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Business Law Today

August 2020

Repeal or Amend Section 16(b) of the Securities Exchange Act of 1934, the “Short Swing” Disgorgement Provision

Stuart J Kaswell


  • A fair reading of Section 16(b) leads to the conclusion that this provision: (1) never achieved its original purpose; (2) creates a trap for the unwary; and (3) needlessly complicates ordinary business transactions.
  • Section 16(b) does not confer a public benefit proportionate to its attendant cost; if a proposed transaction does not fall squarely within an exemption, legal expense, delay, an uncertainty may prevent what would be a harmless transaction.
  • Congress should repeal Section 16(b) because it is an ineffective deterrent against true insider trading.
Repeal or Amend Section 16(b) of the Securities Exchange Act of 1934, the “Short Swing” Disgorgement Provision ozel

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Congress should repeal or modify section 16(b) (Section 16(b)) of the Securities Exchange Act (Exchange Act) of 1934. This provision requires certain corporate “insiders” to disgorge profits that they earn from “short swing” transactions in the stock of public companies. Section 16(b) defines a purchase and sale, or sale and purchase, within six months’ time as a short-swing transaction. Congress included the provision as part of the original Exchange Act in an effort to discourage insider trading.

A fair reading of Section 16(b) leads to the conclusion that this provision: (1) never achieved its original purpose; (2) creates a trap for unwary; and (3) needlessly complicates ordinary business transactions. Furthermore, other provisions of the Exchange Act and attendant rules more effectively prohibit the activity that the framers of Section 16(b) sought to stop. The Department of Justice and the Securities and Exchange Commission (the SEC or Commission) use other prohibitions, some of which the SEC and the courts developed later, against insider trading and market manipulation.

Section 16(b) was just one of a multitude of provisions that Congress enacted in 1934 with the hope of cleaning up Wall Street. Faced with 85 years of evidence, it is time to recognize that Section 16(b) was a mistake and that keeping it on the books causes much more harm than good. I explain my reasoning below.

Congress’s Enactment of Section 16(b)

Section 16(b) of the Exchange Act provides that an officer, director, or 10-percent beneficial owner of any equity security that is registered pursuant to section 12 of the Exchange Act (a covered person) must disgorge any profit that he or she derives from the sale and purchase, or purchase and sale, of any equity security of such issuer within any period of less than six months. The provision creates a private right of action for the issuer to recover the profit from a covered person and allows the owner of any security to sue on behalf of the issuer. Congress stated that the purpose of the provision was to prevent the unfair use of information to which such covered persons might have access. Congress created a strict liability provision, i.e., covered persons are liable irrespective of any intention that they may have had.

Section 16(b) is unique in at least two respects. It does not authorize the SEC to bring an action against insiders who trade within the six-month period. Instead, it provides that the issuer may bring an action to recover the profit, and if the issuer declines to do so, that the shareholder may bring such an action. The U.S. Supreme Court noted that “Congress clearly intended to put ‘a private-profit motive behind the uncovering of this kind of leakage of information, [by making] the stockholders [its] policemen.’” Although Section 16(b) provides that the profits belong to the issuer, the attorneys who bring cases for shareholders obtain attorney’s fees for their efforts.

Congress’s inclusion of Section 16 was no accident. The Pecora Report outlines a litany of shameful practices in which officers, directors, large shareholders, specialists, and others engaged. These activities manipulated markets, penalized public shareholders, and earned such insiders large profits. The Pecora report notes in part:

Among the most vicious practices unearthed at the hearings before the subcommittee was the flagrant betrayal of their fiduciary duties by directors and officers of corporations who used their positions of trust and the confidential information which came to them in such position, to aid them in their market activities. Closely allied to this type of abuse was the unscrupulous employment of inside information by large stockholders who, while not directors and officers, exercised sufficient control over the destinies of their companies to enable them to acquire and profit by information not available to others.


(e) Regulation of market activities of officers, directors, and principal stockholders.—The Securities Exchange Act of 1934 aims to protect the interests of the public against the predatory operations of directors, officers, and principal stockholders of corporations by preventing them from speculating in the stock of the corporations to which they owe a fiduciary duty. Every person who is the beneficial owner of more than 10 percent of any class of equity security registered on an exchange or who is a director or officer of the of issuer such security must report to the Commission whenever any change occurs in his ownership of stock in the corporation. In the event that he realizes any profits from the purchase and sale or, sale and purchase of an equity security within period of less than 6 months, he is bound to account to the corporation for such profits. It is also made unlawful for insiders to sell the security of their corporations short or to make “sales against the box.” By this section, it is rendered unlawful for persons intrusted [sic] with the administration of corporate affairs vested with substantial control over corporations to use inside information for their own advantage.

