It has been over five years since the U.S. Supreme Court’s June 2010 decision in Morrison v. National Australia Bank restricted the ability of shareholders of non-U.S. companies who purchased their shares outside the U.S. to file securities fraud lawsuit in U.S. courts under the U.S. securities laws. During that five year period, the lower courts have sorted out many of the issues the Morrison decision raises. But one issue continues to percolate – that is, the question of Morrison’s effect on securities suits brought in U.S. court under U.S. law against non-U.S. companies by investors who purchased the companies’ unlisted ADRs over- the-counter in the U.S. The investor lawsuits filed in U.S. court just in the last few days by holders of unlisted Volkswagen ADRs raise this very issue.
The action filed in Southern District of New York in October 2014 by holders of unlisted ADRs of Tesco raise these same issues as well. The parties’ briefing in connection with the defendants’ motion to dismiss in the Tesco case present a detailed examination of the issues involved in the question of the applicability of Morrison to transactions in unlisted ADRs, as discussed below.
In a series of announcements in September and October 2014, Tesco, the U.K.-based grocery store firm, revealed that its prior profit forecasts had been overstated by more than $400 million. Various management changes followed, and the U.K.’s Financial Conduct Authority commenced an investigation. The company’s share price declined, and as discussed here, on October 23, 2014, a plaintiff filed the first of several securities class action lawsuits in the Southern District of New York on behalf of investors who had purchased Tesco’s unlisted ADRs over the counter in the U.S. (A separate action on behalf of Tesco investors who purchased their shares in the company on the London Stock Exchange is being organized in the U.K., as discussed here.) The consolidated cases are now pending before Southern District of New York Judge Richard M. Berman. The plaintiff’s consolidated amended complaint can be found here.
The critical issue for decision in the determination of whether or not the plaintiff’s case can go forward is the question of how the Supreme Court’s holding in Morrison applies to the purchase over-the-counter in the U.S. of the unlisted ADRs of a non-U.S. company. In Morrison, the U.S. Supreme Court had said in its two-pronged standard that the Section 10(b) of the Securities Exchange Act of 1934 applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” The question for the court in cases involving unlisted ADRs of foreign companies is whether the transactions in these securities meets the second prong of Morrison’s two-prong test.
At the heart of this dispute here are the Tesco ADRs, which were not listed on any securities exchange but instead only traded over-the-counter in the U.S. The Tesco ADRs are what is known as sponsored Level 1 ADRs. Tesco’s ADRs, which were issued by Deutsche Bank, represent an ownership interest in Tesco stock; each ADR represents three Tesco ordinary shares. The ADRs are registered in the United States with the SEC, but Tesco is not required to and does not file annual or periodic reports with the SEC.
The Defendants’ Motion to Dismiss
On August 17, 2015, the defendants filed their motions to dismiss. As detailed in their memorandum in support of their motion (here), the centerpiece of their arguments in favor of dismissal is their contention that, under Morrison, the “plaintiff’s claims exceed the territorial reach of Section 10(b).” The defendants argue not only that the case involves an English company, but allegations of alleged fraud in England involving personnel in England, with witnesses and documents in England, and that is already under investigation in England. The case, the defendants argue, belong in England.
Moreover, the defendants argue, Judge Berman himself, in a 2010 decision in the Société Générale securities class action lawsuit held that unlisted ADRs of a foreign issuer that trade over-the-counter could not serve as the basis for 10(b) claims under Morrison. In the Soc Gen case, Judge Berman had concluded that trades in the unlisted ADRs, because they involve the sale of certificates representing the home country-traded shares, represent “predominantly foreign securities transactions.”
In making this argument that the trading in Tesco’s ADRs represents a predominantly foreign securities transaction, the defendants further relied on the Second Circuit’s 2014 decision in the Porsche Auto Holdings case (about which refer here), which held under Morrison’s second prong that while a domestic transaction securities is necessary, it is “not necessarily sufficient.” The Porsche case requires courts to look further at the “character” of the security at issue, in order to determine whether or not the transactions are “so predominately foreign as to be impermissibly extraterritorial.” The defendants argue that the “character” of the Tesco ADRs, like the securities-based swaps at issue in the Porsche case, is “clearly foreign,” because they are derivative of a foreign security, and further that the plaintiffs’ claims are based on actions that all took place abroad.
The defendants further argue that the plaintiff’s complaint should be dismissed on forum non conveniens grounds; and finally that plaintiff’s claims fail to state a claim for relief and accordingly should be dismissed.
The Plaintiff’s Opposition to the Motion to Dismiss
In opposition to the defendants’ motion to dismiss, the plaintiff argues (in his memorandum in opposition, here) that the controlling Second Circuit authority on the issues before the court is not the Porsche case that the defendants cite, but rather the Second Circuit’s 2012 decision in Absolute Activist Value Master Fund Limited v. Ficeto (discussed here). In the Absolute Activist case, the Second Circuit said that in order to demonstrate that a transaction was sufficiently “domestic” in order to meet the requirements of Morrison’s second prong, a plaintiff “must allege facts suggesting that either irrevocable liability was incurred or title transferred within the United States.”
In his opposition, the plaintiff argues that the ADR transactions at issue meet the requirements of Morrison’s second prong because “irrevocable liability to carry out the ADR transaction was incurred in the United States, because ADRs are created, purchased and sold entirely within the United States.” The ADRs are created to be separate from the shares of the company in order that the investor can purchase and re-sell the securities in the U.S., whether through and exchange or over the counter. All of the aspects of the transactions at issue, the plaintiff argues, took place in the U.S., and, further, title to the ADRs passed in the U.S., because a U.S. depositary bank created the ADRs, issued them to investors in the U.S., and the plaintiff took ownership of the ADRs in the U.S. by purchasing them through a U.S. broker.
