The Securities and Exchange Commission has amended its rules on short-swing dealings by officers and directors to make clear that profits made from certain merger and acquisition transactions are exempt from restrictions on insider profit-making.
The SEC’s actions come in the wake of a court decision by the Philadelphia-based 3rd Circuit two years ago limiting the exemptions in rules promulgated under Section 16(b) of the Securities Exchange Act to compensation-related transactions, and stating that exemptions aren’t always available in the context of stock reclassification. The Commission itself had, to no avail, told the court that the rules were not meant to be interpreted so narrowly.
Margulis
Michael Margulis, of Duane Morris in New York, says “it’s terrific that the SEC adopted these amendments. Most people familiar with [these] rules—and who are not plaintiffs’ lawyers—would agree that the [3rd Circuit case] was wrongly decided.”
The 3rd Circuit’s decision “made it very difficult to know whether certain transactions that are very common were going to be exempted,” Margulis says, noting that the kind of short-swing transactions covered by the rules don’t involve unfair advantage for insiders.
Gartenberg
Edward Gartenberg, of Thelen Reid & Priest in Los Angeles, agrees that the rules were “designed to prevent an insider from taking advantage in the marketplace,” and that the court’s focus on compensation wasn’t consistent with that intent. “The 3rd Circuit imported something into the rules that the SEC had not intended,” Gartenberg says.
Although “there can conceivably be an abuse” in such situations, “Section 16(b) is not the vehicle to address that,” Gartenberg says. “Plaintiffs’ concerns are otherwise taken care of by the law of fiduciary duty.”
Kimball
Robert Kimball, a partner with the law firm Vinson & Elkins in Dallas, tells Compliance Week that an interesting aspect of the SEC’s amendments is that the Commission made them retroactive. “They don’t want a bunch of new litigation coming in based on transactions [prior to] these amendments, and they want existing litigation to be [affected],” he says.
The plaintiffs’ bar “should never have gotten as far as it did” in the 3rd Circuit, according to Kimball. “This is what happens when you have too little presence in the judiciary of people who are experienced in corporate securities transactions; it gets too easy to get judges and law clerks confused.”
The Case
Section 16(b) of the Securities Exchange Act—which applies to officers, directors and 10 percent shareholders—says a company is entitled to recover any profit that such insiders realize from purchases and sales of securities of the company that take place within less than six months.
The 3rd Circuit case, Levy v. Sterling Holding Co., involved a shareholder’s attempt to recover for the company short-swing profits resulting from a reclassification of preferred stock of Fairchild Semiconductor owned by Sterling Holding and National Semiconductor. In the shareholder-approved reclassification, non-convertible preferred stock was converted into common stock simultaneously with an initial public offering of Fairchild common stock, with Sterling increasing its common stock ownership from 48.03 percent to 52.18 percent and National increasing its common stock ownership from 14.80 percent to 15.08 percent. Within less than six months from the reclassification, Sterling and National each sold Fairchild common stock.
The case involved an interpretation of two Commission rules exempting certain transactions from Section 16(b): Rules 16b-3 and 16b-7.
Rule 16b-3 exempts any transaction with a company by an officer or director—other than certain “discretionary transactions” pursuant to employee benefit plans—as long as the transaction is approved by the company’s board, a committee of two or more non-employee directors, or the company’s shareholders.
Rule 16b-7 exempts the acquisition of securities, in a merger or consolidation, in exchange for securities of a company which, prior to the merger or consolidation, owned 85 percent or more of either (1) the equity securities of all other companies involved in a merger or consolidation or (2) the combined assets of all of the companies involved in the merger or consolidation. The rule also exempts the disposition of securities, in a merger or consolidation, of a company that, prior to the merger or consolidation, owned 85 percent or more of either (1) the equity securities of all other companies involved in a merger or consolidation or (2) the combined assets of all of the companies involved in the merger or consolidation.
In Levy, the 3rd Circuit said that that Rule 16b-3, did not apply because there was no compensatory purpose with respect to the recapitalization. In terms of Rule 16b-7, the court said the rule would not exempt Fairchild’s reclassification if the resulting percentage equity interests of National and Sterling in Fairchild before and after the recapitalization were not the same.
Leaving Flexibility
In announcing amendments to Rules 16b-3 and 16b-7, the SEC criticized the 3rd Circuit for creating “uncertainty regarding the exemptive scope of these rules,” and said that the uncertainty had “made it difficult for issuers and insiders to plan legitimate transactions, and may discourage participation by officers and directors in issuer stock ownership programs or employee incentive plans.”
With respect to Rule 16b-3, relating to approved transactions between the company and an insider, the SEC clarified that it exempted non-compensation situations, including ones where “the acquisition of acquiror equity securities (including derivative securities) by acquiror officers and directors through the conversion of target equity securities in connection with a corporate merger” and “an officer’s or director’s indirect pecuniary interest in transactions between the issuer and certain other persons or entities.”
The Commission’s amendments to Rule 16b-7 clarify that the only conditions that apply for exempting a reclassification are those applicable to mergers and consolidations—that the company whose securities are acquired or disposed of owns 85 percent or more of the equity or assets of all companies that are parties to the transaction. Where a single issuer reclassifies one class of its securities into another, there is effectively 100 percent “cross-ownership” and the exemption is available, the SEC stated.
Margulis notes that the Commission didn’t define reclassification, “and it declined to adopt some suggestions to expressly cover things like share exchanges or some foreign types of transactions.”
He notes that the Commission wanted to provide some flexibility, and avoid opening an avenue for plaintiffs’ lawyers to attack. According to Margulis, if the SEC gave “a laundry list of things that were in the term ‘reclassification,’ they might include seven things, and then an eighth thing not on the list that should have been on it” could trigger a lawsuit.
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