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In 1934, the United States Congress passed the Securities Exchange Act, which, in addition to establishing the Securities Exchange Commission (SEC), also lays out regulations for secondary trading of bonds, stocks, and debentures by corporation directors, officers, and principal stockholders. Section 16 stipulates filing requirements with the SEC for insiders or stock owners who are holding more than 10 percent of the outstanding stock of a company. According to Section 16, significant owners and affiliated insiders must electronically file Form 3 with the SEC within 10 days of the stock purchase or affiliation date. Insiders must report all substantial changes in their holdings on Form 4. Company officers who engage in insider transactions that are not reported on Form 4 must describe such transactions on Form 5 annually.
Section 16 applies to all beneficial owners of a given security or stock. The term beneficial owner may refer to any person or group that has the capacity to influence decisions pertaining to that stock or security. This includes individuals with voting rights, even if they do not have title to the stock or security. The President of the United States or the director of an Executive Branch agency may exempt corporations from reporting requirements of the Securities Exchange Act of 1934 when such reporting involves matters of national security.
In order to prevent the inequitable use of insider information to make a profit, Part b of Section 16 requires that all insiders report all profits obtained from buying or selling company stock before the tenth day of the next month following the transaction. The Sarbanes-Oxley Act of 2002 tightened the reporting period to two days. In addition, profits from short-swing transactions, involving a quick purchase-and-sale or sale-and-repurchase made within six months of each other, belong to the company, not the trader. The SEC tracks this information, but it does not directly enforce the rule. Shareholders of a corporation must uncover the facts and sue the insider who engaged in the improper short-swing if he fails to return the profits to the company.
If a registered investment company carries out the transactions, and the commission has exempted both component deals of the purchase and sale of the involved security, 16b does not apply. In addition, transfers that represent genuine gifts or inheritance are also exempted from 16b. Exemptions may also apply to employee benefit plans, mergers, consolidations, and voting trusts. Finally, transactions that are ratified by the shareholders of a company or approved by a board of directors that contains at least two non-employee members may not be subject to Part b of Section 16.
How does an organization account for the disgorgement of profits under Section 16b?