- 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.