Enforceable 9.99% “Blockers” Defeat Section 16(b) Short-Swing Liability Absent Plausible Allegations of Sham, Waivability-in-Sole-Discretion, or Real-World Cap Breach

1. Introduction

In 20230930-DK-Butterfly-1, Inc. v. HBC Invs. LLC (2d Cir. July 7, 2026), the Court of Appeals for the Second Circuit addressed—explicitly as an issue of first impression in the Circuit—whether “blocker” provisions in derivative instruments (conversion caps preventing ownership from exceeding 9.99%) can preclude “beneficial owner” status for purposes of Section 16(b) of the Securities Exchange Act of 1934, and thus defeat strict-liability disgorgement of alleged short-swing profits.

The plaintiff, 20230930-DK-Butterfly-1, Inc. (“Butterfly”), is the post-bankruptcy successor to Bed Bath & Beyond Inc. (“BBBY”). Defendants HBC Investments LLC and Hudson Bay Capital Management LP (collectively, “Hudson Bay”) had purchased BBBY-issued derivatives (convertible preferred stock and warrants) shortly before BBBY’s bankruptcy, then traded in and out of BBBY common stock for substantial profits.

The central dispute was whether the derivatives’ contractual “blockers” were (i) illusory/sham (so Hudson Bay still had the “right to acquire” >10% beneficial ownership) or (ii) part of an evasion scheme triggering recharacterization under SEC Rule 13d-3(b). The district court (S.D.N.Y., Vyskocil, J.) dismissed the complaint, and the Second Circuit affirmed.

2. Summary of the Opinion

The Second Circuit held that effective, binding conversion caps (“blockers”) that prevent an investor from ever obtaining more than 9.99% beneficial ownership at any one time generally shield the investor from Section 16(b) liability. To survive a motion to dismiss, a plaintiff must plausibly allege that such blockers were actually defective in operation—e.g., waivable by the investor in its sole discretion, lacking enforcement mechanisms, or ignored in practice such that the cap was exceeded.

The Court rejected Butterfly’s theories that (a) blockers become “illusory” simply because contracts can be amended by mutual agreement; (b) compliance mechanisms are inadequate merely because the issuer cannot audit in real time; (c) beneficial ownership can be computed by including shares already sold but not yet settled; and (d) a side letter converted otherwise valid blockers into an evasion device under Rule 13d-3(b).

3. Analysis

3.1. Precedents Cited

  • Knapp v. Barclays PLC, 171 F.4th 166 (2d Cir. 2026): Provided the de novo standard of review for Rule 12(b)(6) dismissals; the panel applied this framework to assess plausibility and inferences in Butterfly’s favor.
  • Ashcroft v. Iqbal, 556 U.S. 662 (2009): Supplied the plausibility standard; Butterfly needed factual allegations making “illusory blocker” or “evasion scheme” plausible—not speculative.
  • Magma Power Co. v. Dow Chem. Co., 136 F.3d 316 (2d Cir. 1998): Reinforced Section 16(b) as a “blunt instrument” imposing strict liability to remove temptation for insider trading; the Court used this to frame the statute’s purpose while still insisting on its defined limits.
  • Levy v. Southbrook Int'l Invs., Ltd., 263 F.3d 10 (2d Cir. 2001): The opinion’s doctrinal anchor. Levy recognized “blockers” as devices that can deny an investor the right to acquire >10% at any one time and emphasized that beneficial ownership is determined “at any one time, not cumulatively.” The Court treated Levy as identifying practical indicators of when blockers might be disregarded as sham/illusory.
  • Roth v. Solus Alternative Asset Mgmt. LP, 124 F. Supp. 3d 315 (S.D.N.Y. 2015): Cited to define common market terminology (“blocker”/“conversion cap”) and to situate the contractual practice in Section 16(b) litigation.
  • Lend Lease (US) Const. LMB v. Zurich Am. Ins. Co., 28 N.Y.3d 675 (2017): Used for the contract-law concept of “illusory” promises—i.e., a promise so insubstantial it imposes no obligation—supporting the Court’s rejection of the notion that ordinary amendability makes a term illusory.
  • Avalon Holdings Corp. v. Gentile, 597 F. Supp. 3d 640 (S.D.N.Y. 2022): Cited for the principle that Section 16(b) analysis focuses on the moment of the trading decision rather than settlement technicalities; used to reject Butterfly’s attempt to count shares already sold but still “sitting” in an account.
  • Bershad v. McDonough, 428 F.2d 693 (7th Cir. 1970): Quoted in Levy (and discussed here) for substance-over-form concerns aimed at shell/proxy disguises of effective ownership—not for a general license to ignore unambiguous contract text absent allegations of sham.
  • Foremost-McKesson, Inc. v. Provident Sec. Co., 423 U.S. 232 (1976): Provided the Supreme Court’s instruction that Section 16(b) imposes “liability without fault” only “within its narrowly drawn limits,” supporting the Second Circuit’s reluctance to expand liability beyond the statutory and regulatory definitions.
  • Gollust v. Mendell, 501 U.S. 115 (1991): Invoked for the Supreme Court’s warning against exceeding a “literal, mechanical application” when determining who is subject to Section 16(b), reinforcing the Court’s focus on the contractual text defining the “right to acquire” beneficial ownership.
  • CSX Corp. v. Children's Investment Fund Management (UK) LLP, 654 F.3d 276 (2d Cir. 2011): Particularly Judge Winter’s concurrence, used to delineate when Rule 13d-3(b) applies—i.e., to schemes that conceal or ensure vesting of ownership at the would-be owner’s signal, reflecting “substantial equivalence” to ownership.
  • Reliance Elec. Co. v. Emerson Elec. Co., 404 U.S. 418 (1972): Critical Supreme Court authority that investors may structure transactions with the intent of avoiding Section 16(b) liability, so long as they do so within the law—supporting the legitimacy of bona fide blockers.

