Opposition Brief — Morgan Capital, L. L. C. v. Medtox Scientific, Inc.

Supreme Court, U.S.

FILED

@® JAN 2 8 2002

No. 01-739 | OFFICE OF THE CLERK

In the

Supreme Court of the Anited States

MORGAN CAPITAL, L.L.C.,

Petitioner,

v.

MEDTOX SCIENTIFIC, INC.,

Respondent.

On Petition for a Writ of Certiorari to the United

States Court of Appeals for the Eighth Circuit

RESPONDENT'S BRIEF IN OPPOSITION

GREGORY J. SCHAEFER STEPHEN R. SWOFFORD

DUANA J. GRAGE Counsel of Record

HINSHAW & CULBERTSON TIMOTHY G. SHELTON

3100 Piper Jaffray Tower HINSHAW & CULBERTSON

222 South Ninth Street 222 North LaSalle Street

» Minneapolis, MN 55402 Suite 300

(612) 333-3434 Chicago, IL 60601-1081

(312) 704-3000

Counsel for Respondent

Medtox Scientific, Inc.

Midwest Law Printing Company/Photex — Chicago — (312) 321-0220

3H

i

CORPORATE DISCLOSURE STATEMENT

Pursuant to Rule 29.6 of the Rules of tne Supreme

Court of the United States, Respondent Medtox Scien-

tific, Inc. (Medtox) states that it is publicly traded on the

American Stock Exchange, that it has no parent com-

pany, and that no publicly held company owns 10% or

more of its stock.

ii

TABLE OF CONTENTS

PAGE

CORPORATE DISCLOSURE STATEMENT ........ i

Te CO AUT Te ko chk cece cievcene’ iv

INTRODUCTION AND SUMMARY

Ce a ae 1

REASONS FOR DENYING THE WRIT............ 2

I. The Third “Question Presented” in the

Petition Was Not Pressed or Passed on

TN re es eens ete eee Lea aes a 2

II. The Eighth Circuit’s Decision Does Not

Present a Conflict. The Existence of a

Federal District Court Opinion Does Not

Create a Cognizable Conflict in the Cir-

cuits ..........5. hc SUR Eee 6 acelin 5

III. The Eighth Circuit’s Decision Was Cor-

eib-s0'0 a CUE OR SKS RLS eee 6

A. Morgan Capital Was a Deemed Ten

Percent Beneficial Owner of Medtox

Common Stock Before May 1, 1996 ...... 7

B. Morgan Capital’s Conversion of Its

Medtox Preferred Stock Into Common

Stock Constituted a “Purchase” of the

i I a i coy iene is 11

ili

C. Morgan Capital Mischaracterizes the

Actual Language in the SEC Rules

and Ignores Means Readily Available

to Issuers and Investors to Avoid Sec-

tion 16(b) Liability Problems .......... 13

i iin che rides bébeeenveveaeveves 17

iv

TABLE OF AUTHORITIES

Cases PAGE(S)

Blau v. Lehman,

286 F.2d 786 (2d Cir. 1961),

aff'd, 368 U.S. 403 (1962) ...............- 12, 13

Editek, Inc. v. Morgan Capital, L.L.C.,

150 F.3d 830 (8th Cir. 1998), rev’g,

974 F. Supp. 1229 (D. Minn. 1997) .... 4, 7, 8, 9, 10

Foremost-McKesson, Inc. v. Provident

Securities Co., 423 U.S. 232 (1976) ............ 17

Global Intellicom, Inc. v. Thomson

Kernaghan & Co., 1999 U.S. Dist.

LEXIS 11378, Fed. Sec. L. Rep.

(CCH) 4 90,534 (S.D.N.Y. 1999) .............. 16

Heli-Coil Corp. v. Webster,

352 F.2d 156 (Sd Cir. 1965) ....... ccc ccccees 12

Kern County Land Co. v. Occidental

Petroleum Corp., 411 U.S. 582 (1973) .......... 16

Levy v. Clearwater Fund IV, Lid.,

2000 U.S. Dist. LEXIS 1305,

Fed. Sec. L. Rep. (CCH) 4 90,938

Gh FE bia dene Oeeukivsdnsaedands 6, 13

Levy v. Oz Master Fund, Lid.,

2001 U.S. Dist. LEXIS 9251,

Fed. Sec. L. Rep. (CCH) 4 91,503

Ges SE no hxencdcacuGeei hen chbad neues 5

v

Levy v. Southbrook Int’l Investments, Lid.,

263 F.3d 10 (2d Cir. 2001) .............

Medtox Scientific, Inc. v. Morgan Capital,

L.L.C., 258 F.3d 763 (8th Cir. 2001),

affg, 50 F. Supp. 2d 896 (D. Minn. 1999)

National Collegiate Athletic Ass’n v. Smith,

ats et Pree irre erie

Park & Tilford, Inc. v. Schulte,

160 F.2d 984 (2d Cir.), cert.

denied, 332 U.S. 761 (1947) ............

