United States District Court, Northern District of Illinois, E.D
June 19, 1969
JOHN BERSHAD, PLAINTIFF,
BERNARD P. MCDONOUGH AND CUDAHY COMPANY, DEFENDANTS.
The opinion of the court was delivered by: Marovitz, District Judge.
Cross-Motions for Summary Judgment
Pursuant to Section 16(b) of the Securities Exchange Act of
1934 ("Act"), 15 U.S.C. § 78 p(b), this action is brought by John
Bershad, owner of certain of the common stock of defendant Cudahy
Company (Cudahy) to recover for the benefit of Cudahy the
purported "short swing" profits accruing to the defendant Bernard
P. McDonough from the alleged purchase by him and sale to United
States Smelting, Refining and Mining Company (Smelting) of
272,000 shares of the common stock of Cudahy within a period of
less than six months. In part, Section 16(b) reads as follows:
"(b) For the purpose of preventing the unfair use of
information which may have been obtained by such
beneficial owner, director, or officer by reason of
his relationship to the issuer, any profit realized
by him from any purchase and sale, or any sale and
purchase, of any equity security of such issuer
(other than an exempted security) within any period
less than six months, unless such security was
acquired in good faith in connection with a debt
shall inure to and be recoverable by the issuer,
irrespective of any intention on the part of such
beneficial owner, director, or officer in entering
into such transaction of holding the security
purchased or of not repurchasing the security sold
for a period exceeding six months."
Both sides have moved for summary judgment.
The essential facts in this case are undisputed. Cudahy is a
Maine corporation whose common stock at all pertinent times was
registered and traded on the New York Stock Exchange and not an
exempted security under Section 3(12) of the Act,
15 U.S.C. § 78c(12). On March 15 and 16, 1967, Bernard P. McDonough
purchased 141,363 shares of common stock of Cudahy from Continental
Illinois National Bank and Trust Company of Chicago, which was
acting as Executor of the Estate of Edward A. Cudahy. On the same
date McDonough, as attorney in fact for Alma McDonough, purchased
at a like sale for Alma McDonough 141,363 shares of Cudahy common
stock. These purchases were made at a price of $6.75 per share.
About two weeks later, on April 4, 1967, Bernard P. McDonough,
Donald E. Martin, Carl L. Broughton and Otto Gressens were
elected directors of Cudahy.
Thereafter, on July 20, 1967, Bernard P. and Alma McDonough
each owners of 141,363 shares of the common stock of Cudahy,
executed an agreement entitled "Option Agreement" with Smelting,
a copy of which agreement is attached to the respective
affidavits of the McDonoughs as "Affiant's Exhibit No. 1." At the
same time that the option agreement was executed, the McDonoughs
executed an escrow agreement, a copy of which is attached to both
the respective McDonough affidavits as "Affiant's Exhibit No. 2."
Also on July 20, 1967, the McDonoughs executed and delivered to
Jack Wilder, President of Smelting, a proxy, a copy of which is
attached as "Affiant's Exhibit No. 3" to the respective McDonough
affidavits. All of the negotiations which resulted in the
execution of the option agreement, escrow agreement and proxy
took place in Wood County, West Virginia, on July 20, 1967.
Bernard P. McDonough resigned as an officer of Cudahy on July
18, 1967, and as a director of Cudahy on July 25, 1967. Those
persons who were elected with McDonough as Cudahy directors on
April 4, 1967, resigned as well. On July 28, 1967, these
positions on Cudahy's Board of Directors were filled by persons
with strong ties to Smelting, including Martin Horwitz, then
Chairman of the Board of Directors of Smelting, and Jack Wilder,
then President and a director of Smelting.
Under the Option Agreement, Smelting paid $350,000.00 to the
McDonoughs for an option to purchase 272,000 shares of Cudahy
common at a price of $9.00 a share on or before October 1, 1967.
While the $350,000 belonged to the McDonoughs absolutely if the
option were not exercised, the money was to be applied against
the $2,448,000.00 purchase price if the option to buy the stock
were exercised. Under the proxy agreement, the McDonoughs granted
Smelting a proxy, irrevocable until October 1, 1967, to vote the
272,000 common shares of Cudahy. Following the execution of the
option agreement, escrow agreement and proxy, certificates
representing 272,000 shares of the common stock of Cudahy were
delivered to Ralph Bohannon, which certificates remained in his
possession in Clarksburg, West Virginia, until September 27,
On September 22, 1967, Martin Horwitz, then Chairman of the
Board of Smelting, directed a letter to the McDonoughs notifying
them of the exercise by Smelting of its option to purchase the
272,000 shares of Cudahy common stock. Five days later, in
Parkersburg, West Virginia, delivery of certificates representing
the 272,000 shares was made to Robert Pirie, who represented
himself to be an attorney for Smelting. At the time of the
delivery to Pirie, Bohannon, on behalf of the McDonoughs,
received a check in the amount of $2,098,000.00 from Pirie.
