December 16, 2002
Mr. Jonathan G. Katz,
Re: Proposed Rule on Insider Trades During Pension Fund
Dear Mr. Katz:
We are responding to Release No. 34-46778, in which the Commission solicits comments on its proposed rules relating to the prohibition of insider trading during pension fund blackout periods under Section 306(a) of the Sarbanes-Oxley Act of 2002.
We appreciate the efforts of the Commission to implement Congress's intent to achieve a balance that minimizes the risk that directors and executive officers put "their personal interests ahead of their responsibilities" while at the same time avoiding unintended, negative consequences from an overly harsh application of the statutory trading prohibition. Inappropriately implemented, Section 306(a) could result in issuers limiting the share ownership opportunities available to non-executive employees. In particular, the potential for criminal liability for violations of Section 306(a) requires that the Commission should not apply to Section 306(a) some of the concepts developed under Section 16 (which provides only for disgorgement of profits).
In light of the limited time available for submitting comments on the Release, we have set forth below key aspects of the proposal that we believe, based on our review and on discussion with our U.S. and non-U.S. issuer clients, can be improved or clarified consistent with the statutory intent of Section 306(a) and the Commission's directive to coordinate with the Secretary of Labor in developing rules under Section 306(a).
A. Proposed Regulation BTR Should Reflect Section 306(a)'s Explicit Policy to Specifically Identify Equity Securities
1. Specific identification should be applied in place of the irrebuttable presumption.
The Release solicits comments on whether it is "appropriate to presume that any equity securities acquired or disposed of [by a director or executive officer] during a blackout period were acquired in connection with service or employment as a director or executive officer." This presumption effectively extends the statutory trading prohibition of Section 306(a) to the sale or transfer of any of the equity securities of the issuer held by a director or executive officer, regardless when the equity securities were acquired.
We believe that this result is not consistent with the express terms of Section 306(a) and its legislative history, as discussed in subsection b. below, and is not necessary to prevent evasion of the statutory trading prohibition. We suggest, in subsection c. below, an alternative approach that we believe will implement the statutory trading prohibition in a manner consistent with Section 306(a) based on specific identification (or tracing) of shares consistent with an insider's tax calculations and other reporting obligations.
a. Effect of the irrebuttable presumption
Proposed Rule 101(b) establishes an irrebuttable presumption that, if a director or executive officer sells any issuer equity securities during a blackout period, the first share sold will be deemed to be a share acquired "in connection with service or employment as a director or executive officer" - unless, effectively, the director or executive officer has never acquired any shares in connection with such service. This is the case without regard to the insider's other holdings, the reason for the sale or the actual source of the shares sold.
In our experience, almost every director or executive officer will have acquired at least one equity security "in connection with service or employment as a director or executive officer" as broadly defined in the Release. Moreover, major shareholder groups are advocating increased equity-ownership requirements for directors and executive officers that, if adopted, would have the effect of increasing further the number of insiders acquiring shares in connection with service. All, or nearly all, persons subject to Section 306(a) therefore will be unable to sell a single share of issuer equity securities during a blackout period without engaging in a transaction that violates the statutory trading prohibition.
The Release suggests this outcome is not "overly-broad" because, in a given blackout period, equity securities acquired in connection with service or employment could only count against one disposition transaction during that blackout period (even though they could count again in a subsequent blackout period). At the same time, however, the Release asserts that liability for violating Section 306(a) is not limited to the recovery of the profit realized by the insider from the prohibited transaction. A director or executive officer who violates the statutory trading prohibition is instead subject to the possibility of "civil injunctive actions, cease-and-desist proceedings, civil penalties and all other remedies available to the Commission to redress violations of the Exchange Act." The possibility of criminal liability is also discussed in the Release.