The SEC Historical Society explains:

In a 1965 interview, Ferdinand Pecora recalled how he, [Thomas] Corcoran, James Landis and Benjamin Cohen had drafted Section 16 as “the anti-Wiggin section,” named after Albert H. Wiggin, who headed the Chase Manhattan Bank from 1921 to 1933. Pecora recalled how Wiggin had testified that he short-sold Chase National Bank stock that he didn’t own but expected to repurchase at a lower price, and thereby took a profit through six different private investment corporations he had established. One of them had taken a profitable position with Sinclair Oil and Refining Company at a time when Sinclair had a large line of credit with Chase Bank. The securities trading abuses of such people, said Pecora, “were the reason that we drafted [Section 16] of the Act, as we burnt the midnight oil.”

The SEC clearly liked Section 16(b). A 1941 SEC report reads:

Section 16(b) of the act recognizes that profits realized by officers, directors, or 10-percent stockholders from any purchase and sale or any sale and purchase of any equity security within a period of 6 months rightfully belong to the corporation and should be recoverable in an action by, or on behalf of, the corporation. Representatives of the securities industry propose that section 16(b) be repealed. The Commission is unalterably opposed to this suggestion, since it would strip investors of one of their most essential protections.

It has been asserted that the provision operated to deter insiders from making purchases to retard a falling market. But if an insider really wishes to cushion a decline, section 16(b) does not make it unlawful for him to do so. It is only where the insider makes a profit within the relatively short period of 6 months that his profit is required to be turned over to the corporations. Furthermore, that particular argument for repeal of section 16(b) presupposes that insiders would act to bolster the market by trading primarily against the trend, buying in weak markets and selling in strong markets. But, even if it be assumed that some corporate officials would so act, the mere fact that the activities of some trustees might be advantageous to their beneficiaries has never been considered an adequate reason for an abolition of the prohibition against self-dealing by trustees in trust property.

Moreover, even if insiders would purchase in order to bolster the market, there is serious doubt whether investors would always be benefited. If the market continued to fall after the insiders had attempted to support the market, their activities would have injured those new investors who had been induced not to sell and those new investors who had been induced to purchase by the false appearance of stability thus created.

It has been argued that section 16(b) applies in some instance to profits even though made without the use of inside information. This argument is clearly beside the point. The mere existence of temptation on the part of fiduciaries to abuse their position had traditionally led the courts to bar them from activities in fields where such temptations exist. Thus, where trustees acting in their own interest with trust assets, it has long been settled that they will be required to account for any personal profits made regardless of whether they take advantage of their position and regardless of whether the beneficiaries suffered. Similarly, a corporate officer may not acquire for himself an opportunity which is available to his corporation even though it cannot be demonstrated that the corporation has been damaged by the acquisition. And this is true even where the corporation has not had the financial resources to avail itself of the opportunity. The deterrent of section 16(b) to in-and-out trading by insiders is thus consistent with the time-honored doctrine that a trustee must avoid any activity which involves even a remote possibility of a conflict of interest between his fiduciary obligation and his personal self-interests. The Commission is convinced that any legislation which sought to distinguish between situations where inside information is actually used and those where it is not used would be self-defeating because of the inherent difficulties of establishing the use of inside information in particular cases.

It may also be urged with much force that even to the extent that section 16(b) may permit the recovery of profits made without the use of inside information it achieves a highly desirable objective. It is to be doubted whether the interests of security holders are benefited when the attention of their officers and directors is diverted from the corporation’s affairs to stock market speculation in its securities.