3.2. Legal Reasoning

A. The statutory/regulatory trigger: “beneficial owner” >10%, including a “right to acquire”

The Court began with the core Section 16(b) framework: strict disgorgement applies to directors, officers, and “beneficial owner[s] of more than ten percent” of a class of equity security. Importantly, the SEC’s beneficial ownership rules include not only present ownership but also the right to acquire beneficial ownership (e.g., via options, warrants, convertibles). The Court treated the “right to acquire” as the key hinge for derivatives.

B. Blockers work by extinguishing the “right to acquire” above the threshold at any one time

The Court accepted the basic legality of blockers: if a contract denies the investor the ability to cross 10% at any one time, then the investor lacks the “right to acquire” above 10% and thus avoids Section 16(b) insider status for short-swing purposes. This tracks Levy v. Southbrook Int'l Invs., Ltd. and its emphasis that beneficial ownership is measured at a point in time, not cumulatively.

C. When courts may disregard blockers: “sham” or “illusory” caps

While recognizing a “dearth” of caselaw on sham/illusory blockers, the Court treated Levy as pointing to three practical indicators:

  1. Sole-discretion waivability: Is the cap waivable by the investor “in its sole discretion”? If yes, the cap may be a façade.
  2. Compliance mechanisms: Does the cap lack “a means of ensuring compliance”?
  3. Adherence in practice: Did the investor ever exceed the cap as a practical reality?

Applying those considerations, the Court found Hudson Bay’s blockers not illusory:

  • Not unilaterally waivable: Butterfly’s argument that the cap was illusory because contracts can be amended “like any other contract” failed. The Court reasoned that bilateral amendability is a universal feature of contracts and cannot itself render a term illusory; Levy’s concern is unilateral, sole-discretion waiver.
  • Self-executing enforcement: The blockers made any conversion/exercise “null and void” to the extent it would exceed 9.99%, and stripped voting/transfer power for any excess issuance. The Court treated this as an internal contractual mechanism preventing above-threshold acquisition.
  • Certifications: Hudson Bay had to certify compliance each time it sought conversion/exercise, reinforcing the cap’s operational seriousness.
  • No plausible cap breach alleged: The complaint, including attached trading records, did not plausibly allege Hudson Bay actually exceeded 10% beneficial ownership.

D. Rejecting “settlement-based” beneficial ownership inflation

Butterfly attempted to compute beneficial ownership by counting shares Hudson Bay had already agreed to sell but that had not yet fully transferred, producing a momentary snapshot above 10%. The Court rejected this approach because beneficial ownership turns on “investment power” to dispose; once sold, Hudson Bay lacked power to dispose of those shares even if they were still in its account during settlement mechanics. The Court relied on the regulatory definition and cited Avalon Holdings Corp. v. Gentile for focusing on the trading decision moment rather than transfer technicalities.

E. Text versus “substance”: the Court’s constrained role under Section 16(b)

Butterfly urged a broad “substance over form” inquiry, relying on dicta in Levy’s footnote referencing Bershad v. McDonough. The Court narrowed that concept: it is aimed at disguises of effective ownership (shells, proxies), not an invitation to disregard clear contractual limits absent plausible allegations that the parties ignored the contract or that the cap failed in practice.

