Section 16 Reporting Requirements as Amended by the Sarbanes-Oxley Act
|To:||Our Clients and Friends|
|From:||Olshan Grundman Frome Rosenzweig & Wolosky LLP|
|Date:||February 27, 2003|
|Re:||Section 16 Reporting Requirements as Amended by the Sarbanes-Oxley Act|
Section 16 of the Securities Exchange Act of 1934, as amended (the "1934 Act"), applies to officers, directors and beneficial owners of more than 10% of a class of an issuer's equity securities (the "Insiders") registered under Section 12 of the 1934 Act. Pursuant to Section 16(a), Insiders must file with the Securities and Exchange Commission (the "SEC") a Form 3 upon becoming an Insider, a Form 4 for any transaction that represents a change in their beneficial ownership, and a Form 5 to report certain exempt or unreported transactions. Section 16(b) provides that an issuer may recover the "short-swing" profits from any purchase and sale or sale and purchase, by the Insider, of the issuer's equity securities within a six-month period. Section 16(a) was recently amended by the passage of the Sarbanes-Oxley Act of 2002 (the "Act"). Pursuant to the Act, Insiders are required to file a Form 4 within 2 business days after a reportable transaction (except for certain Rule 10b5-1(c) and discretionary transactions), and certain transactions that were formerly reported on Form 5 are now to be reported on Form 4. These changes went into effect on August 29, 2002. The Act has further amended Section 16(a) by requiring reports to be filed electronically and posted on an issuer's website by the end of the business day following the date of the filing. While the Act has imposed a deadline of July 30, 2003, the SEC has indicated that it intends to implement this requirement as soon as reasonably practicable before that date.
Definition of Officers
Rule 16a-1(f) provides the definition for an "officer". It includes the president, the principal financial officer, and the chief accounting officer (or controller), and in addition includes any vice president in charge of a principal business unit, division or function, and any person who performs a significant policymaking function for the issuer.
Determining whether a business unit, division or function is a "principal" one, or whether a person's sphere of responsibility involves significant policymaking for the issuer, is essentially a judgment call. At most companies, the judgment is made by the board of directors, annually by resolution, at the same time the board approves the list of executive officers included in the Form 10-K. This action by the board allows the issuer to take advantage of the presumption in the note to Rule 16a-1(f) that the persons designated as officers by the board of directors are the only officers subject to Section 16. Some issuers include as officers those who really don't have important functions or policymaking responsibility, however, given the burdens of two-day reporting issuers may want to be more principled in their application of the Rule 16a-1(f) criteria.
Transactions While Not an Insider
Transactions occurring prior to the date a person becomes an officer or director are not subject to the reporting and liability provisions of Section 16. However, transactions occurring after a person terminates officer or director status must be reported if they occur within six months of a transaction that took place while the person was an officer or director. A 10% beneficial owner not otherwise subject to Section 16 must report only those transactions conducted while he was a ten percent beneficial owner. If a person ceases to be an Insider, he must note in a box on a Form 4 or Form 5 that he is exiting from the reporting system.
The term "beneficial owner" has two applications under Section 16 and the rules promulgated thereunder. The first is to determine whether a person is a 10% holder of a class of an issuer's equity securities registered under Section 12 of the 1934 Act. The second, known as the pecuniary interest test, is used to determine the holdings and transactions to be reported under Section 16(a) and the transactions subject to short-swing profit under Section 16(b).
Rule 16-1(a)(1) defines "beneficial owner" as any person who is deemed a beneficial owner pursuant to Section 13(d) and who owns more than 10% of a class of an issuer's equity securities registered under Section 12. Pursuant to Rule 13d-3(a), a beneficial owner is any person who has or shares: (1) voting power, which includes the power to vote, or to direct the voting of, such security; and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, such security. [1 ] A person shall be deemed to be the beneficial owner of a security if that person has the right to acquire beneficial ownership of such security within sixty days through conversion, exercise of options, revocation of trust or otherwise. A person may not divest him or herself of beneficial ownership through the use of trusts, proxies, powers of attorney, pooling arrangements or any other contract, arrangements. [2 ] Once a person qualifies as a beneficial owner, in order to be deemed an Insider, he or she must own 10% of a class of an issuer's equity securities registered under Section 12.
Where an issuer has more than one class of equity securities, classes that are related to one another can, in certain situations, be combined into a single class. By doing so, a person would be less likely to own 10% or more of the combined class. Under Rule 16a-4(a), a derivative security and the underlying security are combined into a single class as well as convertible debt and the underlying security. Furthermore, where an issuer has two or more series of preferred stock outstanding, with slightly different ancillary privileges, the various series ordinarily should be considered a single class. However, securities that are substantially similar in character and that convey similar rights and privileges to holders may not be combined for the purpose of determining 10% beneficial ownership and neither can convertible preferred stock and the underlying security. 