Representatives of the securities industry couple their proposal to repeal section 16(b) with a suggestion that section 16(a) require that insiders, instead of reporting their transactions monthly, do so within 10 days after becoming offices, directors, or 10-percent stockholders. They assert that the publicity provisions of section 16(a) as thus amended would be adequate to prevent abuses. Although the reporting of transactions may in some cases operate as a deterrent, it cannot be expected to prevent insiders from taking advantage of inside information. The temptations and the potential returns are too great to be effectively overcome merely by subsequent publicity. It was because the Congress did not believe that publicity alone would be sufficient that it defined the standard in section 16(b)—that insiders, because of their fiduciary relationship, should not trade in-and-out in the securities of their companies for personal gain. The consequences of failing to comply with this standard are not penal. The section does not make insiders’ trading unlawful; it does not even subject insiders to injunctive proceedings. It simply guards against the use of inside information since such information is not the personal property of the insiders themselves and since any profits resulting from its use belong to the insides no more than does the insider information itself.

What Law Makes Insider Trading Unlawful?

Section 16(b) is not an effective tool for policing insider trading. Section 16(b) does not make it unlawful for insiders to trade; it simply requires them to disgorge the profit. It does not grant the SEC or any other government body authority to enforce its prohibitions. By comparison, Section 10(b) of the Exchange Act and Rule 10b-5 allow U.S. attorneys to prosecute wrongdoers criminally and allow the SEC to bring civil enforcement actions against malefactors.

The U.S. government’s efforts to prosecute insider trading has taken a very different path. The Commission adopted Rule 10b-5 in 1942, i.e., after Congress enacted Section 16(b). The history of SEC enforcement for insider trading began in 1961. The SEC brought an administrative action for insider trading, relying on Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. In In the Matter of Cady, Roberts & Co., the SEC concluded that when a board member of a public company tipped a registered representative of a broker-dealer about the issuer’s plan to reduce its dividend, and the representative sold the issuer’s securities, the representative violated Rule 10b-5 and Section 17 of the Securities Act of 1933.

Since that early case, the law of insider trading has evolved. Congress, the U.S. Supreme Court, and the SEC all have ensured that Section 10(b) and Rule 10b-5 now constitute strong weapons against insider trading. For example, Congress enacted the Insider Trading Sanctions Act in 1984, which authorizes the SEC to bring a court action seeking a civil penalty of up to three times the wrongdoers’ profits. The Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA), among other measures, expanded controlling personal liability for insider trading and required broker-dealers and investment advisers to have surveillance systems reasonably designed to prevent insider trading. In 2016, a unanimous U.S. Supreme Court upheld criminal convictions for insider trading under Section10(b) of the Exchange Act and Rule 10b-5. The court unanimously reaffirmed its view of the law that it first had articulated in 1983. In addition to Rule 10b-5, the SEC adopted Rule 14e-3 to outlaw insider trading in connection with a tender offer. Prosecutors often also charge defendants with violating federal mail and wire fraud statutes because those statutes may have lower burdens of proof. In summary, presumptive insider trading under Section 16(b) buys you an expensive lawsuit; actual insider trading under Rule 10b-5 lands you in jail.

Section 16(b) in Practice

If Section 10(b) and Rule 10b-5 are the meaningful insider trading prohibitions, what harm is there in keeping Section 16(b)? Isn’t it better to be safe than sorry? Even a cursory examination of the practical effects of Section 16(b) should lead an honest observer to question the utility of the provision. Section 16(b) has spawned countless interpretive questions, such as who is an officer, who is a “real” versus an honorary director, and how one must calculate 10-percent ownership. The SEC has adopted rules to clarify many aspects of Section 16(b), but for reasons discussed below, all of this complexity has not made the securities markets more honest for investors.

1. Does Not Deter Insider Trading Effectively

Congress assumed that a covered person trading within six months must “know something” that other investors or the public does not, regardless of what the insider actually knows. Section 16(b) does not prohibit insider trading; it merely seeks to remove its profitability.Accordingly, Section 16(b) imposes liability regardless of whether the covered person actually traded on inside information. As a strict liability provision, it imposes liability even if the insider:

  • did not know of the existence of Section 16(b);
  • received inaccurate legal advice about the provision;
  • miscalculated the six-month period;
  • mistakenly assumed that the restriction did not apply to transactions with other insiders;; or
  • rescinded a trade to avoid liability.

These are just a few examples of when Section 16(b) imposes liability under circumstances that do not further its policy objective. Romeo & Dye note that Section 16(b) does not impose liability on many situations that do constitute insider trading. For example, Section 16(b) does not apply to:

  • all persons who might have actual access to, and while in possession of, inside information;
  • tippers or tippees; or
  • insider trading that occurred after six months.

In short, Section 16(b) does not deter insider trading because it is both over- and under-inclusive. Many observers have called it a “trap for the unwary.

