In the course of my various foreign travels, I have had occasion to speak to many underwriters and brokers who place D&O insurance for non-U.S. companies whose American Depository Receipts (ADRs) trade in the U.S. There is a pervasive, inexplicable, and mistaken belief among some underwriters and brokers that companies whose Level I ADRs trade in the U.S cannot be subject to a U.S. securities suit. These individuals persist in this error despite the Toshiba case, in which the Ninth Circuit reversed a district court’s dismissal of the securities suit brought by investors in Toshiba’s unsponsored Level I ADRs. Because of the persistence of the error about the potential liability of companies with ADRs trading in the U.S., it is mandatory for every single underwriter or broker who places D&O insurance for a non-U.S. ADR company to read the latest court ruling in the Toshiba case. As discussed below, the U.S. securities lawsuit brought against Toshiba brought by purchasers of the company’s unsponsored Level I ADRs is going forward.
On January 28, 2020, Central District of California Judge Dean Pregerson not only held that the securities against Toshiba can go forward and that Toshiba had sufficient connection to the unsponsored Level I ADR transactions to sustain the claims, but also that the separate liability claims against Toshiba under the Japanese securities laws can go forward as well. Judge Pregerson’s opinion can be found here.
Toshiba is based in Japan. Its common shares trades on the Tokyo stock exchange. Toshiba has unsponsored Level I ADRs trading in the U.S. (meaning that Toshiba ADRs were set up in the U.S. by a depositary bank, without Toshiba’s involvement). After Toshiba was ensnared in an accounting scandal, it was hit with a U.S. securities class action lawsuit. The complaints in the securities lawsuit asserted claims both under U.S. and Japanese securities laws. 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 district court also declined to hear the claims under the Japanese securities laws in light of principles of comity.
The plaintiffs in the Toshiba lawsuit appealed to the Ninth Circuit, which reversed the lower court’s ruling. 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.
On October 15, 2018, Toshiba filed a petition to the U.S. Supreme Court, urging the court to take up the case and consider the questions raised in the courts below. A number of international trade associations filed amicus briefs in support of Toshiba’s petition, and in addition the Trade and Finance Ministries of Japan and the government of the United Kingdom also filed amicus briefs, urging the court to take up the case in order to prevent extraterritorial application of the U.S. securities laws. However, the U.S. Solicitor General suggested that the Supreme Court did not need to take up the case, since all the Ninth Circuit had said is that the case needed to go back to the district court for further pleading. As discussed here, on June 24, 2019, the U.S. Supreme Court denied the cert petition. The case was remanded back to the district court for further proceedings.
On remand to the district court, the plaintiffs filed a second amended consolidated complaint seeking to establish that their ADR transaction were sufficiently domestic. The defendants renewed their motion to dismiss, arguing that the plaintiffs had failed to allege a domestic transaction and that the plaintiffs had failed to allege that the defendants’ allegedly wrongful conduct was “in connection with” the plaintiff’s purchase of the ADRs.
The January 28, 2020 Order
In denying the defendants’ motion to dismiss, Judge Pregerson first concluded that the plaintiffs’ amended complaint sufficiently alleged that their purchase of ADR securities was a domestic transaction, because the plaintiffs had pled sufficient allegations to support the conclusion that “irrevocable liability” for the securities transaction had taken place in the U.S. Among other things, the plaintiffs had alleged that location of the broker, the tasks carried out by the broker, the placement of the purchase order, the passing of title, and the payment were all in or had all taken place in the U.S., all of which Judge Pregerson said were relevant to the domestic transaction inquiry.
The defendants had tried to argue that the nature of the transaction was that the investors had first purchased the underlying foreign-traded securities and then the depositary institution had “converted” the ownership of the shares into unsponsored ADR. Judge Pregerson declined to consider this allegation, saying that it would require him to disregard the plaintiffs’ allegations (which he could not do at the motion to dismiss stage), but noting that the defendants could if they chose to do so raise the arguments again at the summary judgment stage.
Judge Pregerson then addressed the defendants’ argument that the plaintiffs had not sufficiently alleged that the alleged fraud had been committed “in connection with” the plaintiffs’ securities transaction. Judge Pregerson rejected this argument quoting with approval prior judicial authority for the proposition that “deception related to the value or merit of the securities in question has sufficient connection to the securities transaction to bring the fraud within the scope of Section 10(b).”
In arguing the absence of the requisite connection, the defendants argued further that Toshiba (whose ADRs were after all unsponsored by the company) had done nothing to “induce” the transaction, and indeed that Toshiba did not have “anything at all to do with the transaction.”
