Directors by Deputization Who Are Also 10% Shareholders Are Exempt From Short-Swing Profit Liability
 
May 5, 2008
 

Recently, the United States Court of Appeals for the Second Circuit ruled that Rule 16b-3, which exempts certain transactions between an issuer and an officer or director from short swing profit liability under Section 16(b) of the Exchange Act, is applicable to directors by deputization who hold more that 10% of the issuer’s securities. The plaintiff, a shareholder of the issuer, brought an action under Section 16(b) in federal district court against the defendants to recover short swing profits realized by the defendants. The defendants held more than 10% of the issuer’s stock. In addition, the defendants were “directors by deputization” by virtue of their investment in the issuer, which permitted the defendants to appoint two directors to the issuer’s board of directors who represented the interests of the defendants. The district court dismissed the complaint, and the plaintiff appealed.

The Second Circuit noted that although Rule 16b-3 does not expressly exempt directors by deputization, the SEC has construed Rule 16b-3 to cover directors by deputization. The court also noted that Rule 16b-3 does not expressly exempt shareholders who own more that 10% of the issuer’s stock.

The SEC, in an amicus brief, reasoned that “the rationale underlying adoption of the Rule – i.e., that the fiduciary constraints placed on officers and directors, coupled with the Board approval requirement, were sufficient to protect against the speculative abuse Section 16(b) was designed to prevent – was an equally effective safeguard even if the director was also a 10% shareholder.” The Second Circuit, accepting arguments raised by the SEC in its amicus brief, held that the Rule 16b-3(d)(1) protection is available to a director by deputization who also owns more than 10% of the issuer’s shares.

(Roth v. Perseus, LLC et al., 2008 WL 961270 (2d Cir. April 10, 2008))