• Second Circuit Affirms Dismissal Of Short-Swing Trading Suit Against Lead Underwriters And Pre-IPO Shareholders Arising From Facebook IPO
   

  11/07/2016
  On November 3, 2016, the United States Court of Appeals for the Second Circuit affirmed the dismissal of a “short-swing” trading suit brought against the lead underwriters in connection with Facebook, Inc.’s initial public offering (“IPO”).  In re: Facebook Inc., IPO Sec., No. 14-3800 (2nd Cir. Nov. 3, 2016).  The Second Circuit held that standard lock-up agreements in an IPO between lead underwriters and pre-IPO shareholders are not alone sufficient to render those parties a “group” under Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”), and therefore those parties were not subject to disgorgement pursuant to Section 16(b) of the Exchange Act.  Plaintiff had sought to hold the defendants liable under Section 16(b) for disgorgement of short-swing profits received in connection with their sales and purchases of shares in Facebook’s IPO.
  
  Section 16(b) of the Exchange Act requires a statutory “beneficial owner” of ten percent or more of an issuer’s stock to disgorge all profits realized from short sales or purchases of that security within a six-month period.  While none of the defendants alone met the ten percent threshold, plaintiff alleged that defendants together formed a “group” as defined in Section 13(d) of the Exchange Act, and therefore constituted a beneficial owner sufficient to meet the threshold of Section 16(b).  To support its “group” allegations, plaintiff pointed to lock-up agreements between the defendants and pre-IPO shareholders that prevented the shareholders from selling their stock for a specified period of time except as permitted by the agent for the lead underwriters.  Judge Robert W. Sweet of the United States District Court for the Southern District of New York dismissed the complaint on the grounds that the lock-up agreements alone were insufficient to render defendants beneficial owners of the shares under Section 13(d) of the Exchange Act.
  
  The Second Circuit agreed with Judge Sweet and affirmed the dismissal, holding that while lock-up agreements “may bear upon” the question of whether a group exists, such agreements are generally “one-way streets keeping certain shareholders out of the IPO markets for a specified period of time,” rather than agreements “to act together.”  The Court, citing an amicus brief submitted by the Securities and Exchange Commission, emphasized that lock-up agreements are “common [and] even essential, to the typical IPO” because they assure potential buyers of securities in the IPO that shares owned by pre-IPO shareholders of the issuer will not enter the public market too soon after the offering.  Finding these agreements to be “essential to the regulation of public offerings,” the Court held that such agreements, without more, do not establish a “group” under Section 13(d), and thus defendants may not be held liable under Section 16(b).  Moreover, the Court found that even though the underwriters and the pre-IPO shareholders hoped to profit from the IPO, such common objective did not create a need for information concerning potential changes in control beyond that inherent in the IPO process.
  
  The Court, however, cautioned that its analysis applies only to standard lock-up agreements like those at issue in the case, and that “atypical language in a lock-up agreement” or evidence of “coordination between underwriters and the other parties to a lock-up agreement with implications for control changes beyond those inherent in an IPO might trigger such a [group] finding.”  Nevertheless, the Court’s ruling should reassure underwriters that the common practice of engaging pre-IPO shareholders in standard lock-up agreements will not by itself create a “group” under Section 13(d) or create Section 16(b) liability. 
  Category: Short-Swing Trading
  

Links & Downloads

• In re Facebook Inc., IPO