Over the past two quarters, we have reported on claims filed in federal court by plaintiff shareholders seeking to recover “short-swing profits” from Section 16 officers by matching an allegedly discretionary (non-exempt) withholding of equity award shares from a Section 16 officer that occurred within six months of an acquisition (such as a purchase) of shares by such officer that was non-exempt under Section 16(b) of the Exchange Act.
Although in each case the withholding of shares was authorized by the issuer’s board or compensation committee-approved award agreement and therefore should be exempt from Section 16(b) under Rule 16b-3(e), the shareholder has argued that a share withholding transaction is so exempt only if the authorized withholding occurs automatically in accordance with the Board or Compensation Committee approval and without any ability on the part of the Section 16 officer or the company to determine that an alternative method may be used to satisfy tax withholding obligations.
In what appears to be the first ruling on the issue, on April 26 2017, the US district court for the Southern District of Texas dismissed the shareholder’s claim in its entirety. See J.D. Jordan v. Robert Flexton, et al., No. 4:16-CV-03316 (S.D. Tex. filed November 9, 2016). In this case, the plaintiff shareholder’s claim centered around share withholding transactions that occurred pursuant to the terms of a compensation committee-approved RSU agreement that required the defendant Section 16 officers to satisfy their tax withholding obligations by delivering cash to the company, but if they failed to do so, the company was authorized to either withhold from cash or stock otherwise payable to the officers, including shares deliverable under the RSU.
The plaintiff claimed that the withholding in shares was non-exempt both because (i) the officers had discretion to pay their taxes in either cash or in shares, which demonstrated their ability to take advantage of their inside information, and (ii) the company had discretion as to whether to withhold in shares or from cash compensation - which the plaintiff asserted would mean that the withholding was not “automatic” as required by the SEC in Compensation and Disclosure Interpretation 123.16 relating to Rule 16b-3, issued in 2007.
In dismissing the plaintiff’s claim, the court stated simply that “the transactions in question are compensation related and are designed to be exempt under Section 16b-3(e) of the Securities Exchange Act of 1934.” Although the court did not provide further analysis of the basis for its decision, it has clearly rejected the arguments on which these plaintiff shareholder claims are based and it is to be hoped that it will be persuasive for the courts considering the other pending cases.
Until such other cases are decided, it remains advisable to limit the use of discretion around share withholding in equity award agreements with Section 16 officers, particularly discretion on the part of the company in view of the existing SEC guidance on this point.
SEC Amends Settlement Cycle Rule from T+3 to T+2
Stepping into line with the EU and much of the Asia/Pacific, effective September 5, 2017, broker-dealers in the U.S., Canada and Mexico will be required to settle most securities transactions, including those under equity compensation plans, within two business days after the trade date (“T+2”), a shortening of the current settlement cycle of T+3. The effectiveness of the change to the settlement rule is subject to regulatory support and completion of industry-wide testing in the second and third quarters of 2017. In adopting the amended Settlement Cycle Rule on March 22, 2017 (Rule 15c6-1(a) under the Securities Exchange Act of 1934), the SEC stated that the amendment is designed to increase efficiency and reduce risk for market participants.
The shortened settlement cycle will have an immediate effect on equity plan transactions that involve a sale on the market, including “same-day-sale” and “sell-to-cover” option exercises (or “cashless” exercises). Companies need to be prepared to administer these transactions in one day less, including calculating the amount of withholding taxes and delivering shares to the broker in time to enable the broker to deliver the net shares or cash proceeds to the participant by the second business day after the exercise date.
For US plan participants, where withholding will typically be done using the flat supplemental withholding rate, the reduced settlement period may not cause a significant administrative burden. However, bear in mind the IRS’s next day deposit rule, which requires the deposit of employment taxes with the IRS within one business day when an employer accumulates $100,000 or more of employment taxes at any one point. The IRS issued a Field Directive in 2003 which considers timely a deposit of taxes relating to a broker-assisted cashless option exercise if the deposit is made within one day of the settlement of the transaction, i.e., by T+4 under the existing Settlement Cycle Rule.
Although the IRS has not yet issued any guidance on the rule change, with the implementation of the new T+2 settlement rule, the next day deposit rule will likely mean a corresponding reduction of the deposit deadline for taxes relating to such exercises to T+3 (assuming $100,000 of accumulated employment taxes).
Companies with a large number of non-US equity plan participants or mobile participants who have worked in several countries and/or states during the life of the award may face additional challenges in implementing the shortened settlement period, given the potential difficulty with quickly calculating withholding taxes when non-US and/or multi-jurisdictional tax rules and rates have to be considered.
To facilitate compliance, it may be worth moving to maximum rate or other single flat rate withholding per non-US jurisdiction; many companies already do this or are considering it, particularly with the effectiveness of Accounting Standards Update 2016-09, allowing for withholding in shares at maximum rates without triggering liability accounting. Also, now is the time to engage with any tax advisors assisting with mobile employees to confirm they can deliver their calculations of taxes due on multi-jurisdictional transactions within 24 hours of a transaction. Finally, plan prospectuses or other employee communications that discuss the settlement period for market transactions should be reviewed and updated to reflect the new rule.
House of Representatives Passes Increase to the Dollar Threshold for Additional Disclosure Under Rule 701
The House of Representatives recently passed the Encouraging Employee Ownership Act of 2017. If enacted, this legislation would increase the value of securities a company that is not subject to US public reporting requirements could provide to its employees and other service providers pursuant to a compensatory benefit plan without having to provide additional disclosure, including financial information, to award recipients.
Many companies that are not subject to the periodic reporting requirements under Section 12 of the Exchange Act, such as US private companies and non-US public and private companies that are not publicly traded in the US, rely on Rule 701 of the Securities Act of 1933 when offering equity awards to employees under a compensatory benefit plan (or arrangement). Although the 701 exemption is self-executing, it has several requirements, including that the following information must be provided to award recipients if the aggregate value of securities “sold” in reliance on Rule 701 during any consecutive 12-month period exceeds $5 million:
- A summary of the material terms of the plan;
- Information about the risks of investing in the securities sold pursuant to the plan; and
- Certain financial statements, prepared in compliance with U.S. GAAP (or prepared in compliance with IFRS in the case of foreign private issuers) or reconciled to U.S. GAAP, including a current balance sheet and statements of income, cash flows and stockholders’ equity for each of the two fiscal years preceding the date of the balance sheet and for any interim period.
The financial statements must be prepared no more than 180 days before the offering or sale of securities, which may be burdensome for companies that prepare these materials less frequently or that are sensitive about providing the company’s financial information. Due to these disclosure obligations, private companies often seek alternative exemptions to Rule 701 or scale back their offerings if they anticipate having offerings greater than $5 million in a 12-month period.
The Encouraging Employee Ownership Act of 2017 would raise the 12-month sales limit from $5 million to $10 million (indexed for inflation), with those in favor saying that it is meant to encourage small business growth. The House of Representatives passed the bill with bipartisan support with a final vote of 331 yeas and 87 nays. Similar legislation has been introduced in the Senate.