User:Mattchiota/Short swing

A short swing rule restricts officers and insiders of a company from making short-term profits at the expense of the firm. It is part of United States federal securities law, and is a prophylactic measure intended to guard against so-called insider trading. The rule mandates that if an officer, director, or any shareholder holding more than 10% of outstanding shares of a publicly traded company makes a profit on a transaction with respect to the company's stock during a given six-month period, that officer, director, or shareholder must pay the difference back to the company. Note that the profit calculated is the maximum considering each pair of sales and purchases, a larger trade could be paired with trades up to six month prior as well as up to six months later and the correct calculation is a linear programming problem

As stated by a federal circuit court of appeals: In order to achieve its goals [of curbing the evils of insider trading], Congress chose a relatively arbitrary rule capable of easy administration. The objective standard of Section 16(b) imposes strict liability upon substantially all transactions occurring within the statutory time period, regardless of the intent of the insider or the existence of actual speculation. This approach maximized the ability of the rule to eradicate speculative abuses by reducing difficulties in proof. Such arbitrary and sweeping coverage was deemed necessary to insure the optimum prophylactic effect.

[NOTE: TEXT ABOVE IS BACKGROUND INFO ALREADY PUBLISHED ON WIKIPEDIA]

Elements of a Short-Swing Claim
The short-swing profit rule is a Securities and Exchange Commission (SEC) regulation that requires company insiders to return any profits made from the purchase and sale of company stock if both transactions occur within a six-month period. Such a claim requires a plaintiff, who is usually a shareholder, to establish that 1) an insider 2) made a purchase and a sale 3) within a period of six months.

Insider Requirement
An insider, also referred to as a beneficiary owner, is any person who owns 10% or more of the outstanding common stock, or holds an executive position at the company.

In 2013, the Second Circuit limited the scope on Section 16(b) claims by holding that the purchases and sales of securities had to be of the same class, meaning they needed to have the same rights or be able to be converted to the other classes of stock. Thus, an insider must only prove that their different stock holdings have meaningfully distinct rights. If the stock holdings have distinct rights, and cannot be converted to make those rights consistent, the holdings cannot be lumped together to satisfy the 10% beneficiary owner threshold.

Regarding the scope of Section 16(b), convertible debentures are held to be viewed as if they were converted into equity. So, if an investor holds enough convertible debentures, that would allow him to convert the debt instruments into an equity position that consists of at least 10% of a company's class of stock, the holder would be an insider and those trades would be subject to short swing liability under Section 16(b).

An insider can also be held liable under Section 16(b) if their spouse makes short-swing trades on a corporation in which the other spouse is a beneficiary owner. Even a showing that their finances and financial decisions are independent from each other, courts have held that this falls within the type of behavior that the rule was created to prohibit.

Six Month Timeframe
In order to be considered a "short-swing" trade, there must be two trades within six months of each other. A plaintiff must be able to point to two separate trades that occurred less than six months apart in order to be successful for a §16(b) claim against an insider or a director.

Purchase and Sale
Generally, a purchase is the acquisition of stock, and a sale is the disposition of stock. However, unorthodox transactions have become quite normal and have required Courts to subjectively analyze a series of transactions to determine whether or not there has been a purchase or sale. The purchase and sale do not have to be of the same exact shares.

The emergence of derivatives created issues in applying the short swing profit rule because insiders were able to trade a derivative of the underlying stock in order to capture short-swing profits, without ever trading the actual stock of the corporation. In 1991, the Short-Swing section of the Securities Exchange Act of 1934, was amended in order to clean up the rule as it applies to derivative securities. This was accomplished "by equating transactions in derivative securities with the analogous purchase or sale of the underlying stock..."

Liability Calculation
Due to Section 16(b) providing for strict liability, there is no requirement that there was a profit made by an insider. The mere engagement of short swing trading while an insider is prohibited, thus an insider can be liable even if they incur a loss on the trades made.

Generally, liability is calculated by matching the lowest valued purchase, with the highest valued sale. For example, If a CEO purchased 100 shares at $10, sold those shares for $5 per share, and then repurchases the shares at $4 per share, the CEO would be liable for $100. However, the CEO actually lost $600 through those trades.

