Impact of SEC insider trading rules on executive compensation arrangements.

The Securities and Exchange Commission (SEC) has adopted revised rules and forms that apply to purchases and sales of employer securities by corporate "insiders" (directors, certain officers and 10% shareholders). These new rules, which generally became effective May 1, 1991, relate to the short-swing profit recovery provisions of various statutes, principally Section 16 of the Securities Exchange Act of 1934.

Exemption for option exercises

The exercise of a stock option is not considered a "purchase" under the Section 16 liability provisions, although the exercise remains subject to the Section 16 reporting provisions. The SEC reasoned that the grant of an option is a purchase, while the exercise merely changes the form of ownership from indirect to direct.

For tax purposes, taxable income from the exercise of a non-qualified option must now be recognized at the exercise date. Sec. 83(c)(3) no longer delays income recognition for six months, because there is no longer a substantial risk of forfeiture. Likewise, for incentive stock options (ISOs), the alternative minimum tax adjustment (Sec. 56(b)(3)) is measured at the exercise date (rather than six months later).

The timing of the income recognition is unclear, however, if an insider makes a separate, nonexempt purchase within six months of an option exercise. For example, assume an insider makes an open-market purchase of company stock on June 1, 1991 and exercises a nonqualified stock option on June 2, 1991. Due to the Section 16(b) liability provisions, the insider would be unable to sell the stock acquired from the option exercise until six months after the June 1 purchase (i.e., Nov. 30, 1991). However, based on Regs. Sec. 1.83-3(j)(2), Example (3), it would appear that the insider is taxed on the option spread on June 2, 1991. Similarly, the tax preference on an ISO exercise would also be measured on June 2, 1991.

Exempt plans

Most of the complexity of the new rules centers on the exemption from liability for certain transactions under "exempt plans." Because most companies grant options or other stock-based awards at least every 12 months, any insider's sale of stock would necessarily occur within six months before or after a purchase and therefore result in short-swing liability. To alleviate this problem, an exemption has been provided under Rule 16b-3 for two types of plans--award plans (e.g., traditional stock and option plans), under which an award is made to an insider, and participant-directed plans (e.g., a Sec. 401(k) plan or a directors' plan permitting election of cash or stock), in which company stock is acquired or disposed of by the insider's volitional act. Award plans: While specific detailed conditions must be met to obtain the exemption, most award plans should have little, if any, problem in complying with Rule 16b-3. Thus, option grants and restricted stock awards generally are not considered purchases for Section 16 liability purposes. (Note: The grants or awards, however, must be reported by the insider.) Participant-directed plans: The revised rules exempt participant-directed transactions under certain plans from the Section 16 liability provisions, but not the reporting provisions. The best examples of this type of plan are thrift/savings plans (e.g., Sec. 401(k) plans with a company stock fund) and plans permitting corporate directors to elect to receive their annual retainers and other fees in either cash or stock. The conditions for exempting participant-directed transactions are slightly different than those exempting stock-award transactions and arguably somewhat more complicated; satisfying this portion of Rule 16b-3 involves insider action, generally an election six months in advance of the transaction or holding distributed stock or an interest in a stock fund for at least six months. Nevertheless, insiders (subject to their making the appropriate election) will be able to purchase and sell interests in company stock and transfer account balances under their company's Sec. 401(k) plan without incurring short-swing liability. Previously, these plan transactions were, in virtually all cases, exempt from Section 16. Thus, the new rules require insiders to report their "purchases" under these plans and take affirmative action to avoid subjecting such "purchases" to the liability provisions of Section 16(b).

Special exemption from Section 16 reporting and liability provisions

Certain plans and arrangements that provide benefits only in cash are completely exempt from the Section 16 reporting and liability rules. Such plans may include those that provide stock appreciation rights (SARs), phantom stock, performance units, and supplemental employee stock ownership plans (ESOPs) and/or Sec. 401(k) plans that mirror investment in company stock. These types of arrangements may be very attractive to companies that want to avoid the new Section 16 rules. Adverse accounting implications (i.e., variable accounting) could result, however.

