Securities Exchange Act of 1934 — Section 16

December 20, 1996

Response of the Office of Chief Counsel
Division of Corporation Finance

You have asked the Division's views regarding the following questions of general applicability with respect to the amendments to the rules under Section 16 of the Securities Exchange Act of 1934 (the "Exchange Act") adopted in Release No. 34-37260 (May 31, 1996) [61 FR 30376] (the "Adopting Release").

1. Non-Employee Directors. For purposes of determining whether a director satisfies the tests for Non-Employee Director status set forth in Rules 16b-3(b)(3)(i)(B), (C) and (D), the issuer generally may rely on the Regulation S-K Item 404 disclosure with respect to the issuer's most recently completed fiscal year set forth in the disclosure document most recently filed with the Commission in which Item 404 disclosure is presented (the "filing").

Where a transaction or relationship disclosed in the filing (including a transaction or relationship that occurred before the issuer's initial public offering) was terminated before the director's proposed service as a Non-Employee Director, such transaction or relationship will not bar the director from acting as a Non-Employee Director.

However, because the Rule 16b-3(b)(3)(i) tests envision compliance at the time the director votes to approve a transaction, the issuer may rely on the positions stated above only where the issuer in good faith believes that any current or contemplated transaction or relationship with such director will not require disclosure under Items 404(a) and (b), respectively, based on information readily available to the issuer and the director at the time such director proposes to act as a Non-Employee Director. In making this determination, the issuer may rely on information obtained from the director, for example, pursuant to a response to an inquiry.

At such time as the issuer in good faith believes, based on information readily available, that a current (or currently contemplated) transaction or relationship with a director will require Item 404(a) or (b) disclosure in a future filing, such director no longer will be eligible to serve as a Non-Employee Director. However, a determination that a director no longer is eligible to serve as a Non-Employee Director will not result in the retroactive loss of a Rule 16b-3(d)(1) or 16b-3(e) exemption with respect to a transaction previously approved by such director while serving as a Non-Employee Director in reliance on the interpretation set forth above.

Issuers are reminded of n. 75 of the Adopting Release, which states, in pertinent part, that "[f]or purposes of the definition of "Non-Employee Director," each test that refers to S-K Item 404 will be measured by reference to the Regulation S-K disclosure Item, whether the disclosure requirements applicable to the issuer are governed by Regulation S-K or S-B."

2. Scope of Discretionary Transaction Definition: Cash Settlement of Derivative Securities.

The Division is of the view that the cash settlement of a derivative security is not a Discretionary Transaction, as defined in Rule 16b-3(b)(1), where the derivative security is not held in a multi-fund plan that permits fund switching. Such transactions include:

1. Cash settlement of a stock option;
    
2. Cash settlement of a stock appreciation right; and
    
3. Cash settlement of a phantom stock right.

Accordingly, the disposition to the issuer in return for cash that occurs pursuant to these transactions is eligible for exemption pursuant to Rule 16b-3(e) and need not satisfy the conditions of Rule 16b-3(f). In reaching this conclusion, the Division notes that the terms of such instruments contemplate cash settlement as a form of compensation and do not permit fund switching. Accordingly, their cash settlement pursuant to the terms of issuance does not present the potential for abuse that the conditions of Rule 16b-3(f) were designed to prevent.

In contrast, the cash-out of a derivative security, such as a phantom stock unit, held in a multi-fund plan that permits fund switching is a Discretionary Transaction. Further, a cash-out from an issuer stock fund, such as a common stock fund, will not be eligible for exemption pursuant to Rule 16b-3(e), but instead is a Discretionary Transaction eligible for exemption pursuant to Rule 16b-3(f), whether the plan is single-fund or multi-fund.¹

The following transactions do not involve the disposition of a derivative security subject to Section 16 of the Exchange Act: (1) a withdrawal of cash from an employee stock purchase plan before any equity security is purchased at the end of the purchase period; and (2) an election to take a bonus award in cash rather than stock (prior to the receipt of any award).

3. Scope of Discretionary Transaction Definition: Qualified Plans — The "Required to be Made Available" Requirement.

Rule 16b-3(b)(1)(iii) excludes from the definition of "Discretionary Transaction" a transaction that is required to be made available to a plan participant pursuant to a provision of the Internal Revenue Code (the "Code"). This exclusion applies to a distribution pursuant to a provision of a plan, qualified under Section 401(a) of the Code, that:

1. complies with Section 401(a)(9) of the Code;
    
2. permits distributions to commence in the year a participant reaches age 70 1/2 (rather than April 1 of the following year, as required by the Code), and/or allows participants to select a shorter distribution period than the maximum period required by the Code; and
    
3. applies equally to all plan participants.

4. Approval of Subsequent Transactions/Phantom Stock Reporting. Note 3 to Rule 16b-3 provides generally that the approval conditions of Rules 16b-3(d)(1), 16b-3(d)(2) and 16b-3(e) require the approval of each specific transaction. However, Note 3 states that initial approval of a plan in its entirety will be sufficiently specific where the terms of each transaction are fixed in advance. The Note also provides that where the terms of a subsequent transaction are provided for in a transaction as initially approved, the subsequent transaction will not require further specific approval. The Division is of the view that the specific approval standards of Note 3 to Rule 16b-3 and the reporting requirements of Section 16(a) will be satisfied as described below:

1. Cash Settlement of Derivative Securities. As stated in question 2 above, the disposition to the issuer that occurs upon cash settlement of stock options, stock appreciation rights and phantom stock rights is eligible for exemption under Rule 16b-3(e). The specific approval standards of Note 3 will be satisfied to exempt these transactions where:
    
1. the derivative securities are issued pursuant to terms that contemplate settlement in cash that is either non-volitional or upon exercise at the holder's discretion within a finite term;²
    
2. the derivative securities are issued upon terms that do not grant the plan participant discretion as to the number of derivative securities initially acquired;³ and
    
3. the disposition to the issuer of the derivative securities is pursuant to terms specified at the time of initial approval of the acquisition of the derivative securities in accordance with Rule 16b-3(d)(1) or (2).
    
