Corporate Insiders
Shareholders’ Complaint
Disgorgement of Profits
Section 16(b) of the Securities Exchange Act of 1934. Section 16(b) requires corporate insiders like CEO Pourhassan to disgorge to the corporation all profits the insiders make from buying and then selling (or selling and then buying) company securities within any six-month period (a so-called “short-swing” transaction)
The acquisition of a securities option is deemed to be equivalent to the acquisition of the security underlying that option
CytoDyn, Inc. is a publicly traded corporation incorporated in the state of Delaware. Appellee Nader Pourhassan is (and was, at all relevant times) CytoDyn’s Chief Executive Officer (CEO) and a member of its board of directors. In late 2019, CytoDyn granted Pourhassan options and warrants entitling him to purchase several million CytoDyn shares at certain, specified prices. In mid-2020, about five months after that option and warrant award, Pourhassan exercised those options and warrants and then sold the resulting CytoDyn stock at a profit. Appellants here—several shareholders of CytoDyn (the “Shareholders”)—sued Pourhassan, alleging that he violated Section 16(b) of the Securities Exchange Act of 1934. Section 16(b) requires corporate insiders like CEO Pourhassan to disgorge to the corporation all profits the insiders make from buying and then selling (or selling and then buying) company securities within any six-month period (a so-called “short-swing” transaction).
The district court dismissed the Shareholders’ complaint, finding that Pourhassan need not disgorge his short-swing profits to CytoDyn because his short-swing transaction fell within an exemption to the federal rule because the option and warrant award was “approved” by CytoDyn’s board of directors. We affirm.
Section 16(b) of the Securities Exchange Act of 1934 is meant to prevent corporate insiders (i.e., corporate executives, officers, and directors) from “exploiting information not generally available to others to secure quick profits.” Kern Cnty. Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 592 (1973). In Congress’s view, short-swing transactions by corporate insiders pose an “intolerably great” risk of this type of exploitation. Dreiling v. Am. Express Co., 458 F.3d 942, 947 (9th Cir. 2006) (quoting Kern, 411 U.S. at 592). So, to prevent potential abuse by corporate insiders, Section 16(b) requires such insiders to return to the corporation any profits they realize from short-swing transactions. See 15 U.S.C. § 78p(b). Section 16(b) “imposes strict liability regardless of motive,” requiring all corporate insiders to disgorge their profits from all short- swing transactions, even those transactions “not actually based on inside information.” Dreiling, 458 F.3d at 947.
Recognizing Section 16(b)’s broad reach, Congress authorized the Securities and Exchange Commission to issue rules exempting from Section 16(b) certain transactions that the SEC deemed unlikely to involve inside information. See 15 U.S.C. § 78p(b). Under that rulemaking authority, the SEC issued rules creating several exemptions from Section 16(b). As relevant here, SEC Rule 16b-3(d) exempts from Section 16(b) any “transaction . . . involving an acquisition from the issuer” (i.e., an acquisition from the insider’s corporation itself) so long as the transaction was either: 1) “approved by the board of directors of the issuer” (here, the issuer is CytoDyn); 2) approved by “a committee of the board of directors that is composed solely of two or more Non-Employee Directors”; or 3) approved by a shareholder vote. 17 C.F.R. § 240. 16b-3(d)(1), (2). In the SEC’s view, an insider’s acquisition of securities from the issuer does not “present the same opportunities for insider profit on the basis of non-public information as do” other types of transactions. Dreiling, 458 F.3d at 948 (quoting Ownership Reports and Trading by Officers, Directors and Principal Security Holders, 61 Fed. Reg. 30,376, 30, 377 (June 14, 1996)). “Where the issuer, rather than trading markets, is on the other side of an officer or director’s transaction in the issuer’s equity securities, any profit obtained is not at the expense of uninformed shareholders and other market participants of the type contemplated by [Section 16(b)].” Id. (quoting Ownership Reports and Trading, 61 Fed. Reg. at 30,377).