In light of the foregoing, the irrebuttable presumption of proposed Rule 101(b) effectively extends the statutory trading prohibition of Section 306(a) to all equity securities held by directors and executive officers. While the proposed limit on double-counting for a particular blackout period suggests that the Commission seeks to steer clear of this result, this proposal will have no practical effect in light of the threat of civil and criminal action under the Exchange Act.
b. Inconsistency of the irrebuttable presumption with Section 306(a)
There are at least three principal reasons why the irrebuttable presumption of proposed Rule 101(b) is inconsistent with Section 306(a). First, it is inconsistent with both the unambiguous words of Section 306(a) and the clearly expressed intent of Congress to permit some sales by directors and executive officers during blackout periods.
As we have described, proposed Rule 101(b) has the effect of erasing the "in connection with" requirement from Section 306(a). This requirement is an important, substantive part of Section 306(a) and its omission fundamentally changes the operation of the section. As the Release itself recognizes, Section 306(a) specifically permits insiders to sell a portion of their holdings during blackout periods:
Despite the general lack of legislative history relating to the Act, it is clear that Congress did not intend to impose a blanket restriction on trading by persons subject to Section 306(a) during blackout periods. Both the House and the Senate specifically considered and voted on versions of Section 306(a) that would have imposed a blanket trading restriction on insiders during blackouts.2 In the conference between the House and the Senate immediately preceding enactment of Section 306(a), however, Congress determined to revise the blanket restriction by having the statutory trading prohibition apply only to shares acquired "in connection with service or employment." Proposed Rule 101(b) would frustrate this unambiguously expressed intent by making the sale of the first share during any blackout by almost all directors or executive officers unlawful, no matter how that share was acquired.
Second, although we appreciate the simplicity of establishing an irrebuttable presumption that operates in a manner analogous to the short-swing profit recovery provisions of Exchange Act Section 16(b), we believe that the presumption concept is not appropriate in the context of Section 306(a). In the Section 16 context, the courts have found it appropriate to approve the maximum possible recovery and to refuse tracing individual purchases and sales because there is no basis for tracing in the statute.3 Under Section 306(a), however, the statute specifically contemplates tracing by including the "in connection with" requirement.
Finally, in contrast to Section 16, the Release asserts the potential for criminal liability for sales by directors and executive officers during a blackout period. It seems inconsistent with long-standing principles of criminal jurisprudence to establish any kind of presumption of guilt in the criminal context, and even more so to make it irrebuttable.4
c. Specific identification as an alternative to the irrebuttable presumption
We believe that a better approach is available. Although it will probably be rare for directors or executive officers to need to sell shares during a blackout period, a mechanism should be in place to permit the sales specifically authorized by the statute. We suggest that:
Tracing shares is a concept that has long been endorsed under the Internal Revenue Code and Federal securities laws. The Code has a well developed system for identifying shares sold, including procedures for identifying certificated shares and shares held in the custody of a broker or agent.5 Similarly, both Exchange Act Rule 16b-3(d)(3) and Securities Act Rule 144(d) require tracing to calculate compliance with applicable holding periods. All of Rule 16b-3 requires tracing with respect to approvals of shares issued or granted.
There is little potential for abuse so long as persons subject to Section 306(a) are required to identify shares sold consistently among the various reporting regimes. In cases where shares are not specifically identified in accordance with the Code, we believe that the "first-in, first-out" rule of the Code should apply to facilitate consistent reporting.
2. Specific identification should be applied to calculate realized profit.
The Release also requests comments as to whether there should be a specific formula for the calculation of "realized profits" recoverable under the private right of action provided in Section 306(a). If the Commission adopts the concept of tracing shares discussed above, it will be possible readily to ascertain the amount of gain realized by the insider because the price paid by the insider for the equity security and the price received by the insider will be readily available. Any other method will again effectively extend the statutory trading prohibition of Section 306(a) to all equity securities of an issuer that are held by the insider and erase the Congressional mandate to allow insiders to sell some of their holdings during pension blackout periods.
Thus, we believe the specific identification method described above should be used to calculate any profit subject to the private right of action. We believe this specific identification method is appropriate for the profit calculation whether or not the Commission adopts it for the prohibition on sales. We urge the Commission to revise proposed Rule 103 to incorporate this concept, in order to avoid the inevitable litigation that will otherwise be required to establish the required profit calculation method, and the many years of uncertainty until that occurs.