I have summarized below some of the perverse outcomes that Section 16(b) has created. It is just a sampling of the problems that Romeo & Dye and others have described.

2. Damage Calculation May Be Unfair

The courts have developed a methodology for calculating profitability on Section 16(b) that is needlessly punitive. “Operating on the premise that Congress intended Section 16(b) to have the maximum deterrent effect, the first appellate court to decide a Section 16(b) case stated that ‘[t]he only rule whereby all possible profits can be surely recovered is that of lowest price in, highest price out.’’’ The Commission noted that “under this method, profit is computed by matching the highest sale price with the lowest purchase price within six months, the next highest sale price with the next lowest purchase price within six months, and so on, until all shares have been included in the computation.” The net result of this methodology is that a covered person who violates Section 16(b) may have to pay illusory profits to the plaintiff, notwithstanding that the covered person will have lost money under any conventional calculation of gain or loss.

3. Fiduciary Theory—Not Sensible in This Context

As the preamble to Section 16(b) notes, Congress enacted the prohibition “[f]or 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. . . .” As noted above, the Pecora report expressed the view that officers, directors, and ten-percent shareholders should not take advantage of their position in the corporation for personal profit. The 1941 SEC Report suggests that any such profit rightfully belongs to the issuer.

Of course, it is unethical, and should be illegal, for corporate insiders to benefit from such inside information. However, I disagree with the notion that such a profit rightfully belongs to the issuer. Section 16(b) claims to reflect principles of fiduciary law, including the idea that a covered person should not benefit personally from his or her position of trust. A covered person who engages in a short-swing transaction is not usurping a corporate opportunity. For example, I appreciate that an officer should not secretly buy a tract of land in which the issuer is interested, and then raise the price of the land in a subsequent sale to issuer, but an issuer should not trade its own securities without making proper public disclosure to the markets. Doing so would violate Section 10(b) and Rule10b-5 and perhaps other Exchange Act provisions.

SEC Rule 10b-18 provides a safe harbor for issuers that repurchase their shares. The Division of Trading & Markets Frequently Asked Question notes:

Question 1: If an issuer executes purchases that are in technical compliance with the safe harbor conditions, will that protect the issuer from all liability for such purchases?

Answer: No. Some issuer repurchase activity that meets the safe harbor conditions may still violate the anti-fraud and anti-manipulation provisions of the Exchange Act. For example, Rule 10b-18 confers no immunity from possible Rule 10b-5 liability where the issuer engages in the repurchases while in possession of material, non-public information concerning its securities, or where purchases are part of a plan or scheme to evade the federal securities laws. Therefore, regardless of whether an issuer’s repurchases technically satisfy the conditions of Rule 10b-18, the safe harbor would not be available if the repurchases are fraudulent or manipulative, when all the facts and circumstances surrounding the repurchases are considered (i.e., facts and circumstances in addition to the volume, price, time, and manner of the repurchases). For example, the safe harbor would not be available if the repurchases are made as part of a manipulative scheme to influence the closing price of a company’s securities, or are done to mask other motives, such as inflating or manipulating short-term earnings.

An issuer that does not disclose material information or otherwise engages in manipulative behavior will have broken the law. It is difficult to see that an insider who trades on material nonpublic information is usurping a corporate opportunity from the issuer, such that the issuer should claim any profits.

Of course, if an officer, director, or shareholder trades on the basis of material nonpublic information, that person probably has violated Section 10(b) and Rule 10b-5. In U.S. v. Chiarella, the U.S. Supreme Court articulated what the courts now call the “classic” theory of insider trading. The Court stated that:

one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information “that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.

* * *

The federal courts have found violations of § 10 (b) where corporate insiders used undisclosed information for their own benefit. E. g., SEC v. Texas Gulf Sulphur Co., 401 F. 2d 833 (CA2 1968), cert. denied, 404 U. S. 1005 (1971). The cases also have emphasized, in accordance with the common-law rule, that “[t]he party charged with failing to disclose market information must be under a duty to disclose it.” Frigitemp Corp. v. Financial Dynamics Fund, Inc., 524 F. 2d 275, 282 (CA2 1975). Accordingly, a purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a fiduciary has been held to have no obligation to reveal material facts. See General Time Corp. v. Talley Industries, Inc., 403 F. 2d 159, 164 (CA2 1968), cert. denied, 393 U. S. 1026 (1969).

