UNITED STATES DISTRICT COURT SOUTHERN DISTRICT OF NEW YORK
March 28, 2006
DEBORAH DONOGHUE, PLAINTIFF,
CENTILLIUM COMMUNICATIONS INC. AND KAMRAN ELAHIAN, DEFENDANTS.
The opinion of the court was delivered by: William H. Pauley III, District Judge
MEMORANDUM AND ORDER
Deborah Donoghue ("Plaintiff") brings this shareholder derivative action on behalf of nominal Defendant Centillium Communications Inc. ("Centillium") against Kamran Elahian ("Elahian") pursuant to Section 16(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), 15 U.S.C. § 78p(b). Plaintiff seeks disgorgement of alleged short-swing profits realized by Elahian through transactions involving Centillium stock. Plaintiff and Elahian move for summary judgment. For the reasons set forth below, Elahian's motion is granted and Plaintiff's motion is denied.
On November 9, 2001, Elahian, a director of Centillium, entered into a "variable prepaid forward" transaction with CSFB Cayman International LDC ("CSFB") (the "Forward").*fn1 A variable prepaid forward "is a contract entered into by an insider with a counterparty under which the insider contracts to sell a fixed number of shares of stock of the insider's company on a fixed future date (usually at least a year in the future) at a fixed price (typically the market price on the date of entering into the contract)." Peter J. Romeo & Alan L. Dye, Section 16 § 10.05[a] at 942-43 (2d ed.). Variable prepaid forwards are used to convert stock assets into cash before the stock is transferred.
Pursuant to the Forward agreement, Elahian deposited 300,000 Centillium shares into a trust account for CSFB in November 2001. (Confirm. at 2.) In return, CSFB paid Elahian $1,593,479.85, or $5.3115995 per share. (56.1 Stmt. ¶ 2; Confirm. at 2.) The shares were to be transferred from the trust account to CSFB on January 12, 2005 (the "Settlement Date"). (Confirm. at 4.) Because Elahian was paid up front, he was protected from the downside risk of Centillium once the price of $5.3115995 per share was set. However, the Forward agreement granted Elahian a limited upside participation in the 300,000 shares ending on January 7, 2005. If the stock price exceeded $6.5173 (the "Floor") on that date, Elahian could withhold from delivery to CSFB the number of shares equal in value to the amount by which the value of the 300,000 shares exceeded $6.5173 per share. (Confirm. at 4.) For example, if Centillium's share price closed at $7.5173 on January 7, 2005, Elahian would be entitled to withhold $300,000 in Centillium stock ($7.5173 minus $6.5173 multiplied by 300,000 shares) from the 300,000 shares owed to CSFB on the Settlement Date. Because the share price in this hypothetical is $7.5173, Elahian would withhold 39,908 shares ($300,000 divided by $7.5173 per share) and deliver the remaining 260,092 Centillium shares to CSFB.
Elahian's upside participation in the 300,000 shares was capped at $11.4053 per share. (Confirm. at 2, 4) That is, regardless of the extent to which the stock price exceeded $11.4053 on January 7, 2005, Elahian would be entitled to withhold a maximum of $1,466,400 in Centillium stock ($11.4053 minus $6.5173, or $4.8880, multiplied by 300,000 shares). For example, if Centillium closed at $20 on January 7, 2005, Elahian would withhold 73,320 shares ($1,466,400 divided by $20 per share) and tender the remaining 226,680 shares to CSFB.
As an alternative to settling the transaction in shares, the Forward agreement gave Elahian the option of settling the transaction in cash. (Confirm. at 4-5.) So, if Elahian wished to retain all 300,000 shares, the Forward agreement permitted him to pay CSFB the fair market value of the shares owed in lieu of delivering those shares to CSFB.
