SEC Adopts Rule 16(b) Amendments: Eliminates Uncertainty Caused By Sterling

Tuesday, November 1, 2005 - 01:00

In August 2005, the Securities and Exchange Commission (the "SEC" or "Commission") adopted the long awaited amendments (the "Amendments")1 to Rules 16b-3 and 16b-7 which it had proposed sixteen months earlier in response to the uncertainty created over the scope of the rules by the 2002 decision, Levy v. Sterling Holding Companies, LLC ("Sterling").2 While denominated as "amendments," the Commission has in fact clarified two rules which, prior to Sterling, had been relied on by issuers and their insiders (directors, officers and greater than 10% stockholders), to exempt from Section 16(b) liability acquisitions and dispositions of equity securities that take place in certain mergers, consolidations, reclassifications, share repurchases and similar corporate restructurings. The Commission's discussion of the reason for the Amendments is unusual in that it takes to task the Third Circuit Court of Appeals for declining to follow the SEC's interpretation of its own rules, as advanced by the SEC in its amicus brief in Sterling.

Rule 16b-3

Under Section 16(b) of the Securities Exchange Act, any director, officer or greater than 10% stockholder of an issuer with equity securities registered under Section 12 of the Securities 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 within a six-month period. In Sterling, the Third Circuit Court of Appeals narrowly construed two exemptions to Section 16(b) short swing trading liability, holding that Rule 16b-3 only applied to acquisitions of equity securities by insiders from an issuer where the acquisition had a compensation-related purpose.

The problem with this cramped interpretation is that in mergers or consolidations, where insiders exchange one class of securities for securities in a newly formed or acquirer company, the exchange is not typically intended to compensate the insider; more often, it simply provides the insider with an equivalent equity interest in the new entity following the cancellation of the insider's securities in the old company, as occurred in Gryl v. Shire Pharmaceuticals Group PLC,3 where directors and officers' stock options were converted into acquirer stock options in a merger. The adopting release for the Amendments faults the Sterling Court for reading the words "grants, awards, or other acquisitions" in Rule 16b-3(d), to require that other acquisitions must have a compensation-related purpose. "This construction of Rule 16b-3(d) is not in accord with our clearly expressed intent in adopting the Rule." Release at *3. By changing the title of Rule 16(b)-3 from "grants, awards and other acquisitions," to just, "Acquisitions from the issuer," the Commission clarified that acquisitions which qualify for the exemption are not limited to employee stock grants and other similar compensation awards.

Rule 16b-7

Rule 16b-7 exempts a variety of transactions from Section 16(b) including reincorporations, a reorganization of a corporation's structure, as well as mergers and consolidations involving entities with at least 85% cross-ownership, under the theory that these types of transactions "do not significantly alter in an economic sense the investment the insider held before the transaction." Release at *8. The Sterling court also narrowly construed Rule 16b-7's exemption, holding that it did not apply to all reclassification transactions. Generally, reclassifications include transactions in which the 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.

In response to the Sterling decision, the Commission revised Rule 16b-7 to add the term "reclassification" to the text of the rule and a paragraph explaining that the rule applies to any number of transactions that are similar to reclassifications. Formerly, the term reclassification, unlike the terms "merger and consolidation," only appeared in the title of the rule, not the text, leading the Third Circuit in Sterling to hold that Rule 16b-7 did not apply to all reclassifications, only those that could not arguably be used by insiders for speculative abuse. The Commission elected not to define reclassification in the Amendment, as some commentators urged it should do, reasoning that this "preserve[s] flexibility to apply the rule appropriately to evolving forms of transactions." Id . at *9. The Release makes clear that the rule exemption is to apply to a broad array of transactions which have the same characteristics and effect as a reclassification, i.e., transactions that have the same effect on all holders of the reclassified class or series.