The plaintiff further argues that the defendants mischaracterize the Second Circuit’s Porsche holding, which, the plaintiff emphasizes, by its own terms was a reflection of the “particular character of the unusual security at issue” in the Porsche case. In swap transactions involved in Porsche, the holder of the swap never acquired title or ownership of the referenced security, but simply received cash value according to changes in the price of the underlying security. The plaintiff argued that in the Porsche case itself, the Second Circuit had drawn a distinction between the swap agreement at issue in that case and an ADR, suggesting, the plaintiff contends, that if instead of the swap an unlisted ADR had been involved, the transaction would not have been impermissibly extraterritorial.
Moreover, the plaintiff argued, unlike in Porsche where the defendant company had no involvement with or even awareness of the securities at issue, the Tesco ADRs involved are sponsored ADRs, which the company registered with the SEC so that the ADRs could trade in the U.S. The plaintiff argued that the absence of the defendants’ involvement with the swap securities at issue in the Porsche case was critical to the Second Circuit’s decision, because of the unfairness of subjecting the Porsche defendants to the U.S. securities laws. By contrast, the defendants here cannot claim such lack of involvement, meaning that the unfairness that the Second Circuit sought to avoid in the Porsche case is not present here.
Finally, the plaintiff argues that Judge Berman’s decision in the Société Générale case is no longer good law in light of the Absolute Activist case and its focus on the place that the transaction took place.
One of the things I miss about the active practice of law is participating in the kind and quality of advocacy that can take place when excellent lawyers square off and skillfully present their client’s best positions. Reading the parties’ brief here, I was reminded how rousing excellent advocacy can be.
While I am prepared to comment on the parties’ briefing on the defendants’ motion to dismiss, I should emphasize at the outset that the briefing is not yet complete. The defendants have not yet filed their reply brief, which undoubtedly will further inform this discussion. In particular, the defendants reply brief undoubtedly will address the plaintiffs’ arguments made in reliance on the Absolute Activist case, as well as the plaintiff’s efforts to distinguish the Porsche case. The defendants’ forthcoming arguments on these issues likely would aid consideration of the issues involved.
In the end, the question the court ultimately will be asked to decide is whether or not the ADR transactions involved here are sufficiently “domestic” to satisfy the requirements of Morrison’s second prong. The plaintiff’s argues that all aspects of the transaction took place in the U.S., and therefore that the requirements articulated in the Absolute Activist case have been met, which in turn, the plaintiff contends, represents a substantial showing that the ADR transactions are “domestic” and therefore that the U.S. securities laws apply.
However, as the Second Circuit said in the Porsche case, while it is “necessary” in order for the U.S. securities laws to apply that a transaction is “domestic,” that alone is not “sufficient.” In addressing the defendants’ motion to dismiss, the district court, in light of the Porsche case, will have to further consider the nature of the securities involved, as well. The district court will have to consider whether or not the ADRs at issue are, as the defendants contend, “predominantly foreign,” like the swap agreements in Porsche, or rather are more domestic in nature than that.
The factors that the court might take into account when addressing these issues remains to be seen. The fact that the ADRs are not listed certainly will be one factor; but on the other hand, as the plaintiff argues, the ADRs themselves are sponsored ADRs. Tesco registered the ADRs in the U.S., which ameliorates the unfairness that might otherwise arise if the defendants were to be held to be subject to the U.S. securities laws. Whether or not these considerations will prove persuasive to Judge Berman is at best uncertain, given his earlier ruling in the Société Générale case.
The ultimate determination will likely come down to the question of whether the ADRs involved here are as “predominately foreign” as the swap agreements at issue in the Porsche case. Judge Berman certainly did conclude in the Soc Gen case that the unlisted ADRs involved there were predominately foreign. However, Judge Berman’s Soc Gen ruling predated the Second Circuit’s opinions in both the Absolute Activist Investor case and the Porsche case. At a minimum, the Second Circuit’s subsequent case law will require further analysis of the issues.
One question I asked at the time of Judge Berman’s ruling in the Soc Gen case that recurs to me now is that if the U.S. securities laws do not apply to the ADR transactions here, which jurisdiction’s laws would apply? This clearly is not the situation of the kind that the U.S. Supreme Court was worried about in Morrison, where the application of the U.S. securities laws could create a conflict with other jurisdictions’ enforcement of their securities laws.
In any event, it will be interesting to see how these issues play out in the Tesco case. Whichever way the case unfolds, the outcome could have a significant impact on other U.S. cases. There have been a host of cases filed in the U.S. over the last several years involving non-U.S. companies, and some of these cases – including, as I noted at the outset, the recently filed cases involving Volkswagen—involve transactions in unlisted ADRs. The court’s ruling on the defendants’ motion to dismiss in the Tesco case could have a significant impact on these other cases.
Special thanks to a loyal reader for sending me the parties’ opening briefs on the Tesco defendants’ motion to dismiss.
As noted above, Tesco investors are attempting to mount a separate proceeding in the U.K., on behalf of investors who purchased their Tesco shares on the LSE. As I discussed in an earlier post, these U.K. efforts are being organized by a litigation funding firm. As discussed in an accompanying post, litigation funders are now seeking to organize an effort in Germany on behalf of investors who purchased their VW shares on the Frankfurt Stock Exchange. As noted in the post, litigation funding has become a very important force in the litigation environment in the U.K. as well as in the rest of Europe.
Sunday Afternoon in October: Chagrin River, South Chagrin Reservation, Squaw Rock Overlook, Bentleyville, Ohio, October 4, 2015, 4:25 p.m.