SEC Files Amicus Brief Urging Third Circuit to Reverse Troublesome Decision Limiting Rule 16b-3 Short-Swing Profit Exemption to Compensatory Transactions

Article from Goodwin Procter's Section 16 Committee

By Stephen W. Carr, P.C., Jeffrey C. Hadden, P.C., Laura C. Hodges Taylor, P.C. and James A. Matarese, P.C.
Michael S. Turner, Esq. contributed to the preparation of this article.

In the recent case of Levy v. Sterling Holding Company, LLC, 314 F.3d 106 (3d Cir. 2002), the Third Circuit Court of Appeals considered a claim that two large institutional holders were liable under Section 16(b) of the Securities Exchange Act of 1934. In reaching its decision, which resulted in $72 million in potential liability for the defendants, the court limited the exemption provided by the SEC’s Rule 16b-3 to transactions having a compensatory element, such as awards of options under employee benefit plans. The court’s decision is contrary to the position taken by the SEC when it revamped Rule 16b-3 in 1991 and came as a surprise to the SEC and practitioners alike. The consequences of the decision are potentially far-reaching. As discussed in more detail below, the SEC has filed an amicus curiae brief with the Third Circuit in which it urges the Court to rehear the matter and reverse its decision or grant en banc review of the decision.*

Section 16(b) applies to 10% owners of equity securities registered under Section 12 of the 1934 Act and to directors and officers of issuers of those securities. Section 16(b) permits issuers to recover so-called "short-swing" profits, that is, profits insiders realize from purchases and sales, or sales and purchases, of the issuer’s securities within a period of less than six months. The SEC has authority to adopt exemptive rules and, pursuant to that authority, adopted Rule 16b-3, which as amended in 1991 expressly provides officers and directors an exemption from Section 16(b) liability for grants, awards or other acquisitions of securities from an issuer if the transaction is approved by the issuer’s board of directors or shareholders.

The decision of the Third Circuit (which has jurisdiction over Section 16(b) suits involving Delaware corporations) is contrary to the commonly accepted reading of Rule 16b-3 and, as stated by the SEC in its brief, is inconsistent with the SEC’s intention in adopting the rule. If the decision is not reversed, the implications are potentially broad – and unfortunate – for a great variety of transactions involving acquisitions of securities from an issuer.

The SEC’s decision to file an amicus curiae brief with the Third Circuit is a welcome development. In its brief, the SEC pointed out:

• In prior decisions, the Third Circuit has recognized that the SEC’s interpretation of its own regulations should be controlling unless the interpretation is plainly erroneous or inconsistent with the regulation.
• The court’s interpretation that Rule 16b-3 only applies to acquisitions having a compensatory purpose is contrary to the language of the rule and the SEC’s interpretation of it.
• In adopting Rule 16b-3, the SEC intended to provide an exemption from Section 16(b) liability for transactions between an issuer and its officers and directors so long as certain gate-keeping conditions (such as board of director or shareholder approval) are satisfied, whether or not the transactions have a compensatory purpose.
• The Rule 16b-3 exemption is appropriate because, when the issuer, rather than the trading markets, is on the other side of the transaction, any profit obtained is not at the expense of uninformed shareholders or other market participants.

We expect that if a claim based on facts similar to those in Sterling Holding were to be brought in a circuit other than the Third Circuit, the court would adopt the positions taken in the SEC’s brief. We are also hopeful that the Third Circuit will grant a rehearing. Nonetheless, because this case has introduced a degree of uncertainty (especially with respect to transactions involving Delaware issuers), we urge you to seek the advice of legal counsel when considering any of the following:

• acquisitions of securities of an acquirer in a merger by executives of the target who are to become officers or directors of the acquirer;
• acquisitions of securities from an issuer during the six-month period prior to an initial public offering by an investor (such as a private equity fund or other institution) where the investor has a representative on the board of the issuer;
• acquisitions of securities (not having a compensatory purpose) from an issuer by officers and directors of the issuer; and
• acquisitions of securities from an issuer by investors with a representative on the board of the issuer.

For purposes of Section 16, securities of an issuer includes options, convertibles and other derivative securities. With proper planning, the severe consequences of Section 16(b) often can be avoided even without relying on the exemption provided by Rule 16b-3.

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* The court decision also limits the applicability of the SEC’s Rule 16b-7 so that it would not exempt certain reclassifications that generally have been thought to be exempt. The SEC’s brief challenges that limitation as well.