Exchange Fund Transactions:An Advantageous Instrument For Corporate Insiders; A Potential Nightmare For Public Investors

• Author: Jed Wulfekotte
• Position: JD candidate at American University Washington College of Law
• Pages: 02

Jed Wulfekotte is a second-year JD candidate at American University Washington College of Law, where he is a member of the Administrative Law Review. Mr. Wulfekotte has an undergraduate degree, cum laude, in Business Administration and Philosophy from Muhlenberg College in Allentown, Pennsylvania, and is interested in pursuing a career in securities and financial regulation.

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Introduction

RECENT INVESTIGATIONS into America's "corporate scandalfest"¹ revealed that corporate insiders² across the country secretly dumped their stock, causing uninformed shareholders to bear the bulk of the loss as each company sank into bankruptcy. In response, the Securities and Exchange Commission (SEC) tightened disclosure rules and mandated the immediate public disclosure of insider trades. However, by transferring stock into an exchange fund, corporate insiders can still divest corporate shares without alerting investors. An exchange fund is a private company in which shareholders, who own highly appreciated, undiversified stock, contribute a portion of their shares to a common fund. In return, investors receive shares in this fund without incurring immediate taxation on capital gains.³ Although exchange funds have always been a topic of controversy due to their tax-deferral benefit, these funds have recently come under fire because they enable executives to divest shares of their companies' stock without disclosing the initial transaction to the public. In September 2004, the Wall Street Journal reported that the SEC was investigating dozens of corporate insiders who may have used exchange funds as mechanisms to reduce their respective economic stakes in their companies without alerting investors.⁴ Although section 16(a) of the Securities Exchange Act of 1934 requires corporate insiders to report every exchange fund transaction, neither the SEC, nor the courts, require insiders to report the exchange fund transactions as a "sale." According to section 16(a), insiders must file reports with the SEC disclosing any changes in beneficial ownership of their companies' shares. These reports, which are publicly available at SEC offices, permit insiders to label dispositions as either a "sale" or "other." While some executives elect to disclose the initial transaction as a "sale" to avoid the appearance of abuse, most corporate insiders elect to label the initial exchange fund transaction as "other," increasing the odds that analysts and public investors who monitor insider trading will not take notice of the transactions.⁵

In the post-Enron business world, attorneys should encourage, and the SEC should require, corporate insiders to report these transactions as "sales." This requirement would facilitate full disclosure of insider trades and would prevent corporate abuse. The purpose of the disclosure requirements in section 16(a) is to keep public investors informed about purchases and sales which may indicate insiders' private opinions of their corporation's future prospects.⁶ This interpretation of SEC reporting requirements emphasizes the purpose of section 16(a), is permissible under the current definition of a "sale," and is consistent with subsequent case law interpreting this definition.

Exchange Funds as a Diversification Mechanism for Concentrated Wealth

ALTHOUGH CONGRESS REPEATEDLY TRIED to eliminate exchange funds since they emerged in the mid-1960s, corporate insiders have organized these funds to conform to the evolving regulations. In 1966, Congress effectively eliminated exchange funds by abolishing the tax-deferral benefit for individuals who transferred stock into an investment company organized as a corporation. ⁷ To ensure that this prohibition included exchange funds, Congress defined an "investment company" as any corporation in which more than 80 percent of its assets consisted of readily marketable stocks and securities.⁸ Following this legislation, investors attained tax-free diversification by organizing exchange funds as partnerships, which was permissible under the 1966 regulations.⁹ Congress responded by redefining the term "investment company," hoping to close the taxfree loophole.¹⁰ However, brokers countered again in the 1990s by offering exchange funds that held at least 20 percent of assets in illiquid securities, thus conforming to the existing Page 6 definition of an "investment company."¹¹ In response, the Taxpayer Relief Act of 1997 redefined "investment company" as an entity investing at least 80 percent of its assets in stock or securities.¹² Currently, exchange fund investors organize funds by investing at least 20 percent of fund assets in nonfinancial investments, such as real estate. "The primary benefit of investing in an exchange fund is that it enables investors to diversify a single stock, tax-free, until they decide to redeem their share of the fund. "

Currently, exchange funds provide a highly advantageous tool for corporate insiders. The primary benefit of investing in an exchange fund is that it enables investors to diversify a single stock, tax-free, until they decide to redeem their share of the fund. Investment banks offer this option to qualified purchasers and to accredited investors, which includes investors with a net worth of at least $5 million dollars (excluding property, furnishings, and automobiles) and with a $200,000 annual income. Due to the benefits of tax-free diversification, most exchange funds are quite large, ranging from 50 to 499 investors who have highly appreciated shares in a single company.

Section 16(a) Disclosure Requirements

CONGRESS INTENDED SECTION 16(a) of the Exchange Act of 1934 to require complete disclosure of securities holdings and...