IN THE UNITED STATES COURT OF APPEALS
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IN THE UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
______________________________________________________
No. 04-35715
___________________________________________________________
THOMAS R. DREILING, a shareholder of INFOSPACE, INC.,
Plain tiff-Ap p e llan t,
v.
AMERICAN EXPRESS TRAVEL RELATED SERVICES
COMPANY, INC.,
De fe n d an t-Ap p e lle e ,
and
INFOSPACE. INC., a Delaware corporation,
No m in al De fe n d an t-Ap p e lle e .
___________________________________________________________
On Appeal from the United States District Court
for the Western District of Washington
______________________________________________________
BRIEF OF THE SECURITIES AND EXCHANGE COMMISSION,
AMICUS CURIAE, IN PARTIAL SUPPORT OF EACH PARTY
______________________________________________________
GIOVANNI P. PREZIOSO
General Counsel
JACOB H. STILLMAN
Solicitor
ERIC SUMMERGRAD
Deputy Solicitor
ALLAN A. CAPUTE
Special Counsel to the Solicitor
Securities and Exchange Commission
Washington, D.C. 20549-0606
(202) 942-0837 (Capute)
TABLE OF CONTENTS
PAGE
INTEREST OF THE SECURITIES AND EXCHANGE
COMMISSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
BACKGROUND . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
A.
The Statutory and Rule Provisions at Issue . . . . . . . . . . . . . . . . . . . . . . 3
B.
Facts and Proceedings Below . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
ARGUMENT
I.
II.
........................................................ 6
THE ADOPTION OF RULE 16b-3(d) WAS WITHIN
THE COMMISSION’S AUTHORITY. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
A.
The Transactions Exempted by Rule 16b-3 Are
Not Comprehended Within the Purposes of
Section 16(b), Which Seeks to Prevent the “Unfair”
Use of Inside Information. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
B.
Rule 16b-3(d) Is Not Invalid Because It Attempts to
Achieve a Measure of Simplicity and Flexibility. . . . . . . . . . . . . . . . . . 17
C.
The Commission’s Judgment In Adopting Rule 16b-3
Is Entitled to Full Chevron Deference. . . . . . . . . . . . . . . . . . . . . . . . . . . 19
TO THE EXTENT A PERSON IS A DIRECTOR
BY DEPUTIZING ANOTHER TO SIT ON THE
BOARD, THE DEPUTIZING PERSON IS
SUBJECT TO SECTION 16(b), AND MAY RELY
ON RULE 16b-3(d), BUT ONLY TO THE EXTENT
THE BOARD APPROVING THE TRANSACTION
IS AWARE OF THE DEPUTIZATION, AN ISSUE
OF FACT IN THIS CASE. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
-i-
TABLE OF AUTHORITIES
CASES
PAGE
Bershad v. McDonough, 428 F.2d 693 (7 th Cir. 1970) . . . . . . . . . . . . . . . . . . . . 8, 9, 18
Blau v. Lamb, 363 F.2d 507 (2d Cir. 1966) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Blau v. Lehman, 368 U.S. 403 (1962) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21, 22, 23
passim
Bragdon v. Abbott, 524 U.S. 624 (1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc.,
467 U.S. 837 (1984) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11, 19
Diamond v. Oreamuno, 24 N.Y.2d 494, 301 N.Y.S.2d 78,
248 N.E.2d 910 (1969) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Feder v. Martin Marietta Corp., 406 F.2d 260 (2d Cir. 1969) . . . . . . . . . . . . . . . . . . 23
Foremost-McKesson, Inc. v. Provident Securities Co.,
423 U.S. 232 (1976) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9, 13, 14
Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Gollust v. Mendell, 501 U.S. 115 (1991) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9, 11
Gryl v. Shire Pharmaceuticals Group, 298 F.3d 136 (2d Cir. 2002) . . . . . . . . . . . . . 12
Jackson v. Smith, 254 U.S. 586 (1921) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Kern County Land Co. v. Occidental Petroleum Corp.,
411 U.S. 582 (1973) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6, 8, 13
passim
Mosser v. Darrow, 341 U.S. 267 (1951) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
-ii-
CASES (Continued)
PAGE
Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418 (1972) . . . . . . . . . 8, 9, 13
passim
SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968) . . . . . . . . . . . . . . . . . . 14
Smiley v. Citibank (South Dakota), N.A., 517 U.S. 735 (1996) . . . . . . . . . . . . . . . . . 19
United States v. Mead Corp., 533 U.S. 218 (2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
United States v. O'Hagan, 521 U.S. 642 (1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
STATUTES AND RULES
Securities Exchange Act of 1934, 15 U.S.C. 78a, et seq.
Section 2, 15 U.S.C. 78b . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Section 3(a)(9), 15 U.S.C. 78c(a)(9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
Section 16(b), 15 U.S.C. 78p(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1, 2, 3
passim
Section 23(a), 15 U.S.C. 78w(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Rules under the Securities Exchange Act of 1934, 17 C.F.R. 240.01, et seq.
