Amendment of Derivative Security May (or May Not) Constitute a Purchase and Sale
A judge in the SDNY has granted in part and denied in part a motion to dismiss a complaint asserting two separate 16(b) claims against a husband and wife, one based on the defendants’ transactions in repos and the other based on their transactions in variable prepaid forward contracts (VPFs). Both claims were based on an argument that the amendment of a derivative security involves a simultaneous purchase and sale of the underlying stock.
The defendants owned more than 10% of the Class A common stock of Knight-Swift Transportation Holdings, primarily through wholly owned LLCs. The alleged short-swing transactions were engaged in by LLCs, but to avoid having to refer to multiple entities I’ll just attribute all of the transactions to “the defendants.”
The Repo Transactions
Well before the transactions in question, the defendants had entered into a repurchase agreement with an investment bank under which the defendants “sold” stock to the bank at current market prices and agreed to repurchase the shares at the end of the agreement’s term (or earlier, at the defendants’ election), at the same price plus interest on the money the bank had advanced. By December 2018, the defendants had drawn down $125 million under the agreement and had delivered 4,868,208 shares of Knight-Swift stock to the bank.
On December 21, 2018, the defendants and the counterparty agreed to a partial “termination” of the repo agreement to allow the bank to sell 1,537,205 of the shares and apply the proceeds ($37,612,793, or $23.98 per share) against the $125 million advanced under the repo agreement. At the same time, the parties amended the repo agreement to reflect that the repurchase price for the remaining 3,331,003 shares ($125 million — $37,612,793) effectively increased the per-share price from $25.68 to $26.23. Less than six months after these transactions, the defendants engaged in two sales of Knight-Swift stock.
The plaintiff alleged that the repo agreement was a derivative security, in the form of a call equivalent position, and that the amendment to its per-share “exercise price” was a disposition of the original agreement and the purchase of a new one which could be matched with the defendants’ subsequent sales. The defendants, in turn, argued that the repo agreement was not a derivative security, but instead was a loan secured by a pledge of stock. Alternatively, the defendants argued, the partial termination of the repo agreement merely reduced the defendants’ call equivalent position and therefore involved only a sale.
The court agreed with the plaintiff that the repo agreement was a derivative security but held that the amendment of the agreement did not result in a purchase because the amendment increased, rather than decreased, the per-share repurchase price and therefore did not provide the defendants with a greater opportunity to profit from inside information during the term of the agreement.
On February 13, 2019, the defendants repurchased the 3,331,003 shares subject to the repo agreement and entered into a VPF covering those shares, with maturity dates between August 30 and September 4, 2019. These maturity dates were roughly the same as the maturity dates of four other VPFs the defendants had entered into on earlier dates.
More than six months later, on August 23, 2019, the defendants rolled over, or amended, all five of the prepaid forwards to extend the maturity dates (to various dates between March 13 and June 22, 2020) and set new floor and cap prices. At the same time, the defendants entered into a “Trigger Price Agreement” which allowed them to reset the maturity dates, cap prices and floor prices under the agreements if Knight-Swift’s stock traded within certain ranges. Less than a month later, in September, the defendants exercised their rights under the Trigger Price Agreement and amended the terms of all of the prepaid forwards.
The plaintiff alleged that the September amendments constituted a purchase of the shares underlying the VPFs and a simultaneous sale of the shares pursuant to new VPFs. The defendants did not contest that allegation but argued that the plaintiff had not alleged that they realized a profit. The court disagreed, finding that the plaintiff adequately alleged that a profit was realized and was not obligated to quantify the amount.
-Alan Dye, Section16.net October 8, 2020
Want to keep reading?
Great. Enter your email address and gain instant access to this article