In Depth
Under Section 16(b) of the Securities Exchange Act of 1934, as amended, public company “insiders” are required to pay back to the company any “short-swing profits” (i.e., profits realized from the purchase and subsequent sale (or sale and subsequent purchase) of the company’s securities within a six-month period, absent an applicable exemption). For purposes of Section 16, a reporting company’s “insiders” include the company’s officers, directors and every person who, directly or indirectly, is the beneficial owner of more than 10 percent of a registered class of the company’s equity securities. Under SEC Rule 16b-3(e) (Rule 16b-3(e)), any disposition of shares by an insider back to the issuer is exempt from Section 16(b) (i.e., is not treated as a sale that can be matched with a purchase to trigger short-swing profits), so long as the terms of the disposition are approved in advance by the board of directors, the compensation committee of the board or the shareholders. The long-standing customary interpretation of Rule 16b-3(e) is that it applies to an insider’s election to have shares withheld to (1) pay income taxes associated with vesting of restricted stock, restricted units or stock appreciation rights, or (2) pay income taxes or the exercise price associated with the exercise of stock options. Simply put, public companies and insiders have consistently interpreted Rule 16b-3(e) to allow insiders to elect share withholding without triggering potential short-swing profits, so long as share withholding is permitted under the terms of the governing long-term incentive plan.
During the past several months, a shareholder has been submitting letters to public companies taking the position that, contrary to the customary interpretation, there is no exemption under Rule 16b-3(e) for elective share withholding by an insider. Under the shareholder’s interpretation of Rule 16b-3(e), an insider’s elective share withholding constitutes a non-exempt sale of shares back to the issuer for purposes of Section 16(b), unless the share withholding was required, and not merely permitted, under the terms of the governing long-term incentive plan. The shareholder’s interpretation would require elective share withholding by an insider to be matched with any non-exempt purchase made by the insider within six months of the share withholding, thereby triggering short-swing profits that must be repaid to the issuer.
On April 26, 2017, the United States District Court for the Southern District of Texas dismissed a claim based on this unconventional interpretation of Rule 16b-3(e). The plaintiff sought disgorgement of insiders’ alleged short-swing profits arising from the insiders’ election to have shares withheld to satisfy income tax liability upon vesting of their restricted stock units. This withholding was permitted, but not required, by the governing long-term incentive plan. The court rejected the plaintiff’s argument that Rule 16b-3(e) does not apply to elective share withholding, essentially ratifying the customary interpretation of Rule 16b-3(e) that has been broadly relied on by public companies in administering long-term incentive plans and by insiders in buying and selling their employer’s securities.
This decision is good news for any public company maintaining a long-term incentive plan that permits, but does not require, grantees to satisfy income tax liability and/or a stock option exercise price with share withholding, and for insiders who desire flexibility to elect share withholding without triggering a non-exempt sale under Section 16(b). However, we anticipate an appeal of the district court’s ruling, and similar cases are currently pending in other courts. It is possible that an appellate court reviewing this decision, or a different court considering one of the similar pending claims, could accept the argument that Rule 16b-3(e) does not exempt elective share withholding for purposes of Section 16(b) liability. Given the prevalence of elective share withholding provisions in public company long-term incentive plans, such a ruling would have significant negative impact. Even if courts continue to reject these claims, there is also the possibility, if the plaintiffs’ bar pursues this argument, that a public company will be forced to defend against a similar lawsuit, which could itself take considerable resources and several months, even if the suit is ultimately dismissed. Accordingly, public companies whose insiders engage in open market or other non-exempt purchases may find it prudent to consider one or more of the below actions to mitigate the risk of claims under Section 16(b).
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Advise insiders not to engage in an elective withholding transaction if they have engaged in a non-exempt purchase in the six months prior to the potential withholding transaction or intend to engage in a non-exempt purchase in the six months following the potential withholding transaction. Similarly, advise insiders not to engage in a non-exempt purchase if they have engaged in an elective withholding transaction during the six months prior to the potential purchase or intend to engage in an elective withholding transaction during the six months following the potential purchase.
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Amend outstanding equity awards to make withholding automatic, which can be accomplished under many long-term incentive plans without the consent of the grantee.
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Draft a form of unanimous written consent approving stock withholding to be signed by the compensation committee each time an insider proposes to elect share withholding to satisfy income tax liability or pay a stock option exercise price.
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Review long-term incentive plans, related award agreements and compensation committee resolutions to ensure they support a conclusion that any share withholding in connection with equity awards was adequately approved in accordance with the requirements of Rule 16b-3(d). If a long-term incentive plan permits share withholding, but only if expressly authorized by the compensation committee with respect to a particular award, ensure that individual award agreements expressly permit share withholding. If the long-term incentive plan or an individual award agreement provides that the issuer has discretion to prevent an insider from electing share withholding, create a record (e.g., in the minutes of a compensation committee meeting) that only the board of directors or compensation committee may exercise that discretion, to avoid the implication that an insider’s ability to elect share withholding is within management’s discretion.
