SEC Interpretive Letter to Bank of America Merrill Lynch Permits Derivative Hedging Transactions for Section 16 Insiders of UPREITs and UP-C Issuers
April 11, 2019
On April 8, 2019, the Division of Corporation Finance in the Securities and Exchange Commission issued an interpretive letter to Bank of America, N.A. and Merrill Lynch, Pierce, Fenner & Smith Incorporated clarifying the application of Section 16(c) of the Securities Exchange Act of 1934 and Rule 16c-4 thereunder to option-based derivative hedging transactions entered into by Section 16 insiders of publicly traded U.S. companies structured as umbrella tax partnerships (including most real estate investment trusts and other “UP-C” issuers). The letter (the BAML Letter), was issued in response to a request submitted by Bank of America Merrill Lynch and O’Melveny & Myers LLP, and is available here.
The BAML Letter continues O’Melveny and BAML’s leadership of analytical innovation with respect to equity-linked derivative transactions, solving a complex interpretive question that for decades deterred officers, directors and significant shareholders of many REITs and UP-C issuers from engaging in hedging transactions available to insiders of other public companies. Indeed, the BAML Letter is the fifth example of formal interpretive guidance obtained by O’Melveny and BAML from the Division of Corporation Finance in the context of equity-linked derivatives since 2011 (including three prior interpretive letters and a compliance and disclosure interpretation issued in response to a formal interpretive request).1
Prior to the BAML Letter, Section 16 insiders of UPREIT and UP-C issuers that held units in the UPREIT or UP-C’s operating partnership (OP Units) could not be certain that they were deemed to “own” the shares of listed common stock underlying the OP Units for purposes of Section 16(c), generally precluding the entry into derivative hedging transactions referencing that common stock.
The BAML Letter complements prior regulatory relief obtained by O’Melveny, such as a related March 14, 2016 interpretive letter issued by the Division of Corporation Finance in response to a request from Bank of America Merrill Lynch and three law firms, including O’Melveny, clarifying that the holding period for common stock received upon exchange of OP Units for purposes of Rule 144 under the Securities Act of 1933 generally commences when the unitholder acquired the OP Units.2 The BAML Letter, together with the 2016 interpretive letter, greatly facilitates the ability of insiders to enter into derivative hedging transactions referencing the public common stock underlying OP Units. Our detailed analysis of the 2016 interpretive letter is available here.
UPREIT and UP-C Corporate Structures
The BAML Letter relates to option-based derivative hedging transactions referencing the common stock of a publicly traded company structured as an umbrella tax partnership. Businesses that are taxed as partnerships for U.S. federal income tax purposes frequently employ an UPREIT or UP-C structure when they elect to conduct a public offering of their common equity securities: rather than offering a direct investment in the existing tax partnership to public investors, such businesses instead form a separate corporation that publicly offers shares of its common stock and in turn acquires a corresponding equity interest in the existing tax partnership. As a result, the pre-IPO owners of the business continue to hold their equity interests directly in the tax partnership (via OP Units) and public investors hold an indirect equity interest in the tax partnership through the public corporation.
There is generally no public market for OP Units. OP Units are, however, exchangeable at the option of the holder for common stock of the public corporation (or, often, an equivalent amount of cash, at the option of the company). Because Section 16 insiders of the public corporation may elect to retain OP Units indefinitely and because OP Units are the economic equivalent of the public common stock, such insiders may from time to time want to hedge the economic value of the OP Units and limit their exposure to fluctuations in the trading price of the common stock underlying the OP Units. Since there is no public market for OP Units, derivative hedging transactions with respect to the OP Units directly are not economically feasible and unitholders seeking to hedge the value of OP Units instead enter into derivative hedging transactions referencing the liquid common stock underlying the OP Units.
Section 16(c) and Rule 16c-4
Section 16(c) of the Exchange Act prohibits Section 16 insiders from selling any equity security of the issuer if the insider does not “own” the security sold. Rule 16c-4 further provides that establishing or increasing a put-equivalent position (e.g., writing or selling a call option or buying a put option) is exempt from the Section 16(c) prohibition, but only if the amount of securities underlying the put-equivalent position does not exceed the amount of such securities “otherwise owned” by the insider. Since the adoption of Rule 16c-4, the staff of the Division of Corporation Finance has generally taken the view that securities underlying convertible or exchangeable securities are not “owned” for purposes of Section 16(c) or “otherwise owned” for purposes of Rule 16c-4.3 Because most derivative hedging transactions result in the insider establishing a put-equivalent position with respect to the referenced securities, insiders of UPREIT and UP-C issuers that held OP Units directly were therefore not generally permitted to enter into derivative hedging transactions referencing the public common stock underlying those OP Units.
