Back in December I reported on a shareholder who was sending demand letters to companies alleging that share withholding transactions aren’t exempt from Section 16(b) unless the transaction is automatic, i.e., insiders have no choice in how to pay their taxes (“Shareholder Challenging 16(b) Status of Share Withholding“). I have a few updates on this development.
The Bad News
Back in December, it was just one shareholder but now there at least two more shareholders that are issuing demand letters like this. Also, we’ve now progressed beyond demand letters, with several companies now in litigation over this.
Both Good and Bad News
As noted in the March 2017 issue of Section 16 Updates, the shareholders have submitted demand letters to around 70 companies. One bit of good news is that in most cases, the amount of the alleged short-swing profits has been small, so payments to the shareholders have also been small.
But this is also bad news because it means that most companies would prefer to settle rather than pursuing costly litigation, which is necessary to get clarification on this matter from the courts. As noted in Section 16 Updates:
A clear ruling on the issue is much needed, given the chilling effect that the shareholders’ demand letters have had on the grant and exercise of elective stock withholding rights and the burden that re-approvals have imposed on compensation committees.
The court dismissed the complaint for failure to state a claim, holding in a one-page order that “the transactions in question are compensation related and are designed to be exempt under” Rule 16b-3(e). While a lengthier discussion of the issue might have been more helpful in resolving other pending cases, the court’s holding is nevertheless important because it clearly rejects the plaintiff’s argument that Rule 16b-3 exempts withholding transactions only if they are “automatic.” Moreover, the court allowed reliance on the exemption even where the decision to withhold shares was made by the issuer (i.e., employees) rather than the insider or the compensation committee. The case therefore provides reason to believe that courts will reach a similar result regarding all forms of stock withholding so long as withholding was authorized by the compensation committee as part of the initial equity award.
I’m sure this is a topic that Alan will be discussing in his session “Section 16 & Insider Considerations in Today’s Market” at the 25th Annual NASPP Conference—don’t miss it!
Just when you thought it was safe to withhold shares to cover taxes, a shareholder has started issuing demand letters to companies claiming that share withholding is a nonexempt sale for purposes of Section 16b.
Shareholder?
Yep, I say “shareholder” because apparently it’s just one guy and he’s representing himself, he’s not even engaging the services of the plaintiffs’ bar.
What the Heck?
But wait, you say, that’s ridiculous. Share withholding is exempt from Section 16(b) pursuant to Rule 16b-3(e), which covers dispositions back to the issuer that are approved in advance by the board or compensation committee (and approval of the grant agreement allowing said disposition counts as approval of the disposition).
You are correct, but the shareholder is claiming that Rule 16b-3(e) applies only if shares are withheld automatically. His claim is that if the insider could pay the taxes in some other way (e.g., cash), the transaction isn’t exempt.
Is My Company Going to Hear from this Guy?
Only if the share withholding transaction can be matched against a nonexempt purchase that occurs within six months before or after it. A nonexempt sale by itself is nothing to be alarmed about; the sale has to be matched against a nonexempt purchase to trigger profits recovery.
Also, since the shareholder’s argument hinges on the share withholding transaction being at the election of the insider, if you don’t allow insiders a choice in how to pay their taxes (and the shareholder can figure this out), you may not hear from him.
“For what it’s worth, Peter Romeo and I disagree strongly with the shareholder’s position, as do the attorneys I’ve spoken with who are responding to similar demand letters.”
Alan also notes that the shareholder has just issued demand letters, he hasn’t filed any complaints yet. But Alan says that he has been litigious in other Section 16(b) contexts.
What Should We Do?
If you allow insiders to use share withholding to cover their taxes on either awards or stock options, you should make sure your in-house legal team is aware of this, so they can decide how to proceed.
In addition, at the time shares are withheld to cover taxes, it is a good idea to check (or have whoever is responsible for Section 16 filings check) for nonexempt purchases by insiders in the past six months. Even though you might still allow the insiders to go ahead with the share withholding, it will be helpful to know ahead of time that the transaction might attract a demand letter, so your legal team can be prepared for it.
In June, I wrote about two important 16(b)short-swing profit recovery cases. Last week, Alan Dye’s Section16.net blog pointed me to another noteworthy case, Segen v. OptionsXpress Holdings, Inc., 2009 WL 1868611 (D. Del. 2009). This case offers a view into the process of determining the attorney fees provided for bringing short-swing transactions to the attention of the company. The original short-swing recovery was settled without litigation, which means that the attorney fees, if negotiated privately, would remain undisclosed.
