In view of the high potential exposure in US litigation, it is important that global companies and their insurers understand the extraterritorial reach of US laws. Despite the US Supreme Court’s 2010 ruling in Morrison v. National Australia Bank limiting the application of US securities laws to foreign transactions, shareholders continue to file record numbers of US securities class actions. against companies based outside of the US. We discuss below some of the recent court decisions applying Morrison in different factual scenarios and clarifying further the exterritorial reach of US securities laws under the second prong of its transactional test.
The Morrison decision limited the ability of shareholders who purchased shares in a company based outside of the US to file securities actions against the company and its directors and officers (“D&Os”) in US courts. Morrison rejected the prior “conduct and effects test,” which considered whether the alleged conduct occurred in the US or whether conduct occurring overseas had a substantial effect in the US. Instead, the Court created a two-part “transactional test” intended to provide more certainty and consistency regarding the extraterritorial reach of US securities laws. Specifically, Morrison held that §10(b) of the Securities and Exchange Act of 1934 (the “Exchange Act”) only applies to (i) “transactions in securities listed on domestic exchanges” and (ii) “domestic transactions in other securities.” With respect to securities not listed on a domestic exchange, the Court found that the exclusive focus should be on domestic purchases and sales.
While Morrison was generally viewed as favorable for defendants, it did not end US securities lawsuits against foreign companies and likely contributed to an increase in litigation in other countries. By limiting access to US courts, Morrison encouraged investors blocked from US courts to develop and pursue class or collective actions in new jurisdictions. At the same time, in the years after Morrison, purchasers of American Depository Receipts (“ADRs”) of companies based outside of the US have filed high numbers of US securities class actions. In 2016, shareholders filed 42 new securities class actions against foreign issuers, which is well-above the annual average number of filings against foreign companies prior to Morrison.
Morrison also did not limit the rising number of US regulatory investigations and actions against foreign companies and their D&Os. Within a month after the Supreme Court issued its decision in Morrison, the US Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”). Pursuant to Section 929P of Dodd Frank, the broad conduct and effects test applies to determine jurisdiction in actions brought by the Securities and Exchange Commission (the “SEC”) or the Department of Justice (the “DOJ”) under the antifraud provisions of the Exchange Act, the Securities Act of 1933 and the Investment Advisers Act. Accordingly, the SEC and DOJ have asserted that Dodd Frank essentially overruled Morrison with respect to their regulatory and criminal actions, and they have continued to aggressively pursue investigations and actions against foreign companies and their D&Os around the world.1 Since Morrison, appellate and district courts have provided further guidance regarding when shareholders may bring securities fraud claims against foreign companies and their D&Os in the US. Pursuant to the first prong of the Morrison test, courts have consistently allowed shareholder claims under US securities laws against foreign companies that listed securities on one of the US registered securities exchanges. Determining whether US securities laws apply to transactions in securities that are not listed on a US exchange has been more challenging. A consensus has emerged, however, that under Morrison’s second prong, the US securities laws apply to foreign companies where irrevocable liability was incurred or title was transferred in the US for the relevant securities transaction. Further, a number of recent decisions have found that US securities laws apply with respect to transactions in sponsored ADRs, but not unsponsored ADRs.2
The Second Circuit Line of Cases Addressing Morrison’s Second Prong
The US Court of Appeals for the Second Circuit has issued a series of decisions addressing the second prong of Morrison and taken the lead among US courts on this issue. In Absolute Activist Master Fund Ltd. v. Ficeto,3 the Second Circuit examined whether transactions involving securities that were not traded on a US registered exchange, could still be subject to § 10(b) as “domestic transactions” under Morrison’s second prong. The plaintiffs were Cayman Islands hedge funds that allegedly suffered USD 195 million in losses in a pump-and-dump scheme by their US broker and investment manager. The defendants allegedly advised the funds to purchase through the US broker penny stocks of thinly capitalized US companies that were not traded on a US registered exchange. The defendants had secretly invested in the stocks, and after causing the funds to purchase the stocks directly from the companies, they allegedly artificially inflated the stock prices for their own benefit.
The court first noted that Morrison provided little guidance as to what constitutes a domestic purchase or sale. Under the Exchange Act, the definitions of the terms “purchase” and “sale” “suggest that the act of purchasing or selling securities is the act of entering into a binding contract to purchase or sell securities.” In other words, “the ‘purchase’ and ‘sale’ take place when the parties become bound to effectuate the transaction.” Accordingly, the point of irrevocable liability determines the locus of a securities purchase or sale. Therefore, the Second Circuit held that Morrison’s second prong applies to securities transactions where (i) the parties incurred irrevocable liability to purchase or deliver a security within the US, or (ii) title was transferred within the US. Applying this test to the complaint in Absolute Activist, the court found that the plaintiffs failed to allege facts demonstrating that the purchaser incurred irrevocable liability within the US to “take and pay for a security” or “deliver a security”, or “that title to the shares was transferred within the [US].” The following facts and allegations were insufficient to allege a domestic transaction in the US: (a) a conclusive allegation that the transactions took place in the US; (b) the investors wired money to the funds in the US; (c) the funds were marketed in the US; (d) investors in the US were harmed; (e) certain defendants were US citizens or resided in the US; and (f) some of the fraudulent conduct occurred in the US. While the identity of the parties to the transaction, the type of security at issue, and whether each individual defendant engaged in conduct in the US could make it more likely that the transactions were domestic, such factors alone did not demonstrate that the purchases and sales were made in the US. The court dismissed the complaint but allowed plaintiffs to file an amended complaint pleading facts regarding the location of the securities transactions and that might suggest that irrevocable liability was incurred within the US.
