Tag: Exchange Act s.16

SEC Enforcement Actions Regarding Section 16 Reporting Obligations

The following post comes to us from John P. Kelsh, partner in the Corporate and Securities group at Sidley Austin LLP, and is based on a Sidley Austin publication by Mr. Kelsh, Paul V. Gerlach, and Holly J. Gregory.

Last month, the SEC announced that it brought enforcement actions primarily relating to Section 16(a) under the Securities Exchange Act against 34 defendants. The defendants were 13 individuals who were or had been officers or directors of public companies, five individual investors, ten investment funds/advisers and six public companies.

This post briefly discusses several noteworthy points regarding this development and also discusses practical steps that companies could consider taking in response.


Second Circuit Rules on Short-Swing Profit

The following post comes to us from Lewis Liman, partner focusing on commercial litigation at Cleary Gottlieb Steen & Hamilton LLP. This post is based on a Cleary Gottlieb memorandum by Mr. Liman and Jennifer Kennedy Park.

On January 7, 2013, the Second Circuit Court of Appeals ruled that Section 16(b) of the Securities Exchange Act of 1934, which provides for the disgorgement of profits that corporate insiders realize “from any purchase and sale, or any sale and purchase, of any equity security” of the corporate issuer within any period of less than six months (the “short-swing profit rule”), does not apply to a corporate insider’s purchase and sale of shares of different types of stock in the same company where those securities are separately traded, nonconvertible stocks that have different voting rights. Gibbons v. Malone, No. 11 Civ. 3620, 2013 U.S. App. LEXIS 398 (2d Cir. Jan. 7, 2013). Throughout its analysis, the court characterized § 16(b) as a blunt, mechanical rule that prioritizes ease of enforcement over maximum deterrence. Acknowledging the policy reasons for a more flexible interpretation of the rule, the Second Circuit invited the SEC to consider interpreting the short-swing profit rule to cover “similar” equity securities.


Court Rules on Short-swing Liability Rules

Richard J. Sandler is a partner at Davis Polk & Wardwell LLP and co-head of the firm’s global corporate governance group. This post is based on a Davis Polk client memorandum.

On March 26, 2012, in Credit Suisse Securities (USA) LLC v. Simmonds, the U.S. Supreme Court held 8-0 that the two-year statute of limitations for suits under the short-swing liability rules of Section 16(b) of the Securities Exchange Act of 1934 is not tolled (i.e., suspended) until an insider files a Section 16(a) disclosure statement; the limitations period can begin running even if the disclosure statement is filed at a later date or never filed at all. The Court’s decision provides insiders of U.S. public companies with better protection and more certainty against time-barred claims.

The Supreme Court reversed the Ninth Circuit, which had held, citing to its precedent, that the limitations period is tolled until an insider files the Section 16(a) disclosure statement “regardless of whether the plaintiff knew or should have known of the conduct at issue”. In dicta, the Supreme Court also rejected the Second Circuit’s rule that the limitations period is tolled until the plaintiff “gets actual notice that a person subject to Section 16(a) has realized specific short-swing profits that are worth pursuing”.

The Supreme Court did indicate some willingness to permit equitable tolling of the Section 16(b) limitations period, but under circumstances more limited than the “disclosure” rule of the Ninth Circuit or the “actual notice” rule of the Second Circuit.


SEC Proposes Reaffirmation of Existing Treatment of Security-Based Swaps

James Morphy is a partner at Sullivan & Cromwell LLP specializing in mergers & acquisitions and corporate governance. This post is based on a Sullivan & Cromwell client memorandum.

As anticipated, the U.S. Securities and Exchange Commission has proposed to readopt certain of its current rules, with no changes, in order to confirm that the Dodd-Frank Wall Street Reform and Consumer Protection Act did not alter the treatment of “security-based swaps” for purposes of determining “beneficial ownership” of equity securities under Sections 13 and 16 of the Securities Exchange Act of 1934. Comments on the proposal are due by April 15, 2011.


Driving a Constitutional Stake through Section 16(b)

This post is by Phillip Goldstein of Bulldog Investors.

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.

Hedge Funds Settle “Short Swing” Profits Litigation

Editor’s Note:

As part of the continuing confrontation between CSX Corporation and hedge funds holding CSX shares and equity swaps on CSX shares – and which earlier this year mounted a successful proxy fight, replacing four members of the CSX board of directors – the hedge funds have agreed to settle an action to recover “short-swing” profits pursuant to Section 16(b) of the Securities Exchange Act of 1934.

