Mark Levy v. Sterling Holding Company, LLC.

PRECEDENTIAL
Filed December 19, 2002
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 02-1698
MARK LEVY,
Appellant
v.
STERLING HOLDING COMPANY, LLC.;
NATIONAL SEMICONDUCTOR CORPORATION;
FAIRCHILD SEMICONDUCTOR INTERNATIONAL, INC.
On Appeal from the United States District Court
for the District of Delaware
(D.C. Civ. No. 00-00994)
Honorable Gregory M. Sleet, District Judge
Argued October 29, 2002
BEFORE: NYGAARD, GREENBERG, and MICHEL,*
Circuit Judges
(Filed: December 19, 2002)
_________________________________________________________________
* Honorable Paul R. Michel, Judge for the United States Court of Appeals
for the Federal Circuit, sitting by designation.
Mitchell M. Twersky
Fruchter & Twersky
60 East 42nd Street
Suite 4700
New York, NY 10165
Jeffrey S. Abraham (argued)
Abraham & Associates
One Penn Plaza
Suite 1910
New York, NY 10019
Attorneys for Appellant
Steven B. Feirson (argued)
Carolyn H. Feeney
Thomas L. Kenyon
Dechert, Price & Rhoads
1717 Arch Street
4000 Bell Atlantic Tower
Philadelphia, PA 19103
Attorneys for Appellee
Sterling Holding Company, LLC

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Paul Vizcarrondo, Jr. (argued)
Michael A. Charish
Wachtell, Lipton, Rosen & Katz
51 West 52nd Street
New York, NY 10019
Attorneys for Appellee
National Semiconductor Corporation
Kenneth J. Nachbar
Morris, Nichols, Arsht & Tunnell
1201 North Market Street
P.O. Box 1347
Wilmington, DE 19899
Attorneys for Fairchild
Semiconductor International, Inc.
2
OPINION OF THE COURT
GREENBERG, Circuit Judge.
I. INTRODUCTION
This matter comes on before this court on an appeal from
an order granting a motion to dismiss for failure to state a
claim on which relief may be granted entered in the district
court on February 5, 2002. Plaintiff-appellant, Mark Levy,
a shareholder in Fairchild Semiconductor International,
Inc. ("Fairchild"), a nominal defendant-appellee not
participating in this appeal, brought this shareholder
derivative action on November 28, 2000, against
defendants-appellees Sterling Holding Co. ("Sterling") and
National Semiconductor Corp. ("National") after Fairchild
declined to initiate a lawsuit seeking relief for the matters
of which Levy complains. Levy by this action seeks a
judgment requiring Sterling and National to disgorge what
he alleges were "short-swing insider trading profits of more
than $72 million" in Fairchild stock. Levy predicates the
action on section 16(b) of the Securities Exchange Act of
1934, 15 U.S.C. S 78p(b), which deprives specified insiders
from profiting from certain offsetting purchase and sale
securities transactions completed within less than a six-
month period. The district court had jurisdiction under
section 27 of the Exchange Act, 15 U.S.C. S 78aa, and we
have jurisdiction under 28 U.S.C. S 1291. We exercise
plenary review on this appeal. See Gallo v. City of
Philadelphia, 161 F.3d 217, 221 (3d Cir. 1998).
II. HISTORY
In view of the procedural posture of the case we take the
facts from Levy’s allegations. On March 11, 1997, National
spun off Fairchild pursuant to an Agreement and Plan of
Recapitalization. At that time National retained in Fairchild
4,380,000 shares of Class A common stock, 5,243,621

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shares of Class B common stock (as measured after a four-
for-one common stock split on April 29, 1998), and 11,667
3
shares of 12% Series A cumulative compounding preferred
stock. Sterling, on or around the same date, purchased for
$58.5 million approximately 3,553,000 shares of Class A
common stock, 7,099,000 shares of Class B common stock
(as measured after the split), and 53,113 shares of 12%
Series A cumulative compounding preferred stock in
Fairchild.
On July 1, 1999, a majority of Fairchild’s common and
preferred shareholders voted to convert all shares of its
preferred stock into Class A common stock "automatically"
upon completion of a contemplated Initial Public Offering
(IPO). Inasmuch as the preferred shares previously had not
been convertible into common stock, an amendment of
Fairchild’s certificate of incorporation was required to
effectuate the conversion.1 On July 26, 1999, a majority of
the shareholders of all three classes of Fairchild stock
approved by written consent a restatement of Fairchild’s
certificate of incorporation containing an amendment
authorizing the conversion. In accordance with a formula in
the amendment each share of preferred stock was worth
75.714571 shares of class A common stock. Upon
completion of the IPO on August 9, 1999, Sterling and
National respectively acquired 4,021,428 and 888,362
shares of Class A common stock. Levy alleges that the
conversion of preferred stock into common stock
constituted a non-exempt "purchase" by National and
Sterling within the meaning of section 16(b) of the
Exchange Act.
On January 19, 2000, within six months after the alleged
purchase (the conversion), Sterling sold 11,115,000 shares
of class A common stock for a profit of $58,511,777, and
National sold 7,243,360 shares of class A common stock for
a profit of $14,124,958. Levy’s complaint alleges that
"[t]hese sales are matchable against the purchases
[conversions] alleged." While we have some difficulty
understanding why there is a matchable situation here in
view of Sterling’s and National’s earlier ownership of class
_________________________________________________________________
1. We were told at oral argument that the conversion was undertaken
because the existence of the preferred stock would have been an
impediment to the IPO.
4
A common stock, we nevertheless at this time accept the
allegation as true.
National and Sterling have or had officers who sat on
Fairchild’s seven-member board of directors pursuant to a
Stockholder’s Agreement. The agreement, dated March 11,

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1997, provided that Sterling would designate two of
Fairchild’s directors and two of Fairchild’s independent
directors (subject to the veto of Fairchild’s chief executive
officer), and that National, if it continued to hold stock in
Fairchild, would designate one director who was an
executive officer of National. At the times relevant to this
action, Fairchild’s directors included Sterling’s chairman
and chief executive officer, the president of Citicorp Venture
Capital Ltd. which, Levy alleges, owns an interest in Sterling,2
and a managing director of Citicorp Venture Capital. In
addition, an individual who served as the president, chief
executive officer and chairman of National, was on the
Fairchild board.
According to a Fairchild prospectus filed on August 4,
1999, National owned 14.8% of Fairchild’s class A common
stock and 14.9% of class B common stock and Sterling
owned 48.0% of its class A common stock and 85.1% of its
class B common stock. For this and other reasons, Levy
made the uncontroverted allegation that National and
Sterling were beneficial owners of more than 10% of
Fairchild’s outstanding stock.
III. DISCUSSION
A. Was the reclassification exempted by Rule 16b-7
from section 16(b) or otherwise not included in the
section?
1. Statutory Background
Section 16(b) of the Securities Exchange Act of 1934
requires that any profits earned by insiders through"short-
swing" trading must be disgorged, or returned to the issuer
of the security. The section provides:
_________________________________________________________________
2. Sterling’s disclosure statement included in its brief on this appeal
pursuant to Fed. R. App. P. 26.1 and Third Circuit LAR 26.1(b) recites
that Citicorp Venture Capital Ltd. owns Sterling.
5
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 any sale and purchase,
of any equity security of such issuer (other than an
exempted security) or a security-based swap agreement
. . . involving any such equity security 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 intention on the part of such
beneficial owner, director, or officer in entering into
such transaction of holding the security or security-
based swap agreement purchased or of not

