If you’re non-U.S., execute your unlisted U.S. securities trades on U.S. soil
A foreigner cheated by a U.S. person in the purchase or sale of an unlisted U.S. security – such as an interest in a hedge fund or private equity fund — can only sue the swindler for securities fraud under U.S. law if the transaction actually takes place in the U.S.
That’s the test laid down in 2010 by the U.S. Supreme Court in Morrison v. National Australia Bank and just refined by the Second Circuit in Absolute Activist Value Master Fund v. Ficeto.
In Morrison, which involved Australian securities not traded on any U.S. exchange, the Court held that civil fraud claims can be brought under U.S. law only with respect to “securities listed on domestic exchanges and domestic transactions in other securities.” In its opinion, however, the Court did not define exactly what was meant by the term domestic transactions.
The Second Circuit faced that question in Absolute Activist, a case in which nine Cayman Islands hedge funds sued their investment manager and U.S. broker-dealer for snookering them in a “pump-and-dump” scheme involving SEC-registered ‘penny stocks’. The penny stocks were all listed on U.S. over-the-counter bulletin boards (“pink-sheets”) but not on any U.S. exchange. The defendants caused the funds to purchase the stocks from their issuers in so-called PIPE transactions (Private Investments in Public Equities) through which the defendants were able to artificially inflate their values. The defendants then sold their own substantial holdings in the same penny stocks at enormous profits, while the funds lost almost $196 million in the scam.
The open issue in Absolute Activist was whether the PIPE transactions satisfied the domestic transaction test in Morrison, and the Second Circuit held that title to the securities in the PIPE transactions would have to have been transferred in the U.S. or at least one of the parties to those transactions would have to have become legally obligated to deliver or pay for the securities in the U.S.
Importantly, the Second Circuit’s opinion made it clear that U.S. anti-fraud protections would not be extended extraterritorially just because the issuers of the securities in the case were U.S. entities, the securities were registered with the SEC and quoted in the U.S. “pink sheets”, many of the fund investors asserting the claim were U.S. persons and one of the defendants was the U.S. broker-dealer who executed the PIPE trades.
Looked at another way, the ruling also means that the SEC can only enforce fraud claims against foreigners in cases involving U.S. exchange-listed securities or transactions that occur on U.S. soil.
For foreigners who invest in unlisted U.S. securities – including the offshore master funds of U.S. managers – the lesson of Morrison and Absolute Activist is to issue your trade orders, sign your purchase/sale agreements and close your transactions in the U.S. if you want to preserve your legal rights against your counterparties.