Federal Common Law Governs Insider Duties Under §10(b)

, New York Law Journal

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Sarah S. Gold and Richard Spinogatti
Sarah S. Gold and Richard Spinogatti

'Most people are free to buy and sell stock on the bases of valuable private knowledge without informing their trading partners. Strangers transact in markets all the time using private information that might be called 'material' and, unless one has a duty to disclose, both may keep their counsel." Jordan v. Duff and Phelps, 815 F.2d 429, 435 (7th Cir. 1987), citing Dirks v. SEC, 463 U.S. 646, 653-54 (1983) and Chiarella v. United States, 445 U.S. 222, 227-35 (1980) (emphasis added). However, the Supreme Court made clear in Chiarella that an insider must either disclose material non-public information or refrain from trading in the stock and that the duty to disclose or abstain may arise from "a fiduciary or other similar relation of trust and confidence." 445 U.S. at 228.

As Justice Felix Frankfurter remarked in S.E.C. v. Chenery, 318 U.S. 80, 85-86 (1943), "[t]o say that a man is a fiduciary only begins the analysis; it gives direction to further inquiry. To whom is he a fiduciary? What obligations does he owe as a fiduciary? In what respect has he failed to discharge those obligations? And what are the consequences of his deviation from duty." Accordingly, there is a "need for clarity as to what duty is involved and what its requirements are." United States v. Whitman, 904 F.Supp.2d 363, 368 (S.D.N.Y. 2012) (Rakoff, J.)

In several recent New York cases, litigants seeking to avoid Section 10(b) liability for insider trading have raised the issue of the source of the corporate insider's fiduciary-like duty to disclose or abstain from trading, by arguing that state or foreign fiduciary duty law would not support liability in particular cases. Although generally, corporate fiduciary duties are the province of state law, as noted by Judge Jed S. Rakoff in Whitman, a recent criminal insider trading case: "[a]ll the Supreme Court cases dealing with insider trading have implicitly assumed that the relevant fiduciary duty is a matter of federal common law for they have described it and defined it without ever referencing state law." Id. 904 F. at 369. Now, the U.S. Court of Appeals for the Second Circuit has put the question to rest in this circuit, holding explicitly for the first time that the duty of corporate insiders to either disclose material non-public information or to abstain from trading is defined by federal common law and applies to registered and unregistered securities alike (pursuant to the explicit language of Section 10(b)). Steginsky v. Xcelera, 2014 WL 274419 (2d Cir. 2014) (Walker, J.).

The District Court Decision

In February 2012, a former minority shareholder of Xcelera, Gloria Steginsky, sued in federal court in Connecticut, alleging that corporate insiders, acting secretly through a shell corporation, had purchased her Xcelera stock in a tender offer in 2010. Steginsky alleged, among other things, violations of Section 10(b) because the insiders had traded while in possession of material non-public information and had manipulated the market for Xcelera stock by failing to comply with Securities and Exchange Commission reporting requirements and thereby causing the stock, of which they were the majority holders, to be delisted by the American Stock Exchange in 2004 and deregistered by the SEC in 2006. It was alleged that defendants' failure to comply with their reporting obligations was the first step in a scheme to buy back minority shares at depressed prices, which defendants allegedly did, both in individual instances and through the 2010 tender offer. The stock price, which had traded at a high of $110 a share in 2000 but had fallen to around $1 by 2004, declined further to 25 cents at the time the stock was delisted.

The manipulation claim had a lengthy history, prior to the filing of the Steginsky lawsuit, having been the subject matter of years of litigation in the Southern District of New York, brought by another minority stockholder, the Feiner Family Trust, which was represented by the same counsel as Steginsky. By the time the Feiner litigation finally ended in late 2010, there had been a total of six complaints either amended, withdrawn, or dismissed. One decision by Judge Robert Patterson in the Southern District of New York, dismissing a manipulation claim in one of the Feiner complaints predicated upon the same scheme theory as Steginsky, was appealed to, and was affirmed by, the Second Circuit. Feiner Family Trust v. Xcelera Com., 2008 WL 5233605 (S.D.N.Y. 2008) (Patterson, J.), aff'd 352 Fed. Appx. 461 (2d Cir. 2009).

