Professors Argue Against U.S. Courts Hearing Foreign Securities Claims

The following post comes to us from Richard W. Painter, S. Walter Richey Professor of Corporate Law at the University of Minnesota, and is based on an amicus brief submitted by a group of professors in Elliott Associates v. Porsche, available here. The group submitting the brief includes Harvard Law School Professor J. Mark Ramseyer, along with Forum contributors Joseph A. Grundfest, Lynn A. Stout, Roberta Romano, and Larry E. Ribstein.

A group of professors of American and German securities law submitted an amicus brief to the Second Circuit Court of Appeals in Elliott Associates v. Porsche, on Wednesday August 3, 2011. Amici urged the Court to prevent private parties from using U.S. courts to litigate claims that exceed the subject matter that Congress intended to regulate in Section 10(b) of the Securities Exchange Act as held by the Supreme Court in Morrison v. National Australia Bank. 130 S. Ct. 2869 (2010).

The case was brought by a group of hedge funds and other investors who took short positions in security based swap agreements that referenced the stock of Volkswagen (VW), which is traded in Germany but not in the United States. The plaintiffs sued Porsche for allegedly manipulating the price of VW stock in Germany and for allegedly misrepresenting Porsche’s intentions concerning takeover of VW. The United States District Court for the Southern District of New York (Judge Baer) held that these claims were precluded under Morrison because the plaintiffs’ transactions were the functional equivalent of transactions in VW stock, which was not traded in the United States. Amici urged affirmance of the holding below.

The amicus brief pointed out that premising a Section 10(b) claim on the location of the plaintiff contradicts the Supreme Court’s holding in Morrison, which looks to the location of the transaction. The brief pointed out that the place where a transaction clears might be a logical place to identify as the location of the transaction but the complaint in Porsche does not allege that the swap agreements cleared inside the United States. The complaint does not even allege that the swap agreements cleared in U.S. Dollars. The complaint furthermore did not identify many of the counterparties in the swaps.

The one thing that is known about the security-based swap agreements is that they referenced the stock of VW, which traded in Germany and not in the United States. The amici said that the Court below correctly identified this as the overwhelmingly important consideration in ascertaining the location of the swap agreements. The plaintiffs’ economic risk in the swap agreements and the loss that is complained about were in connection with the market for the underlying security and virtually identical to the risks and losses incurred by persons who took a short position in the underlying VW stock in Germany. Critically, plaintiffs do not allege any fraud regarding the swap itself, thereby making irrelevant questions concerning the location of counterparties or the locus of settlement. Plaintiffs allegations instead go to components of the swap transaction that are undeniably outside the United States and beyond the reach of Section 10(b).

The amicus brief also discussed in detail how German law prohibits the conduct alleged in the complaint and provides for both civil and criminal penalties for violations. The defendants’ conduct is already the subject of extensive investigations and litigation in Germany. The public prosecutor’s office in Stuttgart announced on February 22, 2011 that its investigation of two former board members of Porsche for manipulating VW shares was ongoing, and civil suits are also pending in Germany.

Section 20a of the German Wertpapierhandelsgesetz (WpHG) (the Securities Trading Act, a German equivalent to the US Securities Exchange Act) explicitly states in subsection 1-3 that it is prohibited to engage in market manipulation and misrepresentation. A question not explicitly addressed is whether a violation of section 20a WpHG – apart from criminal and administrative sanctions – gives rise to a private cause of action. There likely will be a private right of action if Section 20a WpHG is regarded as a “Schutzgesetz” (protective statute) in favor of individual investors in the ambit of sec. 823 subsection 2 of the Bürgerliches Gesetzbuch (the German Civil Code). The question of whether or not section 20a of the WpHG constitutes a “Schutzgesetz” and, therefore, can be used as a basis for a private cause of action, is disputed. See generally Mock/Stoll/Eufinger, in: Koelner Kommentar zum WpHG, Cologne 2007, Sec. 20a marginal numbers 425 et. seq.; in particular number 426 footnote 561. Nonetheless, a significant number of legal writers argue in favor of a protective character of section 20a of the WpHG and thus in favor of a private right of action.

