Recently, opportunistic potential litigants have sent letters to public companies threatening legal action based on a novel interpretation of Section 16(b) of the Securities Exchange Act of 1934. Specifically, the letters claim that, despite the customary interpretation, there is no exemption under Rule 16b-3(e) for elective share withholding by an issuer. In April 2017, a federal court rejected their theory in J.D. Jordan v. Robert Flexton. That case is currently on appeal, however, and similar lawsuits have been filed in other jurisdictions.
Section 16(b) requires that a company insider pay back to the company “any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security” of the company within a six-month period. An insider is defined as an officer, director, or someone who is a beneficial owner, either directly or indirectly, of more than 10% of the securities of the company. “‘The statute imposes a form of strict liability’ and requires insiders to disgorge these ‘short-swing’ profits ‘even if they did not trade on inside information or intend to profit on the basis of such information.’” The statute allows the corporation or any person who owns the corporation’s stock—regardless of the percentage or amount owned and regardless of whether such person owned the stock when the short-swing trade occurred—to sue to compel insiders to pay back short-swing profits to the corporation. Recently, these lenient standing requirements have given rise to nuisance claims asserted by opportunistic plaintiffs .
Section 16(b)-3(e) provides an exception to the short-swing trading rule for compensation transactions that are approved by the corporation’s board of directors or by a majority of the voting shareholders (i.e., profit sharing or incentive compensation plans). The traditional interpretation of Section 16(b)-3(e) is that elective share withholding is exempt from short-swing profit disgorgement when connected to a compensation transaction that is permitted by the terms of the governing long-term incentive plan. For example, instances in which insiders purchase stock within six months of withholding shares for the purposes of satisfying tax liabilities or exercising employee stock options are typically thought to be exempt under Section 16(b)-3(e).
Lately, litigants have asserted that transactions that are permitted, but not required, by a governing incentive compensation plan do not fall under the Section 16(b)-3(e) exception and thus should be subject to matching under the short-swing profit rule. This theory is allegedly based on the SEC’s May 23, 2007 Compliance and Disclosure Interpretation 123.16, which states:
“Approval of a grant that by its terms provides for automatic reloads would satisfy the specificity of approval requirements under Rule 16b-3(d) for the reload grants, unless the automatic reload feature permitted the reload grants to be withheld by the issuer on a discretionary basis. The same result applies under Rule 16b-3(e) where the automatic feature is a tax- or exercise-withholding right.” (emphasis added)
In J.D. Jordan v. Robert Flexton, the plaintiff brought suit in the United States District Court for the Southern District of Texas alleging that elective withholding to satisfy income tax liability was not exempt from short-swing profit recovery because the transaction was discretionary rather than automatic under the governing incentive compensation plan. The court dismissed the claims “with prejudice due to the fact that the transactions in question [were] compensation related and [were] designed to be exempt under Section 16b-3(e) of the Securities Exchange Act of 1934; 15 U.S.C. § 78p(b).”
While this case appears to be a clear rejection of the plaintiff’s interpretation of the scope of share withholding exemptions, an appeal is currently pending and similar cases have been filed in other jurisdictions around the country. The view expressed by the court in J.D. Jordan seems to represent the traditional interpretation of Rule 16b-3(e): approved withholding of stock pursuant to an employee compensation transaction is exempt under Rule 16b-3(e).
To safeguard against potential litigation, companies should inform beneficial insiders of the risks attendant to elective share withholding or consider altering their employee benefit plans to require share withholding to satisfy income tax liability and to pay stock exercise prices. Also, it would be prudent for the board of directors to approve each withholding transaction. Adopting these measures will likely help fend off these potential claims of short-swing trading.