The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

The U.S. Supreme Court’s blockbuster opinion in Morrison v National Australia Bank has had an enormous impact, resulting as it has in the dismissal of numerous securities suits involving non-U.S. companies that previously would have been permitted to go foward in U.S. courts. But over time it has become clear that the Supreme Court's opinion does not answer every question, which in turn has meant challenges for the lower courts in certain circumstances.  

In an interesting June 1, 2012 post on the Dealbook blog entitled “Securities Law Ruling Creates Unintended Problems” (here), Ohio State University law professor Steven Davidoff examines problems that have arisen following Morrison in two specific contexts – domestic ADR transactions and derivatives transactions. Davidoff’s column points out that a couple of appeals now pending in the Second Circuit could have an enormous impact on the reach of U.S. securities to these kinds of transactions. There will be much more to be said on these topics once the Second Circuit has ruled in the pending appeals. Though the pending cases could sort out many of these problems, it is still worth considering the problems Davidoff identified in his column now.

Just by way of background and to set the table for discussion of these issues, it is worth briefly reviewing Morrison’s holding. Prior to the Supreme Court’s holding in Morrison, the lower courts, it attempting to determine whether or not a specific transaction was within the jurisdiction of the U.S. securities laws, applied a “conduct and effects” test to determine whether or not there had been sufficient conduct in the United States or whether there were sufficient effects in the United States to support the exercise of jurisdiction under the U.S. securities laws.

As Davidoff points out in his column, the Morrison court “took a sledgehammer to decades of case law” and rejected the “conduct and effects” test. Rather, the Morrison court said, the U.S. securities laws apply only to “transactions in securities listed on domestic exchanges and domestic transactions in other securities.” Though a single test, this standard has two prongs, the first of which relates to transactions on U.S. securities exchanges, and the second of which applies to all other transactions. 

While the lower courts have applied Morrison aggressively, problems have nevertheless arisen, particularly with respect to the meaning of the second prong. What, after all, is a “domestic transaction in other securities”? As I discussed in a prior post (here), in its March 2012 decision in the Absolute Activist Value Master Fund Limited v. Ficeto case, the Second Circuit took an active step to try to define what makes an off-exchange transaction sufficiently “domestic” for the U.S. securities laws to apply. The court said in order to establish the existence of a domestic transaction in other securities, a plaintiff “must allege facts suggesting that either irrevocable liability was incurred or title transferred within the United States.”

Davidoff correctly points out that the Absolute Activist Value Master Fund case could have a significant impact on the Porsche case now pending on appeal in the Second Circuit. (Refer here for background on the Porsche case.)  In the Porsche case, the lower court had dismissed a securities lawsuit brought by numerous hedge funds that entered various swap transactions in the U.S. The lower court had held that because the swap referenced a security traded on a German exchange, they were “the functional equivalent of trading the underlying VW shares on a German exchange.” The Absolute Activist Value Master Fund case suggests that rather than looking where the referenced securities trade, the proper inquiry should be on the swap transactions themselves, and whether or not “irrevocable liability” in the swaps transactions was incurred or title was transferred in the U.S.

Davidoff notes an ironic aspect of the Absolute Activist Value Master Fund holding, which is that it seems to require an inquiry about where conduct took place – in effect, it could be argued, reinstating a kind of a “conduct” test in order to determine the applicability of Morrison’s second prong, even though Morrison itself expressly rejected the “conduct and effects” test that previously had applied in the Second Circuit. This is an interesting observation. However, the “conduct” referenced in the old “conduct and effects” test was the allegedly fraudulent misconduct, not transactional conduct. So even if the Absolute Activist Value Master Fund holding requires an inquiry into the location of conduct, it is not the same test, because it attempts to determine where the deal took place, not where the misconduct took place.

Davidoff also comments that the Absolute Activist Value Master Fund holding raises a number of unanswered questions, “including what it means to incur irrevocable liability in the United States, whether a purchaser of a security from a foreign entity by an American is enough, and what happens to the foreign purchaser of unlisted American securities.”

I agree with Davidoff that the Absolute Activist Value Master Fund decision raises a number of questions, and also that before all is said and done, the U.S. Supreme Court may need to weigh in again in order to explicate Morrison’s second prong. However, at the same time, I think it is fair to point out that the Absolute Activist Value Master Fund decision actually answers a number of the questions Davidoff raises.

In emphasizing that the inquiry to determine whether or not the U.S. securities laws apply should be focused on the transaction itself, the Second Circuit rejected the arguments that the nationality of the parties to the transaction or even the identity of the security involved mattered in the determination. The Second Circuit said that “rather than looking to the identity of the parties, the type of security at issue, or whether each individual defendant engaged in conduct within the United States, we hold that a securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed with the United States.” That is, the Second Circuit’s opinion does, it seems to me, answer at least some of the questions Davidoff identifies as unanswered.

Davidoff also objects to the Absolute Activist Value Master Fund Limited opinion on the grounds that it “could lead to absurd results with foreigners flying into the United States to purchase derivatives on foreign securities to create jurisdiction.” I have a different interpretation of the implications of the case. My own view is that the decision provides some highly desirable risk management guidance for non-U.S. parties seeking to avoid the risks and uncertainties of U.S. securities litigation. By managing the location of essential events of financial transactions, participants in cross-border transactions can avoid U.S. securities litigation exposures. That is, rather than parties conniving to bring their transactions within the reach of the U.S. securities laws as a result of this decision, I envision parties taking prudent steps to ensure that their cross-border transactions do not wind up in U.S. courts – which many non-U.S. investors and entities doubtlessly would view as a highly desirable thing.

Davidoff correctly points out that there is a tension between the Second Circuit’s holding in the Absolute Activist Value Master Fund decision and Judge Berman’s opinion in the Société Générale case, in which Judge Berman, applying Morrison, held that the U.S. securities laws do not apply to ADR transactions on the U.S. exchanges. (For background regarding the Société Générale decision, refer here.) Judge Berman reasoned that because the ADR represents the foreign company’s underlying shares, an ADR transaction is “predominately a foreign transaction.” (The Société Générale opinion is also now on appeal in the Second Circuit.)

However, I think is important to note that, at least to my knowledge no other court has followed Judge Berman’s decision in the Société Générale case. To the contrary, numerous other courts have concluded that the U.S. securities laws do apply to domestic ADR transactions. Indeed, at least two other rulings in the Southern District of New York have allowed securities claims brought by domestic ADR purchases  to proceed – in the Vivendi case (refer here) and in the RBS case (refer here). Similarly, in the BP securities litigation pending in the Southern District of Texas and arising out of the Deepwater Horizon disaster, the court allowed the securities claims of domestic ADR purchasers to go forward. Taking these other results into account, there may be less inconsistency in the lower court decisions than Professor Davidoff’s column might suggest.

Of course, none of us can know for sure what the Second Circuit may do in the pending appeal in the Société Générale case or in the pending appeal in the Porsche case. But I think it is fair to point out that the lower courts have generally held that the U.S. securities laws apply when the place of the transaction is in the U.S, regardless of the identity of the security or the nationality of the parties involved. If, as Morrison requires, the focus of the inquiry is on the place of the transaction, then the U.S. securities laws should apply to domestic ADR transactions, regardless whether issuers’ common shares are listed elsewhere – just as the U.S. securities laws should apply to derivative transactions that take place in the U.S, regardless  whether the referenced security trades elsewhere. In other words, it seems possible that these post-Morrison problems could soon be sorted out.

