Opinion ID: 272506
Heading Depth: 2
Heading Rank: 1

Heading: The Purchase and Conversion of Air-Way Preferred by Lamb and Enterprises.

Text: 21 The district court held, and on appeal Lamb and Enterprises do not contest the holding, that the exchange with Air-Way in the summer of 1955 of Industries Common for Air-Way Preferred constituted a Section 16(b) 'purchase' by Lamb and Enterprises of the Air-Way Preferred. The district court also held that the September 1955 conversion of the Air-Way Preferred into Air-Way Common constituted a Section 16(b) 'sale' of the Air-Way Preferred, and went on to conclude that Lamb and Enterprises had 'realized' a profit of.$1,138,782.31 from this conversion, which was the difference between what it found to be the 'cost' of the Air-Way Preferred (based upon its valuation of the Lamb Industries Common exchanged for the Air-Way Preferred) and the highest market price of the Air-Way Common on the relevant dates of conversion. Lamb and Enterprises maintain that this conversion did not constitute a 'sale' resulting in any 'profit realized' within the intendment of Secion 16(b). Blau contends the district court's only error was in undervaluing the 'profit realized' that resulted from the sale. For reasons given hereafter we reverse the district court and hold that the conversion of Air-Way Preferred into Air-Way Common was not a Section 16(b) 'sale' by Lamb or Enterprises. Thus we do not reach the valuation issue raised by Blau. 22 The question to be decided is whether a conversion of preferred stock into common constitutes a Section 16(b) 'sale' of the preferred. It is possible to resolve this question by holding that the broad reach of Section 16(b), the unambiguous legislative history stating that Congress intended the section to deter unfair insider trading by rendering unprofitable all 'insider trading' within any lessthan-six-mongh period, and early judicial declarations that the section embodies an 'objective' test of insider liability, 14 require the unstinting application of this section to any exchange of shares that can be described as a 'purchase' or a 'sale.' One can, as a matter of language, describe the conversion of a company's convertible preferred stock into an equivalent amount of common stock as a 'disposition' or 'sale' of one equity security (the preferred) and an 'acquisition' or 'purchase' of another (the common). Thus it follows from this approach to the problem that, if the conversion can be paired with another 'sale' or 'purchase,' and the paired transactions occur within a six month period, the paired transactions are, without further inquiry, the type of insider activity that Section 16(b) was designed to prevent. A 1947 decision of our court, authored by Judge Clark, has become the medel of this approach to the problem of the section's application. Park & Tilford, Inc. v. Schulte, 160 F.2d 984 (2 Cir.), cert. denied, 332 U.S. 761, 68 S.Ct. 64, 92 L.Ed. 347 (1947). In Park & Tilford the defendants held preferred and common representing a controlling interest in the company. In late 1943 and early 1944 the market price of the common rose significantly. The company served notice of redemption of its preferred stock on December 20, 1943. On January 19, 1944, the defendants converted their preferred into common and within six months they sold the common. Holding the defendants liable for insider profits, Judge Clark stated, 160 F.2d 987: 23 We think a conversion of preferred into common stock followed by a sale within six months in a 'purchase and sale' within the statutory language of 16(b). Whatever doubt might otherwise exist as to whether a conversion is a 'purchase' is dispelled by definition of 'purchase' to include 'any contract to buy, purchase, or otherwise acquire.' 3(a)(13). Defendants did not own the common stock in question before they exercised their option to convert; they did afterward. Therefore they acquired the stock, within the meaning of the Act. 24 This language certainly suggests that every conversion should be said to involve a Section 16(b) 'purchase' of the common, subjecting the insider to liability if the conversion can be paired with a 'sale' of common within a lessthan-six-month period and the paired transaction shows a profit to the insider. Several courts have read Park & Tilford as standing for precisely such a rule. E.g., Heli-Coil Corp. v. Webster, 352 F.2d 156 (3 Cir. 1965); Petteys v. Northwest Airlines, Inc., 246 F.Supp. 526 (D.Minn.1965); cf. Blau v. Hodgkinson, 100 F.Supp. 361 (SDNY 1951). Of course, Park & Tilford dealt specifically with whether a conversion should be considered a Section 16(b) 'purchase' of the common. Recently, however, the Third Circuit has concluded that precisely the same approach required an affirmative answer to the question whether a conversion is a Section 16(b) 'sale' of the preferred. Heli-Coil v. Webster, supra. 