Source: s3://data.kl3m.ai/documents/govinfo/USCOURTS/USCOURTS-cand-3_06-cv-02786/USCOURTS-cand-3_06-cv-02786-17/pdf.json

Nature of Suit Code: 850
Nature of Suit: Securities, Commodities, Exchange
Cause of Action: 15:78m(a) Securities Exchange Act

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United States District Court

For the Northern District of California

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United States District Court

For the Northern District of California

IN THE UNITED STATES DISTRICT COURT

FOR THE NORTHERN DISTRICT OF CALIFORNIA

ANDREW E. ROTH,

Plaintiff,

 v.

GREGORY REYES, et al.,

Defendants. /

No. C 06-02786 CRB

ORDER DISMISSING PLAINTIFF’S

SECOND AMENDED COMPLAINT

WITH PREJUDICE

This derivative action is an attempt to transform a case about stock options backdating

into a case about insider trading. Because Plaintiff’s latest complaint, like his last two, rests

on an untenable theory of liability, the Court hereby dismisses it with prejudice. For the

reasons set forth below, Defendants’ motions to dismiss are GRANTED.

BACKGROUND

Capital markets require a level playing field for all investors. To protect the integrity

of the markets, Congress has passed laws designed to prevent “the unfair use of [inside]

information.” 15 U.S.C. § 78p(b).

It is exceedingly difficult, however, to police the use of non-public information. 

Recognizing this, Congress chose not to prohibit outright the act of using inside information,

but instead to prohibit “short-swing” trading by corporate insiders. In other words,

“Congress sought to ‘curb the evils of insider trading by taking the profits out of a class of

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transactions in which it believed the possibility of abuse was intolerably great.’” ForemostMcKesson, Inc. v. Provident Sec. Co., 423 U.S. 232, 243-44 (1976) (quoting Reliance Elec.

Co. v. Emerson Elec. Co., 404 U.S. 418, 422 (1972)). 

Congress enacted a ban on short-swing trading in Section 16(b) of the Securities

Exchange Act of 1934. This provision prohibits insiders from making a pair of trades on

their company’s stock within a period of six months. 15 U.S.C. § 78p(b). The prohibition

extends to “directors, officers, and principal stockholders.” Id. § 78p(a). Shareholders are

empowered enforce Section 16(b) by filing a lawsuit on the company’s behalf to recoup any

profits from prohibited short-swing transactions. Id. § 78p(b). Lawsuits must be filed not

later than “two years after the date such profit was realized.” Id.

In this case, Plaintiff portrays himself as seeking to disgorge short-swing profits

reaped by insiders at Brocade Communications Systems (“Brocade”). The impetus for this

action, however, was not a revelation about certain undisclosed purchases or sales of stock

by Brocade insiders. Rather, it was an investigation by Brocade into the company’s practice

of granting stock options--an investigation that led the company in January of 2005 to restate

its earnings for the previous four fiscal years. See Second Am. Compl. ¶ 21 (hereinafter

“SAC”). Plaintiff alleges that the cause of this restatement was a scheme at Brocade to

“backdate” stock options. Id. ¶ 22.

This alleged backdating scheme was the genesis of several other lawsuits, including a

criminal indictment against two Brocade executives; a civil enforcement action by the

Securities and Exchange Commission; a class action by Brocade shareholders; and another

different derivative action. All of these other cases are also now pending before this Court. 

See SEC v. Byrd, No. 07-4223-CRB (N.D. Cal. filed Aug. 17, 2007); United States v. Reyes, 

No. CR-06-0556-CRB (N.D. Cal. filed July 20, 2006); SEC v. Reyes, No. C-06-4435-CRB

(N.D. Cal. filed July 20, 2006); In re Brocade Commc’ns Sys., Inc. Derivative Litig., No. 

C-05-2233- CRB (N.D. Cal. filed June 1, 2005); Smajlaj v. Brocade Commc’ns Sys., Inc.,

No. C-05-02042-CRB (N.D. Cal. filed May 19, 2005).

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The claims presented in this lawsuit, however, are different from the claims of fraud

presented in all of those other cases. Here, Plaintiff claims that Gregory Reyes, Michael

Byrd, Antonio Canova, and Jack Cuthbert (“Defendants”)--all officers of Brocade--received

backdated stock options and then sold shares of Brocade within six months of their grants. 

Plaintiff argues that the Brocade insiders thereby violated Section 16(b). He filed this action

to recoup what he perceives as roughly $230 million in illegal short-swing profits.