Securities Suit Against U.S.-Listed Chinese Company Dismissed: In a May 31, 2012 ruling (here), Central District of California Judge George Wu granted without prejudice  the motion of defendants' to dismiss the securities suit shareholders filed against A-Power Energy Generation Systems Ltd, certain of its directors and officers, and its auditor. The plaintiffs have been given until July 16, 2012 to file an amended complaint.

As discused at greater length here, the plaintiffs filed suit against the defendants in July 2011, alleging that the company's operataing subsidiaries' filings with a regulatory agency in  China (the SAIC) reported substantially less revenue and net income than the company reported on its SEC filings. The plaintiffs also alleged that the defendants had misrepresented certain related party transactions.

In granting the motions to dismiss with respect to the financial reporting discrepancies, Judge Wu said that, because the plaintiffs' complaint does not allege whether the allegedly conflicting reports were prepared in compliance with the same financial reporting standards. "Plaintiff does not appear to h ave alleged that compliance with PRC's GAAP is even required when filing with the SAIC or that A-Power's subsidiaries preparaed their filings in complinace with GAAP." Without these allegations, "it is not clear to the Court that Plaitiff has adequately falsity" as the Court "would have no way of knowing whether it was comparing apples-to-apples or instead apples-to-oranges" and "Plaintiff would not have satisfactorily alleged why the SEC filings were false as opposed to the SAIC filings." 

The Court also granted the auditor's motion to dismiss, stating that "at best, plaintiff has painted a picture of a negligent or grossly negligent auditor," but that "does not amount to stating a claim for securities fraud."

A Dearth of Consolation for Sorrows to Come: The headlines in Saturday’s issue of the Wall Street Journal were full of dire warnings and troublesome portents. “Euro-Zone Reports Deepen Gloom,” one article was titled. Another was headed “Asia Weakness Heightens Fear of Contagion.” Yet another read “Brazil Loses Steam as World Slows.” Reading the paper was an altogether depressing experience. But as discouraging as these news reports were, there was still more sad news.

A front page article in the Saturday Journal entitled “Spring is No Bowl of Cherries for Michigan Growers” (here) explained that due to the “freakish” weather in March, with its stretch of balmy weather followed by a hard freeze, Michigan’s entire crop of cherries has been wiped out. It is sad news indeed that even before the season has even begun, one of summer’s greatest delights has been completely precluded.

Cherries are one of life’s great pleasures. As my son said when a small boy and enjoying a fistful of the fruit, “Cherries make me happy.” But as good as cherries are anywhere, they are a sublime treat when eaten fresh on a July afternoon on sandy beach on the shores of Lake Michigan.

We all knew when we were basking in warm sunshine in mid-March that there we were going to pay for it somehow. Now we know one of the bills we have to pay. It is even worse that the whole world seems to be going to hell in a hand-basket. If the Eurozone blows up this summer the situation will be dire, and we won’t even be able to draw upon the consolation that can be found in a bowl of cherries.  Alas.

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On April 11, 2012, as required by the Dodd-Frank Act, the SEC released its study of cross-border private securities litigation, entitled “Study on the Cross-Border Scope of the Private Right of Action Under Section 10(b) of the Securities Exchange Act of 1934” (here). This Commission study considers possible alternative approaches to the question of cross-border private securities litigation. It also provides a useful and detailed over view of the ways in which the lower courts have been approaching these issues in the wake of the U.S. Supreme Court’s decision in the Morrison v. National Australia Bank case.

By way of background, the Supreme Court in the Morrison case found that the ’34 Act itself did not expressly apply extraterritorially but rather applied only to transactions on domestic exchanges and domestic transactions in other securities.  Shortly thereafter, in connection with its passage of the Dodd-Frank Act, Congress supplied an extraterritorial reach to the Exchange Act in connection with actions brought by the SEC and the DoJ. Section 929P(b)(2) provide extraterritorial effect for these types actions when certain defined types of conduct take place in the United States or when it takes place outside the United States with a foreseeable effect in the U.S.

Section 929Y of the Dodd Frank Act directed the SEC to solicit public comment and then conduct a study to consider whether there should be an extension of a private right of action on the same basis as for the regulators, or in some other manner. This same statutory provision required the SEC to consider the potential implications on international comity and the potential economic costs and benefits of extending the cross-border scope of private actions.

The SEC’s April 11 report, weighing in at 106 pages including indexes and appendices, represents the Commission’s response to this statutory requirement. The report carefully lays out the history of Morrison as well as the lower court case law that has developed since the Supreme Court released its opinion. The report also carefully catalogues all of the various comments the SEC received with respect to the statutory mandate to produce this study.

The report is detailed, interesting and informative. Nevertheless, the SEC could have saved itself a lot of effort (not to mention a lot of paper) if it had just bypassed all of the intervening steps and admitted that  its position has not changed since it filed, in collaboration with the Solicitor General, its amicus brief in connection with the Morrison case, when it was before the U.S. Supreme Court.

After all of the preliminary review, the Commission lays out the available alternatives. The Commisoin does not take a position on the question of whether or not Congress shoudl overturn Morrison. Indeed, the report specifically states that an option woudl be for Congress "to take no action." 

However, in reviewing the alternatives that Congress might take, it leads with the position it advocated before the Supreme Court, which is to preserve some form of the “conduct and effects test” that prevailed prior to the Supreme Court’s decision in Morrison, but with the test narrowed so that “a private plaintiff seeking to base a Section 10(b) private action on it must demonstrate that the plaintiff’s injury resulted directly from conduct within the United States.”  The report notes that the direct injury requirement “could serve as a filter to exclude claims that have a closer connection to another jurisdiction.”

The Commission noted that this was the position it took with the SG before the Supreme Court, adding that “the Commission has not altered its view in support of this standard.”  Indeed, in the study, the SEC takes the opportunity to reiterate in the report the arguments that it raised in support of this position before the U.S. Supreme Court.

The report does, however, note that even the narrow direct injury test could nonetheless pose challenges to international comity when litigants are able to seek and obtain remedies that would not be available in their own country. The direct injury test could require a fact-intensive inquiry that could result in burdensome costs both for U.S. courts and foreign corporations.

The report also suggest, in addition to some form of the conduct and effects test, four options to “supplement and clarify the transactional test.” First, the report suggests the possibility that investors would be permitted to pursue a Section 10(b) claim in connection with the purchase or sale of any securities that are of the same class of securities registered in the United States, regardless of the location of the transaction. A second non-exclusive option is to allow private rights of action against broker-dealers and other intermediaries that engage in securities fraud while purchasing or selling securities overseas for U.S. investors or otherwise providing services to U.S. investors.

A third option is to permit a private right of action if investors can show they were fraudulently induced while In the U.S. to enter a transaction, regardless of where the transaction took place. Fourth, it could be clarified that an off-exchange transaction takes place in the U.S. if either party made or accepted the offer to purchase or sell the security while in the U.S.

Congress did ask for this report. But it is really hard to know what if anything Congress is likely to do with it. There is a sense in reading this report that the SEC is energetically fighting the last war, right up to and including repeating the arguments that the Commission made to  (and that were rejected by) the U.S. Supreme Court. It is probably important to keep in mind that Congress asked for this report before the extensive body of case law was built up in the lower courts interpreting the Morrison decision. But now that the case law has developed, you do have to wonder whether Congress is really prepared to set all of that aside to start tinkering on its own with these issues.