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repurchasing the security or security-based swap
agreement sold for a period exceeding six months. Suit
to recover such profit may be instituted at law or in
equity in any court of competent jurisdiction by the
issuer, or by the owner of any security 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 diligently to prosecute the same
thereafter; but no such suit shall be brought more
than two years after the date such profit was realized.
This subsection shall not be construed to cover any
transaction 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 . . . or 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. S 78p(b).
The Supreme Court has explained the purpose of section
16(b):
The general purpose of Congress in enacting S 16(b) is
well known. . . . Congress recognized that insiders may
have access to information about their corporations not
available to the rest of the investing public. By trading
6
on this information, these persons could reap profits at
the expense of less well informed investors. InS 16(b)
Congress sought to ‘curb the evils of insider trading
(by) . . . taking the profits out of a class of transactions
in which the possibility of abuse was believed to be
intolerably great.’ . . . It accomplished this by defining
directors, officers, and beneficial owners as those
presumed to have access to inside information and
enacting a flat rule that a corporation could recover the
profits these insiders made on a pair of security
transactions within six months.
Foremost-McKesson Inc. v. Provident Sec. Co., 423 U.S. 232,
243-44, 96 S.Ct. 508, 516 (1976) (citing Kern County Land
Co. v. Occidental Petroleum Corp., 411 U.S. 582, 591-92, 93
S.Ct. 1736, 1742-43 (1973), and citing and quoting
Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S. 418, 422,
92 S.Ct. 596, 599 (1972)) (footnote omitted).
Section 3(a)(13) of the Securities Exchange Act provides
that "[t]he terms ‘buy’ and ‘purchase’ each include any
contract to buy, purchase, or otherwise acquire " any equity
security. 15 U.S.C. S 78c(a)(13) (emphasis added). In
applying this definition in the section 16(b) context, the
Supreme Court has said, "[t]he statutory definitions of
‘purchase’ and ‘sale’ are broad and, at least arguably, reach
many transactions not ordinarily deemed a sale or
purchase." Kern County Land Co., 411 U.S. at 593-94, 93

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S.Ct. at 1744.
Thus, section 16(b) of the Exchange Act, by requiring
insiders to disgorge any profits earned as a result of their
short-swing trading of an equity security without regard to
their intent, "imposes a strict prophylactic rule" of "liability
without fault within its narrowly drawn limits," Foremost-
McKesson, 423 U.S. at 251, 96 S.Ct. at 519, to protect
against insiders engaging in speculative abuse.
Nevertheless, section 16(b) has its limits and not every
transaction that could fall within the definition of
"purchase" or "sale" is so treated by that section. Thus, the
Exchange Act provides that the SEC may exempt certain
transactions from the coverage of the statute. See 15 U.S.C.
S 78p(b) (The statute "shall not be construed to cover . . .
7
any transaction or transactions which the Commission by
rules and regulations may exempt as not comprehended
within the purpose of this subsection."). Furthermore, the
Supreme Court has explained that, as to certain
"unorthodox" or "borderline" transactions not meeting the
usual definition of purchase or sale, "the courts have come
to inquire whether the transaction may serve as a vehicle
for the evil which Congress sought to prevent -- the
realization of short-swing profits based upon access to
inside information." Kern County Land Co., 411 U.S. at 594,
93 S.Ct. at 1744; see also id. n.26, 93 S.Ct. at 1744 n.26
("By far the greater weight of authority is to the effect that
a ‘pragmatic’ approach to S 16(b) will best serve the
statutory goals."); Reliance Elec. Co., 404 U.S. at 424 n.4,
92 S.Ct. at 600 n.4 ("In interpreting the terms‘purchase’
and ‘sale,’ courts have properly asked whether the
particular type of transaction involved is one that gives rise
to speculative abuse.").
The elements of a claim under section 16(b) are 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." Gwozdzinsky v.
Zell/Chilmark Fund, L.P., 156 F.3d 305, 308 (2d Cir. 1998).
There is no dispute on this appeal as to National’s and
Sterling’s status as insiders or beneficial owners of ten
percent or more of the stock and it is undisputed that there
were "sales" within the meaning of section 16(b) that
occurred within six months of the alleged (and vigorously
disputed) "purchases." Thus, the issue on this appeal is
whether the "reclassification" transactions upon the
conversion of the preferred stock into common stock were
non-exempt "purchases" within section 16(b) of the Act.
While we recognize that Sterling and National are discrete
entities, inasmuch as they appear, at least at this point in
the case, to be in the same position, as a matter of
convenience we will refer to their "purchases" and "sales"
singularly.

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2. Does Rule 16b-7 exempt reclassifications generally
from liability under section 16(b)?
We are satisfied that SEC Rule 16b-7, 17 C.F.R.
S 240.16b-7, in which the SEC exercises its authority to
8
exempt transactions from section 16(b) does not exempt
reclassifications categorically from the section. Our
conclusion in this regard differs from that of the district
court which determined that Rule 16b-7 exempted
reclassifications of stock from the reach of section 16(b) so
that a reclassification could not be the opening or purchase
leg of a swing transaction subject to section 16(b). It was,
of course, this conclusion that led it to grant National’s and
Sterling’s motions to dismiss. According to the district
court, "[i]n light of the SEC’s own interpretation of its rules
and regulations, it seems clear the provisions of Rule 16b-
7 apply to reclassifications. It would seem then that
reclassifications are exempt from the scope of Section
16(b)." Levy v. Sterling Holding Co., C.A. No. 00-994, at 5-6
(D. Del. Feb. 5, 2002).
As we have indicated, section 16(b) explicitly authorizes
the SEC to exempt "any transaction . . . as not
comprehended within the purpose of " the statute. This
section is critical for courts defer to an agency’s
interpretation of statutes, particularly where the statute
provides the agency with authority to make the
interpretation. See Chevron U.S.A. Inc. v. Natural Res. Def.
Council, Inc., 467 U.S. 837, 843-44, 104 S.Ct. 2778, 2781-
82 (1984). In this case, however, the SEC has not set forth
its interpretation clearly so our threshold challenge is to
ascertain what in fact was its interpretation.
The text of Rule 16b-7, including its title, states:
S 240.16b-7 Mergers, reclassifications, and
consolidations.
(a) The following transactions shall be exempt from the
provisions of section 16(b) of the Act:
(1) The acquisition of a security of a company,
pursuant to a merger or consolidation, in exchange
for a security of a company which, prior to the
merger or consolidation, owned 85 percent or more
of either
(i) The equity securities of all other companies
involved in the merger or consolidation, or in the
case of a consolidation, the resulting company; or
9
(ii) The combined assets of all the companies
involved in the merger or consolidation, computed

