I have been fortunate in recent years to be able to travel around the world and to speak to D&O insurance professionals in a wide variety of different countries. One recurring question I get in these meetings has to do with non-U.S. companies that have Level I American Depository Receipts (ADRs) trading in the U.S. The question is usually something along the lines of – “these Level 1 ADR companies don’t have U.S. securities litigation exposure, right?” This question always puzzles me, given the several high profile cases in recent years (discussed below) demonstrating that — while there may be an interesting question between sponsored and unsponsored ADRs — transactions in Level 1 ADRs certainly can be subject to the U.S. securities litigation.
A June 6, 2019 memo by the global insurer AIG entitled “U.K. Public Companies and U.S. Securities Class Actions – A Hidden Risk?” (here) takes a look at these issues in light of the many U.K companies with Level 1 ADRs trading in the U.S. The memo provides a strong warning against the persistent belief that somehow companies with Level 1 ADRs trading outside the U.S. are not susceptible to U.S. securities litigation.
An ADR is a derivative security issued by a depositary bank and is a negotiable instrument representing a beneficial interest in the company referenced by the ADR, whose common stock the depositary bank holds. The ADR permits trading in the U.S., in dollar denominated terms and during U.S. trading hours, of the company-referenced security. Readers can find more background information about ADRs here.
There are three types of ADRs, denominated as Level 1, Level II, and Level III. Level I ADRs do not trade on a national exchange, but rather are traded over the counter (OTC), and the referenced company does not have SEC reporting requirements. Level II ADRs trade on a national exchange, and the company does have SEC reporting requirements. Level III ADRs have the same characteristics as Level II ADRs, but in addition a company issuing Level III ADRs may raise capital on a U.S. exchange. ADRs frequently have the same characteristics of the underlying securities they represent, including paying dividends and allowing voting rights. Readers can find more info about the different ADR levels here.
The AIG Memo
The AIG Memo focuses primarily on Level I ADRs, for the simple reason that approximately 200 U.K. public companies have Level I ADRs trading in the U.S. The memo observes that many corporate executives at these companies may believe that because their ADRs are only Level I ADRs, their companies have little or no liability under the U.S. securities laws. These officials, the memo notes, “may not appreciate the danger of having a class action brought against them in the U.S. based on” these ADRs.
The report notes that, contrary to the belief and expectation of many of these U.K. corporate executives about their companies’ potential U.S. securities litigation exposure (or lack thereof), a number of non-U.S. companies with Level I ADRs trading in the U.S. have recently been held subject to the U.S. securities lawsuits. While the question of whether or not any particular company is subject to the U.S. securities laws is, as the memo note, very fact-specific, a number of companies with Level I ADRs have been hit with U.S. securities class action lawsuits, including Volkswagen, Tesco, Nissan, and Toshiba.
As noted here, the federal district court in the U.S. securities class action lawsuit against Volkswagen specifically held that the U.S. securities laws apply to transactions in Volkswagen’s sponsored Level I ADRs.
The Toshiba Case
The Toshiba case is particularly interesting and is discussed at length in the AIG memo. Toshiba has unsponsored Level I ADRs trading in the U.S. (meaning that Toshiba ADRs were set up in the U.S. by the depositary bank, without Toshiba’s involvement). After Toshiba was involved in an accounting scandal, it was hit with a U.S. securities class action lawsuit. The district court dismissed the lawsuit, holding among other things the OTC (where the Toshiba ADRs trade) is not a national exchange and there was no securities transaction in the U.S. between Toshiba and the ADR investors.
The plaintiffs in the Toshiba lawsuit appealed to the Ninth Circuit, which reversed the lower court’s holding. The appellate court considered the case in light of the U.S. Supreme Court’s 2010 holding in Morrison v. National Australia Bank, which held that the U.S. securities laws apply to “transactions on a national securities exchange” (the first prong) and to “domestic transactions in other securities” (the second prong). While the appellate court agreed that the OTC is not a national exchange (and therefore the plaintiffs’ claims did not meet the first prong of the Morrison standard), the question was whether or not the U.S. trading in the ADRs is a “domestic transaction in other securities” under Morrison’s second prong.
The Ninth Circuit adopted the Second Circuit’s standard in the Absolute Activist Investor case providing that a transaction is “domestic” if “irrevocable liability” is incurred in the U.S. The Ninth Circuit remanded the case back to the district court to allow the plaintiffs the opportunity to plead that irrevocable liability was established in U.S. sufficiently to permit a determination that the Toshiba ADR transactions involved domestic transactions in other securities under the Morrison test.
