On October 1, the U.S. Court of Appeals for the Third Circuit reversed its controversial decision in 2002 in Levy v. Sterling Holding Co., LLC restricting the availability of two important exemptions from Section 16(b) of the Exchange Act, which requires disgorgement of “short-swing” trading profits realized by public company insiders. The court based the reversal on its belief that clarifying amendments to the two rules adopted by the SEC in 2005 in response to the original decision resolved ambiguities that had led to the court’s previous rulings. The reversal removes a cloud of uncertainty that had hung over the two rules, and will ease planning for future reclassifications and similar corporate transactions of the type affected by the 2002 decision. In addition, because the Third Circuit decided that the amendments apply retroactively, the new ruling may protect from challenge past transactions that could have been vulnerable to attack based on the court’s earlier decision.


Section 16(b) is a prophylactic provision intended to deter public company insiders from using confidential information about their companies for personal trading gain. It does so by requiring officers, directors and ten percent owners to disgorge to their company any profits realized by them from “shortswing” transactions involving a purchase and sale, or sale and purchase, of the company’s equity securities within less than six months. To mitigate the harshness of the statute, which imposes strict liability without proof of actual use of confidential information, the SEC has adopted a number of exemptions from Section 16(b). One of these exemptions, Rule 16b-3, is intended to shield from Section 16(b) transactions by officers and directors directly with their companies rather than with public investors. Another exemption, Rule 16b-7, exempts transactions by insiders pursuant to mergers, reclassifications, consolidations and similar corporate transactions involving a company that, prior to the transaction, owned at least 85% of the securities of the entities involved in the transaction or at least 85% of their combined assets.

The defendants in Levy resisted a Section 16(b) claim of $72 million by arguing that both Rule16b-3 and Rule 16b-7 exempted acquisitions of securities by them in 1999 pursuant to a reclassification related to their company’s initial public offering. In a decision we discussed in our SEC Update of October 16, 2003, the Third Circuit did not agree that the exemptions were available, and denied the defendants’ motion to dismiss the claim. The court held that the defendants could not rely on Rule 16b-3, which until 1996 applied only to transactions under employee benefit plans, because the defendants’ acquisitions did not have a compensatory purpose, notwithstanding the absence of any reference in the revised rule to a compensatory purpose requirement. The court also ruled that Rule 16b-7 was not available for reclassifications that involve (as did the transactions in Levy) a change in the proportionate interests of security holders or an alteration of the risks and benefits of their investment, even though the rule makes no mention of these considerations.

The SEC’s Response

The SEC recognized that the rulings in Levy were contrary to the language and purpose of the two rules, and would sharply restrict the availability of the rules for insiders of the many public companies domiciled in Delaware, which is one of the states within the Third Circuit’s jurisdiction. It therefore sought to overturn the decision soon after it was issued by filing an amicus curiae brief urging the court to vacate its rulings. The Third Circuit declined en banc to reconsider the decision, however, and the Supreme Court denied the defendants’ petition for certiorari.

Because no further relief was available from the courts, the SEC took the unprecedented step of proposing in 2004 and adopting in 2005 amendments to the two rules to mute the effects of the decision. We discussed the amendments in our SEC Update of August 11, 2005. The amendments clarified that (1) Rule 16b-3, as revised in 1996, has never had a compensatory purpose requirement, and (2) Rule 16b-7 has never contained requirements for transactions covered by the rule other than the 85% ownership test. Further, the SEC said that because the amendments constituted clarifications rather than substantive changes, they were applicable retroactively to the dates on which the current versions of the rules became effective, which was May 1, 1991 for Rule 16b-7 and August 15, 1996 for Rule 16b-3.

The Controversy

The SEC’s determination to make the clarifying amendments retroactive meant that they applied to the transactions at issue in Levy, which therefore were exempt under both rules. The plaintiff objected, contending that the amendments were invalid because the SEC had exceeded its rulemaking authority in adopting them, and that applying the two rules retroactively to the reclassification transactions was impermissible.

The Third Circuit responded by acknowledging that it had “struggled to divine” the scope of the two rules in its earlier decision, and that the rule amendments and the SEC’s explanation of their background and purpose had made clear that the court’s previous rulings were incorrect. The court rejected the plaintiff’s argument that the amendments were invalid, explaining that they were “comprehended within the purpose” of Section 16(b), which is all that is necessary under the SEC’s broad rulemaking authority. The court also held that the amendments could be applied retroactively because they resolved ambiguities in the rules without changing their substance, and were consistent both with the text and purpose of the pre-amendment rules.

Effects of the Court’s Decision

The Third Circuit’s reversal of its 2002 decision undoubtedly was greeted with sighs of relief from many within the corporate community and at the SEC. The Levy controversy has been ongoing for nearly eight years and has been a continuing cause of concern because of the possibility that Section 16(b) plaintiffs might mount similar challenges to other transactions undertaken in reliance on one or both of the rules at issue. The reversal assures that a reclassification of one class of an issuer’s securities into another class will always be exempt under Rule 16b-7 because the issuer, as the sole participant in the transaction, will always satisfy the 85% ownership test. The new decision also makes it clear that Rule 16b-3 has no compensatory purpose requirement, and that only the stated requirements of the rule must be satisfied in order to qualify for an exemption under it.