The US Court of Appeals for the Second Circuit in Parkcentral Global Hub Limited v. Porsche Automobile Holdings, SE, 11-397-CV (2d Cir. N.Y. Aug. 15, 2014) upheld a lower-court's decision to dismiss a series of private civil actions brought under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, the anti-fraud provisions of the US federal securities laws, by a group of hedge funds against Porsche Automobile Holdings SE ("Porsche"), and two of its senior officers, alleging that the defendants defrauded them by making false statements about their intent to take over Volkswagen AG ("VW"). The plaintiff hedge funds had entered into securities-based swap agreements relating to the stock of VW, which meant that the amount of gain and loss in the transactions depended on prices of VW stock recorded on foreign exchanges. The Second Circuit held that "the imposition of liability under § 10(b) 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 this opinion, the Second Circuit clarified the manner in which courts should apply the Supreme Court's seminal decision in Morrison v. National Australia Bank, 561 U.S. 247 (2010), and further limited the extraterritorial application of § 10(b) in private civil actions.
The plaintiffs, more than thirty international hedge funds, employed securities-based swap agreements pegged to the price of VW shares, which trade on European stock exchanges, to bet that VW stock would decline in value. The positions they took through their swap agreements were roughly economically equivalent to short positions in VW stock, in that they would gain to the extent VW stock declined in value and would lose to the extent it rose.
Porsche's Alleged Scheme To Obtain Control Of VW:
The Plaintiffs alleged that, in 2008, Porsche (which, in addition to manufacturing and selling automobiles, was also an active investor in various securities and derivatives), and its senior executives made various fraudulent statements and took various manipulative actions to deny and conceal Porsche's intention to take over VW. Specifically, plaintiffs alleged that as early as February 2008, Porsche had developed a secret plan to acquire the minimum seventy-five percent interest needed to gain control of VW under German law. Plaintiffs alleged that Porsche devised a manipulative scheme to conceal its acquisition of VW stock and options and fraudulently made repeated public statements denying that it intended to acquire a controlling share of VW.
The plaintiffs alleged that Porsche's scheme caused their investment managers—located in New York City and elsewhere in the United States—to conclude that Porsche was unable or unwilling to acquire control of VW and that VW stock was thereby overvalued. Accordingly, they entered into securities-based swap agreements that were akin to short sales.
The October 2008 Short-Squeeze:
In late October 2008, as the global financial crisis worsened, VW's stock price began a sharp decline. The plaintiffs alleged that, in order to prop up VW's share price and avoid an enormous loss, Porsche decided to disclose its plan to acquire control of VW to the public.
On October 26, 2008, Porsche issued a press release disclosing that it had acquired 74.1 percent of VW through a combination of direct holdings and options to purchase VW shares, and explaining that it hoped to increase its stake to 75 percent. As the market absorbed Porsche's disclosure, the price of VW stock increased dramatically. Short sellers were forced to purchase shares to unwind their short sales and limit their losses, a process which was complicated by the circumstance that more than 95 percent of VW's outstanding shares were held by parties who could not or would not sell, including Porsche. The scramble by short sellers to buy stock to cover their positions caused the price to rise even more rapidly, leading to a classic "short squeeze." When all was said and done, parties with short positions in VW had lost an estimated total of $38.1 billion.
Lower Court Decision:
The plaintiff hedge funds brought actions in federal court in New York, alleging violations of the antifraud provisions of the US federal securities laws and common law fraud. While the litigation was pending, the Supreme Court issued its decision in Morrison, which changed the landscape concerning extraterritorial application of Section 10(b) and Rule 10b-5. The defendants moved to dismiss the actions on Morrison grounds. The district court granted the motion to dismiss the federal claims with prejudice and declined to exercise jurisdiction over the state law claims. In doing so, the district court focused on the Supreme Court's emphasis on avoiding interference with foreign securities regulation that application of §10(b) abroad would produce. Elliott Assocs. v. Porsche Automobile Holding SE, 759 F.Supp.2d 469, 474 (S.D.N.Y.2010). The district court evaluated the economics of the swap agreements at issue in light of that concern, noting that the securities-based swap agreements were intrinsically tied to the value of the reference security. Id. at 476. The district court found that because the swap transactions were the functional equivalent of trading the underlying VW shares on a German exchange "the economic reality is that [the swaps] are essentially 'transactions conducted upon foreign exchanges and markets,' and not 'domestic transactions' that merit the protection of § 10(b)." Id.
