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.
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Andrew E. Roth v. Foris Ventures LLC, et al.
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