Opinion
Civil Action No. 00-CV-11649-RWZ.
March 8, 2002
MEMORANDUM OF DECISION
Plaintiffs represent a class of investors who purchased common stock of Defendant, Xcelera.com, Inc. ("Xcelera"), between April 1, 1999 and August 8, 2000 (the "Class Period"). The Consolidated Amended Class Action Complaint (the "Complaint") alleges three counts of federal securities violations under Section 10(b), 20(a) and 20A of the Securities Exchange Act, respectively, against Xcelera and its directors, Alex and Gustav Vic (the "individual defendants"). Defendants filed a motion to dismiss all claims, based on Plaintiffs' alleged failure to present facts sufficient to support viable causes of action. In deciding a motion to dismiss, the court must rely on the facts as they are set forth in the Complaint. See Scheuer v. Rhodes, 416 U.S. 232, 236 (1974) (district court must accept allegations in the complaint as true and make all reasonable inferences in favor of the plaintiff). They fall into the following three factual predicates.
I. Defendants' Obligation to Pay Kahnberget 32% of Mirror Image Equity
In 1998, Defendant Alexander Vik, Xcelera's Chairman and Chief Executive Officer, began discussions with Tryggwe Karlsten ("Karlsten"), an agent of Kahnberget Holding Ltd. and its subsidiary, JAM Investments Ltd. (Kahnberget/JAM"), about investing in Mirror Image Internet ("Mirror Image"). In January 1999, Xcelera entered into a 50%-50% joint venture with Kahnberget/JAM to acquire equal shares of Mirror Image. On March 29, 1999, Xcelera signed a Private Placement Agreement with Mirror Image to purchase 51% of its shares. Despite the joint agreement, Vik deleted any reference to Kahnberget/JAM, so that the Private Placement Agreement reflected Xcelera alone as the controlling shareholder of Mirror Image. Nevertheless, and contrary to the information reflected in the Private Placement Agreement, Kahnberget/JAM kept up its end of the joint venture and tendered $3.24 million for its share of Mirror Image to Defendants. That share was later determined to constitute 32.7% of Mirror Image.
In April 1999, Defendants announced that Xcelera had acquired a majority interest in Mirror Image. Plaintiffs allege, however, that Defendants failed to disclose the Kahnberget/JAM contribution of $3.24 million for the acquisition, and that it was therefore entitled to 50% of Xcelera's newly acquired Mirror Image stock. According to Plaintiffs, the alleged concealment of this third-party partial ownership of Mirror Image resulted in an inflated Xcelera share price during the class period.
II. The 60%-40% Private Placement Agreement Modification
Later in April, 1999, the parties modified the 50%-50% joint venture agreement to reflect a 60%-40% allocation of shares. Defendants were to provide 60% of the capital investment in Mirror Image and Kahnberget/Jam was to provide 40%, with the understanding that each party would receive a corresponding equity stake. In exchange for the modification, Defendants agreed to issue 219,000 shares of Xcelera stock to Kahnberget/Jam. These shares, however, were never delivered.
In August, 1999, Xcelera's Form 20-F Annual Report for the previous fiscal year became available. It referenced the monetary contribution from Kahnberget/JAM, and the 60%-40% joint venture agreement, but failed to mention the promise of shares to Kahnberget/JAM. The modified agreement was not made public knowledge until November 29, 2000, when Xcelera filed its Form 6-K with the SEC. As a result of stock splits since the 60%-40% agreement, the original 219,000 shares are now equivalent to approximately 5.2 million shares. The modified agreement, Plaintiffs argue, has therefore substantially diluted Xcelera shareholder equity.
III. FPHC Tax Status
Plaintiff's final allegation states that Xcelera failed to disclose the possibility that it would meet the stock ownership prong of the Foreign Personal Holding Company ("FPHC") rules. FPHC status subjects shareholders to special income tax liability. The Complaint, however, concedes that although the possible tax ramifications were concealed for over four months, they never did materialize. That is, the company was never classified as an FPHC and the shareholders were not subject to any FPHC tax liability, and thus suffered no damages. Absent damage to Xcelera shareholders from the concealment of a possible future tax liability issue, Plaintiffs cannot use the FPHC issue to support any of its federal securities claims. Therefore, the tax issue is extricated from all claims in this case and need not be addressed any further.
