Introduction

This article is designed to provide directors and officers with practical advice about the areas of securities law that most directly affect them personally. With that in mind, it is useful to refresh your understanding of the key terms listed below before turning to the discussion that begins on page 2.

Securities Jargon – Key Terms

Issuer: A company selling (or "issuing") securities.

Affiliates: Entities or individuals that an issuer (or a "reporting person," as the case may be) controls, is controlled by, or is under common control with. For example: a parent company and its sister/subsidiary companies, or an issuer and its directors/officers/principal shareholders.

Insider: A company’s directors, officers, principal shareholders, and individuals or entities who control the company’s policy. For the purposes of this article, the term "officer" includes the issuer’s president, principal financial officer, principal accounting officer (or controller), vice presidents in charge of business divisions or functions (such as sales, administration or finance), and others who perform policy-making functions, even if they do not have a title such as "Vice President."

Insider Information: The important buzz words are "material non-public information."

Insider Trading: Purchases and sales of securities by those who have access to "inside information" or information that is generally not available to those with whom they are dealing.

SEC or the Commission: The Securities and Exchange Commission – a federal agency charged with protecting investors and maintaining the integrity of the securities markets.

Securities Act: The Securities Act of 1933, as amended. Laws that govern the sale of securities, which together with the Exchange Act (below), were originally enacted to restore investor confidence after the stock market’s "Great Crash of 1929."

Exchange Act: The Securities Exchange Act of 1934, as amended. An equally formidable collection of rules and regulations governing issuers of securities, officers and directors, brokers, dealers, exchanges, quotation systems and other means through which securities are traded.

Registrant or Reporting Person: An entity or individual filing reports with SEC.

EDGAR: Catchy acronym for the Commission’s "Electronic Data Gathering, Analysis, and Retrieval" system, which performs automated collection, validation, indexing, acceptance, and forwarding of various electronic reports to the Commission. Accessible by the public, free of charge, via the Internet at: www.freeedgar.com.

Beneficial Ownership: Having the opportunity to, directly or indirectly, profit from or share in the profits resulting from transactions in a company’s equity or derivative securities. For example, an individual is deemed to "beneficially own" securities held in his or her own name, as well as those securities that are held in the name of his or her spouse (and in some cases, his or her children), a business that he or she owns, and securities held by a trust of which he or she is a beneficiary. May also mean the power to vote or the power to sell or otherwise dispose of the securities.

Short-Swing Profits: Profits derived from the purchase and sale (or sale and purchase) of any equity and derivative securities of a company by its insiders occurring within a six (6) month window (a "short-swing transaction"). Note that this period may be extended as discussed below.

Derivative Securities: Securities that are exercisable for, or convertible into, equity securities (such as warrants, options, convertible preferred stock, etc.)

SECTION 16

Section 16 of the Exchange Act is designed to control insider trading by requiring a company’s officers, directors and 10% shareholders to publicly report their transactions in the company’s equity and derivative securities and disgorge (or "forfeit") short-swing profits.

Reporting Obligations Under Section 16(a)

Under Section 16(a), insiders must file periodic reports on Forms 3, 4 and 5 with both the Commission and the applicable stock exchange (NYSE® or AMEX®) or automated quotation system (Nasdaq National Market® and The Nasdaq SmallCap Market^TM) via which the companies securities are publicly traded or quoted. These forms may be filed in either paper format (by mail) or electronic format (via EDGAR). Regardless of the filing method, once filed, all information disclosed in these forms becomes public, and anyone may access these reports, with no charge, via EDGAR and free Internet sites such as Yahoo!® Finance.

These periodic reports serve a dual purpose. First, they discourage high levels of insider trading by requiring public disclosure. Reporting allows the public (including bounty hunter attorneys who specialize in the recovery of short-swing profits under Section 16(b) discussed below) to police violations. Second, they provide current and potential investors with insight into insiders’ investment actions with respect to their own company's stock. Although officers and directors acquire or sell stock for many reasons, including portfolio diversification and tax reasons, purchases and sales by insiders may also reflect optimism or pessimism about the company's future prospects.

A brief summary description of Form 3, 4 and 5 and the applicable filing requirements follows. Generally, insiders should report all transactions, even if their beneficial ownership is uncertain (in which case the insider may expressly disclaim beneficial ownership by footnoting his or her responses) to avoid the potential for Section 16(a) violations and the resulting sanctions discussed below.

Form Types/Descriptions

FORM 3: Initial Statement of Beneficial Ownership

• Due on the effective date of the issuer’s initial public offering or within 10 days of becoming an insider.

• Used to report the amount of each class of equity security and derivative securities owned as of the date the company went public or as of the date that the insider became an insider.

• Filed only one time for each insider.

• 10% shareholders and all directors and officers must file, even if some individual officers or directors do not own any securities of the company.