From this relatively simple set of facts, the respective
parties ask us to draw opposing conclusions. Defendants contend
that what took place was the granting of an option which was not
exercised and therefore did not mature into a sale of stock until
more than six months after the stock was originally purchased by
the McDonoughs. Plaintiff, on the other hand, suggests that the
transactions between the McDonoughs and Smelting constituted a
sale or contract to sell within the meaning of the statute.
Initially, it is clear that the law has drawn a distinction
between an option and a sale. The pure option contract is one by
which the owner of property agrees with another person that the
latter shall have the right to buy the former's property at a
fixed price within a fixed time. Graney v. United States,
258 F. Supp. 383, 386 (S.D.W. Va. 1966), aff'd 377 F.2d 992 (4th Cir.
1967); Whitelaw v. Brady, 3 Ill.2d 583, 588-589, 121 N.E.2d 785
(1954). For a price, the optionee purchases the right to choose
to conclude or not to conclude a particular transaction. For
example, in Silverman v. Landa, 306 F.2d 422 (2d Cir. 1962),
which was an action to recover "short swing" profits allegedly
accruing the result of violation of Section 16(b) of the Act, the
optionee paid a premium of $4,000 for the right to buy 1,000
shares of stock at the market price ($24 3/8 per share) on the
date that the option was granted.
In the pure option agreement, "(w)hile the option extends the
right to purchase, it imposes no binding obligation to do so upon
the person holding the option." Graney v. United States,
258 F. Supp. 383, 386 (S.D.W.Va. 1966), aff'd, 377 F.2d 992 (4th Cir.
1967). Discussing such an agreement in relation to Section 16(b),
the Second Circuit has said:
"By its nature, the option is one-sided; it fixes the
obligations, but not the rights, of the issuer. Landa
cannot be said to have `sold' or `purchased' Fruehauf
stock; should the options lapse unexercised (and in
fact the call options did so lapse), no change in his
beneficial ownership of the underlying security would
occur. And, most importantly, any change would occur
at the pleasure of the optionee. Only if both the
options had been exercised within their first six
months would there have been a `sale and purchase' of
the underlying security within the reach of § 16(b)."
Silverman v. Landa, 306 F.2d 422, 424 (2d Cir. 1962).
See also Stella v. Graham-Paige Motors Corp., 232 F.2d 299, 301
(2d Cir. 1956); Blau v. Ogsbury, 210 F.2d 426 (2d Cir. 1954);
Shaw v. Dreyfus, 79 F. Supp. 533 (S.D.N.Y. 1948).
At the same time, in securities law as in other areas, things
are not always what they seem to be. Recognizing this, the
judiciary has recently shifted away from an objective,
mechanistic interpretation of the securities statutes toward a
more subjective, pragmatic approach designed to deal with the
particular facts of a case in light of the purpose of the
relevant statutory section. Lowenfels, "Section 16(b): A New
Trend in Regulating Insider Trading," 54 Cornell L. Rev. 45,
50-57 (1968). In a recent Section 10(b) matter, the Supreme Court
said the real questions to be asked in securities cases were
whether the defendant's conduct was that type of behavior meant
to be forbidden by the law and whether the broad purposes of the
securities laws would be furthered by an application to the
situation under review. SEC v. National Securities, Inc.,
393 U.S. 453, 467, 89 S.Ct. 564, 21 L.Ed.2d 668 (1969). Such an
approach had already been invoked in a suit, similar to the
instant action, to recover short-swing profits. In Blau v. Lamb,
363 F.2d 507, 516 (2nd Cir. 1966), the Second Circuit noted that
the scope of Section 16(b) was extensive, reaching every
transaction, including options, "that might possibly permit an
insider to use inside information unfairly * * *." The
application of Section 16(b) in a particular situation
consequently "depends upon
whether the transaction in question could tend to accomplish what
the section was designed to prevent." Id. at 519. In brief, we
are concerned more with substance than form.
It is plaintiff's contention that this case involves more than
a pure option by virtue of the substantial down payment which was
to be credited against the purchase price, the grant of the
irrevocable proxy, and the resignations of McDonough and
associates. Unlike the situation in Silverman v. Landa, supra,
the money paid to the McDonoughs for the right to purchase Cudahy
stock was not a premium, but was to be credited to the purchase
price if the option to buy were exercised. To make the simple
generalization that all such arrangements, regardless of the
extent of the potential credit, fall outside the scope of Section
16(b) would open the door for flagrant violations of this
remedial law. If, for instance, the holder of an "option" pays
the "optionor" $900,000 for an "option" to buy certain securities
for $1,000,000 within a set time, and that payment is to be
credited to the sale price upon exercise of the "option," it
could hardly be said, from a practical business viewpoint, that
the "optionee" was not irrevocably bound to exercise his "option"
and technically conclude the sale. A substantial down payment is,
in reality, tantamount to a sale.
