Securities and executive benefits attorneys and public companies that maintain equity incentive plans should be aware of a new theory of recovery under the “short-swing profit rule.” Plaintiffs’ attorneys have recently asserted a new form of claim alleging liability under the short-swing profit rule when shares are withheld to satisfy applicable taxes upon the vesting of awards.
Overview of the Short-Swing Profit Rule
The short-swing profit rule generally provides for strict liability of Section 16 insiders (i.e. an executive officer, director or 10% or more shareholder) if they engage in purchases and sales, or sales and purchases, of issuer equity securities within a six-month period that are not exempt under Section 16. Pursuant to Section 16 of the Exchange Act, a suit to recover short-swing profits may be instituted by the issuer or a shareholder in the name and on behalf of the issuer if the issuer fails or refuses to bring suit within 60 days after request. In practice, a plaintiff’s attorney will frequently make a demand on an issuer to seek recovery of short-swing profits after the attorney identifies non-exempt insider purchases and sales of issuer equity securities within a six-month period and, if the issuer does not resolve the issue to the attorney’s satisfaction, the attorney may then bring suit against the insider. The potential liability to a Section 16 insider is the disgorgement of any profits earned between the purchase and the sale of the subject securities. While there is no direct liability on the issuer under the short-swing profit rule, plaintiffs’ attorneys frequently seek a fee from the issuer for identifying the transaction creating Section 16 liability.
New Plaintiffs’ Claims when Shares are withheld to pay Taxes
The withholding of shares to satisfy the applicable taxes upon vesting of an award under an equity incentive plan is considered a disposition of shares to an issuer and has traditionally been considered exempt from the short-swing profit rule under Exchange Act Rule 16b-3(e) if the plan or award agreement permits such withholding and such plan or agreement has been approved in advance of the transaction by the issuer’s board of directors, a committee of two or more “non-employee directors” (as defined in Rule 16b-3), or an issuer’s shareholders. However, in several recent cases, plaintiffs’ attorneys have claimed that insider or issuer discretion to elect to have shares withheld at the time of vesting of awards (as opposed to the automatic withholding of shares upon vesting of the award) is not exempt under Rule 16b-3(e), and as a result, the executive is subject to liability under the short-swing profit rule. In one such case, the court summarily rejected the plaintiff’s claims. Other cases remain pending. Commentators have suggested that plaintiffs’ new theories are very weak.
Considerations in response to Plaintiffs’ Claims
Notwithstanding the lack of success of these new theories to date, issuers should consider taking steps to minimize the risk of these types of claims either by providing for automatic withholding of shares to satisfy applicable taxes in equity plans and award agreements (which issuers may find undesirable or impracticable), or alternatively, having their board of directors or a committee of non-employee directors approve each withholding transaction in advance (which many issuers will also find impractical). Also, issuers may want to confirm that their forms of award agreements clearly provide for withholding of shares, and that the board or committee clearly approve the use of such forms when making equity grant awards, to ensure that Section 16 prior approval requirements are met. In any event, issuers may wish to warn their insiders of potential claims resulting from engaging in a withholding transaction and a non-exempt purchase of securities within any six-month period.