This article is reprinted with permission from the
December 01, 1995
edition of
New York Law Journal.
1995 NLP IP Company.


The SEC's Alternative Proposal on Rule 16b-3

By Joseph E. Bachelder


THIS COLUMN DISCUSSES the "Alternative Proposal" by the Securities and Exchange Commission to substantially simplify compliance with Rule 16b-3 under 16(b) of the Securities Exchange Act of 1934 (Exchange Act). It also discusses the Ninth circuit decision in Cramer v. Commissioner concerning stock options and 83 of the Internal Revenue Code. Note also is made of the Oct. 23 release by the Financial Accounting Standards Board (FASB) of Statement of Financial Accounting Standards No. 123, "accounting for Stock-based Compensation."

Alternative Rule 16b-3 Proposal

On Oct. 11, the Securities and Exchange Commission released an "Alternative Proposal" for amending existing Rule 16b-3, concerning employee benefit plan transactions, under the Exchange Act. 1 This proposal is an alternative to the SEC's previously proposed amendments to Rule 16b-3 in August 1994 (Original Release), on which the SEC has never taken any action. 2

According to the SEC, the purpose of the Original Release was to address certain practical problems that had arisen since the adoption in 1991 of the new 16 rules and to further streamline those rules. The amendments included in the Original Release would, among other things:

* exempt from 16(b) liability certain purchases and transfers in broad-based, tax-qualified plans;

* permit option and other derivative securities to be transferable without losing their status under Rule 16b-3;

* exclude from the definition of "derivative security" under Rule 16b-3 compensatory instruments that can be redeemed or exercised solely for cash;

* provide that the right to have securities withheld, upon the exercise of an option or other derivative security or the vesting of restricted stock, for purposes of payment of (a) withholding taxes or (b) the exercise price of the derivative security would not itself be a derivative security and would not be subject to the provisions of 16(b). 3

While the Original Release attempted to address certain specific problems under the existing rules, the SEC states in the Alternative Proposal Release that it "has continued to consider whether issues arising from the treatment of employee benefit plan transactions, as well as other officer and director transactions, could be better resolved through a simpler and more flexible approach. . . . "

In this new approach, the SEC has "focused on the distinction between market transactions by officers and directors . . . which present opportunities for profit based on non-public information that 16(b) is intended to discourage, and transactions between an issuer and its officers and directors, which typically constitute a legitimate and increasingly popular mechanism for an issuer to compensate persons in its service."

Based on this distinction, the SEC has proposed in the Alternative Proposal Release significantly more far-reaching amendments of Rule 16b-3 than the amendments included in the Original Release. Basically, the Alternative Proposal would exempt from 16(b) liability most transactions between a company and its officers and directors pursuant to compensatory plans so long as certain minimal conditions are met.

Revisions would include the following:

* Transactions pursuant to thrift, stock purchase and other broad-based tax-qualified plans, including non-qualified excess benefit plans, would generally be exempt. The only exception would be an intra-plan transfer of company securities at the election of the officer or director or a cash distribution funded by a disposition of company securities at the election of the officer or director. Such a transfer or disposition would, however, remain exempt if it were made (a) in connection with the death, disability retirement or termination of the employment of the officer or director, (b) under an election made at least six months following the last such election or (c) available to the officer or director pursuant to a provision of the Internal Revenue Code.

* Acquisitions or securities pursuant to a plan that satisfies the conditions applicable to performance-based compensation under Code 162(m) would be exempt.

* Grants of stock options, restricted stock and other equity securities would be exempt if any one of the following conditions were met:

The grant is approved by the company's board of directors or a committee composed solely of two or more non-employee directors;

The grant is approved or ratified by shareholders at the next annual meeting; or

The stock option or other security is held by the officer or director for at least six months after the date of grant (or in the case of an option that is exercised during such six-month period, the underlying stock is held until the end of such six-month period).

* Sales or other dispositions to the company of company securities would be exempt if approved in advance by the board of directors, a committee composed of two or more non-employee directors or the shareholders. This exemption would apply to, among other transactions, (i) the withholding of securities to pay the exercise price of an option or to satisfy the tax-withholding obligation in connection with an option exercise or the vesting of restricted stock, (ii) the surrender of an option in exchange for a replacement option and (iii) the cash settlement of a stock appreciation right.