25 We do not agree that we should, without further inquiry, so resolve the question of whether a conversion of preferred stock into common constitutes a Section 16(b) 'sale' of the preferred. Certainly we are not compelled to do so by any Second Circuit precedent. Aside from the intimations to the contrary in Park & Tilford, our court appears always to have recognized that in deciding whether a certain transaction is a Section 16(b) 'purchase' or 'sale' it is relevant to first consider whether the transaction in any way makes possible the unfair insider trading that Section 16(b) was designed to prevent. For example, in a 1954 case in this Circuit Insiders owning more than 45 per cent of their company's single class of common stock arranged for the company's stock to be reclassified into a new class of preferred and a new class of common in order to improve the marketability of their interest in the company. Within six months of the exchange incident to the reclassification the insiders sold the new securities at a profit. In an opinion authored by Judge Clark, our court held that the insiders' acquisition of the newly created common and preferred was not a 'Section 16(b) purchase' of this stock. Roberts v. Eaton, 212 F.2d 82 (2 Cir.), cert. denied, 348 U.S. 827, 75 S.Ct. 44, 99 L.Ed. 652 (1954). The court reasoned that the 'cumulative effect' of several factors established that the 'reclassification at bar could not possibly lend itself to the speculation encompassed by 16(b). This being so, it was not a 'purpose'   .' 212 F.2d at 86. See also Shaw v. Dreyfus, 172 F.2d 140 (2 Cir.), cert. denied, 337 U.S. 907, 69 S.Ct. 1048, 93 L.Ed. 1719 (1949); Truncale v. Blumberg, 80 F.Supp. 387 (SDNY 1948). In 1960, Judge Medina, in a considered dictum, stated that he understood the rule to be that a 'transaction is a 'purchase' if in any way it lends itself to the accomplishment of what the statute is designed to prevent.' Blau v. Lehman, 286 F.2d 786, 792 (2 Cir. 1960), aff'd, 368 U.S. 403, 82 S.Ct. 451, 7 L.Ed.2d 403 (1962). The view that Section 16(b)'s purpose can be fully accomplished wothout subjecting to 16(b) sanctions every transaction describable in its terms has also commended itself to other United States Courts of Appeals. In a case, like Park & Tilford, involving a conversion and subsequent sale of common, the Sixth Circuit held the conversion was not a Section 16(b) 'purchase' of the common on the ground that, under the circumstances of that case, the conversion 'was not one that could have lent itself to the practices which Section 16(b) was enacted to prevent.' Ferraiolo v. Newman, 259 F.2d 342, 346 (6 Cir. 1958), cert. denied, 359 U.S. 927, 79 S.Ct. 606, 3 L.Ed.2d 629 (1959). 15 And the Ninth Circuit recently adopted the same approach when faced with deciding whether an insider's conversion of one class of outstanding common into another class of outstanding common with different dividend attributes constituted a Section 16(b) 'purchase' of the latter. Blau v. Max Factor & Co., 342 F.2d 304 (9 Cir.), cert. denied, 382 U.S. 892, 86 S.Ct. 180 (1965). 26 Thus far we have only established that the decided cases in this and other circuits do not require us to hold that, without further analysis, the conversion of Air-Way Preferred into Air-Way Common must be regarded as a Section 16(b) 'sale' of the Air-Way Preferred. Instead, most of the appellate decisions, including the more recent decisions of our court, state that the application of Section 16(b) depends upon whether the transaction in question could tend to accomplish what the section was designed to prevent. Contra, Heli-Coil Corp. v. Webster, supra. It is, of course, clear that this judicial limitation on the reach of Section 16(b) is perfectly consistent with the section's underlying purpose of preventing the unfair use of inside information by corporate insiders. This underlying purpose provides no reason for the application of Section 16(b) to a transaction that poses no danger whatever of insider abuse. Nevertheless, it is arguable that the regulatory mechanism chosen by Congress to effectuate Section 16(b)'s underlying purpose may have removed the power a court otherwise would have to hold that this legislative command should not apply to a transaction that could not possibly permit the mischief the legislature wished to remedy. The argument for such a position recognizes that in Section 16(b) Congress chose to effectuate the section's underlying purpose by making it unprofitable for insiders to engage in any trading at all within