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SEC Amends Section 16(b) Rules in Response to Court Opinion

The SEC has adopted amendments to rules under Exchange Act Section 16(b) to clarify the regulatory conditions that apply to transactions between issuers of securities and their officers and directors. The SEC adopted the amendments in response to a 2003 appellate court opinion that cast doubt on the SEC's rules despite what it believed were explicit interpretations to the contrary. The SEC also amended Item 405 of Regulations S-K and S-B to reflect the two-business day due date of Forms 4 and the mandated electronic filing and Web site posting of Section 16 reports.

In Levy v. Sterling Holding Co., LLC, 2003 CCH Dec. ¶92,496, the 3rd U.S. Circuit Court of Appeals held that Rules 16b-3 and 16b-7 had to satisfy conditions that were not contained in the text of the rules nor intended by the SEC. The decision has made it difficult for issuers and insiders to plan legitimate transactions, according to the SEC. The amendments to Rule 16b-3 clarify the regulatory conditions that the SEC says have applied to transactions that rely on this exemption since August 1996. The amendments to Rule 16b-7 clarify the conditions that have applied since May 1991.

The 3rd Circuit construed Rule 16b-3 to apply only to transactions that are compensation-related. The SEC noted that it broadened the rule's exemptions in 1996 to cover other transactions between issuers and their officers and directors. The revised rule stated that a transaction need not be pursuant to an employee benefit plan or any compensatory program to be exempt, nor does it have to have a compensatory element.

As adopted in 1996, Rule 16b-3(d) exempted from short swing profit liability any transaction involving a grant, an award or another acquisition from the issuer, other than a discretionary transaction, if any of three conditions is satisfied. The conditions include the approval of the transactions by the board or a committee composed of two or more non-employee directors, approval or ratification of the transaction by shareholders, or the holding by the officer or director of the acquired securities for six months from the date of acquisition. To eliminate the uncertainty caused by the Levy opinion, the SEC included acquisitions among the transactions that are exempt as long as any of the alternative conditions are met.

Rule 16b-7 exempts transactions that do not involve a significant change in the issuer's business or assets, such as reincorporations or reorganizations. The acquisition of a security pursuant to a merger or a consolidation is not subject to Section 16(b) if the security exchanged is of a company that, before the merger or consolidation, owned 85 percent or more of the equity securities of the other companies party to the transaction, or 85 percent of the combined assets of all of the companies involved in the merger or consolidation. These transactions do not alter in an economic sense the investment the insider held before the transaction, the SEC explained.

However, the 3rd Circuit opinion imposed upon reclassifications additional exemptive conditions that are not found in the rule, according to the SEC. The court's opinion restricts the availability of the exemption for reclassifications to situations where the original security and the security for which it is exchanged have the same characteristics. The SEC believes that a reclassification differs little from a merger exempted by Rule 16b-7, and the court's opinion unnecessarily restricts the exemption's availability.

The SEC noted that the exercise or conversion of a derivative security is not exempted by Rule 16b-7, and it must satisfy the conditions of Rule 16b-3 or 16b-6(b). Stock splits, stock dividends or acquisitions of shareholder rights are not exempted by Rule 16b-7 either, and must satisfy the conditions of Rule 16a-9. The SEC's amendments do not change this analysis.

The amendments to Rules 16b-3 and 16b-7 are effective August 9, 2005, the date of publication in the Federal Register. Because they clarify conditions that applied to exemptions from 1996 and 1991, respectively, the rules are available to any transactions after those dates that satisfy the clarified regulatory conditions. The amendments to Item 405 are effective 30 days after publication in the Federal Register.