Securities Law--Section 10(b) Liability Not Applicable to Domestic Securities-Based Swap Agreements on Foreign Securities--Parkcentral Global Hub Ltd. v. Porsche Auto. Holdings SE, 763 F.3d 198 (2d Cir. 2014).

AuthorPatterson, Alisha

The Securities Exchange Act of 1934 (the Act) has long provided protections for investors from fraud and misrepresentation through section 10(b) of the Act ([section] 10(b)) and the Securities Exchange Commission Rule 10b-5 (Rule 10b-5); however, the extraterritorial application of the Act has undergone changes since 2010. (1) In Parkcentral Global Hub, Ltd. v. Porsche Auto. Holdings SE, (2) the Second Circuit focused on the extraterritorial application of [section] 10(b) to alleged fraud perpetrated by Porsche Automobile Holdings SE (Porsche), a German based automobile manufacturer, in Germany relating to domestic se- curities-based swap agreements on foreign listed securities of another German automobile corporation, Volkswagen (VW). (3) Securities-based swap agreements are derivative securities, which are based on predicting the volatility of an underlying security, but are still considered protected securities under the Act. (4) The Second Circuit held that domestic securities-based swap agreements are not regulated by [section] 10(b) when the alleged fraud occurs overseas because the application of [section] 10(b) in such cases would undermine Congressional intent, conflict with foreign laws, and impermissibly extend [section] 10(b) extraterritorially. (5)

Between 2005 and 2007, Porsche gradually increased investments in VW stock and acquired 31% of VW stock by the end of 2007. (6) VW shares were primarily traded on European stock exchanges, and were not available for purchase on any stock exchange in the United States. (7) In 2008, Porsche allegedly made false statements regarding their motive for increasing shareholdings in VW by stating that their reason for acquiring shares was to prevent a hostile takeover of VW by another company. (8) In reality, Porsche intended on gaining a 75% interest in VW stock in order to take over VW itself. (9) The problem Porsche faced with this plan was that most of VW shares were owned by shareholders who could not, or would not sell; however, Porsche's allegedly false 2008 statements made VW shares appear overvalued in relation to other companies, which induced investors to short sale VW stock and encouraged Parkcentral Global Hub Ltd. and other hedge funds (Parkcentral) to purchase securities-based swap agreements through various financial institutions located in the United States. (10) The statements made by Porsche also induced shareholders to lend shares to third parties by short sales, providing Porsche the opportunity to purchase these shares as call options. (11)

Once shareholders began short-selling VW stock, Porsche purchased enough call options to acquire 74.1% of VW stock at a future date and price. (12) In October of (2008), Porsche disclosed its intentions after VW stock fell 39% and purchased the call options, securing 74.1% of stock in VW, as any further decrease in VW stock would create a greater loss for Porsche's call options. (13) The high demand for stock required various short-sellers to return nearly 13% of the stock they borrowed but they were unable to because of the shortage, creating a short-squeeze. (14) Only 5.9% of stock was theoretically available for purchase because Porsche owned the majority of stock and the German State of Lower Saxony owned another 20%. (15) Porsche agreed to release 5% of its holdings to ease the market demand, at a windfall to Porsche. (16) These actions dramatically increased value in VW stock, which created a huge loss for Park central's securities-based swap agreements because the agreements predicted that VW stock price would decrease. (17)

At the trial court level, multiple plaintiffs filed separate complaints, at varying times, in the United States District Court for the Southern District of New York regarding the same operative facts. (18) Porsche's motion to dismiss was granted by the district court and was applied to all claims, including the one brought by Parkcentral. (19) The district court held that the securities-based swap agreements were not covered under [section] 10(b) because it would "extend extraterritorial application of the Act's antifraud provision to virtually any situation in which one party to a swap agreement is located in the United States." (20) The district court reasoned that the VW stocks and the alleged fraud took place in Germany, and would not be subject to jurisdiction in the United States and the "economic reality" of the swap agreements were that they were essentially trades on the underlying security. (21) The Second Circuit affirmed the district court's ruling, however, on different grounds. (22) The circuit court held that even though the securities-based swap agreements were domestic transactions, it was not enough to determine the agreements to be domestic when other facts were predominantly foreign. (23)

