When Is a Securities Transaction “Domestic” Under Morrison?

 

Screenshot of Shanda Website

In Morrison v. National Australia Bank (2010), the Supreme Court held that § 10(b) of the Securities Exchange Act applies only to “transactions in securities listed on domestic exchanges, and domestic transactions in other securities.” This holding doomed the securities fraud claims in Morrison because the plaintiffs purchased their shares on the Australian Securities Exchange.

At first glance, the quoted language seems simple enough—§ 10(b) apparently applies if the transaction occurs in the United States. That could happen in two ways. First, the transaction could involve listed securities and take place on a domestic exchange. Second, the transaction could involve unlisted securities and still take place in the United States, though not on an exchange.

However, a recent decision from the Second Circuit tests this understanding of Morrison. The securities in In re Shanda Games Limited Securities Litigation were listed on a U.S. exchange. But the freeze-out merger that extinguished those securities occurred outside the United States. The court of appeals held that § 10(b) applied because it involved “securities listed on domestic exchanges” even though the transaction occurred abroad.

Gaming the Proxies

Shanda Games Limited was a video games company registered in the Cayman Islands with American Depository Shares (ADS) listed on the NASDAQ exchange in the United States. Shanda had the right to market Mir II, a multiplayer online computer game, in China. Mir II proved very successful in China, but by 2013 sales were declining. So, Shanda developed a mobile version to access the expanding mobile games market.

At the same time, members of Shanda’s board of directors, including its CEO, were exploring the possibility of taking Shanda private. In 2015, the buyer group agreed to pay $7.10 per ADS, which the company’s financial advisor Merrill Lynch opined was a fair price.

Although the buyer group controlled enough voting power to approve the freeze-out merger, Shanda had to hold a shareholders meeting to allow shareholders to approve the merger before tendering their shares or to dissent before exercising their appraisal rights. In connection with the meeting, Shanda issued two proxy statements with financial projections which allegedly understated the company’s prospects.

Some shareholders tendered their shares and were cashed out at $7.10 per ADS. Three shareholders dissented and filed an appraisal action in the Cayman Islands. During that action, errors in the financial projections were discovered, and the Cayman courts awarded the dissenting shareholders $12.84 per ADS. Tendering shareholders who received less than this brought a putative class action for securities fraud under § 10(b) and other provisions of U.S. securities law.

The Challenges of Interpreting Morrison

Morrison’s critical language is this: “it is in our view only transactions in securities listed on domestic exchanges, and domestic transactions in other securities, to which § 10(b) applies.” The Second Circuit has struggled to interpret this language before.

With respect to Morrison’s second prong—“domestic transactions in other securities”—the court has had to develop a test to determine when a transaction in unlisted securities is “domestic.” It has also created an exception to Morrison for cases in which the claims are “predominantly foreign” although the transaction occurs in the United States. I have discussed the problems with these decisions here.

The Second Circuit has also had to interpret Morrison’s first prong—“transactions in securities listed on domestic exchanges.” In City of Pontiac Policemen’s & Firemen’s Retirement System v. UBS AG (2014), the plaintiffs purchased shares on a foreign stock exchange, but the shares were cross-listed on the New York Stock Exchange. The court held that the cross-listing was not enough to bring the plaintiffs’ claims within the scope of Morrison’s holding, emphasizing that it is the place of the transaction that matters. In City of Pontiac, the transaction was not domestic because it occurred on a foreign exchange.

The Question in Shanda Games

In Shanda Games, the ADS were not cross listed. They were listed only on the NASDAQ in the United States, which is where the plaintiffs purchased them. But Shanda argued that the freeze-out merger was not a domestic transaction because the shareholders meeting occurred in China, which is where the plaintiffs tendered their shares.

Writing for the panel majority, Chief Judge Debra Ann Livingston disagreed. “[U]nlike in City of Pontiac,” she wrote, “[plaintiffs’] ADS were traded only on a U.S. exchange, were purchased there, and ultimately delisted there. This case therefore falls squarely within Morrison’s first prong.” In her view, the first prong is primarily concerned with the domestic listing and not with the location of the transaction. “City of Pontiac,” she wrote, “merely carved out an exception to prong one’s general rule—that ‘transactions in securities listed on domestic exchanges’ fall with the scope of § 10(b)—for claims arising from purchases of ‘foreign-issued shares on a foreign exchange.’” Judge Raymond Lohier concurred with Judge Livingston, whereas Judge Dennis Jacobs dissented on other grounds.

The panel’s extraterritoriality holding seems questionable. Morrison begins its analysis of extraterritoriality by noting that “the focus of the Exchange Act is … upon purchases and sales of securities in the United States” (emphasis added). It is this premise from which Morrison’s two prongs are derived (at the end of the very same paragraph). Thus, as the Second Circuit explained in City of Pontiac, “Morrison’s emphasis on ‘transactions in securities listed on domestic exchanges,’ makes clear that the focus of both prongs was domestic transactions of any kind, with the domestic listing acting as a proxy for a domestic transaction” (second emphasis added).

Conclusion

I have some sympathy for the result that Chief Judge Livingston reached. It may well be that when a foreign company accesses U.S. securities markets by listing shares on a U.S. exchange, investors in those shares should be protected by U.S. securities laws regardless of where a subsequent transaction occurs. But I find it hard to square that result with the language of Morrison and City of Pontiac. Both of those decisions, unlike Shanda, looked to the location of the transaction to determine when § 10(b) applies.

One thing is certain. Morrison continues to generate difficult interpretive questions. I have noted previously that Justice Scalia thought Morrison would establish a clear, bright-line rule for courts to apply. The last fifteen years of securities litigation have shown that Morrison’s line is not so clear after all.