Second Circuit Section 16 Decision Creates Uncertainties in Certain "Group" Situations
June 28, 2007
A recent decision of the Second Circuit Court of Appeals, in the case of Roth v. Jennings, 2007 WL 1629889 (2d Cir., June 6, 2007), creates potentially significant new uncertainties for persons who may be deemed to be insiders for purposes of the short-swing liability provisions of Section 16 of the Securities Exchange Act of 1934, as amended (the ”Act”), by virtue of being part of a “group” within the meaning of Section 13(d) of the Act. The decision vacates a ruling of the District Court for the Southern District of New York that dismissed a shareholder’s suit under Section 16 for disgorgement of short swing profits. The specific legal interpretation on which the decision turns had not previously been decided in a published opinion.
The case involves two persons – T. Benjamin Jennings (”Jennings”) and European Metal Recycling, Ltd. (”EMR”) – who were presumed to constitute a group at the time that Jennings purchased securities of Metal Management Inc. (”MMI”). At the time of the purchase, Jennings and EMR together beneficially owned more than 10% of the stock of MMI. Jennings subsequently sold MMI stock at a profit within six months of the purchase, at a time when he individually beneficially owned less than 10% of MMI’s stock. The Circuit Court held as a matter of law that, for purposes of determining whether Jennings was liable for short-swing profits under Section 16(b) as a result of his sales of MMI stock, it was irrelevant whether Jennings and EMR continued to constitute a group at the time of the sales. In an alternative holding, the Circuit Court also stated that the District Court’s determination that Jennings and EMR ceased to constitute a group at the time of the sales was, in the context of a motion to dismiss, improper as a procedural matter.
The basic facts of Jennings are as follows. In May 2003, Jennings, the former Chairman and CEO of MMI, purchased shares of MMI stock representing 8.3% of MMI’s outstanding stock with an unsecured $10 million loan from EMR, a company that owned 14.3% of MMI’s outstanding stock at that time. On September 8, 2003, EMR and MMI signed a standstill agreement stipulating that EMR would not buy additional MMI shares, or sell its MMI holdings, until the companies explored a potential business combination. In the meantime, between July 14 and September 9, 2003, Jennings sold the majority of his MMI shares at a profit of approximately $4.25 million.
Roth brought a shareholder derivative action against Jennings and MMI for disgorgement of profits from Jennings’ short swing transactions, alleging that, although Jennings individually owned less than 10% of MMI’s stock, he and EMR acted as a group within the meaning of Section 13(d), and thus his ownership of MMI stock should be aggregated with EMR’s. The District Court, in granting Jennings’ motion to dismiss, stated that in order for Section 16 liability to attach the Act requires that group status exist during both the purchase and sale of securities, and that the defendants’ actions (including, among other things, Jennings’ refusal in August 2003 of EMR’s request to sell his shares to EMR at a price below the market price at the time) belied any coordinated action between Jennings and EMR at the time of Jennings’ sales.
The Second Circuit, in rejecting the District Court’s theory, noted that the plain language of Section 13(d) confers group status on persons who reach an agreement for the purpose “of acquiring, holding or disposing of securities.” The Court held that because Section 13(d) is written in the disjunctive, if a purchase of securities occurs at the time the group exists it is not necessary for the group to exist at the time of a sale in order for Section 16 short-swing liability to attach:
Because [Section 13(d)(3) of the Act and Rule 13d-5(b)(1)] list those purposes in the disjunctive, a group is formed as a matter of law if those persons act for any one of the listed purposes. The district court thus erred in holding that “for traders to constitute a ’group’, the Exchange Act requires that their coordinated activity persist during the time of purchase and during the time of sale of the securities.”
This holding is inconsistent with the widely accepted view that persons who engage in a Section 16 transaction at a time they are insiders solely by virtue of being part of a group can avoid short-swing liability by terminating their membership in the group prior to engaging in an “other-way” transaction. That view rests on the holdings of the U.S. Supreme Court in Foremost-McKesson, Inc. v. Provident Sec. Co., 423 U.S. 232, 96 S.Ct. 508, 46 L.Ed.2d 464 (1976) and Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418, 92 S.Ct. 596, 30 L.Ed.2d 575 (1972), that a person can only be liable for short-swing profits under Section 16(b) by virtue of being a 10% beneficial owner if the person is a 10% beneficial owner at the time of both the purchase and the sale giving rise to liability. The Court in Jennings concludes that Foremost-McKesson and Reliance Electric are not controlling authorities in respect of the Jennings facts because, in effect, they address the conditions under which an insider might become liable under Section 16, but not when a person – that is, in particular, a person who is a member of a 10% group – is deemed to be an insider.
It is also notable in this regard that a prior decision of the Second Circuit Court of Appeals, in Morales v. Quintel Entertainment, Inc., 249 F.3d 115 (2d Cir., May 2, 2001) stated (albeit in dicta) that the opposite view – i.e., that an agreement to engage in concerted action must exist at the time of both purchase and sale – “finds support in the plain language” of the statute, and cited Foremost-McKesson and Reliance Electric on the point.
In Jennings, the Circuit Court seems to have concluded that, at least for purposes of Section 16 short-swing liability, group status will be deemed to continue during the potential six-month matching period following a Section 16 purchase by a member of a 10% group. The effect is that if a member of a 10% group engages in a purchase the member cannot sell shares without a risk of short-swing profit liability within six months of the purchase unless the group’s membership’s aggregated security ownership drops below 10% (collectively) at the time of the sale, regardless of whether the group members continue to act in concert.
Nevertheless, the ultimate impact of the Circuit Court’s holding and how it would be applied in other contexts is unclear. As noted, the Court’s opinion included an alternative basis for its decision to vacate the District Court’s dismissal, which is far narrower and not inconsistent with the heretofore accepted view that a group must exist at the time of both the matching purchase and sale to comply with Foremost-McKesson and Reliance Electric if group aggregation is necessary for the purchaser/seller to beneficially own more than 10%. The inclusion of this alternative predicate may well be considered an indication that the Circuit Court had concluded that, for purposes of a motion to dismiss, the group in fact did continue to exist at the time of Jennings’ sale. Indeed, the Circuit Court, in explaining its initial holding, recounted the circumstantial evidence suggesting that Jennings’ decision to sell “could well have been based on inside information,” and concluded:
That type of trading on the basis of advance information is the sort of conduct that Congress sought to deter by enacting § 16(b) and making short-swing profits automatically disgorgeable “without proof of actual abuse of insider information, and without proof of intent to profit on the basis of such information,” Kern, 411 U.S. at 595.
At a minimum, however, Jennings should cause potential Section 16 insiders to be more sensitive to Section 16 risks arising from group settings.
The case should be of specific interest to persons who form groups for the purposes of potentially acquiring control of a public company, the context in which the Jennings case actually arose. In addition, the ruling also has important potential applicability in the context of broker-dealer activities, including equity derivatives trading and equity financing activities. In those contexts, arguments can sometimes be made that a broker-dealer may be deemed to be part of a group with its counterparty and/or with other financial institutions that are engaged at the same time in financing acquisitions by the counterparty. Frequently, it is assumed that if a group is deemed to have been formed at all in those circumstances, the group should be considered to cease existence shortly thereafter. The Jennings decision calls into question that analytical approach to assessing Section 16 risks arising from potential group status.
A copy of the Jennings 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 Derivatives, Employee Benefits, Mergers, Acquisitions and Joint Ventures, or Capital Markets in the Our Practice section of this website if you have any questions.
CLEARY GOTTLIEB STEEN & HAMILTON LLP