In Rubenstein v. Int’l Value Advisers, LLC, No. 19-560-CV, 2020 WL 2549507 (2d Cir. May 20, 2020), the United States Court of Appeals for the Second Circuit affirmed a district court’s decision holding that an investor was not a member of a “group” of corporate insiders for purposes of short-swing profit liability under Section 16(b) of the Securities Exchange Act of 1934 (the “1934 Act”), 15 U.S.C. § 78p(b).  In affirming, the Second Circuit determined that the investor’s investment management agreement delegating discretionary authority to an advisor was not an agreement with the “issuer,” and that an investment advisor’s client does not become an insider group member simply because the advisor files a Schedule 13D.  The decision provides helpful guidance regarding the extremely narrow limits of Section 16(b) liability, and shields passive investors who merely delegate management authority over their portfolios to investment advisors.

A stockholder of DeVry Education Group filed suit against International Value Advisers, LLC (“IVA”), two of its portfolio managers (collectively, the “IVA defendants”) and an unnamed investor “John Doe” alleging violations under Section 16(b).  Section 16(b) requires insiders and certain large stockholders to disgorge to the issuer any profits earned from “short-swing” trading.  Section 16(b) defines short-swing trading as “any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . irrespective of any intention on the part of [the insider].”  15 U.S.C. § 78p(b).

The plaintiff alleged that the defendants were insiders subject to Section 16(b) liability because they collectively held 19.5% of DeVry stock.  He alleged that “John Doe” was a member of a “group” with the IVA defendants under Section 13(d) of the 1934 Act, which provides that “[w]hen two or more persons act as a . . . group for the purpose of acquiring, holding, or disposing of securities of an issuer,” the group shall be subject to Section 16(b).  15 U.S.C. § 78m(d)(3).  In his suit, the plaintiff only sought to recover short-swing profits from “John Doe,” who realized profits in the account managed for him by IVA, and contended that his investment management agreement with IVA qualified as an agreement to trade in the securities of an issuer under Section 13(d).

The United States District Court for the Southern District of New York granted the defendants’ motion to dismiss the complaint.  It concluded that the plaintiff failed to allege a “common objective” among the defendants and that the shares which had been purchased for “John Doe’s” account on a discretionary basis by his investment manager did not qualify as a Section 13(d) agreement.  The district court also held that the plaintiff failed to allege that the defendants acted together for the purpose of acquiring not just any security but the securities of a particular “issuer” within the meaning of Section 13(d).  Plaintiff appealed.

On appeal, the Second Circuit’s decision turned on whether “John Doe” was a member of a “group” with the IVA defendants.  The Court analyzed the text and structure of Section 16(b) to conclude that “John Doe’s” portfolio management agreement with the investment advisor was not an agreement with “the issuer” as explicitly required by Section 13(d).  In other words, an agreement “must be issuer-specific before it can give rise to group liability” under Section 16(b). The Court’s opinion also made clear that an investor does not 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.”  The panel reasoned that the plaintiff’s position was incompatible with the legislative purpose of Section 16(b), which is designed to prevent groups from evading liability by pooling their shares of an issuer, so that no one individual owns more than 10% of the shares.  The plaintiff made no allegation that “John Doe” pooled his shares with the IVA defendants.

The Court also rejected several of the plaintiff’s public policy arguments, holding that they were “based either on a misunderstanding of certain regulatory exemptions or on erroneous legal positions.”  Specifically, the Court cautioned against exceeding the “narrowly drawn limits” of Section 16(b), and noted that broader anti-fraud provisions of the 1934 Act exist to address Rubenstein’s concerns regarding illicit insider trading.  The Court observed that its opinion would not encourage advisors to avoid Section 13D disclosure requirements because the IVA defendants had to disclose their insider status with respect to DeVry regardless of whether they formed a “group” with their clients.

The Court similarly rejected the plaintiff’s arguments that “John Doe” “silently [acquiesced]” and that he formed an “implied agreement” with the IVA defendants finding that it would be impractical to expect investors to be conscious of the securities held by their advisors’ other clients, or to control their advisors’ compliance procedures.  The Court specifically declined to go down a path that “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.”  Finally, the Court held that an investment advisor’s act of deputizing a particular issuer’s director did not automatically convert his investors into statutory insiders.

The Second Circuit’s decision confirms that stockholders cannot plead Section 16(b) claims against individual investors by alleging that they constitute a “group” connected to each other only by way of investing through the same investment advisor.  Given that Section 16(b) imposes strict liability (i.e., without any requirement to provide a defendant’s knowledge, intent or fault), the decision’s refusal to expand the reach of Section 16(b) beyond the explicit language and purpose of the statute will likely serve as a significant defense against Section 16(b) claims.