One of the ABA Business Law Section’s most prized publications is A Manual of Style for Contract Drafting, by Ken Adams. It was published in 2004, and it’s now in its fourth edition. It has accomplished a feat rare in legal publishing—each new edition has proven even more popular than the previous edition.

Although we have no meaningful milestone or anniversary to commemorate, we thought it appropriate to check in with Ken to see how he feels about his magnum opus. Here’s what he had to say:

What, is it Happy 16th Birthday to A Manual of Style for Contract Drafting or something? Whatever prompted your inquiry, I’m always happy to ruminate about MSCD. Here goes:

It’s Big. I started my work on contract language over 20 years ago, with the aim of figuring out what works and what doesn’t work. And I’ve been at it ever since. But when your focus is on slowly fitting one brick of analysis next to another, your perspective is narrow; step back a bit and you might realize, to your surprise, that you’ve built an edifice. That’s how I felt when I got my hands on the fourth edition.

It’s Comprehensive. Over the years I’ve refined and expanded analysis of lots of topics and added some new ones. We’re almost at the stage where in response to pretty much any question about a word or phrase commonly used in contracts, I can say, it’s in MSCD. But I routinely surprise myself by finding new and different things to write about. My 2019 article in The Business Lawyer on efforts provisions (here) will allow me to add new material to the chapter on that topic. And to choose just the most recent example, my post on the phrase hereby instructs (here) means that a section on that will appear in chapter 3 (Categories of Contract Language).

It’s Popular. People all over the world tell me they consult MSCD routinely in their daily work. That’s gratifying to hear. And heck, for a few years now I’ve been able to say that MSCD has sold tens of thousands of copies. Please have someone at the ABA tell me, in thirty years or so, when I can start saying it’s sold hundreds of thousands of copies!

It’s Leading to Change—Slowly. If you were to skim a random sample of contracts, you’d be hard pressed to find any sign that drafters are following MSCD’s recommendations. That prompted someone to suggest, in a comment on my blog, that MSCD has “failed.” (See this 2017 post.) They’re mistaken. People purchased those tens of thousands of copies for a reason. And there’s all the anecdotal evidence I hear. But beyond that, anyone expecting MSCD to prompt wholesale change in contract drafting doesn’t understand how the system works. Contracts have long been drafted by copy-and-pasting from precedent contracts. MSCD by itself isn’t going to change that. MSCD helps people become better informed consumers of contract language. Even in a copy-and-paste world, that helps people save time and money and steer clear of trouble.

MSCD Is Necessary for Major Change, But Not Sufficient. I wrote MSCD because I thought we won’t be able to turn contract drafting into a commodity task without a set of guidelines for clear contract language. We now have those guidelines, so over the past ten years I’ve sporadically looked for a way to give those who work with contracts an alternative to riding the copy-and-paste train, namely an automated library of customizable commercial contracts. The challenges facing such an initiative are old-fashioned: instead of requiring gee-whiz technology, it would require expertise, publishing, and imaginative marketing. But I’m confident that before too long I’ll be able to put MSCD guidelines to use for the purpose I originally had in mind.

A Fifth Edition Is Coming, But Not Soon. The fourth edition was published in 2017. I’m in no rush to replace it. The fifth edition will continue the process of refining and expanding, but you’ll have to wait a good while. A more pressing need is the boiled-down version of MSCD, called Drafting Clearer Contracts: A Concise Style Guide for Organizations—I’d like it to come out sometime in 2021. I originally thought that MSCD would be a style guide, but it has long been way too big to serve that function.

It’s Been a Blast. Writing MSCD has been the intellectual adventure of a lifetime. I feel very fortunate.

We already know that in this review the Law Society Gazette (published by the Law Society of England and Wales) said that the fourth edition of A Manual of Style for Contract Drafting is “extraordinary,” but we wanted to hear some feedback from readers. Here’s what Ken has seen recently in posts and messages on LinkedIn.

Last week, I recommended A Manual of Style of Contract Drafting to a co-worker. She followed up today with a reply that made my week, “[My manager] ordered one and was going to drop it off at my house, but he loved it so much he didn’t want to share. He ordered me my own copy, arriving tomorrow.” Now that is leadership.

Ken Adams is someone I’ve been reading since law school. (If you draft contracts for a living, get a copy of A Manual of Style for Contract Drafting.)

I’ve just purchased your book and I’m finding it a very useful reference tool.

Ken, I recently picked up your book and wanted to let you know that I’m enjoying it! I have found it and your blog very useful in my practice. Thanks!

I joined the group after reading your manual which should be mandatory reading for all corporate lawyers.

If you work in contracts, Ken’s book is essential.

For information about Ken’s activities, go to www.adamsdrafting.com. That’s where you’ll find his blog, as well as information about his new online course, Drafting Clearer Contracts: Masterclass. It’s built around eight live hour-long sessions held once a week and supplemented by reading, quizzes, and short assignments. It’s offered to individuals and to organizations; the course home page is here. Besides his writing and training, Ken is chief content officer of LegalSifter, an artificial-intelligence company that helps with review of draft contracts. You can reach Ken at [email protected] and [email protected].

Jurisdiction over patent licensing disputes is a tricky concept to navigate. The U.S. Code grants district courts original jurisdiction “of any civil action arising under any Act of Congress relating to patents, plant variety protection, copyrights and trademarks.”[1] However, cases involving patent license agreements implicate federal patent law issues and state contract interpretation issues. Thus, in such situations, the issue presented is determining the presence of “arising under” jurisdiction under 28 U.S.C. § 1338.

In Gunn v. Minton, the U.S. Supreme Court synthesized and applied a four-part test for “arising under” jurisdiction. The claim(s) must raise an issue of federal law that is(1) necessarily raised; (2) actually disputed; (3) substantial;[2] and (4) capable of resolution in federal court without disrupting the federal-state balance approved by Congress.[3] The second factor is typically addressed briefly because usually parties are disputing the use of a patented device, process, etc.

Gunn was a malpractice case in which the plaintiff-appellant claimed his patent was invalidated because his attorney failed to timely raise an exception to the on-sale bar.[4] Applying the above four-factor test, the Supreme Court held the malpractice claims brought were so hypothetical, backward-looking, and fact-specific that the outcome of the case would affect only the parties involved; thus, jurisdiction was proper in state court.[5] However, Gunn did not provide a road map for determining jurisdiction in patent license disputes. Thus, courts have wrestled with the four-factor test established in Gunn and its jurisdictional consequences in such disputes. It is a fact-intensive test requiring analysis of contract language to find potential avenues of resolving a dispute. The test is unforgiving—resolution of the contract issue must absolutely depend on resolution of an underlying patent issue. So, under the current regime, if there is any route that does not involve resolution of an issue unique to patent law, jurisdiction is not proper in federal court.

Jang v. Boston Scientific Corporation

Interestingly, one of the first cases to apply the Gunn test did not involve a dispute concerning state versus federal jurisdiction. In Jang v. Boston Scientific Corporation, diversity jurisdiction existed, and the issue was whether the Ninth Circuit Court of Appeals or the Federal Circuit should have jurisdiction over an appeal in a patent licensing case.[6] The Federal Circuit cited language of the agreement defining “Contingent Payment Products” as “any stent . . . the development, manufacture, use, or sale of which is covered by one or more Valid Claims of the Patents . . . or which, but for the assignment made pursuant to this Agreement, would infringe one or more Valid Claims of the Patents.”[7] The agreement further defined “Valid Claim” as “(a) a claim of any issued patent which is contained within the [licensed patents] and which has not expired, lapsed, or been held invalid, unpatentable or unenforceable by a final decision, which is unappealed or unappealable, of a court of competent jurisdiction, or of an administrative agency having authority over patents.”[8] Importantly, the court noted that (1) the contract claim itself requires resolution of the underlying issue of patent infringement, and (2) because of the diversity jurisdiction and the potential for future infringement suits to be brought, maintaining jurisdiction in the Federal Circuit was best for consistency.[9]

Levi Strauss & Co. v. Aqua Dynamics Systems, Inc.

Parties have since relied on Jang to argue jurisdiction of federal courts over state courts and other agreed forums. First, in Levi Strauss & Co. v. Aqua Dynamics Systems, Inc., the Northern District of California applied Jang to a jurisdictional dispute involving an arbitration clause in a license agreement.[10] Levi Strauss entered into a licensing agreement with Aqua Dynamics’ predecessor in interest, Earth Aire.[11] Aqua claimed that Levi breached the contract by discontinuing royalty payments. [12]

The court analyzed the relevant provisions:

10.1.1 For the use of any Licensed Ozone Process which is covered by a valid and enforceable patent [“Covered Process”], during the life of the patent as to product produced by the process claimed by that patent, but in no event for more than seventeen (17) years after the end of the Development Period.

10.1.2 For the use of any Licensed Ozone Process not covered by a valid and enforceable patent [“Uncovered Process”], for seven (7) years after the end of the Development Project. LS&CO may freely use the affected Licensed Ozone Process after the expiration of this Agreement as to it.[13]

The court then reasoned that this case required that Levi continued using the Covered Processes after its obligation to pay royalties on the Uncovered Processes had lapsed on December 14, 2001, thus requiring a finding that Levi infringed Aqua’s patents and that Aqua’s patents were valid.[14] In addition, Aqua did not dispute that (1) a validity determination was necessary, and (2) there was potential for further enforcement of the patents.[15] Thus, the court determined that it would be consistent with Jang to find that the patent issues sufficiently supported “arising under” jurisdiction, and therefore jurisdiction was proper in federal court, despite the arbitration clause.[16]

Sanyo Electric Co., Ltd. v. Intel Corporation

Next, in Sanyo Electric Co., Ltd. v. Intel Corporation, the District of Delaware decided jurisdiction in a dispute involving a cross-license agreement and the products defendant Intel was authorized to make under the agreement.[17] Hera Wireless had acquired a portion of Sanyo’s patent portfolio relating to Wi-Fi chips.[18] Hera and its authorized licensing company, Sisvel UK Ltd., sued Lenovo, a client of Intel.[19] Lenovo used Intel’s chips and Intel raised a license defense.[20] Sanyo sought declaratory judgment that Intel was not authorized to sell wireless communication modules under the cross-license agreement.[21] Intel counterclaimed that the asserted patents were invalid or unenforceable as to Lenovo computers containing the accused Wi-Fi chips, and the patent rights covering those chips were exhausted.[22]

Sanyo claimed that Intel incorrectly informed third parties that Hera’s patent rights were exhausted because Sanyo had authorized Intel to make the Wi-Fi chips.[23] Analyzing the first Gunn factor, the court reasoned that although it was possible to resolve Sanyo’s claims and Intel’s breach of contract counterclaim using patent exhaustion, the controversy could be resolved by determining the products Intel could rightfully sell pursuant to the agreement. Accordingly, an issue of federal law was not necessarily raised.[24] For much the same reason, in analyzing the third Gunn factor, the court found that the potential federal issue was not substantial because the issue revolved more around an interpretation of the contract than an interpretation of federal patent law.[25] (Note that the court determined it need not make a finding as to whether a federal issue was actually disputed to satisfy the second Gunn factor.[26])

Regarding the fourth Gunn factor, the court decided the federal-state balance would be disrupted by bringing this case into federal court because the patent issues at hand did not sufficiently outweigh the interest in having the state court resolve issues involving state contract law.[27] Unlike in Levi or Jang, where determinations of infringement or invalidity were necessary, there was at least one avenue to resolve the dispute that did not involve making a determination on a patent issue. Having made these considerations, the court granted Sanyo’s motion for remand, holding that it did not have jurisdiction because the claims and counterclaims did not satisfy the Gunn test.[28]

Inspired Development Group, LLC v. Inspired Products Group, LLC

Next, in Inspired Development Group, LLC v. Inspired Products Group, LLC d/b/a KidsEmbrace, LLC, the Federal Circuit distinguished Jang and clarified the requirements for obtaining federal jurisdiction over a licensing dispute, holding that some patent law issue must need resolution, with no alternative route offered in contract law.[29] Plaintiff Inspired Development granted KidsEmbrace an exclusive license to manufacture and commercialize car seats.[30] KidsEmbrace sought additional investment from a third party, which forced KidsEmbrace and Inspired Development into a binding letter agreement.[31] The third party forced the founder and CEO out of KidsEmbrace, which then terminated the initial license agreement.[32] Inspired Development sued KidsEmbrace in the Southern District of Florida for breach of contract (i.e., failing to pay royalties) and, alternatively, unjust enrichment.[33] The court granted summary judgment in KidsEmbrace’s favor, and Inspired Development appealed to the Court of Appeals for the Eleventh Circuit.[34] The Eleventh Circuit found that diversity jurisdiction did not exist and transferred the case to the Federal Circuit to determine whether “arising under” jurisdiction existed.[35]

KidsEmbrace argued that “arising under” jurisdiction existed because Inspired Development’s unjust enrichment claim was actually an infringement claim in that proving unjust enrichment required showing that KidsEmbrace continued to use the process described in the letter agreement.[36] The court disagreed, and much of its decision hinged on substantiality. It reasoned that the license agreement conferred a number of potential benefits on KidsEmbrace, including litigation avoidance and securing investment.[37] Thus, the patent law issue was not dispositive of the case—a negative for substantiality.[38] The lack of potential for conflicting future rulings and a dearth of government interest in the dispute further cut against substantiality, a distinguishing factor in view of Jang.[39] Finally, the court reasoned federal jurisdiction was improper because otherwise parties could insert any infringement or invalidity issue that would pull a contract dispute into federal court.[40] Taking all these factors into account, the court held federal jurisdiction was improper.[41]

Sasso v. Warsaw Orthopedic, Inc.

