It has been nearly six years since the U.S. Supreme Court’s landmark 2010 decision in Morrison v. National Australia Bank, in which the Court 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. In the intervening years, many of the issues questions that the Morrison decision presented have been resolved by the lower courts. However, one issue that has continued to percolate is the question of whether under Morrison the U.S. securities laws apply to transactions involving foreign companies’ unsponsored ADRs traded over-the-counter (OTC) in the U.S.
These issues were presented in the class action lawsuit filed in June 2015 in the Central District of California against Toshiba Corporation. The consolidated lawsuit purported to be filed on behalf of a class of investors who purchased unsponsored Toshiba American Depositary Shares (ADS) over-the-counter in the U.S., as well as on behalf of investors who purchased Toshiba shares on the Tokyo stock exchange. In an interesting May 20, 2016 opinion (here), Central District of California Judge Dean Pregerson held under Morrison that the U.S. securities laws do not apply to unsponsored OTC transactions in Toshiba’s ADSs. Judge Pregerson also granted the defendants’ motion to dismiss the claims of the investors who purchased Toshiba shares on the Tokyo stock exchange.
This litigation arises out of the massive accounting scandal involving Toshiba in which it emerged that the company had overstated pre-tax profits by as much as $2.6 billion over a period of at least six years. The scandal resulted in the resignation of the company’s CEO as well as the imposition of a record $60 million fine by Japanese securities regulators. In their complaint, the plaintiffs allege that the company’s concealment of its true financial condition violated the U.S. securities laws, as well as the securities laws of Japan. Toshiba’s common shares trade on the Tokyo stock exchange. In addition, unsponsored Toshiba ADSs trade OTC in the U.S. The purported class consists of investors who purchased Toshiba ADSs OTC in the U.S, as well as U.S.-domiciled persons who purchased Toshiba common stock on the Tokyo stock exchange.
Toshiba filed a motion to dismiss, arguing under Morrison that the U.S. securities laws do not apply to the OTC transactions in Toshiba ADSs, and that Japanese law claims should be dismissed under principles of comity and forum non conveniens.
The May 20 Order
In his May 20, 2016 order, Judge Pregerson granted the company’s motion to dismiss with prejudice. In reaching this ruling, he examined the issues presented in light of Morrison, which under its two-pronged standard held 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.” Because, Judge Pregerson determined, Morrison’s first prong does not apply to OTC transactions in unsponsored ADSs, Judge Pregerson considered the question of the U.S. securities laws’ applicability to the OTC transaction in light of Morrison’s second prong.
With respect to Morrison’s second prong, Toshiba argued that any domestic transaction involving the unsponsored ADSs did not involve Toshiba; rather, the Toshiba common stock underlying the OTC transaction was purchased by a depositary bank on a foreign exchange, and the depositary bank then sold ADSs based on those common shares in the U.S. Thus, the company argued, the only domestic transaction was between the depositary bank and the ADS purchasers, in an arrangement in which Toshiba was not involved and did not sponsor.
The plaintiffs argued that the OTC transaction met the requirements of Morrison’s second prong, because the purchases and sales involved all took place in the U.S. The plaintiffs also argued that the distinction between sponsored and unsponsored ADRs or ADSs is irrelevant because the disclosure requirements are the same regardless. The plaintiffs further argued that Toshiba evinced its consent to the ADS arrangements as it allowed the transactions to continue without objection, while purporting to comply with U.S. disclosure requirements.
Judge Pregerson held that that the OTC transactions do not fall under Morrison’s second prong. While he noted that “facially” the OTC transactions “occurred domestically,” the plaintiffs have not alleged that Toshiba was involved in those transactions in any way, nor would discovery aid the plaintiffs in making such a claim. Judge Pregerson noted that “nowhere in Morrison did the Court state that U.S. securities laws could be applied to a foreign company that only listed it securities exchanges but whose stocks are purchased by an American depositary bank on a foreign exchange and then resold a different kind of security (an ADR) in the United States.” In fact, Judge Pregerson said, “all the policy and reasoning in Morrison point in the other direction.”
Plaintiffs’ understanding, Judge Pregerson said, would “create essentially limitless reach of Section 10(b) claims” because even if a foreign company took steps to prevent its securities from being sold in the U.S., “the independent actions of depositary banks selling on OTC markets could create liability,” a development that would be “inconsistent with the spirit and law of Morrison” which “properly limited the reach of Section 10(b) claims based on the plain language of the statute, the presumption against extraterritorial reach of the U.S. laws, and comity concerns.”
Judge Pregerson went on to note that the plaintiffs had not alleged any affirmative act of Toshiba with respect to the ADSs, noting that under Section 10(b) and under Morrison, some “affirmative act is required.” The plaintiffs have not alleged that Toshiba used a manipulative or deceptive device or contrivance in connection with the sale of any security in the United States. While there are allegations that Toshiba committed accounting fraud, “there is no allegation that those fraudulent actions were connected to Toshiba selling its securities in the United States.” Because the plaintiffs have not alleged that Toshiba listed its shares in the U.S., or sponsored, solicited, or engaged in any other affirmative act in connection with securities sales in the U.S., Section 10(b) does not apply to Toshiba.
