This article is reprinted with permission from the
July 31, 1996
edition of

New York Law Journal.

1996 NLP IP Company.


The SEC's New Rule 16b-3

By Joseph E. Bachelder.


EFFECTIVE AUG. 15, the Securities and Exchange Commission significantly changes the conditions that must be met under Rule 16b-3 for an exemption to apply from the insider rules, as applicable to officers and directors, under 16(b) of the Securities Exchange Act of 1934 (Exchange Act). 1 (References to Rule 16b-3 as it takes effect Aug. 15 will be to "new Rule 16b-3," and references to Rule 16b-3 as currently in effect will be to "current Rule 16b-3.")

After highlighting the more important changes, this column summarizes the basic rules under new Rule 16b-3. It does not discuss concurrent changes made by the SEC in the reporting requirements pursuant to 16(a) of the Exchange Act.

For nearly 50 years, officers and directors of public corporations have looked to Rule 16b-3 as the primary basis for exemption from the profit recapture provisions of 16(b). During that period, Rule 16b-3 has gone through a number of revisions.

The revision prior to the new promulgation occurred in 1991. 2 That revision not only substantially modified Rule 16b-3 but affected the 16 rules across the board. The 1991 revision was made as a result of a comprehensive review of the rules that the SEC undertook in response to developments in the trading of derivative securities, the growth of complex and diverse employee benefit plans and a rise in filing deficiencies. Among other things, the 1991 revision changed the treatment of options and other derivative securities so that the acquisition of a derivative security would be deemed the significant event, not the exercise.

Notwithstanding the 1991 modifications, the SEC was under substantial pressure to further reduce the complexities of the rules under 16. In August 1994 the SEC proposed substantial changes in the rules, primarily with respect to employee benefit plan transactions. 3

Rule 16b-3, even after the 1991 changes, involved numerous compliance issues regarding eligibility for an exemption from the penalties of 16(b). These included a number of problems associated with tax-qualified and other broad-based plans.

In October 1995, while the 1994 proposals were pending, the SEC proposed an alternative set of amendments to the 16 rules. 4 The new promulgation (adopted May 31, 1996) very much tracks the 1995 proposals in respect of Rule 16b-3. It eliminates, or modifies significantly, a number of requirements for an exemption imposed under current Rule 16b-3. (The 1995 proposals were the subject of a prior column (New York Law Journal, Dec. 1, 1995.) Following are highlights of major changes.

Optional Shareholder Approval

Shareholder approval of a plan no longer is required as a condition to obtaining an exemption (although it remains an optional means of qualifying for an exemption as discussed below). Other concerns, such as corporate law, tax law and stock exchange requirements, nonetheless, may call for shareholder approval.

New York State corporation law, for example, requires shareholder approval of options and certain other rights granted to officers, directors and employees. 5 The New York Stock Exchange, the American Stock Exchange and NASDAQ each has shareholder approval requirements applicable to stock-related plans. 6

Federal income tax considerations are another reason shareholder approval of a plan may be needed. Section 162(m) of the Internal Revenue Code of 1986 limits to $1 million the deduction for most non-performance based compensation paid to the very top officers of publicly held corporations (ordinarily the top five "named executive officers" in the proxy statement). To qualify as performance based, a plan must meet certain requirements including shareholder approval. Code 422, covering incentive stock options, also contains a shareholder approval requirement.

No Written Plan

Under current Rule 16b-3 a grant or award must be pursuant to a written plan containing, among other things, a maximum limit on the number of shares that can be granted pursuant to the plan. This will no longer be required. Among the benefits of the new rule will be the flexibility it provides in negotiating individual arrangements with senior level executives. On the other hand, other considerations may call for a written plan. Both the performance-based plan exception under Code 162(m) (already noted above in connection with shareholder approval) and the incentive stock option provisions of Code 422 (also noted above) contemplate written plans. Other legal considerations, as noted in paragraph 1, also may call for a written plan.

'Non-Employee Director'

Administration of a plan under current Rule 16b-3 must be by directors who are "disinterested persons." Under new Rule 16b-3, to the extent a committee of directors is relevant to the exemption (see discussion under Basic Rules below), the directors must be "non-employee directors." For the definitions of "non-employee director" under New Rule 16b-3 and "disinterested person" under current Rule 16b-3, see box below.

