Calculating “Profit Realized”
Under Section 16(b)
Andrew Chin
chin@unc.edu
AndrewChin.com
The Learned Hand Unformula:
Why Gratz Says Nothing About How to
Calculate Short-Swing Insider Trading Liability
(forthcoming 2016)
“The only rule whereby all possible
profits can be surely recovered is
that of lowest price in, highest price
out — within six months…”
Smolowe (1943)
Bought
3/1
200@$40
4/1
5/1
100@$20
100@$35
6/1
7/1
Sold
200@$50
100@$45
8/1
100@$40
LIHO (Smolowe):
$0
Bought
3/1
200@$40
4/1
5/1
100@$20
100@$35
6/1
7/1
Sold
200@$50
100@$45
8/1
100@$40
LIHO (Smolowe):
+ $1500
Bought
3/1
Sold
200@$40
4/1
100@$20
5/1
6/1
7/1
100@$50
100@$45
8/1
100@$40
LIHO (Smolowe):
+ $1500
Bought
3/1
Sold
200@$40
4/1
100@$20
5/1
6/1
7/1
100@$50
100@$45
8/1
100@$40
LIHO (Smolowe):
+ $1000
Bought
3/1
Sold
100@$40
4/1
100@$20
5/1
6/1
7/1
100@$45
8/1
100@$40
LIHO (Smolowe):
$2500
Bought
3/1
200@$40
4/1
5/1
100@$20
100@$35
6/1
7/1
Sold
200@$50
100@$45
8/1
100@$40
($16,000)
Net profit:
$16,000
$0
Strict Fiduciary Liability Doctrine
“We must suppose that the statute
was intended to be thorough-going,
to squeeze all possible profits out of
stock transactions, and thus to
establish a standard so high as to
prevent any conflict between the
selfish interest of a fiduciary officer,
director, or stockholder and the
faithful performance of his duty.”
Smolowe (1943)
Statutory Interpretation
“any profit realized… from any purchase and sale,
or any sale and purchase…within any period of
less than six months… shall inure to and be
recoverable by the issuer…
“but no such suit shall be brought more than two
years after the date such profit was realized.”
Strict Liability
Smolowe: “its generality permits
and points to … an arbitrary
matching to achieve the
showing of a maximum profit.”
“any profit realized… from any purchase and sale,
or any sale and purchase…within any period of
less than six months… shall inure to and be
recoverable by the issuer…
“but no such suit shall be brought more than two
years after the date such profit was realized.”
Strict Liability
Maximum after-the-fact value
that inside information could have had,
given the insider’s stock transactions,
regardless of how such information may or may not
actually have been used.
(R. Davis, 1974)
The Smolowe Formula
“The only rule whereby all possible
profits can be surely recovered is
that of lowest price in, highest price
out — within six months…”
Smolowe (1943)
Arnold Jacobs
(1987)
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
LIHO (Smolowe):
+ $5000
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
9/1
1000@$9
LIHO (Smolowe):
1000@$11
+ $5000
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
9/1
1000@$9
LIHO (Smolowe):
1000@$11
+ $3000
Bought
1/1
Sold
1000@$10
5/1
8/1
9/1
1000@$11
LIHO (Smolowe):
$8000
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
Bought
1/1
Sold
1000@$10
5/1
1000@$12
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
Jacobs:
+ $2000
Bought
Sold
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
1/1
5/1
Jacobs:
+ $2000
Bought
Sold
8/1
1000@$8
1000@$13
9/1
1000@$9
1000@$11
1/1
5/1
Jacobs:
+ $5000
Bought
Sold
1000@$9
1000@$11
1/1
5/1
8/1
9/1
Jacobs:
+ $7000
Bought
Sold
1000@$9
1000@$11
1/1
5/1
8/1
9/1
Jacobs:
+ $2000
Bought
Sold
1/1
5/1
8/1
9/1
Maximum:
+ $9000
Bought
1/1
5/1
8/1
9/1
}
Sold
more than six months
Maximum:
LIHO (Smolowe):
+ $9000
+ $8000
Smolowe rule cannot be
used when:
• trades cover a period of
more than six months, OR
• some trades are outside
statute of limitations
[ open ]
¶1. What is the
Smolowe rule’s
worst-case error?
