With Alan Dye’s annual Q&A webcast coming up next week, I’ve got Section 16 on my mind, so I thought I’d address an issue that comes up quite frequently in the NASPP Q&A Discussion Forum: the required reporting when an insider ceases to be subject to Section 16. I’ve found that many people assume that all transactions that occur in the six months after Section 16 status ceases are reportable, but this is not true. In many cases, no post-Section 16 reporting is required at all.
Previously Unreported Transactions
First off, any reportable transactions the insider engaged in while still subject to Section 16 that haven’t yet been reported still have to be reported. For example, suppose an insider gifts stock; since gifts are reportable on Form 5, the gift may not be reported immediately. If the insider ceases to be subject to Section 16 prior to when the gift is reported, this doesn’t let the insider off the hook: the gift still must be reported.
Probably the smart thing to do is to check for any unreported transactions whenever an insider ceases to be subject to Section 16 and file a Form 4 to report those transactions at that time, so you don’t forget about them later. Even so, when reviewing insider transactions and holdings for Forms 5, it’s a good idea to include individuals that ceased to be subject to Section 16 during the past year, to make sure nothing was missed (and to get a statement from them that no Form 5 is due).
No Reporting Necessary for Exempt Transactions
Once someone ceases to be subject to Section 16, none of his/her exempt transactions is reportable, no matter how shortly the transactions occur after cessation of insider status. Thus, option exercises and forfeitures of restricted stock that occur after an individual is no longer subject to Section 16 generally are not reportable.
Moreover, cancellations and forfeitures of derivative securities, such as options and restricted stock units, for no value are never reportable, even if they occur while the holder is subject to Section 16.
Reporting Might Be Required for Non-Exempt Transactions (But Then Again, Might Not)
Non-exempt transactions (such as open market purchases and sales) that occur after cessation of insider status may be reportable, but only if they occur within six months of an opposite-way, non-exempt transaction that the individual engaged in while still an insider.
For example, assume an insider terminates employment and is no longer subject to Section 16 as of her last day of employment. She did not engage in any non-exempt transactions in the six months prior to her termination. After termination, she engages in a same-day sale exercise. The exercise should be an exempt transaction; as such, it is not reportable. The sale is a non-exempt transaction, but, as such, it would only be reportable if it occurred within six months of a non-exempt purchase that the insider had engaged in prior to her termination. We know that this isn’t the case, since she had no non-exempt purchases within the six months before her termination. Thus, the sale also is not reportable.
Now, let’s take the same scenario, but, this time, let’s assume that the insider purchased stock on the open market five months prior to her termination. An open market purchase is a non-exempt transaction. This fact changes things a bit. As an exempt transaction, the post-termination exercise still does not have to be reported. The sale of the exercised shares will have to be reported if it occurs within six months of the pre-termination open market purchase:
If the sale occurs within the first month after the insider terminated, the sale will be within six months of the purchase and, thus, will be reportable. Incidentally, this is the exact situation in which short-swing profits recovery is also required; assuming the sale price is higher than the purchase price, the company might as well get started on that also.
If the sale occurs more than one month after the insider terminates, it will be more than six months after the open market purchase and the sale will not be reportable (nor will any profits have to be recovered).
More Next Week
Be sure to tune in next week, when I will cover who is responsible for post-termination Section 16 reporting, the Exit box, Forms 144, and best practices.
Got Questions on Section 16? Alan Dye has the answers. Email your burning Section 16 questions to adye@section16.net and Alan will answer them during his popular, annual Q&A webcast on Section 16. This year’s webcast will be held on January 25; this is your one chance all year to get answers from one of the nation’s foremost authorities on Section 16–don’t miss it!
Quick Survey on Section 16 Take our quick survey on Section 16 and find out how your practices compare to your peers’. With only 12 questions, the survey can be completed in less than five minutes!
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Form 5 filings, if needed, are due 45 days after the end of a company’s fiscal year or within six months of an individual ceases to be an insider. If December is your year end, now is the time to start reviewing your Section 16 filings to determine if any Form 5 filings are required for your insiders.