B. Proposed Regulation BTR Should Interpret "Acquired in Connection With Service" in a Manner That is Designed to Prevent Abuse
1. Equity securities acquired in the open market should not be treated as "acquired in connection with service."
The Release proposes that "securities that a director or executive officer has acquired to satisfy an issuer's minimum ownership guidelines or requirements for directors or executive officers, including equity securities acquired on the open market for such purposes" will be considered acquired "in connection with service" for purposes of Section 306(a). We believe that this restriction, as provided in proposed Rule 100(a)(3), both contradicts the express language of Section 306(a) and is in fact contrary to the intent of the statute.
Securities purchased in the open market are not acquired "in connection with" service, regardless of the extrinsic motivation. They represent an investment that is made in the issuer without any benefit derived from being a director or executive officer, namely, an investment that does not represent any compensation paid by or charged to an issuer and that does not receive any special tax or other treatment. We believe that the addition of the "service requirement" to Section 306(a) clearly evidences an intent to put directors and executive officers on par with other employees and not to disadvantage them substantially relative to non-executive employees. Proposed Rule 100(a)(3), however, significantly disadvantages directors and executive officers because other employees will be free to sell shares acquired in the open market and held outside of a plan (and thereby not receiving any tax benefits related to holding assets in the plan) during any blackout period.
We are also concerned that proposed Rule 100(a)(3) will ultimately discourage issuers from adopting new, and encourage issuers to reduce or eliminate, minimum ownership requirements. One of the goals of Section 306(a) is to "tie the interests of directors and executive officers more closely to that of other security holders." Minimum ownership requirements for directors and executive officers are designed precisely to accomplish the intent of "tying the interests" of the insiders to those of other security holders. We believe Section 306(a) should not be used to discourage these types of arrangements.
Thus, we respectfully request that the Commission expressly provide in the final rule or adopting release that open market purchases will not be deemed "acquired in connection with service," regardless of the reason for the purchase.
2. Equity securities acquired before becoming a director or executive officer should not be treated as being "acquired in connection with service."
The Release proposes that equity securities acquired before an individual became a director or executive officer but that are "clearly related to his or her service or employment, such as a grant or award made to induce an individual to join an issuer's board of directors or to become an employee of the issuer or as a result of a merger, consolidation or other acquisition transaction involving the issuer," will be considered acquired "in connection with service or employment as a director or executive officer." While the Release and proposed Rule 100(a)(4) are not entirely clear, this language could be read to include awards given as an inducement to become a non-executive officer of the issuer.
The language of Section 306(a) clearly contemplates that equity securities acquired other than in connection with service or employment "as a director or executive officer" would be outside of the trading restriction. Treating equity securities acquired as inducements to becoming a non-executive employee as "tainted" if and when the employee is promoted to the status of executive officer contradicts the express language of the statute and fails to serve the goals of Section 306(a). Furthermore, proposed Rule 100(a)(4) turns what is typically an incentive for rank-and-file employees to remain with an issuer into a disincentive to do so. We believe proposed Rule 100(a)(4) should capture only inducements directly in connection with becoming a director or executive officer (for example, if there is a specific clause in the employment contract under which an individual becomes a director or executive officer promising a specific grant of issuer equity securities prior to the date such individual becomes a director or executive officer).
Accordingly, the Commission should clarify proposed Rule 100(a)(4) to limit its application to direct inducements to becoming a director or executive officer and should expressly clarify in the adopting release that awards received while a non-executive employee are not covered.
C. Issues Relating to Non-U.S. Issuers
1. The 15% test for non-U.S. issuers should relate to the number of participants affected in the United States as a percentage of the non-U.S. issuer's worldwide workforce.