Whether or not there is a private right of action for these particular plaintiffs in Germany, the Morrison decision recognizes that the United States is not the only country capable of regulating securities markets and that Congress did not intend to impose American securities law on the rest of the world. Germany and the other EU member states decide for themselves the appropriate mix of civil penalties, criminal penalties and private rights of action.

The amicus brief also argued that Congress, when it amended Section 10(b) in 2000 to include security based swap agreements intended (i) to cover only swaps that reference securities traded in the United States, and (ii) did not in any event intend to endorse an implied private right of action by swap parties against the issuers of underlying reference securities and persons who trade in those securities rather than the swap itself.

Common law had even questioned the enforceability of side bets decoupled from an underlying interest (so-called “difference contracts”). See Lynn Stout, Derivatives and the Legal Origin of the 2008 Credit Crisis, 1 Harv. Bus. L. Rev. 1, 4 (2011). Whether security-based swap agreements between parties that do not otherwise have an interest in the underlying security would have been unenforceable under the common law by courts in the late twentieth century is a matter of some debate. See Stout, supra at 11-12 (arguing that such swaps would have been considered unenforceable difference contracts); see Roberta Romano, A Thumbnail Sketch Of Derivative Securities And Their Regulation, 55 Md. L. Rev. 1, 54-55 (1996) (discussing questions regarding swap enforceability prior to the 1990s but only in insolvency proceedings).

In the 1990’s Congress enacted legislation making security-based swap agreements and other over the-counter-derivatives easier to enforce (particularly in the insolvency context). Congress, however, did not take the additional and radical step of creating a private right of action by swap parties against issuers and other traders in underlying reference securities. If Congress intended to bestow any private right of action for swap parties in 1999 it was most likely a private right of action for the parties to a security-based swap agreement to sue each other or other participants in the swap for fraud. Such would at least be consistent with Congress’s determination earlier that decade to support the contractual rights of swap parties.

The amicus brief pointed out that there would be a great potential cost to such an implied private right of action. Security-based swap agreements of enormous magnitude can be entered into referencing the stock of a relatively small company. Swap traders, for example could enter into billions of dollars of swaps referencing the value of stock in a corporation owning a single coffee shop off Wall Street if they wanted to. They could do likewise for the stock of a relatively small company that just made an offering of a few million dollars of stock on the NASDAQ. The potential for strike suits of enormous proportions is obvious.

Even if federal courts were to decide that Congress intended to impose such an illogical liability regime on securities markets in our own country, Morrison makes it clear that unless Congress expressly so provides, such a liability regime should not be imposed by our law on securities markets outside the United States. Holding that U.S. parties to swap agreements could sue issuers and investors in foreign markets would do just that. An absurd litigation regime for our country would be foisted upon others, which is precisely what Morrison prohibits.

Finally, the amicus brief raised but did not answer a range of other issues that would have to be resolved if the Second Circuit were to disagree with the district court and hold that the plaintiffs’ claims were not precluded by Morrison. Since plaintiffs did not trade in the reference security itself, the foreseeability aspect of loss causation seems almost impossible to assess. Investors’ potential losses in a security itself are often foreseeable because information about trading volume in the security (and even trading volume in derivative options) is usually public information. Given the private nature of swap agreements, however, it is difficult to see how a defendant involved in a fraud concerning the swap’s reference security can be said to have foreseen losses occasioned by the fraud.

The problems with establishing a clear standard for standing and foreseeability contribute to a problem regarding intent. How is the intent element to be analyzed when a foreign defendant’s actions in a foreign stock on a foreign stock exchange affects the value of a swap agreement allegedly transacted in the United States? How can the plaintiff possibly meet the requirement to plead specific facts giving rise to a strong inference of scienter that is at least as believable as another inference about the defendant’s state of mind? See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007). Amici suggested in their brief that these problems stem from, or at the very least are exacerbated by, plaintiff’s attempt to extend Section 10(b) to situations that neither Congress nor the courts expected it to cover.

Both comments and trackbacks are currently closed.
  • Subscribe or Follow

  • Supported By:

  • Program on Corporate Governance Advisory Board

  • Programs Faculty & Senior Fellows