Court Opinion

ID: 3021061
Source: CourtListenerOpinion
Date Created: 2015-10-13 22:24:02.534546+00
Date Added: 2024-06-11T09:34:37.466067
License: Public Domain

United States Court of Appeals
                            FOR THE EIGHTH CIRCUIT
                                   _____________

                                   No. 97-3400MN
                                   _____________

Editek, Inc.,                            *
                                         *
                    Appellant,           *
                                         *
      v.                                 * Appeal from the United States
                                         * District Court for the District
Morgan Capital, L.L.C.; Alex             * of Minnesota.
Bistricer; David Bistricer,              *
                                         *
                    Appellees.           *
                                   _____________

                            Submitted: May 15, 1998
                                Filed: July 24, 1998
                                 _____________

Before RICHARD S. ARNOLD and FAGG, Circuit Judges, and BOGUE,* District
      Judge.
                         _____________

FAGG, Circuit Judge.

      Editek, Inc. brought this lawsuit against Morgan Capital, L.L.C. and its officers,
Alex and David Bistricer (collectively Morgan Capital), under § 16(b) of the Securities
Exchange Act of 1934 (the 1934 Act), 15 U.S.C. § 78p(b), to recover claimed short-
swing profits. Section 16(b) applies only to corporate insiders: directors, officers, and

      *
       The Honorable Andrew W. Bogue, United States District Judge for the District
of South Dakota, sitting by designation.
beneficial owners of more than ten percent of a corporation’s registered equity
securities (ten percent beneficial owners). Only the ten percent beneficial owner
category is involved here. Based on a misreading of the applicable rules, the district
court concluded Editek’s complaint failed to allege facts that, if proven, would make
Morgan Capital a beneficial owner at the legally required time. On that basis, the
district court granted Morgan Capital’s motion to dismiss under Federal Rule of Civil
Procedure 12(b)(6). Editek appeals. We reverse and remand for further proceedings.

      The purpose of § 16(b) is to prevent corporate insiders from exploiting inside
information to turn a quick profit trading in their company’s stock. See 15 U.S.C. §
78p(b) (1994); Foremost-McKesson, Inc. v. Provident Sec. Co., 423 U.S. 232, 234
(1976). To achieve this purpose, Congress enacted a flat rule: any profit realized by
an insider “from any purchase and sale, or any sale and purchase, of any equity security
of such issuer . . . within any period of less than six months, . . . shall inure to and be
recoverable by the issuer.” 15 U.S.C. § 78p(b). A further provision of the statute
applies only to ten percent beneficial owners. To be liable under § 16(b), a ten percent
beneficial owner must have been such “both at the time of the purchase and sale, or the
sale and purchase, of the security involved.” Id. As the Supreme Court has made
clear, to be a ten percent beneficial owner “at the time of the purchase,” a person must
have already become a ten percent beneficial owner before the purchase. See
Foremost-McKesson, 423 U.S. at 249-50. Because an owner below the statutory
threshold presumptively lacks access to inside information, the acquisition that takes
a buyer above ten percent ownership does not count as a “purchase” matchable against
a later sale for § 16(b) purposes. See id. at 253-54 & n.28; 17 C.F.R. § 240.16a-2(c)
(1997).

       With these principles in mind, we set forth the relevant background, accepting
as true the facts asserted in Editek’s complaint and construing the complaint in the light
most favorable to Editek. See Doe v. Norwest Bank Minnesota, N.A., 107 F.3d 1297,
1303-04 (8th Cir. 1997). Around February 1, 1996, Editek issued shares of preferred

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stock, convertible into Editek common stock, and sold some shares to Morgan Capital
in a private placement. Editek acknowledges in its brief that the preferred shares were
nonvoting. Thus, only the underlying common stock, not the preferred stock, counts for
purposes of determining Morgan Capital’s ten percent beneficial ownership status. 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) ¶ 84,709, at 81,252 n.36 (Feb. 8, 1991). Morgan Capital had the right to convert
its preferred stock into Editek common stock beginning sixty days after issuance of the
preferred stock. Despite the complaint’s vagueness about the issuance date, the parties
now agree March 30 marked the start of the conversion period. The conversion price
floated: the number of common shares Morgan Capital would acquire at conversion
would be based on the average closing price of Editek common stock for the five
trading days just before the conversion date. In other words, as the price of Editek
common stock dropped, the number of common shares Morgan Capital’s preferred
stock would buy increased. Around March 28, 1996, the price of Editek common stock
fell low enough that Morgan Capital’s preferred stock was worth more than ten percent
of the outstanding shares of Editek’s common stock. On May 1, 1996, Morgan Capital
received more than ten percent of Editek’s outstanding common stock when it exercised
its conversion right. According to Editek, this conversion was the “purchase”
matchable against later sales for § 16(b) purposes. Later that month and the next,
Morgan Capital sold part of its newly acquired Editek common stock, realizing a profit
of at least $500,000.