Rule 10b-5, 17 C.F.R. 240.10b-5 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Rule 16b-3(d), 17 C.F.R. 240.16b-3(d) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2, 4, 5
passim
Federal Rule of Appellate Procedure 29(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Congressional Material
H.R. Rep. No. 1383, 73d Cong., 2d Sess. (1934) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
S. Rep. No. 792, 73d Cong., 2d Sess. (1934)
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7, 10
Stock Exchange Practices, S. Rep. No. 1455, 73d Cong., 2d Sess. (1934) . . . . . . . . . . 7
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Congressional Materials (Continued)
PAGE
Hearings on Stock Exchange Practices before the
Senate Committee on Banking and Currency,
73d Cong., 1st Sess. pt. 15 (1934) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
MISCELLANEOUS
3D Harold Bloomenthal & Samuel Wolff, Securities &
Federal Corporate Law (WestLaw 2004) . . . . . . . . . . . . . . . . . . . . . . . 10, 11, 16
3 Fletcher Cyc. Corp.(Perm. ed. 1994) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
D. Block, S. Radin and N. Barton, The Business Judgment
Rule: Fiduciary Duties of Corporate Directors (4th ed. 1993) . . . . . . . . . . . . 15
Memorandum of the Securities and Exchange Commission,
Amicus Curiae, in Support of Appellees' Petition for
Rehearing or Rehearing En Banc, filed in, Levy v.
Sterling Holding Co., LLC., 314 F.3d 106, 124
(3d Cir. 2002), cert. denied, 540 U.S. 947 (2003),
available at, www.sec.gov/litigation/briefs/levy-sterling022703.htm . . . . . . 24
Notice of Proposal to Adopt a Rule Exempting from the
Operation of Section 16(b) Certain Acquisitions
and Dispositions of Securities Pursuant to Mergers or
Consolidations, Securities Exchange Act Rel. No. 4696,
17 Fed. Reg. 3177, 1952 SEC LEXIS 63 (April 9, 1952) . . . . . . . . . . . . . . . . . 9
Ownership Reports and Trading by Officers,
Directors and Principal Security Holders,
Exchange Act Rel. No. 37260,
61 Fed. Reg. 30376 (June 14, 1996) . . . . . . . . . . . . . . . . . . . . . . . . . . . 10, 14, 15
passim
Ownership Reports and Trading by Officers,
Directors and Principal Stockholders,
Exchange Act Rel. No. 26333, 53 Fed.
Reg. 49997 (Dec. 13, 1988) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
-iv-
MISCELLANEOUS (Continued)
PAGE
Ownership Reports and Trading by Officers,
Directors and Principal Security Holders,
Exchange Act Release No. 36356,
60 Fed. Reg. 53832 (Oct. 17, 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Interpretive Release on Rules Applicable to Insider
Reporting and Trading, Exchange Act Release
No. 18114, 1981 WL 31301 (Sept. 24, 1981) . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Peter J. Romeo & Alan L. Dye, Comprehensive Section 16
Outline (2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Peter J. Romeo & Alan L. Dye, Section 16 Treatise and
Reporting Guide (2d ed. 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20, 23
William Meade Fletcher, Fletcher Cyclopedia of Private
Corporations (WestLaw 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
-v-
UNITED STATES COURT OF APPEALS
FOR THE NINTH CIRCUIT
______________________________________________________
No. 04-35715
______________________________________________________
THOMAS R. DREILING, a shareholder of INFOSPACE, INC.,
Plaintiff-Appellant,
v.
AMERICAN EXPRESS TRAVEL RELATED SERVICES
COMPANY, INC.,
Defendant-Appellee,
and
INFOSPACE. INC., a Delaware corporation,
Nominal Defendant-Appellee.
______________________________________________________
On Appeal from the United States District Court
for the Western District of Washington
______________________________________________________
BRIEF OF THE SECURITIES AND EXCHANGE COMMISSION,
AMICUS CURIAE, IN PARTIAL SUPPORT OF EACH PARTY
______________________________________________________
INTEREST OF THE SECURITIES AND EXCHANGE COMMISSION
The Securities and Exchange Commission submits this brief as amicus curiae to
address important legal issues relating to the “short-swing” trading provision in
Section 16(b) of the Securities Exchange Act of 1934, 15 U.S.C. 78p(b). The objective
of Section 16(b) is to deter corporate insiders from trading in their companies’
securities on the basis of inside information. Congress viewed short-swing trading -purchases and sales occurring within a period of less than six months -- as a type of
trading that posed a particular risk of misuse of inside information. Therefore, it
provided in Section 16(b) that any profits realized by the insider from such trading
shall inure to and be recoverable by the issuer.
Although Section 16(b) actions are brought only by issuers and their
shareholders, Congress delegated to the Commission the responsibility of formulating
rules exempting from Section 16(b) transactions that, in the Commission’s view, are
“not comprehended within the purpose of” Section 16(b). The defendant in this case
contends, and the district court agreed, that its acquisition of stock was exempt under
Commission Rule 16b-3(d), 17 C.F.R. 240.16b-3(d). The issues in this case are
whether the Commission had the authority to adopt that exemption in its present
form, a matter patently of great interest to the Commission, and how the exemption
should be construed, a matter as to which the Commission, as the rule’s promulgator,
likewise has a plain interest. 1/
1/
Although the Commission could have filed this brief on a timely basis as a
matter of right, see F.R.A.P. 29(a), it did not do so. On March 18, 2005, the
Court authorized the Commission to file this brief out of time on April 5, 2005.
-2-
BACKGROUND
A.
The Statutory and Rule Provisions at Issue
Section 16(b) of the Exchange Act provides “For the purpose of preventing the
unfair use of information which may have been obtained” by an officer, director, or
beneficial owner of more than 10% of an class of any issuer’s equity securities “any
profit realized by him from any purchase and sale, or any sale and purchase, of any
equity security of such issuer * * * within any period of less than six months” shall be
recoverable by the issuer or the beneficial owner of any security of the issuer.
Recovery may be obtained “irrespective of any intention on the part of such beneficial
owner, director, or officer in entering into such transaction.” The section states,
however, that “[t]his subsection shall not be construed to cover * * * any transaction
or transactions which the Commission by rules and regulations may exempt as not
comprehended within the purpose of this subsection.”