To be sure, Congress has shown a remarkable willingness to tinker with the securities laws. Congress has been willing to pass the Sarbanes-Oxley Act, the Dodd-Frank Act, and the JOBS Act, all just in the last ten years, and before that there was the PSLRA, SLUSA, and even CAFA. So I guess we should never assume that Congress won’t take up these issues. However, I am guessing that this will not be a high priority item. Especially in the wake of the JOBS Act, I just don’t see Congress taking any actions that would likely increase the amount of private securities litigation.

All of that said, I do think there is one issue we could all use a little help with; that is, when the Supreme Court articulated the transaction test, the Court specified that the U.S. securities laws apply  not only to transactions on domestic exchanges but also  to “domestic transactions in other securities.” The Supreme Court did not explain what it mean in this so-called second prong of the transactions test, but it has given the lower court fits and it has the potential to cause a lot of mischief. The lower courts are trying to piece together a coherent interpretation of the second prong, but until there is either a uniform lower court consensus on this standard or where get further guidance from the U.S. Supreme Court, lower courts are going to struggle with this. While that is probably OK in the long run, it wouldn’t be a bad thing if Congress could clarify when the U.S. Supreme Court applies to non-exchange transactions.

One final note, on April 11, 2012, SEC Commissioner Luis Aguilar filed a dissenting statement regarding the SEC's report, in which he states among other things " I write to convey my strong disappointment that the study fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that resulted and that will continue to result due to Morrison v. National Australia Bank, Ltd." Aguilar advocates the enactment for private litigants of a standard that is identical to that for the SEC and the DoJ in Section 929P of the Dodd Frank Act.

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In its June 2010 decision in the Morrison v. National Australia Bank, the U.S. Supreme Court enunciated a "transactions" test to determine the applicability of the U.S. securities laws. The Court said that the U.S. securities laws apply only to "transactions in securities listed on domestic exchanges and domestic transactoins in other securities." Subsequent courts have wrestled with the second prong as they struggled to determine what constitutes a "domestic transaction in other securities."

In a March 1, 2012 opinion (here), the Second Circuit in the Absolute Activist Value Master Fund Limited v. Ficeto case for the first time examined the requirements under Morrison’s second prong, holding that in order to establish the existence of a domestic transaction in other securities, a plaintiff “must allege facts suggesting that either irrevocable liability was incurred or title transferred within the United States.” The opinion helpfully suggests the kinds of allegations that would satisfy this test, and also clarifies that certain allegations that are not relevant in determining whether or not this standard has been satisfied.

Background

The plaintiffs in this case are nine Cayman Island hedge funds (the “Funds”) that invested on behalf of hundreds of investors around the world, including also U.S. investors. In 2004, the Funds engaged Absolute Capital Management Holdings Limited (“ACM”) to act as investment manager. The complaint alleges that various individual ACM officers and employees engaged in a “pump and dump scheme,” using in part a California broker-dealer in which several of the individual defendants had ownership interests. (The SEC’s related February 25, 2011 enforcement action against many of the same individuals can be found here.)

The plaintiffs allege that the defendants caused the Funds to purchase billions of shares of thinly capitalized U.S. companies. All of these companies were incorporated in the U.S. and their  shares were quoted on the OTC BB or on Pink Sheets. However, the Funds’ shares in these companies were purchased directly from the companies themselves in private offerings in the form of private investment in public equity transactions (“PIPE” transactions).

The plaintiffs allege that the defendants used transactions to and between the Funds to generate commissions and to inflate the prices of the companies’ shares. The plaintiffs further allege that after the companies’ share prices were inflated, the individual defendants unloaded their personal holdings in the companies’ securities for a substantial profit. The Funds allegedly suffered losses of over $195 million.

The Funds filed suit against certain ACM officers and employees, as well as against the California brokerage and its principles. The defendants moved to dismiss. The district court dismissed the case on the basis of Morrison, and the plaintiffs appealed.

The March 1 Decision

Apparently because the securities the Funds had purchased were procured by Cayman Island hedge funds through PIPE offerings, the parties did not argue and the Second Circuit did not address whether or not the plaintiffs allegations satisfies Morrison’s first prong relating to “transactions in securities listed on domestic exchanges.” The Second Circuit addressed only Morrison’s second prong, attempting to determine “under what circumstances the purchase or sale of a security that is not listed on a domestic exchange should be considered ‘domestic’ within the meaning of Morrison.” The Court noted in that regard that Morrison itself “provides little guidance as to what constitutes a domestic purchase or sale.”

Examining prior decisions addressing the question of what determines the timing of a purchase or sale, the Second Circuit said that “given that the point at which the parties become irrevocably bound is used to determine the timing of a purchase or sale, we similarly hold that the point of irrevocable liability can be used to determine the locus of a purchase or sale.” In order for a plaintiff to allege sufficient facts to support a plausible inference that the parties incurred irrevocable liability within the United States, the plaintiffs must allege 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.”

The Second Circuit went on, in recognition of the Eleventh Circuit’s June 2011 decision in the Quail Cruise Ship Management case also interpreting Morrison’s second prong (about which refer here, scroll down), to note that “a sale of securities can be understood to take place at the location at which title is transferred.”

Combining these two tests, the Second Circuit concluded that “to sufficiently allege a domestic transaction in securities not listed on a domestic exchange, we hold that a plaintiff must allege facts suggesting that irrevocable liability was incurred or title was transferred within the United States.”

Having thus enunciated what is required in order to satisfy Morrison’s second prong, the Second Circuit proceeded to reject other tests the parties had proposed. In particular, the Second Circuit said the location of a broker-dealer alone should not be used to determine the location of a securities transaction (although the location of a broker could be relevant to the extent the broker carries out tasks that irrevocably bind the parties to buy or sell securities).

The Second Circuit also rejected the argument that the identify of the securities themselves could be used to determine whether a transaction is domestic, even if the securities are issued by United State companies and are registered with the SEC. The Second Circuit said that it “cannot conclude that the identity of the securities necessarily has any bearing on whether a purchase or sale is domestic.”

Similarly, the Court held that the identity of the buyer or seller alone is not determinative of the issue whether a transaction is domestic. Even if both the buyer and the seller are both foreign, that alone would not resolve the question of whether or not a transaction is domestic. The Second Circuit also rejected the argument that the Court must determine with respect to each defendant whether that defendant engaged in at least some conduct in the United States, noting that the transaction test does not require each defendant alleged to be involved in the fraudulent scheme to have engaged in conduct in the United States.

In summing up its rulings, the Second Circuit said that “rather than looking to the identity of the parties, the type of security at issue, or whether each individual defendant engaged in conduct within the United States, we hold that a securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed with the United States.”

Having determined the standard to be applied, the Second Circuit held that the allegations of the plaintiffs in this case were not sufficient to establish that the transactions at issuer were “domestic” and therefore subject to the U.S. securities laws -- which is hardly surprising given that the plaintiffs had framed their allegations before the U.S. Supreme Court issued its Morrison decision. The Second Circuit held that the case should be remanded to the district court so that the plaintiffs could attempt to amend their pleading to try to address Morrison’s requirements. The Second Circuit specifically said that the kinds of allegations to be included to establish that the transactions at issue were domestic include “facts concerning the formation of the contracts, the placement of the purchase orders, the passing of title, [and] the exchange of money.”

