Brief Amicus Curiaei — Blau v. Lehman

-~

INDEX

Page

I SE 6 as Gkdeudin cand esau tac bagnctSihsesceuxe’ 1

Jurisdiction .. PE EOSEESOSS 1

CU i oir aacawckna veces Buu N ene Saab cketcan 2

I I ed oh a eg eae dn bkeekaeeanene ae 2

ree eee cece ees cec cc ccnenscccecsccceens 3

sacs cc cncancccnetedvaberanwebadee 6

: Argument:

A corporation, which has stock registered on a national secu-

rities exchange, may recover under Section 16(b) of the

Securities Exchange Act of 1934 the entire ‘‘short-swing’’

profits realized from trading in the corporation's stock by

a partnership which has a partner on the board of direc-

Sie OE Tt I 5 is ov ssin dS oc cece hs dctvenes ce x

I. Congress intended that a corporation should recover

all the profits made in ‘‘short-swing’’ transactions of

SSRIS eee perigee say bats Pape eho eee 8

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

may properly be interpreted to compel surrender of

all the partnership profits ...................000-- 15

III. In comparable situations the interposition of co-owner-

ship has not been permitted to alter the impact of

RE I obin bc dndca bans acbesncbebsic ences 20

GL Cube rebcabtagweeneeeedaane db cataauecesienne 24

Appendix ........... eee ee eee e cece e ce cee cere sec eceeenece \ 26

CITATIONS

CasEs :

Bee ©. Camtants, BER Te. TO onc hse ck ic issccccccvccs 21

Central States Electric Corp., In re, 206 F. 2d 70, certiorari

denied sub nom. Henis v. Egan, 346 U.S. 899 ........... 23

Hallenback’s Estate, In re, 122 F. Supp. 212 ......... ica. . ae

Higgins v. Shenango Pottery Company, 279 F. 2d 46, cer-

tiorari denied sub nom. Zahniser v. Higgins, 364 U.S. 899 21

ii Index Continued

Page

Hornor v. New South Oil Mill, 130 Ark. 551 .............. 21

Inland Gas Corporation, In re, 73 F. Supp. 785 .......... 23

Irving Trust Company v. Deutsch, 73 F. 2d 121, certiorari

nmin, TOG BEM, TO iv obi togicicdwccccscccceséstcccte 21

Jackson v. Smith, 254 U.S. 586 ... 2... 2... cee eee eee 21

Lehman v. Civil Aeronautics Board, 209 F. 2d 289, certiorari

Ge le SEE Sawa cba nods so ssddavdasistexstaice 21

Los Angeles Lumber Products Company, In re, 37 F. Supp.

We dtiidiuiah ohénpaiseksdssndess Pchcivatavaasaaves 23

Magruder v. Drury, 235 U.S. 106 .......... S PRES ce .. 2

Meinhard v. Salmon, 249 N.Y. 458 ... 22.2... ee ee eee cee 20

Midland United Company, In re, 64 F. Supp. 399 ......... 23

Mosser v. Darrow, 341 U.S. 267 ..... 2.2... a, eee eee eee ae

Mountata StaterPOGer Company, In re, 118 F. 2d 405 . 23

Ozawa v. United States, 260 U.S. 178 ........ 7 aE ae 14

Rattner v. Lehman, 193 F. 2d 564 .............2..0.2005 17,18

Reynolds Investing Company, In re, 130 F. 2d 60 ......... 23

Securities and Erchange Commission v. Dumaine, 218 F. 2d

308, certiorari denied, 349 U:8._929 .--.. oo... eee eee. 23

Smolowe v. Delendo Corporation, 136 F. 2d 231, certiorari

BO ee eG TUE Walaa cictecisidedcspendcccccices 10, 15

Third Avenue Transit Corporation, In re, 159 F. Supp. 440,

affirmed sub nom. Surface Transit, Inc. v. Sare, Bacon &

PE Mc ME EE Gi oeweddndkodedevdusdeckcnsaacs 23, 24

_United States v. American Trucking Associations, Inc., 310

Wey SE eth GadiaWs cb cbncdwdkecdkeersccdvern Po Ree 14

United States. DuPont, 353 U.S. 586 ..............-025- 13

United States v. Morgan, 118 F. Supp. 621 .............. 12, 13

United States v. Public Utilities Commission of California,

De WE Seek hbdg sds ceded céccbneddsdabscvacecie 14

Walet v. Jefferson Lake Sulphur Co., 202 F. 2d 433, certiorari

Se ie OE bck vhcewign dnd 0064006000804 sbe0s 20

StarutTzes aNp Ruizs:

Bankruptcy nay 3 Section 249, 52 Stat. 901, 11 U.S.C. 649

7, 22, 23, 24

Civil eRe Act of 1938, Section 409(a), 52 Stat. 1002 21

Public Utility Holding Company Act of 1935, 49 Stat. 803

et seq., Rule 62, 17 CPR 250.62 .........cccccccccccecs 23

iy

y

Index Continued iii

Page

Securities Exchange Act of 1934, 48 Stat. 881, as amended:

Section 3(a)(9), 15 U.S.C. 7Re(a)(9) .............. 6, 16

Section 16(a), 15 U.S.C. 78p(a) .............. 2, 10, 18, 26

Section 16(b), 15 U.S.C. 78p(b) ......... 2, 3, 4, 6, 7, 8, 10,

‘11, 12, 13, 14, 15, 16, 17, 18, 20, 23, 24, 26

Ss Sis ee Se A ck cow unceacs cadbnctssneses 3

~~~ Uniform Partnership Act

EN tt EG bees ween paduenatasendeeeaes eae 14

SE ME ae Sen haa bbans ks Gkse dias sdssaninedons 19

New York Partnership Law

EE lc icra asa nsuhacieskansesseandexreas 14

SRE Sit beka cea canesdddced end tanctkeabaccunes 19

Securities and Exchange Commission Rules, Rule 16a-3, 17

CFR 240.16a-3 (1961 Supp.) ..................--- ‘oe 18

MISCELLANEOUS : %

¥

Hearing before the House Committee on the Judiciary on

: ILR. S te Sef | re ere Pee: 22

Hearings before the House Committee on Interstate and

Foreign Commerce on H.R. 7852 and H.R. 8720, 73d

Ci eo hss hcsg seacevewinenss , See

Hearings before the Senate Committee on Banking and Cur-

rency, 73d Cong., 2d Sess., pursuant to S. Res. 84, 72d

Cong., and S. Res. 56 and S. Res. 97, 73d Cong., 2d Seas. 15

H. Rep. No. 1278, 85th Cong., Ist Sess. ................5- 12

S. Rep. No. 792, 73d Cong., 2d Seas. .........c2ccsccecees 9-10

S. Rep. No. 1455, 73d Cong., 2d Sess. ..............22005: 9

Securities and Exchange Commission File No. 8-246-1 ...... 3

Securities and Exchange Commission File No. 801-364 ...° 4

Securities Exchange Act Release No. 4754 ................ 18

Inthe Supreme Court of the United States

OctToBER TERM, 1961

No. 66

IsaporE Bau, Etc., PETITIONER

v.

Rosert LEHMAN, ET AL.

ON WRIT OF CERTIORARI TO THE UNITED STATES

COURT OF APPEALS FOB THE SECOND CIRCUIT

BRIEF FOR THE SEGURITIES AND EXCHANGE

COMMISSION AS AMICUS CURIAE

OPINIONS BELOW :

The opinions of the court of appeals (R. 174-192 and

198-203) are reported at 286 F, 2d 786. The opinion

of the district court (R. 149a-157a) is reported at 173

F. Supp. 590.

JURISDICTION

The judgment of the court of appeals was entered

on December 20, 1960 (R. 193). A_ petition for

rehearing was denied by the court en banc on Febru-

ary 21, 1961* (R. 198-199). The petition for a writ of

1A request for amicus curiae participation by the Commission

was also denied at that time (R. 198-199).

(1)

2

certiorari was filed on March 14, 1961 and granted on

April 24, 1961 (R. 205). The jurisdiction of this Court

is invoked under 28 U.S.C. 1254(1).

QUESTION PRESENTED

When a director of a corporation which has stock

registered on a national securities exchange is also a

_ partner in an investment banking firm which trades

- in the corporation’s securities, may the corporation

* pecover, under Section 16(b) of the Securities Ex-

change Act of 1984, the entire ‘‘short-swing”’ profits

realized by the partnership or is recovery limited to

the director-partner’s proportionate ownership share

of his firm’s profits ?.

STATUTE INVOLVED

The portion of Section 16(b) of the Securities Ex-

change Act of 1934, 15 U.S.C. 78p(b), which is most

directly involved 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

such issuer (viher than an exempted security)

within any period of less than six months, unless

such security was acquired in good faith in con-

nection with a debt previously contracted, shall -

inure to and be recoverable by the issuer, irrespec-

tive of any intertion on the part of such beneficial

owner, director, or officer in entering into such

transaction of holding the security purchased or -

of not repurchasing the security sold for a period

exceeding six mon vata

Sections 16(a) and 16(b) of the Securities Exchange

Act of 1934 are set forth in full in an Appendix, infra, ‘

pp. 26-27.

3

STATEMENT

The stock of Tide Water Associated Oil Company

(‘Tide Water’’) is registered on the New York Stock

Exchange. Petitioner, a stockholder of Tide Water,

brought this action on behalf of the corporation under

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

to recover the profits realized by the firm of Lehman

Brothers from purchases and sales of Tide Water stock

within a period of less than 6 months. The complaint

invoked the jurisdiction of the district court under

Section 27 of the Securities Exchange Act of 1934.

Lehman Brothers is a partnership consisting of nine-

teen partners * and is a member of the New York Stock

Exchange and other stock exchanges. The firm is en-

gaged in the investment banking business, acts as a

broker in securities, and trades in securities for its own

account (R. 32a-33a). John A. Thomas, a partner of

Lehman Brothers, was elected to the Tide Water board

of directors on August 5, 1954, when his partner, John

Hertz, resigned from the board. Mr. Thomas has

served as a Tide Water director continuously since

that date (R. 9a).

During the period October 8, 1954, to November 15,

1954, Lehmadi Brothers purchased for its own account

50,000 shares of Tide Water common stock (R. 43a-

44a). On December 8, 1954, it converted these shares

into a like amount of Tide Water preferred stock (R.

86a). The district court held that these acquisitions of

the preferred stock constituted a ‘‘purchase’’-within

2 This is the number of partners named in the complaint (R. 4a-

5a). Defendants’ Exhibit D indicates there were 18 partners of

Lehman Brothers at the end of 1955 when profits from the

transactions involved were distributed (R. 119a-120a, 166a). The

Commission’s public records show that the firm now has 24 partners

(SEC File No. 8-246-1).

7

the meaning of Section 16(b) and found that Lehman

Brothers sold the preferred stock at a profit of $98,-

686.77 within 6 months of these acquisitions (R. 156a).

Various partners in Lehman Brothers hold director-

ships in industrial and banking corporations (R. 33a).

While one partner testified that this practice has

‘‘[njot always’”’ resulted from suggestions of the firm

(R. 79a), John Hertz, the Lehman Brothers’ partner

who had been for many years Mr. Thomas’ predecessor

on the Tide Water board, testified in answer to the

question whether it was (R. 65a) ‘‘the practice of

Lehman Brothers to have some of its partners go on

boards of corporations in order to further the interests

of Lehman Brothers’’:

Well, I surely joined Tide Water Company

thinking it was going to be in the interests of Leh-

man Brothers.