Once the determination is made that a person is a 10% beneficial owner, or an officer or director, the pecuniary interest test is used to determine the securities holdings and transactions to be reported pursuant to Section 16(a) and the transactions subject to short-swing profit liability under Section 16(b). In addition to the Rule 13d-3(a) definition of beneficial owner, an Insider will also be a beneficial owner of all shares in which he or she holds a direct or indirect pecuniary interest through any contract, arrangement, understanding, relationship or otherwise. [4 ] Rule 16a-1(a)(2)(I) defines pecuniary interest as "the opportunity, directly or indirectly, to profit or share in any profit derived from a transaction in the subject securities." An indirect pecuniary interest includes the Insider's ability to profit from purchases and sales in securities held by family members or through partnerships, corporations, trusts, performance fee arrangements, dividends and the exercise or conversion of derivative securities. [5 ] If an Insider has a pecuniary interest in a transaction, it is subject to liability under Section 16(b).
Once all holdings involving a direct or indirect pecuniary interest have been ascertained, such holdings and transactions must be reported on the appropriate form (as discussed below). Insiders do not have to report beneficial ownership of securities in which they do not have a pecuniary interest, notwithstanding their authority to vote, acquire, or dispose of the securities.
The Reporting System
Insiders must file reports on Forms 3, 4 and 5 with the SEC as well as send copies to the issuer whose securities are the subject of the filing and all exchanges on which the securities are listed (unless one exchange is designated for filing). However, as amended by the Act, Insiders will soon be required to file such reports electronically and, also, to post them on their issuer's website. The Act has imposed a deadline of July 30, 2003 for electronic filing but the SEC has indicated that it plans to implement final rules for electronic filing to be effective prior to the deadline. 
An Insider files a Form 3 upon becoming an Insider, disclosing his or her holdings of the issuer's equity securities as of the date of becoming an Insider. Under Section 16 rules, the Form 3s are due the day the issuer's registration statement on Form 10 is declared effective. An Insider files a Form 5 within 45 days after the close of a fiscal year in which he or she was an Insider for any portion thereof. An Insider must disclose any transactions that were subject to reporting but not required to be shown on Form 4 and transactions that should have been previously reported but were not. [7 ] No Form 5 will be necessary if there are no such transactions to report. 
An Insider files a Form 4 whenever he or she is involved in any transaction that represents a change in his or her beneficial ownership, or any purchase or sale of a security-based swap agreement. The reporting requirements of Form 4 have been amended by Section 403(a) of the Act. Reportable transactions under Form 4 must be filed before the end of the second business day on which the transaction has been executed. [9 ] The SEC has amended Rule 16a-3 in order to require certain transactions formerly reported on Form 5, to be reported on Form 4 instead. Reportable transactions under Form 4 now include: 1) grants, awards and other acquisitions from the issuer exempted by Rule 16b-3(d); 2) dispositions to the issuer exempted by Rule 16b-3(e); and 3) discretionary transactions pursuant to employee benefits plans exempted by Rule 16b-3(f). The 2 day filing period shall apply to all of these transactions. The SEC has also amended Rule 16a-6 in order to apply the 2 day filing period to small acquisitions that no longer qualify for deferred reporting on Form 5.  There are, however, two exceptions to the 2 day filing rule where Insiders are given 3 days to file.
The first exception relates to transactions pursuant to Rule 10b5-1(c) arrangements. Such arrangements involve a transaction pursuant to a contract, instruction or written plan for the purchase or sale of issuer equity securities that satisfies the affirmative defense conditions of Exchange Act Rule 10b5-1(c). Where the reporting person does not select the date of execution, the date on which the executing broker, dealer or plan administrator notifies the reporting person of execution of the transaction is deemed the date of execution, so long as the notification date is not later than the third business day following the trade date. 
The second exception addresses Discretionary Transactions, which involve intra-plan transfers of previously invested assets into or out of a plan issuer securities fund, or a cash-out from a plan issuer securities fund. The logistics of plan administration related to Discretionary Transactions may prevent a reporting person from selecting the date of execution. Where the reporting person does not select the date of execution, the date on which the plan administrator notifies the reporting person that the transaction has been executed is deemed the date of execution, so long as the notification date is not later than the third business day following the trade date. 
In each case, a reporting person must report the transaction on Form 4 before the end of the second business day following the deemed date of execution, as calculated under the applicable rule, for the transaction. However, neither exception will be available if the reporting person has selected the date of transaction execution. For both Rule 10b5-1(c) transactions and Discretionary Transactions, the SEC expects the reporting person to make specific arrangements for the broker, dealer or plan administrator to provide the reporting person actual notice of transaction execution as quickly as feasible.  It is recommended that brokers and dealers provide the information needed for Section 16(a) reporting purposes to the reporting person either electronically or by telephone.
Section 16(b) Liability of Insiders for Short-Swing Profits
Pursuant to Section 16(b), an issuer may recover any profit realized by an Insider from the purchase and sale or sale and purchase of any equity security or security-based swap agreement, involving any such equity security, made within a six-month period ("Short-Swing Transaction"). Section 16(b) imposes strict liability and no proof of actual misuse of inside information is required in order for the issuer to recover profits from a Short-Swing Transaction. Where it is necessary or desirable to engage in a transaction, there are several acceptable structuring methods for avoiding short-swing liability. An Insider may delay the second leg of the Short-Swing Transaction (i.e. the sale following the purchase or purchase following the sale) until at least six months has elapsed, or deferring both legs until after the Insider ceases to be an Insider. For Insiders who are beneficial owners, only purchases and sales made after passing the 10% threshold are subject to short-swing liability.