Unlike Section 16(b), Section 10(b) and Rule 10b-5 apply to any person, and not just to officers, directors, and ten-percent shareholders. Accordingly, Section 10(b) and Rule 10b-5 apply more broadly than does Section 16(b). Further, Section 16(b) penalizes officers, director, and ten-percent shareholders regardless of whether their trading was on the basis of material nonpublic information. Therefore, Section 16(b) is both over- and under-inclusive.

As noted, the 1941 SEC Report discusses the futility of trying to distinguish situations in which a covered person did or did not engage in insider trading:

The Commission is convinced that any legislation which sought to distinguish between situations where inside information is actually used and those where it is not used would be self-defeating because of the inherent difficulties of establishing the use of inside information in particular cases.

I doubt that the SEC would make this argument today. Identifying persons who engage in insider trading is a central element of the Commission’s enforcement program. In the wake of Dirks and Salmon, it is essential that the Commission demonstrate that persons who trade (or their tippees) obtained, and traded on the basis of, material nonpublic information in breach of a fiduciary duty. Again, the SEC had not adopted Rule 10b-5 in 1934 or 1941, and the courts and SEC had not developed this area of the law. Moreover, at the time Congress was considering the Exchange Act, it also was considering legislation that fundamentally altered the federal rules of discovery.

Six Months Is Not as Short as It Used to Be

In 1934, it may have been reasonable for Congress to assume that a covered person who traded within six months was trading with atypical speed; that is no longer the case. As we have discussed above, a six-month period is purely arbitrary because Section 16(b) liability does not depend on the investor’s actual knowledge. Even if that judgment were reasonable in 1934, it no longer reflects the world of today. By every measure, a six-month period no longer constitutes a short period of time for securities trading.

  • In 1934, telecommunications consisted of telegrams, telex, radio, and telephone calls, recalling that long-distance calls required operator intervention and were expensive. Computers were barely in their infancy. No one had even conceived of the telecommunications revolution that we enjoy today.
  • There was no such thing as computer-driven algorithmic trading; the world’s first electronic computer did not begin functioning until 1945. At that time, the idea of a personal computer would have seemed as absurd as a personal nuclear reactor. Today, quantitative hedge funds and proprietary trading firms may buy and sell financial instruments within a fraction of a second.
  • Today’s securities trading volumes dwarf what Congress contemplated in 1934. For example, in the 1929 stock market crash, the volumes noted below were extraordinarily large for that era. Trading volume overwhelmed the “ticker” price dissemination mechanism, and it was hours late.
Day Open Close Percent Change Shares Traded
Black Thursday, Oct. 24 305.85 299.47 -2% 12,894,650
Friday, Oct. 25 299.47 301.22 +1% 6,000,000
Saturday, Oct. 26 301.22 298.97 -1% Not available
Black Monday, Oct. 28 298.97 260.64 -13% 9,250,000
Black Tuesday, Oct. 29 260.64 230.07 -12% 16,410,000
  • By comparison, the 50-day average volume for Apple, i.e., one stock, is 26,769,660 shares. In 2017, the Depository Trust & Clearing Corporation noted that “on average, we process around 100 million transactions [e., not shares] each day, but we also need to be prepared to handle many multiples of that when markets are at their most volatile. Our record is 315 million transactions in a single day, which occurred in October 2008 at the height of the financial crisis.”

In summary, the speed at which society communicates today vastly outstrips any assumptions that Congress made about short-swing transactions in 1934.

SEC Exemptive Rules

The SEC has adopted rules that mitigate some of the mischief of Section 16(b). Many of these exemptions protect the parties from liability in routine business transactions that may involve covered persons making purchases and sales within the prohibited six-month period. For example:

  • Rule 16b-5 exempts gifts from Section 16(b). The exemption provides that “both the acquisition and the disposition of equity securities shall be exempt from the operation of section 16(b) of the Act if they are: (a) Bona fide gifts; or (b) transfers of securities by will or the laws of descent and distribution.”
  • Rule 16b-7 exempts many mergers, reclassifications, and consolidations. For example, Rule 16b-7(a)(1) exempts from Section 16(b) the acquisition of a security of a company, pursuant to a merger, reclassification, or consolidation, in exchange for a security of a company that before the merger, reclassification, or consolidation owned 85 percent or more of either: (i) the equity securities of all of the companies involved in the transaction; or (ii) the combined assets of the companies involved in the transactions.

