On July 17, 2018, the United States Court of Appeals for the Ninth Circuit reversed the dismissal of a putative securities class action, which alleged that a technology company (the “Company”) and its current and former chief executive officers engaged in fraudulent accounting in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as well as Japanese securities law. Automotive Industries Pension Trust Fund, et al. v. Toshiba Corp., No. 16-56058 (9th Cir. July 17, 2018). In its ruling, the Ninth Circuit analyzed the second prong of the transaction test articulated in Morrison v. National Australia Bank, 561 U.S. 247 (2010) and adopted the Second and Third Circuits’ “irrevocable liability” test, which evaluates where the purchasers incurred the liability to take and pay for securities, and where the seller incurred the liability to deliver the securities. The Ninth Circuit remanded the case to the district court so that plaintiffs could amend their complaint to try to meet this standard.
The Company is based in Tokyo, Japan and its ordinary shares trade on the Tokyo Stock Exchange. Lead plaintiff is a U.S.-based pension fund that purchased the Company’s American Depository Receipts (“ADRs”) on an over-the-counter market. At issue in the case is the scope of the Supreme Court’s decision in Morrison, where the Court held that the Exchange Act did not apply extraterritorially and thus is limited to deceptive conduct in connection with the purchase or sales of any securities (i) registered on a national securities exchange, or (ii) domestic transactions in other securities not so registered. In the district court, defendants argued that, under Morrison, the putative securities fraud class action should be dismissed because the over-the-counter market on which the ADRs were sold is not a “national exchange” within the meaning of Morrison, and there was not a domestic transaction between the ADR purchaser and the Company. The district court agreed and dismissed the case.
On appeal, the Ninth Circuit first ruled that lead plaintiff could not satisfy the first prong of the Morrison test because the over-the-counter market on which the Company’s ADRs traded is not an “exchange” under the Exchange Act. With regard to the second prong of the Morrison test (i.e., domestic transactions in other securities not so registered), the Ninth Circuit adopted the Second and Third Circuits’ “irrevocable liability” test, which looks to where purchasers incurred liability to take and pay for securities, and where sellers incurred the liability to deliver the securities. The Court noted that lead plaintiff purchased the ADRs in the United States and the depositary bank sold the ADRs in the United States. Missing from the complaint, however, were specific factual allegations regarding where the parties to the transaction incurred irrevocable liability. As a result, the Ninth Circuit remanded the case to the district court to allow plaintiffs to file an amended complaint.
This decision is significant because it establishes in the Ninth Circuit that non-U.S. companies can be subject to liability under the Exchange Act in connection with the purchase and sale of ADRs, even when the ADRs do not trade on a U.S. exchange.