Second Circuit Upholds Effectiveness of Section 16 Beneficial Ownership Blockers

On July 7, 2026, the U.S. Court of Appeals for the Second Circuit confirmed the legitimacy of properly drafted contractual beneficial ownership “blockers” when it affirmed the district court’s dismissal of a disgorgement claim under Section 16(b) of the Securities Exchange Act of 1934 (the Exchange Act) brought by the bankruptcy successor of Bed Bath & Beyond Inc. (BBBY) against an investment fund and its manager (the Fund) that held BBBY warrants and convertible preferred stock. 

The Second Circuit’s decision provides reassurance that an investor may rely on a contractual beneficial ownership blocker, as long as it is adhered to by the parties in practice and not otherwise illusory, to avoid becoming subject to the disclosure and profit-disgorgement provisions of Section 16. The decision should be welcomed by private fund managers and others who use blockers when acquiring warrants, convertible preferred stock, or similar derivative instruments in the context of PIPE investments and other transactions.

10% Beneficial Ownership and Section 16 

An investor becomes subject to Section 16 if it beneficially owns more than 10% of an issuer’s outstanding voting equity securities registered as a class under Section 12 of the Exchange Act — for example, an issuer’s class of common stock listed on a U.S. securities exchange. Section 16(a) requires such an investor to disclose its holdings of and transactions in the issuer’s equity securities. More dramatically, Section 16(b) makes the investor liable to disgorge to the issuer any so-called “short-swing” trading profits the investor realizes from buying and selling the issuer’s equity securities within any six-month period while above the 10% beneficial ownership threshold. 

An investor’s beneficial ownership percentage for purposes of Section 16 is calculated in accordance with Section 13(d) of the Exchange Act and its related rules, which define beneficial ownership as the power to vote and/or dispose of a security. Rule 13d-3(d) is especially important in this regard. It generally states that in addition to the securities an investor beneficially owns outright, the investor is also “deemed” to beneficially own any securities over which it has a right to acquire beneficial ownership within the next 60 days.

Thus, if an investor holds an instrument granting the right to acquire an issuer’s common stock that is, or in the next 60 days will become exercisable or convertible, the investor currently beneficially owns the underlying common stock. It is possible that holding such an instrument, either on its own or together with common stock the investor already owns, will push the investor above 10% and into the coverage of Section 16. 

The Role of Blockers

An investor can eliminate that concern by ensuring that the instrument entitling the investor to acquire the issuer’s common stock contains a beneficial ownership “blocker” provision (sometimes called a “conversion cap”).

A blocker is a contractual agreement between the issuer and the holder of the instrument. It provides that notwithstanding the number of underlying common shares, the holder is not entitled to exercise or convert any portion of the instrument, and the issuer will not give effect to any purported exercise or conversion, to the extent that doing so would result in the holder exceeding 9.99% beneficial ownership of the outstanding common stock.  

Courts for some time have recognized beneficial ownership blockers as a permissible tool for avoiding Section 16. The Second Circuit’s seminal Levy decision held that “where a binding conversion cap denies an investor the right to acquire more than 10% of the underlying equity securities of an issuer, at any one time, the investor is not, by virtue of his or her ownership of convertible securities, the beneficial owner of more than 10% of those equity securities.” 

By the same token, courts may disregard a blocker that is “illusory.” Prior to the Second Circuit’s decision, however, there was limited judicial  guidance on how  an “illusory” determination should be made. The Second Circuit’s decision, with its emphasis on applying a three-factor test suggested by  Levy, provides a clearer framework to analyze whether a blocker is illusory. 

Background of the Litigation

Prior to its bankruptcy, BBBY sold the Fund warrants and convertible preferred stock underlain by large amounts of common stock. The documentation for those securities contained blocker clauses providing, among other things, that the holder had no right to engage in and BBBY would not give effect to an exercise or conversion to the extent it would cause the holder to exceed 9.99% beneficial ownership of the outstanding common stock; and that to the extent any exercise or conversion resulted in the holder exceeding the 9.99% cap, it would be deemed null and void and treated as if never made. In addition, each time it sought to exercise or convert, the holder was required to certify to BBBY that after giving effect to the exercise or conversion it would not beneficially own common stock in excess of the 9.99% limit. 

BBBY received a much-needed cash infusion by issuing the warrants and convertible preferred stock. The Fund, for its part, found the instruments alluring because they enabled the Fund to purchase heavily discounted common stock that could be resold promptly for a profit in the public market. The Fund did that repeatedly over a three-month period until BBBY filed for bankruptcy. 

