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Exchange Act Section 16(b) is typically applied as a
"blunt instrument," according to the courts. Crafted as the only provision to
specifically address insider trading at the time the Exchange Act was written
in 1934, the Section precludes what are called "short swing" profits. Those are
trading profits from transactions in company securities by directors, officers
and 10% shareholders where there is a purchase and sale within six months.
Transactions which fall within the literal reach of the Section are barred. The
profits are forfeit to the corporation in a suit brought for its benefit in its
The Second Circuit recently affirmed this "blunt
instrument" interpretation of Section 16(b), finding for the shareholder who
initiated the suit. Yet in that case the transaction was initiated by the
company and was beneficial to it. Huppe v. WPCS International, Inc., No.
08-4463 (2nd Cir. Decided Jan. 20, 2012) [an enhanced version of this opinion is available to lexis.com subscribers
/ unenhanced version available from lexisONE Free Case Law].
Huppe centers on transactions in
the shares in WPCS International, Inc. by two investment funds. The first part
of the transaction took place from December 2005 through the end of January
2006. During that period the funds sold WPCS securities in a series of open
market transactions at prices between $9.183 and $12.62 per share.
The second part of the transaction took place in April
2006. Following the restatement of its financial statements in March 2006, the
share price of WPCS securities dropped. This ended the plans of the company to
raise money for a strategic acquisition through a secondary offering.
Accordingly, the company approached the funds about a PIPE offering. In April
2006 the funds, in conjunction with other affiliated investment vehicles,
purchased 876,951 shares of WPCS at $7.00 per share. That price represented a
discount of approximately 7% from the market price. The transaction was
approved by the WPCS board of directors which used the capital infusion from
the PIPE to make the acquisition. The share price for WPCS began to improve.
WPCS shareholder Maureen Huppe brought a derivative
action in the name of the company against the funds. It alleged a violation of
Exchange Act Section 16(b) since the funds first sold WPCS shares within six
months of the purchases. On cross motions for summary judgment, the district
court ruled in favor of the plaintiff, concluding that Section 16(b) had been
The Second Circuit affirmed. Section 16(b) was "designed
to prevent these [directors, officers and 10% shareholders] from engaging in
speculative transactions on the basis of information not available to others"
the court noted, citing the legislative history. Here there can be no doubt
that the transactions fall within the literal prohibitions of the Section.
The funds however argued that the transactions here
should be exempt from the prohibitions of the Section because they were the
product of direct negotiations with the company and were approved by the board.
Thus even if the funds had access to inside information, the board which
approved the deal had the same information. Accordingly, the funds could not
have obtained any informational advantage, the difficulty the Section was
designed to address.
The Court rejected the contention of the funds. In limited
circumstances the Court will scrutinize what it called "borderline" or
"unorthodox" transactions in a pragmatic manner to determine whether they might
serve as a vehicle for the type of transactions congress sought to prevent the
Court noted. The predicate for the implementation of this approach however is
an involuntary transaction by an insider having no access to inside
information. Thus"we have been clear that Section 16(b) should be applied
without further inquiry if there is at least the possibility of speculative
abuse of inside information." (internal quotes eliminated).
In this case the PIPE deal was not a "borderline"
transaction the Second Circuit noted. In it the funds gave WPCS "a wholly
volitional capital infusion and had access to inside information." The sales
and purchases not only fall within Section 16(b) but also present the kind of
potential congress sought to bar when drafting the Section. Accordingly, the
judgment of the district court was affirmed. In the end WPCS thus benefited twice
- once from the capital infusion and a second time from the trading profits
forfeit to it through the suit. It seems questionable at best that Congress
intended the original insider trading provision to create such a windfall for
the company and its shareholders.
For more cutting edge commentary on
developing securities issues, visit SEC Actions, a
blog by Thomas Gorman.
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