The U.S. Court of Appeals for the Second Circuit’s Recent Decision Clarifying the Extraterritorial Limits of U.S. Securities Laws

In 2010, the U.S. Supreme Court ruled in Morrison v. National Australia Bank Ltd. that Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) does not apply extraterritorially¹ see WSLR, July 2010, page 9. According to the Supreme Court, this bedrock antifraud provision of U.S. securities law applies only to “transactions listed on domestic exchanges and domestic transactions in other securities.”

Since Morrison was decided, plaintiffs’ lawyers have been testing the limits of what constitutes a “domestic” transaction for purposes of a federal securities fraud claim.

On May 6, 2014, the U.S. Court of Appeals for the Second Circuit defined some of those limits. In City of Pontiac Policemen’s and Firemen’s Retirement System v. UBS AG, the Second Circuit held that Morrison precludes private claims arising out of foreign-issued securities purchased on foreign exchanges, even if the securities were cross-listed on a domestic exchange. The Second Circuit further held that mere placement of a buy order in the United States for the purchase of foreign securities on a foreign exchange is insufficient to establish a “domestic transaction” under the Exchange Act
² see WSLR, June 2014, page 34.

As a result of the Second Circuit’s City of Pontiac decision, investors—including U.S.-based investors who use U.S.-based broker-dealers—will have a harder time bringing claims against foreign issuers for federal securities fraud. Foreign issuers, meanwhile, can rest easier knowing that cross-listing shares on a U.S. exchange will not create worldwide exposure to class action lawsuits under U.S. law.

Nevertheless, City of Pontiac leaves open a number of questions about how U.S. securities laws will be enforced in an era where securities transactions are electronic and may not easily be classified as “domestic” or “foreign.”

Background

The plaintiffs in City of Pontiac were foreign and domestic institutional investors who purchased shares of Swiss-based UBS AG (“UBS”) that were listed on foreign exchanges and cross-listed on the New York Stock Exchange. The plaintiffs alleged, among other things, that UBS (and certain of its former officers and executives) violated the Exchange Act by making purportedly misleading statements regarding UBS’s mortgage-related assets portfolio and compliance with U.S. tax and securities laws.³

On September 13, 2011, Judge Richard Sullivan, of the U.S. District Court for the Southern District of New York, dismissed the claims of the plaintiffs who purchased UBS shares on foreign exchanges, relying on the Supreme Court’s Morrison decision that barred the extraterritorial application of U.S. securities laws.⁴

On May 6, 2014, a Second Circuit panel unanimously affirmed the District Court’s dismissal with prejudice.

The Second Circuit’s Ruling on What Constitutes a Domestic Transaction

The Second Circuit considered, and rejected, two principal arguments as to why Morrison permitted the plaintiffs to bring suit based on purchases of foreign shares on foreign exchanges.

First, the Second Circuit addressed the plaintiffs’ so-called “listing theory”— that because the relevant shares were cross-listed on the New York Stock Exchange, they came within the purview of the Exchange Act. Specifically, the plaintiffs contended that, under Morrison, their purchases of these shares were “transactions in securities listed on domestic exchanges.”

The Second Circuit disagreed. According to the court, the relevant inquiry under Morrison is not the location of an exchange where securities may be dually listed, but rather the location of the securities transaction. Thus, so long as the plaintiffs’ UBS shares were purchased outside the United States on foreign exchanges, the fact that the shares were also listed in the U.S. could not support the application of Section 10(b) of the Exchange Act. The court held: “In sum, Morrison does not support the application of [Section 10(b)] to claims by a foreign purchaser of foreign-issued shares on a foreign exchange simply because those shares are also listed on a domestic exchange.”⁵

Second, a U.S.-based plaintiff argued that, by placing a “buy order” in the United States for foreign securities to be purchased on a foreign exchange, the plaintiff satisfied the other prong of Morrison, which allows Exchange Act claims based on a “domestic transaction in other securities.”

The panel rejected this theory, too, applying the Second Circuit’s 2012 decision in Absolute Activist Value Master Fund Ltd. v. Ficeto.⁶ In Absolute Activist, the Court of Appeals held that “[a] securities transaction is domestic [for purposes of Morrison’s second prong] when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States”⁷ see WSLR, April 2012, page 6.

