SEC Enforcement Actions Regarding Section 16 Reporting Obligations

The following post comes to us from John P. Kelsh, partner in the Corporate and Securities group at Sidley Austin LLP, and is based on a Sidley Austin publication by Mr. Kelsh, Paul V. Gerlach, and Holly J. Gregory.

Last month, the SEC announced that it brought enforcement actions primarily relating to Section 16(a) under the Securities Exchange Act against 34 defendants. The defendants were 13 individuals who were or had been officers or directors of public companies, five individual investors, ten investment funds/advisers and six public companies.

This post briefly discusses several noteworthy points regarding this development and also discusses practical steps that companies could consider taking in response.

Observations Regarding Enforcement Actions

  • Section 16 is premised on the irreducible fact that insiders will always know more about their company than outsiders. The only absolute prohibition on insiders’ taking advantage of their knowledge about their company is Section 10(b) of the Exchange Act—insiders cannot trade on the basis of material, non-public information. Because this is a fairly high threshold, there are two other tools in the federal securities laws that regulate insiders’ trading activity in company stock: first, no short-swing profits under Section 16(b) of the Exchange Act, and second, real-time reporting of insider purchases and sales under Section 16(a) of the Exchange Act, which allows the market to monitor and even copy the insiders’ trading activity if they wish. The SEC vigorously enforces the prohibition on insider trading. The private securities bar vigorously enforces Section 16(b) short-swing profit recovery. And now, while Section 16(a) reporting has typically been viewed by insiders and companies as an exercise on how to correctly report a transaction on Form 4, this enforcement action can be seen as the SEC’s renewed appreciation that timely Section 16(a) reporting of insider transactions is an important component of regulating insiders’ trading activity.
  • This type of coordinated enforcement action regarding Section 16(a) reporting obligations has not been undertaken since at least the mid-1990s. Section 16(a)-based enforcement actions of any sort are rare, and when they are brought they tend to be brought in conjunction with other violations. In these cases, the enforcement proceedings were based primarily on matters relating to Section 16(a), although in some instances they also involved failures to comply with reporting obligations under Section 13(d) or (g).
  • Notwithstanding that Section 16(a) reporting obligations are personal to the officer, director or 10 percent holder subject to Section 16, six of these actions were brought against public companies. The enforcement actions against the companies were predicated on either or both of two theories. The first was that the companies had not included in their proxy statements the disclosure required by Item 405 regarding untimely Section 16(a) filings by a company’s officers or directors. The second was that the companies had, by taking on the obligation to assist their insiders in their filings but failing to do so in a competent way, caused the underlying violations by the officers/directors. These companies all paid fines of either $75,000 or $150,000.
  • A number of the individual officers/directors who were charged raised as a defense that the companies where they worked or served as a director had undertaken to assist them with their filings but had not done so properly. This was not recognized as a valid defense, with the SEC noting that the filing obligations are personal to the insider.
  • With one possible exception, these enforcement actions were not predicted on “foot faults.” The number of late or missed filings varied but was in each case somewhat substantial and in many cases numbered in the dozens. The one possible exception involved an individual defendant, chief accounting officer at his company, who had not been advised by the company that he was required to make Section 16 filings. This was a mistake given that the chief accounting officer is, by operation of Rule 16a-1(f), an “officer” for purposes of Section 16. This was not enough to deter the SEC from bringing an action against the individual (and the company). The individual paid a fine of $25,000 (the company paid a fine of $75,000).
  • Given that most of these fact patterns involved extensive failures to comply with reporting obligations under Section 16, we do not think that clients need to worry that this means that the SEC will deviate from its typical practice and begin to bring enforcement actions in the case of inadvertent and isolated reporting violations. It does serve as a reminder, however, that companies should take care to establish reliable systems for ensuring that information regarding equity transactions is captured and that the transactions are properly reported.

Practical Considerations

Errors with respect to Section 16(a) filings are common and, as noted above, we do not expect that last month’s enforcement actions foreshadow a new posture by the Enforcement Division regarding errors that are inadvertent and isolated. That being said, there are some steps that public companies can consider taking in response to this development. These include:

  • Confirm that the company has correctly identified all of its Section 16 officers and directors. The most common error in this regard is with respect to the chief accounting officer.
  • Ensure that there is coordination between the company and the various individuals, be they brokers, trust administrators or financial advisors, who in any way touch any of the equity securities held by a company’s Section 16 insiders.
  • Review the company’s equity compensation program and assess where in the life cycle of each award Section 16 reports will be required to be filed. Ensure that the team that assists with filings is aware in advance of when reports will be due. Be particularly mindful of vesting events related to restricted stock and restricted stock units. One of the public companies that was the subject of an enforcement action had more than 70 late filings relating to restricted stock units.
  • Ensure that there is coordination between the team that assists insiders with Section 16 filing obligations and the team that prepares the proxy statement. Ensure that someone on the proxy preparation team double checks the Item 405 disclosure (particularly when reporting “no untimely filings”) with the team, if different, that is responsible for Section 16 filings.
  • Review your D&O questionnaire to ensure that it includes an appropriate representation from directors and officers regarding their compliance with their Section 16 reporting obligations over the course of the year.
  • Use this as an opportunity for training officers and directors regarding their Section 16 reporting obligations.
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