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Securities Law Commentary
Roth v. Jennings Seeks to Address Issue of What Constitutes a Group in Applying Section 16(b) of the Exchange Act
Roth v. Jennings
Posted: 10/19/2007
By: Joel B. Ginsberg, Esq.
Companies Mentioned: European Metal Recycling, Ltd., Metal Management, Inc.
Introduction
In Roth v. Jennings, 489 F.3d 499 (2nd Cir. 2007), the Second Circuit Court revisited the issue of pleading a “group” 1 for purposes of Section 13(d) of the Securities Exchange Act of 1934. The court reversed a district court’s dismissal of a plaintiff’s Section 16(b) claim seeking disgorgement of short-swing profits. The appellate court said that the district court had improperly given too much weight to the defendants’ disclaimers of their “group” status in SEC filings and had misconstrued the final sentence of Section 16(b), which states that the section does not apply if the short-swing trader is not a “beneficial owner” at both ends of the purchase-sale transaction.
Detailed Commentary
BACKGROUND
Plaintiff Andrew Roth brought this shareholder’s derivative suit on behalf of defendant corporation Metal Management Inc. (“MMI”) against T. Benjamin Jennings and European Metal Recycling (“EMR”), alleging violation of Section 16(b) of the Securities Exchange Act of 1934 (the “Act”). Jennings was the former chairman and CEO of MMI. MMI, a publicly-traded company based in Delaware, is the self-proclaimed largest national full-service scrap metal recycler.
In mid-May 2003, EMR, a United Kingdom scrap metal recycling company, purchased 14.8% of the outstanding stock of MMI. EMR contemporaneously filed a Schedule 13D expressing its intent to make agreements and purchases that would enable it to take over control of MMI.
At the end of May 2003, Jennings purchased 8.3% of MMI stock for $9.5 million, which he paid for with a $10 million unsecured loan he obtained from EMR with a low 4% annual interest rate. At the time he purchased the shares, Jennings filed a Schedule 13D disclaiming any agreement or understanding with EMR as to how Jennings would spend the loan money. EMR also filed its own Schedule 13D, disclaiming any agreement or understanding with Jennings, disclaiming any right to the MMI stock bought by Jennings, and specifically disclaiming that EMR and Jennings were acting as a “group.”
In August 2003, EMR sent a letter to Jennings, offering to buy his shares at a below-market price. Jennings declined and instead—within six months of his purchase of the MMI stock—he sold a significant portion of his shares for $4 per share more than EMR’s offer. Jennings’ sales resulted in a profit to him of about $4.25 million.
Roth, on behalf of MMI, filed suit, claiming that Jennings and EMR were functioning as a group for purposes of Section 16 of the Act, and because the Jennings/ EMR group was a beneficial owner of MMI at all relevant times, Jennings had to disgorge the profits from his stock sales. The district court dismissed the complaint as to both Jennings and EMR, and Roth filed this appeal.
Relevant Provisions of the Act and SEC Rules
Section 16(b) of the Act, addressing short swing trading, provides as follows:
(b) Profits from purchase and sale of security within six months. 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)… within any period of less than six months, … shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in entering into such transaction of holding the security … purchased or of not repurchasing the security…sold for a period exceeding six months… 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…
15 USC §78p(b).
A “beneficial owner” is defined in Section 16 of the Act as any “person who is directly or indirectly the beneficial owner of more than 10% of any class of any equity security (other than an exempted security).” 15 USC §78p(a)(1).
Roth’s argument turns on whether or not Jennings and EMR could be considered a “group” under the Act. If they were not a group, Section 16(b) would not apply because Jennings alone was not a 10% owner, director or officer at the time of his purchase and sale. The SEC Rules offer the following definition of a group:
“[W]hen two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, the group formed thereby shall be deemed to have acquired beneficial ownership, for purposes of sections 13(d) and (g) of the Act, as of the date of such agreement, of all equity securities of that issuer beneficially owned by any such persons.”
17 CFR §240.13d-5(b)(1).
Case law precedent regarding the definition of “group” activity
Courts have stated that “the touchstone of a group within the meaning of Section 13(d) is that the members combined in furtherance of a common objective.” Wellman v. Dickinson, 682 F.2d 355, 363 (2nd Cir. 1982). The question of whether a group exists under the Act is a question of fact. Morales v. Quintel Entertainment Inc., 249 F.3d 115, 124 (2nd Cir. 2001).
