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Litigation: 2nd Circuit steps up to the plate on short-swing profits

Court’s ruling finds Section 16(b) of 1934 Act doesn’t provide short-swing exemption in issuer-solicited deal

Section 16(b) of the Securities Exchange Act of 1934 imposes strict liability on insiders whose purchases and sales of securities result in “short-swing profits,” i.e., profits realized from the purchase and sale (or sale and purchase) of a company’s shares within a six-month period. “Insiders” include directors, officers and “beneficial owners” of more than 10 percent of a company’s registered securities—namely, persons who exercise voting or investment control over, and hold a pecuniary interest in, more than 10 percent of a company’s registered securities. Section 16(b) aims to prevent these insiders from engaging in speculative transactions on the basis of information not available to others.

On Jan. 20, 2012, the 2nd Circuit held that a beneficial owner’s acquisition of securities directly from an issuer—at the issuer’s request and with the board’s approval—is covered by Section 16(b), and that limited partnerships are beneficial owners for the purposes of Section 16(b) liability, notwithstanding their delegation of voting and investment control over their securities portfolios to their general partners’ agents. (See Huppe v. WPCS Intern. Inc., --- F.3d ---, 2012 WL 164072 (2d. Cir. 2012).)

The defendants-appellants were two funds (the Funds) that invest in publicly traded companies through so-called PIPE (private investment in public equity) transactions. Each fund owned more than 10 percent of the shares of nominal defendant, WPCS International Inc. The Funds assigned to general partners the exclusive power to make all investment and voting decisions on behalf of the Funds. Austin Marxe and David Greenhouse were members or limited partners of these general partners, and were appointed as agents to perform the respective general partners’ duties.

In April 2006, Marxe and Greenhouse acquired securities directly from WPCS—at WPCS’s request and with the approval of the WPCS board of directors. A WPCS shareholder then filed a derivative action alleging that the Funds, as 10-percent holders, were liable to WPCS under Section 16(b) for their short-swing profits.

The Funds argued that the April transaction should be exempt from Section 16(b)’s coverage because it resulted from direct negotiations between WPCS and the Funds and was approved by WPCS’s board of directors. They argued that even if one assumes the Funds had access to inside information about WPCS, “it was impossible for the Funds to gain any speculative advantage from such information because WPCS and its board, which approved the transaction—had access to the same information.” Id. at *3.

The 2nd Circuit ruled that the April transaction was, in fact, subject to Section 16(b)’s coverage, noting that the fact that “issuers and insiders will share access to the same ‘inside’ information in most issuer-insider transactions does not mean that every issuer-insider transaction is invulnerable to information asymmetry.” Id. at *5.

The Funds also argued that the limited partners’ delegation of exclusive power to vote and dispose of the Funds’ portfolio securities to their respective general partners, and then to Marxe and Greenhouse, precluded the Funds from being 10-percent holders under the SEC’s rules. They argued that Marxe and Greenhouse—who actually controlled the securities—were the only conceivable insiders with the ability to misuse inside information, and consequently they, but not the Funds, should be subject to the restrictions of Section 16(b).

The 2nd Circuit found this argument “inventive,” but contrary to basic principles of Delaware agency law. Marxe and Greenhouse served as agents of the Funds’ respective general partners, who delegated to them their “rights and power” to exercise voting and investment control over the securities held by the Funds, and so their actions bound the partnership.


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Alex Romain

Alex G. Romain is a partner at Williams & Connolly LLP, where he concentrates his practice on securities litigation and professional liability defense. He can...

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