On September 10, the SEC announced that it had charged 28 public company insiders with alleged violations of the insider reporting requirements of Section 16(a), 13(d) or 13(g) of the Exchange Act and six public companies for contributing to filing failures or not disclosing their insiders’ filing delinquencies as required under Item 405 of the SEC’s Regulation S-K. With the exception of one individual who is contesting the charges, all of the respondents settled the charges by consenting to orders that they cease and desist from future violations and pay monetary penalties. A copy of the SEC’s announcement can be found here.
The SEC’s wide-ranging enforcement actions are unprecedented for insider reporting violations. In a press release announcing the actions, the Director of the SEC’s Division of Enforcement warned insiders and their companies that the SEC in the future “will vigorously pursue these sorts of violations through streamlined actions.” The new enforcement initiative represents an abandonment by the SEC of its largely passive approach of the past decade of charging insider reporting violations only when they relate to fraud or other major violations of the securities laws. If reporting violations are flagrant, the SEC now promises to target the offenders for enforcement on a stand-alone basis without regard to other possible wrongdoing.
Section 16 and Section 13 reporting requirements
The SEC highlighted in its September 10 announcement the importance of ownership reports filed by insiders under Sections 16(a), 13(d) and 13(g) of the Exchange Act by pointing out that the reports provide investors with an opportunity to evaluate whether the holdings and transactions disclosed in the reports could be indicative of a company’s prospects.
Section 16(a). Section 16(a) requires officers and directors of a company with a class of equity securities registered under Section 12 of the Exchange Act, and beneficial owners of more than ten percent of such a class, to file reports electronically with the SEC on Forms 3, 4 and 5 of their holdings and transactions involving the company’s equity securities. Form 3 is required to be filed within ten days after becoming a Section 16 insider to disclose the person’s holdings of the company’s equity securities at the time of becoming an insider. Form 4 is required to be filed to report any change in an insider’s beneficial ownership of the company’s equity securities within two business days after the transaction that resulted in the change. Form 5 must be filed within 45 days after the end of the company’s fiscal year to report any transaction allowed to be deferred from reporting on Form 4, as well as any transaction that should have been reported earlier but was not.
Public companies are required by Item 405 to disclose in their annual meeting proxy statement and annual report on Form 10-K any delinquent filings by their insiders under Section 16(a) during the company’s most recent fiscal year that are evident from a review of Forms 3, 4 and 5.
Sections 13(d) and 13(g). The reporting requirements of Sections 13(d) and 13(g) are intended to inform investors of significant accumulations of shares that may lead to a change in control of an issuer. Under these provisions, any person or group who becomes the beneficial owner of more than five percent of a class of voting equity security registered under Section 12 of the Exchange Act must disclose such ownership and other required information on a Schedule 13D or, if the filer is eligible, on a Schedule 13G. A filing on Schedule 13D must be amended “promptly” following a material change in the information disclosed in the schedule. A Schedule 13G filing must be amended within 45 days after the end of each calendar year to disclose changes in the information filed in the previous report. Additional Schedule 13G amendments may be required as specified in the form.
Prior SEC enforcement activity
The SEC enforces Sections 16(a), 13(d) and 13(g) through cease-and-desist orders and injunctions. Cease-and-desist orders are the preferred method of enforcement because, unlike injunctive proceedings, they do not require proof of multiple violations or approval by a court. Instead, the orders can be issued by an SEC administrative law judge and may involve as little as a single violation.
In practice, the SEC generally does not need to engage in proceedings before an administrative law judge to obtain cease-and-desist orders with respect to reporting violations by insiders. Because there are no acceptable excuses for not filing Section 16(a) reports on a timely basis — lack of knowledge of the requirements, inadvertence and reliance on others to prepare the reports are among the many defenses that have been rejected — it is relatively easy for the SEC to prove a Section 16(a) violation. As a result, in nearly every instance in which the SEC has claimed Section 16(a) violations, it has been able to settle the claims by working out a settlement in which the respondents neither admit nor deny the allegations but consent to a cease-and-desist order and any associated penalties, such as a civil monetary penalty or occasionally other remedies.
