On November 23, 2020, the Second Circuit Court of Appeals issued an opinion by Judge Jon O. Newman in Packer v. Raging Capital Management, reversing a magistrate judge’s summary judgment order that had found Raging Capital Master Fund Ltd. to be a “beneficial owner” of more than 10% of the shares in 1-800-Flowers.com Inc. and therefore required, under Section 16(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), to disgorge nearly $5 million in short-swing profits.
The Second Circuit ruling addresses, and offers guidance on, the determination of beneficial ownership for purposes of the 10% rule, when a member of the board of directors of a fund is also an executive officer of its adviser and such fund delegates its disposition and voting authority over the shares to the adviser. The case promises to be of particular significance for investment managers that advise a family of funds, which, either individually or in the aggregate, may have a greater than 10% position in the shares of an issuer that are registered with the Securities and Exchange Commission (the “SEC”).
Section 16(b) of the Exchange Act allows an issuer to recapture so-called “short-swing profits” earned by officers, directors, and owners of more than 10% of a class of the issuer’s equity securities registered with the SEC. “Short-swing profits” are profits made on matching purchases and sales of the issuer’s equity securities within a six-month period. The right to recapture these profits can be exercised by the issuer itself, but if the issuer declines to do so, any shareholder of the issuer can file a derivative suit to recapture the profits on the issuer’s behalf. In determining whether a holder is a 10% owner, the SEC’s Section 16 regulations look to the beneficial ownership rules under Section 13(d) of the Exchange Act—the section that requires reporting on Schedule 13D and Schedule 13G.
Under the Section 13(d) rules, beneficial ownership is determined not by economic interest but by the power to vote or dispose of shares. If an investor has that power, or has the right to acquire that power within 60 days, it is deemed a “beneficial owner” of those shares. The Section 16 regulations, however, provide an important exception to this rule for certain types of institutional investors, listed in Rule 13d-1, that are subject to relaxed reporting requirements under Section 13(d). These types of investors are not deemed to be 10% owners under Section 16(b), no matter how many shares in which they have beneficial ownership for purposes of Section 13(d).
In particular, a registered investment adviser may have the power, on behalf of its clients, to vote or dispose of more than 10% of an issuer’s shares. Nevertheless, the adviser will not be subject to Section 16(b) despite its control over these client shares. Importantly, however, even though the adviser enjoys this exemption, the exemption does not necessarily extend to the adviser’s advisory clients. For example, if an adviser controls more than 10% of an issuer’s shares in a discretionary account for an advisory client, but the client has retained for itself the right to also make voting and investment decisions, the adviser will not be subject to short-swing profit recaptures, but the client will.
From April 30, 2014 to January 31, 2015, Raging Capital Management (“RCM”), an SEC-registered investment adviser, executed purchases and sales of stock in 1-800-Flowers Inc. (“Flowers”) on behalf of its advisory client Raging Capital Master Fund Ltd. (the “Master Fund”), when the Master Fund owned more than 10% of Flowers common stock. One hundred percent of the Master Fund’s common shares were owned by two “feeder funds,” Raging Capital Offshore Fund and Raging Capital Fund (QP). The relationship between the four entities was governed by an Investment Management Agreement (“IMA”) that one individual—RCM’s Sole Owner, Managing Member, Chairman and Chief Investment Officer (“Managing Member”)—signed on behalf of all four entities (see Figure A). The IMA delegated investment and voting authority to RCM as investment adviser, terminable on not less than 61-days’ notice—a common device to prevent investors from being deemed “beneficial owners” under Sections 13(d) and 16.
Brad Packer, a shareholder of Flowers, filed a derivative suit on behalf of the issuer, alleging that the Master Fund was a “beneficial owner” of more than 10% of the issuer’s shares and therefore required under Section 16(b) to disgorge nearly $5 million in profits on various short-swing transactions. The Master Fund in turn argued that because it delegated investment and voting authority to RCM under the IMA, it was not a “beneficial owner” of those shares and was not required to disgorge profits. As a registered investment adviser, RCM itself was not subject to Section 16. At its core, the dispute hinged on whether the Master Fund’s delegation of investment and voting authority to RCM could be disregarded, with the consequence that the Master Fund had the right to acquire voting and investment power within 60 days and therefore had beneficial ownership of more than 10% of the issuer’s shares.