Discussion

Prior to the Second Circuit’s ruling in this case, and In trying to flesh out what makes a transaction “domestic” under Morrison’s second prong, the courts had worked out two competing standards. The first of these standards, enunciated in June 2011 by Southern District of New York Judge Barbara Jones in the SEC v. Goldman Sachs case, held that the place of the transaction is determined based upon the place where” irrevocable liability” is incurred (as discussed here). An alternative interpretation of the standard was described in the Eleventh Circuit’s 2011 opinion in the Quail Cruise Ship Management case (about which refer here, scroll down), in which place of the location of the transfer of title could be sufficient to establish that a transaction was domestic. (Judge Jones, in reliance of the District Court opinion in the Quail Cruise Ship Management case, had held that the place of the closing alone was insufficient to determine whether or not a transaction was domestic.)

Rather than chose between these two potentially competing lines of analysis for determining under Morrison’s second prong whether or not a transaction is domestic, the Second Circuit simply incorporated both, holding that facts suggesting either that irrevocable liability was incurred in the United States or that title was transferred in the United States were sufficient to establish that a transaction was “domestic.”

By affirming both tests, the Second Circuit arguably broadened the circumstances that could be sufficient to satisfy Morrison’s second prong. On the other hand, by stating firmly the kinds of things that would not be sufficient (such as the identity of the buyers or sellers and the identity of the securities), the Second Circuit arguably restricted the circumstnaces under which plaintiffs may be able to argue that a transaction is domestic.  Finally, by enumerating the kinds of issues the plaintiffs should attempt to address (such as the facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money), the Second Circuit provided at least some guidance of the kinds of things plaintiffs should include in their allegations in order to try to satisfy Morrison’s second prong.

Even in the short amount of time since the U.S. Supreme Court issued the Morrison opinion, a considerable number of disputes had arisen in which plaintiffs asserting claims under the U.S. securities laws had tried to rely on Morrison’s second prong in order to establish that the U.S. securities laws apply to the non-market transaction that is the basis of their claim. The Second Circuit’s opinion could have a significant impact on these non-market transaction cases, especially those pending in the Second Circuit.

Among other cases that would seem to be significantly affected by the Second Circuit’s opinion in this case is the appeal in the Porsche case now pending in the Second Circuit. As noted here, in December 2010, Southern District of New York Judge Harold Baer had held in the Porsche case that a swap transaction could not come within Morrison’s second prong where the referenced security traded on a non-U.S. exchange. The Second Circuit’s holding in the Absolute Activist Value Master Fund Limited case, in which the Second Circuit said among other things that the identify of the securities involved in the transaction is not determinative, would seem to suggest that the district court’s holding in the Porsche case may not withstand scrutiny on appeal.

Although it remains to be seen, the Second Circuit’s ruling in the Absolute Activist Value Master Fund Limited case could expand the number of types of cases in which plaintiffs seeking to assert securities claims involving non-market trades may be able to survive a motion to dismiss made in reliance on the Morrison decision.

A March 2, 2011 memo by the Cahill law firm about the Second Circuit's opinion can be found here. A March 2, 2012 memo by the Debevoise law firm about the opinion can be found here. Special thanks to the several loyal readers who send me copies of the Second Circuit's opinion.

Fourth Circuit Excoriates Prosecutors for Use of Uncivil Language: In a recent post (here), I quoted the pointed words of Central District of California Judge Dale Fischer in a hearing in one of the FDIC lawsuits arising out of the failure of IndyMac bank, in which she urged lawyers to cut the overheated rhetoric and to get to the point.

Judicial impatience with lawyers’ verbal excesses seems to be catching on. As noted in a February 16, 2012 post on the Volokh Conspiracy blog (here), the Fourth Circuit, in a footnote in a January 18, 2012 opinion (here), takes U.S. prosecutors to task for the language the lawyers used in their briefs in the case.

The footnote, which appears at the conclusion of the Court’s opinion (written by Fourth Circuit Judge Allyson Kay Duncan), opens with the observation that “we feel compelled to note that advocates, including government lawyers, do themselves a disservice when their briefs contain disrespectful or uncivil language directed against the district court, the reviewing court, opposing counsel, parties, or witnesses.”

The government’s brief, the Court notes, is “replete with such language;” : it “disdains the district court’s ‘abrupt handling’ of Appellant’s first case; “sarcastically refers to Appellant’s previous counsel’s ‘new-found appreciation for defendant’s mental abilities’”; criticizes the district court’s "oblique language" on an issue unrelated to the appeal; states that a district court opinion "revealed a crabby and complaining reaction to Project Exile;” insinuates that the district court’s concerns "require[ ] a belief in the absurd that is similar in kind to embracing paranormal conspiracy theories;"  and accuses Appellant of being a "charlatan" and "exploit[ing] his identity as an African-American."

The Court said that “the government is reminded that such disrespectful and uncivil language will not be tolerated by this court.”

It certainly can be hoped that these two judicial reactions to the lawyers’ rhetoric represents a growing willingness to take a stand against lawyers’ use of excessive, vituperative or abusive language. There is no doubt that lawyers’ increasing willingness to use intemperate language of this type is disrespectful to the Court; inconsistent with basic notions of professionalism; and undermines civility in the profession. If courts were to become more engaged in calling out lawyers who employ excessive language of this type, perhaps lawyers might tone it down and keep things a little more civil.

In his blog post about the opinion cited above, Eugene Volokh includes an interesting additional gloss on the critical footnote, and also quotes at length from the letter of apology that the government lawyer responsible for the language wrote to the Court.

Chancellor Strine: In an interesting March 1, 2012 article in the American Lawyer (here), Susan Beck takes a detailed look at the new Chancellor of the Delaware Court of Chancery, Leo Strine. I commend the article to anyone who is interesting in business litigation in Delaware. And as Francis Pileggi pointed out in a March 3, 2012 post on his Delaware Corporate and Commercial Litigation Blog (here), Professor Stephen Bainbridge has also published an interesting perspective on Chancellor Strine, in a March 1, 2012 post on his Professor Bainbridge.com blog (here), in which Bainbridge compares Strine to one of the minor biblical prophets.

Strine has only been in the Chancellor position since last June, and he has already triggered a profusion of interesting commentary.

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I am pleased to present below a guest post from Angelo G. Savino of the Cozen O’Connor law firm discussing the Southern District of New York’s application of the Morrison decision in an SEC enforcement action pending against Goldman Sachs employee Fabrice Tourre. This guest post will also be published and distributed in the future as a Client Alert from the Cozen law firm.

My thanks to Angelo for his willingness to publish his guest post here. I welcome guest posts from responsible commentators on topics relevant to this blog. Any readers who are interested in publishing a guest post on this site are encouraged to contact me directly.

Here is Angelo’s guest post::

On June 10, 2011, Judge Barbara Jones of the United States District Court for the Southern District of New York issued a decision in a case entitled SEC v. Goldman Sachs & Co., No. 10-3229 (“Goldman Sachs”), that applied the Supreme Court’s Morrison decision to claims by the SEC under both the Securities Exchange Act of 1934 and the Securities Act of 1933. Goldman had previously settled the claims against it for $550 million, but left Fabrice Tourre, a Goldman Vice President who had worked at its New York headquarters, to face the SEC’s claims. 

The decision is noteworthy because it is the first to apply Morrison, which held that section 10(b) of the Exchange Act does not apply extraterritorially, to claims by the SEC. It is also the first decision to provide a detailed analysis of the second prong of Morrison’s transactional test involving domestic transactions in securities that are not listed on an exchange. Lastly, the decision is the first to apply Morrison to section 17(a) of the Securities Act. 