At the last board meeting prior to his resignation, Mr.

Hertz suggested that his partner, Mr. Thomas, be

named to succeed him, partly because it would be in

the interests of Lehman Brothers (R. 64a-65a). Mr.

Hertz felt he did not have to tell his partner that serv-

ing on the board of Tide Water would further the

interests of Lehman Brothers since Mr. Thomas ‘‘is

a smart fellow.’’ (R. 64a). After Mr. Thomas became

a director of Tide Water, Lehman Brothers partici-

pated with two other firms in underwriting $50,000,000

of Tide Water bonds (R. 42a, 51a). Mr. Thomas was

the partner assigned to the ‘Tide Water financing

business’”’ (R. 77a).

The purchases of Tide Water stock here involved

* The Commission’s publie records currently disclose that part-

ners of Lehman Brothers hold over 100 directorships (SEC File No.

801-364), many of which are in companies registered on national

securities exchanges.

5

were authorized by William J. Hammerslough, the

partner of Lehman Brothers in charge of its Portfolio

Committee (R. 70a, 135a-136a). This Committee,

which supervises the holdings of the firm, operates

very informally and all members of the firm are some-

times invited to attend meetings (R. 70a, 8la). Al-_

though Mr. Thomas did not participate in the Com-

mittee discussions with respect to this purchase of

Tide Water stock, he did have conversations with his

partners concerning Tide Water affairs, suggesting

‘*from time to time that I thought Tide Water under.

the new management was an attractive investment’’

and expressing ‘‘the opinion freely that I thought the

management was first-rate, that the company would do

well under that management”’ (R. 54a-56a). ‘‘Thomas

spoke very highly of the management and _pros-

pects of’? Tide Water to Mr. Hammerslough, with

whom he had most extensive conversations concern-

ing Tide Water (R. 55a, 69a). .

When Mr. Thomas learned that purchases of Tide

Water were being made by his firm he instructed the

controller ‘‘to exclude me from any risk of the pur-

_chase or any profit or loss from the subsequent sale

a

and to take the necessary steps to carry out my instruc-

tions.”’? (R. 122a.) He and his partners agreed that

he was to have no part in the transaction. (R. 123a).

After a trial without a jury, the district court dis-

missed the complaint against Lehman Brothers and

entered judgment against Mr. Thomas for his propor-

tionate interest in the partnership profits from the

transactions involved, which amounted to $3,893.41

out of the total partnership profits of $98,686.77. No

interest was allowed by the court (R. 158a). The court

of appeals affirmed by a divided court (R. 174-192).

6

SUMMARY OF ARGUMENT

By providing in Section 16(b) of the Securities Ex-

change Act of 1934 that profits by insiders in ‘‘short-

swing’’ transactions in stock of their corporations

should be recoverable by the corporations, Congress

intended to eliminate the ‘‘vicious-practices’”’ that re-

. sulted frong.trading by officers, directors and large

stockholders on the basis of inside information. The

legislative history shows that this trading was often

condueted through organized ‘‘pools,”’ in which mem-

bers of investment banking firms played a prominent

part. These practices were not only unfair to members

of the investing public, with whom the insiders traded,

but also led to manipulation of corporate affairs in

order to promote trading profits for the insiders.

To allow recovery against the partner-director of

only his share of his firm’s profits from trading in the

stock of his corporation, as did the majority below,

gives only token effect to the legislative purpose of

- festion 16(b). With respect to large investment bank-

ers such as the respondents’ firm, the result is merely to

reduce by a small percentage (in this case less than 4

per cent) the firm’s total profits from transactions

encompassed by Section 16(b), for the relationship

between partners is such that one who must pay over

the profits from one transaction will normally be other-

wise compensated, perhaps by profits from the firm’s

trading in the stock of another corporation of which

another partner is a director.

Section 3(a)(9) of the Securities Exchange Act

defines ‘‘person”’ to include a partnership, making it

clear that, for the purposes of the Act, a partnership

p is to be treated as an entity, rather than as

ae 1 individuals. Thus, a partnership is held to be

7

the insider when liahility rests on a ten pereent stock-

holding. Similarly, to carry out the intention of See-

tion 16(b), the partnership should be treated as the

‘*directes"’ for purposes of liability under the Act in

the circumstances of this case since the partner-direc-

tor was, as a matter of law, acting for his partners.

In any event, the individual rartner-director should

be held liable for the entire profits from the transac-

tions for under partnership law he is a co-owner of all

property purchased with firm funds and of all profits

realized from the sale of firm assets. Intra-partner-

ship agreements az to the distribution of profits should

not be permitted to control liability imposed by Con-

gress for the protection of the public.

In comparable situations, the interposition of co-

ownership has not been permitted to alter the impact

of remedial liability. In equity, restrictions on a

trustee with respect to dealings in trust property apply

with equal force to a firm of which he is a member;

and where other persons associate with a trustee in a

breach of his fiduciary duties, both the trustee and his

associates are held liable for the entire profits realized

by the group. The Civil Aeronautics Board has

treated partners as representatives of each other in

enforcing its restrictions on intercorporate relation-

ships in the industry. Under Section 249 of the Bank-

ruptey Act, which involves a denial of compensation

as a rule-of-thumb deterrent to trading in the debtor’

securities, the courts have consistently denied compen-

sation to an attorney or other person when his firm,

partner, or wife has purchased or sold securities of the

debtor.

Section 16(b) of the Securities Exchange Act of

1934 (‘the Act’’), supra, p. 2, provides that ‘‘ For the

purpose of preventing the unfair use of information