In October 2018, Toshiba filed a petition for writ of certiorari, urging the U.S. Supreme Court to take up the question of whether or not a company with unsponsored Level I ADRs can be subject to the U.S securities laws. Toshiba’s cert petition remains pending and will be considered by the Court in its June 20, 2019 conference. (In other words, we may know as early as this week whether or not the Court will take up the case.)
The AIG memo observes that the Ninth Circuit’s holding involving unsponsored ADRs “should make directors of all listed companies stand up and take notice.” If the Ninth Circuit’s disposition should hold, it could result in “U.K. directors being dragged into court despite the company itself not seeking to sell its shares to U.S. investors.”
At a minimum, the Toshiba case, as well the number of other lawsuits pending against other companies with Level I ADRs trading in the U.S., “shows that even a foreign company with Level I ADRs may still be subject to U.S. securities laws.”
It remains to be seen how the Toshiba case will turn out. It may well be that, if the U.S. Supreme Court takes up the case, it will conclude that the U.S. securities laws do not apply to transactions in unsponsored Level I ADRs. In that regard, it is interesting to note that the U.K. government filed an amicus brief in connection with Toshiba’s cert petition, in which the U.K. government, urging the U.S. Supreme Court to take up the case, arguing that the Toshiba case involves “a particularly alarming example of interference with a foreign nation’s legal system… even where a foreign registered company’s activities have no factual nexus to the U.S.”
The fact that Toshiba did not purposely avail itself of the U.S. in order to trade its securities there is a compelling argument. However, there is the counter problem that if the U.S. securities laws do not apply to transaction of these securities in the U.S., what jurisdiction’s law does apply?
In the end, the U.S. Supreme court might decline to take up the case, which would leave the Ninth Circuit’s decision in the Toshiba case standing. Meaning that, in the Ninth Circuit, even a company that did not sponsor ADRs referencing its securities could be subject to the U.S. securities laws. If the Supreme Court takes up the case, well, then it will remain to be seen how it will all turn out.
While the question of whether companies with unsponsored securities trading in the U.S. can be subject to the U.S. securities laws is interesting, there are still the many companies that in fact sponsored the Level I ADRs referencing their securities and trading in the U.S. Many of the questions surrounding unsponsored Level I securities do not apply to sponsored Level I securities. (As noted above, the federal district court in the Volkswagen securities class action lawsuit specifically held that the U.S. securities laws apply to transactions in Volkswagen’s sponsored Level I ADRs.) As things currently stand, and regardless of the pending Toshiba cert petition, it should be assumed transactions in sponsored Level I ADRs in the U.S. are subject to the U.S. securities laws.
I emphasize this last point because of the initial observation I made at the outset of this post. That is, there is this odd persistent belief among insurance professionals outside the U.S. that companies with Level I ADRs trading in the U.S. are not subject to U.S. securities lawsuits. The AIG memo demonstrates that while there may well be an interesting question with respect to unsponsored Level I ADRs, there is not the same question with respect to sponsored Level I ADRs. In that regard, the AIG memo makes a valuable contribution to the dialogue.
In a recent post, I noted that during 2019, the D&O insurance marketplace for non-U.S. companies with U.S. listings has been shifting significantly. In the past, these non-U.S. companies paid significantly less for their D&O insurance than their U.S. counterparts, largely because D&O insurers in the companies’ home jurisdiction used a pricing model that was discounted relative to the pricing prevalent in the U.S. for U.S. companies. I characterized this willingness to price the D&O insurance for these non-U.S. companies at a discount to their U.S. counterparts, despite their obviously equivalent U.S. litigation exposure, as the product of “magical thinking.”
The persistent belief that Level I ADR companies are not subject to U.S. securities lawsuits is one more aspect of this magical thinking. In recent months, as D&O insurance pricing for non-U.S. companies with U.S. listings has begun to rationalize, it will also be important for pricing to rationalize for companies with Level I ADRs trading in the U.S. I can only hope that the AIG memo will help others understand and appreciate the true liability situation.
I will say that it was very interesting to learn from the AIG memo that there are a whopping 200 U.K. companies with Level I ADRs trading in the U.S. These questions are an even bigger deal than I previously understood.