Second Circuit: Insider Trading Duty is Federal Common Law

The Second Circuit Court of Appeals concluded that an Exchange Act Section 10(b) claim for insider trading in a private damage action is based on federal law and applies to the purchase of shares of a delisted company by corporate insiders. In reaching this conclusion the Court relied on the classic theory of insider trading, finding the misappropriation theory inapplicable. Steginsky v. Xcelera, Inc., Nos. 13-1327-cv; 13-1892-cv (2nd Cir. Jan. 27, 2014).

Plaintiff Gloria Steginsky is a former minority shareholder of Xcelera Inc., a Cayman Islands holding corporation based in Connecticut. Each of the individual defendants is an officer and or director of Xcelera: Alexander Vik, is COB and CEO; Gustav Vik, Director, EVP, secretary and treasurer; and Hans Erik Olav is a director. The two corporate defendants are controlled by the Vik defendants. VBI Corporation, owned by Alexander Vik and Erik Vik (Gustav’s father) is the controlling shareholder of the firm. OFC Ltd. was created in 2010 by the Vik defendants as a vehicle to acquire the share of Xcelera.

The complaint alleges that the shares of Xcelera were at one time listed on the American Stock Exchange. In 2000 the shares traded at prices as high as $110 per share. In 2004 when the price plummeted the Vik defendants began refusing to make the required periodic filings with the SEC. Since 2005 the defendants have not disclosed any information regarding the company. The next year the Commission revoked the registration of the firm. The share price dropped to $0.25.

Subsequently, investors were told they could sell their shares back to the company. In December 2010 OFC made a tender offer for Xcelera shares at $0.25 per share. While the offer was made by Olav, the complaint clams that it was orchestrated by the Vik defendants. In April 2011 plaintiff sold her 100,100 shares of Xcelera common stock to OFC.

Plaintiff filed a complaint alleging a series of claims including violations of Exchange Act Sections 10(b) and 14(e). The district court dismissed the complaint.

The Second Circuit affirmed the dismissal of a market manipulation and Section 14(e) claims while vacating the dismissal of the insider trading claim under Section 10(b).

First, the market manipulation claim is time barred the Court ruled. A securities fraud claim must be filed not later that the earlier of either two years after discovery of facts constituting the violation or five years after that violation. Here the alleged manipulation was the failure to make SEC filings which caused the price to plummet. That began in 2004, more than five years before the complaint was filed.

Second, plaintiffs can assert a claim for insider trading under Section 10(b). Under the classic theory of insider trading Section 10(b) is violated when a corporate insider trades in the securities of his or her company on the basis of material, nonpublic information. To establish such a claim it is not necessary to demonstrate that the insiders used the nonpublic information. Rather, it is sufficient to prove that the person traded while knowingly in passion of it. Likewise, the plaintiff need not prove reliance where, as here, the necessary nexus between plaintiffs’ injury and the wrongful conduct is established by the breach of a duty to disclose.

The complaint in this action alleges that the defendants, while in control of the company, purchased the shares without disclosing any information about the firm. That is adequate under the classic theory – the misappropriation theory, which “targets non-insiders, is not applicable here.”

The district court’s conclusion that the defendants had no duty to disclose under the circumstances here because the shares are not registered and Cayman Island law governs the company is incorrect. The “duty of corporate insiders to abstain from trading or to disclose material inside information applies to unregistered securities . . .” since Section 10(b) by its plain terms applies to “any security registered on a national securities exchange or any security not so registered.” (emphasis original).

Furthermore, the duty of insiders is derived from federal common law, not state law. The Court held that while it had not previously identified the source of the “the fiduciary-like duty against insider trading under section 10(b) . . . [it is] defined by federal common law, not the law of the Cayman Islands.” Thus here, while the defendants had no general affirmative duty to disclose once Xcelera was deregistered by the SEC, “they could not trade in Xcelera shares based on undisclosed material inside information that they possessed.”

Finally, the Court affirmed the dismissal of the Section 14(e) claim. That Section and the related rule provide that if any person has taken substantial steps toward a tender offer it is unlawful for another person who is in possession of inside information relating to the tender offer to trade. In this instance, however, the complaint alleges that not that someone possessed inside information about the tender offer but that the offer itself was made by corporate insiders who possessed material nonpublic information. Accordingly, the Court remanded the Section 10(b) claim to the district court.

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