At issue in this case is the exemption contained in Rule 16b-3(d). That rule
exempts from Section 16(b) certain transactions where an officer or director of the
issuer obtains a “a grant, award or other acquisition from the issuer.” To qualify, the
transactions must be either: (1) approved by the board of directors of the issuer, or a
committee of the board of directors that is composed of at least two non-employee
directors; (2) approved or ratified by the affirmative votes of the holders of a majority
of the securities of the issuer; or (3)the securities acquired are held by the officer or
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director for a period of six months following the date of such acquisition. 2/
B.
Facts and Proceedings Below
The plaintiff in this case, Thomas R. Dreiling, is a shareholder of InfoSpace,
Inc. He alleges that American Express Travel Related Services, Inc. (“TRS”) was a
director of InfoSpace and, while in that capacity, within a six month period, “engaged
in a purchase and corresponding sales, and/or sales and a corresponding purchase of
InfoSpace stock” and that TRS “profited from the corresponding purchases and sales
and/or sales and purchases of InfoSpace stock.” 3/ TRS, as a corporation, was not
elected a member of the InfoSpace board, but Dreiling claims it served in that
capacity by deputizing one of its executive officers, David C. House, to sit on the
board and represent its interests. House did not himself own or trade in any
InfoSpace stock.
By letter dated September 17, 2003, Dreiling made a statutory demand on
InfoSpace. The letter stated that TRS “should be compelled to disgorge the profits
made through the purchase and sales of InfoSpace stock within a six month period
from February 25, 2000 through August 24, 2000,” adding that TRS was liable for the
2/
The complete text of Section 16(b) and Rule 16b-3(d) are reprinted in the
Addendum (1A-2A).
3/
TRS acquired stock in Infospace after that company merged with a company
called Prio, Inc., in which TRS owned a substantial amount of stock.
-4-
recovery of short-swing profits as an insider through its representation on the board
of InfoSpace by House. In a response dated November 14, 2003, counsel for
InfoSpace rejected Dreiling’s demand, stating that House did not “in any way”
represent TRS on the board of InfoSpace.
Dreiling then brought this action under Section 16(b) on November 26, 2003.
Dreiling’s First Amended Complaint, filed on December 15, 2003, alleges that from
January 21, 2000 through May 21, 2001 TRS was, for purposes of Section 16(b), a
director of InfoSpace through House, whom it “deputized” “to represent its interests
on InfoSpace’s Board of Directors.” It further alleges that “[w]ithin periods of less
than six months, [TRS] engaged in purchases and corresponding sales and/or sales
and a corresponding purchase of InfoSpace stock.” It also alleges that TRS failed to
report these transactions as required by Section 16(a) of the Exchange Act, thereby
tolling the two-year statute of limitations.
The district court dismissed Dreiling’s amended complaint, finding that the
defendant’s acquisition of InfoSpace securities was exempt under Rule 16b-3(d). On
appeal, Dreiling contends that the Commission exceeded its authority when it
promulgated Rule 16b-3(d). Alternatively, Dreiling argues that the Rule 16b-3(d)
exemption should not apply where, as alleged here, the director is not a person sitting
on the board, but rather is a director by virtue of having deputized a person to sit on
-5-
the board.
ARGUMENT
I.
THE ADOPTION OF RULE 16b-3(d) WAS WITHIN THE
COMMISSION’S AUTHORITY.
A.
The Transactions Exempted by Rule 16b-3 Are Not
Comprehended Within the Purposes of Section 16(b),
Which Seeks to Prevent the “Unfair” Use of Inside
Information.
In arguing that the Commission exceeded its authority when it promulgated
Rule 16b-3(d), Dreiling would like to make it appear that Section 16(b) was principally
concerned with reining in any form of self-interested securities transaction by officers
and directors, while Rule 16b-3 unleashes them. This argument, however, overstates
the purpose of Section 16(b) and mischaracterizes the effect of Rule 16b-3(d).
The Supreme Court has stated that Congress’s concern when it enacted Section
16(b) was that corporate “[i]nsiders could exploit information not generally available
to others to secure quick profits” and that “Congress recognized that shortswing
speculation by stockholders with advance, inside information would threaten the goal
of the Securities Exchange Act to ‘insure the maintenance of fair and honest
markets.’” Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 591-92 (1973)
(quoting Exchange Act Section 2, 15 U.S.C. 78). In the 1934 report that summarized
the findings of its extensive investigation into stock exchange practices, the Senate
Committee on Banking and Currency, in a portion of the report entitled “Market
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Activities of Directors, Officers, and Principal Shareholders of Corporations,” stated:
Among the most vicious practices unearthed at the hearing before the
subcommittee was flagrant betrayal of their fiduciary duties by directors
and officers of corporations who used their positions of trust and the
confidential information which came to them in such positions, to aid
them in their market activities.
Stock Exchange Practices, S. Rep. No. 1455, 73d Cong., 2d Sess. 55 (1934).
(emphasis added). The Senate Report is replete with examples of corporate insiders
who, armed with inside information, engaged in unfair trading with market
participants. Id. at 55-68. See S. Rep. 792, 73d Cong., 2d Sess. 9 (1934); Blau v. Lamb,
363 F.2d 507, 514-15 (2d Cir. 1966).
The statutory language itself shows that Congress sought to suppress the
speculative abuse where insiders with the advantage of possessing inside information
traded with investors who were disadvantaged by the lack of equal information. This
is why Congress stated that Section 16(b) was enacted “for the purpose of preventing
the unfair use of information” (emphasis added).
