Petition for Writ of Certiorari — Morrison v. Madison (No. 06-843)

In The

Supreme Court of the Anited States

¢

LARRY MORRISON,

Petitioner,

V.

MADISON DEARBORN CAPITAL PARTNERS III L.P.,

MADISON DEARBORN SPECIAL EQUITY III L.P.,

MADISON DEARBORN PARTNERS III L-P.,

MADISON DEARBORN PARTNERS LL&,

XM SATELLITE RADIO HOLDINGS INC.,

Respondents.

On Petition For A Writ Of Certiorari

To The United States Court Of Appeals

For The Third Circuit

*» Annee

PETITION FOR A WRIT OF CERTIORARI

e

ABRAHAM FRUCHTER & TWERSKY LLP

MITCHELL M.Z. TWERSKY

Counsel of Record

JEFFREY S. ABRAHAM

One Penn Plaza, Suite 2805

New York. New York 10119

Telephone: (212) 279-5050

Counsel for Petitioner Larry Morrison

COCKLE LAW BRIEF PRINTING CO) 800) 225-6664

OR CALL COLLECT gz $42 2501

QUESTIONS PRESENTED

1. Whether the Circuit Court’s failure to follow the

plain language of an agency regulation, which was consis-

tent with both the contemporary regulatory history and

subsequent releases disseminated by the agency, is incon-

sistent with this Court’s precedents concerning the proper

method for interpreting agency regulations?

2. Whether the Circuit Court’s conclusion that it was

inconsistent with the statutory purpose of Section 16(b) of

the Securities Exchange Act of 1934, 15 U.S.C. §78p(b)

(2006) (“Section 16(b)”) to impose liability on a statutory

insider where the subject transaction was involuntary is

consistent with this Court’s precedent analyzing the

statutory purpose of Section 16(b) and concluding that

both involuntariness and a lack of access to inside infor-

mation are necessary for a transaction to be outside the

scope of Section 16(b)?

TABLE OF CONTENTS

QUESTIONS PRESENTED

TABLE OF CONTENTS

STATUTORY PROVISIONS AND REGULATORY

PROVISIONS INVOLVED

I.

A.

B.

C.

D. Proceedings in the Court of Appeals

REASONS FOR GRANTING THE PETI-

A. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With Prin-

ciples of Statutory Interpretation Em-

ployed by This Court

1. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With the

Plain Language of the Rule

2. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With the

Regulatory History of the Rule

. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With

SEC No-Action Letters Addressing

the Rule

TABLE OF CONTENTS -— Continued

Page

B. The Circuit Court’s Views on the Statu-

tory Purpose of Section 16(b) and the

Impact on Liability Are in Error and

Contrary to This Court’s Decisions on

the Same Issues

CONCLUSION

TABLE OF AUTHORITIES

FEDERAL CASES

Christensen v. Harris County, 529 U.S. 576 (2000)...

Circuit City Stores, Inc. v. Adams, 532 U.S. 105

Foremost-McKesson, Inc. v. Provident Secs. Co., 423

U.S. 232 (1976)

Gollust v. Mendell, 501 U.S. 515 (1991)

International Brotherhood of Elec. Workers, Local.

Union No. 474, AFL-CIO v. NLRB, 814 F.2d 697

(1987)

Kern County Land Co. v. Occidental Petroleum

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

Meeks v. West, 216 F.3d 1363 (Fed. Cir. 2000)

~ Mendell v. Gollust, 909 F.2d 724 (2d Cir. 1990)

Morales v. Lukens, Inc., 593 F. Supp. 1209 (S.D.N_Y.

Morrison v. Madison Dearborn Capital Partners III,

L.P., 463 F.3d 312 (3d Cir. 2006)

Morrison v. Madison Dearborn Capital Partners III,

L.P., 389 F. Supp. 2d 596 (D. Del. 2005)

Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S.

418 (1972)

Roberto v. Dep’t of the Navy, 440 F.3d 1341 (Fed.

Cir. 2006)

TABLE OF AUTHORITIES — Continued

Rust v. Sullivan, 500 U.S. 173 (1991)

Thomas Jefferson Univ. v. Shalala, 512 U.S. 504

STATUTES AND RULES

15 U.S.C. §78b (2006)

15 U.S.C. §78p(b) (2006)

28 U.S.C. §1254(1) (2006)

17 C.F.R. §240.16a-1(b) (2006)

17 C.F.R. §240.16b-6(a) (2006)

Fed. R. Civ. P. 12(b)(6) (2006)

3rd Cir. LAR 34.1(b) (1997)

REGULATORY MATERIALS

Davis Polk & Wardwell, SEC No-Act. LEXIS 1006

(Aug. 23, 1991)

Jenny Craig, Inc., SEC No-Act. LEXIS 106 (Jan. 30,

Ownership Reports and Trading by Officers, Direc-

tors, and Principal Security Holders, Exchange

Act Release 28869, 56 Fed. Reg. 7242 (Feb. 21,

Self-Regulatory Organizations; The Options Clear-

ing Corporation; Notice of Filing of Proposed

Rule Change to Revise Option Adjustment Meth-

odology, Release No. 34-53400, 2006 SEC LEXIS

496 (March 2, 2006)

\

TABLE OF AUTHORITIES - Continued

OTHER AUTHORITIES

A.S. Jacobs, Section 16 of the Securities Exchange

Act, §3.12 (2003)

Black’s Law Dictionary (Eighth Ed. 2004)

OPINION BELOW

The opinion of the court of appeals, (App. 1-8),' is

reported at 463 F.3d 312. The opinion of the district court

is reported at 389 F. Supp. 2d 596. (App. 9-22).

+

JURISDICTION

The court of appeals issued its decision on September

17, 2006 and the judgment was issued on September 19,

2006. The jurisdiction of this Court is invoked under 28

U.S.C. §1254(1).

+

STATUTORY PROVISIONS AND

REGULATORY PROVISIONS INVOLVED

This case arises under section 16(b) of the Securities

Exchange Act of 1934, 15 U.S.C. §78p(b) (2006) (“Section

16(b)”) which provides in relevant part:

Profits from purchase and sale of security within

six months. For the purpose of preventing the

unfair use of information which may have been

obtained by such beneficial owner, director, or of-

ficer by reason of his relationship to the issuer,

any profit realized by him from any purchase and

sale, or any sale and purchase, of any equity se-

curity of such issuer (other than an exempted se-

curity) or a security-based swap agreement (as

defined in section 206B of the Gramm-Leach-

Bliley Act) involving any such equity security

* Documents reproduced in the Appendix to this petition will

hereinafter be referenced as (“App. __”).

within any period of less than six months, unless

such security or security-based swap agreement

was acquired in good faith in connection with a

debt previously contracted, shall inure to and be

recoverable by the issuer, irrespective of any in-

tention on the part of such beneficial owner, di-

rector, or officer in entering into such transaction

of holding the security or security-based swap

agreement purchased or of not repurchasing the

security or security-based swap agreement sold

for a period exceeding six months ... This sub-

section shall not be construed to cover any trans-

action where such beneficial owner was not such

both at the time of the purchase and sale, or the

sale and purchase, of the security or security-

based swap agreement (as defined in section

206B of the Gramm-Leach-Bliley Act) involved,

or any transaction or transactions which the

Commission by rules and regulations may ex-

empt as not comprehended within the purpose of

this subsection.

This case primarily involves the interpretation of Rule

16b-6(a) promulgated by the Securities and Exchange

Commission (“SEC” or the “Commission”), 17 C.F\R.

