Portnoy v. Memorex Corp.

DUNIWAY, Circuit Judge:

In response to Portnoy’s complaint, Bank of America N.T. & S.A. and Bankamerica Foundation moved for summary judgment, which was granted. Portnoy appeals, and we affirm.

I. The Question Presented.

Portnoy’s complaint pleads a derivative claim on behalf of Memorex Corporation, of which he is a shareholder. He claims that the Bank and the Foundation are liable to Memorex under Section 16 of the Securities and Exchange Act of 1934,15 U.S.C. § 78p.

Section 16 deals with profits realized by insiders in dealing in equity securities of corporations. It defines insiders, in § 16(a) as:

(a) Every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security (other than an exempted security) which is registered pursuant to section 781 of this title, or who is a director or an officer of the issuer of such security, (15 U.S.C. § 78p(a)).

Section 16(b) provides:

(b) For 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, any profit realized by him from any purchase and sale, ... of any equity security of such issuer ... within any period of less than six months, unless such security was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, ... in entering into such transaction of holding the security purchased or of not repurchasing the security for a period exceeding six months.. .. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, . . . of the security involved, .... (15 U.S.C. § 78p(b)).

The operation of subsection (b) is mechanical. If the insider purchases an equity security of the issuer on January 2, and sells it on June 30, he must turn over his profit to the issuer. On the other hand, if he purchases on January 2 and sells on July 3, he can keep the profit. Similarly, purchase and sale by one who is not a director or officer, within six months, of 9.99% of a class of an equity security does not fall within § 16(b), and such a purchaser-seller can keep his profit. But if the purchase and sale is of 10% or more, he must surrender his entire profit.

II. The Transaction Involved.

Our problem is simplified by certain assumptions made by the trial judge. For the purpose of deciding the defendants’ motion for summary judgment, he assumed that if Portnoy had been allowed to make discovery he could have proved that the Bank officer who served on the Memorex board of directors served also as the deputy of the Foundation and also that the Foundation was the alter ego of the Bank. In other words, the judge assumed that both the Bank and the Foundation were “beneficial owners” and that, by reason of their relationship to Memorex, they were the kind of beneficial owners to which subsection (b) applies.

The undisputed facts are these: On August 30, 1974, the Bank acquired from Memorex a warrant to purchase 600,000 shares of Memorex stock at $10 per share. This was done by a purchase agreement and was in connection with a debt previously contracted by Memorex. On April 26, 1978, the Bank made a bona fide donation to the Foundation of a part of that warrant exercisable for 350,000 shares. The Foundation is a non-profit charitable organization under California law. On August 9, 1978, the Foundation sold the warrant to a syndicate of underwriters at a price of $38.75 per share. This was part of a larger transaction in which others also sold warrants to the underwriters and Memorex sold to the underwriters newly issued shares at $48.75 each. The underwriters exercised the warrants and sold the shares to the public at $50.75. The underwriting agreement was for a firm commitment underwriting. The underwriters purchased warrants and stock for their own account as principals. They were not agents of the Bank or of the Foundation. Through this arrangement the Foundation received the same amount of money as it would have if it had itself exercised the warrant and sold the stock. The agreement between the Foundation and the underwriters obliged the latter to exercise the stock warrant immediately upon its receipt. The underwriters could not control the date of exercise of the warrant.

III. The Application of the Statute to Portnoy’s Complaint.

The acquisition of the warrant by the Bank in 1974 was not a “purchase” within the meaning of § 16(b). The warrant was “acquired in good faith in connection with a debt previously contracted” (§ 16(b), supra ). This is not disputed. The transfer of the warrant to the Foundation by the Bank was not a “sale” by the Bank within the meaning of § 16(b). It was a gift, not a sale. The terms “buy” and “purchase” and “sale” and “sell” are broadly defined to include contracts to buy, purchase or otherwise acquire, and contracts to sell or otherwise dispose of. See § 3(a)(13) and (14), 15 U.S.C. § 78c(a)(13) and (14). But these definitions do not include gifts. Moreover, the transfer occurred more than six months (indeed, more than three and one-half years) after the Bank acquired the warrant.

The acquisition of the warrant by the Foundation was not a “purchase” by it within the meaning of § 16(b). A donee does not “purchase.” Thus the sale of the warrant by the Foundation does not fall within the meaning of § 16(b), even though it occurred within six months of the acquisition of the warrants by the Foundation. This is because there must be a “purchase and sale,” or “sale and purchase” to bring § 16(b) into play. There was a sale, but no purchase, of the warrant by the Foundation.

Portnoy argues that we should consider the hypothetical situation where the Foundation had itself exercised the warrant and then sold the resulting stock to the underwriters. He says that there would then have been a purchase (the exercise of the warrant), a sale (to the underwriters) within less than six months, a profit, and liability under § 16(b). He then urges that the actual transaction was different in only a formalistic way, so that the same result should obtain.

We do not agree. We assume, but do not decide, that the outcome in Portnoy’s hypothetical case would be what Portnoy says it would be. But we do not think it would be proper for the courts to recast the actual transaction into Portnoy’s hypothetical one in order to create a liability under § 16(b).