To remedy this speculative abuse, Congress focused on short-swing trading by
insiders, believing that unfair use of information was most likely to occur in that type
of trading. This does not mean, however, that Congress believed that short-swing
trading was in and of itself wrong. Rather, it chose to allow recovery of all shortswing profits realized by specified insiders trading in their own stock, in order to deter
that trading which was abusive. The Supreme Court has repeatedly recognized that
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“‘the only method Congress deemed effective to curb the evils of insider trading was
a flat rule taking the profits out of a class of transactions in which the possibility of
abuse was believed to be intolerably great.’” Kern County Land Co. v. Occidental Petroleum
Corp., 411 U.S. at 592 (quoting Reliance Electric Co. v. Emerson Electric Co., 404 U.S. 418,
422 (1972)). The Court has also observed:
In order achieve its goals, Congress chose a relatively arbitrary rule
capable of easy administration. The objective standard of Section 16(b)
imposes strict liability upon substantially all transactions occurring within
the statutory time period, regardless of the intent of the insider or the
existence of actual speculation. This approach maximized the ability of
the rule to eradicate speculative abuses by reducing difficulties in proof.
Reliance Electric Co. v. Emerson Electric Co., 404 U.S. at 422 (quoting Bershad v. McDonough,
428 F.2d 693, 696 (7th Cir. 1970)). 4/
This type of remedy was described by its drafters as a “crude rule of thumb.”
Hearings on Stock Exchange Practices before the Senate Committee on Banking and Currency, 73d
4/
As summarized by the Commission, a six month period was chosen because:
Short swing speculation is deemed to involve incentives
and opportunities to profit improperly to a degree not
present in connection with long term investment and
changes in investment position. The arbitrary period of six
months was selected as roughly marking the distinction
between short swing speculation and long term investment.
Notice of Proposal to Adopt a Rule Exempting from the Operation of Section 16(b) Certain
Acquisitions and Dispositions of Securities Pursuant to Mergers or Consolidations,
Exchange Act Release No. 4696, 17 Fed. Reg. 3177, 1952 SEC LEXIS 63
(April 9, 1952).
-8-
Cong., 1st Sess. pt. 15, 6557 (1934) (testimony of Thomas Corcoran as spokesman for
the drafters of the Exchange Act). It can extract a high price, since it can deprive
insiders of profits even in transactions that involve no abuse of inside information.
Because Section 16(b) can be harsh in imposing liability without fault, “Congress itself
limited carefully the liability imposed by §16(b).” Foremost-McKesson, Inc. v. Provident
Securities Co., 423 U.S. 232, 252 (1976) (quoting Bershad v. McDonough, 428 F.2d at 696).
See also Gollust v. Mendell, 501 U.S. 115, 122 (1991); Reliance Electric Co. v. Emerson Electric
Co., 404 U.S. at 422-23. “Even an insider may trade freely without incurring the
statutory liability if, for example, he spaces his transactions at intervals greater than six
months. When Congress has so recognized the need to limit carefully the ‘arbitrary
and sweeping coverage’ of §16(b) * * * courts should not be quick to determine that
* * * Congress intended the section to cover a particular transaction.” ForemostMcKesson, Inc. v. Provident Securities Co., 423 U.S. at 252. See also Gollust v. Mendell, 501
U.S. at 122; H.R. Rep. No. 1383, 73d Cong., 2d Sess. 13 (1934).
Of particular relevance, Congress protected against overreaching by vesting in
the Commission the authority to exempt from Section 16(b) “any transaction or
transactions which the Commission by rules and regulations may exempt as not
comprehended within the purpose of this subsection.” Congress made clear that
“[t]he expressed purpose of [Section 16(b)] is to prevent the unfair use of inside
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information. The Commission may exempt transactions not falling within this
purpose.” S. Rep. No. 792, supra at 21. 5/
In adopting the current version of Rule 16b-3(d), the Commission was clear in
explaining why the transactions it exempts generally do not lend themselves to the
abusive use of inside information with which Section 16(b) is concerned:
Generally, these transactions do not appear to present the same
opportunities for insider profit on the basis of non-public information as
do market transactions by officers and directors. Typically, where the
issuer, rather than the trading markets, is on the other side of an officer
or director's transaction in the issuer's equity securities, any profit
obtained is not at the expense of uninformed shareholders and other
market participants of the type contemplated by the statute.
Ownership Reports and Trading by Officers, Directors and Principal Security Holders, Exchange
Act Rel. No. 37260, 61 Fed. Reg. 30376, 30377 (June 14, 1996). See 3D Harold
Bloomenthal & Samuel Wolff, Securities & Federal Corporate Law §21:66.55 (WestLaw
2004) (“Market transactions present opportunities for profit based upon non-public
information in a way that transactions with the issuer do not.”).
There is no basis for this Court to dispute the Commission’s conclusion.
“[T]he well-reasoned views of the agencies implementing a statute ‘constitute a body
5/
In adopting Rule 16b-3, the Commission relied, not only upon the authority to
adopt exemptive rules provided in Section 16(b) itself, but also on the
Commission’s general rulemaking authority found in Section 23(a) of the
Exchange Act, 15 U.S.C. 78w(a), reprinted in the Addendum (3A). See
Ownership Reports, Exchange Act Rel. No. 37260, 61 Fed. Reg. at 30391.
-10-
of experience and informed judgment to which courts and litigants may properly
resort for guidance.’” United States v. Mead Corp., 533 U.S. 218, 227 (2001) (quoting
Bragdon v. Abbott, 524 U.S. 624, 642 (1998)). Thus, where, as here, “Congress has
explicitly left a gap for the agency to fill, there is an express delegation of authority to
the agency to elucidate a specific provision of the statute by regulation. Such
legislative regulations are given controlling weight unless they are arbitrary, capricious,
or manifestly contrary to the statute.” Chevron, U.S.A., Inc. v. Natural Resources Defense
Council, Inc., 467 U.S. 837, 843-44 (1984). See also United States v. O’Hagan, 521 U.S.