Section 16(b) provides that beneficial owners of more than 10% of the stock of publicly traded corporations (as well as officers and directors) are liable to disgorge to the corporation any profit derived from purchases and sales of the stock of the corporation within a period of less than six months. While the hedge funds which invested in CSX did not directly hold a position of more than 10% in CSX shares, their aggregate interest in the shares and the equity swaps – which involved matching positions in CSX stock by the banks which had written the swaps – together exceeded 10%. As we discussed in our memo of June 12th, in a separate litigation brought by CSX against the funds, Judge Kaplan of the U.S. District Court for the Southern District of New York held that the hedge funds were the beneficial owners of over 10% of CSX shares for purposes of SEC Rule 13d-3(b) on account of the shares they directly held and the swaps they entered into.

Following Judge Kaplan’s decision, a CSX shareholder filed suit pursuant to Section 16(b) seeking to recover for the benefit of CSX short-swing trading profits achieved by the hedge funds while they beneficially held more than 10% of CSX stock directly and by virtue of their derivative positions. Rule 16a-1(a)(1) provides that a beneficial owner of more than 10% for purposes of Section 16 means any person who is deemed a beneficial owner pursuant to Section 13(d) and the rules thereunder. Based on the hedge funds’ swaps and stock transactions, plaintiff and CSX identified potential recoverable damages from the hedge funds under Section 16(b) of approximately $138 million. The hedge funds agreed to pay $11 million to settle the Section 16(b) action. The amount of the settlement was reportedly influenced by, among other things, the fact that Judge Kaplan’s decision regarding beneficial ownership is still pending appeal to the Second Circuit.

We have long advised that non-traditional economic and voting arrangements be approached with extreme caution. Such arrangements not only can have significant implications for investors’ disclosure obligations under Section 13(d), but can also trigger shareholder rights plans, change-incontrol provisions of commercial and employee contracts and compensation plans, and, as the CSX settlement makes clear, investors’ “short-swing” profit repayment obligations under Section 16(b). We continue to urge the SEC to undertake comprehensive regulatory reform that addresses derivative arrangements in a clear and uniform manner, generally treating all such arrangements that are coupled with direct or indirect ownership of actual shares by counterparties as in all respects equivalent to actual ownership, and requiring appropriate disclosure of all such arrangements involving more than 5% economic equivalent ownership, whether long or short, and whether accompanied by underlying ownership positions or otherwise. In the meantime, it continues to be important for public companies and investors alike to consider all potential legal obligations and liabilities that may arise as a result of such economic ownership equivalent positions and to take appropriate action in that regard.

Third Circuit Upholds Validity of SEC: Amendments Clarifying Exemptions from Section 16 Liability

This post is based on a memorandum by Paul Vizcarrondo and Michael Winograd of Wachtell, Lipton, Rosen & Katz.

The Third Circuit recently upheld the validity of two clarifying amendments adopted by the SEC in 2005. The amendments clarified two important exemptions from shortswing-profit liability under Section 16(b) of the Securities Exchange Act: (1) Rule 16b-3, which exempts certain transactions between an issuer and its officers or directors; and (2) Rule 16b-7, which exempts certain mergers, reclassifications, and consolidations. In so doing, the Court expressly overruled a prior decision of the Third Circuit that imposed novel restrictions on the applicability of the two exemptions.

In Levy v. Sterling Holding Co., 314 F.3d 106 (3d Cir. 2002) (“Levy I”), the Third Circuit held that grants, awards, and other issuances to officers or directors must be compensation-related to be eligible for exemption under Rule 16b-3(d). The Third Circuit also suggested that Rule 16b-7 would not exempt reclassifications that involve classes of securities with different risk-return characteristics (such as an exchange of non-convertible preferred stock for common stock) or that increase shareholders’ percentage of common-stock ownership. (See our memo dated March 10, 2003.)

In response to the Third Circuit’s holding in Levy I, the SEC adopted clarifying amendments to Rules 16b-3 and 16b-7. The amendment to Rule 16b-3 made clear that the exemption would apply regardless of whether a compensation-related purpose could be demonstrated. The amendment to Rule 16b-7 made clear that the only condition for exempting a reclassification is that the company whose securities are acquired or disposed of owns 85% or more of the equity or assets of all companies that are parties to the transaction. Thus, where a single issuer reclassifies one class of its securities into another, there is effectively 100% “crossownership” and the exemption is available. (See our memo dated August 8, 2005.)