The SEC alleged that in 2007, Goldman structured and marketed a synthetic collateralized debt obligation (“CDO”) called Abacus 2007-ACI (“Abacus”) that was based on the performance of subprime residential mortgage-backed securities (“RMBS”). CDOs are debt securities collateralized by other debt obligations such as, in this case, RMBSs. The complaint also alleged that Goldman was assisted by a hedge fund, Paulson & Co. Inc. (“Paulson”) in selecting the RMBSs that would collateralize the CDO. At the same time, Paulson allegedly entered into a credit default swap (“CDS”) that essentially bet that the RMBSs would perform poorly. According to the SEC, Goldman and Tourre marketed the CDOs without disclosing to investors that the underlying portfolio of mortgage-backed securities had been selected by Paulson while Paulson was betting against their performance. Tourre was allegedly the Goldman employee principally responsible for structuring and marketing the Abacus securities. 

The SEC also alleged that Goldman and Tourre marketed and sold $150 million worth of Abacus notes to IKB, a German commercial bank, and $42 million worth of notes to ACA Capital Holdings, Inc. (“ACA Capital”), a U.S.-based entity. ACA Capital also entered into a credit default swap involving a $909 million super senior tranche of Abacus. Essentially, ACA Capital assumed the credit risk associated with that portion of Abacus’s capital structure in exchange for premium payments. Thereafter, through a series of credit default swaps among ABN, Goldman, and ACA Capital, ABN assumed the credit risk regarding that $909 million tranche. ABN is a Dutch bank.

The closing for Abacus occurred in New York City and Goldman delivered the notes through the book entry facilities of Depository Trust Company in New York City. Tourre, however, provided the court with trade confirmation indicating that Goldman Sachs International, located in London, was listed as the seller of the notes to an IKB affiliate based on the Island of Jersey, a British dependency. Similarly, the CDS confirmations regarding the ABN transaction listed the seller as Goldman Sachs International and the purchaser as the London branch of ABN. 

The SEC claimed that Tourre had violated section 17(a) of the Securities Act and section 10(b) of the Exchange Act, Rule 10b-5 thereunder, and aided and abetted violations of section 10(b). Tourre moved to dismiss and for judgment on the pleadings based on Morrison on the ground that the complaint failed to state a claim because it did not allege securities transactions that took place in the United States. 

Judge Jones first analyzed the SEC’s Exchange Act claims against Tourre. She noted that the Supreme Court, in Morrison, had adopted a clear transactional test: “whether the purchase or sale is made in the United States, or involves a security listed on a domestic exchange.” Nevertheless, Judge Jones also noted that, because the securities at issue in Morrison were traded only on foreign exchanges, the Supreme Court was largely silent regarding how lower courts should determine whether a purchase or sale is made in the United States. That, however, was the issue she faced because the Abacus securities were not traded on an exchange. 

The court began its analysis of the issue by looking to the statutory definitions of “purchase” and “sale” in the Exchange Act, which were relatively “unhelpful.” The court then turned to case law and determined that the concept of “irrevocable liability” was at the core of both a “sale” and a “purchase.” The court noted that at some time a purchaser incurs irrevocable liability to take and pay for a security while a seller incurs irrevocable liability to deliver a security. 

In applying this concept to the IKB transaction, the court rejected the SEC’s arguments based on Tourre’s presence in New York while he engaged in structuring and marketing of Abacus on the grounds that it was merely conduct, which had been rejected as the determinative factor in Morrison. Judge Jones also rejected the SEC’s argument that courts must look to the “entire selling process” to determine whether a securities transaction is foreign or domestic. The court observed “in reality, the SEC’s ‘entire selling process’ argument is an invitation for this court to disregard Morrison and return to the ‘conduct’ and ‘effects’ tests.” 

The SEC had also conceded at oral argument that the closing in New York, by itself, was not sufficient to make IKB note purchases domestic transactions for purposes of Morrison. For good measure, however, the court noted Quail Cruises Ship Mgmt. v. Agencia De Viagens CVC Tur Limitada, which also rejected the place of closing as determinative under Morrison. Accordingly, the court concluded as follows: 

In view of the fact that none of the conduct or activities alleged by the SEC, including the closing, constitute facts that demonstrate where any party to the IKB note purchases incurred “‘irrevocable liability[,]’” . . . the SEC fails to provide sufficient facts that allow the court to draw the reasonable inference that the IKB note “purchase[s] or sale[s were] made in the United States.” 

Turning to the ABN transaction, the court stated that the SEC provided no facts from which the court could draw the reasonable inference that any party to the ABN CDS transaction incurred “irrevocable liability” in the United States. Thus, Judge Jones ruled that the SEC failed to allege that the ABN CDS transaction constituted a domestic transaction under Morrison for the same reasons as the IKB purchases. 

Because AKA Capital was based in the United States, there appears to have been no opportunity for the court to apply Morrison to those transactions. Instead, the court analyzed whether the SEC had sufficiently pled the elements of a violation of section 10(b), and found that it had. 

The court also analyzed the sufficiency of the SEC’s claim under section 17(a) of the Securities Act, and whether Morrison applied to that statutory section. The court observed that Morrison did not involve or consider section 17(a), none of the parties had cited any cases applying Morrison to section 17(a), and the court was not aware of any such case. Judge Jones observed that In re Royal Bank of Scotland Grp. PLC. Litig. applied Morrison to sections 11, 12 and 15 of the Securities Act, but did not address section 17(a). Nevertheless, the court agreed with Tourre that Morrison applies to section 17(a), stating that “Morrison itself expressly states that the Exchange Act and the Securities Act share ‘[t]he same focus on domestic transactions.’” Because Morrison focused on whether sales of securities were domestic or foreign, Judge Jones concluded that, to the extent section 17(a) applied to sales, it does not apply to sales that occur outside the United States. The court therefore dismissed the section 17(a) claim, but only to the extent that it was based on sales to IKB and ABN. 

The court continued its analysis, however, observing that section 17(a), unlike section 10(b), applies not only to sales of securities, but also to offers to sell securities. The court examined the definition of the term “offer” in the Securities Act, which states that an offer includes “every attempt to offer or dispose of, or solicitation of an offer to buy, a security or interest in a security, for value.” The court stated that this definition left no doubt that the focus of “offer,” under the Securities Act, was on the person or entity attempting, or offering, to dispose of, or soliciting an offer to buy, securities. Applying this definition to the allegations of the complaint, the court noted that the SEC alleged Tourre, acting from New York City, offered Abacus notes to IKB and solicited ABN’s participation in Abacus CDSs. The court observed that Tourre allegedly engaged in numerous communications from New York City that constituted domestic offers of securities or swaps. Thus, Judge Jones permitted the section 17(a) claim to survive to the extent that it was based on such “offers.” 

Conclusion

This case adds significantly to the jurisprudence applying the Supreme Court’s Morrison decision. As an initial matter, the case represents the first time that any court has applied Morrison to claims by the SEC. Because this action was brought prior to the enactment of Dodd-Frank, which purports to grant subject matter jurisdiction over extraterritorial claims by the SEC, it remains to be seen whether subsequent post-enactment SEC cases will follow this decision. It is arguable that Dodd-Frank should not change the Morrison analysis as applied to the SEC. Although Dodd-Frank purports to grant subject matter jurisdiction over extraterritorial securities claims by the SEC, the Supreme Court, in Morrison, held that district courts already had subject matter jurisdiction, but that section 10(b) itself had no extraterritorial reach. Nothing in Dodd-Frank modified section 10(b) in that regard. Thus, courts in post-enactment cases may conclude that they are able to follow Judge Jones’s decision in Goldman Sachs. 

