In May 2021, the U.S. Court of Appeals for the First Circuit decided SEC v. Morrone, holding that U.S. federal securities laws applied to defendants’ solicitation of securities purchases from foreign investors. The First Circuit’s decision in Morrone is the latest in a series of appellate decisions seeking to interpret the appropriate territorial reach of U.S. securities laws in light of the Supreme Court’s guidance in Morrison v. National Australia Bank, 561 U.S. 247 (2010). Morrone is significant because (i) it deviates from the Second Circuit’s decision earlier this year in Cavello Bay Reinsurance Ltd. v. Shubin Stein, 986 F.3d 161 (2d Cir. 2021), which held that the fact that one of the parties to a securities transaction executed the transaction documents within the United States is insufficient to establish a domestic transaction, and (ii) it aligns with the Ninth Circuit in expressly rejecting the Second Circuit’s holding in Parkcentral Global Hub Ltd. v. Porsche Automobile Holdings SE, 763 F.3d 198 (2d Cir. 2014) that, notwithstanding a domestic transaction in securities, U.S. securities laws do not apply to “predominantly foreign” transactions. These emerging circuit splits offer important lessons for non-U.S. participants in over-the-counter securities transactions with U.S. counterparties and provide critical lessons for defendants in U.S. securities litigations.
- The First Circuit found that U.S. securities laws can reach securities transactions where a party’s contract created irrevocable liability in the United States if one of the signatories executed the contract in the United States. Thus, a domestic issuer, not listed on a U.S. exchange, was found to have become irrevocably liable under the subscription agreements when it signed the agreements in the United States and then issued shares under the agreements from the United States. That the securities were marketed outside the United States to non-U.S. investors who signed subscription documents outside of the United States did not alter the court’s view.
- However, the First Circuit’s focus on the language of the subscription agreements in holding that the securities transactions in question are domestic provides guidance on when a transaction’s structure will place it beyond the protections and obligations of U.S. securities laws. Specifically, the precise words used in securities-related investment materials—and subscription agreements in particular—might well affect whether a party incurs “irrevocable liability” in the United States.
- While the First Circuit is now aligned with three other circuits in adopting the “irrevocable liability” test, the decision also deepens the circuit split over the “predominantly foreign” test. Because the question now appears ripe for the Supreme Court input, securities defendants are well advised to preserve the issue for appeal, including in the First and Ninth Circuits, which have outright rejected the predominantly foreign test.
Legal Background and Factual History
In its seminal 2010 Morrison decision, the Supreme Court held that federal securities law have no extraterritorial reach and apply only to transactions in securities that occur in the United States or transactions in securities listed on a U.S. securities exchange. In so holding, the Supreme Court rejected the so-called “conduct-and-effects” test created by a series of courts of appeals cases allowing federal securities claims to proceed if the facts involved either substantial wrongful conduct in the United States or wrongful conduct that had a substantial effect in the United States.
Despite the new test, in the decade that followed, lower courts have struggled with determining the scope of Morrison’s “domestic transaction” test for securities not traded on a U.S. exchange. Three circuits have endorsed the “irrevocable liability” test, under which off-exchange transactions are domestic if “irrevocable liability was incurred or title was transferred within the United States.” Absolute Activist Value Master Fund Ltd. v. Ficeto, 677 F.3d 60, 68, 71 (2d Cir. 2012); accord United States v. Georgiou, 777 F.3d 125, 137 (3d Cir. 2015); Stoyas v. Toshiba Corp., 896 F.3d 933, 949 (9th Cir. 2018). In addition, the Second Circuit found that some transactions in securities which took place within the United States are so “predominantly foreign” as to be outside the reach of the anti-fraud provisions of U.S. securities laws. Parkcentral, 763 F.3d at 215. While declining to set forth a specific rule on how to determine whether a transaction is predominantly foreign, the Second Circuit pointed to the unique character of the transactions at issue and the defendants’ “largely foreign conduct” to find the claims to be predominantly foreign. Id. at 201-02. In Parkcentral, the conduct was “predominantly foreign,” because the claims were brought by a foreign plaintiff that invested in a U.S. swap transaction referencing a non-U.S. company listed on a foreign exchange, and the claim itself concerned fraudulent conduct in Germany. The Ninth Circuit expressly rejected the Parkcentral approach, holding that the “predominantly foreign” test is inconsistent with Morrison, which asks only whether an off-exchange transaction took place within the United States. Toshiba, 896 F.3d 933
Since Toshiba, the Second Circuit has expanded the reach of the “predominantly foreign” test. Earlier this year, the Second Circuit held in Cavello Bay that the location of the transaction is less important than the structure of the transaction and whether it effectuated the purpose of federal securities laws. 986 F.3d at 165. The Cavello Bay court found the transaction at issue to be “impermissibly foreign”— even though the defendant’s principal place of business was in New York and the subscription agreement was governed by New York law and partially signed in New York—because the structure of the transaction was such as to avoid the application of U.S. securities laws. The court’s holding allows a court to sidestep the “irrevocable liability” analysis altogether if it determines that the transaction was “predominantly foreign.”