2. Single Fund Deferral Plans. You have described a plan that defines a class of eligible participants (e.g., all non-employee directors or all employees above a certain salary grade) and permits such participants to elect to defer a specified portion (e.g., up to 100%) of their cash compensation in phantom stock units. The election is made before the year in which the compensation to be deferred will be paid. At the time or times the compensation otherwise would be paid, the participant instead receives a number of phantom stock units based on the then fair market value of the stock. The plan may provide that dividends will be credited in additional phantom stock units. At the time the participant elects to defer compensation, the participant also elects that all phantom stock units will be paid in cash or stock at a fixed date (including pursuant to an installment schedule specified by the plan) more than six months following the election. The phantom stock units also may be paid out automatically within a fixed interval of time specified by the plan following death, disability, retirement or termination of service, if any of such events occur before the fixed payout date elected by the participant.

The election to participate in such a plan is not an event subject to Section 16. Initial approval of the plan will satisfy the approval requirements of Rules 16b-3(d) and (e) to exempt (a) the acquisition of phantom stock units (including the crediting of dividends in additional phantom stock units) and (b) the subsequent payout on the fixed date elected by the participant or automatically pursuant to the terms of the plan, as described above.

However, dispositions resulting from the participant's subsequent election to change the fixed payout date or installment schedule, or to elect installment payments in lieu of a lump sum, would not be exempted by initial approval of the plan. Instead, such dispositions would require further specific approval in order to be exempted by Rule 16b-3(e).

3. Multi-Fund Deferral Plans. A plan permits participants to invest deferred amounts in one or more alternative investments as well as phantom stock units, and permits intra-plan transfers between phantom stock units and alternative investments. The same analysis as in paragraph (b) applies, except that payout on a fixed date elected by the participant will not be exempt under Rule 16b-3(e) pursuant to the initial approval of the plan unless the participant specifically agrees, at the time of the election to defer, that deferred funds invested in phantom stock units will not be eligible for intra-plan transfers out of the phantom stock units. Absent such a limitation, initial approval of the plan will not be sufficiently specific to exempt payout of the phantom stock units at a date elected by the participant.

Further, where a payout of the phantom stock units is a Discretionary Transaction, as defined by Rule 16b-3(b)(1), the transaction will need to satisfy the conditions of Rule 16b-3(f) in order to be exempt. In cases where the payout is neither a Discretionary Transaction nor exempted pursuant to initial plan approval as provided above, approval of the individual payout transaction will be necessary to satisfy the standards of Rule 16b-3(e) and Note 3 to Rule 16b-3.

4. Reporting. Exempt transactions in phantom stock units ("units") are reportable as follows:
    
1. The election to participate in a plan is not a transaction subject to Section 16, and accordingly is not reportable.
    
2. The acquisition date for the units would be the date on which the price is fixed and units are allocated to the participant's account where the units are not subject to any performance criteria (other than the passage of time and continued employment). Exempt acquisitions would be reported on Form 5. Pursuant to Instruction 4(a)(ii) to Forms 4 and 5, each transaction should be reported on a separate line. Transactions may not be reported on an aggregate basis.
    
3. The acquisition of units that are payable only in stock would be reportable on Table II. A payout in stock would be reported as the disposition of a unit on Table II and the acquisition of stock on Table I. A payout in stock is not a change in the form of beneficial ownership exempted by Rule 16a-13, but instead is the exercise of a derivative security, reportable on Form 4 pursuant to Rule 16a-3(f)(1)(i)(A).

However, where the units are settled automatically on a one-for-one basis in stock, the acquisition of the units alternatively may be reported on Form 5 the same way as an acquisition of restricted stock, i.e., as the acquisition of the underlying shares on Table I. Cf. Lincoln National Corporation (Mar. 20, 1992) Q.3.

4. The acquisition of units that are payable in cash or stock, or cash only, would be reportable on Table II. Settlement of such a unit would be the exercise of a derivative security. A payout in stock would be reported on Form 4 as the disposition of the unit on Table II and the acquisition of stock on Table I. A payout in cash would be reported on Form 4 as the simultaneous disposition of the unit on Table II, and acquisition and sale of the underlying stock on Table I.

5. Domestic Relations Orders. Rule 16a-12 exempts an acquisition or disposition of any equity security pursuant to a domestic relations order. The exemption is not limited to transfers of securities acquired under employee benefit plans that satisfy the standards of a "qualified domestic relations order," as defined under the Internal Revenue Code.

Because these positions are based on the representations made to the Division in your letter, it should be noted that any different facts or conditions might require a different conclusion.

Endnotes

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¹ This is the case whether or not the issuer stock also is a derivative security (for example, convertible preferred stock).

² The duration of the derivative security will be considered finite where it is a fixed term of years, or otherwise discernible at the time the award is initially approved, such as a term that is coextensive with employment.

³ Because deferral plans allow a plan participant such discretion, transactions pursuant to such plans must satisfy the conditions described in paragraphs (b) and (c) of this response to meet the specific approval standards of Note 3.

Incoming Letter:

The Incoming Letter is in Acrobat format.

http://www.sec.gov/divisions/corpfin/cf-noaction/aba122096-sec16.htm