TheCorporateCounsel.net

Here’s a recent update on litigation surrounding contractual blockers (common tool in offerings of preferred stock and warrants to cap an investor’s beneficial ownership at 4.9% or 9.9%, which can effectively prevent the investor from becoming subject to Section 13(d) or Section 16 if they’re both binding and not illusory) from Alan Dye’s Section16.net Blog:

Resolving an issue of first impression in the Second Circuit, a panel has affirmed the SDNY’s holding that blocker provisions in the defendant’s derivative securities were valid and binding and not illusory, such that the defendants did not beneficially own shares in excess of the cap and therefore were not subject to Section 16(b) as ten percent owners. As discussed in my blog about the district court’s dismissal of the complaint, the plaintiff is the post-bankruptcy successor to Bed Bath & Beyond (BB&B), which sought to recover $310 million of short-swing profits from an investment manager and its client fund based on their conversions of derivative securities and immediate sale of the securities acquired, often executing multiple conversions/sales in a single day, each time acquiring up to 9.9%, selling, and then converting again.

The district court held that a valid blocker must be both contractually binding and not illusory and that the blockers in BB&B’s derivatives met both tests. On appeal, BB&B argued that the blockers were illusory and also constituted a “scheme to evade” the Section 13(d)/(g) reporting requirements within the meaning of Rule 13d-3(b).

Illusoriness. In determining that the blockers were not illusory, the Second Circuit applied the three factors suggested by the Second Circuit’s 2001 decision in Levy v. Southbrook (which are not the same factors suggested by the SEC in an amicus brief filed in Levy that the district court judge had applied, but which the court here did not consider binding):

1. Whether the holder may waive the blocker in its sole discretion. The blockers did not allow the defendants to waive them unilaterally, but BB&B argued that the parties could have mutually agreed to waive or amend the blockers, and that BB&B would have happily agreed to a waiver to allow for additional cash infusions. The Second Circuit rejected the argument (which the SDNY said was “nonsensical”), saying that deeming a contractual provision to be illusory because the parties could waive or amend it “would render virtually every clause of every contract a sham.”
2. Whether the blocker lacks a means of ensuring compliance. BB&B argued that it had no means of enforcing the blockers because it had no means of ascertaining the defendants’ total ownership. The court held that the defendants’ obligation to certify, in each notice of conversion, that conversion would not cause them to own more than 10% of the outstanding common was sufficient under Levy to ensure compliance. Here, in addition, the blockers provided that any shares acquired in excess of the cap would automatically be deemed null and void, which prevented the defendants from exceeding the cap.
3. Whether as a practical reality the investor has ever exceeded the conversion cap. BB&B argued that multiple serial conversions and sales in a single day resulted in the defendants’ ownership of all shares held in the account pending settlement, which exceeded 10% of the class at the end of some trading days. The court held that shares were no longer beneficially owned at the moment of execution of sale, regardless of the technicalities of passing of title or moving shares out of the account. At the moment of execution, the defendants lost beneficial ownership because (i) they no longer had the power to dispose of the shares, since they’d already been sold, and (ii) they could not vote the shares because the governing documents rendered void any shares exceeding the cap.

BB&B argued that the district court’s holding promoted form over substance and gave “a free pass to essentially any competently drafted blocker.” In rejecting that argument, the Second Circuit said that “a comprehensive and legally binding blocker generally should insulate a defendant from Section 16(b) liability” and “it is only when the parties have ignored the terms of their contract and allowed the investor to exceed the conversion cap that we will look beyond the otherwise binding language of the blocker.”

Scheme to Evade. BB&B also argued that the blockers were invalid because they constituted a scheme to evade the reporting requirements of Section 13(d)/(g) (and, indirectly, Section 16). The Second Circuit forcefully rejected that argument, citing Judge Winter’s concurring opinion in the CSX case to say that BB&B confused arrangements “that conceal a defendant’s effective ownership with contractual provisions that prevent an investor from owning a security in the first place.” Judge Winter was expressing disagreement with the district court’s holding that cash-settled total return swaps represent a scheme to evade and said there that Rule 13d-3(b) applies only when “the transaction … [involves a] substantial equivalence of the rights of ownership relevant to control, or include[s] steps that stop short of, or conceal, the vesting of ownership, while nevertheless ensuring that such ownership will vest at the signal of the would-be owner.” The court seemed clearly to endorse Judge Winter’s articulation of what constitutes a scheme to evade for purposes of Rule 13d-3(b), which is consistent with the longstanding view of the SEC staff, as coincidentally restated in new CFIs published only last week.

– Liz Dunshee