Deferred Reporting
Some transactions are exempt from Form 4 reporting requirements under Rule 16b-6 and may instead be reported on a Form 5. There are two types of transactions that are eligible for this deferred reporting: acquisitions and dispositions through gift or inheritance and “small acquisitions.” Although these types of transactions are not required to be reported on a Form 4, insiders may choose to report them on a Form 4.
Many companies encourage Form 4 reporting of transactions that are eligible for deferred reporting. While these transactions themselves may not need to be reported on a Form 4, they do impact the total holdings which must be reported on a Form 4 any time there is a reportable acquisition or disposition of common stock. Reporting the actual transaction on a Form 4 provides clarity for potential investors or shareholders and reminds insiders that the transaction is only eligible for deferred reporting, not exempt from reporting altogether.
Small acquisitions are particularly tricky because they may not exceed $10,000 when aggregated over the preceding six months. Additionally, a disposition of the same class of securities that is not exempt from Section 16-b in the proceeding six months disqualifies an acquisition from deferred reporting; it must be included on a Form 4 within two days of the disposition. Simply reporting the acquisition on a Form 4 in the first place eliminates the need to track the total value of small acquisitions and monitor for matching dispositions.
Form 4 and Form 3 Errors
The other reason a Form 5 may be required is if transactions or holdings were either missed or not reported correctly on a Form 4 or Form 3 during the year (or the past two years if the individual became an insider in the current year). Of course, nobody wants to have to file a Form 5 for this reason (see Barbara’s blog entry, “Ignore the Romeo & Dye Model Forms At Your Own Risk“). For these errors, insiders do not need to file a Form 5; a late or amended Form 4 may also be used. If an issue is discovered prior to the year-end reconciliations, the correction should be reported immediately. Additionally, only Form 4 errors from the same year can be included on a Form 5. If there is a Form 4 transaction between the end of the year and the Form 5 filing deadline, it should not be reported on the prior year’s Form 5, regardless of whether or not it was reported timely and correctly on a Form 4.
Know Your Insiders
Your company should have a process in place to confirm if a Form 5 is needed for each of your insiders. This can be done by reconciling reported transactions and holdings in combination with a questionnaire or other verification completed by the insiders. If it appears no Form 5 is needed, have your insiders confirm your findings in a signed statement.
Form 5 Details
For small acquisitions that are eligible for deferred reporting on a year-end Form 5, use “L” as the transaction code. Code G is used for gifts (either acquisitions or dispositions) and code W is used for acquisitions or dispositions by will or the laws of descent and distribution.
If incorrectly reported holdings from a Form 3 are being reported on the Form 5, add a “3” to the transaction code. When reporting a missed or incorrectly reported Form 4 transaction on a Form 5, no special code is needed. Use the footnotes to explain any Form 3 or Form 4 item included on the Form 5. A Form 5 has checkboxes to indicate that it includes line items that should have been reported on a Form 3 or Form 4, but EDGAR will automatically check the appropriate box based on the transaction code.
For more information on Forms 3, 4, and 5, see the NASPP’s Section 16 portal. The most comprehensive resource on Section 16 filings is the Romeo & Dye Section 16 Annual Service, which includes the Section 16 Deskbook along with the Section 16 Updates Quarterly Newsletter.
This week marked the annual changing of my EDGAR password. I rarely use EDGAR these days, so I have an appointment in my Outlook calendar to remind me to do this every year. Even though, in the event that my password expired, I could easily generate a new password using the EDGAR Filer Management website and my EDGAR passphrase, I prefer to be proactive about these things. Since the topic of EDGAR access codes is fresh in my mind, I thought it might be helpful to review the various codes for our blog readers.
