The United States District Court for the Southern District of New York recently held that a shareholder was not a "group" member subject to disgorgement of profits for short-swing trading under Section 16(b) of the Securities Exchange Act of 1934 (the "Exchange Act"), despite that the shareholder had identified himself as a "group member" in SEC filings and had entered into an agreement containing two "lock-up" provisions restricting his ability to dispose of the shares in question.
In January 1996, Psychic Reader's Network ("PRN") sold one-half of its interest in New Lauderdale LLC to Quintel Entertainment Inc. ("Quintel"). As part of this transaction, PRN entered into an agreement with Quintel (the "Agreement") containing two "lock-up" provisions that prohibited PRN's shareholders, including defendant Eric Stolz ("Stolz"), from (i) selling shares of Quintel stock for two years unless a Quintel principal sold shares and (ii) selling more than a specific number of Quintel shares in any quarter. In connection with the Agreement, all PRN shareholders received an aggregate of 18% of Quintel's outstanding shares. Of that, Stoltz received 2.5% of Quintel's outstanding shares.
Between November 1996 and December 1998, Stolz made 40 purchases and 51 sales of Quintel stock. A Quintel shareholder subsequently filed suit seeking disgorgement of Stolz's profits from his Quintel transactions pursuant to Section 16(b) of the Exchange Act, alleging that the transactions constituted short-swing trading by an insider since Stolz had identified himself as a "group member" with the other PRN shareholders in certain SEC filings, and thus beneficially owned more than 10% of Quintel's stock.
On cross-motions for summary judgment, the court noted that the only issue before it was whether Stolz was a beneficial owner of more than 10% of Quintel's stock at the time of his transactions. The court explained that in order to be a beneficial owner under Section 16(b), a defendant inter alia, must be a beneficial owner as defined by Section 13(d) of the Exchange Act. Under Section 13(d), two or more persons acting as a group for the purpose of acquiring, holding or disposing of securities is deemed a "person," and their stock aggregated to determine whether this "person" is a beneficial owner of more than 10% of the issuer's stock.
As a preliminary matter, the court stated it would look beyond Stolz's ostensible admission in SEC filings that he was a Section 13(d) group member, and instead conduct an independent inquiry into the existence of a Section 13(d) group by considering the following factors: (i) the existence of a common objective to, inter alia, control the stock price or effect a shift in corporate control; (ii) the group members' ability to exert influence over the corporation; and (iii) the voluntariness of the agreement to acquire, hold or dispose of stock.
Based on these factors, the court concluded that the PRN shareholders did not constitute a group under Section 13(d) of the Exchange Act. First, the court noted that the PRN shareholders did not share a common objective to effectuate a shift in corporate control. Rather, the court stated, the only common objective shared by the PRN shareholders was to sell PRN's holdings in New Lauderdale LLC. Further, the "lock-up" provisions in the Agreement, the court explained, reflected Quintel's objective to control the price of its stock, not any objective held by the PRN shareholders. Second, the court noted that there was no evidence that the PRN shareholders, whose aggregate Quintel holdings totaled only about 18%, had the ability, or the common objective, to exert substantial influence over Quintel. Finally, the court explained that the PRN shareholders did not voluntarily enter into the "lock-up" provisions. Rather, the court found that they were bound to the provisions as a condition of PRN's sale of its interest in New Lauderdale LLC. Since Stolz's Quintel holdings could not be aggregated with those of the other PRN shareholders, he was deemed by the court to be the beneficial owner of only 2.5% of Quintel's stock, and thus not subject to Section 16(b) liability. *
Morales v. Quintel Entertainment, Inc., 72 F. Supp. 2d 344, (S.D.N.Y 1999).