Reliance Electric Co. v. Emerson Electric Co.,

| a Se oe

Roberts v. Galen of Virginia, Inc.,

et) eee

Schaffer v. CC Investments, LDC,

115 F. Supp. 2d 440 (S.D.N.Y. 2000) ....

Youakim v. Miller,

SMEAR ERED civeciccciececeses

a a a rrr ee eee

16 UBC. § TEpla), D) .. 2... cccccwcccces

Rules

AF Ci ei EN ee cee ER eed becndbbcoccccccce 9

UF Gr 6 oa Cole dec bt Cbs ccc wcswen 9

17 C.F.R. § 240.13d-3(d)(1iMB) ........0005. passim

17 C.F.R. § 240.1Ga-MaN)) ..ccccccccccvcsee passim

17 CLP .RR. © BOG. Demi RR a ib ain a 0d seb cee ncdc cs 3,4

Other Authorities

Ownership Reports and Trading by Officers,

Directors and Principal Security Holders,

Exchange Act Release No. 28,869,

[1990-1991 Transfer Binder]

Fed. Sec. L. Rep. (CCH) 4 84,709, 1991

WL 292000 (Feb. 8, 1991) .............005- 4,12

1

INTRODUCTION AND

SUMMARY OF ARGUMENT

Medtox respectfully requests that this Court deny the

Petition for a Writ of Certiorari filed by Petitioner

Morgan Capital, L.L.C. (Morgan Capital), seeking review

of the opinion and judgment of the United States Court

of Appeals for the Eighth Circuit entered on August 3,

2001.

The last of the three questions presented in the Peti-

tion is not properly before this Court. Morgan Capital

never once pointed out the factual predicate for that

issue during the four and one-half years this case was

litigated in the federal district court and on two appeals

to the Eighth Circuit. Morgan Capital never once raised

that legal issue before the lower courts, notwithstanding

two rounds of dispositive motion practice and two ap-

peals. Morgan Capital’s last-ditch, midnight hour effort

to assert that issue for the first time in its Petition to this

Court does not properly present that issue for this

Court’s consideration.

The Eighth Circuit’s opinion does not give rise to a

cognizable conflict. Its holding does not conflict with the

holdings of any prior decisions of this Court or those of

other courts of appeals.

Finally, the Eighth Circuit’s decision is correct. The

United States Securities and Exchange Commission

(SEC) has promulgated detailed rules, pursuant to sec-

tions 13 and 16 of the Securities Exchange Act of 1934

(Act), governing “beneficial ownership” for purposes of

section 16(b)’s proscription of “insider” short-swing trad-

ing. Applying the plain language of these rules, the

Eighth Circuit correctly held that Morgan Capital was a

deemed ten percent beneficial owner of Medtox common

2

stock before May 1, 1996. That status arose from (1)

Morgan Capital’s ownership of Medtox preferred stock,

(2) the conversion feature giving Morgan Capital the con-

tractual right to convert its preferred stock into common

stock, (3) the conversion price formula, and (4) the de-

clining price of Medtox’s common stock during the critical

period. The Eighth Circuit also correctly held that Mor-

gan Capital’s May 1, 1996 conversion of its preferred

stock into common stock (at a time when Morgan Capital

was a deemed ten percent beneficial owner of Medtox

common stock) constituted a purchase of the common

stock for section 16(b) purposes.

REASONS FOR DENYING THE WRIT

1.

THE THIRD “QUESTION PRESENTED”

IN THE PETITION WAS NOT

PRESSED OR PASSED ON BELOW.