Pleading Requirements
In order to sufficiently allege securities fraud, Plaintiffs must comply with the pleadings standards of Fed.R.Civ.P. 9(b) ("Rule 9(b)"), as well as the Private Securities Litigation Reform Act ("PLSRA"), 15 U.S.C. § 78u-4. Rule 9(b) requires that the "circumstances constituting fraud . . . be stated with particularity." This means Plaintiffs must (1) specify statements that they contend are fraudulent; (2) identify the speaker; (3) state when and where the statements were made; and (4) explain why the statements were fraudulent. Suna v. Bailey Corp., 107 F.3d 64, 68 (1st Cir. 1997). The PLSRA heightens the Rule 9(b) standard by requiring that Plaintiffs also set forth "each statement alleged to have been misleading, the reason or reasons why the statement is misleading; and, if an allegation regarding the statement or omission is made on information and belief, [that] the complaint . . . state with particularity all facts on which that belief is formed." 15 U.S.C. § 78u-4(b)(1). To fulfill the scienter requirement, a complaint must "state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind." 15 U.S.C. § 78u-4(b)(2).
Plaintiffs' Borrowed Complaint
Defendants' first argument in support of dismissal is that Plaintiffs copied their complaint directly from an earlier one filed in New York by JAM, against Xcelera and the individual defendants, concerning the acquisition of Mirror Image shares. Therefore, they contend that the complaint in this case is nothing more than an "information and belief" pleading, inconsistent with the requirements of the PLSRA and Rule 9(b).
Although the duty to plead fraud with particularity is not satisfied by a generic claim that the pleading is based on "investigation of counsel," W.R. Carney v. Cambridge Tech. Partners, 135 F. Supp.2d 235, 247 (D.Mass. 2001), if the complaint provides a "general description of the personal sources of plaintiffs' beliefs," the pleading requirement is met. Fitzer v. Security Dynamics Techs., 119 F. Supp.2d 12, 22 (D.Mass. 2000). Unlike the situation in several of the cases relied on by Defendants, the Complaint at issue is not merely based on "bald assertions" and "general illusions." Nor is it "predicated on allegedly false statements in documents which they have not bothered to read." Garr v. U.S. Healthcare, Inc., 22 F.3d 1274 (3d Cir. 1994). Rather, Plaintiffs' 172 paragraph Complaint specifically sets forth a list of nine investigative sources, which Plaintiffs used to verify the contents of the earlier complaint. It continuously refers back to these sources to support each allegation. For example, paragraph 132 states that, according to the former senior sales development manager, the reason the Company had no revenue through the fiscal year ending January 31, 2000, was that it did not have a viable product. See Fitzer, 119 F. Supp.2d at 20 (complaint met particularity requirements only because specific positions of employee contacts were provided). Moreover, Plaintiffs identify and quote from supporting documentation to butress their allegations. See In re Boston Tech., Inc. Sec. Litig., 8 F. Supp.2d 43, 57-58 (D.Mass. 1998) (requiring that documents and internal reports be specifically identified). The specificity with which they continuously refer to press releases, annual reports, and agreements between Kahnberget/JAM and Xcelera, upon which the complaint is based, far surpasses mere "information and belief" pleading.
Count I, 10b-5 Violations
A. The 60%-40% Modification
Plaintiffs' dilution claim is based on Xcelera's alleged failure to disclose the 60%-40% modification and accompanying stock agreement to its shareholders during the class period. According to the Complaint, the original 219,000 Xcelera shares owed to Kahnberget/JAM under that agreement are now equivalent to approximately 5.2 million and constitute nearly 5% of Xcelera's value. Although this agreement was finalized on July 31, 2000, it was not disclosed until November 29, 2000. The transaction, according to Plaintiffs, effectively diluted all then-existing Xcelera shares.
