Many readers will recall a widely-reported news story from July of this year concerning President Bush’s failure to timely disclose his 1990 sale of 212,140 shares of Harken Energy Group. At the time, the President served on Harken’s Board of Directors. The President’s digression (which he eventually cured in a late filing after publicly censuring his errant lawyers) fell squarely afoul of the ’34 Act’s Section 16 reporting mandate. Section 16 governs the reporting obligations of insiders: officers, directors, and beneficial owners of more than ten percent of any fully reporting issuer. The recently enacted Sarbanes-Oxley Act imposed accelerated reporting deadlines on insiders. In this edition of the Securities Law Report, we will revisit Section 16’s dictates (including the short swing and short selling prohibitions) with special attention to recent changes to insider’s reporting obligations.
Who Is Subject to Section 16?
Section 16 applies to 10% beneficial owners, directors, and officers of fully reporting companies. While the notion of a “10% beneficial owner” is determinable with a reasonable degree of certainty, the terms “officer” and “director” are considerably more slippery. SEC Rule 3b-2 offers some guidance, but does not resolve the matter: it provides that “officer” means a president, vice president, treasurer, secretary, comptroller, and anyone who performs equivalent duties. This uncertainty has led to a good deal of litigation to consider the scope of the terms “director” and “officer”. Rule 16a-1(f) brings further clarity, defining “executive officer” as a principal financial officer, principal accounting officer, any VP in charge of a business unit, division, or function (the SEC points specifically to sales, administration, or finance), as well as any maker of significant policy.
The prevailing wisdom adopts a necessarily expansive definition, consistent with the disclosure purposes of Section 16. Titles are ignored, and courts have adopted the “functional equivalent” test: they inquire whether the person, although not holding a formal office, performs the functions of an officer and therefore has access to inside information. A 1978 case found that a company with 350 persons who enjoyed the honorary title of “executive vice president” did not necessarily enjoy “opportunities for confidential information.” Access to inside information is an important trigger because one of Section 16’s principal purposes is to expose transactions by insiders that might be motivated by insider information, or in violation of the short swing rules.
Disgorgement of “Short Swing” Profits
Section 16’s reporting obligations dovetail neatly into the Short Swing rules, found in subsection (b) of Section 16. Quite simply, the Short Swing rules prohibit directors, officers and 10% beneficial owners from realizing profits from the sale/purchase or purchase/sale of the issuer’s securities within a six-month period. The remedy is a private, civil claim: any Short Swing profits realized by the offending insider are recoverable by the issuer itself, or by a shareholder. The doctrine does not require the trading insider to have evil intent: liability is imposed regardless of the absence of wrongdoing.
A strict reading of the 6-month trading prohibition would seem to prohibit the exercise and immediate sale of stock options. However, such option transactions are exempted from the short swing prohibition; the grant date of the option (under certain circumstances) is deemed the purchase date. Thus, a sale of the option does not violate the rule if the sale is made more than 6 months following the grant of the option.
Short Sale and Against the Box Prohibitions
Certain types of speculative transactions are expressly forbidden by subsection (c) of Section 16 and deserve brief mention. Specifically, the following are prohibited: (1) “short sales”, where a seller anticipates a price drop and sells borrowed stock to a buyer, replacing the borrowed stock later at a lower price, and (2) “sales against the box”, where a seller anticipates a price drop and sells his or her stock to a buyer, but delays delivery of the stock, thereby creating a paper profit at a later date.
The Insider’s Reporting Obligations and Forms
Section 16’s reporting mandate falls neatly into three categories (with three corresponding forms):
* An initial report of ownership, reported on Form 3 , which must be made within 10 days of becoming an insider.
* A report of changes to an insider’s ownership, reported on Form 4 , which formerly had to be made within 10 days of the end of each calendar month in which such a change in ownership occurred (as we’ll see, this filing deadline changed following Sarbanes-Oxley’s passage).
* A supplementary annual report, reported on Form 5 for any transactions that were not reported on Form 3 or Form 4 during the year. Form 5 is due by 45 days after the end of the issuer’s fiscal year.
So What Changed?
Essentially, congress and the SEC accelerated the reporting time for Form 4 transactions from the end of the calendar month plus 10 days to 2 days after the transaction. Previously, Form 4 was monthly form in which an insider might report several transactions that took place during the previous calendar month. Form 4 now reports transactions almost immediately after they occur. The Sarbanes-Oxley Act dictated the change, and the SEC put the corresponding rules into effect at the end of August.
Making the Calculation
An example will illustrate the use of the new deadline. Formerly an insider sale on October 1 would not need to be reported on Form 4 until the end of the calendar month, plus 10 days (no later than November 10). Under the current rule, an October 1 sale must be reported “before the end of the second business day following the day on which the subject transaction” was executed. Transactions that place on a Friday need not be filed until the following Tuesday. In our example, because October 1 fell on a Tuesday, the Form 4 would be due on Thursday, October 3. This frantic timeline is even more pronounced when one considers that EDGAR preparation and filing usually requires some back-and-forth with both an attorney and an EDGAR filer.
Where to Find More Information
The SEC’s final rule discussion in its entirety can be found at: http://www.sec.gov/rules/final/34-46421.htm
Some Related Articles
Michael Spadaccini is the author of 8 books on self-help legal matters such as, Ultimate LLC Compliance Guide: Covers All 50 States (Ultimate Series), Ultimate Book of Forming Corps, LLCs, Partnerships & Sole Proprietorships, and Ultimate Guide to Forming an LLC in Any State, Second Edition (Ultimate Series).
You can view his Amazon Author Profile Here.