Friday, May 22, 2020

Adviser's clients are not a group sans agreement to trade specific securities

By Rodney F. Tonkovic, J.D.

A Second Circuit panel has affirmed the dismissal of two separate short-swing trading actions brought by the same plaintiff. At issue in both appeals, which were argued in tandem, was the existence of agreements to act together for the purposes of forming a group of insiders. In both cases, the court found no group could exist for the purposes of liability under Exchange Act Sections 13(d) and 16(b) without an agreement to trade in the securities of a specific issuer, and there was no such agreement (Rubenstein v. International Value Advisers, LLC, May 20, 2020, Parker, B., and Rubenstein v. Rofam Inv. LLC, May 20, 2020, per curiam).

International Value Advisers. Plaintiff Aaron Rubenstein is a shareholder in AdTalem Global Education Services (f/k/a DeVry Global Education Group, Inc.). Rubenstein sought disgorgement by an unidentified "John Doe" defendant who was an account-holder at International Value Advisers, LLC (IVA), an investment adviser. The John Doe account held shares of DeVry selected and purchased for it by IVA acting as its investment manager and holding discretionary authority over the account.

According to Rubenstein, while John Doe did not hold more than 10 percent of DeVry shares, Doe, IVA, and IVA's other clients collectively owned 19.5 percent of the shares and acted as a "control group" that executed short-swing trades in Doe's account. There was no dispute that IVA itself was subject to Section 16(b)'s short-swing profit rule. Rubenstein contended that Doe silently acquiesced to becoming a member of a group with IVA because of Doe's delegation of authority to IVA's to manage his account. The district court disagreed, finding that Rubenstein had not plausibly pleaded the existence of a Section 13(d) agreement. That is, there was no common purpose shared by the IVA defendants (who sought to appoint an IVA partner to DeVry's board) and Doe, whose DeVry shares had been purchased for his account on a discretionary basis by his investment manager.

On appeal, the panel agreed that John Doe was not a member of an insider group. At its core, Rubenstein's theory was that IVA's clients became members of a group with their investment adviser and its other clients when they signed investment management agreements delegating discretionary trading authority to IVA. This, the panel said, is incompatible with the statutory and regulatory text of the Exchange Act, which provides that a group is formed when parties agree to act together "for the purpose of acquiring, holding, or disposing of securities of an issuer." These provisions, the court concluded, impose liability only when insiders enter into an agreement to trade the securities of a specific issuer, and no such agreement to trade in DeVry securities, or any other common objective, was alleged here. The panel rejected Rubenstein's arguments because his interpretation would read the requirements of agreement and issuer-specificity out of the statute.

The court noted further that the statute is intended to prevent a group of persons, where no individual owns over 10 percent, from evading Section 16(b)'s disclosure requirements. Rubenstein, however, never alleged that IVA's clients sought to pool their shares to evade the requirements of the statute. The court noted in addition that an investment adviser's holdings of its clients' securities may qualify it as a beneficial owner for the purposes of Section 13(d)'s disclosure requirements, and in this case, IVA filed a Schedule 13D disclosing its insider status with respect to DeVry.

Rubenstein also argued that, in the absence of an agreement to trade, there was an implied agreement through which IVA's clients silently acquiesced to trading as a group. The panel found no support for this theory which would impose liability based on the trades of other investors to whom the only connection is sharing an adviser. His last argument was that IVA acted as an agent or director by deputization for its clients. The panel found no support for these theories and, in any event, they were not raised in the court below.

Fairholme. The same panel also issued a summary order affirming the dismissal of a similar action brought by Rubenstein to recover short-swing profits made on Sears stock. In this case, Rubenstein alleged that clients of investment adviser Fairholme Capital Management delegated discretionary control over their accounts to Fairholme, thus forming, along with Fairholme itself, a "group" of Sears insiders. The complaint cited the clients' investment management agreements, through which they delegated to Fairholme discretionary authority to use their shares to pursue the adviser's goal of pushing for changes in control of the company.

The district court granted dismissal in favor of Fairholme, concluding that Rubenstein failed to adequately plead that the clients and their adviser formed an insider group. Specifically, the court determined that Rubenstein failed to allege the existence of any express agreement to trade in Sears stock.

Here, as in the opinion above, there was no dispute that Fairholme was a statutory insider and subject to the short-swing profit rule. Indeed, the firm and its clients held more than 10 percent of Sears common stock, and the firm's founder served on the Sears board of directors. But, the court said, it was also undisputed that Fairholme's clients were not Sears insiders. The only agreements in this case were investment management agreements between Fairholme and its clients under which the client's delegated discretionary investment authority to the firm. These agreements made no mention of any specific issuer in whose stock Fairholme was expected to trade, and this, the court said, is insufficient to form a group under Section 13(d). The court accordingly affirmed the district court's dismissal.

The cases are Nos. 19-560-cv and 19-796-cv.