This Court’s settled practice is not to grant the writ

when the “question presented was not pressed or passed

upon below” because this Court does not decide, in the

first instance, issues not decided below. National Colle-

giate Athletic Ass’n v. Smith, 525 U.S. 459, 469 (1999);

Roberts v. Galen of Virginia, Inc., 525 U.S. 249, 253-254

(1999); see also Youakim v. Miller, 425 U.S. 231, 234

(1976) (per curiam) (“{o}rdinarily, this Court does not

decide questions not raised or resolved in the lower

court(s]”).

In its Petition, Morgan Capital points out that the

conversion feature in its Medtox preferred stock had, in

addition to the floating-price component which was

actually used in calculating the number of shares of

common stock Morgan Capital received upon conversion

3

of its preferred stock, a fixed-price component (Pet. at 2,

3-4, 9 n.5 and 12). Morgan Capital chides the Eighth

Circuit for “ignoring” this fixed-price component in de-

termining that the Medtox preferred stock was not a

“derivative” security (Pet. at 13, 15, 17 and 19). This

“hybrid” nature of the conversion feature is the predicate

for the third “question presented” in the Petition (Pet.

at i).

Morgan Capital omits to inform this Court that, during

the four and one-half years in which this case was

litigated in the federal district court in Minnesota and

the Eighth Circuit, Morgan Capital never once brought

to any court’s attention that the conversion feature in its

Medtox preferred stock contained a fixed-price compo-

nent (intended to fix the minimum number of shares

Morgan Capital would be entitled to receive on conver-

sion). Morgan Capital never once argued, in the two

rounds of dispositive motion practice before the district

court or on either of the two appeals to the Eighth

Circuit, that that fixed-price component feature had any

relevance to the substantive section 16(b) issues and

Morgan Capital’s liability for its proscribed short-swing

trading.

Morgan Capital consistently maintained during the

course of the litigation in the lower courts that its Med-

tox preferred stock was not a “derivative” security be-

cause the conversion privilege was based on a “floating”

rather than a “fixed” exercise price.’ See, e.g., Docket

' SEC Rule 16a-1(cX6) instructs that convertible securities

with a “floating exercise price”—i.e., a “conversion privilege at

a price that is not fixed”—are excluded from the definition

of “derivative” securities for section 16 purposes. 17 C.F.R.

(continued...) -

4

Nos. 10, 16, 35 and 37 (JA 6, 7, 8, 9); see also Morgan

Capital’s Appellee’s Brief in Editek, Inc. v. Morgan

Capital, L.L.C., 150 F.3d 830 (8th Cir. 1998) (Medtox J),

at p. 8 (“until the conversion right was exercised and the

floating price became fixed, the convertible Preferred

Stock was not a “derivative security” under Section 16 so

as to implicate beneficial ownership status and the re-

sultant potential for short-swing profits liability”); see

also id. at p. 24; Morgan Capital’s Appellant’s Brief in

Medtox Scientific, Inc. v. Morgan Capital, L.L.C., 258

F.3d 763 (8th Cir. 2001) (Medtox II), at pp. i, 2, 5, 6, 12,

15, 22, 25, 28, 30, 32; Morgan Capital’s Reply Brief in

Medtox II, at 4, 7.

The Eighth Circuit’s opinions also accurately note Mor-

gan Capital’s position in this regard:

(1) “Because, as Morgan Capital acknowledges, none of

the securities involved in this transaction were de-

rivatives, these provisions are inapposite” (Medtox

IT, 258 F.3d at 765 n. 4 (Pet., App. A, p. 4a));

(2) “(Morgan Capital] argues that it was not an insider

until the preferred stock was converted into com-

mon stock because the conversion price was float-

ing, rather than fixed” (Medtox II, 258 F.3d at 767

(Pet., App. A, p. 7a)); and

' (...continued)

§ 240.16a-1(c)(6); see also “Ownership Reports and Trading by

Officers, Directors and Principal Security Holders,” Exchange

Act Release No. 28,869, [1990-1991 Transfer Binder] Fed. Sec.

L. Rep. (CCH) 4 84,709, 1991 WL 292000, at *17, text accom-

panying nn. 134-139 (Feb. 8, 1991) (1991 SEC Release); Medtox

I, 150 F. 3d at 834 (Pet., App. C, p. 48a).