any less-than-six-month period and emphasizes that Congress contemplated that the section would be applied to transactions that did not involve unfair insider trading. In other words, this argument is based upon the proposition that Congress by choosing to regulate in this fashion implicitly forbade the federal courts to have recourse to the maxim cessante ratione legis, cessat et ipsa lex as a tool of construction in close cases. We do not find this argument persuasive. To be sure, the theory of regulation underlying Section 16(b)'s regulatory mechanism provides a sufficient reason for refusing to examine the details of transactions once it has been determined that they might possibly have served as vehicles for unfair insider trading. But it does not supply an equally sufficient reason for applying Section 16(b) in this same automatic fashion when a substantial question is raised whether a certain conversion transaction permits a possibility of insider abuse. Congress adopted the sweeping, arbitrary regulatory mechanism embodied in Section 16(b) in order to insure that even the possibility of insider abuse was deterred, but it would seem to follow that in order to avoid 'purposeless harshness' a court should first inquire whether a given transaction could possibly tend to accomplish the practices Section 16(b) was designed to prevent. Blau v. Max Factor & Co., supra, 342 F.2d at 307. Frequently this initial inquiry will convince a court that the transaction in question held out at least the possibility of abuse; in such cases Section 16(b)'s regulatory mechanism requires that the section be applied without further inquirty. In some cases, however, this initial inquiry will convince a court that the conversion transaction in question could not possibly have lent itself to insider abuse. In such a case it is not inconsistent with Section 16(b)'s regulatory mechanism to hold that the section does not apply. 27 One further point deserves brief notice. In Heli-Coil Corp. v. Webster, supra, a majority of the Third Circuit concluded that Congress intended Section 16(b) to be 'entirely objective.' 352 F.2d at 165. The limitation on Section 16(b)'s application we here adopt was there rejected on the ground that decision as to whether a certain transaction could possibly lend itself to the abuses Section 16(b) was designed to prevent 'must be determined to some degree at least by the minds of the finders of fact,' 352 F.2d at 164, and thus imported an impermissible 'subjective' consideration into the task of applying the section. We consider this observation unobjectionable but point out that it is irrelevant. Of course, the inquiry whether a certain transaction lends itself to the accomplishment of what Section 16(b) is designed to prevent must be decided 'by the minds of the finders of fact.' This is true of the task of law application generally. There is no rule so 'objective' ('automatic' would be a better word) that it does not require some mental effort in applying it on the part of the person or persons entrusted by law with its application. 28 We thus turn to consider whether the conversion of Air-Way Preferred into Air-Way Common in September 1955 by Lamb and Enterprises in any way lent itself to the accomplishment of what Section 16(b) was designed to prevent. The court below answered this question affirmatively. 242 F.Supp. at 157. It held that the conversion was a Section 16(b) 'sale' of the Air-Way Preferred, which, when matched with the earlier 'purchase' of the Preferred by Lamb and Enterprises, rendered Lamb and Enterprises liable for insider profits. The district court's decision appears to rest on two rather separate grounds. First, the court said that in view of the circumstances surrounding the purchase of the Air-Way Preferred and its subsequent conversion, 'it requires little imagination to infer    a corporate milieu rife with opportunities for speculation and misuse of inside information.' 242 F.Supp. at 157. Second, the court seems to have implicitly conceded that an insider's conversion of preferred into common should not be deemed a Section 16(b) 'sale' if the common is economically equivalent to the preferred, but it went on to say that the 'simple answer' to this contention in this case was that by converting the preferred Lamb and Enterprises 'received a totally different security with an attendant alteration in the risks and advantages involved.' 242 F.Supp. 157-158. We disagree with both grounds the district court advanced in support of its decision. 