§240.16b-6(a) (2006), pursuant to Section 16(b) providing

that:

The establishment of or increase in a call equiva-

lent position or liquidation of or decrease in a put

equivalent position shall be deemed a purchase

of the underlying security for purposes of section

16(b) of the Act, and the establishment of or in-

crease in a put equivalent position or liquidation

of or decrease in a call equivalent position shall

be deemed a sale of the underlying securities for

purposes of section 16(b) of the Act: Provided,

however, that if the increase or decrease occurs

3

as a result of the fixing of the exercise price of a

right initially issued without a fixed price, where

the date the price is fixed is not known in ad-

vance and is outside the control of the recipient,

the increase or decrease shall be exempt from

section 16(b) of the Act with respect to any offset-

ting transaction within the six months prior to

the date the price is fixed.

I. STATEMENT OF THE CASE

A. The Nature of The Case

This action arises under Section 16(b) and is brought

on behalf of XM Satellite Radio Holdings, Inc. (“XM” or the

“Company”) by Larry Morrison, a shareholder of XM.

Plaintiff-petitioner alleges that Defendants Madison

Dearborn Capital Partners III, L.P., Madison Dearborn

Special Equity III, L.P., Madison Dearborn Partners III,

L.P. and Madison Dearborn Partners, LLC (collectively

referred to herein as “Defendants” or “Madison”) were at

all relevant times statutory insiders of XM subject to the

liability provisions of Section 16(b) and realized short-

swing insider trading profits recoverable under Section

16(b) from the purchase and corresponding sale of XM

common stock (the “Common Stock”).

B. Statement Of Facts

XM is a publicly traded company, the common stock of

which (the “Common Stock”) is registered with the SEC

pursuant to Section 12 of the Securities Exchange Act of

1934. Defendants were part of a group whose members

collectively owned more than ten percent of the out-

standing common stock of XM and also designated a

member to sit on XM’s board of directors.

4

On or about August 8, 2000, Madison acquired 50,000

shares of Series C Preferred Stock (the “Preferred Stock”)

for $1,000 per share or a total of $50,000,000. At the time

it was issued, the Preferred Stock was convertible into

1,886,792 shares of Common Stock at a price of $26.50 per

share (the “Conversion Price”).

The Conversion Price, however, was subject to down-

ward adjustment if the Company sold securities to other

investors ‘below the Conversion Price. This downward

adjustment in the Conversion Price, in turn, increased the

number of shares_of Common Stock into which the Pre-

ferred Stock was convertible.

Prior to January 28, 2003, the Conversion Price was

$19.68. XM then issued additional securities to new

investors, causing the Coziversion Price to be adjusted

downward to $8.96 by June 30, 2003. This decrease in the

Conversion Price caused Madison to acquire the right to

purchase an additional 3,039,707 shares of Common

Stock.’

Also, in June 2003, within six months of the changes

in the Conversion Price, Defendants sold 2,674,154 shares

* The additional issuances included the sale of $210.0 million of

10% Senior Secured Discount Convertible Notes due December 31, 2009

to certain institutional and accredited investors. See January 29, 2003,

Form 8-K at 4, available at http://www.sec.gov/cgi-bin/browse-edgar

(File No. 000-27441). Petitioner will be pleased to lodge a copy of the

Form 8-K or any other document referenced in this petition at the

request of the Court.

* At a conversion price of $8.96 the Preferred Stock was convertible

into 5,580,357 shares of Common Stock ($50,000,000 + $8.96 =

5,580,357), while at the previously existing conversion price of $19.68,

the Preferred Stock was convertible into 2,540,650 shares of Common

Stock ($50,000,000 + $19.68 = 2,540,650). ae

of XM Common Stock at prices exceeding the purchase

price. See July 14, 2003 Schedule 13D at Item 4, available

at http://www.sec.gov/cgi-bin/browse-edgar (File No. 000-

27441). As a result, Defendants earned millions of dollars

in short-swing insider trading profits.

C. Proceedings in the District Court

On January 7, 2004, Plaintiff filed his Complaint in

the United States District Court for the District of Dela-

ware. On March 1, 2004, Defendants moved, pursuant to

Fed. R. Civ. P. 12(b)(6), to dismiss the Complaint for

failure to state a claim for relief. Plaintiff opposed the

motion. The District Court, on October 5, 2005, and

without having taken oral argument on the motion, issued

a Memorandum Opinion and an Order granting Defen-

dants’ motion to dismiss.

D. Proceedings in the Court of Appeals

Petitioner filed a Notice of Appeal on November 2,

2005 and timely filed his opening brief on January 26,

2006. Oral argument was originally scheduled for Septem-

ber 14, 2006, but was subsequently cancelled, with the

Circuit Court choosing to take the case on submission

pursuant to Local Appellate Rule 34.1(b). On September

19, 2006, the Circuit Court issued its decision and on

October 11, 2006, the Circuit Court issued its mandate.

II. REASONS FOR GRANTING THE PETITION

The Circuit Court decision conflicts with decisions of

this Court and other Circuit Courts holding that where the

language of a regulation is clear, there is no need to

consult the regulatory history. Also, the Circuit Court’s

reliance on a snippet of regulatory history taken out of

context while ignoring other indicia of the regulation’s

meaning, including other relevant portions of the regula-

tory history and no-action letters written by staff attor-

neys at the SEC, is contrary to this Court’s guidance on

the correct means of interpreting statutes. Finally, the

Circuit Court’s interpretation of the statutory purpose of

Section 16(b) is contrary to the views previously expressed

by this Court on the very same subject.

A. The Circuit Court’s Interpretation of Rule

16b-6(a) is Inconsistent With Principles of

Statutory Interpretation Employed by This

Court

This Court requires that agency regulations be inter-

preted in a manner similar to statutes with the first

inquiry being on the plain language of the rule. See, e.g.,

Christensen v. Harris County, 529 U.S. 576 (2000). These |

devices of judicial construction are “the regulation’s plain

language” and “other indications of... intent at the time

of the regulation’s promulgation.” Thomas Jefferson

Univ. v. Shalala, 512 U.S. 504, 512 (1994) (emphasis

added). Here, Petitioner respectfully submits, these

devices of judicial construction demonstrate that the

Circuit Court erred in its interpretation of Rule 16b-6(a)

and, in doing so, acted contrary to decisions of this Court

as to how Courts should interpret agency regulations.

1. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With the

Plain Language of the Rule

The law of statutory interpretation is clear that where

the plain language of a statute (or regulation) is clear,

there is no need, nor is it even permitted to review the

statutory (or regulatory) history in order to determine the

correct meaning. See, e.g., Circuit City Stores, Inc. v.

Adams, 532 U.S. 105, 119 (2001) (citing Ratzlaf v. U.S.,

510 U.S. 135, 147-48 (1994) (“we do not resort to legisla-

tive history to cloud a statutory text that is clear.”)).

Accord, Roberto v. Dep’t of the Navy, 440 F.3d 1341, 1350

(Fed. Cir. 2006) (where “the plain meaning of the regula-

tion is clear, no further inquiry is required into agency

interpretations or the regulatory history to determine its

meaning.”) (citing Meeks v. West, 216 F.3d 1363, 1366 (Fed.

Cir. 2000)); International Brotherhood of Elec. Workers,

Local Union No. 474, AFL-CIO v. NLRB, 814 F.2d 697, 712

(1987) (“courts have no authority to enforce [a] principle

gleaned solely from legislative history that has no statu-

tory reference point.”).

Rule 16b-6(a) provides that: “The establishment of or

increase in a call equivalent position . .. shall be deemed a

purchase of the underlying security for purposes of section

16(b) of the Act.” 17 C.F.R. §240.16b-6(a) (2006) (emphasis

added). The more than 3 million additional shares of

Common Stock into which the Preferred Stock became

convertible as a result of the change in the Conversion

8

Price is precisely such an increase in a call equivalent

position."

