Form 4 and Form 5 Model Form 168: Purchases, Sales, and Conversions of Convertible Securities
ILLUSTRATIVE FACTS: On May 21, 2009, Timothy T. Timbers, a director of TUV Corporation, sold 1,000 shares of TUV Series A convertible preferred stock on the open market for $52 per share, pursuant to a market order. The Series A preferred stock, which was listed on the American Stock Exchange, was convertible into TUV common stock on a share-for-share basis. On May 22, Timbers converted into TUV common stock 2,000 shares of TUV Series B convertible preferred stock having a face value of $25 per share. Timbers converted the shares by delivering to TUV a notice of exercise and a certificate representing his Series B preferred stock, in accordance with procedures specified in TUV’s certificate of incorporation. The Series B preferred stock had a floating conversion price equal to the market price of TUV common stock on the date of conversion. On May 22, the market price of TUV common stock was $50 per share, and therefore Timbers became entitled to 1,000 shares of TUV common stock in connection with the conversion ($50,000 face value ¸ $50 = 1,000 shares of common stock). On May 25, Timbers converted $75,000 face amount of TUV 4% convertible debentures due 2011, which also were listed on the American Stock Exchange, into 1,500 shares of TUV common stock. The debentures were convertible into common stock at $50 per share (i.e., into one share of common stock per $50 face amount of the debentures). TUV’s common stock was trading at $48 per share on the date of conversion, but the debentures were trading at a discount to par because of their low interest rate, and therefore converting the debentures was economically preferable to selling them. On May 26, Timbers received stock certificates for the shares of TUV common stock issuable upon his conversion of his Series B preferred stock and his debentures.
REPORTING PRINCIPLES: (1) Convertible Security A Derivative Security Only If Conversion Price Is Fixed. Convertible preferred stock, debentures, warrants, and other instruments that are convertible into common stock at a fixed price are derivative securities. If the conversion price floats based on the market price on the underlying common stock, the preferred stock is not a derivative security (because Rule 16a-1(c)(6) excludes floating-price instruments from the definition of “derivative security”). See Editek, Inc. vs. Morgan Capital, L.L.C., 150 F.3d 830, 834 (8th Cir. 1998); Release No. 34-28869, n. 147 (1991). Accordingly, the Series A preferred stock sold by Timbers on May 21 was a derivative security, while the Series B preferred stock converted by Timbers on May 22 was not. Similarly, Timbers’ debentures were convertible into TUV common stock at a fixed price ($50 per share) and therefore were derivative securities for purposes of Section 16. (2) Open Market Sale Reportable On Form 4. An open market sale of preferred stock, effected pursuant to an order to sell the stock at the market price, is reportable on Form 4, by the end of the second business day following the date of “execution” of the sale. The date of execution of an open market sale is the trade date (not the date on which the order is placed, and not the settlement date). The trade date of Timbers’ open market sale of Series A preferred stock was Thursday, May 21, and therefore his Form 4 reporting the sale was due Monday, May 25. For a discussion of reporting principles applicable to an open market sale, see Model Form 58. Timbers’ transactions in the Series A preferred stock would be reportable even if the class of preferred stock were not registered under Section 12 of the Exchange Act. See Model Form 24. (3) Purchases And Sales Of Derivative Securities Reportable Only In Table II. Convertible preferred stock is an equity security in its own right and, if the conversion price is fixed, is a derivative security based on its convertibility into common stock. While this dual classification might suggest that purchases and sales of convertible preferred stock having a fixed conversion price should be reported in both Table I and Table II, Instruction 4(c)(i) to Form 4 and Form 5 provides that convertible preferred stock should be reported only in Table II. (Non-convertible preferred stock, on the other hand, would be reportable only in Table I.) Accordingly, Timbers has reported his sale of Series A preferred stock only in Table II. (4) Perpetual Preferred Stock Has No Expiration Date. Perpetual preferred stock (i.e., preferred stock that does not provide for automatic conversion or redemption on a specified date in the future) does not have an “expiration date” for purposes of Forms 3, 4, and 5. Accordingly, in