These and other exemptive provisions prevent Section 16(b) from being an even greater obstacle to legitimate business than it currently creates. The exemptions also include a litany of SEC interpretations and court decisions, adding glosses to the provisions.

Aggressive Plaintiffs’ Bar

Some members of the plaintiff’s bar have sought recovery under Section 16(b), proposing theories that are aggressive. As noted below, courts may reach very different conclusions on similar Section 16(b) claims.

1. “Deputization” of Directors

Some courts have held that “a corporation, partnership, trust, or other person” may be a director for purposes of Section 16 by expressly or impliedly “deputizing” another person to serve on its behalf on the board of directors of a Section 12 registrant. A director is liable under Section 16(b) without regard to any amount of stock ownership.

Courts’ determinations run the gamut and are fact-specific. R&D summarize the key factors as follows:

  • the entity recommended the director for election or appointment to the board;
  • the entity recommended the director for the purpose of protecting or representing the entity’s interests rather than for the purpose of guiding or enhancing the issuer’s business activities;
  • the director regularly gained access to material nonpublic information about the company;
  • the director shared the confidential information with the entity; and
  • the entity used the information to inform its investment decisions regarding the company’s securities.

Courts will deem a director by deputization only “if the director has a relation with the entity (e.g., as an employee or principal) that either allows the entity to influence the director’s decisions as a director or allows the director to influence the entity’s investment decisions regarding the company.”

The SEC and some courts have concluded that a director by deputization may rely on the exemption in Rule 16b-3.

Investment entities must be mindful of the risk that a court will conclude that it has deputized a director. It is important to recall that a director who tips others in breach of duty risks violating Section 10(b) and Rule 10b-5. As noted, Section 16(b) liability is not the only or even the best way to address insider trading.

2. Investment Manager Exemption

Rule 16a-1(a)(1) and subpart (v) create an exemption for investment managers. The SEC’s rule defines “beneficial owner” for purpose of Section 16 and not just for Section 16(a). The rule excludes investment managers from the definition of “beneficial owner” under the following conditions:

  • the owner of securities of such class held for the benefit of third parties or in customer or fiduciary accounts in the ordinary course of business;
  • as long as such shares are acquired by such institutions or persons without the purpose or effect of changing or influencing control of the issuer or engaging in any arrangement subject to Rule 13d-3(b); and
  • any person registered as an investment adviser under Section 203 of the Investment Advisers Act of 1940 or under the laws of any state.

Given that many hedge fund managers invest their own funds along with outside investors, some plaintiffs’ lawyers have argued that the manager is not investing purely for the benefit of third parties. As a result, some plaintiffs’ attorneys have argued that hedge fund managers flunk the second prong of the test and are not entitled to the investment adviser exemption. The courts have split on that argument. The structure of the fund may offer some protection from such claims, but practitioners indicate that the litigation risk is significant.

Money managers were concerned that a covered person who received a fee for managing an investment account that holds the issuer’s securities would have an indirect pecuniary interest in those securities and therefore would be subject to Section 16(b). In response to those concerns, the SEC added subsection Rule 16a-1(a)(2)(ii)(C) to the rule, creating an exemption for performance-related fees. The courts have issued numerous opinions delineating when they will and will not apply the exemption.

3. Definition of a “Group”

In a recent case, a plaintiff unsuccessfully argued that every discretionary account under the control of an investment adviser is member of a “group” and therefore subject to the short swing transaction provision of Section 16(b). In Rubenstein v. International Value Advisers LLC et al., the investment adviser International Value Advisers LLC (IVA) and two of its principals managed funds and separately managed client accounts that purchased shares in DeVry Education Group (DeVry), a public company. IVA had developed a control purpose for purposes of Section 13(d) under the Exchange Act and accordingly filed a Schedule 13D. A customer of IVA “John Doe” had a brokerage account that IVA managed and to which John Doe granted discretionary trading authority. IVA subsequently purchased shares in DeVry for that account and subsequently sold those shares in less than six months. The plaintiff argued that the Section 16(b) 10% shareholder liability provision applied to all such accounts. The U.S. Court of Appeals for the Second Circuit disagreed:

Between June and December 2016, the IVA defendants reported on ownership reports filed under Section 13(d) and Section 16(a) of the ’34 Act that they beneficially owned, through their voting and investment power over their advisee-clients, more than 10% of DeVry’s outstanding common stock. Specifically, at various times in 2016, the IVA defendants filed Schedule 13Ds with the SEC indicating that, in accumulating their position in DeVry, they had formed a “control purpose” with respect to DeVry and that they sought the appointment of IVA’s managing partner to the DeVry board to represent the investment interests of IVA and its clients who held DeVry shares. *** In July 2016, IVA, as investment manager for John Doe’s account, purchased 31,847 shares of DeVry and within six months sold DeVry shares at a profit.