The fact is that the Foundation did not exercise the warrant, and did not obtain or sell Memorex stock. To exercise the warrant, the Foundation would have had to pay Memorex $3,500,000 for 350,000 shares at $10 per share, thus acquiring 350,000 shares. It did no such thing. It paid no money at all to Memorex. Moreover, if the Foundation had. exercised the warrant, Memorex would have had to issue 350,000 shares to the Foundation. It did not do so, and the Foundation never received any Memorex shares. To complete the hypothetical, the Foundation would then have had to sell its Memorex stock to the underwriters for $48.75 per share, and the latter would have had to pay it that amount per share. This did not happen. The underwriters paid the Foundation for the warrant at $38.75 per share, and paid Memorex $10 per share to exercise the warrant.

We are guided by two decisions of the Supreme Court. The first is Reliance Electric Co. v. Emerson Electric Co., 1974, 404 U.S. 418, 92 S.Ct. 596, 30 L.Ed.2d 575. There, Emerson acquired 13.2% of the outstanding common stock of a corporation. Within six months, Emerson sold the stock in two transactions. First, it sold enough to bring its holding down to 9.9%. Then it sold the rest. The court found Emerson liable under § 16(b) for the profits from the first sale, but not liable for the profits from the second. It was no longer a holder of 10% of stock at the time of the second sale. The statute imposes a “flat rule.” “Liability cannot be imposed simply because the investor structured his transaction with the intent of avoiding liability under § 16(b). The question is, rather, whether the method used to ‘avoid’ liability is one permitted by the statute.” 404 U.S. at 422, 92 S.Ct. at 599. The provision “cannot be disregarded simply on the ground that it may be inconsistent with the ‘wholesome purpose’ of the Act.” Id. at 424, 92 S.Ct. at 600. Congress intended to predicate liability upon an “objective measure of proof.” “If a ‘two-step’ sale of a 10% owner’s holdings within six months of purchase is thought to give rise to the kind of evil that Congress sought to correct through § 16(b), those transactions can be more effectively deterred by an amendment to the statute that preserves its mechanical quality than by a judicial search for the will-o’-the-wisp of an investor’s ‘intent’ in each litigated case.” Id. at 425, 92 S.Ct. at 600.

The second Supreme Court decision is Foremost-McKesson, Inc. v. Provident Securities Co., 1976, 423 U.S. 232, 96 S.Ct. 508, 46 L.Ed.2d 464. There, the issue was the interpretation of the statutory provision that § 16(b) “shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved.. .. ” The question was whether the person who made a purchase which brought his holding to over 10% held 10% at the time of the purchase. The Court looked to the legislative history of the section and found that the intended reading was before the purchase. It also indicated that this reading would still have been the correct one even had the legislative history been ambiguous because “this statute imposes liability without fault within its narrowly drawn limits,” 423 U.S. at 251, 96 S.Ct. at 519. “It is inappropriate to reach the harsh result of imposing § 16(b)’s liability without fault on the basis of unclear language. If Congress wishes to impose such liability, we must assume it will do so expressly or by unmistakable inference.” Id. at 252, 96 S.Ct. at 519.

These cases do not compel our decision in this case. They concerned the relatively definite 10% restriction on shareholder liability. Our case is somewhat different. Here, we are asked to go behind the face of the transaction and recharacterize it in terms less favorable to the defendants. However, as Reliance Electric Co. and Foremost-McKesson show, we should not impose liability without fault unless Congress instructs us so to do expressly or by unmistakable inference. The rule of § 16(b) should be read as a flat rule setting objective standards of conduct whenever this is possible. The conduct of the defendants does not fall within the literal language of the section. We do not think that we should extend the scope of the section by recharacterizing the transaction in the way asked by Portnoy.

Portnoy draws our attention to a case in the Seventh Circuit where the court said that “the commercial substance of the transaction rather than its form must be considered. .. . ” Bershad v. McDonough, 7 Cir., 1970, 428 F.2d 693, 697. However, the facts there were very different from those here. A defendant had purchased stock and had within six months sold an “option” for 14% of the value of the stock, put the stock in escrow, given the purchaser an irrevocable proxy to vote the stock, and resigned from the board of directors, and caused his associates to resign, at the request of the purchaser who replaced them with its own nominees. The option price was applicable to the purchase price of the shares and the option was in fact exercised just over six months from the purchase of the shares. The court found that the date of the option contract was the date of the sale of the stock for the purpose of § 16(b). If we had been faced with those facts we too might have regarded the use of the option as a sham and found the date of stock sale to be that of the option sale. But that is not this case.

Here, as counsel for the Foundation point out:

The underwriting agreement establishes ... that the Foundation was not free to “speculate” with regard to the conversion of what had formerly been its Memorex warrant or the sale of the converted shares. That conversion and sale took place pursuant to a registered public offering. Not only did the registration statement and prospectus accompanying that offering disclose to the public all material information concerning both Memorex and the transaction, but the underwriting agreement . .. controlled the terms upon which the warrant would be sold to the underwriting syndicate, the terms upon which the warrant would be exercised, and the terms upon which the converted shares of common would be offered to the public. That agreement was a compact between Memorex, fourteen selling warrant holders, and more than 100 underwriters constituting the underwriting syndicate. The price at which the converted shares of Memorex common stock was to be sold was arrived at through agreement among all of these parties. Further, the timing of sale of the warrant, the exercise of the warrant, and the subsequent sale of the converted shares was determined by that same process. The Foundation had neither the opportunity, nor the means to speculate. It had the power only to agree to sell its warrant in connection with the offering, or to refuse to be part of that offering and thus retain its warrant.

The conversion of what had been the Foundation’s warrant and the simultaneous sale of the converted Memorex common stock was accomplished by the firm-commitment underwriters and may not be imputed to the Foundation. (Brief, pp. 27-28)

Affirmed.