In addition, the Goldman Sachs decision is significant for its analysis of how Morrison applies to transactions in securities that are not listed on an exchange. As Judge Jones noted, because Morrison involved securities traded on foreign exchanges, the decision is essentially silent on the second prong of its transactional test involving the purchase or sale of any other security in the United States. The Goldman Sachs decision furnishes a well reasoned analytical roadmap for other courts to follow in this respect. 

Lastly, the decision is noteworthy for its articulation of the applicability of Morrison to claims under section 17(a) of the Securities Act involving sales of securities, and to the Securities Act generally. 

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In the latest demonstration of just how far the U.S. Supreme Court’s holding in Morrison v. National Australia Bank may restrict Section 10(b) claims involving foreign companies, on December 30, 2010, Southern District of New York Judge Harold Baer held that U.S.-based hedge funds could not pursue the claims that Porsche and certain of its officers had misrepresented Porsche’s intent to take over Volkswagen, which the hedge funds claim put them in a "short squeeze" that cost them $2 billion.

A copy of Judge Baer’s December 30 ruling in the Porsche case can be found here.

Background

The plaintiff hedge funds had entered security based swap agreements that referenced the price of VW shares. The swaps did not trade on any exchanges. The swap agreements generated gains for plaintiffs as VW’s shares decline and produced losses as the price of VW shares rose.

The plaintiffs allege that all of the steps necessary to transact the swap agreements were carried out in the United States. The swap agreements contain choice of law and forum selection provisions that designate New York law and a New York forum.

In the lawsuits, the hedge fund plaintiffs allege that the defendants had caused a dramatic rise in VW stock prices by buying nearly all of the few freely-traded shares as part of a secret plan to take over the company. The plaintiffs allege that after months of denying that it sought to take over VW, Porsche on October 26, 2008 disclosed the extent of its accumulated holdings in VW stock, as a result of which the VW share price shot up, causing the plaintiffs losses on their share agreements.

The defendants moved to dismiss in reliance on Morrison, on the grounds that the transaction was not within the ambit of Section 10(b) of the Securities Exchange Act of 1934.

The December 30 Holding

Morrison had held that Section 10(b) applies only to "transactions in securities listed on domestic exchanges, and domestic transaction in other securities." Because the plaintiffs’ swap agreements do not trade on U.S. exchanges, the relevant inquiry, according to Judge Baer, is whether the swap agreements constitute "domestic transactions in other securities."

The plaintiffs argued that because they signed confirmations for securities-based swap agreements in New York, they engaged in "domestic transactions on other securities" within the scope of Section 10(b).

Judge Baer held that these arguments were "inconsistent" with the "Supreme Court’s intention" to "curtail the extraterritorial application of Section 10(b)." He added that if the argument were allowed, it "would extend extraterritorial application of the Exchange Act’s antifraud provisions to virtually any situation in which one party to a swap agreement is located in the United States."

Judge Baer found this situation to be indistinguishable from one in which a U.S.-based investor bought securities in a non-U.S. company on a foreign exchange, circumstances that other courts previously have held to be outside the ambit of Section 10(b) in the wake of Morrison.

Looking to what he described as the "economic reality" of the swap transaction, Judge Baer found that "Plaintiffs’ swaps were the function equivalent of trading the underlying shares on a German exchange," noting that "the swap agreements were transacted with undisclosed counterparties who may well have been located outside the United States," and that both the issuer and the perpetrator of the alleged fraud were also located outside the United States.

Judge Baer noted that he is "loathe to create a rule that would make foreign issuers with little relationship to the U.S. subject to suits here simply because a private party in this country entered a derivatives contract that references the foreign issuer’s stock. Such a holding would turn Morrison’s presumption against extraterritoriality on its head."

Discussion

Perhaps the most telling line in Judge Baer’s opinion is his statement that the U.S. Supreme Court’s intention in Morrison had been to "curtail the extraterritorial application of Section 10(b)," Clearly, that has been the lower courts’ approach, effectively "curtailing" the reach of Section 10(b) in a wide variety of circumstances.

With this presumption about Morrison’s intention as his starting point, Judge Baer seems very clear that the swap transaction at issue here did not satisfy the Morrison "domestic transaction" test. But while the mere U.S. location of one swap counterparty may not be sufficient to subject a foreign-domiciled issuer to U.S securities laws, Judge Baer’s analysis still does beg several questions left unanswered in his opinion, namely: if this transaction is not a U.S. "domestic transaction," of what jurisdiction is it a domestic transaction? If the transaction details here are not sufficient to constitute a "domestic transaction," what transaction details are sufficient?

It remains for other courts to work through these kinds of questions. In the meantime, Judge Baer’s analysis, if followed by other courts, could restrict other prospective plaintiffs’ ability to rely on Morrison’s second prong to try to bring Section 10(b) claims involving foreign companies. Judge Baer’s analysis, along with that of other courts, suggests that courts will take a narrow view of what constitutes a "domestic transaction in other securities."

Certainly, a court proceeding, as did Judge Baer, on the assumption that Morrison intended to "curtail the extraterritorial effect of Section 10(b)" arguably will be predisposed against finding that a transaction involving a foreign company’s securities not traded on U.S. exchanges is a "domestic transaction in other securities." Morrison’s second prong may not prove to be as valuable to plaintiffs as they initially thought it might.

Allison Frankel’s January 3, 2011 Am Law Litigation Daily article about the Porsche decision can be found here. The Sullivan & Cromwell firm, which argued the case on behalf of Porsche, has a detailed January 3, 2011 memorandum about the case here.

Special thanks to the several readers who provided me with copies of Judge Baer’s opinion.

Editorial Note: In my January 3, 2011 post, I mentioned that I would be publishing a list of the top ten D&O stories of 2010 today (January 4, 2011). However, because of the several time sensitive developments (including the above), I will postpone the publication of the top ten list until later in the week. Sorry for any confusion.　

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Earlier this week, I hosted a guest post from the counsel for the plaintiffs in the Vivendi securities class action lawsuit, in which plaintiffs’ counsel summarized their position on the impact that the U.S. Supreme Court’s decision in Morrison v. National Australia Bank had on their case.

In response to their post, University of Minnesota Law Professor Richard Painter prepared the following commentary and submitted it to me for publication here. By way of background, Professor Painter’s opening reference is to George Conway of the Wachtell Lipton firm, who, as reported in the prior post on this topic, briefed and argued the Morrison case for National Australia Bank, and who has been quoted as characterizing the position of the Vivendi plaintiffs on this issue as “Completely nuts, N-U-T-S.” 

Here are Professor Painter’s comments:

Actually, Conway has to be right. The argument that Section 10(b) applies to foreign transactions in securities merely because those securities are listed in the United States is absurd.

First, a reading of the entire Morrison opinion leads to the conclusion that the Court did not extend the reach of Section 10(b) to foreign transactions in securities listed on an American exchange. The Court’s unequivocal holding is that Section 10(b) does not apply “extraterritorially.” The Court repeatedly emphasizes that the “focus” of American securities laws is on “domestic transactions” and on “purchases and sales of securities in the United States.”

An extremely large hole would be driven through that holding if the mere listing of a stock or an ADR on an American exchange were enough to justify application of U.S. law to a foreign purchase of the stock on a foreign exchange, as there are hundreds if not thousands of foreign issuers that list their home-country shares or ADRs on a U.S. exchange.