642, 673 (1997).
Indeed, Dreiling does not dispute the common-sense proposition that, in
general, an issuer knows any inside information that its officers or directors know, so
that an issuer is typically not at an informational disadvantage in dealing with its
insiders. Instead, he misstates the rule, contending that the rule allows a corporate
board of directors to give its blessing to any transaction that would otherwise be
subject to suit under Section 16(b) (Brief of the Plaintiff-Appellant, p. 9). But that
simply is not the case. Rule 16b-3(d) is available only to exempt transactions between
an officer or director and the issuer. It only applies in a limited type of transaction in
which the risk of abuse is inherently limited.
The risk that a transaction will be a vehicle for speculative abuse by an insider is
also limited by the conditions the rule imposes on those transactions. Either the
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acquisitions must be approved by the issuer’s board (or committee or non-employee
directors) or by the shareholders, or the insider must hold the securities for six
months. Board or shareholder approval will remove the timing of the acquisition
from the control of any one insider and also tend to assure that the acquisition is for a
legitimate corporate purpose. See Gryl v. Shire Pharmaceuticals Group, 298 F.3d 136, 14546 (2d Cir. 2002).
This is not to say that issuer-insider transactions will never in any circumstance
involve abuse of inside information. There may be situations, for example, where a
dominant insider is privy to inside information that he conceals from the board or
shareholders in obtaining approval for a transaction. But even assuming these
deceptions might occur on occasion, that does not preclude the Commission from
adopting a general exemption for issuer-insider transactions. While Dreiling would
have this Court believe that Section 16(b) states that it was enacted “for the purpose
of preventing any unfair use of information” by corporate insiders (see Brief of the
Plaintiff-Appellant, pp. 9, 14, 17, 35-36, 38). But the word any does not appear in the
provision’s introductory sentence. To the contrary, the Supreme Court has stated that
“Congress sought to ‘curb the evils of insider trading [by] * * * taking the profits out
of a class of transactions in which the possibility of abuse was believed to be intolerably
great.’” Foremost-McKesson, Inc., 423 U.S. at 243 (quoting Reliance Electric Co., 404 U.S. at
-12-
422) (emphasis added). 6/ In adopting current Rule 16b-3(d), the Commission
concluded that the exempted transactions did not pose a significant risk of abusive
insider trading with less informed investors. This was a highly appropriate approach,
while Dreiling’s approach is not. Section 16(b) imposes a harsh and arbitrary remedy,
which can ensnare innocent insiders who simply bought and sold securities within six
months. While those effects on innocent insiders are unavoidable when short-swing
trading occurs in contexts where unfair use of information is a significant risk, there is
no reason to impose such liability in contexts where generally there is a diminished
risk of unfair use of inside information. 7/
Dreiling also argues that insiders obtaining securities from an issuer may engage
6/
Relying on Kern County Land Co., 411 U.S. at 600, Dreiling contends that Section
16(b) liability must be extended to the acquisition of InfoSpace stock by TRS
unless there is “absolutely no possibility” of any abuse (Brief of the Plaintiff Appellant, p. 17). Kern announced no such rule. Indeed, a very similar
argument was addressed by the Court in Foremost-McKesson, Inc., 423 U.S. at 252,
where also relying on Kern, supra, at 595 and Reliance Electric Co., 404 U.S. at 424,
the plaintiff argued that where any “alternative construction” of Section 16(b) is
possible, liability must be imposed. To this argument, the Court responded
noting that the Court declined to impose liability in either case, “thus
recognizing that serving the congressional purpose does not require resolving
every ambiguity in favor of liability under §16(b).” Foremost-McKesson, 432 U.S.
at 252.
7/
The Commission noted that “There are also potential liability considerations
under Rule 10b-5 [17 C.F.R 240.10b-5].” 61 Fed. Reg. 30377, n.17. If such a
transaction involved unfair use of information, the transaction would likely be
subject to such liability. See SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848,
850 (2d Cir. 1968).
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in other forms of abusive conduct. For example, Dreiling posits two scenarios in
which officers or directors, privy to inside information, receive securities from the
issuer on favored terms, and then sell them in the market after full disclosure of the
true facts is made. Typically, however, the issuer will also know this information at
the time of the acquisition, so there is no fraud in the acquisition. Nor does the later
sale, which takes place after the inside information is disclosed, involve fraud.
Of course, there could be other insider misconduct in these scenarios. They
may involve self-dealing in breach of the officer’s or director’s fiduciary duties. While
Dreiling contends that Section 16(b) is designed to prevent such abusive conduct,
such self-dealing generally does not involve insider trading and is not what Section
16(b) was directed at. As the Commission noted when it revised Rule 16b-3(d):
An insider's breach of fiduciary duty to profit from self-dealing
transactions with the company is a concern of state corporate law.
Generally, states have created potent deterrents to insider self-dealing
and other breaches of fiduciary duty.” Id. at n.17, citing 3 Fletcher Cyc.
Corp. § 837.60 (Perm. ed. 1994); D. Block, S. Radin and N. Barton, The
Business Judgment Rule: Fiduciary Duties of Corporate Directors 124-37 (4th ed.
1993).
Ownership Reports, Exchange Act Rel. No. 37260, 61 Fed. Reg. at 30377. Thus, if a selfinterested board disregards the corporation’s interest and engages in self-dealing or
sweetheart deals, it plainly breaches its fiduciary duty and may be held liable under
state law.
Dreiling contends that state fiduciary law does not generally apply to these sorts
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of transactions, and that Section 16(b) is needed as a substitute. But he
misunderstands the fiduciary law the Commission talked about in its adopting release.
