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KORNFELD v. EATON

April 24, 1963

Harold KORNFELD and Thelma Kornfeld, stockholders of The Norwich Pharmacal Company, suing on behalf of themselves and all other stockholders similarly situated and on behalf and in the right of The Norwich Pharmacal Company, Plaintiffs,
v.
Thomas J. EATON and The Norwich Pharmacal Company, Defendants



The opinion of the court was delivered by: WEINFELD

These are cross-motions for summary judgment in an action brought under section 16(b) of the Securities Exchange Act of 1934 *fn1" on behalf of the Norwich Pharmacal Company to recover short-swing profits realized by one of its officers and directors. The matter is ripe for summary judgment since the basic facts are not in dispute. What is at issue is the validity of Rule X-16B-6 of the Securities and Exchange Commission which in effect limits the amount of profits recoverable when stock, involved in a short-swing transaction, has been purchased by an 'insider' *fn2" by the exercise of an option acquired more than six months before its exercise. In short, the Rule recognizes a distinction between the long term and short term aspects of profits realized in such purchases and sales, and grants exemption only on the long term profits. The Commission appears as amicus curiae and urges the validity of its Rule, *fn3" which provides in pertinent part:

'(a) To the extent specified in paragraph (b) of this section the Commission hereby exempts as not comprehended within the purposes of section 16(b) of the act any transaction or transactions involving the purchase and sale or sale and purchase of any equity security where such purchase is pursuant to the exercise of an option or similar right either (1) acquired more than six months before its exercise, or (2) acquired pursuant to the terms of an employment contract entered into more than six months before its exercise.

 '(b) In respect of transactions specified in paragraph (a) of this section the profits inuring to the issuer shall not exceed the difference between the proceeds of sale and the lowest market price of any security of the same class within six months before or after the date of sale. Nothing in this section shall be deemed to enlarge the amount of profit which would inure to the issuer in the absence of this section.'

 The undisputed facts are:

 The defendant Thomas J. Eaton, at all times hereinafter mentioned, was a director and officer of the Norwich Pharmacal Company, the stock of which was listed on the New York Stock Exchange. On August 23, 1956 Norwich granted to Eaton an option to purchase 2,000 shares of its common stock at ninety-five per cent of its fair market value at the time of the grant of the option. The then market price was $ 13.63 per share and the option price was $ 12.95 per share. *fn4" The option was exercisable at any time within eight years after its issuance; it was conditioned upon continuance in Norwich's employ for one year after grant and was not transferrable or assignable except by will or intestacy. The option was granted and the conditions attached thereto were pursuant to a Key Employees' Stock Option Plan approved in September, 1951 by the Norwich stockholders. Eaton did not exercise his option until almost four years after it accrued, when on July 12, 1960 he purchased 2,000 shares of the stock at $ 12.95 per share. Within six months before this purchase, between February 25 and May 12, 1960, on three separate occasions he sold a total of 2,228 shares of Norwich common stock at net prices ranging from $ 40.55 to $ 44.93 per share. There is no dispute but that the foregoing sales and purchase come within the scope of section 16(b). The range of the lowest price of the stock at any time within six months before or after the respective sale dates of the stock was between $ 32.50 and $ 37.25 per share.

 In October, 1961 plaintiffs' attorney requested Norwich to institute suit against Eaton to recover the short-swing profits realized by him upon the transactions. Thereafter, upon Norwich's demand, Eaton paid to Norwich $ 15,418.96 together with interest from July 12, 1960 to the date of payment. Plaintiffs concede that the sum was computed in accordance with the provisions of Rule X-16B-6. However, contending that the Rule was invalid, they demanded that Norwich institute action to recover the claimed additional profits, which they computed at $ 45,945.62 plus interest. This figure is based upon their contention that the purchase price of the stock was its value on the day the options accrued, to wit, on August 23, 1956, when the market value was $ 13.63. The company refused, whereupon the present suit was commenced.

 The plaintiffs' fundamental position is that the Rule is beyond the power of the Commission since it offends the basic purpose of section 16(b) of the Act and, in any event, since it limits the amount of profits recoverable from a short-swing transaction, it exceeds the Commission's statutory power of exemption. Eaton and Norwich not only join the SEC in urging the validity of the Rule, but make the further defense that the payment of $ 15,418.96 plus interest made by Eaton to Norwich, and accepted by it, was a good faith settlement of defendant's liability for the short-swing transaction; and moreover that the defendant cannot be held for additional 'profit,' for he had in good faith relied upon the Commission rule. In practical terms what is involved is whether the market increment of the stock from the time Eaton acquired his option up to the short-swing period surrounding the sales herein is to be included in computing the profits of the short-swing transactions.