Second, the Court was well aware that NAB had ADRs listed in New York. In order for a foreign issuer to sponsor and list ADRs on a U.S. exchange, it must register the underlying, deposited shares with the SEC and, at least for the NYSE, actually list the underlying shares (though not for trading). NAB’s registration statement in the United States, for example, pertained to “ordinary shares” (At page 58 of the Supplemental Joint Appendix in Morrison v. NAB, the 20-F cover says NAB’s ordinary shares were “registered on the NYSE.” This cover looks exactly like the 20-F cover for Vivendi that the plaintiffs there are relying on.)

The Court nonetheless held that Section 10(b) did not apply to NAB’s ordinary shares traded in Australia. This holding is inconsistent with a theory that the Court would apply Section 10(b) to any security listed on a U.S. exchange even if the transaction in that security is outside the United States.

Many companies have ADRs trading in the United States. It cannot possibly be the case that the Court intended Section 10(b) to apply not only to the ADR itself but also to a foreign purchase of the underlying stock on a foreign exchange simply because the underlying shares are registered in the United States to enable the company to issue the ADR.

Indeed, if the Vivendi plaintiff’s counsel were correct, Section 10(b) after Morrison would have a broader extraterritorial reach than ever before. Think of the many foreign-cubed claims dismissed under the Second Circuit’s conduct test before the Supreme Court ruled: many – if not most – of the defendant issuers in those cases had sponsored ADRs that traded on American exchanges, just like NAB, and just like Vivendi. On plaintiffs’ reading of Morrison, those cases were wrongly dismissed. Section 10(b) – which the Supreme Court said did not have any extraterritorial application “at all” – according to Vivendi plaintiffs’ counsel would apply more extraterritorially than ever before.

This is the exact opposite of what the Court clearly intended. And it would mean that the Court got the result wrong in Morrison itself.

There are other points to make against the plaintiffs’ contention, such as the significance of Section 30 of the Exchange Act, whose territorial limitations would be rendered meaningless if plaintiffs’ reading of Morrison were correct. The bottom line is: it is quite clear that plaintiffs who transacted in securities outside the United States have no cause of action under Section 10(b) merely because these securities or related ADRs are listed on a U.S. securities exchange.

Nice try plaintiffs, but if you want a different rule, ask the SEC to recommend one in its study of extraterritorial private rights of action that Congress mandated in Dodd-Frank. Don’t waste your time with a meritless interpretation of Morrison.

I encourage reader to respond to Professor Painter’s commentary or to the Vivendi plaintiffs’ prior column using this blog’s comment function.

I welcome guest blog posts from responsible commentators on topics of interests to readers of this blog. Please contact me (using the Contact function in the right hand column) if you are interested in submitting a guest column.

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The U.S. Supreme Court’s decision last month in the Morrison v. National Australia Bank case made it clear U.S. securities laws do not allow so-called "f-cubed" cases -- securities claims against foreign domiciled companies and brought by foreign-domiciled claimants who purchased their company shares on foreign exchanges -- in U.S. courts. The securities laws, the Court said in Morrison, relate solely to "transactions in securities listed on domestic exchanges" and to claims relating to "domestic transactions in other securities."

But what did the Court mean when it referred to "domestic transactions"? Unfortunately the Court didn’t say. As the recent lead plaintiff decision in the securities class action lawsuit involving Toyota demonstrates, this question could be a problem in many cases involving foreign companies, particularly where the cases involve claims brought by or on behalf of U.S. domiciled investors who bought their shares in the foreign companies on foreign exchanges – the so-called "f-squared" claimants.

These issues were addressed recently in the lead plaintiff decisions in the Toyota class action securities litigation. As discussed at greater length here, in February 2010, Toyota and certain related corporate entitles, as well as certain of its directors and officers, were sued in securities class action lawsuit in the Central District of California. The plaintiffs allege that Toyota misled investors by allegedly failing to disclose that there was a design defect in Toyota’s acceleration system that could cause its cars to accelerate suddenly.

Toyota’s common stock trades on the Tokyo stock exchange and its American Depository Shares trade on the NYSE.

The Supreme Court’s Morrison decision became relevant in connection with the court’s selection of lead plaintiff in the Toyota case. As reflected in her July 16, 2010 memorandum opinion, Judge Dale Fischer had to determine whether or not the Morrison decision allows claims under the securities laws by domestic U.S. shareholders who purchased their shares in a foreign company on a foreign exchange. She had to determine for purposes of the lead plaintiff motion whether the claims of U.S. purchasers of Toyota common stock on the Tokyo exchange were relevant for purposes of the lead plaintiff selection.

In her July 16 opinion, Judge Fischer noted the Morrison decision’s statement that the securities laws allows claims relating to "domestic transactions in other securities," which the decision also refers to as "the purchase or sale of any security in the United States." In exploring what these phrases from the Morrison decision might mean, Judge Fischer said:

One view of the Supreme Court’s holding is that if the purchaser or seller resides in the United States and completes a transaction on a foreign exchange from the United States, the purchase or sale has taken place in the United States. However, an alternative view is that because the actual transaction takes place on the foreign exchange, the purchaser or seller has figuratively traveled to that foreign exchange – presumably via a foreign broker – to complete the transaction. Under this second view, "domestic transactions" or "purchase[s] or sales[s]…in the United States" means purchases and sales of securities explicitly solicited by the issuer within the United States rather than transactions in foreign-traded securities where the ultimate purchaser or seller has physically remained in the United States.

Judge Fischer concluded that the latter of these two positions was "better supported" by Morrison, largely because the Morrison decision emphasized that the U.S. securities laws were not intended to regulate the foreign exchanges.

Having worked through this analysis of whose claims were proper under the U.S. securities laws, Judge Fischer then selected as lead plaintiff the proposed lead plaintiff that had the larges alleged American Depository Share loss.

However, Judge Fischer did say at the outset of her opinion with respect to her analysis of whose claims the Court could properly entertain that "this is not a final determination of the issue and Plaintiffs are not foreclosed from arguing that domestic purchasers of Toyota common stock [as opposed to domestic purchasers of Toyota’s American Depository Shares] have claims" under the securities laws." She added, however, that "the Court currently believes that a fair reading of Morrison excludes those claims" – that is, the claims of domestic U.S. shareholders who purchases Toyota’s common stock on the Tokyo stock exchange.

When the U.S. Supreme Court released its opinion in the Morrison case, it was immediately apparent that the decision would have a significant potential impact on pending and future securities cases involving foreign-domiciled companies. However, as the lead plaintiff decision in the Toyota case shows, it may not be entirely clear how the Morrison decision will affect the cases against foreign companies.

It remains to be seen whether or not "f-squared" cases will be precluded on the Morrison decision, but it seems likely that this will be a hotly contested battleground in many of the cases involving foreign companies.

Very special thanks to a loyal reader for providing me with a copy of Judge Fischer’s July 16 opinion.

My pre-Morrison discussion of an" f-squared claimant" case involving European Aeronautic Defence & Space Co. (EADS) can be found here.

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It was possible to overlook it amongst the flurry of high profile opinions the Supreme Court released on the final day of the 2009 court term, but on June 28, 2010 the Court granted yet another petition for writ of certiorari in a case arising under the securities laws. Although the case arises out of the specific context of a mutual fund market timing case, it raises fundamental issues about who may be a "primary violator" under the securities laws. The Court seems poised to delve yet again into critical issues under the federal securities laws.