Practical Impact and Commercial Application; Additional Considerations for UPREIT and UP-C Insiders
The BAML Letter greatly facilitates derivative hedging transactions for holders of OP Units by eliminating the Section 16(c) and Rule 16c-4 prohibition, as long as the conditions set forth in the letter are satisfied. The relief is expressly available only for option-based derivative transactions (such as “collar” transactions)4 structured to ensure that: (i) the insider will receive no net economic or other benefit if the price of common stock falls during the term of the hedging transaction; (ii) the insider will at all times have the ability to cover its delivery obligations under the hedging transaction, and (iii) the insider’s settlement method under the transaction will match the settlement method of any exchange of OP Units pledged to support the transaction, if applicable. Moreover, the insider may not exchange the OP Units pledged to support the transaction (or otherwise transfer, rehypothecate or dispose of the OP Units) until after the maturity date for the transaction has elapsed, except for purposes of facilitating prompt and orderly settlement of the transaction.
The BAML letter also expressly facilitates hedging transactions that incorporate a monetization feature, as the letter covers transactions that involve a loan secured by the OP Units and the insider’s rights under the derivative contract.
The BAML Letter therefore eliminates decades-long legal uncertainty under Section 16(c) and Rule 16c-4 that substantially deterred OP Unit holders from entering into hedging and monetization transactions referencing the common stock underlying their OP Units. Together with the 2016 interpretive letter, it promotes development of a new market for hedging and monetization of the securities of UPREIT and UP-C issuers by officers, directors and significant shareholders.
Insiders and affiliates (and other holders of restricted securities) of the issuer should, however, remain aware of additional regulatory considerations that may impact their ability to enter into derivative hedging transactions referencing UPREIT or UP-C common stock. For example, the exchange mechanism of the OP Units may present novel considerations from a Section 16(b) short-swing liability perspective and with respect to the availability of Rule 144 (including the 1999 interpretive letter issued to Goldman, Sachs & Co.)
If you have any questions regarding the BAML Letter, any other letters or issues discussed in this alert, or how to structure transactions consistent with relevant precedent, please contact the authors of this alert or your O’Melveny advisor. In addition, the authors of this alert wish to thank Glen A. Rae, Eric P. Hambleton, Robert J. Dilworth, Debra L. Marvin, Gary M. Rosenblum, Bess Schachner and Robert J. Stewart of Bank of America Merrill Lynch, who assisted with the submission of the interpretive request to the Division of Corporation Finance and were instrumental in assessing relevant legal issues and current market practice.
1 Bank of America Corporation (June 11, 2009); Bank of America, N.A., Merrill Lynch, Pierce, Fenner & Smith Inc. (December 1, 2011); Compliance and Disclosure Interpretation Question 532.01 (May 16, 2013); Bank of America, N.A., Merrill Lynch, Pierce, Fenner & Smith Incorporated (March 14, 2016).
2 On November 1, 2016, the Division of Corporation Finance issued a follow-on interpretive letter clarifying that the UPREIT Rule 144 relief was also available with respect to OP Units in similar UP-C corporate structures.
3 Prior interpretive letters issued by the Staff in the context of common stock underlying employee options and certain convertible debt instruments did create limited carve-outs from this general view. See Credit Suisse First Boston (March 16, 2004); Berkshire Hathaway (Nov. 12, 1996). The Staff response to the BAML Letter makes clear that it is still generally the Staff’s view that securities underlying derivative securities are not “owned” for purposes of Section 16(c) or “otherwise owned” for purposes of Rule 16c-4.
4 Although the BAML Letter only expressly relates to option-based transactions, we believe that the analysis set forth in the BAML Letter may also support alternative hedging transaction structures, including forward-based transactions, depending on the facts and circumstances. The authors of this alert are available to discuss the applicability of the relief discussed herein to alternative transaction structures.
This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Robert Plesnarski, an O’Melveny partner licensed to practice law in the District of Columbia and Pennsylvania, Jaroslaw Hawrylewicz, an O’Melveny partner licensed to practice law in New York, and James M. Harrigan, an O’Melveny counsel licensed to practice law in the District of Columbia and Maryland, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.
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