On August 16, 2014, in a long-awaited decision that is sure to provoke comment and that could fuel disputes in future cases, the Second Circuit affirmed the dismissal of the securities suits hedge fund purchasers of certain swap agreements had filed against Porsche and its executives.
The plaintiffs contended that because they had completed the swap contracts transactions in the United States, the swap transactions represented “domestic transactions” within the meaning of the “second prong” of the Supreme Court’s holding in Morrison v. National Australia Bank, in which the Court had said that the U.S. securities laws apply to “domestic transactions in other securities.”
In an unsigned per curiam opinion (which can be found here), the Second Circuit — concerned the application of Morrison as the plaintiffs urged would result in the very kind of extraterritorial extension of U.S. securities laws Morrison had sought to avoid — said that while it is necessary for the U.S. securities laws to apply that a domestic transaction is involved, it is not sufficient. The court went on to say that the claims in this case are so “predominately foreign as to be impermissibly extraterritorial.” The court stressed that it was not attempting to establish a rule that would govern future cases, but instead emphasized that future courts would have to make determinations on a case by case basis based on the facts presented.
While the Second Circuit affirmed the district court’s dismissal of the case, the appellate court nevertheless remanded the case to the lower court for further proceedings to see whether or not the plaintiffs could amend their pleadings to try to satisfy the requirements the appellate court had specified.
The plaintiff hedge funds had entered security based swap agreements that referenced the price of VW shares. The referenced VW shares did not trade on any U.S. exchange. 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 took place 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 Porsche 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, while publicly denying that it sought to gain control. 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 massive losses on their swap agreements.
The defendants moved to dismiss in reliance on Morrison, on the grounds that the swap transactions were not within the ambit of Section 10(b) of the Securities Exchange Act of 1934. As discussed here, in a December 30. 2010 opinion, Southern District of New York Judge Harold Baer granted the defendants’ motion to dismiss, holding that the application of the U.S. securities laws to the swap transactions would be “inconsistent” with the Supreme Court’s intention to “curtail the extraterritorial application” of the U.S. securities laws. The plaintiffs appealed.
On March 1, 2012, as discussed here, while the plaintiffs appeal was pending, the Second Circuit issued its opinion in Absolute Activist Value Master Fund Limited v. Ficeto, in which the appellate court examined the requirements under Morrison’s second prong. The Second Circuit held 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 Unites States.”
The August 15 Opinion
On August 15, in a lengthy per curiam opinion, to which Judge Pierre Laval appended a concurring opinion, the Second Circuit affirmed the district court, while also remanding the case back to the district court for the court to determine whether or not the plaintiffs could amend their complaints sufficiently to meet the standards set by the appellate court.
The Second Circuit recognized that the plaintiffs had entered their swap transactions in the United States, which would therefore, based on the Absolute Activist decision, seem to suggest that the transactions met Morrison’s second prong. The problem with this conclusion is that “it would subject to U.S. securities laws conduct that occurred in a foreign country, concerning securities in a foreign company, traded entirely on foreign exchanges.” It would subject foreign defendants to potential liability under the U.S. securities laws based on nothing more than an entirely private transaction of which the defendant were entirely unaware. This result would result in the very extraterritorial application of the U.S. securities laws that the Supreme Court sought to avoid in Morrison.
Accordingly, the Court said, adding its own gloss to Morrison, that while it is necessary for U.S. securities laws to apply that a domestic securities transaction is involved, it is not sufficient. The Court said that it need not even determine whether or not the Absolute Activist standards had been met here, because “we think it is clear that the claims in this case are so predominately foreign as to be impermissibly extraterritorial.”
The Court stressed that its holding in no way forecloses the application of the U.S. securities laws to govern swap transactions where “the transactions are domestic and where the defendants are alleged to have sufficiently subjected themselves to the statute.” The Court warned that its conclusion in this case cannot be “perfunctorily applied to other cases based on the perceived authority of a few facts.” Rather, courts will have to “carefully make their way with careful attention to the facts of each case.” The Court also suggested that it would be better left to the SEC or to Congress to provide a more comprehensive rule.
