Eight years after the Supreme Court's decision in Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), lower federal courts have struggled to consistently apply Morrison in the context of American Depository Receipts (“ADRs”). Last month, the United States Court of Appeals for the Ninth Circuit in Stoyas v. Toshiba Corp., — F.3d —, 2018 WL 3431764 (9th Cir. July 17, 2018) became the first circuit court to address the application of Morrison to unsponsored ADRs purchased in the over-the-counter (“OTC”) market.

The Ninth Circuit held that Morrison did not preclude purchasers of Toshiba's United States-based ADRs from bringing securities claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 and increased the potential exposure of foreign issuers to federal securities claims. In doing so, the Ninth Circuit reversed the decision of the Central District of California and granted plaintiffs leave to amend to allege that the purchases were a domestic securities transaction under the irrevocable liability test, which several circuits have used to determine whether a securities transaction that did not involve a national exchange nevertheless occurred within the United States. Toshiba Corp., 2018 WL 3431764 at *13-14. On August 3, Toshiba requested that the Ninth Circuit stay an issuance of its mandate, as Toshiba plans to seek Supreme Court review.

American Depository Receipts

An ADR is a derivative security that represents an ownership interest in the shares of a non-U.S. company. Securities and Exchange Commission, Investor Bulletin, American Depository Receipts 1-2, available at http://1.usa.gov/1KrLwNW. There are three “levels” of ADR facilities, which are “categorized . . . depending on the extent to which the foreign company has accessed the U.S. markets.” Id. at 2. Level 2 ADRs may be listed and traded on a U.S. securities exchange, and Level 3 ADRs allow foreign companies to raise capital. Foreign issuers with Level 2 and Level 3 ADR programs must file annual reports with the SEC in addition to the Form F-6, which provides disclosure only about the terms of deposit agreement governing the ADRs. Id.

Level 1 ADRs are traded only in the OTC market and are not subject to the same reporting requirements of Level 2 and Level 3 ADRs. “Level 1 ADRs can be either sponsored or unsponsored. An unsponsored ADR is established with little or no involvement of the issuer of the underlying security. A sponsored ADR, in contrast, is established with the active participation of the issuer of the underlying security.” See Pinker v. Roche Holdings Ltd., 292 F.3d 361, 367 (3d Cir. 2002).

The Application of Morrison to ADRs

In Morrison, the Supreme Court held that the Exchange Act's anti-fraud prohibitions apply “only [to] transaction in securities listed on domestic exchanges, and domestic transactions in other securities, to which [the securities fraud section of the Exchange Act] applies.” 561 U.S. at 267. One of the first post-Morrison decisions to address its application to ADRs held that “because trade in ADRs is considered to be a predominantly foreign securities transaction, [the securities fraud section of the Exchange Act] is inapplicable.” In re Societe Generale Sec. Litig., 2010 WL 3910286, at *6 (S.D.N.Y. Sept. 29, 2010) (citations and internal marks omitted).

Subsequent decisions did not embrace the bright line approach of the Societe Generale court. They instead drew a distinction between sponsored and unsponsored ADRs, finding that sponsored ADRs satisfied Morrison while unsponsored ADRs did not. For example, the U.S. District Court for the Northern District of California found that Volkswagen and certain of its officers and directors could not invoke Morrison to defeat securities claims by purchasers of ADRs related to Volkswagen's use of devices to artificially lower diesel emissions, because Volkswagen had taken steps to make its ADRs available to purchasers in the United States. In re Volkswagen “Clean Diesel” Marketing, Sales Practices, and Product Liability Litigation, 2017 WL 66281, at *5 (N.D. Cal. Jan. 4, 2017), reconsideration denied, 258 F. Supp. 3d 1037 (N.D. Cal. 2017). Similarly, the Central District of California held that a claim under the Exchange Act by holders of Daimler A.G.'s ADRs was not barred by Morrison because Daimler sponsored and was directly involved in the offerings of the ADRs, and all of the financial institutions involved in the ADR transactions were in the United States. Vancouver Alumni Asset Holdings Inc. v. Daimler AG, 2017 WL 2378369, at *11 (C.D. Cal. May 31, 2017).

