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.

Introduction

The economic shutdowns related to the COVID-19 pandemic (COVID-19) have created both shortages and surpluses in supply chains; in other words, ripe conditions for a surge in unauthorized gray-market goods (products with genuine trademarks sold outside authorized distribution channels). In the short term, for example, shortages and price gouging have inhibited healthcare systems’ and their suppliers’ access to vetted sources of genuine supplies, including for personal protective equipment (PPE) and pharmaceuticals. Although these market conditions may invite the substitution of gray-market goods for genuine ones based on availability, the inherent material differences in gray-market goods can pose serious health risks, often unbeknownst to end users. As another example, in the longer term, retailers may elect to liquidate unsold, out-of-date seasonal inventory, such as apparel, in international markets to mitigate losses, but risk unauthorized gray-market resellers later importing those goods back into the U.S. market to compete with next year’s fashions at a discount.

Although federal and state trademark and unfair competition laws offer protection to trademark holders against the unauthorized resale of gray-market goods, COVID-19-related closures and restrictions of state and federal district courts across the country have all but suspended activity in many of those venues for civil actions. However, owing in part to its relatively quick investigation-resolution timeframe mandates and not needing to empanel juries, the International Trade Commission’s (ITC) potential to maintain its pre-COVID-19 pace of operations adds to its already powerful ability to exclude unauthorized gray-market goods from importation[1] to make the ITC a key resource for trademark holders in today’s environment.

How Has COVID-19 Created the Potential for Gray-Market Problems?

In the short term, COVID-19 has created shortages and price gouging in numerous product categories, from healthcare to daily household essentials to sports and leisure products, as distribution chains adjust to the new “normal” of life in a pandemic. From the earliest days of the pandemic, however, no impact has been as apparent or as impactful as healthcare systems’ and individuals’ inability to access vetted sources of PPE and pharmaceuticals. These shortages and price gouging may tempt healthcare providers and individuals to turn to gray-market goods to fill the gap, but inherent material differences between the goods can pose serious health risks. For example, when third parties purchase gray-market goods and later resell them, there is no way to verify that those third parties have complied with safe storage and handling or restrictions on one-time use. This is particularly important for PPE and pharmaceuticals; dire consequences can result from using poorly handled pharmaceuticals or used N95 masks.

As just one example, 3M has filed multiple suits against companies attempting to sell its N95 masks and other PPE at multiple times the list price, alleging trademark infringement and other claims.[2] Summing up the concerns, one preliminary injunction order obtained by 3M noted that “[t]he public has an interest in avoiding confusion about the source and quality of goods and services” and that “[t]his is especially true during the global COVID-19 pandemic, when consumers, including experienced governmental procurement officials, are relying on the 3M Marks and 3M Slogan to indicate that goods and services offered thereunder originate from 3M, and are of the same quality that consumers have come to expect of the 3M brand.”[3]

In the longer term, large amounts of unsold inventory that accumulated during the shutdowns portends gray-market goods problems for retailers for years to come. For example, with the public staying home and spending less, apparel retailers may find themselves faced with unsold professional, luxury, seasonal, and vacation clothing. This surplus may be liquidated in international markets at steep discounts to mitigate losses. However, even in normal times this practice invites the later unauthorized importation of those goods back into the United States, where they compete at a discount against trademark owners’ latest fashions.

To prevent serious consequences to the public health in the short term, and to protect the trademark holders’ goodwill and ward off dilution and price erosion in the long term, trademark holders must remain vigilant to police and pursue any unauthorized sellers of trademarked goods due to the COVID-19 pandemic.

How Can the ITC Protect against Gray-Market Goods?

Under what is known as the first-sale doctrine, a person who buys a trademarked good may ordinarily resell that product without infringing the mark. However, this doctrine applies only to the resale of genuine goods and does not apply to the unauthorized resale of a trademarked good that is “materially different” from the genuine goods sold by the trademark owner—such a resale is still trademark infringement. Sections 32, 42, and 43 of the Lanham Act allow trademark owners and their exclusive and nonexclusive licensees to stop unauthorized resellers from selling gray-market goods upon showing a material difference between the authorized and unauthorized goods.

The ITC is empowered by statute to protect American industries from unfair methods of competition and unfair acts in the importation of articles as well as from importation into the United States of articles that infringe a valid and enforceable U.S. trademark.[4] In contrast with federal district courts, however, the ITC exercises in rem jurisdiction over imported articles, which enables the ITC to issue general exclusion orders in certain circumstances that block the importation of all infringing articles, regardless of whether importers participate in the ITC’s investigation. In addition, service of process against accused importers is less rigorous than in district courts in that attempted service by regular mail is all that is required. Finally, unlike in district court, one investigation in the ITC can name many different unauthorized reseller respondents, consolidating resources and avoiding unnecessary multiplication of efforts.

There are also potential advantages to the ITC as an enforcement forum in the COVID-19 environment. First, the ITC has a speedy schedule and time to final determination, which is important when considering the cumulative and continuous loss of goodwill that results from the sale of gray-market goods. The average time to a final decision for 2019 was 14.1 months.[5] The ITC can also grant a form of temporary relief “to the same extent as preliminary injunctions and temporary restraining orders” when the time period until a final determination is only 90 days in most cases and 150 days in “more complicated” cases.[6]

The ITC may also be more suited to maintain its pre-COVID-19 pace of operations than other forums, particularly considering its statutory obligation to conclude section 337 proceedings “at the earliest practicable time.”[7] In fact, a review of investigations that have been instituted since mid-March (Nos. 1192–1202) shows that the target dates have remained on a fairly typical schedule of 15–19 months, showing no significant slowdowns due to COVID-19. For example, in Investigation No. 1200, the respondents proposed that the target date be set for 19 months to allow for flexibility due to COVID-19, and the judge declined, setting the target date for 16 months.[8]

Moreover, because the ITC does not offer jury trials, it has more flexibility in conducting virtual bench trials as well as virtual hearings. Even before the pandemic, the ITC regularly held telephonic hearings and conferences when other courts may have more frequently required in-person attendance. The ITC may also be uniquely prepared to handle remote and alternative formats for trial because it already often uses written witness statements. For example, in Investigation No. 1162, the judge issued a notice and order regarding alternate hearing procedures suggesting that the parties could take depositions of witnesses regarding their written witness statements, and the parties could use that deposition testimony in lieu of live cross-examination. The judge stated that “there is a possibility of conducting the evidentiary hearing without any real-time participation by me at all,” showing the creative solutions the ITC is proposing to keep cases proceeding as quickly as possible.[9] Finally, although the ITC initially suspended in-person hearings, that restriction is set to lift on July 10, 2020.

