Section 16 of the Securities Exchange Act of 1934 requires a public company’s officers, directors and holders of more than 10% of any class of equity security (“company insiders”) to report their transactions in such company’s securities to the Securities and Exchange Commission (“SEC”). To do this, company insiders must file what are known as Forms 3, 4, and 5. The following article provides a brief overview of insider filing requirements and the consequences of failing to do so.
Section 16 of the Securities Exchange Act of 1934
Section 16 of the Exchange Act is intended to deter company insiders from utilizing their company’s nonpublic information for personal financial gain through buying and selling securities based on this insider knowledge. In other words, Section 16 was drafted to prevent insider trading. Section 16 employs two methods to attempt to prevent insider trading. First, section 16(a) generally restricts insider-trading activities by requiring public disclosure of officer, director, and insider trades. If these individuals fail to abide by Section 16(a), then the SEC has the authority to impose administrative and criminal sanctions. Second, Section 16(b) restricts short-term trading in the issuer’s stock by insiders subject to the 16(a) filing requirements. Section 16(b) deters insider-trading through the equitable remedy of disgorgement, permitting recovery of any profits realized by the insiders on acquisitions and dispositions of securities that take place within a six-month period.
Reporting Requirements for Insider Trades
Insiders of public companies must file reports of acquisitions or dispositions of company securities, generally on a Form 4. “Acquisitions and dispositions” include, but are not limited to, any change of ownership, open market and privately negotiated purchases and sales, repricings of stock options, stock option exercises and conversions of convertible securities, grants of restricted stock and stock options, and cancellations of stock options or restricted stock in conjunction with regrants. Unless otherwise stated by the SEC, these reports must be filed no later than two business days following a transaction.
The disclosure filing requirements under Section 16(a) are intended to cover all equity securities beneficially owned either directly by the insider or indirectly through others. These filings are usually done electronically via the SEC’s EDGAR (Electronic Data Gathering, Analysis, and Retrieval) system. Entities subject to reporting include equity securities of the company beneficially owned through partnerships, corporations, trusts, estates and family members. An insider is presumed to be the beneficial owner of securities held by such insider’s spouse and other family members sharing the insider’s home. Transactions involving shares in which a reporting person has no direct or indirect pecuniary interest do not need to be reported.
It should be noted that the SEC no longer accepts paper filings of Forms 3, 4, and 5, except in rare cases. To file electronically, you must obtain EDGAR access codes by completing and submitting SEC Form ID. Reports filed late will trigger the Item 405 disclosure in your company’s proxy statement and Form 10-K, plus the risk of SEC enforcement actions for ongoing violations.
Form 3. The initial filing is on Form 3. When a person becomes an insider they must file a Form 3 to initially disclose his or her ownership of the company’s securities. Form 3 must be filed within ten days after the person becomes an insider.
Form 4. In most cases, when an insider executes a transaction, he or she must file a Form 4. With this form filing, the public is made aware of the insider’s various transactions in company securities, including the amount purchased or sold and the price per share. As previously stated, Form 4 must be filed within two business days following the transaction date. Transactions in a company’s common stock as well as derivative securities, such as options, warrants, and convertible securities, are reported on the form. Each transaction is coded to indicate the nature of the transaction. Changes in ownership are reported on Form 4 and must be reported to the SEC within two business days.
Form 5. A Form 5 is only required from an insider when at least one transaction was not reported during the year. Form 5 is filed to report any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting. For example, some transactions, such as certain purchases by an insider of less than $10,000 in a six-month period, don’t have to be reported on Form 4 when they occur but do have to be reported on Form 5. The Form 5 filing doesn’t have to disclose transactions that have been previously reported. When reporting transactions on Form 5, insiders use the same transaction codes as when reporting on Form 4. It is due within 45 days after the end of the company’s fiscal year.
Form 144. This form must be filed by anyone, insider or otherwise, intending to sell restricted, unregistered securities. The form provides notice of intent to sell more than 500 shares or $10,000 worth of securities within the next 90 days. However, since the form only provides for the intent to complete the sale, it does not obligate the seller follow through with the transaction. Restricted securities are usually provided as part of an executive’s compensation package or exchange for seed capital. Such securities are generally unregistered, meaning the SEC has not approved the shares for sale on the open market. Filing a Form 144 is part of the process of removing this restriction. It must be filed on or before the actual sale date, but does not show the actual transaction. When the security is actually sold, a Form 4 must be filed with the SEC. In practice, Form 144 and Form 4 are often filed at the same time.
Section 16(b) of the 1934 Act provides that, a company insider engages in a purchase and sale of equity securities of such issuer within a period of less than six months, then any profit realized by the insider as a result of the two transactions must be disgorged to the issuer upon demand by the issuer or by any security holder of the issuer. The amount of the profit is calculated by multiplying the difference between the sale and purchase prices by the number of shares sold.
The SEC has no enforcement authority under Section 16(b). Thus, this recovery is not something that the SEC seeks on behalf of shareholders. Rather, class action law firms monitor trading by groups and 10% shareholders through the Forms 4 and 5 filings. The law firms then file lawsuits to recover on behalf of the issuer, and take a substantial portion of the recovery in legal fees. Section 16 imposes strict liability, which means that short-swing profits must be returned even if the insider that obtained them engaged in no wrongdoing.