Most recently, in Sasso v. Warsaw Orthopedic, Inc., the District Court for the Northern District of Indiana found that federal jurisdiction was improper where two separate licensing agreements between plaintiff Dr. Rick Sasso and defendant Warsaw Orthopedic were at issue.[42] The first dispute centered on which provision applied to determine the termination of the agreement.[43] One provision required that the patents be valid, while the other merely depended on the issuance and expiration date of the patents.[44] In any event, the state court decided the governing provision was the provision dependent on the patent’s issuance and expiration date, and it held in Sasso’s favor on that ground.[45]

Under the second agreement, payment of royalties undisputedly required a device covered by a valid claim.[46] However, the plaintiff argued that the issue was not one of the validity of the patent at issue, but whether the patent at issue was covered by the agreement.[47] Given that a party offered a theory that did not require resolution of a patent law issue, no such issue was both actually disputed and substantial.[48] The decision of the Northern District of Indiana comports with the Federal Circuit and other federal district courts: If patent law is not necessary in determining the outcome, federal jurisdiction is improper.

Recommendations

To ensure jurisdiction will properly lie in federal courts, parties should ensure that their claims or counterclaims allow for resolution only by applying the tenets of patent law. IP-related agreements should be drafted so that an analysis of patent law is required to settle a dispute. For instance, a party could include a provision ensuring that the definition of a product covered by the agreement requires a valid claim, such as the provision in Jang. Further, there should be no ambiguity regarding which provision applies to determine which products are covered products, as in Sasso.

A complaint should specifically discuss provisions defining covered products and call out issues of patent validity or infringement. Current caselaw suggests that these actions land a case firmly in federal jurisdiction.

Conclusion

The Federal Circuit and district courts are clearly consistent in application of Gunn to jurisdictional issues presented by patent license disputes. As the Federal Circuit pointed out in Inspired Development, it remains to be seen how Jang would apply to a case with its particular fact pattern but requiring resolution of a jurisdictional issue between state and federal courts, as opposed to two federal courts. One thing is evident: Federal jurisdiction is improper if the dispute can be resolved without patent law.

[1] 28 U.S.C. § 1338(a).

[2] There tends to be overlap between this factor and the fourth factor because in Neurorepair v. The Nath Law Group, the Federal Circuit established a three-part test for substantiality including determination of the decision’s impact on future decisions.

[3] Gunn v. Minton, 568 U.S. 251, 258 (2013).

[4] Id. at 255.

[5] Id. at 261, 264‒65.

[6] Jang v. Boston Scientific Corp., 767 F.3d 1334, 1335 (Fed. Cir. 2014). Note that the Court of Appeals for the Federal Circuit usually handles appeals of patent issues from district courts, as opposed to the circuit courts of appeals for the district courts.

[7] Id. at 1337.

[8] Id.

[9] Id. at 1337‒38.

[10] Levi Strauss & Co. v. Aqua Dynamics Systems, Inc., 15-cv-04718-WHO, 2016 WL 1365946, at *1 (N.D. Cal. Apr. 6, 2016).

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15] Id. at *6.

[16] Id. at *5.

[17] 18-1709-RGA, 2019 WL 1650067, at *1 (D. Del. Apr. 17, 2019).

[18] Id. at *1.

[19] Id.

[20] Id.

[21] Id. at *3.

[22] Id.

[23] Id. at *6.

[24] Id.

[25] Id. at *8.

[26] Id. at *7.

[27] Id. at *9‒10.

[28] Id. at *1, 11.

[29] Inspired Development Group, LLC v. Inspired Products Group, LLC, 938 F.3d 1355 (Fed. Cir. 2019).

[30] Id. at 1358.

[31] Id. at 1358.

[32] Id. at 1358‒59.

[33] Id. at 1359.

[34] Id. at 1358.

[35] Id.

[36] Id. at 1361.

[37] Id. at 1363.

[38] Id. at 1364.

[39] Id. at 1368‒69.

[40] Id. at 1369.

[41] Id. at 1371.

[42] Sasso v. Warsaw Orthopedic, Inc., 3:19-cv-298 JD, 2020 WL 1043104 (N.D. Ind. Mar. 4, 2020).

[43] Id. at *4.

[44] Id.

[45] Id.

[46] Id. at *6.

[47] Id.

[48] Id.

While the availability of video-conferencing technology has proven to be a boon for many given the challenges of working remotely during the COVID-19 pandemic, the use of such technology is not without privacy and security risks. Unfortunately some users have fallen victim to so-called “zoom bombing” or “zoom raiding” incidents whereby their business meetings were hijacked by Internet trolls or hackers that inserted racist, anti-Semitic, sexist, and/or profane imagery on their screens and chat boxes or otherwise disrupted their audio feeds. Many video teleconferencing platform providers were seemingly caught unawares, scrambling to shore up their security settings by hastily releasing updates in order to patch critical vulnerabilities and convince users that they could continue online collaboration safely without fear of unwanted intruders.

Global privacy regulators have taken notice of the headlines and spectacular stories of security flaws, and, in response on July 21, 2020, the Office of the Privacy Commissioner of Canada, along with five other data protection and privacy authorities (The U.K. Information Commissioner’s Office, The Office of the Australian Information Commissioner, The Gibraltar Regulatory Authority, The Office of the Privacy Commissioner for Personal Data, Hong Kong, China, and The Federal Data Protection and Information Commissioner of Switzerland)(“Privacy Regulators”), published an open letter (“Letter”) to companies offering video teleconferencing services (“VTC”) reminding them of their legal obligations to handle people’s personal information responsibly. The Letter is intended for all companies that offer video conferencing services, and it has also been sent directly to Microsoft, Cisco, Zoom, House Party and Google.

The Letter plainly states that its purpose is to set out the Privacy Regulators’ concerns and clarify their expectations and the steps they should be taking as VTC companies to mitigate the identified risks and ultimately “ensure that our citizens’ personal information is safeguarded in line with public expectations and protected from any harm.” It then proceeds to provide a non-exhaustive list of the data protection and privacy issues associated with VTC services. The Letter identified various key principles that should guide VTC companies, as set out below.

Security. Not surprisingly, security is listed as the Privacy Regulators’ premier concern. Security is a “dynamic responsibility,” and security vigilance by VTC organizations is paramount. The Privacy Regulators acknowledged the worrying reports of security flaws in the VTC products leading to unauthorized access to accounts, shared files, and calls and called for minimum standard safeguards to be deployed, including effective end-to-end encryption for all data communicated, two-factor authentication, and strong passwords.  This will be especially important for VTC platforms in certain sectors that routinely process sensitive information, such as hospitals providing remote medical consultations and online therapists, or where the VTC service allows sharing of files and other media, in addition to the video/audio feed.

The Privacy Regulators also expect VTC providers to stay current, remain constantly aware of new security risks and threats to their VTC platforms, and “be agile in your response to them.” Users of the platforms should be routinely required to upgrade the version of the app they have installed, to ensure that they are up-to-date with the latest patches and security upgrades. Additionally, all information must be adequately protected when processed by third-parties, including in other countries.

Privacy-by-design and default. Consistent with the Canadian “privacy by design” approach to data protection and security, the Privacy Regulators note that data protection and privacy should be “baked into” VTC services—if they are mere afterthoughts in the design and user experience of a VTC platform, then there is a greater likelihood of failure that leads to “well documented accounts of unexpected third-party intrusion to calls.”

Accordingly, VTC companies should be taking a privacy-by-design approach to VTC platforms, making data protection and privacy integral to the services provided to customers. Practically, this means that the most privacy-friendly settings should be the default (similar to the principle of least privilege in cyber security). Settings should be prominent and easy to use (including implementing strong access controls as the default, clearly announcing new callers, and setting video/audio feeds as mute on entry); applying features that allow business users to comply with their own privacy obligations (including features that enable them to seek other users’ consent); and minimizing personal information or data captured, used, and disclosed by the product to only that information absolutely necessary to provide the service.  Additionally, VTC providers should also undertake privacy impact assessments to identify the impact of their personal information handling practices on the privacy of individuals, and implement strategies to manage, minimize, or eliminate these risks.

Know your audience. The Privacy Regulators acknowledged that during the Covid-19 pandemic many of the VTC platforms were being used in ways for which they were not originally designed, creating unanticipated risks. Therefore VTC companies should now be reviewing the new and different environments and users of their platforms, in order to better understand and identify children, vulnerable groups, and contexts where discussions on calls are likely to be especially sensitive (in education and healthcare, for example), or when operating in jurisdictions where human rights and civil liberty issues might create additional risk to individuals engaging with the VTC services. As a follow-up step, VTC companies should assess the necessary data protection and privacy and requirements for all contexts in which their platforms are now being used, and implement appropriate measures and safeguards accordingly.

Transparency and fairness.  As a result of several high-profile privacy breaches in recent years, the Privacy Regulators note that global audiences now have heightened community awareness (and expectations) regarding how companies should appropriately handle their personal information and use their data. VTC companies who fail to tell their customers how they use their information, or use the information unfairly or unreasonably, may therefore be in violation of the law in addition to forfeiting the trust of their users.

Accordingly, providers of VTC services should be up-front about what information they collect, how they use it, with whom they share it (including processors in other countries), and why. This is particularly relevant should the VTC do something with the user data that is not expected because it would not be seen as a core purpose of the VTC service. Such disclosure should be provided proactively, be easily accessible, and not simply buried in a privacy policy. Where express user consent regarding the handling of personal information is required, VTC providers should also ensure that such consent is specific and informed. VTC providers should also assess the impact any future changes to the VTC platforms will have and whether users should be made aware of these changes in order to ensure users can make informed decisions about how they use the platform going forward.

End-user control. While practically speaking end-users may often have little choice about the particular use of a VTC platform if their organization has already chosen to use or purchase a specific VTC service, users should be aware that some features of particular VTC platforms may raise the risk of covert or unexpected monitoring and should be better informed (and have more control) over these processes.

For example, users must understand if a VTC platform allows the host to collect their location data, track their engagement or the attention of participants generally, or record or create transcripts of calls. Ideally this is communicated to users through icons, pop-ups, or other measures, not just buried somewhere in the platform’s terms. Where possible, VTC companies should also include a mechanism for end-users to choose not to share that information, i.e. via opt-out, noting that opt-in mechanisms might be more appropriate in certain instances.

Conclusion. While it is clear that the Privacy Regulators recognize the value and importance of the services offered by VTC companies during the COVID-19 pandemic, the Letter reiterates that such solutions must not come at the expense of people’s data protection and privacy rights. Focusing on the key areas identified in the Letter will help VTC companies not only comply with applicable data protection and privacy laws but help build the trust and confidence of their customers and user base. The Privacy Regulators concluded the Letter by welcoming responses from VTC companies by September 30, 2020, asking them to demonstrate how they are taking these principles into account in the design and delivery of their services. Responses will be shared amongst the joint signatories to this letter. It remains to be seen whether the various VTC companies will take up the challenge posed by the Privacy Regulators.

Lisa R. Lifshitz

In Liu v. SEC, the United States Supreme Court confirmed the Securities and Exchange Commission’s (SEC) ability to seek disgorgement of ill-gotten gains as an equitable remedy in SEC enforcement actions in federal court.* However, the court limited the SEC’s ability to obtain such relief, holding that equitable principles require that a disgorgement award not exceed the wrongdoer’s net profits and be set aside to reimburse victims. This decision has clear implications for defendants charged with liability under the federal securities laws, who may now challenge any proposed disgorgement award that fails to deduct the defendant’s legitimate business expenses or does not set aside disgorged funds for fraud victims.

The Liu decision also impacts another frequent target of SEC enforcement action: so-called relief defendants, or parties who have not themselves violated the securities laws but have received some or all of the wrongdoer’s ill-gotten gains. Although Liu’s holding allows relief defendants to argue that their legitimate business expenses should be deducted from any disgorgement order, the equitable principles underlying the decision may, in certain cases at least, equip relief defendants to challenge the SEC’s ability to obtain disgorgement from them at all.  

Relief Defendant Disgorgement

In its efforts to enforce the federal securities laws, the SEC regularly seeks disgorgement of proceeds from a defendant’s alleged fraudulent conduct. Often, however, the defendant no longer possesses some or all of the ill-gotten gains, but has disbursed the property to third parties who played no role in the alleged wrongdoing. The SEC frequently seeks to obtain disgorgement from these innocent third parties on the theory that they are not being sued in their individual capacities, but are rather nominal “relief” defendants who hold assets that, in reality, are fraudulent proceeds from the violative conduct of the wrongdoer.

