Citadel Holding Corp., a Delaware Corporation v. Alfred Roven American Underwriters, Inc., a Delaware Corporation
Docket: 92-55915
Court: Court of Appeals for the Ninth Circuit; June 9, 1994; Federal Appellate Court
Citadel Holding Corporation appeals a summary judgment from the district court favoring Alfred Roven and American Underwriters, Inc. in a case under Section 16(b) of the Securities Exchange Act of 1934, which involves Citadel seeking disgorgement of profits Roven allegedly gained from short-term transactions involving options on Citadel stock. The Ninth Circuit Court has jurisdiction and affirms the lower court's ruling.
Citadel, a Delaware corporation primarily based in California, has its stock traded on the American Stock Exchange, while Roven, as the Chairman of Citadel's Board and sole shareholder of American, is classified as a statutory insider. During the relevant period (1985-87), legal restrictions prevented any shareholder from acquiring more than 10% of Citadel's stock without Federal Home Loan Bank Board approval and prohibited individuals engaged in unrelated business activities from exceeding that threshold, as outlined in Citadel's Certificate of Incorporation.
Roven held approximately 9.8% of Citadel's shares and, on October 8, 1985, entered into an agreement with Bear Stearns to purchase call options for 150,000 shares of Citadel stock for an initial payment of $750,000. The options were nontransferable, fully exercisable only as a whole, and had a thirty-day initial exercise period with extensions available. Although Roven could not sell these options on the market, he had the option to sell them back to Bear Stearns based on market prices.
The Bear Stearns option did not confer voting rights or additional leverage over Citadel's management, and Roven was entitled to dividends from the underlying shares, though none were paid during the option's duration.
Roven renewed the Bear Stearns option for 150,000 shares over two years, utilizing rollovers to extend the option regardless of stock price changes or profit/loss implications. He withdrew cash from his Bear Stearns account on nine occasions, with withdrawals conditional on the value of securities, totaling $5,289,569 withdrawn against $5,288,720 paid for extensions. The contract expired worthless after the October 1987 stock market crash, and Roven never exercised the option.
In April 1986, Roven negotiated three call option contracts for Citadel stock through Prudential Bache Securities, acquiring the right to buy 75,000 shares for a total of $849,200. The Bache options had shorter initial terms, and Roven extended the second option while receiving funds from Prudential Bache upon closing it, but he also never exercised any Bache options.
Roven and American disclosed these transactions in amendments to their Schedule 13D and Citadel’s annual questionnaires. They believed that, since the options were not "presently exercisable," they had no separate reporting obligation under Section 16(a). Citadel's 1986 and 1987 annual proxy statements, filed with the SEC, acknowledged the Bear Stearns and Bache options, indicating that they could not be exercised until regulatory approvals were obtained.
Citadel initiated legal proceedings on October 9, 1987, in California's Central District Court, seeking the disgorgement of profits Roven allegedly obtained through the trading of options. Roven contended that legal restrictions prevented him from acquiring additional Citadel stock without prior approvals, asserting that his option purchases aimed to facilitate ownership increases upon receiving such approvals. Citadel countered that Roven illegally speculated in Citadel stock, violating Section 16(b) of the Securities Exchange Act. To establish a violation, Citadel needed to demonstrate that Roven realized a profit from a transaction involving Citadel equity securities within a six-month timeframe, without an exemption under SEC regulations.
In November 1988, Roven filed for summary judgment, arguing that the options were not considered equity securities under Section 16(b) and were exempt due to not being "presently exercisable." His initial motion was denied, but a renewed motion in November 1990 led to Judge Pfaelzer granting summary judgment on June 16, 1992. The court determined that Citadel did not present a genuine issue of material fact regarding three critical points: (1) there was no qualifying "purchase and sale" within six months, (2) Citadel did not show profits from the option transactions were "realized" within that timeframe, and (3) the transactions were exempt as the options were not "presently exercisable."
The standard of review for the summary judgment is de novo, affirming that a party must sufficiently prove each element of their claim. The court ultimately agreed with the district court's conclusion that Roven's transactions were exempt from Section 16(b) liability due to the options not being "presently exercisable," making it unnecessary to address other arguments presented. Additionally, a 1991 revision by the SEC to Section 16 rules acknowledged the need to address potential abuses in trading derivative securities by recognizing their functional equivalence to underlying securities.
