Under Section 16(b) of the Securities Exchange Act of 1934, certain company insiders are required to disgorge any profits they earn from so-called “short-swing” transactions. Company insiders include executive officers, directors and 10% or greater shareholders.

The short swing rule applies to the disgorgement of profits realized from the purchase or sale, or sale and purchase, of a company’s equity securities within a period of six months or less. Such transactions are referred to as matching transactions. Section 16(b) imposes a strict liability standard that requires the disgorgement of profits once the objective criteria under the statute are met.

The unorthodox transaction exception gained traction from the 1973 Supreme Court case Kern County Land Co. v. Occidental Petroleum Corp. The court’s ruling marked a shift from strict application of Section 16(b)’s objective criteria to a more case-by-case and nuanced analysis. The unorthodox transaction exception does not apply to matching purchases and sales when there is no possibility of speculative abuse based on access to insider information.

However, subsequent cases have interpreted this exception narrowly. More often than not, this exception cannot be relied upon. An example of a situation where the unorthodox transaction exception was successfully applied involved the defendants receiving and selling shares within 6 months under prepaid variable forward contracts. The court in this case determined that there was no risk for speculative abuse under the forward sale agreements because the transactions were settled based on a predetermined formula.

There are three criteria that must be satisfied in order to rely on the unorthodox transaction exception. If any of these factors is present, the exception cannot be used.

• The transaction was “unorthodox” or “borderline”
• The transaction was involuntary
• The transaction was not susceptible to the exploitation of inside information

To satisfy the third prong, the insider must have been devoid of any opportunity to misuse insider information. This entails any possibility of abuse, and not necessarily the occurrence of actual abuse. Merely having access to insider information is often sufficient to expose a company insider to potential short-swing liability.

Exemptions of matching transactions from Section 16(b) liability can also be found under Rule 16b-3 and Rule 16b-7.

Rule 16b-3 is the most widely used exception to the short swing profits rule. Under Rule 16b-3, certain transactions between a company and a director or executive officer will be exempt from Section 16(b) liability if the transaction satisfied the applicable conditions. Rule 16b-3 applies to certain types of employee benefit plans, stock purchase plans and tax-conditioned plans. It can also apply to certain acquisitions of equity securities from the company or dispositions of equity securities to the company.

Rule 16b-7 provides an exemption in the merger context. It applies to any securities acquired or disposed of in a merger or reclassification transaction that meets certain conditions. For instance, the exemption would apply to an acquisition of a company’s equity securities pursuant to a merger that involved an entity which, prior to the merger owned at least 85% of the equity securities of all other entities involved in the merger.

While there are a number of exceptions to the short swing profits rule, it is important to understand the nuances of these exceptions before relying on them. It is also important to note that Section 16(b) liability can arise in connection with purchases and sales of various types of equity securities, including a company’s derivative securities.