The Court tied this restraint to Supreme Court guidance in Foremost-McKesson, Inc. v. Provident Sec. Co. and Gollust v. Mendell that Section 16(b) liability is strict but bounded—courts should not expand insider categories beyond statutory and regulatory limits.

F. Rule 13d-3(b): evasion schemes versus bona fide limitations on ownership

Butterfly’s fallback was SEC Rule 13d-3(b), arguing the blockers were part of a scheme to evade reporting obligations, requiring Hudson Bay to be treated as a beneficial owner anyway. The Court rejected this by drawing a sharp line:

  • Permissible avoidance: Investors may structure transactions to avoid Section 16(b) liability (Reliance Elec. Co. v. Emerson Elec. Co.), and the Second Circuit has “blessed the use of effective blockers” (Levy v. Southbrook Int'l Invs., Ltd.).
  • Impermissible evasion: Rule 13d-3(b) targets arrangements that stop short of, or conceal, vesting of ownership while ensuring ownership will vest at the would-be owner’s signal—i.e., “substantial equivalence” of ownership (CSX Corp. v. Children's Investment Fund Management (UK) LLP (Winter, J., concurring)).

The Court found no plausible allegation that Hudson Bay had the “substantial equivalence” of beneficial ownership above 9.99% or that the Side Letter secretly superseded the public offering documents. To the contrary, the Side Letter expressly required honoring exercises/conversions “in accordance with the terms” of the public-offering documents and expressly preserved (did not supersede) them. Accordingly, Rule 13d-3(b) did not recharacterize Hudson Bay’s position.

3.3. Impact

The decision meaningfully clarifies (in the Second Circuit) how Section 16(b) interacts with common capital-markets documentation for convertibles and warrants:

  • Strong validation of competently drafted blockers: Well-structured, self-executing 9.99% caps that are not unilaterally waivable and that are adhered to in practice will typically defeat “right to acquire” arguments under Section 16(b).
  • Pleading burden for plaintiffs: Plaintiffs challenging blockers must plead concrete facts showing failure in operation (actual cap breaches, unilateral waiver rights, or other sham indicators), not merely theoretical possibilities (e.g., that parties could amend contracts).
  • Reduced traction for settlement/holding-account “snapshots”: Attempts to inflate beneficial ownership using post-sale settlement mechanics face a substantial headwind where “investment power” has been relinquished.
  • Rule 13d-3(b) confined to true concealment schemes: The Court’s distinction between “preventing ownership from arising” (permitted) and “concealing de facto ownership” (prohibited) will influence how litigants frame reporting-evasion and synthetic-ownership theories.

Practically, the opinion may encourage issuers and investors to continue using blockers in PIPEs, distressed financings, and structured equity products—while also incentivizing more explicit anti-waiver language, self-executing nullification, and compliance certifications to reduce litigation risk.

4. Complex Concepts Simplified

  • Section 16(b) “short-swing profits”: If a covered insider buys and sells (or sells and buys) the issuer’s equity within six months, profits are disgorged to the issuer—without needing to prove intent or actual insider trading.
  • “Beneficial ownership”: Not just record title; it includes having the power to vote or dispose of securities, and (via SEC rules) having the right to acquire them (e.g., through warrants/convertibles).
  • “Right to acquire”: If your contract lets you convert/exercise into shares, regulators may treat you as owning those shares for threshold purposes—unless the contract meaningfully prevents you from crossing a specified cap.
  • “Blocker” / “conversion cap”: A contractual term preventing conversion/exercise to the extent it would cause ownership to exceed a limit (commonly 9.99% to stay below 10%).
  • “Illusory” term: A supposed contract commitment that, in reality, imposes no real constraint—often because it can be unilaterally ignored or lacks operative effect.
  • Rule 13d-3(b) “evasion scheme”: A rule that can treat someone as a beneficial owner if they use contracts or devices to hide or prevent formal vesting while retaining de facto ownership/control—aimed at concealment, not bona fide structural limits.

5. Conclusion

20230930-DK-Butterfly-1, Inc. v. HBC Invs. LLC establishes a clear Second Circuit roadmap: facially unambiguous, self-executing blockers that genuinely prevent crossing 10% at any one time will ordinarily defeat Section 16(b) short-swing liability. Courts will not treat such caps as “sham” based on conjecture about hypothetical amendments or imperfect real-time monitoring; plaintiffs must plausibly allege that the cap was unilaterally waivable, unenforced in design, or actually breached in practice. Finally, Rule 13d-3(b) remains targeted at concealment schemes conferring the substantial equivalence of ownership—not at legitimate contractual limitations that prevent ownership from arising in the first place.