        We review de novo a Rule 12(b)(6) dismissal, affirming “only if ‘it appears
beyond a doubt that the plaintiff can prove no set of facts which would entitle the
plaintiff to relief.’” Doe, 107 F.3d at 1304 (quoting Coleman v. Watt, 40 F.3d 255, 258
(8th Cir. 1994)). In other words, dismissal under Rule 12(b)(6) is proper “only if it is
clear that no relief can be granted under any set of facts that could be proved consistent
with the allegations.” Frey v. City of Herculaneum, 44 F.3d 667, 671 (8th Cir. 1995)
(internal quotations omitted). Applying this standard, the district court concluded

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Editek could not show that Morgan Capital was a beneficial owner of Editek common
stock before the conversion. In the district court’s view, Editek’s complaint alleged a
transaction that made Morgan Capital a ten percent beneficial owner--the conversion
itself--followed by profitable sales. Because such conduct is not unlawful, the district
court dismissed Editek’s complaint. See Editek, Inc. v. Morgan Capital, L.L.C., 974
F. Supp. 1229, 1234 (D. Minn. 1997).

      The district court’s decision turns entirely on the term beneficial owner, which
the governing regulations define in two different ways. For purposes other than
determining ten percent beneficial ownership, “the term beneficial owner shall mean
any person who . . . has or shares a direct or indirect pecuniary interest in the equity
securities . . . .” 17 C.F.R. § 240.16a-1(a)(2). For the purpose of determining ten
percent beneficial ownership, the meaning of beneficial owner is a bit more
complicated. Rule 16a-1 states:

      Solely for purposes of determining whether a person is a beneficial owner
      of more than ten percent of any class of equity securities registered
      pursuant to section 12 of the [1934] Act, the term “beneficial owner” shall
      mean any person who is deemed a beneficial owner pursuant to section
      13(d) of the Act and the rules thereunder . . . .

Id. § 240.16a-1(a)(1). Turning to the rules under § 13(d) of the 1934 Act, we find two
relevant provisions. First, a beneficial owner of a security includes any person who has
voting power or investment power in relation to the security. See id. § 240.13d-3(a).
More importantly for our purposes, “[a] person shall be deemed to be the beneficial
owner of a security . . . if that person has the right to acquire beneficial ownership of
such security, as defined in Rule 13d-3(a) (§ 240.13d-3(a)) within sixty days . . . (B)
through the conversion of a security . . . .” Id. § 240.13d-3(d)(1)(i)(B). We will refer
to this last definition as the “within sixty days” rule.

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        The district court gave two explanations why it concluded Editek could not prove
any set of facts that would make Morgan Capital a beneficial owner before the
conversion. The first is based on a misunderstanding of the “within sixty days” rule.
From the way the district court applied the rule, the court must have read it as saying
the right to acquire beneficial ownership within sixty days through a conversion means
the right to acquire this ownership within sixty days of the issuance of the convertible
securities. Reading the rule the same way, Editek argued Morgan Capital was a
beneficial owner of Editek common stock before the conversion “because [Morgan
Capital] had a right to acquire beneficial ownership of Editek Common Stock within
sixty days after issuance of [the] Preferred Stock.” Editek, 974 F. Supp. at 1232
(emphasis and internal quotations omitted). According to Editek’s complaint, however,
the preferred shares were convertible, not within sixty days of issuance, but beginning
sixty days after issuance--that is, on the sixtieth day following the date of issuance. See
id. at 1233. The district court thus concluded Morgan Capital could not be proven a
beneficial owner before the conversion under the “within sixty days” rule. See id. The
district court rejected Editek’s contention that Morgan Capital was a beneficial owner
on March 28 because the conversion right was not immediately exercisable on that date.
See id.

      In our view, the district court’s interpretation of the “within sixty days” rule is at
odds with the rule’s purpose. Section 13(d) of the 1934 Act, under which the rule was
enacted, requires persons who acquire beneficial ownership of more than five percent
of certain classes of securities to report their purchase to the issuer, to the exchanges
where the securities are traded, and to the Securities and Exchange Commission (SEC).
See 15 U.S.C. § 78m(d)(1) (1994). The purpose of this requirement is to alert the
issuing company, the market, and the SEC to transactions that might change or influence
the control of the company. See id. § 78m(d)(6)(D). The “within sixty days” rule
should be read with this forward-looking purpose in mind. An illustration will show
why. Suppose Morgan Capital’s nonvoting preferred stock had been convertible
beginning ninety days after issuance. Suppose further that on the

                                            -5-
first possible conversion date, the preferred stock would be worth more than five
percent of Editek’s voting common stock. Three days before that date, Morgan Capital
sells its preferred stock to a buyer. Under the district court’s reading of the “within
sixty days” rule, the buyer would have no duty to report its purchase to Editek, the stock
exchange, or the SEC, even though the buyer would have a right exercisable in three
days to acquire a potentially control-influencing stake in Editek’s voting securities.

        We think the “within sixty days” rule means just what it says. The SEC does
also:

        The Commission is . . . mindful that as the point in time [at] which the
        right to acquire may come to fruition is extended into the future the . . .
        right’s ability to influence control is correspondingly attenuated. When
        sixty days or less are left until the right to acquire may be exercised, the
        Commission believes that the ability of the holder of such right to effect
        control is sufficient to warrant the imposition of an obligation to file under
        Rule 13d-1.