The text of Rule 16b-6(a) provides for -nly one limited

exemption from Section 16(b) liability where, as here,

purchases occur through increases in a call equivalent

position. However, that exemption applies only where, “[1]

the date the price is fixed is not known in advance and [2]

is outside the control of the recipient,” and is further

limited to “[3] any offsetting transaction within the six

months prior to the date the price is fixed.” See 17

C.F.R. § 240.16b-6(a) (emphasis added).

Even assuming arguendo that the first two elements

of this test have been satisfied here —- a matter which

Petitioner disputes — this exemption still can not apply.

The sale triggering the Section 16(b) profit occurred after

the acquisition triggered by Rule 16b-6(a) and the increase

in the call equivalent position caused by the decrease in

the Conversion Price. Thus, the purchase caused by

reducing the Conversion Price is outside the limited

exemption afforded by Rule 16b-6(a). Accord, Ownership

Reports and Trading By Officers, Directors and Principal

Security Holders, Exchange Act Release 28869, 56 Fed.

Reg. 7242, 7253 (Feb. 21, 1991) (“1991 SEC Release”)

(“The rules have been modified to provide that if the

timing of the event fixing the price is outside the control

‘ It is undisputed that this contractual term allowing for the

conversion of Common Stock at a fixed price caused the Preferred Stock

owned by Defendants constituted to be a “call equivalent position”

within the meaning of Rule 16a-1(b) because it was security that

“increases in value as the value of the underlying equity increases. .. .”

17 C.F.R. § 240.16a-1(b) (2006); see also, Morrison, 469 F.3d at 315

(App. 5).

and knowledge of the holder, then the acquisition would be

... exempt from section 16(b) matching with sales occur-

ring before the fixing of the exercise price, but will not be

exempt from section 16(b) matching with sales oc-

curring thereafter.”) (emphasis added).

Therefore, the plain language of Rule 16b-6(a) demon-

strates that the transaction at issue in this case was a

purchase within the meaning of the rule and that no

exemption is available under the terms of the rule. Given

the clarity of the rule’s language, under this Court’s

controlling precedents, this should have ended the Circuit

Court’s inquiry into the correct meaning of Rule 16b-6(a).

Accord, Circuit City Stores, supra.

2. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With the

Regulatory History of the Rule

Instead of ending its inquiry with the rule’s plain

meaning, the Circuit Court referred to a single line in a

footnote of the 1991 SEC Release stating that: “The

adjustment for pre-specified events do not constitute

acquisitions of additional equity securities.” Morrison, 469

F.3d at 315; (App. 6-7) (citing 1991 SEC Release, 56 Fed.

Reg. 7242, 7252 n.134). However, this line was read by the

Circuit Court completely out of context and, therefore, can

not support the interpretation advanced by the Circuit

Court for Rule 16b-6(a). Accord, Rust v. Sullivan, 500 U.S.

173, 189 (1991).

Petitioner respectfully submits that the first error of

context made by the Circuit Court relates to the location of

this footnote within the 1991 SEC Release. The text of the

discussion to which the footnote relates only deals with

10

which securities fall within the definition of a “derivative

security.” See 1991 SEC Release, 56 Fed. Reg. at 7252.°

Also, the section of the 1991 SEC Release in which this

entire discussion is found is titled “Definitions of Equity

Securities of an Issuer and Derivative Security.” See 1991

SEC Release, 56 Fed. Reg. at 7251.

Therefore, the portion of the 1991 SEC Release upon

which the Circuit Court relied only addresses the circum-

stances in which a security is a derivative security — an

issue not in dispute in this action.” However, the footnote

relied upon by the Circuit Court does not speak to whether

the acquisition of a derivative security constitutes a

purchase within the meaning of Rule 16b-6(a).

Instead, the relevant portion of the regulatory history

is in the next section, titled “Acquisition of Derivative

Securities.” 1991 SEC Release, 56 Fed. Reg. at 7252.

There, the regulatory history states that:

When an insider purchases a derivative security

in the open market or in a negotiated transac-

tion, or is granted a derivative security by

_ the issuer, the opportunity to realize short-

swing profit begins.

* Specifically, the text accompanying footnote 134 of the 1991 SEC

Release upon which the Circuit Court relied states:

Derivative securities are defined in the rules to include op-

tions and convertible securities, and similar rights whose

value depends upon the value of the issuer’s equity securi-

ties. The definition has been clarified to exclude securities

without a fixed exercise price,”

1991 SEC Release, 56 Fed. Reg. at 7252.

* See n.3, supra.

11

1991 SEC Release, 56 Fed. Reg. at 7252 (emphasis added).

Here, the additional shares of Common Stock acquired by

Defendants as a result of the decrease in the Conversion

Price represents a grant of a derivative security by the

issuer (XM) to Defendants (based upon a contractual

obligation which Madison had undoubtedly negotiated for

and actively sought).

Also, Petitioner respectfully submits that the Circuit

Court erred in failing to take account of the sentence

immediately preceding the quoted footnote language relied

upon. That sentence specifically refers to “pre-specified

events such as a stock split.” 1991 SEC Release, 56 Fed.

Reg. at 7252 n.134 (emphasis added). However, here, the

decrease in the Conversion Price which caused the pur-

chase was not a stock split or even a transaction resem-

bling a stock split.

In a stock split or stock dividend, all common stock-

holders are treated equally with the number of shares

outstanding increased by a multiple common to all shares.

E.g., Morales v. Lukens, Inc., 593 F. Supp. 1209, 1214 n.8

(S.D.N.Y. 1984); see also, Black’s Law Dictionary at 1459

(Eighth Ed. 2004). It is common practice to adjust options

by the same multiple applied to create the stock split or

stock dividend to any option outstanding with respect to

the shares that were the subject of such a stock dividend

or stock split. See, e.g., Self-Regulatory Organizations; The

Options Clearing Corporation; Notice of Filing of Proposed

Rule Change to Revise Option Adjustment Methodology,

Release No. 34-53400, 2006 SEC LEXIS 496 at *3 (March

2, 2006) (the “2006 SEC Release”). Thus, “|fJor example, in

the event of a 2-for-1 split, an XYZ $60 option calling

for the delivery of 100 shares of XYZ stock would-be

me 12

subdivided into two XYZ $30 options, each calling for the

delivery of 100 shares of XYZ stock.” Jd. at *3 n.3.

Here, in contrast, the transaction in which Madison

acquired the right to purchase an additional 3,039,707

shares of Common Stock bears no resemblance to a stock

_ split. The benefit which Madison received from the de-

crease in the Conversion Price did not flow to all of XM’s

shareholders but one which Madison alone enjoyed.

Therefore, a fair reading of the regulatory history of

Rule 16b-6(a) also demonstrates that the transaction at

issue in this action was subject to Section 16(b) liability

through the operation of Rule 16b-6(a).

3. The Circuit Court’s Interpretation of

Rule 16b-6(a) is Inconsistent With SEC

No-Action Letters Addressing the Rule

Also left unmentioned in the Circuit Court opinion are

no-action letters issued by the SEC staff interpreting Rule

16b-6(a) and which conflict with the Circuit Court’s deci-

sion. Davis Polk & Wardwell, SEC No-Act. LEXIS 1006

(Aug. 23, 1991), is on point as it involved stock options to

purchase shares in an issuer at a specified price together

with an adjustment to the underlying option. The adjust-

ments, which were referred to as dividend equivalent

rights (“DER”), accumulated and the participant received

additional shares of common stock at the time of the

option’s exercise with respect to the DER. In response to a

request for exemption, the SEC in Davis Polk opined that

the initial option and the DER were two separate securi-

ties. The initial option was deemed to be a derivative

security with the purchase price fixed at the time of grant.