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according to their book values prior to the merger
or consolidation as determined by reference to
their most recent available financial statements for
a 12 month period prior to the merger or
consolidation, or such shorter time as the
company has been in existence.
(2) The disposition of a security, pursuant to a
merger or consolidation, of a company which, prior
to the merger or consolidation, owned 85 percent or
more of either
(i) The equity securities of all other companies
involved in the merger or consolidation or, in the
case of a consolidation, the resulting company; or
(ii) The combined assets of all the companies
undergoing merger or consolidation, computed
according to their book values prior to the merger
or consolidation as determined by reference to
their most recent available financial statements for
a 12 month period prior to the merger or
consolidation.
(b) A merger within the meaning of this section shall
include the sale or purchase of substantially all the
assets of one company by another in exchange for
equity securities which are then distributed to the
security holders of the company that sold its assets.
(c) Notwithstanding the foregoing, if a person subject to
section 16 of the Act makes any non-exempt purchase
of a security in any company involved in the merger or
consolidation and any non-exempt sale of a security in
any company involved in the merger or consolidation
within any period of less than six months during which
the merger or consolidation took place, the exemption
provided by this Rule shall be unavailable to the extent
of such purchase and sale.
17 C.F.R. S 240.16b-7. A leading securities law treatise
describes Rule 16b-7 as follows:
10
Rule 16b-7 was initially adopted in 1952. . . . Its theory
is that certain types of mergers and the like are of
relatively minor significance to the stockholders of the
liquidated corporation and present no significant
opportunities for trading on the basis of advance
information concerning the prospect of a merger. . ..
To provide for such cases, Rule 16b-7 exempts
transactions incident to a merger . . . or a
consolidation when the surviving company was owned
to the extent of at least 85 percent by the liquidated
company, or when the company whose security is given
up held over 85 percent of the combined assets of all
the companies undergoing merger or consolidation.

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5 L. LOSS & J. SELIGMAN, SECURITIES REGULATIONS
S 6(E)(8)(e)(x), at 2474 (3d ed. 2001).
Inexplicably, though the title of Rule 16b-7 includes
"reclassifications," the text of the rule does not mention the
term. While National and Sterling acknowledge this
omission, they argue that nevertheless the inclusion of
"reclassifications" in the title demonstrates the SEC’s
intent. In this regard we point out that even though the
SEC added the word "reclassifications" to the title of Rule
16b-7 when amending the rule in 1991 without providing a
reason for the change, see Ownership Reports and Trading,
Exchange Act Release No. 34-28869, 56 Fed. Reg. 7242,
7273 (Feb. 8, 1991), it seems unlikely that it did so for no
reason. Unfortunately, however, the title and text of the
rule, standing alone, do not provide us assistance in our
effort to ascertain the SEC’s purpose.3
_________________________________________________________________
3. The proposing releases for the 1991 amendment to Rule 16b-7 do not
shed much light either. In one of the proposing releases, the SEC
explained that, to address the "very high""rate of delinquency in Form
3 and 4 filings," it proposed, in part, to "[s]implify[ ] the reporting
provisions to focus on timely reporting of those securities transactions
that are more discretionary in nature and have greater potential for
abuse[,]" Ownership Reports and Trading by Officers, Directors and
Principal Stockholders, Exchange Act Release Nos. 34-26333, 35-24768,
53 Fed. Reg. 49997, 50000 (Dec. 13, 1988), and to that end, would
propose, "[a]s part of the effort to make the rules less complex, minor
language changes to some of the current rules." Id. at 50000 n. 41.
11
In addition to relying on the title of Rule 16b-7 to support
its argument that the rule includes reclassifications which
thus are exempt from section 16(b), National and Sterling
point to an interpretive release that the SEC issued in
1981. Question 142 of this release, and the SEC’s answer,
both concern reclassifications in part:
(142) Question: Although not specifically mentioned,
does Rule 16b-7 apply to transactions structured as (1)
statutory exchanges; (2) liquidations; or (3)
reclassifications?
Answer: The staff is of the view that, for purposes of
Rule 16b-7, a statutory exchange may be the
substantive equivalent of a merger, consolidation or
sale of assets. Therefore, the acquisition and
disposition of stock in a statutory exchange would be
exempt under Rule 16b-7, assuming all of the
conditions of the rule are satisfied. . . . A liquidation on
the other hand, is not covered by Rule 16b-7 since the
liquidation in substance and purpose bears little
resemblance to the types of transactions specified in
the rule. . . . Rule 16b-7 does not require that the
security received in exchange be similar to that
surrendered, and the rule can apply to transactions
involving reclassifications.

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Interpretive Release on Rules Applicable to Insider
Reporting and Trading, Exchange Act Release No. 34-
18114, 46 Fed. Reg. 48147, 48176-77 (Sept. 24, 1981)
(emphasis added) (footnotes omitted). Levy asserts that the
release, by referring to "transactions involving
reclassifications," and making the permissive statement
that the rule "can apply to . . . reclassifications," suggests
that Rule 16b-7 does not provide a blanket exemption for
all reclassifications as the answer that the rule"can apply"
to reclassifications suggests that sometimes it does not so
_________________________________________________________________
National also cites to a second release proposing amendments to the
SEC’s rules, see Ownership Reports and Trading, Exchange Act Release
No. 34-27148, 35-24942, 54 Fed. Reg. 35667 (Aug. 29, 1989), but this
release only identifies the addition of the word"reclassifications" without
providing any reason for the change.
12
apply. Appellant’s Br. at 15. Levy further notes, correctly,
that the illustrative examples contained in Question 142 of
the release do not discuss reclassifications. Id . at 16.
National takes a different approach as it claims in its
brief that the SEC asserted that the amendment of the title
of Rule 16b-7 "made no substantive changes to the rule,
thereby acknowledging that Rule 16b-7 already exempted
stock reclassifications." National Br. at 15 (citing Rules
Applicable to Insider Reporting and Trading, Exchange Act
Release Nos. 34-28869, 35-25254, 56 Fed. Reg. 7242, 7261
(Feb. 21, 1991)). This argument, however, misconstrues the
SEC’s announcement as National merely points to a
statement in a chart comparing the old and new rules
indicating that there was no substantive change in Rule
16b-7. A conclusion that there was no change does not tell
us what the rule meant before the amendment.
National and Sterling also cite the SEC’s proposed
amendments to Form 8-K, which governs reporting
requirements for officer and director transactions. See Form
8-K Disclosure of Certain Management Transactions,
Release No. 33-8090, 34-45742, 67 Fed. Reg. 19914 (Apr.
23, 2002). The SEC proposed an exemption from reporting
requirements for transactions that "do not generally appear
to reflect management’s views of the company’s prospects
or sever the link between executive compensation and
company equity securities performance." Id . at 19919. This
set of transactions exempt from reporting requirements
included "[a]cquisitions or dispositions pursuant to holding
company formations and similar corporate reclassifications
and consolidations." Id. The release indicates that these
"are the transactions exempted from Section 16(b) short-
swing profit recovery by Exchange Act Rule 16b-7." Id.
n.56. Thus, this release also indicates that the SEC
considers that certain reclassifications are exempt under
Rule 16b-7. But the release does not suggest that all
reclassifications are per se exempt. Indeed, the release