He cites Freeman v. Decio, 584 F.2d 186, 196 (7 th Cir. 1978), as supposedly proving that
that there is only limited state fiduciary law for abusive transactions between an insider
and the issuer. But what Freeman was dealing with was whether Indiana would
recognize a derivative action on behalf of a corporation for breach of a supposed
fiduciary duty owed by an insider for transactions between the insider and shareholders
in a market transaction. The New York Court of Appeals had recognized such an action
in Diamond v. Oreamuno, 24 N.Y.2d 494, 301 N.Y.S.2d 78, 248 N.E.2d 910 (1969). As
the Freeman court stated, this was an innovative departure from usual state law
fiduciary standards, which both before and after Diamond, did not recognize an
obligation by insiders to disclose to shareholders with whom they traded material nonpublic information, much less a right of a corporation to sue the insiders.
The Commission, however, was not talking about the application of state
fiduciary law to transactions between insiders and shareholders. It was talking about
dealings between insiders and issuers, since that is all Rule 16b-3 exempts. There is no
question that insiders who unfairly deal with their corporation can be subject to suit
under state fiduciary law for abusive self-dealing. Even commentators heavily relied
on by Dreiling agree that “[s]tate corporate law is sufficient to regulate self-dealing or
breaches of fiduciary duty where directors improperly award securities to themselves
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(or improperly approve awards to other directors or officers).” 3D Harold S.
Bloomenthal & Samuel Wolff, Securities and Federal Corporate Law §21:66.55 (WestLaw
2004). See also William Meade Fletcher, Fletcher Cyclopedia of Private Corporations §1040
(WestLaw 2004) (“The business judgment rule does not protect corporate fiduciaries
who engage in self-dealing or make decisions affected by inherent conflict of
interest.”). In short, self-dealing abuses in insider-issuer transactions are adequately
covered by state law.
Dreiling posits one other example of possible insider abuse. He states that TRS
could, within six months of acquiring InfoSpace shares in the merger, learn from
House, its alleged representative on the board, that InfoSpace is overvalued in the
market and sell its shares in the market to unwitting investors. This would be fraud,
but not a type of fraud at which Section 16(b) was directed. The abuses at which
Section 16(b) was directed involved short-term, in-and-out trading by insiders. Kern
County Land Co., 411 U.S. at 591-92. This contemplated a purchase and subsequent
sale, or sale and subsequent purchase, in which the paired transactions presented the
potential for the “unfair use of information” by transacting with investors who are at
an informational disadvantage. This could occur in the case of a purchase and
subsequent sale, where the insider purchases from a person who is at an informational
disadvantage and then, within six months, sells after the information has become
public. Dreiling’s scenario, in contrast, involves an insider who happened to hold
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stock (and may have for years) and dumps the stock on an unsuspecting market when
he learns of bad news. Congress did not intend Section 16(b) to protect against all
forms of improper corporate management. Nor was Section 16(b) ever intended to
protect against all forms of insider trading.
B.
Rule 16b-3(d) Is Not Invalid Because It Attempts to Achieve a
Measure of Simplicity and Flexibility.
Dreiling argues that in adopting current Rule 16b-3(d), the Commission was
motivated solely by the desire to achieve regulatory simplicity and flexibility. This
contention totally ignores the Commission’s explanation that it did not believe issuerinsider transactions, at least under the gatekeeping conditions in the new rule, present
a significant risk of the abuses Section 16(b) is concerned with.
The release also evaluated the administrative issues generated by the 1991
version of Rule 16b-3, which it replaced. It noted that the 1991 rule proved to be so
cumbersome and difficult to comply with that it discouraged participation in
corporate incentive plans. Given the diversity, complexity, and constantly changing
nature of such plans, a new regulatory regime was required that would allow for
flexibility. Current Rule 16b-3 was thus designed to “facilitate the operation of
employee benefit plans [and] broaden exemptions from Section 16(b) short-swing
profit recovery where consistent with statutory purposes * * * .” Ownership Reports and Trading
by Officers, Directors and Principal Security Holders, Exchange Act Release No. 37260, 61
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Fed. Reg. at 30376 (emphasis added). Just as in Section 16(b) itself “Congress chose a
relatively arbitrary rule capable of easy administration,” Reliance Electric Co. v. Emerson
Electric Co., 404 U.S. at 422 (quoting Bershad v. McDonough, 428 F.2d 693, 696 (7th Cir.
1970)), it is appropriate for the Commission to take ease of application into account in
crafting exemptions, so long as it is consistent with the statute’s purpose. 8/
8/
In his brief, Dreiling quotes Peter J. Romeo & Alan L. Dye, Comprehensive Section
16 Outline 350 (2003), for the proposition that in order to gain regulatory
flexibility and simplicity “there was a ‘price paid’: ‘the loss of some protections
against speculative abuse.’” But Romeo and Dye go on to state that “This loss,
however, does not appear to have had much impact. Because the rule exempts
only transactions with the issuer, it generally does not provide an opportunity
for insiders to engage in speculative abuse at the expense of market
participants.” Romeo & Dye, Section 16 Outline 350.
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C.
The Commission’s Judgment in Adopting Rule 16b-3 Is Entitled to
Full C h e v ro n Deference.