On motion for summary judgment, Eastern District of New York Magistrate Judge Gary Brown, to whom the case had been referred on consent, granted Packer’s motion and found the Master Fund to be a “beneficial owner” of the issuer’s shares. The Magistrate Judge ordered that the Master Fund disgorge $4,909,395 in short-swing profits under Section 16(b) of the Exchange Act, and Defendants appealed to the Second Circuit.
The Second Circuit’s Decision
The Second Circuit reversed the Magistrate Judge’s order and remanded the case, finding that “factual questions remain as to whether [the Master Fund] was a beneficial owner of the shares.” In reversing the Magistrate Judge’s order, Judge Newman addressed each of the Magistrate Judge’s three bases for finding that the Master Fund’s delegation of investment and voting did not divest it of beneficial ownership of the shares.
First, the Circuit Court rejected the lower court’s reasoning that “the intertwined relationship of these parties proves fatal,” because “RCM, [the Managing Member], and [the] Master Fund are not unaffiliated parties.” Judge Newman found that the court’s “generalized wording such as ‘intertwined’ or ‘not affiliated’” was “not consistent with” the principle that Section 16(b) should be applied “narrowly” because it imposes “a form of strict liability.”
Second, the Second Circuit rejected the lower court’s reliance on caselaw holding owners liable for the Section 16(b) violations of their agents. Finding “no comparable state-law based agency relationship between [the] Master Fund and RCM,” which were “distinct corporations,” the Court of Appeals held that “making an investment advisor a customer’s agent for the specified purpose of carrying out the advisor’s traditional functions for a customer does not make the adviser an agent for all purposes.”
Third, the Second Circuit rejected the lower court’s conclusion that, because “nothing prevented defendants from altering the agreement at will,” the Master Fund could at any time reclaim for itself voting and investment authority. Judge Newman reasoned that, even though the Managing Member “had authority to sign the IMA on behalf of all four parties to it,” “[a]uthority for an individual to sign a document on behalf of an entity, however, does not necessarily carry with it authority to commit those entities to making changes in, or terminating, that document.” Based on the record, the Second Circuit held that there were factual issues that could not be resolved on summary judgment. Among other things, the Second Circuit observed that the Master Fund had two other directors in addition to the Managing Member, so that the Managing Member could not necessarily act unilaterally on behalf of the Master Fund to terminate the IMA.
Conclusion and Takeaways
Investment managers often manage a family of funds, which either individually or in the aggregate, can own in excess of 10% of the shares of an SEC-registered issuer. The funds may have acquired their position in the open market or, in some cases, in a restructuring of the debt of a distressed issuer. If the funds are registered investment companies, they themselves will be exempt from Section 16. If not, the funds could be subject to the short-swing profit provisions of Section 16, which would restrict their ability to trade in the shares. The Packer case suggests a mechanism whereby the investment manager and its managed funds can ensure an exemption from short-swing profit recapture. First, the investment manager must be an SEC-registered investment adviser. Second, through contractual arrangements between the funds and their investment manager that cannot be terminated by the funds on less than 61-days’ notice, the funds can divest themselves of beneficial ownership of the shares for purposes of Section 16.
The Second Circuit decision in Packer makes clear that even if a single person (or entity) has management roles at both the funds and the management company, the corporate separateness of those entities and their contractual arrangements should still be respected for purposes of beneficial ownership determinations under Section 16. While the decision only reversed a grant of summary judgment for the plaintiffs and did not direct judgment for the defendant Master Fund, it suggests that that funds and advisors who properly follow corporate formalities and norms in administering funds, including the functioning of their boards, should be well positioned to have the provisions of their investment agreements respected and avoid beneficial ownership attribution under Sections 13(d) and 16.
Although not addressed in the Packer case, it should be noted that the special treatment afforded an SEC-registered investment adviser and other institutional investors under Section 13(d), and the exemption afforded to them under Section 16, only applies if the shares have been acquired in the ordinary course of business and not with the purpose nor with the effect of changing or influencing the control of the issuer. If the funds do seek to influence control of the issuer, which might be the case if they have board representation, the exemption will be unavailable and the funds could be subject to Section 16 profit recapture if their ownership position exceeds 10%.
 See Memorandum of Decision & Order in Packer v. Raging Capital Management et al., No. 15-cv-5933 (GRB), at *9 (S.D.N.Y. Aug. 20, 2019), as modified by the authors of this article.