Alerts and Updates
SEC Adopts Rules to Overturn Section 16 Levy Decision
August 11, 2005
The Securities and Exchange Commission (SEC) has now amended, more than a year after first proposed, two of its rules under Section 16 of the Securities Exchange Act of 1934 (Exchange Act) to remedy the effects of the Third Circuit's decision in Levy v. Sterling Holding Company, LLC.1 The SEC also adopted, as proposed, an amendment to Item 405 of SEC Regulations S-K and S-B, which requires disclosure of delinquent Section 16 filings, to reflect the current filing deadline.
The Levy Decision
Under Section 16 of the Exchange Act, "insiders" - holders of 10 percent of any class of equity security registered under Section 12 of the Exchange Act and officers and directors - must forfeit to the company any profits they may realize from purchases and sales (or the reverse) within a six-month period, so-called "short swing" profits. Two exemptions insiders often rely on are Rule 16b-3, which exempts certain transactions between an officer or director and the company, and Rule 16b-7, which exempts certain mergers, reclassifications and consolidations.
In Levy, the company, prior to an initial public offering, effected a reclassification in which certain preferred stock was converted into common stock. The court held that the reclassification was not exempt under Rule 16b-7, noting that although the title of Rule 16b-7 includes the word "reclassifications," the text of the rule refers only to a "merger or consolidation." Although the SEC staff has stated that Rule 16b-7 "can" apply to reclassifications, the court determined that the reclassification at issue was not exempt because 1) the insiders obtained equity securities with different risk characteristics than the securities surrendered; 2) the surrendered securities had not previously been convertible into the acquired securities; and 3) the result was an increase in the ownership percentage by the insiders - conditions that do not appear in the rule. Next, although the court agreed that the transactions at issue had been approved by the company's board of directors and shareholders, and thus satisfied the conditions of Rule 16b-3, the court held that Rule 16b-3 is "primarily" concerned with employee benefit plans and other compensation events, and thus did not exempt the transactions at issue.
In connection with defendants' petition for a rehearing or rehearing en banc, the SEC filed an amicus brief, arguing strenuously that the court had misconstrued both rules. Nevertheless, the court denied the petition and the Supreme Court subsequently declined to consider the case.
The Levy decision surprised most lawyers familiar with Section 16 precedent and created significant difficulties and uncertainties in planning. Both rules had been heavily relied on for a wide range of transactions that did not raise the potential for speculative abuse that Section 16 was intended to address. After Levy, however, insiders could no longer know whether such transactions would be exempt.
Section 16 Amendments
Fortunately, the SEC has now "clarified" its rules to overcome the difficulties and uncertainties created by the Levy decision. In Rule 16b-3, the SEC has replaced the phrase "grant, award or other acquisition from the issuer" with "an acquisition from the issuer (including without limitation a grant or award)," thus eliminating the implication (as perceived by the Levy court, at least) that an "other acquisition" must be similar to a "grant" or "award." In addition, the SEC added language, immediately after the new phrase, stating that an acquisition from the issuer is exempt under Rule 16b-3 "whether or not intended for a compensatory or other particular purpose."2 Also, in an addition from the proposal, the SEC made a similar change to Rule 16b-3(e), which exempts dispositions to an issuer.
The SEC also amended Rule 16b-7, as proposed, by replacing "merger or consolidation" each time those words appear in the rule with "merger, reclassification or consolidation." The SEC also added a paragraph stating that the exemption is not subject to the transaction satisfying any conditions other than those set forth in Rule 16b-7. Although the SEC, "to preserve flexibility to apply the rule appropriately to evolving forms of transactions," declined to expand or define "reclassification," the SEC stated that the term includes transactions such as statutory share exchanges, conversions to different forms of entity, and changes in domicile transactions, as well as non-U.S. forms of transactions such as amalgamations and schemes of arrangement.
The proposals will be a welcome relief from the uncertainty created by an anomalous decision that contradicted a previously consistent and clear history of precedents and SEC statements. In fact, the SEC stated that while the amendments will be effective September 12, 2005, they "clarify regulatory conditions that applied to these exemptions since they became effective," and thus apply to any transaction effected since those dates - August 15, 1996, for Rule 16b-3, and May 1, 1991, for Rule 16b-7.
Item 405
Item 405 previously allowed an issuer to presume that a filing was made timely if the issuer received a copy of the filing within three business days of the required filing date. That regulation was adopted when Section 16(a) filings were generally required to be made only monthly, within 10 days of the end of each month, and were filed on paper. Under the Sarbanes-Oxley Act and rules subsequently adopted by the SEC, Section 16(a) filings are now filed within two business days of most transactions, are filed electronically, and are generally transmitted to the issuer electronically. In light of these requirements, the SEC believes the three-business-day presumption is no longer appropriate. Moreover, given the electronic filing, the SEC believes that no presumption is appropriate. Accordingly, the SEC has eliminated the prior presumption, without substituting anything in its place.
For Further Information
If you have any questions regarding these amendments, including how they may affect your company, please contact one of the attorneys of the Securities Law Practice Group or the lawyer in the firm with whom you are regularly in contact.
- 314 F.3d 106 (3d Cir. 2002), cert. den. Sterling Holding Co. v. Levy, 124 S. Ct. 389 (2003). The Levy decision is described in more detail in our June 25, 2004 Alert, "SEC Proposes to Overturn Section 16 Levy Decision."
- In response to comments, this phrase was moved from a proposed note into the text of Rule 16b-3 itself. However, the SEC stated that notes to its rules "are integral parts of its regulations," presumably to dispel any implication that notes in SEC rules have less importance than other parts of the rules.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