EDGAR Access Codes Demystified Access to the EDGAR system requires five codes (the SEC takes security seriously–that’s more codes than my online bank and credit card accounts require):
Central Index Key (CIK): Anyone using EDGAR and any entity for which filings are submitted is assigned a CIK and keeps that same CIK for his/her/its entire existence. The CIK identifies filers and users in the system. Even if an insider moves to a new company or is a insider in multiple companies simultaneously, he/she only has one CIK. This allows investors to query all of an insider’s filings using one search, even if the insider has changed companies or changed names (e.g., in the case of marriage). CIKs are public–you can find out any company’s or insider’s CIK just by querying EDGAR.
CIK Confirmation Code (CCC): The CCC is similar to a password and is used to validate EDGAR filings. CCCs should be known only to the insider and those making filings on his/her behalf. CCCs don’t expire and generally don’t change, even when an insider moves from one company to another, but you can and should change a CCC if you think it has been compromised (see my Sept 15, 2009 blog entry “Fraudulent Section 16 Filings“).
Password: The EDGAR password is necessary only to log onto the EDGAR website. It isn’t included in the EDGAR filing and it isn’t necessary for an insider’s password to be current for you to submit filings on his/her behalf. EDGAR passwords have to be changed every 12 months or they expire (but, see my March 10, 2009 blog entry, “EDGAR Passwords: One Less Thing To Do,” about how you can avoid updating all your insiders’ password if you have your own EDGAR login).
Password Maintenance Authorization Code (PMAC): This code must be entered to change an EDGAR password.
Passphrase: This code is used to generate new EDGAR codes (except for the CIK). When a CIK is first assigned, the passphrase is used to generate the rest of the required EDGAR codes. On an ongoing basis, the passphrase can be used to generate new codes when necessary. For example, if I had forgotten to renew my password before it expired, I could use my passphrase to generate a new password (along with the other EDGAR access codes). Passphrases do not need to be updated, but if it necessary to generate a new one (e.g., if you’ve forgotten it or if it has been compromised), you can do so via the EDGAR Filer Management website.
Less Than Two Weeks Left Until the NASPP Conference Catch up with all the latest Section 16 and Rule 144 developments at the 18th Annual NASPP Conference. The Conference is less than two weeks away and the Conference hotel has already sold out–register today to make sure you can attend.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Last week I explored the connection between the affirmative defense provided under Rule 10b5-1(c) and appropriate timing of Rule 10b5-1 trading plans. The same interpretive guidance that got me thinking about creating 10b5-1 trading plans also clarified some issues around the modification or termination of trades under existing Rule 10b5-1 trading plans.
Modifying a Transaction
Any investor may have situations where they want to change their trading behavior based solely on circumstances that are not connected to insider information, including your company’s own insiders. For example, an insider may have an existing plan that includes the sale of 20,000 shares, intending to use the cash generated from the sale to cover a balloon payment that is due on his or her mortgage. If the stock price drops unexpectedly before the trade takes place, the insider may wish to increase the number of shares being sold under the trading plan. In fact, the SEC does say that modifications made “in good faith” may be acceptable.
However, modifications of trades under a Rule 10b5-1 trading plan are not a good practice for insiders. The interpretive guidance from the SEC makes it very clear why. In response to question 120.16, the SEC clarifies that the modification of a trade is the same as terminating the existing trade and entering into a new plan for that trade. Since the modified transaction is considered to be under a new trading plan, the new plan is subject to the same requirements in order to qualify for the affirmative defense under Rule 10b5-1(c), the insider should not be in possession of material nonpublic information at the time of the modification.
One Transaction, One Plan
What’s more, in response to question 120.19 the SEC clarifies that the termination of one or more transactions within a plan is the same as terminating the entire plan and entering into a new plan for all transactions under the plan. Therefore, at the point of the termination of one transaction, all the remaining transactions must still meet the requirements of Rule 10b5-1(c) in order to rely on the affirmative defense. Because this is virtually impossible for your company’s insiders during a closed window, it’s a good idea to require pre-clearance for both modifications and terminations of trades within a plan to ensure that the “new” trading plan created by the modification or termination of a trade still falls within the parameters of your insider trading policy.