Filing and Disclosure Requirements Relating to Beneficial Ownership, Exchange Act
Release No. 14,692, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,571, at
80,310 (Apr. 21, 1978). Applied here, the “within sixty days” rule makes Morgan
Capital a beneficial owner of Editek common stock on every day within sixty days of
every day on which Morgan Capital had the right to acquire Editek common stock
through conversion--including March 28. Of course, whether a beneficial owner under
the “within sixty days” rule is also a ten percent owner, and thus an insider subject to
§ 16(b), is a separate matter.

       We turn next to the second basis for the district court’s conclusion. Noting that
the conversion price floated, the district court found relevant the following passage from
an SEC release:

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      [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. Thus, a right to purchase an equity security is deemed
      acquired as of the date the exercise or conversion price becomes fixed, and
      the acquisition, absent an exemption, would be matchable for Section
      16(b) purposes with a disposition within six months of the fixing of the
      price.

[1990-1991 Transfer Binder] Fed. Sec. L. Rep. ¶ 84,709, at 81,265. As we have just
explained, under the “within sixty days” rule Morgan Capital’s claimed beneficial
ownership before the conversion depended on its having a right to acquire such
ownership within a stated time. Based on the quoted passage, the district court
concluded Morgan Capital did not gain the right referred to in the “within sixty days”
rule until the conversion itself, so it could not have been a beneficial owner before the
conversion. See Editek, 974 F. Supp. at 1233.

       Although this conclusion follows logically from the quoted passage, it contradicts
the conclusion dictated by the “within sixty days” rule itself, under which Editek’s
complaint would make Morgan Capital a beneficial owner of Editek common stock well
before the conversion date. The quoted language is not at odds with the “within sixty
days” rule, however. The SEC is simply talking about something other than determining
ten percent beneficial ownership. Again, for those other purposes, the term beneficial
owner means a person who has a direct or indirect pecuniary interest in registered equity
securities. See 17 C.F.R. § 240.16a-1(a)(2). With that in mind, and taking into
consideration the quoted passage’s context, the SEC’s meaning becomes apparent.

      The passage is lifted from a lengthy discussion of derivative securities. See
[1990-1991 Transfer Binder] Fed. Sec. L. Rep. ¶ 84,709, at 81,258-81,266. A
convertible security is a type of derivative. See 17 C.F.R. § 240.16a-1(c). To own a

                                          -7-
derivative security is to have an indirect pecuniary interest in the underlying security.
See id. § 240.16a-1(a)(2)(ii)(F). But here is the crucial exception: a derivative with a
floating exercise or conversion price is not a derivative security for § 16 purposes. See
id. § 240.16a-1(c)(6); [1990-1991 Transfer Binder] Fed. Sec. L. Rep. ¶ 84,709, at
81,265. In other words, Morgan Capital, as a holder of floating-price convertible
preferred stock, did not own derivative securities, did not have an indirect pecuniary
interest in the underlying common stock, and accordingly (assuming Morgan Capital
had no other form of pecuniary interest) was not a beneficial owner of the common
stock until the conversion--for purposes other than determining ten percent beneficial
ownership. It may seem odd that Morgan Capital both was and was not a beneficial
owner of Editek common before the conversion, but the SEC has long recognized the
two definitions of beneficial owner can result in different determinations of beneficial
ownership. See Interpretive Release on Rules Applicable to Insider Reporting and
Trading, Release No. 34-18,114, 4 Fed. Sec. L. Rep. (CCH) ¶ 26,062, at 19,063-7 n.17
(Sept. 23, 1981). In sum, the quoted passage has no bearing on whether Morgan
Capital was a beneficial owner for the purpose of determining ten percent beneficial
ownership before the conversion. That issue is governed by the “within sixty days”
rule, not the “pecuniary interest” rule.

       The district court held Editek’s complaint failed to state a claim based solely on
the conclusion that Morgan Capital was not a beneficial owner before the conversion.
That conclusion was incorrect, so the district court’s ruling cannot stand. On appeal,
Morgan Capital has raised two other legal challenges to Editek’s complaint. Morgan
Capital claims a holder of convertible preferred stock cannot “float” into and out of ten
percent ownership of the underlying common stock as the price of the common stock
fluctuates. The district court mentioned this issue, but did not resolve it. See Editek,
974 F. Supp. at 1233. At oral argument, Morgan Capital argued its stock conversion
was not a “purchase” matchable against a later sale, but merely a change in the form of
its beneficial ownership. In remanding this case, we express no opinion on these or

                                          -8-
any other issues, which we leave for the district court to address in the first instance as
the parties choose to raise them.

      We reverse the judgment of the district court, vacate the district court’s order
dismissing with prejudice Editek’s complaint under Federal Rule of Civil Procedure
12(b)(6), and remand for further proceedings consistent with this opinion.

      A true copy.

             Attest:

                     CLERK, U.S. COURT OF APPEALS, EIGHTH CIRCUIT.

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