The Sterling decision had the effect of exposing insiders to Section 16(b) liability in just about any reclassification transaction that was followed by a Section 16(b) purchase or sale within six months, including acquisitions of securities that arguably are involuntary. The uncertainty caused by the Sterling decision over the scope of the rule exemptions prompted lawyers to structure transactions such as reclassifications which take place immediately prior to IPOs, where some of the insiders sell their shares in the IPOs or within six months thereafter, in a way to protect pre-IPO investors and controlling shareholders against the occurrence of subsequent transactions which could give rise to a Section 16(b) purchase or sale. For instance, if the issuer planned a secondary offering shortly after the IPO, it may have been advisable to delay that offering for six months from the IPO or underwriter's greenshoe in order to insure that it did not give rise to an involuntary purchase or sale by an insider, including under the deputization theory, where a controlling shareholder can, under certain circumstances, be deemed to be a director of the issuer for Section 16(b) purposes in order to impute the issuer's transactions to the controlling shareholder.4 After the Sterling decision, insiders were often advised by their counsel not to engage in trading within six months of a reclassification if it would result in a purchase or sale of equity securities that could be matched against stock that was acquired in a reclassification. With the amendment of Rule 16b-7, insiders who acquire their securities in a reclassification need not remain locked into their investment for a six month period after the reclassification.


Interestingly, the Sterling case itself, where over $72 million of alleged insider short swing profits are at stake, may not be subject to immediate dismissal by the adoption of the Amendments. While the adopting release states that the Amendments do not represent a change in the law, plaintiff in Sterling is contending that the SEC has engaged in an improper de facto rewriting of the rules and that the Amendments should not be applied retroactively to the reclassification at issue in Sterling . The plaintiff will argue that the Third Circuit's decision in Sterling, holding that Rule 16b-7 does not apply to all reclassifications, reflects that the Amendments are more than just a clarification of existing law, but amount to a new rule of law.

After the SEC proposed the Amendments in June 2004 but before their adoption, the defendants in the Sterling action moved in the district court to stay further proceedings in the action pending a final decision on the proposed Amendments by the SEC. The trial court granted defendants' request. The Third Circuit, however, recently denied a mandamus petition in Sterling in which the plaintiff asked the Court to reverse the decision of the district court staying the litigation. The district court, in the interim, had entered a briefing schedule on the parties' motions for summary judgment. While the Sterling case may continue to be litigated for months or even years, with rounds of appeals, it should not dissuade corporate practitioners from giving out the same advice that had been dispensed prior to Sterling : if a director or officer is exchanging equity securities in a merger, consolidation or restructuring, the board of directors should pass a resolution which expressly references Rule 16b-3 and recites that the board is authorizing the insiders to rely on the exemption from Section 16(b) for the securities they are to receive from the issuer. For insiders and issuers structuring IPOs and secondary offerings, it is no longer necessary to structure the transaction to fit neatly within Rule 16b-7's definition of a merger or consolidation: securities received pursuant to reclassifications are now clearly entitled to exemption from Section 16(b) liability.

In adopting the Amendments, the Commission rejected plaintiffs' arguments in Sterling that any acquisition of equity securities from an issuer by an insider can present an opportunity for misuse of inside information. The legislative history of Section 16(b) supports the Commission's position that the statute was intended to proscribe misuse of information by insiders in open market transactions with investors who were at an informational disadvantage. Release at *6. By contrast, in transactions with issuers, insiders are on an equal footing with the issuer from a standpoint of knowledge. Transactions with issuers typically do not present insiders with significant opportunities to profit by advance information about the transactions.


Adoption of the Amendments was urged by the New York State Bar Association and the American Bar Association for the salutary effect they would have on capital markets transactions: the legal costs to issuers and shareholders of engaging in certain IPOs and secondary offerings is reduced by the Amendments, as is the risk of litigation; and it is no longer necessary to delay legitimate transactions like secondary offerings and IPOs for six months from the date of a reclassification transaction.

1 Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release Nos. 33-8600, 34-52202; 35-28013, IC-27025; 2005 WL 1843461 (Aug. 3, 2005) ("Release").

2 314 F.3d 106 (3d Cir. 2002).

3 298 F.3d 136 (2d Cir. 2002).

4 See Feder v. Martin Marietta Corp., 406 F.2d 260, 263 (2d Cir. 1969).

Miranda S. Schiller is a Partner in the Securities Litigation/Corporate Governance Practice Group of Weil, Gotshal & Manges LLP.

Please email the author at with questions about this article.