Second Circuit Holds That “Blockers” In Derivatives Contracts Shield Liability For Short-Swing Profits Under Section 16(b)

On July 7, 2026, the United States Court of Appeals for the Second Circuit affirmed the dismissal of an action asserting claims under Section 16(b) of the Securities Exchange Act of 1934 seeking disgorgement of short-swing profits from an investment manager and its client fund.  20230930-DK-Butterfly-1, Inc. v. HBC Invs. LLC, --F.4th--, 2026 WL 1954771 (2d Cir. 2026).  Plaintiff alleged that defendants were required to disgorge short-swing profits under Section 16(b) because they beneficially owned 10% or more of a company’s common stock or had the ability to acquire 10% or more pursuant to derivatives contracts, notwithstanding certain “blocker” provisions in the contracts that required defendants to stay below 10% ownership.  The Second Circuit affirmed the district court’s dismissal, and, in an issue of first impression in the Second Circuit, held that the “blockers” protected defendants from Section 16(b) liability.

Plaintiff is the successor entity to a company that, before its bankruptcy, sold derivatives to defendants that gave defendants the ability to acquire large amounts of the company’s stock.  The relevant contracts included “blockers”—provisions that prevented defendants from obtaining more than 9.99% of the company’s common stock at any one time.  Specifically, the contracts provided that any preferred-stock conversion or warrant exercise would “be null and void and treated as if never made” if the exercise would result in defendants holding more than 9.99% of the company, and defendants needed to certify that each exercise would not result in exceeding the 9.99% limit.  Ultimately, defendants exercised nearly all their rights under the derivatives contracts and reaped significant profits (by reselling at market value the company stock it had acquired at a discount pursuant to the derivative contracts).  After bankruptcy proceedings, the successor entity to the company sought disgorgement of defendants’ profits, asserting that the blockers were illusory and that defendants either held or effectively had the right to acquire more than 10% of the company’s stock.

The Court first observed that Section 16(b) is a strict-liability provision requiring statutory insiders—including beneficial owners of more than 10% of a company’s stock—to disgorge short-swing profits, but that investors may use blockers to limit that right and thereby avoid Section 16(b) liability.  The Second Circuit explained that “blockers” may be a sham or illusory if (i) the acquiring party may waive the blocker in its sole discretion, (ii) the blocker lacks a means of ensuring compliance, or (iii) as a practical reality, the investor exceeded the conversion cap.  The Second Circuit concluded that the blockers at issue were not illusory.  First, the Court held the blockers were contractual provisions that the investor could not avoid without the company’s consent.  While these contractual provisions could be amended, that did not render the blockers illusory, because otherwise any blocker would be illusory.  Second, the blockers had a means of ensuring compliance because the warrants in the derivatives voided the purchases of securities above the 10% threshold, and the investor had to certify it would not exceed this threshold.  Finally, the Court held that plaintiff had not plausibly alleged that the investor ever owned more than 10% of the company’s stock.  The Court held that trading records plaintiff attached to its pleading showed that the investor always stayed below 10% ownership.  While plaintiff contended that the investor had more than 10% of company stock “sitting” in its brokerage account, the Court emphasized that was not the test for determining beneficial ownership; rather, the relevant question was whether defendants had the power to dispose of those shares, which they did not because they had had already committed to selling them on the open market.

The Court also rejected plaintiff’s broader contention that the blockers should be evaluated using a substance-over-form standard focused on how they might function in practice rather than on their text.  Rejecting plaintiff’s argument that courts should not give a “free pass to essentially any competently drafted blocker,” the Court emphasized that “a comprehensive and legally binding blocker should generally insulate a defendant from section 16(b) liability.”  (emphasis in original).  Accordingly, the Court held that, to survive a motion to dismiss, a plaintiff must allege that a blocker has in fact failed and defendant has been permitted to exceed the 10-percent cap, rather than merely speculating that the parties could hypothetically waive the blocker or that an investor could breach the contract without the other party learning of it.

The Second Circuit also held that the derivatives did not violate SEC Rule 13d-3(b), which prohibits investor plans to avoid statutory reporting requirements.  The Second Circuit drew a distinction between plans designed to conceal ownership and contracts designed to prevent ownership in the first place.  Thus, the Court explained, this rule only applies when a transaction involves a “substantial equivalence” of control rights or “include[s] steps that stop short of, or conceal, the vesting of ownership, while nevertheless ensuring that such ownership will vest at the signal of the would-be owner.”  However, the Court continued, an investor is free to structure a transaction with the intent of avoiding Section 16(b) liability, and may limit its ownership rights so as not to take on regulatory responsibility, so long as it does not conceal the vesting of its ownership.  And while plaintiff pointed to the fact that defendants entered into a side letter with a company relating to the derivatives—which plaintiff argued superseded other terms and gave defendants the right to acquire as much stock as they wanted—the Court determined that the letter merely required the company to honor the terms of the derivatives contracts “in accordance with the terms” of the other documents (including the blockers) and expressly emphasized that it did not supersede or alter those documents.

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• 20230930-DK-BUTTERFLY-1, INC. V. HBC INVS. LLC