Increased Risks Associated with American Depository Receipts Programs
By James O'Donoghue
Over 2,000 non-U.S. companies are connected to American investors through the purchase of American Depository Receipts (ADR). ADR’s represent securities of foreign companies held by brokerages on overseas exchanges. Such instruments provide foreign companies with access to U.S. capital markets, but also create exposure to US securities laws, the scope of which was explored in a decisive lawsuit filed against Toshiba in the summer of 2016.
In deciding a motion to dismiss in the case against Toshiba, Judge Dean Pregerson of the Central District of California created a bright-line rule for determining whether a foreign company was subject to U.S. securities laws in a civil action involving an unsponsored ADR program. Unsponsored ADR’s are securities purchased by intermediaries on foreign exchanges without any involvement of the original issuer. Based on the test devised by the Supreme Court in Morrison v. National Australian Bank Ltd., Judge Pregerson determined the Securities Exchange Act of 1934 was categorically inapplicable to unsponsored ADR’s, since they do not qualify as a security under Section 10(b) of the 1934 Exchange Act.
In Morrison, the Supreme Court stated the Exchange Act of 1934 applies to “transactions in securities listed on domestic exchanges” and “domestic transactions in other securities.” Judge Pregerson stated that ADR’s are not sold on domestic exchanges and therefore do not apply to the first prong of Morrison. He further concluded that unsponsored ADR’s do not constitute “domestic transactions of securities.” While technically sold in a domestic transaction, the judge reasoned, the lack of involvement by the original issuer effectively distances them from participating in that transaction. To conclude otherwise would “essentially create a limitless reach” of the 1934 Act. This reflects the reality that foreign companies cannot always prevent or control the sale of their securities in second-hand transactions.
Judge Pregerson's decision provided some comfort to foreign companies faced with the prospect of nascent exposure to U.S. litigation, until the ruling was reversed on appeal by the Ninth Circuit and remanded back to district court. The appellate court applied the standard of “irrevocable liability” to determine whether ADR’s constitute a “domestic transaction.” Since the Toshiba ADR’s were purchased in the U.S., by American plaintiffs, on an OTC platform based in the U.S., from American depository banks, the court considered the sale of Toshiba’s unsponsored ADR’s to be a “domestic transaction.”
The Ninth Circuit attempted to dispel concerns of comity and boundless liability by underscoring the fact that claims brought under the 1934 Exchange Act require more than a mere showing that ADR’s are part of a domestic transaction. The court noted that plaintiff's must also demonstrate that the fraud alleged was carried out to induce the purchase at issue. Toshiba appealed to the U.S. Supreme Court in a petition accompanied by amicus briefs of from several business organizations and governments. The Supreme Court denied certiorari on June 24th of this year.
The Ninth Circuit's ruling has significant implications for foreign corporations facing prospect of US securities litigation. The court's attempt to dispel concerns of excess liability by alluding to a need to demonstrate inducement is misleading, since plaintiffs have an implied right of action such cases. Plaintiff’s do not need establish a direct nexus between the alleged misconduct conduct and the specific ADR transaction at issue. The same elements alleged against a domestic defendant, coupled with the proof of purchasing an ADR’s, would suffice to defeat a motion to dismiss, effectively entangling a foreign company in litigation regardless of the merits of the action.
It has yet to be determined whether an unsponsored ADR transaction involving U.S. investor plaintiffs could be so sufficiently foreign as to not constitute a “domestic transaction.” The characteristics of most ADR programs resemble those at issue in the Toshiba case, suggesting such a scenario is unlikely.
In denying certiorari, the Supreme Court has signaled their comfort with the Ninth Circuits broad interpretation of securities under the 1934 Exchange Act. It is important for non-US companies to carefully consider how their securities might inadvertently create exposure to U.S. securities litigation. Alternative forms of capitalization often allow more control in determining the manner and forum for dispute resolution. It is also worth examining what domestic legal restrictions can be placed on the resale of securities once they are issued.