29 In support of its contention that the preferred stock transaction lent itslef to the accomplishment of 'speculation and misuse of insider information' the district court noted that Lamb controlled Air-Way and was the 'guiding force' behind the merger of Industries into Air-Way; that the immediate purpose of the merger was to graft onto Air-Way a management team Lamb had previously recruited for Industries; that Air-Way's noncontrolling stockholders were not asked to approve the merger until that company's next annual meeting in March 1956; that the conversion of Air-Way Preferred by Lamb and Enterprises was 'voluntary'; 16 and that by so converting Lamb was able to increase his holdings of Air-Way Common, consequently tightening his grip on that company. After enumerating these facts, without further analysis, the lower court concluded that the situation was 'rife with opportunities for speculation and misuse of inside information.' We have a substantial problem with this approach. The factors enumerated do serve to emphasize Lamb's control of Air-Way. He was in a position to direct the stock-for-stock merger at an exchange ratio apparently favorable to holders of Industries Common 17 without the formal approval of all Air-Way shareholders expressed at an annual meeting, 18 and, when he converted, his position as a controlling insider became even more secure. As controlling insiders Lamb, and Enterprises, clearly had the power to misuse inside information for speculative purposes. /19/ But the question remains: Did the conversion present Lamb or Enterprises with even the slightest opportunity to exercise that power? The facts enumerated by the district court, standing alone, fail to establish that the conversion in any way made it possible for Lamb, either personally or through Enterprises, to reap speculative profits based on insider information. 20 And we reject the possible suggestion in the lower court's opinion that the existence of an opportunity for speculative profits can be inferred from the fact of control alone, 20A because such a suggestion is inconsistent with our responsibility to analyze the conversion in order to determine whether the possibility of unfair speculative profits might have existed at all even with full corporate control. Lamb's attempt to bolster his control of Air-Way by acquiring and then converting Air-Way Preferred may fall short of our aspirations for the conduct of controlling shareholders. But, to paraphrase Judge Clark, speculation, actual or potential, is the only vice within the purview of Section 16(b). Other possible corporate abuses that can possibly arise out of stock conversions do not now concern us. Blau v. Ogsbury, 210 F.2d 426, 427 (2 Cir. 1954). See Smolowe v. Delendo Corp., supra, 136 F.2d at 235. 30 The second ground advanced by the court below in support of its decision requires more elaborate analysis. Lamb and Enterprises maintain that, in general, the purchase by an insider of his issuer's convertible securities, followed in less than six months by their conversion, cannot facilitate short-swing trading for speculative profits in the convertible securities because normal market activity, including arbitrage trading, will insure that the convertible securities have a market price at least equivalent to the aggregate price of the securities into which they are convertible, if the value of the conversion security is in excess of the investment value of the convertible security without the conversion privilege. 21 We agree with this general proposition and believe that it is applicable in the present case. It is not seriously disputed that when the Air-Way Preferred was converted its market price was equivalent to the market price of the number of shares of Air-Way Common into which it was converted. True, the market value of the Air-Way Common received by Lamb and Enterprises on each relevant conversion date was higher than their cost in the Air-Way Preferred; but the market value of the Air-Way Preferred that was converted on each date fully reflected that appreciation over their cost. Furthermore, after the conversion, Lamb and Enterprises retained the investment position in the securities of Air-Way that they had acquired during the summer of 1955. The appreciation in the value of this position that had occurred since then continued to be at the risk of the makret and could disappear if the market price of the common thereafter declined. In view of this situation, it would seem to be a cold fact of the market that the conversion could not afford Lamb or Enterprises opportunities to realize a trading gain based on speculative judgment exercised when they purchased the Air-Way Preferred. Indeed, by converting, Lamb and Enterprises would appear to have reduced their opportunity for speculation because they surrendered the protection of a senior position and gained no compensating advantage. Ordinarily