Very few people would disagree that insider trading is a serious ethical breach and threat to market fairness. Section 16(b) of the Securities Exchange Act of 1934 combats this by enforcing strict regulations against what is known as "short swing" trading by company insiders. This provision is meant to reinforce the public’s perception of market fairness and deter unfair trading advantages that insiders may have due to non-public information that may be in their possession.
Who is Subject to the Short Swing Profits Rule?
Under Section 16 of the Securities Exchange Act of 1934, certain individuals associated with a company who own any class of registered equity securities are classified as "company insiders." These insiders are closely monitored for their transactions to prevent abuses of non-public information that could influence the company's stock prices.
Examples of Company Insiders:
- Directors:
- Board Members: Individuals who are members of the company's board of directors.
- Board Members: Individuals who are members of the company's board of directors.
- Officers
- The Chief Executive Officer
- The Chief Financial Officer
- Principal Accounting Officer (CAO) or Controller
- Vice Presidents in Charge of a Principal Business Unit, Division, or Function
- These are vice presidents who manage significant parts of the company, such as major departments or divisions.
- Other Officers or Persons Performing Policy-Making Functions
- This includes any other officers or individuals who play a key role in shaping the company's policies, regardless of their official title or position.
- Officers of any parent or subsidiary company who have a policy-making role that affects the operations or finances of the listed company.
- Beneficial Owners
- Owners of more than 10% of the company's registered equity securities
- This includes any person or entity that owns more than 10% of any class of the company's registered equity securities.
- Owners of more than 10% of the company's registered equity securities
What is Short-Swing Trading
Short-swing trading refers to the purchase and sale, or sale and purchase, of a company's securities by insiders within a six-month period. The six-month period under Section 16(b) is calculated on a rolling basis. This means that any sale must be matched with purchases that occur within six months before or after the sale date, thus capturing any potential speculative transactions that could be based on insider information.
How the Calculation Works
Start Date: The clock starts ticking from the date of the first relevant transaction, whether it's a purchase or sale.
Tracking Window: Any subsequent transactions within the next six months are scrutinized to check if they can be matched with the initial transaction to generate a profit.
Matchable Transactions: If an insider first buys shares and sells any portion of those shares within six months, those transactions are considered "matchable." The inverse is true for a sale followed by a purchase.
How Section 16(b) Deters Insider Trading
Section 16(b) mandates that any profits garnered by company insiders from any non-exempt matching two-way transactions of company shares within a six-month period must be returned to the company. This provision serves as a strong deterrent by eliminating any financial incentive that may encourage company insiders to engage in speculative short-swing trading.
But how do you Calculate the Profits to be disgorged Back to the Company?
The method for calculating short-swing profits under Section 16(b) has traditionally been done by matching the lowest possible purchase and the highest possible sale.
The process begins by documenting and reviewing all the purchases and sale transactions made by insiders within the defined rolling 6-month period and once the transactions are identified, the calculation matches each purchase with the sale that yields the highest possible profit margin. The difference between these two prices then represents the profit earned from the trading of these securities.
This calculated profit is then subject to disgorgement, meaning the insider is required to return their gains back to the company.
Example of a Non-Exempt Transaction
Scenario: Michael, the CFO at ABC Company, purchases 200 shares at $100 each on January 1st and another 200 shares at $120 on March 1st. He sells 250 shares on June 15th for $150 each.
Profit Determination:
- First Transaction Pair: The lowest purchase price ($100) and the highest sale price ($150).
- 200 shares: 200 x ($150 - $100) = $10,000.
- 200 shares: 200 x ($150 - $100) = $10,000.
- Second Transaction Pair: The next lowest purchase price ($120) and remaining sale amount.
- 50 shares: 50 x ($150 - $120) = $1,500.
- 50 shares: 50 x ($150 - $120) = $1,500.
- Total Profit: $10,000 + $1,500 = $11,500.
Michael must disgorge $11,500 to ABC Company as this profit was realized within six months of a matching transaction.
Some Exemptions Under Rule 16b-3
Rule 16b-3 offers exemptions for company insiders from the short-swing profits rule. These exemptions are crucial in allowing company insiders the ability to participate in corporate equity transactions without facing legal recourse for short-swing trading.
In this article we’ll be discussing exemptions related to tax-conditioned and routine plan transactions as well as transactions requiring approval, but to learn more about exemptions under Rule 16b-3, please check out our Stock Plan Fundamentals course.
Tax-Conditioned and Routine Plan Transactions
Under Rule 16b-3, transactions that occur as part of tax-conditioned plans, such as Section 401(k) plans, qualified profit-sharing plans, and Section 423 employee stock purchase plans (ESPPs), are exempt from short-swing profits recovery. This exemption is granted and requires no additional conditions to be met, as these plans are structured to comply with specific requirements ensuring regular and routine participation by employees without manipulative intent.
Example: Sarah, a director at CBA Company, participates in the company's qualified Section 423 ESPP. She purchases shares quarterly at a 15% discount, in line with the plan's terms. These purchases are exempt from Section 16(b)'s provisions, allowing Sarah to benefit from the plan without the risk of having to disgorge profits.
Transactions Requiring Approval
Further exemptions are available for transactions such as the acquisition of stock options or other equity awards as long as the transactions meet one of the following conditions:
- Approval by the Board or a Committee: The transaction must be approved in advance by the company’s board of directors or a committee consisting of two or more non-employee directors.
- Shareholder Ratification: The transaction is ratified by shareholders at or before the next annual meeting.
- Six-Month Holding Period: The acquired securities must be held for more than six months following the acquisition date.
Example: Linda, CEO at XYZ Company, receives stock options as part of her compensation package. The grant is approved by a committee of at least two non-employee directors and she is not allowed to exercise these options for six months. Both the approval and the holding period make her subsequent transactions exempt under Rule 16b-3.
Conclusion
In this article we talked about Section 16(b) specifically but in relation to Section 16, there is so much more that needs be understood in order to ensure that the regulatory filing responsibilities that directors, officers, and principal stockholders are legally required to adhere to, are met.
For that reason, I recommend all readers check out the Section 16 Developments with Alan Dye webinar, where Alan Dye, the foremost expert on Section 16 answers the following questions:
- What key Section 16 developments do you need to be aware of?
- What are the answers to the most common questions about Section 16 reporting?
- What should you keep in mind for your upcoming Form 5 filings and Item 405 disclosures?
- What changes has the SEC proposed for Forms 4 and 5 and when will they be final?