Section 10(b) makes it unlawful for a person "[to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device." 15 U.S.C. § 78j(b). Rule 10b-5, promulgated thereunder, further prohibits "any untrue statement of a material fact" or omission of facts necessary to prevent other statements from being misleading. 17 C.F.R. § 240.10b-5 (1998). In order to support a 10b-5 claim, Plaintiffs must show that, in connection with a purchase or sale of a security, Defendants, with scienter, made a misrepresentation or omission of material fact, upon which the Plaintiffs relied to their detriment. Estate of James Soler v. Rodriguez, 63 F.3d 45, 53 (1st Cir. 1995). With respect to the dilution claim, Defendants argue that they had no duty to disclose the fact of the 60%-40% agreement to its shareholders during the class period.
The First Circuit recognizes a duty to disclose material facts when a corporation has made "a statement of material fact that is either false, inaccurate, incomplete, or misleading in light of the undisclosed information." Gross v. Summa Four, Inc., 93 F.3d 987, 992 (1st Cir. 1996). Defendants assert that the press releases and 1999 Form 20-F, neither of which mentioned the risk of dilution from the 60%-40% agreement, were not false or misleading because the agreement did not present any risk of dilution. They base their assertion on Plaintiffs' inability to point to any facts which support a finding that Xcelera was a party to the agreement. Rather, Defendants argue that Vik, himself, offered to sell Kahnberget/JAM a portion of his personal Xcelera shares. The Complaint does not support such an interpretation. It states, in relevant part:
61. In January 1999, Karlsten and Vik agreed to and entered into a joint venture agreement to attempt to acquire an equal share controlling interest in Mirror Image. It was agreed that Scandanavia Fund, Xcelera's predecessor company, would be used as a vehicle for the acquisition of Mirror Image from its parent company, Mirror Image AB. The deal was structured so that Scandinavia would issue 2.5 million new shares and exchange these for outstanding and issued shares of Mirror Image. Karlsten and Karlsten's family-controlled business would then purchase exactly one-half of the Scandinavia shares that Vik and Vik[sic] family-controlled business held.
63. In February 1999, Mirror Image AB . . . rejected Karlsten's and Vik's proposal. . . . Karlsten and Vik agreed that their family-controlled businesses would collectively purchase Mirror Image shares directly in a private placement so as to enable the family-controlled businesses to acquire a controlling interest in Mirror Image. The Mirror Image shares would be purchased in equal numbers by the Karlsten and Vik family-controlled businesses, and registered separately in their respective family-controlled businesses' names.
66. In March 1999, Vik continued to negotiate with Mirror Image and Mirror Image AB to acquire a controlling interest in Mirror Image. Vik continued to represent . . . that he was negotiating on behalf of his and Karlsten's family-controlled businesses.
70. Furthermore, in April 1999, Vik induced Karlsten to modify the previous 50%-50% joint venture agreement to a 60%-40% agreement in which Vik and Scandinavia would provide 60% of the capital investment and Karlsten 40%. In exchange for this modification, Vik agreed to issue to Kahnberget 219,000 shares of Scandinavia stock for the price of $3.00 per share. (emphasis added)
As reflected in the Complaint, Vik negotiated with Kahnberget/JAM on Scandinavia's (Xcelera's) behalf and agreed to give up 219,000 Xcelera shares. Read in the light most favorable to Plaintiffs, the Complaint sets forth facts sufficient to support a finding that this was not a private sale, but rather a transaction calling for the issuance of new shares of stock in a publicly held company. This inevitably affected the ownership interests of other shareholders. Therefore, on the face of the Complaint, Defendants did have a duty to notify Xcelera stockholders of the possible dilution effect from the 60%-40% agreement. Failure to reveal this information may have constituted a material omission that rendered Defendants' press releases and 1999 Form 20-F false or misleading.
B. Defendants' Obligation to Pay Kahnberget 32% of Mirror Image Equity
Plaintiffs allege that Defendants also misled the public with respect to Xcelera's obligation to pay for the 32% stake of newly-acquired Mirror Image shares. Defendants argue that this claim fails as a matter of law because (1) the allegedly omitted material information was timely disclosed, and (2) the information, even if omitted, did not render Xcelera's statements false or misleading.