reporting his sale of Series A preferred stock, Timbers has inserted a footnote in Column 6 of Table II of his Form 4 explaining that the preferred stock has no expiration date. Insiders may not simply leave this column blank, because the electronic filing system will not accept a Form 4 or Form 5 that reports a transaction on a line that leaves blank any of the transaction-related columns on that line (including the expiration date column). (5) Conversion Of Floating-Price Convertible Security Ineligible For Exemption Under Rule 16b-6(b). Because a convertible security that is convertible at a floating conversion price is not a derivative security, the conversion of the security is ineligible for the exemption under Rule 16b-6(b) for exercises and conversions of derivative securities. See Editek, Inc. vs. Morgan Capital, L.L.C., 150 F.3d 830 (8th Cir. 1998). Accordingly, neither Timbers’ disposition of his Series B preferred stock upon its conversion, nor the resulting acquisition of the underlying common stock, was exempt under Rule 16b-6(b). (Such transactions by officers or directors may be exempted under Rule 16b-3(d)(1) or (2) if the terms of the transaction are specifically approved in accordance with the rule, but Timbers’ conversion of his Series B preferred stock did not meet these requirements and therefore did not qualify for exemption under Rule 16b-3. Because Timbers had not engaged in any purchases of Series B preferred stock in the six months prior to the conversion, his non-exempt disposition of 2,000 shares of Series B preferred stock in connection with its conversion on May 22 was not matchable with any other transaction under Section 16(b). (The Series B preferred stock was not a “derivative security” having a value derived from TUV’s common stock, and therefore transactions in the Series B preferred stock could not be matched with transactions in the common stock. See Rule 16b-6(a) and Rule 16a-4(a).) Timbers’ non-exempt purchase of 1,000 shares of common stock on May 22 in connection with the conversion, however, is potentially matchable under Section 16(b) with his non-exempt sale of Series A preferred stock on May 21. (The maximum amount of the potential recovery under Section 16(b) is $2,000, representing the excess of the market price of the common stock on May 21 over the market price on May 22, multiplied by 1,000 shares ($52 – $50 x 1,000 = $2,000). See Rule 16b-6(c).) (6) Conversion Of Preferred Stock That Is Not A Derivative Security Is Reportable On Form 4 Before The End Of The Second Business Day Following The Date Of Conversion. The date of conversion of a convertible security is the date on which the rights and obligations of the issuer and the holder of the convertible security become fixed and the parties are irrevocably committed to the transaction. Generally, that date will be the date on which the holder of the convertible security has satisfied all conditions to an effective conversion. Timbers satisfied all conditions to the conversion of his Series B preferred stock on May 22 by delivering to TUV a notice of conversion and a stock certificate representing the Series B preferred stock. Accordingly, Timbers’ conversion of his Series B preferred stock was deemed to occur on Friday, May 22, and therefore his Form 4 reporting the conversion was due Tuesday, May 26. The date of TUV’s delivery to Timbers of a stock certificate representing the TUV common stock issuable to Timbers upon conversion of the Series B preferred stock is irrelevant. (7) Disposition Of Floating-Price Convertible Preferred Stock Upon Conversion Reportable In Table I, Using Transaction Code “S.” Preferred stock is an equity security in its own right, and therefore an insider’s transactions in preferred stock are reportable under Section 16(a), even where the preferred stock is not a derivative security. See Reporting Principle (3) above. Where the preferred stock is not a derivative security, transactions in the preferred stock are reportable in Table I of Form 4 (or Form 5). Because Timbers’ 2,000 shares of Series B preferred stock were not derivative securities, he must report his disposition of those securities upon their conversion in Table I of Form 4. Because the disposition was for value and did not qualify for any exemption from Section 16(b), Timbers has reported the disposition using transaction code “S” (“Open market or private sale of non-derivative or derivative security”). (8) Purchase Price Of Security Acquired Upon Conversion Of Preferred Stock That Is Not A Derivative Security Is Price At Which Conversion Occurs. Preferred stock that is convertible into common stock at a floating conversion price does not have a “conversion