SULLIVAN & CROMWELL
TELEPHONE: 1-212-558-4000
FACSIMILE: 1-212-558-3588
WWW.SULLCROM.COM
125 Broad Street
New York, NY 10004-2498
LOS ANGELES | PALO ALTO | WASHINGTON, D.C.
FRANKFURT | LONDON | PARIS
BEIJING | HONG KONG | TOKYO
MELBOURNE
June 24, 2002
Jonathan G. Katz, Secretary,
Securities and Exchange Commission,
450 Fifth Street, N.W.,
Washington, D.C. 20549-0609.
| Re: | Proposed Form 8-K Disclosure of Certain Management Transactions - File No. S7-09-02 |
Dear Mr. Katz:
We are pleased to submit this letter in response to the Commission's request for comments on its proposal to require most U.S. issuers to submit current reports on Form 8-K about certain transactions involving their directors and executive officers, as contained in Release No. 34-45742 (the "Release").
Summary
We understand that the Commission is proposing to require current reporting by issuers of insider transaction information because it believes that such disclosure would provide timely information to investors regarding management's views of company performance and prospects. However, as more fully explained below, we respectfully suggest that a detailed disclosure regime like the one proposed would be extremely difficult to comply with and would provide more information than is needed to serve the identified goals. A much simpler disclosure regime, focused on the decision by an insider to purchase or sell securities, would in our view serve the same goals just as well and, moreover, would be far less burdensome. If the Commission nevertheless requires issuer reporting of Section 16-like information as proposed, we respectfully suggest that it require all reportable transactions, other than those that are truly de minimis, to be filed not later than the close of business on the last business day of the week following the week in which the event occurred. Such a universal "next-week" reporting deadline would provide an issuer with sufficient time and flexibility to ensure that its reports are accurate while still serving the goals that the Release identifies. Moreover, the simplicity of a single, predictable deadline, as opposed to the three reporting periods set forth in the Commission's proposal, will aid in compliance and administration of reporting obligations.
We also offer several comments on specific aspects of the proposed rules. In particular, we respectfully suggest that if any final rules require issuers to report Section 16-like information, then Item 10 and Section 16 reporting requirements should be harmonized to the greatest extent possible. Similarity between the two schemes is desirable as it would be likely to lessen confusion among issuers, directors and officers, and the investing public. It also would ease comparisons of the two types of reports by investors and other readers. We also respectfully suggest that, as Section 16 contains its own comprehensive liability scheme and as issuers will have to rely, to a large extent, upon disclosures by their officers and directors in making the proposed reports, any final rules requiring the reporting by issuers of Section 16-like information should make clear that the Item 10 issuer reporting requirement does not impose any independent liability for such reports. We also suggest that, in light of the need for issuers that are largely unfamiliar with Section 16 reporting practices to develop procedures to ensure proper capture and reporting of insider transactions, and the importance of procedures in satisfying any safe harbor from liability that the Commission may establish, effectiveness of any new rules requiring Section 16-like disclosure of issuers be phased in more gradually than proposed.
Nature and Timing of Reports
Issuers should not be required to report Section 16-type information. As recognized in the Release, much of the information that issuers would be required to report with respect to the transactions involving their directors and executive officers is already required to be reported by those same insiders under Section 16 of the Exchange Act. The Release explains that the Commission is proposing to require issuer reporting of insider transactions information on a current basis in addition to the Section 16 reports by the insiders themselves in part because it believes that reports under Section 16 are not sufficiently timely, and also because current disclosure of insider transaction information would enable investors to make investment and voting decisions on a more current and better informed basis, would provide timely information regarding management's views of company performance and prospects and, through the electronic filing requirement, would ensure wider public dissemination of this information.
