Shareholders are filing record numbers of securities class actions against non-U.S. issuers, despite the U.S. Supreme Court's 2010 ruling in Morrison v. National Australia Bank1 limiting the extraterritorial reach of the Securities and Exchange Act of 1934 (the "Exchange Act"). Many of those actions involve American Depository Receipts ("ADRs") and courts have found that under Morrison, U.S. securities laws may apply to ADRs traded on a domestic exchange or sponsored by the company

A recent ruling by the Court of Appeals for the Ninth Circuit (the "Ninth Circuit") in Stoyas v. Toshiba Corp., et al.2 has created some uncertainty regarding the applicability of U.S. securities laws to unsponsored ADRs.

The Application of Morrison to ADRs

In Morrison, the U.S. Supreme Court held that Section 10(b) of the Exchange Act applies only to (1) "transactions in securities listed on a U.S. exchange" ("Prong 1"), or (2) "domestic transactions in other securities" ("Prong 2"). Morrison stated that this test should focus on domestic purchases and sales.

Following Morrison, investors in ADRs continued to file an increasing number of securities class actions against non-U.S. issuers. In each of the past two years, the number of securities class actions against foreign companies was double the 1997-2017 annual average of 24.3

There are two basic types of ADRs: (i) sponsored ADRs issued on behalf of a foreign company; and (ii) unsponsored ADRs issued by depositary banks without the involvement, participation or consent of the foreign company whose stock underlies the ADR.

Courts applying Morrison to securities class actions involving ADRs have consistently found that under Prong 1, the U.S. securities laws apply to ADRs listed on a U.S. registered exchange. Prong 1 does not apply to ADRs listed on overthe-counter ("OTC") markets as they are not listed on a registered securities exchange.

Prong 2 may apply to ADRs where a foreign issuer sponsored or otherwise took affirmative steps to make its ADRs available to U.S. investors.4

The Second Circuit's Application of Morrison's "Domestic Transaction" Test

The Court of Appeals for the Second Circuit (the "Second Circuit") was the first federal appellate court to analyze what constitutes a "domestic transaction in other securities" under Prong 2 of Morrison.

In Absolute Activist Master Fund Ltd v. Ficeto5 , the Second Circuit found that Prong 2 of Morrison applies where (1) the parties "incurred irrevocable liability" to purchase or sell a security in the U.S., or (2) title was transferred in the U.S. Absolute Activist held that Cayman Island hedge funds that purchased penny stocks in U.S. companies not traded on a U.S. exchange failed to sufficiently allege that they incurred irrevocable liability in the U.S. to "take and pay for a security" or "deliver a security", or "that title to the shares were transferred within the [U.S.]"

Two years after Absolute Activist, the Second Circuit revisited Prong 2 of Morrison in Parkcentral Global Hub Ltd. v. Porsche Auto Holdings6 . Parkcentral applied Morrison in the context of swap agreements linked to shares of a foreign company traded on a foreign exchange. Although the swaps were purchased in the U.S., this alone was not sufficient under Morrison. The court reasoned that while a domestic transaction is necessary, it alone is not sufficient as Morrison did not hold that the securities laws apply to any domestic transaction. Further, applying U.S. securities laws whenever a transaction 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 Section 10(b) has no extraterritorial application." The swaps were essentially transactions conducted on foreign exchanges and not domestic transactions, and therefore they did not merit the protection of U.S. securities laws.7

The Ninth Circuit's Application of Morrison to Unsponsored ADRs in Toshiba

Whether U.S. securities laws apply to a foreign company's unsponsored ADRs was examined by a U.S. District Court in California in Stoyas v. Toshiba Corp 8. The District Court dismissed the complaint against Toshiba with prejudice, finding that Prongs 1 and 2 of Morrison did not apply because the ADRs traded on an OTC market and there were no allegations that Toshiba committed any affirmative act related to the purchase or sale of the securities in the U.S.

On July 17, 2018, the Ninth Circuit reversed the District Court and allowed the plaintiff an opportunity to replead sufficient facts to establish that they purchased the unsponsored ADRs in a domestic transaction. The Ninth Circuit adopted the Second Circuit's irrevocable liability test established in Absolute Activist, but rejected its carve-out of "predominantly foreign" securities fraud claims from Section 10(b) under Parkcentral. While the plaintiffs alleged that the ADRs were purchased by investors and sold by depositary institutions in the U.S., the complaint did not specifically allege where the parties incurred irrevocable liability. Therefore, the Ninth Circuit held that the plaintiffs did not sufficiently allege a domestic violation of the Exchange Act, but allowed the plaintiffs to re-plead, noting that there were a number of factual connections to the U.S. and "an amended complaint could almost certainly allege sufficient facts to establish that [the investor] purchased its Toshiba ADRs in a domestic transaction."

