During the more than six years since the U.S. Supreme Court issued its opinion in Morrison v National Australia Bank, the lower courts have worked out a host of issues about how Morrison applies in a variety of circumstances. One issue that has continued to percolate is the question of how the Morrison decision applies to non-U.S. companies that have American Depository Receipts (ADRs) trading over- the-counter (OTC) in the U.S.
These issues arose again the U.S. securities class action lawsuit that Volkswagen ADR investors filed against the company and related defendants based on allegations involving the company’s recent high-profile vehicle emissions scandal. The Volkswagen defendants argued in reliance on Morrison that the U.S. securities laws do not apply to the OTC transactions in the company’s ADRs. In an interesting January 4, 2017 opinion (here), Northern District of California Judge Charles R. Breyer held that the U.S. securities laws do indeed apply to over-the-counter transactions in the U.S. of Volkswagen’s sponsored Level 1 ADRs.
As discussed here, in September 2015, following news that Volkswagen had employed so-called “defeat” devices in order to allow its vehicles to appear as if they met environmental emissions standards, holders of Volkswagen ADRs filed the first of several securities class action lawsuits against the company, related entities, and certain executives. There have also been a number of investor lawsuits filed in other jurisdictions, including Germany (about which refer here) and the Netherlands (refer here).
The investor plaintiffs allege that the defendants misled investors by failing to disclose that the company had utilized a “defeat device” in its diesel cars that allowed the cars to temporarily reduce emissions during testing, while achieving higher performance and fuel economy, as well as discharging higher emissions, when testing was not being conducted. The device’s use allowed Volkswagen to market its diesel vehicles to environmentally conscious consumers, increasing its sale of diesel cars in the United States and abroad and, as a result, its profitability. When the news of the company’s use of the device became public, the company’s share price and the price of the ADR securities declined.
The defendants filed a motion to dismiss on a number of grounds, including, the argument, made in reliance on Morrison, that the U.S. securities laws do not apply to the transactions in which the plaintiffs acquired their Volkswagen ADRs. Specifically, the defendants argued that the Volkswagen ADRs represent foreign shares on a foreign exchange in Germany, and are therefore, under Morrison, beyond the territorial reach of the U.S. securities laws. The defendants also moved to dismiss on forum non conveniens grounds, arguing that Germany was a more appropriate forum for the ADR investors’ lawsuit. (The defendants sought dismissal on a number of additional grounds that I do not discuss below. These other issues and Judge Breyer’s ruling on these other issues are discussed in a January 4, 2017 Law 360 article about Judge Breyer’s ruling, which can be found here.)
An ADR is a U.S. dollar denominated form of equity ownership that represents foreign shares of the company held by a custodian bank in the company’s home country. Volkswagen’s ADRs are sponsored Level 1 ADRs. Unlike Level 2 ADRs, which may trade on U.S exchanges, or Level 3 ADRs, which permit a non-U.S. company to raise capital in the U.S., Level 1 ADRs may not trade on U.S. exchanges and entail minimal U.S. reporting requirements. (Refer here for further background on the difference between the various ADR levels). The Volkswagen ADRs trade over-the-counter in the U.S, on the OTCQX market.
In the Morrison decision, the U.S. Supreme Court held that the U.S. securities law do not apply extraterritorially, but rather apply only transactions in “securities listed on domestic exchanges” or “domestic transactions in other securities.” The two sets of transaction requirements described in Morrison are generally referred to as Morrison’s first and second prongs. The defendants sought to argue that the OTC transactions in which the investor plaintiffs acquired their Volkswagen ADRs do not satisfy either of Morrison’s two prongs.
The January 4 Decision
In his January 4, 2017 decision, Judge Breyer had little trouble concluding that the over-the-counter transactions in Volkswagen’s ADRs did not satisfy the requirements of Morrison’s first prong. Citing with approval Central District of California Judge Dean Pregerson’s May 2016 Opinion in the Toshiba case (about which refer here), Judge Breyer that the OTCQX market on which the Volkswagen ADRs trade is not a “domestic exchange,” and thus Morrison’s first prong is not satisfied.
In contending that the Volkswagen ADR transactions at issue also did not satisfy Morrison’s second prong, the defendants argued, in reliance on the Second Circuit’s 2014 decision in the Parkcentral case (about which refer here), that the character of the securities at issue are “predominately foreign,” and therefore the investors’ purchase of the securities was not a “domestic transaction in other securities.”
Judge Breyer distinguished Parkcentral, by saying that unlike the swap certificates at issue in that case, with which the defendant company there (Porsche) had no involvement, the ADRs at issue in this case “are not independent from Volkswagen’s foreign securities or from Volkswagen itself; instead Volkswagen sponsored the ADRs and thus was directly involved in the domestic offering of the ADRs.”
Judge Breyer added that he was not persuaded that the fact that the Volkswagen ADRs are Level I ADRs – as opposed to Level 2 or Level 3 ADRs — made any difference. In reaching this conclusion, he noted that the ADRs had numerous connections to the U.S. The ADRs traded in the U.S. pursuant to an agreement Volkswagen entered with J.P. Morgan in the U.S. and that was subject to New York law. Volkswagen had submitted a Form F-6 Registration Statement to the SEC to make the ADRs available in the U.S., as a result of which the ADRs were offered to domestic investors on an OTC market located in the U.S. Even though the Volkswagen’s Level 1 ADRs were not subject to the same level of reporting requirements that would have applied if they were Level 2 or Level 3 ADRs, the company is still required to comply with an SEC requirement that it provide on its website an English-language version of its market disclosure documents. These allegations, Judge Breyer said, “establish a sufficient connection between Volkswagen’s ADRs and the United States.”
