In a post-July 4th weekend burst of freedom for defendants whose securities are traded in over-the-counter (OTC) markets, a US federal appeals court in New York provided defendants with a new tool with which to challenge class actions in cases involving a large number of non-US purchasers of OTC securities. In its recent decision in In Re Petrobras Securities, the Second Circuit Court of Appeals held that in a securities class action arising out of the OTC sale of securities, a district court considering class certification is required to determine whether the OTC purchases were made in the United States, a determination that is difficult to make on a class-wide basis. The Second Circuit’s decision in Petrobras provides defendants with a new tool with which to challenge class certification and raises the prospect that, in cases involving a large number of non-US purchasers of OTC securities, class certification may be impossible.[1] The Petrobas ruling is significant for securities cases involving non-US purchasers of OTC securities because it may require plaintiffs to prove each of their claims one at a time, effectively eliminating the threat of a class action lawsuit.

Statutory background

In the United States, class certification is governed by Rule 23 of the Federal Rules of Civil Procedure. Rule 23 permits a district court to certify a class where a plaintiff can establish the following requirements:

(i) numerosity – that the class is so numerous that joinder of class members is impracticable;

(ii) commonality – that there are questions of law or fact common to the class;

(iii) typicality – that the claims or defenses of the class representatives are typical of those of the class; and

(iv) adequate representation – that the class representatives will fairly and adequately protect the interests of the class.[2]

In addition, to certify a class in the context of a securities class action relating to monetary damages for a wrong suffered by the class as a whole, plaintiffs must also establish (i) predominance – i.e., that “the questions of law or fact common to class members predominate over any questions affecting only individual members” and (ii) superiority – that proceeding by way of a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.[3] Finally, US courts of appeals have recognized an additional “implied requirement of ascertainability in Rule 23” requiring that a class be “sufficiently definite so that it is administratively feasible for the court to determine whether a particular individual is a member.”

Factual and procedural background

The Petrobras litigation arises out of what has been described as a “massive” fraud, pursuant to which employees of Petroleo Brasileiro S.A. – Petrobras (Petrobras) conspired with various vendors to manipulate Petrobras’ bidding procedures. As a result of the scheme, Petrobras overpaid for services that it received, while the excess funds were used to pay bribes to corrupt executives and government officials. When the details of the scheme became known, Petrobras made corrective disclosures that resulted in a substantial decrease in the value of Petrobras securities. Since the discovery of the scheme, Petrobras’ market value has dropped more than eighty percent.

In December 2014 and January 2015, Petrobras investors filed putative class actions asserting claims under the Securities Act and the Exchange Act. After extensive dismissal briefing, which expressly addressed the extraterritorial reach of US securities laws, the District Court (Rakoff, J) denied the motions to dismiss and, eventually, certified two classes: one asserting claims under the Securities Act and the other asserting claims under the Exchange Act. Because some of Petrobras’ securities did not trade on a US exchange, the District Court found that claims with respect to these securities were actionable only if the securities transactions occurred within the United States. Thus, in certifying the two classes, the District Court specifically excluded from the class definition any putative class member that purchased Petrobras’ securities outside of the United States.

The impact of Morrison on class certification

In challenging the District Court’s class certification order, defendants argued that neither class could satisfy the predominance requirement because the class members had to show, on an individualized basis, that they purchased their securities in “domestic transactions.” Such a showing is required under the US Supreme Court’s decision in Morrison v. National Australia Bank, which held that the antifraud provisions of the Exchange Act apply only to (i) transactions on US securities exchanges or (ii) domestic securities transactions. Even before the class certification stage, the District Court acknowledged Morrison’s impact on the Petrobras litigation, holding that claims brought by certain named plaintiffs had to be dismissed because they failed to satisfy the Morrison inquiry.

At the class certification stage, defendants argued that the need to assess whether each putative class member had acquired securities in a domestic transaction made the class uncertifiable, as it would require individual adjudications that would predominate over common, class-wide questions subject to class-wide proof. The District Court disagreed, expressly including within the class definition class members that purchased Petrobras securities in OTC domestic transactions – without considering “the ways in which evidence of domesticity might vary in nature or availability across the many permutations of transactions in Petrobras Securities.” Defendants appealed.

In a significant victory for defendants, the Second Circuit held that the District Court committed legal error in failing to “meaningfully address” the question of whether a class member that purchased Petrobras securities in a “domestic transaction” was “susceptible to generalized class-wide proof.” Absent that determination, the Second Circuit continued, the District Court could not properly determine whether plaintiffs satisfied the predominance requirement. While acknowledging that it was not taking a position on whether certification would ultimately be appropriate, the Second Circuit went further, stating that “on the available record,” the question of domesticity appeared to be an “individual question requiring putative class members to present evidence that varies from member to member” and is one that is “not obviously susceptible to class-wide proof.”

In reaching this conclusion, the Second Circuit appears to have been swayed by defendants’ arguments that the classes, as currently constituted, “include numerous foreign and domestic entities that purchased securities from other foreign and domestic entities, possibly through foreign and domestic intermediaries, using different methods, under different circumstances, and reflected in different types of records.” The Second Circuit continued further, identifying one particular distinction between those defendants who purchased Petrobras securities in the original offerings versus those who purchased them in the secondary markets, suggesting that class-wide proof may be available in the former case, but not the latter. The Second Circuit then concluded, “[i]n this case, the potential for variation across putative class members – who sold them the relevant securities, how those transactions were effectuated, and what forms of documentation might be offered in support of domesticity – appears to generate a set of individualized inquiries that must be considered within the framework of Rule 23(b)(3)’s predominance requirement.”

What happens next?

On remand, the District Court will have to engage in a “robust predominance inquiry” to confirm the “domesticity” of the securities transactions at issue. In the meantime, the Petrobras decision raises a broader question: can a class that includes non-US purchasers of OTC securities ever be properly certified? On the one hand, the issues identified by the Second Circuit are likely to be present in any securities class action that involves non-US purchasers of OTC securities. On the other hand, the Second Circuit implicitly acknowledged that its decision may have the unintended consequence of shutting the class action door on these purchasers. To address this risk, the Second Circuit noted the wide array of case management strategies that district courts may employ in managing a securities class action involving foreign issuers and foreign purchasers, including modifying class definitions; bifurcating “proceedings to home in on threshold class‐wide inquiries,” while leaving non-class issues to be addressed at a later date; and certifying sub-classes.

Non-US purchasers of OTC securities will now have to overcome new challenges to obtain class certification. Only time will tell how steep that challenge is.