The problem with Plaintiff’s theory is that a transfer of stock options from a company

to one of its directors or officers is generally exempt from the ban on short-swing trading. 

That is, Section 16(b) ignores most of the issuer-to-insider grants like the ones at issue here. 

Such stock option grants are not “transactions” within the meaning of the statute. 

The source of this exemption is Rule 16b-3(d), which the SEC promulgated in 1991

and amended significantly in 1996. 17 C.F.R. § 240.16b-3(d). This regulation reflects the

SEC’s view that issuer-to-insider grants of stock options typically do not serve as a vehicle

for the improper use of inside information. This is not to say that such grants pose no “risk

of speculative abuse.” Dreiling v. Am. Express Co., 458 F.3d 942, 947 (9th Cir. 2006). The

rule simply reflects the SEC’s considered judgment that issuer-to-insider grants do not

present “the same opportunities for insider profit on the basis of non-public information”

because “the issuer, rather than the trading markets, is on the other side of [the] officer or

director’s transaction.” Ownership Reports and Trading by Officers, Directors and Principal

Security Holders, 61 Fed. Reg. 30,376, 30.377 (June 14, 1996). 

Accordingly, the SEC has exempted issuer-to-insider stock option grants from the ban

on short-swing trading because it considers them generally beyond the pale of Section 16(b). 

See 15 U.S.C. § 78p(b) (excluding as a basis for short-swing liability “any transaction or

transactions which the Commission by rules and regulations may exempt as not

comprehended within the purpose of this subsection”). Although the rationale for the SEC’s

exemption may not be “airtight,” the Ninth Circuit nonetheless has upheld the SEC’s rule as

a valid exercise of its regulatory power. Dreiling, 458 F.3d at 947-48.

//

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The SEC’s exemption is not absolute, however. Under Rule 16b-3(d), an issuer-toinsider grant is outside the scope of Section 16(b) only under certain circumstances. 

Specifically, there is no short-swing liability for a stock option grant if it meets one of three

conditions:

(1) The transaction is approved by the board of directors of the issuer, or a

committee of the board of directors that is composed solely of two or more

Non-Employee Directors;

(2) The transaction is approved or ratified . . . by either: the affirmative votes

of the holders of a majority of the securities of the issuer present, or

represented, and entitled to vote at a meeting duly held in accordance with the

applicable laws of the state or other jurisdiction in which the issuer is

incorporated; or the written consent of the holders of a majority of the

securities of the issuer entitled to vote; provided that such ratification occurs

no later than the date of the next annual meeting of shareholders; or

(3) The issuer equity securities so acquired are held by the officer or director

for a period of six months following the date of such acquisition, provided that

this condition shall be satisfied with respect to a derivative security if at least

six months elapse from the date of acquisition of the derivative security to the

date of disposition of the derivative security (other than upon exercise or

conversion) or its underlying equity security.

17 C.F.R. § 240.16b-3(d). In other words, issuer-to-insider grants are exempt as long as they

are held for a period of six months, are approved by a majority of shareholders, or are

approved by the board of directors or an appropriate committee with outside directors.

Here, Defendants invoke the exemption of Rule 16b-3(d)(1), arguing that their grants

were all approved by the company’s Board of Directors. See 17 C.F.R. § 240.16b-3(d)(1). 

Twice Plaintiff has tried and failed to plead around the exemption. His original complaint

made no mention of Rule 16b-3(d), either explicitly or implicitly, and when a motion to

dismiss called his attention to it, Plaintiff promptly withdrew his complaint. After the

complaint was amended, Defendants again moved to dismiss. Plaintiff presented two

theories why the exemption should not apply. 

First, Plaintiff argued that Rule 16b-3(d) was inapplicable to “illegitimate”

transactions, such as the allegedly backdated grants issued to the Brocade insiders. He

insisted that the SEC’s exemption was “obviously intended for bona fide, legitimate

corporate transactions, not for a scheme by statutory insiders to fraudulently enrich

themselves.” The Court rejected that theory:

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While it is tempting to construe Section 16(b) and Rule 16b-3 as applying only

to “legitimate” transactions, this Court cannot accept Plaintiff’s proposed

construction of the law. . . . Congress enacted this statute not for the general

purpose of forcing insiders to behave well, but rather “[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.” 15 U.S.C. § 78p(b).

. . . .

To be clear, by backdating stock options, a company clearly exploits a certain

type of information--to wit, information about how the market behaved

yesterday. And it is only by virtue of their position within the company that

insiders are able to exploit this hindsight and [obtain] more profitable options.

