United States: Recent Decisions Clarify The Reach Of US Securities Laws Under Second Prong Of Morrison

Last Updated: October 19 2017
Article by Edward J. Kirk and Adeyemi Ojudun

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 investors 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 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 such lawsuits 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 determines 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 (the "Securities Act") 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 continue 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, US courts consistently allow shareholder claims 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 artifi ially 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]." Specifically, the court determined that the following facts and allegations alone 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. As these factors did not demonstrate that the purchases and sales were made in the US, the court dismissed the complaint, although it allowed plaintiffs to file an amended complaint pleading facts regarding the location of the securities transactions.

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 determined 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 held that the transactions did not satisfy 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 under the second prong of Morrison, 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 Litigation.6 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.

On July 7, 2017, the Second Circuit applied the second prong of Morrison with respect to the certifi ation of plaintiff classes in In Re Petrobras Securities Litigation.7 In Petrobras, the defendants appealed an order by the district court certifying two plaintiff classes of all otherwise eligible persons who purchased Petrobras ADSs on the NYSE and Petrobras debt securities in "domestic transactions" as defined in Morrison. As the debt securities traded over-the-counter ("OTC") and not on a domestic exchange, the district court was required to assess whether those securities transactions were domestic transactions under Morrison.

In their appeal, the defendants asserted that the debt securities class failed to satisfy the ascertainability and predominance requirements for class certification because the class members were required to establish on an individual basis that they acquired their securities in a "domestic transaction."8 With respect to ascertainability, the defendants argued that it would be too difficult to determine which of the OTC trades were "domestic transactions" under Morrison. The Second Circuit disagreed, finding that the district court's criteria for identifying the securities purchases was "clearly objective", and it was therefore "objectively possible" to determine whether the debt securities were acquired in domestic transactions.9 Next, the Second Circuit considered whether the predominance requirement for class certification was satisfied, which would require a finding that the resolution of any "material 'legal or factual questions... can be achieved through generalized proof', and 'these [common] issues are more substantial than the issues subject only to individualized proof.'" In Petrobras, this analysis raised two predicate inquiries about the role of Morrison, including (i) whether the determination of domesticity is material to the plaintiffs' class claims, and (ii) if so, is that determination susceptible to generalized class-wide proof such that it represents a common, rather than an individual, question.

The Second Circuit found that although the lower court sought to certify classes that extended as far as Morrison would allow, it failed to carefully scrutinize whether the domesticity of the debt security transactions was susceptible to class-wide proof. Under the second prong of Morrison, a plaintiff must produce evidence of, among other things, "facts concerning the formation of the contract, the placement of purchase orders, the passing of title, or the exchange of money." While the need to show a "domestic transaction" applies equally to putative class members and may therefore present a common question, the "Plaintiffs bear the burden of showing that, more often than not, they can provide common answers." The district court suggested that the pertinent locational details for each transaction were likely to be found in the "record[s] routinely produced by the modern financial system," and "are likely to be documented in a form susceptible to the bureaucratic processes of determining who belongs to a Class." This did not, however, obviate the need to consider the plaintiff specific nature of the Morrison inquiry. The district court did not consider the ways in which evidence of domesticity might vary in nature or availability across the various permutations of the transactions, including who sold the relevant securities, how the transactions were effectuated, and what forms of documents might be offered to support domesticity. Therefore, the Second Circuit vacated the class certification and directed the district court to conduct a robust predominance inquiry with respect to the domesticity of the underlying transactions. The Second Circuit's ruling in Petrobras demonstrates that Morrison may create substantial hurdles to class certification, even after investors have sufficiently pleaded a domestic transaction under Morrison.

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 purchased and sold in the US. In Stoyas v. Toshiba Corp.,10 investors who purchased unsponsored ADRs in Toshiba traded on the 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.

The district court found that the first prong of Morrison did not apply because the OTC market is not a domestic exchange. The plaintiffs also could not satisfy the second prong of Morrison because they had not alleged any affirmative act by Toshiba related to the purchase and sale of securities in the US. Although the ADRs were based on Toshiba common stock traded on a foreign exchange, they were sold by US depository banks without the participation of Toshiba. There were no allegations that Toshiba sponsored, solicited or committed any other affirmative act with respect to the ADRs. The court reasoned that holding companies like Toshiba liable in the US for secondary securities they had not approved would "create essentially limitless reach" for US securities laws.

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,11 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 alleged 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 Parkcentral, argued that Morrison's second prong also did not apply because the ADR transactions were predominately foreign. Unlike the swap agreements in Parkcentral, however, the defendant company had taken affirmative steps to make its sponsored ADRs available to investors in the US. 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. As a result, the ADRs were not predominately foreign and were suffi iently domestic to satisfy the "domestic transactions" requirement under Morrison.

Most recently, in Vancouver Alumni Asset Holdings Inc., et al. v. Daimler AG, et al.,12 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 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 Parkcentraltest 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.


1. See Sec. & Exch. Comm'n v. Traffic Monsoon, LLC, 2017 WL 1166333 (D. Utah Mar. 28, 2017) (finding that with respect to actions by the SEC, pursuant to § 929P(b) of Dodd Frank, Congress intended §§ 10(b) and 17(a) of the Exchange Act to apply to extraterritorial transactions to the extent that the conduct and effects test is satisfied).

2. ADRs are issued by US depository banks and each represents one or more shares of a foreign stock. They allow foreign equities to be traded on US exchanges. Sponsored ADRs are issued by a bank on behalf of a foreign company whose equity serves as the underlying asset for the ADR. Unsponsored ADRs are issued by a depositary bank, usually in response to investor demand, without the involvement, participation or consent of the foreign issuer whose stock underlies the ADR. (See www.investopedia.com).

3. 677 F.3d 60 (2d Cir. 2012).

4. 752 F.3d 173 (2d Cir. 2014).

5. 763 F.3d 198 (2d Cir. 2014).

6. 838 F.3d 223 (2d Cir. 2016).

7. --F.3d --, 2017 WL 2883874 (2d Cir. July 7, 2017).

8. Plaintiffs seeking class certification bear the burden to satisfy the numerosity, commonality, typicality, and adequacy requirements of Rule 23 of the Federal Rules of Civil Procedure. They must also show that "questions of law or fact common to class members... predominate over questions affecting only individual class members." Courts have also recognized an implied requirement of ascertainability under Rule 23.

9. The Second Circuit rejected application of a heightened ascertainability requirement applied by other Circuit Courts, under which any proposed class must be "administratively feasible," over and above the requirement that a class be definite and "defined by objective criteria," and separate from the predominance and superiority requirements.

10. 191 F. Supp. 3d 1080 (C.D. Cal. 2016).

11. 2017 WL 66281 (N.D. Cal. Jan. 4, 2017.

12. 2017 WL 2378369 (C.D. Cal. May 31, 2017).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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