Last week, the U.S. Court of Appeals for the Second Circuit issued its opinion in City of Pontiac Policemen's and Firemen's Retirement System v. UBS AG, No 12-4355, slip op. (2d Cir. May 6, 2014) ("City of Pontiac"), further restricting the extraterritorial application of the Securities Exchange Act of 1934 ("Exchange Act"). The City of Pontiac narrowly interprets the United States Supreme Court's "transactional" test (established in Morrison v. National Australia Bank, 561 U.S. 247 (2010)), which held that section 10(b) of the Exchange Act "only provide[s] a private cause of action arising out of  transactions in securities listed on domestic exchanges, and  domestic transactions in other securities."1 Since Morrison, plaintiffs have argued that non-U.S. securities that also happened to be cross-listed on a United States exchange are listed on a domestic exchange and thus covered by the first prong of the transactional test. And U.S. investors who placed orders in the United States that were subsequently executed on a non-U.S. exchange have argued that those orders were "domestic transactions." The Second Circuit, in the City of Pontiac, rejected both of these arguments.
Plaintiffs in the City of Pontiac purchased shares of the defendant foreign issuer (a global investment bank) on non-U.S. exchanges, but nevertheless sued in the United States under the Exchange Act. The suit accused the issuer and a number of its officers and directors of violating the Exchange Act as a result of alleged misstatements and omissions the bank made concerning both its ownership of residential mortgage backed securities and collateralized debt obligations and its participation in a supposed tax fraud scheme.2 The plaintiffs made two arguments for the extraterritorial application of the Exchange Act, each of which was rejected by the Second Circuit.
First, some of the non-U.S. investor plaintiffs argued that, because the foreign issuer's shares were cross-listed on the New York Stock Exchange, investors could invoke Morrison's first prong – even though their own transactions had taken place on a non-U.S. exchange. While the Second Circuit recognized that this "listing theory" appears, "in isolation," to be supported by the language in the first prong of Morrison, the Court concluded that this theory "was irreconcilable with Morrison read as a whole."3 The Second Circuit emphasized that Morrison "evinces a concern with the location of the securities transaction and not the location of an exchange where the security may be dually listed[,]" and read the domestic "listing" discussed in Morrison's first prong as a "proxy for a domestic transaction."4 Further, the Second Circuit noted that "most tellingly, in rejecting this Circuit’s 'conduct and effects' test in favor of a bright-line rule, Morrison rejected our prior holding that the Exchange Act applies to transactions regarding stocks traded in the United States which are effected outside the United States."5
Second, a domestic plaintiff argued that, because it purchased the foreign issuer's shares on a foreign exchange by placing a buy order in the United States (which was later executed on a Swiss exchange), it satisfied Morrison's second prong concerning domestic transactions in other securities. The Second Circuit rejected this theory as well. Previously, in Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir. 2012), the Second Circuit interpreted the second prong of Morrison to require plaintiffs to allege "facts indicating that irrevocable liability was incurred or that title was transferred within the United States."6 Under Absolute Activist, plaintiffs can demonstrate that irrevocable liability was incurred in the United States by showing that "the purchaser incurred irrevocable liability within the United States to take and pay for a security, or that the seller incurred irrevocable liability within the United States to deliver a security. . . . [or that the United States was] the location in which title is transferred."7
A domestic plaintiff in City of Pontiac contended that it satisfied the Absolute Activist test because it had incurred "irrevocable liability" in the United States as a result of its U.S. buy order. The Second Circuit, recognizing that this was an issue of first impression, disagreed. The Court reiterated that an investor's residency or citizenship does not affect where a transaction actually occurs and thus the fact that the plaintiff was a U.S. entity was irrelevant to the analysis. The Court went on to conclude that the placement of "a buy order in the United States that was then executed on a foreign exchange, standing alone," does not establish that the plaintiff "incurred irrevocable liability in the United States."8 While the decision recognized that facts concerning the placement of purchase orders, like those concerning the formation of the contracts, the passing of title, or the exchange of money, could be relevant to the question of where irrevocable liability occurred, the Court stated that it had "never held that the placement of a purchase order, without more, is sufficient to incur irrevocable liability, particularly in the context of transactions in foreign securities on a foreign exchange."9 Thus, the Second Circuit affirmed the District Court's dismissal of these claims by a domestic purchaser insofar as they were based on purchases of foreign shares on foreign exchanges.10
The City of Pontiac decision appears to have soundly rejected the "listing theory;" thus the fact that a foreign security might be dually listed in the United States is irrelevant to a plaintiff's own transaction in a non-U.S. listed security and the reach of the Exchange Act over their claim. This is a victory for non-U.S. issuers concerned about the extraterritorial limits of the U.S. securities laws over their securities. However, some of the questions regarding the definition of "domestic transactions in other securities" that were left open in Absolute Activist remain open in City of Pontiac. While we now know that, at least within the Second Circuit, placing a buy order in the United States does not by itself constitute a domestic transaction, the question remains as to what combination of facts are necessary to demonstrate that irrevocable liability has been incurred in the United States? Still, although City of Pontiac is not definitive on the scope of Morrison's second prong, the decision will likely further limit liability under the U.S. securities laws for foreign issuers in future litigation -- subject to potential disagreement on the issue by other courts of appeals. Accordingly, the Second Circuit's City of Pontiac likely is an important step in further clarifying Morrison and limiting the extraterritorial application of the federal securities law to foreign securities transactions.