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ROSEN v. BROOKHAVEN CAPITAL MANAGEMENT CO.

September 29, 2000

FELICE ROSEN, DERIVATIVELY ON BEHALF OF EGGHEAD.COM, INC., PLAINTIFF, AGAINST BROOKHAVEN CAPITAL MANAGEMENT CO., LTD., FOCUSED CAPITAL PARTNERS, L.P., WATERSHED PARTNERS, L.P., CADENCE FUND, L.P., BROOKHAVEN CAPITAL MANAGEMENT, LLC, PITON PARTNERS, L.P., SKYE INVESTMENT ADVISORS, LLC, SKYE INVESTMENTS, INC., VINCENT CARRINO, DANIEL COLEMAN, PAUL MCENTIRE, ROBERT LISHMAN, AND EGGHEAD.COM, INC., DEFENDANTS.


The opinion of the court was delivered by: VICTOR Marrero, United States District Judge.

DECISION AND ORDER

Plaintiff Felice Rosen ("Rosen") brings this action under Section 16(b) of the Securities Exchange Act of 1934 (the "Act") for disgorgement of short-swing profits allegedly obtained by defendants acting as a group in violation of that section of the Act. Before the Court is defendants' motion to dismiss, pursuant to Federal Rule of Civil Procedure 12(b)(6), for failure to state a claim upon which relief can be granted. For the reasons set forth below, the Court denies the motion.

BACKGROUND*fn1

Rosen is a New York resident who owns the common stock of Egghead.Com, Inc. ("Egghead"). Egghead, a nominal defendant in this action, is a Washington corporation. Rosen brings this action derivatively on behalf of Egghead.

Defendants are Focused Capital Partners, L.P. ("FCP"), Watershed Partners, L.P. ("WP"), and Cadence Fund, L.P. ("CF"), all Delaware limited partnerships; Brookhaven Capital Management Co., Ltd. ("BCM"), a New York corporation and investment adviser to certain accounts, including FCP, WP and CF; Piton Partners, L.P. ("Piton"), a Delaware investment limited partnership; Brookhaven Capital Management, LLC ("LLC") and Skye Investment Advisors, LLC ("Skye"), limited liability companies, investment advisers, and Piton's two general partners; and Skye Investments, Inc. ("SII"), the manager and majority member of Skye.

The remaining defendants are four individuals. Vincent Carrino ("Carrino") is a general partner of FCP, CF and WP; the sole director and president of BCM; and the sole manager and majority member of LLC. Daniel Coleman is a general partner of FCP, CF and WP. Paul McEntire is chairman and managing director of Skye and chairman, director and chief executive officer of SII. Robert Lishman is a director of Skye (collectively, defendants referred to as "Brookhaven")

Rosen alleges that the twelve named-defendants constitute a group (the "Group") as defined under Section 13(d) of the Act and for purposes of determining beneficial ownership under Securities and Exchange Commission ("SEC") Rule 16a-1(a)(1) and thus liability under Section 16(b) of the Act; that the Group, through the combined shares of its members, held a greater than 10% beneficial interest in Egghead; that the Group engaged in certain short-swing stock transactions within a six month period; that defendants are liable for at least $7,000,000.00 in disgorgeable profits; and that no exemption from liability is available to defendants.

DISCUSSION

I. STANDARD OF REVIEW

In considering a Rule 12(b)(6) motion, the Court must accept Rosen's factual allegations as true and draw all reasonable inferences in her favor. See Hamilton Chapter of Alpha Delta Phi, Inc. v. Hamilton College, 128 F.3d 59 (2d Cir. 1997). It is the Court's task to assess the legal sufficiency of the complaint and not to judge the credibility of the pleadings or to assess the weight of any evidence offered in support of the action. See Cooper v. Parsky, 140 F.3d 433 (2d Cir. 1998). A claim may not be dismissed "unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief." Morris v. Local 819, Int'l Bhd. of Teamsters, 169 F.3d 782, 784 (2d Cir. 1999) (quoting Conley v. Gibson, 355 U.S. 41, 45-46 (1957)).