which may have been obtained * * * by reason of his

relationship to the issuer,’’ a director, officer, or large

and purchase, within a 6-month period, of his corpora-

tion’s stock registered on a national securities exchange.

The Congressional study on which the Act was based

“had demonstrated the urgent need for restraints against

the use of inside information in ‘‘short-swing”’ trading

by corporate fiduciaries in the securities of their cor-

9

porations. As stated in a Senate report (S. Rep. No.

1455, 73d Cong., 2d Sess., 1934, at p. 55) :

Among the most vicious practices unearthed

at the hearings before the subcommittee was the

flagrant betrayal of their fiduciary duties by direc-

tors and officers of corporations who used their

positions of trust and the confidential information

which came to them in such positions, to aid them

in their market activities. Closely allied to this

type of abuse was the unscrupulous employment

of inside information by large stockholders who,.

while not directors and officers, exercised sufficient

control over the destinies of their companies to

enable them to acquire and profit by information

not available to others.

The report (S. Rep. No. 1455, supra at pp. 56-58) gave

numerous illustrations of how these abuses had been

accomplished through personal holding companies or

pools in which a prominent part was played by large

investment banking firms and their individual members,

who were either direetors themselves or collaborated

with corporate fiudciaries. Not only was this activity

unfair to the investing public, because the insiders had

information not available to*those with whom they

traded, but the unrestricted trading of insiders led to

deliberate manipulation of the affairs of their corpora-

tions for the purpose of enhacing their personal profits

without regard to the effect on the corporation. Thus,

it was found (S. Rep. No. 792, 73d Cong., 2d Sess.

(1934) at p. 9):

In a particularly glaring instance, the chairman

of the executive committee and another director

participated in a pool organized to trade in the

stock of their company when the stock was pay-

ing no dividends. During the operation of the

10

pool, which continued for a period of 2 years, they

caused the company to resume the payment of

dividends, more than 25 percent of which were

received by the pool participants. These dividends

were paid during the pool’s operation in spite of

the fact that the company’s earnings were not suf-

ficient to meet them and part of its surplus had

. to be diverted for that purpose. In another case,

the president of the corporation testified that he

and his brothers controlled the company with a

little over 10 percent of the shares; that shortly

before the company passed a dividend, they dis-

posed of their holdings for upward of $16,000,000

and later repurchased them for about $7,000,000,

showing a profit of approximately #9,000,000 on

the transaction.

Section 16 of the Act was the means adopted by the

Congress to put an end to such practices. Under Sec-

tion 16(a), Appendix, infra, p. 26, the officers, direc-

tors and ten-percent stockholders of corporations with

equity securities registered on a national securities ex-

change are required to file with the Securities and

Exchange Commission reports showing their owner-

ship of such securities and, on a monthly basis, all

changes in ownership. Under Section 16(b) profits

realized by these insiders from trading in such securi-

ties within a 6-month period are recoverable by the

corporation without proof of the actual use of inside

information and, in fact, even if it is proved that the

person had no inside information whatever. |

The court below stated in Smolowe v. Delendo Cor-

poration, 136 F. 2d 231, 239, certiorari denied, 320 U.S.

751:

We must suppose that the statute was intended

to be thoroughgoing, to squeeze all possible

11

profits out of stock transactions, and thus to estab-

lish a standard so high as to prevent any-éoenflict

between the selfish interest of a fiduciary officer,

director, or stockholder and the faithful perform-

ance of his duty.

The decision below virtually defeats this intention.

If recovery were limited to the portion of the profit

applicable to the partner-director, as the court below

held, an investment banking firm with 20 equal part-

ners, no two of whom were officers or directors of the

same corporation, could use inside information in

short-swing trading ad infinitum and never have to

disgorge more than five per cent of its profits. As to

Lehman Brothers for example, the only effect of See-

tion 16(b) would be to shave a small percentage of

its profits on short-swing transactions. The larger the

firm, the smaller, on the average, the reduction of

profits will be. But the very size of a firm increases its

opportunities for directorships and for greater exploi-

tation of inside information.

Even from the point of view of the individual direc-

tor, the requirement that he disgorge only his share of

the profits is not effective. Its weakness does not depend

upon the partnership directly reimbursing him for his

loss, although it would be difficult to prevent it from

doing so. Without direct reimbursement, a partner

will naturally profit from his firm’s insider transac-

tions since he will share in the profits of the trading in

securities of corporations in. which his partners are

directors. Thus, while he has to surrender the profits

from trading in securities of his corporation, he will

be compensated by receiving his proportionate share of

the profits in other transactions when one or another of

his partners may have to make the sacrifice for the com-

: 2 ¢

mon good. These consequences led Judge Clark to

observe, in effect, that Section 16(b) should be re-

pealed if the decision of the majority below is allowed

to stand. He stated (R. 202-203) that the most serious

vice of this holding

* * * is the unfair discrimination it builds into an

important remedial statute—a discrimination sub-

stantially eliminating the great Wall Street trad-

ing firms from the statute’s operation. So great

is the unfairness of the result that, notwithstand-

ing its remedial nature, the statute, it would ap-

pear, should not stand unless its judicially discov-