Other compensation arrangements

Awards under certain plans (e.g., SARs, phantom stock and performance units) that can be settled in either cash or stock or that pay benefits solely in stock, as well as stock tendered to pay tax withholding on option exercises, are treated as forms of indirect stock ownership subject to Section 16. SARs payable only in cash, but issued in tandem with stock options, are also considered indirect stock ownership. As such, these arrangements must satisfy the conditions for an exempt plan not only to avoid treating awards under such plans as purchases, but also to avoid treating the settlement of the awards as sales. Further, any election to receive a cash payment must be made during a 10-day window period, i.e., the third through twelfth day following the date of the company's quarterly earnings release. Shares for withholding: The prior rules allowed an executive to irrevocably elect to surrender shares to cover tax withholding either six months before the "tax date" or during one of the quarterly window periods. Under the new rules, the tax date for a non-qualified stock option is the exercise date. Thus, to use option shares for tax withholding, an executive must exercise options either during a window period or at least six months after irrevocable electing share withholding. This diminishes planning flexibility somewhat, particularly when the window period is used. (Some advisers and commentators have suggested making the six-month irrevocable election on grant of the options, thereby triggering share withholding on later exercise, even if years after the grant.) Also, the election is not truly irrevocable, as it can be revoked on six months' advance notice. While it can be argued that a share-for-withholding provision is no longer necessary because an executive can simply sell shares to raise the necessary cash to pay the withholding, such a transaction would be a sale, matchable with any purchases made within six months. Use of shares for withholding during a window period, or at least six months after an irrevocable election, is an exempt transaction (i.e., it is not considered a sale). ESOPs and discretionary profit-sharing plans: When an employer makes discretionary contributions to a profit-sharing plan or ESOP that is allocated to a company stock fund within a participant's account and there is no participant direction for such allocation, the allocation is reportable by an insider, but is an otherwise exempt purchase. (See SEC Interpretative Letter, Thompson, Hine and Flory.) The SEC treats the transaction as an exempt grant or award, assuming compliance with the relevant portions of Rule 16b-3. Restricted stock: Awards of restricted stock are largely unaffected by the amended rules, as long as the awards are made under an exempt plan. The awards must be reported, but are not considered purchases. The vesting of the award or lapsing of restrictions is a nonevent, the same as under the current rules. Also, if an executive wishes to surrender shares to cover tax withholding, the election (but not necessarily the actual withholding) must be made during a window period; otherwise, the surrender is treated as a sale. Alternatively, an irrevocable election to surrender shares can be made at least six months in advance of the tax date. (See SEC No-Action Letter, Ralston Purina Company II.) Also, if the award is not pursuant to an exempt plan, it is considered a purchase. Stock appreciation rights: Because insiders can exercise options and obtain cash through an immediate sale without violating Section 16 (assuming no purchases in the six-month period preceding the sale), a company's need for existing or future SARs is questionable. Fluctuations in the value of SARs have a direct impact on a corporation's earnings and profits. However, existing SARs can be capped to eliminate future earnings charges and to allow for future income reversals if the stock price drops. Another solution is to issue limited SARs (LSARs), exercisable only in the event of a tender offer or merger. LSARs do not require an adjustment to earnings until a change in control occurs.

Effective date and transition rule

The new rules became effective May 1, 1991, although an optional phase-in until Sept. 1, 1992 is provided for equity-compensation plans. There is no grandfathering of the old rules, but any equity-compensation plan that does not conform to the new rules until Sept. 1, 1992 is governed by the old rules. If a company (i.e., a registrant under the 1934 Act) chooses to adopt a plan that complies with the new rules or convert one of its plans to the new rules, all of its plans must be converted. Compliance with all of the reporting rules was required beginning on May 1, 1991, even if the underlying plan has yet to conform to the new liability rules.