Overall, the ITC has proven itself to be a speedy and highly adaptable forum. The ITC may be uniquely positioned to help trademark holders end gray-market problems, both generally and in view of the COVID-19 pandemic.

Conclusion

COVID-19 has unfortunately provided the potential for unauthorized gray-market goods to flourish. In the short term, such goods can threaten public health and safety when they affect the supply and quality of PPE and pharmaceuticals. In the long term, trademark holders may be battling against unauthorized gray-market goods sales and damage to their goodwill for years to come. Given its powerful remedies, practical benefits, and potential to maintain pre-COVID-19 operations, the ITC has shown itself to be a strong and effective partner to protect domestic trademark owners’ rights against unauthorized gray-market importers.

[1] See Paul Tanck & Neal McLaughlin, Combating Gray Market Goods: Using the ITC to Solve the Gray Market, Bus. L. Today, July 2, 2019 (explaining that “[t]he International Trade Commission has emerged as the go-to venue in the fight against the importation of gray-market goods”).

[2] Bill Donahue, 3M Sues Amazon Seller Over Fake N95 Masks, Law360, June 8, 2020.

[3] 3M Co. v. Performance Supply, LLC, No. 1:20-cv-02949-LAP (S.D.N.Y. May 4, 2020) (Dkt. 22).

[4] 19 U.S.C. § 1337.

[5] U.S. International Trade Commission, Section 337 Statistics: Average Length of Investigations (last accessed June 9, 2020).

[6] 19 U.S.C. § 1337(e)(2)–(3).

[7] 19 U.S.C. § 1337(b)(1).

[8] In the Matter of Certain Electronic Devices, Inv. No. 337-TA-1200, Order No. 6 (June 17, 2020); id., Joint Discovery Statement, EDIS Doc. No. 712615 (June 12, 2020).

[9] In the Matter of Certain Touch-Controlled Mobile Devices, Inv. No. 337-TA-1162, Order No. 54 (June 5, 2020).

Official committees can play an important role in a bankruptcy case, and chapter 9 municipal bankruptcy is no exception. Committees can ensure efficient, adequate representation of large stakeholder groups, including retirees, equity owners, and of course creditors. They bring together similarly situated parties, allowing the group to develop ideas and take positions that are representative of multiple parties with important interests at stake. Committee ideas and positions can thus be more powerful and persuasive than the views of any one stakeholder in a case.

Some recent decisions may threaten the appointment of official committees in chapter 9, however. Two bankruptcy judges have held that section 1102(a)(1) of the U.S. Bankruptcy Code does not authorize a committee’s appointment in chapter 9 and that, therefore, the committees the U.S. Trustee had appointed in each case should be disbanded.[1]

Section 1102(a)(1) provides, in relevant part, that “as soon as practicable after the order for relief under chapter 11 of this title, the United States trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees . . . as the United States trustee deems appropriate.”[2] It is found in chapter 11 of the Bankruptcy Code but is incorporated in chapter 9 cases through section 901(a).[3] Even though section 1102 as a whole is incorporated into chapter 9, the courts in In re Coalinga Regional Medical Center and In re Detroit each found that section 1102(a)(1)’s reference to chapter 11 relief necessarily precluded that provision from applying in chapter 9 cases because there is no “order for relief under chapter 11” in a chapter 9 case. Both courts reached this conclusion based on the idea that it is important to give effect to every word in a statute.

Although both the Coalinga and Detroit courts disbanded the committees formed under section 1102(a)(1), both left the door open to the possibility that they could order the U.S. Trustee to appoint an official committee under section 1102(a)(2).[4] Under this provision, “[o]n request of a party in interest, the court may order the appointment of additional committees . . . if necessary to assure adequate representation. . . .”[5] However, the idea that a court could use section 1102(a)(2) to order the appointment of an initial committee does not give effect to every word of the statute: the word “additional” in that provision implies that there has already been a committee appointed in the case—a committee that the courts in Coalinga and Detroit have now held cannot be appointed. Coalinga and Detroit have thus raised the possibility that a court could hold that a chapter 9 committee cannot be appointed at all—not even with the consent of all parties.

However, this possibility is not an inevitable outcome. First, courts could adopt the U.S. Trustee’s position that Congress intended to incorporate section 1102 in its entirety into chapter 9 and knew how to exclude particular subsections if it wanted to.[6] Alternatively, courts could look to section 105(a) of the Code, which allows the court to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”[7] Both Coalinga and Detroit contended that section 105(a) gave the court the power to disband committees[8] in that the Code does not explicitly prohibit this action.[9] Following this reasoning, a court could arguably interpret section 105(a) to accept committee appointments because the Code does not explicitly prohibit the court from ordering or allowing the appointment of committees, either.

Given the valuable role committees can play in a case, it is troubling that some courts have seemingly found a route to prohibit committee appointments in chapter 9 outright. To some extent, this is a statutory drafting issue that Congress should address, but courts may also have the statutory tools to fix the very problem they have created.

[1] In re Coalinga Regional Medical Center, 608 B.R. 746, 747–48 (Bankr. E.D. Cal. 2019); In re City of Detroit, Mich., 519 B.R. 673, 675 (Bankr. E.D. Mich. 2014).

[2] 11 U.S.C. § 1102(a)(1).

[3] 11 U.S.C. § 901(a) (“Section[] . . . 1102 . . . appl[ies] in a case under this chapter.”).

[4] Coalinga, 608 B.R. at 759 (continuing creditor’s motion to appoint a committee under section 1102(a)(2)); Detroit, 519 B.R. at 678 (“The U.S. Trustee’s authority to appoint committees in chapter 9 is therefore limited to the authority granted in subsection (a)(2) of § 1102.”).

[5] 11 U.S.C. § 1102(a)(2).

[6] Coalinga, 608 B.R. at 750. See, e.g., 11 U.S.C. § 901(a) (incorporating five out of sixteen subsections of section 1129(a)).

[7] 11 U.S.C. § 105(a).

[8] The U.S. Trustee’s arguments in Coalinga suggest that this would be an expansive reading. Coalinga, 608 B.R. at 750 (arguing that, when section 1102 was amended, it “eliminat[ed] the court’s role in committee formation and limit[ed] court review of committee composition.”).

