Bershad v. McDonough

• Decision Date: 05 August 1970
• Docket Number: No. 17810.,17810.
• Citation: 428 F.2d 693
• Parties: John BERSHAD, Plaintiff-Appellee, v. Bernard P. McDONOUGH, Defendant-Appellant.
• Court: U.S. Court of Appeals — Seventh Circuit

428 F.2d 693 (1970)

John BERSHAD, Plaintiff-Appellee, v. Bernard P. McDONOUGH, Defendant-Appellant.

No. 17810.

United States Court of Appeals, Seventh Circuit.

June 11, 1970.

Rehearing Denied August 5, 1970.

Herbert Underwood, Clarksburg, W. Va., R. V. Houpt, Chicago, Ill., Thomas E. Walsh, Washington, D. C., Peer Pedersen, Chicago, Ill., for appellant.

Jerome H. Stein, Chicago, Ill., Lawrence Milberg, Great Neck, N. Y., Melvyn I. Weiss, David J. Bershad, New York City, of counsel for appellee.

Before SWYGERT, Chief Judge, CUMMINGS, Circuit Judge, and GRANT, District Judge.¹

CUMMINGS, Circuit Judge.

This appeal is from a summary judgment in favor of the plaintiff, a common stockholder in the Cudahy Company of Phoenix, Arizona. Plaintiff brought this action under Section 16(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78p(b)) to recover for Cudahy's benefit the "short-swing" profits coming to defendant from his and his wife's purchase and sale of 272,000 shares of Cudahy common stock.

On March 15 and 16, 1967, defendant Bernard P. McDonough and his wife Alma, who reside in Parkersburg, West Virginia, each purchased 141,363 shares of Cudahy common stock at $6.75 per share, totaling over 10% of the outstanding common stock of Cudahy.² Soon after the purchase, McDonough was elected to the Cudahy Board of Directors and named Chairman of the Board.³ At the same time, Donald E. Martin and Carl Broughton, business associates of McDonough, were elected to the Cudahy Board.

On July 20, 1967, in Parkersburg, West Virginia, Mr. and Mrs. McDonough and Smelting Refining and Mining Co. ("Smelting") entered into a formal "option agreement" granting Smelting the right to purchase 272,000 shares of the McDonoughs' Cudahy stock. Smelting paid $350,000 upon execution of the agreement, which set the purchase price for the shares of $9 per share, or a total of $2,448,000. The option was exercisable on or before October 1, 1967. The $350,000 was to be applied against the purchase price but was to belong to the McDonoughs if Smelting failed to exercise the option. Accompanying this "option" was an escrow agreement under which the McDonoughs' 272,000 shares of Cudahy stock were placed in escrow with their lawyer. They also simultaneously granted Smelting an irrevocable proxy to vote their 272,000 shares of stock until October 1, 1967.

A day or two after the documents were signed, Mr. McDonough and Carl Broughton, his business associate, acceded to the request of Smelting and agreed to resign from the Cudahy Board if Smelting representatives were put on the Board. Both of them resigned as directors on July 25, 1967. About that time, five nominees of Smelting were placed on the Cudahy Board. Smelting subsequently wrote the McDonoughs on September 22, 1967, that it was exercising its option. The closing took place in Parkersburg five days later, with the $2,098,000 balance of the purchase price being paid to the McDonoughs through the escrow agent. From their sales, Mr and Mrs. McDonough realized a profit of $612,000.

In the court below, defendant contended that under West Virginia law the July 20 agreement constituted an option contract with Smelting, and not a contract for the sale of the Cudahy stock. Graney v. United States, 258 F.Supp. 383, 386 (S.D.W.Va.1966), affirmed per curiam, 377 F.2d 992 (4th Cir. 1967), certiorari denied, 389 U.S. 1022, 88 S.Ct. 594, 19 L.Ed.2d 668. A stock option, he argued, does not qualify as a "sale or contract for sale" for purposes of applying the rule of Section 16(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 78p (b)).⁴ The district court, however, took another view of the transaction. In a thoughtful memorandum opinion, the trial judge looked beyond the formal wording of the July 20 "option" and concluded that the transaction between the McDonoughs and Smelting "amounted to a sale or a contract of sale" within the terms of the Securities Exchange Act. Since this event occurred less than six months after the McDonoughs had purchased the Cudahy stock, under Section 16(b) summary judgment for $612,000, together with interest, was entered for plaintiff. We affirm.

Section 16(b) was designed to prevent speculation in corporate securities by "insiders" such as directors, officers and large stockholders. Congress intended the statute to curb manipulative and unethical practices which result from the misuse of important corporate information for the personal aggrandizement or unfair profit of the insider. Congress hoped to insure the strict observance of the insider's fiduciary duties to outside shareholders and the corporation by removing the profit from short-swing dealings in corporate securities. Conversely, Congress sought to avoid unduly discouraging bona fide long-term contributions to corporate capital. See Blau v. Lamb, 363 F.2d 507, 514-516 (2d Cir. 1966), certiorari denied, 385 U.S. 1002, 87 S.Ct. 707, 17 L.Ed.2d 542; Petteys v. Butler, 367 F.2d 528, 532 (8th Cir. 1966), certiorari denied sub nom. Blau v. Petteys, 385 U.S. 1006, 87 S.Ct. 712, 17 L.Ed.2d 545; Blau v. Max Factor & Co., 342 F.2d 304, 308 (9th Cir. 1965), certiorari denied, 382 U.S. 892, 86 S.Ct. 180, 15 L.Ed.2d 150; Smolowe v. Delendo, 136 F.2d 231, 237-239 (2d Cir. 1943), certiorari denied, 320 U.S. 751, 64 S.Ct. 56, 88 L.Ed. 446.