price.” Nevertheless, when the preferred stock is converted, the number of shares of common stock into which the preferred stock converts is based on the market price of the common stock, as calculated in accordance with the terms of the preferred stock. The price assigned to the common stock for conversion purposes is the purchase price of the underlying common stock, and should be inserted in the price column of Column 4 of Table I. Because Timbers’ Series B preferred stock converted into TUV common stock at a price of $50 per share, he has inserted “$50” in Table I of his Form 4. Because Timbers paid the purchase price with Series B preferred stock, not cash, he also has explained the transaction in a footnote. (9) Acquisition Of Common Stock Upon Conversion Of Floating-Price Convertible Preferred Stock Reportable Using Transaction Code “P.” For the same reasons that the disposition of a floating-price convertible security should be reported using transaction code “S” (see Reporting Principle (7) above), the acquisition of the underlying security should be reported using transaction code “P” (“Open market or private purchase of non-derivative or derivative security”). Again, the price column of Table I should be completed by inserting the price utilized to determine the number of shares issuable upon conversion, footnoted to explain the transaction, as Timbers has done in his Form 4. (10) Conversion Of Convertible Security Having Fixed Conversion Price Exempt Under Rule 16b-6(b). The conversion of a fixed-price derivative security is exempt from Section 16(b) by virtue of Rule 16b-6(b). The conversion of a convertible security, unlike the exercise of an option, warrant, or right, is exempt from Section 16(b) whether the convertible security is in or out of the money. Accordingly, although Timbers’ convertible debentures might be deemed to have been out of the money at the time they were converted into common stock (because the conversion price was $50 and the market price was $48), the conversion was exempt from Section 16(b) by virtue of Rule 16b-6(b). (11) Conversion Of Derivative Security Reportable On Form 4. The conversion of debentures that are derivative securities is reportable on Form 4, within two business days after the effective date of the conversion. Because the effective date of Timbers’ conversion of his convertible debentures was May 25, his Form 4 reporting the conversion was due May 27. The date on which Timbers received a certificate representing the 1,500 shares of common stock issuable in connection with the conversion is irrelevant. (12) Conversion Of Derivative Security Reportable In Both Table I And Table II. The conversion of a fixed-price convertible security, like the exercise of an option, triggers disclosure in both tables of the applicable reporting form. Specifically, the disposition of the convertible security must be reported in Table II, and the acquisition of the underlying securities must be reported in Table I. Accordingly, Timbers has completed both tables of his Form 4 in reporting his conversion of debentures. (13)Transaction Code “C” Applies To Conversion. The conversion of a fixed-price convertible security is reportable using transaction code “C” (“Conversion of derivative security”). Accordingly, Timbers has used code “C” in reporting his conversion of debentures, in both Table I and Table II. (14) Amount Of Convertible Debt Securities Owned Is Aggregate Face Amount. When reporting debt securities in Table II of Form 4 or Form 5, the number of derivative securities reported in Column 5 should be stated in dollars and should equal the face amount of the debt securities. See Instruction 3(c) to Form 4 and Form 5. Accordingly, Timbers has reported in Column 5 of Table II his conversion of “$75,000” of convertible debentures. (15) Insert “$0” Or Footnote In The Price Column Of Table II When Reporting Conversion Of Convertible Security. The conversion of a convertible security involves the disposition of the convertible security in exchange for the underlying security. Column 8 of Table II, however, which calls for the price received for a derivative security, will accept only dollar amounts (due to the programming of the SEC’s electronic filing system). Because the transaction code (“C”) and the conversion price (in Column 2), together with the related information in Table I, adequately explain the terms of the transaction, insiders may insert “$0” in Column 8 when reporting the conversion of a convertible security, as Timbers has done in reporting the conversion of his debentures. Alternatively, insiders may insert a footnote in Column 8, and explain in the footnote that the insider received the underlying security in