II. THE ACT AND RELATED PROVISIONS

Under Section 16(b), directors, officers and beneficial owners of the equity shares of an issuer may not purchase and sell shares of that issuer within any period of less than six months. 15 U.S.C. § 78 (p)(b). "Beneficial owner" is defined in Section 16(a) of the Act as a person who "directly or indirectly" owns more than ten percent of any equity security (other than exempted security) registered under § 12 of the Act. 15 U.S.C. § 78 p(a). These insiders are presumed to possess or have access to non-public information about the issuer and thus to be able to take advantage of their position by trading in the issuer's securities based on private knowledge gained thereby.

Rule 16a-1(a)(1)(i) through (xi) enumerate eleven classes of institutions whose security holdings held in fiduciary or customer accounts maintained for the benefit of third parties in the ordinary course of business are exempt from the definition of beneficial ownership as long as the shares of the issuer in question are acquired by such institutions or persons "without the purpose or effect of changing or influencing control of the issuer". 17 C.F.R. § 240.16a-1(a)(1). Accordingly, shares of the issuer held by these institutions or persons are not counted for the purposes of calculating whether the ten percent threshold has been exceeded. The eleven categories are:

(i) a registered broker or dealer;
(ii) a bank;
(iii) an insurance company;
(iv) a registered investment company;
(v) a registered investment advisor;
(vi) an employee benefit plan subject to ERISA or maintained for the benefit of government employees, or an endowment fund;
(vii) a parent holding company or control person;
(viii) a savings association;
(ix) a religious institution plan;
(x) a group, provided that all the members of such group qualify as persons enumerated in subsections (i) through (ix) above; and
(xi) a group, provided that all the members of such group qualify as persons enumerated in subsections (i) through (vii) above.

17 C.F.R. § 240.16a-1(a)(1)(i) — (xi).

In adopting the Rule setting forth these exemptions, the SEC acknowledged that without such exemptions the listed institutions, which in the ordinary course of their business manage customer and fiduciary accounts, would be subject to liability under Section 16(b) if they exercised either their voting or investment power over accounts that when aggregated held over ten percent of a class of equity securities. See Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Release No. 34-27148, 54 Fed. Reg. 35667, at 35670 (Aug. 18, 1989) (the "1989 Ownership Reports"). Responding to this concern, the SEC stated that "[t]he proposed revision appears necessary to avoid undue interference with the day-to-day business of banks, brokers, dealers, investment advisers and other specified institutional fiduciaries and custodians." Id.

III. RATIONALE OF THE SEC RULES

In defining beneficial ownership for the purposes of potential Section 16(b) liability, only certain securities from among those in the various forms of institutional holdings qualify to be counted towards the ten percent threshold. Others are exempt. The exceptions explicitly recognize commercial necessity and practicalities of not hampering the business activities of the specified institutional entities which on any given day may be custodians to shares in fiduciary or customer accounts exceeding the ten percent limit. Keeping track of such holdings for large numbers of investors would place undue administrative burden on these institutions. Implicit in the exemptions is also an equitable consideration: that it would be unfair to place Section 16(b)'s strict liability for disgorgement of short-term profits on certain passive investors who may possess no inside knowledge or purpose to engage in the management or to influence control of the issuer.

Accordingly, for the purposes of imposing liability, the SEC Rules strike a middle ground that gives expression to these practical and equitable concerns. The relevant inquiry entails identifying which equity securities, from among the shares of a given issuer in various institutional accounts, may be included in the calculation of the ten percent beneficial ownership. Under the Rules, the computation of securities of an issuer counted to define a beneficial owner subject to the ten percent threshold excludes stock of the issuer that the specified entities hold on behalf of third parties, but only to the extent that such shares are acquired and held truly passively, in other words, "without the purpose or effect of changing or influencing the control of the issuer." See 17 C.F.R. § 240.16a-1(a)(1).

The Act and the corresponding Rules may be construed to reflect two different concepts of a "group". Section 13(d)(3) provides that when two or more persons "act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding or disposing of securities of an issuer, such syndicate or group shall be deemed a `person' for the purposes of this subsection." 15 U.S.C. § 78m(d)(3).

In accordance with Section 13(d)(3), the corresponding SEC Rule provides:

When two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, the group formed thereby shall be deemed to have acquired beneficial ownership, for purposes of Sections 13(d) and 13(g) of the Act, as of the date of such agreement, ...

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