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Final Section 16 Reporting and Short Swing Profit Rules: Final Section 16 Rules Are User Friendly

This article analyzes the practical impact of the new Section 16 rules on the planning of executive compensation for officers and directors. The new rules eliminate many of the requirements and uncertainties that consumed an inordinate amount of time for the executive compensation planner. Perhaps the greatest benefit of the new rules is that they virtually eliminate one of the major regulatory considerations involved in any executive compensation decision, the Section 16 reporting and short-swing profit recovery rules.

Old Requirements Eliminated

The new rules eliminate many of the reporting requirements and exemption conditions of current Rule 16b-3.


The following transactions are exempt from reporting requirements:

  • transactions pursuant to the exemption for Tax Conditioned Plans, such as 401(k) plans, excess benefit plans and employee stock purchase plans;
  • transactions pursuant to dividend or interest reinvestment plans and domestic relations orders;
  • transactions that change only the form of beneficial ownership, e.g., distributions of stock from a trust or an employee benefit plan;
  • cancellations or expirations of stock options without value; and
  • exempt transactions by a person who has ceased to be an insider.

Under the new rules, exercises and conversions of derivative securities, i.e., stock options and stock appreciation rights ("SARs") must be reported on Form 4. Non-exempt transactions must also be reported on Form 4. Gifts, stock option grants and employer stock fund switching transactions are reportable on Form 5, with earlier reporting on Form 4 permitted.

The new reporting rules are effective for transactions effected on and after August15, 1996. However, the reporting exemption for Tax Conditioned Plans only applies if the company has elected to comply with new Rule 16b-3, which has a phase-in period for compliance ending on November 1, 1996.

Phantom stock or stock units, i.e., "cash only instruments," become derivative securities under the new rules subject to reporting on August 15, 1996. However, phantom stock and stock units granted before August 15, 1996 are generally exempt from the new reporting rules.

Rule 16b-3

The following requirements of current Rule 16b-3 have been eliminated:

  • Written Plan Condition. The new exemption focuses on transactions between officers and directors and the issuer and there is no longer a need for a written plan. Although the written plan requirement of Rule 16b-3 has been eliminated, a plan is still required by the Internal Revenue Code or ERISA in the following circumstances:
    • incentive stock options;
    • section 423 employee stock purchase plans;
    • 401(k) plans, ESOPs and profit sharing plans; and
    • excess benefit plans
  • The Prohibition on Transfer of Stock Options. Almost all stock plans prohibit the transfer of stock options except pursuant to a qualified domestic relations order ("QDRO"). This prohibition is required by the incentive stock option rules and current Rule 16b-3. Under the new rules, this prohibition may be liberalized to permit the grant of fully transferable nonstatutory stock options, and to permit transfers pursuant to "domestic relations orders," as defined under the Internal Revenue Code or ERISA, that do not qualify as QDROs.

The gift of stock options has become an increasingly popular income, estate and gift tax planning tool, and this change will facilitate such gifts, e.g., gifts to charities may increase. For income tax purposes, an option that is fully transferable and fully exercisable on the date of grant should have a "readily ascertainable value" even if the option is not actively traded on an established market. The taxable value of the grant of a transferable option will likely be determined under a Black Scholes or other accepted valuation model. If the IRS agrees that a fully transferable option has a "readily ascertainable value," that value is taxable income to the executive, to be determined on the date of grant, and the employer-issuer will have an equivalent deduction. There should be no further taxation until the donee sells the shares and then the excess of the sale price over the executive's basis in the shares, i.e., the amount the executive included in income at the time of the grant, should qualify as capital gain for the donee. Executives will want to transfer options out of their estates by timing their gifts to take maximum advantage of the $10,000 per donee exclusion.

The grant of a transferable option is an exempt transaction under the Approval Exemption, described below, and is reportable on Form5. Currently, Form S-8 is unavailable for donees. Therefore, an issuer should consider Form S-8 registration and possible proxy disclosure issues (e.g., how stockholders will react to options that may be exercised by persons other than the executive or his or her family members) before granting fully transferable stock options.

