On August 27, 2002, the Securities and Exchange Commission adopted rule changes requiring directors, executive officers and the holders of 10 percent of a class of equity securities of public companies (insiders) to report most changes in their beneficial ownership interests within two business days after the change. The new two-business-day filing requirement applies to transactions in equity securities that take place on or after August 29, 2002. This replaces the prior rule which generally required that such changes be reported on the 10th day of the month following the month in which the transaction occurred. This client update summarizes these new reporting requirements and discusses steps that public companies should take to help ensure that their insiders comply with the new reporting requirements.
The SEC amended existing rules under Section 16 of the Securities Exchange Act of 1934, as required pursuant to the Sarbanes-Oxley Act of 2002, which was signed into law on July 30, 2002. In light of the recent wave of corporate scandals and concern on the part of Congress and the SEC that investors do not have confidence in public companies and the insiders at those companies, Sarbanes-Oxley and the new SEC rules were adopted, in part, to restore investor confidence that insiders at public companies will refrain from misusing confidential information about their companies for personal trading gain and to provide prompt notice to the public when insiders are buying or selling stock. For further information on the sweeping securities law changes effected by Sarbanes-Oxley, please visit Pepper Hamilton’s Web site.
General Purpose of Section 16
Section 16 of the Exchange Act is and has been intended to deter insiders from misusing confidential information about their companies for personal trading gain. Section 16 generally operates to restrict trading activities of insiders by permitting recovery of any profits realized by the insiders on acquisitions and dispositions of equity securities that take place within a six-month period, and by requiring public disclosure of their trades.
The new accelerated disclosures required to be filed under Section 16(a) are intended to cover all equity securities beneficially owned either directly by the insider or indirectly through others. Equity securities of the company beneficially owned through partnerships, corporations, trusts, estates and family members generally are subject to reporting. An insider is presumed to be the beneficial owner of securities held by such insider’s spouse and other family members sharing the insider’s home. Transactions involving shares in which a reporting person has no direct or indirect pecuniary interest do not need to be reported.
General Reporting Requirements Prior to August 29, 2002
Under Section 16(a) of the Exchange Act, insiders of a public company must file reports with the SEC disclosing their holdings of, and transactions in, that company’s equity securities. Prior to the adoption of the new rules, an insider had to report any change in beneficial ownership of the company’s equity securities on a Form 4 within ten days after the close of the month in which the change occurred, other than certain transactions eligible for annual reporting, such as grants of stock options in compliance with Rule 16b-3, and certain other transactions which were exempt from reporting entirely, such as routine acquisitions under tax-qualified plans including employee stock purchase plans and 401(k) plans.
A Form 5 was required to be filed annually by an insider no later than 45 days after the end of the company’s fiscal year to report all transactions that were either eligible for deferred reporting (such as grants of stock options and restricted stock) or for which earlier reporting was required but for which the required Form 3, 4 or 5 was not filed.
General Reporting Requirements Effective August 29, 2002
The new rules significantly shorten the time for insiders of public companies to file reports of acquisitions or dispositions of company securities under Section 16 of the Exchange Act. For purposes of the new reporting rules, acquisitions and dispositions include any change of ownership, including open market and privately negotiated purchases and sales, grants of restricted stock and stock options, stock option exercises and conversions of convertible securities, repricings of stock options, cancellations of stock options or restricted stock in conjunction with regrants, and most other types of acquisitions and dispositions. Except for situations in which the SEC has established a later deadline, the reports of acquisitions and dispositions must be filed no later than two business days following a transaction.
As was the case under the old rules, the date of a transaction is considered to be the "trade date" of the transaction, not the "settlement date" which, in the case of market transactions, takes place three business days after the trade date. This means that a Form 4 for market transactions is required to be filed within two business days of the trade date. Meeting the new two-business-day deadline will require significant preparedness by insiders and public companies in advance of the trade and close coordination with the broker and any other participants involved in the transaction.