Elimination of Requirements

If the Alternative Proposals are adopted, the following Rule 16b-3 requirements, among others, would be eliminated:

* the requirement of a written plan meeting certain specified standards;

* restrictions on transferability;

* approval of the plan by shareholders, except to the extent of providing an alternative exemption;

* disinterested administration of the plan;

* the six-month holding period, except to the extent of providing an alternative exemption;

* with respect to cash settlements of stock appreciation rights, (i) the provisions for current public information, (ii) registration of the company's securities under the Exchange Act for at least a year and (iii) exercise within the

In addition, the SEC contemplates modifying the 16(a) reporting system so that exempt grants, as well as dispositions, would be required to be reported on a current basis on Form 4, rather than annually on Form 5, as now permitted for transactions exempt under current Rule 16b-3. Reporting no longer would be required for most transactions pursuant to certain broad-based plans (qualified plans, excess benefit plans and stock purchase plans), dividend or interest reinvestment plan transactions, gifts and transactions pursuant to qualified domestic relations orders.

The SEC has asked for public comment on a great number of questions and issues in the Alternative Proposal Release, suggesting that the SEC has not necessarily reached any conclusions at this point as to the direction it wishes to take. Interestingly, one of the questions posed by the SEC is whether it should recommend to Congress that 16(b) be repealed.

Use of the Black-Scholes model and other methods of valuing employee stock options has become common-place. Uses range from the valuation of stock option grants in the stock option grant tables in proxy statements to the pending new disclosures in footnotes to financial statements for stock option grants, required under new Statement of Financial Accounting Standards No. 123 (see below).

Seemingly impervious to these advances in stock option valuation techniques is Treasury regulation 1.83-7 (1978). Section 83 of the Internal Revenue Code provides for the taxation of the transfer of property in connection with the rendering of service. Section 83(e)(3) excepts from the application of 83 "the transfer of an option without a readily ascertainable fair market value. . . . "

Treasury Regulation 1.83-7(b)(2), adopted in 1978, establishes a four-part test for determining whether an option (other than one that is "actively traded on an established market") has a "readily ascertainable fair market value." 4 This test makes it almost impossible for the typical grant of an employee stock option to have a "readily ascertainable fair market value" for purposes of 83.

Treasury Regulation 1.83-7(b)(2) provides that an option does not have a readily ascertainable fair market value unless each of the following four circumstances is present:

(i) The option is transferable by the optionee;

(ii) The option is exercisable immediately in full by the optionee;

(iii) The option or the property subject to the option is not subject to any restriction or condition . . . which has a significant effect upon the fair market value of the option; and

(iv) The fair market value of the option privilege is readily ascertainable. . . . 5

Many executives and their tax advisors would like an option grant, assuming it is a non-qualified option, to satisfy the "readily ascertainable fair market value" test at the time of grant. This would permit the executive to elect under Code 83(b) to be taxed on the option grant rather than the exercise of the option. This would create opportunity for long-term capital gain after the option is exercised and the stock is sold. Otherwise, in the case of a non-qualified stock option, the spread when the option is exercised constitutes ordinary income to the executive.

In Cramer v. Commissioner, 64 F3d 1406 (9th Cir. Sept. 11, 1995), aff'g 101 T.C. 225 (1993), the Ninth Circuit affirmed a Tax Court decision that indicates, once again, the difficulty in creating an employee stock option grant that can be taxed at time of grant. The reasoning of the Court of Appeals emphasizes the difficulty. (In fact, the actual circumstances of the case, which reflect rather egregious behavior by the executives involved, were very unfavorable to the taxpayers.)

In this case, three executives -- the founder/CEO, a vice president and the general counsel -- received option grants. Without, apparently, any careful review of the tax issues, the executives filed elections under Code 83(b) to be taxed on certain of the option grants. The options were granted during the years 1979-81. The 1981 options were granted to a trust of which the executives were the beneficiaries.

At no time during the 1979-81 period were the employer's securities registered with the SEC, even though there were 150 to 250 shareholders in those years. In 1982 Warner-Lambert Corp. purchased all the stock of the employer and "bought out" the stock options of the executives in question.

The executives reported the buyouts as long-term capital gains. In fact, most of the transactions were reported as sales of stock rather than buyouts of options. Two of the executives calculated their tax by reporting basis in the "stock" even though they had not shown any value associated with the stock option grants when they filed the 83(b) elections.