  • Stockholder Approval. Stockholder approval of a plan or a plan amendment that (i)increases shares subject to the plan, (ii)changes the class of eligible executives, or (iii)materially increases benefits, will no longer be required as a condition of the new Rule 16b-3 exemption. The deletion of this requirement is a major benefit for tax qualified plans and for amendments to stock plans that increase benefits. However, stockholder approval of the adoption of a plan and plan amendments to increase available shares or change the class of covered individuals is still generally required for stock plans subject to stock exchange requirements, incentive stock options and qualified employee stock purchase plans. In addition, Section 162(m) of the Internal Revenue Code requires stockholder approval of the adoption or amendment of individual award limits or the establishment or amendment of the material terms of a performance goal. As a result, stockholder approval will still generally be sought, but not for the purpose of obtaining a Rule 16b-3 exemption which previously was the major motivating reason.
  • Disinterested Administration. Current Rule 16b-3 requires that a plan or arrangement be administered by a committee of at least two "disinterested directors." A director is disinterested if the director has not received a discretionary grant of a derivative or equity security during the 12 months preceding the date of service on the committee. The new rules replace the disinterested director requirement with a "Non-Employee Director" requirement, discussed below, that does not prohibit the receipt of discretionary awards. This renders the "formula plan" for outside directors,a familiar fixture of executive compensation,obsolete for Section16 purposes. However, as a matter of convenience, if not corporate governance, it is unlikely that these plans will soon disappear. Formula plans readily solve the somewhat thorny question of how much equity each outside director deserves. It is likely, however, that formula plans will be amended to permit committee members (and if necessary, all outside directors) to receive discretionary grants.
  • Advance Six-Month and Window Period Election Requirements. Under current Rule 16b-3, in order for certain transactions to be exempt, they must be made pursuant to an irrevocable election made at least six months in advance of the transaction or in advance of the transaction during a 10-day window period following the issuer's quarterly earnings release. These advance election requirements applied to the exercise of SARs for cash, investment fund switching in tax qualified plans and withholding rights for taxes or the exercise price of an award. The advance election requirements were very difficult to understand and administer. Under the new rules, withholding rights do not constitute a separate derivative security, and SARs and fund switching are exempted under much less complicated provisions. However, for SARs, many insider trading policies will still require that the exercise of the SAR for cash occur in a window period.
  • The Six-Month Holding Period Requirement. Current Rule 16b-3 requires that the grant of an equity security will only be exempt if the security is held by the officer or director for six months from the date of grant, or in the case of a derivative security, e.g., a stock option, six months must pass before the sale of the underlying security. Although the new rules preserve the six-month holding period as a way to exempt an acquisition, they also add two alternative conditions that do not require the holding period. Under the new rules, the grant of an equity security or derivative security will also be exempt if it is simply approved in advance or ratified (see "Approval Exemption" below).

The substitution of the Approval Exemption for the nettlesome six-month holding period requirement is most welcomed by executive compensation planners, who will no longer need to spend time worrying about such things as:

  • Internal Revenue Code section 83(b) elections when options are exercised within six months of the date of grant;
  • amendments to awards that under the current rules would result in the cancellation and re-grant of the award (and the commencement of a new six-month holding period); and
  • when awards become derivative securities for purposes of the six month rule if they have an exercise or conversion feature that is not based on the price of the underlying security. The cancellation/re-grant issue was especially problematic in the case of mergers where the new award or option must be exercised within three months of termination of employment.

The New Exemptions

Under the new rules, transactions will be exempt if they satisfy one of the following simple and straightforward exemptions:

Tax Conditioned Plans

Under the current rules, the reporting and liability provisions of Sections 16(a) and (b) were a nightmare for tax qualified plans, such as 401(k) plans, stock bonus plans and ESOPs and qualified section 423 stock purchase plans. Sections 16(a) and (b) generally did not apply to a cash-only "excess benefit plan" that was operated in conjunction with a tax qualified plan.

The new rules exempt from reporting and short-swing profit liability almost all transactions under "Tax Conditioned Plans." A Tax Conditioned Plan is defined as a:

  • Qualified Plan;
  • Excess Benefit Plan; or
  • Stock Purchase Plan.

A "Qualified Plan" is any plan, whether or not tax qualified, that satisfies the coverage rules under the Internal Revenue Code for qualified plans. An "Excess Benefit Plan" is an employee benefit plan that is operated in conjunction with a Qualified Plan and provides benefits in excess of those permissible under the Qualified Plan, e.g., a "supplemental 401(k) plan." A "Stock Purchase Plan" is either a section423 qualified stock purchase plan or a nonqualified stock purchase plan that satisfies the coverage requirements for Qualified Plans. Typical transactions which will be completely exempt without regard to any requirements include:

  • purchases of stock or derivative securities with plan contributions;
  • dispositions pursuant to domestic relations orders;
  • distributions in the event of death, disability, retirement or termination of employment;
  • investment diversification or distributions required by the Internal Revenue Code, e.g., excess contributions under 401(k) or 401(m); and
  • purchases of employee stock purchase plan stock.