Smolowe rule cannot be
used when:
worstcase
error:
• trades cover a period of 50%
more than six months
• some trades are outside
100%
statute of limitations
Bought
1/1
Sold
1000@$1
2/1
1000@$1001
5/1
1000@$1002
9/1
1000@$2
Bought
1/1
Sold
1000@$1
2/1
1000@$1001
5/1
1000@$1002
9/1
1000@$2
$2,000,000 vs. $1,001,000
(sued 4/1/15)
Bought
1/1/13
1000@$1
2/1/13
1000@$1000
Sold
3/1/13
1000@$1002
5/1/13
1000@$1001
(sued 4/1/15)
Bought
1/1/13
1000@$1
2/1/13
1000@$1000
Sold
3/1/13
1000@$1002
5/1/13
1000@$1001
$1,000,000 vs. $1,000
¶6. Has the
Smolowe rule
produced errors in
any actual cases?
Chechele v. Vicis Capital (2012)
252 purchases, 81 sales
8/2009–10/2010
Smolowe rule: $34,967
Settlement: $30,000
Maximum possible profit: $35,361
¶7. Is there a
method that is
always accurate?
16(b) calculation reduces to
Linear Programming
(via the transportation problem)
Chin (1997)
Simplex Algorithm
(1947)
Karmarkar Algorithm
(1984)
¶7. Can it be made
easy and free for
public use?
unclaw.com/chin/16b
[with help from David Adler, Stephen Dew, Tim Kang, Kevin Valakuzhy]
Cf. Bennigson v. Huntsman (S.D.N.Y. 2013)
¶8. Is there any
mathematical
justification for
continuing to use
Smolowe in
simple cases?
Smolowe rule cannot be
used when:
• trades cover a period of
more than six months, OR
• some trades are outside
statute of limitations
Smolowe rule can be
used when:
• trades cover a period of
less than six months, AND
• no trades are outside
statute of limitations
Given:
Input F satisfies @pre
Prove:
(1) Loop Invariant LI is
true initially and
remains true after each
iteration;
(2) P is eventually false;
and
(3) when P is false,
@post is true.
CS207 blog @ Harvard
¶¶ 2-5. Why should
we care?
“The only rule whereby all possible
profits can be surely recovered is
that of lowest price in, highest price
out — within six months…”
Smolowe (1943)
“The only rule whereby all possible
profits can be surely recovered is
that of lowest price in, highest price
out — within six months…”
Smolowe (1943)
Judgment: $283,835
(common stock)
Smolowe: $337,599
(common stock)
LP: $337,800
(common stock)
Citations to Gratz as Authority for Smolowe Formula
Adler v. Klawans (>7 months)
Donoghue v. MIRACOR (>13 months)
Donoghue v. Casual Male (>10 months)
Heli-Coil v. Webster (>9 months)
Ark.-La. Gas v. W.R. Stephens (>13 months)
Gratz v. Claughton
“[T]he plaintiff has not appealed, so
that she is not entitled to any more
than she has recovered. On this
account we have not examined the
master’s computations in detail and
are not to be understood to have
passed upon them.”
- L. Hand
Smolowe rule cannot be
used when:
worstcase
error:
• trades cover a period of 50%
more than six months
• some trades are outside
100%
statute of limitations
Tamersoy et al. (2013)
12 million transactions by 370,000 insiders
0–6 months: 45% profitable
6–7 months: 70% profitable
$247,122,712 verdict (2003)
$1000 loan at 14.1%
Total of payments = $1078
Rule of 78
Jan
$12.00
Feb $11.00
Mar $10.00
Apr
9.00
May
8.00
Jun
7.00
Jul
6.00
Aug
5.00
Sep
4.00
Oct
3.00
Nov
2.00
Dec
1.00
$1000 loan at 14.1%
Total of payments = $1078
Amortization
Jan
$11.75
Feb $10.83
Mar
$9.90
Apr
8.96
May
8.01
Jun
7.05
Jul
6.08
Aug
5.10
Sep
4.10
Oct
3.09
Nov
2.07
Dec
1.04
unclaw.com/chin/16b