In certain respects, "non-employee director" is a less limiting definition that "disinterested person." A recently retired officer can now serve as a "non-employee director" without regard to the fact he received a grant or award of "equity securities" within one year prior to becoming a "non-employee director." (But see comment and the box below if the issuer also seeks to qualify a plan as performance-based under Code 162[m].)

In addition, under the new rule, a "non-employee director" may receive awards of "equity securities" as compensation for serving as a director. (He can even participate in that decision himself without creating a problem under new Rule 16b-3. There may be corporate governance reasons unrelated to Rule 16b-3 for his not doing so.)

On the other hand, there are new requirements such as those relating to Items 404(a) and 404(b) of Regulation S-K that make it more difficult to meet the new test. For example, it will disqualify some professional advisors who serve on boards of directors from qualifying as "non-employee directors." In particular, lawyers and investment bankers (who are subject to special disclosure requirements under Items 404[b][4] and [b][5], respectively) will in many instances be precluded from serving as "non-employee directors." On the other hand, the availability of an exemption under Rule 16b-3 is no longer dependent on the definition of the directors eligible to administer the plan; an exemption may be obtained on other grounds, as discussed below.

For those companies intending to qualify a plan for the performance award plan exception from Code 162(m), careful attention must be given to the difference between the definition of "outside director" under Code 162(m) and the definition of "non-employee director" under new Rule 16b-3. For example, under Treasury Regulation 1.162.27(e)(3)(C) a former officer of "the publicly held corporation" cannot qualify as an "outside director." See the box below for a summary of the term "outside director" under Treasury Regulation 1.162-27(e)(3)(C).

Stock Option Transfer

Current Rule 16b-3(a)(2) prohibits transferability of stock options. New Rule 16b-3 eliminates this prohibition. Among the benefits of the new rule will be the opportunity to transfer options to family members. It even opens the possibility of transfers to third parties, including transfers to third parties, including transfers for consideration (if an issuer concluded that such transfers were not contrary to the interests of the corporation and its shareholders).

Before implementing transferability of options, issuers should give careful consideration to federal securities law issues. For purposes of the Exchange Act, a gift by an executive to a family member should be exempt under Rule 16b-5. On the other hand, if the executive sells an option there may be a disposition that can be matched against a purchase for purposes of 16(b). In addition, there are registration issues under the Securities Act of 1933. Current Form S-8, the short form registration for employee plans, provides that an option must be non-transferable in order to be registerable pursuant to it. 7

Six-Month Rule

Current Rule 16b-3(c)(1) conditions the exemption for an option (or grant of other "equity security" of the issuer) upon its being held for six months. New Rule 16b-3 eliminates this requirement.

It does provide, as noted further below, that a holding for six months from date of award or grant is one of the alternative bases for obtaining an exemption from 16. It is not, however, any longer a requirement for exemption.

'Cash Only' Awards

"Cash only" SARs, stock units or other stock equivalents are subject to the new Rule 16b-3. (This has been accomplished by modifying current Rule 16a-1(c), which excluded such rights from the definition of "derivative security.") The requirement of a window period for cash settlement of an SAR has been eliminated.

Basic Rules

The remainder of the column will discuss the basic rules of new Rule 16b-3. New Rule 16b-3 introduces rules governing four different types of situations involving transactions between an issuer and its officers and directors:
* grants, awards and other acquisitions
* dispositions (to the issuer)
* transactions involving tax-qualified and certain other broad-based plans and
* "discretionary transactions"

Grants, Awards

Basically the new rule provides that "a grant award or other acquisitions from the issuer" (except for "discretionary transactions" -- see below) will be exempt from 16(b) if any one of the following alternative conditions is met: 8
(i) Approval is given by the board of directors of the issuer or by a committee composed of two or more "non-employee directors";
(ii) The transaction is approved or ratified by shareholders;
(iii) The equity securities acquired are held for at least six months following the date of acquisition.

On the other hand, such a transaction must be distinguished from a transaction covered by one of the other exemptions. One of those other exemptions is the tax-qualified plan, or other broad-based plan, exemption. The "discretionary exemption that may apply. If the transaction comes within the "discretionary transaction" definition, exemption must be obtained pursuant to the requirements of this exemption, or not at all. As discussed in the text of the column, the discretionary transaction exemption is directed at transactions involving two or more funds in which a participant may invest (such an an issuer stock fund, a bond fund or a money market fund) and, typically, switch investments among funds. The release describes these transactions as "fund-switching transactions."

