Smolowe v. Delendo Corporation
1943 U.S. App. LEXIS 4018, 148 A.L.R. 300, 136 F.2d 231 (1943)
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Rule of Law:
Section 16(b) of the Securities Exchange Act of 1934 imposes strict liability on corporate insiders (directors, officers, and principal stockholders) for profits realized from any purchase and sale, or sale and purchase, of the company's equity securities within a six-month period, regardless of whether inside information was actually used or whether there was an intent to profit. Such recoverable profits are computed by matching the lowest purchase price against the highest sale price within the period to maximize recovery.
Facts:
- Defendants Seskis and Kaplan were directors, president, and vice-president, respectively, of Delendo Corporation.
- Seskis and Kaplan each owned approximately 12% of the 800,000 shares of Delendo stock, which was listed on the New York Curb Exchange.
- Delendo Corporation had previously negotiated to sell all its assets to Schenley Distillers Corporation in 1935-1936, but negotiations ended due to a contingent federal tax claim against Delendo.
- The $3.6 million tax claim was later reduced by agreement to $487,265, with a trial postponement until December 31, 1939.
- On February 29, 1940, defendants' attorney submitted a formal offer of settlement for $65,000 for the tax claim, which was accepted on April 2, 1940, and publicly announced on April 5, 1940.
- Negotiations with Schenley's reopened on April 11, 1940, and the sale of Delendo's assets was consummated on April 30, 1940, for $4,000,000 plus assumed liabilities.
- Between December 1, 1939, and May 30, 1940, Seskis purchased 15,504 shares and sold 15,800 shares, while Kaplan purchased 22,900 shares and sold 21,700 shares.
- The parties conceded that Seskis and Kaplan conducted these transactions in good faith and without any 'unfair' use of inside information.
Procedural Posture:
- Plaintiffs Smolowe and Levy, stockholders of Delendo Corporation, brought separate actions in federal district court under § 16(b) of the Securities Exchange Act of 1934 on behalf of themselves and other stockholders to recover profits from defendants Seskis and Kaplan.
- The United States intervened in the actions after being notified that the constitutionality of a federal statute had been called into question.
- The two separate actions were consolidated by the district court.
- After a trial where the facts were stipulated, the district court (46 F.Supp. 758) held defendants Seskis and Kaplan liable for the maximum profit shown by matching their purchases and sales of corporate stock and ordered them to pay the Delendo Corporation.
- Both the named defendants (Seskis and Kaplan) and the Delendo Corporation appealed the district court's decision to the United States Court of Appeals for the Second Circuit.
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Issue:
Does Section 16(b) of the Securities Exchange Act of 1934 impose strict liability on corporate insiders for short-swing profits, without requiring proof of actual unfair use of inside information, and should such profits be calculated by matching the lowest purchase price against the highest sale price within a six-month period?
Opinions:
Majority - Clark, Circuit Judge
Yes, Section 16(b) imposes strict liability on corporate insiders for short-swing profits without requiring proof of actual unfair use of inside information, and such profits are to be calculated by matching the lowest purchase price against the highest sale price within a six-month period to maximize recovery. The court rejected the argument that the statute's preamble, stating its purpose was 'preventing the unfair use of information,' required proof of actual misuse. Citing legislative history, the court noted that Congress intended an 'objective measure of proof'—a 'crude rule of thumb'—because proving an insider's intent or expectation to profit from short-swing trading is 'absolutely impossible.' A subjective standard, the court reasoned, would render other provisions of the statute (like the six-month liability period and the immateriality of intent) senseless and make the statute ineffective. Although Seskis and Kaplan did not make 'unfair' use of information in the sense of illegality, their knowledge of corporate plans (tax settlement, asset sale) provided 'most valuable inside knowledge' that the statute was designed to curb. The court also rejected the application of income tax rules for profit calculation, such as identifying specific stock certificates or the 'first-in, first-out' method. These rules, it found, would allow large stockholders to evade liability and 'emasculate' the statute's purpose. Instead, the court affirmed the 'lowest price in, highest price out' method, regardless of certificate identity or actual transaction sequence, as the only rule to 'surely recover all possible profits' and 'squeeze all possible profits out of stock transactions,' thereby establishing a high standard for fiduciaries. Finally, the court found Section 16(b) constitutional, holding that it did not violate due process, as it was a reasonable response to known abuses and imposed a level of conduct 'higher than that trodden by the crowd.' It also affirmed Congress's power to regulate private sales that affect national security exchanges under the Commerce Clause, and upheld the SEC's delegated authority to grant exemptions as clearly lawful and guided by the statute's purpose.
Analysis:
This case is foundational for the interpretation and enforcement of Section 16(b) of the Securities Exchange Act of 1934, establishing the 'objective' or 'strict liability' approach to insider short-swing profit recovery. By rejecting the need to prove actual misuse of inside information, the court significantly streamlined enforcement, making Section 16(b) a potent deterrent against insider trading abuses. Furthermore, the adoption of the 'lowest price in, highest price out' profit calculation method ensures maximum recovery for the corporation, aligning with the statute's remedial purpose to eliminate any incentive for fiduciaries to profit from short-term market fluctuations. This ruling underscores Congress's broad authority to regulate securities markets and enforce high ethical standards for corporate insiders.
