District Court Dismisses Shareholder Claim that Equity Award Share Withholding Triggers Section 16(b) Liability


A US District Court recently dismissed a claim that an insider’s election to satisfy an income tax obligation by having shares withheld from the delivery of an award constituted a non-exempt sale of shares back to the issuer for purposes of Section 16(b) of the Exchange Act, unless the share withholding was required, rather than merely permitted. While an encouraging development, this decision is now on appeal to the US Court of Appeals for the Fifth Circuit and there are similar unresolved complaints in other jurisdictions. Until this matter is resolved, public companies should continue to consider what steps are appropriate to avoid Section 16 exposure and to review this situation with their executive officers.

In Depth

Under Section 16(b) of the Securities Exchange Act of 1934, as amended, public company “insiders” are required to pay back to the company any “short-swing profits” (i.e., profits realized from the purchase and subsequent sale (or sale and subsequent purchase) of the company’s securities within a six-month period, absent an applicable exemption). For purposes of Section 16, a reporting company’s “insiders” include the company’s officers, directors and every person who, directly or indirectly, is the beneficial owner of more than 10 percent of a registered class of the company’s equity securities. Under SEC Rule 16b-3(e) (Rule 16b-3(e)), any disposition of shares by an insider back to the issuer is exempt from Section 16(b) (i.e., is not treated as a sale that can be matched with a purchase to trigger short-swing profits), so long as the terms of the disposition are approved in advance by the board of directors, the compensation committee of the board, or the shareholders.

The long-standing interpretation by the securities bar of Rule 16b-3(e) is that it applies to an insider’s election to have shares withheld to (1) pay income taxes associated with vesting of restricted stock, restricted units or stock appreciation rights, or (2) pay income taxes or the exercise price associated with the exercise of stock options. Simply put, public companies and insiders have consistently interpreted Rule 16b-3(e) to allow insiders to elect share withholding without triggering potential short-swing profits, so long as share withholding is permitted under the terms of the governing long-term incentive plan.

During the past several months, a shareholder has been submitting letters to public companies taking the position that, contrary to the customary interpretation, there is no exemption under Rule 16b-3(e) for elective share withholding by an insider. Under the shareholder’s interpretation of Rule 16b-3(e), an insider’s elective share withholding constitutes a non-exempt sale of shares back to the issuer for purposes of Section 16(b), unless the share withholding was required, and not merely permitted, under the terms of the governing long-term incentive plan. The shareholder’s interpretation would require elective share withholding by an insider to be matched with any non-exempt purchase made by the insider within six months of the share withholding, thereby triggering short-swing profits that the insider would need to repay to the issuer (as well as negative optics for the issuer).

On April 26, 2017, in JD Jordan v. Robert C. Flexton, et al, the US District Court for the Southern District of Texas dismissed a claim based on this unconventional interpretation of Rule 16b-3(e). The plaintiff sought disgorgement of insiders’ alleged short-swing profits arising from the insiders’ election to have shares withheld to satisfy income tax liability upon vesting of their restricted stock units. This withholding was permitted, but not required, by the governing long-term incentive plan. The court rejected the plaintiff’s argument that Rule 16b-3(e) does not apply to elective share withholding, essentially ratifying the customary interpretation of Rule 16b-3(e) that has been broadly relied on by public companies in administering long-term incentive plans and by insiders in buying and selling their employer’s securities.

This decision is an encouraging development towards the ultimate rejection of the plaintiff’s theory as to the scope of the Section 16 exemption for share withholding. However, this decision is on appeal to the Fifth Circuit, and similar cases are currently pending in other courts. It remains possible that other courts could reach a contrary conclusion, and that a plaintiff strike suit firm could file a complaint alleging a Section 16 violation if there is a non-exempt purchase within six months of discretionary share withholding.

Given the prevalence of elective share withholding provisions in public company long-term incentive plans, which are likely to increase due to recent, favorable accounting changes, public companies whose insiders engage in open market or other non-exempt purchases may find it prudent to consider one or more of the below actions to mitigate the risk of these types of claims:

  • Inform insiders of the risks of electing share withholding if they has been, or will be, a non-exempt purchase with six-months of a non- exempt purchase.
  • Consider whether it is appropriate to amend your equity plan and/or outstanding equity award agreements so that shares are automatically withheld to satisfy income tax liability and pay stock option exercise prices under certain circumstances. If automatic share withholding for taxes does not apply, it may be appropriate to have the board of directors or compensation committee approve specific share withholding requests.

Confirm that relevant document substantiates that the board or compensation committee approved any share withholding. For example, if an equity plan permits share withholding to the extent share withholding is permitted under an individual award agreement, confirm that the form of award agreement approved by the board or compensation committee specifically allows share withholding. Similarly, if an equity plan or individual award agreement permits the company to prevent a participant from electing share withholding, memorialize that only the board of directors or compensation committee may exercise that discretion (e.g., in the minutes of a compensation committee meeting). This will refute claims that management controls an insider’s ability to elect share withholding.