Although almost anything can be relevant to determination of whether a group exists, there are virtually no factors that per se establish the existence of a group, other than a written agreement to act as a group. Courts have found that the following factors may be suggestive of group activity under Section 13(d)2 :
• Communications between alleged group members regarding the company
• A pattern of parallel actions by alleged group members over a relatively short and virtually concurrent period of time
• One alleged group member’s shares being held in another member’s name
• Alleged group members providing funds and/or advice to other members
• An alleged group member sending copies of his communications with the company to other alleged group members
• Statements by alleged group members that they have the ability to influence management
On the other hand, the courts have found that the following factors do not automatically suggest group activity: family relationships among investors3 ; prior business relationships between group members; each alleged group member hiring separate independent counsel to represent their interest4 ; sporadic communications evidencing little more than support .5
The District Court dismissed Jennings and EMR
The district court dismissed Jennings and EMR on their 12(b)(6) motion,6 finding that Jennings’ and EMR’s disclaimers of their group status were controlling.7 The district court determined that it was appropriate to look at SEC filings when considering a 12(b)(6) motion on a complaint alleging securities fraud. 2006 WL 278135, at 3. The district court then took the defendants’ disclaimers of group status in the Schedule 13Ds as true, referring to Roth’s allegations of group status as “unadorned” and based on “unmitigated speculation” that were insufficient to defeat the disclaimers. 2006 WL 278135, at 5.
Moreover, the district court found that Jennings’ refusal to sell his shares to EMR was independent proof of an absence of a group. The court said that Jennings’ refusal “contradicted precisely what one would have expected of him had he been acting in concert with EMR.” 2006 WL 278135, at 5. Because the Act requires that the coordinated group activity exist both at the time of purchase and at the time of sale of the securities, and at the very least, it did not exist at the time of sale in this case, Jennings and EMR could not be considered a group. 2006 WL 278135, at 6.
The district court further ruled that the complaint should be dismissed against EMR because it failed to allege that EMR itself had engaged in any short-swing trades or received any profit therefrom. 2006 WL 278135, at 6. The district court granted the Motion to Dismiss. Roth appealed.
SECOND CIRCUIT FINDS SUFFICIENT EVIDENCE OF A GROUP, VACATES DISMISSAL OF JENNINGS
The district court improperly considered the Schedule 13D disclaimers
The appellate court explained that, on consideration of a Rule 12(b)(6) motion, a court can look to pertinent SEC filings if the complaint alleges fraud in those filings. Roth v. Jennings, 489 F.3d 499, 509 (2nd Cir. 2007). Even then, however, the court may only look to the filings to determine whether or not the alleged fraudulent statement is actually in the filing; in a Rule 12(b)(6) motion, the court may not determine whether or not the statement is true. Id.
In this case, the complaint did not allege fraudulent filings. Rather, it alleged a Section 16(b) violation, for which an insider is strictly liable. Accordingly, it was inappropriate for the court to consider the Schedule 13Ds for purposes of the motion to dismiss. Id. at 510.
However, even if the complaint did allege fraud, the district court still overstepped its authority in examining the filings. The district court did not merely look at the filings to ascertain that the allegedly fraudulent representations were present, it made a factual determination that the disclaimers in the Schedule 13Ds were true. The court went beyond the analysis required for a Rule 12(b)(6) motion and impermissibly acted as the final fact-finder on this critical issue. Id.at 511.
The appellate court distinguished the cases relied upon by the district court in making this factual finding of the truth of the disclaimer. The district court had relied on cases stating that when a document contains statements that contradict the allegations in the complaint, the document controls. 2006 WL 278135, at 5. However, the appellate court pointed out that in those cases, merely looking at the document itself, without ascertaining the truth of the statements, was enough to disprove the allegations of the complaint.8 489 F.3d at 510-511. In the instant case, on the other hand, the district court did not merely ascertain whether certain statements were made or omitted in the documents, it determined that those statements were true and based its decision to dismiss on the truth of the statements, and that overreached the court’s authority. Id. at 511.
The appellate court also criticized the district court’s analysis of the Schedule 13D disclaimers, saying that the district court improperly assumed that the disclaimers, which were written in a manner to address Jennings’ future obligations to EMR, automatically applied to and included the defendants’ past understandings. Id. at 511. However, the appellate court noted, the disclaimer did not “actually state that there had not been … an agreement with regard to Jennings’ acquisition of the shares” in the past. Id. Therefore, even if it had been appropriate to consider the SEC disclaimers for their truth, “their representations would not have warranted rulings in their favor, for they did not actually assert that EMR had not agreed to make the loan to Jennings for the purpose of the MMI stock acquisition.” Id.