The only transactions in Qualified Plans and Excess Benefit Plans that will not be exempt pursuant to the exemption for Tax Conditioned Plans are investment fund transfers in and out of employer stock funds, in-service cash withdrawals and participant directed loans from employer stock funds.

Discretionary Transactions

Many employee benefit plans, whether or not they are Qualified Plans or Excess Benefit Plans, permit participants to transfer in and out of employer stock funds and elect to receive cash withdrawals or loans from such funds. Under the new rules, any such transaction will be exempt from Section 16(b) if it is effected pursuant to an election made at least six months following the date of the most recent "opposite-way" election under any plan of the company. For example, a cash withdrawal would be exempt under the new rules as long as a participant had not elected a transfer into an employer fund within the preceding six months. Issuers will want to revise their Section16 insider trading policies to reflect this new requirement.

The Approval Exemption: The Committee Rules

The last exemption covers all other executive compensation transactions between officers and directors and issuers that are not covered by the previous two exemptions. This exemption, which principally relies on advance approval or ratification, will be the workhorse for stock plans and cash-only plan transactions. Fortunately, the advance approval requirement is quite easily implemented.

The Approval Exemption. The Approval Exemption exempts an officer's or director's acquisition of equity or derivative securities from the issuer if:

  • the acquisition is approved in advance by the board of directors or a committee of the board comprised of two or more "Non-Employee Directors;"
  • the acquisition is approved by stockholders in advance or ratified at the next stockholders' meeting; or
  • the equity security or derivative security is held for six months before the disposition of the equity security.

Dispositions to the issuer are exempt if the requirements of paragraphs (i) or (ii) above are satisfied.

The Approval Exemption will exempt most typical stock plan or cash-only plan transactions including:

  • the grant of options (including transferable options), SARs and phantom stock;
  • the exercise of options, SARs and phantom stock and the exercise of withholding rights;
  • the cancellation, expiration or surrender of options, SARs and phantom stock; and
  • deferral elections and distributions from cash-only plans.

A "cashless exercise" involving a broker's sale of shares to the public is still a nonexempt sale.

The new rules also state that the scope of advance approval can be quite broad. For example, if the grant of an award contemplates subsequent transactions, including participant directed transactions, e.g., award exercises, re-load grants, surrenders or deferrals, etc., the subsequent transactions will not require additional approval. This rule should result in the more thoughtful and comprehensive drafting of approving resolutions. Approval of specific transactions is not, however, required if the terms and conditions of such transactions are set forth in a formula plan that has been approved.

The Non-Employee Director Committee. In practice, almost all of the above transactions will be approved in advance by the new "Non-Employee Director" Committee. The two-person non-employee director committee will replace the committee of at least two "disinterested directors." The definition of non-employee director is very similar to the definition of "outside director" for purposes of exempting transactions under the $1 million deduction limitation of section 162(m) of the Internal Revenue Code. This similarity will make the appointment of the committee much easier.

A non-employee director is a director who:

  • is not an officer or otherwise employed by the issuer or a parent or a subsidiary (same as section 162(m) except that former officers and certain former employees are barred under section 162(m));
  • does not receive compensation, directly or indirectly, from the issuer or a parent or subsidiary for services as a consultant or in any capacity other than as a director, except for an amount that does not exceed the amount which requires proxy disclosure, i.e., in excess of $60,000 (section 162(m) prohibits any direct or indirect remuneration); and
  • does not have an interest in any transaction or has not engaged in a business relationship for which proxy disclosure is required (these are not section 162(m) requirements).

The planning of executive compensation in stock plans, and in phantom stock and other cash-only plans, will be much easier under the Approval Exemption. Transactions with issuers will be exempt as long as the committee does what it has always done, approve the transaction in advance. Because the scope of the committee's approval can be very broad, many transactions can simply be approved at the time of the initial grant of the award.


The new rules are streamlined and will eliminate much of the uncertainty that has clouded executive compensation planning. The Tax Conditioned Plan, Discretionary Transaction, Advance Approval and Reporting Exemptions are welcomed insofar as they do not require many changes in the manner in which executive compensation transactions would be executed even in the absence of the SEC's current rules.

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