U.S. Congress may eliminate Section 16 exemption for foreign private issuers

The U.S. Senate version of the National Defense Authorization Act for Fiscal Year 2024 (NDAA) includes a provision that would eliminate the Section 16 exemption for foreign private issuers. If this provision survives the reconciliation of the U.S. Senate and U.S. House versions of the NDAA and is signed into law by President Biden, it would mean that directors, officers and greater than 10% shareholders (reporting insiders) of all SEC reporting companies—including Canadian issuers relying on the multijurisdictional disclosure system (MJDS)—would become subject to U.S. insider reporting requirements under Section 16(a) of the U.S. Securities Exchange Act of 1934 (Exchange Act) as well as liability for “short-swing” profits under Section 16(b) of the Exchange Act.

What you need to know

• U.S. insider reporting requirements for foreign private issuers. If the final version of the NDAA, when signed into law, retains the provision eliminating the Section 16 exemption for foreign private issuers, reporting insiders of all foreign private issuers (including MJDS issuers) that are SEC reporting companies will be required to begin filing insider reports that comply with the requirements of Section 16(a) of the Exchange Act.
• “Short-swing” profit liability for insiders. In addition, all such reporting insiders will become subject to Section 16(b) of the Exchange Act, which imposes “short-swing” liability on reporting insiders who profit from transactions in the issuer’s securities that can be matched to an equal and opposite transaction made within a six-month period, which would require such reporting insiders to disgorge any such profits to the issuer.
• Prohibition on short-selling by insiders. Section 16(c) of the Exchange Act, which prohibits short-selling by reporting insiders, would also be applicable.
• Implementation timeline. The NDAA remains subject to reconciliation by the Houses of Congress, and must be signed into law by President Biden. The current version of the new law instructs the SEC to enact final rules to give effect to the statutory change within 90 days of enactment of the NDAA. However, historically the SEC has taken longer (sometimes much longer) to promulgate their rules.

Background on Section 16

Similar to the insider filings required to be made under Canadian securities laws on the System for Electronic Disclosure by Insiders (SEDI), Section 16(a) of the Exchange Act requires reporting insiders to file statements of ownership of equity securities, including amendments to reflect changes in ownership. Under Section 16(a), “reporting insiders” includes directors, officers and greater than 10% shareholders of the SEC reporting company. Under Rule 16a-1(f), “officer” is defined to align to the definition of “executive officer” used elsewhere in U.S. securities laws. Greater than 10% shareholders are determined based on the calculation of “beneficial ownership” under Section 13 of the Exchange Act.

Under existing SEC rules promulgated under Section 16, reporting insiders must file an initial Form 3 to report their beneficial ownership within 10 days of becoming a reporting insider, or as of the effective date of the SEC reporting company’s initial registration statement under the Exchange Act. Thereafter, reporting insiders are required to file a Form 4 within two business days of transactions in such securities (subject to certain exceptions). Form 5 is also required to be filed within 45 days of calendar year-end to report certain exempted transactions as well as any unreported transactions during the prior year.

Section 16 reports (Forms 3, 4 and 5) require a high level of detail of transactions in equity securities, including option exercises and other derivative transactions, by reporting insiders, and must be publicly filed on EDGAR, appearing alongside the applicable SEC reporting company’s other periodic filings. These reports require disclosures regarding, among other things, the date of transaction, the type of transaction, the amount and price for the transaction, the number of securities owned following the transaction, whether ownership is direct or indirect, and if indirect, the nature of that ownership.

In addition, and perhaps most importantly, Section 16(b) of the Exchange Act imposes so-called short-swing liability on reporting insiders who profit from transactions in the issuer’s equity securities that can be matched to an equal and opposite transaction within a six-month period, which would require such reporting insiders to disgorge any such profits to the issuer (subject to certain exceptions, including for certain equity-based incentive compensation and employee benefit plans). Liability for short-swing profits under Section 16(b) is a strict liability regime that is separate and apart from U.S. insider trading liability under Rule 10b-5, and accordingly there is no requirement to demonstrate insiders were in possession of material non-public information (MNPI). By necessity, Section 16(b) requires careful monitoring of transactions by reporting insiders to ensure liability under this provision is not inadvertently incurred, and infractions are often brought to the attention of issuers by their public shareholders.

Finally, Section 16(c) prohibits reporting insiders from short-selling the applicable SEC reporting company’s equity securities—that is, if the reporting insider either does not own the security sold or fails to deliver it within 20 days of the sale (subject to exceptions if the insider was unable to do so in good faith or without undue inconvenience or expense).

The SEC has long exempted foreign private issuers from the requirements of Section 16 of the Exchange Act, along with other provisions of the Exchange Act (e.g., U.S. proxy rules), in an effort to accommodate home country practices and facilitate cross-listings by non-U.S. companies.

NDAA elimination of Section 16 foreign private issuer exemption

In recent years, researchers as well as the financial press have identified opportunistic corporate selling by insiders of foreign private issuers, taking aim in particular at insiders of Russian and Chinese companies. In response, the Holding Foreign Insiders Accountable Act, which would have expanded Section 16 to foreign private issuers, was introduced in 2022 and again in 2023. These initial legislative efforts failed, but the repeal of the Section 16 exemption has re-appeared in Section 6081 of the NDAA, buried in Congress’s 2,000-plus page annual defense spending bill.

Specifically, Section 6081 would amend Section 16 to expressly indicate that it must apply to reporting insiders of foreign private issuers, and nullify the SEC’s existing rule that provides a Section 16 exemption for foreign private issuers. Under this section, the SEC is directed to issue final rules within 90 days of enactment of the NDAA. Historically, SEC rulemaking has taken a very long time—for example, the new SEC clawback rules under Dodd-Frank (enacted in 2008) were not issued until 2022—and accordingly, it is not guaranteed that the SEC would act swiftly. It also remains to be seen whether the final version of Section 6081 of the NDAA would permit the SEC to enact, by rule, any exceptions—such as, for MJDS issuers. Absent any further changes to Section 6081 of the NDAA and following the promulgation of SEC final rules, reporting insiders of all foreign private issuers—including MJDS issuers—would need to comply with the insider reporting requirements of Section 16(a) and be subject to short-swing profit disgorgement under Section 16(b).

The NDAA, however, remains subject to reconciliation between the U.S. Senate and House of Representatives, which is expected to take place in the next couple of months, and then must be signed into law by President Biden. It is still unclear whether or not Section 6081 will remain in its current form in the final version of NDAA. However, it is expected that the U.S. Congress and President Biden will act to pass the NDAA before the end of 2023, as it is an important piece of annual legislation relating to government spending and is necessary to avoid a government shutdown.

Torys will continue to monitor any developments associated with the NDAA and its treatment of foreign private issuers.