The court notes that without question, Section 16(b) liability applies to the other accounts in the group. The plaintiff alleged that the John Doe account was part of the group and therefore subject to the disgorgement remedy. (IVF did not buy and sell or sell and buy other shares of DeVry within six months’ time.) The court disagreed for a number of reasons.

  • Section 16(b) liability does not apply to a customer’s general grant of discretion. When customers grant discretion to an investment adviser, they grant authority to the adviser to trade securities generally, not with respect to one issuer. Section 16(b) only addresses trading in one issuer, not several.
  • Courts should not read Section 16(b) broadly. “The plaintiff argues that a narrow reading will enable investment managers to evade Section 16(b) and to abuse inside information by trading in client funds rather than their 12 own funds because client funds may not be subject to disgorgement.” First, citing Gollust and other decisions, the U.S. Supreme Court has cautioned against exceeding the narrowly drawn limits of the statute. Moreover, the court notes that:

    Exempting certain client profits from Section 16(b) does not insulate investment advisors from liability under the more general anti-fraud provisions of the ‘34 Act: Section 10(b) and Rule 10b-5. If IVA had improperly used inside information to trade in its clients’ accounts, it could be subject to Rule 10b-5, regardless of whether its clients were part of an insider group. Section 16(b) addresses only a narrow class of potential insider trading. By contrast, Rule 10b-5 addresses a broader sphere, including the insider trading that Rubenstein [the plaintiff] asks Section 16(b) to police. Trading that passes muster under Section 16(b) may not do so under Rule 10b-5. Rubenstein’s fear that our holding will offer a safe harbor to investment managers engaged in insider trading is consequently unwarranted. Suffice it to say that his complaint contains no allegations that Rule 10b-5 has been violated, and that provision plays no part in our resolution of this case.
  • There is no legal basis for ascribing the actions of one of the adviser’s clients to another, purely because they share the same manager that exercises investment discretion.

    An investment advisory client does not form a group with its investment adviser by merely entering into an investment advisory relationship. Nor does an investor become a member of a group solely because his or her advisor caused other (or all) of its clients to invest in securities of the same issuer. And Rubenstein points us to nothing else that might constitute an “agreement” or demonstrate a “common objective” to trade in the securities of “an issuer.”

    The court further noted:
    Rubenstein would have us treat all investors as though they were conscious of the securities held by their advisors’ other clients and would mandate that they tailor their investment decisions to those other clients’ trades. *** Section 16(b) is not designed to threaten liability based on the trades of other investors to whom a defendant’s only connection is sharing an investment advisor. ***Rubenstein would hold a retiree on the beach in Florida liable when he fails to conduct an ongoing analysis of his IRA manager’s trading in other clients’ accounts. We decline to go down this road.

    The court probably is speaking “tongue in cheek.” It probably would be impossible or illegal for one client to obtain information about another client’s trading activity. Nonetheless, the opinion illustrates the absurd outcome that would result from the plaintiff’s argument.

    The Court of Appeals for the Second Circuit issued a similar ruling in another case involving the same plaintiff. Although these decisions clear up some ambiguities in the law of Section 16(b), “it remains to be seen whether courts will apply a similar analysis where the adviser's clients are investment funds under common control with the adviser.”

Although the Second Circuit ultimately vindicated the defendants in both cases, it must have cost them hundreds of thousands of dollars in legal fees and other expenses to fend off aggressive plaintiffs with “creative” new theories of liability at the intersection of Section 13(d) and Section 16(b). Such wasteful litigation does nothing to strengthen the integrity of our capital markets and to protect investors from shameful behavior. Indeed, it has the opposite effect. Moreover, many defendants will not have the disposition nor the resources to litigate a case in the district court and the appellate court. Some defendants, given the choice between a pyrrhic victory and a less costly settlement, will pay the plaintiff go away.