ered defects can be corrected. * * *

The prevalence of partners of investment ‘banking

firms on the boards of directors of the country’s large

corporations is not mere coincidence.‘ Rather, it is

the result of the deliberate effort of investment bank-

ing firms to establish close relationships with the issuers

of securities. As was noted in United States v. Mor-

gan, 118 F. Supp. 621, 652 (S.D. N.Y.), ‘“‘the competi- *

tion for business by investment bankers must start

with an effort to establish or continue a relationship

“with the issuer,” al and the facts indicate that Lehman

Brothers placed a partner on the board of Tide Water

for this purpose (see pp. 3-4, supra).*> Membership on

boards of directors is intimately related to the business

of investment banking, for it is a most effective means

of establishing a close relationship. Thus, to disregard

* These firms, like much of the securities industry, are customarily

organized as partnerships. See H. Rep. No. 1278, 85th Ceng., Ist

Sess. (1957) at pp. XV, 7#81).

5 The trial judge concluded that (R. 153a) ‘‘there was no evi-

dence that the firm of Lehman Brothers deputed Thomas to repre-

sent its interests as a director on the board of Tide Water.’’ Ordi-

13

the relationship of the Lehman directorships to the

business of the firm is to discount a significant portion

of the firm’s goodwill. While the primary purpose of

an investment banking firm in placing its partners on

the boards of corporations may be to obtain underwrit-

ing business, it cannot be assumed in the light of the

text and legislative history of Section 16(b) that a

firm, which is also engaged in the business of trading

in securities, will ignore in its trading activities the

inside information obtained from partner-directors.

As we have seen, Congress in enacting Section 16(b)

was aware of the prominence of the investment bank-

ing firms and their members in the pools organized for

the specific purpose of profiteering with the -use of

inside information. It was this result which led Judge

Clark to state (R. 186-187, 189):

I think the principle is anomalous in grant-

ing exemption in the very cases where the incen-

tive to take insiders’ profits is strongest as a part

of a trading firm’s normal business and where

exception is the most difficult to understand.

** * the exemption of these firms would be hard

to explain to the ordinary small-seale director not

narily, findings of {act will, if supported by the evidence, be

accepted by a reviewing court. However, #here the finding is in

truth a conclusion, the reviewing court is free to draw its own

conelusions from the basic facts which frequently are actually not

in dispute. Cf. United States v. DuPont, 353 U.S. 586, 598.

The court in Morgan further noted (118 F. Supp. at 716) :

Lehman Brothers, together with Goldman Sachs? was a

leader in the pre-Securities Act period in developing director-

ship relations with its customers. And, with the development

of the Industrial Department of Lehman Brothers, these diree-

torships became an important feature of Lehman Brothers’

method of servicing its customers.

io:

so exempt and indeed to the investing ‘jan gen-

erally.

Lire crane eatin:

Even more anomalous is the color of legality that

the holding below lends to the very abuses which Con-

gress sought to eliminate. Partnership law requires

each partner to render to the other partners full infor-

mation on all matters affecting the partnership busi-

ness.* In the case. of investment banking firms, the

partnership business usually includes trading in secu-

rities. If short-swing trading by a partnership in secur -

rities of a corporation of which a partner is a director

were to be sanctioned by this Court, the disclosure of

inside information which offers profit-making possi-

bilities to the partnership would be transformed from

a vice which Congress condemned to a duty of the

partner-director. This result would be completely at

variance with the legislative intent of the broadly

remedial provisions of Section 16(b), a result this

Court should avoid even “‘sacrificing, if necessary, the

literal meaning in order that the purpose may not

fail.”? Ozawa v. United States, 260 U.S. 178, 194. See

also United States v. Public Utilities Commission of

California, 345 U.S. 295, 315; United States v. Ameri-

can Trucking Associations, Inc., 310 U.S. 534, 543.

The court below adopted the district court’s finding

that the.partnership trading was not based on inside

information (R. 177) and concluded that accordingly

it need not determine ‘‘whether the result might be

different had Thomas caused the firm to enter the Tide

Water venture”’ (R. 181). This is an approach which

Judge Clark accurately characterized as forcing ‘‘the

* See N. Y. Partnership Law, Section 42, which is identical with

Section 20 of the Uniform Partnership Act.

x,

15

very step which we felt Congress had avoided, namely,

a ‘subjective standard of proof, requiring a showing

of an actual unfair use of inside information’ ”’ (R.

188). It was precisely beeause of the difficulties of

proof of reliance upon inside information that

Congress determined to enact Section 16(b) as a

“rule of thumb.’’’ Similar difficulties of proof exist

as to whether a partner has advised other members of

his firm of inside information. It is unlikely that the

sume Congress which took a prophylactie approach in |

framing Section 16(b) so as to avoid the practical prob-

lem of proving whether information was in fact used

by an insider intended that the equally difficult prob-

lem of proving what goes on between partners in an

investment banking firm was not to be solved by the

same statute.

II

SECTION 16(b) OF THE SECURITIES EXCHANGE ACT OF 1934

MAY PROPERLY BE INTERPRETED TO COMPEL SURRENDER

OF ALL THE PARTNERSHIP PROFITS

The courts below decided against liability for the |

full amount of the profits because they believed that

the language of Section 16(b) prevented that result.

In their view the partnership itself was not liable to

™See Hearings Before the Senate Committee on Banking and

Currency, 73d Cong., 2d Sess., pursuant to S. Res. 84, 72d Cong.

and S. Res. 56 and S. Res. 97, 73d Cong., 2d Sess. (1934) at p. 6557.

Early drafts of the bill which ultimately became the Securities