But the information exploited is not itself inside information, and therefore,

even though Defendants may have used their privileged position for their own

benefit, or for the benefit of other employees, (or even, arguably, for the

company’s benefit), their conduct does not implicate the specific danger that

Congress sought to mitigate with Section 16(b).

To expand the reach of Section 16(b) to encompass all “illegitimate”

transactions, even assuming that courts could correctly and consistently

discern which transactions are “legitimate” and which are not, would transform

Section 16(b) into an all-purpose prohibition on undesirable stock transactions

by officers and directors. Such an expansion is unwarranted in light of the

more limited purpose explicitly articulated by Congress in the statute’s very

text.

[Moreover,] Plaintiff’s suggested interpretation of the law is inconsistent with

the structure of Section 16(b) and the regulations issued by the SEC under that

statute. As noted above, the law in this area regulates by proxy. Congress

could have prohibited outright any transactions in which insiders exploit

information not available to the public or take[] advantage of their position as

corporate officers. For obvious reasons, Congress did not write the law this

way; instead, it prohibited short-swing trading “without proof of actual abuse

of insider information, and without proof of intent to profit on the basis of such

information.” Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S.

582, 595 (1973); see also Reliance Electric, 404 U.S. at 422 (noting that

Congress “chose a relatively arbitrary rule capable of easy administration” in

order to avoid “difficulties in proof” (quoting Bershad v. McDonough, 428

F.2d 693, 696 (7th Cir. 1970))).

. . . . 

In this sense, the law contemplates its own inadequacy--at least some

undesirable insider activity is bound to escape its grasp, since by design,

Section 16(b) and the regulations passed by the SEC do not directly

circumscribe the perceived evil of insider trading, much less purport to

prohibit all forms of bad corporate behavior. To interpret Section 16(b) as

encompassing all “illegitimate” transactions, regardless of the exemptions set

forth by the SEC, would be inconsistent with the design of the system that

Congress and the SEC have constructed. This system may be imperfect, but

imperfection is inevitable in a system that regulates by proxy, and a court is

not entitled to remedy such imperfections in a manner that is at odds with the

system itself.

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Roth v. Reyes, No. C-05-2786-CRB, at 8-11 (N.D. Cal. Feb. 13, 2007) (unpublished

opinion). The Court concluded that it was bound to apply the exemptions to Section 16(b) as

they were written, rather than to impose “impose an additional gate-keeping requirement for

issuer-to-insider transactions where the SEC [had] not.” Id. at 8. Finally, the Court noted

that there are “a host of other securities laws that prohibit deception or fraud,” suggesting

that the backdating of stock options might well “fall under the umbrella of one of those

laws.” Id. at 12.

Second, Plaintiff argued that the insiders’ grants were not exempt from Section 16(b)

because Gregory Reyes, Brocade’s CEO, had acted as a “committee of one” with respect to

the backdating and granting of stock options. Id. at 13 (quoting Am. Compl. ¶ 12). In other

words, Plaintiff suggested that the company’s Board of Directors had “abdicated its

responsibility to oversee the stock option grants” and “did not properly approve the option

grants.” Id. (quoting Am. Compl. ¶¶ 12, 15). Plaintiff thus insinuated that the approval of

Brocade’s Board of Directors was illusory and that the exemption invoked by the insiders as

a shield really should offer them no protection.

Upon examining the complaint, however, the Court concluded that, even if this second

theory of liability were valid, Plaintiff had not set forth sufficient allegations regarding the

role of Brocade’s Board of Directors. “Fatal to his claim,” the Court wrote, “is the absence

of an allegation that Brocade’s Board of Directors actually failed to approve the backdated

grants.” Id. Specifically, the Court noted that the amended complaint was equivocal in its

allegations regarding the Board’s role, on the one hand suggesting that the Board “did not

properly approve the grants,” and on the other hand suggesting that the grants were improper

“even if the Board itself had approved the grants.” Id. at 13-14 (quoting Am. Compl. ¶¶ 15-

16). The Court thus dismissed the amended complaint without prejudice, and gave Plaintiff

an opportunity to amend his complaint again in order to set forth specific allegations in

support of his theory that “the exemptions set forth under Rule 16b-3(d) are inapplicable to

Defendants’ stock options due to the Board’s failure to approve them.” Id. at 15.

//

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In April of 2007, Plaintiff filed his second amended complaint. Defendants renewed

their motions to dismiss. The question now presented is whether Plaintiff’s new allegations

are sufficient to state a claim under Section 16(b). The Court concludes they are not.

