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The SEC’s amendments to Rule 10b5-1 back at the end of 2022 spawned quite a few interpretive questions that are still being sorted out to this day. One of the areas that prompted questions is the scope of the exception to the limitation on overlapping open-market trading plans and the limitation on single-transaction trading plans that is provided for “eligible sell-to-cover” transactions. Exchange Act Rule 10b5-1(c)(1)(ii)(D)(3) defines an “eligible sell-to-cover” transaction as one where an agent is authorized to sell “only such securities as are necessary to satisfy tax withholding obligations arising exclusively from the vesting of a compensatory award” where the employee does not otherwise exercise control over the timing of such sale.

Last summer, the ABA’s Joint Committee on Employee Benefits submitted a request for interpretive guidance to the Corp Fin Staff seeking clarification as to what actually qualifies as an “eligible sell-to-cover” transaction. There was a concern among practitioners that the language of the definition would limit the amount of securities to only the amount required to satisfy statutory minimum tax withholding rates, when some companies allow employees to designate a higher expected effective tax rate as the rate at which their employer will withhold taxes upon the vesting of a compensatory award. The group proposed the following interpretive Q&A to the Staff:

Question: Can a contract, instruction, or plan qualify as one providing for the sale of “only such securities as are necessary to satisfy tax withholding obligations arising exclusively from the vesting of a compensatory award,” and thus be an “eligible sell-to-cover transaction” under Exchange Act Rule 10b5-1(c)(1)(ii)(D)(3), if it provides for the sale of shares at the rate identified by the employee as the employee’s expected effective tax rate, provided such rate does not exceed the aggregate of the maximum applicable federal, state, and local tax rates applicable to the employee, as permitted under tax and accounting rules?

Suggested Answer: An “eligible sell-to-cover” transaction under Exchange Act Rule 10b5-1(c)(1)(ii)(D)(3) means the sale of shares up to the tax rate designated by the employee for withholding, provided such rate does not exceed the aggregate of the maximum applicable federal, state, and local tax rates applicable to the employee, as permitted under tax and accounting rules.

In a memorandum to the members of the ABA Subcommittee on Employee Benefits, Executive Compensation, and Section 16 posted in our “Rule 10b5-1” Practice Area, Mark Borges, Alex Bahn and Ron Mueller describe their discussions with the Staff on this interpretive question, and note:

As a result of our informal discussion with the SEC Staff, we understand that the reference in Exchange Act Rule 10b5-1(c)(1)(ii)(D)(3) to “only such securities as are necessary to satisfy tax withholding obligations” is not intended to mean only the number of shares required to satisfy minimum tax withholding requirements and that the rule is not intended to use technical tax language or to disrupt practice with respect to legitimate tax arrangements. Put another way, the focus of the SEC Staff appears to be on whether the arrangement is designed to pay the tax obligation arising in connection with the vesting event, which can take into account the expected effective tax rate and is not focused on only the required tax withholding rate. It appears the SEC Staff agrees with our proposed response and will interpret the provision to allow sales of shares to satisfy an employee’s expected effective tax rate. This interpretation, however, does not apply if any of the proceeds from the sale are intended to satisfy taxes relating to income from sources other than the vesting of a compensatory award. The SEC Staff thus cautioned that persons could not characterize a sale as an “eligible sell-to-cover” transaction where shares are sold with the intent of covering taxes for events unrelated to the vesting event. For example, selling shares in an “eligible sell-to-cover” transaction where the proceeds are intended in part to cover taxes for the sale of property other than the shares received in the vesting event would not be considered an “eligible sell-to-cover” transaction.

It is very helpful to know that the Staff is not reading the “eligible sell-to-cover” transaction exception so narrowly as to exclude the many situations where an expected effective tax rate is used to determine the amount of securities to be sold rather than the statutory minimum tax withholding rate, thus making this exception more useful to avoid running afoul of the overlapping plan and single trade restrictions.

– Dave Lynn