The opinion of the court was delivered by: RYAN
Before we consider the significance of the opinions in Greene v. Dietz, it might be well to examine the background and development of Rule X-16b-3, which evidences a continuous broadening of exemption from the stricture of Section 16(b).
In this suit filed under Section 16(b) of the Securities Exchange Act of 1934, (15 U.S.C.A. § 78p(b)) to recover shortswing profits all parties have moved for summary judgment.
The claim pleaded is that defendant Timberlake, while a director of corporate defendant Jones & Laughlin (J & L), between April 1, 1957 and July 16, 1957 sold 1,800 shares and bought under a restricted stock option plan 2,500 shares of J & L common stock at a statutory profit of $ 56,132.74, measured against the shares sold.
The answers of both defendants admit the transactions alleged -- the sale and a purchase pursuant to a non-transferable option held by Timberlake under a Stock Option Plan, which they allege met all the conditions set forth in Rule X-16b-3 of the General Rules and Regulations under the SEA of 1934. The answers also allege as a defense the good faith reliance of Timberlake on this Rule. The answer of Timberlake further pleads that any recovery of profits should be limited by Rule X-16b-6 and the answer of J & L in addition seeks a declaratory judgment of validity of Rule X-16b-3.
The Statutes and Rules under consideration are: The Securities Exchange Act of 1934, (Title 15, Sec. 78a et seq.),
Secs. 16(a)(b)(c)-78p; 23(a)-78w; 3(a)(12), 3(b)-78c; General Rules and Regulations under the SEA of 1934 -- :
Rules X-16B-3, (17 C.F.R. 240.16b-3) three versions as it read from 3/19/51 to 11/1/52; from 11/1/52 to 5/29/56; from 5/29/56 to date; X-16B-6 (17 C.F.R. 240.16b-6).
It is plaintiff's contention that Rule X-16B-3 has been held invalid by the Court of Appeals of this Circuit in the two opinions rendered in Greene v. Dietz, on June 7, 1957, and on the Petition for Rehearing August 12, 1957 (2 Cir., 247 F.2d 689 and 697); that this as a matter of law precludes reliance on the Rule by defendant Timberlake under Sec. 23(a); and that Rule X-16B-6 reducing the recoverable profits is invalid.
Defendants contend that the Court of Appeals did not determine invalidity; that the Rule is valid; and that in any event plaintiff may not recover because of Timberlake's good faith reliance on the validity of the Rule, but that if he be held liable, the profits are limited by Rule X-16B-6.
The Commission's motion to appear herein as amicus curiae in support of the validity of Rule X-16B-3 (it has filed a brief limited to that question) was granted on consent of all parties; it takes no position with respect to defendant's good faith or the validity of Rule X-16B-6.
The questions of law presented by the pleadings and the stipulated facts on these motions are: the validity of Rule X-16B-3; and if the Rule is found to be invalid by (a) a prior holding or (b) this court, defendant's immunity from liability under Sec. 23(a).
The following facts are not in dispute.
Plaintiff is a resident of State of New York and with his wife is co-owner of 11 shares of common stock of the corporate defendant.
Jones & Laughlin is a Pennsylvania corporation with its principal place of business at Pittsburgh whose common stock at all times material was registered on the New York Stock Exchange and was not an exempted security either under Secs. 3(a)(12) or 16(b) of the SEA of 1934; prior to June 5, 1953, and continuously since then defendant Timberlake has been a vice-president and since January 27, 1955 has also been a director of J & L, with his office at Pittsburgh and his residence a Mt. Lebanon, Pa. On January 17, 1951, a stock option plan applicable to officers and certain key employees was approved by amendment to the by-laws by a majority of the security holders entitled to vote at a special meeting for which proxies were solicited in accordance with the Rules and Regulations under Sec. 14(a) of the SEA (15 U.S.C.A. § 78n(a); the purpose of the plan was stated to be to provide added incentive to those charged with promoting the welfare of the corporation; the by-laws so amended authorized the Board of Directors to appropriate 15,000 shares of common stock for the Plan and to appoint a Stock Option Committee to administer the Plan subject to the approval of the Board of Directors. By amendment on December 9, 1954 this authority and power granted to the Stock Option Committee was given to the Compensation Committee and it was then also provided that no options were to be granted to any member of this Committee, although the Committee remained still subject to the Board of Directors, who themselves were eligible to participate in the plan. The option price, payable in cash, was set at the closing price on the day of the granting of the option or by amendment of February 8, 1952 at such higher price as the Committee might fix. No option was to be granted to any member of the Stock Option Committee with the exception of 15,000 shares (the maximum number) which were granted to Ben Moreell the Chief Executive Officer of the corporation, and also the Chairman of the Committee; the number of optionees (who might also be members of the Board of Directors) was to be determined by the Board but was not to exceed 100; the option was exercisable for a period of 8 years but only by the optionee while alive, and transferable only on death by will or descent and distribution, with no restriction on the resale of the stock so acquired; and it was only exercisable after one year's employment and on consideration of the optionee's remaining in the employ of the Corporation for at least two years from the granting of the option.
