One of the questions that courts have wrestled with as they have struggled to apply the U.S. Supreme Court’s decision in Morrison is whether or not the U.S. securities laws apply to transactions in American Depositary Receipts (ADRs). In the U.S. securities class action lawsuit filed against Toshiba in the wake of the company’s massive accounting scandal, the district court granted the company’s motion to dismiss on the grounds that the Exchange Act did not apply to the plaintiffs’ over-the-counter (OTC) transactions in the company’s unsponsored American Depositary Receipts (ADRs). The plaintiffs appealed. In a July 17, 2018 decision, the Ninth Circuit reversed the dismissal and remanded the case in order for the plaintiffs’ to have the opportunity to try to plead facts that might be sufficient to establish that the securities laws apply, notwithstanding the fact that the ADRs were unsponsored. The Ninth Circuit’s opinion can be found here.



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 U.S. securities class action lawsuit, the plaintiffs alleged 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 ADRs trade OTC in the U.S. The purported class consists of investors who purchased Toshiba ADRs 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 ADRs, and that Japanese law claims should be dismissed under principles of comity and forum non conveniens.


In a May 20, 2016 order (here), Central District of California Judge Dean 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.


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 had 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.” 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. The plaintiffs appealed the rulings relating to the ADRs.


The July 17, 2018 Opinion

In a July 17, 2018 opinion written by Judge Kim McLane Wardlaw for a unanimous three-judge panel of the Ninth Circuit, the appellate court reversed the district court’s dismissal ruling and remanded the case back to the district court, holding that the plaintiffs must be allowed to amend their complaint to attempt to allege that the purchase of Toshiba ADRs on the U.S. OTC market was a domestic transaction and that the alleged fraud was “in connection with” the purchase.


In reaching its decisions, the appellate court made a number of determinations. First, the court concluded that Toshiba’s ADRs are “securities” within the meaning of the Exchange Act. Next, without resolving the legal question of whether or not the term “domestic exchange” as used in Morrison is the equivalent of the term “national securities exchange” as used in the Exchange Act, the appellate court held that the OTC market on which Toshiba’s ADRs trade is not an “exchange” under the Exchange Act, and therefore that Morrison’s first prong does not apply to the plaintiffs transactions in the Toshiba ADRs.


The appellate court then turned to Morrison’s second prong and the standards that courts have evolved in order to determine whether or not a particular transaction is “domestic transaction.” The appellate court adopted the “irrevocable liability” test that the Second Circuit articulated in the Absolute Activist Investor case, under which the place of the transaction is determined by the place in which the parties to the transaction incur “irrevocable liability.”  (The Second Circuit’s Absolute Activist Investor case is discussed in detail here.)


The court then reviewed the numerous connections that the Toshiba ADRs and the plaintiffs’ transactions in the Toshiba ADRs have to the U.S. The ADRs were purchased in the U.S., the plaintiffs are U.S. entities located in the U.S., the OTC platform on which the ADRs were traded is located in the U.S., the depositary banks that maintain the ADR trading are located in the U.S. After reviewing these factors, the court said, in light of these numerous U.S. connections, “an amended complaint could almost certainly allege sufficient facts to establish that [the plaintiffs] purchased [their] Toshiba ADRs in a domestic transaction” in light of the “irrevocable liability” standard.


The appellate court rejected Toshiba’s effort to rely the Parkcentral Global Hub case, in which the Second Circuit said that the existence of a domestic transaction is necessary but not sufficient to establish the applicability of the U.S. securities laws under Morrison. (The Parkcentral Global Hub case is discussed at length here.) Toshiba argued that, notwithstanding the various connections between the Toshiba ADRs and the U.S., the securities laws still should not apply because the plaintiffs had not alleged any connection between Toshiba and the ADR transactions. This, the appellate court said, turns Morrison and the U.S. securities laws on their heads; “because we are to examine the location of the transaction it does not matter that a foreign entity was not engaged in the transaction.”


The appellate court went on to say that Parkcentral is distinguishable on numerous factual grounds, adding that the principal reason it could not follow Parkcentral is that “it is contrary to Section 10(b) and Morrison itself.” Parkcentral’s test for whether a claim is “so predominately foreign as to be impermissibly extraterritorial” is an “open-ended, under-defined, multi-factor test, akin to the vague and unpredictable tests that Morrison criticized and endeavored to replace.” The appellate court noted in a foot note that no Second Circuit case, nor any other circuit, has applied Parkcentral’s rule.


The Court then turned to Toshiba’s argument that applying the U.S. securities laws to these ADR transactions would “undermine Morrison’s animating comity concerns.” The court noted that this concern alone is “not a basis for declining to follow the Court’s clear instructions in Morrison” and that “it may very well be that the Morrison test in some cases will result in the Exchange Act’s application to claims of manipulation of share value from afar.” The Court noted that showing that the Exchange Act applies alone is not sufficient to state a claim under the Exchange Act; while “applicability is necessary, it is not sufficient to state an Exchange Act claim.”


