The Second Circuit Finds No Section 16(b) Violation Where Different Securities of the Same Issuer Are Bought and Sold

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In Gibbons v. Malone, No. 11-3620-cv, 2013 WL 57844 (2d Cir. Jan. 7, 2013), the United States Court of Appeals for the Second Circuit held that the “short-swing profits rule” imposed by Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b), requiring corporate insiders to disgorge profits earned from certain purchases and sales of their company’s securities that take place within a six month period, applies only to purchases and sales of the same equity security of the company. This decision clarified the restrictions that Section 16(b) places on the types of securities that are covered by the statute, thereby limiting the scope of the statute.

John Malone, a director of Discovery Communications, Inc. (“Discovery”), sold 953,506 shares of Discovery’s Series C stock and purchased 632,700 shares of Discovery’s Series A stock within a thirteen day period in 2008. Even though both Series A and Series C shares are issued by Discovery, they are separately registered with the Securities & Exchange Commission (“SEC”) and are separately traded on the NASDAQ stock market. Series A also is different from Series C in that Series A grants voting rights while Series C does not. Series A and Series C are not convertible, and do not have a fixed value relative to each other. Malone allegedly earned $313,573 in profits from his sales and purchases of these shares.

A shareholder of Discovery brought suit on behalf of Discovery against Malone under Section 16(b). Section 16(b) provides that corporate insiders must disgorge to the issuer profits realized from the paired sale and purchase (or vice versa) within a six month period of “any equity security” of their company. Congress enacted this “short-swing profits rule” to “curb the use of nonpublic knowledge by corporate insiders.” Courts have recognized that Section 16(b) is a “blunt instrument,” imposing strict liability on anyone who violates it — irrespective of the insider’s intent or actual use of inside information.

The United States District Court for the Southern District of New York dismissed the action for failure to state a claim under Section 16(b). The district court held that, among other things, the paired sale and purchase here were of different types of securities, whereas Section 16(b) requires the paired sale and purchase to be in the same type of security. Plaintiff appealed.

The Second Circuit affirmed. It agreed with the district court that the Series A and Series C securities cannot be “paired.” The Second Circuit observed that for plaintiff’s position to be correct, Section 16(b) would have to apply to the sale and purchase of “any equity securities” instead of “any equity security.” In other words, the fact that the word “security” appears in the statute in the singular means that only sales and purchases of the same security can be “paired” under Section 16(b). Further, the Series A and C securities are not subject to the “economic equivalence” exception — which is based upon rules promulgated by the SEC that would deem the securities as “paired” because of their interconnectedness — because that exception is limited primarily to fixed-ratio convertible instruments.

The Court declined plaintiff’s invitation to interpret Section 16(b) broadly to cover transactions in different securities that are substantially similar to each other. The Court maintained that the language of Section 16(b) requires identity, and not mere similarity. The Court reasoned further that Congress intended for Section 16(b) to be a “relatively arbitrary rule capable of easy administration” and introducing the concept of “substantial similarity” would run contrary to Congress’ stated goal. The Court did note, however, that the SEC has the authority to issue further guidance with respect to Section 16(b), and that such direction from the SEC might affect the impact of this ruling.

In the absence of further guidance from the SEC, courts in the Second Circuit will apply a bright-line rule exempting from Section 16(b) profits earned in transactions by insiders in different, unconnected securities from the same issuer.

For further information, please contact John Stigi at (310) 228-3717 or Rena Andoh at (212) 634-3092.

 

Topics:  16(b), Disgorgement, Nasdaq, SEC, Short-Swing Trading

Published In: Business Organization Updates, Business Torts Updates, Civil Procedure Updates, Finance & Banking Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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