In rejecting this argument, Judge Pregerson found that the plaintiffs had “plausibly alleged” that Toshiba had consented to the sale of its stock in the U.S. through transactions in ADRs. Judge Pregerson noted that the Bank of New York Mellon, which held 55 million shares of Toshiba’s stock and was one of Toshiba’s largest shareholders. Judge Pregerson quoted the investors’ assertion that “it is unlikely that that many shares could have been acquired on the open market without the consent, assistance or participation of Toshiba.” Judge Pregerson concluded that the plaintiffs “have sufficiently alleged Toshiba’s plausible participation in the establishment of the ADR program.”
Finally, Judge Pregerson rejected the defendants’ argument that principles of comity required the U.S. court to forebear from proceeding with a lawsuit in the U.S. against Toshiba, a Japanese company. Judge Pregerson found that the U.S. has a strong interest in regulating securities transactions made in the U.S. He also found that the nationality of the parties strongly weighs in favor of strong U.S. interests in the case, since the proposed class is composed entirely of U.S. nationals only.
In a last twist, Judge Pregerson reconsidered his prior ruling in the case that under principles of comity the court should not take up the plaintiffs’ claims under the Japanese securities laws, and ruled that in light of his conclusion that the plaintiffs had sufficiently alleged claims under the U.S. securities laws, principles of comity and of forum non conveniens did not compel dismissal of the plaintiff’s claims under the Japanese securities laws.
There is a lot to Judge Pregerson’s decision, and there is no doubt that the outcome of the defendants’ dismissal motion turns in significant part on the specifics of the plaintiffs’ allegations in their amended complaint.
Nevertheless, the fact is that Judge Pregerson concluded that the claims of investors who purchased unsponsored Level I ADRs of a non-U.S. company could go forward.
He absolutely did not hold that there can never be claims under the U.S. securities laws against non-U.S. companies whose Level I ADRs trade in the U.S. Indeed, he absolutely did not hold that there can never be claims against under the U.S. securities laws against non-U.S. companies whose unsponsored Level I ADRs trade in the U.S.
Brokers and underwriters who are placing D&O insurance for non-U.S. companies whose ADRs trade in the U.S. need to note and understand – a non-U.S. company that has Level I ADRs trading in the U.S. can be subject to a U.S securities suit. Even if the Level I ADRs are unsponsored.
I know from discussing this issue with non-U.S. D&O insurance professionals that one difficulty they have in trying to understand these issues is the question of how a company can be subject to a U.S. securities suit if it had nothing to do with its ADRs trading in the U.S.
The answer is that if the company really did have nothing to do with the fact that its securities trading in the U.S, it would have substantial ground to try to make the argument that Toshiba unsuccessfully tried to make here. Toshiba had in fact tried to argue that it had nothing to do with the transactions in its unsponsored Level I ADRs. Judge Pregerson rejected this argument because of the plaintiffs’ allegations about the Bank of New York Mellon’s substantial holdings in Toshiba’s common stock. (Bank of New York Mellon frequently acts as a depositary institution in connection with ADRs.)
We can all question whether this kind of allegation ought to be sufficient to subject Toshiba to a securities lawsuit in the U.S. And it definitely was a factual allegation of a kind that might not apply to other kinds of companies whose ADRs trade in the U.S. But the fact is that Judge Pregerson concluded that the plaintiffs’ had alleged that Toshiba had sufficient connection to the unsponsored ADRs to support a claim against the company in U.S. court and under U.S. securities laws.
The final blow to the defendants here is Judge Pregerson’s conclusion not only that the plaintiffs’ U.S. law claims can go forward, but also that the plaintiffs’ claims under the Japanese securities laws can go forward as well. The defendants’ lawyers may feel particularly bitter about this conclusion. They had tried to argue in their briefs in support of their most recent motion to dismiss with respect to the Japanese law issue that they relied on the arguments they had made on the same issue in the prior submissions to the Court. Judge Pregerson said in a footnote (somewhat cantankerously, in my view) that “the court declines to review prior briefing made for a separate motion.”
The bottom line, friends, is that even companies with unsponsored Level I ADRs trading in the U.S. can be subject to liabilities under the U.S. securities laws if the claimants are able to establish that that the ADR transactions are sufficiently domestic. It certainly is not enough for a company to avoid litigation simply by contending that the securities involved were Level I ADRs, or that company did not sponsor the ADRs that the claimant purchased. To be sure, there could be factual issues that could determine whether or not any specific set of allegations would go forward. But the potential for the case to survive is there – the case will not be eliminated just because the securities are Level I ADRs or even because the ADRs are unsponsored.
And the sting in the tail of this conclusion is that it is possible that if the claims under the U.S. laws are permitted to go forward that claims against the defendant company under the securities laws of its home country could go forward as well.