We recognize that many people have supported these objectives, but we question some of the benefits that are foreseen from the new regime as compared with the costs and difficulties to issuers, as well as reporting insiders, in complying with these new requirements. In particular, we question whether the information would provide insight into management's views of company performance and prospects. Our understanding has always been that Section 16 reporting was designed to inform shareholders and the public about insiders' transactions, but Section 16 reports are a crude tool for informing the trading markets about management's views on the issuer's prospects. The Release cites articles that indicate insider trading is, at best, an imprecise ground on which to base a rational trading strategy. We similarly do not believe that insider trading, by itself, serves as an accurate indicator of an insider's true estimation of the issuer's prospects, although we agree that it may be a useful device for evaluating public statements by insiders that are at variance with their personal trading. We are also concerned that the volume of transaction information that would be reported under the regime proposed by the Commission would be likely to result in widespread investor confusion and cynicism as analysts ponder the true significance of the information.
Our understanding of the true purpose of Section 16, however, has always been that it was intended to discourage insider "short-swing" trading by subjecting it to profit recapture, and the reporting requirements were designed to enhance enforcement of recapture by giving the public the means to determine whether liability exists. The rules and regulations governing Section 16 reporting have been carefully developed over the years, and as a result Section 16 reporting today has become a complex, comprehensive system that reports primarily particular transaction details that are relevant to profit recapture. As long as insider trading is subject to profit recapture under Section 16, the reporting requirements with respect to such trading should require enough transaction detail to enable potential profit recapture to be assessed, but also allow persons that are required to file reports enough time to gather and report the relevant information accurately. We believe that current Section 16 reporting practices and the timing requirements for the filing of Section 16 reports generally strike the appropriate balance between the complexity of the required disclosures and the purpose of subjecting insider trades to public scrutiny.1
Assuming that the Commission believes that insider decisions to buy or sell company equity securities are so important to investors that they should be disclosed on a current basis, it should be adequate to disclose only that an insider has entered an order to purchase or sell such securities without adding the detailed Section 16-like information, such as per share acquisition or disposition prices and the aggregate value of transactions. A simpler disclosure scheme such as this, focused solely on decisions by insiders to purchase or sell, would enable investors to obtain the core information that the Commission believes they need, while issuers and reporting persons would have a much easier time complying with their new insider transaction filing obligation. The details of particular insider trades would still be reported in Section 16 filings made in the normal course. Thus, there would be no effect on the ability to enforce the profit recapture rule.
In any event, two business days is not adequate time to prepare and file reports. While we believe that issuers generally could meet an accelerated reporting requirement if the Commission were to simplify the requirements as we have suggested above, we believe that a requirement of two-day reporting of Section 16-like information would be extremely difficult for issuers and insiders to meet with consistency and does not sufficiently account for the complexity of current Section 16 reporting. Much of the information about particular transactions simply is not reasonably available within two business days of a trade. Moreover, complex legal determinations often have to be made relating, for example, to "pecuniary interest," "deputized" directors or derivative securities. Whenever groups of related persons need to consider filing together, further complexity enters into the legal determinations of what should be reported. Indeed, certain information is not even available to trading persons - for example, the exact price and quantity of securities purchased or sold on a particular day as a result of a limit order placed with a broker - within sufficient time to be reported within two business days.
In addition to sharing the same burdens faced by Section 16 reporting persons, issuers will face the additional practical difficulties associated with filing the proposed Form 8-K reports electronically in EDGAR format.2 In general, at least one full business day is needed in order to produce an EDGAR draft document, review and proofread that draft for coding information and content, make any necessary changes and electronically file the document with the Commission. This is true whether the EDGAR document is prepared by the issuer itself or by a financial printer or other outside contractor. In light of these difficulties, although we believe that it may be possible to collect the information required to be reported by Section 16 for some insider transactions within two days, we are not confident that any class of insider transactions could be reported consistently on the EDGAR system within two business days.