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clearly hedges on the point and thus supports a conclusion
that some but not all reclassifications are exempt from
section 16(b)’s restrictions.
Overall, we are satisfied from our review of the text of
Rule 16b-7 and the SEC releases that we have discussed
13
offering the SEC’s partial interpretations of the rule that the
SEC has not included all reclassifications in Rule 16b-7
and thus has not exempted all reclassifications from the
reach of section 16(b). On the other hand, the rule must
encompass some reclassifications. After all, we hardly can
conclude otherwise inasmuch as the 1981 release states
that Rule 16b-7 "can apply to reclassifications" and the
1991 amendment included the term "reclassifications" in
the title of the rule. This conclusion requires us to
determine whether the reclassification here is included in
the rule.
3. Is the reclassification here exempt under Rule 16b-7?
In the absence of specific SEC guidance about which
reclassifications are exempt from section 16(b) under Rule
16b-7, we believe that two principles should guide us in
determining which reclassifications should be included in
Rule 16b-7. First, just as Rule 16b-7 limits exemptions to
certain transactions related to mergers and consolidations,
so, too, should it impose analogous limits on exemptions
for transactions involving reclassifications. Second, the
reclassification exemption should extend only to those
"transactions . . . not comprehended within the purpose of "
section 16(b). 15 U.S.C. S 78p(b).
The text of Rule 16b-7 does not exempt transactions
involving all mergers and consolidations, but rather, a
limited class of transactions.4 As one treatise elaborates,
The Commission has exempted from Section 16(b)
combinations effectuated by merger or the purchase of
substantially all corporate assets for stock in certain
limited situations. In the event a parent combines with
a subsidiary or subsidiaries in which it owns 85
percent of the outstanding equity securities, or if a
_________________________________________________________________
4. See, e.g., Harvey L. Pitt,Merger and Acquisition Implications, in A
PRACTICAL GUIDE TO SECTION 16: REPORTING AND COMPLIANCE S 11.3 (Amy L.
Goodman, ed. 3d ed. 1997 & Supp. 2000) ("Rule 16b-7 contains an
exemption of the acquisition or disposition of a security of a company
pursuant to certain specified types of mergers, consolidations, and
reclassifications that do not result in a ‘significant change in the
character of the structure of the Company.’ ") (footnotes and citations
omitted).
14

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company combines with other companies in a situation
in which it owns 85 percent of the combined assets of
all the companies prior to the merger, and the parent
(or principal asset owner as the case may be) is not the
surviving corporation, the corporate combination does
not involve a sale of its securities or a purchase of the
surviving corporation securities for purposes of Section
16(b) liability. If the parent (or principal asset owner) is
the surviving corporation the rule is not applicable, but
on the other hand it is not necessary for Section 16(b)
purposes as the corporate combination will not involve
a purchase or sale of its shares by its shareholders
unless they are also shareholders in the subsidiary.
The staff has refused to extend the rule to the latter
situation, stating that it was intended to provide an
exemption ‘for a limited class of mergers which result
in technical rather than substantial changes in the
affected securities.’
3D HAROLD BLOOMENTHAL & SAMUEL WOLFF,
SECURITIES AND FEDERAL CORPORATE LAW S 21:74 (2d
ed. & 2002 supp.) (quoting Xidex Corp., SEC No-Action
Letter (Mar. 6, 1995), Fed. Sec. L. Rep. (CCH) P 77,928
(Mar. 6, 1995)).5 Thus, by its terms Rule 16b-7 applies to
_________________________________________________________________
5. National cites this treatise to support its claim that Rule 16b-7 applies
to reclassifications. National Br. at 21-22 n. 3. The treatise states:
Is a statutory reclassification resulting in the exchange of
outstanding shares of a corporation for other shares of the same
corporation a sale for purposes of Section 16(b)? Rule 145,
discussed at S 3:54, now treats such transactions as involving a sale
for purposes of the registration provisions of the Securities Act. The
Second Circuit early took the view that it was not a sale for Section
16(b) purposes on the ground that it did not afford insiders an
opportunity for speculative abuse. While this view was expressed in
1954, it has been cited with approval by the Second Circuit and it
is apparent that it would take unique circumstances to convince the
Second Circuit to extend Section 16(b) to such transactions. New
Rule 16b-7 applies to reclassifications.
Bloomenthal & Wolff, 3D SECURITIES AND FEDERAL CORPORATE LAW
S 21.75 (footnotes omitted). The reference to the Second Circuit was to its
decision in Roberts v. Eaton, 212 F.2d 82 (2d Cir. 1954), which we cite
below.
15
transactions involving the combination of companies where
one company owns at least 85% of the other company or
companies involved in the transaction; that is, transactions
akin to a short-form merger.
National argues that Rule 16b-7 was designed to exempt
transactions involving at least "85% cross-ownership"
because "such transactions change only the form of a
shareholder’s investment, not its substance, and thus ‘do
not present significant opportunities to insiders to profit by

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advance information.’ " National Br. at 15-16 (quoting
Exemption of Certain Transactions from Section 16(b),
Exchange Act Release No. 34-4696, 17 Fed. Reg. 3177,
3177 (Apr. 10, 1952)). According to National,
"[r]eclassifications change the form of a shareholder’s
investment, not its substance, and do not materially alter
the character of the enterprise," and, because a
reclassification involves the "exchange of securities of the
same company," there is "100% cross-ownership, so to
speak." Id. at 16 (emphasis in original).
National and Sterling both cite the SEC’s no-action letter6
in Monk-Austin, SEC No-Action Letter, 1992 WL 337451
(Nov. 19, 1992), in support of their positions. But"SEC no-
action letters constitute neither agency rule-making nor
adjudication and thus are entitled to no deference beyond
whatever persuasive value they might have." Gryl ex rel.
Shire Pharms. Group PLC v. Shire Pharms. Group PLC , 298
F.3d 136, 145 (2d Cir. 2002) (citations omitted). In Monk-
Austin, the SEC issued a no-action letter expressing its
opinion that Rule 16b-7(a) would exempt a recapitalization
transaction "pursuant to which the company’s capital
structure will be changed through the surrender of
currently outstanding shares of Class A common stock,
Class B common stock and preferred stock in exchange for
a new class of Common Stock, in preparation for an initial
_________________________________________________________________
6. Usually issuance of a "no-action" letter means that the SEC does not
intend to undertake an enforcement action against the party requesting
and receiving such a letter. In this context, then, the term "no action"
letter is not precisely accurate, insofar as the Act does not authorize the
SEC to enforce section 16(b); rather, that task is left to the issuer of the
security, or an owner of the security (e.g., a shareholder). See Gollust v.
Mendell, 501 U.S. 115, 122, 111 S.Ct. 2173, 2178 (1991).
16
public offering." Monk-Austin, 1992 WL 337451, at *8. The
Commission staff explicitly noted "[i]n this regard . . . [the
Monk-Austin Company’s] representation that shareholders’
proportionate interests in the Company will not be changed
by the Recapitalization." Id.7
National and Sterling argue that the SEC considered a
situation in issuing the Monk-Austin no-action letter
directly applicable to this case. Levy responds that here,
unlike in Monk-Austin, National and Sterling did not
maintain proportionate interests in Fairchild, but rather, as
a result of the conversion of preferred shares into common
stock, experienced a change in their proportionate
interests. Appellant’s Br. at 19-20.8 Levy also seeks to
distinguish Monk-Austin on the basis that, whereas in
Monk-Austin, the preferred stock was convertible into
common stock, in this case it was not. Id. at 20. Levy
asserts:
Thus, at issue here is not the reclassification of one
type of common stock into . . . another economically