5

(3) “In other words, Morgan Capital, as a holder of

floating-price convertible preferred stock, did not

own derivative securities” (Medtox I, 150 F.3d at

834 (Pet., App. C, p. 48a)). |

Consequently, neither the federal district court nor the

Eighth Circuit was ever asked to pass on whether the

Medtox preferred stock was a “derivative” security be-

cause of the presence of the fixed-price component in

addition to the floating-price component of its conversion

feature. Moreover, even assuming, arguendo, that the

presence of the fixed-price component could render the

Medtox preferred stock a derivative security, neither the

district court nor the Eighth Circuit was ever asked to

consider whether under all the facts and circumstances

presented by this case, Morgan Capital was nevertheless

still liable under section 16(b). Because this issue was

never presented by Morgan Capital below and because it

was never passed upon by any of the courts below, this

issue is not properly considered by this Court on the

Writ.

i.

THE EIGHTH CIRCUIT'S DECISION DOES

NOT PRESENT A CONFLICT. THE EXISTENCE

OF A FEDERAL DISTRICT COURT OPINION

DOES NOT CREATE A COGNIZABLE

CONFLICT IN THE CIRCUITS.

Morgan Capital relies upon a district court decision,

Levy v. Oz Master Fund, Ltd., 2001 U.S. Dist. LEXIS

9251, Fed. Sec. L. Rep. (CCH) 4 91,503 (S.D.N.Y. 2001),

in an attempt to create a conflict with the Eighth Cir-

cuit’s decision (Pet. at 18-19). In Levy, the Southern

District held that, under the circumstances in that case,

6

the floating-price and fixed-price features of the convert-

ible security at issue there rendered it a “derivative”

security. But see Levy v. Clearwater Fund IV, Ltd., 2000

U.S. Dist. LEXIS 1305, Fed. Sec. L. Rep. (CCH) 4 90,938

(D. Del. 2000) (holding that convertible securities with

such hybrid conversion price features are not derivative

securities). The existence of a district court opinion,

which passed on facts and legal issues never presented to

and not decided by the Eighth Circuit, does not give rise

to a cognizable conflict with the Eighth Circuit’s opinion

in Medtox II, within the meaning of Rule 10 of the Rules

of the Supreme Court of the United States. No cognizable

conflict exists between the Eight Circuit’s decision and

the decisions of any other federal circuit court decisions

warranting granting of the Writ.

Iti.

THE EIGHTH CIRCUIT'S

DECISION WAS CORRECT.

Morgan Capital also contends the Eighth Circuit erred

in holding that (1) Morgan Capital was a deemed ten

percent beneficial owner of Medtox common stock by

virtue of its ownership of Medtox convertible preferred

stock, under the facts and circumstances here, prior to

May 1, 1996 (Question 1), and (2) Morgan Capital’s con-

version of its Medtox preferred stock into common stock

on May 1, 1996 constituted a “purchase,” for section 16(b)

liability purposes, of the common stock (Question 2) (Pet.

at i). Morgan Capital simply rehashes well-worn argu-

ments that both the district court and the Eighth Circuit

correctly rejected. See Medtox IT, 258 F.3d at 766 (Pet.,

App. A, p. 6a), affg, 50 F. Supp. 2d 896, 901-05 (D. Minn.

1999) (Pet., App. B, pp. 24a-33a). The Eighth Circuit’s

holding was correct on both issues.

7

A. Morgan Capital Was a Deemed Ten Percent

Beneficial Owner of Medtox Common Stock Be-

fore May 1, 1996.

The Eighth Circuit’s holding on the first question

presented is based on a straightforward reading of the

applicable SEC Ruies and application of those rules to

the undisputed facts. Fundamentally, the Eighth Cir-

cuit’s two opinions in this case stand only for the unre-

markable proposition that those rules “mean just what

[they] say[ ].” Medtox I, 150 F.3d at 833 (Pet., App. C, p.

45a).

At issue in this case is whether Morgan Capital was a

ten percent beneficial owner of Medtox common stock

before May 1, 1996 by virtue of its ownership of Medtox

preferred stock.’ If so, then Morgan Capital was a cov-

ered “insider,” for purposes of section 16(b)’s proscrip-

? Morgan Capital’s assertion that it purchased Medtox pre-

ferred stock “on or about February 1, 1996” is misleading (Pet.

at 2). The record shows that Medtox and Morgan Capital en-

tered into Private Securities Subscription Agreements (e.g., JA

170-177), pursuant to which Morgan Capital purchased Med-

tox preferred stock on January 30, 1996 (JA 156, Table 1; JA

171 Art. 1(ii)). January 30, 1996 is the legally significant date:

it is the date on which the first shares of Medtox preferred

stock were issued, and the pertinent agreement provided that

the preferred stock was convertible to common stock commenc-

ing on the sixtieth day after the first share was issued which,

in this case, was March 30, 1996 (JA 183 § 4(c)). February 1,

1996 is the date on which the transaction “closed” and Morgan

Capital actually received its shares of Medtox preferred stock

(JA 175 Art. 4).

