On November 16, 2023, the United States Court of Appeals for the
Ninth Circuit affirmed in part and reversed in part a motion to
dismiss a derivative action brought by a shareholder of a publicly
traded biotechnology company (the "Company") under
Section 16(b) of the Securities Exchange Act of 1934 against the
Company, its beneficial owner (the "Beneficial Owner"),
one of the Company's directors (the "Director
Defendant") and his wife, and their trust (the
"Trust"). Andrew E. Roth v. Foris Ventures LLC, et
al., 22-16632 (9th Cir. Nov. 13, 2023). The Court held that
the district court erred by imposing a purpose-specific approval
requirement regarding an exemption for Section 16(b) liability
pursuant to Rule 16b-3, but did not err in finding that the
Company's board was aware that the Director Defendant had an
indirect pecuniary interest in the challenged transactions when the
board approved those transactions. The Court remanded to the
district court to determine whether the Beneficial Owner was a
director by deputization and thus eligible for the exemption.
The Beneficial Owner is a private investment company that owns
greater than 10% of the Company's common stock and related
derivative securities. The Director Defendant and his wife are
trustees of the Trust, which is a member of the Beneficial Owner.
The Director Defendant also indirectly owns all membership
interests in the Beneficial Owner. The Company and the Beneficial
Owner allegedly entered into several transactions involving Company
stock, warrants, and debt between April 2019 and January 2020, each
allegedly approved by the Company's board of directors.
Plaintiff filed suit alleging that the transactions violated
Section 16(b), which requires the disgorgement of any profit
realized from sales and purchases of securities of an issuer by a
beneficial owner (a person or entity that owns more than 10% of
stock of the issue), director, or officer of that issuer that occur
within six months of each other. Defendants moved to dismiss on the
basis that the alleged transactions were exempt from 16(b)
liability pursuant to Rule 16b-3 because those transactions were
approved by the Company's board. The district court denied the
motion, holding that although Rule 16b-3's exemption covers
transactions in which a director has an indirect pecuniary
interest, such as those between the Company and its Beneficial
Owner, these transactions were not exempt because the board did not
approve the transactions for the specific purpose of exempting them
under Rule 16b-3.
On appeal, the Ninth Circuit emphasized that both plaintiff and the
SEC, which filed an amicus brief, acknowledged that Rule 16b-3
lacks a purpose-specific approval requirement. The Court noted that
the district court derived its purpose-specific approval
requirement from an SEC no-action letter stating that a board must
specify that its approval was "granted for purposes of making
the transaction exempt under Rule 16b-3." The Court also noted
that the SEC subsequently disavowed the purpose-specific approval
requirement in amicus briefs field before both the Second Circuit
and the Ninth Circuit in the case at hand. The Court agreed with
the SEC's disavowal, finding that the text of Rule 16b-3 does
not include a purpose-specific approval requirement, as nothing in
the rule indicates that a board must approve the transaction for
the specific purpose of exempting it from Section 16(b) liability.
The Court also cited to Gryl v. Shire Pharms. Grp. PLC,
298 F.3d 136, 144-145 (2d Cir. 2002), in which the Second Circuit
made the same observation regarding the text of the rule and held
that the requirements of the exemption are satisfied if the
relevant securities transaction is between an issuer and insider,
and the terms and conditions of the transaction receive advance
approval by the board of directors. The Court also observed that
the Gryl decision supports the proposition that courts
generally do not defer to the SEC's no-action letters.
The Court turned next to plaintiff's two other arguments.
First, plaintiff argued that remand was required to determine
whether the Company's board knew about and acknowledged the
Director Defendant's alleged pecuniary interest in the
challenged transactions when approving them. The Court agreed with
the district court's finding that the board showed awareness of
the Director Defendant's indirect interest in the transactions
because SEC filings showed that the board considered the Director
Defendant's indirect ownership of the Beneficial Owner when
approving the transactions, and included the Company's shares
in the Beneficial Owner when calculating the Director
Defendant's ownership of the Company.
Second, the Court addressed plaintiff's argument that because
Section 16(b) imposes liability for transactions between issuers
and beneficial owners while Rule 16b-3(d) exempts transactions
between issuers and directors or officers (but not beneficial
owners), the Beneficial Owner is only eligible for the exemption if
it can show that it is a "director by deputization,"
which means a corporation may be a virtual director, and therefore
an insider for purposes of Section 16(b) liability, by deputizing a
natural person to perform duties on the board. Noting that the
issue of whether a company is a director by deputization is a
question of fact rather than a conclusion of law, the Court agreed
with the district court's determination that the complaint and
the judicially noticed documents did not suffice to show that the
Beneficial Owner was a director by deputization at the motion to
dismiss stage, and remanded the case to the district court for
further proceedings to determine that issue.
Lastly, the Court declined to address the issue of whether
challenged transactions are exempt under Rule 16b-3 regardless of
whether the Beneficial Owner is a director by deputation because
Rule 16b-3(d) exempts entire transactions, rather than specific
defendants, from Section 16(b) liability. The Court noted that this
issue was never addressed by the district court, and therefore left
it to the district court to address this issue in the first
instance.
Originally published November 21, 2023.
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