Exchange Act contained a provision for recovery of ‘‘short-swing’’

profits realized by anyone proved to be acting on the basis of inside

information. This provision was dropped from final drafts because

of anticipated difficulties of enforcement. See Hearings Before the

Senate Committee on Banking and Currency, supra, at pp. 6560-

6561; Hearings Before the House Committee on Interstate and

Foreign Commerce on H.R. 7852 and H.R. 8720, 73d Cong., 2d

Sess. (1934), pp. 135, et seq.; Smolowe v. Delendo Corporation, 139

F. 2d 231, 236 (C.A. 2).

16

account because it was not a ‘‘director’’; and the direc-

tor, Mr. Thomas, was not required to account because

he did not ‘‘realize’’ the partnership profits. Neither

of these objections is valid.

1. Section 3(a)(9) of the Securities Exchange Act

defines the term ‘‘person”’ to include a ‘‘partnership.”’

The intent of°this definition is, of course, to treat a

partnership as an entity subject to regulation, rather

_ than as merely a number of persons acting in concert.

Thus, when restrictions are imposed on, or liability

exacted from, ‘‘persons,’’ the law applies equally to

partnerships as such, rather than solely to their indi-

vidual members. The recovery of insider profits di-

rected against stockholders holding a ten percent

interest in a corporation is equally applicable to part-

nership holdings. The partnership and its members

are inseparable; therefore the partnership is consid-

ered the insider.

A like construction should be given the Act with

respect to the application of Section 16(b) to profits

by directors. The essence of Section 16(b) liability

described above requires that the partnership itself be

treated as the real insider. It is the partnership’s

expertise which is ordinarily made available to the cor-

poration, and it is the partnership which profits from

the business relationship established. While it is quite

true that under corporate law only natural persons

may be directors, for the purpose of Section 16(b) we

are not concerned with corporate law, but with the

practical problem of protecting the public interest

against short-swing trading by insiders. Therefore,

when a member of a partnership holds a directorship

with the knowledge and consent of his firm, it is entirely

17

reasonable to consider the partnership as the ‘‘diree-

tor’’ for the purposes of Section 16(b).

Since Mr. Thomas accepted the directorship in Tide

Water with the knowledge of his partners; since such

an action by a’partner of Lehman Brothers was not

an occasional or isolated event, but entirely consistent

with the business practices of the firm; and since

advising and representing such industrial concerns as

Tide Water in their financial affairs was an important

part of Lehman Brothers’ business, Mr. Thomas must,

as a matter of law, be considered to have been acting

within his authority. As we have noted, the lower

courts’ determinations to the contrary are essentially

legal conclusions. See footnote 5, supra, p. 12. In

these circumstances Mr. Thomas and the partnership

are inseparable for the purposes of Section 16(b) as

a matter of law. We do not have to consider what the

situation would have been had Mr. Thomas been acting

in a field unrelated to the partnership business and

without its knowledge.

Judge Learned Handygoncurring in Rattner v. Leh-

man, 193 F. 2d 564 (C.A. 2), which involved a holding

similar to that below, was troubled by the possibility

_ of the situation where a partner is deputized by his

partnership to serve on a corporate board of directors.

He stated (p. 567):

18

* * * but I wish to say nothing as to whether, if a

firm deputed a partner to represent its interests as

a director on the board, the other partners would

not be liable. True, they would not even then be

formally ‘‘directoxs’’; but I am not prepared to

say that they could not be so considered; for some

purposes the common law does treat a firm as a

jural person.’

-We believe it is*unnecessary that there be a formal

deputization for this result to obtain.

In view of the fact that the sanction of Section 16(b)

is admittedly designed as a rule of thumb to make

unnecessary the proof of the existence of inside infor-

mation in particular cases, it is entirely reasonable to

apply the same rule of thumb to a partnership situation

without specific proof that the partner was installed

as a director to aid his partnership or that he trans-

mitted inside information to his associates.

2. Regardless of the liability of the firm as such, we

urge that in any event Mr. Thomas should be held

® At the time of the Rattner case the Commission’s Rule X-16a-3

implementing the reporting requirements of Section 16(a) allowed

a partner-director to report only that amount of the equity secu-

rities of his corporation held by his partnership whieh represented

his proportionate interest in the partnership. The Rattner litiga-

tion served to focus the attention of the Commission on the easy

evasion of Section 16(b) available where full partnership profits

from trading are not reported, and changes in this rule were being

considered even before the litigation was completed. The rule,

16a-3, 17 CFR 240.16a-3 (1961 Supp.), was subsequently amended

to require that a partner-director report.the entire amount of the

equity securities of his corporation held by his partnership. See

Securities Exchange Act Release No. 4754 (1952). These require-

ments have now been incorporated into the instructions for the use

of Form 3 adopted by the Commission for reports required to be

filed pursuant to Section 16(a).

19

liable for the entire profits from the transactions. All

partners are co-owners of all property whicb is pur-

chased with firm funds. Purchases and sales of seeu-

rities by the partnership are in legal effect purchases

and sales by all of its partners.” While the profits of

the enterprise may be divided among the partners in

‘any proportions upon which they agree, this agree-

ment cannot be permitted to control the issue of the

extent of a partner's liability. Just as the courts

below refused to permit a waiver of profits from the

particular transactions to control liability, so, on a

parity of reasoning, the arrangement that 96 per cent

of the profits should go to others should similarly not