-- 13 of 25 --

equivalent class of common stock, but rather the
change from the set contractual rights of preferred
shareholders to that of complete residual equity
_________________________________________________________________
7. Monk-Austin, in its letter, told the SEC that
The plan of recapitalization will set forth conversion ratios for the
stock. Each outstanding share of preferred stock, which by its terms
is currently convertible at the holder’s option into shares of current
Class B common stock equal in value to the par value of the
preferred ($52 per share), will be converted in the Recapitalization
into the number of shares of Common Stock determined by dividing
$52 by the initial public offering price. Each share of outstanding
Class A common stock and each share of outstanding Class B
common stock will be converted into an identical, specified number
of shares of Common Stock. Thus, the shareholders’ proportionate
interests in the Company will be unchanged in the Recapitalization.
Monk-Austin, 1992 WL 337451, at *1 (emphasis added).
8. Levy appears to conflate two distinct issues: (1) whether the particular
reclassification transaction is exempted by Rule 16b-7 and (2) whether,
under the "unorthodox transaction" doctrine, the reclassification
transaction constitutes a purchase within the meaning of section 16(b).
As it turns out, however, the two issues conceptually are intertwined.
17
ownership embodied by common stock. In other words,
Defendants acquired an equity interest they did not
own prior to the conversion of the Preferred Stock.
Id. Furthermore, Levy argues that "Sterling’s proportionate
interest in the [Fairchild] Common Stock increase[d] from
48.03% to 52.18% and National Semiconductor’s increased
from 14.80% to 15.08%." Appellant’s Br. at 17. If Levy’s
allegation that there was a proportionate increase in
National’s and Sterling’s interests in Fairchild as a result of
the conversion can be substantiated, Monk-Austin is
distinguishable. Thus, for this reason alone we will not hold
by following Monk-Austin, in considering this appeal from
an order granting a motion to dismiss, that Rule 16b-7
exempts the reclassification in this case from section 16(b).
We believe that there is a second independent reason
why we should not regard, at least at this time, the
reclassification here as being within Rule 16b-7. It is
undisputed that the preferred stock was not convertible
into common stock before the July 26, 1999 amendment to
Fairchild’s certificate of incorporation. We are of the view
that at this stage of the proceedings we must regard the
conversion of the preferred stock pursuant to the
amendment as the type of reclassification that the SEC
would not have intended to exempt by Rule 16b-7. We
reach this conclusion for while we do not suggest that the
risks and opportunities of shareholders of nonconvertible
preferred stock are divorced from the fortunes of the
company involved, still they are very different than the

-- 14 of 25 --

risks and opportunities of shareholders holding common
stock.
In this regard we point out that preferred shares
ordinarily, at least, have a priority claim to dividends. Thus,
a diminution in the company’s earnings may have less an
impact on the value of its preferred shares than on the
value of its common shares. On the other hand, if a
company prospers the preferred shareholders may benefit
little, if at all, for their dividends may be fixed. Thus, both
the upside opportunities and downside risks of preferred
and common shareholders are significantly different. While
these differences may be lessened when the preferred stock
is convertible at the holder’s option into common shares,
18
still even in that situation there are differences in risks and
opportunities. In this case both the amendment of
Fairchild’s certificate of incorporation, which made the
conversion possible, and the actual conversion took place
with the six-month period prior to the January 19, 2000
sales date. In viewing this matter we think that at this time
we should regard the reclassification in this case as so
changing the risks and opportunities of the preferred
shareholders in National and Sterling that the SEC would
not have intended to exempt the reclassification from
section 16(b) by Rule 16(b)-7. Our conclusion furthers
Congress’ purpose in enacting section 16(b) by depriving
the insiders from obtaining short-swing profits because of
their access to information not available to the investing
public.
4. Even if Rule 16b-7 does not exempt the reclassification
transaction at issue, is the transaction one that does
not constitute a "purchase" within the meaning of
section 16(b) of the Securities Exchange Act?
Of course, our conclusion that the SEC did not intend to
exempt all reclassifications from section 16(b) and would
not have intended to exempt the transactions here still
leaves us with the fundamental question whether, without
regard for the SEC’s position, the reclassification was a
statutory purchase within section 16(b). There is little
recent case law on whether reclassifications are section
16(b) purchases. In a footnote in Kern County Land Co. the
Supreme Court stated that reclassifications are among
those transactions labeled "unorthodox." See Kern County
Land Co., 411 U.S. at 593 n.24, 93 S.Ct. at 1744 n.24 ("The
term . . . has been applied to stock conversions, exchanges
pursuant to mergers and other corporate reorganizations,
stock reclassifications, and dealings in options, rights, and
warrants.") (citing 2 L. LOSS, SECURITIES REGULATION
1069 (2d ed. 1961)).9 This specific identification of
_________________________________________________________________
9. Often courts treat the term "unorthodox transactions" as meaning
transactions that are neither purchases nor sales, and in addition, do
not give rise to the potential for speculative abuse. But the term, as