Dreiling argues that the Commission’s revision of Rule 16b-3 is not entitled to
Chevron deference because it represents an interpretation of Section 16(b) that is
different from that the Commission adopted in 1991 (Brief of the Plaintiff-Appellant,
p. 40-41). The Supreme Court, however, has made clear that where a statute does not
speak to an issue unambiguously, “legislative regulations are given controlling weight
unless they are arbitrary, capricious, or manifestly contrary to the statute.” Chevron,
U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. at 843-44. This is so even
if the agency is changing its statutory interpretation. Smiley v. Citibank (South Dakota),
N.A., 517 U.S. 735, 740-41 (1996). See, e.g., Chevron, 467 U.S. at 857-58. Thus, “the
mere fact that an agency interpretation contradicts a prior agency position is not
fatal.” Smiley v. Citibank, 517 U.S. at 742. Indeed, Chevron itself approved a rule that
changed after a change in administrations. 467 U.S. at 857-58. Only “[s]udden and
unexplained change, * * * or change that does not take account of legitimate reliance
on prior interpretation, * * * may be ‘arbitrary, capricious [or] an abuse of
discretion.’ But if these pitfalls are avoided, change is not invalidating, since the whole
point of Chevron is to leave the discretion provided by the ambiguities of a statute with
the implementing agency.” Smiley v. Citibank, 517 U.S. at 741 (citations omitted).
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While the 1996 version of Rule 16b-3 changed the exemptive conditions of the
rule, Rule 16b-3 has long been available to exempt acquisitions of securities by officers
and directors, based on satisfaction of appropriate regulatory conditions designed to
protect against the abuses at which Section 16(b) was directed. 9/ The Commission
was careful to explain when it adopted current Rule 16b-3 that its prior method of
exempting insider acquisitions of issuer securities - - which required all such
acquisitions take place pursuant to an approved written employee benefit plan - simply did not work and actually discouraged some insiders from acquiring issuer
securities through employee benefit plans. Ownership Reports, Exchange Act Release
No. 37260, 61 Fed. Reg. at 30376-78. After careful study, notice, and public
comment, the Commission adopted the current rule that takes a new approach to
addressing the same issue. The new Rule 16b-3 generally allows officers or directors
to acquire issuer securities where certain standards and certain objective gate-keeping
provisions are in place to safeguard against the abuse of inside information. Id. at
30377. This is not a case where the Commission made a “sudden and unexplained
change.” Indeed, the Commission never changed its interpretation of Section 16(b) at
all.
9/
See Exchange Act Release No. 392 (1935). See also Peter Romeo and Alan L.
Dye, Section 16 Treatise and Reporting Guide §14.01 (2d ed. 2004).
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II.
TO THE EXTENT A PERSON IS A DIRECTOR BY DEPUTIZING
ANOTHER TO SIT ON THE BOARD, THE DEPUTIZING
PERSON IS SUBJECT TO SECTION 16(b), AND MAY RELY ON
RULE 16b-3(d), BUT ONLY TO THE EXTENT THE BOARD
APPROVING THE TRANSACTION IS AWARE OF THE
DEPUTIZATION, AN ISSUE OF FACT IN THIS CASE.
The other issue in this case is whether TRS may rely on Rule 16b-3, even
though it was a director of InfoSpace solely by virtue of the fact that it had allegedly
deputized House to act on its behalf on the board. The parties dispute whether there
was a deputization, an issue of fact on which the Commission has no knowledge and
will not comment. Dreiling does, however, contend that as a matter of law Rule 16b3(d) is not available to directors who function through deputies. We believe that is
incorrect, although we do agree with Dreiling that the board (or shareholders)
approving an acquisition by a director operating through deputization must be aware
of the deputization, a matter of fact which is in dispute in this case.
The “deputization theory” is a judicially developed doctrine that was adopted
by the Supreme Court in Blau v. Lehman, 368 U.S. 403 (1962). Under the theory, “[a]
person who has the power, by agreement or otherwise, to name another to be a
corporate director is likely to have the same sort of access to inside information by
reason of that relationship as any other insider * * *.” Interpretive Release on Rules
Applicable to Insider Reporting and Trading, Exchange Act Release No. 18114, 1981 WL
31301, at *5 (Sept. 24, 1981). In Blau v. Lehman, the plaintiff alleged that Thomas, a
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member of the firm of Lehman Brothers, a partnership, was deputized by Lehman
Brothers to represent its interests as a director of Tide Water Associated Oil
Company, in whose stock Lehman Brothers traded. In assessing the validity of the
deputization theory, the Court noted that, since Lehman was neither a more than ten
percent owner nor an officer of Tide Water, the firm could only be liable under
Section 16(b) if Lehman was a director. Furthermore, because Lehman was not
formally a member of Tide Water’s board, the firm could only be liable as a director
through Thomas. Id. at 409. Although it was not “literally designated” as a director,
the Court determined Lehman
could for purposes of §16 be a ‘director’ of Tide Water and function
through a deputy, since §3(a)(9) of the [Exchange ] Act provides that
‘person’ means * * * partnership’[10/] and §3(a)(7) that ‘director’ means
any director of a corporation or any person performing similar functions
with respect to any organization, whether incorporated or
unincorporated.’ Consequently, Lehman * * * would be a ‘director’ of
Tide Water, if as petitioner’s complaint charged Lehman actually
functioned as a director through Thomas, who had been deputized by
Lehman to perform a director’s duties not for himself but for Lehman.
368 U.S. at 409-10. 11/
10/
Section 3(a)(9) has since been revised to eliminate “partnership” from its
definition of person, but continues to include “company.”
11/
While the Commission has stated that it “does not propose to codify case law
relating to deputization,” it has recognized that “a corporation, partnership,
trust or other person can be deemed a director for purposes of section 16
where it has expressly or impliedly ‘deputized’ an individual to serve as its
representative on a company’s board of directors.” Ownership Reports and Trading
by Officers, Directors and Principal Stockholders, Exchange Act Release 26333, 53
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But whether or not a “deputization” has transpired is a question of fact. Blau v.
