New Sec Short-swing Profit Rules-heightened Scrutiny of Insiders
| Publication year | 1991 |
| Pages | 13 |
| Citation | Vol. 4 No. 5 Pg. 13 |
Ronald S. Poelman, J.
On January 10, 1991, the United States Securities and Exchange Commission (the "SEC") adopted the long-awaited changes to the short-swing profit rules that apply to directors, officers, and major shareholders of most companies with publicly traded stock.[1] These new rules were adopted pursuant to §16 of the Securities Exchange Act of 1934 (the "Exchange Act").[2] These changes constitute a comprehensive revision of the prior rules. The new rules are clearer and more coherent than the old rules, but they are also significantly more complex. They became effective on May 1, 1991.[3]
SIGNIFICANT CHANGES
The highlights of these §16 rule changes are as follows:
Who Must File. The new rules clarify who must file, especially who is an "officer" and what constitutes "ownership" for the purpose of determining who is a more-than-10-percent shareholder.
What Stock Must Be Reported as "Beneficially Owned." The new rules adopt a new "pecuniary interest" definition for determining when stock is "beneficially owned" and thus reportable under §16. This standard is broader than the standard under the prior rules.
New Form 5. The new rules adopt a new Form 5 to be filed annually, in addition to the current Forms 3 and 4. The information required by Forms 3 and 4 has also been expanded.
Public Disclosure of Delinquent Filers. The new rules require companies to disclose the names of delinquent filers in their Form 10-K Annual Reports to the SEC and in their proxy statements to shareholders.
Reversal of Treatment of Options. Etc. In what is probably the most significant change of all, the new rules reverse the treatment of stock options and other so-called "derivative securities." For the purpose of determining short-swing profits, the grant of an option, etc., is now a §16 "purchase" and the exercise of the option is not.
Rules for Employee Benefit Plans. The rules relating to the special exemptions for certain transactions under qualifying employee benefit plans have been revised.
SECTION 16 GENERALLY
Application. Section 16 applies to any person who is the direct or indirect owner of any class of equity security that is registered pursuant to § 12 of the Exchange Act and to every director and officer of a company that has a class of equity securities so registered.[4] This encompasses almost every company with publicly traded stock.[5]For the purposes of this article, such directors, officers, and more-than-10-percent shareholders of such companies are collectively referred to as "insiders."[6]
Short-Swing Profits. Section 16(b) prohibits insiders from making any purchase and sale (or any sale and purchase) of such stock within a six-month period.[7]The rationale of this prohibition is that such trades by insiders within six months are likely to be based on material, non-public information. Accordingly, §16 makes all "profits" from such transactions illegal and repayable to the company. "Profits" are basically the largest price spread between any matchable purchase and sale.[8]Section 16(b) gives a right of action for recovery of these illegal profits both to the company and to its stockholders in a derivative suit. In fact, however, it is plaintiffs' attorneys who most often initiate such suits.[9]Their incentive is attorneys' fees.[10]
Reporting Obligation. As a monitoring device, § 16(a) requires all insiders to file beneficial ownership reports with the SEC that publicly disclose the initial extent of the insider's beneficial ownership of the company's stock (Form 3) and that dis- c lose any subsequent changes in such ownership (Form 4).[11]
WHO MUST FILE
Directors. The definition of a "director" is unchanged under the new rules. The definition contained in §3 (a)(7) of the Exchange Act will thus continue to apply.[12]This definition includes any director or a person who performs similar functions. The SEC has now made clear that §16 will apply only to directors who perform policy-making functions.[13]Accordingly, §16 does not apply to honorary, emeritus, or advisory directors. This is in accord with prior judicial interpretations.[14]
Officers. The new rules make clear that §16 applies only to officers who perform a policy-making function.[15]This may include an officer of a parent or subsidiary corporation if such person performs a policy-making function for the company. Officer titles are not determinative, except that the persons holding the following titles are presumed to perform policymaking functions: the president, the principal financial officer, the principal accounting officer or controller, and any vice president in charge of a principal business unit, division, or function (such as sales, administration, or finance). This definition is patterned after the existing definition of an "executive officer" in Rule 3b-7 under the Exchange Act.[16]Notably, all "executive officers" whom the company includes in its management disclosure pursuant to Item 401(b) of Regulation S-K[17]are now presumed by the SEC to be subject to §16.[18]
Transactions Before Becoming a Director or Officer. The old rules required a person who became a director or officer to report all transactions that occurred within six months of such election.[19]New Rule 16a-2 now eliminates this requirement, with one exception.[20]of the company registering a class of stock under §12 of the Exchange Act.[21]
Transactions After Ceasing to Be a Director or Officer. No change has been made in the treatment of §16 transactions that occur after a person ceases to be a director or officer. New Rule 16a-2(b) states that such trades must still be reported and will be subject to short-swing profit liability.[22]
More-Than-10-Percent Shareholders. The new rules adopt a "voting/investment power" definition of ownership for the purpose of determining who is a more-than-10-percent shareholder under §16.[23] This test is adopted from the rules already existing under § 13(d) of the Exchange Act.[24] Specifically, these rules state that any direct or indirect power to vote and/or dispose of the securities constitutes ownership. Notably, this "voting/investment power" test for determining whether a shareholder is a §16 insider is different from the "pecuniary interest" test described in the next section for determining what transactions must be reported under §16.
WHAT STOCK MUST BE REPORTED AS "BENEFICIALLY OWNED"
Pecuniary Interest. The new §16 rules require that an insider (as determined above) report any transaction in which such insider has a "pecuniary interest."[25] A "pecuniary interest" is defined as "the opportunity, directly or indirectly, to profit or share in any profit derived from a transaction in the subject securities."[26] This opportunity may arise from "any contract, arrangement, understanding, relationship, or otherwise."[27] Notably, this "pecuniary interest" test for determining when a transaction must be reported is different and perhaps broader than the "voting/investment power" test described above for determining whether a person is a more-than-10-percent shareholder.
Indirect Pecuniary Interests. The SEC has defined in large part in the new §16 rules what constitutes an "indirect pecuniary interest."[28] An insider, for example, is deemed to have a pecuniary interest in the stock held by the insider's family members who share the same household.[29] A general partner is deemed to have a pecuniary interest in the portfolio securities held by the partnership to the greater extent of such general partner's capital account or profit interest.[30] A shareholder is deemed to have a pecuniary interest in the portfolio securities of the corporation, but only if such shareholder is a controlling shareholder and has investment authority over such securities.[31] Attribution rules also exist for the trustee, settlor, or beneficiary of a trust, if such person has investment authority over the trust's portfolio securities.[32] Other rules exclude certain remote interests.[33]
THE NEW REPORTING SYSTEM
Form 3. Form 3 is the Initial Statement of Beneficial Ownership that must be filed by the insider within 10 days of the date on which a person assumes the status as an insider.[34] The information on Form 3 has been expanded under the new rules.
Form 4. Form 4 is the Statement of Changes in Beneficial Ownership that must be filed by the insider within the first 10 days of any month following a month in which a reportable transaction has taken place.[35] The information required on Form 4 has been expanded under the new rules. With one significant exception, transactions that are exempt from short-swing profit liability, such as gifts, do not need to be reported on Form 4, but rather are now to be reported on the annual Form 5 described below.[36] The significant exception to this rule is the exercise of stock options and...
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