Appeal by plaintiff-stockholder from an order of the United States District Court for the Southern District of New York, Robert J. Ward, Judge, denying his motion for summary judgment on the issue of liability in his derivative action under § 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b), for recovery of profits realized by an underwriter upon distribution of a securities issue and granting the motion of defendant-underwriter, William Norton & Company, Inc. for summary judgment dismissing the complaint. Affirmed in part and remanded.
Hays, Anderson and Mansfield, Circuit Judges.
MANSFIELD, Circuit Judge:
Invoking § 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b),*fn1 commonly known as the "short swing profits" provision, H. Perine, a stockholder of Designcraft Jewel Industries, Inc. ("Designcraft"), brought this stockholder's derivative action against William Norton & Company, Inc. ("Norton"), a broker-dealer in securities, to recover the profits earned by it in its underwriting of the distribution within six months of 250,000 shares of Designcraft's common stock, which represented more than 10% of the latter's issued and outstanding common shares. Prior to the underwriting Norton was not an insider of Designcraft (i.e., an officer, director, or beneficial owner of more than 10% of Designcraft's stock). The district court, in an opinion by Judge Ward reported at 372 F. Supp. 341 (S.D.N.Y. 1974), held that while § 16(b) is applicable to the underwriting transaction, Rule 16b-2, 17 C.F.R. § 240.16b-2,*fn2 provides an exemption from the application of the statute in these circumstances. We affirm in part and remand.
On May 23, 1972, Designcraft made a public offering of 300,000 shares of its common stock. The total outstanding common stock of Designcraft, including the 300,000 newly issued shares, was then 817,500 shares. Norton was counderwriter of the public offering, distributing 250,000 shares itself. The underwriting was made on a firm-commitment basis requiring Norton to buy the shares from Designcraft and resell them to the public, a process completed within a few days. At all material times Designcraft was registered pursuant to § 12(g) of the Securities Exchange Act of 1934, 15 U.S.C. § 78l(g), with the Securities and Exchange Commission as a company the shares of which are traded over-the-counter so that § 16(b) was applicable to Designcraft's common stock. There was no relevant connection between Norton and Designcraft before the underwriting transaction took place.
Perine contends that by buying and then selling within a few days more than 10% of Designcraft's outstanding common shares in the course of the underwriting, Norton became an insider of Designcraft and subject to suit for recovery of profits under § 16(b). That section allows recovery by the issuer of profits realized by insiders (officers, directors, or beneficial owners of more than 10% of the issuer's equity securities at the time of both purchase and sale) from the purchase and sale of any equity security of the issuer within any period of less than six months. As Norton was not an insider before undertaking the distribution, Perine relies principally on Stella v. Graham-Paige Motors, 232 F.2d 299 (2d Cir.), cert. denied, 352 U.S. 831, 77 S. Ct. 46, 1 L. Ed. 2d 52 (1956), which held that, upon making a purchase of securities which brings his holdings above the 10% level, the purchaser becomes an insider subject to liability under § 16(b).
Perine further argues that Norton is not exempted from § 16(b) liability by Rule 16b-2, which exempts purchases and sales made in connection with the distribution of a substantial block of securities, provided three specified conditions are met. It is claimed that the third condition (clause (a)(3)) of the rule was not met here.
Norton denies that § 16(b) is applicable to this underwriting transaction. It also contends that in these circumstances it is not in any event required to satisfy the third condition of Rule 16b-2 and that since it has satisfied both of the other conditions the distribution pursuant to the underwriting is exempted by that rule.
Section 16(b) is a remedial statute designed to prevent a corporate insider from profiting through speculation in the stock of a publicly traded corporation with which he is connected by unfairly using information available to him as an insider. See Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418, 30 L. Ed. 2d 575, 92 S. Ct. 596 (1972); Blau v. Max Factor & Co., 342 F.2d 304 (9th Cir. 1965); Adler v. Klawans, 267 F.2d 840 (2d Cir. 1959). Making administration of the statutory scheme simple, Congress adopted a prophylactic measure which permits recovery by the corporation of the profits from a class of insider transactions in which "the possibility of abuse was believed [by Congress] to be intolerably great," i.e., purchases and sales by an insider within six months, Reliance Electric Co. v. Emerson Electric Co., supra, 404 U.S. at 422, "without proof of actual abuse of insider information, and without proof of intent to profit on the basis of such information," Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 595, 36 L. Ed. 2d 503, 93 S. Ct. 1736 (1973).
As its first line of defense Norton contends that, in the conceded absence of a prior insider relationship between it and the issuer, § 16(b) does not apply to the underwriting in the present case, which was a traditional firm-commitment distribution of a substantial block of securities in which it acted as a mere conduit. Without the possibility of its having had prior access to inside information, it argues, the distribution did not present the potential for abuse that is inherent in short-term transactions by insiders. See Kern County Land Co. v. Occidental Petroleum Corp., supra, 411 U.S. at 594-95.
Were it not for the plain language of § 16(b) and the established policy in favor of mechanical application of that language, see Reliance Electric Co. v. Emerson Electric Co., supra, Norton's argument might be persuasive. But § 16(b) provides in sweeping and unequivocal terms that " any profit realized by [such beneficial owner] from any purchase and sale . . . of any equity security of such issuer . . . within any period of less than six months . . shall . . . be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner . . in entering into such transaction . .." (emphasis supplied). In Stella v. Graham-Paige Motors, supra, for example, the purchaser's acquisition of more than 10% of the issuer's outstanding shares rendered it a "beneficial owner" within the meaning of § 16(a), subjecting it to liability under § 16(b) for profits upon a sale within six months.
Applying the plain language of the rule as thus interpreted, Norton became an insider when it purchased more than 10% of Designcraft's stock. It then sold the shares within the statutory six-month period. Thus there is a clearly sufficient basis for invoking § 16(b). See Newmark v. RKO General, Inc., 425 F.2d 348, 354-56 (2d Cir.), cert. denied, 400 U.S. 854, 27 L. Ed. 2d 91, 91 S. Ct. 64 (1970). Nothing by way of legislative history or other authority has been cited to support the view that the statute was not designed to apply to underwriting transactions at all. On the contrary, Congress appears to have assumed that the statute would have broad coverage by expressly authorizing the S.E.C., in anticipation that such a strict and categorical prohibition might work harsh results in certain situations, to adopt rules and regulations exempting from its operation any transactions which the SEC might consider to be "not comprehended within the purpose of this subsection." Pursuant to this authority the S.E.C. has adopted Rule 16b-2 to exempt certain transactions. If Norton's distribution of Designcraft common stock as underwriter is to be excluded from the application of § 16(b), therefore, it must be by exemption under this rule rather than by a restrictive interpretation of the language of § 16(b) itself.
Rule 16b-2 exempts any transaction "which is effected in connection with the distribution of a substantial block of securities," provided three conditions are met: (1) that the underwriter be in the business of distributing securities and engaged in good faith in the distribution in question; (2) that the securities be acquired by the ...