-- 15 of 25 --

described in Kern, appears to mean only those transactions that do not
meet the usual understanding of purchase or sale and for which it is
necessary to engage in the inquiry whether the transactions may allow
for speculative abuse.
19
reclassifications confirms that we should undertake the
pragmatic analysis that the Supreme Court has described:
"the courts have come to inquire whether the transaction
may serve as a vehicle for the evil which Congress sought
to prevent -- the realization of short-swing profits based
upon access to inside information." Kern County Land Co.,
411 U.S. at 594, 93 S.Ct. at 1744. As Kern County
counsels, to determine whether an "unorthodox"
transaction constitutes a purchase, a court must ask
whether the transaction gives rise to the potential for the
type of speculative abuse that Congress enacted section
16(b) to prevent.
Levy cites Colan v. Mesa Petroleum Corp., 951 F.2d 1512
(9th Cir. 1991), for the proposition that a changed exposure
to market risk is a factor suggesting the potential for
speculative abuse. In Colan, the Court of Appeals for the
Ninth Circuit reversed a district court’s grant of summary
judgment to the defendants in a case where the plaintiff in
a shareholder derivative suit had sued prospective
acquirers of a target company for short-swing profit liability
under section 16(b). The principal issue was whether an
exchange of common stock for debt securities constituted a
"sale" under section 16(b). Id. at 1518. The court of appeals
concluded that the exchange was neither automatic nor
involuntary, and determined that the volitional nature of
the exchange rendered it a sale under section 16(b).
Significantly for our purposes, the Colan court emphasized
that the "nature of the . . . [d]efendants’ investment was
changed [as] [t]hey exchanged common stock for negotiable
debt securities with a higher market value," thus changing
the character of their risk. Id. at 1525.
Here, the amendment to the certificate of incorporation
provided that the conversion of preferred to common would
occur automatically upon the IPO. We recognize, therefore
that the conversion itself was thus not voluntary. However,
the process by which the certificate was changed was
voluntary in the sense that interested parties voted on the
question.
Regardless of whether or not the conversion was
volitional, however, the question remains whether the
transaction had the potential for speculative abuse. We are
20
convinced that we should not hold, as a matter of law, that
the transaction lacked that potential. Taking all allegations
as true and drawing all reasonable inferences in favor of
Levy, it seems at least possible that he can demonstrate the

-- 16 of 25 --

presence of facts consistent with the allegations in the
complaint to show that the reclassification transaction had
the potential for speculative abuse. Cf., e.g., Conley v.
Gibson, 355 U.S. 41, 45-46, 78 S.Ct. 99, 102 (1957) ("[T]he
accepted rule [is] that a complaint should not be dismissed
for failure to state a claim unless it appears beyond doubt
that the plaintiff can prove no set of facts in support of his
claim which would entitle him to relief."). This is
particularly so inasmuch as Sterling and National were the
dominant shareholders and controlled at least three seats
on Fairchild’s Board of Directors. See Roberts v. Eaton, 212
F.2d 82, 85 (2d Cir. 1954) (contrasting situation in that
case to situation "where an insider controls and can work
his will through the board of directors") (citing Park &
Tilford v. Schulte, 160 F.2d 984, 988 (2d Cir. 1947)). We
also reiterate that the reclassification involved a conversion
of previously nonconvertible preferred stock into common
stock that at this stage of the case we must hold materially
changed National’s and Sterling’s risks and opportunities.
See Colan, 951 F.2d at 1525.10
Our conclusion that the district court erred in granting
the motion to dismiss is in accord with a recent decision
from the District of Delaware contrary to that of the district
court here. In Rosenberg v. Harris Corp., No. Civ.A.01-518-
SLR, 2002 WL 1459502 (D. Del. June 10, 2002) (mem.
order), the court denied a motion to dismiss in a
shareholder derivative lawsuit involving facts remarkably
similar to those here. The district court rejected the
defendants’ argument that the reclassification of Intersil
Corp.’s preferred stock into common stock pursuant to an
amended certificate of incorporation, when the conversion
took place on the same day as Intersil’s IPO, was exempted
_________________________________________________________________
10. In Colan the risk was reduced because common stock was exchanged
for debt securities but in our view it does not matter whether the
conversion enhanced or reduced the risks involved. The point is that the
risks were changed.
21
under Rule 16b-7 from section 16(b) liability. Id. at *1-2.
The district court observed that:
with the exception of [the district court’s decision in]
Levy, no court has exempted a reclassification, under
the ambit of Rule 16b-7 or otherwise, as a matter of
law. Rather, courts have considered the facts and
circumstances surrounding each transaction before
concluding that a particular transaction did not pose
the risk of speculative, insider ‘short-swing trading’
profits that Section 16(b) sought to prevent.
Id. at *2. The court explained "that the SEC has never
expressly exempted all reclassifications from Section 16(b),
just as all mergers and consolidations are not exempt --
only mergers and consolidations that meet specific, strict
guidelines are exempt as a matter of law." Id .

-- 17 of 25 --

In summary we conclude that Rule 16b-7 does not
exempt the reclassification from section 16(b) and that the
reclassification is not, for other reasons, outside the scope
of the section. While we acknowledge that this case is
difficult we believe that our result is consistent with
Congress’ intentions and Rule 16b-7.
B. Does SEC Rule 16b-3 exempt the reclassification?
National and Sterling argue that, even if we do not hold
that Rule 16b-7 exempts reclassifications generally or that
the transaction here is an exempt reclassification, we
nonetheless should affirm the district court on the alternate
ground they advanced in that court, but which it had no
reason to consider, that SEC Rule 16b-3 exempts the
transaction from the rule. Plainly, if we agreed with that
contention we would affirm as a court "may affirm a
judgment on any ground apparent from the record, even if
the district court did not reach it." Kabakjian v. United
States, 267 F.3d 208, 213 (3d Cir. 2001).
Rule 16b-3, entitled "Transactions between an issuer and
its officers or directors," provides, as relevant to this case:
(a) General. A transaction between the issuer
(including an employee benefit plan sponsored by the
issuer) and an officer or director of the issuer that
involves issuer equity securities shall be exempt from
22
section 16(b) of the Act if the transaction satisfies the
applicable conditions set forth in this section.
(b) Definitions.
(1) A Discretionary Transaction shall mean a
transaction pursuant to an employee benefit plan
. . .
(2) An Excess Benefit Plan shall mean an employee
benefit plan that is operated in conjunction with a
Qualified Plan . . .
(3)(i) A Non-Employee Director shall mean a director
who:
(A) Is not currently an officer (as defined in
S 240.16a-1(f)) of the issuer or a parent or
subsidiary of the issuer, or otherwise currently
employed by the issuer or a parent or subsidiary of
the issuer;
(B) Does not receive compensation, either directly
or indirectly, from the issuer or a parent or
subsidiary of the issuer, for services rendered as a
consultant or in any capacity other than as a
director, except for an amount that does not

-- 18 of 25 --

exceed the dollar amount for which disclosure
would be required pursuant to S 229.404(a) of this
chapter;
(C) Does not possess an interest in any other
transaction for which disclosure would be required
pursuant to S 229.404(a) of this chapter; and
(D) Is not engaged in a business relationship for
which disclosure would be required pursuant to
S 229.404(b) of this chapter.
(ii) Notwithstanding paragraph (b)(3)(i) of this
section, a Non-Employee Director of a closed-end
investment company shall mean a director who is
not an ‘interested person’ of the issuer, as that term
is defined in Section 2(a)(19) of the Investment
Company Act of 1940.
(4) A Qualified Plan . . .
23
(5) A Stock Purchase Plan . . .
(c) Tax-conditioned plans. . . .
(d) Grants, awards and other acquisitions from the
issuer. Any transaction involving a grant, award or
other acquisition from the issuer (other than a
Discretionary Transaction) shall be exempt if:
(1) The transaction is approved by the board of
directors of the issuer, or a committee of the board
of directors that is composed solely of two or more
Non-Employee Directors;
(2) The transaction is approved or ratified, in
compliance with section 14 of the Act, by either:
the affirmative votes of the holders of a majority of
the securities of the issuer present, or represented,
and entitled to vote at a meeting duly held in
accordance with the applicable laws of the state or
other jurisdiction in which the issuer is
incorporated; or the written consent of the holders
of a majority of the securities of the issuer entitled
to vote; provided that such ratification occurs no
later than the date of the next annual meeting of
shareholders; or
(3) The issuer equity securities so acquired are
held by the officer or director for a period of six
months following the date of such acquisition,
provided that this condition shall be satisfied with
respect to a derivative security if at least six
months elapse from the date of acquisition of the
derivative security to the date of disposition of the
derivative security (other than upon exercise or
conversion) or its underlying equity security.