Centillium stock closed at $2.38 on January 7, 2005. (56.1 Stmt. ¶ 3.) This obligated Elahian to deliver all 300,000 shares to CSFB, because the share price was below the Floor. Elahian chose not to exercise his cash settlement option, and the 300,000 shares were delivered to CSFB on January 12, 2005. (56.1 Stmt. ¶ 3.)
On February 28, 2005, Elahian executed an open-market purchase of 162,814 Centillium shares at an average share price of $2.01. (56.1 Stmt. ¶ 4.) These purchases were unrelated to the Forward. (56.1 Stmt. ¶ 4.) Plaintiff alleges that Elahian recognized a short-swing profit in violation of Section 16(b) through the combination of the January 12, 2005 "sale" of Centillium stock at $2.38 per share and the February 28, 2005 purchase of Centillium stock at $2.01 per share. Defendant contends that he is not liable under Section 16(b) because the settlement of the Forward cannot be considered a sale and therefore, he sold no Centillium stock within six months of any purchase.
I. Legal Standard
A. Summary Judgment
Summary judgment is warranted "if the pleadings, depositions, answers to interrogatories, and admissions on file, together with the affidavits, if any, show there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed. R. Civ. P. 56(c); see also Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 247 (1986); Celotex Corp. v. Catrett, 477 U.S. 317, 322-23 (1986). Here, the parties agree that there are no disputed issues of fact, and that the parties' respective motions turn solely on questions of law.
B. Section 16
Section 16 was enacted to prevent corporate insiders from using non-public information to "speculate in the stock of the corporations to which they owe a fiduciary duty." Senate Comm. on Banking & Currency, Stock Exchange Practices, S. Rep. No. 1455, 73d Cong., 2d Sess. at 68 (1934); accord Gwozdzinsky v. Zell/Chilmark Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998) (Section 16is designed "to deter 'insiders' who are presumed to possess material information about the issuer, from using such information as a basis for purchasing or selling the issuer's equity securities at an advantage over persons with whom they trade."). Section 16(b) provides, in pertinent part:
For the purposes of preventing unfair use of information which may have been obtained by [a] beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security within any period of less than six months, . . . shall inure to and be recoverable by the issuer . . .
15 U.S.C. § 78p(b). Thus, a Section 16 claim for disgorgement requires that the plaintiff prove the existence of (1) a purchase and (2) a sale of securities (3) by a statutory insider (4) within a six-month period. Feder v. Frost, 220 F.3d 29, 32 (2d Cir. 2000). Section 16(b) is a strict liability statute which applies "irrespective of any intention on the part of [the] beneficial owner." 15 U.S.C. § 78p(b); accord Magma Power Co. v. Dow Chem. Co., 136 F.3d 316, 320-21 (2d Cir. 1998); Schaffer v. CC Invs., LDC, 280 F. Supp. 2d 128, 133-34 (S.D.N.Y. 2003). Insiders who violate Section 16(b) are required to disgorge any profits earned on the prohibited transactions. 15 U.S.C. § 78p(b); Magma Power, 136 F.3d at 320.
C. Rule 16b-6
In 1991, the Securities and Exchange Commission (the "SEC" or the "Commission") amended its rules under Section 16(b) to clarify the statute's application to derivative securities. See SEC Release No. 34-28869, 56 Fed. Reg. 7242, 7242-43 (Feb. 8, 1991). The SEC rules define "derivative securities" to include "any option, warrant, convertible security, stock appreciation right, or similar right with an exercise or conversion privilege at a price related to an equity security or similar securities with a value derived from the value of an equity security . . ." 17 C.F.R. § 240.16a-1(c). Expressly excluded from this definition are "rights with an exercise or conversion privilege at a price that is not fixed." 17 C.F.R. § 240.16a-1(c)(6). Section 16 applies to derivative securities because "holding derivative securities is functionally equivalent to holding the underlying equity securities for purposes of Section 16." SEC Release No. 34-28869, 56 Fed. Reg. at 7248.
