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Federal Court Dismisses Claim That Conversion Price Reduction For Preferred Stock Was A "Purchase" Under Section 16(b)

Morrison v. Madison Dearborn Capital Partners III, L.P.., 389 F.Supp.2d 596 (D.Del. 2005). . This is a shareholder derivative action to recover short-swing profits derived from insider trading activity of XM Radio stock by a group of defendants ("MDP") and XM Radio ("XM"). Defendants filed Motions to Dismiss under Fed. R. Civ. P. 12(b)(6). Jurisdiction for the action was laid under 28 U.S.C. §1331 and 15 U.S.C. §78aa. Neither personal jurisdiction, nor venue was contested. The Court granted the Motions to Dismiss. At issue was MDP's acquisition of 50,000 Redeemable Convertible Preferred Stock ("Preferred Stock") of XM at $1,000 per share, in 2000. The share exchange price was initially set at $26.50 per share of common stock. A trigger in the duly filed Certificate of Designations permitted adjustment of the conversion price to preserve the value of the conversion privilege on the occurrence of specified events. The specified events included stock-splits, issue of dividends or issue of common stock because they would dilute the conversion of preferred stock to common stock. Due to events prior to 2003, the preferred stock price was adjusted to $19.68 from $26.50, corresponding to an exchange of 50,000 preferred stock for 5.6 million shares of common stock. Within 6 months of the June 2003 conversion, MDP sold 2.7 million shares of XM stock unrelated to its preferred stock acquisition. Plaintiff claimed that the January conversion price adjustment was really a purchase of XM stock. Its occurrence within 6 months of the June 2003 sale violated Section 16(b) of the Securities Exchange Act of 1934 and therefore MDP was required to disgorge its profits from such "short-swing" trading activity under 15 U.S.C. §78p(b) (2004). The Court quoted Levy v. Sterling Holding Co. L.L.C., 314 F.3d 106, 111 (3d Cir. 2002), cert. denied, 540 U.S. 947 (2003) and held that to state a claim under Section 16(b), allegations of the following must exist: (1) a purchase; (2) a sale of securities; (3) by the issuer's officer or director, or by a shareholder owning more than 10% of any one class of the securities of the issuer; (4) within the six month period. Accordingly, the sole issue before the Court was whether the plaintiff had properly alleged that the "purchase" of the offending stock sold was within the six month period. Plaintiff's primary contention in this matter was that the January 2003 conversion price reduction for the Preferred Stock was a "purchase" under Section 16(b), as interpreted by the Securities and Exchange Commission ("SEC") under Rule 16b-6(a). Both parties conceded that the preferred stock was a derivative security under Rule 16a-1(c). The plaintiff argued that the adjustment was really a call equivalent and therefore was a purchase under Rule 16b-6(a). The Court disagreed with the plaintiff's argument because it ran counter to the SEC's interpretation of Rule 16b-6(a) and the Congressional intent driving Rule 16(b). The Court relied on the Exchange Act Release No. 28,869, 56 Fed.Reg. 7242 (Feb. 21, 1991) (the "Release") and explained that the SEC considered derivative securities possessing a series of preset prices, or an adjustable price to accommodate earlier designated events such as stock-splits, stock issue and the like as fixed, for the purposes of Rule 16a-1(c ). Therefore, such adjustments did not constitute the acquisition of further equity securities. Specifically, the Court pointed out that the Release demonstrated that the SEC intended: (1) that such preferred securities would be treated as having a fixed conversion price; (2) would be considered derivative securities under Rule 16a-1(c); (3) therefore adjustments to its conversion price would not equal an acquisition of additional stock; and (4) under Rule 16b-6 "the relevant event would be the purchase of the preferred stock, not the change in conversion price." Plaintiff attempted to introduce SEC no-action letters in support of his "purchase" contention. That effort was rejected by the Court because no-action letters had limited applicability in the circumstances presented by this case. Additionally, plaintiff's attempt to have the Court treat such preferred stock as hybrid derivative securities was rejected. The Court observed that unlike hybrid derivative securities holders, preferred stock holders have no choice in the price determination and therefore, the analogy was incorrect. In summary, the Court concluded that because the SEC had treated "conversion price adjustment bearing mechanism securities" such as the preferred stock at issue here, as possessing a fixed price, they could not be treated as a purchase and therefore plaintiff had failed to state a claim under Section 16(b). The Court did not consider the application of Rule 16a-9(b) and plaintiff's factual counter of that Rule's application because they did not impact the grounds on which the court granted the Motions to Dismiss. The Court also did not consider MDP's contention that the conversion price reduction was an "unorthodox transaction" that did not cause a danger of speculation because it was unnecessary. Authored by: Raj Srivatsan 302-888 6831 rsrivatsan@morrisjames.com