Section 16(b) Treatment of Derivative Securities & Rights with Unfixed Exercise Prices
Special attention should be paid in the application of short-swing liability to transactions involving stock options and other derivative securities  as well as rights with unfixed exercise prices. Rule 16b-6(a) treats the acquisition of an option or other derivative security as a purchase, while the exercise or conversion is an exempt, non-event under Rule 16b-6(b). Consequently, if an option is held for at least six months, the Insider could exercise the option and sell the underlying securities immediately without matching the exercise against the sale (assuming no other matching transactions occurred during the period). However, although exercises and conversions of derivative securities are exempt, non-events under 16(b), such transaction must be reported on Form 4, subject to the 2 day filing requirement.
Call equivalent and put equivalent positions are forms of a derivative security. A call equivalent position is a derivative security position that increases in value as the value of the underlying equity increases,  whereas a put equivalent position is a derivative security that increases in value as the value of the underlying equity decreases.  The establishment of or increase in a call equivalent position or the liquidation of or decrease in a put equivalent position is deemed a purchase of the underlying security.  The establishment of or increase in a put equivalent position or the liquidation of or decrease in a call equivalent position is deemed a sale of the underlying security. 
A right with a floating exercise price is not an equity security or a derivative security and is not required to be reported, and will not be deemed to be acquired or purchased, until the purchase price of the underlying security becomes fixed.  When the exercise price become fixed, the right then becomes a derivative security.  The date of purchase is the date the price becomes fixed, not the date the right is exercised.
The Rule 16b-3 Exemption
Rule 16b-3 exempts from short-swing liability most transactions between an issuer, including an employee benefit plan  sponsored by an issuer, and an officer of director. However, the exemption does not cover 10% beneficial owners unless they are an officer or director. The exemption is not limited to transactions undertaken pursuant to an employee benefit plan nor must the transaction be entered into for compensatory purposes. The exemption includes grants, awards and other acquisitions from the issuer, any transaction involving the disposition to the issuer of the issuer's equity securities, and Discretionary Transactions.  However, in order for the 16b-3 exemption to be applied to these transactions certain conditions must be met such as shareholder approval, board or committee approval, and a six month holding period.  Derivative securities may be granted, awarded or acquired from an issuer and if such transaction does not met the criteria for the Exemption, the treatment of derivative securities under Rule 16b-6, as discussed above, is still applicable.
This memorandum is a nontechnical summary of complex legal requirements. In an effort to achieve relative simplicity, a number of details, refinements and exceptions have been omitted, and this memorandum should not be considered a legal opinion on which you should place reliance in taking specific actions. As a working guideline, we suggest that, in any case where any doubt exists as to the effect of these new provisions you should contact a member of our firm to give you whatever interpretations and advice may be necessary. In light of the penalties for delinquent filing, of immediate concern is the establishment of a compliance system that ensures that all reports are timely made.
 Directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise. Rule 13d-3(a).
 Rule 13d-3(b).
 Release No. 34-28869, § VIII.C, and n.36(1991).
 Rule 16a-1(a)(2).
 Rule 16a-2 et seq.
For the most part, the SEC simply proposes technical rule amendments to mandate filing of Forms 3, 4 and 5 via EDGAR and minor revisions to these forms and their instructions to facilitate electronic filing.
 Rule 16a-3(f) et seq.
 Rule 16a-3(f)(2).
 Or at such other time as the SEC shall establish by rule, in any case in which the SEC determines that such 2-day period is not feasible.
 Pursuant to Rule 16a-6, a small acquisition is an acquisition of an equity security not exceeding $10,000 in market value, or the right to acquire such securities. A small acquisition shall be reported on Form 5 provided that such acquisition, when aggregated with other acquisitions of securities of the same class 10 within the prior six months, do not exceed $10,000 in market value; and the person making the acquisition does not within six months thereafter make any disposition, other than by a transaction exempt from section 16(b) of the 1934 Act.
 Rules 16a-3(g)(2) and 16a-3(g)(4).
 Rules 16a-3(g)(3) and 16a-3(g)(4).
 The broker, dealer or plan administrator may use any means of communication, including oral, paper or electronic means, to notify the reporting person that the transaction has been executed.
 Derivative securities are defined to include any option (either call or put), warrant, convertible security, stock appreciation right, or similar right with an exercise privilege at a price related to an equity security, or similar securities with a value derived from the value of an equity security. Rule 16a-1(c).
 Rule 16a-1(b).
 Rule 16a-1(h).
 Rule 16b-6(a).
 Rule 16a-1(c)(6).
 Exchange Act Release No. 28,869 (Feb. 9, 1991).
 Rule 16b-3 exempts excess benefit plans, qualified plans, stock purchase plans and tax-conditioned plans pursuant to qualified plans, excess benefit plans, or stock purchase plans.
 Rule 16b-3(d)-(f).
 Rule 16b-3(d).