As part of the 1991 amendments, the SEC promulgated Rule 16b-6, which states that the acquisition of a fixed-price option-rather than its exercise-constitutes a "sale" or "purchase" for purposes of Section 16(b). 17 C.F.R. § 240.16b-6(a); see also Magma Power, 136 F.3d at 322-23. Thus, the receipt of a put option is deemed to be a "sale" of the underlying common stock, even if the option is never exercised. Likewise, warrants and call options are deemed "purchased" on the date of receipt. 17 C.F.R. § 240.16b-6(a). The Commission considers the grant or receipt of an option as the operative date because: just as an insider'sopportunity to profit commences when he purchases or sells the issuer's common stock, so too the opportunity to profit commences when the insiderengages in transactions in options or other derivative securities that provide an opportunity to obtain or dispose of the stock at a fixed price.
SEC Release No. 34-28869, 56 Fed. Reg. at 7248. Under the SEC's treatment, "the exercise of a fixed-price option [is] nothing more than a change from an indirect form of beneficial ownership of the underlying securities to a more direct one; because the insider by then is already bound by the terms of the option, the potential for abuse of inside information is minimal." Magma Power, 136 F.3d at 322.
It is undisputed that Elahian is a statutory insider who has owned at least 10% of Centiullium shares at all relevant times. (56.1 Stmt. ¶ 5.) He entered into the Forward with CSFB on November 9, 2001, and the Forward settled on January 12, 2005. Elahian then made an unrelated open-market purchase of Centillium shares on February 28, 2005. If Elahian's "sale" of stock to CSFB is deemed to have occurred in November 2001, there would be no matching purchase within six months of that sale and Section 16(b) would not apply. If the sale is deemed to have occurred on January 12, 2005, the sale would be paired with the February 28, 2005 purchase, giving rise to Section 16(b) liability.
Defendant contends that under Rule 16b-6, the "sale" occurred at the inception of the Forward transaction in November 2001. Plaintiff responds that Rule 16b-6 does not apply for two reasons: (1) Elahian retained the option of delivering cash instead of shares at maturity; and (2) when the Forward was purchased, the number of shares (or the cash equivalent) owed at maturity was not fixed.
A. Cash Settlement
The Forward agreement permitted Elahian to settle the transaction in cash in lieu of Centillium shares. Plaintiff contends that this option enabled Elahian to make speculative use of non-public information until the option expired 30 days prior to settlement on December 13, 2004. For example, Elahian might have determined, based on inside information, that the price of Centillium stock was likely to increase after settlement. This would have prompted Elahian to settle the transaction in cash and retain the stock while its value increased. Thus, Plaintiff argues that the "sale" should be deemed consummated at the expiration of the Forward.
Plaintiff's argument has been foreclosed by the Second Circuit's decision in Magma Power. In that case, defendant Dow Chemical Company issued notes exchangeable for a fixed number of Magma Power Company's common shares. 136 F.3d at 319. If the noteholder opted to exchange his notes, Dow had the option to deliver the cash equivalent of the shares owed in lieu of the shares themselves. Magma Power, 136 F.3d at 319. "In other words, to the extent that Dow is viewed as having sold Magma stock when it issued the Notes exchangeable into Magma shares, it might be viewed as having retained the option of reaquiring the shares that were subject to the exchange by paying the noteholders the market price prevailing at the time of the exchange." Magma Power, 136 F.3d at 319. In fact, Dow did not exercise its option to buy back the shares. Magma Power, 136 F.3d at 325. The plaintiff in Magma Power characterized the expiration of Dow's option as a "sale." Magma Power, 136 F.3d at 325. The Second Circuit disagreed, holding that "an insider's inactivity cannot give rise to Section 16(b) liability." Magma Power, 136 F.3d at 325. The Court of Appeals reasoned that if the failure to exercise an option could be considered a sale, then "virtually every insider transaction could give rise to liability." Magma Power, 136 F.3d at 325.