13

The DER component, however, was only deemed acquired

on the date its terms were fixed.

Similarly, Jenny Craig, Inc., SEC No-Act. LEXIS 106

(Jan. 30, 1992), opined that where the number of shares

underlying a warrant (i.e., the call equivalent position)

would increase if the Company failed to meet certain

specified financial goals, the warrants were derivative

securities only with respect to the number of shares

originally underlying the warrants. However, with respect

to the additional shares of stock to be issued if the Com-

pany did not meet its financial goals, they would be

deemed acquired on the date they were issued.

Here, applying Davis Polk and Jenny Craig to this

action confirm the interpretation reached by the plain

language of Rule 16b-6(a) and a reasonable reading of the

rule’s regulatory history, and correctly results in the

Preferred Stock being deemed a derivative security on the

date it was acquired by Defendants. The increased number

of shares into which the Preferred Stock became converti-

ble constituted a Section 16(b) purchase only on the date

those provisions became effective.

B. The Circuit Court’s Views on the Statutory

Purpose of Section 16(b) and the Impact on

Liability Are in Error and Contrary to This

Court’s Decisions on the Same Issues

The Circuit Court also justified its decision as being

“consistent with the statutory purpose.” Morrison, 463

F.3d at 315 (App. 7). Specifically, the Circuit Court opined

that “[t]he potential for abuse is minimal when the ad-

justments are automatic, and the triggering events were

specified at the time when the stock was purchased.” Jd.

14

However, the Circuit Court cites no support either

from the legislative record or from this Court’s prior

decisions discussing the statutory purpose of Section 16(b).

Id. Petitioner respectfully submits that this finding

concerning Section 16(b)’s statutory purpose is inconsis-

tent with this Court’s decisions addressing the issue.

Section 16(b)’s goal is to prevent manipulative trading

and the resulting harm to the securities markets and

other elements of the national economy. See 15 U.S.C.

§78p(b); see also, 15 U.S.C. §78b (cited in Gollust v. Men-

dell, 501 U.S. 515, 121 (1991)). It is equally clear that

Congress intended to accomplish this result by requiring

insiders to disgorge any profits obtained from matching

“any purchase” with “any sale” occurring within a six

month period. See 15 U.S.C. §78p(b) (emphases added).

Accord, Foremost-McKesson, Inc. v. Provident Secs. Co.,

423 U.S. 232, 253 (1976) (“Congress thought that all

short-swing trading by directors and officers was vulner-

able to abuse because of their intimate involvement in

corporate affairs.”) (emphasis added). “[T]he 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.” Reliance Elec. Co. v. Emerson Elec.

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

This Court has allowed certain transactions to be

exempted from Section 16(b) liability. However, such an

exemption has been held to be appropriate only where “the

involuntary nature of [the] exchange, [is] coupled with the

absence of the possibility of speculative abuse of inside

information.” Kern County Land Co. v. Occidental Petro-

leum Corp., 411 U.S. 582, 600 (1973). See also, A.S. Jacobs,

Section 16 of the Securities Exchange Act, §3.12 at 3-110-11

15

(2003) (“under Kern County — both factors — involun-

tariness and no access to inside information — must

exist before an unorthodox transaction can escape

being a statutory purchase or sale.”) (emphasis added).

Here, Defendants are still presumed to have inside

information based upon, inter alia, their having desig-

nated one of the members of XM’s board of directors.’

Thus, the mere fact that a transaction is automatic or

involuntary is insufficient to take it outside the scope of

those transactions which Section 16(b) was intended to

address.

Also, the Circuit Court extended the holding of Kern

County from a situation in which the involuntary transac-

tion caused the imposition of Section 16(b) damages to one

in which, as here, the statutory insider could have avoided

all liability by simply refraining from selling for a period of

six months. Accord, Foremost, 423 U.S. at 252 (“Even an

insider may trade freely without incurring the statutory

liability if, for example, he spaces his transactions at

intervals greater than six months.”). No one forced Defen-

dants to sell XM stock and realize a short-swing profit.

Having done so voluntarily, they ought not to be in the

position of crying foul or claiming unfairness.

+

"Defendants are presumed to have access to inside information by

virtue of their insider position. See, e.g., Mendell v. Gollust, 909 F.2d

724, 728 (2d Cir. 1990) (“The statute presumes that insiders in a

company have access to non-public information regarding its operation

and will use that information when trading in the issuer’s stock, and

thus proof of the actual use of such inside information is not required.”)

(citing Foremost-McKesson, supra, 423 U.S. at 243 & 251; Reliance

Elec., supra, 404 U.S. at 422)).

16

CONCLUSION

The petition for a writ of certiorari should be granted.

Respectfully submitted,

ABRAHAM FRUCHTER &

TWERSKY LLP

MITCHELL M.Z. TWERSKY

Counsel of Record

- JEFFREY S: ABRAHAM

One Penn Plaza, Suite 2805

New York, New York 10119

Telephone: (212) 279-5050

Counsel for Petitioner

App. 1

LARRY MORRISON, Appellant v. MADISON

DEARBORN CAPITAL PARTNERS III L.P.;

MADISON DEARBORN SPECIAL EQUITY III L.P.;

MADISON DEARBORN PARTNERS III L.P.;

MADISON DEARBORN PARTNERS LLC;

XM SATELLITE RADIO HOLDINGS INC.

No. 05-4901

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

463 F.3d 312; 2006 U.S. App. LEXIS 23739;

Fed. Sec. L. Rep. (CCH) P93,956

September 14, 2006, Submitted Under

Third Circuit Lar 34.1(a)

September 19, 2006, Filed

COUNSEL: Jeffrey S. Abraham, Esq., Mitchell M.

Twersky, Esq., Abraham Fruchter & Twersky LLP, New

York, NY, for Appellant.

Michael R. Robinson, Esq., Lisa A. Schmidt, Esq., Rich-

ards, Layton & Finger, P.A., Wilmington, DE; James A.

Langan, Esq., Kathryn F. Taylor, Esq., Kirkland & Ellis

LLP, Chicago, IL, Attorneys for Madison Dearborn Capital

Partners III, L.P., Madison Dearborn Special Equity III,

L.P., Madison Dearborn Partners III, L.P., and Madison

Dearborn Partners, LLC.

John C. Keeney, Jr., Esq., Hogan & Hartson LLP, Wash-

ington, DC, Carolyn S. Hake, Esq., Ashby & Geddes,

Wilmington, DE, Attorneys for XM Satellite Radio Hold-

ings, Inc.

JUDGES: Before SLOVITER, WEIS, and GARTH,

Circuit Judges.

App. 2

OPINION BY: SLOVITER

OPINION:

OPINION OF THE COURT

SLOVITER, Circuit Judge.

I.

Larry Morrison, a shareholder of XM Satellite Radio

Holdings, Inc. (“XM”), brought a derivative suit under

Section 16(b) of the Securities Exchange Act of 1934, 15

U.S.C. § 78p(b), to recover alleged short-swing profits

realized by corporate insiders Madison Dearborn Capital

Partners III, L.P., Madison Dearborn Special Equity III,

L.P., Madison Dearborn Partners III, L.P., and Madison

Dearborn Partners, LLC (collectively “Madison Dear-

born”). The District Court dismissed the complaint for

failure to state a claim on which relief can be granted. Fed.