* Section 16(b) incorporates by reference section 16(a)’s

scheme of three categories of an issuer’s covered “insiders”:

(continued...)

8

tion on short-swing trading for a profit by “insiders” in

their issuer’s securities, on May 1, 1996, which is the

date on which Morgan Capital engaged in the first of the

transactions that Medtox contends (and the Eighth Cir-

cuit held) gave rise to its section 16(b) liability. Medtox

II, 258 F.3d at 766-67 (Pet., App. A, pp. 6a-7a). In its

Schedule 13D filed in May 1996 after the conversion,

Morgan Capital admitted that it owned 18.2% of Med-

tox’s outstanding common stock as of May 9, 1996 (JA

273, 4 4; JA 283, Items 11, 13). By an Amended Schedule

13D filed in July 1996, Morgan Capital admitted that,

even after selling off a portion of its Medtox common

stock in May and June 1996, it still owned 15.44% of

Medtox’s outstanding common stock as of July 3, 1996

(JA 273 4 5; JA 289).

SEC Rule 16a-1(aX(1) instructs that, in “determining

whether a person is a beneficial owner of more than ten

percent of any class of [registered] equity securities,” the

term “‘beneficial owner’ shall mean any person who is

deemed a beneficial owner pursuant to section 13(d) of

the Act.” 17 C.F.R. § 240.16a-1(aX1) (Pet., App. E, pp.

67a-68a); see Medtox I, 150 F.3d at 832 (Pet., App. C,

p. 43a); Medtox II, 258 F.3d at 765 (Pet., App. A, p. 4a).

3 (...continued)

officers, directors, and ten percent beneficial owners. 15 U.S.C.

§ 78p(a), (b) (Pet., App. E, p. 65a). The first two “classes” of

covered “insiders”—the issuer’s officers and its directors—are

not applicable here because Morgan Capital was not an officer

or director of Medtox, and Morgan Capital’s principals, David

and Alexander Bistricer, did not become members of the

Medtox board until after the challenged transactions giving

rise to liability here had been completed. Medtox II, 258 F.3d

at 765, 766 (Pet., App. A, pp. 2a, 6a).

9

SEC Rule 13d-3, promulgated under section 13(d) of

the Act, provides rules governing the determination of

beneficial ownership. 17 C.F.R. § 240.13d-3. Rule 13d-

3(d)(1\i(B) expressly and unambiguously provides that:

A person shall be deemed to be the beneficial owner

of a security .. . if that person has the right to

acquire beneficial ownership of such security, as

defined in Rule 13d-3(a)*’ within sixty days, includ-

ing but not limited to any right to acquire... .

[t}hrough the conversion of a security.

17 C.F.R. § 240.13d-3(d)(1)iXB) (Pet., App. E, p. 66a); see

Medtox I, 150 F.3d at 832-33 (Pet., App. C, pp. 43a-44a);

Medtox II, 258 F.3d at 765 (Pet., App. A, p. 4a). As the

Eighth Circuit observed, the import of Rule 13d-3(d)

(1)G)(B) is that a person is deemed to own beneficially

any securities the person has the right to acquire “within

sixty days” through conversion of another security. Med-

tox IT, 258 F.3d at 765 (Pet., App. A, p. 4a).

In the first appeal, the Eighth Circuit simply applied

the plain meaning of SEC Rules 16a-1(a)(1) and 13d-3(d)

(1B) in holding that Morgan Capital was a deemed

beneficial owner of Medtox common stock before May

1, 1996, by virtue of its ownership of Medtox preferred

stock which provided Morgan Capital the contractual

right to convert the preferred stock into common stock

* Rule 13d-3(a) provides that a person beneficially owns a

security when the person has either voting power or invest-

ment power with respect to the security, whether directly or

indirectly. 17 C.F.R. § 240.13d-3(a); see Medtox I, 150 F.3d at

832 (Pet., App. C, p. 43a).