FORM 4: Statement of Changes in Beneficial Ownership of Securities

• Due within 10 days of the end of each calendar month in which there are any changes in insiders’ beneficial ownership – unless such transactions are reportable on Form 5 on a deferred basis. (See below.)

• Used to report changes in insiders’ beneficial ownership, and must be filed even if there is no net change.

• Disclosure of certain transactions (such as stock purchases that meet specific "small acquisition" criteria) may be deferred and reported on "the next Form 4 or 5 otherwise required to be filed"; however, it is advisable to voluntarily report transactions sooner, rather than later, to avoid inadvertent violations.

• Generally, directors and officers are not required to report transactions that occur during the six (6) months immediately prior to becoming subject to these reporting requirements and following the termination of their status as a director or officer (with some exceptions).

• Ten percent (10%) beneficial owners who are not directors or officers are only required to report transactions that occurred while they beneficially owned ten percent (10%) or more of the company’s securities.

FORM 5: Annual Statement of Changes in Beneficial Ownership of Securities

• Due within 45 days of the end of the company’s fiscal year.

• Used by any person who was an insider at any time during the company’s fiscal year to report any transactions in the company’s securities that have not been previously reported on a Form 3 or Form 4.

• Not required of insiders who have no reportable transactions or if all reportable transactions have previously been reported.

Current versions of each of these forms may be downloaded free of charge from the Commission’s website at: http://www.sec.gov/divisions/corpfin/forms/exchange.shtm. However, it is highly advisable to consult your securities counsel for advice on completing these forms, as Section 16(a) contains numerous intricacies that are too complex to addresses in this article.

Unfortunately, there is no way to truly "remedy" an insider’s failure to file or delinquency in filing a required report. Nonetheless, a corrective report should be filed as soon as any Section 16(a) violation is discovered. Consequences for failing to timely file Forms 3, 4 and 5 may include:

Forfeiture of Short-Swing Profits Under Section 16(b)

Section 16(b) is the enforcement mechanism through which a company, or any of its shareholders may compel insiders to pay over to the company any short-swing profits that they derive as a result of certain transactions in the company’s securities that occur within a specified period. However, in most cases, Section 16(b) violations are policed by a small group of attorneys who review each Form 3, 4 or 5 filed and seek to "match" transactions that have occurred within six months. These attorneys receive a portion of the disgorged profits that they assist in recovering as their fee.

Insiders are "strictly liable" under Section 16(b), meaning that if they receive short-swing profits, they must forfeit them to the company upon demand – even if they did not intend to or knowingly violate the provisions of this section. Additionally, there is nothing that a company can do to "waive" this liability, and companies cannot indemnify insiders for violations of securities regulations. Furthermore, insiders are liable for short-swing profits even if they are not in possession of "material non-public information."

Short-swing profits from transactions involving either equity securities or derivative securities of the same type are based upon the difference between the purchase prices and sale prices of those securities. With respect to transactions involving a mix of equity securities and derivative securities, or different types of derivative securities, short-swing profits are calculated based upon the value of underlying securities, measured as of the purchase date and sale date.

Generally, short-swing profits are measured by matching insiders’ purchases and subsequent sales (or sales and subsequent purchases) over any six (6) month window; however, this time period may be extended to two (2) years for insiders who have not timely filed all required reports under Section 16(a) above.

Furthermore, courts maximize the dollar amounts that companies may recapture by matching the lowest purchase prices within the applicable time period to the highest sales prices within that same period (and vice versa for sales followed by purchases). Therefore, a company’s insiders who transact in its securities may literally encounter the proverbial "lose-lose" situation and be compelled to disgorge short-swing profits even though they have actually sustained a net loss.

Insider Trading

"Greed is good. Greed is right. Greed works. Greed cuts through, clarifies, and captures the essence of the evolutionary spirit…" – or so the opportunistic Gordon Gekko (played by Michael Douglas) in Oliver Stone’s 1987 classic movie Wall Street would have you believe. Whatever you own philosophical opinion of the Gordon Gekko’s of the world may be, be assured that the Securities and Exchange Commission sees things VERY differently.

Rule 10b-5 & the "Disclose or Abstain" Rule

Do you remember Wall Street’s overly-ambitious young cold-caller Bud Fox (played by Charlie Sheen) who buys Gekko’s favor by leaking information to Gekko about the business plans of and labor issues involving his father’s publicly-traded company, BlueStar Airlines? Under Rule 10b-5 of the Exchange Act, anyone possessing this type of "material nonpublic information" (or "inside information") that "might affect the judgment of reasonable investors" regarding an issuer or its securities must disclose the information to the investing public. Alternatively, if he or she cannot publicly disclose the inside information without revealing a corporate confidence or simply chooses not to do so, he or she must abstain from trading in the securities of the company for as long as that inside information remains nonpublic.

