Page 166 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

152 The Complete Guide to Executive Compensation

Section 16(b) prevents insiders from profiting on their information. Profits from
purchase or sales within a six-month period of each other are to be returned to the company.
This includes so-called profits from lower-priced purchases that occur within six months
following higher-priced sales. These are deemed short-swing profits.
The SEC also ruled in the late 1970s that there is a 10-day period following a public
release of company financial statements when insiders may cash out their stock appreciation
rights without being in violation of short-swing actions. More specifically, this 10-day period
is defined as the third to the twelfth day after the disclosure. This requirement effectively
disappeared with the 1991 ruling that stated the “purchase” was at time of grant. Thus, if there
were more than six months between date of the grant of the SAR and its exercise, there could
be no short-swing issues. Nonetheless, a number of companies use this same 10-day definition
for permitting executives to exercise stock options and sell stock. An additional restriction that
companies impose (to not be in violation of insider-trading rules) is a blackout period, during
which insiders are prohibited from any stock transactions.
Section 16(b)3 specifies exceptions to the 16(b) rule and what needs to be done to meet
those exceptions. For example, in 1991, the SEC ruled that the grant, not the exercise of a
stock option, constituted a purchase. Therefore, if options were exercised more than six
months after grant, the acquired shares could be sold immediately without triggering short-
swing profits. To comply, the following is required: shareholder approval of the plan (except
for certain broad-based plans); document must prescribe price and number of shares reserved
for calculating number; plan must be administered by disinterested parties; and eligibility
must be stated as well as other requirements.
In 1996, the SEC further clarified its 1991 ruling by permitting an exemption for Section
16 equity awards (including options). Previously, only equity awards that were made in accord
with a plan approved by shareholders (or issued within 12 months of receiving such approval)
were exempted from the six-month purchase/sale rule. The new ruling’s focus is on approval
of the transaction, rather than approval of the plan. Dispositions of stock sold back to the
company can be exempted in basically a similar manner. An exemption will be granted for
stock options or awards meeting one of the following conditions:
• The board of directors, a board committee, or two or more non-employee board direc-
tors have approved the action. Remuneration for services to company and pecuniary
interest dollar limits apply.
• Shareholders have approved the action, either in advance or at the next annual meet-
ing (note the similarity with the old rule substituting specific action for the full plan).
Note, however, that delay in getting shareholder approval might result in FASB
considering the price at time of shareholder approval and, if higher than at time of
grant, considering the option a discounted option requiring a charge to earnings.
• The acquired stock has been held by the insider for at least six months.
Additionally, stock transactions between the company and an insider would be exempt
under one of several conditions:
•A routine transaction (e.g., employee contribution and matching employer contribution)
under a tax-qualified plan (Section 401 and 423 plans) and/or excess plan (restoring
limits imposed by Section 415).
• Discretionary transaction (e.g., fund switching) if an opposite type transaction were not
made within a six-month period.