Under proposed Rule 100(b), directors and executive officers of a non-U.S. issuer will be subject to the statutory trading prohibition of Section 306(a) if a blackout satisfies a two-part test: (1) the blackout applies to 50% of U.S. participants and beneficiaries under individual account plans providing for investment in issuer securities and (2) the blackout applies to more than 15% of the worldwide participants and beneficiaries under individual account plans.
We have discussed proposed Regulation BTR with our non-U.S. clients, who have informed us that they would have many problems applying the proposed rules. As a threshold matter, it is clear that the second part of this test, the 15% calculation, will be completely impracticable for most of them. One reason is that the definition of "individual account plan" used in the test does not have a practical meaning or application outside the United States. While non-U.S. issuers are able to apply the definition with respect to U.S. plans (because substantial guidance exists on how to categorize these plans), it will be difficult to determine with any certainty whether non-U.S. plans constitute "individual account plans" under U.S. law. Plans under which shares are purchased by a combination of employee contributions and employer matching contributions are available outside the United States, including in the United Kingdom and France,6 and some tax-favored types of purchase plans hold the shares in trust under individual account arrangements that may or may not be individual account plans that satisfy the ERISA7 definition incorporated in Section 306(a). Non-U.S. plans may have features that are not readily classified under existing Department of Labor advisory opinions, which would be applicable for purposes of Section 306(a) categorization, but provide guidance with respect to features that are typical of U.S. plans only.
Another reason the proposed 15% test is impracticable is the fact that many non-U.S. issuers do not maintain centralized information on the types of plans they maintain or the numbers of participants and beneficiaries under plans subject to the laws of other jurisdictions. There does not appear, currently, to be any legal reason to maintain this data. Compiling this information would be difficult and burdensome for many non-U.S. issuers.
We believe that non-U.S. issuers should not be required perform a complex recordkeeping and legal analysis of their worldwide plans for purposes of the 15% test. As an alternative, we suggest a test that looks to whether the blacked-out participants and beneficiaries constitute at least 15% of the non-U.S. issuer's worldwide workforce. This alternative test would be easily performed and we believe that it could be used to determine whether the blacked-out U.S. employees are a significant component of the non-U.S. issuer's active business operations. Requiring that the issuer have a significant presence in the United States appears to us to be a more appropriate predicate to imposing the restrictions of Section 306(a) extraterritorially. We recognize that our proposal will result in a higher threshold before a non-U.S. issuer will be subject to the statutory trading prohibition relative to the calculation proposed in the Release. We believe that this higher standard is appropriate and strongly encourage the Commission not to reduce the percentage should it determine to adopt a revised calculation.
2. The 50% test should relate only to individual account plans maintained in the United States.
Although the Release clarifies that the 50% test is a comparison applicable only to participants and beneficiaries located in the United States and its territories and possessions, the text of the 50% test in proposed Rule 100(b)(1), taken literally, does not limit the calculation to individual account plans maintained in the United States. Rather, as currently proposed, the 50% test is a comparison that applies to participants and beneficiaries under all individual account plans that "permit participants or beneficiaries located in" the United States and its territories and possessions "to acquire or hold equity securities of the issuer." U.S.-based employees or U.S. citizens on assignment outside the United States are sometimes permitted to participate in a non-U.S. issuer's home country plan, and occasionally U.S. employees performing services in the United States also participate in offerings under plans maintained outside the United States. The U.S. employees participating in these plans will be a de minimis percentage of total participants. Non-U.S. issuers do not typically maintain records of such participation, because plans maintained outside the United States primarily for the benefit of nonresident aliens are not subject to ERISA, even if they have a few U.S. participants.8 However, under proposed Rule 100(b)(1), it appears that if a few of the participants and beneficiaries under an individual account plan maintained outside of the United States are located in the United States and that plan undergoes a blackout period, because of the limited number of participants located in the United States, all of the participants of the plan maintained outside of the United States (whether or not the participants are located in the United States) would come into and potentially distort the 50% calculation.
