Last week, in Gibbons v. Malone, the Second Circuit affirmed the lower court's dismissal of a shareholder suit brought under Section 16(b) of the Securities and Exchange Act of 1934 against a former director of Discovery Communications, Inc. Also known as the short swing profit rule, Section 16(b) provides for the disgorgement of any profits earned from the purchase and sale, or sale and purchase, by a corporate insider, of any equity security within a six-month period. In Gibbons, the corporate insider sold Series C common stock, which had no voting rights, and purchased Series A common stock which had voting rights, within a six-month period. The three-judge panel held that absent SEC guidance, the purchase and sale of different types of stock in the same company, where those securities are separately traded, nonconvertible, and come with different voting rights cannot be matched, and therefore do not trigger the short swing profit rule.
The Court took pains to explain that nominally distinct equity securities that are not meaningfully distinguishable, despite a designation as separate classes or series may be considered of the same type of security and thus subject to potential matching under Section 16(b) enforcement. However, the Court emphasized that in this case, the difference in voting rights between Discovery Series A and Series C common stock was a substantive distinction sufficient to merit distinguishing the two securities.
The Second Circuit's decision provides welcome clarity to a previously murky area involving the enforcement of Section 16(b) violations and seems unlikely to prompt action on the part of the SEC staff. Indeed, the Second Circuit's reasoning is in line with the SEC staff interpretive position that classes of stock that differ in terms of voting and dividend rights should be considered separate types of stock for purposes of determining whether an individual owns more than 10% of a registered class, and thus subject to Section 16. The decision may further incentivize young companies progressing through separate rounds of financing to create such multi-class equity structures for a variety of reasons, including but not limited to somewhat more favorable treatment under Section 16.