Following the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank (here), the lower federal courts have set about implementing the Morrison decision’s holding that the U.S. securities laws do not apply extraterritorially. One issue that the courts have wrestled with is whether or not the U.S. securities laws apply to over-the-counter (OTC) transactions in the U.S. of a foreign company’s American Depositary Receipts (ADRs). A series of recent cases suggest the courts are closer to having these issues sorted out. Most recently, a May 31, 2017 decision by Central District of California Judge James Otero held, consistently with other recent federal district court decisions, that the U.S. securities laws do apply to OTC transactions in Daimler, A.G.’s sponsored level 1 ADRs. A copy of Judge Otero’s decision can be found here.
In October 2017, plaintiff ADR holders filed a securities class action lawsuit against Daimler and certain of its directors and officers in Central District of California alleging that the defendants had made misrepresentations regarding the company’s diesel engine cars and vans emissions control systems, known as BlueTEC. The plaintiffs allege that the defendants allegedly had failed to disclose that the engines were designed in a way to allow the engines to meet emissions control tests, while at the same time the engines operating under normal conditions emitted pollutants at levels that exceeded allowed emissions control levels. The plaintiffs further allege that following news of governmental investigations in the U.S. and Germany of certain of the company’s vehicles, the price of the company’s ADRs declined and investors allegedly were harmed.
According the plaintiff’s amended consolidated complaint (here), the company established sponsored Level I ADRs in September 2010, which trade over-the-counter in the United States. The plaintiff’s complaint purports to be filed on behalf of all persons who purchased the company’s ADRs between February 22, 2012 and April 21, 2016.
The defendants filed motions to dismiss the plaintiff’s amended complaint on a number of grounds, including, in particular for purposes of this blog post, the argument made in reliance on Morrison that the U.S. securities laws do not apply to OTC transactions in the company’s ADRs. The defendants argued that the OTC transactions in the Daimler ADRs did not satisfy either prong of the Morrison’s two-prong standard, which holds that the U.S securities laws do not apply extraterritorially, but rather apply only to transactions in “securities listed on domestic exchanges” or “domestic transactions in other securities.”
The May 31, 2017 Decision
In his May 31, 2017 opinion, Judge Otero granted in part and denied in part the defendants’ motion to dismiss. With respect to the question of the applicability of the U.S. securities laws, Judge Otero held that the U.S. securities laws do apply to the domestic OTC transactions in the company’s sponsored ADRs.
Daimler had argued that prior to the institution of its ADRs, the company had delisted its shares from the New York Stock Exchange and delisted its stock with the SEC, and argued further that the company had played no role in issuing the ADR certificates or administering the ADR program. However, Judge Otero cited the plaintiffs’ allegations that the company actively and voluntarily contracted with an American depositary bank to sell ADRs to American investors, registered its ADRs with the SEC, and provided information to American investors in compliance with SEC rules. Judge Otero cited these considerations in concluding that the plaintiffs’ allegations established personal jurisdiction over the company.
With respect to the question of whether or not the U.S. securities laws apply to transactions in the company’s ADRs, the company sought to argue that while the ADR transactions took place in the U.S., they were “predominately foreign in nature.” In making this argument, the defendants relied on the Second Circuit’s decision in the Parkcentral case (discussed here), in which the Second Circuit had said that although a domestic transaction is necessary for a claim under Section 10(b), “such a transaction is not alone sufficient to state a properly domestic claim under the statute.”
In rejecting this argument, Judge Otero said that the defendants’ reliance on Parkcentral is “misplaced,” not only because “the ‘predominately foreign’ test is not binding on this Court,” but also because the plaintiffs in the Parkcentral case had not alleged that the defendant was a party to the swap agreements at issue nor that it participated in the market for swaps.
Here, by contrast, Judge Otero said, the ADRs “were not independent from Daimler AG’s foreign securities or from Daimler itself.” Instead, Daimler sponsored the ADRs and was “directly involved in the domestic offering of the ADRs” and that “Daimler AG took affirmative steps to make its securities available to investors in the United States.” Judge Otero found that the allegation of a connection between the company and the ADRs “satisfies the second prong of Morrison, even under the non-binding ‘predominately foreign’ test put forth in Parkcentral.”
