The Accidental Short Swing Profit

Thursday, October 18th, 2012 at 12:48 pm, by So Yeon Kim

The disgorgement of short swing profits, a principle supported by section 16(b) of the Securities and Exchange Act of 1934, has been actively used by financial regulators to prevent the exploitation of insider information for securities transactions in the corporate realm. The gist of the provision is that it imposes strict liability on certain persons who realize any short swing profits resulting from the purchase and sale, or sale and purchase, of securities within a six-month period. The law covers specific types of registered and publicly issued equity securities like common shares. The provision regulates the actions of any officer or director of a corporation that publicly issues securities and beneficial owners of more than 10% of the equity securities. Although the initial impetus of the provision was to prevent the unlawful use of insider information, the clause itself finds liability without regard to the insider’s actual use or possession of material non-public information. Because 16(b) operates on a strict liability basis, in essence, all the plaintiff (the issuer or the owner of any security by the issuer in the name or in behalf of the issuer) needs to prove in a 16(b) case is that the insider traded securities within a six-month period.

The proponents of 16(b) claim that a strong and far-reaching restriction is necessary to prevent the unlawful exploitation of insider information. Even though the causal link between the actions of the director that fall under the purview of the law and the loss incurred by outsiders may be difficult to prove, the clear information advantage of the director bestows on him a heavier obligation to act responsibly.

One consistent criticism of section 16(b) is that it is over-inclusive, primarily because of the strict liability aspect of the provision. It not only includes the rogue director in possession of information of a looming merger who intentionally purchases shares and sells them at a profit but also the officer who buys shares of her company and sells them at a slight or no profit six months later to gather funds to pay for expensive medical care of a family member. The latter may not have used, or even been in possession of, any insider information. She may not have intended to make a profit and might not have even known that a profit would arise out of the transaction. Nonetheless, regardless of the officer’s knowledge or intent, the officer is subject to the provision. Casting a wide net to catch potential misuses of insider information may be disproportionate to the severity of the offense or the actual profits realized.

Another over-inclusive aspect of the provision is the definition of profits. The term profits is not defined in the statute, and thus, leads to an array of different interpretations. The result often is that courts define profit so that the sum to be disgorged would be maximized. If a director has engaged in multiple securities transactions during a six-month period, the court will not combine the transactions to ascertain whether the defendant has actually made a profit at the end of the day, but will calculate the profit to be disgorged by matching the lowest purchase price and the highest sale price within the six-month period. As a result, the sum that the director is required to disgorge is in some cases considerably more than the taxable profit actually realized. In some cases, the director may have incurred a cumulative loss but still be obligated to disgorge fictitious profits. This is because in the case of multiple sales and purchases over a six-month period, the court does not discount the losses but simply adds the profits. In other words, if a director incurs a loss from a transaction, the loss is not discounted but is simply accounted for as zero profits, even if the losses are larger than the profits made. All in all, profits are not disgorged in the sense that the officer is simply returning ill-gotten gains, but rather, the effect is patently punitive. It a legal culture where punitive damages are awarded only in special cases where the defendant’s conduct has been especially egregious, punitive damages seem to have no place in at least certain types of activities covered by the provision.

On the opposite end of the spectrum, the provision is under-inclusive. That aspect of the provision stems from arbitrary line-drawing by Congress. First, the provision itself only affects largely three sets of people: directors, officers, and holder of more than 10% of the equity securities. It does not hold responsible employees who engage in short swing securities transactions although they may just as well have access to material non-public information. Another instance of line-drawing is the six-month limitation, which seems not to be based on any statistical or empirical evidence on the use of information that is not publicly available, but rather is a convenient duration devised by congress by which the courts limit their analysis.

The unfortunate result of this bluntness of the provision is the unwillingness on the part of directors and officers to own shares of the companies for which they work for fear of being required to return profits made out of transactions of securities. Director or officer share-ownership is valuable in the sense that it decreases agency costs by aligning the interests of management and shareholders. Insider trading is undoubtedly a severe breach of fiduciary and other duties owed by officers and directors, undermines public trust in corporations, and creates inefficiencies in the capital market. However, the regulation of such activity requires more precision than 16(b) provides.