2d Circuit Section 16 Decision regarding Variable Share Prepaid Forward

On March 28, 2006, the U.S. District Court for the Southern District of New York held, in granting a motion for summary judgment by a Section 16 insider, that the settlement of a physically settled variable share prepaid forward contract did not constitute a sale for purposes of the short swing liability provisions of Section 16 under the Securities Exchange Act of 1934. Donoghue v. Centillium Communications Inc., 2006 U.S. Dist. LEXIS 13221 (S.D.N.Y. March 28, 2006). As a result, the court held that the settlement of the forward contract could not be matched with a purchase that occurred within six months of settlement. The court held that the sale occurred at the time that the forward contract was entered into, approximately three years prior to settlement. The decision significantly helps to reduce uncertainty among practitioners concerning the consequences under Section 16 upon the expiration of a variable share prepaid forward contract.

The contract could have been settled through physical or cash settlement, at the option of the insider. Under the contract, the insider was protected against a fall in the price of Centillium stock below $6.52 per share. (The court’s opinion notes that, because the insider was paid up front, the insider was protected from the downside risk of Centillium once the price of $5.31 per share was set. The $5.31 per share price generally reflects a present valuation of the payment of the $6.52 per share floor price.) Appreciation from $6.52 to $11.41 was for the benefit of the insider, and appreciation above $11.41 was for the benefit of the financial institution (an affiliate of Credit Suisse). The value of the stock at settlement was $2.38, and the insider elected to physically settle, so that all of the shares subject to the contract were delivered to Credit Suisse.

The court first addressed whether the cash settlement option resulted in a non-exempt transaction at settlement. The court held that it did not, on the basis of the Second Circuit’s 1998 decision in Magma Power Co. v. Dow Chem. Co., 136 F.3d 316 (2d Cir. 1998). That case involved notes issued by Dow that were exchangeable into common stock of Magma Power Co. Dow retained the right to deliver cash rather than Magma stock in the event that a holder elected to exchange the notes. The plaintiff argued that the lapse of Dow’s right to deliver cash, and in effect to repurchase the Magma stock, by exercising its cash settlement option constituted a deemed sale by Dow of the stock. The court in Magma Power held that the lapse of an option could not give rise to Section 16 liability. By analogy, the court in Centillium held that the lapse of the insider’s right to cash-settle his obligation under the forward contract could not give rise to Section 16 liability.

The court next addressed whether the forward contract constituted a “derivative security” within the meaning of Section 16, such that a sale of the underlying Centillium stock occurred at the time that the contract was entered into, or whether it was not a derivative security because it was a “financial instrument with a floating price” in which case the exercise of the financial instrument would constitute a sale. The court reasoned that the contract should be deemed to be a derivative security for purposes of Section 16 because the determination of the number of shares to be delivered under the contract was “dictated by financial formulae and criteria set forth in the [Forward agreement] and . . . could not be modified by” the insider. Accordingly, the court concluded, the insider was powerless to exploit insider information about Centillium other than at the inception of the contract, and so it would be inconsistent with the policy underlying Section 16 for the settlement of the contract to constitute a transaction that could be matched with another transaction to give rise to Section 16 liability.

Some practitioners have raised questions about whether a transaction would be deemed to occur upon expiration of a physically settled variable share forward contract. The Staff of the Division of Corporation Finance has not issued interpretive guidance on this issue. In particular, the concern has been expressed that the physical settlement of a variable share forward contract for less than the full number of shares subject thereto might be deemed to constitute a purchase of the shares retained by the insider under Section 16 at the time of expiration. Although the facts of Centillium do not specifically raise this issue, because none of the Centillium shares were retained by the insider, dicta in the analysis of the “derivative security” question (“Defendant could only have exploited inside information at the inception of the Forward”) supports the view that physical settlement upon expiration of a variable share prepaid forward transaction (which has a duration of more than six months) should not be deemed to constitute a matchable transaction that could give rise to liability under Section 16.

Please feel free to call any of your regular contacts at the firm or any of our partners and counsel listed under Corporate Governance, Derivatives or Employee Benefits in the Our Practice section of our web site if you have any questions.