Dreiling v. America Online: Ninth Circuit Rejects an Attempt to Expand Liability Under Section 16(b)

In Dreiling v. America Online Inc., 578 F.3d 995 (9th Cir. 2009), the Ninth Circuit Court of Appeals rejected an attempt to expand the scope of liability under §16(b) of the Securities Exchange Act of 1934.  The court held that strict liability under § 16(b) required plaintiffs to clearly prove insider status. 

In August, 1998 America Online, Inc. (“AOL”) and InfoSpace, Inc. (“InfoSpace”) entered into an agreement (the “Agreement”) to jointly provide an interactive website called the “AOL White Pages.”  InfoSpace CEO, Naveen Jain (“Jain”), represented InfoSpace during negotiations with AOL.  Under the agreement, InfoSpace would produce and manage the AOL White Pages and AOL would distribute the product to its subscribers. 

InfoSpace agreed to compensate AOL by: (1) granting AOL conditional warrants to purchase up to 5% of InfoSpace stock, (2) making quarterly cash payments to AOL, and (3) sharing advertising revenue generated by the AOL White Pages.  InfoSpace proposed to expense the warrants at InfoSpace’s pre-IPO price in order to mitigate its own expenses.  In late 1999, Jain and AOL agreed in principle to suspend InfoSpace’s revenue-sharing obligations under the Agreement.  Jain sought to formalize this amendment (“Amendment 1”) before the second quarter of 2000 in order to bulk up InfoSpace’s second-quarter balance sheet after learning about InfoSpace’s inability to meet analyst expectations.  In 1999 and 2000, Jain sold a significant amount of his InfoSpace stock.  As a result, AOL executed its first InfoSpace stock transaction in early 2000 followed by further sales during the year.  Subsequently, InfoSpace’s stock price crashed.

Dreiling, a former InfoSpace shareholder, filed a derivative shareholder action against AOL, seeking disgorgement of AOL’s profits derived from the sale of its InfoSpace stock.  Dreiling’s complaint alleged that AOL and Jain sought to (1) secretly influence the corporate affairs of InfoSpace by creating artificial revenues and earnings, (2) hold their shares during the creation of artificial revenues and earnings, and (3) then sell their shares to unsuspecting investors at artificially inflated prices as a result of their concerted efforts. 

The district court granted AOL’s motion for summary judgment on the ground that Dreiling had not provided any evidence suggesting that AOL was subject to short-swing profit rules under § 16(b). 

Section 16(b) of the Act identifies three classes of “insiders” whose profits from short-swing trades are subject to disgorgement: directors, officers, and beneficial owners of more than 10% of any class of security registered under U.S. securities laws.  Short-swing profits are those realized by any class of insiders from a securities transaction within any period of less than six months from the date of initial purchase.  This rule imposes strict liability on insiders, regardless of motive, and disgorges profits from all short-swing trades, even those not actually based on inside information. 

In the current case, AOL was neither an InfoSpace director nor officer.  Therefore, the court noted, that AOL may only be required to disgorge short-swing trading profits by being a beneficial owner of more than 10% of InfoSpace shares.  Although the Act does not define “beneficial owner,” case law suggests reference to § 13(d) of the Act to define beneficial owner for purpose of establishing insider status.  The Rule extends to groups of shareholders.  Rule 13d-5 defines a group as arising “when two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer.”  Ultimately, the relevant inquiry in determining whether a group existed to create a beneficial ownership is whether the parties “agreed to act together for the purpose of acquiring, holding voting or disposing of a firm’s securities.” 

The court held that § 16(b) of the Act does not provide Dreiling any remedy for his first assertion that AOL and Jain acted as a group.  The 9^th Circuit held that at most AOL and Jain worked together to fraudulently inflate InfoSpace’s revenues and earnings.  Concerted efforts to engage in accounting fraud do not form a group for §13(d) purposes.  Furthermore, while § 10(b) of the Act permits actions brought by private litigants against issuers, it bars private litigants from bringing actions against “secondary actors”, such as AOL, for aiding and abetting securities fraud.  Ultimately, the court stated that Dreiling may not assert a securities fraud claim that he could not bring under § 10(b) simply by accommodating the claim into § 16(b).

Next, Dreiling’s allegation that AOL and Jain entered into a beneficial agreement to acquire InfoSpace stock at pre-IPO price was also unsuccessful.  The court held that Dreiling failed to present evidence that AOL and InfoSpace entered into an agreement for anything other than to create a website and market it to AOL members.  The warrants given to AOL were merely compensation for marketing InfoSpace’s product.  Moreover, even if Dreiling established an agreement mainly to purchase InfoSpace stock at pre-IPO price, the agreement was with InfoSpace, not Jain.  Dreiling did not point to authority for his assertion that Jain became a member under § 13(d) merely by participating in negotiations that resulted in a business agreement.

Finally, Dreiling argued that AOL’s agreement to enter into Amendment 1 in 2000 suggested “hold” and “sell” claims.  The court found that these arguments failed on several grounds.  Primarily, the agreement was between AOL and InfoSpace, not AOL and Jain.  Moreover, numerous InfoSpace employees participated in drafting Amendment 1.  Finally, Amendment 1 did not involve an effort to “hold” and “sell” stock, but was an attempt to affect InfoSpace’s balance sheets.  This is not the type of agreement that  §13(d) sought to regulate.  Ultimately, the court concluded that Dreiling failed to show any evidence of coordination between AOL and Jain in his personal capacity, regarding the stock transactions they separately executed. 

Overall, the Ninth Circuit Court of Appeals affirmed the district court’s decision to grant AOL summary judgment. 

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