By Dennis R. Delaney
Most corporate officers and directors are well aware of the frenetic new two-day reporting regime ushered in with the passage of the Sarbanes-Oxley Act last summer.
Most publicly traded corporations have established (or revamped) their SEC compliance programs to accommodate the new system. Many insiders, however, are not aware that family events as seemingly innocuous as a child moving in or out of their home or the birth of a grandchild may trigger a reporting obligation.
Many also have not reviewed and coordinated their SEC compliance with their estate plans, their parents' estate plans and their annual giving. Nor are they tracking (on a real-time basis) the transactions of all trusts of which they are trustees to ensure that they do not run afoul of the act's requirements.
With embarrassing and potentially costly penalties for Section 16 violations, some insiders may unwittingly be candidates for the next corporate scandal poster child.
Not long after the roaring '20s came to a screeching halt, Congress enacted the Securities Exchange Act of 1934. The concern back then was the same concern that drove the Sarbanes-Oxley Act through Congress last summer, namely curbing stock market manipulation by insiders.
Section 16 of the '34 Act addresses this problem by requiring a corporate insider (officers, directors and any beneficial owner of 10 percent of the company's stock) to report to the SEC all company securities that he owns and all transactions involving those securities.
It also prohibits "short swing transactions," which occur if any sale and purchase occur within six months of each other. Finally, it requires insiders to refrain from short sales and sales against the box.
Once a person becomes an insider, he must file a Form 3 reporting his holdings within 10 calendar days. Prior to the Sarbanes-Oxley Act, an insider then had to report all purchases and sales within the first 10 days of the next calendar month. The theory was that making this information publicly available would be a vital part of the '34 Act's enforcement mechanisms by enabling plaintiffs' lawyers to monitor the reporting and take action when a violation occurs.
Now, Congress has decided that the public needs more timely disclosure from insiders, and under the Sarbanes-Oxley Act the insider has only two business days to report transactions.
Failing to report a transaction can result in fines and even criminal prosecution, and missing the 48-hour deadline forces the company to publish an embarrassing disclosure in its annual proxy statement detailing the infraction.
Unfortunately, the application of Section 16 in the family and estate planning context is not always clear. A Section 16 insider must identify shares that he owns directly as well as any shares of which he is the indirect, "beneficial" owner. Thus the insider may have to report shares owned by a family member or a trust.
A trust itself can even be a reporting "person" if it owns 10 percent or more of a publicly traded company's stock. Essentially, the insider must take a thorough look at his entire universe of family and trust holdings and make a determination as to which shares must be reported. If possible, this determination should be made in advance of becoming an insider, given the 10-day deadline for a new insider to file Form 3.
Once a determination is made as to which shares the insider reports, a system must be put in place to provide real-time, if not advance, notice of any transactions involving those securities.
Brokers, financial advisors and SEC compliance counsel must have open and instantaneous lines of communication. Moreover, even developments not directly involving purchases and sales must be communicated to the SEC.
For example, if an insider were to resign as a trustee of a trust that owns shares of the subject company, the resignation may have to be reported. Why? Because the insider, as trustee, had investment and voting control over the shares, and then relinquished that control by resigning from the trust.
This change in beneficial ownership is reportable, notwithstanding that the trust neither bought nor sold shares in the subject company at any relevant point.
To take matters to an even further extreme, an insider whose child moves out of the house could have a reporting obligation if the insider has set up a trust for that child and the trust owns shares of the subject company, even if the trust does not actually buy or sell any shares at any relevant point.
The insider is presumed to be the beneficial owner of the shares owned by the trust so long as the child lives at home. Thus when the child moves out, a reportable change in beneficial ownership has occurred.
Perhaps more common is a situation where an insider is a co-trustee who has investment and voting control over the trust's securities but another trustee actually handles the day-to-day investing.
If the insider's co-trustee does not provide real time information to the insider's SEC compliance counsel, there is a considerable risk that the insider will miss the 48 hour reporting deadline after the trust executes a purchase or sale, or even fail to report a transaction altogether.
Unfortunately, there are no good faith exceptions to the rule, so the insider must be particularly vigilant about tracking and reporting transactions.
The SEC reporting rules for insiders are voluminous and complex. A corporate officer or inside director should check with their company's SEC compliance counsel to ensure that family events and estate planning are properly coordinated with SEC reporting.
An outside director and any 10-percent owner may have an even more urgent need to review (or set up) a compliance system, especially if the company itself is not providing support.
Even a shareholder who owns 5 percent of a company's outstanding shares will have SEC reporting obligations under the '34 Act. These people, too, would do well to review their SEC compliance arrangements.
With increased attention from the media, corporations and the general public, the cost of inaction may be extremely high.
Dennis R. Delaney is a lawyer at the Boston firm of Hemenway & Barnes, where he concentrates on estate planning and fiduciary matters, as well as probate and taxation.
May 12, 2003
