Beneficial Ownership of an Issuer’s Securities Is a Prerequisite to Joining a Section 13(d) Group

On December 29, 2008, the United States Court of Appeals for the 11th Circuit held that a beneficial ownership interest in an issuer’s securities by a person is a prerequisite to membership by such person in a “group” for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended (Exchange Act).¹ This decision will be of interest to both the investor and public company communities as shareholder activism activities increase. It is binding precedent in Florida, Georgia and Alabama and persuasive authority elsewhere.

Hemispherx Biopharma, Inc. v. Johannesburg Consolidated Investments confirmed an earlier decision in the 3rd Circuit as the Court considered whether persons who were not beneficial owners of Hemispherx stock, but who together with an existing 30 percent shareholder joined in a hostile takeover attempt of the issuer, were members of a “group” required to file a Schedule 13D under Section 13(d)(1) of the Exchange Act. The Court concluded that only persons who have an existing “beneficial ownership” interest in the securities of the issuer can be considered members of a group under Section 13(d)(1).
 
Interested persons should note that courts may find that a shareholder who is not the “record holder” of securities may be deemed to be the “beneficial owner” of such securities for purposes of Section 13(d). Such beneficial ownership could trigger the reporting requirements of Section 13(d)(1), and such beneficial owner could be considered a member of a “group” under Section 13(d)(1).

Background

Hemispherx, a publicly traded pharmaceutical research and development company that specialized in nucleic acid technologies, brought this action against Bart Goemaere, a 30 percent shareholder in Hemispherx, and other defendants (South African defendants) who did not own Hemispherx shares, but with whom he allegedly colluded in an attempted hostile takeover of Hemispherx. While the hostile takeover never came to fruition, Hemispherx alleged, among other things, that the defendants violated Section 13(d)(1) of the Exchange Act by not filing the required disclosures on Schedule 13D despite acting together in an attempt to effect a hostile takeover of Hemispherx.

Under Section 13(d)(1) of the Exchange Act, a person who acquires more than a five percent beneficial ownership interest in an issuer’s equity securities, which are registered pursuant to Section 12 of the Exchange Act, is required to make certain disclosures to the issuer, the relevant stock exchange and the SEC on a Schedule 13D. The disclosures include: (1) the background and identity of the purchaser, (2) the source and amount of the funds used to make the purchase, (3) any plans to acquire control of the issuer’s business, (4) the number of shares that are beneficially owned by the purchaser and the number of shares that the purchaser and any associate have a right to acquire, and (5) information as to arrangements or understandings with a person with respect to the issuer’s securities. Any material changes in the disclosures set forth in a Schedule 13D require that amendments be sent to the issuer of the securities and the relevant stock exchange and be filed with the SEC.

For purposes of Section 13(d), Exchange Act Rule 13d-3 defines a beneficial owner as “any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares…[v]oting power which includes the power to vote, or to direct the voting of, such security…and/or, [i]nvestment power which includes the power to dispose, or to direct the disposition of, such security. Exchange Act Rule 13d-5 states that for purposes of Section 13(d), “[w]hen two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, the group formed thereby shall be deemed to have acquired beneficial ownership…of all equity securities of that issuer beneficially owned by any such persons. Additionally, Section 13(d)(3) states that a group is deemed a “person” for purposes of Section 13(d) “[w]hen two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer.”

Court’s Analysis

The Court, in determining whether beneficial ownership of stock is a prerequisite to joining a 13(d) group, first looked to the text of Sections 13(d)(1) and 13(d)(3), and Rules 13d-3 and 13d-5. Finding that the plain language of the law and the rules did not answer the question, the Court next looked to the context and congressional intent of Section 13(d)(3) and the decision of the United States Court of Appeals for the Third Circuit (Rosenberg v. X M Ventures, 274 F.3d 137, (3d Cir. 2001)), which had addressed the same issue. According to the 11th Circuit Court, the purpose of Section 13(d)(1) is to prevent an individual from accumulating shares without the issuer’s knowledge. The Court went on to state that the purpose of Section 13(d)(3) is to prevent a group from combining their interests in a company while evading a person’s disclosure obligation under the statute. The implication of Section 13(d)(3), therefore, is that a person must have some interest to “pool” before becoming a member of a Section 13(d) group. Consequently, the Court agreed with the Third Circuit and held that a person must be a beneficial owner to be a part of a Section 13(d) group.
 
The Court also noted that the purpose of Section 13(d)(3) is not eroded if beneficial ownership is necessary to joining a Section 13(d) group. An existing shareholder who accumulates a beneficial interest in an issuer’s securities must file disclosures on Schedule 13D. If that shareholder is a party to an arrangement regarding the issuer’s securities, the details of the arrangement must be disclosed, whether it involves an arrangement with another beneficial owner or a person without an existing beneficial interest in the issuer’s securities. In either scenario, an issuer would be made aware of an accumulation of interest in its securities and the identity of the parties involved. The Court concluded that the allegedly collusive activity between Goemaere and the South African defendants was sufficient to require disclosure in Goemaere’s Schedule 13D.

Additionally, the Court addressed practical considerations, stating that if non-beneficial owners could be considered part of a Section 13(d) group, then attorneys, investment bankers and others who assisted in an acquisition, holding or disposal of the issuer’s securities may be considered part of the group. The Court stated that this was unlikely the intent of Congress and would not be necessary or useful to attain the goal of the statute. The Court concluded that while the South African defendants were not required to make Schedule 13D disclosures, Goemaere was required to disclose on his Schedule 13D filing the identities of and his arrangements with the South African defendants regarding his Hemispherx shares.