-- 19 of 25 --

(e) Dispositions to the issuer. Any transaction
involving the disposition to the issuer of issuer equity
securities (other than a Discretionary Transaction)
shall be exempt, provided that the terms of such
disposition are approved in advance in the manner
prescribed by either paragraph (d)(1) or paragraph
(d)(2) of this section.
(f) Discretionary Transactions . . . .
24
17 C.F.R. S 240.16b-3 (emphasis added).
National and Sterling argue that Rule 16b-3(d), which
exempts "[g]rants, awards, and other acquisitions from the
issuer," exempts the reclassification transaction. In
particular, they contend that the conversion of their
preferred stock holdings into common stock constitutes a
transaction that (1) was approved by the issuer’s
(Fairchild’s) board of directors; and (2) was approved by a
majority of shareholders entitled to vote, either of which
circumstance suffices to trigger the rule’s exemption.
National Br. at 50 & n.13; Sterling Br. at 45-46. Levy
disagrees with their contention as he urges that Rule 16b-
3 by its terms is not applicable here.
According to Levy, the term "other acquisitions" in Rule
16b-3(d) cannot mean "any" and "all" other transactions for
several reasons. First, Levy argues that the principle of
ejusdem generis supports construing the term"other
acquisitions" in Rule 16b-3’s exemption of grants, awards,
and "other acquisitions" as constrained within a category
that includes grants and awards. Appellant’s Br. at 25-27;
Appellant’s Reply Br. at 18-20. In other words, Rule 16b-
3(d) does not, in Levy’s view, apply to all other acquisitions,
but only those that contain some element of compensation.
Appellant’s Br. at 26-27; Appellant’s Reply Br. at 18-26.
Second, Levy asserts that the SEC’s regulatory history
surrounding Rule 16b-3(d) suggests that we should limit
the rule to compensatory transactions. Appellant’s Br. at
23-24; Appellant’s Reply Br. at 21-23.
Third, Levy argues that Rule 16b-3(f) is more restrictive
than the interpretation of Rule 16b-3(d) National and
Sterling advance to the extent that Rule 16b-3(f), regulating
"discretionary transactions" involving employee benefit
plans, requires a six-month waiting period between
purchases and sales.11 Levy states that it would be
_________________________________________________________________
11. A discretionary transaction is
a transaction pursuant to an employee benefit plan that:
(i) Is at the volition of a plan participant;
(ii) Is not made in connection with the participant’s death,

-- 20 of 25 --

disability, retirement or termination of employment;
25
irrational for the SEC to impose greater restrictions on
transactions pursuant to an employee benefit plan, as such
transactions provide "less opportunity for speculative abuse
and serve a legitimate compensatory purpose." Appellant’s
Br. at 28.12
National and Sterling counter by pointing to the text of
the SEC’s 1996 release adopting Rule 16b-3. National Br.
at 51-52; Sterling Br. at 48-49. As National and Sterling
note, the release states that
New Rule 16b-3 exempts from short-swing profit
recovery any acquisitions and dispositions of issuer
equity securities . . . between an officer or director and
the issuer, subject to simplified conditions. A
transaction with an employee benefit plan sponsored
by the issuer will be treated the same as a transaction
_________________________________________________________________
(iii) Is not required to be made available to a plan participant
pursuant to a provision of the Internal Revenue Code; and
(iv) Results in either an intra-plan transfer involving an issuer
equity securities fund, or a cash distribution funded by a
volitional disposition of an issuer equity security.
17 C.F.R. S 240.16b-3(b)(1).
Rule 16b-3(f) provides:
Discretionary Transactions. A Discretionary Transaction shall be
exempt only if effected pursuant to an election made at least six
months following the date of the most recent election, with respect
to any plan of the issuer, that effected a Discretionary Transaction
that was:
(1) An acquisition, if the transaction to be exempted would be a
disposition; or
(2) A disposition, if the transaction to be exempted would be an
acquisition.
Id. S 240.16b-3(f).
12. Levy makes a fourth argument that "the rule as a whole only speaks
to transactions between an issuer and an officer or director who is a
natural person." Appellant’s Br. at 32. This argument, however, is
premised upon the argument that Rule 16b-3(d) deals with transactions
involving compensation; it does not have any independent force.
26
with the issuer. However, unlike the current rule, a
transaction need not be pursuant to an employee

-- 21 of 25 --

benefit plan or any compensatory program to be
exempt, nor need it specifically have a compensatory
element.
Ownership Reports and Trading by Officers, Directors and
Principal Security Holders, Release Nos. 34-37260, 35-
26524, 61 Fed. Reg. 30376, 30378-79 (June 14, 1996)
(footnotes omitted). Levy asserts, however, that"the mere
fact that the transaction does not need . . . to have a
specifically compensatory element does not mean that the
transaction does not need to have any compensatory
element whatsoever. . . . In fact, what specifically implies is
that there still needs to be some compensatory element to
the transaction even if it is not the primary one."
Appellant’s Reply Br. at 23-24 (emphasis in original).
Our review of the adopting release convinces us that Rule
16b-3 primarily is concerned with employee benefit plans.
The release indicates that the new rule was adopted in part
to encourage participation in employee benefit plans:
In February 1991, in response to developments in the
trading of derivative securities, the growth of complex
and diverse employee benefit plans, and substantial
filing delinquencies, the Commission adopted
comprehensive changes to the beneficial ownership and
short-swing profit recovery rules and forms applicable
to insiders pursuant to section 16. While many aspects
of the new section 16 rules were favorably received,
unanticipated practical difficulties arose in
implementing the new rules, particularly with respect
to thrift and similar employee benefit plans. In
particular, issuers and insiders stated that the
application of current Rule 16b-3 to these plans is
cumbersome, presents significant record-keeping
problems and discourages insiders from participation
in plan funds holding employer securities.
Ownership Reports and Trading, 61 Fed. Reg. at 30376
(footnotes omitted). The adopting release further explained
that the 1995 proposals being adopted, which included the
proposed new Rule 16b-3, were related to compensation:
27
The 1995 proposals presented a simplified, flexible
approach based on the premise that transactions
between an issuer and its officers and directors are
intended to provide a benefit or other form of
compensation to reward service or to incentivize
performance. Generally, these transactions do not
appear to present the same opportunities for insider
profit on the basis of non-public information as do
market transactions by officers and directors. Typically,
where the issuer, rather than the trading markets, is
on the other side of an officer or director’s transaction
in the issuer’s equity securities, any profit obtained is
not at the expense of uninformed shareholders and
other market participants of the type contemplated by

