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As we have previously discussed, in Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010), the United States Supreme Court limited the extraterritorial application of the antifraud provisions of the federal securities laws — in particular, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder — by rejecting the U.S. Second Circuit Court of Appeal's "conducts and effects" test and establishing a transaction-based test focusing on the location of the purchase or sale of the securities. The Supreme Court held that Section 10(b) covers only "transactions in securities listed on domestic exchanges, and domestic transactions in other securities." As predicted, while Morrison has provided much needed clarity for securities traded on exchanges, there has been further litigation regarding the application of "domestic transactions in other securities."
The Ficeto Test
Last month, in Absolute Activist Value Master Fund Limited, et al. v. Ficeto, et al., No. 11-0221, 2012 WL 661771 (2d Cir. Mar. 1, 2012), the Second Circuit had its first opportunity to interpret and apply this second prong of the Morrison test. The plaintiffs in Ficeto conceded the inapplicability of Morrison's first prong, regarding securities listed on domestic exchanges. As such, in examining the second prong, the Second Circuit held that "to sufficiently allege the existence of a 'domestic transaction in other securities,' plaintiffs must allege facts suggesting that either irrevocable liability was incurred or title was transferred within the United States." The court stated that irrevocable liability "marks the point at which the parties obligate themselves to perform what they had agreed to perform, even if the formal performance of their agreement is to be after a lapse of time."
Ficeto involved claims by nine Cayman Island hedge funds (the Funds) arising out of an alleged "pump-and-dump scheme" orchestrated by employees of the Funds' investment manager and a securities agent based in California. The defendants allegedly engaged in a series of transactions in U.S.-based "penny stock" companies — which were quoted on the Over-the-Counter Bulletin Board and on the Pink Sheets — by purchasing securities directly from the companies in subscriptions pursuant to PIPE transactions. While certain defendants allegedly coordinated the fraudulent scheme by making the "pump-and-dump" transactions, others traveled around the world, including to the U.S., to court investors for future subscriptions.
In announcing its ruling, the court found that the "locus of a securities purchase or sale," is domestic when "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." Additionally, citing recent Eleventh Circuit precedent, the Second Circuit held, in the alternative, that a domestic transaction would also occur where “title to shares was transferred within the United States.” See Quail Cruises Ship Mgmt. Ltd. v. Agencia de Viagens CVC Tur Limitada, 645 F. 3d 1307, 1310-11 (11th Cir. 2011).
Applying its test to the transactions before it, the Second Circuit found that the complaint contained only "a few allegations that mention or even hint at the location of the securities transactions," and that those allegations — including that a California-based broker-dealer executed the transactions and that the Funds wired money to a bank in the U.S. — were insufficient to show that the transactions were domestic. The court delineated what types of allegations might be sufficient to plead a domestic transaction: "factual allegations suggesting that the Funds became irrevocably bound within the United States or that title was transferred within the United States, including but not limited to facts concerning the formation of contracts, the placement of purchase orders, the passing of title, or the exchange of money." Indeed, "the mere assertion that transactions 'took place in the United States' is insufficient to adequately plead the existence of domestic transactions."
In arriving at this test, the Second Circuit rejected several other tests proposed by the parties. First, although the location of the broker "could be relevant to the extent the broker carries out tasks that irrevocably bind the parties to buy or sell securities," the court stated that "the location of the broker alone does not demonstrate where the contract was executed." Next, the court rejected a test based on the identity of securities, because the "identity of the security [does not] necessarily ha[ve] any bearing on whether a purchase or sale is domestic within the meaning of Morrison." Third, the court acknowledged that while "it may be more likely for domestic transactions to involve parties residing in the United States … [a] purchaser's citizenship or residency does not affect where a transaction occurs; a foreign resident can make a purchase within the United States, and United States resident can make a purchase outside of the United States." Recognizing that it was establishing a new test, the court remanded the case to give plaintiffs the opportunity to file an amended complaint to address these issues.
What to Expect
There still remains additional litigation over "domestic transactions in other securities." For example, there is an appeal pending in the Second Circuit relating to Morrison's application to securities-based swap agreements whose referenced securities are traded on a foreign exchange. Viking Global Equities LP v. Porsche AG (2d. Cir 11-397). The Ficeto test is not directly applicable because swap agreements — derivatives on securities — are fundamentally different from the shares of the U.S. companies at issue in Ficeto. Unlike such equity shares, for example, no title or ownership passes in swap transactions, which here are private, bilateral “bets” on the price of a stock which, in the Porsche case, was traded on a foreign exchange. Moreover, the “irrevocable liability” test would not apply easily to swaps because, among other things, it would ignore the location of the transactions that determine the swaps’ economics. Because Congress added security-based swaps to Section 10(b) to prevent fraud in the “functionally equivalent” U.S. securities markets and provided that Section 10(b) applies to swaps only “to the same extent” as securities, the location where the referenced stock trades should determine whether such swaps are “domestic transactions.”
We continue to expect additional litigation regarding the interpretation of "domestic transactions in other securities" and the Second Circuit's newly announced "irrevocable liability or passing title" test.
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