Corporate Governance

Expanding Morrison to Bar 10(b) Claims for ADR Transactions Made on the OTC

By Daniel Snare

Last term, the Supreme Court addressed the extraterritorial application of Rule 10b-5 in Morrison v. National Australia Bank, Ltd., 130 S.Ct. 2069 (2010).  The Court essentially held that there was no extraterritorial jurisdiction.  Cases could only be brought if they involved "transactions in securities listed on domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies."  Id. at 2884.

Lower courts are now having to wrestle with this standard.   In re Société Générale Securities Litigation, No. 08 Civ. 2495(RMB), 2010 WL 3910286 (S.D.N.Y. Sept. 29, 2010); here the plaintiffs argued that a Rule 10b-5 action could be maintained against a company that held American Depository Receipts ('ADRs') traded in the US.  The distrcit court, however, disagreed and held that the anti-fraud provisions of the Exchange Act are inapplicable to ADR purchases made in New York on the over-the-counter market ('OTC').  The court also suggested that the anti-fraud provisions of the Exchange Act would be similarly inapplicable to ADR transactions made on the NYSE or the NASDAQ.

The Defendant, SocGen, is a French bank engaged in equity derivative securities trading, and is itself traded on the Euronext Paris Stock Exchange.  In 2008, it became embroiled in a scandal stemming from the actions of trader Jerome Kerviel, who made un-hedged, directional trades in Collateralized Debt Obligations and Residential Mortgage Backed Securities, causing €4.9 billion ($7 billion) in losses.  Plaintiffs are three pension funds:  (1) Vermont Pension Investment Committee ('Vermont'), (2) Boilermaker-Blacksmith National Pension Fund ('Boilermaker'), and (3) United Food and Commercial Workers Pension Fund ('UFCW'). 

While the case was pending, the Supreme Court decided Morrison, which we discussed here.  Briefly, Morrison addressed the extraterritorial effect of the anti-fraud provisions of the Exchange Act.  The court adopted the 'transactional test,' whereby Section 10(b) applies only to trading in 'a security listed on an American stock exchange,' and trading in 'any other security in the United States.'  103 S.Ct. 2869, 2885.  After Morrison, SocGen promptly moved to dismiss the claims from Vermont and Boilermaker, who purchased SocGen stock on a foreign exchange.  SocGen did not, however, move to dismiss the claims from UFCW, who purchased ADRs in New York on the OTC. 

The Plaintiffs argued for a narrow reading of Morrison, asking the court to limit it to its facts:  foreign plaintiffs purchasing foreign securities on a foreign exchange (so called 'Foreign-Cubed' parties).  Unlike Morrison, all of the Plaintiffs were U.S. investors who purchased foreign securities from inside the U.S..  Therefore, the Plaintiffs argued, the anti-fraud provisions of the Exchange Act should apply.  The court rejected the approach.

• Where, as here, domestic plaintiffs purchased shares of a foreign bank traded on a foreign exchange, the Exchange Act is inapplicable, and Plaintiffs Vermont and Boilermaker have not shown otherwise.  "Domestic transactions" under Section 10(b) are defined as "purchases and sales of securities explicitly solicited by the issuer within the United States rather than transactions in foreign-traded securities where the ultimate purchaser or seller has physically remained in the United States."  In re Société Générale at *5.
  

Significantly, the court then sua sponte dismissed the claims of UFCW, who purchased SocGen ADRs domestically on the OTC.  'Even though Defendants do not argue that UFCW's claims should be dismissed under Morrison, the court concludes that the Exchange Act is inapplicable to UFCW's ADR transactions.'  In re Société Générale at *6.  The court reasoned that ADRs are a 'predominately foreign securities transaction' because they represent shares of foreign stock.  Id.

Therefore, despite their domestic purchase on an American exchange by U.S. investors, the Exchange Act is inapplicable under Morrison's 'transaction test.'  Further, 'SocGen ADRs were not traded on an official American securities exchange; instead, [the] ADRs were traded in a less formal market with lower exposure to U.S.-resident buyers.'  Id.  In a footnote, the court also suggested that even if the ADRs had been listed on an official American exchange, because of their 'predominately foreign' nature, the Exchange Act's anti-fraud provisions would still be inapplicable.  

This case makes explicit that issuers listing ADRs on the New York OTC are free from Section 10(b) claims because the securities themselves are 'predominately foreign.'  In addition, it also suggests that ADRs listed on major national exchanges are similarly free from Section 10(b) claims.  This may encourage foreign companies to favor the use of ADRs over a direct listing on the stock exchange.  

The primary materials for this post are available on the DU Corporate Governance website.

Full post as published by The Race to the Bottom on November 15, 2010 (boomark / email).