As a matter of first impression, the Second Circuit concluded in City of Pontiac that “the mere placement of a buy order in the United States” was insufficient to establish “that a purchaser incurred irrevocable liability in the United States, such that the U.S. securities laws govern the purchase of those securities.” The court also noted that “a purchaser’s citizenship or residency does not affect where a transaction occurs.”⁸ Accordingly, the panel affirmed the judgment of the district court dismissing the claims of a domestic purchaser insofar as the claims were based on purchases of foreign shares on foreign exchanges.

What the Ruling Means for Securities Litigation in the United States

The Second Circuit’s City of Pontiac decision helps clarify when the purchase of foreign securities will, or will not, be subject to Section 10(b) claims. At least in the Second Circuit, it is the location of the securities transaction, not the location of an exchange where the securities happen to be listed, that will determine whether investors in foreign securities can bring suit under Section 10(b) in the United States.

Foreign issuers now can take greater comfort that listing their shares in the U.S. will not expose them to costly U.S. securities class actions with respect to shares traded on other, non-U.S. exchanges. In this regard, City of Pontiac may encourage more foreign issuers to access U.S. capital markets by cross-listing their shares here.

However, foreign issuers should bear in mind that City of Pontiac and Morrison may not restrict the ability of the U.S. Securities and Exchange Commission (“SEC”) or other federal authorities to enforce the Exchange Act’s antifraud provisions. Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (enacted post-Morrison), federal courts have jurisdiction over claims brought by the government for any violation involving “(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.”⁹

For private parties seeking to sue foreign issuers under U.S. antifraud law, City of Pontiac creates a number of practical difficulties. The Second Circuit has made clear that it will not consider a transaction “domestic” simply because a buy order was placed in the United States. The Morrison bar on extraterritorial suits therefore will apply to so-called “foreign-squared” transactions involving a foreign defendant and foreign securities, as well as to “foreign-cubed” transactions involving a foreign plaintiff, a foreign defendant, and foreign securities. In other words, a U.S. investor who places an order in the U.S. through a U.S. broker still may not satisfy the Exchange Act’s territorial requirements.

However, the Second Circuit left open the question of what additional facts must be pled to establish that a purchase of foreign securities constitutes a “domestic transaction” for purposes of a Section 10(b) claim. In City of Pontiac, the court noted that “facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money may be relevant to determining whether irrevocable liability was incurred in the United States.”¹⁰ But what combination of these facts will be sufficient to create U.S. jurisdiction remains unclear. Perhaps that is why a U.S. district court judge recently cited City of Pontiac as an example of the “somewhat unsettled and evolving nature of the law with respect to Morrison.”¹¹

As a practical matter, establishing that “irrevocable liability was incurred in the United States” may prove quite difficult for plaintiffs. When an investor places an order to buy the securities of a foreign issuer, the investor may not know (or care) where the order will be executed. A broker may execute the order on a U.S. exchange, on a foreign exchange, or through an institution’s dark pool (away from a centralized exchange), depending on the execution price and other factors.

Indeed, a single order may be executed in multiple places. So, assuming that an investor can ascertain the operative location(s) of a transaction—no easy task in an age of rapid electronic trading—the investor’s right to sue the issuer of those securities could potentially be divided across jurisdictions.

While Morrison and its progeny may drive some shareholder litigation to other countries or simply out of U.S. courts, plaintiffs are likely to continue testing Morrison’s limits. After all, U.S. class actions remain enticing for investors in foreign securities and the lawyers who represent them. In comparison to other countries, the U.S. still offers liberal discovery rules and the prospect of large jury awards, which, among other factors, can lead to sizeable settlement payments.

U.S. courts will have to continue to grapple with how Morrison should be applied to the realities of modern capital markets—unless the U.S. Congress or a future Supreme Court overrides Morrison’s territorial-based “transaction” test for Section 10(b) of the Exchange Act.

Stewart Aaron is a Partner and heads Arnold & Porter LLP’s New York office. He practices commercial and international litigation. For 30 years, Mr. Aaron’s practice has involved the representation of clients in litigated matters in U.S. state and federal courts, and before regulatory bodies and self-regulatory organizations. He may be contacted at stewart.aaron@aporter.com.

Daniel Bernstein is an Associate at Arnold & Porter LLP’s New York office, where he focuses on complex commercial litigation, corporate internal investigations, and white collar defense. Mr. Bernstein has drafted dozens of briefs in courts around the United States, including four briefs in the U.S. Supreme Court. He may be contacted at daniel.bernstein@aporter.com.