SEC Adopts Amendments to Rules Under Section 16

By: Cydney Posner

The SEC has adopted amendments to two rules that exempt certain transactions from short-swing profit recovery under Section 16(b) of the Exchange Act. The amendments are intended to clarify the exemptive scope of the rules in light of a third circuit opinion, Levy v. Sterling Holding Company, LLC, December 2002, which cast doubt as to the scope of the 16b-3(d) and 16b-7 exemptions. In that case, the third circuit held that neither rule exempted directors' acquisitions in a reclassification (amendment of preferred to provide for automatic conversion on an IPO) effected prior to an IPO and matched those transactions with sales occurring within six months post-IPO. The SEC believes that Levy reads into those rules conditions that are not contained in the text of the rules or intended by the SEC, notwithstanding, the SEC points out, "explicit interpretations to the contrary." The amendments are designed to clarify the applicable conditions.

The SEC has also amended Item 405 of Regs S-K and S-B to eliminate the timely filing presumption.

Rule 16b-3(d) and (e)

Rule 16b-3(d) exempts grants, awards and other acquisitions from the issuer that meet specified conditions. Levy held that this exemption applied only to transactions with the issuer that have a compensatory aspect. The SEC makes clear that that was not the SEC's stated intent in adopting the rule. To eliminate the uncertainty generated by Levy, the SEC has amended Rule 16b-3(d). As amended, this paragraph of the rule would be entitled "Acquisitions from the issuer" and would provide that any transaction involving an acquisition from the issuer (other than a "discretionary transaction"), including without limitation a grant or award, whether or not intended for a compensatory or other particular purpose, will be exempt if any one of the rule's three existing alternative conditions is satisfied. Rule 16b-3(e) exempts certain dispositions to the issuer and, although it was not addressed in Levy, the provision is designed to be parallel with 16b-3(d). Accordingly, the SEC has also amended that rule to exempt any transaction, other than a "discretionary transaction," involving the disposition by an officer or director to the issuer of issuer equity securities, whether or not intended for a compensatory or other particular purpose, provided that the applicable conditions are satisfied.

Rule 16b-7

Rule 16b-7, entitled "Mergers, reclassifications and consolidations," exempts certain transactions that do not involve a significant change in the issuer's business or assets. The rule is typically relied upon for reincorporations or reorganizations of corporate structure. The text of the rule, however, refers specifically to mergers and consolidations, but not to reclassifications. In Levy, the court held that the rule would apply to a limited class of reclassifications, but not to reclassifications that resulted in the insiders' owning shares with different risk characteristics and involving an increase in the percentage ownership of common by insiders. The SEC again maintains that these are not conditions found in the language of the rule and are inconsistent with the SEC's intent. As a result, the SEC eliminates the uncertainty generated by Levy by amending Rule 16b-7 so that, consistent with the rule's title, the text would state "merger, reclassification or consolidation" each place it currently states "merger or consolidation." In addition, a new paragraph states that the exemption created by Rule 16b-7 applies to any securities transaction that satisfies the conditions of the rule and is not conditioned on the transaction's satisfying any other conditions.

Although, to preserve flexibility, the SEC did not acquiesce to some commenters request for a definition of reclassification, it does provide some guidance in the release: transactions "that are exempt as reclassifications generally include transactions in which the terms of the entire class or series are changed, or securities of the entire class or series are replaced with securities of a different class or series of securities of the company, and all holders of the reclassified class or series are entitled to receive the same form and amount of consideration per share. Rule 16b-7 also applies in such transactions where shareholders have the right to receive cash instead of stock by exercising their dissenters’ appraisal rights, or the option to surrender their shares for stock or for cash in certain circumstance.

"These transactions, which do not involve a substantial change in the business owned, do not involve the holders’ payment of consideration in addition to the reclassified class or series of securities, and have the same effect on all holders of the reclassified class or series, do not present insiders the significant opportunities to profit by advance information that Section 16(b) was designed to address. A transaction that has the same characteristics and effect as a reclassification, whether domestic or foreign, is exempt without regard to its formal name, including but not limited to a statutory exchange, conversion to a different form of entity, and redomicile or continuance in a different jurisdiction. Similarly, a transaction that has the same characteristics and effect as a merger or consolidation, whether domestic or foreign, is exempt without regard to its formal name, including but not limited to an amalgamation or scheme of arrangement."

Regs S-K and S-B, Item 405

Item 405 of Regs S-K and S-B allows the issuer to presume that notices it receives within three calendar days of the required Form 4 filing date were filed by the required date. Since Section 16 now requires filing within two business days, the SEC has amended Item 405 of Regs S-K and S-B to delete the Item 405(b)(1) presumption, without substituting a different presumption or otherwise modifying the substance of Item 405. The SEC contends that, by reviewing Section 16 reports posted on EDGAR, an issuer is readily able to evaluate their timeliness. Moreover, according to the SEC, a report that is not received by the issuer in time for the issuer to post that report on its website by the end of the business day following filing should not be presumed to have been timely filed.

Effective Dates

The amendments to Item 405 are effective 30 days after publication in the Federal Register. The amendments to Rules 16b-3(d) and (e) are effective on the date of publication in the Federal Register, but because they clarify regulatory conditions that applied to these exemptions since they became effective on August 15, 1996, they are available to any transaction on or after August 15, 1996 that satisfies the regulatory conditions so clarified. Similarly, the amendment to Rule 16b-7 is effective on the date of publication in the Federal Register, but because it clarifies regulatory conditions that applied to that exemption since it was amended effective May 1, 1991, it is available to any transaction on or after May 1, 1991 that satisfies the regulatory conditions so clarified.

IRS Circular 230 Notice: To the extent the above constitutes tax advice, under IRS Circular 230 I am obligated to inform you that it cannot be relied upon by you or any other taxpayer to avoid penalties.