Additionally, he or she may not make any recommendations to others on the basis of this inside information (an unlawful practice known as "tipping"). Furthermore, if while serving as an agent of one company, an insider of that company learns inside information about a second publicly-held company, the insider is similarly prohibited from effecting transactions in the second company’s securities.

The Faustian Bargain’s High Price Tag

While the prospect of reaping a quick and easy fortune often looms as a powerful temptation, the criminal and civil penalties for insider trading are necessarily severe. To avoid being led out of their offices in handcuffs by the feds, insiders must absolutely refrain from trading on the basis of inside information – without exception. In addition to state and federal criminal penalties, various other statutes such as the Insider Trading and Securities Fraud Enforcement Act of 1988 (or "ITSFEA") also impose hefty civil fines.

For example, the ITSFEA provides that "controlling persons" who directly or indirectly control a person who participates in insider trading may also be held civilly liable for up to three (3) times the amount profit gained (or loss avoided) – up to $1 million for individuals and $2.5 million for entities. In this context, "controlling persons" include employers and those who have managerial or supervisory responsibilities, such as a company’s officers and directors). Under the ITSFEA, a controlling person is liable if her or she 1) knows or recklessly disregards facts that would lead a reasonable person to believe that a person within his or her control is likely to commit a violation; and 2) fails to take appropriate measures to prevent him or her from committing the illegal act.

While the Commission’s efforts to protect the investing public are certainly understandable, these restrictions on directors and officers – many of whom receive a substantial portion of their compensation in the form of equity – can be especially problematic for insiders who wish to diversify their equity positions. Because SEC Rules broadly define trading "on the basis of" material non-public information as simply possessing any such insider information at the time a trade takes place, a company’s management might always be in possession of insider information and thus never be able to sell.

In an effort to alleviate this problem and in connection with the adoption of Regulation FD, effective October 23, 2000, the Commission adopted new rules regarding insider trading. These new rules provide an exemption to the insider trading rules designed to cover specific situations in which an insider can clearly demonstrate that the material nonpublic information was not a factor in his or her trading decision.

In order to rely on this exemption, prior to becoming aware of the insider information, the insider must have either: i) entered into a binding contract to buy or sell the security; (ii) instructed another person to purchase or sell the security for the instructing person’s account; or (iii) adopted a written plan for trading securities that meets the criteria outlined in the rules. The written plan under (iii) above must specify the amount of securities to be purchased or sold and the price at which they are to be sold; or include a formula for determining the amount of securities to be bought or sold, the price at which they are to be bought or sold, and the date upon which they are to be bought or sold; or not permit the insider to exercise any control over the purchase or sale while that person is in possession of nonpublic information.

The intent of these new rules is to provide appropriate flexibility to those who would like to plan securities transactions in advance at a time when they are not aware of material nonpublic information, and allow them to carry out those pre-planned transactions at a later time, even if they later become aware of material nonpublic information.

Members of the Board of Directors of a public company live in a fishbowl. Securities laws require disclosure of information that many people would prefer remain private. Section 14 of the Exchange Act is a intricate set of rules and regulations governing communications with shareholders. In particular, Section 14 lays out the rules and regulations regarding the form and information that must be provided to shareholders in connection with a company’s annual meeting and actions requiring shareholder approval.

Among other things, the company’s proxy statement (or "Schedule 14A") must fully disclose the following information about the company’s directors and officers: their individual interest regarding matter(s) to be considered and voted upon; legal proceedings in which any insider has a material interest adverse to the company’s interests; names, ages, positions, and offices; terms of office; and any understandings or agreements regarding such positions or offices. Officers and directors must also disclose relevant family relationships; each insider’s business experience during the last five (5) years; any involvement in certain legal proceedings during the last five (5) years (including criminal convictions); transactions with the company and others (in excess of $60,000); certain business relationships with the company; indebtedness to the company (in excess of $60,000 per person); whether any insiders are delinquent or have failed to comply with their periodic reporting requirement under Section 16(a); information regarding committees of the Board of Directors; compensation (including fringe benefits & stock option plans); and the company’s audited financial statements.

Under the proxy rules, is unlawful to solicit proxies using a proxy statement or other communication that is false or misleading in material fact, or fails to state a material fact, and Section 18 of the Exchange Act also imposes civil liability upon companies that publicly distribute misleading proxy statements. In this context, a "material" fact is information that reasonable investors are substantially likely to consider important. Unlike Rule 10b-5, a claim under Section 14 does not require proof that the company or its insiders has a bad motive or demonstrated a careless disregard; rather, simple negligence is enough.

The most common remedy for violating these rules is a preliminary injunction preventing the company from circulating, and requiring the company to revise, the misleading proxy statement. In cases where it has been determined that the "best interests" of all of a company’s shareholders would be served by equitable relief, courts have gone a step further to set aside transactions and order new votes.

Reviewing SEC Filings
(Forms, 10-K, 10-Q, 8-K, etc.)