[9] See Detroit, 519 B.R. at 680 (“[N]owhere does the bankruptcy code explicitly prohibit the bankruptcy court from disbanding an unsecured creditors’ committee.”).

The COVID-19 pandemic (COVID-19) has created unparalleled uncertainty for nearly all businesses in that companies are unable to predict when and how businesses and consumers will resume buying their goods and services. This unpredictability has made it more difficult for dealmakers to use historical earnings to predict a company’s future earnings, and accordingly their valuation, which has severely curtailed the number of M&A transactions at the present time. Somehow, however, a trickle of deals are getting done and others are being pursued, although at a much slower pace than in 2019.

Why Would Buyers and Sellers Want to Do a Deal in This Environment?

Buyers with available funds may find that the current environment provides opportunities that would not have existed before the pandemic. In particular, strategic buyers with deep industry expertise will look for transactions that will allow them to add a new product or service, acquire new technology or a set of skilled employees, or some combination thereof. Private equity buyers have a lot of available funds to invest and will need to deploy capital, especially if they perceive this to be a buyer’s market. One of the pandemic’s principle effects for M&A transactions has been to lower seller valuation expectations, motivating sellers to be more flexible than they were only a few short months ago. As a result, valuation expectations are materially lower for sellers, making it easier to structure a transaction that makes sense for both parties.

Throughout this article, reference to “private equity” generally means platform acquisitions by a private equity fund, which are acquired to be a standalone portfolio company, as opposed to a “tuck-in” acquisition by a portfolio company. “Strategic buyer” generally means an existing company already operating in an industry, which can include both public and private companies, and can include a private equity portfolio company looking for a tuck-in acquisition.

Many young start-ups and technology companies may lack sufficient cash resources to weather the COVID-19 storm and may be unable to find additional funding quickly enough. This predicament may increase the attractiveness of a larger strategic buyer capable of providing stability and added resources that the seller and its employees sorely need. Sellers may have other reasons to seek a sale, including the death or divorce of a founder, the need for liquidity to provide some diversification for the owners, or a management team that has reached its limits for moving the company forward. Such sellers may have been trying to find a buyer before COVID-19 and do not have the luxury of waiting a year or longer for a more favorable selling environment. There are also distressed situations in which a company may face insolvency and bankruptcy, but transactions involving bankruptcy have very different rules and considerations which are beyond the scope of this article.

How Has Due Diligence and the M&A Process Changed in the Post-COVID-19 Environment?

Acquisitions typically are the start of a long-term relationship between the seller’s management team and the buyer, the success of which depends heavily on the seller’s key employees. For buyers, face-to-face meetings with the seller’s management team remain a critical component of deal-making and due diligence, and few buyers will be willing to close a transaction without several opportunities to interact in person with the management team. Most deals closing today were likely underway before the pandemic, so the buyer already had spent time with the seller and the seller’s management team. Due to the challenges posed on travel by COVID-19, the nature of due diligence on the management team is likely to change. For new transactions in which the buyer has no prior relationship with the seller, video conferences will allow the sale process to get started between motivated parties. For now, however, buyers will likely insist on meeting the management team in person before they are willing to close the deal.

If travel remains constrained for an extended period, buyers may need to rethink their dependence on face-to-face meetings. Similar to hiring decisions, buyers will become more comfortable sooner or later with video conferencing, both for getting to know the management team during due diligence and for interacting with them post-closing. Buyers may also increase their use of personality tests and similar assessment tools to better understand the management teams of the seller during due diligence. You can also expect to see buyers becoming more structured in their due diligence discussions on video conferences, similar to the hiring methodology Geoff Smart and Randy Street recommend in their book, Who—The A Method for Hiring. Although right now partners at private equity funds and strategic buyers may say that they would never buy a company without extensive meetings with the management team in person, this attitude could change if the effects of the pandemic persist.

The inability to meet with the seller’s management in person is one of several reasons to extend the due diligence time period. An extended due diligence period allows the buyer more time to assess more accurately COVID-19’s impact on the seller and to find any needed financing for the deal. As a result, look for the exclusivity period in letters of intent to be extended from the typical period of 60 days pre-COVID-19 to 90 or 120 days, if not longer.

The nature of due diligence will strongly depend on whether the key assets of the seller are intellectual property, such as for a software company, or whether the key assets are physical, such as inventory or a factory or distribution facility. The more the key assets are physical, the more likely the buyer (and the buyer’s lenders) will require physical inspections that will lengthen the closing timetable.

Certain physical assets, such as a factory or distribution facility, will require more rigid due diligence on new health and safety measures put into place to protect workers at the facility. Similar to having Phase I environmental reports for real property, third-party health and safety inspections must be added to due diligence checklists for physical facilities.

The pandemic provides new lines of questions to ask the management team to better assess its capabilities and the operations of the target business.

• What decisions did you make to cope with the pandemic and why? How did they turn out? How did you treat your employees and vendors? What did you learn, and what would you do differently?
• What is the seller’s supply chain vulnerability, especially to China and other overseas sources? What plans does management have to change the supply chain in a post-COVID-19 world?
• What additional operating costs are required to operate in a post-COVID-19 world?
• What plans does management have if the pandemic re-emerges in the Fall?

Buyers will also ask if the seller received a loan under the Paycheck Protection Program (PPP), and especially if the loan was for more than $2.0 million so that it is subject to the automatic audit promised by the Small Business Administration (SBA). Buyers should ask about the seller’s eligibility for a PPP loan under the SBA’s affiliation rules. Buyers will be leery about buying a company subject to an SBA audit when the seller’s eligibility was questionable, or there are questions regarding the seller’s good-faith certification regarding the “necessity” of the loan.

Due to the shift from a seller’s market to a buyer’s market, sellers must find ways to distinguish themselves. One way to do that is to make due diligence easier and more transparent for the buyer. In this new environment, sellers should make the up-front investment in pre-sale due diligence. This will include investing in a more thorough quality of earnings (Q of E) review before starting the sale process. The Q of E will provide the buyer with better visibility into the seller’s pre-COVID-19 financial performance and how the seller will manage through the disruptions caused by the pandemic. A seller will also want to prepare a “stress test” analysis for its business under different possible scenarios in a post-COVID-19 world. Buyers will find sellers with more transparent financial data and a plan for an uncertain future to be much more attractive. These types of “stress test” analyses are critical to help develop more creative deal structures required under the current environment, as discussed below.

