(CN) - A group of investors in Analytical Surveys Inc. cannot claim a debt exemption to liability for its short-swing sales of stock in the company and will have to disgorge nearly $5 million in profits, the 2nd Circuit ruled.
On November 10, 2004 Tonga Partners LLC converted outstanding principal of $1.7 million on a promissory note issued by ASI into company stock. Under the terms of the note Tonga received over 1.7 million shares which it promptly sold by November 15 for prices ranging from $3.53 and $6.62 a share.
ASI cried foul and filed suit against Tonga for disgorgement of its profits on the sale under section 16(b) of Securities Exchange Act which prohibits shareholders owning more than 10 percent of a company from profiting on the purchase-and-sale, or sale-and-purchase of its shares in a six month period.
Tonga argued before Judge Kimba Wood of the U.S. District Court for the Southern District of New York that its acquisition of shares didn't count as a purchase and that the profits were protected from disgorgement under section 16(b)'s exemption for debt because its shares were acquired from the conversion of a promissory note.
Judge Wood rejected both arguments, finding, in part, that because Tonga did not wait till the note matured before converting the balance to stock, it couldn't be considered satisfaction of a debt.
On appeal, Tonga argued that Judge Wood was wrong because the note that it acquired, and then converted to shares in 2004, was in satisfaction of a debt ASI owed after it defaulted on the 2003 note and the default accelerated the maturity date of 2003 note.
Writing for the three-judge panel, Circuit Judge Debra Ann Livingston said that under 9th Circuit precedent set in Rheem Mfg Co. v. Rheem and Heli-Coil v. Webster, "for a transaction to qualify for the debt exception the debt must constitute 'an obligation to pay a fixed sum certainly and at all events' and be a 'mature debt which existed apart form any existing obligation to transfer the securities.'"
While accepting that under the terms of the 2003 note Tonga could have accelerated its maturity date, Judge Livingston noted that Tonga chose instead to accept a new note whose maturation date, like the 2003 issue it replaced, was 2005. Thus when it was converted in 2004 it wasn't in satisfaction of a mature debt under the Heli-Coil precedent.
Tonga argued that such a conclusion "exalts form over substance," but, quoting from the terms of the 2003 note, Livingston said that it "expressly distinguishes between certain categories of default, which render 'the outstanding principal balance and accrued interest ... automatically due and payable,' from other categories-including the type of default that occurred here-in the event of which the Note's principal and accrued interest 'shall be accelerated and so due and payable' only at the option of the holder."
Livingston said the appeals court declined to depart from the clear meaning of the 2003 note. "In the absence of a demand by Tonga for acceleration or prepayment following the May 2004 default, the obligation of the 2003 Note had not matured at the time that ASI issued the 2004 Note, and the acquisition of the 2004 Note was therefore not made 'in connection with a debt previously contracted' for the purpose of section 16(b)," she wrote.
Tonga also claimed that it was exempted for disgorgement by the so-called "borderline transaction" exemption which the Supreme Court recognized in Kern County v. Occidental Petroleum Corp. where the transaction does not result in the "evil," i.e. insider trading, that section 16(b) seeks to prevent. Even if it did have access to inside information, Tonga said, the board of ASI had the same access so there was no asymmetry it could exploit for advantage.
Livingston countered that the 2nd Circuit had specifically rejected this defense in Huppe v. WPCS Int'l Inc., holding "that both an involuntary transaction and lack of access to inside information are prerequisites to the Kern County analysis, and added, 'we have been clear that Section 16(b) should be applied without further inquiry if there is 'at least the possibility' of speculative abuse of inside information.'" [Internal quotation from Blau v. Lamb]
In addition, Tonga argued that at its roots, the conversion of debt to equity wasn't a "purchase" of the equity for the purposes of section 16(b) because it made the conversion at a fixed price removing the possibility that it could use inside knowledge to game the transaction and redeem the stocks when their value was high.
Livingston said it didn't matter if Tonga had accepted less of a profit from its sale by converting at a fixed rate; the purpose of the section was to eliminate any possibility of profit from inside information and thus "the acquisition of a hybrid instrument that allows for the purchase of shares constitutes a section 16(b) purchase of the minimum number of shares that could be acquired if exercise were at the fixed price."