Absolute Activist: Second Circuit Clarifies Meaning of "Domestic Transactions" under Morrison

Practical Law Legal Update 7-518-3312 (Approx. 4 pages)

Absolute Activist: Second Circuit Clarifies Meaning of "Domestic Transactions" under Morrison

by PLC Corporate & Securities

Background

In October 2009, nine Cayman Islands hedge funds (plaintiffs) claimed their investment manager, an affiliated US-based broker-dealer and certain principals of both firms (defendants) violated US securities laws by fraudulently causing the plaintiffs to buy penny stock through the broker-dealer from US companies in PIPE transactions. The plaintiffs brought suit against the defendants in the US District Court for the Southern District of New York (District Court) under Section 10(b) and Rule 10b-5 of the Exchange Act. On June 24, 2010, the US Supreme Court issued its decision in Morrison, which held that Section 10(b) does not apply extraterritorially and only applies to transactions in securities listed on domestic exchanges and domestic transactions in other securities. On December 22, 2010, the District Court dismissed the complaint in its entirety, ruling that it lacked subject matter jurisdiction over the case under Morrison. The plaintiffs appealed to the Second Circuit.

Issue

The issue before the Second Circuit was whether foreign funds' purchases and sales of securities issued by US companies brokered through a US broker-dealer constitute "domestic transactions" under Morrison v. National Australia Bank.

Court's Reasoning

The Second Circuit reversed the District Court's dismissal for lack of subject matter jurisdiction because Morrison makes clear that whether Section 10(b) applies to certain conduct is a "merits" question. The Second Circuit noted that, while Morrison held that domestic transactions in non-US listed securities are subject to private claims under Section 10(b) and Rule 10b-5, the case provides little guidance on what constitutes a domestic transaction. In applying Morrison, the Second Circuit ruled that for a transaction to be considered domestic, plaintiffs must allege facts suggesting either that:

The agreement to purchase or sell securities was made in US. The Second Circuit noted that, under the Exchange Act, the point when the parties become irrevocably bound to perform the sale and purchase is used to determine the timing of a securities transaction. The court held that this same point should also be used to determine the location of a securities purchase or sale. To adequately allege the existence of a domestic transaction, it is sufficient for a plaintiff to allege facts leading to the plausible inference that the parties incurred irrevocable liability within the US to purchase or sell a security. The Second Circuit did not indicate what specific actions in a location would be relevant to whether a sale had occurred there. The opinion suggests that "facts concerning the formation of contracts [and] the placement of purchase orders" might be relevant.
Title to securities was transferred in the US. The Second Circuit held that a securities transaction can also be understood to take place at the location where title to the securities is transferred. Therefore, to adequately allege a domestic transaction, a plaintiff can allege that title to the shares was transferred within the US.

The Second Circuit found the plaintiffs did not sufficiently allege these facts. However, it concluded the plaintiffs should be given leave to amend their complaint because:

Plaintiffs filed their complaint before the Morrison decision was issued. Therefore, their complaint was drafted to satisfy the Second Circuit's pre-Morrison "conduct and effects" test.
Facts alleged in the plaintiffs' reply brief and at oral argument suggested that both the agreement to purchase the securities and the delivery of the securities may have occurred within the US.

The Second Circuit indicated that the following facts do not standing alone cause a securities transaction to be domestic under Morrison:

The transaction involved a US-based broker-dealer. While the broker's location may be relevant to the question of where a contract to sell a security was executed, standing alone, the broker's location is not determinative.
The securities were issued by a US company or were registered with the SEC. The Second Circuit noted that these facts are irrelevant to where the a securities transaction occurred.
The place of residency or citizenship of the buyer or seller. The Second Circuit noted that US residents can enter into transactions outside the US and foreign residents can enter into transactions within the US.
Whether each individual defendant engaged in at least some conduct in the US. The court noted that a defendant's personal conduct may be relevant to whether a US court has personal jurisdiction over the defendant. Morrison's "domestic transaction" test, however, does not look to the location of an individual's conduct, but instead to the location of the transaction.

Practical Implications

The ruling in this case provides some clarity on what securities transactions, other than transactions in US listed securities, will likely be considered domestic under Morrison, therefore, making them subject to private claims under Section 10(b) and Rule 10b-5. The Second Circuit indicated that, rather than looking to the identity of the parties, the type of security at issue or whether each individual defendant engaged in conduct within the US, it will hold that a securities transaction is domestic when either:

The parties incur an irrevocable contractual obligation within the US to carry out the transaction.
Title is passed within the US.

Absolute Activist: Second Circuit Clarifies Meaning of "Domestic Transactions" under Morrison | Practical Law