an investor would convert in this situation, where the convertible security is protected against dilution and has not beem called for redemption, only because he hoped to gain a long-term benefit from receiving dividend income in excess of the dividend payable upon the convertible security. Here the conversion would appear to have been prompted by Lamb's desire to increase his control of Air-Way. But whatever the motives that prompted this conversion, we hold that the economic equivalence of the Air-Way Preferred and the Air-Way Common and the unchanged investment position of Lamb and Enterprises combined to insure that this conversion afforded the insiders no opportunity to realize a gain by speculative trading in Air-Way Preferred. For this reason, we hold that the conversion was not a Section 16(b) sale of the Preferred. See Heli-Coil Corp. v. Webster, supra, 352 F.2d at 172-173 (Hastie and Kalonder, JJ. dissenting in part). See also Blau v. Max Factor & Co., supra. 31 The district court implicitly recognized the force of much of this argument based on economic equivalence and unchanged investment position; yet it held that the Air-Way Common was not the economic equivalent of the Air-Way Preferred and that Lamb and Enterprises had substantially changed their investment position. It reached this result by noting that the Common conferred greater voting power, permitted greater dividends, and was more easily marketed. In the present case we do not find these facts determinative of the issues posed by Section 16(b), and disagree with the result the district court reached. It is true that the conversion increased the voting power of Lamb and Enterprises. Each share of Air-Way Preferred had one vote and each of the 3 1/2 shares of Air-Way Common (or, after the two-for-one split, 7 shares of Air-Way Common) obtainable upon coversion had one vote. However, the increase in voting power would seem to be irrelevant to the central question whether the conversion facilitated short-swing trading in the Air-Way Preferred. If the voting power of the Air-Way Common had value, that value would be forthwith reflected in the value of the Air-Way Preferred because the Preferred was immediately convertible into Air-Way Common. In short, the increased voting power incident to the conversion conferred no trading advantage 'and, therefore, is not relevant to our present problem.' Heli-Coil Corp. v. Webster, supra 352 F.2d at 172 (Hastie and Kalonder, JJ., dissenting in part). Parallel reasoning leads us to the conclusion that the different dividend attributes of the Air-Way Preferred and the Air-Way Common are also irrelevant for present purposes because this difference did not present Lamb and Enterprises with the possibility of reaping a trading advantage. 22 Cf. Blau v. Max Factor & Co., supra. Finally, we do not believe that it was appreciably more difficult to market Air-Way Preferred than Air-Way Common. Anyone wishing to sell Air-Way Preferred needed only to convert it into Air-Way Common, which was listed on the American Stock Exchange. We cannot agree with the district court's conclusion that the relative marketability of these securities destroyed their otherwise economic equivalence. Ibid. 32 The limitations inherent in our holding, the questions it leaves unresolved, and some general observations on its scope should be set forth, lest we be misunderstood. We do not hold that the economic equivalence of that which an insider surrenders and that which he receives in an exchange always, or even usually, will suffice to remove the exchange from the ambit of Section 16(b). To the contrary, sales or purchases by an insider of his issuer's securities for cash, the securities of a different company, or other property are within the reach of Section 16(b), even though, if these are arms-length transactions, each side side will receive what it considers to be at least economically equivalent to what it surrendered. Focus on the factor of economic equivalence is only relevant when-- as in a conversion or a reclassification-- that which the insider surrenders and that which he recevies are simply different forms of the same participation in his issuer. Second, it should be noted that the 'economic equivalency' argument may not necessarily be of equal relevance in each of the four prototype situations in which a conversion may be paired with another transaction in an attempt to establish a violation of Section 16(b). 