Vesting of Options Not a “Purchase” Under Section 16(b)

The vesting of options did not constitute "purchases" under Exchange Act Section 16(b), and according to a 9th Circuit panel, a company officer was therefore not entitled to defer the tax consequences of her option exercises. When the officer was hired, she entered into stock option arrangements involving the right to purchase a fixed number of shares on specified future dates. The officer exercised the options at a time when the market price greatly exceeded the option price. The issue before the 9th Circuit panel was whether the officer could postpone the tax consequences of her option exercises. If the calculation of income could be deferred until a period after the stock price dropped, the officer’s taxes would be significantly lower.

The panel explained that an employee ordinarily realizes income for tax purposes upon exercising options based on an amount equal to the fair market value of the stock on the date of exercise minus the option price. Section 83 of the Internal Revenue Code, however, allows recognition and valuation of income to be deferred if a profitable sale of the stock acquired through the exercise of the options could subject the taxpayer to suit under Exchange Act Section 16(b), which forbids a corporate insider from profiting on a purchase made within six months of a sale and requires the disgorgement of any profits. The district court granted the officer’s motion for summary judgment, using the Rule 11 frivolousness standard in determining whether a Section 16(b) suit would be viable and holding that the calculation and recognition of income attributable to the option exercises could be deferred for almost the entire period at issue.

The appeals court determined that the tax consequences of exercising options could be postponed if the taxpayer could show that if he or she had sold the stock, a suit brought under Section 16(b) would have an objectively reasonable chance of success. The panel noted language in Section 83 indicating that it applies when rights in property are "subject to a substantial risk of forfeiture" and "not transferable," and concluded that this meant that the section applies only if a Section 16(b) suit has a "realistic" chance of success. This standard, wrote the court, "roughly equates to a determination of whether a reasonably prudent and legally sophisticated person would not have sold her stock, because if a Section 16(b) suit had been brought against her, she likely would have been forced to forfeit the profit obtained by the sale."

Continuing, the panel found that the officer failed to demonstrate that a sale of her stock could have subjected her to a Section 16(b) suit with an objectively reasonable chance of success. The officer contended that her options were "purchased" on each date that they vested, which was approximately every six months, and which would preclude her from selling her stock during the two years in question; the government maintained that the options were purchased on the date that they were granted, creating a single, six-month period for Section 16(b) liability.

The court examined a 1991 SEC rulemaking release discussing the treatment of derivative securities for purposes of Section 16. The SEC rules, the panel observed, did not differentiate between vested and unvested securities, and the release interpreted the rule to mean that unvested securities are purchased under Section 16(b) when granted and that the vesting of the stock is not a reportable event under Section 16(a) and thus not a purchase under Section 16(b). The panel concluded that "the SEC’s interpretation that both vested and unvested securities are "purchased" when acquired governs treatment of [the officer’s] options." Additionally, because the vesting of the options was conditioned on the passage of time and continued employment, an exception for options contingent on meeting the performance targets did not apply. Therefore, the panel found that " a reasonably prudent and legally sophisticated person in [the officer’s] position would have felt free to sell her property, because, if a Section 16(b) suit had been brought against her, she would not have been forced to forfeit the profit obtained by the sale, nor would she have faced substantial legal expenses defending herself in a suit not readily dismissible." Finally, the panel determined that the district court had applied the incorrect standard in assessing the viability of a Section 16(b) suit and reversed the grant of summary judgment in favor of the officer.

□ Strom v. U.S. (9thCir) is reported at ¶96,275.