To satisfy either clause (i) or (ii) above as a basis for exemption, the transaction must be specifically approved. This means that each award transaction as to each recipient of an award must b e approved by the board, by the committee or by the shareholders, as the case may be.

Note 3 to new rule 16b-3 states that the rule requires the approval of "each specific transaction." It also says that such requirements "are not satisfied by approval of a plan in its entirety except for the approval of a plan pursuant to which the terms and conditions of each transaction are fixed in advance, such a formula plan." 12

This means that a general approval of a plan by shareholders will no longer itself provide the necessary approval for an exemption under Rule 16b-3. On the other hand, if specific approval is based on action by the board or action by a committee, approval as to the specifics of a transaction will likely involve a procedure in line with prior practices of an issuer (i.e., shareholder approval of the plan with specific awards being made by the board or by the administering committee).

One problem posed by the new procedures is that if there is a material modification in the terms of a transaction previously approved with the specificity required by Note 3 to new Rule 16b-3, reapproval may be required in order to continue the exemption provided by clause (i) or (ii) above. (Of course, holding of the security for the requisite six-month period is an alternative method, as described in clause (iii) above, for compliance with the new exemption requirements.)

A second problem involves grants made under current Rule 16b-3 that have not been the subject of a qualifying specific approval as required by new Rule 16b-3 and therefore are not in compliance with new Rule 16b-3. (There is no grandfather clause in this respect in new Rule 16b-3.) At a recent conference, a member of the staff of the SEC indicated that in such a case a new approval under clause (i) or (ii) (or compliance with the six-month waiting period) may be necessary to enjoy exemption under new Rule 16b-3. 13

Note 3 to new Rule 16b-3, already noted above, also comments on subsequent transactions provided for in the original transaction. "Where the terms of a subsequent transaction (such as the exercise price of an option, or the provision of an exercise or tax withholding right) are provided for in a transaction as initially approved . . . such subsequent transaction shall not require further specific approval." 14

Dispositions to Issuer

The new rule exempts any disposition of equity securities to the issuer (exempt for "discretionary transactions" -- see below), provided that the approval requirements, described in connection with grants and awards above, are met in respect of the disposition. In this connection, however, the rule provides that the terms of the disposition must be approved in advance. 15

Among the types of transactions that will benefit from this new provision are dispositions
* to pay withholding taxes
* to pay the exercise price of a stock option
* for estate planning purposes
* in connection with (prior to) a merger

As also noted above, if a tax withholding or other disposition is provided for in the original transaction, as originally approved, separate approval is not later required as to such disposition. 16

Tax-qualified Plans

Various broad-based plans are provided specific exemption (except for "discretionary transactions" -- see below). In this category are:
* "qualified plans"
* "excess benefit plans"
* "stock purchase plans"

Tax-qualified plans. This category includes thrift plans, savings plans and 401(k) plans as well as any employee benefit plan that "satisfies the coverage and participation requirements of sections 410 and 401(a)(26)" of the Code. 17

Excess benefit plans. New Rule 16b-3 defines an "excess benefit plan" for purposes of this exemption as follows: An employee benefit plan that is operated in conjunction with a Qualified Plan, and provides only the benefits or contributions that would be provided under a Qualified Plan but for any benefit or contribution limitations set forth in the [Code] . . ." 18

Stock purchase plans. "Stock purchase plan" is defined as "an employee benefit plan that satisfies the coverage and participation requirements of 423(b)(3) and 423(b)(5), or 410, of the [Code] . . ." 19 Such a plan typically provides for payroll deductions and a purchase price at a discount from market price (at time of purchase).

