(Article from Securities Law Alert, July 2018)
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On July 17, 2018, the Ninth Circuit found the district court “misapplied” Morrison v. National Australia Bank, 561 U.S. 247 (2010), in holding that Section 10(b) does not reach securities fraud claims involving domestic transactions in unsponsored American Depositary Receipts and Shares (“ADRs”).[1] Stoyas v. Toshiba Corp., 2018 WL 3431764 (9th Cir. 2018) (Wardlaw, J.). The Ninth Circuit emphasized that under Morrison, courts must “examine the location of the transaction[;] it does not matter that a foreign entity was not engaged in the transaction.”
Background
In Morrison, 561 U.S. 247, the Supreme Court held that Section 10(b) applies only to (1) “transactions in securities listed on domestic exchanges,” and (2) “domestic transactions in other securities.” The district court found Morrison’s first prong inapplicable because the unsponsored ADRs at issue were traded on an over-the-counter market, rather than a “domestic exchange.” Stoyas v. Toshiba Corp., 191 F. Supp. 3d 1080 (C.D. Cal. 2016).
As to Morrison’s second prong, the district court acknowledged that the transactions “occurred domestically” because the ADRs were “both sold and purchased in the United States.” The court nevertheless found Section 10(b) did not govern the transactions because the foreign issuer did not sponsor the ADRs at issue. The court noted that “nowhere in Morrison did the Court state that U.S. securities laws could be applied to a foreign company that only listed its securities on foreign exchanges but whose stocks are purchased by an American depositary bank on a foreign exchange and then resold as a different kind of security (an ADR) in the United States.” The court reasoned that “[p]laintiffs’ proffered understanding would create essentially limitless reach of § 10(b) claims because even if the foreign defendant attempted to keep its securities from being sold in the United States, the independent actions of depositary banks selling on [over-the-counter] markets could create liability.” The court found such a result would be “inconsistent with the spirit and law of Morrison.” Plaintiffs appealed.
Adopting the Absolute Activist Test, Ninth Circuit Finds Domestic Trades in Unsponsored ADRs Constitute “Domestic Transactions” Under Morrison’s Second Prong
As an initial matter, the Ninth Circuit found the Exchange Act applies to ADRs because “the economic reality of [ ] ADRs is closely akin to stock” and thus, “ADRs fit comfortably within the Exchange Act’s definition of ‘security.’” The Ninth Circuit also agreed with the district court’s determination that the transactions did not satisfy Morrison’s first prong because “[t]he over-the-counter market on which [the unsponsored ADRs at issue] trade is simply not an ‘exchange’ under the Exchange Act.”[2]
The Ninth Circuit then considered the application of Morrison’s second prong under the irrevocable liability test set forth in Absolute Activist Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir. 2012), which the Ninth Circuit adopted.[3] The Absolute Activist court held that plaintiffs may plead a “domestic transaction” by alleging facts demonstrating “that the purchaser incurred irrevocable liability within the United States to take and pay for a security, or that the seller incurred irrevocable liability within the United States to deliver a security.” Alternatively, plaintiffs may allege that title was transferred within the United States. In the case before it, the Ninth Circuit found plaintiffs “could almost certainly allege sufficient facts” to satisfy the irrevocable liability test because the ADRs were traded in the United States by United States entities.
A Foreign Issuer’s Involvement in a Domestic Transaction Is Irrelevant for Purposes of the Morrison Analysis
Defendant did not challenge the domestic nature of the ADR transactions. Rather, defendant contended that Morrison precludes plaintiffs’ claims because plaintiffs did not allege that defendant had “any connection” to the transactions. Rejecting this argument, the Ninth Circuit found that a foreign issuer’s level of involvement has no bearing on the location of a securities transaction—which is the focus of the Morrison analysis. The Ninth Circuit explained that in order “[f]or the Exchange Act to apply, there must be a domestic transaction.” The possibility that a foreign issuer “may ultimately be found not liable for causing the loss in value to the ADRs does not mean that the Act is inapplicable to the transactions.”