In concluding that the ADR purchases “are domestic transactions subject to Section 10(b) liability,” Judge Otero cited with approval to the similar ruling in the Volkswagen emissions-related securities lawsuit. As discussed here, in January 2017, Northern District of California Judge Charles Breyer held that transactions in Volkswagen’s sponsored Level 1 ADRs satisfied Morrison’s second prong and therefore were subject to the U.S. securities laws.
However, both Judge Otero in the Daimler case and Judge Breyer in the Volkswagen case both contrasted their conclusions in their respective cases with Judge Dean Pregerson’s May 2016 decision in the Toshiba case (about which refer here), in which Judge Pregerson held that the U.S. securities laws do not apply to OTC transactions in the U.S. of Toshiba’s unsponsored ADRs.
Significantly, it was not a factor in either the Volkswagen case or in the Daimler case that the ADRs at issue traded only over-the-counter and did not trade on a U.S. exchange. While the fact that the ADRs did not trade on a U.S. exchange may establish that the transactions do not satisfy Morrison’s first prong, the fact that the ADRs trade only OTC is not dispositive of the question of whether or not the transactions satisfy Morrison’s second prong.
With respect to the analysis under Morrison’s second prong, the courts in the Volkswagen and Daimlar cases suggest that the question depends on whether or not the ADRs involved were sponsored. If the ADRs are sponsored, as was the case in the Volkswagen and Daimler cases, then Morrison’s second prong may be satisfied. If, however, as was the case with the ADRs in the Toshiba case, the ADRs at issue are unsponsored, then Morrison’s second prong is not satisfied.
For many readers, this extended debate about whether U.S. investors’ purchase in the U.S. of ADR securities may be puzzling. If a U.S. investor buys a security in the U.S., isn’t that a “domestic transaction in other securities,” even if it does not take place on a securities exchange? The key here is that, as the Second Circuit noted in the Parkcentral case, and as Judge Pregerson discussed in the Toshiba case, while these transactions are “facially” domestic, and while a domestic transaction is “necessary” under Morrison’s second prong, a domestic transaction alone is not necessarily “sufficient” to establish that the U.S. securities laws apply. The Second Circuit’s decision in the Parkcentral case suggests that the courts should look further at the “character” of the security at issue, in order to determine whether or not the transactions are “so predominately foreign as to be impermissibly extraterritorial.”
In the Daimler case, Judge Otero did indeed look at the character of the securities involved, and concluded, because Daimler had sponsored the ADRs at issue and had taken a number of affirmative steps to allow the ADRs to trade in the U.S., the securities were not predominately foreign but were sufficiently domestic to satisfy Morrison’s second prong. It is important to note that along the way, Judge Otero specifically considered the facts and circumstances surrounding Daimler’s involvement with the ADRs at issue. This analysis suggests that the ultimate outcome of a Morrison-based dismissal motion could be factually dependent, based upon not only the character of the security involved but also the nature of the involvement of the foreign company with the domestic security. For that reason, these issues could continue to percolate in other cases.
As I have noted in numerous recent posts on this blog (most recently here), non-U.S. companies continue to be hit with U.S. securities lawsuit at a disproportionately greater rate than their representation among U.S.-listed companies would suggest. Many of these non-U.S. companies that have been hit with securities suits have ADRs trading in the U.S., some of them only with ADRs trading over-the-counter. The question of the applicability of the U.S. securities laws to these OTC transactions in ADRs likely will be important in many of these cases. Based on the Daimler case, the Volkswagen case, and the Toshiba case, it seems likely that the key issue will be whether or not the ADRs, if not trading on a U.S. exchange, were sponsored ADRs.
Reader Pictures: Loyal reader Jim Roskopf of Insurica in Plano, Texas sent along these great pictures of his recent vacation at Acadia National Park in Maine.