Larry Morrison v. Madison Dearborn Capital Partners, III, L.P., et al.

Larry Morrison, a shareholder of XM Satellite Radio
Holdings, Inc. ("XM"), brought a derivative suit under Section
16(b) of the Securities Exchange Act of 1934, 15 U.S.C. §
78p(b), to recover alleged short-swing profits realized by
corporate insiders Madison Dearborn Capital Partners III, L.P,
Madison Dearborn Special Equity III, L.P., Madison Dearborn
Partners III, L.P., and Madison Dearborn Partners, LLC
(collectively "Madison Dearborn"). The District Court
dismissed the complaint for failure to state a claim on which
relief can be granted. Fed. R. Civ. P. 12(b)(6). Morrison
appeals.

II.

In August 2000, Madison Dearborn purchased 50,000
shares of "8.25% Series C Convertible Redeemable Preferred
Stock Due 2012" (hereinafter "Preferred Stock") issued by XM
for $1000 per share. Combined with other purchases, Madison
Dearborn was the beneficial owner of 13.58% of the underlying
XM Common Stock.

Holders of Preferred Stock are entitled to exchange their
shares for XM Common Stock. The Certificate of Designation
for the Preferred Stock set the conversion price at $26.50 per
share, but also contained "anti-dilution" provisions which
automatically decreased the conversion price when certain
events occurred, such as a stock split, payment of dividends, or
issuance of additional Common Stock. By 2003, the conversion
price had decreased to $19.68. On and subsequent to January
28, 2003, XM issued additional Common Stock, which further
reduced the conversion price to $8.96 per share as of June 30,
2003. Prior to the adjustment, Madison Dearborn was entitled to
convert its Preferred Stock into 2,540,650 shares of Common
Stock. Afterwards, it was entitled to 5,580,357 shares but never
exercised its right to convert those shares.

In June 2003, Madison Dearborn sold 2,674,154 shares of
XM Common Stock that it had acquired independently of the
Preferred Stock. Morrison requested that XM bring suit against
Madison Dearborn to recover the alleged short-swing profits
realized by this sale. When XM declined to do so, Morrison
brought this derivative shareholder lawsuit.

* * *

Section 16(b) of the Securities Exchange Act of 1934
prohibits corporate insiders from using their privileged position
to profit from short-term transactions in the company's stock. 15
U.S.C. § 78p(b).1 Short-swing trading is a strict-liability offense and does not require proof of actual abuse of insider information
or an intent to profit from such information. Foremost-
McKesson, Inc. v. Provident Sec. Co., 423 U.S. 232, 251 (1976).
The plaintiff need only prove that "‘there was (1) a purchase and
(2) a sale of securities (3) by an officer or director of the issuer
or by a shareholder who owns more than ten percent of any one
class of the issuer's securities (4) within a six month period.'"
Levy v. Sterling Holding Co., 314 F.3d 106, 111 (3d Cir. 2002)
(quoting Gwozdinksy v. Zell/Chilmark Fund, L.P., 156 F.3d
305, 308 (2d Cir. 1998)). For the purposes of the motion to
dismiss, Madison Dearborn does not dispute that it is a corporate
insider or that it sold almost 2.7 million shares of XM Common
Stock in June 2003. The only issue is whether the automatic
adjustment to the conversion price of the Preferred Stock in
January 2003, was a "purchase" of securities.

The Securities Exchange Act of 1934 authorizes the SEC
to enact regulations defining which transactions are included in
the ban on short-swing trading and which are "exempt as not
comprehended within the purpose of this subsection." 15 U.S.C.
§ 78p(b). In 1991, the SEC adopted new regulations on the
applicability of Section 16(b) to transactions in derivative
securities. A derivative security is "any option, warrant,
convertible security, stock appreciation right, or similar right
with an exercise or conversion privilege at a price related to an
equity security, or similar securities with a value derived from
the value of an equity security . . . ." 17 C.F.R. § 240.16a-1(c)
(emphasis added).

The parties agree that, because the Preferred Stock is
convertible into Common Stock, the Preferred Stock is a
derivative security. More specifically, the Preferred Stock is a
"call equivalent position," because it "increases in value as the
value of the underlying equity increases . . . ." 17 C.F.R. §
240.16a-1(b). The regulations state that "[t]he establishment of
or an increase in a call equivalent position . . . shall be deemed a
purchase of the underlying security for purposes of section 16(b) . . . ." 17 C.F.R. § 240.16b-6(a). Morrison argues that the
adjustment in the conversion price increased Madison
Dearborn's call equivalent position from 2,540,650 shares to
5,580,357 shares of XM Common Stock. Thus, he argues, under
the plain meaning of the regulations, the adjustment constituted a
"purchase."

Morrison's argument is contrary to the SEC's
interpretation of the regulations. An agency's reasonable
interpretation of its own regulations "attracts substantial judicial
deference." United States v. Cleveland Indians Baseball Co.,
532 U.S. 200, 219 (2001) (citation omitted). "Our task is not to
decide which among several competing interpretations best
serves the regulatory purpose. Rather, the agency's
interpretation must be given controlling weight unless it is
plainly erroneous or inconsistent with the regulation." Thomas
Jefferson Univ. v. Shalala, 512 U.S. 504, 512 (1994) (internal
quotation marks omitted). Deference is especially warranted
when the regulations concern "a complex and highly technical
regulatory program[.]" Id. (internal quotation marks omitted).
Particular weight is given to agency interpretations made at the
time the regulations are promulgated. Gardebring v. Jenkins,
485 U.S. 415, 430 (1988).

The SEC anticipated, and rejected, Morrison's argument.
In the release announcing the new regulations, the SEC states
that the regulations only apply to derivatives with a "fixed
exercise price." Ownership Reports and Trading By Officers,
Directors and Principal Security Holders, 56 Fed. Reg. 7242,
7252 (Feb. 21, 1991) (hereinafter "Release"). The Release
clarifies what constitutes a "fixed" price, saying,

A convertible security with a fixed conversion privilege is
deemed to have a fixed exercise price. A derivative
security having a series of preset prices, or having a price
that is adjusted to reflect pre-specified events such as a
stock split, is considered fixed for purposes of the Rule.
The adjustments for pre-specified events do not constitute
acquisitions of additional equity securities.

Release, at 7252 n.134 (emphasis added). Therefore, under the SEC's interpretation, the adjustment to the conversion price of
the Preferred Stock is not a "purchase."

The SEC's interpretation is consistent with the statutory
purpose. The ban on short-swing trading was enacted "[f]or the
purpose of preventing the unfair use of information which may
have been obtained by [corporate insiders.]" 15 U.S.C. § 78p(b).
The SEC has attempted to identify those transactions which have
a "potential for abuse." Release, at 7249. The potential for
abuse is minimal when the adjustments are automatic, and the
triggering events were specified at the time when the stock was
purchased. The shareholder cannot control when, or even if, the
adjustment occurs. Cf. Lerner v. Millenco, L.P., 23 F. Supp. 2d
337, 343 (S.D.N.Y. 1998) (holding that a shareholder had
purchased additional securities by negotiating with the company
to reduce the conversion price of convertible debentures). While
the possibility of insider trading is not entirely eliminated, it is
not so great as to impose strict liability as provided in Section
16(b).