1 The parties do not contest that the board of directors need only approve the insider’s acquisition of securities from the issuer and need not also approve the insider’s subsequent sale of those securities. So we assume without deciding that the parties are correct. See also Gryl ex rel. Shire Pharms. Grp. PLC v. Shire Pharms. Grp., 298 F.3d 136, 140–46 (2d Cir. 2002) (affirming a lower court ruling that the 16b-3(d)(1) exemption applied because the board approved a compensation plan that “precisely delimited the securities grants that the individual defendants would ultimately receive” without inquiring whether the plan also specified how the defendants were to sell the securities).
3 The parties do not contest that Pourhassan’s acquisition of the options and warrants was a “purchase” of securities under Section 16(b), so we assume without deciding that the parties are correct on this matter. See also Gryl, 298 F.3d at 141 (“For purposes of the rules promulgated under Section 16(b) the acquisition of a securities option is deemed to be equivalent to the acquisition of the security underlying that option.”).
(…) The operative text from the rule is “approved by the board of directors”; the two component phrases are “approved” and “board of directors.” Neither phrase supports the Shareholders’ proposed unanimity requirement.
(…) 5 The law of Delaware, the state where CytoDyn is incorporated, has an analogous understanding. Boards of directors are groups of “1 or more members, each of whom shall be a natural person,” and “the business and affairs of every corporation incorporated in Delaware shall be managed by or under the direction of” that corporation’s board. 8 Del. Code. § 141(a), (b).
So, if Rule 16b-3(d)(1) sets out no specific procedure for how a board must approve an insider-issuer securities acquisition, where do we find any procedural requirements? The specific context here—corporate boards of directors—provides the answer. In situations like this, the Supreme Court has recognized that the “gaps” in the federal laws “bearing on the allocation of governing power within a corporation” should generally be “filled with state law.” Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 99 (1991). Here, state law fills the gap well. State corporate codes, supplemented by the articles of incorporation and corporate bylaws of individual corporations, typically specify the procedures that a corporate board must follow to “approve” corporate decisions. For instance, the corporate law of Delaware, CytoDyn’s state of incorporation and the home of most American corporations, explains that the “vote of the majority of the directors present at a meeting at which a quorum is present shall be the act of the board of directors.” 8 Del. Code § 141(b). In turn, Delaware defines a quorum as a “majority of the total number of directors.” Id. Note the precise language in the statute: a board decision made by majority of a quorum of a board constitutes an “act of the board of directors,” not an act of just part of the board. Id. So, for Delaware corporations like CytoDyn, a quorum of the board can take action by a majority vote. 6 Here, Delaware law thus fills the gap left by Rule 16b-3(d)(1). Delaware state law controls the specific procedures that CytoDyn’s board must follow to “approve” insider-issuer security transactions under Rule 16b-3(d)(1).
6 Delaware law does permit corporations to specify, through their bylaws or articles of incorporation, different procedures that their boards can use. Corporations may, for instance, require a larger or smaller number of directors than a simple majority for a quorum, or may require an affirmative vote by more than a simple majority of directors for the vote to be an “act of the board of directors.” See 8 Del. Code § 141(b). CytoDyn elected to retain Delaware’s default rules, such that a “majority” of CytoDyn’s board of directors “constitutes a quorum” and “the vote of a majority of the directors present . . . constitutes action by CytoDyn’s Board of Directors.”
(…) Pourhassan thus was not required to disgorge to CytoDyn his profits when he sold stock less than six months after receiving the 2019 option and warrant award. See 15 U.S.C. § 78p(b); 17 C.F.R. § 240.16b-3(d)(1). The Shareholders’ complaint was properly dismissed.
(U.S. Court of Appeals for the Ninth Circuit, April 8, 2022, Alpha Venture Capital Partners LP v. Nader Pourhassan, Docket No. 21-35274, for Publication)
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