In its landmark 2010 decision in Morrison v. National Australia Bank, the Supreme Court articulated what seemed to be a bright-line test for determining the extent to which the U.S. securities laws apply to transactions with international elements. In so doing, the Court harshly rejected the fact-intensive “conduct/effects” tests propounded several decades ago by the Second Circuit and followed by many other courts throughout the country.

Last week, the Second Circuit got its revenge. In a long-awaited decision in ParkCentral Global Hub Limited v. Porsche Automobile Holdings SE, the court declined “to proffer a test that will reliably determine when a particular invocation of [the Securities Exchange Act’s anti-fraud provision] will be deemed appropriately domestic or impermissibly extraterritorial.” Instead, the Second Circuit held that courts must carefully consider the facts and circumstances of each case to avoid the very result that the Supreme Court had hoped to prevent in Morrison: promiscuous application of the U.S. securities laws to transactions that have little, if any, relationship to the United States.

The ParkCentral decision illustrates the difficulties that the Morrison test created for determining whether U.S. law should apply to transactions involving unlisted securities and international elements. The decision reinforces the trend against extraterritorial application of U.S. law – while perhaps not closing the door to applying U.S. law where facts so warrant.

Background of the Second Circuit’s Decision

Until June 2010, most courts throughout the United States had analyzed the Exchange Act’s applicability to transnational securities transactions under the well-established “conduct/effects” tests. The conduct test had traditionally considered whether the defendant’s conduct in the United States was so significant as to have been more than merely preparatory to the alleged fraud and to have directly caused non-U.S. investors’ losses. The effects test had considered the alleged fraud’s effects on U.S. markets or investors.

Morrison rejected the fact-specific conduct/effects tests, observing that “there is no more damning indictment of the ‘conduct’ and ‘effects’ tests than the Second Circuit’s own declaration that ‘the presence or absence of any single factor which was considered significant in other cases . . . is not necessarily dispositive in future cases.'” Instead, the Supreme Court adopted a supposedly “clear test,” which the Court called “a transactional test”: § 10(b) of the Exchange Act applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other [i.e., non-U.S.-listed] securities.

The first prong of this transactional test – for U.S.-listed securities – has seemed relatively comprehensible, although it has generated some litigation. The second prong, however – “domestic transactions in other securities” – has raised many questions.

In March 2012, in Absolute Activist Value Master Fund Ltd. v. Ficeto, the Second Circuit attempted to clarify the second prong and held that, “to sufficiently allege the existence of a ‘domestic transaction in other securities,’ plaintiffs must allege facts indicating that irrevocable liability was incurred or that title was transferred within the United States.” A plaintiff can demonstrate that irrevocable liability was incurred in the United States by pleading facts showing that “the purchaser incurred irrevocable liability within the United States to take and pay for a security, or that the seller incurred irrevocable liability within the United States to deliver a security.” A plaintiff can also satisfy Morrison’s second prong by showing that the United States was “the location in which title is transferred.”

The ParkCentral Case

The ParkCentral case arose from an allegedly secret plan by Porsche, a German company, to take over Volkswagen (“VW”), another German company. The plaintiffs – U.S. and non-U.S. hedge funds managed in the U.S. – had entered into security-based swap agreements that referenced the price of VW shares. The swaps’ value fluctuated with the price of VW shares: their value rose as the price of VW shares declined, and fell as the price of VW shares rose. The swap agreements were not traded on any exchange – and thus were not subject to Morrison’s first prong.

The plaintiffs alleged that Porsche had violated § 10(b) by secretly accumulating large amounts of VW’s shares while falsely denying its intent to take over VW. When Porsche ultimately disclosed that it had acquired more than 74% of VW’s shares, the price of VW’s stock soared, and the value of the plaintiffs’ swap contracts plummeted.