The Court of Appeals began its analysis by considering the two leading cases in the Second Circuit concerning the extraterritorial application of Section 10(b) and Rule 10b-5: Morrison and Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir.2012). In Morrison, the U.S. Supreme Court established that, by virtue of the presumption against extraterritorial application of U.S. statutes, § 10(b) of the Exchange Act has no extraterritorial application, and no civil suit under that section may be brought unless predicated on a purchase or sale of a security listed on a U.S. exchange or on a U.S. domestic purchase or sale of another security. In Absolute Activist, the Second Circuit set forth the test to be used to determine when a transaction in securities is “domestic” such that it may furnish the basis for a suit under that section, concluding that in order for such a transaction to qualify as domestic, “the parties [must] incur irrevocable liability to carry out the transaction within the United States or ... title [to the securities must be] passed within the United States.” 677 F.3d at 69.
Because the Second Circuit accepted that the plaintiffs' securities-based swap agreements were executed and performed in the United States, the court addressed the threshold question of whether, underMorrison, a domestic transaction in a security (or a transaction in a domestically listed security) – in addition to being a necessary element of a domestic § 10(b) claim – is also sufficient to justify the application of § 10(b) to otherwise foreign facts. The court concluded that, whileMorrison unmistakably made a domestic securities transaction (or transaction in a domestically listed security) necessary to a properly domestic invocation of § 10(b), such a transaction is not alone sufficient to state a properly domestic claim under the statute. The court reached this conclusion for two reasons. First, the Supreme Court in Morrisondid not say that such a transaction was sufficient to make the statute applicable. Second, the court concluded that "a rule making the statute applicable whenever the plaintiff’s suit is predicated on a domestic transaction, regardless of the foreignness of the facts constituting the defendant’s alleged violation, would seriously undermine Morrison’sinsistence that § 10(b) has no extraterritorial application." In addition, it would inevitably place § 10(b) in conflict with the laws of other nations because it would courts to apply the statute to wholly foreign activity clearly subject to regulation by foreign authorities solely because a plaintiff in the United States made a domestic transaction, even if the foreign defendants were completely unaware of it.
Having concluded that a domestic transaction is necessary, but not sufficient to make § 10(b) applicable, the court focused on the facts of the alleged scheme and found that the claims were so predominantly foreign as to be impermissibly extraterritorial. The court found that, because the complaints concern statements made primarily in Germany with respect to stock in a German company traded only on exchanges in Europe, the case presented obvious potential for regulatory and legal overlap and conflict between U.S, law and foreign laws. Moreover, throughout the opinion, the court highlighted other facts demonstrating that the conduct at issue was predominantly foreign:
- The foreign defendants were not parties to, nor did they participate in, the plaintiffs’ swap agreements.
- The swap agreements referenced the German company’s stock but did not give the plaintiffs any ownership interest in that stock.
- The alleged fraud has been investigated by German authorities and was the subject of adjudication in German courts.
Accordingly, the court concluded that "[a]lthough we recognize that the plaintiffs allege that the false statements may have been intended to deceive investors worldwide, we think that the relevant actions in this case are so predominantly German as to compel the conclusion that the complaints fail to invoke § 10(b) in a manner consistent with the presumption against extraterritoriality."
Further Limitation on Extraterritorial Application Of § 10(b):
The Second Circuit's decision in Parkcentral Global represents an application of Morrison to derivative securities, namely securities-based swap agreements, and its decision is animated by the character of those securities. The court emphasised that the swap agreements did not involve the actual ownership, purchase, or sale of the reference securities. Instead, the court observed, "as bilateral agreements to pay money on the occurrence or non-occurrence of wholly independent events, securities-based swap agreements are essentially wagers on changes in the price of the reference security." Viewed in that light, one can see that the court separated the securities-based swap agreements held by the plaintiffs from the underlying VW securities that were the object of the alleged fraud scheme. Although the former were rooted in US-based transactions, the VW securities (which traded on overseas exchanges) and the fraud scheme (which took place in Germany) were plainly foreign. By holding that a US domestic transaction was necessary, but not sufficient, for § 10(b) to apply, the court demonstrated that it will consider the substance of the relevant transactions and factual allegations in assessing the extraterritorial nature of a given case. In this case, the court declined to allow the plaintiffs to utilize domestic derivative securities transactions that did not involve the defendants to bring a dispute that was predominantly foreign into US courts. The Second Circuit's focus on an overall factual circumstances approach may provide an argument for defendants that the Morrison extraterritoriality test can limit a plaintiff's ability to bring §10(b) claims relating to transactions executed in the United States involving foreign conduct and foreign issuers, depending on the factual circumstances of the transactions and conduct at issue.