The SEC revised its regulatory approach under Section 16 of the Securities Exchange Act, shifting its focus from the exercise of derivative securities to their acquisition. Consequently, the SEC updated its rules to classify the acquisition of derivative securities as a reportable event, regardless of whether the security can be exercised immediately. Although these new regulations could significantly affect the analysis of a case, evaluations must be based on the SEC rules in effect at the time of the transactions, provided they do not conflict with Section 16 of the Act. Section 23(a)(1) protects individuals from liability for actions taken in good faith according to SEC rules. Roven, in this context, could rely on the SEC regulations as they existed during the relevant transactions. Section 16(a) mandates reporting of beneficial ownership changes by corporate insiders, while Section 16(b) imposes liability for short-swing transactions. The reporting requirements enable the SEC to assess compliance with Section 16(b) easily. Although Section 16(b) imposes strict liability, it allows for exemptions through SEC rules. Specifically, Rule 16a-10 states that if a transaction is not subject to reporting under Section 16(a), it cannot incur liability under Section 16(b), thereby establishing a clear link between the two sections.
Section 16 of the Act does not explicitly mention options, but prior to the SEC's 1991 rule changes, there was debate about whether options qualified as 'equity securities of [the] issuer' under Sec. 16(b). The SEC established that, for reporting under Sec. 16(a), options are deemed to confer beneficial ownership rights if they are 'presently exercisable' according to 17 C.F.R. Sec. 240.16a-6. This regulation mandates that the granting or acquisition of any presently exercisable options necessitates a statement reflecting a change in beneficial ownership. If options are not initially exercisable, they must be reported once they become exercisable.
Roven contends that his options were not 'presently exercisable' due to two conditions: he held approximately 9.8% of Citadel's shares, and exercising any options would push his ownership above the 10% threshold, which is prohibited by Citadel's Certificate of Incorporation and federal law. Specifically, the Article 8 restriction defines 'control' as owning more than 10% of voting securities, and federal statutes require Bank Board approval for insiders to exceed this limit.
Citadel disputes Roven's claim by arguing that the options did not indicate any lack of present exercisability and that the SEC evaluates options based solely on their contractual terms. Additionally, Citadel asserts that Roven’s options conferred beneficial ownership of the underlying securities, thereby obligating him to report the acquisition under Sec. 16(a), irrespective of any conditions implied by Rule 16a-6(a). Citadel's counterarguments will be considered in subsequent sections.
Options were not 'presently exercisable' due to the requirement of Bank Board approval, which Roven failed to obtain. Legal precedent establishes that all relevant laws and regulations become part of an agreement, indicating that Roven's ability to exercise the Bear Stearns and Bache options was contingent upon this approval. Citadel acknowledged that Bank Board approval can be viewed as an implied condition precedent but argued that Rule 16a-6(a) applies only to options explicitly stated to be exercisable after a certain date or event, without providing supporting authority for this claim. No definitive cases or SEC publications clarify whether an implied condition can affect the 'presently exercisable' status under Rule 16a-6(a). The SEC's intent appears to limit reporting requirements to options that can be exercised at the holder's discretion, exempting those subject to conditions such as regulatory approval.
Additionally, Citadel contended that even if the options were not currently exercisable, Roven had a reporting obligation under Sec. 16(a) due to 'beneficial ownership' stemming from his ability to profit from the options aligned with fluctuations in Citadel's stock price. Citadel cited legal authority indicating that beneficial ownership is determined by the economic substance rather than the transaction's form, warning against sham transactions that mask the effective transfer of stock rights.
The 'sham transaction' principle, as cited by Citadel, indicates that Roven's acquisition of options did not equate to 'beneficial ownership' of the underlying Citadel stock under Section 16(a) of the Act. At the time of these transactions, neither the SEC nor any court recognized the mere potential for profit from options as sufficient for establishing beneficial ownership. Roven's agreements with Bear Stearns and Prudential Bache did not grant him control over the underlying Citadel securities or leverage over Citadel management, which distinguishes this case from three cited precedents. In Bershad, the option holder had significant control through endorsed shares and voting proxies, while in Whittaker, the insider operated under a power of attorney that allowed full control of the shares. Newmark involved options that ensured alignment with the optionee's interests in management decisions. Because Roven's options lacked similar ownership rights or control, they did not confer beneficial ownership under Section 16(a). Consequently, it was concluded that the options were not currently exercisable and did not grant Roven beneficial ownership of Citadel securities, leading to the affirmation of the district court's summary judgment in favor of Roven.
Section 16(b) addresses the prevention of unfair use of information by directors, stating that any profits derived from transactions involving equity securities of the issuer within a six-month period must be returned to the issuer. This rule does not apply to transactions that the Securities and Exchange Commission (SEC) may exempt through its regulations. The document indicates that the Article 8 restriction is not utilized due to the lack of a district court finding regarding Roven's engagement in unrelated business activities, leaving uncertainty about the applicability of that restriction. Citadel references an SEC release which clarifies that an employee's option exercisable only upon retirement does not activate reporting obligations under Section 16(a); however, this does not relate to options not currently exercisable due to implied conditions. Case law, such as Colan v. Cutler-Hammer, Inc. and Portnoy v. Revlon, Inc., supports the interpretation of 'sale' under Section 16(b), indicating that certain agreements with significant conditions precedent do not constitute a 'sale' if those conditions are unfulfilled.