What Are Ways to Bridge the Valuation Gap, Given the Uncertainty in the Seller’s Future Financial Performance?

I. Setting the Stage—Valuation Methodologies and Changing Expectations

Three common ways to value target companies are:

• Multiple of prior 12 months of EBITDA, which is used for companies with earnings. This is the most common valuation methodology.
• Multiple of revenues, most commonly used for software and other technology companies that have been able to build significant sales but are not at the stage of having earnings.
• A “build versus buy” analysis, in which the buyer assesses the cost to duplicate the functionality of the seller’s product or technology from scratch, versus the cost to buy the seller and its employee team. This measure is most commonly used for early-stage software and other technology companies prior to them having significant sales revenues. Acquisitions of these types of companies are especially attractive if they have a skilled set of employees who can jump-start the buyer’s efforts to add a new product or service or technology. This valuation methodology generally leads to lower valuations, but not always, depending on the immediate needs of the buyer. When Facebook paid $1 billion for Instagram in 2012 for a one-year-old company with 13 employees, it sounded insanely high at the time, but in retrospect, it has turned out to be a bargain.

A seller’s historical earnings are no longer a predictable measure of future performance due to the uncertainty caused by COVID-19. Before the pandemic, in a seller’s market, the multiples of EBITDA and revenue used to value sellers were at all-time highs, with auctions attracting a large number of potential buyers. Using trailing 12 months (TTM) of EBITDA or TTM of revenues were reasonable ways for buyers to predict future financial performance. COVID-19, however, has upended these metrics as a way to value companies. How do you value a company after COVID-19 when you cannot predict with any certainty how a company will perform over the next 12 to 18 months? For the “build versus buy” valuation analysis, the changed environment probably will not materially change the buyer’s analysis, but it has substantially changed the seller’s expectations, making them more receptive to an acquisition.

One big difference between the current environment and prior recessions, such as the recession of 2008–09, is that sellers have quickly grasped the uncertainty caused by the pandemic. In prior recessions, it took 12 to 18 months for sellers to fully understand the new reality. Today, sellers’ expectations have reset almost immediately. Sellers that have the staying power and resources to wait may be content to do so until conditions improve. Sellers that have other pressures may be more motivated to sell, notwithstanding the current uncertainty, and more willing to share the risks with the buyer. From the buyer’s perspective, and especially for strategic buyers, if a target company is a strategic fit that provides a new product or service, or a new technology or skilled group of employees, this may be an excellent time to make an acquisition. If both the buyer and seller are motivated and are willing to be more flexible than before the pandemic, then deals can still happen.

How do you bridge the valuation gap to deal with the uncertainty caused by COVID-19? The answer is to creatively allocate the uncertainty risk between buyer and seller. The tools to do this can differ for private equity and strategic buyers.

II. Tools to Bridge the Valuation Gap

1. Reduced Total Purchase Price and Reduced Cash at Closing. Companies that are valued as a multiple of earnings or revenues are not worth as much today as they were in January 2020 in the pre-COVID-19 world. Particularly attractive companies that were in auction processes in January 2020 with multiple bidders may have received bids of 10 times 2019 EBITDA, with 90% or more of the purchase price paid in cash at closing. In the current environment, however, a more realistic multiple might be eight or nine times 2019 EBITDA, with only 50% to 60% of the purchase price paid in cash at closing. The remaining portion of the purchase price will be contingent, deferred, or subject to an equity rollover, using some of the tools laid out in more detail below.

2. Earn-outs. Earn-outs are a tool that can be used by both private equity and strategic buyers. According to the 2020 M&A Deal Terms Study by SRS Acquiom (the SRS Study), which analyzed 1,200+ private-target acquisitions from 2015 to 2019 (i.e., the pre-COVID-19 period), earn-outs for non life-science deals were used in an average of approximately 18% of transactions over the past four years, as shown in the chart below. Given that earn-outs are used more frequently in life-science transactions, the SRS Study excluded those transactions to get a better measure of how earn-outs are used outside of life-science transactions. For transactions with earn-outs, the metrics used were revenues, EBITDA, and other milestones (such as unit sales or product launches), or sometimes combinations of these metrics, depending upon the business and the stage of development of the target company. The chart below shows how the use of these metrics has changed.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

According to the SRS Study, the chart below show that in non life-science transactions with earn-outs, the earn-out potential as a percentage of the closing payment generally hovered around 40%, and the length of the earn-out period ranged from less than one year to more than five years, with a median of 24 months.

Source: 2020 M&A Deal Terms Study by SRS Acquiom

Before COVID-19, both buyers and sellers were wary of using earn-outs. Earn-outs have often half-jokingly been referred to as “litigation magnets” because disputes regarding whether the earn-out has been achieved are common. Some of the reasons for the disputes have been due to ambiguous metrics for determining whether the earn-out has been met, changes in the buyer’s operations post-closing, the allocation of expenses, and the difficulty caused by changing circumstances, especially when the earn-out period is long (more than two years). As a result, before COVID-19, earn-outs were imperfect tools that were used only when absolutely necessary to bridge the valuation gap between buyer and seller.

After COVID-19, however, earn-outs will become increasingly popular to allocate more risk to the seller for the uncertainty of future performance. As a result, these are likely changes for earn-outs:

• Earn-outs will be used in a higher percentage of transactions, from the current 18% to perhaps 30% to 40% of deals, or higher.
• The time period for earn-outs will increase from the current median of 24 months to longer timeframes. Given the uncertainty with how long it will take for companies to recover from COVID-19, most companies have no visibility into what their results will be for 2020, and even into 2021. Therefore, earn-out periods may extend into 2022, 2023, and longer to give the seller more opportunity to achieve the earn-out.
• The earn-out potential as a percentage of the closing payment can be expected to increase from the current 40% to 50% or higher.

3. Equity Rollovers. Equity rollovers are a tool used almost exclusively by private equity buyers in platform acquisitions, and sometimes for tuck-in acquisitions. Equity rollover transactions typically involve rollover participants taking between 10% and 40% of the purchase price in the form of equity in the buyer. Equity rollovers are generally restricted to founders and other members of the seller’s management team who are joining the buyer post-closing. This provides founders and management with a meaningful equity stake in the buyer to align their respective interests to grow and sell the target company. Generally, existing equity holders in the seller who are not founders or part of the management team (i.e., venture capital, private equity, or angel investors) are excluded from the equity rollover because they have no ongoing role with the buyer post-closing and would rather exit the investment in the seller. Private equity buyers also like equity rollovers because they serve as a form of seller financing that reduces the buyer’s up-front cash payments at closing.