As the Second Circuit said, this case “illustrates the problem with treating the location of a transaction as the definitive factor in the extraterritorial inquiry.” If the mere fact that the swap transactions –between private parties and entered without Porsche’s involvement or knowledge — were completed in the U.S. were sufficient to subject Porsche and its executives to potential liability under the U.S. securities laws, it “would seriously undermine Morrison’s insistence that Section 10(b) has no extraterritorial application.”
Just the same, it could be argued that the Second Circuit ranged beyond the strict confines of Morrison and extended entirely new guidelines when it stated that it was necessary but not sufficient that a domestic transaction was involved in order for the U.S. securities laws to apply.
The difficulty with the Second Circuit’s extension is that it invites further disputes, particularly given the lengths to which the Court went to avoid any suggestion that it was laying down a bright-line rule. (Indeed, Judge Leval’s concurrence was written in defense of the fact that the Second Circuit has taken the Supreme Court’s single-factor “domestic transaction” test and turned it into a multi-factor formulation.) While the Morrison court laid down what is “necessary,” the Second Circuit arguably has now begged the question of what is “sufficient” for U.S. securities laws to apply.
The Second Circuit provided little guidance about what may be “sufficient,” except to say that the U.S. securities laws are implicated when a domestic transaction is involved and the defendants “are alleged to have sufficiently subjected themselves to the statute.” But what activities are relevant in consideration of the question whether the defendants have “subjected” themselves to the U.S. securities laws – and doesn’t risk getting courts back into the “conduct” part of the old “conduct and effects” test that the Supreme Court rejected in Morrison? And what degree of activity is enough to say that defendants have “sufficiently subjected” themselves to the U.S. securities laws? Obviously, the Second Circuit standard leaves much for subsequent courts to fill in, which seems to put us back on the slippery slope toward the inconsistent case law the Supreme Court sought to eliminate when it rejected the “conduct and effects” test.
By the same token, defendants will now seek to resist the application of the U.S. securities laws by attempting to argue that the transaction in question was “predominately foreign.” Which of course begs the question of what factors establish that something is “foreign” rather than “domestic,” and what degree of showing is required to establish that something is predominately foreign.
Perhaps these disputes can be avoided. The Second Circuit’s focus on the fundamental importance of avoiding extraterritorial application of the U.S. securities laws may prove a sufficient guiding principle that many line-drawing disputes can be avoided. Nevertheless, the groundwork seems to be set for future disputes about whether a plaintiff’s allegations have established the elements that are both “necessary” and “sufficient” to warrant the application of the U.S. securities laws.
An interesting final question is what the plaintiffs will do next. On the one hand, they could just go back to the district court and try their luck at amending their pleading to try to satisfy the Second Circuit’s standard. The Second Circuit’s opinion states that after the dust settled following Porsche’s disclosure that it was well on the way to acquiring control of VW, short sellers lost a total of $38.1 billion. The plaintiffs, whose losses constitute a part of that $38.1 billion, seem to have substantial financial incentives to try to take their fight to the U.S. Supreme Court. Given the U.S. Supreme Court’s propensity to take up securities cases in recent years, and given the magnitude of the changes that the Second Circuit’s formulation works on Morrison, the Supreme Court might well want to take up this case.
The Porsche case presented difficult issues. Based on Morrison, the Second Circuit was correctly concerned about the possible extraterritorial application of the U.S. securities laws. Nevertheless, the basis of its decision could provide fodder for protracted battles as other courts struggle to determine what factors are “sufficient” to warrant the application of the U.S. securities laws.
Interruption in the Publication Schedule: Due to my overseas business travel obligations, there will be an interruption in The D&O Diary’s publication schedule over the next several days. The regular publication schedule will resume upon my return at the end of next week.