by an affiliated market maker for its trading account even though the shares may be purchased on a national securities exchange, if the transactions occur in the ordinary course of business for the purpose of maintaining a foreign over-the-counter market for the securities and the purchases and sales are in response to actual or anticipated demand of its customers in the foreign market. 226 This interpretation is extended to transactions, even those made on a national securities exchange, that are incident to the establishment or maintenance of a domestic or foreign over-the-counter market, provided that the transactions are in the ordinary course of the dealers business in providing liquidity in the over-the-counter market and the securities purchased on a national securities exchange are held in the dealers trading account to be used solely for providing liquidity and not for investment.
VI. COMPLIANCE WITH SECTION 16(a)
A. Delinquent Reporting Under Section 16(a)
Compliance with Section 16(a) continues to be a problem, 227 despite publicly expressed Commission concern, continued enforcement actions against delinquent filers, and recent legislation that permits the Commission to seek fines for Section 16(a) violations. 228 Although the percentage of delinquencies has decreased in the past two years, it continues to be unacceptably high.
To address the non-compliance problem, Item 405 of Regulation S-K adopted today requires a registrant 229 to disclose in proxy and information statements, Form 10-K reports, and Form N-SAR reports information regarding delinquent Section 16 filings by insiders. 230 A registrant must identify by name its insiders who, during the fiscal year, reported transactions late or failed to file required reports, and must disclose the number of delinquent filings and transactions for each such insider. It is not necessary to disclose the details of the late reported transactions. Upon further consideration, the Commission has determined not to adopt the proposal to require registrants to disclose their procedures to assist insiders with their Section 16(a) compliance, since such a requirement would not likely result in disclosure useful to shareholders.
Item 405 requires a registrant to disclose any known late filing or failure by an insider to file a report required by Section 16(a) . 231 As stated in the proposing releases, a registrant will not be liable for incorrect disclosures pursuant to Item 405 if the information reported is consistent with the information disclosed on the Forms 3, 4 and 5 or amendments sent to the registrant by the insider pursuant to Rule 16a-3(e) . A registrant does not have an obligation under Item 405 to research or make inquiry regarding delinquent Section 16(a) filings. Any form received by the registrant within three calendar days of the required filing date may be presumed to have been filed with the Commission on a timely basis. 232 An issuer may rely on a written representation from the insider that no Form 5 filing is required. 233 The Item has been revised to make it clear that, while the registrant must retain the written representation for two years, failure to do so does not violate the Commission rules, but simply removes the safe harbor protection for responsibility for incorrect disclosure.
If a particular transaction or holding has not been reported, the insider should amend the original filing or make a new filing to report the transaction. 234 The transaction reported in an untimely manner would be disclosed pursuant to Item 405 for the fiscal year in which the report was filed, even if the transaction related to and should have been reported in a prior fiscal year. 235
Delinquent filings reported prior to the effective date of the new rules are not required to be disclosed pursuant to Item 405. Although not disclosed in the proxy statement, such delinquencies nonetheless are violations of Section 16(a) . On or after the effective date of the new rules, if a registrant receives a Form 3, 4, or 5 during the fiscal year reporting holdings or transactions that were required to have been reported at an earlier date, disclosure of delinquent filers under Item 405 would be required.
To assist the Commission and shareholders in identifying those registrants disclosing delinquent filings or transactions by insiders, the cover page of Form 10-K has been amended. Registrants will check the designated space on the cover page if disclosure of delinquent filers pursuant to Item 405 is not contained in the Form and will not be contained in the proxy or information statement incorporated by reference. If at the time of filing the Form 10-K the registrant does not yet know whether such disclosure will be contained in the proxy or information statement or the Form 10-K amendment containing the Part III information, the box should not be checked. If the box is not checked, this will not be taken as a statement that there will be Item 405 disclosure of delinquent filers, but rather than the registrant may not have the requisite knowledge at the time the Form 10-K is filed. 236
All of the rules adopted today, except for Rule 16b-3, Item 405 of Regulation S-K, and, in certain cases, Rule 16b-6(b) become effective May 1, 1991 (effective date) . As discussed below, a phase-in period until September 1, 1992 is provided for employee benefit plans. Disclosure of delinquent filers under Item 405 will be required for registrants whose fiscal year ends on or after November 1, 1991. In general, the Rule 16b-6(b) exemption for specified option exercises is effective May 1, 1991, subject to a six month holding period requirement as discussed below.
There is no grandfathering of the former rules. Thus, no benefit plan or reporting person will be entitled to rely on the former rules once the new rules are phased in, except as to reporting and transactions conducted prior to the effective date of the new rules. Staff interpretations inconsistent with the new rules may not be relied upon for transactions occurring after the effective date of the rules and the related phase-in schedule.
The new rules affect the application of Section 16 to various persons. Those subject to Section 16 under the new rules will be required to file a Form 3 by the later of May 1, 1991, or 10 days after becoming an officer, director or ten percent holder, if they have not already filed one under the former rules