Equity rollovers were already very common before COVID-19. In the future, they will likely be used as a tool to allocate more risk to the seller to deal with the unpredictability of post-COVID-19 financial performance. Below are some of the changes we are likely to see.

• The equity rollover percentage is likely to increase. Prior to the pandemic, a private equity buyer might have been agreeable to only a 10% or 20% rollover by the founders and management team. In the post-COVID-19 world, the equity rollover percentage will likely increase to 30% or 40% as a means of shifting more of the risk to the seller and decreasing the need for outside financing.
• The seller participants in the equity rollover are likely to expand to include more of the equity holders in addition to the founders and management team. The buyer may insist on having venture capital, private equity, or angel investors included in the equity rollover. This may not be ideal for those investors who may have wanted to completely exit their investment, but they may have no choice in the current environment. For the buyer, this shifts the post-COVID-19 risk to more of the seller’s equity holders and increases the amount of seller financing.
• The private equity buyer may insist on having a liquidation preference for its equity, which will be paid out prior to the equity rollover received by the seller participants. Before COVID-19, it was typical for the seller participants to receive rollover equity with the same economic rights and preferences as the private equity buyer. In the current environment, however, private equity buyers are more likely to insist on receiving a 1X liquidation preference, or a 1X plus a return of some amount (i.e., 8%), to provide downside protection to the buyer. The buyer will argue that the seller participants have already cashed out a significant portion of their investment so it is only fair for the buyer to be protected if the post-COVID-19 performance of the seller is significantly worse than expected.

4. Targeted Incentive Bonus Plans for the Management Team. Strategic buyers generally will not use equity rollovers. The reasons include that the strategic buyer will have no timeline to sell the target company, so the rollover recipient will never be able to exit the investment, or the strategic buyer may be privately owned by a family or other small group and have no desire to have any minority equity holders.

Strategic buyers also may not want to use earn-outs if the management team that is joining the buyer has only a small equity stake in the seller. Therefore, an earn-out may increase the purchase price for the other equity holders of the seller (i.e., venture capital, private equity, or angel investors), but the management team will not receive much of the earn-out due to its small equity holding in the seller. As a result, the management team will not have the needed incentives to help the buyer achieve the desired results post-closing. This is particularly needed when the buyer is making the acquisition to acquire new software or other technology, as well as the skilled group of employees responsible for developing the technology (i.e., a so-called acqui-hire).

This situation, especially in a post-COVID-19 world, requires the strategic buyer to be more creative in designing a structured incentive bonus plan for the management team. Even in a post-COVID-19 world of higher unemployment, talented technology employees (and especially the “A” players) may still be able to find other attractive jobs or may be motivated to start a new company. As a result, the buyer must design targeted incentive bonus plans that may be outside the norm for the buyer and are specifically tailored to incentivize the management team to achieve specific buyer goals for the transaction. Below are some thoughts for what a targeted incentive bonus plan might include:

• Specific milestones that could include the development of new software or other products, or improving existing software or other products to meet market needs, in both cases using the larger resources of the buyer. These milestones may be part of a long-term project that may take two to five years to achieve; accordingly, the incentive plan must have a longer-term horizon that matches the achievement of specific milestones.
• Specific milestones that could include sales or other financial targets for the software or other technology products acquired in the acquisition to connect the management team to the sales efforts for their products. These milestones may be combined with the other milestones in the prior bullet.
• Monetary rewards that are large enough to provide sufficient incentives for the management team to stay with the buyer. If the management team is being asked to create significant value for the buyer, then they should share in a portion of the value they create.

5. Purchase Less Than 100% of the Target Company’s Equity (With Deferred Purchase Options for the Balance). In the typical rollover structure, the rollover participants cannot sell their rollover equity until the private equity fund sells the entire company. As discussed above, strategic buyers are unlikely to use rollover equity. However, a hybrid rollover structure that can be utilized by strategic buyers is to:

(i) purchase less than 100% of the target company’s equity in the initial closing (typically more than 50% of the equity, but less than 80% (to avoid consolidation for tax purposes)); and

(ii) purchase the balance of the equity at a later date, perhaps two to three years after the initial closing, based upon a pre-set formula to determine the purchase price based upon future performance.

This structure allows the seller’s equity holders to sell a portion of their equity at the initial closing and provide some partial liquidity for their investment. In the post-COVID-19 environment, the pricing multiple for the portion of the equity purchased at the initial closing may reflect some of the uncertainty for how quickly operations of the target company will get back to pre-COVID-19 levels.

The second-step purchase of the remaining equity can use a preset formula to determine the purchase price, which will be based on the financial performance of the target company during a future time period. This structure provides potential upside to the seller if the financial performance improves within a reasonable time period, while at the same time providing downside protection to the buyer if the financial performance is permanently impaired or takes an extended time period to get back to pre-COVID-19 levels. A variation of this structure is to provide for a combination of puts to allow the seller to require the purchase of the remaining equity at a preset formula, and calls to allow the buyer to require the sale of the remaining equity based on the pre-set formula, in each case at future dates.

For example, assume that the buyer purchases 60% of the seller’s equity at the initial closing at an 8X multiple of EBITDA (which might have been a 9X or 10X multiple in January 2020). The purchase agreement would provide that the remaining 40% of seller’s equity will be purchased by the buyer based on an 8X multiple of 2021 or 2022 EBITDA, perhaps with some minimum price to provide some downside protection to the seller’s equity holders. This structure allocates the downside risk to the seller of a slow or extended recovery while providing upside incentives to the seller if the target company’s financial performance improves more quickly. This structure can be especially advantageous for a smaller target company with limited sales and distribution resources for its products, or a new product with adoption risk, being acquired by a larger company with more extensive sales and distribution channels. Obviously, there can be many variations of this structure to fit the specific circumstances of the target business and to fairly allocate post-COVID-19 uncertainty between the seller and the buyer.

How Do Buyers Finance Acquisitions in the Current Environment?

In January of 2020, senior and mezzanine lenders were avidly competing to loan money to finance acquisitions. This led to an increase in the percentage of the purchase price that buyers could borrow to finance a deal and favorable loan terms with low interest rates and relaxed financial covenants. Life was good for buyers before the pandemic hit!