We also believe that the existence of different reporting deadlines for different kinds of insider transactions as the proposal contemplates is likely to cause confusion among both reporting companies and readers of reports. A single reporting deadline would promote the development of reporting procedures and would lessen the issuer's and the reporting person's compliance burden by ensuring that issuers need not wait on particular details of transaction information (such as aggregate value) in order to determine the reporting deadline for that transaction. Issuers also would have a greater ability to consolidate several insider transactions into one report, which would likely reduce the overall time needed to be spent by the issuer in preparing reports and might enhance the ability of readers to compare the trades of all of the insiders of a particular issuer.
If the Commission nevertheless decides that the reporting process has to be accelerated, we would respectfully suggest that the Commission require a single next-week reporting deadline for all transactions required to be reported, although on a slightly longer "next-week" reporting period than proposed in the Release. Instead of reports being due not later than the close of business on the second business day of the week following the week in which the transaction occurred, we would suggest that issuers be given until the end of the following week. Based upon our experience, this period would be the shortest one that could reasonably be imposed while still allowing issuers sufficient time to collect, process and report Section 16-like information in the normal course. If the Commission were to adopt this "next-week" reporting, even the transactions that would be eligible for deferred reporting under the Commission's proposal (i.e., de minimis transactions) could possibly be reported on this basis.
Conforming Item 10 and Form 4 Requirements
If the Commission decides to require issuers to report Section 16-like information as proposed in the Release, we respectfully suggest that the reporting requirements of Item 10 and Section 16 should be harmonized to the greatest extent possible. This would mean that the list of transactions, the transaction details reportable and the list of persons whose transactions are covered by Item 10 of Form 8-K should essentially replicate those covered by Section 16 and Forms 3, 4 and 5 reporting.
We appreciate that many of the proposed Item 10 reporting exclusions are similar to exclusions from Section 16 reporting that the Commission has made by rule, including, for example, receipt of stock dividends, acquisitions pursuant to broad-based dividend reinvestment plans and tax-conditioned employee benefit plans, transactions pursuant to domestic relations orders and transfers by will or the laws of descent and distribution. However, the proposal also would exempt some categories of transactions required to be reported under Section 16 from reporting under Item 10 and, likewise, some transactions that would be required to be reported under Item 10 are exempt from Section 16. For example, transactions in derivative securities with a floating exercise price and awards of performance-based units would be required to be reported under Item 10 but are exempt from Section 16, whereas certain trust transactions by directors or executive officers required to be reported under Section 16 would be exempt under Item 10. Grants and awards of stock options, which for Section 16 purposes are generally eligible for deferred reporting on Form 5, would be required to be reported under Item 10.
The details about a transaction that must be reported under Item 10 also are not identical to those required in Form 4. For example, Form 4 requires the number of shares and the price per share but not the aggregate value of the transaction, which would be required in Item 10 reports. Form 4 reports employ transaction codes as opposed to the textual description of the nature of the transaction that would be required under Item 10. We would leave to the Commission whether Forms 3, 4 and 5 should be changed or Item 10 changed to make the reported information the same.
Similarly, with respect to the group of insiders whose transactions are subject to the two reporting schemes, Item 10 would rely upon the definition of executive officer set forth in Exchange Act Rule 3b-7, as opposed to the Rule 16a-1 definition of executive officer. We believe that the group of persons covered under Item 10 should essentially be coterminous with the group of Section 16 insiders,3 so that Item 10 should expressly include the principal accounting officer and the principal financial officer, as well as officers of parents and subsidiaries of the issuer who perform significant policy-making functions for the registrant.
Even though the Item 10 reports are designed to serve a different function than the Section 16 reports, we believe that, if the Item 10 reporting scheme sufficiently resembles Section 16 reporting, most reporting insiders and issuers will tend to assume that the reporting schemes are identical. Different requirements, then, will result only in a trap for the unwary - a trap that under the current proposal could have independent liability consequences for the issuer and/or reporting insiders. Insiders may well be confused as to what transactions are reportable in what way and on what form. Practitioners, investors and issuers who already are familiar with Section 16 reporting requirements may be similarly confused.