The new rules permit a slightly longer deadline than two business days only for transactions under which objective criteria prevent the insider from controlling (and in many cases predicting) the timing of transaction execution. The following types of transactions are eligible for deferred reporting:
- a transaction involving a valid Rule 10b5-1 trading plan or other pre-existing contract or arrangement, including a limit order, where the insider does not select the date of execution
- a "discretionary transaction" involving an employee benefit plan, where the insider does not select the date of execution. A "discretionary transaction" generally refers to fund-switching transactions and distributions of cash funded through a disposition of issuer securities under a 401(k) plan, deferred compensation or similar employee benefit plan offering multiple investment alternatives.
For these types of transactions, the insider is required to file a Form 4 reporting the transaction within two business days after the "deemed execution date," which is defined as the earlier of the date that the insider receives notice of the transaction from the executing broker or three business days after the trade date. This effectively means that for these types of transactions, an insider will have up to a maximum of five business days after the trade date to file the Form 4. The new Form 4 and Form 5 will include a box to indicate the "deemed execution date" carried out under either of these two deferred reporting transactions.
The deferred reporting provisions described above are available only where the insider does not select the date of execution. In the case of a transaction where the insider selects the date of execution, such as a 10b5-1 plan calling for the sale of a specified number of shares on the first day of every month, deferred reporting is not available, and a Form 4 would be required to be filed within two business days after each trade date.
The SEC had considered allowing a deferred reporting requirement for a transaction pursuant to a single market order that is executed in portions over more than one day, but because of the SEC’s view that it is not infeasible for the insider to obtain information concerning the separate partial trades as they are executed, the SEC decided not to allow deferred reporting of such transactions.
Under the new rules, Form 5 is retained as an annual form, due within 45 days after the end of a company’s fiscal year, to report certain types of transactions such as gifts, inheritances and acquisitions of less than $10,000 of securities within a six-month period. Form 5 can no longer be used to report grants of stock options or restricted stock. In addition, insiders are still required to report on Form 5 any transactions that were required to have been reported earlier under Section 16, but were not.
As under prior rules, any late or delinquent Section 16 filings are required to be reported in the company’s proxy statement in a separate captioned section, naming names. The SEC has broad authority to seek "any equitable relief that may be appropriate or necessary for the benefit of investors" for violations of any provisions of the securities laws.
Transactions that did not require reporting under prior Section 16 rules and still do not require reporting under the new rules include the following:
- routine purchases made through payroll deductions under certain tax-qualified benefit plans, such as 401(k) plans and employee stock purchase plans
- cancellation or expiration of stock options where no value is received by the insider from the cancellation or expiration
- securities received in connection with stock splits
- securities received as a dividend on currently held securities
- stock issued as a result of certain anti-takeover devices, such as poison pills
- stock acquired or disposed of pursuant to domestic relations orders
- changes in the form of ownership of securities, such as from indirect to direct ownership
- receipt of options that vest upon achievement of a specified performance objective as a prerequisite to the vesting of such options (although such options would need to be reported upon vesting).
Cashless Exercise Programs for Insider’s Stock Options
The Sarbanes-Oxley Act prohibits public companies from lending funds to any of its directors or executive officers or arranging for loans to such insiders after July 30, 2002, subject to certain limited exceptions. Company or broker-sponsored cashless exercise programs typically involve the issuance of stock upon exercise of a stock option where the insider pays the exercise price out of the proceeds of the contemporaneous sale of a portion of the stock acquired upon exercise. The settlement date for the sale takes place three business days after the exercise date, resulting in a three-day period in which the officer beneficially owned the shares purchased upon exercise of the option before paying the exercise price. Such an arrangement could conceivably be construed as a loan from either the issuer or the broker, depending on the type of cashless exercise program used.
Based on the breadth of Section 402 and the lack of any further guidance as yet from the SEC, we recommend that the use of cashless exercise programs be discontinued until further guidance is available as to whether cashless exercises are considered loans from the company or loans arranged by the company, of the sort prohibited by Sarbanes-Oxley. Similarly, companies should be scrupulous about not releasing stock certificates upon exercise of stock options until they actually receive in hand the exercise price for the shares.