Adding to the taxpayers' problems, at least one tax advisor provided written statements, avaliable in the files of the accountant for the employer and, in one case, sent to one of the taxpayers, that he had serious doubts as to the appropriateness of the positions being taken by the taxpayers regarding the options under 83.

Several paragraphs of the Tax Court opinion include discussion of the presentation of the taxpayers' valuation experts, which included in effort to show that computer-based models such as Black-Scholes could establish a readily ascertainable value for the stock options at time of grant for purposes of 83.

In its decision against the taxpayers, the Tax Court made the following comment:

In these cases, that a valuation expert may be able to calculate a value for the options is not enough to satisfy the requirement that the value be "ready ascertainable." Brodenstein's [Brodenstein was a valuation expert for certain of the taxpayers] models did not account for the effect of any restrictions on the option values. 6

The Court of Appeals "shut the door" as to any implication that Black-Scholes or other models would have solved the problem raised by Treasury Regulation 1.83-7(b)(2):

We need not address whether the fourth condition was satisfied, because, even though appellants presented evidence below that the value of each IMED "option privilege" was ascertainable, these options . . . clearly failed the first three conditions. Therefore, according to Reg. 1.83-7(b)(2), the value of the options was not readily ascertainable at the time of transfer [and] 83 did not apply to the transfer. . . . 7

In other words, even if the option itself has a readily ascertainable value under Black-Scholes or other valuation method, the conditions of option transferability and immediate exercisability exclude options such as those in Cramer (and most other cases) from the application of 83. Only if an employer provides an option that is transferable and immediately exercisable will the Ninth Circuit consider the issue of value of the option privilege. 8

On Oct, 23, the FASB released its Statement of Financial Accounting Standards No. 123, "Accounting for Stock-based Compensation" (Statement 123). As previously reported in this column, 9 in discussions of the background to Statement 123, the new rule, among other things, allows companies to choose between two methods of accounting for grants of stock options:

(1) continue to use the existing accounting rules for accounting for stock options provided by APB Opinion No. 25 (1972), "Accounting for Stock Issued to Employees" (which generally does not result in a charge against earnings for stock options), but provide footnote disclosure in the financial reports as to what the charge against earnings would have been had the company elected method (2) below, or

(2 determine the "fair value" of a stock option award as of the grant date and use such value as a charge against earnings. (It is not anticipated that many employers will choose to charge earnings for stock option grants despite the encouragement given this method by the FASB.)

Statement 123 is effective for fiscal years beginning on or after Dec. 15, 1995; however, grants made in fiscal 1995 must also be covered in the footnote disclosure appearing in the fiscal 1996 financial statements.


1 SEC Release Nos. 34-36356; 35-26389; 1C-21406. The Alternative Proposal Release was published in the Federal Register on Oct. 17, 1995, 60 Fed. Reg. 58,832.

2 SEC Release Nos. 34-34514; 35-26100; 1C-20467. The Original Proposal was published in the Federal Register on Aug. 17, 1994. 59 Fed. Reg. 42,449.

3 See this column, New York Law Journal, Aug. 31, 1994.

4 A stock option that is actively traded on an established market has a readily ascertainable fair market value. Treas. Reg. 1.83-7(b)(1).

5 Id. at 1,83-7(b)(2). In the case of a compensatory stock option, the regulations describe the "option privilege," in the case of an option to purchase securities, as the "opportunity to benefit during the option's exercise period from any increase in the value of property subject to the option during such period, without risking any capital." The regulations go on the provide that "in determining whether the fair market value of an option is readily ascertainable, it is necessary to consider whether the value of the entire option privilege can be measured with reasonable accuracy" and that such determination must take into account "(i) [whether] the value of the property subject to the option can be ascertained; (ii) [the] probability of any ascertainable value of such property increasing or decreasing; and (ii) [the] length of the period during which the option can be exercised." Id. at 1.83-7(b)(3).

6 Cramer v. Commissioner, 101 T.C. 255, 244 (1993).

7 Cramer v. Commissioner, 64 F3d 1406, 1412 (9th Cir. 1995).

8 To similar effect, see Pagel Inc. v. Commissioner. 91 T.C. 200 (1988), aff'd, 905 F2d 1190 (8th Cir. 1990)

9 See this column, NYLJ, March 29, 1993; June 30, 1993; June 30, 1994; Aug. 31, 1994; Nov. 29, 1994; March 30, 1995; Aug. 29, 1995.