-
Second Circuit Affirms Dismissal Of Actions Seeking Disgorgement Of “Short-Swing” Profits From Investment Advisors’ Clients, Holding That Clients’ Delegation Of Discretionary Investment Authority Did Not Render Them Members Of A “Group” With Their Investment Advisors
05/27/2020On May 20, 2020, the United States Court of Appeals for the Second Circuit issued two decisions affirming, on substantially similar grounds, the dismissal of two actions asserting claims under Section 16(b) of the Securities Exchange Act against clients of investment advisors. Rubenstein v. International Value Advisers, LLC, No. 19-560-cv (2d Cir. May 20, 2020) (“IVA”); Rubenstein v. Rofam Inv. LLC, No. 19‑796‑cv (2d Cir. May 20, 2020). Plaintiff alleged that certain investment advisors’ clients earned improper “short-swing” profits from equity trades because the advisors, who were statutory insiders of the issuers of the stock, bought and sold securities on their clients’ behalf within a six-month period; plaintiff, a shareholder of the issuers in question, thus sought disgorgement of the clients’ profits. Affirming the lower courts’ decisions, the Second Circuit held that plaintiff failed to establish that the clients formed a “group” with their investment advisors such as to impute insider status on the clients, and therefore failed to show that the trades were prohibited under the Exchange Act.
Plaintiff alleged that the clients, who were not themselves statutory insiders of the issuers, nevertheless qualified as part of a Section 13(d) group because they had provided discretionary trading authority to their investment advisors, id. at 10, and thereby inherited their advisors’ insider status. See IVA, slip op. at 3.
The Court explained that a Section 13(d) group is formed when “two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer.” Id. at 9. The Court emphasized, however, that the Exchange Act’s definition of a group relates to an agreement regarding securities of “an” issuer, and therefore such an agreement must be targeted to a specific issuer. Id. at 10–11. Because the investment management agreements in question were general and provided broad discretion to the advisors, rather than specifying a particular issuer, the Court concluded that the agreements were insufficient to establish group status under the Exchange Act. Id. at 11–12. Moreover, the Court concluded that plaintiff’s theory of liability did not serve the purpose of Section 13(d), which was to prevent the evasion of the disclosure requirements by those owning more than ten percent of a company’s securities. Id. at 12. The Court emphasized that plaintiff had not alleged that the investment managers’ clients sought to evade these disclosure requirements.
The Court also considered and rejected plaintiff’s policy arguments. For example, plaintiff argued that the Court’s holding would facilitate insider trading because an investment advisor could use inside information to trade in its clients’ accounts. The Court, however, explained that other fraud protections existed in Section 10(b) of the Exchange Act, and the Supreme Court had cautioned against exceeding the “narrowly drawn limits” on the class of insiders subject to strict liability under Section 16(b). Id. at 13–14 (citing Gollust v. Mendell, 501 U.S. 115, 122 (1991)). In addition, plaintiff argued that, if not deemed part of a group with its clients, an investment advisor could evade disclosure requirements by spreading out holdings across clients; however, the Court observed that all such holdings already count toward an investment advisor’s beneficial holdings for purposes of disclosure under Section 13(d). IVA, slip op. at 15‑16.
Plaintiff separately proposed that, after the investment advisors filed Schedule 13Ds disclosing their insider status, the advisors’ clients “silently acquiesce[ed]” in their advisors’ trading for their benefit and therefore “implicitly agreed to trade . . . as members of the insider group.” Id. at 20. The Court observed that this theory was unsupported in the relevant statutes or regulations and would impose impracticable requirements on the clients to monitor their advisors’ activity on corporate boards and to tailor their investment decisions depending on other clients’ trades. Id.
The Court also rejected plaintiff’s argument that, when an investment advisor appointed or “deputized” a director to the company’s board, this rendered the advisor’s clients insiders because they had effectively delegated this deputization authority. The Court determined that there was no authority to suggest that a “non-insider principal may unknowingly inherit the insider status of its agent,” and further that there was no evidence that the clients here were even aware that the advisor had deputized a director or agreed to the deputization. Id. at 22.
