Impact of SEC insider trading rules on executive compensation arrangements.

• Author: Bubnovich, Nick

The Securities and Exchange Commission (SEC) has adopted revised rules and forms that apply to purchases and sales of employer securities by corporate "insiders" (directors, certain officers and 10% shareholders). These new rules, which generally became effective May 1, 1991, relate to the short-swing profit recovery provisions of various statutes, principally Section 16 of the Securities Exchange Act of 1934.

Exemption for option exercises

The exercise of a stock option is not considered a "purchase" under the Section 16 liability provisions, although the exercise remains subject to the Section 16 reporting provisions. The SEC reasoned that the grant of an option is a purchase, while the exercise merely changes the form of ownership from indirect to direct.

For tax purposes, taxable income from the exercise of a non-qualified option must now be recognized at the exercise date. Sec. 83(c)(3) no longer delays income recognition for six months, because there is no longer a substantial risk of forfeiture. Likewise, for incentive stock options (ISOs), the alternative minimum tax adjustment (Sec. 56(b)(3)) is measured at the exercise date (rather than six months later).

The timing of the income recognition is unclear, however, if an insider makes a separate, nonexempt purchase within six months of an option exercise. For example, assume an insider makes an open-market purchase of company stock on June 1, 1991 and exercises a nonqualified stock option on June 2, 1991. Due to the Section 16(b) liability provisions, the insider would be unable to sell the stock acquired from the option exercise until six months after the June 1 purchase (i.e., Nov. 30, 1991). However, based on Regs. Sec. 1.83-3(j)(2), Example (3), it would appear that the insider is taxed on the option spread on June 2, 1991. Similarly, the tax preference on an ISO exercise would also be measured on June 2, 1991.

Exempt plans

Most of the complexity of the new rules centers on the exemption from liability for certain transactions under "exempt plans." Because most companies grant options or other stock-based awards at least every 12 months, any insider's sale of stock would necessarily occur within six months before or after a purchase and therefore result in short-swing liability. To alleviate this problem, an exemption has been provided under Rule 16b-3 for two types of plans--award plans (e.g., traditional stock and option plans), under which an award is made to an insider, and...