Two years later, the Second Circuit expanded upon its analysis in Absolute Activist in two other cases involving different securities transactions. In City of Pontiac Policemen’s and Firemen’s Retirement System, et al. v. UBS AG, et al.4, the court examined whether Morrison applied to claims by US investors who purchased securities of a foreign issuer on a foreign exchange through a buy order initiated in the US. First, the court rejected the plaintiffs’ so-called “listing theory,” which argued that the dual listing of the securities on both domestic and foreign exchanges satisfied the first prong of Morrison. Next, the court found that “the fact that a US entity places a buy order in the [US] for the purchase of foreign securities on a foreign exchange” did not constitute a domestic transaction under Morrison. As both prongs of the Morrison test focus on the domestic location of the securities transaction, the mere cross-listing of the security on a US exchange is insufficient to satisfy Morrison with respect to claims brought by foreign and American plaintiffs who purchased their shares on a foreign exchange.
Shortly after its decision in City of Pontiac, the Second Circuit revisited Morrison under more complex circumstances in Parkcentral Global Hub Ltd. v. Porsche Auto Holdings SE.5 In the Parkcentral case, US investors asserted §10(b) claims for losses incurred on swap agreements they purchased in the US, but which were tied to the value of Volkswagen shares traded on foreign exchanges. For purposes of the defendants’ motion to dismiss, the court assumed that the swap agreements were executed and performed in the US and the underlying transaction therefore constituted a domestic securities transaction. Nevertheless, the court declined to allow the case to proceed, finding that while a domestic transaction is necessary, it is not alone sufficient under Morrison, as the Supreme Court did not hold that §10(b) applies to any domestic securities transaction. Applying the statute whenever a claim is predicated on a domestic transaction, “regardless of the foreignness of the facts constituting the defendants’ alleged violation, would seriously undermine Morrison’s insistence that §10(b) has no extraterritorial application.”
In granting the defendants’ motion to dismiss, the district court found that the “value of securities-based swap agreements is intrinsically tied to the value of the referenced security [and] the economic reality is that [the swaps] are essentially ‘transactions conducted upon foreign exchanges and markets,’ and not ‘domestic transactions’ that merit the protection of §10(b).” The Second Circuit found that applying US securities laws based only on the execution of such swap agreements in the US “would subject to US securities laws conduct that occurred in a foreign country, concerning securities in a foreign company, traded entirely on foreign exchanges, in the absence of any congressional provision addressing the incompatibility of US and foreign law nearly certain to arise.” Therefore, as the claims were “so predominantly foreign as to be impermissibly extraterritorial,”the court determined that it was unnecessary to decide whether the transactions satisfied the standards for a domestic transaction under Absolute Activist.
The Second Circuit acknowledged in Parkcentral the complexity of determining the extraterritorial reach of US securities laws, particularly “in a world of easy and rapid transnational communications and financial innovation,” and declined to adopt a comprehensive rule or “bright-line” test for extraterritoriality in §10(b) cases. Instead, courts must carefully consider the facts of every case “so as to eventually develop a reasonable and consistent governing body of law on this elusive question.”
In 2016, the Second Circuit revisited Morrison in In re Vivendi, S.A. Securities Litigation6 Shareholders in Vivendi common stock filed a securities class action against the company, which is a foreign media corporation, and certain of its D&Os. The plaintiffs argued that they incurred irrevocable liability in the US and thus satisfied Morrison’s second prong because they were located in the US when a three-way merger through which they acquired Vivendi ordinary shares was completed. The Second Circuit upheld the dismissal of the securities fraud claims, finding that incurring irrevocable liability means either “becom[ing] bound to effectuate the transaction” or “entering into a binding contract to purchase or sell securities.” The location of the investors in the US who acquired ordinary shares as a result of the merger, but were not parties to the merger, was irrelevant to a determination of whether the merger qualified as a “domestic purchase or sale.” The plaintiffs did not point to any evidence that the parties to the merger otherwise incurred irrevocable liability in the US.