During the first 12 years after the SEC was empowered in 1990 to issue cease-and-desist orders, it typically issued approximately five to seven such orders annually involving alleged violations of Section 16(a) and, to a lesser extent, Section 13(d). In 2001, however, the SEC generally discontinued its practice of issuing cease-and-desist orders directed solely at these types of reporting violations. Instead, with rare exceptions, it adopted the practice of citing such violations only as additional counts in proceedings involving other, more serious violations of the securities laws, such as fraud. Neither the SEC nor its staff has explained the reasons for this change in enforcement practice, although it seems probable that the shift was due to budgetary considerations and the need to devote the SEC’s limited enforcement resources to other violative conduct considered to pose a greater risk to investors.
New enforcement actions
The 34 enforcement actions announced by the SEC in its September 10 press release represent a significant departure from its general practice of the past dozen years. The actions against officers, directors and significant stockholders relate exclusively to alleged violations of Section 16(a), 13(d) or 13(g) and do not involve alleged violations of other securities laws or regulations. The Enforcement Division indicated in its announcement and a press conference that it is now better able to bring stand-alone actions based on reporting violations, as well as other violations of the securities laws, due to efficiencies achieved through the use of quantitative data sources and ranking algorithms that enable the SEC to identify violators more easily.
The respondents include not only officers, directors and major stockholders (including ten investment firms), but also several companies that allegedly undertook to assist their insiders in complying with Section 16(a) but failed to do so properly, thereby contributing to their violations of Section 16(a). In all of the proceedings, the SEC took into account remedial actions by the respondents when deciding the amount of the penalties levied against them, which amounted to a total of $2.6 million in monetary penalties for the 33 respondents who settled the charges.
Some of the other notable features of the enforcement actions include the following:
Officers and directors. The SEC cited 13 officers and directors for alleged violations of Section 16(a), Section 13(d) or, in one case, Section 13(g). One of the officers is contesting the charges. The respondents consisted of two directors and a wide range of officers, including three CEOs, a CFO, a president, a vice president (one of whom served as general counsel) and a principal accounting officer.
In most instances, the SEC’s order does not indicate the number of Section 16 reports filed late by the insider, but instead contains a table setting forth in summary form at least some of the transactions reported late. Based on the information in the orders, the number of transactions that were unreported or reported late by the respondents varied from as few as nine to as many as 70, and the filings were days, months and even years late. Transactions reported late included open-market purchases and sales, transactions under trading plans adopted in reliance on Exchange Act Rule 10b5-1, and grants and awards under equity compensation plans. Each respondent was assessed a penalty, which ranged from $25,000 to $100,000. The factors used to determine the amount of the individual penalties appeared to include the number of late reports and the duration of the filing delinquencies. The order for one respondent referred to 44 transactions, reported up to 12 weeks late, and imposed a $25,000 penalty, while the order for another referred to 18 transactions, all reported in a single Form 4 from two to three years late, and imposed a $100,000 penalty.
Major stockholders. The SEC sanctioned for reporting violations five individuals who were beneficial owners of more than ten percent of the voting equity of public companies. Four of the five were alleged to have violated both Section 16(a) and Section 13(d) on numerous occasions. One reported late 17 transactions, another 23 transactions and the other two 44 and 49 transactions, respectively. All four had multiple late filings of Section 13(d) amendments. The fifth respondent had 63 Section 16(a) reporting violations. All were required to pay stiff penalties, with two agreeing to pay penalties of $100,000 and the other three agreeing to pay penalties of $80,000, $75,000 and $64,124, respectively.
Investment firms. The SEC cited ten investment firms for reporting violations. The firms were alleged to have committed some of the violations themselves as beneficial owners of more than ten percent of the voting equity of public companies, or to have caused funds or other entities under their control to commit violations. Six of the firms were charged with violations of Sections 16(a) and 13(d), three were charged with violations of Section 16(a) only, and one was charged with violations of Section 13(d) only. All paid penalties, ranging from $60,000 to $120,000.
Public companies. The SEC sanctioned six publicly traded companies for contributing to filing failures by their insiders or not reporting accurately under Item 405 filing delinquencies by the insiders. Five of the companies were charged with violating Section 13(a) of the Exchange Act by failing to disclose Section 16(a) reporting delinquencies by their insiders, as required by Item 405. In each case, the inaccurate Item 405 disclosures occurred over a period of at least two years and omitted disclosure of at least 25 reporting delinquencies. The SEC charged that four of the six companies were "a cause" of Section 16(a) violations by their insiders by undertaking to prepare and file reports for them on a timely basis but, in the SEC’s characterization, “negligently” failing to do so. Three of the six companies paid penalties of $75,000 each for their violations and the other three paid penalties of $150,000 each.
