In Huppe v. WPCS International Inc., No. 08-4463-CV, 2012 WL 164072 (2d Cir. Jan. 20, 2012), the court affirmed the district court’s decision to grant summary judgment against the defendants Special Situations Fund II, QP, L.P. and Special Situations Private Equity Fund, L.P. (collectively, the “Funds”). Both were found liable under Section 16(b) of the Securities Exchange Act of 1934 for the short-swing profits earned from the purchase and sale of WPCS International Incorporated (“WPCS”) shares.
Maureen A. Huppe (“Huppe”), a WPCS shareholder, filed a derivative action seeking disgorgement of $486,000 in profits from the Funds’ sale and purchase of WPCS shares. The Funds each held over ten percent of WPCS shares at all times relevant to the plaintiff’s complaint. Under the Funds’ limited partnership agreement, two general partners were given “the exclusive power to make all investment and voting decisions . . . on behalf of the Funds.” Between December 2005 and January 2006, the general partners sold WPCS “on the open market at prices between $9.193 and $12.62 per share.” The general partners bought an additional 876,931 shares of WPCS at $7.00 per share, a 7% discount from the market price, as part of a WPCS board-approved transaction to raise capital.
Huppe alleged that as undisputed ten percent holders, the Funds were liable for their short-swing profits under Section 16(b). The Funds argued that they were not “beneficial owners” under Section 16(b) because the transaction was solicited and approved by the WPCS board of directors.
Section 16(b) states that “officers, directors, and principal shareholders [owning over 10% of the shares] of a company are liable for profits realized from the purchase and sale (or sale and purchase) of its shares within a six-month period,” and its coverage applies to routine purchases and sales, as well as transactions involving “conversions, options, stock warrants, and reclassifications.” Huppe (citing 15 U.S.C. § 78p(b). The provision strictly applied; “no showing of actual misuse of inside information or of unlawful intent is necessary to compel disgorgement.” Huppe. Accordingly, the stock purchase in April 2006 fell within the parameters of Section 16(b).
Under Section 16(b), “a ‘beneficial owner’ is any ‘person’ who, directly or indirectly, has or shares (1) voting or investment power over, and (2) a pecuniary interest in a security.” 17 C.F.R. § 240.16a–1(a)(1)–(2). The Funds argued that they did not meet this definition because they had delegated “exclusive power” to vote and dispose of the shares to the Funds’ general partners.
The court disagreed and determined that the general partners were agents of the Funds and “their actions bound the partnerships.” The Funds, therefore, qualified as beneficial owners for the purpose of Section 16(b), and they were liable for short-swing profits derived from the April 2006 purchase of WPCS stock.
Furthermore, the Funds argued that the sale of shares directly from the company should not be subject to the short-swing profit prohibition in Section 16(b). They pointed to the provisions of Rule 16b-3(d) that exempted from the short-swing profits provision, board-approved transactions between officers and directors and the company. Although the Rule did not apply to ten percent shareholders, the Funds asserted that their acquisition of stock directly from WPCS “was similarly ‘not comprehended within the purpose’ of Section 16(b).’” The court rejected this reasoning, finding that the Rule did not apply because the Funds were not directors or officers of the WPCS. In addition, the Rule’s exemption does not cover ten percent holders because they do not owe a fiduciary to the company.
The primary materials for this case may be found at the DU Corporate Governance website.