Today, the environment is different because lenders are much more cautious. It will take time for lenders to become more comfortable after the economy opens up and they can get real-time information on the target company’s financial performance in the new environment. As a result, many senior and mezzanine lenders are sitting on the sidelines or simply moving slowly until the smoke clears to permit some visibility on how the target company is likely to perform over the next 12–36 months.

When lenders are willing to move forward, their appetite for risk is likely to be substantially reduced, meaning that buyers can expect the following changes:

• Due diligence will take longer and be more involved, especially when there are physical assets and facilities that must be inspected. Mezzanine lenders in particular may look closer to home for financing transactions to eliminate the need to travel far to meet the management team.
• Lenders will reduce the percentage of the purchase price they are willing to finance, which will require the buyer to provide more equity.
• Interest rates and other fees and expenses will be higher than before. Interest rates may increase by 200 basis points or more than in 2019 to account for the increased risks. Closing fees and due diligence costs will also be larger than before the pandemic.

If outside financing is not obtainable at all, or not available at the desired level, then sellers and buyers must find new ways to allocate the financing risk in the post-COVID-19 environment. We expect some combination of the following structures to be used in the coming months, some of which have already been discussed above:

1. Reduce the cash portion of the purchase price payable at closing, and increase the amount of the equity rollover, and/or add an earn-out.
2. Bridge any financing gap with seller notes, which would be subordinated to any senior or mezzanine lenders. In the current environment, this may be the only way to get a transaction financed. Although the seller may request collateral or guarantees from the private equity fund or strategic buyer, buyers can be expected to react adversely to these requests and expect the seller to bear the risk with the seller notes until the entire company can be recapitalized and the seller notes can be repaid.
3. Provide for the buyer to pay an increased portion of the purchase price in cash at closing, and then recapitalize the company with an appropriate amount of debt after the lenders have better visibility on the target company’s financial performance in the post-COVID-19 environment.

Like the rest of the economy, M&A participants and their advisors are having to deal with an extraordinary amount of uncertainty as a result of COVID-19. As a result, due diligence efforts and transaction structures are expected to change from a pro-seller environment to one in which buyers and sellers must be more flexible and creative in how they allocate the valuation and financing risks between them. If a seller can wait for a more favorable environment, then they will do so, but many sellers will not be able to wait and will still desire to get a transaction closed. Similarly, private equity buyers have a lot of funds to invest and will need to deploy capital at some point, especially those with funds that have investment periods coming to a close. Cash-rich strategic buyers, especially those looking for companies with new products and technology, may find this an attractive opportunity to acquire companies that are a strategic fit. This environment may present strategic buyers already familiar with the industry and the target company with great opportunities, especially if they are willing to move quickly and are willing to be more creative with their deal structures.

Paul Pryzant, a partner at Seyfarth Shaw LLP, has represented clients in a variety of mergers and acquisitions, equity and debt financings, and other corporate transactions for over 35 years.

The author thanks Axial, which has been hosting a series of COVID-19 virtual roundtables each week with different sets of middle-market deal professionals who have been sharing their views on how COVID-19 has been changing the way they view transactions in the current environment. The virtual roundtables can be accessed at this link. These virtual roundtables inspired some of the ideas for this article.

Delaware Bankruptcy Court Holds That Minority Shareholder Blocking Rights Are Void

A little over two years ago, I reviewed a handful of decisions confirming the public policy against permitting limited liability companies from contracting away the right to seek bankruptcy protection in operating agreements.[1] In those cases, courts held that notwithstanding state law policy of freedom of contract in LLC agreements, so called blocking rights that give a creditor the ability to bar an entity from filing a bankruptcy petition may be void under federal law.[2]

Whereas “parties to an operating agreement generally have the freedom to contract limited only by the parameters in the relevant articles of organization and statutory law,” courts have recognized “a strong federal public policy in favor of allowing individuals and entities their right to a fresh start in bankruptcy.” Last month, in a ruling from the bench,[3] the Bankruptcy Court for the District of Delaware affirmed and strengthened that public policy as it relates to a debtor’s minority shareholder’s blocking rights, setting up a potential split between the Third and Fifth Circuits.[4]

On May 5, 2020, in In re Pace Industries, LLC, Case No. 20-10927 (MFW) (Bankr. D. Del.), Bankruptcy Judge Mary Walrath, in denying a motion by Macquarie Septa (US) I, LLC (Macquarie) to dismiss the debtor’s chapter 11 case, ruled that a minority shareholder’s blocking rights were “void” in the face of the debtor’s constitutional right to file bankruptcy. Judge Walrath explained:

I do recognize that there is no case directly on point, holding that a blocking right by a shareholder who is not a creditor is void as contrary to federal public policy that favors the constitutional right to file bankruptcy. But I think that, based on the facts of this case, I am prepared to be the first court to do so, and therefore conclude that the motion to dismiss must be denied.[5]

After Pace Industries and certain affiliates commenced their chapter 11 cases, Macquarie moved to dismiss the filings. Macquarie, which had made a $37 million investment in the debtor’s preferred stock, argued that the filing was unauthorized because the debtor did not obtain Macquarie’s consent, as provided for in the applicable corporate governance agreements. Macquarie argued that its right to block a bankruptcy filing was a heavily negotiated and critical component of its investment.

Macquarie acknowledged the cases holding that blocking rights in the hands of certain creditors might violate public policy, but attempted to distinguish those cases—including Intervention Energy and Lake Michigan[6]—on the basis that those cases involved shareholders who were also creditors, and that the equity stakes at issue were in the nature of “golden shares” intended only to vest the creditor with the blocking right. Here, however, Macquarie held only preferred equity—indeed, a substantial, albeit minority, stake—and was not a creditor. Accordingly, Macquarie argued that the court was constrained by U.S. Supreme Court precedent in Price v. Gurney, 324 U.S. 100, 106 (1945), to dismiss the bankruptcy petition where those who purported to act on behalf of the corporation lacked authority to do so under applicable state law. Based on the Fifth Circuit’s Franchise Services decision, which applied Delaware law, Macquarie argued that as a minority shareholder, it was not a controlling shareholder that owed any fiduciary duties and, specifically, the fact that Macquarie was not given opportunity to even exercise its consent rights prior to the chapter 11 filing shows that it did not control the board. In Franchise Services, the Fifth Circuit held that a shareholder with a blocking right did not have control over the debtor’s conduct and concluded that not being consulted as to a bankruptcy filing where it held such a consent right was indicative of a lack of control; accordingly, the Fifth Circuit did not reach the issue of whether it breached any purported fiduciary duty.[7]