Relief defendants are not alleged to have engaged in any wrongdoing and are therefore not liable for any underlying securities law violations. Instead, courts have found these defendants to be simply “trustee[s], agent[s], or depositor[ies]” for the wrongdoer, with no real ownership interest in the property in their possession. Given that a relief defendant is merely a trustee for the wrongdoer’s profits, equitable principles counseling against the wrongdoer’s unjust enrichment usually apply, and the relief defendant steps into the shoes of the wrongdoer solely for the remedial purpose of recovering the wrongdoer’s ill-gotten gains.

Courts have developed a two-part test to determine the propriety of ordering disgorgement from a relief defendant. First, the SEC must show that the third party received funds from the alleged wrongdoing and, second, that the third party does not have a “legitimate claim” to those funds. Federal courts have interpreted this test expansively, requiring innocent third parties to disgorge any property derived from the liability defendant’s wrongdoing for which the third party did not pay adequate consideration. In SEC v. George, for instance, the United States Court of Appeals for the Sixth Circuit affirmed a disgorgement order requiring a wrongdoer’s fiancée to disgorge her diamond engagement ring purchased with proceeds from the wrongdoer’s Ponzi scheme and given to the fiancée as a gift. Further, the court ordered three other relief defendant investors to disgorge the entirety of the profits distributed to them by the wrongdoer from the unlawful scheme, when those investors failed to rebut the SEC’s evidence that the money they received from the scheme came from the investments of others, rather than profits of the relief defendants’ investments. The Sixth Circuit, like other federal courts that have examined the issue, held that because these relief defendants did not have a “legitimate claim” to the disputed property, disgorgement relief was both equitable and appropriate.

The Liu Decision

In Liu, the Supreme Court addressed whether federal district courts have authority to order disgorgement in SEC enforcement actions at all. This question was left open by the court’s 2017 decision in Kokesh v. SEC, holding that disgorgement is a “penalty” for the purposes of 28 U.S.C. § 2462, which imposes a five-year statute of limitations on SEC enforcement actions seeking “any civil fine, penalty, or forfeiture.” There is no statutory authority for the SEC to obtain disgorgement in federal court actions. In fact, pursuant to 15 U.S.C. § 78u(d), the SEC may seek only civil monetary penalties and “equitable relief.” Prior to Kokesh, lower federal courts routinely authorized disgorgement in SEC enforcement actions on the premise that disgorgement is a form of equitable relief. However, given that equitable relief typically does not include punitive sanctions, Kokesh left open the issue of whether the SEC could pursue disgorgement in its civil enforcement actions.

The Liu court—faced with a direct challenge to the SEC’s ability to seek disgorgement orders in federal court—upheld the practice, albeit subject to some significant limitations. Initially, the court held that disgorgement is not punitive when its effect is limited to the well-established equitable practice of “strip[ping] wrongdoers of their ill-gotten gains.” Noting that “it would be inequitable that [a wrongdoer] should make a profit out of his own wrong,” the court held that to avoid transforming disgorgement into a punitive sanction, equitable disgorgement relief must be limited to a wrongdoer’s net profits from the illegal conduct, deducting legitimate business expenses, and may be assessed “against only culpable actors and for victims.” Expansion of the practice beyond this scope runs the risk of turning an appropriate equitable remedy into an improper penalty. Though unmentioned in Liu, this equitable analysis has important implications for innocent third parties who have found themselves with assets causally connected to a wrongdoer’s illegal conduct.  

Significance of Liu for Relief Defendants

Although Liu does not expressly discuss relief defendant disgorgement, the opinion does offer relief defendants various avenues for challenging attempts by the SEC and other federal agencies to seek disgorgement awards. Most obviously, relief defendants are now relying on Liu to contest disgorgement orders in instances where the issuing court arguably failed to deduct the nominal defendant’s legitimate business expenses from its disgorgement order. Indeed, the Liu decision equips parties to challenge disgorgement orders that bar innocent investors from subtracting the amount they invested in the wrongdoer’s fraudulent scheme from the disgorgement award. Courts have ordered such relief on the premise that it is inequitable to allow these unwitting investors in a fraud scheme to recover all or the majority of their investments when other investors are unable to do the same. However, after Liu, these relief defendants may be able to argue that any disgorgement award that exceeds the investor’s net profits is punitive and therefore improper, even if other innocent investors cannot recover their initial investments.

Given the equitable principles supporting the Liu holding, however, relief defendants may in certain cases be able to rely on the opinion to challenge not only disgorgement of legitimate business expenses, but whether equitable disgorgement is even appropriate at all. The argument against disgorgement is perhaps most clear in cases like SEC v. Forex Asset Management LLC, where the United States Court of Appeals for the Fifth Circuit ordered a handful of innocent investors to disgorge not only their initial investments in the wrongdoer’s fraudulent scheme, but also their profits that were directly traceable to those investments (as opposed to gains coming from the investments of others). This practice appears to conflict with language in Liu suggesting that equitable disgorgement is unavailable where the defendant is “merely a passive recipient of profits” from the illegal scheme, rather than a partner in the wrongdoing. Going forward, we should expect to see relief defendants argue that such disgorgement is improper without a finding that the third party acted in concert with the alleged wrongdoer.

More broadly, after Liu, relief defendants may be able to argue that third-party disgorgement is punitive and therefore improper in any case where the relief defendant cannot clearly be characterized as a trustee, agent, or depository for the wrongdoer’s ill-gotten gains—regardless of whether the relief defendant paid adequate consideration for the disputed property. The Liu opinion authorizes equitable disgorgement only when such disgorgement is assessed “against only culpable actors.” Accordingly, although relief defendant disgorgement appears consistent with Liu to the extent the relief defendant is a mere trustee or agent for the culpable actor—for instance, a bank with “only a custodial claim to the [the wrongdoer’s] property”—the more attenuated the relationship between the wrongdoer and the relief defendant, the less likely disgorgement may be to pass muster under Liu.

Take, for instance, the SEC v. George case discussed above. There, the SEC was able to obtain disgorgement of an engagement ring that the wrongdoer purchased with profits from his illegal scheme and then gifted to his fiancée, with no evidence that the fiancée, in accepting the ring, was acting as a mere trustee for the wrongdoer’s ill-gotten gains. As the recipient of a gift derived from illegal profits, rather than, for instance, a fraudulent transfer of those profits, the relief defendant in George arguably does not stand in the shoes of the wrongdoer. Accordingly, any assessment against her or similar defendants may exceed the bounds of equity under Liu, even if the relief defendant failed to pay consideration for the property in her possession.

Whether lower courts will accept these and similar arguments against relief defendant disgorgement remains to be seen. Still, the Liu decision opens up several avenues for innocent third parties to challenge attempts by the SEC and other federal agencies to obtain equitable disgorgement, and we should expect to see federal agencies and courts grappling with the implications of Liu for relief defendants in the months and years to come.

*Jay Dubow is a partner in the Philadelphia office of Troutman Pepper; Ghillaine Reid is a partner in the New York office; and Kaitlin O’Donnell is an associate in the Philadelphia office.

The surveillance society is upon us. Cameras are now everywhere in the public sphere. Business Insider reports that in two years the world may have 45 billion cameras, and the video-surveillance industry is likely to be worth $64 billion.

More insidious than capturing video of all activities in cities and towns all the time, however, is the facial recognition technology used to apply a name to nearly every person found by these cameras. Activating artificial intelligence (AI) for identification in crowds threatens our civil rights, and very few lawmakers have tried to address this concern.

Although Amazon, IBM, and Microsoft have all at least temporarily limited supplying U.S. law enforcement with the tools to identify anyone captured on video, companies like Clearview AI, Japanese tech giant NEC, iOmnicient, Hert Security LLC, and Idemia are happy to sell facial recognition systems to the police. If we are concerned about allowing law enforcement to properly use this tool in the right circumstance and still protect the Constitutional rights of Americans, we cannot rely on the private sector for solutions.

The best way to address this problem is to require police to secure a warrant before applying biometric AI systems to identify people in pictures and videos. Requiring a warrant in this circumstance is a reasonable solution for law enforcement, protects the Constitutional rights of U.S. citizens, and is within the U.S. Supreme Court’s current application of the Fourth Amendment to technological change.

Obtaining a warrant is practical for law enforcement. This is the system all of our policing agencies use when they want to go somewhere or do something that might otherwise intrude on the Fourth Amendment right to be secure in our persons, homes, and papers. The officer simply must show that he or she reasonably suspects that a person has committed a crime, and then the officer is issued a warrant that allows intrusion on private spaces and information.

This keeps our police force from searching everyone and everything hoping to find something for which to arrest someone. That is why the protection was written into the Constitution by our nation’s founders. It is supposed to slow the process down so that someone can think about whether the one group in society with a legal monopoly on violence should be pushing down your front door and rifling through your underwear drawer.

Police already have the right forms to fill out. They know how the process works. Judges are addressing these matters all the time. In other words, the only extra time required will be the extra time that police are supposed to take when they intrude on a person’s privacy.

Requiring a warrant for police to run facial recognition software will protect our Constitutional rights. Assume that a crowd was lawfully demonstrating against the police force itself—perhaps because the police are enforcing restrictive gun laws or because the police have misbehaved in some way. Every color of the political spectrum is affected by this concern. Would demonstrators feel violated if law enforcement used its multiple surveillance cameras to capture their activity? Maybe, but they are likely to expect to be seen by cameras. Would they feel violated if police ran an AI program over the camera footage to take down the names of all people who demonstrated against them? You bet.

As Judge Flaum of the Seventh Circuit Court of Appeals pointed out in language later quoted by the U.S. Supreme Court,

Judge Flaum was writing in 2011 about tracking a person’s movement around town, but the same logic also applies to technology that allows police to not only see all the people in a given space at any particular time, but to apply names to all the faces that appear there as well.

We cannot simply bury our heads in the sand and pretend that these new technologies aren’t affecting the relationship between police and citizens. Replacing horses with automobiles affected policing. When photography was introduced, mug shots made identifications much easier. Computers, lapel cameras, drones, stingrays, military hardware, speech, AI, and DNA databases all changed the nature of policing. Judges across the entire political and judicial philosophy spectrum have noted the changes and how they may affect Constitutional rights.

Even the late originalist Justice Scalia wrote, “Applying the Fourth Amendment to new technologies may sometimes be difficult, but when it is necessary to decide a case we have no choice.” This, he continued, is because, “We must ‘assur[e] preservation of that degree of privacy against government that existed when the Fourth Amendment was adopted.’” In other words, if the technology allows law enforcement to intrude deeply into our lives in new ways that would have been unconsidered 250 years ago, it must be checked by the Fourth Amendment, requiring police to obtain a warrant before using the intrusive tech.

When we apply this thinking to facial recognition technology, we can require a warrant be issued to seek the identity of obvious wrongdoers. Thus, if you are caught on camera throwing a Molotov cocktail through the plate-glass window of a local business, the police can clearly and easily use a facial recognition program to find you and bring you to justice. If you are simply walking in a peaceful political demonstration, however, the police would not be allowed to run facial recognition software to place you in the crowd at that time. With no warrant requirement, law enforcement can run the identification program under no limitations.

Requiring a warrant to use this powerful tech may soon be required by the current U.S. Supreme Court. The Court has already begun to insist on Fourth Amendment protections for transformative technologies, requiring that police need a warrant to place a 30-day tracking beacon on your personal vehicle, for example, and that police need a warrant to open and review the contents of your smart phone. SCOTUS even changed their previous rule that information held by a third party was not Constitutionally protectable when they recently held that police need a warrant to request the past month’s worth of cell phone tracking records to pinpoint your location at different times.

Seventy years ago the Supreme Court held that keeping your name from being associated with political causes was part of your right to free speech and free association. You may have reason to fear the government taking note of your association, which is why that particular Supreme Court decided that the State of Alabama in the 1950s was not allowed to require a list of all local NAACP members. The unfettered technology to see who is entering gay bars, gun clubs, and political protests, and then to identify each individual, allows the government to invade and chill people’s speech and assembly rights.

This concern for privacy even in public places is echoed by our current Chief Justice, John Roberts, who wrote, “A person does not surrender all Fourth Amendment protection by venturing into the public sphere. To the contrary, ‘what [one] seeks to preserve as private, even in an area accessible to the public, may be constitutionally protected. In the past, attempts to reconstruct a person’s movements were limited by a dearth of records and the frailties of recollection. . . . [With current technology] police need not even know in advance whether they want to follow a particular individual, or when.’”

Thus, the Court has recognized that attending politically sensitive meetings anonymously is an important right covered by the First Amendment, and that limited technological intrusions on privacy is an important value of the Fourth Amendment. It seems well within the court’s present mindset to limit the government’s use of overly intrusive technology, like running facial recognition systems on people in the public sphere without specific law enforcement reason to do so.

