The U.S. District Court for the Northern District of California held on January 4, 2017 that the federal securities laws apply to U.S. transactions in sponsored, but unlisted, American Depositary Receipts (“ADRs”) for a foreign issuer’s shares. The decision in In re Volkswagen “Clean Diesel” Marketing, Sales Practices, and Products Liability Litigation adds to the handful of decisions addressing whether U.S. transactions in sponsored, but unlisted, ADRs are covered by the federal securities laws. Most of those decisions have held that U.S. law applies to those transactions. The Volkswagen ruling also joins the majority of decisions in holding that the over-the-counter (“OTC”) markets are not considered to be “exchanges” for purposes of determining the scope of the federal securities laws.

Factual Background

The Volkswagen case involves allegations that Volkswagen – a German company – engaged in misconduct related to its “clean diesel” vehicles’ compliance with emissions regulations. A U.S. securities class action was filed on behalf of persons who had purchased Volkswagen’s Level 1 ADRs on an OTC market in the United States during the putative class period. Level 1 ADRs are the lowest of the three levels of ADRs. Unlike Level 2 and Level 3 ADRs, Level 1 ADRs are not listed on a U.S. exchange, although they can be traded OTC in the United States. Level 1 ADRs can be sponsored (the foreign issuer participates with the depositary bank that issues the ADRs for the issuer’s foreign shares) or unsponsored (the depositary bank issues the ADRs without the issuer’s involvement and, perhaps, even without its consent).

Defendants moved to dismiss the securities-law claims in light of the U.S. Supreme Court’s 2010 decision in Morrison v. National Australia Bank, 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.” Defendants argued that Morrison’s first prong did not apply because Volkswagen’s ADRs were not listed on an exchange; they were traded only on the OTC market, which is not a “stock exchange.” Defendants also contended that Morrison’s second prong did not apply because the ADR transactions were predominately foreign.

The court agreed with defendants on the first point, but not on the second.

The Court’s Decision

The court first held that the OTCQX market, which is run by OTC Markets Group Inc., “is not a ‘domestic exchange’ and therefore does not satisfy the first prong of Morrison.” In so ruling, the court followed earlier decisions by the U.S. Court of Appeals for the Third Circuit and the U.S. District Court for the Central District of California. Those decisions explained that the securities laws distinguish between securities exchanges and OTC markets.

But the court concluded that plaintiffs had satisfied Morrison’s second prong, for “domestic transactions in other [i.e., unlisted] securities.” The court observed that defendants “do not dispute . . . that Plaintiffs’ purchases of the Volkswagen Level 1 ADRs in the United States constitute domestic transactions.” Quoting plaintiffs’ Complaint, the court noted that the ADRs “‘were sold to US investment advisers for the benefit of the US-resident Plaintiffs and were delivered through DTC, the principal US securities clearing and settlement system, to accounts at US financial institutions, and title transferred in the United States.’” The transactions thus satisfied the standard articulated in 2012 by the U.S. Court of Appeals for the Second Circuit in Absolute Activist Value Master Fund Ltd. v. Ficeto: “to sufficiently allege the existence of a ‘domestic transaction in other securities,’ plaintiffs must allege facts indicating that irrevocable liability was incurred or that title was transferred within the United States.”

Defendants’ main argument appears to have been based on a later Second Circuit decision, Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, which held that, even if a domestic transaction technically exists, the federal securities laws should not apply if the transaction is “predominately foreign.” The Volkswagen court noted that “the Ninth Circuit has not adopted Parkcentral’s ‘predominately foreign’ test and so the undisputed existence of a domestic transaction here arguably ends the inquiry under Morrison’s second prong.” But the court nevertheless “reache[d] the same conclusion even under Parkcentral” and addressed defendants’ arguments “for the sake of completeness.”

The Parkcentral case involved alleged misrepresentations that Porsche had made about its intentions concerning Volkswagen shares. The plaintiffs had purchased private swap agreements whose value depended on Volkswagen’s share price, and they sued Porsche for allegedly making false statements that had affected Volkswagen’s stock. The Second Circuit held that, even if the plaintiffs had purchased their swap agreements in U.S. transactions, Porsche had not been a party to or otherwise involved in those transactions, the transactions had not involved Porsche’s own shares, and all of the underlying events had occurred in Germany. In those circumstances, the Second Circuit said, “the imposition of liability under [the U.S. securities laws] on these foreign defendants with no alleged involvement in plaintiffs’ transactions, on the basis of the defendants’ largely foreign conduct, for losses incurred by the plaintiffs in securities-based swap agreements based on the price movements of foreign securities would constitute an impermissibly extraterritorial extension of the statute.”

In the Volkswagen case, however, the court ruled that the securities at issue “are not independent from Volkswagen’s foreign securities or from Volkswagen itself; instead, Volkswagen sponsored the ADRs and thus was directly involved in the domestic offering of the ADRs.” Even though the ADRs were unlisted Level 1 ADRs, Volkswagen “took affirmative steps to make its securities available to investors here in the United States.” Volkswagen and the depositary bank had entered into Deposit Agreements governed by New York law, and Volkswagen had submitted Form F-6 Registration Statements to the SEC to make the ADRs available in the United States. “These allegations establish a sufficient connection between Volkswagen’s ADRs and the United States.”

Implications

The Volkswagen decision adds to the number of cases holding that sponsored, Level 1 ADRs purchased on U.S. OTC markets fall within Morrison’s second prong for “domestic transactions in other [i.e., unlisted] securities.” So far, only one case (Stoyas v. Toshiba Corp.) appears to have addressed whether unsponsored, unlisted ADRs are covered by the federal securities laws – and has held that they are not. Sponsorship thus is an important factor in assessing whether the U.S. securities laws apply to unlisted, Level 1 ADRs.

The Volkswagen court, however, does not appear to have directly addressed another argument that has been raised in several cases: the so-called “economic reality” argument, which posits that the purchase of an ADR is the economic or functional equivalent of purchasing a foreign share on a foreign exchange, because the ADR is merely a receipt for a foreign share held on deposit by a custodian bank in the foreign issuer’s home country. It is possible that the Volkswagen court considered this issue in holding that, regardless of economic realities or functional equivalencies, the thing that was purchased (the receipt) was acquired in a U.S. transaction. But litigants are likely to continue to pursue the economic-reality argument in cases involving ADRs and other derivative securities.

The irony of the Volkswagen decision – and of Parkcentral and similar cases – is that the focus on U.S.-based conduct (such as sponsorship of ADRs) tends to resurrect the type of factual analysis that the Supreme Court had hoped to bury by promulgating Morrison’s transaction-based test. But, as Parkcentral so vividly illustrated, a purely mechanistic transactional analysis, divorced from any consideration of the defendant’s involvement in U.S. activities, can lead to the very type of promiscuous extraterritorial extension of U.S. law that the Morrison court had sought to avoid.