Chapter 16 - § 16.18 •SECTION 16(b)

• Jurisdiction: Colorado

§ 16.18 •SECTION 16(b)

Section 16(b) of the 1934 Act is a potent section frequently found to trap unwary directors and officers of companies with securities registered under the 1934 Act. Section 16(b) makes it unlawful for any officer or director of a company whose shares are registered under the Act, or for a beneficial owner of more than 10 percent of such registered shares (insiders), to purchase and sell, or to sell and purchase, any non-exempt shares of the company within a period of less than six months.⁴⁴¹

The company may recover any profits realized by an insider in violation of § 16(b). This is a strict liability statute that, with some exceptions, is determined without regard to fault or the use of any inside information. See Foremost-McKesson, Inc. v. Provident Securities Co.:⁴⁴²

Congress recognized that insiders may have access to information about their corporations not available to the rest of the investing public. By trading on this information, these persons could reap profits at the expense of less well informed investors. In § 16(b) Congress sought to "curb the evils of insider trading [by] . . . taking the profits out of a class of transactions in which the possibility of abuse was believed to be intolerably great."⁴⁴³

Issuers and their insiders may, however, purposefully structure their transactions so as to avoid falling within the scope of § 16(b). See Reliance Electric Co. v. Emerson Electric Co.,⁴⁴⁴ where a 10-percent shareholder split its disposition of stock into two transactions completed at different times in an effort to avoid the applicability of § 16(b) — and this transaction was found to be acceptable.

All shares purchased and sold, or sold and purchased, are treated as fungible. Therefore, if there are several in-and-out transactions during any given six-month period, courts will match the purchases against the sales according to the "lowest price in, highest price out," so as to maximize the profits recoverable by the company. For example, a debtor was found liable for § 16(b) violations when a bank that held his pledged shares sold the stock after foreclosure; the bank's sales were matched with his other purchases.⁴⁴⁵

For § 16(b) to be applicable, the same class of security must be involved. This may include transactions in derivative securities, such as options or convertible securities. Section 16(b) will not act to impose liability based on transactions in different types of equity securities, such as a purchase of voting common stock with a sale of non-voting common stock. As the Southern District Court in New York has said, where two equity securities have different voting rights and different dividend preferences, they are not in the same class for the purposes of § 16(b).⁴⁴⁶

Furthermore, although the stated purpose of § 16(b) is to prevent the unfair use of information that the insider may have obtained by reason of his or her relationship to the corporation, it is not necessary for a plaintiff (the corporation or someone suing on its behalf) to prove that the insider actually traded on the basis of such information.

In determining whether a person is subject to the application of § 16(b), one must determine whether that person functions as an officer rather than merely looking at corporate titles. See the definition of "officer" in Rule 16a-1(f) adopted in 1991 and modeled after the definition of "executive officer" in Rule 3b-7. The rule includes persons, regardless of title, who "perform . . . policy-making functions for the issuer." In C.R.A. Realty Corp. v. Crotty,⁴⁴⁷ the court held that a corporate vice president was not an officer for the purposes of § 16(b) since he did not have access to inside information. "[I]t is the actual functions of an employee . . . and not his corporate title that determine whether he is an officer within the purview of § 16(b)."⁴⁴⁸

When liability is predicated on the person's status as a 10 percent shareholder, the person must have been a 10 percent shareholder at the time of both sides of the transaction — the purchase and sale or the sale and purchase. If the purchase puts the shareholder over the 10 percent limit, it cannot be matched against a subsequent sale.⁴⁴⁹ When the ownership of convertible or exercisable securities places a person over the 10 percent threshold, that determination is made when the securities first become convertible or exercisable.⁴⁵⁰

The strict application of § 16(b) can lead to liability even when the insider lost money in the transactions. The profit computation method most frequently used by courts in multiple-transaction cases is the one adopted by the Second Circuit in Smolowe v. Delendo Corp.,⁴⁵¹ using the formula "lowest price in; highest price out." For example:

• January 2 — bought 100 shares for $100.
• March 1 — sold 100 shares for $80.
• April 1 — bought 100 shares for $50.
• May 1 — sold 100 shares for $40.

In that case, the insider lost actual cash of $20 on the first purchase and sale, and $10 on the second. It is not likely anyone would accuse him or her of misappropriating inside information since he or she did lose money. For § 16(b) purposes, however, he or she would be held to have profited by $30 by matching the April purchase with the March sale.

In other words, only transactions occurring within two years prior to the institution of suit are subject to scrutiny. There have been arguments made and accepted by courts that the two-year statute of limitations is tolled during any period that the insider is delinquent in the obligation to file Form 3/4/5⁴⁵² unless the plaintiff was aware of the potential claim.⁴⁵³ In an 8-0 vote, the Supreme Court rejected this disclosure approach in Credit Suisse Securities (USA) LLC v. Simmonds.⁴⁵⁴ The Court was, however, equally divided on whether the two-year statute of limitations was absolute (as in a statute of repose) or a notice statute, commencing the statute of limitations upon actual or constructive discovery. Because there was no majority, the Simmonds court affirmed the Ninth Circuit's rejection of the absolute two-year statute, but without precedential effect. The Supreme Court remanded the case to the Ninth Circuit to "consider how the usual rules of equitable tolling apply to the facts of this case."⁴⁵⁵ In a footnote, the Court also rejected the Second Circuit's requirement for "actual notice" of the § 16(b) violation as a condition precedent to commencement of the statute of limitations.⁴⁵⁶

Historically, there has been no equitable tolling permitted in § 16(b) actions when the SEC filings provide investors with sufficient notice.⁴⁵⁷ Even the filing of inaccurate forms has been deemed not to toll the statute of limitations.⁴⁵⁸

In addition to actual cash purchases and sales, § 16(b) has been held applicable to numerous unorthodox transactions. In Whittaker v. Whittaker Corp.,⁴⁵⁹ the court said that, in interpreting § 16 for situations that do not obviously fall within its scope, "a certain tension is immanent."⁴⁶⁰ In deciding whether unorthodox transactions fall within the reach of § 16(b), two approaches have been...