R. Civ. P. 12(b)(6). Morrison appeals.

Il. ~

In August 2000, Madison Dearborn purchased 50,000

shares of “8.25% Series C Convertible Redeemable Pre-

ferred Stock Due 2012” (hereinafter “Preferred Stock”)

issued by XM for $1000 per share. Combined with other

purchases, Madison Dearborn was the beneficial owner of

13.58% of the underlying XM Common Stock.

Holders of Preferred Stock are entitled to exchange

their shares for XM Common Stock. The Certificate of

Designation for the Preferred Stock set the conversion

price at $26.50 per share, but also contained “anti-

dilution” provisions which automatically decreased the

App. 3

conversion price when certain events occurred, such as a

stock split, payment of dividends, or issuance of additional

Common—Stock. By 2003, the conversion price had de-

creased to $19.68. On and subsequent to January 28, 2003,

XM issued additional Common Stock, which further

reduced the conversion price to $8.96 per share as of June

30, 2003. Prior to the adjustment, Madison Dearborn was

entitled to convert its Preferred Stock into 2,540,650

shares of Common Stock. Afterwards, it was entitled to

5,580,357 shares but never exercised its right to convert

those shares.

In June 2003, Madison Dearborn sold 2,674,154

shares of XM Common Stock that it had acquired inde-

pendently of the Preferred Stock. Morrison requested that

XM bring suit against Madison Dearborn to recover the

alleged short-swing profits realized by this sale. When XM

declined to do so, Morrison brought this derivative share-

holder lawsuit.

III,

The District Court had jurisdiction over this action

under 15 U.S.C. § 78aa. We have jurisdiction over this

appeal from the final judgment of the District Court under

28 U.S.C. § 1291. We exercise plenary review over the

order dismissing the complaint, as well as the District

Court’s interpretation of securities law. In re Rockefeller

Ctr. Properties, Inc. Sec. Litig., 311 F.3d 198, 215 (3d Cir.

2002). When reviewing a motion to dismiss, “we accept all

factual allegations in the complaint as true and view them

in the light most favorable to the plaintiff] ].” Accardi v. IT

Litig. Trust (In re IT Group, Inc.), 448 F.3d 661, 667 (3d

Cir. 2006).

App. 4

IV.

Section 16(b) of the Securities Exchange Act of 1934

prohibits corporate insiders from using their privileged

position to profit from short-term transactions in the

company’s stock. 15 U.S.C. § 78p(b).' Short-swing trading

is a strict-liability offense and does not require proof of

actual abuse of insider information or an intent to profit

from such information. Foremost-McKesson, Inc. v. Provi-

dent Sec. Co., 423 U.S. 232, 251, 96 S. Ct. 508, 46 L. Ed. 2d

464 (1976). The plaintiff need only prove that “‘there was

(1) a purchase and (2) a sale of securities (3) by an officer

or director of the issuer or by a shareholder who owns

more than ten percent of any one class of the issuer’s

securities (4) within a six month period.’” Levy v. Sterling

Holding Co., 314 F.3d 106, 111 (38d Cir. 2002) (quoting

Gwozdzinsky ex rel. Revco D.S., Inc. v. Zell/Chilmark

Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998)). For the

purposes of the motion to dismiss, Madison Dearborn does

not dispute that it is a corporate insider or that it sold

almost 2.7 million shares of XM Common Stock in June

’ Section 16(b) provides, in pertinent part:

For the purpose of preventing the unfair use of information

which may have been obtained by such beneficial owner, di-

rector, or officer by reason of his relationship to the issuer,

any profit realized by him from any purchase and sale, or

any sale and purchase, of any equity security of the issuer

... Within any period of less than six months... shall inure

to and be recoverable by the issuer, irrespective of any in-

tention on the part of such beneficial owner, director, or offi-

cer in entering into such transaction.... This 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.

15 U.S.C. § 78p(b) (2006) (emph. »is added).

App. 5

2003. The only issue is whether the automatic adjustment

to the conversion price of the Preferred Stock in January

2003, was a “purchase” of securities.

The Securities Exchange Act of 1934 authorizes the

SEC to enact regulations defining which transactions are

included in the ban on short-swing trading and which are

“exempt as not comprehended within the purpose of this

subsection.” 15 U.S.C. § 78p(b). In 1991, the SEC adopted

new regulations on the applicability of Section 16(b) to

transactions in derivative securities. A derivative security

is “any option, warrant, convertible security, stock appre-

ciation right, or similar right with an exercise or conver-

sion privilege at a price related to an equity security, or

similar securities with a value derived from the value of

an equity security....” 17 C.F.R. § 240.16a-1(c) (emphasis

added).

The parties agree that, because the Preferred Stock is

convertible into Common Stock, the Preferred Stock is a

derivative security. More specifically, the Preferred Stock

is a “call equivalent position,” because it “increases in

value as the value of the underlying equity increases... .”

17 C.F.R. § 240.16a-1(b). The regulations state that “[t]he

establishment of or an increase in a call equivalent posi-

tion ... shall be deemed a purchase of the underlying

security for purposes of section 16(b)....” 17 C.FR.

§ 240.16b-6(a). Morrison argues that the adjustment in the

conversion price increased Madison Dearborn’s call

equivalent position from 2,540,650 shares to 5,580,357

shares of XM Common Stock. Thus, he argues, under the

plain meaning of the regulations, the adjustment consti-

tuted a “purchase.”

App. 6

Morrison’s argument is contrary to the SEC’s inter-

pretation of the regulations. An agency’s reasonable

interpretation of its own regulations “attracts substantial

judicial deference.” United States v. Cleveland Indians

Baseball Co., 532 U.S. 200, 220, 121 S. Ct. 1433, 149 L.

Ed. 2d 401 (2001) (citation omitted). “Our task is not to

decide which among several competing interpretations

best serves the regulatory purpose. Rather, the agency's

interpretation must be given controlling weight unless it is

plainly erroneous or inconsistent with the regzulation.”

Thomas Jefferson Univ. v. Shalala, 512 U.S. 504, 512, 114

S. Ct. 2381, 129 L. Ed. 2d 405 (1994) (internal quotation

marks omitted). Deference is especially warranted when

the regulations concern “a complex and highly technical

regulatory program [.]” Jd. (internal quotation marks

omitted). Particular weight is given to agency interpreta-

tions made at the time the regulations are promulgated.

Gardebring v. Jenkins, 485 U.S. 415, 430, 108 S. Ct. 1306,

99 L. Ed. 2d 515 (1988).

The SEC anticipated, and rejected, Morrison’s argu-

ment. In the release announcing the new regulations, the

SEC states that the regulations only apply to derivatives

with a “fixed exercise price.” Ownership Reports and

Trading By Officers, Directors and Principal Security

Holders, 56 Fed. Reg. 7242, 7252 (Feb. 21, 1991) (hereinaf-

ter “Release”). The Release clarifies what constitutes a

“fixed” price, saying,

A convertible security with a fixed conversion

privilege is deemed to have a fixed exercise price.

A derivative security having a series of preset

prices, or having a price that is adjusted to re-

flect pre-specified events such as a stock split, is

App. 7

considered fixed for purposes of the Rule. The ad-

justments for pre-specified events do not consti-

tute acquisitions of additional equity securities.

Release, at 7252 n.134 (emphasis added). Therefore, under

the SEC’s interpretation, the adjustment to the conversion

price of the Preferred Stock is not a “purchase.”

The SEC’s interpretation is consistent with the

statutory purpose. The ban on short-swing trading was

enacted “(flor the purpose of preventing the unfair use of

information which may have been obtained by [corporate

insiders.]” 15 U.S.C. § 78p(b). The SEC has attempted to

identify those transactions which have a “potential for

“abuse.” Release, at 7249. The potential for abuse is mini-

mal when the adjustments are automatic, and the trigger-

ing events were specified at the time when the stock was

purchased. The shareholder cannot control when, or even

if, the adjustment occurs. Cf. Lerner v. Millenco, L.P., 23 F.