Discretionary Act

New Rule 16b-3 provides a special exemption for so-called "discretionary transactions." Such transactions are specifically excluded from the three other categories of exemptions described above. As described earlier in the column, a "discretionary transaction" typically is one pursuant to a plan in which a participant is given the opportunity by the issuer to invest in, switch into and cash out of various investment funds. The release describes the circumstances of concern to the SEC as follows:

Fund-switching transactions involving an issuer equity securities fund and cash distributions from these funds may present opportunities for abuse because the investment decision is similar to that involved in a market transaction. Moreover, the plan may buy and sell issuer equity securities in the market in order to effect these transactions, so that the real party on the other side of the transaction is not the issuer but instead a market participant. 20

New Rule 16b-3(b)(1) specifically defines a "discretionary transaction" as follows:

A Discretionary Transaction shall mean a transaction pursuant to an employee benefit plan that:
(i) Is at the volition of a plan participant;
(ii) is not made in connection with the participant's death, disability, retirement or termination of employment;
(iii) is not required to be made available to a plan participant pursuant to a provision of the Internal Revenue Code; and
(iv) Results in either an intraplan transfer involving an issuer equity securities fund, or a cash distribution funded by a volitional disposition of an issuer equity security.

In order to qualify for exemption under new Rule 16b-3(f), a discretionary transaction must occur at least six months after a discretionary transaction that is in the "opposite way," a term used in the release but not in the new Rule itself). "Opposite way," for this purpose means an acquisition as opposed to a disposition and vice versa. The test applies to any such transaction even if it occurs pursuant to a different plan from that of the transaction in question.

Effective Dates

The new rules take effect Aug. 15, but issuers can take advantage of a phase-in period,if they choose, until Nov. 1, in order to comply with requirements of new Rule 16b-3. To come within the new Rule 16b-3 exemption, the issuer must choose to comply as to all plans (with certain minor exceptions). 22 There is no formal election to be made to use new Rule 16b-3 during this period according to the SEC staff; it simply will be based on compliance "in fact." 23 Care must be taken that amendments to existing plans and grants comply with applicable provisions of those plans and grants.

Three "Director Status" Tests Compared:
Current Rule 16b-3, New Rule 16b-3, Code Section 162(m)
Current Rule 16b-3(c)(2)(i)
"Disinterested Person" Test
New Rule 16b-3(b)(3)(i)
"Non-Employee Director" Test
Code 162 (m)
(Treas. Reg. 1.162-27(e)(3)(C))
"Outside Director" Test

Plan must be administered solely by directors who are "disinterested persons."

A "disinterested person" for this purpose must be a director who while serving as an administrator of the plan in question and "during the one year prior to service as an administrator" is not "granted or awarded equity securities [of the issuer] pursuant to the plan or any other plan of the issuer or any of its affiliates" except for

* participation in a "formula plan"or in any capacity other than as a within the meaning of Rule 6b-3(c)(2)(ii);

* participation in an "ongoing securities acquisition plan under Rule 16b-3(d)(2)(i);"

* election to receive an annual retainer fee in cash or "an equivalent amount of securities" or a combination thereof; and

* participation in a plan, other than the plan in question, pursuant to which equity securities of the issuer are awarded

To be eligible as a "non-employee director" who can take part in approving grants or awards of equity securities of the issuer so as to exempt them under new Rule 16b-3, a director must not

* currently be employed by, or be an officer (whether or not an employee) of, the issuer, or the parent or a subsidiary of the issuer;

* receive compensation from the issuer, or the parent or a subsidiary of the issuer, for service as a consultant, director, except for an amount not required to be reported under Item 404(a) of Regulation S-K (generally an amount not greater than $ 60,000 in a given year);

* have an interest in any other transaction requiring disclosure under Item 404(a) of Regulation S-K; or

* have a business relationship requiring disclosure under Item 404(b) of Regulation S-K (except in the case of law firms and investment banks, generally a situation in which the amount involved exceeds five percent of the consolidated gross revenue of either the issuer or the other entity)

(Note: special rules apply to closed-end investment companies.)

For an award to qualify as a "performance-based" award by a publicly held corporation certain steps must be taken in respect of the award committee of "outside directors." An "outside director" must not

* be a former employee of the publicly held corporation receiving compensation
for prior services (other than under a tax-qualified retirementplan);

* be a current employee of the publicly held corporation;

* be a former officer of the publicly held corporation

* receive remuneration, directly or indirectly, from the publicly held corporation in any capacity other than as a director.


