Driving a Constitutional Stake through Section 16(b)

Section 16(b) of the Securities Exchange Act of 1934 has long been criticized for its “purposeless harshness,” and its “arbitrary, some might say Draconian” nature, as one court put it. Section 16(b) generally requires directors, officers and beneficial owners of more than 10% of the stock of a publicly traded corporation to disgorge to the corporation any so called “short swing profits” from purchases and sales of stock (or vice versa) made within a period of less than six months.

The stated purpose of Section 16(b) is to “[prevent] the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer.” To that end, the law authorizes any shareholder to file a derivative suit to recover such profit “if the issuer shall fail or refuse to bring such suit within sixty days after request.” There is no requirement that the shareholder own any shares at the time of the alleged insider trading. The predictable result has been to create a cottage industry of Milberg, Weiss style legalized barratry.

For example, The Children’s Investment Fund and 3G Capital Partners LP recently settled a Section 16(b) lawsuit brought by a small shareholder of CSX Corporation to recover their alleged short swing profits in CSX stock. The shareholder made no allegation that TCI or 3G were privy to any inside information let alone that any inside information about CSX even existed at the time of the trades. Under the settlement CSX will receive $10 million from TCI and $1 million from 3G and the plaintiff’s lawyer will seek approval by the court for fees and costs of up to $550,000, payable from the proceeds.

In another recent Section 16(b) case, Huppe v. Special Situations Fund III QP, L.P., No. 06 Civ. 6097 (S.D.N.Y. July 3, 2008) the District Court ruled that a 10% shareholder of WPCS International Incorporated had to disgorge its short swing profits to the company despite the absence of any allegation of the existence of inside information. The Court acknowledged that the shareholder’s purchase of stock from WPCS in an arm’s length transaction had probably rescued the issuer from financial disaster but ruled that equitable defenses are inapplicable in a Section 16(b) case:

Although it is undisputed in this case that WPCS genuinely needed and was provided capital through PE’s and QP’s purchases of WPCS stock, nothing in the statute permits the Court to consider as a mitigating factor the issuer’s intent or any benefit inuring to the issuer, nor is there any equitable defense available based on such theories.

That is because Section 16(b) creates a conclusive presumption that a 10% shareholder who realizes a short swing profit is presumed to have had access to and abused inside information. No allegation that inside information existed, e.g., a proposed merger or dividend increase, is even required. While there have been several failed due process challenges to Section 16(b), I know of none since Vlandis v. Kline, 412 U.S. 441 (1973), in which the Supreme Court held that an irrebuttable statutory presumption that a university student who recently moved to Connecticut was not a legitimate resident of the state (for university tuition purposes) is invalid because the presumption was not warranted. A court should be equally skeptical of Section 16(b)’s presumption that any short swing profits by a 10% shareholder stems from access to inside information. Unlike a director of a corporation, no shareholder has a legal right to obtain inside information and in fact, 10% shareholders of public corporation usually do not possess such information. Thus, a constitutional challenge based on Section 16(b)’s irrebuttable presumption of insider trading appears promising.

An even more obvious constitutional flaw of Section 16(b) is that it does not meet the Supreme Court’s requirement for Article III standing because it purports to authorize a “suit to recover such profit . . . by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer” even though the issuer has not been harmed. In Gladstone, Realtors v. Village of Bellwood, 441 U.S. 91, the Supreme Court found that one could not sue for damages unless the party alleged that (1) it suffered an actual injury as a result of the defendant’s actions and (2) that a favorable ruling would compensate the plaintiff for the injury suffered:

Congress may, by legislation, expand standing to the full extent permitted by Art. III, thus permitting litigation by one “who otherwise would be barred by prudential standing rules.” Warth v. Seldin, 422 U.S., at 501, 95 S.Ct. at 2206. In no event, however, may Congress abrogate the Art. III minima: A plaintiff must always have suffered “a distinct and palpable injury to himself,” ibid., that is likely to be redressed if the requested relief is granted. Simon v. Eastern Kentucky Welfare Rights Org., supra, 426 U.S., at 38, 96 S.Ct., at 1924.

One might argue that Congress created “a distinct and palpable injury” to an issuer when it passed a law requiring the transfer of short swing profits from the statutory insider to the issuer. However, that is circular reasoning and contrary to the Court’s insistence that Congress cannot abrogate Article III’s requirement that the plaintiff must suffer a true injury to himself to have standing. If Congress could create an artificial injury by fiat, that would effectively eviscerate Gladstone.

Abe Lincoln reputedly popularized this riddle: “How many legs does a dog have if you call a tail a leg?” “The answer is four because calling a tail a leg does not make it a leg.” Similarly, Congress does not have the power to legislate the existence of “a distinct and palpable injury” to a corporation when such an injury does not exist. The plain truth is that a corporation does not suffer any injury from short swing profits realized by a 10% shareholder and hence does not have standing to bring a Section 16(b) lawsuit against that shareholder.