Harkening back to one of the first important privacy opinions written in 1928, Chief Justice Roberts noted recently, “As Justice Brandeis explained in his famous dissent, the Court is obligated—as ‘[s]ubtler and more far-reaching means of invading privacy have become available to the Government’—to ensure that the ‘progress of science’ does not erode Fourth Amendment protections. Here the progress of science has afforded law enforcement a powerful new tool to carry out its important responsibilities. At the same time, this tool risks Government encroachment of the sort the Framers, ‘after consulting the lessons of history,’ drafted the Fourth Amendment to prevent.”

When will the technology rise to the level that a warrant is required? In the recent  decision, the Court held that “a Fourth Amendment search occurs when the government violates a subjective expectation of privacy that society recognizes as reasonable.” It seems reasonable that peaceful political protesters could subjectively fear being named to police during political gathering.

The Supreme Court recently addressed this precise question. “I would ask whether people reasonably expect that their movements will be recorded and aggregated in a manner that enables the Government to ascertain, more or less at will, their political and religious beliefs, sexual habits, and so on. I do not regard as dispositive the fact that the Government might obtain the fruits of [new technology] through lawful conventional surveillance techniques,” wrote Justice Sotomayor. She continued, “I would also consider the appropriateness of entrusting to the Executive, in the absence of any oversight from a coordinate branch, a tool so amenable to misuse, especially in light of the Fourth Amendment’s goal to curb arbitrary exercises of police power to and prevent ‘a too permeating police surveillance.’”

The most defensible Constitutional choice in this circumstance is for Congress or multiple state legislatures to place limits on policing power by requiring warrants to run biometric ID software. Several Justices seem to agree in that they joined Justice Alito in his sentiment in Jones: “

In November of last year, U.S. Senators Coons and Lee introduced bi-partisan legislation requiring federal law enforcement to obtain a court order before using facial recognition technology. This act provided a logical framework for protecting Americans from a powerful, new state-operated technology that has grown unchecked as a tool for intruding on citizens’ privacy.

Since that time, the Facial Recognition and Biometric Moratorium Act was introduced into both houses of Congress this summer. The act calls for a complete prohibition on police use of facial recognition software and similar biometric technology like voice recognition or gait identification systems. However, this act, like some of the city-level bans that have been enacted in the United States, overreacts to the technology. Biometric identification tools are valid and useful law enforcement implements, so banning them completely tosses the baby out with the bath water.

Requiring a warrant to use the powerful technologies, however, stops indiscriminate and likely political applications while keeping it available to help catch criminals. Warrant obligations are the right step to protect our privacy and other Constitutional rights while applying the technology to important problems. We should not wait for the right case to rise to the Supreme Court before limiting use of this technology. A legislative solution is best and most efficient.

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This article is an excerpt from The Lawyer’s Guide to Family Business Succession Planning: A Step-by-Step Approach for Lawyers, Business Owners, and Advisors, by Gregory Monday (ABA 2020). (An introduction has been added to provide context.)

In family business succession planning, it is important to consider contracts with related parties.  If a person affiliated with the owners provides goods or services to the family business, that relationship should be formalized in a written contract to the extent that the owners would want that relationship to continue after the business transitions to the successors. Consider the following examples:

Real Estate and Equipment Leases

If one of the family’s companies leases real estate or equipment from a related individual or another family-owned company, the owners should sign a written lease that will continue to apply after ownership succession. In most cases, it should be a long-term lease, with automatic renewals and periodic rate enhancers that are specified in the lease or are tied to an objective measure, such as an appropriate consumer price index.

Leases should allow one party or the other to terminate the lease obligation if a particular change of circumstances occurs. For example, it may be appropriate for a building tenant to have a right to terminate the lease if the building is sold to a buyer outside the family. Similarly, it might be appropriate to grant the lessee a right of first refusal if the leased asset (e.g., building or equipment) is sold to a buyer outside the family.

Note that if the asset and the lessee currently are owned by the same owners, then there may be tax efficiencies or cash-flow considerations that dictate the optimal lease terms as long as the ownership remains the same. (The owners should consult their accountants and tax advisor regarding these arrangements.) In such cases, the lease should be reviewed as part of the owners’ estate planning process. If ownership of the leased asset and ownership of the lessee business will or may diverge under the succession plan, then the owners should arrange for their successors to be bound by a lease that is equitable to both lessor and lessee.

Service Agreements

If one of the family companies provides services to other family companies that are owned by different owners, or by the same owners but in different proportions, then the companies should execute a service agreement to ensure that the service relationship is equitable and will continue under similar terms. For example, if the family owns a portfolio of real estate, with each property in a different LLC, and the properties are managed by a separate management company also owned by the family, then service agreements will help ensure that the management company has cash flow that it needs to compensate employees and for other expenses of operations.

Employment Agreements

Family members who have chosen to work for the family business in a substantial capacity might assume that their employment status with the business and their compensation will not be adversely affected by ownership succession, but if they do not have an employment agreement, they may be at risk of being treated as an employee-at-will who may be terminated, demoted, or geographically displaced by a successor board or new management.

Therefore, if there are family members who rely on their employment with the family business and compensation at a particular level (sometimes including a history of bonuses), it may be appropriate to protect such family members with employment agreements that state they cannot be terminated or demoted without cause and that establish a minimum level of compensation, including perhaps cost-of-living increases and terms of bonus practices. The employment agreement also can provide for severance compensation and benefits upon a change of control (such as a sale of the business to an unrelated third party) or other change of circumstance that may warrant separation without cause.

If the employee is not an owner, it may be best for the business to include confidentiality, noncompetition, and nonsolicitation language in the employment agreement, but if the employee is an owner or may become an owner, then the confidentiality, noncompetition, and nonsolicitation agreement might be better addressed in the owners’ agreement. In many states, broad noncompetition provisions in an employment agreement are harder to enforce than similar provisions in an owners’ agreement. Further, if an employee is an owner, it may be appropriate to provide that if his or her employment with the business terminates, then the business or other owners may purchase his or her ownership interest.

Finally, although it usually is desirable to include alternative dispute resolution provisions in all family business agreements, an arbitration clause in an employment agreement might not be enforceable in some states.

Debt Obligations

If the business owes any sum to an owner or other family member or affiliated business, then the existence and terms of the debt should be clearly and formally documented. This will help ensure that successor owners and management will honor the obligation; it will help ensure that the payments are treated properly for taxes; and it will help ensure that the obligation will be given proper priority vis-à-vis the business’s other creditors. Such obligations may arise, for example, if an owner lent cash to the business, or if the business purchased assets from an owner on an installment basis, or if the business redeemed an owner’s shares on an installment basis.

In some cases, it may be desirable to grant the lender security (perfected, such as by recording a mortgage or filing UCC statements) to give the lender priority as against a tort creditor or in the event of the borrower’s bankruptcy. It is likely, however, that the lender will have to agree that the obligation will be subordinate to existing third-party debt. (Commercial lenders do not want their rights to be subordinate to, or even pari passu with, insider obligations.)

Contingent Liability

If owners have personally guaranteed debt of the business, each may be at risk of a disproportionate loss under his or her guaranty, unless the owners execute a reimbursement agreement with the business and contribution agreements among one another. This is particularly important for an owner who is exiting ownership but has not been released as a guarantor.

Under most commercial loan facilities, guaranties are joint and several, and in the event of a default, the lender can proceed against any one of the guarantors for the full amount, even without trying to collect from the borrower or the other guarantors. In fact, often the lender is allowed to release the borrower or a guarantor without the consent of the other guarantors. Further, a default may be something that neither the borrower nor the guarantors can control, such as the death or bankruptcy of one of the guarantors.

For these reasons, an owner who guarantees debt of the business should execute a reimbursement agreement granting the guarantor the right to be reimbursed by the business for any losses incurred under the guaranty. The lender may need to consent to a reimbursement agreement and will probably not allow it to be enforceable until the lender is satisfied in full.

Similarly, the guarantors should execute a contribution agreement among one another. A guarantor’s common-law rights to seek contribution from other guarantors for losses he or she incurs under a guaranty usually are not particularly effective. Often, they do not reflect the guarantors’ expectations. Under a contribution agreement, however, the guarantors can be clear about what percentage of the loss each guarantor will contribute and how the loss will be measured. As with the reimbursement agreement, the guarantors may need the lender to consent to the contribution agreement, and it may not be enforceable until the lender is satisfied in full.

Tort Liability Indemnification

Owners who serve as directors and officers or managers of the business should be protected against liability for their service for acts taken in good faith. Usually such provisions appear in a company’s articles, bylaws, or operating agreement. These should be drafted to include protection for directors and officers who are no longer serving in that capacity. If such fiduciaries are covered by directors’ and officers’ insurance, either directly or as a way to fund the indemnification, the coverage should include former fiduciaries as well.

Introduction

Congress should repeal or modify section 16(b) (Section 16(b)) of the Securities Exchange Act (Exchange Act) of 1934.[1] This provision requires certain corporate “insiders” to disgorge profits that they earn from “short swing” transactions in the stock of public companies. Section 16(b) defines a purchase and sale, or sale and purchase, within six months’ time as a short-swing transaction. Congress included the provision as part of the original Exchange Act in an effort to discourage insider trading.

A fair reading of Section 16(b) leads to the conclusion that this provision: (1) never achieved its original purpose; (2) creates a trap for unwary; and (3) needlessly complicates ordinary business transactions. Furthermore, other provisions of the Exchange Act and attendant rules more effectively prohibit the activity that the framers of Section 16(b) sought to stop. The Department of Justice and the Securities and Exchange Commission (the SEC or Commission) use other prohibitions, some of which the SEC and the courts developed later, against insider trading and market manipulation.

Section 16(b) was just one of a multitude of provisions that Congress enacted in 1934 with the hope of cleaning up Wall Street. Faced with 85 years of evidence, it is time to recognize that Section 16(b) was a mistake and that keeping it on the books causes much more harm than good. I explain my reasoning below.[2]

Congress’s Enactment of Section 16(b)

Section 16(b) of the Exchange Act provides that an officer, director, or 10-percent beneficial owner of any equity security that is registered pursuant to section 12 of the Exchange Act (a covered person) must disgorge any profit that he or she derives from the sale and purchase, or purchase and sale, of any equity security of such issuer within any period of less than six months. The provision creates a private right of action for the issuer to recover the profit from a covered person and allows the owner of any security to sue on behalf of the issuer. Congress stated that the purpose of the provision was to prevent the unfair use of information to which such covered persons might have access. Congress created a strict liability provision, i.e., covered persons are liable irrespective of any intention that they may have had.[3]

Section 16(b) is unique in at least two respects. It does not authorize the SEC to bring an action against insiders who trade within the six-month period. Instead, it provides that the issuer may bring an action to recover the profit, and if the issuer declines to do so, that the shareholder may bring such an action.[4] The U.S. Supreme Court noted that “Congress clearly intended to put ‘a private-profit motive behind the uncovering of this kind of leakage of information, [by making] the stockholders [its] policemen.’”[5] Although Section 16(b) provides that the profits belong to the issuer, the attorneys who bring cases for shareholders obtain attorney’s fees for their efforts.[6]

Congress’s inclusion of Section 16 was no accident. The Pecora Report[7] outlines a litany of shameful practices in which officers, directors, large shareholders, specialists, and others engaged. These activities manipulated markets, penalized public shareholders, and earned such insiders large profits. The Pecora report notes in part:

Among the most vicious practices unearthed at the hearings before the subcommittee was the flagrant betrayal of their fiduciary duties by directors and officers of corporations who used their positions of trust and the confidential information which came to them in such position, to aid them in their market activities. Closely allied to this type of abuse was the unscrupulous employment of inside information by large stockholders who, while not directors and officers, exercised sufficient control over the destinies of their companies to enable them to acquire and profit by information not available to others.[8]

***

(e) Regulation of market activities of officers, directors, and principal stockholders.—The Securities Exchange Act of 1934 aims to protect the interests of the public against the predatory operations of directors, officers, and principal stockholders of corporations by preventing them from speculating in the stock of the corporations to which they owe a fiduciary duty. Every person who is the beneficial owner of more than 10 percent of any class of equity security registered on an exchange or who is a director or officer of the of issuer such security must report to the Commission whenever any change occurs in his ownership of stock in the corporation.  In the event that he realizes any profits from the purchase and sale or, sale and purchase of an equity security within period of less than 6 months, he is bound to account to the corporation for such profits. It is also made unlawful for insiders to sell the security of their corporations short or to make “sales against the box.” By this section, it is rendered unlawful for persons intrusted [sic] with the administration of corporate affairs vested with substantial control over corporations to use inside information for their own advantage.[9]

The SEC Historical Society explains:[10]

In a 1965 interview, Ferdinand Pecora recalled how he, [Thomas] Corcoran, James Landis and Benjamin Cohen had drafted Section 16 as “the anti-Wiggin section,” named after Albert H. Wiggin, who headed the Chase Manhattan Bank from 1921 to 1933. Pecora recalled how Wiggin had testified that he short-sold Chase National Bank stock that he didn’t own but expected to repurchase at a lower price, and thereby took a profit through six different private investment corporations he had established. One of them had taken a profitable position with Sinclair Oil and Refining Company at a time when Sinclair had a large line of credit with Chase Bank. The securities trading abuses of such people, said Pecora, “were the reason that we drafted [Section 16] of the Act, as we burnt the midnight oil.”

