On January 29, 2014, the US Court of Appeals for the Second Circuit ruled in Roth v. Goldman Sachs Group, Inc. that expiration of a short-term call option constitutes a purchase under Rule 16b-6(d) for purposes of Section 16(b) of the Exchange Act (No. 12-2509, (2d Cir. Jan. 29, 2014)). However, the Second Circuit held that for a greater than ten percent shareholder to be liable for disgorgement of profits, it must have owned more than ten percent at both the time of the sale (when it wrote the call options) and the later time of purchase (at the expiration of the options).

Section 16(b) of the Exchange Act applies to companies with equity securities registered under Sections 12(b) or 12(g) under the Exchange Act. Section 16(b) requires certain insiders to disgorge profits from any purchase and sale, or sale and purchase, of a company's equity securities within a period of less than six months. Section 16 insiders include any person who beneficially owns more than ten percent of a company's equity securities.

Under Section 16, transactions in certain derivative securities, such as options, are deemed to be transactions in the underlying securities. Rule 16b-6(d) provides that if an option expires within six months of being written, without being exercised, the option writer must disgorge any profit derived from writing the option under Section 16(b).

In September 2009, Goldman Sachs Group, Inc. (Goldman) wrote 32,000 call options covering 3.2 million shares of Leap Wireless International, Inc. (Leap). Goldman owned over 10% of Leap's shares at the time, making it a statutory insider subject to the reporting and disgorgement requirements of Section 16 of the Exchange Act. The options were sold for a total of $1,056,000 and had an expiration date of January 16, 2010. In October 2009, Goldman's ownership share in Leap dropped to below 10%. The call options expired unexercised in January 2010.

In June 2011, a Leap shareholder brought a derivative action on behalf of Leap to sue Goldman under Section 16(b) and Rule 16b-6(d) for Goldman's alleged failure to disgorge profits earned by writing the short call options that expired unexercised within six months. The US District Court for the Southern District of New York dismissed the action and the Leap shareholder appealed.

The Second Circuit affirmed the dismissal, holding that:

In reaching its decision, the Second Circuit noted that Rule 16b-6(d) requires strict liability but does not identify option expiration as either a purchase or a sale. However, in making its decision, the Second Circuit relied on an amicus brief filed by the SEC, as well as the SEC's language in a 1988 release proposing amendments to the Section 16 rules, highlighting that if a short-term option expires, the expiration should be treated as a purchase of that option because of the short swing profit potential.

The Second Circuit also distinguished prior precedent in which the court held that expiration of one call option could not be matched with the later writing of another different call option. In Roth, the Second Circuit clarified that the expiration of a specific short-term option can only be matched with its own writing as a transaction; the writing of a call option is a sale and the expiration of that call option within six months is the matched purchase.

For more information on short-swing profit liability, see Practice Note, Section 16(b) Short-swing Profit Liability: The Perils of Turning a Quick Profit.