The plaintiffs contended that § 10(b) applied to their transactions because their purchases of swaps constituted “domestic transactions in other [i.e., unlisted] securities” under Morrison’s second prong: U.S.-based investment managers had allegedly made the investment decisions; all steps necessary to the transactions had allegedly been carried out in the United States; the investment managers had signed swap confirmations at their U.S. offices; and the swap agreements contained New York choice-of-law and forum-selection clauses.

The district court dismissed the case based largely on its view of how “the economics of the swaps” affect “securities-based swaps that reference stocks traded abroad.” The parties had agreed that the swap contracts, “which reference VW shares, were economically equivalent to the purchase of VW shares.” The court therefore concluded that “the nature of a reference security [the underlying VW stock] must play a role in determining whether a transnational swap agreement may be afforded the protection of § 10(b).” “Here, Plaintiffs’ swaps were the functional equivalent of trading the underlying VW shares on a German exchange. Accordingly, the economic reality is that Plaintiffs’ swap agreements are essentially transactions conducted upon foreign exchanges and markets, and not domestic transactions that merit the protection of § 10(b).”

The court was “loathe to create a rule that would make foreign issuers with little relationship to the U.S. subject to suits here simply because a private party in this country entered into a derivatives contract that references the foreign issuer’s stock.” The court thus read Morrison’s second prong to cover only “purchases and sales of securities explicitly solicited by the issuer in the U.S., rather than transactions in foreign-traded securities – or swap agreements that reference them – where only the purchaser is located in the United States.”

The Second Circuit’s Decision

The Second Circuit affirmed the dismissal of the claims, but for different reasons. Without accepting or rejecting the district court’s “economic reality” analysis of swaps, the Second Circuit ruled that “the imposition of liability under § 10(b) on these foreign defendants with no alleged involvement in plaintiffs’ transactions, on the basis of the defendants’ largely foreign conduct, for losses incurred by the plaintiffs in securities-based swap agreements based on the price movements of foreign securities would constitute an impermissibly extraterritorial extension of the statute.” The court “express[ed] no view whether we would have reached the same result if the suit were based on different transactions.”

The Second Circuit essentially assumed that the plaintiffs’ swap transactions might have met the Absolute Activist test for satisfying Morrison’s second prong: incurrence of irrevocable liability or transfer of title in the United States. But the possibility that the swaps might have constituted “domestic transactions” under Morrison created a problem for the court: even if the transactions technically fell within the Morrison test, the court “[thought] it clear that the claims in this case are so predominantly foreign as to be impermissibly extraterritorial.”

So the Second Circuit bailed out the Supreme Court. The court looked beyond Morrison’s literal language to reach what it considered a result that was more in line with Morrison’s aim of avoiding inappropriately extraterritorial application of U.S. law.

The Second Circuit began its analysis by limiting Morrison to its facts: “the Supreme Court has said that it is ‘acutely aware . . . that [it] sit[s] to decide concrete cases and not abstract propositions of law’ and has therefore ‘decline[d] to lay down . . . broad rule[s] . . . to govern all conceivable future questions in an area.'” Morrison had involved only common stock, not esoteric financial instruments. The Second Circuit therefore warned of the need to “proceed cautiously in applying teachings the Morrison Court developed in a case involving conventional purchases and sales of stock to derivative securities, like securities-based swap agreements, that vest parties with rights to payments based on changes in the value of a stock.”

The court then considered “whether, under Morrison, a domestic transaction in a security (or a transaction in a domestically listed security) – in addition to being a necessary element of a domestic § 10(b) claim – is also sufficient to make a particular invocation of § 10(b) appropriately domestic” (emphasis in original). The court concluded that, while Morrison “unmistakably made a domestic securities transaction (or a transaction in a domestically listed security) necessary to a properly domestic invocation of § 10(b), such a transaction is not alone sufficient to state a properly domestic claim under the statute” (emphasis added).