-- 22 of 25 --

the statute. Based on its experience with the Section
16 rules, the Commission is persuaded that
transactions between the issuer and its officers and
directors that are pursuant to plans meeting the
administrative requirements and nondiscrimination
standards of the Internal Revenue Code and the
Employee Retirement Income Security Act of 1974
("ERISA"), or that satisfy other objective gate-keeping
conditions, are not vehicles for the speculative abuse
that section 16(b) was designed to prevent. Accordingly,
these transactions are exempted by new Rule 16b-3 as
adopted.
Id. at 30377 (footnotes omitted).13 The release explained
specifically the impetus behind new Rule 16b-3(d):
Plans that authorize ‘grant and award’ transactions
provide issuer equity securities to participants on a
basis that does not require either the contribution of
assets or the exercise of investment discretion by the
participants. For example, awards of bonus stock
pursuant to a salary-based formula and grants of
_________________________________________________________________
13. National argues that the sentence in the above-quoted language
beginning with "Typically . . ." supports a broad reading of the term
"other acquisitions" in Rule 16b-3. See National Br. at 50. Levy argues
that "[t]his quote is . . . taken entirely out of context." Appellant’s Reply
Br. at 24. Whether true or not, in any event, it is clear that the
surrounding language is concerned with compensation.
28
options or restricted stock are grant and award
transactions. In contrast, a ‘participant-directed
transaction’ requires the participant to exercise
investment discretion as to either the timing of the
transaction or the assets into which the investment is
made. For example, the exercise of an option and a
participant’s election pursuant to a thrift plan to invest
either the employee or the employer contribution in
issuer equity securities are participant-directed
transactions.
Both the current and the new rules provide a specific
exemption for the grant or award of issuer equity
securities. The new rule makes the exemption more
readily available, since only one of three alternative
conditions need be satisfied.
Id. at 30380. The release further explained that, whereas
the 1995 proposal referred only to "grants" and "awards,"
the term "other acquisitions" was added to account for the
participant-directed transactions mentioned above.
Commenters responded favorably to this proposal.
They expressed concern, however, that some
participant-directed transactions (such as deferrals of
bonuses into phantom stock and other deferred

-- 23 of 25 --

compensation programs) that are exempt under the
current rule would lack an exemption under the new
rule.
The 1995 proposal was intended to permit such
transactions, which ordinarily do not present
opportunities for abuse, an opportunity for exemption.
Accordingly, as adopted, the proposed grant and award
exemption has been retitled ‘Grants, Awards and Other
Acquisitions from the Issuer’ to make it clear that
participant-directed acquisitions that are not pursuant
to tax-conditioned plans may rely on this exemption.
. . .
Id. (footnotes omitted).14 This statement, as well as the
_________________________________________________________________
14. Sterling argues that the cited language of the release "does not,
however, suggest that ‘participant-directed’ acquisitions, together with
29
others previously cited, in the SEC’s adopting release
strongly suggest that the SEC intended, in Rule 16b-3(d), to
exempt "grants, awards, and other acquisitions" with some
compensatory nexus and thus the rule is inapplicable here.
We acknowledge that the statement that "a transaction
need not . . . to be exempt . . . specifically have a
compensatory element," 61 Fed. Reg. at 30379, appears to
cut against our position. This statement, however, can be
read to mean that the form of a transaction is not what
matters. Rather, the weight of the SEC’s pronouncements
on Rule 16b-3, and particularly Rule 16b-3(d), suggest that
the transaction should have some connection to a
compensation-related function.
The result we reach is sensible. We think that adopting
National’s and Sterling’s view would result in any
transaction between the issuer company and an officer or
director that meets the remaining requirements of Rule
16b-3(d) -- approval of the transaction by the board of
directors or a majority of shareholders, or holding of the
securities by the officer or director for more than six months15
-- being immunized from section 16(b) liability. The
potential for self-dealing could be great: in a closely held
corporation, directors or a majority of shareholders could
arrange for the acquisition of stock in advance of an IPO,
and turn around and sell shares shortly after the IPO.
Because of their insider status, there would be a concern
_________________________________________________________________
grant and award transactions, are the only types of transactions eligible
for exemption under Rule 16b-3(d)." Sterling Br. at 49 (emphasis in
original). Instead, Sterling points to another part of the release, see id.,
which states that "[o]ther acquisitions by an officer or director from the
issuer, including grants, awards and participant-directed transactions,
will be exempt upon satisfaction of any one of three alternative

-- 24 of 25 --

conditions." 61 Fed. Reg. at 30377. Sterling argues that the transactions
encompassed by Rule 16b-3(d) include, but are not limited to, grants,
awards, and participant-directed transactions, and that any transaction
meeting one of the required conditions should be exempt. Sterling Br. at
49-50.
15. This list is a paraphrase of the alternative conditions for exemption
in Rule 16b-3(d).
30
Gryl ex rel. Shire Pharms. Group PLC v. Shire Pharms.
Group PLC, 298 F.3d 136 (2d Cir. 2002), is not to the
contrary. In Gryl, the Court of Appeals for the Second
Circuit held that Rule 16b-3(d) exempted from section 16(b)
transactions involving the grant of stock options to insider-
directors of an issuer company, Roberts, and the
subsequent conversion of those options to options in Shire,
the company with which Roberts merged, pursuant to a
merger plan. See Gryl, 298 F.3d at 139, 146. These stock
options, however, had a compensatory nexus.16
IV. CONCLUSION
In view of the foregoing, we hold that the district court
erred in granting the motion of National and Sterling to
dismiss Levy’s complaint for failure to state a claim on
which relief can be granted. We disagree with the district
court’s holding that Rule 16b-7 exempted the
reclassification transaction as a matter of law and we do
not conclude at this time that the reclassification
transaction is outside the definition of "purchase" under
section 16(b). We also reject the alternative basis that
National and Sterling have advanced for supporting the
judgment below -- Rule 16b-3(d) -- as inapplicable. Thus,
we will reverse the order of February 5, 2002, dismissing
this action and will remand the matter to the district court
for further proceedings consistent with this opinion.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
_________________________________________________________________
16. Levy makes an alternative argument that if National’s and Sterling’s
interpretation of Rule 16b-3(d) is correct the SEC exceeded its authority
in enacting the rule. In view of our result we do not consider this point.
about speculative abuse injurious to other market
participants.
31

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