The SEC Proposes Amendments To Rules 16b-3 And 16b-7

Friday, October 1, 2004 - 01:00

In June 2004, the Securities and Exchange Commission (the "SEC") proposed amendments to Rules 16b-3 and 16b-7 in order to clarify the types of transactions that are excluded from Section 16(b) liability following the uncertainty created by the Third Circuit's decision in Levy v. Sterling Holding Company, LLC ("Sterling"), which significantly narrowed the scope of the two exemptions in transactions involving public companies and their insiders.1 The Sterling decision has made it impossible for directors, officers and 10% stockholders to engage in legitimate transactions in reliance on certain prior SEC interpretations of Rules 16b-3 and 16b7 without exposing themselves to the risk of litigation and potentially significant liability. In this article, we discuss the amendments proposed by the SEC; why the proposed amendments should be adopted; and the opposition that can be expected to the amendments.

Under Section 16(b) of the Securities Exchange Act of 1934, amended ("Exchange Act"), any director, officer or greater than 10% stockholder of an issuer with equity securities registered under Section 12 of the Exchange Act can be required to disgorge to the issuer all profits realized from the insider's purchases and sales (or sales and purchases) of equity securities of the issuer within a six-month period. An action seeking disgorgement may be brought either directly by the issuer or by a shareholder derivatively on behalf of the issuer to recover these profits. Congress enacted Section 16(b) to deter insiders from using confidential corporate information for personal trading gain. Because Congress believed that it would be difficult, if not impossible, to prove that insiders misused material inside information, it imposed strict liability to take "the profits out of a class of transactions in which the possibility of abuse was believed to be intolerably great."2

The Proposed Amendments Are Necessary

Prior to the Third Circuit's 2002 decision in Sterling, companies assumed all non-compensatory distributions (or acquisitions) of their securities to their officers and directors, effected pursuant to the terms of Rule 16b-3, were exempt from §16(b) liability. In addition, when companies recapitalized or restructured by canceling old securities and issuing new securities, their corporate insiders subject to Section 16 usually relied on Rules 16b-3 or 16b-7 (in the case of directors or officers) or Rule 16b-7 (in the case of 10% stockholders) to exempt these transactions from §16(b). The SEC's interpretation of these rules indicated that such reliance was appropriate.3 In 2002, however, the Third Circuit issued a decision, Sterling , which called into question Rule 16b-3's coverage of commonplace transactions between corporations and their officers and directors, and cast into doubt whether 16b-3 or 16b-7 exempted a reclassification of preferred to common stock.

In Sterling , the controlling-shareholders of a company, as an initial step towards taking the company public, exchanged their non-registered preferred stock for registered common. Within six months of the exchange and public offering, the inside investors sold their stock for $72,636,735. A shareholder of the issuer brought an action under §16(b), seeking disgorgement of these profits.4 Although the SEC filed an amicus brief in Sterling advocating that Rule 16b-7 exempted just this sort of reclassification, the Court rejected the SEC's interpretation of its own Rules, and reversed the district court's dismissal of the action.5 The Court's rejection of the SEC's position prompted the proposed rule amendments.

As the SEC has correctly observed, the Sterling decision has made it "difficult for issuers and insiders to plan legitimate transactions."6 Prior to Sterling, insiders could rely on Rules 16b-3 and 16b-7 to exempt from §16(b) liability all issuer-approved exchanges of securities pursuant to a merger, restructuring, or reclassification covered by its terms. Since the Sterling decision, however, investors and their counsel have spent countless hours trying to structure legitimate transactions, such as IPOs, spin-offs, and recapitalizations, to avoid an inadvertent Section 16(b) purchase and/or sale. The SEC believes that the amendments do not reflect any change in the law but simply "clarify the regulatory conditions that apply to these exemptions," consistent with its "previously expressed views."7

Rule 16b-3

Rule 16b-3 exempts from Section 16(b) liability certain transactions between issuers of securities and their officers and directors.8 The language in paragraph (d) of Rule 16b-3, entitled "grants, awards and other acquisitions," suggests that it can be used to exempt from Section 16(b) liability nearly any acquisition from the issuer, so long as any one of three statutory conditions were satisfied.

The Sterling decision narrowed this exemption by holding that it is only available to directors and officers where the grant or award of securities has a compensatory purpose, regardless of whether it was approved by the issuer's directors.9 The problems posed by this narrow construction of the Rule are evident in many common, board-approved securities transactions between companies and their officers and directors, including those involving reclassifications and IPOs. Before Sterling, transactions involving the reclassification of different classes of stock typically involved the exchange of insiders' stock for different securities of equivalent economic value, and the issuance of the new securities would be exempted by Rule 16b-3(d). Similarly, an investor seeking to take a company public before the Sterling decision could receive unregistered securities of that company in exchange for capitalizing the company, and the receipt of such securities would be deemed an exempt acquisition under Rule 16b-3(d) by virtue of the shareholder and/or board approval. The Court in Sterling , however, construed the term "other acquisition" in the title of Rule 16b-3(d) as denoting a form of compensation consistent with the preceding words, "grants" and "awards," which are typically used as a form of compensation.10 As a result, post- Sterling transactions lacking a compensatory nexus would not qualify for the Rule exemption in the Third Circuit, calling into question the legitimacy of previously routine corporate transactions involving officers and directors. For instance, consider a director who, pursuant to a restated certificate of incorporation (effective as part of an IPO), automatically acquires common stock in exchange for previously held non-convertible preferred, and then sells within six months. In contrast to previous interpretations of Rule 16b-3, a court following Sterling could order disgorgement of any profits from the director's sale, absent a showing that the previous, automatic conversion of the director's preferred stock into common had a compensatory purpose.