In other words, Morrison’s self-described “clear test” is not necessarily the whole story (at least for nonconventional securities). As the Second Circuit explained, “a rule making the statute applicable whenever the plaintiff’s suit is predicated on a domestic transaction, regardless of the foreignness of the facts constituting the defendant’s alleged violation, would seriously undermine Morrison’s insistence that § 10(b) has no extraterritorial application. It would require the courts to apply the statute to wholly foreign activity clearly subject to regulation by foreign authorities solely because a plaintiff in the United States made a domestic transaction, even if the foreign defendants were completely unaware of it. Such a rule would inevitably place § 10(b) in conflict with the regulatory laws of other nations.”

Based on its conclusion that satisfaction of the Morrison test was not sufficient to invoke § 10(b), the Second Circuit examined the facts at issue and held that they were so predominantly foreign as to preclude § 10(b) liability. The alleged misrepresentations had been made primarily in Germany and had concerned the stock of a German company traded only on European exchanges. Moreover, the German defendant had not been a party to the plaintiffs’ securities transactions, even if they were domestic transactions under Morrison.

Accordingly, the court refused to “permit the plaintiffs, by virtue of an agreement independent from the reference securities, to hale the European participants in the market for German stocks into U.S. courts and subject them to U.S. securities laws.” But the Second Circuit cautioned that it had “neither the expertise nor the evidence to allow us to lay down, in the context of the single case before us, a rule that will properly apply the principles of Morrison to every future § 10(b) action involving the regulation of securities-based swap agreements in particular or of more conventional securities generally.”

Potential Impact of the Second Circuit’s Ruling

The Second Circuit’s decision rejects the notion that bright-line rules can and should apply to all cases concerning § 10(b)’s reach. The court concluded that slavish application of supposedly clear “tests” can lead to results that might be inconsistent with the underlying principles that the “tests” were designed to promote. Thus, the Second Circuit, while making due obeisances to the Supreme Court, construed Morrison to allow – if not require – courts to “carefully make their way with careful attention to the facts of each case and to combinations of facts that have proved determinative in prior cases, so as eventually to develop a reasonable and consistent governing body of law on this elusive question.”

The ParkCentral decision raises a number of intriguing questions, including the following:

First, if satisfaction of the Morrison test is not sufficient for § 10(b) liability, how wide an opening has the Second Circuit created for consideration of other facts about a transaction’s foreign or domestic nature?

Second, in light of the Second Circuit’s focus on the difference between the conventional securities at issue in Morrison (common stock) and various types of nonconventional securities, how much room exists to argue that the Morrison test is not itself dispositive for transactions involving American Depositary Receipts, derivatives, swaps, etc.?

Third, the Second Circuit did not express any opinion on the district court’s use of an “economic reality” test to analyze whether § 10(b) should apply to U.S. transactions in securities that reference foreign securities listed only on foreign exchanges. The decision thus does not resolve whether the economic-reality analysis is consistent with Morrison.

Fourth, the Second Circuit held that its decision “in no way forecloses the application of § 10(b) to govern fraud in connection with securities-based swap agreements where the transactions are domestic and where the defendants are alleged to have sufficiently subjected themselves to the statute” (emphasis added). Will this language be used to distinguish sponsored ADRs from unsponsored ADRs (which can be issued by U.S. depositary institutions without the foreign issuer’s involvement or even consent)?

Fifth, the Second Circuit took a passing swipe at Congress’s apparent effort in the Dodd-Frank Act to partially overturn the Morrison case by reinstating the conduct/effects tests in actions brought by the SEC or the United States (but not by private plaintiffs). The Act gives federal courts “jurisdiction” over cases involving significant U.S.-based conduct or substantial effects within the United States. However, as Morrison held, the scope of the Exchange Act’s extraterritorial effect is not a jurisdictional issue; it involves a substantive element of the claim. The Second Circuit therefore characterized “the import of this amendment [as] unclear.” Does the Second Circuit mean to suggest that the amendment might not have accomplished what Congress presumably intended to do for actions brought by the Government?

Originally published by Proskauer’s Securities Litigation Practice Group on August 18, 2014. Proskauer’s analysis of this case was also published by BNA Bloomberg’s World Securities Law Report and the Harvard Law School Forum on Corporate Governance and Financial Regulation.