In affirming dismissal of the Feiner complaint, the Second Circuit held that plaintiff had failed to plead with particularity facts giving rise to a strong inference of scienter. The court observed that an alternative "and more cogent" inference of scienter to Feiner's urged manipulation scheme was that defendants decided that the costs of regulatory compliance were too high for a company with declining stock prices and low trading volume. In reaching its conclusion, the Second Circuit expressly noted that the record was "devoid of particular facts that indicated that defendants actively encourage minority shareholders to sell their stock back to Xcelera" and specifically mentioned the absence of "any allegation of a 'going private' transaction, tender offer or scheme to take advantage of depressed share prices." Id. at 463-64.

Oddly, within months of final dismissal of the last Feiner complaint, the defendants, through a shell corporation, launched the tender offer for the remaining shares of Xcelera, in which plaintiff Steginsky sold her shares. In the Steginsky case, the district court dismissed the complaint. 2013 WL 1087635 (D. Conn. 2013 (Underhill, J.) With respect to the insider trading claim, the district court held that the defendants had no duty to disclose any information before trading in Xcelera shares because the duty to disclose does not apply to the sale of unregistered stock and because the duty is defined by Cayman Island law, the place of Xcelera's incorporation, under which law no such disclosure duty exists.

With respect to the manipulation claim, the district court found that Steginsky had not sufficiently pleaded scienter. While acknowledging the Second Circuit's 2009 Feiner decision and its observation about the absence in the record of any affirmative steps taken by defendants to repurchase the shareholders' stock, such as a tender offer, the district court in Steginsky found the additional fact of the 2010 tender offer did not "shore up" the manipulation claim's deficiencies, including the six-year gap between the alleged original market manipulation and the tender offer. The court found the complaint still "defies economic reason" because there was no explanation of how the defendants knew in 2004 that Xcelera "would rebound" or that the tender offer resulted in "a windfall" to defendants that offset the initial substantial economic loss of about $225 million in stock value from the defendants' allegedly intentional acts causing the stock decline.

The Second Circuit Decision

On appeal, the Second Circuit reversed dismissal of the insider trading claim. Adopting Rakoff's analysis of a federal common law duty to disclose in Whitman, the court observed that "looking to idiosyncratic differences in state law would thwart the goal of promoting national uniformity in securities markets." The court noted that defendants "erroneously suggest" that such a duty would federalize an affirmative duty to disclose audited financials in private stock sales of small businesses incorporated under the laws of a myriad of states and countries, when in fact defendants had no general affirmative duty to disclose after Xcelera's deregistration but rather had a choice to either disclose or to abstain from trading while in possession of material non-public information.1

However, as one commentator has observed, "[p]ersons subject to the disclose or abstain theory often are also subject to a duty of confidentiality, which precludes them from disclosing the information. As to them, the insider trading prohibition thus becomes a rule to abstain from trading, rather than a rule requiring disclosure or abstention." Bainbridge, Stephen M., "Incorporating State Law Fiduciary Duties Into The Federal Insider Trading Prohibition," 52 Wash. & Lee L. Kev. 1189, 1203 (1995).

In responding to other arguments made by defendants, the court found that it was unnecessary for plaintiff to show that corporate insiders used the non-public information, only that they traded their corporate securities while in possession of it, and that the Supreme Court in Basic v. Levinson had dispensed with the requirement of reliance upon breach of the duty to disclose "concluding that the necessary nexus between the plaintiffs' injury and the defendants' wrongful conduct has been established." 485 U.S. 224, 243 (1988).

With respect to the manipulation claim, the Second Circuit observed that the scheme "remains somewhat implausible due to the six-year gap between the alleged decision to depress the stock in 2004 and the effort to repurchase stock in 2010," but found it unnecessary to determine the issue of scienter. Instead, citing the appellate rule permitting affirmance on any ground for which there is a sufficient record, the court found the manipulation claim to be barred by the statute of limitations requiring the claim to be filed "not later than the earlier of" two years after discovery of the facts constituting the violation or five years after the violation. 28 U.S.C. §1658 (emphasis in original).

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