In order to achieve its goals, Congress chose a relatively arbitrary rule capable of easy administration. The objective standard of Section 16(b) imposes strict liability upon substantially all transactions occurring within the statutory time period, regardless of the intent of the insider or the existence of actual speculation. This approach maximized the ability of the rule to eradicate speculative abuses by reducing difficulties in proof. Such arbitrary and sweeping coverage was deemed necessary to insure the optimum prophylactic effect. See Petteys v. Butler, supra, 367 F.2d at pp. 532-533; Smolowe v. Delendo, supra, 136 F.2d at pp. 236-237; Blau v. Lamb, supra, 363 F.2d at p. 515. The harshness of the rule was mitigated, however, by confining its coverage to a period of six months, thereby ensuring the minimum adverse effect upon valuable, long-term investments and at the same time facilitating easy and certain compliance with the strictures of Section 16(b). The thrust of the statutory scheme thus placed responsibility for meticulous observance of the provision upon the shoulders of the insider. He was deemed capable of structuring his dealings to avoid any possibility of taint and therefore must bear the risks of any inadvertent miscalculation. Cf. Polaroid Corp. v. Casselman, 213 F.Supp. 379, 382 (S.D.N.Y.1962); see generally, II Loss, Securities Regulation, Ch. 6C, pp. 1040, et seq. (2d ed. 1961).

Under Section 3(a) (14) of the Act (15 U.S.C. § 78c (a) (14)), the "sales" covered by Section 16(b) are broadly defined to include "any contract to sell or otherwise dispose of" any security. See SEC v. National Securities, Inc., 393 U.S. 453, 467, 89 S.Ct. 564, 21 L.Ed.2d 668, n. 8. Construction of these terms is a matter of federal law (see Tcherepnin v. Knight, 389 U.S. 332, 337-338, 88 S.Ct. 548, 19 L.Ed.2d 564; Blau v. Lehman, 368 U.S. 403, 82 S.Ct. 451, 7 L.Ed.2d 403), and "whatever the terms `purchase' and `sale' may mean in other contexts," they should be construed in a manner which will effectuate the purposes of the specific section of the Act in which they are used. SEC v. National Securities, Inc., 393 U.S. 453, 467, 89 S.Ct. 564, 572, 21 L.Ed.2d 668. Applying this touchstone, courts have generally concluded that a transaction falls within the ambit of Section 16(b) if it can reasonably be characterized as a "purchase" or "sale" without doing violence to the language of the statute, and if the transaction is of a kind which can possibly lend itself to the speculation encompassed by Section 16(b). Blau v. Lamb, 363 F.2d 507, 518 (2d Cir. 1966), certiorari denied, 385 U.S. 1002, 87 S.Ct. 707; Petteys v. Butler, 367 F.2d 528, 532 (8th Cir. 1966), certiorari denied sub nom. Blau v. Petteys, 385 U.S. 1006, 87 S.Ct. 712; Heli-Coil Corporation v. Webster, 352 F.2d 156, 162 (3d Cir. 1965); Blau v. Max Factor & Co., 342 F. 2d 304, 307 (9th Cir. 1965), certiorari denied, 382 U.S. 892, 86 S.Ct. 180; Blau v. Lehman, 286 F.2d 786, 792 (2d Cir. 1960), affirmed, 368 U.S. 403, 82 S.Ct. 451; Ferraiolo v. Newman, 259 F.2d 342, 345 (6th Cir. 1958), certiorari denied, 359 U.S. 927, 79 S.Ct. 606, 3 L.Ed.2d 629.⁵

The phrase "any purchase and sale" in Section 16(b) is therefore not to be limited or defined solely in terms of commercial law of sales and notions of contractual rights and duties. Cf. Dasho v. Susquehanna Corp., 380 F.2d 262, 266 (7th Cir. 1966), certiorari denied sub nom. Bard v. Dasho, 389 U.S. 977, 88 S.Ct. 480, 19 L.Ed.2d 470; Lawrence v. SEC, 398 F.2d 276, 280 (1st Cir. 1968); Vine v. Beneficial Finance Co., 374 F.2d 627, 634 (2d Cir. 1967), certiorari denied, 389 U.S. 970, 88 S.Ct. 463, 19 L.Ed.2d 460. Applicability of this Section may depend upon the factual circumstances of the transaction, the sequence of relevant transactions, and whether the insider is "purchasing" or "selling" the security. Cf. Blau v. Lamb, 363 F.2d 507, 523-524 (2d Cir. 1966), certiorari denied, 385 U.S. 1002, 87 S.Ct. 707. By the same token, we conclude transactions subject to speculative abuses deserve careful scrutiny. The insider should not be permitted to speculate with impunity merely by varying the paper form of his transactions. The commercial substance of the transaction rather than its form must be considered, and courts should guard against sham transactions by which an insider disguises the effective transfer of stock. Cf. Blau v. Allen, 163 F.Supp. 702, 705-706 (S.D.N.Y.1958).

The considerations thus guiding the application of Section 16(b) provide substantial support for coverage of an insider's sale of an option within six months of his purchase of the underlying...