Second Circuit Addresses Hybrid Convertible Securities and the "Debt Previously Contracted" Exceptions to Section 16(b) of the Securities Exchange Act of 1934

by Sheppard Mullin Richter & Hampton LLP

In Analytical Surveys, Inc. v. Tonga Partners, L.P., 2012 WL 1970389 (2d Cir. June 4, 2012), the United States Court of Appeals for the Second Circuit addressed (among other things) the scope of two exceptions that apply to liability for short-swing profits under Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b): the exception for derivative securities that do not have a fixed price and the exception for securities acquired in connection with a “debt previously contracted.” The Court concluded that the exception for derivative securities that do not have a fixed price does not apply to hybrid securities exercised at a floating price and that the “debt previously contracted” exception only applies to “mature debts.”

Analytical Surveys, Inc. (“ASI”) filed suit against Tonga Partners, L.P. (“Tonga”) seeking to recoup profits Tonga earned on the sale of ASI stock. ASI’s lawsuit arose out of two senior secured convertible notes, one entered in 2003 (the “2003 Note”) and one in 2004 (the “2004 Note”).

Under the 2003 Note, Tonga loaned to ASI $1.7 million with a maturity date in 2005. Under the terms of the 2003 Note, Tonga could, at any time, convert part or all of the 2003 Note’s principal into ASI stock. The stock’s price could be calculated by: (1) a fixed price dependent on the time of conversion or (2) a floating price dependent on ASI’s average stock price in a defined period prior to conversion. At maturity, the balance on the 2003 Note would automatically be converted into shares.

The 2003 Note also contained a default provision that would allow Tonga to accelerate the amount of debt remaining on the 2003 Note. In October 2003, ASI trigged this default provision, but Tonga chose not to exercise its rights.

Instead, Tonga and ASI negotiated the acquisition of a new note, the 2004 Note. The 2004 Note was similar to the 2003 Note, but had a later maturity date, and, unlike the 2003 Note, gave Tonga the option to convert balance into shares or accept cash payment. Approximately five months after acquiring 2004 Note, Tonga converted the outstanding balance into shares of ASI’s common stock and then proceeded to sell all of those shares for a substantial profit.

ASI filed suit, seeking disgorgement of almost $5 million in profits earned by Tonga, under Section 16(b) of the Securities Exchange Act. Pursuant to Section 16(b), an issuer’s insiders — defined as those with a beneficial ownership interest of more than 10% in an equity security — are prohibited from profiting from a purchase-and-sale or sale-and-purchase of the issuer’s securities within a six-month period. The purpose of this rule is to deter insiders from taking advantage of inside information by forcing such insiders to disgorge those profits back to the issuer. This general rule applies even where the insider acted in good faith and did not actually take advantage of any inside information in his or her purchase and sale of the issuer’s stock.

There are some exceptions to the bright-line rule of disgorgement. For example, Section 16(b) does not apply to financial instruments that can be exercised or converted into the issuer’s stock “at a price that is not fixed.” Nor does Section 16(b) apply to securities “acquired in good faith in connection with a debt previously contracted.” Tonga argued that these exceptions (as well as others) applied in this case.

Tonga first argued that the 2004 Note was not a purchase but was an “amended version” of the 2003 Note. The Second Circuit rejected this argument, noting that the 2004 Note was materially different from the 2003 Note. The later maturity date of the 2004 Note gave Tonga “more time” to determine whether and when to convert the Note into shares. So too, the option provided in the 2004 Note (but not the 2003 Note) to convert the balance to stock or convert to cash at maturity “gave Tonga latitude” to take advantage of inside information.

The Court rejected Tonga’s contention that the form of the 2004 Note — a convertible security that could be either exercised at either a fixed price or floating price, a “hybrid derivative” — fell outside Section 16(b)’s “purchase” requirement. Fixed price convertible securities fall within Section 16(b), whereas convertible securities with a floating price do. No Second Circuit case, however, addressed whether a “hybrid derivative” exercised at a floating price fall within Section 16(b).

The Second Circuit concluded that a “bifurcated approach” was required. Under a “bifurcated” approach, the acquisition of a hybrid instrument “purchase,” and the conversation of the instrument at a lower floating price is a separate “purchase” of any additional shares. Why? The opportunity to rely on inside information to time the date of exercise represents “an insider’s additional opportunity” over and above the initial insider opportunity in acquiring the hybrid derivative. Applying this “bifurcated” approach, the Court ordered Tonga to disgorge approximately $5 million in profits.

Tonga also argued that the “mature” debt in question was the debt owed on the 2003 Note, which was enforceable because of ASI’s default. The Court again disagreed, holding that ASI’s default “permitted,” but did not require, Tonga to accelerate the 2003 Note. Tonga, however, had never demanded acceleration, and, as a result, the 2003 Note “had not matured at the time that ASI issued the 2004 Note.” The acquisition of the 2004 Note, therefore, was not made ‘in connection with a debt previously contracted’ for the purpose of § 16(b).”

Analytical Systems provides some clarity with respect to what counts as a “purchase” under Section 16(b). Hybrid derivative securities exercised at a “floating” price are not merely subject to Section 16(b), but are subject to such an examination twice: once at the time of acquisition and again at the time it is exercised. Likewise, the “debt previously contracted” provision only applies where a debt is really and truly “mature”; the mere possibility that a debt could be treated as mature is itself insufficient, a debt is only “mature” if the parties treat it as such.

For further information, please contact John Stigi at (310) 228-3717 or Martin White at (415) 774-3233.


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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