The facts before this Court do not materially differ from those in Magma Power. Elahian possessed an option to repurchase his Centillium shares at settlement by delivering cash in lieu of the shares. Unless he gave 30 days notice of exercise to CSFB, the option would expire and CSFB would take ownership of the appropriate number of Centillium shares. Elahian chose not to exercise the option, and the option expired thirty days prior to settlement. Because Elahian's mere "inactivity cannot give rise to Section 16(b) liability," this Court cannot treat Defendant's failure to exercise the option as a "sale." Magma Power, 136 F.3d at 325.
B. Floating Price
A financial instrument with a floating price is excluded from Rule 16a-1(c)'s definition of a "derivative security." 17 C.F.R. § 240.16a-1(c)(6). When a financial instrument is so excluded, the exercise of the instrument might be considered a "purchase" or "sale" for matching purposes under Section 16. Plaintiff contends that since the amount CSFB was to receive at the settlement of the Forward was not fixed, Elahian's transfer of Centillium shares to CSFB must be considered a "sale" under Section 16. This Court disagrees.
When a transaction does not fall within the literal terms of Section 16(b), the statute must be interpreted in a way that is consistent with its legislative purpose. Steel Partners II, L.P. v. Bell Indus., Inc., 315 F.3d 120, 124 (2d Cir. 2002); Gwozdzinsky, 156 F.3d at 310. The purpose underlying Section 16 is set forth in the statute itself: to "prevent unfair use of information which may have been obtained by [a statutory insider] by reason of his relationship to the issuer." 15 U.S.C. § 78p(b). Whether the Forward falls within the parameters of Section 16(b) ultimately turns on "whether the transaction may serve as a vehicle for the evil which Congress sought to prevent-the realization of short-swing profits based upon access to inside information." Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 594 (1973); see also Steel Partners II, 315 F.3d at 124.
Plaintiff's reading of Section 16(b) "appears to contradict the statutory purpose of holding traders liable only for those transactions in which they can exploit their inside information for their own profit." Allaire Corp. v. Okumus, 433 F.3d 248, 251 (2d Cir. 2006). Elahian was powerless to manipulate the settlement of the Forward to his advantage. He was obligated to settle the transaction on January 12, 2005, regardless of whether the stock price was favorable to him on that date. "While the ultimate number of shares to be transferred was not [known until January 7, 2005], that number was dictated by financial formulae and criteria set forth in the [Forward agreement] and, as plaintiff concedes, could not be modified by" Elahian. DiLorenzo v. Murphy, 322 F. Supp. 2d 479, 482 (S.D.N.Y. 2004) (holding that for purposes of Section 16, the "sale" of common stock to the defendant took place at the time of the share transfer agreement, as distinct from the date of transferal); see also Peter J. Romeo & Alan L. Dye, Section 16 Updates, Vol. XI, No. 4 at 12-13 (Dec. 2001) ("To the extent less than the full number of shares needs to be delivered at settlement [of a variable prepaid forward], we think there would simply be an exempt expiration of a derivative security."). Defendant could only have exploited inside information at the inception of the Forward in November 2001. The "sale" must have occurred then, because "[t]hat is when [Elahian's] rights and obligations became fixed and irrevocable." Bruh v. Bessemer Venture Partners III, L.P., No. 03 Civ. 7340 (GBD), 2005 WL 2087803, at *5 (S.D.N.Y. Aug. 29, 2005) (holding convertible stock to be a "derivative" for the purposes of Section 16 even though the conversion price was not fixed); cf. T-bar Inc. v. Chatterjee, 693 F. Supp. 1, 5 (S.D.N.Y. 1988) (holding that a purchase occurs when "when the purchaser had incurred an irrevocable liability to take and pay for the stock and his rights and obligations have become fixed" (internal quotation omitted)).
For the foregoing reasons, Plaintiff's motion for summary judgment is denied and Elahian's motion for summary judgment is granted. The Clerk of the Court is directed to mark this case closed.
WILLIAM H. PAULEY III U.S.D.J.