Defendants cannot disclaim the legal effect of their conduct
The appellate court made it clear that the defendants’ disclaimers were irrelevant if in fact they were acting as a group as defined by the Act. Id. “If in fact EMR and Jennings acted together for the purpose of Jennings’ acquiring MMI shares, EMR and Jennings “thereby,” under [§13(d)(3) and Rule 13d-5(b)(1)] “formed” a “group,” regardless of their attempted disclaimers of the legal effect of such joint action.” Id.
Plaintiff’s allegations were not “unadorned” and “without evidence”
The appellate court disagreed with the district court’s statement that Roth’s “group” assertions constituted little more than “unmitigated speculation.” After listing all of the allegations of the complaint that were suggestive of group action, the court stated: “we note that on this record, no rational factfinder would be compelled to believe that EMR and Jennings had had no agreement with respect to Jennings’ acquisition of his shares… a rational factfinder could… easily infer that EMR and Jennings acted together for the purpose of Jennings’ purchase of shares of MMI.” Id. at 512.
Because the allegations in the complaint, uncontradicted by any controlling documents, the complaint should not have been dismissed as to Jennings.9
The District Court erred in cutting off the duration of the group in a way that evaded application of Section 16(b)
The district court had held that even if Jennings and EMR were a “group” under the Act at the time Jennings purchased his shares, they were no longer a “group” when Jennings sold his shares, as evidenced by Jennings’ refusal to sell his shares to EMR. 2006 WL 278135, at 5-6. Accordingly, said the district court, Section 16(b) cannot apply because of the exemptive provision of that statute, which states:
“[T]his 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.”
15 USC §78p(b). The district court interpreted that provision as requiring that the group was pursuing a common purpose both when they acquired the shares and when they sold them; since it appeared that Jennings and EMR has disparate purposes when Jennings sold his stock, 16(b) could not apply. Id. at 6.
The appellate court held that the district court got it wrong. The appellate court pointed out that the purpose of Section 16(b) was to prevent company insiders from profiting from their inside status. 489 F.3d at 513. The appellate court noted that each member of a beneficial owner group is separately also a beneficial owner: “[I]f any two or more persons act together for the purpose of acquiring, holding, or disposing of shares of an issuer, each actor is deemed to be the beneficial owner of the total number of shares owned by all of them.” 489 F.3d at 513. The “group” exists (thus extending beneficial status to all members of the group) as a matter of law if the group members act in concert for any one of the listed purposes, not necessarily all of those purposes. Id. Section 16(b) does not require coordinated activity by the group members both at the time of purchase and sale, it simply requires that the short-swing trader have insider/ beneficial owner status at the time of both of his transactions. Id. at 514.
In this case, assuming that the allegations in the complaint are true, Jennings and EMR formed a group for the purpose of acquiring the shares. At that point, the group and each of its members were all considered beneficial owners under the Act. Jennings’ subsequent sale was done as a beneficial owner, regardless of whether EMR agreed with it or not – Jennings’ status as an insider, by virtue of the group, was already established. The fact that group members “might not always make identical investment decisions” does “not preclude existence of agreement.” Morales v. Quintel Entertainment Inc., 249 F.3d 115, 127 (2nd Cir. 2001).
This result is in keeping with the statute’s purpose, because it ensures that each member of a beneficial owner group is prevented from profiting from insider knowledge or information he may have gained as a member of the group; it would contravene the purpose if a group were bound by Section 16(b), but its members were not just because they stray from the group’s purpose at some point. 489 F.3d at 514-515.
The appellate court also criticized the district court for impermissibly making findings of fact regarding the duration of the group. The district court determined that if Jennings and EMR were still operating as a group at the time of Jennings’ sale of stock, Jennings would have likely sold to EMR instead of on the open market. Id. at 515. The appellate court pointed out that determining what was “likely” and “expected” under the circumstances go to questions of fact that should not be determined on a Rule 12(b)(6) motion. Id.