Despite Section 16(b), imposing strict liability on short swing trades made by insiders, there is a judicially accepted way to avoid at least a portion of the potential liability. In Reliance Electric co. v. Emerson Electric Co., Emerson owned 13.2% of Dodge pursuant to a tender offer that was unsuccessful. Dodge shortly after approved a merger with Reliance. Emerson no longer wanted equity in the new entity so devised a plan to sell enough shares to drop below the 10% threshold of beneficiary owners. Then after, Emerson unloaded the rest of his 9.96% ownership. The Supreme Court held that Section 16(b) did not and could not apply to the second sale of 9.96% ownership because that sale was made as a non-beneficiary owner. If Emerson had sold all of their equity in one trade, that additional 9.96% would have been recoverable by underlying corporation.

However, in ''Reece Corp. v. Walco Nat. Corp''., the District Court in the Southern District of New York took a different approach, and merged two consecutive trades and merged them to be one for purposes of §16(b) liability. The Court differentiated Reliance, because in that case, the defendant sold his shares twice, to two different buyers at two different prices. However, in Reece, the transactions were at the same price, 1 day apart and it was agreed that the singular buying party would buy both portions. For this reason, the Court decided that the 2 sales would constitute 1 sale, thus making 100% of his profit liable under §16(b) and collectible by the issuing corporation.

Statute of Limitations
In Credit Suisse Sec. (USA) LLC v. Simmonds, the Supreme Court was challenged with the issue of whether underwriters could be liable under Section 16(b), after the statute of limitations, if they failed to file the proper disclosure documents. The Court held that the statute of limitations does starts once the profits are realized, not once they are reported. "'The underwriters contended that the actions were barred by the two-year limitations period after the underwriters realized profits, but the shareholder argued that the period did not begin to run until the underwriters filed required statements disclosing the profits. The U.S. Supreme Court unanimously held that the limitations period barred the shareholder's actions since the statutory period expressly began to run when the profits were realized, regardless of when, or if, disclosure statements were filed.'"Thus, Courts will not consider the time of disclosure for purposes of determining whether or not the statute of limitations has passed.

Good Faith Defense
The good faith defense is a Section 16(b) defense that is available to transactions that were instigated by the corporation or issuer. Section 16(b) excludes any acquisitions of securities that were "in connection with a debt previously contracted." "For example, where stock options were granted to key employees, including officers, for the purpose of inducing them to remain in the employment of the corporation at a time when the corporation could not provide direct remuneration comparable to that which the employees could have obtained elsewhere, it being mutually contemplated that the employees would immediately sell some or all of the stock received upon the exercise of such options, recovery of short-swing profits realized from such sales has been denied where the corporation had received the benefit of the continued services of the employees." Thus, if a corporation instigates the transaction, that transaction will not be available to match as a purchase or sale under §16(b) and is exempted from liability.

Recent Changes
The United States Senate passed a bill to repeal the "Foreign Private Issuance" exemption. A foreign private issuance is a targeted issuance of equity to accredited investors outside the United States. "'FPIs are currently exempt from Section 16 pursuant to Rule 3a12-3 of the Exchange Act. As such, insiders of FPIs are exempt from filing Forms 3, 4 and 5, and are not subject to the short-swing profit recapture rule to which insiders of domestic companies are subject. Should the proposed amendment become law, FPIs will lose this exemption, and insiders of FPIs will be required to comply with both the reporting requirement and the short-swing profit recapture provision of Section 16.'"In 2005, the SEC felt obligated to amend two rules after the 3rd Circuit had read the exemptions too narrowly, and the SEC was worried it would have a negative impact on legal transactions. Following the decision the SEC released a statement that said, in part: "the Levy v. Sterling opinion read Rules 16b-3 and 16b-7 to require satisfaction of conditions that were neither contained in the text of the rules nor intended by the Commission. The resulting uncertainty regarding the exemptive scope of these rules has made it difficult for issuers and insiders to plan legitimate transactions, and may discourage participation by officers and directors in issuer stock ownership programs or employee incentive plans. With the clarifying amendments . . . we resolve any doubt as to the meaning and interpretation of these rules . . . ."

In Levy, the Court decided that Rule 16b-3 and 16b-7 required conditions that were not included in the text of the exemptions, nor were they announced by the SEC. Rule 16b-3 and 16b-7, exempt transactions between a company and its officers and mergers and acquisitions respectively. The SEC has shown that they would prefer to manage their rules on their own, rather than allow Courts to impose additional requirements on their behalf.