The Decision on Attorney Fees
In this particular situation, however, OptionsXpress and the attorneys could not come to an agreement. Apparently, OptionsXpress offered an amount that the attorneys considered to be less than the value of the billable hours the firm had already dedicated to the case. What is particularly intriguing about this argument is that attorney fees in 16(b) short-swing profit recovery cases are based on a percentage of the funds recovered, not on billable hours. The percentage of the fee can vary greatly. As Alan Dye pointed out in an earlier blog entry, fees from the cases that must be approved by the court have ranged from 2% to 51%.
In deciding on this case, the court confirmed that the number of hours dedicated to the case should not be a direct factor in the fee that may be recovered. What the court did say, however, is that the billable hours may be used to check the reasonableness of the amount of the fee. In the end, the attorneys received significantly less than they’d asked for (they received 8% vs. the 25% they requested), but more than OptionsXpress had originally offered, and more than they felt had been accrued in billable hours.
Romeo & Dye Handbook – Seventh Edition
Have questions about how recent changes have impacted Section 16 filings? Well, you’re in luck–the 2009 Romeo & Dye Section 16 Forms and Filings Handbook is out! Since the last edition, a dozen new Model Forms have been added, numerous Forms have been updated, and obsolete Forms have been removed. If you currently subscribe to the Section 16 Annual Service, you should have already received your Handbook. If you are not subscribed, don’t miss out–Subscribe now!
In March of this year, we saw two important cases of short-swing profit recovery come to a close. First, the New York Federal Court approved the settlement against two hedge funds for the recovery of short-swing profits resulting from trades of CSX stock (preliminary announcement from the CSX website ). Two unusual aspects of this case are the inclusion of derivative securities in the calculation of shares beneficially owned, and the definition of a “group” for the purposes of determining shares beneficially owned (see Alan Dye’s Section16.net Blog for more details)
The second final ruling was a denial by the U.S. Supreme Court to allow InfoSpace founder Naveen Jain to sue his stock management company for trades relating to Jain’s 2003 short-swing profit recovery judgment — see “Supreme Court turns down appeal from InfoSpace founder (The Seattle Times, March 9, 2009). In 2003, Jain’s case was one of the largest settlements rulings at the time. The judgment was for $247 million, although he settled for $105 million. Jain’s case is important because it highlights that the courts are not likely to allow insiders to recover losses that were alleged to be the fault of actions by another party.
Both of these cases illustrate the complexities involved with short-swing profit recovery.
On the surface, short-swing transactions may appear to be basically straight forward. Section 16(b) of the Securities Exchange Act of 1934 requires Section 16 insiders to return any profits realized by two non-exempt opposite-way transactions that occur within six months of each other. It isn’t relevant which of these transactions takes place first, or even if the transactions resulted in real profit for the insider.
Additionally, the transactions covered include any non-exempt transactions in the company’s shares that are even beneficially owned by the Section 16 insider. This includes transactions by family members or entities in which the insider is a controlling member. For example, if a Section 16 insider sells 1,000 shares of company stock at $10 a share and the insider’s spouse later within the six-month period purchases 1,000 shares at $5 per share, these two transactions could be matched for short-swing profit recovery. The company should recover the difference of $5 per share, or $5,000.
Short-swing profit recovery is designed to discourage insiders from taking advantage of inside information about the company to realize short-term profits. However, the intent behind transactions isn’t relevant; only the outcome. Unlike insider trading, there are no fines or criminal charges that are associated with short-swing profits (although the repayment to the company of the calculated profits can be a very serious loss for the insider).
If the company fails to uncover short-swing profit or does not require the insider to repay the profit, then a shareholder may bring the transactions to the attention of the company. In most cases, that shareholder is entitled to an “attorney’s fee”, which is taken from any profits recovered by the company. This fee is negotiated in a private settlement, and could be a significant amount of money. Because of this, there are attorneys who monitor insider transactions hoping to find short-swing transactions that resulted in a calculated profit.
Your company should include information about Section 16(b) and short-swing profit recovery in the insider trading policy. It is important that your Section 16 insiders understand:
Which transactions may be matched for the purposes of short-swing profit recovery,
how ‘profit’ is calculated,
who at the company is available to discuss transactions with the insider (the compliance officer, for example),
that the insider is ultimately responsible for any Section 16(b) liability,
and to stress that any shareholder may sue the insider for profit recovery if the company does not require the insider to disgorge profits on short-swing transactions.