Hybrid Securities and the Bifurcated Approach to Section 16(b) Liability

In Analytical Surveys, Inc. v. Tonga Partners, L.P., 2008 WL 4443828 (S.D.N.Y. 2008), Plaintiff, Analytical Surveys, Inc. (“Plaintiff” or “ASI”) brought a claim under Section 16(b) of the Exchange Act, seeking disgorgement of short-swing profits realized by Tonga Partners, L.P. (Tonga).  

The issues in this case arise from a series of convertible notes that ASI issued to Tonga. On April 2, 2002, Tonga paid ASI $2M for a senior secured convertible promissory note (the “April 2002 Note”). Under the terms of the note, Tonga could convert the entirety of the principal (and any accrued interest) into shares of ASI common stock. The conversion formula contained fixed and floating price components.

On October 29, 2002, Tonga converted $300,000 of the April 2002 Note into shares of ASI and retained a principal of $1.7M. On November 4, 2003, ASI issued Tonga a senior secured promissory convertible note for $1.7M (the “November 2003 Note”) to replace the April 2002 Note. On June 30, 2004, ASI issued a senior secured promissory note for $1.7M (the “June 2004 Note”) to replace the November 2003 Note. Each replacement note retained the fixed and floating conversion formulas set forth in the initial April 2002 Note. On November 10, 2004, Tonga converted the principal and interest of the June 2004 Note into shares of ASI at the price of $1.05 per share (pursuant to the floating price component of the note). In the five days following this conversion, Tonga sold all of its shares of ASI common stock into the open market.  

Absent an applicable exception, to establish liability under Section16(b), a plaintiff need only show there was (1) a purchase and (2) a sale of securities (3) by an officer, director, or ten percent shareholder of the issuer (4) within a six-month period. If a plaintiff establishes Section 16(b) liability, the plaintiff may compel disgorgement of any profits realized through the short-swing trading.  See Herrick K. Lidstone, Jr., Securities Law Deskbook, §16.18 for a concise overview of Section 16(b) liability.

After finding no applicable exception to Section 16(b), the court turned to Tonga’s potential purchases and sales of ASI stock. Neither party disputed that Tonga’s sales of ASI shares between November 10, 2004 and November 15, 2004 were Section 16(b) sales. However, the parties disputed whether there was a matching purchase within six months of these sales. The only potential purchases within six-months of the sales were (1) the acquisition of the June 2004 Note, and (2) the conversion of the June 2004 Note on November 10, 2004. Ultimately, the court held that both the acquisition and conversion of the June 2004 Note constitute Section 16(b) purchases.  

Acquisition of the June 2004 Note
 
Whether the acquisition of the June 2004 Note constitutes a Section 16(b) purchase turns on whether the June 2004 Note is a new note or merely an amended version of the November 2003 Note. In making this determination, the court looked to the materiality and significance of the changes contained in the June 2004 Note. Both notes contained much of the same language. Importantly, however, the June 2004 Note also contained, among others, the following changes: (1) Tonga gained “the unrestricted right to obtain cash upon maturity,” (2) the June 2004 Note eliminated a feature of the November 2003 Note requiring automatic conversion upon maturity (3) the June 2004 Note waived some of the November 2003 Note’s accrued interest, and (4) the June 2004 Note extended the maturity date.  

The court found these changes significant and material enough to conclude that the June 2004 Note is a new note and a Section 16(b) purchase because these changes provided Tonga with a new opportunity to realize profits from inside information. The court paid particular attention to the extension of the maturity date and cited Exchange Act Release Number 29131 “[a]n extension of an option exercise period is deemed to be a redemption of an old security and grant of a new security for purposes of Section 16.” Thus, while the court seemed to look at all four of the changes mentioned above, the extension alone arguably would suffice to create a new security for purposes of Section 16(b) liability.

Conversion of the June 2004 Note

If a derivative security contains only a fixed price component, the initial acquisition of the derivative security, not the conversion, is a Section 16(b) purchase. See Rule 16b-6(b). On the other hand, if a derivative security contains only a floating price component, the conversion, not the initial acquisition, is a Section 16(b) purchase. See Exchange Act Release No. 28,869 at *17 (Feb. 8, 1991). The reasoning behind their different treatment flows from the point when inside information may be advantageous to the statutory insider (i.e., at the time of acquisition for a fixed price security and the time of conversion for a floating price security). Id.

As mentioned above, however, the June 2004 Note was a hybrid financial instrument with a conversion formula containing a fixed price component and a floating price component. While Release No. 28,869 clarified treatment of financial instruments with only a fixed or floating price component, it did not address instruments with both components. This court adopted the bifurcated approach the SEC recommended in an amicus brief filed in a 2001 case. Under the bifurcated approach, the acquisition of the hybrid instrument is a Section 16(b) purchase based on the fixed price component. And the conversion of the hybrid instrument is a Section 16(b) purchase if the conversion occurs at the floating price. The conversion of the hybrid instrument, however, is not a Section 16(b) purchase if the conversion occurs at the fixed price. Because Tonga converted its shares based on the floating rate component of the note, the court held that it was a purchase of equity securities for purposes of Section 16(b) liability.

The primary materials for the post are available on the DU Corporate Governance Website.