It has also been stipulated that on June 4, 1953 the Board of Directors approved the grant of an option to Timberlake and on June 5, 1953, a formal stock option covering an additional 5,200 shares (apparently there had been a prior option covering 4,800 shares) was given him under an agreement containing the conditions set forth in the plan described; the option price was fixed at $ 27.94 per share ($ 10. par value) which was above the closing market price of $ 22.125 a share and provision was made for dilution. The agreement also provided that Timberlake was to receive for his services a regular salary and such additional compensation as might be fixed from time to time by the corporation which reserved the right to terminate the option upon the commission by him of any act inimical to it.
The SEC on May 29, 1956 amended Rule X-16B-3 so as to exempt from Section 16(b) stock acquired pursuant to non-transferable options; the amendment remains effective to date; on June 1, 1956, Sharp, vice-president in charge of legal and corporate affairs of J & L, sent a letter to eleven officers of J & L including this defendant advising them of the amendment of the Rule and informing them that by virtue of it they were now free to purchase stock under their options at any time and need no longer delay a purchase for more than 6 months following their last sale of stock, but cautioned them that the amended Rule did not apply to any purchase made prior to May 29, 1956 and that it did not exempt any purchase not made pursuant to the option -- which would continue to be matched with any sale within 6 months. Timberlake received the letter and relied on the amended Rule described in the letter when through the Pittsburgh office of a Pennsylvania brokerage firm he entered into the following transactions: on April 9, 1957, he sold 300 shares of common stock of J & L on the New York Stock Exchange at 50 1/8 realizing the net amount from such sale of $ 14,903.36; on July 12, 1957 he sold 1,500 shares of common stock on the New York Stock Exchange at 60 1/2 realizing the net amount of $ 90,063.38; on July 16, 1957, he acquired directly from J & L at its Pittsburgh office 2,500 shares of common stock under his option agreement at $ 27.13 a share or at a cost to him for 1,800 shares of $ 48,834 ($ 27.13 represented a reduction in the option price of $ 27.94 to reflect a 3% dividend on December 28, 1956 in accordance with the anti-dilution provision). At the time of this purchase defendant Timberlake inquired of Wunderlich, vice-president and treasurer in charge of administering the plan, whether in view of his recent stock sales he would incur any Section 16(b) liability in making the intended purchase and was told that because of Rule X-16B-3 he would not. At that time neither Timberlake nor Wunderlich knew of the opinions in Greene v. Dietz of June 7, 1957 and neither learned of them or of the subsequent opinions until August 16, 1957 when they received a memorandum from J. T. Ross, Assistant General Counsel, to the effect that whereas Rule X-16b-3 had provided an exemption for stock acquired under a plan such as that of J & L and that it had been the opinion of their Legal Department that the stock was exempt, the Court of Appeals' recent opinion had cast doubt on the validity of the Rule and warned that it would be ill-advised to rely on it; and he concluded 'although we think that the decision is wrong, you are hereby advised of the danger of reliance on Rule X-16B-3 at this stage.' J. T. Ross had read the first Greene opinions in the last week of June 1957 but had not communicated with any of the officers or directors of J & L until after the second opinions.
The first Greene v. Dietz opinions were reported in the New York newspapers on June 8, 1957; Timberlake was not in the City at any time from June 7 to June 10, 1957.