Terminating the Entire Plan
So, what about the termination of an entire plan? In isolation, there isn’t necessarily an issue with terminating an entire plan. However, in most cases, an insider terminating a plan will want to enter into a new one. This is where the concept of “good faith” comes into play. In addition to not being in possession of material nonpublic information at the creation of a Rule 10b5-1 trading plan, the insider may not enter into a plan that is “part of a plan or scheme to evade” the prohibitions under Rule 10b5-1(c). Therefore, what happens after the termination of a Rule 10b5-1 trading plan will be key to determining if the termination of the plan was in good faith. In real terms, that means that the insider will want to avoid any appearance that the plan was terminated based on inside information.
As an example, let’s assume that an insider has an existing Rule 10b5-1 trading plan that includes a market sale of 10,000 shares. At some point prior to the sale, that insider learns about an upcoming acquisition that is anticipated to greatly increase the value of the company’s stock. In response to this knowledge, the insider terminates the existing plan and enters into a new plan in the next open trading window, after the acquisition has been disclosed or completed and when the company share price has gone up. The new plan has all the appearances of meeting the requirements for a Rule 10b5-1 trading plan. However, in this case the old plan wasn’t terminated in good faith, and the affirmative defense of Rule 10b5-1(c) may not be available.
Cooling Off Period
One of the reasons that a “cooling off” period between the creation of a Rule 10b5-1 trading plan and the first trade under that plan is highly recommended is to maintain the appearance of good faith. So, what about a situation where an insider wishes to terminate an existing plan and enter into a new one for the purposes of adding a new transaction to the plan and one or more of the original transactions is set to take place almost immediately? Obviously, each situation needs to be analyzed individually, but in most cases this shouldn’t cause an issue with complying with Rule 10b5-1(c). Even though each of the transactions within the new plan, including those carried over from the old plan, are subject to the prohibitions under Rule 10b5-1(c), your company should be able to take the position that trades carried forward unmodified from an old plan are considered to be made in good faith.
You can find more information on Rule 10b5-1 trading plans on our Rule 10b5-1 portal.
Heading into the new year, many companies will be starting the annual grant process. If your insiders are due for a new grant this year, they may be looking to modify their Rule 10b5-1 Trading Plan or enter into one for the first time. So, now is the time to review your company’s policy and make sure that it’s solid.
Affirmative Defense
Section 10(b) of the Securities Exchange Act of 1934 prohibits the use of any “manipulative and deceptive device” in connection with the purchase or sale of securities. In 2000, the SEC released Rule 10b5-1, clarifying that trading on the basis of material nonpublic information is just such a “device”. Additionally, the Rule states that entering into a trade while aware of material nonpublic information constitutes trading on the basis of that information. Fortunately, paragraph c of Rule 10b5-1 provides an affirmative defense that basically allows an individual to demonstrate that she or he is not trading on the basis of material nonpublic information.
In order to rely on the affirmative defense, an individual must enter into a contract, instruction, or plan to trade at a point in which she or he isn’t in possession of material nonpublic information. And that is the problem. When exactly is an officer of your company not privy to some piece of nonpublic information? When can an insider enter into a Rule 10b5-1 trading plan?
Timing of Plan Creation
In May of last year, the SEC published interpretive guidance on Rule 10b5-1. Question 120.20 really caught my eye. The question is whether or not the Rule 10b5-1 affirmative defense is available if an individual is aware of material nonpublic information at the time the plan is created, but the trade doesn’t take place until that information is made public.
The SEC answered with a single word: no. Just no. What that means is that no length of “cooling off period” is long enough; in order to garner the protection provided by Rule 10b5-1 a person simply must not be in possession of material nonpublic information at the creation of the trading plan.
When is That Even Possible?
So, what does that mean for companies trying to create a solid policy on Rule 10b5-1 trading plans? How is it even possible that insiders can find a period of time when they are not in possession of information that would negate the affirmative defense? To help me with this dilemma, I called on one of our fabulous panelists from the “10b5-1 Plans: Practical Advice and Implementation” session at our 2009 Conference, Michael Andresino of Boston’s Posternak Blankstein & Lund. (If you missed this session, take time to listen to it now!)