Background

Janus Capital Group (JCG) is the holding company for a family of mutual funds. Janus Capital Management (JCM) is the funds’ investment advisor. In November 2003, JCG investors filed a complaint in the District of Maryland alleging that the two firms were responsible for misleading statements in the certain funds’ prospectuses. The allegedly misleading statements represented that the funds’ managers did not permit, and took active measure to prevent, "market timing" of the funds. The investors claim they lost money when market timing practices JCG and JCM allegedly authorized were made public.

In 2004, JCM reached a settlement with the SEC in connection with the market timing allegations in which the firm paid a disgorgement of $50 million and an additional $50 million in civil penalties. Information regarding the settlement can be found here.

The district court dismissed the shareholders suit in May 2007. The shareholders appealed to the United States Court of Appeals for the Fourth Circuit. In a May 7, 2009 opinion (here), the Fourth Circuit reversed the district court, finding that the shareholders had adequately stated a claim under the securities laws. The defendants’ filed a petition for writ of certiorari, which the Supreme Court granted on June 28, 2010.

Issues Involved

As the Supreme Court itself recently affirmed in its Stoneridge case (about which refer here), there is no private action for aiding and abetting liability under the federal securities laws. Accordingly, the defendants can be liable if at all if they are "primary violators," that is, if they are directly responsible for the allegedly wrongful conduct. The Janus entities contend that as mere service entities for the actual funds, they cannot be held primarily liable.

The plaintiffs argue that JCM was not a "mere service provider" contending that the firm handles all of the funds’ operations, "including preparation, filing, and dissemination of the Fund prospectuses and prospectus statements" and that all of the funds’ officers were executives at the advisor. The investors contend that they had every reason to believe that the Fund prospectus statements were JCM’s work.

The Fourth Circuit ruled that "a service provider can be held primarily liable in a private securities fraud action for ‘helping’ or ‘participating’ in another company’s misstatements." The Fourth Circuit’s ruling is at odds with the decisions of other Circuit courts. Some courts hold that only someone that "makes" a statement and has it attributed to him can be held liable as a primary violator. Other courts, similarly to the Fourth Circuit, have held that someone that "substantially participates" in the activities that led to the creation of the allegedly misleading statement can be held liable as a primary violator, even if the statement is not attributed to him or her.

Discussion

Though this case nominally is just about whether or not a service provider can be held liable, fundamentally it is about who can be held liable as a primary violator. A bright line test would limit primary violator liability to those who speak or who have statements attributed to them. However, a broader "substantial participation" test would substantially widen the scope of persons who potentially could be held liable. The scope of liability could potentially extend to a wide range of persons who are involved in the preparation of public statements, including, for example, potentially even the issuers’ attorneys and accountants.

Indeed, at some level, this "substantial participation" test starts to sound a lot like the "aiding and abetting liability" that the Supreme Court had rejected in connection with private lawsuits in the Stoneridge case. That may, in fact, be why the Supreme Court took up the case – not just to reconcile an apparent split in the Circuits, but to align the principles of primary violator liability with those of the secondary violator jurisprudence. In a June 29, 2009 Am Law Litigation Daily article (here), Susan Beck furhter develops these issues relating to the tension between the Fourth Circuit's standard and the case law relating to secondary liabiltiy.

I have absolutely no way of knowing how this case ultimately will turn out, and indeed the case has yet to be fully briefed or argued. But if I were a betting man, I would bet that the principles on which the Fourth Circuit based its decision are unlikely to survive Supreme Court scrutiny. (I could also be wrong, which is why I don’t gamble.)

It is worth noting that the Court suddenly seems particularly keen to take up securities cases. As I recently noted here while discussing the Court’s cert grant in the Matrixx Intiaitves case, there was a time when the Court would go many terms without taking up any securities cases. For several years now, the Supreme Court has taken up one or two securities cases. The Court’s increased interest in securities cases make great blog fodder, but it also creates the potential for disruptive alterations of the settled litigation landscape.

The Court’s sudden heightened interest in securities cases must be particularly unnerving for plaintiffs’ lawyers as the Court, with its current lineup, has generally proven to be less than entirely plaintiff friendly. There is some considerable risk that the Janus case will provide yet another opportunity for the Court to deliver an opinion the plaintiffs’ bar finds unhelpful.

In any event, the Supreme Court will now have two potentially significant securities cases on its docket next term. I really do find it surprising, given this blog’s topical focus, how often I find myself writing about Supreme Court-related issues –especially lately. I never expected that. I do find it all very fascinating though

Special thanks to the several readers who sent me links and other materials about this case. Special thanks to the SCOTUS Wiki blog (here) for links to some of the key documents to which I linked above.

Surprising Stuff Under the Hood of the Financial Reform Act: In recent posts (most recently here) I noted the possibility that the Supreme Court’s decision in the Morrison v. National Australia Bank case could well trigger Congressional action, particularly with respect to the SEC’s authority over conduct in the U.S. even if the transaction occurred outside the U.S.

An alert reader who clearly has a lot of patience managed to sift through the thousands of pages of the Conference Committee version of the financial reform bill (the "Dodd-Frank Wall Street Reform and Consumer Protection Act," which can be found here), and he reports (and my review of the Bill confirms) that the Conference Bill actually addresses the extraterritorial question.

First, Section 929P(b) authorizes an action brought by the Commission, inter alia, based on "conduct within the United States in furtherance of the violation," in effect allowing the Commission to take enforcement action based on conduct in the U.S. even if the transaction took place outside the U.S. (if all the provision's conditions are met).

Second, Section 929Y, entitled "Study of Extraterritoral Private Rights of Action," directs the Commission to study whether private rights of action should be allowed on the same basis as authorized for the Commission in Section 929P(b). The provision directs the Commission to deliver the report to Congress within 18 months of the statute’s enactment.

In other words, if the Bill is enacted in its current form, the Commission will have the ability to bring cases involving foreign companies and even involving transactions outside the U.S., if the conduct meets the standards defined in the provision, and the Commission will study and report to Congress on whether private claimants should have the same right.

Very special thanks to the alert reader who found these provisions and pointed them out to me.

Bank Shot: Regular readers know I have been reporting frequently on the possibility of litigation arising in the wake of the wave of failed banks. The July 2010 issue of U.S. Banker has an article entitled "First the Failures, Then the Lawsuits" (here) which takes a very interesting look at this possibility.

The article reports that the FDIC "has begun laying the groundwork for potentially years of lawsuits against senior executives and directors it claims may have been responsible for their bank’s collapse." The article notes that the FDIC has sent "hundreds of demand letters," which the article describes as "the necessary first steps in assessing accountability."

Among other things, the article reflects a dispute over who the FDIC is targeting with the demand letters. On the one hand, the article quotes the executive director of the American Association of Bank Directors as saying that the "where there’s money to go after," the FDIC is pursuing the claim, "whether there is a good case or not." On the other hand, the article quotes an agency attorney as saying "How far we go depends on the facts and circumstances of each case…If … there’s nothing there, then we close out the investigation."

The article points out that while the FDIC has not filed any director or officer lawsuits during the current crisis, "but observers say that will likely change soon," particularly in light of the three-year statute of limitation. One attorney is quoted as saying we may start to see the suits in 2011 with more in 2012.

The article quotes an agency official as saying that the purpose of the demand letters "is simply to preserve insurance," adding that "we try to make enough of a preliminary investigation to make sure that when we send the letter we’re sending it to the right people and we have a basis for the claim."

Special thanks to a loyal reader for sending a link to the article.

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