10

beginning on March 30, 1996.° Medtox I, 150 F.3d at 832-

834 (Pet., App. C, pp. 4la-48a); see also Medtox II, 258

F.3d at 766, 767 (Pet., App. A, pp. 5a, 7a-8a). Indeed,

Medtox had publicly reported, on March 27, 1996, that

Morgan Capital was the largest beneficial owner of

Medtox common stock (JA 137-38 4 2 & n.1; JA 140-41).

In the second appeal, the Eighth Circuit held that the

district court had correctly determined that Morgan

Capital was a deemed ten percent beneficial owner of

Medtox common stock from April 9 through April 30,

1996. Medtox II, 258 F.3d at 765, 767-68 (Pet., App. A,

pp. 3a, 7a-10a). The court reasoned that Morgan Capital

had the right to convert its preferred stock into common

stock on each of those days and that, had it done so,

given the prevailing market price of Medtox common

stock during that period and the applicable conversion

formula, the number of shares of Medtox common stock

Morgan Capital would have received on every day during

this period would have constituted more than ten percent

of the outstanding common stock. Jd. The Eighth Circuit —

correctly observed that the five-day trailing average,

look-back feature of the conversion right meant that

Morgan Capital could readily ascertain each day the

number of shares of common stock it would receive if it

elected to convert. Medtox II, 258 F.3d at 767 (Pet., App.

A, pp. 7a-8a).

5 In Medtox I, the Eighth Circuit held that application of SEC

Rules 16a-1(aX1) and 13d-3(dX1iXB) meant that Morgan

Capital was “a beneficial owner of [Medtox] common stock on

every day within sixty days of every day on which Morgan

Capital had the right to acquire [Medtox) common stock

through conversion.” 150 F. 3d at 833 (Pet., App. C, p. 46a).

11

Morgan Capital also argues, at least implicitly, that

holding it liable under section 16(b) is somehow inequita-

ble here, contending that:

This [the fact that the shares of common stock Mor-

gan Capital received upon its May 1, 1996 conversion

of its preferred stock amounted to more than ten

percent of Medtox’s outstanding shares of common

stock] was unintended even by Medtox; Medtox ran

out of a sufficient number of common stock to meet

the demands of all preferred holders exercising con-

version rights.

(Pet. at 4) Morgan Capital does not cite to any evidence

in the record to support this assertion. Jd. Morgan Cap-

ital does not do so for the simple reason that the record

contains no evidentiary support for this assertion.

B. Morgan Capital’s Conversion of Its Medtox Pre-

ferred Stock Into Common Stock Constituted a

“Purchase” of the Common Stock.

The Eighth Circuit’s holding on the second question

presented (Medtox II, 258 F.3d at 768-69 (Pet., App. A,

pp. 1la-12a)), is based on a straightforward reading of

the Act, the 1991 SEC Release, and decades of section

16(b) jurisprudence teaching that conversion of preferred

stock into common, when the preferred stock is not a

“derivative security,” constitutes a “purchase” of the com-

mon for section 16(b) liability purposes.

First, the Act defines the term “purchase” broadly: “The

terms ‘buy’ and ‘purchase’ each include any contract

to buy, purchase, or otherwise acquire.” 15 U.S.C.

§ 78c(a13). Conversion transactions fit into the “other-

wise acquire” language.

12

Second, the 1991 Release also teaches that conversion

of floating exercise price convertible preferred stock con-

stitutes a purchase of the underlying common stock:

The rules adopted today clarify that a right with a

floating exercise price is not required to be reported

and will not be deemed to be acquired or purchased,

for Section 16 purposes, until the purchase price of

the underlying securities becomes fixed or estab-

lished, which commonly occurs at exercise. Thus, a

right to purchase an equity security is deemed

acquired as of the date the exercise or conver-

sion price becomes fixed, and the acquisition,

absent an exemption, would be matchable for

Section 16(b) purposes with a disposition within

six months of the fixing of the price. For example,

the acquisition of an option having an exercise price

equal to 90 percent of the market price as of the date

of exercise would be deemed to be a purchase of the

underlying stock as of the date of exercise.

1991 SEC Release, 1991 WL 292000, at *18, text accom-

panying nn. 146-147 (emphasis added).

Finally, courts have consistently held that conversion

of one security into another constitutes a “purchase” for

section 16(b) liability purposes. See, e.g., Heli-Coil Corp.

v. Webster, 352 F.2d 156, 159, 161, 167, 169 (3d Cir.