exchange for the convertible security. Insiders may not simply leave the price column blank, because the electronic filing system will not accept a Form 4 or Form 5 that reports a transaction on a line that leaves blank any of the transaction-related columns on that line (including the price column). (16) “Date Exercisable” In Column 2 Of Table II May Be Date On Which Convertible Security Was Acquired. Column 6 of Table II of Form 4 and Form 5 calls for the date on which a reported derivative security became exercisable. When reporting the conversion of a derivative security that was convertible when the insider acquired it, the insider may report in Column 6 the date on which he or she acquired the convertible security, as Timbers has done in reporting his debentures. Alternatively, the insider may report the date on which the convertible security became convertible in accordance with its terms, if that date is known, or may simply state in a footnote that the derivative security was convertible “at any time” or “immediately,” as Timbers has done in reporting his Series A convertible preferred stock. (17) When Reporting Multiple Transactions In Table I, Column 5 Of Each Line On Which A Transaction Is Reported Should Reflect Running Tally Of Securities Owned. Column 5 of Table I of Form 4 (and Column 9 of Table II) calls for the amount of securities beneficially owned “following the reported transaction(s).” When reporting multiple transactions in securities of the same class and held in the same form of ownership (e.g., direct), Column 5 should reflect a running tally of the shares beneficially owned by the insider (meaning the insider should complete Column 5 of each line by indicating the number of securities beneficially owned after the transaction reported on that line). Ultimately, Column 5 of the last line on which a transaction is reported will report the number of securities owned after taking into account all of the reported transactions. The total shown in the last completed line of Column 5 should reflect the insider’s beneficial ownership as of the date of the latest transaction reported in the form. The fact that Section 16(a), as amended by Section 403 of the Sarbanes-Oxley Act, calls for disclosure of all securities owned as of the “date of the report” should be disregarded, as the language of the Act has been overridden by the express requirements of Form 4. (18) Floating-Price Convertible Security Becomes Derivative Security On Date That Conversion Price Fixes. A convertible security having a floating conversion price that will become fixed upon the occurrence of a specified event (e.g., the passage of time or the occurrence of a merger) becomes a derivative security once the specified event occurs and the conversion price becomes fixed. See Magma Power Co. vs. Dow Chemical Co., 136 F.3d 316, 325 (2nd Cir. 1998). Unless the fixing of the conversion price qualifies for an exemption from Section 16(b), the fixing of the conversion price results in the insider’s acquisition of a derivative security which must be reported on Form 4, by the end of the second business day following the date on which the acquisition occurs. The acquisition would not be matchable with any disposition of the underlying security within the preceding six months, provided that the date on which the price became fixed was not known in advance and was outside the control of the insider. See Rule 16b-6(a) and the September 1999 issue of Section 16 Updates, at p.9. (19) Transactions Effected On Different Days May Be Reported On Same Form 4. Where an insider engages in a transaction that is reportable on Form 4 and then, before filing a Form 4 to report that transaction, effects one or more additional reportable transactions, the insider is not required to report each day’s transactions on a separate Form 4. Instead, the insider may (but is not required to) choose to report more than one day’s transactions on a single Form 4, as Timbers has done. Because Timbers had to report his May 21 sale of preferred stock by May 25, his decision to report his May 22 conversion of debentures and his May 25 conversion of preferred stock on the same Form 4 meant that he reported the two conversions earlier than would have been required had he reported them on separate Forms 4. (Reporting the conversions in the Form 4 filed on May 25 did not make the reporting of the conversions “voluntary” for purposes of Column 2 of Table I.) (20) Complete Box 3 Of Form 4 By Inserting Day, Month, And Year Of Earliest Transaction Reported. The SEC staff has taken the position that, when reporting on Form 4 transactions occurring on more than one day, the insider should insert in Box 3 the month, day, and year