Filing of Reports
As noted above, a Form 4 will generally need to be filed with the SEC within two business days after a transaction that requires disclosure. Because under applicable rules a filing is deemed to have been made when it is received at the SEC’s Washington, D.C. offices, this means that as a practical matter, filers will no longer be able to use the U.S. mail for Form 4 filings. If an overnight delivery service is used, the Form 4 will need to be sent either on the day of the transaction or, at latest, the day after the transaction. Further, although the SEC will not accept Form 4 filings that are faxed directly to the SEC, arrangements can be made for Pepper Hamilton’s Washington, D.C. office, or a number of local delivery services, to receive a facsimile of the Form 4 and courier the filing to the SEC.
Another alternative is to file the Form 4 with the SEC electronically. Sarbanes-Oxley requires the SEC to mandate electronic filing of Section 16 forms commencing in July 2003, as well as the posting of Section 16 forms on the company’s Web site. The SEC indicated in adopting the new rules that it will likely implement rules requiring electronic filing of Section 16 forms well before the July 2003 deadline, and probably within the next few months.
For a number of reasons, we recommend that insiders begin filing electronically with the SEC as soon as possible. Electronic filing provides the benefit of allowing the filing to be made at any time up to 5:30 p.m. Eastern time on the second day after the trade, and as a result, allows more time to make sure that the information included on the form is correct. Currently, in order to be eligible to use the SEC’s EDGAR electronic filing system, each officer, director and 10 percent shareholder is required to apply for and obtain EDGAR "filer codes." Each person must always use the same filer codes, without regard to how many different public companies he or she serves as an insider. Electronic filings can be made through any of the larger financial printers or using commercially available filing software. Pepper Hamilton stands ready to assist public company directors, executive officers and 10 percent shareholders in obtaining EDGAR filer codes and making electronic filings, and we offer the ability to file Section 16 forms electronically directly from our office.
All transactions that take place prior to August 29, 2002, are required to be reported pursuant to rules in place prior to the new rules adopted on August 27, while all transactions that take place on or after August 29 are subject to reporting under the new rules.
By way of example, a market purchase or sale of stock that takes place on August 26 is required to be reported on a Form 4 filed with the SEC by September 10, 2002, while a market purchase or sale that takes place on August 29 is required to be reported by September 3 (as Monday, September 2 is a legal holiday). Stock option grants made prior to August 29, 2002, in compliance with a Rule 16b-3 exemption remain eligible for deferred reporting on Form 5 within 45 days after the end of the fiscal year in which the grant was made, while grants made on or after August 29 will be required to be reported within two business days after the grant date.
New Forms 4 and 5 will be promulgated that will include certain changes necessary to take into account the rule changes. Until the new Forms are available, insiders are required to use the Forms currently available, and to indicate not only the month and year covered by the Form, but also the specific date of the transactions being reported. In the case of any transaction eligible for deferred reporting involving a "deemed execution date," as described above, the insider is required to include an asterisk next to the trade date and include a footnote disclosing the deemed execution date.
To ensure compliance with the new accelerated reporting requirements, to help prevent in advance any inadvertent violations of the federal securities laws and to avoid even the appearance of trading on inside information, public companies should consider defining and implementing the following as soon as possible:
Who Is an Executive Officer
As noted above, insiders of a public company are directors, executive officers and the holders of 10 percent of any class of equity securities of the company. The first step in establishing successful compliance procedures is for a company to re-evaluate who is considered an "executive officer." SEC rules define executive officers as the president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance) and any other officer who performs a policy-making function for the issuer. In addition, executive officers of subsidiaries may constitute executive officers of the parent if they perform a policy-making function for the parent. For Section 16 purposes, a controller or chief accounting officer is also considered to be an executive officer. Potential adverse consequences for failing to identify properly a management member as an executive officer have increased under the Sarbanes-Oxley Act. Public companies should therefore re-evaluate who should be designated as the company’s executive officers. Conversely, individuals who do not fit within the SEC’s definition should be removed formally as executive officers so they are not bound by the new Section 16 reporting requirements and other restrictions imposed upon executive officers by Sarbanes-Oxley.