1965) (conversion of convertible debentures into issuer’s

common stock and subsequent sale of common stock

within six months held violative of section 16(b), court

reasoning that conversion involves “purchase” of acquired

security as well as “sale” of surrendered security); Blau

v. Lehman, 286 F.2d 786, 792 (2d Cir. 1961) (holding

exchange of common stock for preferred stock was “pur-

chase” of preferred within scope of section 16(b), reason-

ing transaction is “purchase” for section 16(b) purposes

13

if it lends itself in any way to accomplishment of that

which statute was designed to prevent), aff'd, 368 U.S.

403 (1962); Park & Tilford, Inc. v. Schulte, 160 F.2d 984,

987 (2d Cir.) (conversion of preferred stock into common

stock followed by sale within six months held to consti-

tute “purchase and sale” violative of section 16(b)), cert.

denied, 332 U.S. 761 (1947); Levy v. Clearwater Fund IV,

Ltd., 2000 U.S. Dist. LEXIS 1305, at *13, Fed. Sec. L.

Rep. (CCH) { 90,938 (D. Del. 2000) (holding conversion

of stock having both fixed and floating conversion price

components constituted purchase of underlying stock,

subjecting holder to section 16(b) liability for subsequent

sales within six months for profit).

Consistent with the Act, the SEC’s interpretive Rules,

the 1991 SEC Release, and precedent, the Eighth Circuit

correctly held that Morgan Capital’s May 1, 1996 conver-

sion constituted a “purchase” of common stock, subject to

section 16(b)’s proscription on any sales of that common

stock within six months.

C. Morgan Capital Mischaracterizes the Actual

Language in the SEC Rules and Ignores Means

Readily Available to Issuers and Investors to

Avoid Section 16(b) Liability Problems.

Morgan Capital attacks the Eighth Circuit’s holding

that it was a deemed ten percent beneficial owner of

Medtox common stock before May 1, 1996, arguing that

Morgan Capital had no “ascertainable and legally en-

forceable right to acquire” more than ten percent of

Medtox’s outstanding common stock before May 1, 1996

(Pet. at 8-9, 13-14). While it is true that Morgan Capital

did not have a contractual right to acquire ten percent or

more of Medtox’s common stock before May 1, 1996, that

fact is legally irrelevant. It is irrelevant because Morgan

14

Capital’s argument proceeds from a premise that re-

quires the engrafting onto Rule 13d-3(d1XiXB) of the

language “ten percent” after the language “right to ac-

quire.” Rule 13d-3(d)(1)i)(B) does not measure “beneficial

ownership” in terms of a specified percentage of a class

of equity securities. It simply provides that “[a] person

shall be deemed to be the beneficial owner of a security

.. . if that person has the right to acquire beneficial

ownership of such security . . . within sixty days, includ-

ing .. . any right to acquire through the conversion of a

security.” 17 C.F.R. § 240.13d-3(d)(1iXB).

The Eighth Circuit did not hold that Morgan Capital

had any contractual “right,” before May 1, 1996, to ac-

quire more than ten percent of Medtox’s common stock

upon the conversion of its preferred stock. Rather, it held

only that:

(1) Morgan Capital beneficially owned Medtox common

stock before May 1, 1996 because it had the right to

acquire Medtox common stock (without regard to

the actual percentage that might be acquired) with-

in sixty days by converting its preferred stock, sat-

isfying the test set forth in Rule 13d-3(dX1XiXB);

and

(2) Because of the declining price of Medtox common

stock in April 1996, if Morgan Capital had chosen

to convert its preferred stock into common stock on

any of the days between April 9 and 30, the number

of shares it would have received on conversion

would have amounted to more than ten percent of

the outstanding shares of Medtox common stock.

Medtox II, 258 F.3d at 767-68 (Pet., App. A, pp. 6a-10a).

The former is all the Rule requires. The latter, as the

Eighth Circuit reasoned, is mere math, dictated by sec-

15

tion 16’s requirement, but not Rule 13d-3(d\1)\iXB)’s,

-that the beneficial ownership reach the threshold of ten

percent. Medtox II, 258 F.3d at 768 (Pet., App. A, pp. 9a-

10a).

