On July 17, 2018, the Ninth Circuit issued an opinion in Stoyas v. Toshiba Corporation[1], holding that the Supreme Court’s decision in Morrison v. National Australia Bank Ltd.[2] does not preclude U.S. domestic purchasers of Toshiba’s unsponsored American Depository Shares or Receipts (“ADRs”) in transactions completed in the United States from maintaining securities claims under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 against Toshiba. The decision reverses a decision by the federal district court that had dismissed the complaint based on the Second Circuit’s decision in Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings.[3] Reasoning from Parkcentral, the district court had ruled that a domestic transaction was outside of the scope of Section 10(b) and Rule 10b-5 under Morrison because the nature of the transaction and allegations of fraud were “predominantly foreign.” Creating a circuit split with the Second Circuit, the Ninth Circuit rejected the use of the “predominantly foreign” test, holding that a domestic transaction in a security can avoid the presumption against the extraterritorial application of U.S. securities laws even if the fraudulent conduct occurred overseas. However, the Ninth Circuit also held that a domestic transaction is not sufficient in itself to avoid dismissal. A plaintiff must also allege facts that demonstrate that the fraudulent or deceptive conduct occurred “in connection” with the relevant domestic transaction. The Ninth Circuit concluded that making financial statements and other materials available in English alone is not sufficient to meet this second requirement and discussed other facts that may bear on the scope of the connection to the domestic transaction without stating what would be sufficient. The Ninth Circuit’s conclusion that a foreign corporation could be found liable based on a transaction in unsponsored ADRs raises important issues of interest to Japanese issuers whose shares trade in the form of unsponsored ADRs and suggests that such issuers may wish to reexamine their activities in relation to such programs.

The possibility of liability for issuers under Rule 10b-5 in connection with unsponsored ADR programs has been a topic of considerable interest to foreign stock issuers since the 2008 amendments to Rule 12g3-2(b) of the U.S. Securities Exchange Act of 1934 opened the door for a dramatic expansion of unsponsored ADRs and similar securities. After the 2010 decision in Morrison, which held that the federal securities laws apply only to allegedly fraudulent statements or omissions made “in connection with the purchase or sale of (i) a security listed on an American stock exchange, and (ii) the purchase or sale of any other security in the United States,” federal courts have in subsequent cases ruled on the boundaries of Morrison’s strong presumption against extraterritoriality. In 2017, the U.S. District Court for the Northern District of California in In re Volkswagen “Clean Diesel” Marketing, Sales Practices, and Products Liability Litigation held that transactions in sponsored, unlisted ADRs could subject the issuer of the underlying shares to liability under the federal securities laws. The Ninth Circuit in Stoyas agreed and focused on whether the plaintiffs provided allegations sufficient to show that the plaintiff had purchased or sold the relevant ADR in the United States. It applied the “irrevocable liability” test applied in In re Volkswagen “Clean Diesel” Marketing and by other circuits to determine whether this occurred. Once a party establishes a domestic transaction in securities according to this test, it might overcome Morrison’s presumption against extraterritoriality.

To proceed, plaintiffs must also establish that the fraud occurred “in connection” with the domestic purchase or sale of securities. Traditionally, when examined in connection with indisputable domestic conduct, this requirement has not been seen as very stringent, with courts holding that the in connection with requirement is met if the fraud alleged somehow “touches upon” or has some nexus with any securities transaction.[4] In Stoyas, the Ninth Circuit did not define how this element could or could not be met for alleged misconduct arising from foreign activity. According to the panel, simply maintaining an English investor relations website containing financial information required by Rule 12g3-2(b) is not alone sufficient to meet the requirement, but the court left open the question as to whether other activities, such as sending a letter of non-objection or providing some other form of consent to a depositary for an unsponsored ADR program or conducting U.S. investor relations activities in support of an unsponsored ADR program, could fulfill this element.

In light of Stoyas, Japanese issuers whose shares are traded in the form of unsponsored ADRs should not assume that Morrison and its progeny will insulate them from investor claims seeking damages under Rule 10b-5 in respect of such ADRs. Japanese issuers whose shares trade in the form of unsponsored ADRs should carefully consider both the degree to which they consent to and support unsponsored ADRs and reexamine the value of and their relationship to such programs. Steps issuers may consider to reduce their exposure to such liability may include formally disassociating from the unsponsored ADR program, or limiting equity investor roadshows or other activities that could be viewed as promoting a market in such securities. We expect that the Stoyas decision will also bolster the appeal of global depositary receipt (“GDR”) programs as a source of overseas liquidity for issuers seeking to achieve similar benefits with greater remoteness from the U.S. market. Conversely, to the extent the decision (particularly if adopted in other circuits) expands the risk of liability under Rule 10b-5 for unsponsored ADRs to a degree equivalent to sponsored ADRs, issuers may wish to consider converting such unsponsored program to a sponsored program in order to access greater liquidity and gain a better understanding of the ADR investor base.

Going forward, Stoyas is likely to lead to increased litigation involving foreign corporations with unsponsored ADR programs in the United States, as litigants continue to explore the boundaries of the safe harbor established by Morisson and litigate the scope of the requirement that an alleged fraud occurs in connection with the domestic transaction in unsponsored ADRs.