First, I still feel very strongly (and Michael agrees) that companies should require at least their Section 16 insiders to trade exclusively through a plan designed to comply with Rule 10b5-1. You have zero chance of relying on the Rule 10b5-1 affirmative defense if there is no plan in place. Second, the most basic precaution to take on the timing of the creation of these plans is to only allow insiders to enter into a plan after the company has made its quarterly financial disclosures; during an open trading window after the quarterly or annual press release (and conference call) is complete. A lot of companies take the position that at that point all material information has been made public.
Material Nonpublic Information
After that, it’s important to keep in mind that it isn’t just any nonpublic information that creates an issue with the Rule 10b5-1 affirmative defense. The problem is with material nonpublic information. It may be difficult to decide what information is material and what is not. An obvious distinction is that if the information could lead to an event that must be disclosed on a Form 8-K, then it’s reasonable to consider that information to be material. For example, if an individual is aware that your company is in the middle of negotiating a merger or acquisition, then it may be inadvisable for that person enter into a trading plan at that point. On the other hand, if the individual is aware of regular ongoing sales deals or the status of the new widget a company is producing that is part of the normal course of business, these pieces of information may not be considered material.
Situations must be considered on a case-by-case basis. Some companies approach this issue by requiring individuals to disclose to the legal department any nonpublic information that they are aware of at the time they enter into a new plan. This allows the legal department to help insiders determine if that information could be considered material before approving the plan.
How Does Your Policy Measure Up?
Does your company’s insider trading policy address Rule 10b5-1 trading plans? If not, now is the perfect time to have that conversation with your legal team. If you do have a policy, check to see what it says about the timing of the creation of new plans. Confirm that the policy contains components that help ensure that the insider may rely on the Rule 10b5-1 affirmative defense and review those components with your legal team to be sure that everyone is still comfortable that they are adequate.
When an individual becomes a Section 16 insider, she or he must report all beneficially owned company stock. For reporting purposes (as opposed to those used in the calculation of 10% ownership) securities beneficially owned by the insider are those which she or he has the opportunity, directly or indirectly, to profit from a transaction in the shares (a “pecuniary interest”). Because part of your year-end process should be to confirm the current beneficial ownership for each of your Section 16 insiders, I wanted to do a brief review of beneficial ownership.
There is, of course, direct beneficial ownership. This includes all shares or derivative securities that are held in the insider’s name. There are cases where direct beneficial ownership could be a little less straight-forward. These holdings may include shares that are held in a joint account (or held as community property). Shares held in the individual’s 401(k) or other retirement account are also considered directly owned. When filing the Form 3, all shares directly owned by the insider should be aggregated onto one line.
Indirect beneficial ownership is a bit more complex to determine. These are shares or derivative securities in which the insider has a pecuniary interest, but are not held in the insider’s name. The most common indirect beneficial ownership comes through securities held by family members. Securities that are held by immediate family members who share the insider’s household are included in indirect beneficial ownership. Insiders must be careful with this definition because it is an inclusive rather than an exclusive definition. In other words, if the person in question is either an immediate family member or shares the household (but not both), the securities owned by that person can’t be categorically discounted. Family trusts are another common source of securities indirectly owned by your insiders.
Your company should not only have a questionnaire for your insiders to complete, but should also take time to sit down with each insider to review any potential beneficial ownership securities. This should be done at the initial Form 3 filing as well as annually to confirm that any changes in beneficial ownership are correctly reported. You can find an example questionnaire in our NASPP Document library, or on the Section 16.net site here.
The Securities Act of 1933 (1933 Act) is a piece of federal legislation that was enacted to prevent securities fraud by regulating the sale of securities in interstate commerce through registration of offers and sales. The basic filings used by companies are the Form S-1, S-3, and S-8. There are exemptions to the filing requirements outlined in the 1933 Act; Rule 701, Regulation D, and Rule 144. Rule 144 provides an exemption from securities registration through a safe harbor on the resale of restricted and/or control securities. To take advantage of the safe harbor provided by Rule 144, sales must comply with restrictions on the information publicly available on the company, holding period for restricted securities, sale amount limitations, the manner of the sale, and notification requirements.