Lessons to be learned
In light of the SEC’s actions, insiders and their companies should keep a few lessons in mind when dealing with their responsibilities under Sections 16(a), 13(d) and 13(g) and Item 405:
- There is no need to overreact. An occasional reporting violation by an insider should not attract enforcement interest from the SEC staff. The violations cited by the SEC were flagrant in nature, with the smallest number of reporting violations cited for any individual insider involving nine delinquent reports. In addition, the SEC emphasized that it had targeted for enforcement “repeated” late filers and that the SEC’s enforcement initiative is intended to “root out repeated late filers.”
- Companies should continue to assist their insiders. The SEC took action against six companies that promised to assist their insiders in the preparation and filing of their reports, but whose inadequate compliance procedures resulted in numerous late filings and errors. Although company assistance to insiders is not required by SEC rules, and does not relieve insiders of their reporting obligations, company assistance is essential because of the complexity of the reporting requirements. If a company undertakes to assist some or all of its insiders with reporting compliance, it must devote adequate resources to the task and assign knowledgeable persons to conduct and oversee the process in order to avoid the problems cited by the SEC in these actions.
- Companies should adopt measures to prevent violations. Each company should consider adopting the following measures to prevent reporting violations by its insiders:
- Preclearance of transactions. All transactions by officers and directors should be required to be cleared in advance by a person with in-depth knowledge of the insider trading and reporting requirements applicable to insiders of public companies. Preclearance will help compliance personnel to become aware of upcoming transactions in time to make sure that the transactions are reported in a timely manner on Form 4 or Form 5 or in an amendment to a Schedule 13D or 13G.
- Preparation and filing of required reports by insiders. The company should assign responsibility for the preparation of required insider reports to a designated person who is knowledgeable regarding the applicable requirements. This measure should ensure that the filings are prepared correctly and filed on time.
- Training program for insiders. Upon assuming their new duties, all persons who become officers and directors should receive training regarding their reporting obligations and responsibilities under Section 16(a) and, if applicable, Section 13(d) or 13(g). One of the defenses rejected by the SEC in many of the 13 actions brought against officers and directors was that the insider relied on the company to meet the insider’s reporting obligations. The SEC made clear that the reporting obligations are personal to the insiders. Accordingly, insiders must understand their filing obligations and also must monitor the company’s actions on their behalf to ensure that those obligations are satisfied.
- Plan administration procedures. The persons who administer the company’s equity plans should have procedures in place to ensure that all transactions involving officers and directors, including those that often are overlooked (such as dividend reinvestments and elections under 401(k) plans), are communicated promptly to compliance personnel.
- Coordination with brokers. Officers and directors should be required to notify compliance personnel of all brokers they use to effect transactions in company securities on their behalf. This measure is necessary to ensure that compliance personnel will make arrangements to receive from the brokers prompt notification of any transactions by the brokers for the insider’s account, including transactions executed under Rule 10b5-1 trading plans.
- Certification of compliance by insiders. A company’s disclosures under Item 405 should be supported by an annual written certification by each of the company’s officers and directors that they have filed all required reports during the preceding fiscal year. The insider’s certification will support the company’s omission of disclosures regarding delinquent filings or its identification of unreported transactions by the insider that must be disclosed.
- Drafting of Item 405 disclosure. Personnel responsible for drafting the company’s proxy statement and annual report on Form 10-K should be reminded that the Item 405 disclosure is not boilerplate and that its accuracy must be confirmed each year by reviewing the reports that appear in the SEC’s EDGAR system. Two of the companies charged by the SEC with Section 13(a) violations resulting from noncompliance with Item 405 disclosed repeatedly that “all required reports were timely filed,” when in fact dozens of reports had been filed late.
As with any compliance program and system of controls, each company should tailor its program and controls for insider reporting to its special circumstances and resources. Now that the SEC has announced that it intends to police insider reporting more aggressively, however, the need for renewed attention to a comprehensive compliance program cannot be overlooked.