Section 16(b) of the Securities and Exchange Act - Unwary Purchaser

SMU Law Review Volume 20 | Issue 2 Article 12 1966 Section 16(b) of the Securities and Exchange Act Unwary Purchaser Gerald William Ostarch Follow this and additional works at: https://scholar.smu.edu/smulr Recommended Citation Gerald William Ostarch, Section 16(b) of the Securities and Exchange Act - Unwary Purchaser, 20 Sw L.J. 411 (1966) https://scholar.smu.edu/smulr/vol20/iss2/12 This Case Note is brought to you for free and open access by the Law Journals at SMU Scholar. It has been accepted for inclusion in SMU Law Review by an authorized administrator of SMU Scholar. For more information, please visit http://digitalrepository.smu.edu. Section 16(b) of the Securities and Exchange Act - Unwary Purchaser I. BACKGROUND AND APPLICATION A corporate officer or a majority stockholder stands in an advantageous position to profit from inside information which is not available to the public. The abuses wrought by insiders in making a "quick kill" on the market historically have been flagrant and widespread,' and the necessity for proof of bad faith and actual use of such information was a formidable obstacle to would-be litigants. Consequently, a new mode of attack was formulated by section 16(b) of the Securities Exchange Act of 1934, under the theory that once the possibility of profit was removed such trading by insiders would cease.' Section 16(b) provides that benefits obtained by an insider from transactions in equity securities of the corporation with which the insider is affiliated 4 can be recovered by the issuing corporation or by any security holder suing in behalf of the corporation. The section 1Heli-Coil Corp. v. Webster, 352 F.2d 156, 160 n.5 (3d Cir. 1965); Smolowe v. Delendo Corp., 136 F.2d 231, 235 (2d Cir. 1943), cert. denied, 320 U.S. 751 (1943); 2 Loss, SECURITiES REGULATION 1037 (2d ed. 1961); Rubin & Feldman, Statutory Inhibitions Upon Unfair Use of Corporate Information by Insiders, 95 U. PA. L. REv. 648 (1947). 2 15 U.S.C. § 78p(b): "For the purpose of preventing the unfair use of information which may have been obtained by such 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 of such issuer (other than an exempted security) within any period of less than six months, unless such security was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security purchased or of not repurchasing the security sold for a period exceeding six months. Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request or shall fail diligently to prosecute the same thereafter; but no such suit shall be brought more than two years after the date such profit was realized. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or the sale and purchase, of the security involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection." * Cook & Feldman, Insider Trading Under the Securities Exchange Act, 66 HARv. L. REV. 385 4 (1953). Section 16(b) of the Securities Exchange Act of 1934 applies to "every person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security" which is registered on a national exchange or which is required to be registered with the Commission pursuant to § 12(g). 15 U.S.C. S 78p(a) (1965). SOUTHWESTERN LAW JOURNAL [Vol. 20 deals only with "short swing" trading in which securities have been purchased and sold (or vice versa) within a six month period, the time when most abuses were found to have occurred. Section 16 (b) provides a simple, effective,' mechanically applied standard.! All that need be shown is a purchase and sale by an insider within the six month period. Some transactions, however, escape the coverage of section 16 (b).' The section does not cover situations in which the insider buys and then sells (or vice versa) exactly six months and one day later,8 or in which the insider gives "tips" to family members or to an insider of another corporation in return for similar information about the other corporation.! Also, one who is an insider by virtue of his position and who buys stock and then severs his relationship with the issuing company does not come within the express provisions of section 16(b)." Yet bona fide transactions by insiders involving no unfair use of inside information have come within the ban of the act." 5Loss, op. cit. supra note 1, at 1043. Section 12(g) now requires registration for any issuer having total assets exceeding $1,000,000 and a class of equity security held of record by 500 or more shareholders. Section 16(b) also applies to a person who is a director or an officer of the issuer. a "Congress intended the test to be an entirely objective one." Heli-Coil Corp. v. Webster, 352 F.2d 156, 165 (2d Cir. 1965). "[T]he only remedy which its framers deemed effective for this reform was the imposition of a liability based upon an objective measure of proof." Smolowe v. Delendo Corp., 136 F.2d 231, 235 (2d Cir. 1943), cert. denied, 320 U.S. 751 (1943). "Its fundamental purpose, moreover, is to make disgorging of insiders' profits almost automatic." Rubin & Feldman, Statutory Inhibitions Upon Unfair Use of Corporate Information by Insiders, 95 U. PA. L. RRv. 468, 473 (1947). See 40 A.L.R.2d 1358 (1955). "Congress recognized that section 16(b) wosld not correct all the practices thought to be evil; obviously the six month limitation alone 'let many fish out of the net' since the tax laws tend to encourage a holding period longer than six months. The statute makes an honest, if not honorable man out of the insider in that period." Adler v. Klawans, 267 F.2d 840, 845 (2d Cir. 1959). 8 Loss, op. cit. supra note 1, at 1042; Cole, Insiders' Liabilities Under the Securities Exchange Act of 1934, 12 Sw. L.J. 147, 150 n.22 (1958). G'Ibid. ° Loss, op. cit. supra note 1, at 1060. "In Blau v. Lehman, 286 F.2d 786 (2d Cir. 1960), aff'd, 368 U.S. 403 (1962), an investment firm purchased stock in a corporation in which one of the firm's partners served as a director. This purchase was accomplished without seeking that partner's advice, and indeed, without his knowledge. The court held that despite his innocence and good faith, the inside partner had to divest himself of his pro rata share of the profits made when (...truncated)