On Jan. 14, 2019, the U.S. Supreme Court asked the Solicitor General for the government’s views on whether the court should grant review to decide how its landmark extraterritoriality decision, Morrison v. National Australia Bank Ltd., applies to the multi-billion-dollar American Depository Receipt (ADR) market and, potentially, to the multi-trillion-dollar derivatives market.
At issue is whether investors in ADRs that reference the stock of foreign issuers can bring private claims under U.S. federal securities laws.
Morrison itself involved the most straightforward form of investment—common stock. Interpreting the statutory “sale or purchase” language of the 80-year-old securities statutes against the backdrop of the presumption against extraterritoriality, the Supreme Court announced a “transactional” test: investors have recourse to the federal securities laws only for:
- investments that take place on domestic U.S. exchanges, and
- “domestic” transactions in unlisted securities.
As to the second category, the courts of appeals are coalescing around the view that a securities transaction is “domestic” if the parties incur “irrevocable liability” in the United States. See Stoyas v. Toshiba Corp., 896 F.3d 933, 948-49 (9th Cir. 2018).
Lower Courts Grappling With Test
But the lower courts have struggled with this transactional test in the context of more complex instruments, such as ADRs and swaps.
The Toshiba case now before the Supreme Court on a petition for certiorari involves unsponsored ADRs. Unsponsored ADRs represent a beneficial interest in shares issued by a foreign issuer—in this case, Toshiba—and are issued by U.S. depositary institutions without the participation of that foreign issuer (and potentially even over its objection).
Toshiba has listed its shares in Japan, did not list its shares in the United States, did not offer or sell the ADRs in the United States, and has no reporting obligations to the Securities and Exchange Commission.
Yet, according to the Ninth Circuit, because the plaintiffs acquired the ADRs in the United States, the Morrison transaction test is satisfied and Toshiba may be liable under the federal securities laws even though it had nothing to do with those domestic securities transactions—Toshiba sold neither its shares nor the ADRs to the plaintiffs.
The Ninth Circuit rejected the Second Circuit’s approach in an earlier case that arose from derivative transactions—swaps referencing Volkswagen stock, which is listed only in Germany. The Second Circuit acknowledged that those swaps were “domestic” in the sense that the protection buyers and sellers transacted in the United States, but it concluded that Morrison’s anti-extraterritoriality ruling could not support application of the federal securities laws to “predominantly foreign” claims against foreign defendants who made misrepresentations overseas concerning a foreign-listed issuer. See Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, 763 F.3d 198 (2d Cir. 2014).
To reach that ruling, the Second Circuit concluded that, although necessary in every case, a domestic transaction may not always be sufficient to support application of the federal securities laws. A contrary ruling would have opened the doors to unlimited U.S. liability for foreign issuers whenever third parties unilaterally elect to reference their shares in bilateral derivatives transactions.
In the context of simple instruments such as stock, the Morrison transactional test effected a degree of jurisdictional retrenchment. But when applied to ADRs and derivatives, a test that asks only whether the plaintiff entered into a transaction in the United States, can result in the application of U.S. law to securities and issuers that are principally foreign, as the Toshiba case illustrates. And as Toshiba has argued, this is the opposite of what Morrison sought to accomplish through a transactional test that was supposed to let other nations regulate their own securities markets, free from U.S. interference.
Solution: SCOTUS or Congress?
In some ways, this is a problem of the Supreme Court’s own making—it formulated the transactional test in Morrison after rejecting the advice of the SEC and engaging in its own freehand interpretation of the statutory language, and apparently without considering how that test would apply to less plain vanilla instruments like ADRs and derivatives in a globalized capital market.
While U.S. investors may demand foreign-law securities, foreign issuers do not always seek to avail themselves of the U.S. securities market, but they are powerless to stop the flow of their stock or bonds, or of U.S.-targeted derivatives or receipts created by third parties.
But Congress is not blameless either. It has subjected derivatives to the antifraud provisions of securities laws by making inartful amendments to 80-year-old legislation, without giving any obvious thought to the impact on the geographical scope of investors’ private right of action.
It remains to be seen whether the Supreme Court can fix the mess, or whether it will instead throw up its hands and leave it to Congress to legislate a policy-based solution.
Andrew Rhys Davies is a partner with Allen & Overy in New York and assists clients with their U.S. litigation and regulatory problems, focusing on securities and financial services, and cross-border matters involving jurisdictional and comity issues. In 2016 and 2017, Andrew served as Assistant Solicitor General for the State of New York, representing the state and its agencies in appellate litigation.
Diana Billik is a U.S.-qualified partner at Allen & Overy in Paris. She has deep expertise advising issuers, arrangers, and underwriters in relation to a broad range of debt, equity, and liability management transactions by foreign private and sovereign issuers. She focuses primarily on SEC-exempt offerings into the United States and compliance with SEC reporting requirements for foreign issuers and security holders. Diana is admitted to practice in New York and is a member of the Paris bar.