be controlling.

As Judge Clark observed (R. 187-188) :

I submit that on a literal legal reading of the

statute, Thomas was co-owner with all! the other

partners of the Tide Water stock when bought

and of the profits when sold, and that Thomas

stood at all times legally charged with full knowl-

edge of what was going on in his firm, just as the

other partne:s had like knowledge. Further, I do

not doubt thit in any ordinary well-run partner-_

ship, the practical facts of life aetually coincide

with these legal facts, and that one partner either

actually knows what is going on in his group or is

content to leave action to his colleagues. In any

. event, the legal situation seems clear—so much so

that in my view co-owners cannot be exeluded from

® New York Partnership Law, Section 51, which is identical with

Section 25 of the Uniform Partnership Act.

the operation of the statute without a serious dis-

tortion of its terms.

The result reached in Walet v. Jefferson Lake Sul-

phur Co., 202 F. 2d 433 (C.A. 5), certiorari denied, 346

U.8. 820, points in the same direction as the reasoning

employed by Judge Clark, although it dealt with hus-

band and wife ownership in a community property

state, rather than with ownership by a partnership.

In Walet, even though only the husband was a director

of the issuing corporation and the wife owned a half

interest in the stork under community property law,

the entire short-swing profits of both hushand and wife

were recovered under Section 16(b). The wife was

no more a director of the issuing company in that case

_ 4han were Mr. Thomas’ partners directors in Tide

Water.”

Ill

i COSSPARASLE SITUATIONS THE UWITERPOSITION OCF Co.

CWNEREIG? RAS NOT BEEN PENSEITTED TO ALTER THE

DREPACT OF REMEDIAL LIABILITY

The courts have repeatedly shown “[u]ncompromis-

ing rigidity” in dealing with evasion of fiduciary du-

ties; their aim is to insufe that ‘‘the level of conduct

for fiduciaries [be] kept at a level higher than that

trodden by the crowd,” Meinhard v. Salmon, 249 N.Y.

458, 464. Thus, restrictions on a trustee’s dealing with

the trust apply with equal force to a firm of which he is

amember. Magruder v. Drury, 235 U.S. 106, 118-120;

*° To the extent that the opinion in Walet is predicated upon the—

right of a husband to control a wife's half interest in community

property its preeedent value here is weakened but that right is

somewhat analogous to the right of each partner to bind all other

partners in any action he undertakes in the name of the partnership.

21

Higgins \. Shenango Pottery Company, 279 F.2d 46

(C.A. 3) certiorari denied sab nom. Zahniser v. Hig-

gins, 364 U.S. 899; In re Hallenback’s Estate, 122 F.

Supp. 212 (D. D.C.) : Burr v. Contenti, W2 N.J. Eq. 41,

43; Hornor v. New South Oil Mill, 130 Ark. 551, 558.

And in Jackson v. Smith, 254 U.S. 586, where nontidu-

ciaries knowingly associated with a trustee in purchas-

ing property of the trust, this Court held the trustee

and his associates jointly and severally liable for all the

profits realized by the joint venture. See also Irving

Trust Company Vv. Deutsch, 73 F.2d 121 (C.A. 2), cer-

tiorari denied, 294 U.8. 708. .

In Lehman v. Civil Acronautics Board, 209 F. 2d 289

(C.A. D.C.), certiorari denied, 347 U.S. 916, the court

sustained the determination of the Civil Aeronautics

Board that partners of Lehman Brothers who served

as directors of air carriers, other common carriers, or

other companies engaged in the aeronautics business

were representatives of each other, an interlocking re-

lationship generally prohibited by Section 409(a)

of the Civil Aeronautics Act of 1938. The court there

noted that the partners feel ‘‘free to solicit’’ security

underwriting and merger negotiation services for Leh-

man Brothers ‘who have been employed for these pur-

poses not infrequently by Section 409(a) companies’’

(209 F. 2d at 293). Accordingly, it concluded: ‘‘This

is representation within not only the language but the

meaning of the statute’’ (209 F. 2d at 294).

In Mosser v. Darrow, 341 U.8. 267, two key em-

ployees of a trustee of an estate in reorganization

under the Bankruptcy Act profited from trading in

the securities of the debtor. This Court held the trus-

tee, who permitted the trading, liable for their profits,

stating that equity would have deprived him of the

profits had he traded, and that ‘‘delicate inquiries”

as to his relationship with his employees should be

avoided. It stated (341 U.S. at 271-272):

These strict prohibitions would serve little ’

purpose if the trustee were free to authorize others

to do what he is forbidden. While there is no

charge of it here, it is obvious that this would open

up opportunities for devious dealings in the name

of others that the trustee could not conduct in his

own. The motives of man are too complex for

equity to separate in the case of its trustees the

motive of acquiring efficient help from motives of

favoring help, for any reason at all or from antici-

pation of counter-favors later to come. We think

that which the trustee had no right to do he had no

right to authorize, and that the transactions were

as forbidden for benefit of others as they would

have been on behalf of the trustee himself.

Evasions of the ‘‘rule of thumb”’ " embodied in Sec-

tion 249 of Chapter X of the Bankruptcy Act, 11 U.S.C.

649, which is comparable to. the ‘‘rule of thumb”’ here

involved,” have: not been tolerated. Section 249 pro-

vides that ‘‘[n]o compensation or reimbursement shall

be allowed to any committee or attorney, or other per-

son acting in the proceedings in a representative or

fiduciary capacity, who * * * has purchased or sold * * *

: 1! See statement of Commissioner (now Justice) Douglas in

Hearing before the House Committee on the Judiciary on H.R.

8046, 75th Cong., Ist Sess. (1937), p. 184:

We visualized a lot of administrative difficulties in deter-

mining in a particular case whether or not actual inside infor-

mation was used, and so we decided that the best practical way

of doing it was to broaden the base a little bit and establish a

rule of thumb and follow the pattern of the Paramount case

and the Republic Ges case.

12 See footnote 7 on page 15.

23

stock’’ of the debtor. As in the ease of Section 16(b),

