In Steginsky v. Xcelera Inc., Nos. 13-1327-cv, 13-1892-cv, 2014 WL 274419 (2d Cir. Jan. 27, 2014), the United States Court of Appeals for the Second Circuit held that even when a company’s securities are unregistered, federal law requires corporate insiders either to disclose material nonpublic information or abstain from trading in those securities.  The Court also held that the “fiduciary-like” duty to refrain from insider trading under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78j(b), is imposed and defined by federal common law, not common law of the state (or here, country) of incorporation.  This decision marks the first time that the Second Circuit has explicitly announced that the duty against insider trading is rooted in federal common law, and it leaves no question that federal laws prohibiting insider trading apply even to securities that are unregistered.

The case arises out of an alleged scheme by corporate insiders to depress a company’s stock price in connection with a buy out of minority shareholders.  Defendant Xcelera Inc. (“Xcelera”) is a Cayman Islands conglomerate of technology companies based in Connecticut.  It is controlled by two brothers, Alexander and Gustav Vik, and VBI Corporation, a Vik family company and Xcelera’s majority shareholder (collectively, the “Vik Defendants”).  During the “dotcom” bubble, Xcelera common stock reached a high of $110 a share on the American Stock Exchange.  By 2004, however, the stock price plummeted to around $1 a share and, following the delisting of Xcelera’s stock by the American Stock Exchange that same year, the company’s stock price dropped to around $0.25 a share.  Two years later, the Securities & Exchange Commission revoked the registration of Xcelera securities.

In 2010, defendant OFC Ltd. (“OFC”), a company created by the Vik Defendants, made a tender offer for Xcelera stock at $0.25 a share.  No information about Xcelera’s financial state was provided in connection with the tender offer.  A year later, plaintiff, at the time a minority shareholder of Xcelera, sold her 100,010 shares at $0.25 through the tender offer.

Plaintiff filed a complaint in the United States District Court for the District of Connecticut alleging, among other things, claims for insider trading in violation of the Exchange Act.  The complaint alleged that the defendants were corporate insiders who possessed nonpublic information that Xcelera was in fact worth more than $0.25 a share.  The district court dismissed the complaint on the ground that the defendants had no duty to disclose any information before trading in Xcelera stock because (1) the duty to disclose under Section 10(b) does not apply to unregistered securities and (2) the duties potentially applicable here were those defined by the law of the Cayman Islands, where no such duty to disclose exists.  Plaintiff appealed.

The Second Circuit reversed on both counts.  First, the Court held that the defendants did owe a duty to disclose or abstain from trading because Section 10(b) applies to “any security registered on a national securities exchange orany security not so registered.”  In so holding, the Court relied upon a prior case in which it held that “closed corporations that purchase their own stock have a special obligation to disclose to sellers all material information.”  See Castellano v. Young & Rubicam, Inc., 257 F.3d 171, 179 (2d Cir. 2001).

Second, the Court held that this “fiduciary-like” duty is imposed and defined by federal common law, not the law of the Cayman Islands.  Steginsky marks the first time the Second Circuit has explicitly announced that this duty is rooted in federal common law.

Steginsky did reject the notion that federal law imposes a general affirmative duty on corporate insiders to disclose material nonpublic information.  The Court held that although the defendants owed no such general affirmative duty of disclosure once the SEC deregistered Xcelera’s stock, insiders still could not trade in the company’s stock while in possession of material nonpublic information.  The Court observed that, under the Exchange Act, “any insider ‘in possession of material inside information must either disclose it to the investing public, or, if . . . he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.’”  In reiterating that the duty against insider trading under Section 10(b) applies to unregistered securities, the Steginsky decision leaves no question that federal laws prohibiting insider trading apply whether or not securities are registered, including in the context of a tender offer of unregistered securities.

Given differences in state law governing corporate fiduciary duties, it is not always easy to determine when the duty to disclose material nonpublic information or abstain from trading begins and ends.  As the Second Circuit notes in Steginsky, “looking to idiosyncratic differences in state law would thwart the goal of promoting national uniformity in securities markets.”  The clear pronouncement from the Second Circuit is that the duty either to disclose or abstain from trading is derived from federal common law and is not strictly dependent upon the laws of the state (or foreign country) of incorporation.