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(Article from Securities Law Alert, January 2016) 

For more information, please visit the Securities Law Alert Resource Center

In Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010), the Supreme Court held that Section 10(b) only applies to securities fraud claims brought “in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.”

On December 20, 2015, the Southern District of New York dismissed on Morrison grounds securities fraud claims brought by certain investors who had purchased debt securities (the “Notes”) issued by Petróleo Brasileiro (“Petrobras”), a Brazilian oil company, on over-the-counter bond markets in New York. In re: Petrobras Sec. Litig., 2015 WL 9266983 (S.D.N.Y. 2015) (Rakoff, J.). The court held that an on over-the-counter bond markets does not qualify as an “American stock exchange” under the first prong of the Morrison test. The court further ruled that the second prong of the Morrison test is not satisfied whenever a transaction is settled in the United States through the Depository Trust Company (“DTC”) system.

Court Finds That an Over-the-Counter Bond Market Is Not an American Stock Exchange for Purposes of the First Prong of the Morrison Test

Applying the first prong of the Morrison test, the court found that an over-the-counter bond market does not qualify as a national stock exchange. The court reasoned that “over-the-counter transactions are, by definition, those that do not occur on an exchange.”

The court further observed that the Notes “were listed or intended to be listed on the New York Stock Exchange” but “they did not trade there.” The court explained that under Second Circuit precedent, “mere listing, without trading, is insufficient to satisfy Morrison’s first prong” (citing City of Pontiac Policemen’s and Firemen’s Ret. Sys. v. UBS AG, 752 F.3d 173 (2d Cir. 2014)).

Applying the Second Circuit’s Test in Absolute Activist, Court Finds That Settling a Transaction in the United States Through the DTC System Is Not Enough to Satisfy Morrison’s Second Prong

Turning to the second prong of the Morrison test, the court noted that “the Second Circuit has construed the Morrison test narrowly, in line with its underlying rationale.” The court explained that under the Second Circuit’s decision in Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60 (2d Cir. 2012)[1], “the second prong of Morrison is satisfied only ‘when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States’” (quoting Absolute Activist, 677 F.3d 60).  To meet the requirements of Absolute Activist, plaintiffs must “allege . . . specific facts, ‘including but not limited to, facts concerning the formation of contracts, the placement of purchase orders, the passing of title, or the exchange of money’” (quoting Absolute Activist, 677 F.3d 60).

Here, plaintiffs did “not claim that legal title in the Petrobras Notes was transferred in the United States.” Plaintiffs instead contended “that beneficial ownership was transferred in the United States because their Notes purchases settled through the [DTC] in New York, New York.” Plaintiffs argued that “when [the] DTC adjusts its books to settle an investor’s trade, it is the functional equivalent of transfer of title.”

The court acknowledged that “global financial markets could not properly function without the DTC or similar depository institutions and that the chain reaction of adjustments to book entries set off by a securities transaction is necessary to complete a purchase.” However, the court held that “the operations of the DTC are insufficient to satisfy Absolute Activist, even assuming that DTC’s bookkeeping affects a change in beneficial ownership in New York.” The court explained that under Second Circuit precedent, “domestic ‘actions needed to carry out . . . transactions’ . . . are insufficient to satisfy Morrison (quoting Loginovskaya v. Batratchenko, 764 F.3d 266 (2d Cir. 2014)). While “[t]he mechanics of DTC settlement are actions needed to carry out transactions,” the court underscored that those mechanics “involve neither the substantive indicia of a contractual commitment necessary to satisfy Absolute Activist’s first prong nor the formal weight of a transfer of title necessary for its second.”

The court further reasoned that “the entire thrust of Morrison and its progeny would be rendered nugatory if all DTC-settled transactions necessarily fell under the reach of the federal securities laws.” The court explained that “[t]he laws would reach most transactions, not because they occurred on a domestic exchange but because they settled through the DTC.” The court held that “[t]his result cannot be squared with the plain language and careful reasoning of Morrison and Absolute Activist.”