23 For reasons previously stated, we find the argument persuasive in the case of an admitted purchase by an insider of his issuer's preferred followed less than six months later by the preferred's conversion into common. For the time being, we leave open the further question whether this argument is equally persuasive in the second situation-- the conversion by an insider of his issuer's preferred, which has been held for more than six months, followed less than six months later by a new purchase of his issuer's preferred at a lower price. We also leave open the relevance of 'economic equivalence' in the third and forth prototype situations when the question is whether a conversion is a Section 16(b) 'purchase' by an insider of his issuer's common, and, in the one case, an admitted sale of his issuer's common at a higher price precedes that conversion by less than six months, and, in the other, an admitted sale follows the conversion by less than six months. We do think it is clear that 'logic' does not require that 'economic equivalence' be equally relevant in each of these four prototype situations; nor does it follow logically that because one of these four prototype situations may possibly facilitate short-term speculative trading all do. In the first two prototype situations the question is whether the conversion facilitates short-term speculative trading in the issuer's preferred. The question in the latter situations is whether the conversion facilitates short-term speculative trading in the issuer's common. It also may make a difference whether the admitted purchase or sale precedes the conversion as in the present and in the third situations, or whether it follows the conversion as in situations two and four. Third, this analysis should serve to emphasize that when a court examines a particular transaction to determine whether it might possibly have facilitated unfair insider trading it should first ascertain whether there existed any possibility of abuse presented by the prototype situation the court has before it. Thus, in the present case, if we assume for the moment that, despite the factor of economic equivalence, a conversion followed by a sale of the common facilitates speculation in the common, this is a sufficient reason for considering the conversion a Section 16(b) 'purchase' of the common; but it is not, standing alone, a reason for concluding that the conversion should be considered a Section 16(b) 'sale' of the preferred. In order to support thislatter conclusion it must be established that the conversion in some way facilitated short-term speculative trading in the preferred; this has not been established here. 24 Finally, at the risk of being obvious, we simply note that 'economic equivalence' has no relevance in a situation where the convertible security did not trade at a price at least equivalent to the aggregate price of the securities into which it was convertible. 33 We think that in cases like the present involving the purchase of a convertible security and its subsequent conversion, the issue should be whether the underlying security has been sold within six months from the acquisition of the convertible security. See Heli-Coil Corp. v. Webster, Supra, 352 F.2d at 171-174 (Hastie and Kalodner, JJ., dissenting in part). Where the convertible security is purchased, converted, and the underlying security sold, all within less than six months, we believe the entire profit resulting from the transaction is recoverable, either on the theory that the accrued profit on the preferred as well as the profit on the common has been realized, 'within    a period of less than 6 months' for purposes of the statute, or else upon the theory that, under such circumstances, the purchase of a convertible preferred may be treated as a purchase of common stock, for the statute defines 'purchase' as including 'any contract to buy, purchase or otherwise acquire,' and the purchase of the convertible security includes a contractual right to acquire the conversion security. This view of the statute is reflected in amended Rule 16b-9 recently adopted by the Securities & Exchange Commission, effective February 17, 1966, and applicable to all transactions occurring after that date. Securities Exchange Act Release No. 34-7826 (Feb. 17, 1966). Amended Rule 16b-9 provides an exemption from the ambit of Section 16(b) for the conversion of an equity security, which is convertible into another equity, security of the same issuer, provided that no more than fifteen per cent of the value of the security received at the time of the conversion is received or paid in cash or other property. Ibid. The stated reason for this exemption is that, in the judgment of the Commission, the conversion of a convertible security into its conversion security is not 'comprehended within the purpose of Section 16(b)   .' Ibid. We agree. Furthermore, for all of the above reasons, we hold that the same is true of the conversion involved in the present case. 25 34