Judge Breyer rejected the defendants’ arguments that the “relevant actions” giving rise to plaintiffs’ claims “all point to Germany.” The allegedly fraudulent scheme, the defendants argued, was perpetrated from and in Germany. Judge Breyer said he could not conclude as defendants argued that no relevant conduct occurred in the U.S. In addition to the fact that English language versions of the company’s disclosure statements appeared on its website so that its ADRs could trade in the U.S. a number of the allegedly false statements on which the plaintiffs rely allegedly took place in the U.S.
Accordingly, Judge Breyer concluded that Morrison’s second prong was satisfied.
Judge Breyer also rejected the defendants’ motion to dismiss the plaintiffs’ claims on forum non conveniens grounds. While the parties agreed that Germany is an adequate alternative forum, Judge Breyer concluded that the choice of forum by the plaintiffs, who are U.S. residents and who are bringing claims based on U.S. securities laws, is entitled to considerable deference.
Judge Breyer also concluded that the private interest factors (such as the residence and convenience of the parties, the convenience of the forum to the witnesses and evidence, etc.) weigh against the dismissal of plaintiffs’ claims. He found that while the public interest factor on which the defendants sought to rely – that Germany has a stronger interest in adjudicating the claims against Volkswagen – weighs in favor of the defendants, it does not “point squarely to Germany as a superior forum,” as Defendants argue. In light of the deference to the plaintiffs’ choice of forum and the weight of the private interest factors, Judge Breyer denied the defendants’ motion to dismiss on forum non conveniens ground.
As I noted in my recent analysis of 2016 U.S. federal court securities class action lawsuit filings (here), there were a host of lawsuits filed in the U.S. courts in 2016 against non-U.S. companies. By my tally, as many of 46 suits were filed against foreign companies. In many of these cases, the investor class that the plaintiff seeks to represent is a class of holders of ADRs of the defendant foreign company. The defendants in many of these cases may seek to argue, as the defendants did here, that the U.S. securities laws do not apply to the transactions in which the plaintiffs acquired their ADRs in the defendant company.
These arguments obviously will less successful if the ADRs at issue are Level 2 or Level 3 ADRs, as those types of securities trade on U.S. exchanges and therefore would seem to satisfy Morrison’s first prong. The importance of Judge Breyer’s decision in the Volkswagen case is that in those instances in which the securities at issue are Level 1 ADRs, the plaintiffs will have substantial grounds on which to argue in reliance on Judge Breyer’s opinion that Morrison’s second prong has been satisfied.
There are a number of particular ways that Judge Breyer’s opinion is significant in that regard. The first is that Judge Breyer had little trouble dismissing (in a footnote) the suggestion in Judge Berman’s 2010 decision in the Société Générale case (discussed here), made in reliance on Morrison, that the U.S. securities laws do not apply at all to ADR transactions. The usefulness to defendants of the Société Générale decision likely has been substantially diminished, if not eliminated altogether.
By the same token, there will still be a considerable dispute on the applicability of the U.S. securities laws if the defendant is able to argue that the ADRs at issue are unsponsored ADRs. The May 2016 decision in the Toshiba case that Judge Breyer referenced in his opinion specifically held that transactions in unsponsored ADRs purchased OTC in the U.S. are not sufficient to satisfy Morrison’s second prong. Judge Breyer drew substantial support for his conclusion that Morrison’s second prong had been satisfied based on the fact that the ADRs at issue here were sponsored ADRs. The battleground then will be whether or not the ADRs at issue are sponsored or unsponsored ADRs.
For many readers, this extended debate about whether U.S. investors purchase in the U.S. of ADR securities may be puzzling. If a U.S. investor buys a security in the U.S., isn’t that a “domestic transaction in other securities,” even if it does not take place on a securities exchange? The key here is that, as the Second Circuit noted in the Parkcentral case, and as Judge Pregerson discussed in the Toshiba case, while these transactions are “facially” domestic, and while a domestic transaction is “necessary” under Morrison’s second prong, a domestic transaction alone is not necessarily “sufficient” to establish that the U.S. securities laws apply. The Second Circuit’s decision in the Parkcentral case suggests that the 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.”
In the Volkswagen case, Judge Breyer did indeed look at the character of the securities involved, and concluded, because Volkswagen had sponsored the ADRs at issue and had taken a number of affirmative steps to allow the ADRs to trade in the U.S., the securities were not predominately foreign but were sufficiently domestic to satisfy Morrison’s second prong. It is important to note that along the way, Judge Breyer specifically considered the facts and circumstances surrounding Volkswagen’s involvement with the ADRs at issue. This analysis suggests that the ultimate outcome of a Morrison-based dismissal motion could be very factually dependent, based upon not only the character of the security involved but also the nature of the involvement of the foreign company with the domestic security.
The crux of the Morrison decision was the U.S. Supreme Court’s concern about the extraterritorial application of the U.S. securities laws. In the end, the ultimate issue in a Morrison-based dismissal motions is whether or not the transaction involved is sufficiently domestic to support the application of the U.S. securities laws. These principles are relatively easy to state; I suspect these issues will continue to percolate through the courts.
For a thorough discussion of all of these issues in the context of a specific case, please see my analysis of the parties briefing on the defendants’ Morrison-based motion to dismiss in the U.S. securities class action brought by holders of unlisted Tesco ADRs purchased over the counter in the U.S. (here).