Morgan Capital also seeks to construct a “straw man”

in its Petition, arguing that the Eighth Circuit’s holding

creates “a new class of imaginary beneficial ownership,”

and treats what it characterizes as “hypothetical conver-

sions” as “actual conversions” (Pet. at 8). However, the

Eighth Circuit did nothing more than give effect to the

plain meaning of SEC Rules 16a-1(a1) and 13d-3(d)(1)

(iB), applying them to the pertinent provisions in the

contractual agreement between Morgan Capital and

Medtox governing Morgan Capital’s preferred stock.

Finally, Morgan Capital postulates that the Eighth

Circuit’s holding will generate “chaos” and “mass confu-

sion” in the securities marketplace with respect to section

16(a) reporting obligations and section 16(b) liability

concerns because holders of floating price convertible

securities might, over time, float above, and then below,

ten percent beneficial ownership (Pet. at 8-10). This is

an unwarranted concern. Morgan Capital conveniently

ignores the prophylactic measures that are available to

avoid the imaginary “chaos.”

Conversion caps have been upheld as a legitimate

means of structuring transactions to avoid short-swing

liability under section 16(b). Levy v. Southbrook Int'l

Investments, Lid., 263 F.3d 10, 12, 16 (2d Cir. 2001);

Schaffer v. CC Investments, LDC, 115 F. Supp. 2d 440,

442-43 (S.D.N.Y. 2000) (same; citing cases). A conversion

cap limits a convertible security holder’s contractual con-

version rights to the extent a conversion would otherwise

result in the holder crossing over a specified percentage

threshold of beneficial ownership. For example, a share-

16

holder rights agreement could include a provision such

as:

The Preferred Stock shall not be convertible by a

Holder to the extent (but only to the extent) that, if

converted by such Holder, the Holder would benefi-

cially own in excess of 4.9% (9.9% if the applicable

box on the signature page of the Securities Purchase

Agreement for such Holder is marked). . . of the

shares of Common Stock.

See Schaffer, 115 F. Supp. 2d at 442 (quoted example

upheld as valid). By operation of Rule 13d-3(d\1),

holders of freely convertible securities are “generally

deemed to be beneficial owners of the underlying common

stock.” Global Intellicom, Inc. v. Thomson Kernaghan &

Co., 1999 U.S. Dist. LEXIS 11378, at *46-*47, Fed. Sec.

L. Rep. (CCH) 4 90,534 (S.D.N.Y. 1999). However, when

conversion rights are limited, a holder of a convertible

security may not be deemed the beneficial owner of the

underlying common stock. Jd. A conversion cap limits the

holder’s rights to acquire a certain number of shares of

the common stock; a holder who is prevented, by opera-

tion of the cap, from acquiring beneficial ownership of

common stock in excess of a specified threshold within

sixty days cannot become a deemed ten percent beneficial

owner under Rule 13d-3(d1). Levy, 263 F.3d at 12-16;

Schaffer, 115 F. Supp. 2d at 442-43. To the extent holders

of convertible securities desire to avoid getting squashed

by section 16(b)’s “crude rule of thumb” (Kern County

Land Co, v, Occidental Petroleum Corp., 411 U.S. 582,

592 n.23 (1973)), they can bargain for that protection by

including such clauses in their contractual agreements

with issuers. Of course, holders can also avoid any sec-

tion 16(b) liability problems altogether simply by holding

the shares of the common stock obtained upon conversion

17

for a period of six months and one day because section

16(b) only proscribes “short-swing” trading for a profit,

which section 16(b) defines as a sale and purchase or

purchase and sale within less than six months. Foremost-

McKesson, Inc. v. Provident Securities Co., 423 U.S. 232,

252 (1976); Reliance Electric Co. v. Emerson Electric Co.,

404 U.S. 418, 422 (1972).

CONCLUSION

The Petition for a Writ of Certiorari should be denied

for all these reasons.

Respectfully submitted,

STEPHEN R. SWOFFORD

Counsel of Record

TIMOTHY G. SHELTON

HINSHAW & CULBERTSON

222 North LaSalle Street

Suite 300

Chicago, IL 60601

(312) 704-3000

GREGORY J. SCHAEFER

DUANA J. GRAGE

HINSHAW & CULBERTSON

3100 Piper Jaffray Tower

222 South Ninth Street

Minneapolis, MN 55401

(612) 333-3434

Attorneys for Respondent

Medtox Scientific, Inc.