Butterfly, as BBBY’s successor entity, sued the Fund in the Southern District of New York. Butterfly alleged that the blockers were illusory; that the Fund therefore had been a greater-than-10% beneficial owner at the time of its share sales; and that the Fund therefore was liable under Section 16(b) to disgorge to Butterfly some $310 million in alleged trading profits. The district court dismissed the complaint, finding that Butterfly did not sufficiently plead the blockers were illusory. 

The Second Circuit’s Decision

In affirming dismissal, the Second Circuit began by recognizing the basic purpose of a blocker: by “extinguishing” the right to acquire beneficial ownership above 10%, “blockers are designed to shield investors from Section 16(b).” As a result, “a comprehensive and legally binding blocker should generally insulate a defendant from Section 16 liability.” This meant the Fund could face Section 16(b) liability only if its blockers were, as Butterfly alleged, “illusory” rather than valid and binding. 

Blockers Were Not Illusory

The court pointed to Levy as suggesting a “commonsense” three-factor test for assessing whether a blocker is illusory and hence not viable: (1) whether the blocker is waivable by the investor in its sole discretion; (2) whether the blocker lacks a means of ensuring compliance; and (3) whether, as a practical reality, the investor has ever exceeded the blocker’s specified percentage beneficial ownership cap. The court found that the blockers at issue suffered from none of those potential defects. 

(1) No Unilateral Discretion to Waive

The court found that the warrant and preferred stock blockers were “solid contractual provisions, not phantom clauses that [the Fund] could quietly waive without BBBY’s consent.” The court emphasized that the simple fact that both parties theoretically could have agreed to waive or amend the blockers did not render them illusory, noting that “to hold otherwise would render virtually every clause of every contract a sham.” Rather, the question was whether the blockers gave the Fund a unilateral right to waive or eliminate them, which the court found they did not. 

(2) Means of Ensuring Compliance

Nor, in the Second Circuit’s view, did the blockers lack a means of ensuring compliance. The court referred to the blocker terms providing that any acquisition of common stock above the 9.99% limit would be automatically “null and void and treated as if never made.” The court also noted the Fund’s obligation to certify in connection with any planned exercise or conversion that it would not cause the Fund to exceed that limit. The Second Circuit was unmoved by Butterfly’s argument that BBBY had no way to police the Fund’s compliance with the cap, stating that it has “never found that a contractual clause is illusory simply because one party cannot actively audit the other’s compliance in real time.” 

(3) Cap Not Exceeded in Practice

Finally, the Second Circuit found that Butterfly did not plausibly allege the Fund ever exceeded the blockers’ 9.99% cap. In particular, the court rejected Butterfly’s contention that shares of common stock for which the Fund had executed intraday sales that had not yet settled should be counted as still beneficially owned by the Fund, finding instead that the Fund gave up  beneficial ownership of the shares at the time of execution. 

Nor Were the Blockers a “Plan or Scheme to Evade” under Rule 13d-3(b)

Butterfly also argued — in what the opinion characterized as “a last-ditch effort to invalidate the blockers” — that the Fund should be deemed the beneficial owner of all the common shares underlying the warrants and the preferred stock pursuant to Rule 13d-3(b) and thus be treated as a greater-than-10% beneficial owner at all relevant times. 

Rule 13d-3(b) provides that a person who uses any “contract, arrangement or device with the purpose or effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to avoid the reporting requirements” of Section 13(d) of the Exchange Act (and implicitly Section 16 in Butterfly’s telling) “shall be deemed … the beneficial owner of such security.”

The Second Circuit briskly rejected the idea that the blockers at issue were part of such a Rule 13d-3(b) plan or scheme to evade. The court stated that Butterfly was confusing plans or schemes “that conceal a defendant’s effective ownership with contractual provisions that prevent an investor from owning a security in the first place.”

Takeaways

The Second Circuit’s decision confirms that a properly drafted contractual blocker is generally effective to shield an investor from the coverage of Section 16. It also articulates specific criteria to assess whether a Section 16(b) claim challenging a blocker on illusoriness grounds can survive a motion to dismiss. 

Investors using blocker clauses should ensure that they: (1) cannot be unilaterally waived or amended; (2) contain effective enforcement mechanisms, including self-executing provisions stating that a purported exercise or conversion resulting in beneficial ownership above the specified cap is automatically null and void; and (3) are adhered to by the parties in practice.