Given the uncertainty of the outcome and the expense of litigating such cases, some investment managers settle with these lawyers, regardless of the merits of the cases. Such outcomes do not further whatever public policy benefits Congress sought to achieve with Section 16(b); instead, plaintiffs or their lawyers force investment advisers to engage in nothing more than a cost/benefit analysis of whether to settle or litigate.

Distraction for Management

In the 1941 SEC Report, the SEC claimed that Section 16(b) protected shareholders by ensuring that officers and directors would focus their attention on managing the issuer’s business and not trading for their own account. “It is to be doubted whether the interests of security holders are benefited when the attention of their officers and directors is diverted from the corporation’s affairs to stock market speculation in its securities.” The argument is specious.

Why is this the government’s concern? Investors and stock prices are the best judge of whether management is doing its job, not a prohibition on trading. Presumably, investors only care about results, not how officers and directors are spending their time. Indeed, one could argue that it is less of a distraction for covered persons to trade the stock of the issuer than it is for them to trade the stock of another company, for which they would have to devote more time to learn about that issuer and its prospects. Even if one accepted this dubious rationale, it should not apply to 10-percent shareholders who are not also officers or directors of the company.

The federal securities laws should not propose to tell management how to spend its time. Stock prices and investors are the best judges of whether management is doing its job.

Conclusions and Recommendation

This paper outlines only a small sample of the interpretive questions that Section 16(b) has caused. R&D’s materials are replete with discussions of interpretive questions that this provision has created. If Section 16(b) served a useful public purpose, the interpretive issues described above would be an unavoidable cost of applying a simple concept to a complex world. As shown, however, Section 16(b) is an ineffective deterrent against true insider trading. Section 16(b) does not confer a public benefit proportionate to its attendant cost. Notwithstanding the Supreme Court’s pronouncements, if a proposed transaction does not fall squarely within an exemption, legal expense, delay, and uncertainty may delay or prevent what would otherwise be a harmless transaction.

Other portions of the federal securities laws make actual insider trading illegal; prosecutors, the SEC, and private parties provide meaningful sanctions for violating those prohibitions. Further, other prohibitions, such as Section 9 and other aspects of Section 10 of the Exchange Act, along with rules such as Regulation SHO, prohibit the activities about which Congress was concerned. Section 16(b) has failed in its stated purpose, rewards an aggressive plaintiffs’ bar, creates needless complexity, and imposes punishing liability that is out of proportion or unrelated to the behavior it seeks to deter.

In my view, Congress simply should repeal Section 16(b). Congress could never take such action unless both political parties supported the change. It would be easy for one’s political opponents falsely to charge a member of Congress who supported the legislation with favoring insider trading. I appreciate that the political world does not always behave rationally; nonetheless, there is no public policy for retaining the provision, and there are good reasons for Congress to repeal it.

If Congress could not muster the support for outright repeal, there might be a more moderate compromise. Congress could repeal the private right of action and allow the SEC to impose sanctions for short-swing transactions. Congress would need to make clear that the SEC had authority to reshape the rule, given that courts have not always spoken with one voice on many of its provisions. Unlike some courts and plaintiffs’ attorneys, the author hopes that the SEC would use better judgment as to when a covered person had violated Section 16(b). Moreover, Congress should make clear that violators should pay any disgorgement to the U.S. Treasury, rather than to enrich creative plaintiffs or aggressive plaintiffs’ attorneys.

Attachment 1

Month No. of Shares Price per Share Purchases Sales
January 100 $52 $5,200†  
February 100 45   $4,500§
March 100 51 5,100*  
April 100 55   5,500†
May 100 57 5,700§  
June 100 58   5,800*
Net     $16,000 $15,800
Gain (Loss)       ($200)

According to R&D, the Section 16(b) calculations would be as follows:

No. of Shares Lowest Purchase Price Highest Sale Price Recoverable Profit
100 $5,100* $5,800* $700*
100 5,200† 5,500† 300†
Gain (Loss)     $1,000

R&D further note: “The remaining transactions are disregarded because the only remaining purchase was $58 a share, resulting in a loss when matched with the remaining sales. Those losses may not be used to reduce the amount of recoverable profits.”


* Lowest purchase/highest sale price
† Next lowest purchase price/next highest sale price
§ Highest purcase price/lowest sale price - loss not deducted from profit.