The SEC clearly liked Section 16(b). A 1941 SEC report reads:

Section 16(b) of the act recognizes that profits realized by officers, directors, or 10-percent stockholders from any purchase and sale or any sale and purchase of any equity security within a period of 6 months rightfully belong to the corporation and should be recoverable in an action by, or on behalf of, the corporation. Representatives of the securities industry propose that section 16(b) be repealed. The Commission is unalterably opposed to this suggestion, since it would strip investors of one of their most essential protections.

It has been asserted that the provision operated to deter insiders from making purchases to retard a falling market. But if an insider really wishes to cushion a decline, section 16(b) does not make it unlawful for him to do so. It is only where the insider makes a profit within the relatively short period of 6 months that his profit is required to be turned over to the corporations. Furthermore, that particular argument for repeal of section 16(b) presupposes that insiders would act to bolster the market by trading primarily against the trend, buying in weak markets and selling in strong markets. But, even if it be assumed that some corporate officials would so act, the mere fact that the activities of some trustees might be advantageous to their beneficiaries has never been considered an adequate reason for an abolition of the prohibition against self-dealing by trustees in trust property.

Moreover, even if insiders would purchase in order to bolster the market, there is serious doubt whether investors would always be benefited. If the market continued to fall after the insiders had attempted to support the market, their activities would have injured those new investors who had been induced not to sell and those new investors who had been induced to purchase by the false appearance of stability thus created.

It has been argued that section 16(b) applies in some instance to profits even though made without the use of inside information. This argument is clearly beside the point. The mere existence of temptation on the part of fiduciaries to abuse their position had traditionally led the courts to bar them from activities in fields where such temptations exist. Thus, where trustees acting in their own interest with trust assets, it has long been settled that they will be required to account for any personal profits made regardless of whether they take advantage of their position and regardless of whether the beneficiaries suffered. Similarly, a corporate officer may not acquire for himself an opportunity which is available to his corporation even though it cannot be demonstrated that the corporation has been damaged by the acquisition. And this is true even where the corporation has not had the financial resources to avail itself of the opportunity. The deterrent of section 16(b) to in-and-out trading by insiders is thus consistent with the time-honored doctrine that a trustee must avoid any activity which involves even a remote possibility of a conflict of interest between his fiduciary obligation and his personal self-interests. The Commission is convinced that any legislation which sought to distinguish between situations where inside information is actually used and those where it is not used would be self-defeating because of the inherent difficulties of establishing the use of inside information in particular cases.[11]

It may also be urged with much force that even to the extent that section 16(b) may permit the recovery of profits made without the use of inside information it achieves a highly desirable objective. It is to be doubted whether the interests of security holders are benefited when the attention of their officers and directors is diverted from the corporation’s affairs to stock market speculation in its securities.[12]

Representatives of the securities industry couple their proposal to repeal section 16(b) with a suggestion that section 16(a) require that insiders, instead of reporting their transactions monthly, do so within 10 days after becoming offices, directors, or 10-percent stockholders. They assert that the publicity provisions of section 16(a) as thus amended would be adequate to prevent abuses. Although the reporting of transactions may in some cases operate as a deterrent, it cannot be expected to prevent insiders from taking advantage of inside information. The temptations and the potential returns are too great to be effectively overcome merely by subsequent publicity. It was because the Congress did not believe that publicity alone would be sufficient that it defined the standard in section 16(b)—that insiders, because of their fiduciary relationship, should not trade in-and-out in the securities of their companies for personal gain. The consequences of failing to comply with this standard are not penal. The section does not make insiders’ trading unlawful; it does not even subject insiders to injunctive proceedings. It simply guards against the use of inside information since such information is not the personal property of the insiders themselves and since any profits resulting from its use belong to the insides no more than does the insider information itself.[13]

What Law Makes Insider Trading Unlawful?

Section 16(b) is not an effective tool for policing insider trading. Section 16(b) does not make it unlawful for insiders to trade; it simply requires them to disgorge the profit. It does not grant the SEC or any other government body authority to enforce its prohibitions. By comparison, Section 10(b) of the Exchange Act and Rule 10b-5 allow U.S. attorneys to prosecute wrongdoers criminally and allow the SEC to bring civil enforcement actions against malefactors.

The U.S. government’s efforts to prosecute insider trading has taken a very different path. The Commission adopted Rule 10b-5 in 1942, i.e., after Congress enacted Section 16(b).[15] The history of SEC enforcement for insider trading began in 1961. The SEC brought an administrative action for insider trading, relying on Section 17(a) of the Securities Act of 1933 and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. In In the Matter of Cady, Roberts & Co., the SEC concluded that when a board member of a public company tipped a registered representative of a broker-dealer about the issuer’s plan to reduce its dividend, and the representative sold the issuer’s securities, the representative violated Rule 10b-5 and Section 17 of the Securities Act of 1933.[16]

Since that early case, the law of insider trading has evolved. Congress, the U.S. Supreme Court, and the SEC all have ensured that Section 10(b) and Rule 10b-5 now constitute strong weapons against insider trading. For example, Congress enacted the Insider Trading Sanctions Act in 1984, which authorizes the SEC to bring a court action seeking a civil penalty of up to three times the wrongdoers’ profits.[17] The Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA), among other measures, expanded controlling personal liability for insider trading and required broker-dealers and investment advisers to have surveillance systems reasonably designed to prevent insider trading.[18] In 2016, a unanimous U.S. Supreme Court upheld criminal convictions for insider trading under Section10(b) of the Exchange Act and Rule 10b-5. The court unanimously reaffirmed its view of the law that it first had articulated in 1983.[19] In addition to Rule 10b-5, the SEC adopted Rule 14e-3 to outlaw insider trading in connection with a tender offer.[20] Prosecutors often also charge defendants with violating federal mail and wire fraud statutes because those statutes may have lower burdens of proof.[21] In summary, presumptive insider trading under Section 16(b) buys you an expensive lawsuit; actual insider trading under Rule 10b-5 lands you in jail.[22]

Section 16(b) in Practice

If Section 10(b) and Rule 10b-5 are the meaningful insider trading prohibitions, what harm is there in keeping Section 16(b)? Isn’t it better to be safe than sorry? Even a cursory examination of the practical effects of Section 16(b) should lead an honest observer to question the utility of the provision.[23] Section 16(b) has spawned countless interpretive questions, such as who is an officer, who is a “real” versus an honorary director, and how one must calculate 10-percent ownership. The SEC has adopted rules to clarify many aspects of Section 16(b), but for reasons discussed below, all of this complexity has not made the securities markets more honest for investors.

1. Does Not Deter Insider Trading Effectively

Congress assumed that a covered person trading within six months must “know something” that other investors or the public does not, regardless of what the insider actually knows. Section 16(b) does not prohibit insider trading; it merely seeks to remove its profitability.[24] Accordingly, Section 16(b) imposes liability regardless of whether the covered person actually traded on inside information. As a strict liability provision, it imposes liability even if the insider:

• did not know of the existence of Section 16(b);
• received inaccurate legal advice about the provision;
• miscalculated the six-month period;
• mistakenly assumed that the restriction did not apply to transactions with other insiders;[25]; or
• rescinded a trade to avoid liability.[26]

These are just a few examples of when Section 16(b) imposes liability under circumstances that do not further its policy objective. Romeo & Dye note that Section 16(b) does not impose liability on many situations that do constitute insider trading. For example, Section 16(b) does not apply to:

• all persons who might have actual access to, and while in possession of, inside information;
• tippers or tippees; or
• insider trading that occurred after six months.[27]

In short, Section 16(b) does not deter insider trading because it is both over- and under-inclusive.[28] Many observers have called it a “trap for the unwary.”[29]

I have summarized below some of the perverse outcomes that Section 16(b) has created. It is just a sampling of the problems that Romeo & Dye and others have described.

2. Damage Calculation May Be Unfair

The courts have developed a methodology for calculating profitability on Section 16(b) that is needlessly punitive. “Operating on the premise that Congress intended Section 16(b) to have the maximum deterrent effect, the first appellate court to decide a Section 16(b) case stated that ‘[t]he only rule whereby all possible profits can be surely recovered is that of lowest price in, highest price out.’’’[30] The Commission noted that “under this method, profit is computed by matching the highest sale price with the lowest purchase price within six months, the next highest sale price with the next lowest purchase price within six months, and so on, until all shares have been included in the computation.”[31] The net result of this methodology is that a covered person who violates Section 16(b) may have to pay illusory profits to the plaintiff, notwithstanding that the covered person will have lost money under any conventional calculation of gain or loss.[32]

3. Fiduciary Theory—Not Sensible in This Context

As the preamble to Section 16(b) notes,[33] Congress enacted the prohibition “[f]or 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. . . .” As noted above, the Pecora report expressed the view that officers, directors, and ten-percent shareholders should not take advantage of their position in the corporation for personal profit. The 1941 SEC Report suggests that any such profit rightfully belongs to the issuer.

Of course, it is unethical, and should be illegal, for corporate insiders to benefit from such inside information. However, I disagree with the notion that such a profit rightfully belongs to the issuer. Section 16(b) claims to reflect principles of fiduciary law, including the idea that a covered person should not benefit personally from his or her position of trust. A covered person who engages in a short-swing transaction is not usurping a corporate opportunity. For example, I appreciate that an officer should not secretly buy a tract of land in which the issuer is interested, and then raise the price of the land in a subsequent sale to issuer, but an issuer should not trade its own securities without making proper public disclosure to the markets. Doing so would violate Section 10(b) and Rule10b-5 and perhaps other Exchange Act provisions.

SEC Rule 10b-18 provides a safe harbor for issuers that repurchase their shares. The Division of Trading & Markets Frequently Asked Question notes:

Question 1: If an issuer executes purchases that are in technical compliance with the safe harbor conditions, will that protect the issuer from all liability for such purchases?

Answer: No. Some issuer repurchase activity that meets the safe harbor conditions may still violate the anti-fraud and anti-manipulation provisions of the Exchange Act. For example, Rule 10b-18 confers no immunity from possible Rule 10b-5 liability where the issuer engages in the repurchases while in possession of material, non-public information concerning its securities, or where purchases are part of a plan or scheme to evade the federal securities laws. Therefore, regardless of whether an issuer’s repurchases technically satisfy the conditions of Rule 10b-18, the safe harbor would not be available if the repurchases are fraudulent or manipulative, when all the facts and circumstances surrounding the repurchases are considered (i.e., facts and circumstances in addition to the volume, price, time, and manner of the repurchases). For example, the safe harbor would not be available if the repurchases are made as part of a manipulative scheme to influence the closing price of a company’s securities, or are done to mask other motives, such as inflating or manipulating short-term earnings.

An issuer that does not disclose material information or otherwise engages in manipulative behavior will have broken the law. It is difficult to see that an insider who trades on material nonpublic information is usurping a corporate opportunity from the issuer, such that the issuer should claim any profits.

Of course, if an officer, director, or shareholder trades on the basis of material nonpublic information, that person probably has violated Section 10(b) and Rule 10b-5. In U.S. v. Chiarella,[34] the U.S. Supreme Court articulated what the courts now call the “classic” theory of insider trading.[35] The Court stated that:

one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information “that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.”[36]

* * *

The federal courts have found violations of § 10 (b) where corporate insiders used undisclosed information for their own benefit. E. g., SEC v. Texas Gulf Sulphur Co., 401 F. 2d 833 (CA2 1968), cert. denied, 404 U. S. 1005 (1971). The cases also have emphasized, in accordance with the common-law rule, that “[t]he party charged with failing to disclose market information must be under a duty to disclose it.” Frigitemp Corp. v. Financial Dynamics Fund, Inc., 524 F. 2d 275, 282 (CA2 1975). Accordingly, a purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a fiduciary has been held to have no obligation to reveal material facts. See General Time Corp. v. Talley Industries, Inc., 403 F. 2d 159, 164 (CA2 1968), cert. denied, 393 U. S. 1026 (1969).[37]

Unlike Section 16(b), Section 10(b) and Rule 10b-5 apply to any person, and not just to officers, directors, and ten-percent shareholders. Accordingly, Section 10(b) and Rule 10b-5 apply more broadly than does Section 16(b). Further, Section 16(b) penalizes officers, director, and ten-percent shareholders regardless of whether their trading was on the basis of material nonpublic information. Therefore, Section 16(b) is both over- and under-inclusive.