Supp. 2d 337, 343 (S.D.N.Y. 1998) (holding that a share-

holder had purchased additional securities by negotiating

with the company to reduce the conversion price of con-

vertible debentures). While the possibility of insider

trading is not entirely eliminated, it is not so great as to

impose strict liability as provided in Section 16(b).

¥

We defer to the SEC’s reasonable position that an

automatic adjustment to the conversion price of a deriva-

tive security is not a “purchase” for the purposes of Section

16(b). The District Court fully considered Morrison’s

arguments before rejecting his arguments that the in-

crease in the conversion ratio subjected Madison Dearborn

App. 8

to liability under Section 16(b). Therefore, we will affirm

the decision of the District Court to dismiss the complaint.

App. 9

LARRY MORRISON, Plaintiff, vy. MADISON

DEARBORN CAPITAL PARTNERS III, L.P.,

MADISON DEARBORN SPECIAL EQUITY ITI, L.P.,

MADISON DEARBORN PARTNERS III, L.P.,

MADISON DEARBORN PARTNERS, LLC and

XM SATELLITE RADIO HOLDINGS INC.,

Defendants.

Civil Action No. 04-010-KAJ

UNITED STATES DISTRICT COURT FOR THE

DISTRICT OF DELAWARE

389 F. Supp. 2d 596; 2005 U.S. Dist. LEXIS 22603;

Fed. Sec. L. Rep. (CCH) P93,535

October 5, 2005, Decided

COUNSEL: Jeffrey S. Goddess, Rosenthal, Monhait,

Gross & Goddess, P.A., Wilmington, Delaware, for

Plaintiff. Of Counsel: Jack G. Fruchter, Abraham,

Fruchter & Twersky, LLP, New York, New York.

Lisa A. Schmidt, Michael R. Robinson, Richards, Layton

& Finger P.A., Wilmington, Delaware; Lawrence C.

Ashby, Carolyn S. Hake, Ashby & Geddes, Wilmington,

Delaware, for Defendants. Of Counsel: J. Andrew Lan-

gan, Kathryn F. Taylor, Kirkland & Ellis LLP, Chicago,

Iilinois; John C. Keeney, Jr., Hogan & Hartson LLP,

Washington, D.C.; James I. Rim, Hogan & Hartson LLP,

New York, New York.

JUDGES: JORDAN, District Judge.

OPINION BY: KentA. Jordan

OPINION:

App. 10

MEMORANDUM OPINION

October 5, 2005

Wilmington, Delaware

JORDAN, District Judge

I. INTRODUCTION

Plaintiff, a shareholder of XM Satellite Radio Hold-

ings Inc. (“XM Radio”), brought this derivative action to

recover profits from short-swing insider trading of XM

Radio stock by Madison Dearborn Capital Partners III,

L.P., Madison Dearborn Special Equity III, L.P., Madison

Dearborn Partners III, L.P., and Madison Dearborn

Partners, LLC (collectively, “MDP”). Before me are Mo-

tions to Dismiss under Fed. R. Civ. P. 12(b)(6) filed by

MDP (Docket Item [“D.I.”] 14) and XM Radio (a nominal

defendant) (D.I.11). The court has jurisdiction over the

subject matter of this action under 28 U.S.C. § 1331 and

15 U.S.C. § 78aa; jurisdiction over the parties and venue

for this action are uncontested. For the reasons that follow,

the Motions to Dismiss will be granted.

Il. BACKGROUND’

On August 8, 2000, MDP acquired 50,000 shares of

“8.25% Series C Convertible Redeemable Preferred Stock

Due 2012” (“Preferred Stock”) issued by XM Radio at a

price of $1,000 per share. This purchase, along with

previous acquisitions, gave MDP beneficial ownership of

’ The following background information is based on plaintiff’s

allegations, which are assumed to be true for the purposes of these

12(b)(6) motions.

App. 11

13.58% of the underlying XM Radio common stock. Hold-

ers of the Preferred Stock could exchange these shares for

XM Radio common stock at a price initially set to $26.50

per share of common stock. The Certificate of Designation

for the Preferred Stock (“Certificate”) (D.I.15, Ex. B)’

required that this conversion price be adjusted to maintain

the value of the conversion privilege if one of a series of

prespecified events occurred that would dilute this value.

For example, stock splits, payment of stock dividends to

common stock holders, or issuance of additional common

stock would dilute the common stock that could be ac-

quired by Preferred Stock holders, and so if any of these

events happened, XM Radio was required to adjust the

conversion price. This price adjustment would be made

automatically according to a set formula that corrected for

dilution by the triggering event. For example, if additional

stock were issued:

the new Conversion Price shall be determined by

multiplying the Conversion Price then in effect

by a fraction, (x) the numerator of which shall be

the number of shares of Common Stock out-

standing immediately prior to such issuance (the

“Outstanding Common”) plus the number of

shares of Common Stock that the aggregate con-

sideration received by the Issuer for such issu-

ance would purchase at such Conversion Price;

* The Certificate of Designation is a publicly-available document

filed with the Delaware Secretary of State. A certified copy of the

document was included with MDP’s brief in support of this motion, and

it may be considered along with plaintiff’s allegations. See S. Cross

Overseas Agencies, Inc. v. Wah Kwong Shipping Group, Ltd., 181 F.3d

410, 426 (3d Cir. 1999) (“To resolve a 12(b\6) motion a court may

properly look at public records . . . in addition to the allegations in the

complaint.”).

App. 12

and (y) the denominator of which shall be the

number of shares of Outstanding Common plus

the number of shares of such Additional Stock.

(Id. at § 4.2(d)(i)).

Due to events prior to January 2003, the conversion

price for Preferred Stock was adjusted from the initial

value of $26.50 to $19.68. At this adjusted conversion

price, MDP’s 50,000 shares of Preferred Stock could be

exchanged for approximately 2.5 million shares of common

stock. XM Radio issued additional common stock in Janu-

ary 2003, and the conversion price was accordingly ad-

justed again to $8.96. At this adjusted price, MDP could

exchange its Preferred Stock for approximately 5.6 million

shares of common stock. Plaintiff has not alleged that

MDP exercised its conversion privilege.

In June 2003, within six months of the January

conversion price adjustment, MDP sold 2.7 million shares

of XM Radio common stock that it had acquired independ-

ently of its Preferred Stock. According to plaintiff, MDP

still beneficially owned more than 10% of the XM Radio

common stock after this sale.

Plaintiff argues that the January conversion price

adjustment was a “purchase” of XM Radio common stock

that occurred within six months of the June 2003 sale, and

so, under Section 16(b) of the Securities Exchange Act of

1934 (“Section 16(b)”), MDP must turn over its profits

from this short-swing trading. 15 U.S.C. § 78p(b) (2004).

Plaintiff made a written demand on October 16, 2003 for

XM Radio to bring this action to recover MDP’s profits,

and when XM Radio declined, plaintiff brought this

derivative action.

App. 13

Ill. STANDARD OF REVIEW

Fed. R. Civ. P. 12(b)(6) requires a court to accept as

true all material allegations of the complaint. See Trump

Hotels & Casino Resorts, Inc. v. Mirage Resorts, Inc., 140

F.3d 478, 483 (3d Cir. 1998) (internal citation omitted). “A

complaint should be dismissed only if, after accepting as

true all of the facts alleged in the complaint, and drawing

all reasonable inferences in the plaintiff’s favor, no relief

could be granted under any set of facts consistent with the

allegations of the complaint.” Jd. (internal citation omit-

ted). The moving party has the burden of persuasion. See

Kehr Packages, Inc. v. Fidelcor, Inc., 926 F.2d 1406, 1409

(3d Cir. 1991).

