March 2013: White Collar Litigation Update

Second Circuit Declines to Apply Short-Swing Profit Rule to Transactions Involving Different Types of Stock. In a case of first impression, Gibbons v. Malone, No. 11–3620–cv, 2013 WL 57844 (2d Cir. Jan. 7, 2013), the Second Circuit held that an insider’s purchase and sale of different stock types in the same company does not trigger liability under Section 16(b) of the Securities Exchange Act of 1934. Specifically, the court held transactions involving separately traded, nonconvertible stocks with different voting rights fall outside the purview of Section 16(b).

Congress enacted Section 16(b) of the Securities Exchange Act, more commonly known as the “short-swing profit rule,” for the disgorgement of profits obtained by insiders who use their nonpublic knowledge when trading in a company’s securities. The statute allows for the issuing company to recover an insider’s profits from any paired purchase and sale or sale and purchase of any equity security occurring within less than a six-month period.

At issue in Gibbons was whether the profits obtained from sales and purchases of different types of stock by the defendant, John Malone, a director and shareholder of Discovery Communications, Inc., were recoverable by plaintiff shareholder Michael Gibbons under Section 16(b). Over the course of about two weeks in December 2008, Malone had made nine sales of Discovery’s “Series C” stock totaling 953,506 shares and ten purchases of Discovery’s “Series A” stock totaling 632,700 shares. Gibbons v. Malone, 2013 WL 57844, at *1. Discovery’s Series A and C stock are different equity securities, separately registered and traded on the NASDAQ stock exchange, and not convertible into each other. In addition, the Series A stock comes with voting rights while the Series C stock does not.

Alleging that Malone realized illicit profits of at least $313,573 from his sales of Series C stock and purchases of Series A stock, Gibbons brought a derivative suit seeking disgorgement of Malone’s profits under Section 16(b). Id. The United States District Court for the Southern District of New York dismissed Gibbons’ complaint for failure to state a Section 16(b) claim, finding that the statute’s use of the singular term “any equity security” undermined the plaintiff’s theory which “requires the purchase and sale of any equity securities, rather than of one equity security,” while the statute prohibits a paired purchase and sale or sale and purchase of only the latter, not the former. Gibbons v. Malone, 801 F.Supp.2d 243, 247 (S.D.N.Y. 2011).

On appeal, the Second Circuit upheld the District Court’s dismissal, finding that Malone’s sales of Series C stock and purchases of Series A stock are not within the scope of Section 16(b). Gibbons v. Malone, 2013 WL 57844, at *2. First, the court found that Malone’s sales and purchases failed to form the requisite “pair” of securities transactions constituting the “type of insider activity that Section 16(b) was designed to prevent.” Id. at *3. In particular, upon examining the statutory text, the court determined that “Congress’s use of the singular term ‘any equity security’ supports an inference that transactions involving different equity securities cannot be ‘paired’ under § 16(b).” Id. Because the statutory terms “purchase and sale” and “sale and purchase” are both directed at the same singular object – i.e., the same equity security—Malone’s purchase and sale of different equity securities fell outside of the scope of the statute.

Second, while the Second Circuit noted that “§ 16(b) could apply to transactions where the securities at issue are not meaningfully distinguishable,” this was not the case here where the difference in voting rights readily distinguishes Series A stock from Series C stock, rendering the two securities “distinct not merely in name but also in substance.” Id. at *4. Accordingly, the court concluded, “[a]n insider could easily prefer one over the other for reasons not related to short-swing profits.” Id.

Third, the court refused to apply the principle of “economic equivalence” to the stocks at issue, reasoning that the principle had “developed in the context of fixed-ratio convertible instruments, particularly with respect to whether exercising conversion rights is a ‘purchase’ or ‘sale within the meaning of § 16(b).” Id. In this case, “two nonconvertible securities” such as Discovery’s Series A and Series C stocks, “whose prices fluctuate relative to one another,” are not “economically equivalent” and therefore do not fall under the scope of § 16(b) on this basis. Id. at *5.

Finally, the Second Circuit refused to find liability based on the plaintiff’s request “to enter uncharted territory by holding that the two securities are sufficiently ‘similar’ to be paired under § 16(b).” Id. Acknowledging that such a broad interpretation might be plausible, the court nevertheless determined that a “substantial similarity” standard would be at odds with both the plain text and fundamental purpose of the statute. The court noted that the “statutory text appears to require sameness, not similarity.” Moreover, citing the Supreme Court, the Second Circuit explained that Congress intended § 16(b) to establish “mechanical requirements” through “a relatively arbitrary rule capable of easy administration,” as opposed to one that “reach[es] every transaction in which an investor actually relies on inside information.” Id. Accordingly, the court concluded that § 16(b) was designed to establish rules that can be mechanically applied as opposed to standards that must be assessed on a case-by-case basis.

The Second Circuit’s affirmation in Gibbons establishes that § 16(b) liability does not extend to unpaired transactions involving the trading of different types of stock in the same company that are “meaningfully distinguishable” or that are “distinct not merely in name but also in substance.” Id. at *4. Absent further guidance from the Securities and Exchange Commission (“SEC”), we can expect that the Second Circuit will not venture into “unchartered territory” beyond the plain meaning of the statutory text, but instead will adhere to the “strict form of liability” offered by Section 16(b)’s “‘prophylactic’ remedy of disgorgement.”