Mandatory Pre-Clearance Procedures
Insiders should not engage in any transaction involving the company’s securities without first obtaining pre-clearance of the transaction from the company’s general counsel or other appointed compliance officer. A request for pre-clearance should be submitted to the general counsel or the compliance officer at least two days in advance of the proposed transaction. The general counsel or compliance officer would then determine whether the transaction may proceed and, if so, assist in complying with the new reporting requirements. All insiders should certify their understanding of, and intent to comply with, the company’s insider trading policy, including pre-clearance requirements. In addition, insiders should immediately notify the general counsel or compliance officer after a transaction takes place. We recommend that public companies review their insider trading policies and adopt one if they do not already have one.
Any insider who may wish to implement a trading plan under Rule 10b5-1 should be required to pre-clear the plan with the general counsel or other compliance officer and comply with the other requirements applicable to Rule 10b5-1 plans included in a properly designed insider trading policy. Transactions effected pursuant to a pre-cleared trading plan that complies with Rule 10b5-1 would not require further pre-clearance at the time of the transaction if the plan specifies the dates, prices and amounts of the contemplated trades, or establishes a formula for determining the dates, prices and amounts. Those transactions, of course, will need to be reported on Form 4 within between two and five business days after the transaction date (depending on when the insider learns that the transaction took place).
Accordingly, a system should be implemented to ensure that the insider or the company’s general counsel, compliance officer, or other person at the company responsible for preparing Forms 4 becomes aware of the details surrounding the transaction so as to be able to prepare and file the Form in a timely manner.
Power of Attorney
In order to enable the timely preparation and filing of reports under Section 16 of the Exchange Act within the short time frames established by the new rules, we recommend that public companies encourage their insiders to sign and return a power of attorney authorizing one or more designated individuals involved in the Section 16 form preparation and filing process to execute and file reports under Section 16 of the Exchange Act on the insider’s behalf.
New Broker Interface Procedures
The new accelerated reporting of transactions will require tight interface with brokers handling transactions for executives. A knowledgeable, alert broker can act as a gatekeeper, helping ensure compliance with a company’s pre-clearance procedures and helping prevent inadvertent violations.
In this regard, public companies may wish to work out a coordinated procedure with a brokerage firm of choice and encourage or require the company’s insiders to use that brokerage firm to enter all company stock transactions. Where the preferred broker approach is followed, some companies are requiring the broker to agree not to execute any transaction involving company equity securities for an insider without first confirming with the company that the transaction has been pre-cleared in accordance with the company’s insider trading policy and then reporting the details of the transaction immediately following execution.
Notice to Insiders
We recommend that public companies provide formal notice to their executive officers and directors reminding them of these new obligations and that compliance is their personal responsibility.
Prompt Reporting of Option Grants
Each grant of stock options or other stock-based compensation by the Board of Directors or Compensation Committee to an executive officer or director, and any other acquisition or disposition transaction involving equity securities between a public company and an executive officer or director, should be reported immediately by the Board or Committee to general counsel or the compliance officer. These transactions are now required to be reported within two business days.
Public companies and their insiders will need to adapt quickly to the new reporting requirements mandated by the Sarbanes-Oxley Act and the SEC’s new rules. In order for public companies to comply with these new requirements, they will need to review and increase internal staff resources and rely even more on counsel to minimize the risk of failing to comply with the new requirements.
Pepper Hamilton’s Corporate and Securities Practice Group is composed of many attorneys with skill and practical experience in helping companies, and their officers and directors, comply with the requirements of the federal securities laws. We constantly monitor changes in the laws and rules to keep our clients aware of these changes and the impact on their reporting obligations. We also are experienced in representing clients in investigations and proceedings brought by the SEC’s Enforcement Division and the Justice Department.
If you would like to discuss these new requirements, or would like assistance in developing or reviewing and revising your company’s reporting processes and insider trading policy to enable your company to prepare and file timely reports under Section 16 of the Exchange Act within the short time frames established by the new laws, please contact one of the authors or any member of Pepper Hamilton’s Corporate and Securities Practice Group.
©2002 Pepper Hamilton LLP. All rights reserved.
Robert A. Friedel and Andrew L. Romberger