Second Circuit Section 16 Decision Extends Rule 16b-3(d) Protections To Directors By Deputization That Are Also 10% Beneficial Owners

April 21, 2008

The Second Circuit Court of Appeals, in the case of Roth v. Perseus, L.L.C., 2006 WL 2129331 (2d Cir., April 10, 2008), recently held that the Rule 16b-3 exemption from Section 16(b)’s short-swing profit rules, which is available to insiders who are directors or officers, is available to “directors by deputization,” including those that are also 10% beneficial owners. The case should be of specific interest to private equity investors and others who hold significant investments in publicly traded companies and who obtain the right to appoint directors. The decision confirms the views of many practitioners, including us, that the rationale of Rule 16b-3 applies to directors by deputization just as strongly as it does to any other director, and that entities that are entitled to appoint directors should be entitled to the same protections as directors who are natural persons.

Section 16(b) of the Securities Exchange Act of 1934, as amended, imposes strict liability on “insiders” (i.e., officers, directors and 10% beneficial owners) of a public company (other than a foreign private issuer) who realize a profit as the result of a purchase and sale, or sale and purchase, within six months of equity securities of the company.

In 1996, the Securities and Exchange Commission (the ”SEC”) promulgated Rule 16b-3(d), which exempts from the short-swing profit rules transactions (whether or not compensatory) between a company and a director or officer of the company that are approved by the company’s board of directors, or a committee of the board of directors that is comprised solely of non-employee directors. In adopting Rule 16b-3(d) the SEC stated that it was motivated to exempt all transactions between a company and a director or officer, subject to the approval requirements, because it was persuaded that state law and Rule 10b-5 imposed upon directors and officers fiduciary duties and obligations that were sufficient to ensure that any “profit obtained is not at the expense of uninformed shareholders and other market participants of the type contemplated by” Section 16(b).

It is well-settled that the term “directors” as used in Section 16(b) includes “directors by deputization.” That term refers to an entity that is deemed to be a director of a company by reason of having “deputized” a person to sit on the board of directors of the company to act on behalf of the entity. Blau v. Lehman, 368 U.S. 403 (1962). The Ninth Circuit Court of Appeals, in Dreiling v. American Express Company, 458 F.3d 942 (9th Cir., August 14, 2006), took the view, as a matter of first impression, that Rule 16b-3(d) extended to directors by deputization, rejecting, among other arguments, the claim that Rule 16b-3(d) was outside the scope of the SEC’s authority or otherwise contrary to the purposes of Section 16(b).

In Perseus, the Second Circuit came to the same conclusion and took the finding in Dreiling one step further, accepting the position that a director by deputization may rely on the Rule 16b-3(d) exemption even though it is also a 10% beneficial owner, notwithstanding that Rule 16b-3(d) does not exempt transactions between a company and persons who are insiders solely by virtue of being 10% beneficial owners. An amicus brief filed by the SEC in the case supported that view.

The basic facts of Perseus are as follows. Prior to 2005, Perseus, L.L.C. (”Perseus”), through various affiliates, invested in Beacon Power Corporation (”Beacon”), and was permitted to appoint two directors to Beacon’s board of directors. In 2005, two Perseus investment funds acquired Beacon warrants and shares directly from Beacon. Later in 2005, the funds distributed Beacon shares to their investors, including certain affiliated individuals and funds and, it appears, certain passive investors. At least some of those investors, in turn, sold the shares so distributed within six months of the acquisition by the funds from Beacon.

Andrew Roth, a Beacon shareholder, brought an action under Section 16(b) against Perseus, certain of its affiliated individuals and funds and other unnamed parties, including, it appears, the funds’ passive investors. The Second Circuit affirmed the district court’s dismissal of claims against all the defendants, on the basis that the acquisitions were exempt under Rule 16b-3(d).

It should be noted that neither the appellate nor district court opinions in Perseus specifically address potential short swing liability arising from sales by the passive investors in the Perseus funds. It is not clear whether those passive investors in fact sold within six months of the funds’ or their acquisition of shares of Beacon. In Perseus the passive investors were presumed to be part of a group with the Perseus funds, without any analysis of the actual facts. In the likely factual setting of the case, it would have been anomalous for the Perseus funds and their affiliates to be found exempt from liability by virtue of their status as deputized directors, but for the passive investors to have had liability. Nevertheless, sales by the passive investors within a six-month window could have raised the following two analytical questions: (i) is a person who is an insider solely by virtue of being a member of a 10% beneficial ownership group that includes a director (including a deputized director) always entitled to rely on Rule 16b-3; and (ii) is the availability of Rule 16b-3 in this factual setting affected by the fact that a member of the group acquires shares from the issuer through an investment fund, and not directly from the issuer.

A copy of the Perseus decision is attached hereto. Please feel free to call any of your regular contacts at the firm or any of our partners and counsel listed under Capital Markets, Derivatives, Employee Benefits, or Mergers, Acquisitions and Joint Ventures in the Our Practice section of this website if you have any questions.