Congress enacted Section 249 to guard against the

possible conflicts of interest arising from trading on

the basis of inside information and determined that its

provisions must apply regardless of whether in a par-

ticular case actual injury or use of inside information

could be demonstrated. Although Section 249 by its

literal terms restricts trading only by **person[s] act-

ing * * * in a representative or fiduciary capacity.’’ the

courts have consistently invoked its provisions to bar

compensation to an attorney or other person when his

firm, partner, or wife has traded in securities of the

debtor. See Surface Transit, Inc, v. Sacre, Bacon &

O'Shea, 266 F. 2d 862, 868 (CLA. 2); In re Central

States Electric Corp., 206 F, 2d 70, 71-72 (CLA. 4),

certiorari denied sub nom. Henis Vv. Egan, 346 U.S. 899;

In re Reynolds Investing Company, 130 F. 2d 60 (CLA,

3); In re Los Angeles Lumber Products Company, 37

F. Supp. 708 (S.D. Calif.) ; Zn re Inland Gas Corpora-

tion, 73 F. Supp. 785, 791-792 (E.D. Ky.) ; In re Mid-

land United Company, 64 F. Supp. 399, 416-417 (D.

Del.). See also In re Mountain States Power Com-

pany, 118 F. 2d 405, 407-408 (CLA. 3). Cf, Securities

and Exchange Commission v. Dumaine, 218 F. 2d 308,

312-316 (C.A. 1), certiorari denied, 349 U.S. 929,. in-

volving the eomparable provisions of Rule 62 under‘the

Publie Utility Holding Company Act of 1935, As

stated in In re Log Angeles Lumber Company, where

it had been contended that Section 249 did not bar

compensation to the firm or innocent partners thereof

beeause of trading by one partner in the bonds of the

debtor (37 F. Supp. at 711):

The court feels that in a situation such as this,

each member of a law firm should share the respon-

24

sibility for the individual acts of another partner

or other partners. To construe Section 249 other-

wise would largely destroy its effectiveness. The

relationship between partners is too close to make

it possible to insure that compensation allowed to

an innocent partner may not ultimately benefit a

guilty partner, directly or indirectly. If Section

249 were to be construed as suggested, it might be

possible to work out evasions of its provisions

whereby one partner traded and another did legal

work.

Unlike Section 249 of Chapter X of the Bankruptcy

Act, the sanction of Section 16(b) cannot have the

harsh effect of depriving a fiduciary of compensation

earned by years of otherwise devoted labor.” All that

is sought here is recovery of profits from a short term

employment of capital—profits which Congress has

determined must inure to the corporation to maintain

the integrity of the fiduciary relationship between the

corporation and its officers, directors and controlling

shareholders. ¢ Cae

CONCLUSION

For the foregoing reasons the judgment of the -dis—

trict court,s Suld be reversed and yémahded for entry

of judgment against the respondents for the entire

13 See ¢.g., In re Third Avenue Transit Corporation, 159 F. Supp.

440, 443-444 (S.D. N.Y.), affirmed sub nom. Surface Transit, Inc. v.

Saze, Bacon & O'Shea, 266 F. 2d 862 (C.A. 2).

25

profits realized by the partnership from the short-

swing transactions in the stock of Tide Water.

Respectfully submitted,

ARCHIBALD Cox,

Solicitor General.

Joun F. Davis,

> Assistant to the

Solicitor General,

ALLAN F. CoNWILL,

General Counsel,

Watter P. Norta,

Assistant General Counsel,

Davip FERBER,

Assistant General Counsel,

RicHarp M. PHILLIPS,

Attorney,

Securities and Exchange Commission.

August 1961.

Section 16 of the Securities Exchange Aci of 1834.

48 Stat. 896. 15 U.S.C. 78p

Directors, OFFICERS, AND PRINCIPAL STOCKHOLDERS

(a) Every person who is directly or indirectly the

beneficial owner of more than 10 per centum of any

class of any equity security (other than an exempted

security) which is registered on a national securities

exchange, or who is a director or an officer of the issuer

of such security, shall file, at the time of the registra-

tion of such security or within ten days after he be-

comes such beneficial owner, director, or officer, a state-

ment with the exchange (and a duplicate original

thereof with the Commission) of the amount of all

equity securities of such issuer of which he is the bene-

ficial owner, and within ten days after the close of

each calendar month thereafter, if there has been any

change in such ownership during such month, shall file

with the exchange a statement (and a duplicate orig-

inal thereof with the Commission) indicating his own-

ership at the close of the calendar month and such

changes in his ownership as have occurred during such

calendar month.

(b) For the purpose of preventing the unfair use

of information which may have been obtained by_such

beneficial owner, director, or officer by reason of his

relationship to the issuer, any profit realized by him

from any purchase and sale, or anv sale and purchase,

of any equity security of such issuer (other than an

exempted Security) within any period of less than six

months, unless such security was acquired in good

faith in connection with a debt previously contracted,

shall inure to and be recoverable by the issuer, irre-

spective of any intention on the part of such beneficial

owner, director, or officer in entering into such trans-

action of holding the security purchased or of not re-

purchasing the security sold for a period exceeding

six months. Suit to recover such profit may be insti-

tuted at law or in equity in any court of competent

“

27

jurisdiction by the issuer, or by the owner of any secu-

rity of the issuer in the name and in behalf of the: ~~ _

issuer if "the issuer shall fail or refuse to bring such

suit within sixty days after request or shall fail dili-

gently to prosecute the same thereafter; but no such

suit shall be brought more than two vears after the date

such profit was realized. This subsection shall not be

construed to cover any transaction where such bene-

ficial owner was not such both at the time of the pur-

chase and sale, or the sale and purchase, of the security

involved, or any transaction or transactions which the

Commission by rules and regulations may exempt as not

comprehended within the purpose of this subsection.

* * = * *

BU. S. GOVERNMENT PRINTING OFFICE 1961—s04860/P © 173