Lehman, 386 U.S. at 408-09. See also Feder v. Martin Marietta Corp., 406 F.2d 260, 263
(2d Cir. 1969). “In determining whether a person has been deputized for purposes of
section 16, the courts have looked at a variety of factors, focusing primarily on the
alleged deputy’s position of control within the deputizing entity and the deputy’s
independent qualifications to serve on the board of the issuing corporation.”
Ownership Reports and Trading by Officers, Directors and Principal Stockholders, Exchange Act
Release 26333, 53 Fed. Reg. at 50000. See Blau v. Lehman, 368 U.S. at 410; Feder v.
Martin Marietta Corp., 406 F.2d at 264-65. See also Peter J. Romeo & Alan L. Dye,
Section 16 Treatise and Reporting Guide §2.04[4][a] (2d ed. 2004) (discussing relevant
factors in determining the existence of a deputization).
Dreiling claims that the Commission’s rationales for Rule 16b-3(d) do not apply
to directors by deputization. Specifically, Dreiling argues that (1) Rule 16b-3(d) is
based on the supposition that acquisitions from the issuer by insiders are
compensation and directors through deputization, usually other corporations, do not
receive compensation; (2) that state law fiduciary duties serve as no protection as to
directors by deputization because such directors are not subject to state law fiduciary
duties; and (3) that the approval by the board of the acquisition of InfoSpace stock by
the defendant could serve no gatekeeping function in this case, or other cases, where,
Fed. Reg. 49997, 50000 (Dec. 13, 1988).
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as claimed, the members of the board were not aware that TRS was a director
because, as claimed, they did not know that House had been deputized by TRS.
As to the first of these contentions, when Rule 16b-3(d) was adopted the
Commission contemplated its application to all acquisitions from an issuer that met
the objective gatekeeping requirements set forth in the rule (such as board or
shareholder approval), regardless of whether the acquisitions have a compensatory
purpose or not. Ownership Reports, Exchange Act Release No. 37260, 61 Fed. Reg. at
30378-79. See also Memorandum of the Securities and Exchange Commission, Amicus Curiae, in
Support of Appellees’ Petition for Rehearing or Rehearing En Banc, at *4, filed in, Levy v. Sterling
Holding Co., LLC., 314 F.3d 106, 124 (3d Cir. 2002), cert. denied, 540 U.S. 947 (2003),
available at, www.sec.gov/litigation/briefs/levy-sterling022703.htm.
As to the second contention, Dreiling cites no authority for the proposition
that state law fiduciary duties prohibiting self-dealing do not apply to directors who do
not actually sit on the board of a company but who operate through a deputy who sits
on the board and who is working on their behalf. There is no question, however, that
the person actually sitting on the board owes the company fiduciary duties. Not only
can that person not engage in self-dealing on their own behalf, they cannot allow
another to benefit at the expense of the company, even if the fiduciary does not
personally benefit. See, e.g., Mosser v. Darrow, 341 U.S. 267, 272 (1951). Likewise, a
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person who knowingly joins with the fiduciary in such a self-dealing transaction is
liable to the beneficiary. See, e.g., Jackson v. Smith, 254 U.S. 586, 588-89 (1921). See
generally, Dirks v. SEC, 463 U.S. 646, 660 (1983).
Dreiling’s third contention does have merit. The Commission agrees that
board or shareholder approval is not effective as a gatekeeping provision where the
members of the board or shareholders are unaware that a person acquiring stock, in
this case TRS, is a director. When it proposed the current rule, the Commission
stated, “[t]he purpose of these [approval conditions] is to ensure that appropriate
company gate-keeping procedures are in place to monitor any grants or awards and to
ensure acknowledgment and accountability on the part of the company when it makes
such grants and awards.” Ownership Reports and Trading by Officers, Directors and Principal
Security Holders, Exchange Act Release No. 36356, 60 Fed. Reg. 53832, 53835 (Oct. 17,
1995). To that end, Note 3 to the rule requires that each specific transaction be
approved to assure that the board focuses on each particular grant or award, and is
accountable for authorizing each one. Since the basis for the exemption is that
approved grants of securities are likely to be motivated by legitimate corporate
objectives, and not by an attempt to profit from inside information, it is important
that the board actually consider each specific transaction, and that it evidence
“acknowledgment and accountability” as to what it is doing.
-25-
If in this case, other members of the board did not know that House had been
deputized to represent the interest of TRS on the InfoSpace board, as claimed by
Dreiling, then the board would have no way of knowing that TRS was a director and
that TRS, through House, had access to inside information. As such, the other
members of the board of InfoSpace would have no reason for special vigilance as to
the acquisition of InfoSpace stock by TRS, and the board would not effectively serve
its gatekeeping function and ensure accountability. It is, therefore, imperative, for the
purposes of Rule 16b-3(d), that the members of any corporate board know when
another person serving on the same board is deputized by another person or entity to
carry out its interests. Whether the board had such knowledge is a question of fact as
to which the parties dispute, and as to which the Commission expresses no view.
CONCLUSION
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For the foregoing reasons, Commission urges this Court to hold that the
Commission acted within its authority in adopting Rule 16b-3(d) and that, to the
extent a person is a director by “deputization,” exemptive Rule 16b-3(d) only applies
to that person where the board approving the transaction to be covered by the rule is
aware that the deputizing person is a director.
Respectfully submitted,
GIOVANNI P. PREZIOSO
General Counsel
JACOB H. STILLMAN
Solicitor
ERIC SUMMERGRAD
Deputy Solicitor
ALLAN A. CAPUTE
Special Counsel to the Solicitor
Securities and Exchange Commission
Washington, D.C. 20549-0606
(202) 942-0837 (Capute)
Dated: April 5, 2005
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This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.