Restricted and Control Securities
With restricted stock units and award grants growing in popularity, it’s easy for new stock professionals to hear “restricted securities” and think that it refers to a restricted stock grant. Restricted securities, as they apply to the Rule 144 safe harbor, refer to shares that were acquired in an unregistered offering. Restricted securities are restricted from resale until or unless they are registered or sold pursuant to an exemption. The most common example of restricted securities is shares that are acquired by employees of a private equity company, often in anticipation of an initial public offering. Restricted securities become restricted because of the manner in which they are acquired. Control securities are shares that are owned by affiliates of the company or persons who are in a control position in the company (such as your Section 16 officers and directors). Control securities may also be restricted securities (when they are acquired in an unregistered offering), but they are control securities because of the holder’s relationship to the company.
Affiliate Status All directors, policy making executive officers, and 10% shareholders should be considered control persons (affiliates). In addition, any relative or spouse living in the same household, trust or estate in which the affiliate or relative/spouse is a trustee, or any corporation in which the seller or family is a 10% owner fall under the same umbrella and will be considered affiliates of the company for the purposes of determining control securities. There may be other situations that give rise to control securities; stock plan administrators should work closely with their legal team to ensure that these people and/or entities are properly identified.
Safe Harbor Requirements
Restricted securities will need to either be registered, or sold pursuant to Rule 144, including the holding requirements. Restricted securities of a public company must be held for six months prior any sale, and restricted securities of a private company must be held for one year prior to any sale.
Control securities are a more common issue for public companies because they arise due to the holder’s relationship to the company. Even if the shares are acquired by the affiliate through an open market purchase, they become control securities subject to Rule 144 because they are held by the affiliate. In order for affiliates to sell control securities, the company’s publicly available information must be current. Control securities are subject to the same holding requirements as restricted securities, that is one year for private companies, and six months for public companies. However, Rule 144(d)(3)(x) does provide an exception for sales associated with cashless exercise transactions. In addition, the sales must be an amount that is less than one percent of the outstanding securities of the class being sold or the average weekly trading volume during the four weeks preceding the transaction and must be sold through an unsolicited broker transaction, directly to a market maker, or in a “riskless principal transaction”. Finally, the sale must be reported to eh SEC on a Form 144 if the shares sold during a three-month period exceed 5,000 shares or have a value in excess of $50,000.
Stock Plan Management Team
The stock plan administrator will most likely not participate directly with a significant portion of the implications of Rule 144. The stock plan management team should work closely with the legal team to ensure that all affiliates are flagged in the stock plan administration system and that all affiliates are educated regarding their status, including how their status may impact their families, trusts, etc. Once affiliates are identified, the stock plan administrator will want to work with any brokers who are known to sell shares for the affiliates (e.g., the captive broker or a broker whit whom the affiliate has a 10b5-1 trading plan) to confirm that the broker knows the affiliate status of the individual and is prepared to help with the Form 144 filing. The most important action a stock plan administrator can take, however, is to ensure that the company’s public filings are up to date. This is the one portion of Rule 144 that is out of the control of the affiliate themselves and is the direct responsibility of the company.
For more information on Rule 144, visit our Rule 144 portal. Rule 144 is also extensively covered in our Fundamentals of Stock Plan Administration course, which is designed to bring professionals who are new to the field up to date will all regulatory requirements as well as administrative best practices. Finally, if you were in New Orleans for our 16th Annual Conference, be sure to review your conference material from the session “New Rule 144: Updates and Issues”. If you weren’t able to attend in person (or you were there but didn’t get to all the sessions you were interested in), it’s not too late. The full conference audio is now available on CD. Order today to listen to the above sessions and all 40+ panels, including sessions addressing performance plans, hold-til-retirement, termination provisions, global stock plans, and much more.