Court Finds Fund a “Beneficial Owner” Subject to Section 16 Despite Delegation to Investment Adviser

Background

A person or entity “beneficially owns” shares of a class of registered equity securities for Section 16(a) purposes if that person or entity has or shares the power to vote or dispose of such shares, or has the right to acquire such power within 60 days (assuming passivity).² The Securities and Exchange Commission (SEC) staff has stated that its position is that a party need not report as a “beneficial owner” of shares if it “has delegated all authority to vote and dispose of its stock to an investment adviser [and does not] retain[ ] the right under the contract to rescind the authority granted to the investment adviser and regain investment or voting power over the shares within 60 days.”³ For years, many investment advisers and investors have taken the position that an advisory client (including a private fund) that is the record owner of more than 10 percent of a class of registered equity securities need not consider itself a “beneficial owner” of such securities if the adviser manages the client’s portfolio pursuant to a contract that meets the SEC staff’s description.⁴ This position has been recognized by the leading Section 16 treatise.⁵

In 2012, in Huppe v. WPCS Int’l Inc.,⁶ in the context of an investment limited partnership, the U.S. Court of Appeals for the Second Circuit found that this “delegation” analysis did not extend to the general partner, stating that the limited partnership agreement provided the general partner with broad authority to exercise all rights, power and authority of a general partner, as the limited partnership’s agent and on the limited partnership’s behalf, that the general partner’s actions bound the limited partnership and that the general partner’s actions therefore, were the limited partnership’s actions. Because of those observations, the court stated that voting and dispositive power (i.e., beneficial ownership) remained with the limited partnership.

Raging Capital

Raging Capital involved a Cayman Islands fund (Master Fund) that held more than 10 percent of a publicly traded common stock. As a Cayman Islands company, Master Fund was controlled by a board of directors. Two of the three directors were independent of Master Fund’s investment adviser (Adviser). The third was an individual who owned and controlled Adviser and the general partner to the onshore fund (the Common Control Person). Master Fund was owned by two “feeder” funds, a Cayman Islands company and a Delaware limited partnership. Adviser served as the Cayman feeder’s investment adviser, and an affiliate served as the United States feeder’s general partner.

Through an investment management agreement, Master Fund had delegated to Adviser complete authority to (among other things) buy, sell and vote all securities in Master Fund’s account. The agreement provided that Master Fund could not terminate it (and thus, take control of the securities in the account) on fewer than 61 days’ written notice. 

Notwithstanding that delegation, the court granted the plaintiff’s motion for summary judgment, finding that Master Fund remained the beneficial owner of the over-10-percent  position. As a result, Master Fund was found liable under Section 16(b) for almost $5 million in short swing profits.⁷

The court asserted that Huppe “disposed of such delegation theories,” saying that, although the contractual structure was different than in Huppe, because Adviser “was acting on behalf of Master Fund” as Master Fund’s agent, allowing Master Fund to avoid liability as a 10 percent  beneficial owner would be inconsistent with “the text and purposes” of Section 16(b).⁸ This language could be read to extend the Huppe court’s “agency” analysis beyond general partner-limited partnership relationships and apply it more broadly to delegations of voting and dispositive control to investment managers via investment management agreements. If read broadly, the decision would appear inconsistent with the SEC staff’s longstanding position that advisory clients can divest themselves of beneficial ownership.

The court went on to say that even if delegation could shield a fund from short-swing profit liability, Master Fund had not successfully accomplished it. It asserted that nothing prevented the parties from altering the agreement at will and thus, concluded that the delegation was inadequate.

Finally, the court concluded that because Master Fund and Adviser were “not unaffiliated,” the delegation failed to divest Master Fund of beneficial ownership. It cited statements in treatises to the effect that delegation may be effective if made to an unaffiliated third party.⁹ In drawing this conclusion, the court did not cite any particular attributes of the parties’ affiliation, but in other contexts (e.g., the effectiveness of the 61-day notice requirement for termination), it observed that the same person signed the investment management agreement for Master Fund, Adviser and each of the feeders and seemed to conclude that such person could “revise, amend or abrogate that agreement with a few strokes of a pen,” noting that the agreement did not require “unanimous consent” of Master Fund’s directors or shareholders (which the agreement did require for termination by other parties).

The existence of alternative bases for the decision, coupled with the court’s citing of the SEC staff statements and related treatise guidance that acknowledges the ability to delegate away beneficial ownership, suggest that the court might not have intended its rejection of the delegation theory to be as absolute as it might appear. However, the sweeping language will likely provide additional fuel to the aggressive plaintiff’s bar that actively pursues Section 16(b) claims and we expect these attorneys will be scouring Section 16 filings, as well as Schedules 13D, Schedules 13G and Forms 13F, looking for potential claims to bring against private funds that hold over 10 percent.¹⁰ As such, private fund advisers may wish to revisit the analysis of their obligations under Section 16.

We would be pleased to discuss responses to this development, including methods of structuring fund management and documenting advisory arrangements.

¹ The case is Packer v. Raging Capital, 2019 WL 3936813 (E.D.N.Y. Aug. 20, 2019) (Raging Capital) and, as of the date of publication, the decision, made by the U.S. District Court for the Eastern District of New York, is being appealed.

² The same definition of “beneficial ownership” applies for purposes of Schedule 13D and Schedule 13G filings under Section 13(d) and Section 13 (g) of the Exchange Act.

³ SEC Div. of Corp. Fin., Compliance and Disclosure Interpretations, Exchange Act Sections 13(D) and 13(G) and Reg. 13D-G Beneficial Ownership Reporting, Q. 105.04 (Sept. 14, 2009) (citing SEC Exchange Act Release No. 13291, Example 11 (Feb. 24, 1977)). While the staff took this position under Section 13(d), Section 16(a) uses the Section 13(d) definition of “beneficial ownership” when determining whether a person is an over-10-percent beneficial owner — specifically, direct or indirect voting and/or investment power, plus the right to acquire such power within 60 days (if passive) or at any time (if not passive). See Rule 13d-3 under the Exchange Act.

⁴ Further, the investment adviser need not consider itself a “beneficial owner” of such securities to the extent it is a “qualifying institutional investor” under Rule 16a-1(a)(1) under the Exchange Act.

 ⁵ Peter J. Romeo and Alan L. Dye, Section 16 Treatise and Reporting Guide, § 2.03[5][f] (“Generally, an entity is the beneficial owner of its portfolio securities where voting and investment decisions are made by the persons who . . . are charged with making those decisions. The result may be different where the entity delegates voting and investment authority to an unaffiliated third party and does not retain the ability to revoke that authority within 60 days”).

⁶ 670 F.3d 214, 221 (Second Cir. 2012).

⁷ Adviser asserted that it did not beneficially own the shares because of the exemption in Rule 16a-1(a)(1) for “qualifying institutional investors.” It asserted that Master Fund should also be entitled to rely on that exemption, but the court rejected that assertion. Plaintiffs sought summary judgment only against Master Fund. However, the opinion states that the parties agreed at oral argument that as Adviser, the Common Control Person and Master Fund all held interests in essentially the same shares, judgment against Master Fund alone would be coextensive with judgment against Adviser and the Common Control Person.

⁸ Ironically, the court noted the breadth of the authority delegated as evidence of agency — a fact that could be viewed as supporting the position that Master Fund divested voting and dispositive control through delegation.

⁹ See supra note 4.

¹⁰ The court stated it did not need to consider the possible Section 13(d) “group” issue among Master Fund, Adviser and the Common Control Person because Master Fund alone held more than 10 percent of the subject securities.