Many practitioners believe Sterling's ruling was inconsistent with prior SEC interpretations of the Rule in its no-action letters,11 as well as at odds with a Second Circuit decision, Gryl v. Shire Pharmaceuticals Group PLC, which held that Rule 16b-3(d) exempted the acquisition of stock options by directors and officers which were received when the target company's options were converted into acquiror stock options in a merger.12 The SEC has proposed to amend the Rule by changing the title from "grants awards and other acquisitions," to just, "Acquisitions From The Issuer," thus making clear that "any transaction involving an acquisition from the issuer (other than a Discretionary Transaction)" will be exempt if any one of the Rule's three existing alternative conditions are satisfied. In disagreeing with Sterling's interpretation, the SEC pointed out that when the Rule was last amended in 1996, the Commission's adopting release stated that "a transaction need not be pursuant to an employee benefit plan or any compensatory program to be exempt, nor need it specifically have a compensatory element."13 Courts will defer to the SEC's adopting and interpretive releases in construing the SEC's rules.14

The proposed amendment does not exempt all transactions with the issuer, but only those approved by the board, a committee of the board, or shareholders. Rule 16b-3 is entirely consistent with the intent of Congress in enacting Section 16(b), since it exempts only transactions involving parties on equal footing regarding knowledge of inside information, and the directors approving the transactions, like the insider engaging in the transaction, must exercise their fiduciary duties to protect against abuses to which Section 16(b) is directed. The proposed amendment to Rule 16b-3 is necessary to provide a clear safe harbor for board or shareholder-approved acquisitions of an issuer's stock by insiders in routine restructuring or exchange transactions.

Rule 16b-7

SEC Rule 16b-7 provides an exemption for acquisitions and dispositions of securities that take place pursuant to a merger, consolidation, reclassification, or similar transaction involving entities with at least 85% cross-ownership. As with Rule 16b-3, directors and officers often relied on this rule to exempt transactions involving the exchange of securities in corporate restructuring transactions, reincorporations or in transactions leading to an IPO. Moreover, unlike Rule 16b-3, which is limited to transactions between the issuer on the one hand and its directors and officers on the other, Rule 16b-7 is also available to greater than 10% stockholders. The rule is intended to apply whenever the merger or other transaction "does not result in a significant change in the character or structure of the company."15 Rule 16b-7 applies to any securities acquired or disposed of in a covered transaction. It is not necessary that the securities received be similar to those surrendered.16 The Sterling decision, however, placed in doubt the extent to which Rule 16b-7 exempts reclassifications. While acknowledging that 16b-7 could exempt a reclassification, Sterling held that Rule 16b-7 was not available to exempt the automatic conversion of non-convertible preferred stock into common stock immediately prior to the closing of an IPO because the two securities had different risk characteristics and the proportionate ownership interests of some of the insiders increased by approximately 4% as a result of the conversion.17 The SEC has criticized this ruling for "significantly restrict[ing] the exemption's availability for reclassifications by narrowing it to the less frequent situation where the original security and the security for which it is exchanged have the same characteristics. Imposing these conditions is inconsistent with the text of Rule 16b-7, the rule's interpretive history and the Commission's intent."18

The problems created by Sterling are illustrated by the following transaction which poses no opportunity for speculative abuse by insiders but, under Sterling, a shareholder plaintiff could argue that the insiders were required to remain locked into their investment for a minimum of six months following an IPO (and possibly longer if the underwriter exercises a greenshoe after the IPO) because their pre-IPO activities gave rise to a §16(b) purchase: A group of investors own a pool of assets and wish to capitalize a newly-formed company with those assets; in exchange, the investors receive stock from the new company. The company then registers the stock under Section 12 of the Exchange Act and delivers the stock to underwriters to sell to the public. A shareholder-plaintiff who acquires the stock could argue that the investors, by virtue of their holdings and influence over the new company, were "deputized" directors of the new company prior to the IPO and, as such, were insiders subject to Section 16(b) for any transaction taking place six months prior to the offering.19 The shareholder-plaintiff could further argue that the investors' capitalization of the new company was a non-exempt "purchase" of the company's securities, which could be matched against any sales by the investors for six months following the IPO. Although the investors, by capitalizing the company in exchange for securities, retain their exact proportionate ownership in the company's assets, because of the change in their form of ownership and the rights associated therewith, a shareholder could seek to use the Sterling 's analysis to argue that the pre-IPO receipt of stock was a non-exempt §16(b) purchase. This is not a transaction which poses a risk for speculative abuse by insiders, even if the insiders sold in the IPO or shortly thereafter, because, among other things, the prospectus for an IPO is required to contain all material information about the issuer. The directors, officers and incorporators with access to material non-public inside information would remain subject to the insider trading strictures of Section 10(b) of the Exchange Act and state law fiduciary duty requirements. While the plaintiffs' bar may advocate a prohibition on any insider sales in the six months following an IPO, the securities laws contain no such blanket prohibition; Section 16(b) should not be used to create such a prohibition by implication.