The Toshiba Litigation

The Ninth Circuit's recent decision originated from allegations against Toshiba Corporation (“Toshiba”), the Japanese electronics conglomerate. In 2015, Toshiba announced that it had engaged in significant accounting fraud for several years and that it was restating its pre-tax profits and shareholder equity for fiscal years 2008 through 2014. Toshiba's admitted wrongdoing (coupled with a Japanese government order that revealed the accounting fraud) resulted in federal securities claims being asserted in federal court in June 2015. Toshiba's shares did not trade publicly on any stock exchange in the United States. The company's nexus to the United States, in this case, was through ADRs that the class members purchased, which traded in the OTC market.

The Central District of California dismissed the case, holding that the OTC market is not a domestic exchange within the meaning of the Exchange Act, and that the suit failed under Morrison because the ADRs were unsponsored and Toshiba lacked any connection to the ADR transactions. Stoyas v. Toshiba Corp., 191 F. Supp. 3d 1080, 1091 (C.D. Cal. 2016). In a unanimous decision, the Ninth Circuit reversed the District Court's decision and held that Morrison did not bar purchasers of the unsponsored ADRs from bringing claims under the Exchange Act. Stoyas, 2018 WL 3431764, at *13-14.

As a threshold matter, the Ninth Circuit held that ADRs are “securities” within the meaning of the Exchange Act, as they share many of the characteristics associated with stock and because the “economic reality” of ADRs is “closely akin to stock.” Id. at *5, 6. However, even though the ADRs are “securities,” the Ninth Circuit, applying Morrison's two-prong test, agreed with the District Court that the OTC market is nevertheless not an “exchange” under the Exchange Act. Id. at *9. But the Ninth Circuit concluded that the transactions in Toshiba's ADRs were domestic transactions in “other securities” and therefore subject to the Exchange Act. Id.

The Ninth Circuit adopted the “irrevocable liability” test, which was developed by the Second and Third circuits, to determine when a securities transaction is domestic. The test examines where purchasers incur liability to take and pay for securities and where sellers incur liability to deliver the securities. Id. at *12. Applying that test, the panel concluded that the District Court erred in dismissing the complaint on jurisdictional grounds. The ADRs were allegedly purchased in the United States, and one of the depository institutions, Bank of New York, allegedly sold the ADRs in the United States. See id. The panel remanded the case to grant plaintiffs the opportunity to replead, holding that the complaint lacked well-pleaded allegations as to when the plaintiffs incurred irrevocable liability and whether Toshiba's alleged fraud was “done to induce the purchase at issue.” See id.

The Ninth Circuit rejected Toshiba's reliance on Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings, 763 F.3d 198 (2d Cir. 2014), in which the Second Circuit engaged in a fact-intensive analysis and held that the existence of a domestic transaction is necessary for jurisdiction under Morrison but not sufficient. The Ninth Circuit held that the Second Circuit's approach in Parkcentral was “contrary to Section 10(b) and Morrison itself.” 2018 WL 3431764 at *13. The Ninth Circuit instead found that the involvement of a foreign entity in a transaction is irrelevant to the analysis under Morrison, and thus the fact that the ADRs at issue were unsponsored was not relevant. See id. at *12.

Key Insights

The Ninth Circuit's decision represents a favorable outcome for plaintiffs in at least three distinct ways: (i) failing to recognize a distinction between sponsored and unsponsored ADRs for the purposes of Morrison, (ii) refusing to engage in the fact-intensive inquiry employed in Parkcentral and instead examining only whether the transaction was domestic, and (iii) establishing that foreign issuers with unsponsored ADRs can face federal securities claims in connection with domestic ADR transactions.

The Ninth Circuit left open the question of how to interpret Morrison's use of the term “domestic exchange.” While Section 10(b) refers to “national securities exchange[s],” the Supreme Court in Morrison used the term “domestic exchange.” Before the Ninth Circuit, the plaintiffs argued that there was a meaningful distinction, and Toshiba argued that the terms were meant to be interchangeable. Toshiba, 2018 WL 3431764, at *9. But while the Ninth Circuit suggested in dicta that the plaintiffs had the “better” of the argument, id., it left the question open because the OTC market at issue was “simply not an 'exchange' under the Exchange Act.” Id. The meaning of the term continues to be a mystery and could have material consequences given that if the term “domestic exchanges” is more expansive than “national securities exchanges” it would narrow Morrison's reach. This interpretation is still unresolved in the Ninth Circuit and may remain unresolved until the Supreme Court weighs in.

Justin J. Santolli is a special counsel and Andrew B. Cashmore is an associate in the Litigation Department of Fried, Frank, Harris, Shriver & Jacobson.