A person who is the record owner of less than 5% of the stock of a publicly held company, which is registered under Section 12 of the Securities Exchange Act of 1934, becomes a member of an existing group that beneficially owns over 20% of the stock. While a member of the group, the person participates in the joint filing of the group’s Schedule 13D and amendments to it and files a Form 3 and one or more Forms 4 to report the stock it owns (or in which it has a pecuniary interest) and transactions in the stock under Section 16 of the Exchange Act.

That person now wishes, without any sale or transfer of its stock, to cease being a member of the group. It appears that the person will not have to make any filing with the SEC to effect or reflect that exit. The remaining members of the group will sooner or later have to reflect the change in the group resulting from the exit in an amendment to their Schedule 13D. Because the person is not an executive officer or a director of the publicly held company, the SEC’s Rule 16a-2(c) appears to provide that the person does not have any obligation to report on Form 4 (or Form 5) any transaction in the stock after the person’s exit from the group. So it seems straightforward: The person should be able to exit the group and freely engage in trading without any taint from having been a member of the group, right?

Well, perhaps it’s not quite so simple. Rule 16a-2(c) does provide that Section 16 forms must be filed only while a non-insider is a 10% holder, and the SEC’s Compliance and Disclosure Interpretations, Exchange Act Section 16 and Related Rules and Forms, Question. 110.02 confirms that. The Rule and the CDI are consistent with the U.S. Supreme Court’s holding in Foremost-McKesson, Inc. v. Provident Securities Co., 423 U.S. 232 (1976). Nevertheless, a decision of the Second Circuit Court of Appeals in Roth v. Jennings, 489 F.3d 499 (2d Cir. 2007), may pose a concern or raise an issue to be considered.

In the Roth decision, the Court held that the federal District Court had improperly granted a motion to dismiss a Section 16 short-swing liability action against a former member of a group who sold shares of stock within six months after the last purchase of shares as part of, and while he was a member of, the group. The Court’s opinion expressed alternative rationales for that holding:

  • For purposes of short-swing liability under Section 16, a person’s status as a member of a group continues for the six-month matching period following the last purchase while a group member.
  • The District Court erroneously considered, in light of the procedural status of the motion to dismiss, facts indicating that the former group member had ceased to be a member of the group when he sold shares.

Although the second rationale may well have been correct, the first rationale is contrary to other statutory and case law and existing SEC interpretations, as described above. Regarding the first rationale, however, the Court’s view seems to have been prompted by a concern or suspicion that the former member of the group may have based his subsequent sales on material non-public information gained while a group member – so that (to put it another way) the former member should not really be considered as separated from the group.

While the Roth decision is apparently wrong regarding the application of Section 16 to a former group member, it is a reminder that the existence and duration of a “group” under Section 16 (based on Section 13 of and Rule 13d-3 under the Exchange Act) can be uncertain and that a former group member – no matter how clearly separated from the group – must be sensitive to the possession of material non-public information that the member may have, or may reasonably be attributed to him, from participation in the group.

OUR TAKE: Even if a non-insider exiting a group of beneficial owners is not required to file with the SEC any amendment to a Schedule 13D or any Form 4 to effect or reflect the exit from the group or in connection with any trades made after the exit, the person should carefully consider, before effecting any trade, whether any material non-public information may reasonably be attributed to it because of the person’s former membership in the group.