DISCUSSION

In his newest complaint, Plaintiff again is fuzzy about the role of the Board of

Directors in approving the relevant stock option grants. He alleges that Seth Neiman and

Neal Dempsey, outside directors and members of Brocade’s Compensation Committee, were

responsible for approving stock option grants to Brocade insiders. SAC ¶ 14. He continues: 

None of the Options Grants at issue in this case were approved in advance by

the Board or an authorized committee of the Board. Moreover, neither the

Board nor an authorized committee of the Board considered the specific

transactions and approved them as required by the SEC Rule 16b-3(d)(1). On

the contrary, the Board impermissibly delegated the gate-keeping functions of

the Rule by placing the fox in charge of the henhouse. Accordingly, the

Option Grants are not entitled to the exemption provided by SEC Rule 16

b-3(d)(1).

Nor is it possible that the Board or an authorized committee of the Board could

have approved in advance the Option Grants. As evidenced by the Company’s

successive restatements of its financial statements, the Option Grants were

improperly accounted for as though they were granted on dates prior to their

actual grant dates with exercise prices equal to the market prices on such dates.

. . . Neither the Board nor any committee of the Board knowingly approved

in advance backdated options.

Id. ¶¶ 17-18. Such artful language implies that the Board of Directors never actually

approved the grants in question. A closer look at the allegations, however, precludes that

reading of the complaint.

When the complaint is carefully examined, it is clear that Plaintiff’s theory of the case

once again rests on backdating. It never directly alleges that Brocade’s Board of Directors or

a relevant committee actually failed to approve the stock options in question. It states only

that the Board did not approve stock options “in advance.” Id. ¶ 17. Or it states that the

Board never “knowingly approved in advance backdated options.” Id. ¶ 18 (emphasis

added). Or it offers a legal conclusion that the options were not approved “in a manner that

satisfied the requisite gate-keeping requirements of the Rule.” Id. ¶ 20. Or it describes how

executives backdated stock options and then asserts, based entirely on the “circumstances” of

backdating, that “the Board did not approve or authorize the Option Grants.” Id. ¶ 21-24.

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These are nothing more than allegations of backdating in semantic disguise. Once

again, Plaintiff’s theory is that the grants are subject to Section 16(b) because they are

backdated, and for no other reason. The shadowy language of the newest complaint purports

to focus its allegations on the conduct of the Compensation Committee, which condoned the

challenged grants. But all of its adverbs and adjectives beg the same question: why was the

Compensation Committee’s approval unsatisfactory, unknowing, improper, or not in

advance? Each allegation suggests the same answer: because the grants were backdated. Id.

¶ 18 (“Nor is it possible that the Board or an authorized committee of the Board could have

approved in advance the Option Grants . . . [because they] were improperly accounted for as

though they were granted on dates prior to their actual grant dates . . . .”). The theory of the

newest complaint merely bootstraps the backdating theory already presented, and rejected by

this Court, in the last complaint.

Plaintiff’s main contention is that backdated grants, by their nature, cannot be

approved “in advance,” as required by Rule 16b-3(d)(1). He argues that allowing an

exemption for backdated grants, regardless of whether those grants have been approved, is

contrary to the SEC’s “gate-keeping requirements,” which are designed to ensure that the

board or committee “actually considers each specific transaction and that it evidence[s]

acknowledgment and accountability as to what it is doing.” Brief of the Securities and

Exchange Commission as Amicus Curiae in Partial Support of Each Party at 25, Dreiling v.

Am. Express Co., 458 F.3d 942 (9th Cir. 2006) (No. 04-35715).

The Court rejects this interpretation of Rule 16b-3(d)(1). First, it is worth noting that

this ostensible requirement of “approval in advance” appears nowhere in the text of Rule

16b-3(d)(1), but rather in so-called “adopting releases” issued by the SEC. See, e.g.,

Ownership Reports and Trading by Officers, Directors and Principal Security Holders, 70

Fed. Reg. 46,080, 46,082 n.32 (Aug. 9, 2005). The Court finds it implausible that

unexplained dicta in the SEC’s adopting releases would somehow implicitly proscribe the

granting of backdated stock options. Instead, to the extent that the SEC can even be said to

have construed its exemptions as requiring “approval in advance” of executive stock options,

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1 “For completeness,” Plaintiff remarks in his brief that the exemption set forth under

Rule 16b-3(d) is an affirmative defense, and he claims that he “is not obligated to refute this

affirmative defense in the Complaint.” Pl.’s Corrected Mem. of P. & A. in Opp. to Motions to

Dismiss the Second Am. Compl. at 11 n.4. In this respect, Plaintiff’s description of the law is

anything but complete. As Wright & Miller explain:

On occasion a plaintiff’s complaint will contain allegations that seek to avoid

or defeat a potential affirmative defense that he or she anticipates will be

included in the responsive pleading; technically this is improper pleading

because these allegations are not an integral part of the plaintiff’s claim for

relief and lie outside his or her burden of pleading. If the attempt to avoid the

affirmative defense actually demonstrates the defense’s effectiveness, a

situation similar to that of a complaint that contains a built-in defense is

presented. As a result, the defendant may test the validity of the defense, since

it appears on the face of the complaint, by a motion to dismiss or a motion for

summary judgment. However, if the plaintiff purports to negative an

affirmative defense by way of anticipation but does not admit the effectiveness

fo the defense in his pleading, the district court should treat the plaintiff’s

references to the defense as mere surplusage.

5 Charles Alan Wright & Arthur R. Miller, Federal Practice and Procedure § 1276, at 623-24 (3d

ed. 2004). Here, Plaintiff candidly concedes the effectiveness of the affirmative defense. SAC

¶ 11 (“Absent a valid exemption, a grant of options is deemed to be a purchase of the underlying

securities . . . .” (emphasis added)). Indeed, Plaintiff spills most of his ink crafting allegations

in an effort to render the SEC’s exemptions inapplicable. See id. ¶¶ 12-28 (“No Exemption For

The Option Grants”). Having dedicated his amended complaint to explaining why Rule 16b-3(d)

does not apply, Plaintiff is hardly in a position to complain about the Court’s examination of his

theory.

9

the Court reads the SEC’s construction as pertaining to the approval in advance of the

insiders’ receipt of the stock option, and not as requiring approval in advance of the date

actually listed on the stock option grant. This construction of the exemption is the most

plausible reading of the SEC’s rule, and in the Court’s view, it adequately promotes the

SEC’s goal of ensuring that the relevant grantor “actually considers each specific

transaction” before an insider or executive receives a bundle of stock options. Here, Plaintiff

makes no allegation that Compensation Committee failed to acknowledge or accept

responsibility for the executive compensation conferred by the challenged grants. Further,

there is no allegation that Reyes, Byrd, Canova, or Cuthbert ever received a grant before

Brocade’s Compensation Committee approved it. Accordingly, the Court finds that, on the

facts alleged in the second amended complaint, Plaintiff has still failed to plead himself

around the exemption set forth in Rule 16b-3(d)(1).1

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G:\CRBALL\2006\2786\second order re motion to dismiss.wpd 10

Equally unpersuasive is Plaintiff’s suggestion that the Rule 16b-3(d)(1) exemption is

unavailable because the Compensation Committee “plac[ed] the fox in charge of the

henhouse.” Id. ¶ 17. What Plaintiff means is that the exemption should not apply because

the Compensation Committee delegated its grant-making authority to Gregory Reyes, the

company’s CEO, to act as a “committee of one” with respect to certain grants. Id. ¶¶ 14-15. 

Again, this vague allegation is insufficient to state a claim for liability under Section 16(b). 

Plaintiff does not say that the Compensation Committee ever delegated its authority “to

approve stock option grants to Brocade’s executives.” Id. ¶ 14. Plaintiff does not say that

Reyes ever issued stock options unilaterally to Brocade executives. Id. ¶ 14 (alleging that

Reyes acted as a committee of one “to grant options to certain employees”). And most

significantly, Plaintiff does not state that Reyes unilaterally granted, or that the

Compensation Committee failed to approve, the stock options actually challenged in this

lawsuit. Only transactions by Brocade insiders and executives fall under Section 16(b), and

Plaintiff makes no claim that any grants to Brocade’s executives were not reviewed or

approved by the Compensation Committee. Nor, it appears, can Plaintiff make such

allegations consistent with Rule 11, having been given an opportunity to amend his

complaint to present precisely that allegation. The only plausible inference to be drawn from

Plaintiff’s delicately worded complaint is that no delegation of authority was made as to the

executives’ grants challenged here.

CONCLUSION

This is the third time that Plaintiff has attempted to advance a claim against Brocade

insiders to disgorge the profits they reaped from short-swing trading. On the facts alleged,

however, the challenged transactions are exempt from the statute under which Plaintiff seeks

to impose liability. See 15 U.S.C. § 78p(b); 17 C.F.R. § 240.16b-3(d)(1). For this reason,

his second amended complaint is hereby DISMISSED with prejudice.

IT IS SO ORDERED.

Dated: August 27, 2007 

CHARLES R. BREYER

UNITED STATES DISTRICT JUDGE

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