The Second Circuit will again address this issue in the near future when it issues a decision on a pending appeal of a decision by the US District Court for the Southern District of New York relating to the Petrobras scandal. In In re Petrobras Securities Litigation,7 investors in Petrobras, a Brazilian state-owned oil company, allege that the company and related individuals and entities committed securities fraud in connection with a multi-year, multi-billion dollar money laundering and bribery scheme. As the plaintiffs did not claim that they purchased certain Petrobras debt securities on a domestic exchange, the district court focused on whether the plaintiffs sufficiently plead that they incurred irrevocable liability in the US or that title to the debt securities passed within the US. The district court held that the plaintiffs failed to plead specific facts demonstrating a domestic transaction in the debt securities under the second prong of Morrison, such as the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money in the US.
The plaintiffs argued that their claims satisfied Absolute Activist because they purchased the debt securities in initial offerings which allegedly indicated that they were purchased in the US. Even if the plaintiffs had adequately alleged that they purchased the debt securities in the initial offerings, however, that fact alone did not satisfy Absolute Activist as the supplemental prospectus for the offering indicated that some underwriters offered the securities outside of the US. The plaintiffs also argued that the purchases were domestic transactions because they were settled through the Depository Trust Company (“DTC”) in New York. The court disagreed, finding that “the mechanics of DTC settlements involve neither the substantive indicia of a contractual commitment necessary to satisfy Absolute Activist’s first prong nor the formal weight of a transfer of title necessary for its second.” Additionally, the court reasoned that as many securities transactions settle through the DTC or similar depository institutions, the “thrust of Morrison and its progeny would be rendered nugatory” if all transactions settled through the DTC fell within the reach of federal securities laws.
Application of Morrison to Sponsored and Unsponsored ADRs
A number of recent district court decisions have examined whether US securities laws apply to foreign companies’ ADRs that were purchased and sold in the US. In Stoyas v. Toshiba Corp.,8 investors who purchased unsponsored ADRs in Toshiba traded on the over-the-counter (“OTC”) market in the US alleged that the company and certain of its D&Os violated US securities laws as well as Japan’s Financial Instruments & Exchange Act. The defendant argued that under Morrison, §10(b) and §20(a) of the Exchange Act did not apply because Toshiba had not listed the ADRs on a US exchange or sold the securities in the US.
Other courts have determined that US securities laws may apply where the defendant company sponsored the ADRs at issue. In In re Volkswagen “Clean Diesel” Marketing, Sales Practices, and Product Liability Litigation,9 the Northern District of California found that under Morrison, Volkswagen and certain of its D&Os could be liable under US securities laws with respect to ADRs sponsored by the company and traded in the US Investors in Volkswagen ADRs filed a securities class action alleging that the defendants misled investors by failing to disclose that the company had utilized a “defeat device” in its diesel cars that allowed the cars to temporarily reduce emissions during testing. The defendants filed a motion to dismiss arguing that under Morrison the US securities laws did not apply to the ADR transactions.
As the ADRs traded on the OTC market and were not listed on a US exchange, Morrison’s first prong did not apply. The defendants, citing to Parkcentral, also argued that Morrison’s second prong did not apply because the ADR transactions were predominately foreign. Unlike the swap agreements in Parkcentral, however, the defendant company took affirmative steps to make its sponsored ADRs available to investors in the US. As a result, the securities were not predominately foreign and were sufficiently domestic to satisfy the “domestic transactions” requirement under Morrison. The court also noted that the ADRs had numerous connections to the US, including that they were traded in the US pursuant to an agreement subject to New York law and a Form F-6 Registration Statement submitted to the SEC.
Most recently, in Vancouver Alumni Asset Holdings Inc., et al. v. Daimler AG, et al.,10 another district court in California held that US securities laws apply to OTC transactions in Daimler A.G.’s sponsored ADRs. As in Volkswagen, the ADR shareholders alleged damages from misrepresentations and omissions pertaining to emission control systems in certain of the defendant company’s diesel vehicles. The defendants also cited to Parkcentral and argued that the plaintiffs could not satisfy either prong of Morrison because the ADRs were “predominantly foreign in nature.”
The court disagreed, noting that the Parkcentral test was not binding on its determination and the plaintiffs in that case had not alleged that the defendant company was a party to the relevant swap agreements or participated in the market for the swaps. In contrast, the ADRs were not independent from Daimler foreign securities or from Daimler itself, and the company sponsored and was directly involved in the domestic offering of the ADRs. Further, Daimler took affirmative steps to make its securities available to investors in the US, and all broker-dealers, settling agents and clearing houses associated with the transactions were US institutions. Therefore, the court determined that the plaintiffs alleged a sufficient connection between the ADR transactions and the US as required under Morrison’s second prong.
As plaintiffs continue to target foreign companies and their D&Os in US securities actions, it is important that they understand whether they could be subject to claims under US securities laws. The cases discussed above have provided greater certainty regarding the exterritorial reach of US securities laws. As the Second Circuit noted in Parkcentral, however, application of Morrison’s “transactional test” is often not a straightforward exercise, and US courts will likely continue to update and refine the extraterritorial reach of US securities laws to increasingly complex fact patterns and securities transactions. Therefore, global companies and their insurers should closely monitor developments in this area.