In response to recent insider securities scandals, the Securities and Exchange Commission (SEC) in April proposed rules to accelerate the periodic reporting deadlines for most public companies. The regulations also would require all public companies to report most director and officer transactions in company securities and company loans on a current basis on Form 8-K.
While the accelerated filings proposals will prove challenging for young, venture-backed companies, the proposed current reporting requirements for insider transactions will present even more significant issues for venture capitalists and their portfolio companies.
Under current SEC rules, directors and officers of public companies are personally responsible for filing paper reports under Section 16 for most company securities transactions in the month following the transaction. Some transactions, such as option grants, stock repurchases and gifts, can be reported on an annual basis. Current rules also allow for delayed reporting of company loans made to insiders. There are currently no reporting requirements for trading plans adopted pursuant to Rule 10b5-1, which provides an affirmative defense to insider trading claims.
The proposed rules would require that companies also file current reports for most transactions in company securities by directors and officers, including option grants and repricings, stock repurchases and gifts. Also reportable would be hedging transactions, company loans, pledges of stock, company guarantees of third-party loans and the forgiveness or modification of, or foreclosure on, an outstanding loan. Finally, companies would be required to report when their insiders entered into, amended or terminated 10b5-1 trading plans, as well as the duration of those plans and the aggregate number of securities to be purchased or sold.
For transactions with an aggregate value of $100,000 or more, the rules would require that reports be filed electronically within two business days. Most other transactions would have to be reported by the second business day of the following week.
Here are some steps venture capitalists and their portfolio companies might consider taking in light of these proposed rules:
Limit Restricted Stock Grants and Loans
Accounting rules already place constraints on the ability of companies to issue restricted stock or provide loans to officers without triggering variable accounting or compensation charges. The proposed rules would require that every material amendment of a restricted stock grant or a company loan, as well as any repurchase of restricted stock or loan repayment or forgiveness, be reported currently. Given that these arrangements will likely require some modification, waiver or other reportable action over their term, companies should consider minimizing use of these incentives to avoid adverse reporting events.
Manage Hedging Transactions
Directors and executives of public companies have increasingly utilized costless collars, margin loans, exchange funds and other techniques to achieve diversification without having to sell company securities outright. At the same time, insider trading policies at many public companies have not kept pace with this trend and deal with such arrangements either imperfectly or not at all. Under the proposed rules, such arrangements will have to be subject to prior clearance or notification provisions to ensure timely reporting.
At the same time, the fact that these arrangements will now be subject to current reporting means that insiders should consider whether they are not better off achieving their diversification goals through outright sales.
Adopt 10b5-1 Policies
Companies should adopt policies governing the use of Rule 10b5-1 stock trading plans by insiders to ensure timely and accurate reporting about such plans, as well as to minimize the frequency and amount of disclosure required on these plans. Likewise venture capitalists should establish comprehensive strategies for their 10b5-1 plans in order to minimize the need for frequent and potentially adverse modifications or terminations of such plans.
Evaluate Impact on Exit Strategies
Under current rules, directors representing venture funds are responsible for determining whether they have a “pecuniary” (i.e. monetary) interest in company shares held by their funds that will require a sale or distribution of those shares to be reported. Under the proposed rules, companies will be responsible for tracking sales and distributions by venture funds with representatives on their board and determining the pecuniary interest those representatives have in shares held by the fund. The increased oversight and reduced flexibility that these new rules will impose on venture capitalists as they seek to exit their investments could lead to tension between venture funds and their public portfolio companies and may increase the likelihood that VCs will seek to sell more shares in IPOs and follow-on offerings and favor M&A exits to avoid these complications. These rules as proposed would also provide impetus for VCs to get off public boards sooner rather than later since they would only be relevant to a venture fund when it has board representation.
The proposed insider transaction reporting rules are open to comment until June 24, 2002. Among other issues, commentators are expected to object to the coverage of non-executive directors given the burdens this will impose on companies and the marginal benefit of extending the new reporting requirements beyond executive officers. Given the current political environment, however, it is likely that the rules will take effect substantially as proposed. That meansventure capitalists should begin preparing now for this more expansive disclosure regime.
John Egan and David Cifrino are partners in the Boston office of McDermott, Will & Emery. Egan is the head of the firm’s Private Equity/Emerging Companies Group while Cifrino specializes in corporate disclosure by public companies, executive compensation and securities law.