We believe that the Commission should limit the 50% test to individual account plans maintained in the United States. This limitation will avoid confusion, inaccurate calculations and the inclusion of non-ERISA "individual account plans." We note that the Commission's broader approach, which reaches non-U.S. plans having a handful of U.S. participants, is not necessary to prevent evasion of Section 306(a). ERISA will apply to any individual account plan (as defined in Section 3(34) of ERISA9) that is primarily for the benefit of U.S. participants and beneficiaries and Section 404(b) of ERISA10 provides that the indicia of ownership of the assets of plans subject to ERISA may not be maintained outside the jurisdiction of U.S. district courts. As a result, such plans cannot be established outside of the United States or relocated outside the United States to evade Section 306(a).
3. Transactions under comparable "tax conditioned" employee benefit plans maintained by non-U.S. issuers should be exempt from the statutory trading prohibition of Section 306(a).
The Commission solicits comments as to whether "foreign private issuers have employee benefit plans that are substantially similar to Qualified Plans, Excess Benefit Plans and Stock Purchase Plans that should be exempt from the statutory trading prohibition of Section 306(a) and proposed Regulation BTR."
We understand that some non-U.S. issuers maintain employee benefit plans designed to accomplish the same general purposes as U.S. employee benefit plans that satisfy requirements of the Code "designed to ensure non-discriminatory treatment of plan participants" (we refer to such plans generally as "tax conditioned plans"). Tax conditioned plans maintained by non-U.S. issuers in other jurisdictions are typically approved by or established under rules of the local or national tax authority (such as "Save-As-You-Earn (SAYE) schemes" in the United Kingdom, at least some of which are substantially similar to stock purchase plans under Section 423 of the Code) or permitted under statutory provisions requiring that the plans be made available to a broadly-based group of employees.11 Furthermore, it appears that there is a trend towards broad-based stock participation plans around the world.12
Given the Commission's position that Section 306(a) has extraterritorial application, we recommend that non-U.S. issuers be afforded an exemption from Section 306(a) for transactions under employee benefit plans maintained in another country that are comparable to a U.S. tax conditioned plan. In light of the variety of approved non-U.S. arrangements and the likelihood of future legislation providing for new arrangements, we recommend that the Commission forego trying to compile a specific list of non-U.S. arrangements that would qualify as non-U.S. tax conditioned plans in favor of setting out an objective standard for the non-U.S. plan to meet in order to be treated as a tax conditioned plan. We suggest that the Commission should exempt from Section 306(a) transactions in plans sharing the characteristics of U.S. tax conditioned plans, that is, that the exemption should cover plans that are either approved by a foreign taxing authority or eligible for special treatment under foreign tax law because such plans are broad-based.
D. Proposed Regulation BTR Should Make It Easier to Determine When a Blackout Period Has Occurred
1. It should be clear that issuers aggregate participants and beneficiaries under each of their individual account plans (without regard to overlapping plan participation).
Many issuers have multiple individual account plans that will be subject to proposed Regulation BTR and in many cases individual employees will participate in more than one of these plans. Rule 100(b)(1) is not clear as to how to treat multiple plan participation in calculating whether a blackout has occurred. We believe that the most straight-forward approach is to permit issuers to calculate the aggregate number of participants and beneficiaries under each of their individual account plans, even if some individuals are counted more than once, and we suggest that the Commission confirm this approach.
We believe that aggregating the number of participants and beneficiaries under all individual account plans of an issuer (even if some individuals participate in more than one plan) is both consistent with the plain meaning of Section 306(a)(4)(A) and the most practical approach to the 50% test for two principal reasons. First, this approach would accurately reflect that the same individual may be subject to a blackout period under one individual account plan, but not another such plan in which he or she participates. Second, when calculating the number of participants and beneficiaries under all individual account plans, it would be administratively burdensome to require issuers to identify all individuals who may participate in or be beneficiaries of more than one individual account plan maintained by the issuer and to filter them out from any aggregate coverage data. Such filtering is not required for any current reporting purposes under ERISA nor is there any guidance as to how such filtering should be accomplished, e.g., whether the plan under which the participant should be counted is the one in which he or she has the largest balance, etc. For example, it is highly possible that individuals participating in deferred compensation arrangements would also participate in other individual account plans or that individuals transferring from one U.S. subsidiary to another during a year might participate in more than one plan during the year. Moreover, it is possible that the deferred compensation arrangement or one or more other plans would not be subject to a blackout period at the same time another individual account plan (or plans) of the issuer was subject to a blackout period.
