Securities Regulation - Securities Exchange Act - Second Circuit Holds That Transactions in Unlisted Securities Are Domestic If Irrevocable Liability Is Incurred or If Title Passes within the United States
When confronting securities transactions that involve multiple jurisdictions, U.S. courts have struggled to delimit the extraterritorial reach of U.S. securities law. Whereas a narrow application of U.S. securities law to global securities transactions could turn the United States into "a 'Barbary Coast' for malefactors perpetrating frauds in foreign markets," (1) an expansive application could make the United States "a Shangri-La of class-action litigation for lawyers representing those allegedly cheated in foreign securities markets." (2) The Second Circuit historically has played a prominent role in navigating this thorny issue, having developed two influential tests -- the conduct and effects tests (3) -- for determining whether section 10(b) of the Securities Exchange Act (4) (Exchange Act) applies extraterritorially. But in its 2010 decision Morrison v. National Australia Bank Ltd., (5) the Supreme Court rejected the flexible conduct and effects tests and re-placed them with a bright-line transactional test. (6) Reaffirming the presumption against extraterritoriality, (7) the Court held that section 10(b) of the Exchange Act applies only to (1) "transactions in securities listed on domestic exchanges," and (2) "domestic transactions in other securities." (8)
Recently, in Absolute Activist Value Master Fund Ltd. v. Ficeto, (9) the Second Circuit interpreted the second prong of the Morrison extraterritoriality test. The court held that transactions in securities unlisted in the United States are "domestic," and thus subject to U.S. securities law, if the parties incur irrevocable liability or if title passes within the United States. (10) Given the complexities associated with locating the site of irrevocable liability, the Second Circuit's test facilitates a context-specific application of U.S. securities law that is likely to protect against the evasion of U.S. law. But the court's test could also lead to arbitrary results, reflecting the problematic nature of the Supreme Court's standard of using a transaction's "location" as the basis for applying U.S. law.
In 2004, a group of nine Cayman Islands hedge funds enlisted Absolute Capital Management (ACM) as their investment manager, paying monthly management and performance fees to ACM based on the net asset values of their respective funds. (11) Employees of ACM, working with U.S.-registered securities agent Todd Ficeto, directed the hedge funds to purchase billions of shares of thinly capitalized U.S. companies ("U.S. Penny Stock Companies") during three years through over-the-counter domestic offerings. (12) At the time of these transactions, the ACM investment managers owned substantial shares in the U.S. Penny Stock Companies and received more shares from the companies in exchange for directing the hedge funds to invest in them. (13) The ACM managers then traded and re-traded the shares at successively higher prices, "often between and among the [hedge funds]" themselves. (14) The purpose of this "pump-and-dump" scheme was to generate greater fees for the ACM managers and to inflate prices artificially so the managers could reap a windfall by selling their own personal shares to the hedge funds. (15) The hedge funds filed a federal complaint asserting securities fraud claims against the ACM managers under the Exchange Act and under New York common law. (16)
The district court dismissed the case for lack of subject matter jurisdiction. (17) The court based its dismissal on Morrison, which was decided the day after the district court heard oral argument in Absolute Activist. (18) The court held that the transaction failed to satisfy Morrison's first prong because the securities were not listed on any domestic exchange. (19) The court then held that the transaction failed to satisfy Morrison's second prong because "[t]he [hedge funds] were based in the Cayman Islands and managed in Europe," placing the transactions outside the United States. …