 The essential purpose of section 16(b) as appears from its policy declaration and as repeatedly emphasized by the courts is to assure a fair and honest market and to prevent short-swing speculation and market manipulation by directors, officers and ten per cent stockholders through the use of inside or advance information. *fn5" To effectuate that purpose, Congress provided that 'any profit realized' by an insider on any purchase and sale, or any sale and purchase, of an equity security within any period of less than six months, the so-called swing period, was to inure to the benefit of the corporation. The Act itself does not specify how the 'profit realized' is to be computed. The Courts, in the absence of such legislative direction, have fashioned their own rules largely on an ad hoc basis. In enforcing the Act, they have gone upon the assumption that it intended 'to squeeze all possible profits out of stock transactions' *fn6" as the effective means of discouraging short-swing transactions. Thus, in the early and oft cited case of Smolowe v. Delendo Corp. *fn7" our Court of Appeals, in considering the method for computing 'any profit realized,' rejected such concepts as 'identity of certificates,' 'first in, first out' and 'average cost of shares,' as permitting possible evasion of the purposes of the Act. It reached an empirical judgment that 'The only rule whereby all possible profits can be surely recovered is that of lowest price in, highest price out -- within six months * * *.' *fn8" This doctrine was independently examined and adhered to in Gratz v. Claughton *fn9" with the observation by Judge Learned Hand that the proper method for determining 'any profit realized' was 'in such a way as to increase them to the greatest possible amount' -- in short, that maximization of profits was the yardstick of recovery. This concept, now too firmly entrenched to be questioned in any respect, presents no problem in its application to transactions involving securities which had their origin wholly within the short-swing period.

 The plaintiffs urge that the same underlying rationale of 'squeezing all possible profits' applies in computing profits upon the stock acquired by the defendant through the exercise of his four-year old option, constituting one of the items within the short-swing period. Essentially, what is involved is the determination of the cost basis of the stock in order to determine the profits realized. The plaintiffs, relying upon Steinberg v. Sharpe, *fn10" urge that the cost basis is the option price plus the value of the option on the date it accrued, that is, when the defendant had the right to exercise it -- in short, the market value of the underlying stock on the accrual date. In the instant case, this would be the date the option was granted, August 25, 1956, when the market price was $ 13.63. Under this method of computation the defendant Eaton would be required to turn over to the corporation the entire market appreciation of the stock from the time he acquired the option, a period of almost four years.

 Steinberg does not control the instant situation. First, since the accrual date, the exercise date of the option and the date of sale in that case were all within a six-month period, no long term gain was at issue or included in the recovery. Second, Rule X-16B-6 expressly provides that it is inapplicable if it enlarges the recoverable profits, and under the facts of Steinberg, the Rule was inapplicable.

 However, shortly after the promulgation of the Rule, its validity was squarely upheld in Blau v. Hodgkinson *fn11" and indeed applied retroactively. There the sale took place within six months of the date of the exercise of the option and more than five years had elapsed between the accrual date and the exercise date. Notwithstanding Blau v. Hodgkinson, the plaintiffs urge that the Rule be declared invalid. They rely heavily upon a statement in Rattner v. Lehman *fn12" that 'the Commission may exempt 'transactions'; but it cannot reduce the liability imposed by section 16(b).' Admittedly, the statement was dictum and, as we shall presently indicate, was concerned with other problems.

 The plaintiffs further press their attack by reference to decisions with respect to another Rule, X-16B-3, which entirely exempted stock purchases by insiders pursuant to certain restricted option plans from the operation of section 16(b). *fn13" In Greene v. Dietz, *fn14" our Court of Appeals in dictum cast doubt upon the validity of Rule X-16B-3, and subsequently Judge Ryan, in Perlman v. Timberlake, *fn15" held it was invalid. *fn16" Accordingly, the plaintiffs say that since under these decisions the Commission was without power to exempt from the operation of section 16(b) a purchase of stock acquired by the exercise of an option, it necessarily follows that the Commission had no authority to reduce recoverable profits as Rule X-16B-6 contemplates. These cases do not control the present situation. They concerned a different rule which sought to exempt entirely a purchase of option stock from the operative effect of section 16(b). It exempted both the long-term gain and the short-swing profit. Moreover, the Greene v. Dietz dictum drew a sharp dissent. These cases alone do not justify disregarding Blau v. Hodgkinson or concluding that its holding has been overruled. If it is not to be followed, more persuasive arguments must be presented.

 The plaintiffs' basic position is that the use of options by insiders to manipulate the market in short-swing trading in large measure led to the enactment of section 16(b), and that only by literal and rigid interpretation of its provisions can its purpose to prevent recurrence of the evils be enforced. They emphasize that the reference therein to the recapture of 'any profit realized' for the benefit of the corporation can only mean all profits derived from short-swing transactions, whether realized by reason of long-term investment or short-swing speculative activities. Accordingly, they urge that the Rule which excludes a portion of 'any profit realized' is inconsistent with and frustrates the Congressional purpose, and hence is beyond the rule-making competence of the Commission. Further, they stress that the Act authorizes the Commission to exempt only transactions '* * * as not comprehended within the purpose of (16(b)).' They argue that once 'a purchase and sale' or 'a sale and purchase' is within the ambit of section 16(b), liability automatically attaches and perforce the Commission is without power to reduce the recovery of 'any profit realized.' However, to state the plaintiffs' position begins rather than ends inquiry, since 'any profit realized' may have varied meanings, *fn17" depending upon the method used to compute the profits in order to carry out the statutory intent -- and, as we have noted, Congress itself has provided no specific guidelines.

 Before considering the Commission's position, it is desirable to note that section 16(b) was not intended to discourage long-term investments or transactions by insiders. The short-swing period, a six-month limitation, was referred to by its chief proponent as a 'crude rule of thumb.' *fn18" That period was declared 'off limits' for insiders. At best it reflected a realistic judgment as to how to achieve the objectives of the law to discourage short-swing trading by depriving insiders of their profit on the transactions. Thus, it eliminated the difficult problem of proof if intention to 'get out on a ...


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