Accordingly, we recommend that the Commission clarify that issuers must aggregate the total number of participants and beneficiaries under each of their individual account plans, even if some individuals are consequently counted more than once.
2. Issuers should be entitled to use readily available participant and beneficiary data for purposes of applying the 50% test.
The count of participants and beneficiaries to determine whether a blackout has occurred should be made by reference to data already required to be maintained for purposes of ERISA and compliance with the Code.
In particular, issuers should be permitted to rely on the participant and beneficiary census data required to be filed with the Department of Labor annually as part of the mandatory Form 5500 annual reporting requirement under ERISA.13 Item 7 of that Form requires specific counts of active, retired, and terminated plan participants who still have an unpaid account balance as well as of deceased participants whose beneficiaries are receiving benefits, as of the last day of each plan year. The signature section of Form 5500 requires a certification under penalties of perjury that that information is "true, correct, and complete" to the best of the knowledge of the individual signing the form. Issuers should be permitted to use data from item 7 of the most recently filed Form 5500 for each individual account plan required to file Form 5500, provided that they can make a determination that they have no reason to believe that there have been material changes in participation (such as admission of many new participants as a result of an acquisition or reduction due to a significant layoff or other event) since the date as of which the item 7 data is reported. (The small number of plans that are not required to file Form 5500 should be permitted to compile the same information as for item 7 as if they were a filer and use that data to the same extent as a filer.)
Those issuers that have a reason to believe there have been material changes since the reporting date for the Form 5500 data should be permitted to rely on participant and beneficiary data as of the most recent individual account plan entry date preceding the blackout commencement date. This date would typically be the first day of a month or of a calendar or plan quarter during the individual account plan's plan year. Neither ERISA nor the Code requires that participant and beneficiary data be updated on a daily basis, and no benefit would be derived by requiring issuers to update participant and beneficiary data solely in order to determine whether there has been a blackout for purposes of Section 306(a).
3. Customary ERISA documents should satisfy proposed Rule 102(a).
Proposed Rule 102(a) seeks to implement Section 306(a)(4)(B)(i)'s exclusion of "regularly scheduled" blackouts from the statutory trading prohibition. Specifically, proposed Rule 102(a) provides that issuers must furnish notice of a regularly scheduled blackout period (1) in the "documents or instruments under which the individual account plan operates" and (2) prior to, or within 30 days of enrollment or after the adoption of an amendment to an individual account plan.
Neither proposed Rule 102(a) nor the Release provides guidance as to which particular individual account plan documents or instruments will satisfy the first prong of the disclosure requirement. We recommend that the Commission revise proposed Rule 102(a) to confirm that disclosures that fulfill existing ERISA and Code requirements are sufficient to comply. In particular, we note that there are no ERISA or Code requirements to distribute actual plan documents to participants or to incorporate these rules in the individual account plan text. Instead, we believe that an ERISA Section 404(c)14 notice, any advance notice included in a summary plan description ("SPD") or any other official plan communication should be adequate disclosure of a regularly scheduled blackout period.15
Furthermore, we recommend that notice should be considered timely under proposed Rule 102(b) if the documents or instruments are provided at the time such disclosure is required by ERISA, even if ERISA does not require notice prior to, or within 30 days of enrollment or after the adoption of an amendment to an individual account plan.16 In addition, most issuers typically have procedures in place to deliver ERISA notices and the Department of Labor has issued comprehensive regulations on the permissible methods of disclosure.17 We suggest that if an issuer has reasonable procedures to insure compliance with ERISA and has followed such procedures so that notice has been widely disseminated to substantially all individual account plan participants and beneficiaries, the failure to reach a de minimis number of participants or beneficiaries should not result in a loss of the exception. We believe that by clarifying that ERISA disclosure of a regularly scheduled blackout period would be both sufficient in content and timely if delivered within the time frame permitted by ERISA, the Commission would (1) be consistent with the directive to consult with the Secretary of Labor in promulgating rules clarifying Section 306(a) and (2) avoid imposing unnecessary burdens on individual account plan sponsors by requiring special documents.18 If the Commission does not revise proposed Rule 102(a) to permit notices that are timely under ERISA, we recommend that individual account plans that have timely provided ERISA disclosure to current participants and beneficiaries should be grandfathered and proposed Rule 102(a) should apply to new participants and beneficiaries only. We believe that this approach would simplify and clarify compliance.