Harmonization of the two disclosure schemes will have the additional benefit of facilitating investor comprehension of Item 10 disclosures by easing comparison among Form 8-K reports and Section 16 reports. It also will make more practical the Commission's suggestion in the Release that officers and directors be permitted to satisfy their Section 16 reporting obligations by attaching a Form 4 to the issuer's Form 8-K reporting the same transactions and, conversely, that issuers be allowed to satisfy their Form 8-K reporting obligations by adding Form 8-K header information to an officer's or director's Form 4.
Application to Particular Transactions
Loans and Guarantees. The Release takes the position that it is important that insider loans and guarantees be disclosed because they can be a form of director and officer compensation. We agree that information about loans and guarantees in favor of insiders (and forgiveness thereof) can be important for investors in determining the compensation of directors and executives officers. However, we see no reason why loans and guarantees should be treated differently from other elements of compensation. Singling out loans for current disclosure on Form 8-K seems to be a piecemeal way of re-examining the content and timing of director and officer compensation and transaction disclosures now required to be reported under current rules in the company's Form 10-K and its definitive proxy statement for the annual meeting at which directors are elected, where such information is most relevant to investors. If the Commission believes that reporting about director and officer compensation generally is too stale under the current requirements, then we believe it should propose changes in the reporting of compensation generally, as part of a broader re-examination of director and officer compensation and transaction disclosures, perhaps including whether some information should be reported more frequently than on an annual basis.
The Release also suggests that the Commission believes that one particular type of insider loan - one secured by a pledge of the issuer's equity securities - can be of particular current interest to investors. But many insiders use the issuer's equity securities as collateral for loans that they have every intention of repaying, only because these securities often represent a major portion of their personal assets. We believe that only non-recourse loans secured by a pledge of issuer equity securities should be reported currently, and only to the extent that such a loan amounts to a sale under Section 16.4
Rule 10b5-1 Arrangements. We believe that the reporting of actual transactions effected under Rule 10b5-1 plans is sufficient for investors to assess the alignment between management's and shareholders' economic interests, the strength of the link between executive compensation and insiders' views of the issuer's prospects. Whatever marginal benefit there may be to disclosure about the existence, modification or termination of such a plan, we do not believe that it outweighs the risk that disclosure of the details of such plans could be used by others to manipulate or influence the market for such securities in advance of insider trades thereunder. In addition, the requirement to report the entry into a Rule 10b5-1 plan as well as any trade thereunder could lead investors to be confused by apparent double-reporting, unless the actual transactions under the plan were specifically identified as being entered into pursuant to a 10b5-1 plan. The proposed rule does not appear to require explicit identification of a purchase or sale of the issuer's equity securities as having been made pursuant to a plan, although issuers could do so in describing the nature of the transaction or in identifying other material information. Finally, we do not understand why disclosure of the counterparty or agent of a plan would serve the Commission's identified goals, and we are not sure why this information would otherwise be of importance to investors. At the very least, we believe that any final rule in this regard should contemplate counterparty or agent requests for confidentiality.
Derivatives. As we have suggested above, we believe that consistency in Item 10 and Section 16 reporting requirements is important to eliminate the possibility of confusion among reporting persons and investors, and to facilitate comparisons of issuer reports with Section 16 reports. Accordingly, we believe that the definition of "derivative security" in Rule 16a-1(c) should apply in full to the proposed issuer reporting requirements, including the exclusion for rights with an exercise or conversion privilege at a floating price. The exclusion (by interpretive letter) of performance-based units should also carry over to reporting by issuers.
