Friday, March 31, 2023
Section 16(b) is Unconstitutional, Apparently
On March 13, 2023, Magistrate Judge Wicks dismissed a claim for disgorgement of short-swing profits against a 10% beneficial owner of 1-800 Flowers, on the grounds that the plaintiffs lacked Article III standing. See Packer on Behalf of 1-800 Flowers.com v. Raging Capital Mgmt LLC, 2023 WL 2484442 (E.D.N.Y. Mar. 13, 2023). The decision is currently on appeal.
Section 16(b) of the Exchange Act provides:
For the purpose of preventing the 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 of such issuer … within any period of less than six months, … 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 …
The statute was enacted in 1934 to prevent insider trading; Congress believed that corporate insiders regularly misused information they obtained in their capacity as fiduciaries, and that the only feasible way to prevent such misuse was to bar insiders from earning profits (or avoiding losses) via short swing trading. See, e.g., Kern Cnty. Land Co. v. Occidental Petroleum Corp., 411 U.S. 582 (1973); Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S. 418 (1972); Smolowe v. Delendo Corp., 136 F.2d 231 (2d. Cir. 1943). Rather than being enforced by the SEC, the statute is enforced by the issuing company or, more commonly, derivatively by its shareholders.
It is well established that in order to have standing to bring a case in federal court, a private plaintiff must demonstrate that he or she experienced a concrete injury. In TransUnion LLC v. Ramirez, 141 S. Ct. 2190 (2021), the Supreme Court held that Congress cannot create such an injury merely by granting the plaintiff a statutory right of action. Instead, any statutorily-created rights and injuries must have a “close historical or common-law analogue” to satisfy Article III of the Constitution. 141 S. Ct. at 2204.
In 1-800 Flowers, Judge Wicks relied on TransUnion to hold that the mere fact that an insider earns short-swing profits does not itself demonstrate that there was an injury to the corporation, and therefore no Section 16(b) action may be maintained, either by the issuer itself or, in this case, derivatively by its shareholders. The court allowed for the possibility that some kind of injury might be associated with such profits in a particular case, but held that such an injury must be alleged and proven in order for plaintiffs to maintain an action; the fact of trading alone would be insufficient.
Now, a lot could be – and has been – written about the TransUnion decision, but taking it at face value, it raises the question what kind of “historical or common-law analogue” is sufficient. Let’s start with some basics: First, it’s blackletter common law that fiduciaries may not make personal use of their principal’s property and confidential information. See, e.g., Restatement (First) of Agency § 395 (1933). Second, it’s blackletter common law that the principal may disgorge any profits associated with such use without showing any injury; or, to put it another way, the injury is the principal’s loss of exclusive control over his property. See, e.g., Restatement (First) of Agency § 404 (1933). The rule is partially prophylactic in nature; it serves to ensure that the agent acts solely to benefit the principal, and does not abandon or alter his performance for personal gain.
Those axioms map very well to the notion that insider trading is a violation of a fiduciary’s duty to the corporate principal, see Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949), and were apparently among the concerns that animated the 1934 Congress. Now, my understanding is, at the time of the statute's enactment, there were few common law prohibitions on insider trading, but then, many of the cases seemed to be brought by stockholders in their individual capacities rather than on the corporate principal’s behalf. See Kenneth L. Yourd, Trading in Securities by Directors, Officers and Stockholders: Section 16 of the Securities Exchange Act, 38 Mich. L. Rev. 133 (1939). So the real question should be whether Section 16(b) is similar enough to the common law agency principles (and even TransUnion does not hold that there needs to be an exact match) to satisfy Article III. I think there’s a pretty close family resemblance; the bright line prohibition against short swing profits was established merely to avoid difficulties of proof. We can call it an irrebuttable evidentiary presumption that such trades were predicated on inside information.
To be sure, there is more distance from agency law when the trader is a 10% owner than when the trader is an officer or director, because 10% owners do not usually have fiduciary duties to the company, but the statute is rooted in a presumption that 10% owners have either the influence of a fiduciary or access to information that comes from fiduciaries, and that kind of relationship to the corporation would be covered even under the common law rule. So, in my view, under TransUnion, the cause of action should survive without any additional showing of injury. I guess we’ll see if the Second Circuit sees it the same way.