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January 8, 2013

LITIGATION AND ENFORCEMENT

CORPORATE GOVERNANCE-2ndCir: Short-Swing Profit Rule Does Not Apply to Transactions in Stocks with Different Voting Rights

By Rodney F. Tonkovic, J.D.

In the absence of guidance from the SEC, a 2nd Circuit panel held that the Exchange Act Section 16(b) short-swing profit rule does not apply to an insider's purchase and sale of shares of different types of stock in the same company. The court held that such a purchase does not trigger liability under Section 16(b) if the transactions involve separately traded, nonconvertible stocks with different voting rights (Gibbons v. Malone, January 7, 2013, Cabranes, J.).

According to the court, a director and large shareholder of a company engaged in nine sales of the company's "Series C" stock and ten purchases of its "Series A" stock. The "Series C" stock did not confer any voting rights, while the "Series A" stock did, and neither type was convertible into the other. A shareholder later brought suit seeking disgorgement of the profits realized from these transactions. The district court dismissed the complaint for failure to state a claim, explaining that the statute's use of the term "any equity security" in the singular undermined the shareholder's argument and noting further that that the two series were not functionally equivalent under Section 16(b).

The issue on appeal was the same as that before the district court: whether the short-swing profit rule applies when a corporate insider sells shares of one type of stock issued by the insider's company and then buys shares of a different type of stock in that same company. The appellate court first examined the statutory text and concluded that "Congress' use of the singular term 'any equity security' supports an inference that transactions involving different equity securities cannot be paired under Section 16(b)." The court agreed with the district court's explanation that the "purchase and sale" under the statute must be directed to the same equity security. The court then remarked that it has been its "longstanding view" that while a literal reading of Section 16(b) might permit a recovery in a situation like that presented here, the likelihood "that Congress intended such a result is beyond the realm of judicial fantasy."

The shareholder argued that the Series A and C stocks were "the same security" under the short-swing rule because they were economically equivalent. The court agreed that "essentially indistinguishable securities" would be equivalent and at risk of short-swing speculation, but, in this case, the two stock series were "readily distinguishable," most importantly in their different voting rights. The court explained that the stocks were distinct not merely in name but also in substance and that an insider could prefer one security over the other for reasons unrelated to short-swing profits. The stocks are also not economically equivalent because they are nonconvertible securities whose prices fluctuate relative to one another.

Finally, the court rejected the argument that the series were sufficiently similar to be paired under Section 16(b). First, the statute requires sameness, not similarity, the court wrote. Second, to allow a doctrine of similarity would, the court stated, create administrative concerns that would be contrary to the statute's stated purpose of being "simple and arbitrary in its application." The court accordingly affirmed the judgment of the district court.

The case is No. 11-3620-cv.

Daniel Eugene Doherty (Law Offices of Daniel E. Doherty, Esq.) and Charles J. Hyland, Esq., (Hyland Law Firm, LLC) for Michael D. Gibbons. Seth T. Taube, Esq., Melissa J. Armstrong, and Alexandra Margaret Walsh (Baker Botts LLP) for John C. Malone. John F. Batter, III and Nolan Mitchell (Wilmer Cutler Pickering Hale and Dorr LLP) for Discovery Communications Inc.

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