IV. DISCUSSION

A. The Purpose and Strictures of Section 16(b)

Section 16(b) provides:

For the purpose of preventing the unfair use of

information which may have been obtained by

such beneficial owner, director, or officer by rea-

son of his relationship to the issuer, any profit

realized by him from any purchase and sale, or

any sale and purchase, of any equity security of

the issuer ... within any period of less than six

months ... shall inure to and be recoverable by

the issuer, irrespective of any intention on the

part of such beneficial owner, director or officer

in entering into such transaction ....

15 U.S.C. § 78p(b) (2004).

Because of the danger of corporate insiders using

inside information to generate profits from short-term

buying and selling of their company’s stock, Congress

App. 14

imposed strict liability for profiting from purchases and

sales made within six months of each other. Magma Power

Co. v. Dow Chem. Co., 1386 F.3d 316, 320 (2d Cir. 1998).

Thus, “no showing of actual misuse of inside information

or of unlawful intent is necessary to compel disgorge-

ment.” Id.; see also Foremost-McKesson, Inc. v. Provident

Sec. Co., 423 U.S. 232, 251, 46 L. Ed. 2d 464, 96 S. Ct. 508

(1976). Rather, the statute operates mechanically to force

insiders to turn over any short-swing profits. To state a

claim under Section 16(b), plaintiff must allege that “there

was (1) a purchase and (2) a sale of securities (3) by an

officer or director of the issuer or by a shareholder who

owns more than ten percent of any one class of the issuers

securities (4) within a six-month period.” Levy v. Sterling

Holding Co., 314 F.3d 106, 111 (3d Cir. 2002); see also

Gwozdzinsky v. Zell/Chilmark Fund, L.P., 156 F.3d 305,

308 (2d Cir. 1998). For purposes of these motions, MDP”

does not dispute its insider status, or that it sold XM

Radio stock in June 2003. The only issue before me is —

whether plaintiff has alleged a “purchase” that occurred

within six months of the June 2003 sale.

Plaintiff argues that the January 2003 conversion

price reduction for the Preferred Stock is a “purchase”

under Section 16(b), as interpreted under Securities and

Exchange Commission (“SEC”) Rule 16b-6(a). Because of

the conversion privilege, the parties agree that the Pre-

ferred Stock is a derivative security according to Rule 16a-

l(c). 17 C.F.R. § 240.16a-1(c) (2004). As the value of XM

* XM Radio has waived its right to file separate briefs in support of

its motion to dismiss, and has joined in MDP’s briefs. Therefore, my

analysis of MDP’s arguments determines the disposition of XM Radio’s

motion as well.

App. 15

Radio common stock increases, the value of the Preferred

Stock with its conversion privilege increases. Thus, the

conversion privilege operates like a call option covering

the underlying XM Radio stock, and so, under Rule 16a-

1(b), the Preferred Stock is a “call equivalent position.” 17

C.F.R. § 240.16a-1(b) (2004). As a call equivalent position,

the Preferred Stock is subject to Rule 16b-6(a), which

provides that “the establishment of or increase in a call

equivalent position ... shall be deemed a purchase of the

underlying security for purposes of section 16(b).” 17

C.F.R. § 240.16b-6(a) (2004).

The January 2003 conversion price reduction gave

MDP the privilege of obtaining over 3 million additional

shares in exchange for its Preferred Stock. According to

plaintiff, this is an “increase in a call equivalent position”

that should be treated as a purchase of XM Radio stock for

determining Section 16(b) liability. Because this interpre-

tation of Rule 16b-6(a) differs from that of the SEC, and

because it is not consistent with the purpose behind

Section 16(b) and Rule 16b-6, I disagree with plaintiff’s

position and conclude that the January 2003 conversion

price reduction is not a purchase.

B. SEC Revision of Rules Under Section 16(b)

In 1991, the SEC revised its Rules under Section 16(b)

“in response to developments in the trading of derivative

securities.” Ownership Reports and Trading By Officers,

Directors and Principal Security Holders, Exchange Act

Release No. 28,869, 56 Fed. Reg. 7242, 7243 (Feb. 21,

1991) (“1991 SEC Release”). The revisions made it clear

that for derivative securities, the relevant event for

Section 16(b) purposes is the purchase or sale of the

App. 16

derivative security rather than its exercise or conversion.

Id. at 7252-53. For example, the purchaser of a convertible

security-is able to lock in a conversion price for the under-

lying stock when the convertible security is purchased,

making that a time when an insider could take advantage

of inside information to set up or realize a short-swing

profit. Therefore, Rule 16b-6(a) requires that “the estab-

lishment of or increase in a call equivalent position ...

shall be deemed a purchase of the underlying security for

purposes of section 16(b).” 17 C.F.R. § 240.16b-6(a). The

later conversion into the underlying stock is a change of

form but not of substance. Thus, the conversion is a non-

event under Section 16(b). See Magma Power, 136 F.3d at

321-22; 1991 SEC Release, at 7253.

The situation changes if the conversion price is not

fixed at the time the convertible security is purchased. For

example, if the conversion price is set at a percentage of

the market price, the conversion price will float, and the

time for an insider to take advantage of non-public infor-

mation would be at the conversion of the stock, rather

than the time of purchase. See Lerner v. Millenco, L.P,

23 F. Supp. 2d 337, 341-42 (S.D.N.Y. 1998); 1991 SEC

Release, at 7253. Because the danger of insider trading

occurs at a different time for securities with floating

conversion prices, Rule 16a-1(c)(6) excludes them from the

derivative securities subject to Rule 16b-6, and the rele-

vant event under Section 16(b) is the conversion. See

Lerner, 23 F. Supp. 2d at 342,

C. The Rules Applied, In Light of the SEC’s Inter-

pretation

Here, the conversion price for the Preferred Stock was

adjusted because of the issuance of additional XM Radio

App. 17

stock. Plaintiff argues that the adjustment is an increase

in a call equivalent position, and therefore a purchase

under Rule 16b-6(a), because it allows MDP to acquire

additional XM Radio stock. But it appears that the SEC

anticipated such price adjustments and reached a different

conclusion. In the 1991 Release, as the revised Rule 16b-6

was promulgated, the SEC stated that:

A convertible security with a fixed conversion

privilege is deemed to have a fixed exercise price.

A derivative security having a series of preset

prices, or having a price that is adjusted to re-

flect pre-specified events such as a steek split, is

considered fixed for purposes of [Rule 16a-1l(c)].

The adjustment for pre-specified events do not

constitute acquisitions of additional equity secu-

rities.

1991 SEC Release, at 7252 n.134. Stock splits, payment of

stock dividends, and issuance of additional stock were

prespecified in the Certificate as events requiring the

adjustment of the conversion price for the Preferred Stock.

The SEC release thus demonstrates that, when the Rules

were revised to better account for derivative securities

trading, the SEC intended the following: (1) that securities

like the Preferred Stock would be treated as if they had a

fixed conversion price; (2) that, as a result, such securities

would be derivative securities under Rule 16a-1(c); (3) that

adjusting the conversion price would not be an acquisition

of additional stock; and (4) that under Rule 16b-6, the

relevant event would be the purchase of the Preferred

Stock, not the change in conversion price.