E. Proposed Exemptions From the Statutory Trading Prohibition
1. Equity securities acquired or disposed of in connection with a merger or acquisition should be exempt.
We believe that the Commission should exempt acquisitions and dispositions of equity securities by a director or executive officer resulting from a merger, acquisition, divestiture or similar transaction that occurs by operation of law. These transactions may result in a conversion of all of an insider's equity securities as part of a transaction affecting all equity security holders of the issuer, including those whose securities are subject to the blackout period. For example, if a merger closes during a blackout period, all equity securities of the issuer will be affected - including those held in the blacked-out individual account plans and those held by directors and executive officers. So long as the directors and executive officers are not permitted to sell their equity securities during the blackout, they will be in the same position as the employees who hold securities in individual account plans. However, if the conversion as a result of the merger were viewed as a prohibited transaction, any director and executive officer holding securities acquired in connection with service would be deemed to have violated Section 306(a) notwithstanding that the director or executive officer is in exactly the same position as all other employee and non-employee shareholders. We believe that subjecting directors and executive officers to liability in such a circumstance will not mitigate "the differential treatment between plan participants and beneficiaries and the directors and executive officers of the issuer with respect to such securities" and remedies which may extend to criminal liability are inappropriate.
We recommend that, for purposes of the statutory trading prohibition, the Commission ignore substitutions of a director's or executive officer's equity securities (including stock options) for cash or stock (or replacement stock options) to which substantially all of an issuer's equity security holders are subject and that occur upon the closing of a statutory merger, acquisition, divestiture or similar transaction that coincides with a blackout period.
2. Events not in the discretion of the insider or the issuer should be exempt.
The Commission requests comments on whether acquisitions or dispositions of equity securities resulting from involuntary events such as the death of a director or executive officer or pursuant to an order of a court or other judicial or administrative authority should be exempt from the statutory trading prohibition of Section 306(a). We recommend that an exemption be provided for these types of involuntary events, as well as other non-discretionary transactions pursuant to elections made at a time when the director or executive officer was unaware of an upcoming blackout.
Events such as death or court orders do not provide a director or executive officer any opportunity to evade the purposes of Section 306(a). Moreover, in the case of death or a court order, Section 306(a) could operate to deprive an estate of all of an insider's savings and a spouse of a substantial portion of his or her settlement. If these results were possible, persons subject to Section 306(a) would be well advised to limit their holdings of company equity securities at all times. It is clear that Section 306(a) was not intended to have any of these effects.
Rule 16b-5 of the Exchange Act exempts from Section 16(b) all equity securities acquired or disposed pursuant to death. Moreover, Rule 16a-12 of the Exchange Act exempts from Section 16 all equity securities acquired or disposed pursuant to a domestic relations order as defined in the Code or ERISA. The concept of excluding transactions that are not discretionary is expressed in footnote 68 of the Release, which refers to the fact that with respect to purchases and sales pursuant to Qualified Plans, Excess Benefit Plans, or Stock Purchase Plans, acquisitions and dispositions "of equity securities made in connection with death, disability, retirement or termination of employment or a transaction involving a diversification or distribution required by the Internal Revenue Code to be made available to plan participants would be exempt from . . . Section 306(a) . . . because these transactions are not discretionary transactions." We recommend that the Commission extend these basic concepts to proposed Regulation BTR.
