In Roth v. The Goldman Sachs Group, Inc., No. 12-2509-cv, 2014 WL 305094 (2d Cir. Jan. 29, 2014), the United States Court of Appeals for the Second Circuit held that the short-swing profits rule imposed by Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78p(b), requiring corporate insiders (including ten-percent stockholders) to disgorge profits earned from certain purchases and sales of their company’s securities that take place within a six month period, does not apply where the purchaser was an insider when it wrote call options, but was no longer an insider by the time that the same options expired less than six months later. This decision, which adopts the views expressed by the Securities and Exchange Commission (“SEC”) in an amicus curiae brief, also clarifies that the expiration of a call option within six months is considered a “purchase” within the meaning of Section 16(b), and that “purchase” is paired with the “sale” which is deemed to occur at the time when the option was originally written.
Plaintiff was a stockholder of Leap Wireless International, Inc. (“Leap”). Plaintiff sued The Goldman Sachs Group, Inc. and Goldman Sachs & Co. (collectively, “Goldman”) derivatively on behalf of Leap for alleged violations of Section 16(b). Plaintiff alleged that Goldman owned more than ten percent of Leap’s equity securities at the time it wrote certain call options with respect to Leap stock (the “Options”). Plaintiffs alleged that the Options were written to expire less than six months later, and acknowledged that at the time that the Options expired Goldman no longer owned ten percent or more of Leap’s shares.
This fact pattern left the Court with two fundamental questions to answer: (1) was the expiration of the Options within six months a “purchase” within the meaning of Section 16(b) to match the “sale” that is deemed under SEC Rule 16b-6(a), 17 C.F.R. § 240.16b-6(a), to have occurred at the time the Options were written; and (2) even if the expiration is deemed a “purchase,” whether the fact that Goldman was no longer a ten-percent stockholder at the time of expiration took Goldman outside the disgorgement requirement of Section 16(b). (It should also be noted that derivatives, such as the Options, are considered “securities” within the meaning of Section 16(b).)
The Second Circuit held that “for purposes of Section 16(b), the expiration of a call option within six months of its writing is to be deemed a ‘purchase’ by the option writer to be matched against the ‘sale’ deemed to occur when that option was written.” The rationale for this ruling, which was also endorsed by the SEC, is simple: “When an insider sells a call option, and that same option expires unexercised less than six months later, the writer’s opportunity to profit on the underlying stock is realized.” Therefore, the expiration of the call option is considered a “purchase” under Rule 16(b).
However, the Court also held that because Goldman was no longer a statutory insider by the time the “purchase” occurred (because Goldman no longer owned ten percent or more of Leap’s shares), Goldman was not obligated under Section 16(b) to disgorge the profits it made on the transaction.
Going forward, statutory insiders writing six-month options can avoid Section 16(b) liability by making sure they relinquish insider status before the six-month period ends.