Finally, Judge Pregerson held that principles of comity and of forum non conveniens weighed in favor of the court dismissing the plaintiffs’ Japanese law claims, in favor of a Japanese forum.
Judge Pregerson’s ruling in the Toshiba case does not represent the first occasion when a U.S. federal district court judge has ruled under Morrison that the U.S. securities laws do not apply to ADRs trading over-the-counter in the U.S. In 2010, Southern District of New York Judge Richard M. Berman held in the Société Générale securities class action lawsuit 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 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.”
The analytic difficulty with Judge Pregerson’s ruling in the Toshiba case, as well as Judge Berman’s in the Soc Gen case, is that the purchase and sale transactions by which the plaintiffs acquired the ADSs or ADRS all took place in the United States. As Judge Pregerson himself noted, the ADS transactions “facially” are domestic. However, as the Second Circuit held in its 2014 decision in the Porsche Auto Holdings case (about which refer here), that while under Morrison’s second prong a domestic transaction securities is necessary, it is “not necessarily sufficient.” The Porsche case suggests that courts should look further at the “character” of the security at issue, in order to determine whether or not the transactions are “so predominately foreign as to be impermissibly extraterritorial.”
Judge Pregerson went even further with respect to Toshiba to determine whether or not Toshiba was in any way involved with the OTC transactions in which the plaintiff acquired their ADSs. In Judge Pregerson’s view, the fact that Toshiba was not involved in any way with the OTC availability of the ADSs militated against subjecting the transaction to U.S. securities laws. There is certainly a fairness issue involved with the idea of subjecting a non-U.S. company to potential liability under the U.S. securities laws where the company has done nothing to subject itself to the U.S. securities laws.
The crux of the Morrison decision is the Court’s concern about the extraterritorial application of the U.S. laws. The difficulty is seeing which way this concern cuts in this case. On the one hand, as Judge Pregerson’s opinion suggests, there is a fundamental fairness concern with subjecting a foreign company to potential liability under the U.S. securities laws where the company has done nothing affirmative to put itself at risk for that potential liability. On the other hand, the purchase and sale transactions at issue took place in the U.S., which would not seem to present a risk of extraterritoriality. For that matter, if the U.S. securities laws do not apply to the OTC transactions, which jurisdiction’s laws do apply?
Certainly, there would be a “reverse-extraterritoriality” issue if another jurisdiction were to assert that its laws apply to an OTC transaction in the U.S. That is, it seems to me that if the question asked in this situation is not what is the nature of the security involved or whether the company issuing the security did anything to subject itself to U.S. securities laws, but rather which jurisdiction’s law makes most sense to have apply to the transaction, then a different outcome than the one Judge Pregerson reached here might be suggested.
In any event, these issues are likely to continue to recur, both with respect to sponsored ADRs and with respect to unsponsored ADRs. There have been a number of recent cases against foreign companies whose only securities in the U.S. are ADRs or ADSs trading over the counter. For example, the investor lawsuits filed in the U.S. by holders of unlisted Volkswagen ADRs raise this very issue, as did the lawsuit filed in the U.S. on behalf of holders of unlisted Tesco ADRs.
Foreign companies sued in securities cases involving claims filed by holders of unlisted sponsored ADRs will continue to try to rely on the issues that Judge Berman found to be determinative in the Soc Gen case, that is, that the nature of the securities involved militates against the application of the U.S. securities involved. Foreign companies sued in securities cases involving unlisted and unsponsored ADRs will argue further, in addition to the nature of the securities, that the companies were not involved in the transactions at issue, and therefore the transactions are not subject to the U.S. securities laws, in reliance on Judge Pregerson’s ruling in the Toshiba case.
For the record, investors have filed actions against Toshiba and its executives in court in Japan. As I noted in a prior post, as a result of a combination of a series of accounting scandals and the U.S. Supreme Court’s decision in Japan, there has been a growth in securities litigation in Japan. One recent Japanese accounting scandal resulted in a very significant settlement on behalf of shareholder claimants; in 2015, plaintiffs’ attorneys acting on behalf of Olympus investors reached a $92 million out-of-court settlement with Olympus (refer here, subscription required).
ADDENDUM: An alert reader called my attention to the May 24, 2016 decision of Southern District of New York Judge Denise Cote in the Poseidon Concepts Securities Litigation (here), in which Judge Cote held that the U.S.-based plaintiffs’ purchase of publicly traded common stock of Canada-based Poseidon over-the-counter in a Pink Sheets transaction in the U.S. is a “domestic transaction in other securities” within the meaning of Morrison’s second prong, to which the U.S. securities laws apply. However, Judge Cote was careful to note that the security the plaintiff in the Poseidon Concepts case purchased was Poseidon stock, not a derivative security tied to the value of Poseidon’s stock, which distinction may help to explain the difference in the interpretation of Morrison’s effect between the OTC transactions involved in the Toshiba case, on the one hand, and the OTC transactions involved in the Poseidon Concepts case, on the other hand.