1 Release No. 34-37260, 61 Fed. Reg. 30,376 (June 14, 1996).

2 Release No. 34-28869, 56 Fed. Reg. 7242 (Feb. 21, 1991).

3 Release No. 34-34514, 59 Fed. Reg. 42449 (Aug. 17, 1994). A related release a month later concerned the issue of whether compensatory cash-only instruments based on the value of the issuer's equity securities should continue to be excluded from 16 liability. Release No. 34-34681 59 Fed. Reg. 48579, (Sept. 22, 1994).

4 Release No. 34-36356, 60 Fed. Reg. 53832 (Oct. 17, 1995).

5 N.Y. Bus. Corp. Law 505(d).

6 New York Stock Exchange Listed Company Manual 312.03; American Stock Exchange Company Guide 711; National Association of Securities Dealers Inc. Manual -- The NASDAQ Stock Market Rule 4460(i).

7 General Instruction A(1)(a) to Form S-8 permits the registration of non-transferable employee stock options that allow transfers pursuant to the laws of decedent and distribution.

8 New Rule 16b-3 does not clarify what is meant by "grant, award or other transaction." The release does indicate that grants of stock options and restricted stock, as one would expect, are examples of "grant and award" transactions. The release indicates that "other transactions" may include one that "requires the participant to exercise investment discretion as to either the timing of the transaction or the assets into which the investment is made." 61 Fed. Reg. at 20380. Such a transaction may include, for example, an exercise of an option or an elective deferral of bonus in the form of deferred stock or the equivalent.

9 The adopting release states that approval by the board of directors or a committee thereof must be obtained in advance, while new Rule 16b-3(d)(1) is silent on the timing of the approval by the board or committee. In contrast to acquisitions, Rule 16b-3(e) specifically provides that a disposition to the issuer must be approved in advance. See footnote 15.

10 New Rule 16b-3(d)(2) permits shareholder ratification as the basis of exemption for acquisitions from the issuer if obtained by the date of the next annual shareholders' meeting.

11 New Rule 16b-3(d)(3) provides that holding the security granted for six months is another basis for exemption from 16(b) liability, provided that in the case of a derivative security, the six-month period is measured from the acquisition date of the derivative security to the disposition date of the derivative security or "its underlying equity security." Securities are not treated fungibly for this purpose and exemption premised on the six-month holding period will not be nullified by dispositions of other issuer equity securities.

12 61 Fed. Reg. 30394 For this purpose "formula plan" is explained by the release (see release footnote 71) as meaning a "formula plan" under staff interpretations of current Rule 16b-3(c)(2)(ii).

13 Approval of grants that were exempt under the current rules may not have had the specificity required under the new rules for approval of future transactions (such as dispositions to issuers), or, if the needed specifity was met, the "disinterested directors" may not meet the "non-employee director" requirements of the new rules. Although the initial grant exemption would not be jeopardized, future transactions such as dispositions to the issuer may require additional approval meeting the requirements of new Rule 16b-3. See also discussion in footnote 23 below.

14 61 Fed. Reg. at 30394.

15 New Rule 16b-3(e) provides that dispositions to the issuer "are approved in advance in the manner prescribed by either paragraph (d)(1) or paragraph (d)(2) . . ." 61 Fed. Reg. at 30393.

16 Note 3 to new Rule 16b-3, 61 Fed. Reg. at 30394.

17 New Rule 16b-3(b)(4)

18 New Rule 16b-3(b)(2)

19 New Rule 16b-3(b)(5)

20 61 Fed. Reg. at 30379.

21 61 Fed. Reg. at 30393.

22 The adopting release to New Rule 16b-3 provides that during the transition period the new rule is available to "any transaction between an issuer and its officers or directors that occurs outside the scope of a formal plan or pursuant to a plan that permits only the issuance of cash-only instruments" without requiring that all other plans be adopted or converted to comply with new Rule 16b-3. 61 Fed. Reg. at 30390

23 Efforts to comply with new Rule 16b-3 are likely to raise a number of issues. For example, will the amendment of an award or grant, originally made under current Rule 16b-3, for the purpose of complying with, or taking advantage of, new Rule 16b-3, constitute a new grant or award for purpose of 16? The adopting release does not provide very much guidance in this respect. In a limited comment, footnote 169 of the release provides that, once an existing plan is converted to new Rule 16b-3, "the amendment of outstanding derivative securities to permit their transferability will not be deemed a cancellation of such securities and a grant of new securities for 16 purposes." 61 Fed. Reg. at 30390.