United States: The Great Purchase Date Debate: When Does An Investor In a Convertible Security With a "Hybrid" Conversion Privilege "Purchase" Common Stock For Section 16 (b) Purposes?

Many investors know all too well how important it is to avoid the unforgiving sweep of Section 16(b) liability. Section 16(b) of the Securities Exchange Act of 1934 presumes that certain insiders – including 10% shareholders – have inside information, and it requires those insiders to disgorge all profits made by virtue of "short swing" trades in equity securities, i.e., trades in which both a purchase and sale of a company’s common stock occur within a six month period. Section 16(b) is a strict liability statute, and profit disgorgement is required regardless of whether the defendant possessed material, non-public information when making the trades. Thus, it is critical for these investors to understand the contours of Section 16(b).

One unsettled question regarding Section 16(b) liability has been the scope of its application to certain convertible securities with "hybrid" conversion privileges – conversion features that have both fixed and floating rates of exchange into common stock. The nettlesome issue with respect to these securities is whether the "purchase" of the underlying equity security occurs for Section 16(b) purposes when the investor purchases the convertible security or when the investor converts that convertible security into common stock.

Until recently, only two courts had considered this issue, and those courts reached opposite conclusions. In Lerner v. Millenco, a court in the Southern District of New York concluded that the "purchase" date is the time of purchase of the "hybrid" convertible security. But in a subsequent decision, Levy v. Clearwater Fund IV, Ltd., a court in the District of Delaware held that the "purchase" date is the time of conversion.

The reason for the split was plain. It is well-settled that an investor "purchases" an underlying equity security upon purchase of a convertible security with a fixed conversion feature. But an investor "purchases" the underlying equity security upon conversion of a convertible security with a floating conversion feature. Where exactly a security with a "hybrid" conversion feature fits in the regulatory framework was not clear. Certain SEC rule amendments in 1991 stated that the acquisition of a "derivative security" is the "purchase" of underlying stock for purposes of Section 16(b), but some plaintiffs’ lawyers argued that the definition of a "derivative security" should not include a convertible security with a "hybrid" conversion feature.

Specifically, in promulgating the amended rules, the SEC noted that "holding derivative securities is functionally equivalent to holding the underlying equity . . . since the value of derivative securities is a function of or related to the value of the underlying security." Although the definition of "derivative security" included "any . . . convertible security with a value derived from the value of an equity security," it excluded from that definition "[r]ights with an exercise or conversion privilege at a price that is not fixed." Thus, the issue of when an investor "purchases" a convertible security with a "hybrid" conversion feature can be seen to depend on whether such a security satisfies the definition of a "derivative security" under the SEC rules, or falls within the exception to that definition.

A recent decision in the Southern District of New York has helped to clarify the law on this issue by tilting the balance two-to-one in favor of the proposition that the "purchase" date should be at the time the investor acquires the "hybrid" convertible security, not when the investor converts, holding that such a security is a "derivative security" for Section 16(b) purposes. In Levy v. Oz Master Fund, et al., the court reasoned that the opposite conclusion would be contrary to the underlying purpose of Section 16(b), because it would permit an investor with inside information to "lock in" a profit by virtue of the fixed conversion rate. The Levy v. Oz court also rejected the plaintiff’s argument that a different result should obtain based on whether the investor actually converted the "hybrid" security at the floating or the fixed rate. The court found that this argument would impermissibly alter the analysis from the nature of the security to the mechanics of the transaction.

Thus, with the decision in Levy v. Oz, investors in convertible securities with a "hybrid" conversion feature now have a reasonable degree of assurance as to the contours of Section 16(b) liability within the Southern District of New York. However, investors should be aware that the decision in the District of Delaware court still stands, and it is less clear how courts outside of the Southern District of New York will treat hybrid convertible securities under Section 16(b).

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