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SECOND CIRCUIT CLARIFIES SHORT-SWING PROFIT RULES AS APPLIED TO OPTIONS

Under § 16(b) of the Securities Exchange Act of 1934, directors, officers and 10% shareholders of public companies who, within six months, purchase and sell (or sell and purchase) securities of their company can be compelled to disgorge their profits on the transaction. In the words of § 16(b), this provision has “the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer.”

The US Court of Appeals for the Second Circuit (which covers New York, Connecticut and Vermont) recently decided two cases about how § 16(b) applies when the “purchase” or “sale” is part of a more complicated transaction that occurs in more than one step. These recent cases highlight some of the potential minefields that corporate officers and directors, as well as substantial equity investors, must navigate when transacting in stock of their company. Careful analysis of each transaction is key: in both these cases, the defendants prevailed and did not have to disgorge their profits, but it took an appeal to the Second Circuit to establish that.

In DiLorenzo v. Murphy, 443 F.3d 224 (2d Cir. 2006), which was decided on March 28, the Second Circuit decided that the relevant “purchase” date is when the buyer no longer has the ability to affect the price at which he buys. That means short swing profits are calculated based on sales made within six months from that date, rather than six months from a later date such as when the shares are distributed or the price gets fixed by an independent third party. In At Home Corp. v. Cox Communications, At Home Corp. v. Cox Communications, et al., __ F.3d __, No. 05-0115-cv (2d Cir. April 28, 2006), decided April 28, the Second Circuit explained how § 16(b) applies to “hybrid options” that are potentially exercisable at more than one price. Each of these cases highlights how important it is for directors, officers and substantial shareholders to bear in mind possible § 16(b) issues whenever they engage in transactions in equity securities of their company.

A. DiLorenzo

The defendants in DiLorenzo sold their business to Smithfield Corporation in exchange for Smithfield stock. The sale closed on January 28, 2000. The sale documents called for the defendants to receive Smithfield shares in an amount to be determined later by independent accountants, based on values as of January 28, 2000. At the closing on January 28, 2000, the sellers were issued ten million shares of stock; the amount of additional stock they would get (or would have to return) was still to be determined by the accountants.

The accountants’ analysis was completed in July. Based on the accountants’ calculations, the defendants were issued an additional 1.2 million shares. Between September and November, i.e., less than 6 months after they were issued the additional 1.2 million shares, the defendants sold some Smithfield shares. The plaintiffs sued under § 16(b) of the 1934 Act to compel them to disgorge their profits on the sales.

The District Court granted summary judgment to the defendants and the Second Circuit affirmed. Both courts held that the shares had been purchased by the defendants in return for the business they had sold to Smithfield on January 28, 2000. It was on that date that the terms of the transaction were irrevocably fixed, and all adjustments to the price were based on an analysis that was performed by an independent third party (the accounting firm). Because the purpose of § 16(b) is to prevent insider speculation, and because the defendants had no power to control either the number of shares or the value of the shares at any time after the sale closed on January 28, 2000, the relevant date for § 16(b) purposes was the closing of the sale and not the later date when some of the shares were issued.

B. At Home

In At Home, AT&T had granted a “hybrid put” option to Cox and Comcast under which Cox and Comcast could sell to AT&T their shares of At Home Corp. for the higher of $48 a share or a price to be determined by a formula. AT&T granted the put option on March 28, 2000. Cox and Comcast exercised the put option on January 11, 2001 at the fixed $48 price. At Home sued Cox and Comcast under § 16(b) to compel them to disgorge their profits on purchases made within six months before or after the date they exercised the put option.

The Second Circuit affirmed the trial court’s decision that, in cases where the put is exercised at a fixed price, the date of the sale for § 16(b) purposes is the date the option was granted, not the date of exercise. The Court viewed SEC Rule 16b-6 as dispositive: under that rule, the date a fixed-price put is established is deemed to be the sale date, not the date of exercise. The “hybrid” na-ture of this put was not relevant in this case because the put was exercised at the fixed price, not the floating price.

Cox and Comcast had not purchased any At Home shares during the six months before or after March 28, 2000, when the put was granted. But Comcast had acquired three cable systems between March and August 2000. The three systems owned warrants to purchase At Home stock. At Home argued that this purchase subjected Comcast to § 16(b) because it took place within six months of March 28, 2000. The Second Circuit rejected this argument, and held that a bona fide corporate acquisition does not trigger § 16(b) liability. The concern animating § 16(b) – preventing speculation by insiders holding nonpublic information – is simply not present in such a case. The Court noted that there might be cases where an acquisition is aimed at obtaining securities held by the acquired company, in which case § 16(b) might well apply – but that was not the case here.

If you have any questions about the foregoing article or any related issues, please feel free to contact Stuart M. Riback at 212-981-2326 or via e-mail at sriback@sillerwilk.com.

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