As this case presents a rather novel question, and there is no
direct precedent to guide us in determining how substantial a
down payment must be in order to be characterized as equivalent
to a sale, we must resolve the issue "in a manner that is
practical and logical and will be most consonant with the
statutory purpose." Booth v. Varian Associates, 334 F.2d 1, 4
(1st Cir. 1964), cert. denied, 379 U.S. 961, 85 S.Ct. 651, 13
L.Ed.2d 556 (1965). The down payment paid by Smelting was
$350,000. This payment amounted to approximately 14% of the total
purchase price. In a similar, if not identical situation, Blau v.
Allen, 163 F. Supp. 702 (S.D.N.Y. 1958), two parties agreed that
the seller would deliver 800,000 shares of stock if the purchaser
paid $2,000,000 within one week, another $10,000,000 two months
later, and a final $10,000,000 two months after that. Under the
agreement, any payments were to be treated as liquidated damages
in the event all payments were not forthcoming. Id. at 705. The
first payment was made within the required time. The court
recognized that the payment, which was 11% of the sales price,
"was not just a binder but constituted a substantial portion of
the purchase price." Id. It then said that if the agreement was
to be considered an option, then it appeared to have been
exercised by initial down payment. Id. In our case, the down
payment was made at the time the agreement was written as opposed
to one week later as in Blau v. Allen. Yet, under the approach of
that case, all that this distinction means is that the "option"
herein was exercised immediately by the payment of a substantial
portion of the purchase price.
Yet, while speaking in hypotheticals about considering the
agreement as an option, the court, in fact, construed the
transaction as a sale or, perhaps, a contract to sell which
provided for installment payments. Under either view, once a
significant payment was made,
"the buyer would be bound to complete the agreement
or suffer the loss of his first payment and the
sellers bound to await further payment by the buyer.
The rights and obligations of the respective parties
had become fixed and there was a sale within the
meaning of section 16(b). Citation omitted." Id. at
See 2 Loss, Securities Regulation 1099 (2d ed. 1961).
The instant case is much stronger than that of Blau v. Allen.
In the first place, the down payment is somewhat larger. Second,
here, although not in Blau v. Allen, the final payment was made,
thereby lending credence to the view that a firm sale with a
payment provision was the essence of the agreement. Third, as the
McDonoughs insured the success of the sale by requiring a high
down payment, Smelting insured that it had the equivalent of a
purchase by securing an irrevocable proxy. The resignation of
Bernard P. McDonough and others as directors of Cudahy and their
replacement by key Smelting officials soon after the execution of
the agreement indicates that control of Cudahy passed to
Smelting, that a sale, had, in effect, been accomplished.
In conclusion, that defendant McDonough is subject to the
provisions of Section 16(b) has not been questioned. Adler v.
Klawans, 267 F.2d 840, 845-847 (2d Cir. 1959); Blau v. Allen,
163 F. Supp. 702, 704 (S.D.N.Y. 1958); see 2 Loss, Securities
Regulation 1060-61 (2d ed. 1961). McDonough, in fact,
acknowledges that this case turns solely on whether or not the
purchase and sale of the Cudahy stock by the McDonoughs occurred
within a period of less than six months. (McDonough's Memorandum
of Law in Support, at 8.) The resolution of that question depends
on whether the sale to Smelting was consummated when the option
was exercised by Smelting or when Smelting made a substantial
payment to the McDonoughs, received their proxy, and effected a
change in the Cudahy Board of Directors. Looking to the substance
rather than to the form of the transaction, we are convinced that
such an arrangement could serve as a vehicle for the unfair use
of inside information leading to unfair profitable insider
trading, all of which Section 16(b) was enacted to prohibit. Blau
v. Lamb, 363 F.2d 507, 516, 518-519 (1966).
We conclude that transaction entered into between the
McDonoughs and Smelting amounted to a sale or a contract to sell
within the terms of the statute and less than six months after
the purchase. Because abuses are made possible, Section 16(b)
must be invoked without further inquiry and irrespective of any
actual abuse. Id. at 516; Newmark v. R K O General, Inc.,
294 F. Supp. 358, 362 (S.D.N.Y. 1968). Summary judgment is granted to
plaintiff and denied to defendant.
© 1992-2003 VersusLaw Inc.