We also recommend that the Commission exempt transactions under non-qualified deferred compensation arrangements that permit a director or executive officer to defer compensation through pre-determined, periodic and routine investments in issuer securities so long as the deferral election was made at a time when the director or executive officer was unaware of an upcoming blackout. While such elections are conceptually analogous to the affirmative defense provision of Rule 10b5-1(c) of the Exchange Act, the elections may not in all cases technically meet Rule 10b5-1(c)'s specific requirements. Because transactions pursuant to pre-determined elections are in essence "non-discretionary," they do not pose the same insider trading concerns that Section 306(a) and proposed Regulation BTR are aimed at prohibiting and, accordingly, we recommend that the Commission specifically exempt such transactions.
3. Employee stock option exercise transactions should be exempt.
The Commission requests comments on whether the closing of a derivative security position as a result of its exercise or conversion, and the acquisition of underlying securities at a fixed exercise price due to the exercise or conversion of a call equivalent position, should be exempt from Section 306(a). We believe that such exercises of derivative securities (which we refer to generally as "stock options") should be treated consistently with their treatment under Section 16 and, accordingly, exempt from the statutory trading prohibition of Section 306(a).19
For purposes of Section 16 of the Exchange Act, the exercise of most stock options is exempt from Section 16(b) pursuant to Rule 16b-6 of the Exchange Act. As discussed by the Commission in its release adopting Rule 16b-6 and other amendments (the "1991 Release"),20 "[t]he functional equivalence of derivative securities and their underlying equity securities for Section 16 purposes requires that the acquisition of the derivative security be deemed the significant event, not the exercise." Furthermore, the 1991 Release states that ". . .the exercise [of the derivative security] represents neither the acquisition nor the disposition of a right affording the opportunity to profit. . . ." For these reasons, the Commission concluded that an insider's market risk is not minimized if the stock option is exercised, but the underlying security is not sold - "[b]ecause the option holder already owns the right to purchase stock at a fixed price, his decision to actually exercise the option does not provide him the ability to earn insider profits. . . ."
We find the Commission's reasoning for exempting most exercises of stock options from Section 16(b) of the Exchange Act persuasive and believe that similar reasoning should be applied to exempt from Section 306(a) exercises of stock options similar to those exempt pursuant to Rule 16b-6 of the Exchange Act, - i.e., for purposes of Section 306(a), the date of grant of a stock option should be treated as the date the insider "purchases" the equity security and the date underlying equity security is sold as the date the insider "sells" the equity security. Consequently, the date the insider exercises the stock option would be a non-event for purposes of Section 306(a). Such treatment of insider stock options for purposes of Section 306(a) would be consistent with the concerns Section 306(a) is intended to address, namely the ". . . allegations that, at the time rank-and-file employees were precluded from selling their employer's equity securities . . corporate executives were exercising and cashing out their employee stock options. . ." (emphasis added).
We believe that limiting the exemption of stock option exercises to situations where the stock option would expire, mature or otherwise terminate during the blackout period would not be appropriate, as it would arbitrarily permit some exercises but not others. However, in no event should the exercise of stock options that would otherwise expire, mature or terminate during a blackout period be prohibited. The coincidence of involuntary events such as the expiration, maturity or termination of a stock option occurring at the same time as a blackout period does not present the concerns that Section 306(a) is intended to mitigate.
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We appreciate the opportunity to comment on the proposed rules relating to insider trades during pension fund blackout periods, and would be happy to discuss any questions the Commission may have with respect to this letter. Any questions about this letter may be directed to Max J. Schwartz (212-558-3936), Marc R. Trevino (212-558-4239), Carol I. Buckmann (212-558-3636), Bindu M. Culas (212-558-3979) or Parisa Samii (212-558-7347).
cc: Mark A. Borges
Elizabeth M. Murphy
Janet A. Walters