of the earliest reported transaction required to be reported on Form 4. See Compliance and Disclosure Interpretations, Exchange Act Section 16 and Related Rules and Forms, Q. 135.02 (May 23, 2007). Accordingly, Timbers has inserted “05/21/2009” in Box 3 of his Form 4. (21) Holder Of Floating-Price Convertible Security May Float Into And Out Of Ten Percent Owner Status. A holder of preferred stock that is convertible into a registered class of common stock at a floating conversion price is deemed, for purposes of determining ten percent owner status, to be the beneficial owner of the number of securities into which the preferred stock is convertible from time to time. Accordingly, a holder of a floating price convertible security who, due to a decline in the price of the underlying common stock, becomes entitled to convert the security into a number of shares of common stock exceeding 10% of the shares outstanding would be deemed a ten percent owner subject to Section 16. See Medtox Scientific, Inc. vs. Morgan Capital, L.L.C., 258 F.3d 763 (8th Cir. 2001). Such a holder would remain a ten percent owner unless and until the price of the underlying common stock increased to the point where the number of shares issuable upon conversion of the convertible security amounted to less than 10% of the class outstanding. If the price of the underlying common stock were to decline again, so that the holder of the convertible security once again became a ten percent owner, the holder would be obligated to file a new Form 3. (22) Instrument Convertible Into Common Stock At Lower Of Fixed Price Or Market Price Is A Derivative Security. A security or other instrument convertible into issuer stock that does not have a fixed conversion price, or that is convertible into an indeterminate number of securities, is not deemed to be a derivative security. See Model Form 85. The Commission has expressed the view, however, that a security or other instrument that has both a fixed price component and a floating price component should be deemed a derivative security for purposes of Section 16, at least to the extent of the fixed price component. See SEC amicus brief filed in Levy vs. Southbrook International Investments, Ltd., 263 F. 3d 10 (2d Cir. 2001). The courts have taken a similar view. See, e.g., At Home Corp. v. Cox Communications, Inc., 446 F.3d 403 (2d Cir.), cert. denied, 127 S. Ct. 384 (2006); Levy vs. Oz Masterfund Ltd., CCH Fed. L. Rep. ¶ 91, 503 (S.D.N.Y. 2001) and Lerner vs. Millenco, L.P., 23 F. Supp. 2d 337, recon., 23 F. Supp. 2d 345 (S.D.N.Y. 1998). For a discussion of reporting principles applicable to the acquisition and conversion of “hybrid” preferred stock, see Model Forms 170 and 171. (23) Convertible Security That Provides For Automatic Adjustment Of Conversion Price Upon Occurrence Of Specified Events Is Not A Floating-Price Instrument. Preferred stock that has a fixed conversion price that is subject to adjustment upon the occurrence of one or more events set forth in the certificate of designations for the preferred stock is deemed to have a fixed conversion price and therefore is a derivative security. See, e.g., Morrison v. Madison Dearborn Capital Partners III, L.P., 463 F. 3d 312 (3d Cir. 2006), cert. denied, 127 S. Ct. 1330 (2007). In addition, a reduction in the conversion price of the preferred stock resulting from the price adjustment provisions, resulting in the holder’s acquisition of beneficial ownership of a greater number of underlying securities, is not a purchase for purposes of Section 16(b). See id. and Model Form 178. An automatic adjustment to the conversion price of preferred stock should be distinguished from a repricing or other discretionary amendment of the conversion price of a derivative security, which the staff views as equivalent to a disposition of the “old” security and the acquisition of a new one. See Model Form 100. (24) Satisfaction Of Performance Conditions To Convertibility Of Preferred Stock May Constitute A Purchase For Purposes Of Section 16(b). The staff takes the position that an option awarded to an insider involves a “purchase” by the insider, even though the insider pays no consideration for the award (other than continued service). See Release No. 34-26333, n. 101 (1998). Presumably, the staff would take the position that the satisfaction of performance conditions to the convertibility of preferred stock also constitutes a purchase. One court has acknowledged the possibility (but did not decide) that the vesting of a warrant upon satisfaction of performance criteria may constitute a purchase. See Dreiling v. America Online, Inc., 2005 WL 3299828 (W.D. Wash.).
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