Congress gave the SEC the power to exclude transac-

tions from the reach of Section 16(b). 15 U.S.C. § 78p(b)

(“This subsection shall not be construed to cover ... any

App. 18

transaction or transactions which the Commission by rules

and regulations may exempt as not comprehended within

the purpose of this subsection.”). Thus, courts often defer

to the SEC’s interpretations, even when they are not

formalized as Rules. See, e.g., Press v. Quick & Reilly, Inc.,

218 F.3d 121, 128 (2d Cir. 2000) (deferring to SEC inter-

pretations presented in an amicus brief); Schaffer ex rel.

Lasersight Inc. v. CC Invs., LDC, 280 F. Supp. 2d 128, 143

(S.D.N.Y. 2003) (same).

Here, the statement in the 1991 Release is not only

clear, it is consistent with the policy behind the treatment

of derivative securities under Rule 16b-6. The purchase of

derivative securities is the relevant event under Rule 16b-

6 because, at that point, the buyer is able, for the last

time, to negotiate the price at which the underlying stock

will be obtained. Thus, that is the last time that inside

information can be exploited when setting the purchase

price. In contrast, a security with a floating price leaves

the purchaser the option of setting a price later, as the

market fluctuates. MDP’s last opportunity to influence the

conversion price of the Preferred Stock was when it actu-

ally purchased the stock in August 2000. The later, auto-

matic adjustments to the price only maintained the value

of MDP’s conversion privilege in the face of dilution from

the issuance of additional stock, and the formula for those

adjustments was set at the time the Preferred Stock was

issued. Thus, as the SEC stated in the 1991 Release, for

the purposes of Section 16(b), the conversion price for the

App. 19

Preferred Stock should be treated as fixed, and changes in

the price should not be treated as purchases.*

This result is not inconsistent with the lone case that

plaintiff points out as an example of conversion price

adjustments being considered purchases under Section

16(b). In Lerner v. Millenco, L.P., supra, the court con-

cluded that a reduction in the conversion price for a

convertible debenture “raised the number of shares that

[the holder] could acquire by converting the debentures,

and thus increased the defendant’s call equivalent posi-

tion.” 23 F. Supp. 2d at 343. So, under Rule 16b-6(a), the

reduction was a purchase of the underlying stock. Jd. But

the conversion price reduction in Lerner resulted from a

separate agreement between the holder and issuer to

modify a price that was fixed when the debentures issued.

Id. at 339. In return for this favorable revision of the

“conversion formula,” the debenture holder agreed not to

exercise the conversion privilege for several months. Jd.

This adjustment was not made in response to prespecified

events. The automatic conversion price adjustment for the

XM Radio Preferred Stock was set when the stock was

issued, making it qualitatively different from the negoti-

ated one-time adjustment in Lerner.

* MDP also argues that several SEC no-action letters support the

view that the conversion price adjustment was not a purchase under

Section 16(b). (D.I. 15 at 15) (citing Diasonics Inc., SEC No-Action

Letter, Fed. Sec. L. Rep. J 76,695 (Sept. 27, 1993); Control Data Corp.,

SEC No-Action Letter, Fed. Sec. L. Rep. 9 76,231 (July 30, 1992);

Pittston Co., SEC No-Action Letter, Fed. Sec. L. Rep. J 76,164 (May 18,

1992), Cravath, Swaine & Mowre, SEC No-Action Letter, Fed. Sec. L.

Rep. 7 76,002 (Oct. 22, 1991)). These no-action letters make fact-specific

determinations about the effect of anti-dilution adjustments to em-

ployee incentive plans, and so are of limited utility in examining the

circumstances here.

App. 20

Plaintiff also points to cases involving hybrid deriva-

tive securities, and argues that the Preferred Stock should

be treated similarly. A hybrid derivative security gives the

holder an option to purchase at either a fixed price or a

floating price. See Schaffer, 280 F. Supp. 2d at 130; Levy v.

Clearwater Fund IV, Ltd., No. CIV.A.99-004, 2000 WL

152128, at *1 (D. Del. Feb. 2, 2000). At the time a hybrid

derivative security is purchased, the buyer has locked in a

maximum price and a minimum number of shares that

can be purchased with the fixed price option. As the

market price changes, the floating price option leaves open

the possibility that the buyer will be able to choose a lower

price (and obtain a greater number of shares). See id. In at

least one case, such securities have been treated as two

separate pieces: the minimum number of shares obtain-

able at the fixed price are viewed as being purchased when

the derivative security is purchased, and any additional

shares obtained by choosing the floating price are deemed

to be purchased when the derivative security is converted.

Schaffer, 280 F. Supp. 2d at 140.

Plaintiff argues here that the Preferred Stock should

be treated similarly to hybrid derivative securities, so that

the purchase of Preferred Stock is considered a purchase

of the underlying stock that can be obtained at the then-

current price, and additional shares that can be obtained

after conversion price reductions are treated as being

purchased when the price adjustment is made. But, as

already noted, holders of the Preferred Stock, unlike those

who hold hybrid derivative securities, have no choice: the

price is determined automatically by factors that do not

include the market price. Thus, the Preferred Stock should

be treated as if it had a fixed conversion price. In any

event, treating the Preferred Stock like a hybrid derivative

App. 21

security would mean that the relevant events for Section

16(b) would be the purchase of the Preferred Stock, which

took place outside the six-month window, and its conver-

sion, which has not been alleged to have taken place at all.

Thus, plaintiff’s argument still fails.”

The SEC has stated that securities like the Preferred

Stock, with conversion prices adjusted for prespecified

events, should be treated as if they had a fixed price, and

that a conversion price adjustment should not be treated

as a purchase. This treatment is consistent with Con-

gress’s purpose of preventing short-swing insider trading.

I therefore conclude that the January 2003 conversion

price reduction is not a purchase, and as a result, plaintiff

has failed to state a claim under Section 16(b).°

° Plaintiff also argues that two SEC no-action letters support his

claim that the Preferred Stock should be treated as a two-part hybrid

security. (D.I. 24 at 16-17) (citing Jenny Craig, Inc., SEC No-Action

Letter, Fed. Sec. L. Rep. 9 76,068 (Jan. 30, 1992); Davis, Polk &

Wardwell, SEC No-Action Letter, Fed. Sec. L. Rep. J 79,769 (Aug. 23,

1991)). These no-action letters address situations where additional

shares are granted as dividends or compensation for poor company

performance rather than as prespecified anti-dilution measures, and so

they are not persuasive here.

* MDP argued in its initial brief that the Preferred Stock conver-

sion privileges were exempt from Section 16(b) under SEC Rule 16a-

9(b). (D.I. 15 at 11-12.) Plaintiff countered with factual contentions

concerning the application of this rule, and since these motions are

granted on other grounds, I need not decide that issue here.

MDP also argued that the conversion price reduction is an “unortho-

dox transaction that does not present the danger of speculative abuse.

(Id. at 19-24.) See Kern County Land Co. v. Occidental Petroleum Corp.,

411 US. 582, 593-95, 36 L. Ed. 2d 503, 93 S. Ct. 1736 (1973). Because the

SEC stated how its Rules should apply in this case, deciding the “unor-

thodox transaction” issue is unnecessary. I note, however, that the

factual] nature of the inquiry likely makes it “inappropriate for resolu-

tion on a motion to dismiss.” Clearwater, 2000 U.S. Dist. LEXIS 1305,

2000 WL 152128, at *7.

App. 22

Vv. CONCLUSION

Accordingly, I will grant XM Radio’s and MDP’s _

Motions to Dismiss under Fed. R. Civ. P. 12(b)(6). An

appropriate order will issue.

ORDER

For the reasons set forth in the Memorandum Opinion

issued in this matter today,

IT IS HEREBY ORDERED that the Motions to

Dismiss (D.I. 11; D.I. 14) are GRANTED.