Source: https://m.openjurist.org/136/f3d/316
Timestamp: 2020-02-18 11:14:21
Document Index: 549451380

Matched Legal Cases: ['§ 78', '§ 240', '§ 240', '§ 240', '§ 240', '§ 240', '§ 10']

136 F3d 316 Magma Power Company v. Dow Chemical Company | OpenJurist
136 F. 3d 316 - Magma Power Company v. Dow Chemical Company
136 F3d 316 Magma Power Company v. Dow Chemical Company
136 F.3d 316
Fed. Sec. L. Rep. P 90,216
MAGMA POWER COMPANY, Plaintiff-Appellant,
No. 545, Docket 97-7407.
15 U.S.C. § 78p(b) (1994) (emphasis added). Section 16(b) thus compels statutory insiders to disgorge profits earned on any purchase and sale (or sale and purchase) made within six months of each other. Congress intended this strict liability provision to remove any temptation for insiders to engage in transactions which "may serve as a vehicle for the evil which Congress sought to prevent--the realization of short-swing profits based upon access to inside information." Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 594, 93 S.Ct. 1736, 1744, 36 L.Ed.2d 503 (1973).
No showing of actual misuse of inside information or of unlawful intent is necessary to compel disgorgement. See Foremost-McKesson, Inc. v. Provident Sec. Co., 423 U.S. 232, 251, 96 S.Ct. 508, 519, 46 L.Ed.2d 464 (1976); Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S. 418, 424 n. 4, 92 S.Ct. 596, 600 n. 4, 30 L.Ed.2d 575 (1972). Section 16(b) operates mechanically, and makes no moral distinctions, penalizing technical violators of pure heart, and bypassing corrupt insiders who skirt the letter of the prohibition. "Such is the price of easy administration." Robert Charles Clark, Corporate Law 295-96 (1986). Congress believed that such a blunt instrument was the only way to control insider trading:
Smolowe v. Delendo Corp., 136 F.2d 231, 235-36 (2d Cir.1943) (quoting Rep. Corcoran, chief spokesman for the drafters and proponents of the Act). "In short, this statute imposes liability without fault [but only] within its narrowly drawn limits." Foremost-McKesson, 423 U.S. at 251, 96 S.Ct. at 519.
One feature of the Notes is functionally the equivalent of a call option in the noteholder, the value of which is pegged to the price of Magma stock; the Notes are therefore derivative securities, i.e., financial instruments that derive their value (hence the name) from an underlying security or index. In 1991, the SEC adopted comprehensive amendments to its rules and forms under Section 16(b) in order to clear up uncertainties as to how that section applies to derivative securities, including options.2 See Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange Act Release No. 28,869, [1990-1991 Transfer Binder] Fed.Sec.L.Rep. (CCH) p 84,709, at 81,258 (Feb. 8, 1991) ("Release No. 28869"). The amendments reflect the SEC's "recogni[tion] that holding derivative securities is functionally equivalent to holding the underlying equity securities for purposes of Section 16, since the value of the derivative securities is a function of or related to the value of the underlying equity security." Id. The SEC was concerned that unless this functional equivalence were recognized and accounted for, insiders could "evade disgorgement of short-swing profits simply by buying call options and selling the underlying stock, or buying underlying stock and buying put options." Id.
Rule 16a-1(c), as revised, defines "derivative securities" as "any option, warrant, convertible security, stock appreciation right, or similar right with an exercise or conversion privilege at a price related to an equity security, or similar securities with a value derived from the value of an equity security." 17 C.F.R. § 240.16a-1(c) (1997). The definition expressly excludes "[r]ights with an exercise or conversion privilege at a price that is not fixed." 17 C.F.R. § 240.16a-1(c)(6) (1997). The exclusion ends when the exercise or conversion price becomes fixed. See Release No. 28869, at 81,265 ("[A] right with a floating exercise price ... will not be deemed to be acquired or purchased, for Section 16 purposes, until the purchase price of the underlying securities becomes fixed or established, which commonly occurs at exercise.").
One other revised provision is potentially implicated: Rule 16b-6(a) provides that "the fixing of the exercise price of a right initially issued without a fixed price, where the date the price is fixed is not known in advance and is outside the control of the recipient ... shall be exempt from section 16(b) of the Act with respect to any offsetting transaction within the six months prior to the date the price is fixed." 17 C.F.R. § 240.16b-6(a) (1997). This exemption avoids the unfairness of subjecting insiders to liability under Section 16(b) who engage in a purchase or sale and then have an offsetting sale or purchase thrust upon them thereafter by events "not known in advance" and "outside the[ir] control." Id.; see Release No. 28869, at 81,265.