Moreover, the appellate court noted the facts that Jennings and EMR seemed to set up a loan for Jennings to buy shares, then disclaimed any group status, then EMR made a highly unattractive and rejectable offer to buy Jennings’ shares for an amount significantly lower than the market price. Id. at 515-516. The court did not blatantly state that it looked like EMR and Jennings were deliberately trying to manufacture evidence that they were not acting as a group, but the insinuation was plain. The appellate court wrote, “we note that the present record would easily permit a rational factfinder draw to factual inferences contrary to those drawn by the court.” Id. at 515. Not only did the district court err in making factual determinations, it made factual determinations that were highly disputable, given the allegations in the complaint.
In all, the appellate court found that the complaint should not have been dismissed against Jennings, because Roth had alleged sufficient facts to state a claim of group status that made Jennings an insider subject to Section 16(d) of the Act.10
The Claim against EMR was properly dismissed
The appellate court agreed with the district court that the complaint should be dismissed against EMR, since the complaint did not allege that EMR had engaged in a short-swing transaction or received any profit from the same. Under the Act, only the short-swing trader is liable for disgorgement of his profits, not other group members who did not receive a profit from the short swing sale. 489 F.3d at 516-517. Although Roth asserted that EMR must have derived some pecuniary benefit from the sale, given the relationship between Jennings and EMR, that speculation was insufficient to state a proper claim against EMR under Section 16(d). Id.
CONCLUSION
The Roth v. Jennings opinion continues the case-by-case approach courts have taken in defining “group” activity under Section 13(d). Plaintiffs can bring in almost anything to support allegations of group status. And as Roth instructs, defendants cannot avoid being labeled as a group by simply disclaiming group status.
Without a bright line rule to follow, parties seeking to avoid group status will need extreme care and the assistance of counsel. While it’s obvious that explicit communications between investors regarding the purchase, sale or voting of stock will be evidence of group activity, investors should exercise caution in the less explicit communications as well. Investors should avoid sharing funds, legal counsel and other resources, keeping everything as separate and independent as possible.
The author, Joel B. Ginsberg, Esq., is an associate in the transactional department of Zuber & Taillieu LLP, focusing on corporate law, and securities and finance law.
1 When one or more shareholders act together, they may be considered a “group” under the SEC rules, which means their actions may be viewed collectively rather than separately.
2See, e.g., Wellman v. Dickinson, 682 F.2d 355, 363 (2nd Cir. 1982); Hallwood Realty Partners v. Gotham Partners, 286 F.3d 613, 617-618 (2nd Cir. 2002) Global Intellicom v. Thomson Kernaghan & Co., No. 99 CIV 342, 1999 WL 544708 (SDNY July 27, 1999); Hollywood Casino Corp. v. Simmons, No. 3:02-CV-0325-M, 2002 WL 1610598 (N.D. Tex. July 18, 2002).
3 Torchmark v. Bixby, 708 F. Supp. 1070 (W.D. Mo. W. Div. 1988).
4 Litzler v. CC Investments, 411 F. Supp. 2d 411, 415 (SDNY 2006).
5meVC Draper Fisher Jurvetson Fund I Inc. v. Millennium Partners LP, 260 F. Supp. 2d 616 (SDNY 2003).
6 A Rule 12(b)(6) motion is a motion to dismiss the complaint on the grounds that it does not state a cause of action upon which relief can be granted.
7Roth v. Jennings, No. 03-CV-7760, 2006 WL 278135 (SDNY Feb. 2, 2006)
8For example, in Matusovsky v. Merrill Lynch, 186 F. Supp.2d 397, 400 (SDNY 2002), the plaintiff claimed that he signed a general release without consideration, but the release showed consideration on its face – no factual determination was required – so the court dismissed the case. In Rapoport v. Asia Electronics Holding Co., 88 F. Supp. 2d 179, 184 (SDNY 2000), the prospectus in question on its face showed the disclosure of facts that the complaint alleged were omitted – again, no factual analysis was necessary – so the court dismissed the case. The documents may be considered only to show that they contain something, not for the truth of what they contain.
9 See below for discussion of the dismissal of EMR.
10On March 24, 2008, following the remand from the Second Circuit, the district court entered a default judgment against Jennings due to his failure to appear before the court or respond to Plaintiff’s communications. Roth v. Jennings, No. 03 CV 7760, 2008 WL 782725 (SDNY, March 24, 2008).
Securities Law Summary
Read the related Securities Law summary: Second Circuit Affirms in Part and Vacates in Part District Court's Ruling in Roth v. Jennings
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