It is also stipulated that Timberlake relied in good faith on the Rule when he sold and purchased the 1,800 shares of stock, unless the further facts or the opinions in Greene v. Dietz 'as matter of law preclude such finding of good faith'. It is also agreed further, that on the first day on which he could have exercised his option the opening, high and low market price of J & L common stock was 24 1/4, 24 1/4 and 23 7/8; the lowest market price within six months before and after April 9, 1957 was 45 3/8 (on October 8, 1957); the lowest within 6 months before and after July 12, 1957 was 35 1/4 (on December 1957); and the high and low on July 16, 1957, 61 7/8 and 61 1/8. The profit made by Timberlake on his sales and purchase was $ 56,132.74 but if Rule X-16B-6 were to be applied the recoverable profit would be reduced to $ 38,479.24.
It appears that on April 9 and on May 8, 1958, replying to a request by plaintiff that the corporation institute suit to recover the profit, Sharp, vice-president and general counsel, declined to do so describing in detail the circumstances surrounding the Timberlake transactions and expressing the view that the Rule was valid. This suit followed.
One of plaintiff's arguments, which need not detain us, is that since, at the time the option was granted to Timberlake, the plan of J & L did not conform to the requirements of Rule X-16b-3, the acquisition of the stock by him at a subsequent time was not exempt under the amended Rule.
In 1951 and 1953, the plan permitted Ben Moreell, a member of the Committee which nominated optionees, to participate in the plan thus precluding it from coming within the protection of the Rule as it then read. But, in 1956 the Rule was amended to remove this disqualification of a Committee member, and in 1957 when Timberlake exercised his option the plan conformed to the Rule.
We are concerned here with the effect of Rule X-16b-3 on the acquisition of the stock by Timberlake in 1957, not with its effect on the dates the plan was adopted or the option was granted to him. The Rule exempts 'any acquisition' and when this acquisition took place the plan qualified. A similar argument was rejected by the trial Court in Greene v. Dietz, D.C., 143 F.Supp. 464, and its conclusion approved by the Court of Appeals. That the amendment to the Rule was not intended to affect only, or was limited to plans adopted and options granted after its effective date was made clear by the Commission release (No. 5312, May 21, 1956). The amendment was but an effectuation of the basic intention of the Rule as amended in 1950 and a clarification and simplification of it in order to abolish the prior restriction. The J & L plan at the time in question here qualified under Rule X-16b-3.
In 1935, when the Rule was first promulgated it applied only to non-transferable options granted and purchases made prior to June 6, 1934 in connection with an employment contract (SEC Release No. 5312, May 21, 1956); in 1949, it was substantially changed and broadened to encompass securities acquired by corporate officials as compensation under a bonus, profit-sharing, retirement or similar plan, so long as the securities were issued for services, their aggregate amount was limited to a percentage of the net profits and no cash was paid for them (SEC Rel. 4216, 4253, 2/25 and 5/6/49). This amendment did not deal with options at all but only with acquisition of securities 'issued to directors and officers as a part of their remuneration.'
Then, in 1952, the Rule was again amended to cover restricted stock option plans which met the same standards as the rule prescribed for bonus plans above. This amendment was to enable optionees to take advantage of the favorable tax treatment accorded these plans under certain conditions by the passage of Sec. 130A, Internal Revenue Act of 1950, 26 U.S.C.A. § 130A; now Secs. 401, 404 and 421, I.R.A.1954, 26 U.S.C.A. §§ 401, 404, 421. Its purpose was to 'broaden the exemption hitherto provided for by the rule by making it applicable to acquisitions of non-transferable options, as well as to acquisitions of shares of stock' (Release No. 4754, 9/24/52). To accomplish this the Rule eliminated the requirement that such options be acquired as part of remuneration for services by permitting the payment of cash pursuant to the option contract. Finally, on May 29, 1956, the Rule was further 'clarified' to codify the interpretations rendered by the Commission in the interim and 'to simplify the provisions and reinforce the investor protections.' Specifically, to the phrase 'any acquisition of non-transferable options or of shares stock' were added the words: 'including stock acquired pursuant to such options' -- making it clear that the exemption also applied to acquisition of stock pursuant to non-transferable options. The provisions dealing with ineligibility to participate by Committee members selecting the optionees and with the payment of cash were completely eliminated.
The purpose of the Commission in enacting the 1956 revision was not to change the meaning and scope of the rule but to effectuate its basic intention of exempting acquisitions pursuant to both bonus and similar plans and restricted stock option plans favorably treated by the Revenue Act of 1950. In the opinion of the Commission, the clarification of the Rule seemed urgent ...