As noted, the 1941 SEC Report discusses the futility of trying to distinguish situations in which a covered person did or did not engage in insider trading:

The Commission is convinced that any legislation which sought to distinguish between situations where inside information is actually used and those where it is not used would be self-defeating because of the inherent difficulties of establishing the use of inside information in particular cases.[38]

I doubt that the SEC would make this argument today. Identifying persons who engage in insider trading is a central element of the Commission’s enforcement program.[39] In the wake of Dirks and Salmon,[40] it is essential that the Commission demonstrate that persons who trade (or their tippees) obtained, and traded on the basis of, material nonpublic information in breach of a fiduciary duty. Again, the SEC had not adopted Rule 10b-5 in 1934 or 1941, and the courts and SEC had not developed this area of the law. Moreover, at the time Congress was considering the Exchange Act, it also was considering legislation that fundamentally altered the federal rules of discovery.[41]

Six Months Is Not as Short as It Used to Be

In 1934, it may have been reasonable for Congress to assume that a covered person who traded within six months was trading with atypical speed; that is no longer the case. As we have discussed above, a six-month period is purely arbitrary because Section 16(b) liability does not depend on the investor’s actual knowledge. Even if that judgment were reasonable in 1934, it no longer reflects the world of today. By every measure, a six-month period no longer constitutes a short period of time for securities trading.

• In 1934, telecommunications consisted of telegrams, telex, radio, and telephone calls, recalling that long-distance calls required operator intervention and were expensive. Computers were barely in their infancy. No one had even conceived of the telecommunications revolution that we enjoy today.[42]
• There was no such thing as computer-driven algorithmic trading; the world’s first electronic computer did not begin functioning until 1945.[43] At that time, the idea of a personal computer would have seemed as absurd as a personal nuclear reactor. Today, quantitative hedge funds and proprietary trading firms may buy and sell financial instruments within a fraction of a second.
• Today’s securities trading volumes dwarf what Congress contemplated in 1934. For example, in the 1929 stock market crash, the volumes noted below were extraordinarily large for that era. Trading volume overwhelmed the “ticker” price dissemination mechanism, and it was hours late.

• By comparison, the 50-day average volume for Apple, i.e., one stock, is 26,769,660 shares.[44] In 2017, the Depository Trust & Clearing Corporation noted that “on average, we process around 100 million transactions [e., not shares] each day, but we also need to be prepared to handle many multiples of that when markets are at their most volatile. Our record is 315 million transactions in a single day, which occurred in October 2008 at the height of the financial crisis.”[45]

In summary, the speed at which society communicates today vastly outstrips any assumptions that Congress made about short-swing transactions in 1934.

SEC Exemptive Rules

The SEC has adopted rules that mitigate some of the mischief of Section 16(b). Many of these exemptions protect the parties from liability in routine business transactions that may involve covered persons making purchases and sales within the prohibited six-month period. For example:

• Rule 16b-5 exempts gifts from Section 16(b). The exemption provides that “both the acquisition and the disposition of equity securities shall be exempt from the operation of section 16(b) of the Act if they are: (a) Bona fide gifts; or (b) transfers of securities by will or the laws of descent and distribution.”[46]
• Rule 16b-7 exempts many mergers, reclassifications, and consolidations. For example, Rule 16b-7(a)(1) exempts from Section 16(b) the acquisition of a security of a company, pursuant to a merger, reclassification, or consolidation, in exchange for a security of a company that before the merger, reclassification, or consolidation owned 85 percent or more of either: (i) the equity securities of all of the companies involved in the transaction; or (ii) the combined assets of the companies involved in the transactions.

These and other exemptive provisions prevent Section 16(b) from being an even greater obstacle to legitimate business than it currently creates. The exemptions also include a litany of SEC interpretations and court decisions, adding glosses to the provisions.[47]

Aggressive Plaintiffs’ Bar

Some members of the plaintiff’s bar have sought recovery under Section 16(b), proposing theories that are aggressive. As noted below, courts may reach very different conclusions on similar Section 16(b) claims.

1. “Deputization” of Directors

Some courts have held that “a corporation, partnership, trust, or other person” may be a director for purposes of Section 16 by expressly or impliedly “deputizing” another person to serve on its behalf on the board of directors of a Section 12 registrant.[48] A director is liable under Section 16(b) without regard to any amount of stock ownership.

Courts’ determinations run the gamut and are fact-specific. R&D summarize the key factors as follows:

• the entity recommended the director for election or appointment to the board;
• the entity recommended the director for the purpose of protecting or representing the entity’s interests rather than for the purpose of guiding or enhancing the issuer’s business activities;
• the director regularly gained access to material nonpublic information about the company;
• the director shared the confidential information with the entity; and
• the entity used the information to inform its investment decisions regarding the company’s securities.

Courts will deem a director by deputization only “if the director has a relation with the entity (e.g., as an employee or principal) that either allows the entity to influence the director’s decisions as a director or allows the director to influence the entity’s investment decisions regarding the company.” [49]

The SEC and some courts have concluded that a director by deputization may rely on the exemption in Rule 16b-3.

Investment entities must be mindful of the risk that a court will conclude that it has deputized a director. It is important to recall that a director who tips others in breach of duty risks violating Section 10(b) and Rule 10b-5. As noted, Section 16(b) liability is not the only or even the best way to address insider trading.

2. Investment Manager Exemption

Rule 16a-1(a)(1) and subpart (v) create an exemption for investment managers. The SEC’s rule defines “beneficial owner” for purpose of Section 16 and not just for Section 16(a).[50] The rule excludes investment managers from the definition of “beneficial owner” under the following conditions:

• the owner of securities of such class held for the benefit of third parties or in customer or fiduciary accounts in the ordinary course of business;
• as long as such shares are acquired by such institutions or persons without the purpose or effect of changing or influencing control of the issuer or engaging in any arrangement subject to Rule 13d-3(b); and
• any person registered as an investment adviser under Section 203 of the Investment Advisers Act of 1940 or under the laws of any state.

Given that many hedge fund managers invest their own funds along with outside investors,[51] some plaintiffs’ lawyers have argued that the manager is not investing purely for the benefit of third parties. As a result, some plaintiffs’ attorneys have argued that hedge fund managers flunk the second prong of the test and are not entitled to the investment adviser exemption. The courts have split on that argument. The structure of the fund may offer some protection from such claims, but practitioners indicate that the litigation risk is significant.[52]

Money managers were concerned that a covered person who received a fee for managing an investment account that holds the issuer’s securities would have an indirect pecuniary interest in those securities and therefore would be subject to Section 16(b). In response to those concerns, the SEC added subsection Rule 16a-1(a)(2)(ii)(C) to the rule, creating an exemption for performance-related fees. The courts have issued numerous opinions delineating when they will and will not apply the exemption.[53]

3. Definition of a “Group”

In a recent case, a plaintiff unsuccessfully argued that every discretionary account under the control of an investment adviser is member of a “group” and therefore subject to the short swing transaction provision of Section 16(b).  In Rubenstein v. International Value Advisers LLC et al.[54], the investment adviser International Value Advisers LLC (IVA) and two of its principals managed funds and separately managed client accounts that purchased shares in DeVry Education Group (DeVry), a public company.  IVA had developed a control purpose for purposes of Section 13(d) under the Exchange Act and accordingly filed a Schedule 13D.[55]  A customer of IVA “John Doe” had a brokerage account that IVA managed and to which John Doe granted discretionary trading authority.  IVA subsequently purchased shares in DeVry for that account and subsequently sold those shares in less than six months. The plaintiff argued that the Section 16(b) 10% shareholder liability provision applied to all such accounts.  The U.S. Court of Appeals for the Second Circuit disagreed:

Between June and December 2016, the IVA defendants reported on ownership reports filed under Section 13(d) and Section 16(a) of the ’34 Act that they beneficially owned, through their voting and investment power over their advisee-clients, more than 10% of DeVry’s outstanding common stock. Specifically, at various times in 2016, the IVA defendants filed Schedule 13Ds with the SEC indicating that, in accumulating their position in DeVry, they had formed a “control purpose” with respect to DeVry and that they sought the appointment of IVA’s managing partner to the DeVry board to represent the  investment interests of IVA and its clients who held DeVry shares.  *** In July 2016, IVA, as investment manager for John Doe’s account, purchased 31,847 shares of DeVry and within six months sold DeVry shares at a profit.[56]

The court notes that without question, Section 16(b) liability applies to the other accounts in the group.  The plaintiff alleged that the John Doe account was part of the group and therefore subject to the disgorgement remedy. (IVF did not buy and sell or sell and buy other shares of DeVry within six months’ time.)  The court disagreed for a number of reasons.

• Section 16(b) liability does not apply to a customer’s general grant of discretion. When customers grant discretion to an investment adviser, they grant authority to the adviser to trade securities generally, not with respect to one issuer.  Section 16(b) only addresses trading in one issuer, not several. 
• Courts should not read Section 16(b) broadly. “The plaintiff argues that a narrow reading will enable investment managers to evade Section 16(b) and to abuse inside information by trading in client funds rather than their 12 own funds because client funds may not be subject to disgorgement.”  First, citing Gollust and other decisions[57], the U.S. Supreme Court has cautioned against exceeding the narrowly drawn limits of the statute.  Moreover, the court notes that:

Exempting certain client profits from Section 16(b) does not insulate investment advisors from liability under the more general anti-fraud provisions of the ‘34 Act: Section 10(b) and Rule 10b-5. If IVA had improperly used inside information to trade in its clients’ accounts, it could be subject to Rule 10b-5, regardless of whether its clients were part of an insider group. Section 16(b) addresses only a narrow class of potential insider trading. By contrast, Rule 10b-5 addresses a broader sphere, including the insider trading that Rubenstein [the plaintiff] asks Section 16(b) to police. Trading that passes muster under Section 16(b) may not do so under Rule 10b-5. Rubenstein’s fear that our holding will offer a safe harbor to investment managers engaged in insider trading is consequently unwarranted. Suffice it to say that his complaint contains no allegations that Rule 10b-5 has been violated, and that provision plays no part in our resolution of this case.[58]

• There is no legal basis for ascribing the actions of one of the adviser’s clients to another, purely because they share the same manager that exercises investment discretion.

An investment advisory client does not form a group with its investment adviser by merely entering into an investment advisory relationship. Nor does an investor become a member of a group solely because his or her advisor caused other (or all) of its clients to invest in securities of the same issuer. And Rubenstein points us to nothing else that might constitute an “agreement” or demonstrate a “common objective” to trade in the securities of “an issuer.”[59]

The court further noted:

Rubenstein would have us treat all investors as though they were conscious of the securities held by their advisors’ other clients and would mandate that they tailor their investment decisions to those other clients’ trades. *** Section 16(b) is not designed to threaten liability based on the trades of other investors to whom a defendant’s only connection is sharing an investment advisor. ***Rubenstein would hold a retiree on the beach in Florida liable when he fails to conduct an ongoing analysis of his IRA manager’s trading in other clients’ accounts. We decline to go down this road.[60]

The court probably is speaking “tongue in cheek.” It probably would be impossible or illegal for one client to obtain information about another client’s trading activity.  Nonetheless, the opinion illustrates the absurd outcome that would result from the plaintiff’s argument.

The Court of Appeals for the Second Circuit issued a similar ruling in another case involving the same plaintiff.[61]  Although these decisions clear up some ambiguities in the law of Section 16(b), “it remains to be seen whether courts will apply a similar analysis where the adviser’s clients are investment funds under common control with the adviser.”[62]

Although the Second Circuit ultimately vindicated the defendants in both cases, it must have cost them hundreds of thousands of dollars in legal fees and other expenses to fend off aggressive plaintiffs with “creative” new theories of liability at the intersection of Section 13(d) and Section 16(b).  Such wasteful litigation does nothing to strengthen the integrity of our capital markets and to protect investors from shameful behavior.  Indeed, it has the opposite effect.  Moreover, many defendants will not have the disposition nor the resources to litigate a case in the district court and the appellate court.  Some defendants, given the choice between a pyrrhic victory and a less costly settlement, will pay the plaintiff go away.

Given the uncertainty of the outcome and the expense of litigating such cases, some investment managers settle with these lawyers, regardless of the merits of the cases. Such outcomes do not further whatever public policy benefits Congress sought to achieve with Section 16(b); instead, plaintiffs or their lawyers force investment advisers to engage in nothing more than a cost/benefit analysis of whether to settle or litigate.

Distraction for Management

In the 1941 SEC Report, the SEC claimed that Section 16(b) protected shareholders by ensuring that officers and directors would focus their attention on managing the issuer’s business and not trading for their own account. “It is to be doubted whether the interests of security holders are benefited when the attention of their officers and directors is diverted from the corporation’s affairs to stock market speculation in its securities.” The argument is specious.

Why is this the government’s concern? Investors and stock prices are the best judge of whether management is doing its job, not a prohibition on trading. Presumably, investors only care about results, not how officers and directors are spending their time. Indeed, one could argue that it is less of a distraction for covered persons to trade the stock of the issuer than it is for them to trade the stock of another company, for which they would have to devote more time to learn about that issuer and its prospects. Even if one accepted this dubious rationale, it should not apply to 10-percent shareholders who are not also officers or directors of the company.