Judge Walrath rejected those arguments, however, and denied Macquarie’s motion to dismiss, holding that:

under Delaware state law, contrary to the Fifth Circuit, my interpretation of the law would and does find that blocking rights, such as exercised in the circumstances of this case, would create a fiduciary duty on the part of the shareholder; a fiduciary duty that, with the debtor in the zone of insolvency, is owed not only to other shareholders, but to all creditors.[8]

In declining to follow Franchise Services, Judge Walrath began by focusing on the debtor’s clearly deteriorated financial condition, stating that “[t]here is no contest that the debtor needs a bankruptcy,” having closed its plants and furloughed workers, and having effectively no liquidity.[9] She went on to find that the bankruptcy case would “benefit most stakeholders” because the debtor’s lenders had agreed to a proposal that would pay all creditors in full if the plan were confirmed.[10] The court determined that under such circumstances, Macquarie’s blocking rights did create a fiduciary duty, and that allowing a shareholder like Macquarie to block a bankruptcy filing to advance its own interests offends federal public policy and interferes with a company’s constitutional right to seek bankruptcy relief. The court saw “no reason to conclude that a minority shareholder has any more right to block a bankruptcy—the constitutional right to file a bankruptcy by a corporation than a creditor does,” and therefore broke from the Franchise Services decision.^[11]

In conclusion, Judge Walrath stated, “whether or not the person or entity blocking access to the Bankruptcy Courts is a creditor or a shareholder, federal public policy does require that the Court consider what is in the best interest of all, and . . . whether the party seeking to block [the filing] has a fiduciary duty that it appears it is not fulfilling[.]”^[12] Importantly, Macquarie had conceded that it was “not considering the rights of others in its decision to file the motion to dismiss.”[13] Thus, Judge Walrath’s decision should put minority shareholders seeking to block a chapter 11 case—at least one filed in Delaware—on notice that such efforts will likely be met with strong resistance, and could even give rise to liability for breach of fiduciary duties if the efforts to prevent a debtor’s filing result in harm to other stakeholders. In addition, minority shareholders seeking to negotiate such blocking rights in connection with an investment should understand that going forward, such provisions in an entity’s corporate governance documents may be of little value. Thus, if the blocking rights are so essential to the deal terms, an investor might be well-advised to walk away.

[1] Brett S. Theisen is the director and vice-chair of the Financial Restructuring and Creditors’ Rights department at Gibbons P.C.

[2] See, e.g., In re Lexington Hosp. Grp., LLC, 2017 WL 4118117 (Bankr. E.D. Ky. Sept. 15, 2017); In re Intervention Energy Holdings, LLC, 553 B.R. 258 (Bankr. D. Del. 2016); In re Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

[3] See Docket No. 173. At present, the court’s docket does not indicate that a written decision will be forthcoming.

[4] See In re Franchise Servs. of N. Am., Inc., 891 F.3d 198, 206–08 (5th Cir. 2018), as revised (June 14, 2018).

[5] Tr. of Hr’g, dated May 5, 2020 (Case No. 20-10927(MFW) (Bankr. D. Del.), at 38:10-13.

[6] See infra, note 1.

[7] 891 F.3d at 213. 

[8] Tr. of Hr’g, dated May 5, 2020 at 40:22–41:3.

[9] Id. at 38:17-25.

[10] Id. at 39:1-4.

[11] Id. at 40:14-17.

[12] Id. at 41:24–42:4.

[13] Id. at 42:5-7.

In the beginning of the treatise On War, Carl Von Clausewitz explained war as follows:

I shall not begin by expounding a pedantic literary definition of war, but go straight to the heart of the matter, to the duel. War is nothing but a duel on a larger scale. Countless duels go to make up war, but a picture of it as a whole can be formed by imagining a pair of wrestlers. Each tries through physical force to compel the other to do his will; his immediate aim is to throw his opponent in order to make him incapable of further resistance.[1]

Insurance policies often contain so-called war exclusions. These provisions, which can differ significantly in how they are worded, purport to limit coverage for losses arising out of war or warlike actions.[2]

The issue came into recent prominence in 2018 as a result of litigation initiated by Mondelez International, Inc. against Zurich American Insurance Company. Mondelez suffered losses as a result of the malware known as “NotPetya.” According to a Wired article, “[NotPetya’s] goal was purely destructive. It irreversibly encrypted computers’ master boot records, the deep-seated part of a machine that tells it where to find its own operating system. Any ransom payment that victims tried to make was futile. No key even existed to reorder the scrambled noise of their computer’s contents.”[3] Per Mondelez’s complaint, Zurich denied Mondelez’s claim for insurance coverage based on a war exclusion which purported to exclude coverage for a “hostile or warlike action. . . .”

Although much has been written on the subject of the “war” exclusion, this article seeks to take a deeper dive into cyber threats.

Cyber Threats and the War of Words

States, nonstate actors, and criminal groups regularly engage in malicious cyber activities that eschew easy classification[4] in that subtle differences are often all that separates cyber crime, espionage, terrorism, and “hacktivism.”[5] Cyber crime, in its most simple distillation, is characterized as a crime that involves the use of computer-based means to commit an illegal act.[6] Cyber criminals develop and use various tools that delve deeply and covertly into public, commercial, and private networks[7] and are motivated, for the most part, by financial gain. According to Interpol:

[c]ybercrime is one of the fastest growing areas of crime. More and more criminals are exploiting the speed, convenience and anonymity that modern technologies offer in order to commit a diverse range of criminal activities. These include attacks against computer data and systems, identity theft, the distribution of child sexual abuse images, internet auction fraud, the penetration of online financial services, as well as the deployment of viruses, Botnets, and various email scams such as phishing.[8]

In contrast, the sine quo non of cyber espionage is gathering intelligence—governmental, corporate, or individual[9]—and often involves stealing trade secrets, intellectual property, and confidential government information. Despite the military nexus, and the “real and serious threat” to the state, cyber espionage typically will not trigger “application of international law on the use of force” but rather require a domestic or international criminal law response.[10]

Cyber terrorism and “hacktivism” are also commonly used in describing hostile cyber practices. Cyber terrorism has been defined as “the intimidation of civilian enterprise through the use of high technology to bring about political, religious, or ideological aims, and actions that result in disabling or deleting critical infrastructure data or information.”[11] In turn, a “hacktivist” is a “private citizen who on his or her own initiative engages in hacking for, inter alia, ideological, political, religious, or patriotic reasons.”[12] Both of these activities can obviously cause significant damage to a state.[13]

Though certain cyber activities occur “below the level of a ‘use of force’ as this term is understood in the jus ad bellum,”[14] a “lack of agreed upon definitions, criteria, and thresholds for application” coupled with “the rapidly changing realities of cyber operations” continue to raise questions concerning law enforcement versus military responses.[15] Determining the appropriate response may be possible only by discerning the goals and motives underlying the activity,[16] which is usually very difficult in that transparency and attribution are often nonexistent in cyberspace.