The First Circuit’s Decision in Morrone
Morrone involved a U.S. company, Bio Defense Corporation. The defendants, Jonathan Morrone and Paul Jurberg, were senior executives at Bio Defense. Along with other senior employees and consultants, Morrone and Jurberg solicited domestic and foreign investors to purchase Bio Defense stock and collected “consulting fees” for doing so.
In 2008, Morrone, Jurberg, and others signed a consulting agreement with Agile Consulting, a Cyprus-based firm running call centers targeting investors in Europe. Agile Consulting agreed to solicit investors in Europe in exchange for a consulting fee. Although the fee equaled 75% of all investor funds raised, Bio Defense failed to disclose the fee to investors.
After Agile Consulting began soliciting European investors through its call centers, information for any interested investor would be sent to Morrone and Jurberg to their offices in Boston. Morrone and Jurberg in turn would send subscription agreements to investors for signature. Once the subscription agreements were signed, Morrone and Jurberg would process the documents and have them countersigned in Boston. The stock certificates would then be mailed to the investors. For any such purchases, both Morrone and Jurberg would collect hundreds of thousands of dollars in commissions.
The SEC filed a complaint against Bio Defense, its founder, Morrone, Jurberg, and others alleging violations of the Securities Act of 1933, the Securities Exchange Act of 1934, and Exchange Act Rule 10b-5. Ultimately, the SEC moved for summary judgment against the defendants, and the district court granted partial summary judgment against Morrone and Jurberg. As part of the ruling, the district court held that federal securities laws applied to the defendants’ conduct in soliciting foreign investors because the relevant acts demonstrated that liability was incurred in the United States.
The First Circuit (Lynch, Lipez, and Thompson, JJ.) unanimously affirmed.
The court first turned to Morrison. Because Bio Defense’s stock was not exchange-traded, the court had to determine whether the purchase and sale of those securities were “domestic.” Noting that this was an issue of first impression in the First Circuit, the court looked to other circuits for guidance. The court agreed with the Second, Third, and Ninth Circuits that the “irrevocable liability” test was the proper measure to determine whether off-exchange transactions occur domestically. Under that test, the court explained, the key factor is where the parties to a securities transaction become irrevocably bound.
Applying this standard, the court easily concluded that Bio Defense incurred irrevocable liability within the United States to deliver the securities at issue. In its analysis, the court focused on where, according to the parties’ contract, Bio Defense became irrevocably bound. Finding that the subscription agreements provided that Bio Defense incurred no legal obligations under the agreements until the company executed and delivered agreements to the investor purchasers, the court found that Bio Defense became irrevocably liable in Boston to deliver the shares because the subscription agreements were executed in Boston and the defendants then issued the shares from Boston.
The court next rejected defendants’ attempt to invoke the Second Circuit’s Parkcentral holding that a “predominantly foreign” transaction is exempt from the federal securities laws even if irrevocable liability is incurred in the United States. The First Circuit—like the Ninth Circuit in Toshiba—concluded that the existence of a domestic transaction suffices under Morrison to trigger the application of the federal securities laws. The court then added that defendants would lose even if the “predominantly foreign” test applied, reiterating that there were significant U.S. connections, including that defendants were based in Boston, nearly all conduct in furtherance of fraud occurred in Boston, and Bio Defense was a U.S. company that was not traded on a foreign exchange.
Implications and Practice Pointers
The First Circuit’s decision has some important implications.
First, the First Circuit’s focus on the contractual provisions in the subscription agreements, under which “irrevocable liability” would be incurred where the agreements were executed and from which the stock was delivered, offers guidance on when and whether a transaction will be within or beyond the reach of U.S. securities laws, at least within the First Circuit. Under Morrone, parties to a securities transaction can do so by drafting contractual provisions that would bind the parties based on conduct to be performed outside of the United States. For instance, a contract can provide that the parties become bound only when the foreign purchaser executes or receives the signed agreement. Thus, through careful drafting, foreign issuers engaging in over-the-counter transactions can have greater certainty whether the U.S. courts will find that their transaction is subject to U.S. securities laws.
Second, in joining the Second, Third, and Ninth Circuits, the First Circuit further expanded the reach of the “irrevocable liability” test in federal securities claims with extraterritorial elements. At the same time, however, the court deepened the circuit split over whether finding the existence of a domestic transaction in and of itself is enough to apply federal securities laws or whether something more—i.e. the “predominantly foreign’ test—is required to bring an extraterritorial securities claim. While the Supreme Court has previously refused to address the question, denying certiorari in Toshiba, the First Circuit’s decision may cause the Supreme Court to reconsider taking up the issue. Thus, defendants faced with potential federal securities lawsuits should preserve the extraterritoriality question, and the “foreign predominance” issue in particular.
Lastly, it should be noted that the “irrevocable liability” test primarily applies to private litigants. Although the First Circuit applied the Morrison transactional test in Morrone, which involved litigation commenced by the SEC, the court noted that after the district court issued its opinion, Congress amended the federal securities laws to expand regulators’ enforcement authority, reinstating for the SEC and the DOJ actions the conduct-and-effects test that Morrison rejected. Accordingly, defendants should be cognizant that they are still subject to the more far-reaching “conducts-and-effects” test for government enforcement actions.