By Anne Sherry, J.D.
The Southern District of New York dismissed a derivative lawsuit seeking disgorgement of short-swing profits. The challenged transactions satisfied an exemption from short-swing liability because they were between the issuer and a “director by deputization.” The policy rationale for this exemption—that the board’s approval serves a gatekeeper function—applied even if the board was unaware of this legal doctrine when it approved the transactions (Roth v. Armistice Capital, LLC, March 27, 2024, Rochon, J.).
Exchange Act Section 16(b) bars short-swing insider profits (and the court held that derivative plaintiffs do have Article III standing to bring Section 16(b) claims). But Rule 16b-3(d) provides an exemption where the insider is a director or officer who had advance board approval to acquire issuer equity securities directly from the issuer. Under Second Circuit precedent, an exempt director can include a “director by deputization,” or an investor who deputizes an individual to serve as its representative on the issuer’s board.
That was the case here: both the Chief Investment Officer and a managing director of the short-swing purchaser, Armistice Capital, sat on the issuer’s board. The issuer’s SEC filings confirmed its belief that the Armistice-affiliated directors were not independent, and representatives of the issuer testified that the board understood that the Armistice-nominated directors would be representing Armistice’s interests.
Both the plaintiff and the defendants relied on the SEC’s views about the Rule 16b-3(d) exemption as stated in a 2006 amicus brief. There, the SEC argued that board or shareholder approval is not effective gatekeeping where the board or shareholders were unaware that the person acquiring stock is a director. The plaintiffs particularly highlighted the SEC’s statement that the gatekeeping function would fail if the board “did not know that [the board member] had been deputized.”
But the court said that while the amicus brief was persuasive and perhaps even entitled to deference, it should not be parsed as rigorously as a statute. Reading the SEC’s reference to knowledge of deputization in context, it was best understood as requiring that the board know that the director sits on behalf of, and represents the interests of, the short-swing seller. The Second Circuit has already rejected the argument that a board must have acted for the express purpose of invoking the exemption. Gryl v. Shire Pharms. Grp. PLC (2d Cir 2002).
The case is No. 20-cv-08872.