The Exchange Act requires that in order to state a claim, the deceptive conduct must be “in connection with” the purchase or sale of a security. In order for fraud to be “in connection with” the purchase or sale of a security “it must be done to induce the purchase at issue.” The plaintiffs’ amended complaint, the court said, fell short of pleading the requisite connection. The court detailed the aspects of the plaintiffs ADR transactions omitted from the amended complaint, included the details about the market on which the ADRs are listed, the role and function of the depositary banks, the forms used to register the securities. The court noted that the amended complaint also lacks details about the plaintiffs’ purchases of the ADRs, include how and from whom the securities were acquired. The appellate court noted further that in the district court and on appeal, the plaintiffs had asserted that Toshiba was indeed involved in the establishment of the ADRs; however, the amended complaint provides none of the supporting facts.


Having reviewed the allegations the plaintiffs could have but had not alleged in order to state a claim, the appellate court concluded, contrary to district court, that leave to amend would not be futile. Accordingly the Court reversed the district court and remanded the complaint to allow the plaintiffs to amend their complaint.



The upshot of the appellate court’s analysis is not a comprehensive determination that the U.S. securities laws apply to unsponsored over-the-counter ADR transactions. Rather, the court’s holding represents only a statement that under Morrison it is not the case that the U.S. securities laws could never apply to unsponsored over-the-counter ADR transactions. Whether or not the U.S. securities laws apply is a matter of pleading, both with respect to the place of the transaction and with respect to whether the alleged manipulative conduct was undertaken “in connection with” the purchase or sale of a security.


My perspective on the appellate court’s analysis is significantly affected by a practical concern I had about the district court’s opinion in this case. If the U.S. securities laws do not apply to an ADR transaction such as the one involved here — a transaction that clearly took place in the United States — what jurisdiction’s law would apply? It has always seemed to me that if the question asked is not what is the nature of the security or whether the company to which the securities are related did anything to subject itself to the U.S. securities laws, but rather – as Morrison itself requires – what is the place of the transaction, the outcome reached by the district court could not be supported. Which is in fact what the Ninth Circuit concluded here.


The unfairness of allowing a litigant to seek to hold Toshiba liable here even if it did not sponsor the ADRs was a significant factor in Judge Pregerson’s district court opinion. Judge Pregerson was concerned that in these circumstances, the outcome would be tantamount to the very extraterritorial reach with which Morrison was concerned. The appellate court here expressly acknowledged that Morrison’s applicability standard could result in the securities laws being applied to allegedly manipulative conduct “from afar.” However, while it is necessary to show that the securities laws apply, applicability alone is not sufficient to state a claim. The claimant must also show that the manipulative conduct was “in connection with” the purchase or sale of a security. If in fact there is no connection between the company to which the securities refer and the securities transactions at issue, then the claimants will not have stated a claim under the Exchange Act and the case should be dismissed.


The appellate court made it clear that establishing that the alleged misconduct is “in connection with” the purchase or sale of a security is a matter of pleading. On remand, it will remain to be seen whether or not the plaintiffs can plead facts sufficient to establish that the securities laws apply as well as to state a claim for violation of the Exchange Act.


One particularly interesting aspect of the appellate court’s analysis was its obvious disdain for the principles the Second Circuit enunciated in the Parkcentral case and its “predominately foreign” test. Judge Wardlaw’s opinion makes it clear that the lines of analysis in the Parkcentral case diverged from the spirit of Morrison and indeed risk taking consideration of the applicability issues down a not particularly useful rabbit hole. The Ninth Circuit made it clear that in its view, Morrison’s concerns over extraterritoriality relates to the place of the transaction, not the location of the fraudulent conduct, the place of the company referenced in the security, or the other factors the court cited in Parkcentral.


All of that said, there is a troubling aspect of the Ninth Circuit’s conclusions here. It seems to significantly limit the ability of a non-U.S. company to ensure that it will not be subject to liability suits under the U.S. securities laws. The fact is that securities suits in the U.S. are expensive and burdensome, and companies that purposely avoided U.S. securities transactions in order to avoid U.S. securities litigation may well contend they should not be subject to securities litigation here. (This concern was in fact an important aspect of Judge Pregerson’s district court dismissal opinion.) The answer, such as it is from the appellate court here, is that company should not be subject to a securities suit here unless the allegedly deceptive conduct was “in connection with” the purchase or sale of a security. If the plaintiffs cannot plead or prove the requisite “connection” then the non-U.S. company should not be subject to litigation here.