The federal securities laws should not propose to tell management how to spend its time. Stock prices and investors are the best judges of whether management is doing its job.

Conclusions and Recommendation

This paper outlines only a small sample of the interpretive questions that Section 16(b) has caused. R&D’s materials are replete with discussions of interpretive questions that this provision has created. If Section 16(b) served a useful public purpose, the interpretive issues described above would be an unavoidable cost of applying a simple concept to a complex world. As shown, however, Section 16(b) is an ineffective deterrent against true insider trading. Section 16(b) does not confer a public benefit proportionate to its attendant cost.  Notwithstanding the Supreme Court’s pronouncements, if a proposed transaction does not fall squarely within an exemption, legal expense, delay, and uncertainty may delay or prevent what would otherwise be a harmless transaction.

Other portions of the federal securities laws make actual insider trading illegal; prosecutors, the SEC, and private parties provide meaningful sanctions for violating those prohibitions. Further, other prohibitions, such as Section 9 and other aspects of Section 10 of the Exchange Act, along with rules such as Regulation SHO, prohibit the activities about which Congress was concerned. Section 16(b) has failed in its stated purpose, rewards an aggressive plaintiffs’ bar, creates needless complexity, and imposes punishing liability that is out of proportion or unrelated to the behavior it seeks to deter.

In my view, Congress simply should repeal Section 16(b). Congress could never take such action unless both political parties supported the change. It would be easy for one’s political opponents falsely to charge a member of Congress who supported the legislation with favoring insider trading. I appreciate that the political world does not always behave rationally; nonetheless, there is no public policy for retaining the provision, and there are good reasons for Congress to repeal it.

If Congress could not muster the support for outright repeal, there might be a more moderate compromise. Congress could repeal the private right of action and allow the SEC to impose sanctions for short-swing transactions. Congress would need to make clear that the SEC had authority to reshape the rule, given that courts have not always spoken with one voice on many of its provisions. Unlike some courts and plaintiffs’ attorneys, the author hopes that the SEC would use better judgment as to when a covered person had violated Section 16(b). Moreover, Congress should make clear that violators should pay any disgorgement to the U.S. Treasury, rather than to enrich creative plaintiffs or aggressive plaintiffs’ attorneys.

Attachment 1

According to R&D, the Section 16(b) calculations would be as follows:

R&D further note: “The remaining transactions are disregarded because the only remaining purchase was $58 a share, resulting in a loss when matched with the remaining sales. Those losses may not be used to reduce the amount of recoverable profits.”

[1] © Stuart J. Kaswell 2019, 2020, who has granted permission to the ABA to publish this article in accordance with the ABA’s release, a copy of which is incorporated by reference. Stuart Kaswell is an experienced financial services lawyer. He has worked at the Securities and Exchange Commission, as securities counsel to the Committee on Energy and Commerce of the U.S. House of Representatives (when it had securities jurisdiction), and has been a partner at two law firms and general counsel of two financial trade associations. Mr. Kaswell wishes to thank Alan L. Dye, Esq. for reviewing the draft and other technical assistance, including access to Romeo & Dye, Section 16 Deskbook (Summer 2019) (hereinafter R&D) and to other materials from section16.net. Mr. Kaswell also wishes to thank Stephen A. Blumethal, Esq. for reading a draft of the article and for his suggestions. All of the opinions and recommendations in this article are the author’s alone and do not reflect the views of any reviewer or of any current or prior clients or employers. Any errors are the author’s alone.

[2] The author does not suggest that Congress repeal Section 16(a) of the Exchange Act. That provision requires certain insiders publicly to disclose their securities transactions.

[3] In its current form, Section 16(b) provides:

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) or a security-based swap agreement involving any such equity security within any period of less than six months, unless such security or security-based swap agreement 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 or security-based swap agreement purchased or of not repurchasing the security or security-based swap agreement 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 [sic] 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 or security-based swap agreement involved, or any transaction or transactions which the Commission by rules and regulations may exempt as not comprehended within the purpose of this subsection. [Emphasis added.]

Section 16 includes other provisions, such as:

• subsection (a) requiring covered persons to disclose changes in ownership of such equity securities; and
• subsection (c) prohibiting covered persons from selling short any equity of the issuer.

Congress amended 16(b) as part of the Consolidated Appropriations Act of 2001, 106th Cong., Pub. L. No. 554, (Appropriations Act) and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Congress amended the subsection to add security-based swaps into its various provisions.

The Appropriations Act added, and the Dodd-Frank Act amended, Section 3A of the Exchange Act. Subsection 3A(b)(3) currently provides:

(3) Except as provided in section 16(a) with respect to reporting requirements, the Commission is prohibited from—

(A) promulgating, interpreting, or enforcing rules; or

(B) issuing orders of general applicability;

under this title in a manner that imposes or specifies reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, or insider trading with respect to any security-based swap agreement.

[4] See double underlined text in note 3, supra.

[5] Hearings on H.R. 7852 and H.R. 8720 before the House Committee on Interstate and Foreign Commerce, 73d Cong., 2d Sess., 136 (1934) (testimony of Thomas G. Corcoran) , as quoted in Gollust et al v. Mendell et al, 501 U.S. 115, 126 (1991). See also Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418 (1972) in which the U.S. Supreme Court states:

As one court observed:

In order to achieve its goals, 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. Bershad v. McDonough,428 F.2d 693, 696.

Thus [the U.S. Supreme Court explained] Congress did not reach every transaction in which an investor actually relies on inside information. A person avoids liability if he does not meet the statutory definition of an ‘insider,’ or if he sells more than six months after purchase. Liability cannot be imposed simply because the investor structured his transaction with the intent of avoiding liability under § 16(b). The question is, rather, whether the method used to ‘avoid’ liability is one permitted by the statute.

In Donoghue v. Bulldog Investors General Partnership, 696 F.3d 170 (2012), the U.S. Court of Appeals for the Second Circuit rejected a claim that Section 16(b) is unconstitutional “because it presents no live case or controversy affording standing to sue.” The defendant, Bulldog, argued that the plaintiff, Donoghue, lacked standing because she had not suffered any actual injury. The Second Circuit rejected that argument, noting, among other things, that:

Nor can Bulldog deny any injury to the issuer from its short-swing trading by pointing to the fact that § 16(b) operates without regard to whether the statutory fiduciaries were actually privy to inside information or whether they traded with the intent to profit from such information. This confuses the wrongdoing that prompted the enactment of § 16(b)—trading on inside information—with the legal right that Congress created to address that wrongdoing—a 10% beneficial owner’s fiduciary duty to the issuer not to engage in any short-swing trading.

The U.S. Supreme Court denied Bulldog’s petition for certiorari, 569 U.S. 994 (2012).

[6] R&D, supra note 1, at 390.

[7] Stock Exchange Practices, Report of the Committee on Banking and Currency, United States Senate, Pursuant to S. Res. 84 (72d Cong.), 73d Cong., 2d Sess., Report No. 1455 (the Pecora Report). See also Hearings before the Committee on Banking and Currency, U.S. Senate, 73rd Cong., 1st Sess. on S. Res. 84 (72d Cong.), at 6555 (discussing early versions of what became Section 16(b)). Thomas Corcoran, one of the drafters of the federal securities laws, discussed the proposed short-swing transaction with Senator Hamilton F. Kean (R-NJ). Earlier in the hearing, Senator Kean and Mr. Corcoran discussed short selling and customers’ failures to deliver certificates by the date of settlement. They engaged in the following shameful discussion:

Senator Kean: There are a great many women that order you to sell some bonds, and then they do not come down for 2 or 3 days, but you are forced to deliver them.

Mr. Corcoran: Sir, I cannot pretend in this statute to govern the vagaries of women customers.

Id. at 6506.

[8] Pecora Report, supra note 7, at 55.

[9] Pecora Report, supra note 7, at 68.

[10] SEC Historical Society, Fair to All People: The SEC and the Regulation of Insider Trading (reprinted by permission).

[11] See discussion below.

[12] See discussion below.

[13] Report of the Securities and Exchange Commission on Proposals for Amendments to the Securities Act of 1933 and the Securities Exchange Act of 1934, Aug. 7, 1941, Printed for the Use of the Committee on Interstate and Foreign Commerce, 77^th Cong., 1^st Sess., at 37–38 (1941 SEC Report).

[14] Section 10(b) of the Exchange Act currently provides that:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange or any security not so registered, or any securities based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Rule 10b-5 provides that:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security.

[15] Exchange Act Release 3230 (May 31, 1942). Rule 10b-5 is quite similar to Section 17(a) of the Securities Act. However, the SEC crafted Rule 10b-5 to be slightly broader than Section 17(a). See In the Matter of Cady, Roberts & Co., File No. 8-3925, Nov. 8, 1961, at 911 and n.11.

[16] In the Matter of Cady, Roberts & Co., File No. 8-3925, Nov. 8, 1961. From today’s perspective, the SEC was extremely lenient in this case. It suspended the representative for 20 days. Apparently, the SEC did not sanction the issuer’s board member who tipped the representative, even though the board member also was a principal at the broker-dealer. The settlement did not include a sanction against the broker-dealer.

[17] Section 21A of the Exchange Act.  See also  Hearing before the Subcommittee on Oversight and Investigation of the Committee on Energy and Commerce, U.S. House of Representatives, Dec. 11, 1986, Serial No 99-179, Testimony of the Hon. John Shad, Chairman SEC, at 53: “Prior [to Congress’s enactment of] the Insider Trading Sanctions Act of 1984 (ITSA), insider traders were required only to disgorge their illegal profits, which was not much of a deterrent. Now they are subject to fines of up to three times their profits.” The author was Associate Minority (Republican) Counsel to the Committee and was present at the hearing. Id. at 191.

[18] See Kaswell, An Insider’s View of the Insider Trading and Securities Fraud Enforcement Act of 1988, 45 Bus. Law 245 (1989), revised and republished in American Bar Association, Securities Law Administration, Litigation, and Enforcement, Selected Articles on Federal Securities Law, Vol. III 252 (1991) (Kaswell, ITSFEA). This article also discusses the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 at n.53

[19] Salmon v. United States, 580 U.S. ___ ;137 S. Ct. 420 (2016); 196 L.Ed.2d 351 (citing Dirks v. SEC, 463 U.S. 646 (1983)).

[20] 17 C.F.R. § 240.14e-3, Release 33-6239; 34-17120; 45 Fed. Reg. 60410 (Sept. 12, 1980).

[21] E.g., Matthews, Prosecutors Broadly Use Mail-Fraud, Wire Fraud Statues, Wall St. J., June 9, 2015.

[22] Of course, the courts have found private rights of action implicit in Section 10(b) and Rule 10b-5 as well as in other provisions. E.g., Superintendent of Ins. of N.Y. v. Bankers Life & Casualty Co., 404 U.S. 6 (1971); Central Bank of Denver, N.A, v. First Interstate Bank of Denver, 511 U.S. 164 (1994). See also Hon. Elisse B. Walter, Commissioner, SEC, Remarks Before the FINRA Institute at Wharton Certified Regulatory and Compliance Professional Program, Nov. 8, 2011.

[23] R&D, supra note 1. See also discussion of Rubenstein v. International Value Advisers, LLC, infra.

[24] R&D, supra note 1, at 364.

[25] R&D, supra note 1, at 367–68.

[26] R&D at 642-643.  Courts may not impose liability if the parties rescinded for purposes unrelated to Section 16(b).  Id.  The U.S District Court for the Southern District of New York recently held that a party that rescinds the purchase of securities before settlement is not liable under Section 16(b). The court stated that the defendant “did not rescind a purchase of shares; rather, a purchase never occurred because he cancelled the transaction and was not irrevocably committed to it.  Connell v. Johnson, No 20 Civ 1864 (LLS), May 27, 2020.  “This the first time a court has addressed whether a market transaction that is canceled through the broker’s error account is subject to Section 16.”  Romeo and Dye, Section 16 Updates, Vol. 30. No. 2, June 2020 (R&D June 2020), at 6.

[27] R&D, supra note 1, at 365.

[28] In very limited circumstances, courts have sought to exclude certain transactions from the scope of Section 16(b). R&D, supra note 1, at 369, but this “pragmatic exception to the objective test” is too limited to a cure Section 16(b) of its inherent arbitrariness. Moreover, the courts have limited the exceptions such that it would be risky for covered persons to rely on them and them hope to vindicate their trading activity in an expensive legal battle.

[29] R&D, supra note 1, at 367.

[30] R&D, supra note 1, at 488 (citing Smolowe v. Delendo Corp. 136 F.2d at 239).

[31] 46 Fed. Reg. 48097, 48162 (Oct. 1, 1981), as cited in R&D, supra note 1, at 488.

[32] See Attachment 1, infra, for an example of the onerous methodology that the courts adopted for calculating gains.

[33] R&D, supra note 1, at 364.

[34] 455 U.S. 222 (1980).