Section 10(b) and Rule 10b-5, enacted pursuant to [section] 10(b), were implemented to protect investors from fraudulent, manipulative, or deceptive practices, used to circumvent the purposes of the Act. (24) These two provisions work together to protect "any security registered on a national security exchange or any security not so registered." (25) Prior to (2010), the Second Circuit applied the well-established conduct-and-effects test to determine the extraterritorial reach of [section] 10(b). (26) The test was termed the conduct-and-effects test because the extraterritorial reach of [section] 10(b) was linked to the effect the alleged fraud had in the United States. (27) The test would extend jurisdiction to foreign actors if their fraudulent conduct resulted in injury to security holders, or that conduct was promulgated in the United States. (28)

In 2010, the Supreme Court of the United States decided Morrison v. National Australia Bank, Ltd. {Morrison), (29) in which the Court highlighted issues with the conduct-and-effects determination of the extraterritorial reach of [section] 10(b). (30) The Supreme Court vacated the conduct-and-effects test in favor of a transactional test. (31) The transactional test was adopted to limit the applicability of [section] 10(b) to only those transactions where "the purchase or sale is made in the United States, or involves a security listed on a domestic exchange." (32) The Court clarified that [section] 10(b) would only apply to transactions in domestic securities or transactions in other securities, so long as they are domestic. (33) The Court also indicated that if a statute is silent on the topic of extraterritorial application, the presumption would be that a law would not apply extraterritorially; however, no guidance was provided as to how to assess the extraterritorial reach of [section] 10(b). (34) With the increasing popularity of foreign security relationships, the lower courts were left to try and apply this new jurisprudence to cases relating to pervasively transnational based securities and transactions with foreign actors. (35)

Soon after the U.S. Supreme Court ruling, the Second Circuit had difficulty applying the second prong of the new test; domestic transactions in other securities. (36) In Absolute Activist v. Ficeto (Absolute Activist), (37) the court held that domestic transactions exist when irrevocable liability is acquired in the United States, or when title to the security is passed within the United States. (38) Factual allegations are required to show that liability is incurred in the United States; however, a mere statement of purchase orders or money exchanges taking place in the United States is not sufficient to show whether a transaction is domestic. (39) Furthermore, the Absolute Activist court held that the mere presence of a broker in the United States does not indicate the location of where the transaction takes place. (40) Courts continue to struggle with applying the transaction test to different types of unconventional securities. (41)

In Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, the Second Circuit interpreted the application of Morrison to the security-based swap agreements based on VW stock that Parkcentral purchased. (42) The Second Circuit highlighted two important considerations from the Morrison decision to determine the applicability of [section] 10(b) to a fraud claim. (43) The first consideration was the presumption against applying [section] 10(b) extraterritorially because Congress was silent on the extraterritorial application of [section] 10(b). (44) The second consideration the court took from Morrison was that [section] 10(b) only applied in suits where there was a "domestic securities transaction or a transaction in a domestically listed security." (45) The court interpreted whether a domestic transaction was, alone, sufficient to satisfy the domestic application of [section] 10(b). (46) The court analyzed the extraterritorial application of [section] 10(b) using the transactional test provided by the U.S. Supreme Court and held that evidence of a domestic transaction is necessary in assessing the extraterritorial application of [section] 10(b). (47)

In determining whether a transaction is domestic, the court determined that the U.S. Supreme Court required a domestic transaction to be present for [section]10(b) to apply, but highlighted that the Court did not say that a domestic transaction is sufficient for [section] 10(b) to apply. (48) The court also determined that extending [section] 10(b) application to any situation where a domestic transaction took place would undermine the presumption against extraterritoriality and Congressional intent. (49) The reasoning behind limiting extension of protections to domestic transactions is that extending [section] 10(b) too broadly would conflict with foreign laws and would wrongly subject U.S. securities laws on foreign acts based on foreign securities listed on foreign exchanges. (50) The court concluded that the transactions were clearly domestic, however, applying the test under Absolute...

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