Given the hubbub over the SEC’s new EDGAR Next, I thought it would be useful to provide a FAQ explaining the rationale for Section 16 to a new director or officer who is unfamiliar with the concept.
1. What’s the primary purpose?
The purpose goes all the way back to 1934 in the wake of the Great Depression. Congress included this provision in the Securities Exchange Act of 1934 – which also created the SEC – to try to minimize advantages that senior officers and directors had when they traded in their own company’s stock.
Back then, trading on material nonpublic information – “insider trading” – was rampant. Section 16 requires these insiders to “disgorge” any profit they made trading in their own company’s stock if they had a “short-swing transaction” – which was defined in Section 16 as a purchase and trade that took place within a period of six months. To keep track of these insider transactions, Section 16 required insiders to report their trades to the SEC in “Section 16 filings” (which are Forms 3, 4 and 5).
2. What’s the other incidental purpose?
Over the past few decades, an incidental purpose arose from Section 16 filings. When insiders buy or sell stock in their own company, some investors divine that as a signal as to whether that insider is bullish or not about that company’s prospects.
3. How are Section 16 filings made?
Even though these Section 16 filings are the responsibility of the actual insiders, companies essentially always make these filings on behalf of their own insiders. This is because the deadlines under Section 16(a) are quite short – often two business days – and insiders are busy people who don’t have experience with making SEC filings.
4. Are Section 16 filings easy to make?
For those with experience, most of the Section 16 filings are simple and easy to make. But “purchases” and “sales” are broadly defined, and sometimes determining whether a filing is required can be quite convoluted. There is a cottage industry with only a handful of true experts in this area to flesh out these tricky situations.
5. Why is Section 16 dangerous?
When enacting Section 16, Congress did something novel in the securities laws by allowing private actions to serve as the de facto enforcement mechanism of this law. Oddly enough, a mere handful of plaintiff lawyers who bring private lawsuits in this area drive the bus.
Section 16(b) allows any lawyer to bring a lawsuit against an insider – on behalf of a shareholder with a nominal holding of stock in the company – if the insider engages in a short-swing transaction.
6. Why do plaintiff lawyers specialize in this area?
They can earn a sizable lawyer’s fee under this ambulance-chasing framework. Once a Section 16 filing is made with the SEC, these lawyers review them right away to see if there might be a case to be brought.
Under Section 16(b), liability is strict and absolute – so it doesn’t make any difference if the insider engaged in the short-swing transaction innocently or inadvertently. It also doesn’t matter if there wasn’t any material inside information known at the time of the transaction. And these plaintiff lawyers sometimes try novel legal theories to broaden their terrain.
Authored by
Broc Romanek