Midlantic Corp., SEC No-Action Letter, [1990-1991 Transfer Binder] Fed.Sec.L.Rep. (CCH) p 79,674 (Apr. 19, 1991), is not to the contrary. The SEC concluded in Midlantic that the Notes in question there were not derivative securities because their conversion price was not fixed. Like the Notes here, the Midlantic Notes were exchangeable for stock or cash, at the issuer's sole discretion. But the instrument in Midlantic did not specify in advance the number of shares that each noteholder would receive upon conversion; so the Midlantic option was a genuinely floating option, and as such it was outside the SEC's definition of derivative securities. See 17 C.F.R. § 240.16a-1(c)(6) (1997). Here, each $1,000 Note was exchangeable for 26-2/3 shares of Magma stock, so that Dow granted the noteholders a fixed-price option to acquire Magma shares at $37.50 each and, for Section 16(b) purposes, "sold" the shares at that price, as the district court correctly determined, in 1991. The noteholders' exercise of their fixed-price options in 1994 was a non-event for Section 16(b) purposes, see 17 C.F.R. § 240.16b-6(b) (1997), because at that time the parties were bound by the contractual terms of the option.
Further, Dow in fact never exercised its option to buy back the Magma shares. Magma characterizes the decision by Dow to deliver the shares instead of the cash--i.e., its decision not to exercise its option to repurchase the shares--as a sale. A failure to purchase, however, is not a sale. Were this not the case, virtually every insider transaction could give rise to liability. Every day, an insider has the opportunity to buy shares at the market price. If the foregoing of that opportunity constitutes a sale, then every occasion upon which the market for the stock exceeds the purchase price within six months of an insider purchase, the insider would be deemed to have sold at such higher prices, creating illegal profit. The settled rule is that an insider's inactivity cannot give rise to Section 16(b) liability. See Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 737-38, 95 S.Ct. 1917, 1926, 44 L.Ed.2d 539 (1975) (holding that the failure to enter into a voluntary securities transaction is neither a purchase nor a sale under the federal securities laws). Many times every trading day, an insider may decide not to purchase further shares in light of inside information that the share price is likely to decline, or decide not to sell portfolio shares in light of inside information that the share price is likely to rise. But such passivity is not a transaction for purposes of Section 16(b), which restricts insiders' trading, not their forbearance.
Magma argues that "[w]hile the timing of Noteholders' requests to convert their Notes certainly required Dow to give consideration to how it would exercise its rights under the embedded option, Dow completely retained control over the time at which the price of that option would cease to float by retaining absolute and sole control over the decision of whether to provide converting Noteholders with cash or Magma shares." Brief of Plaintiff-Appellant Magma Power Co., at 28. Under the Indenture, however, the value of Dow's retained option became fixed on the date the noteholder's demand was received, and Dow had fourteen days to provide the shares or the cash. The noteholders were entitled under the Indenture to demand exchange at any time up to 2001, a decision over which Dow had no control. (They did so within six months of the Garantia purchase, evidently because California Energy's tender offer had run up the price of Magma's stock to a level that made exercise of their exchange rights worthwhile.) Because the value of Dow's option to satisfy the exchange demands became fixed on the date that the exchange demand was received, see Section 13.14 of Indenture, an event entirely in the control of third parties, we agree with the district court that the exemption prevents the imposition of Section 16(b) liability.
An option, the type of derivative at issue here, is a purchased right to buy or sell property at a fixed or floating price. John Downes and John Elliot Goodman, Dictionary of Financial and Investment Terms at 390 (1995). If not exercised within the contractually-specified period, an option expires and the buyer of the option loses the acquisition price. A call option gives the option holder the right to buy shares of an underlying security at a particular price; thus, "[a] 'call equivalent position' is a derivative security position that increases in value as the value of the underlying equity increases." 3C Harold S. Bloomenthal and Samuel Wolff, Securities and Federal Corporate Law § 10.11 at 10.73 (1997). A put option is the right to sell a security at a specified price; thus, the value of a put option increases as the price of the underlying security falls. "[A] 'put equivalent position,' ... means a derivative security position that increases in value as the value of the underlying equity security decreases." Id. at 10.74