The Ninth Circuit was also unpersuaded by defendant’s contention that “applying the Exchange Act to . . . unsponsored ADRs would undermine Morrison’s animating comity concerns.” The Ninth Circuit reasoned that this “is not a basis for declining to follow the [Morrison] Court’s clear instructions,” even if “the Morrison test in some cases will result in the Exchange Act’s application to claims of manipulation of share value from afar.”
Ninth Circuit Declines to Follow the Second Circuit’s Decision in Parkcentral
The Ninth Circuit expressly disagreed with the Second Circuit’s holding in Parkcentral Global Hub v. Porsche Automobile Holdings, 763 F.3d 198 (2d Cir. 2014), that “a domestic transaction is necessary but not necessarily sufficient to make § 10(b) applicable.”[4] The Ninth Circuit found Parkcentral’s approach “contrary to Section 10(b) and Morrison itself” because it “carves out ‘predominantly foreign’ securities fraud claims from Section 10(b)’s ambit, disregarding Section 10(b)’s text.” The Ninth Circuit stated that “Parkcentral’s test for whether a claim is foreign is an open-ended, under-defined multi-factor test, akin to the vague and unpredictable tests that Morrison criticized and endeavored to replace with a clear, administrable rule.”[5] Finally, the Ninth Circuit concluded that “Parkcentral’s analysis relies heavily on the foreign location of the allegedly deceptive conduct, which Morrison held to be irrelevant to the Exchange Act’s applicability, given Section 10(b)’s exclusive focus on transactions.”[6]
Section 10(b)’s “in Connection With” Requirement Could Potentially Preclude Claims Involving Unsponsored ADRs
The Ninth Circuit made it clear that while “Morrison delineates the transactions to which the Exchange Act can theoretically apply without being impermissibly extraterritorial,” satisfying the Morrison test is “not sufficient to state an Exchange Act claim.”
To survive dismissal, plaintiffs asserting a Section 10(b) claim must plead “a connection between the misrepresentation or omission and the purchase or sale of a security.” The Ninth Circuit stated that “for fraud to be ‘in connection with the purchase or sale of any security,’ it must ‘touch’ the sale—i.e., it must be done to induce the purchase at issue.” The Ninth Circuit found the complaint “falls short” of meeting this standard, and suggested that plaintiffs may need to allege facts concerning the foreign issuer’s involvement in the ADRs to satisfy the “in connection with” requirement.[7]
[1] “An ADR is a receipt that is issued by a depositary bank that represents a specified amount of a foreign security that has been deposited with a foreign branch or agent of the depositary, known as the custodian. . . . An unsponsored ADR is established with little or no involvement of the issuer of the underlying security. A sponsored ADR, in contrast, is established with the active participation of the issuer of the underlying security.” Stoyas v. Toshiba Corp., 191. F. Supp. 3d 1080 (C.D. Cal. 2016).
[2] The Ninth Circuit noted that OTC Link, the over-the-counter market on which the unsponsored ADRs at issue trade, “is separately regulated by the [SEC] and is specifically exempt from the Exchange Act’s definition of ‘exchange.’”
[3] Please click here to read our discussion of the Second Circuit’s decision in Absolute Activist.
[4] Please click here to read our discussion of the Parkcentral decision.
[5] The Parkcentral court stated that it did “not purport to proffer a test that will reliably determine when a particular invocation of § 10(b) will be deemed appropriately domestic or impermissibly extraterritorial.” The Parkcentral court further stated that “courts must carefully make their way with careful attention to the facts of each case and to combinations of facts that have proved determinative in prior cases, so as eventually to develop a reasonable and consistent governing body of law on this elusive question.”
[6] The Ninth Circuit also explained that Parkcentral was factually “distinguishable on many grounds.” For instance, the court noted that Parkcentral concerned “entirely private” securities-based swap agreements which are “[u]nlike ADRs” because they “do not constitute investments in the company on whose securities they are based nor do they confer any ownership interest in those reference securities.”
[7] The Ninth Circuit noted that “before the district court and on appeal, [plaintiffs] argued that ‘it is likely that [the foreign issuer] was indeed involved in the establishment’ of the ADRs . . . However, none of these facts is alleged in the [complaint].” The Ninth Circuit remanded the action to allow plaintiffs an opportunity to amend their complaint.