[35] In U.S. v. O’Hagan, 521 U.S. 642, 643 (1997), the U.S. Supreme Court noted:

Under the “traditional” or “classical theory” of insider trading liability, a violation of § l0(b) and Rule l0b-5 occurs when a corporate insider trades in his corporation’s securities on the basis of material, confidential information he has obtained by reason of his position. Such trading qualifies as a “deceptive device” because there is a relationship of trust and confidence between the corporation’s shareholders and the insider that gives rise to a duty to disclose or abstain from trading. Chiarella v. United States, 445 U. S. 222, 228–29.

[36] Id. at 228 (citing “Restatement (Second) of Torts § 551(2)(a) (1976). See James & Gray, Misrepresentation—Part II, 37 Md. L. Rev. 488, 523-527 (1978). As regards securities transactions, the American Law Institute recognizes that ‘silence when there is a duty to . . . speak may be a fraudulent act.’ ALI, Federal Securities Code § 262 (b) (Prop. Off. Draft 1978).”).

[37] Id. at 229 (citations omitted).

[38] 1941 SEC Report, at 37.

[39] In 2019, the SEC brought cases against “42 individuals who allegedly misappropriated or traded unlawfully on material, nonpublic information. . . .” SEC Division of Enforcement, 2019 Annual Report, at 24. Six percent of the Commission’s “standalone” cases involved insider trading. Id. at 15.

[40] Dirks v. SEC, 463 U.S. 646 (1983); Salman v. U.S., 137 S. Ct. 420 (2016). Rule 14e-3 does not require the SEC to prove that the person trading (or his or her tippee) traded in breach of a duty.

[41] It also may be that the lack of discovery in federal courts contributed to Congress’s decision to enact Section 16(b). During the first third of the 20th century, Congress, the federal judiciary, and lawyers debated whether Congress should expand the limited discovery rules for civil litigation in federal courts. Traditionally, English and American courts opposed extensive discovery as intrusive and an invasion of citizens’ privacy. Existing federal law discouraged discovery and uniformity. “The Conformity Act of 1872 . . . required (excepting equity and admiralty cases) that the civil procedure in each federal trial court [must] conform ‘as near as may be’ with that of the state in which the court sat.” In 1934 and as part of the New Deal, Congress enacted the Rules Enabling Act of 1934 (Enabling Act), i.e., the same year that Congress enacted the Exchange Act. The Enabling Act authorized the federal courts to adopt the Federal Rules of Civil Procedure, which they did in 1938 (Federal Rules). The Federal Rules substantially increased discovery in federal civil litigation and created more uniformity across the country. Subrin, Fishing Expeditions Allowed: The Historical Background of the 1938 Federal Discovery Rules, 39 Boston College L. Rev. 691 (1998). Although it is not clear from the legislative history that the lack of discovery in federal court was a factor in Congress’s decision to enact Section 16(b), presumably Congress was aware of the debate over the Enabling Act. Perhaps the framers of the Exchange Act did not wish to assume that Congress would be successful in expanding discovery in federal court to facilitate the SEC or a private party’s ability to prove a claim of willful insider trading.  If Congress was concerned about the lack of discovery in federal courts, the Enabling Act and the Federal Rules are further justification to repeal Section 16(b) and its imposition of strict liability.

[42] In 1945, Dr. Vannevar Bush of MIT wrote “As We May Think”, a groundbreaking article that imagines a world of rapid communication and data storage. It is a remarkable, if not perfect, prediction of how people would calculate and share data in the future. Expressing frustration at the slow pace of data dissemination and the difficulty of finding relevant information, Dr. Bush noted the example of “[Gregor] Mendel’s concept of the laws of genetics [that] was lost to the world for a generation because his publication did not reach the few who were capable of grasping and extending it; and this sort of catastrophe is undoubtedly being repeated all about us, as truly significant attainments become lost in the mass of the inconsequential.” Dr. Vannevar Bush, As We May Think, Atlantic Monthly, July 1945.

[43] ENIAC (Electronic Numerical Integrator And Computer). The U.S. Army built ENIAC between 1943 and 1945; it had nearly 18,000 vacuum tubes. See Birth of a Computer, Computer History Museum.

[44] Accessed on Nov. 8, 2019.

[45] Joseph Cuniglio, Director, NSCC Operations, How does a market stress event or high-volume trading day impact DTCC systems?, DTCC Connection, Nov. 6, 2017.

[46] 34- 288869, 56 Fed. Reg. 7270, at 7272 (Feb. 21, 1991).

[47] R&D, supra note 1, at 523 et seq.

[48] R&D, supra note 1, at 90.

[49] R&D, supra note 1, at 168–72. See also Rule 16-3, which exempts certain transactions by an officer or director with the issuer. Id. at 692–94.

[50] The introductory language of Rule 16a-1 provides: “Definition of terms. Terms defined in this rule shall apply solely to section 16 of the Act and the rules thereunder. These terms shall not be limited to section 16(a) of the Act but also shall apply to all other subsections under section 16 of the Act.” By excluding an entity from the definition of “beneficial owner,” the rule excludes entities from liability under Section 16(b).

[51] Prospective investors in a hedge fund often seek to know whether employees of the fund manager have invested their own money in that hedge fund. In response to a request from the Managed Funds Association, the SEC staff clarified and liberalized restrictions permitting more employees to invest in the fund than under the SEC’s prior views. SEC, Division of Investment Management, Investment Company Act of 1940—Section 7 and Rule 3c-5

Managed Funds Association, Feb. 6, 2014, incoming letter from Stuart J. Kaswell, General Counsel, Managed Funds Association, Feb. 5, 2014.

[52] Michael Swartz, Schulte Roth & Zabel, Hedge Fund Legal & Compliance Digest, Apr. 6, 2017.

[53] Rule 16a-1(a)(2)(ii)(C) provides:

(2) Other than for purposes of determining whether a person is a beneficial owner of more than ten percent of any class of equity securities registered under Section 12 of the Act, the term beneficial owner shall mean any person who, directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares a direct or indirect pecuniary interest in the equity securities, subject to the following:

            ***

(ii) The term indirect pecuniary interest in any class of equity securities shall include, but not be limited to:

***

(C) A performance-related fee, other than an asset-based fee, received by any broker, dealer, bank, insurance company, investment company, investment adviser, investment manager, trustee or person or entity performing a similar function; provided, however, that no pecuniary interest shall be present where:

(1) The performance-related fee, regardless of when payable, is calculated based upon net capital gains and/or net capital appreciation generated from the portfolio or from the fiduciary’s overall performance over a period of one year or more; and

(2) Equity securities of the issuer do not account for more than ten percent of the market value of the portfolio. A right to a nonperformance-related fee alone shall not represent a pecuniary interest in the securities.

R&D at 292 et seq.

[54] 959 F. 3d 541 (2d Cir. 2020) available at GovInfo.gov.  See also R&D June 2020,

[55]  In 1968, Congress amended the Exchange Act to add section 13(d) as part of the Williams Act.  Briefly, that provision requires purchasers of more than 5% of a public company to file disclosure statements with the SEC.  “The primary purpose of the Williams Act was to regulate cash tender offers and other potential acquisitions of corporate control by requiring acquirers of registered securities to make public disclosure of their actions and intentions.”  R&D at 102.  The SEC adopted rules for calculating the 10% ownership under Section 16(b) by employing the standards in Section 13(d) and the rules thereunder.  Id at 100. 

[56] Rubenstein supra, at 6.

[57] Supra at note 5.

[58] Rubenstein at 14-15.

[59] Id at 12.  See also R&D June 2020, at 5.

[60]  Id. at 21.

[61] Rubenstein v. ROFAM INV., LLC et al., 19-796-cv, Summary Order,2d Cir, May 20, 2020, affirming Rubenstein v. Berkowitz et al and Sears Holdings Corp., 17-CV-821 (JPO), SDNY, March 27, 2019. 

[62] R&D, June 2020, at 5.

The role of a public corporation’s in-house general counsel/chief legal officer has always been a difficult balancing act. The general counsel must be an expert advisor to the company’s CEO and board of directors. He or she must fulfill significant legal obligations to the company’s owners and creditors. An effective general counsel also must function as a knowledgeable business partner in senior management. The complex responsibilities of the position have been written about extensively in numerous professional publications and have been amplified by laws passed, regulations issued, and court cases over many years.[1]

Similar complexity is involved in the obligations of boards of directors to monitor, oversee, and direct the affairs of a public corporation—to carry out effective corporate governance. In companies of all sizes, the fact that board meetings occur only on a periodic basis can make it challenging to meet these obligations. To fulfill governance responsibilities, a board must be able to understand and address issues and developments that can arise in a company at any time.

Given that management is a continuous process and boards of directors processes are intermittent, the creation of an “executive committee” can improve the flow of information that assists a company’s management and board in governing effectively. Providing relevant and timely information is one of the important checks and balances in managing and directing the affairs of a company.

What Is a Board Executive Committee?

Public company boards of directors typically have three standing committees that are mandated by regulators and listing exchanges: an audit committee, a nominating and governance committee, and a compensation committee. The responsibilities of these standing committees are described and discussed in a company’s public disclosures. Financial institutions are also mandated to have a committee to address risk.

Companies may have other committees of the board to specialize in such matters as technology; risk identification and management; safety and security; environmental issues; human capital; and other subject areas. In addition, some companies have created an executive committee to address matters that may need monitoring and attention between regularly scheduled board meetings. The roles of such executive committees can vary among companies and with changing circumstances within a company. One company describes its executive committee in its annual report as follows:

Executive Committee (3 directors) is to, as more fully specified herein, (1) monitor and review the operations of the Company and its subsidiaries (collectively, the “Group”), (2) exercise specific delegated powers of the Board, (3) review and provide recommendations on matters that would require the approval of the Board and (4) exercise such other powers and responsibilities as may be delegated to the Committee by the Board from time to time consistent with the Company’s Amended and Restated Certificate of Incorporation (the “Certificate”) and Amended and Restated Bylaws (the “Bylaws”), within the parameters delegated by the Board. The Committee shall meet as and when any member of the Committee deems necessary or desirable, subject to notice (or waiver of notice) being given in accordance with the rules and procedures of the Committee.[2]

Charters for executive committees may also describe specific limitations on committee activities. Information about a company’s board committees and board committee charters can generally be obtained from annual reports, proxy statements, or upon request to a company’s investor relations organization.

Three Reasons for a Company to Consider the Use of an Executive Committee

First, an executive committee can be a flexible resource to monitor a wide range of developments on a continuous basis. Without a necessity for periodic meetings requiring scheduling or travel, and with good use of technology, such a group can be nimble in staying abreast of internal and external developments affecting the business and can act whenever such matters arise. It can be on the lookout for issues that warrant consultation and discussion among the CEO, CFO, general counsel, and other senior management.

Second, an executive committee can serve as a sounding board for the general counsel and CEO, other members of senior management, and/or independent directors to explore emerging issues or concerns that may or may not ultimately require a presentation to the full board. Having a small, knowledgeable group with whom the CEO and general counsel can consult can facilitate preliminary evaluation of a matter and provide practical and useful advice. Such an approach enables issues to be discussed and evaluated—and possibly in some cases resolved—before they progress to a point needing to be placed upon the formal board agenda. Preliminary evaluation also facilitates definition and preparation of matters that do go forward to the full board.

Third, the effectiveness of a company’s corporate governance—its system of “governing the corporation”—is heavily dependent on creating the right checks and balances and information flows. A small executive committee can institute flexible and efficient information processes that start, stop, and change easily as needed.

Executive committee access to “inside the company” sources, with an ability to inquire about matters as needed, can strengthen the checks and balances in the corporation. One cannot help but wonder if better communications and stronger information flows at early stages might have helped to avoid the widespread and highly publicized control breakdowns that occurred at Enron, Worldcom, and more recently at Wells Fargo. In these cases, massive reputational and financial damage was done to companies and individuals.

Some Caveats for Creating and Using an Executive Committee

It is important to distinguish between “monitor, discuss, and advise” versus “make decisions.” In creating an executive committee, a company must not create an undesirable “two-tier” power dynamic inside the board, whereby the executive committee takes on decision-making authority that under the bylaws properly belongs with the full board. To minimize this risk, the committee should have a well-defined charter with clearly described delegations, along with its own internal set of checks and balances.

An executive committee’s processes for information gathering should be relevant, timely, and efficient, as well as cognizant of the need to avoid placing unnecessary burdens on management. Reporting to the full board should similarly be efficient, using written summaries to advantage in order to avoid taking up time on routine matters in periodic board meetings.

An executive committee should be small, generally not more than three to five people, including the CEO. It should include two independent directors who have relevant experience and business knowledge, as well as a mix of desirable personal and professional attributes.

The authors wish to thank other members of the Grace & Co. Board of Advisors and Senior Paralegal, Allison Hawkins, for their input and assistance.

[1] See E. Norman Veasey & Christine T. Di Guglielmo, Indispensable Counsel (Oxford University Press, 2012) (a comprehensive description of the responsibilities and obligations of counsel, the relevant legal environment, and numerous experiences of job incumbents).

[2]  BOE Annual Report 2019, at www.cboe.com.