Thought Leadership

U.S. District Court Dismisses Shareholder’s Claim that SEC Rule 16b-3(e) Does Not Exempt Share Withholding for Purposes of Section 16(b) Liability

Client Updates
On November 10, 2016, we issued a client update noting that a shareholder had submitted letters to a number of public companies demanding that they seek to recover alleged short-swing profits under Section 16(b) of the Securities Exchange Act of 1934 from insiders who made non-exempt purchases of stock within six months of having shares withheld either (i) to satisfy tax liabilities upon the vesting of restricted stock, restricted stock units, or stock appreciation rights, or upon the exercise of employee stock options, or (ii) for payment of the exercise price of employee stock options. The withholding transactions generally were reported on Form 4s using transaction code “D” or “F,” indicating the dispositions were exempted from matching for purposes of Section 16(b) liability by SEC Rule 16b-3(e) because the withholding right was a term of the initial award as approved by the board or a committee of non-employee directors. The shareholder took the position that Rule 16b-3(e) does not exempt withholding unless (i) the company has no discretion to accept or reject the withholding, and (ii) the withholding is “automatic” in that the insider must pay the tax or exercise price with shares and cannot elect to pay the tax or exercise price with cash instead.

On April 26, 2017, the United States District Court for the Southern District of Texas granted a group of defendants’ motion to dismiss this type of claim in J.D. Jordan v. Robert Flexton, et al., No. 4:16-CV-03316. The plaintiff alleged that dispositions of restricted stock units that insiders made to their company to cover tax withholding liability in connection with stock grants they received under the company’s long-term incentive compensation plan constituted “sales” subject to Section 16(b) that could be matched to other purchases, resulting in profits required to be disgorged under Section 16(b). The insiders argued that the dispositions were expressly exempt from Section 16(b) under the plain language of Rule 16b-3(e) and did not involve an opportunity for the type of speculative abuse that Section 16(b) was meant to prevent. The Court dismissed the plaintiff’s claim “due to the fact that the transactions in question are compensation related and are designed to be exempt under Section 16b-3(e) of the Securities Exchange Act of 1934.” To our knowledge, this is the first court ruling on this issue. We do not know whether the plaintiff intends to appeal.

This ruling strikes a blow to the plaintiff’s theory of liability under Section 16(b). Given the recent claims, however, it may still be advisable for you to (i) reexamine your employee incentive award documentation to see how the shareholder’s theory could apply to your executives and (ii) warn insiders about the potential of a Section 16(b) claim if they make a non-exempt purchase of stock within six months of having shares withheld from them either to satisfy tax liabilities or for payment of the exercise price of employee stock options. We are, of course, available to consult with you about these issues.

Related Professionals