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.