A beneficial owner's acquisition of securities directly from an issuer, at the issuer's request and with the board's approval, is covered by Exchange Act Section 16(b), concluded a 2nd Circuit panel. This action was brought derivatively on behalf of a communications systems company against two funds that owned over 10 percent of the company's shares. In December 2005 and January 2006, the funds sold company shares in their portfolios on the open market, and, in April 2006, the funds bought company shares in a private investment in public equity, or “PIPE” transaction at a discount from the market price.

The shareholder bringing the suit claimed that the funds were liable to the company for short-swing profits and sought their disgorgement. The funds argued that the transaction was issuer-solicited and approved by the board, and thus differed from the type of abusive transactions that Section 16(b) was enacted to prevent. The district court held that because the PIPE transaction was neither hostile nor involuntary, the potential for abuse existed, and the funds were liable for their short-swing profits.

On appeal, the funds argued that the district court erred in determining that the PIPE transaction was not exempt and that the funds were "beneficial owners" under Section 16(b). According to the funds, the transaction was the result of direct negotiations between the funds and the company's board and should have been exempt from Section 16(b)'s coverage. There was no possibility of speculative abuse, the funds contended, because both the company and the funds had access to the same information.

The court concluded that the PIPE transaction was not exempt from Section 16(b)'s coverage. According to the panel, the transaction was not "borderline" or "unorthodox" because the fund had access to inside information and gave the company a volitional capital infusion. The panel noted that the SEC has held that 10 percent holders are presumed to have access to inside information and can influence or control the issuer. Further, an exemption for officers or directors did not apply to the funds, and 10 percent holders are excluded from that exemption because they do not necessarily owe fiduciary duties to the company.

The appellate court then determined that the funds were beneficial owners and liable for short-swing profits. The funds argued that only the two partners who had voting and investment power over the funds' securities were the only insiders and should have been held liable, but the panel responded that this argument did not square with the basic principles of agency law. The partners were agents with delegated rights and powers over the securities held by the funds, and their actions bound the partnerships. The definition of "person" in Section 16(b) includes "partnerships," the panel continued. Accordingly, the panel held that the funds were beneficial owners, that April 2006 acquisition was a "purchase" under Section 16(b), and that they were consequently liable for the short-swing profits from that purchase.

□ Huppe v. WPCS International Incorporated (2ndCir) is reported at ¶96,714.