We question whether information about collars or other hedges associated with insider's derivative transactions generally would serve the purposes of the proposed rules, in that it would not appear to be particularly useful in assessing the alignment between management's and shareholders' economic interests, or in signaling that any link between executive compensation and company equity securities performance has been severed. We are also concerned that there is a risk that disclosure of the material terms of a counterparty's trading activity, including hedges and collars in connection with the insider's derivative transactions, could reveal proprietary trading strategies. However, in the interests of lessening confusion by conforming Item 10 and Form 4 requirements as discussed above, we suggest that the release containing any final rules expressly provide that collars or other hedges associated with derivative transactions be disclosed only to the extent that they would have to be disclosed under current Section 16 reporting requirements.
As a technical matter, we note that the Commission has not yet amended its rules to reflect the addition of security-based swaps (which are not securities, pursuant to Exchange Act Section 3A) to the Section 16 reporting and profit recapture scheme, effected by the Commodity Futures Modernization Act of 2000. While the Commission states in the Release that reporting of security-based swaps will be required by Item 10, the proposed Instructions refer only to Rule 16a-1(c), which does not include such instruments in the definition of "derivative securities". We recommend that the Instructions be revised to expressly refer to security-based swap agreements and respectfully urge the Commission not to include these instruments, because they are not securities, in the definition of derivative securities.
Liability and Consequences of Late Filing
Liability. We respectfully urge the Commission to reconsider its proposal to consider Item 10 Forms 8-K as "filed" for purposes of liability under Exchange Act Section 18. If an issuer must "file" the information on Form 8-K, the report will be subject to liability under Section 18. The information also will be subject to automatic incorporation by reference into the issuer's Securities Act registration statements, which will be subject to liability under Sections 11 and 12(a)(2) of the Securities Act. Any underwriter would, of course, be subject to Section 11 liability as well. In addition to issuer and underwriter liability under Section 11, the seemingly odd possibility of cross-director liability for information about the transactions of another director would also exist.
We respectfully suggest that, in light of the fact that most of the information that issuers will be required to disclose will have to come from its directors and officers who would be required to report the information individually and would be subject to Section 16's own comprehensive liability scheme, Item 10 Form 8-K reports should not be considered "filed" unless the company specifically states that the information is to be considered "filed" (similar to Item 9 of Form 8-K for Regulation FD disclosures), and any final rules should make clear that there is no independent liability scheme created by the proposal to require issuers to disclosure Section 16-like information.5
Safe Harbor For Reporting Violations. We are encouraged by the Commission's proposal to include in the general instructions to any final rules a Commission finding that it is not in the public interest to impose any sanction on an issuer, notwithstanding a reporting violation, that is able to demonstrate that: (1) at the time of the violation, it had designed procedures and a system for applying such procedures sufficient to provide reasonable assurances that Item 10 events are timely reported; (2) at the time of the violation, it followed those procedures; and (3) as promptly as reasonably practicable, it made a filing to correct any violation.
However, we believe that framing this safe harbor as an enforcement policy does not provide strong enough protection to be of real benefit to issuers. Instead, this concept should be set forth in any final rules as an explicit safe harbor, one that expressly provides that if an issuer has and follows reasonable procedures for reporting of Item 10 events (and corrects any violations promptly), then that issuer will not in any way be subject to sanction in connection with the reports or late filing thereof, including freedom from any liability under Section 18 of the Exchange Act and Sections 11 and 12(a)(2) under the Securities Act. As the Release points out, granting safe harbor protection for the issuer would not limit the Commission's ability to proceed against any director or executive officer for such person's reporting violation.
Consequences of Late Filing. We strongly support the Commission's proposal to amend the applicable registration statement form instructions and Securities Act Rule 144 so that any Item 10 Form 8-K delinquency would not affect an issuer's short-form eligibility or the issuer's current reporting status under Rule 144(c).