The SEC proposes to amend Rule 16b-7 by substituting the phrase "merger, reclassification or consolidation" in each place in the text of the rule where it now refers only to "merger or consolidation."20 The current version of the Rule only contains a reference to "reclassification" in the title; this prompted the Sterling Court to conclude that the Rule did not apply to all reclassifications. If the proposed amendment to Rule 16b-7 is adopted, receipt of stock in exchange for capitalizing a new entity as a first step toward an IPO will clearly not constitute a 16(b) purchase, since this is a form of reclassification.

Likely Challenges

The first objections to the SEC's proposed amendments, not surprisingly, have been filed by three law firms that are actively engaged in prosecuting Section 16(b) actions on behalf of shareholders. The principal objection to the proposal is that transactions between issuers and their officers and directors are rife for speculative abuse, the facts of Sterling being a prime example according to these firms.21 Assuming the amendments are adopted by the SEC as proposed, additional challenges to the amendments are likely to be grounded in the arguments that: the SEC exceeded its rule making authority and that the amendments represent an unconstitutional interference with the judiciary;22 the rules as amended are not consistent with the purpose of the statute (Section 16(b));23 and the amendments are not "clarifications" but unlawful retroactive rule making.24


The proposed amendments to Rules 16b-3 and 16b-7 provide much needed clarification. The amendments are entirely consistent with the rules as they are written and had been interpreted by the SEC and understood by practitioners who advise clients on corporate transactions. The amendments do not create a loophole for insiders to trade on material, non-public information, but are aimed at legitimate transactions that do not pose a potential for speculative abuse by insiders. Moreover, if adopted, the amendments will reduce the risks to insiders of finding themselves inadvertently ensnared with §16(b) liability and will reduce §16(b) litigation and related legal costs over transactions between issuers and their insiders.

1 314 F.3d 106 (3d. Cir. 2002), cert. denied , Sterling Holding Co. v. Levy, 124 S. Ct. 389 (US, Oct. 14, 2003).
2 Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418, 442 (1972).
3 See Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Release Nos. 34-37260; 35-26524, (1996); SEC Release No. 34-18114, Q. 142 (1981) ; Skadden, Arps, Slate, Meagher & Flom LLP , SEC Interpretive Letter (Jan. 12, 1999); Monk-Austin, Inc., SEC No-Action Letter (November 19, 1992).
4 314 F.3d at 108-109.
5 Id. at 125. See SEC amicus curiae brief dated February 27, 2003, filed with Third Circuit in Levy v. Sterling Holding Co. litigation.
6 Proposed Rule: Ownership Reports and Trading by Officers, Directors and Principal Security Holders, SEC Release Nos. 34-49895; 35-27861 (June 21, 2004).
7* Id.
8 17 C.F.R. §240.16b-3.
9 314 F.3d at 124.
10 Id. at 121.
11 See Skadden, Arps, Slate, Meagher & Flom LLP, SEC Interpretive Letter (Jan. 12, 1999); American Bar Association, SEC Interpretive Letter (Feb. 10, 1999).
12 298 F.3d 136 (2d Cir. 2002).
13 SEC Release No. 34-37260, n.40 (1996).
14 See e.g., Editek, Inc. v. Morgan Capital, L.L.C., 150 F.3d 830, 834 (8th Cir. 1998).
15 SEC Release No. 34-4717 (1952).
16 SEC Release No. 34-18114, Q.142 (1981).
17 314 F.3d at 117.
18 SEC Release No. 34-49895 (2004).
19 See Feder v. Martin Marietta Corp., 406 F.2d 260, 263 (2nd Cir. 1969).
20 SEC Release No. 34-49895 (2004).
21 Comments on Proposed Rule: "Ownership Reports and Trading by Officers, Directors and Principal Security Holders, File No. S7-27-04," Jonathan P. Meier and Richard E. Spoonemore, August 9, 2004; Jeffrey S. Abraham & Mitchell M.Z. Twersky, August 5, 2004 (http://; Paul D. Wexler, July 30, 2004 (
22 See, e.g., Whitman v. American Trucking Ass'n, 531 U.S. 457, 474 (2001).
23 See Feder v. Martin Marietta, 406 F.2d 260, 268 (2d. Cir. 1969).
24 See Mason General Hospital v. Secretary of Health and Human Services, 809 F.2d 1220, 1227-28 (6th Cir. 1987).

Miranda Schiller is a Partner and Monte Albers de Leon is an Associate in the Business and Securities Litigation Department of Weil, Gotshal & Manges LLP.

Please email the authors at or with questions about this article.