Cyber warfare, by contrast, generally “trigger[s] the international law governing the resort to force by States as an instrument of their national policy,” the Law of Armed Conflict,[17] and the associated risks of traditional hostilities.[18]

 Universal Cable Productions

A September 2019 decision regarding the war exclusion, albeit not in the cyber context, addressed some of these issues.[19] In that case, the U.S. Court of Appeals for the Ninth Circuit reviewed a lower court decision regarding an insurance claim by two production companies who were forced to relocate the production of a television program from Jerusalem due to Hamas rocket attacks.[20] The insurance company denied coverage on the grounds that the covered expenses were barred by virtue of exclusions for “war” and “warlike action by a military force.”[21] The Ninth Circuit rejected these arguments and held that “war” in the insurance context is limited to hostilities between sovereigns, and that although Hamas has control over Gaza, “Gaza is part of Palestine and not its own sovereign state” and that Hamas “never exercised actual control over all of Gaza.”[22]

Resolving Cyber Insurance Disputes

As cyber threats increase in the face of COVID-19 distractions,[23] it is likely that there will be related insurance claims and disputes regarding such claims. Policyholders, brokers, CFOs, and risk-management professionals should pay close attention to the wording of “war” exclusions to assess whether insurers may seek to invoke those provision in the event of a claim.

Should a dispute arise, stakeholders may want to consider utilizing alternative dispute resolution methods. As discussed in a prior article by the authors, there may be unique advantages to doing so in the context of a cyber insurance dispute, including, among other things, confidentiality and the ability to select a neutral who is versed in the key technical issues.[24] Doing so will allow the parties to go straight to the heart of the matter and perhaps, to the chagrin of Clausewitz, avoid the duel.

[1] Carl Von Clausewitz, On War 75 (Michael Howard & Peter Paret, eds., 1989 ed.).

[2] IRMI, “War Exclusion.”

[3] See Andy Greenberg, The Untold Story of NotPetya, the Most Devasting Cyberattack in History, Wired, Aug. 22, 2010.

[4] See Scott J. Shackelford, In Search of Cyber Peace: A Response to the Cybersecurity Act of 2012, 64 Stan. L. Rev. Online 106 (Mar. 8, 2012).

[5] See Tom Bradley, When Is a Cybercrime an Act of Cyberwar?, PC World, Feb. 20, 2012; see also Brad Lunn, Strengthened director duties of care for cybersecurity oversight: Evolving expectations of existing legal doctrine, 4 J. L. & Cyber Warfare 1, 109–137 (2014).

[6] Oona A. Hathaway, Rebecca Crootof, et al., The Law of Cyber-Attack, 100 Cal. L. Rev. 817, 834 (2012); Gary Solis, Cyber Warfare 1 (unpublished manuscript) (on file with authors).

[7] See Chris C. Demchak, Wars of disruption and Resilience: Cyber Conflict, Power, and National Security 8 (2011).

[8] Interpol (last visited April 23, 2015).

[9] Tallinn Manual on the International Law Applicable to Cyber Warfare 193 (Michael Schmitt ed., 2013) [hereinafter Tallinn Manual] (defining cyber espionage narrowly as “any act undertaken clandestinely or under false pretences [sic] that uses cyber capabilities to gather information.”). The Tallinn Manual was developed “to help governments deal with the international legal implications of cyber operations.” See, e.g., Manual Examines How International Law Applies to Cyberspace, IT World (Sept. 3, 2012) (noting that The Cooperative Cyber Defense Center of Excellence, which “assists NATO with technical and legal issues associated with cyber warfare related issues,” created the Tallinn Manual to address a variety of cyber legal issues). The Tallinn Manual examines the “international law governing cyber warfare” and encompasses both jus ad bellum and the jus in bello. Tallinn Manual, supra, at 4.

[10] Tallinn Manual, supra note 9, at 4.

[11] William L. Tafoya, Cyber Terror, FBI Law Enforcement Bulletin (Nov. 2011).

[12] Tallinn Manual, supra note 9, at 259.

[13] See, e.g., Nicole Perlroth, Anonymous Attacks Israeli Web Sites, N.Y. Times, Nov. 15, 2012; Michael Rundle, ‘Anonymous’ Hackers Declare Cyber War On North Korea, Claim Internal Mail System Hacked, Huff. Post UK, Apr. 4, 2013.

[14] Id.

[15] Id. at 42.

[16] See Bradley, supra note 5.

[17] Tallinn Manual, supra note 9, at 4.

[18] See Philippa Trevorrow, Steve Wright, et al., Cyberwar, Netwar and the Revolution in Military Affairs 1, 3 (2006) (discussing how modern societies are, for the most part, highly dependent on the continuous flow of information); Michael McMaul, Hardening Our Defenses Against Cyberwarfare, Wall St. J., Mar. 6, 2013, at A19 (“Digital networks could be used as a conduit to gas lines, power grids and transportation systems to silently deliver a devastating cyberattack to the U.S.”).

[19] Peter Halprin & Nicolas Pappas, Cyber Insurance for Critical Infrastructure and Debate About War, IIoT World Cybersecurity Blog (Nov. 5, 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).

[20] Universal Cable Productions, Inc., v. Atlantic Specialty Ins. Co., 929 F.3d 1143 (9th Cir. 2019).

[21] Id. at 1147.

[22] Id. at 1148.

[23] See, e.g., Peter A. Halprin & Jacquelyn Mohr, COVID-19 Cybersecurity and Insurance Coverage, N.Y.L.J. (Apr. 20, 2020).

[24] See, e.g., Peter A. Halprin & Daniel Garrie, Arbitrating Cyber Coverage Disputes, 29 Coverage Magazine 1 (Winter 2019); see also Michael Gervais, Cyber attacks and the laws of war, J. L. & Cyber Warfare 1.1, 8-98 (2012).