Effectiveness of Rules
If the Commission adopts final rules requiring issuers to disclose Section 16-like information, we suggest effectiveness of those rules be delayed for at least 180 days for all reportable transactions, while encouraging earlier compliance as a best practice during those 180 days. It is our belief that issuers (especially smaller ones) are generally not used to dealing with Section 16-like information, at least not on a regular basis. In many cases, issuers will have to develop ab initio procedures for ensuring appropriate data collection and compliance with the proposed rule. Until issuers begin the process, it will be difficult to assess the extent to which issuers may be able to make use of existing procedures, what additional resources they will have to devote and what additional costs they will have to incur in order to compile and report the required information and convert it into electronic format for filing. Therefore, we believe that a delay of 180 days would be necessary, in many cases, and desirable in all others, to ensure that issuers have sufficient time to develop reporting procedures that are adequate to ensure the collection of relevant data and that they can consistently report the required information on a current basis as well as to collect any information that they may need regarding outstanding 10b5-1 arrangements, loans and guarantees (which the proposal indicates the issuer will have to report shortly after the proposed effective date). We believe that it is particularly important to give registrants enough time to develop adequate procedures in light of the Commission's stated enforcement policy.
Alternatively, the Commission could require a shorter deadline, perhaps 120 days, with respect to officer transactions and allow the longer, 180-day phase-in period with respect to directors only. Issuers may well need the longer period in dealing with directors as some Boards may meet only on a quarterly basis, or every other month. It may take several Board meetings to fully discuss compliance procedures, to educate directors about the requirements and to secure their agreement to provide the necessary transactional information to the issuer upon the entry into a transaction.
Technical Suggestion Concerning Foreign Private Issuers
It is clear that the proposal is not intended to apply to foreign private issuers even if they have equity securities registered under Section 12, as only domestic issuers are required to file Form 8-K reports as per Exchange Act Rule 13a-11(b). This is consistent with the Exchange Act Rule 3a12-3(b) exemption from Section 16 with regard to the securities of foreign private issuers. Nevertheless, we believe that it would be helpful if the release containing any final rules included an express statement that the issuer reporting of insider transactions scheme only applies to U.S. issuers.
* * *
We appreciate this opportunity to comment on the Commission's proposal to require Form 8-K disclosure of certain management transactions, and would be happy to discuss any questions the Commission may have with respect to this letter. Any such questions may be directed to John T. Bostelman (212-558-3840) or Richard R. Howe (212-558-3612) in our New York office or to Eric J. Kadel, Jr. (202-956-7640) in our Washington office.
Very truly yours,
SULLIVAN & CROMWELL
Endnotes
| 1 | However, we would also note one change in the Section 16 requirements that would better serve the purpose of informing the markets on a reasonably current basis. In particular, reporting of insider transactions that are eligible for deferred reporting on Form 5 because they are exempt from profit recapture, such as transactions with the issuer, could be changed so that these reports are filed more currently. We would suggest that the Commission require reporting on Form 4 of all reportable transactions other than those that are truly de minimis. We do not believe that additional notice and comment rulemaking would be required for the Commission to amend Form 5 in this manner. |
| 2 | If the Commission believes that electronic filing of Section 16 reports is important to ensure widespread public dissemination of the information, it could, as it has indicated that it intends to do, require Section 16 reports to be filed electronically. We believe that such action should be taken by subsequent notice and comment rulemaking, as there are many issues (not the least of which would be the prospect of providing filing numbers for each Section 16 reporter) that the Commission would have to address in connection with such a requirement. |
| 3 | We agree that more than 10% beneficial owners who are subject to Section 16 reporting should not be covered by the proposed rule for the reasons stated in the proposing Release (i.e., the issuer has no control over such persons, and they may even be adverse to the issuer). |
| 4 | As suggested above in footnote 1 and the accompanying text, we also would support the Commission requiring monthly reporting of these non-recourse secured loan transactions on Form 4. |
| 5 | We appreciate the Commission's acknowledgement that, as with other alleged Section 13(a) violations, there would be no private right of action against the issuer for its failure to timely file a required Form 8-K report. |