The Complaint states that Xcelera's 1999 Annual Report misled its shareholders into believing that $3 million of the company's $5.95 million in Mirror Image had been advanced to the company by "affiliated entities." In fact, these "affiliated entities" were Kahnberget/JAM, who were entitled to a 50% ownership of the Mirror Image (later modified to a 40% ownership) shares. Xcelera's obligation was never disclosed as a liability or as constituting a risk of dilution until the August 4, 2000 Annual Report. Therefore, all shareholders who invested after the April 1999 Agreement, but before the August 4 disclosure, relying on explicit and implicit assurances of Xcelera's full ownership of the Mirror Image majority share, bought at an inflated price. Had shareholders been aware, Plaintiffs argue, that a third party was entitled to 50% ownership of the Mirror Image shares, and that Xcelera would have to issue its shares to cover this liability, a lower stock price would have resulted. These allegations permit the inference that Xcelera failed to timely disclose the potential material adverse impact of this liability.
In its April 1999 Annual Report, Xcelera claimed a "majority interest" in Mirror Image. It now argues that the Complaint does not sufficiently rebut that claim. This argument ignores the very basics of Plaintiffs' contentions. Whether or not Xcelera actually owned a majority share does not change the fact that it misled shareholders regarding its significant liability to Kahnberget/JAM resulting from the parties' joint venture agreement. This liability was not disclosed as a possible risk of dilution until the August 4, 2000 Annual Report. Therefore, the Complaint sets forth sufficient facts to support a claim of misrepresentation based on the April 1999 Annual Report. In addition, it continuously alleges that this misrepresentation was the proximate cause of their losing investment. See Miller v. New Am. High Income Fund, 755 F. Supp. 1099, 1107 (D.Mass. 1991). Although Plaintiffs' causation argument is fraught with holes and may not ultimately prevail on the merits, it is sufficient to withstand a motion to dismiss.
Count II, Section 20(a) Control Person Liability
The Complaint charges that Alexander and Gustav Vik are liable as controlling persons of the Company under section 20(a) of the Exchange Act. To state a claim for control person liability, Plaintiffs need only allege a primary violation of the federal securities law and "control" by the alleged controlling person. Gelfer v. Pegasystems, Inc., 96 F. Supp.2d 10, 15, n. 5 (D.Mass. 2000). As stated above, Plaintiffs have satisfied the first prong. They need not assert that the individual defendants actually participated in the underlying violation, Bray v. R.W.Tech., Inc., C.A. No. 88-0470-Z, 1990 WL 44084, at *1 (D.Mass.), or that they exercised their power by causing the acts or omissions upon which the underlying violation is predicated. In re Centennial Tech. Sec. Litig., 52 F. Supp.2d 178, 186 (D.Mass. 1999). Rather, Plaintiffs need only set forth facts which support a finding that the individual defendants exercised control over the company. See Id. As senior officers of Xcelera with a substantial voting ownership of company securities, access to internal documents and integral participation in the creation of the joint venture agreement between the company and Kahnberget/JAM, Alexander and Gustav Vik may well be subject to liability under Section 20(a) of the Exchange Act.
Count III, Section 20A Insider Trading
Section 20A provides a private right of action for individuals trading "contemporaneously" with an insider who is in possession of material non-public information. Colby v. Hologic, 817 F. Supp. 204, 216 (D.Mass. 1993). In support of their claim, Plaintiffs state that the individual defendants sold over 3.22 million shares of Xcelera common stock for about $250 million while in possession of material non-public information about Xcelera's ownership interest in Mirror Image. Although Defendants suggest that the shares sold only represent a small percentage of the company, which, if true, would support dismissal of the insider trading claim under prevailing case law, see e.g. In re Peritus Software Services Sec. Litig., 52 F. Supp.2d 211, 225 (D.Mass. 1999) (defendants' retention of 94%, 62%, and 75% of their stock holdings suggest that "sales were not unusual"), it is inappropriate on a motion to dismiss to dispute the facts as they are set forth in the Complaint.
Accordingly, Defendants' motion to dismiss is allowed as to all claims predicated on the tax issue, but denied as to the remainder of Counts I-III.