The Ninth Circuit rejected the defendants' argument that because the plaintiffs did not allege any connection between Toshiba and the ADR transactions, Morrison precluded the Exchange Act claims. The court reasoned that "this would turn Morrison and Section 10(b) on their heads: because we are to examine the location of the transaction, it does not matter that a foreign entity was not engaged in the transaction." Instead, "[f]or the Exchange Act to apply, there must be a domestic transaction: that Toshiba 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 transaction."

In rejecting Parkcentral, the Ninth Circuit found that carving out "predominantly foreign" securities claims disregarded Section 10(b)'s application to "the purchase or sale of any security registered on a national securities exchange or any security not so registered." Moreover, Morrison held that the foreign location of the alleged deceptive conduct was irrelevant regarding the applicability of the Exchange Act, "given Section 10(b)'s exclusive focus on transactions." Accordingly, the Ninth Circuit focused solely on the location of the securities transaction, rather than where the alleged deceptive conduct took place, to determine whether the Exchange Act applied under Prong 2 of Morrison.

Importantly, the Ninth Circuit explained that Morrison merely determines transactions "to which the Exchange Act can theoretically apply", and while applicability is necessary, it is not sufficient to state an Exchange Act claim. Specifically, Section 10(b) makes it unlawful "to use or employ, in connection with, the purchase or sale" of a security "any manipulative or deceptive device or contrivance." A plaintiff must show "a connection between the misrepresentation or omission and the purchase or sale of a security" to establish a claim under Section 10(b). For the fraud to be in connection with the purchase or sale of any security, it must "touch" the sale, or be done to induce the purchase of the securities at issue.

Following the Ninth Circuit's ruling, Toshiba petitioned the U.S. Supreme Court regarding whether a domestic transaction is sufficient for the Exchange Act to apply, even when a case is foreign in other respects. Toshiba argued that there is a split of authority regarding Morrison in view of the Ninth Circuit's rejection of the Second Circuit's holding in Parkcentral, and the Toshiba decision opens up the Ninth Circuit as a new forum against any issuer in the world. On June 24, 2019, the U.S. Supreme Court denied without explanation Toshiba's petition. The plaintiffs later filed a Second Amended Complaint. On September 19, 2019, Toshiba filed another motion to dismiss, arguing that plaintiffs again failed to allege that the company induced them to purchase the ADRs or had an involvement in the unsponsored ADRs. This motion has not yet been heard, but will be closely watched.

Comment

Some commentators have raised concerns that the Ninth Circuit's ruling in Toshiba will "open the floodgates" to securities class actions against foreign companies with unsponsored ADRs in the U.S. However, even if plaintiffs can sufficiently allege facts allowing the application of the Exchange Act under Prong 2 of Morrison to unsponsored ADRs, they also must plead and prove a connection between the misrepresentations or omissions and the purchase or sale of the ADRs to establish liability under Section 10(b). This will be a high hurdle for plaintiffs to overcome where a foreign issuer took no affirmative act related to the purchase or sale of the ADRs in the U.S., and so ultimately, Toshiba may not substantially increase the exposure of foreign companies whose securities back unsponsored ADRs.

Footnote

1. 561 U.S. 247, 130 S. Ct. 2869 (2010)

2. 896 F.3d 933 (9th Cir. 2018).

3. Securities Class Action Filings - 2018 Year in Review, Cornerstone Research

4. See e.g., in re Volkswagen "Clean Diesel" Marketing, Sales Practices, and Product Liability Litigation, 2017 WL 66281 (N.D. Cal. Jan. 4, 2017); Vancouver Alumni Asset Holdings Inc., et al. v. Daimler AG, et al., 2017 WL 2378369 (C.D. Cal. May 31, 2017).

5. 677 F. 3d 60 (2d Cir. 2012).

6. 763 F.3d 198 (2d Cir. 2014); see also City of Pontiac Policemen's and Firemen's Retirement System, et al. v. UBS AG, et al., 752 F.3d 173 (2d Cir. 2014) (rejecting plaintiffs' dual listing theory and finding placement of buy orders in U.S. insufficient under Prong 2 of Morrison).

7. The Second Circuit recently reaffirmed Parkcentral in Prime Int'l Trading, Ltd. v. BP P.L.C., 937 F.3d 94, 106 (2d Cir. Aug. 29, 2019).

8. 191 F. Supp.3d 1080 (C.D. Cal. 2016).

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