Global hedge funds managed by US investment managers could not bring a Rule 10b-5 action in a US federal court against a German car manufacturer (Porsche) based on securities-based swap agreements referencing the share price of another German car company (VW). A federal judge (SD NY) ruled that a party’s execution in the U.S. of a swap agreement that references foreign securities was not enough to overcome the Supreme Court’s Morrison transactional test for the extraterritorial application of Rule 10b-5. The court said that the swap agreements were the functional equivalent of trading the shares of a German company on a German exchange. Moreover, the swap agreements were transacted with undisclosed counterparties who may well have been located outside the United States.
In light of Morrison’s strong pronouncement that U.S. courts ought not interfere with foreign securities regulation without a clear Congressional mandate, the court was loathe to create a rule that would make foreign issuers with little relationship to the U.S. subject to suits here simply because a private party in the US entered into a derivatives contract that references the foreign issuer’s stock. Such a holding, said the court, would turn Morrison’s presumption against the extraterritoriality reach of Rule 10b-5 on its head. (Elliott Associates v. Porsche Automobil Holding SE, SD NY, 10 Civ. 0532, Dec. 30, 2010).
The hedge funds alleged that Porsche caused a dramatic rise in VW stock prices by buying nearly all the freely-traded voting shares of VW as part of a secret plan to take over that company. When Porsche revealed its holdings in VW, the share price shot up and caused enormous losses to the funds, who stood to benefit through their swap agreements from decreases in the VW share price. The hedge funds alleged that Porsche violated Rule 10b-5 when it falsely denied its intent to take over VW, and engaged in a series of manipulative derivatives trades to hide the extent to which the company controlled VW shares.
In Morrison, the Supreme Court explained that the Exchange Act antifraud rule applies only to transactions in securities listed on domestic exchanges, and domestic transactions in other securities. Since the swap agreements at issue were not listed on domestic exchanges, the court’s inquiry focused on whether they constituted domestic transactions in other securities within the ambit of § 10(b).
The hedge funds argued that they signed confirmations for securities-based swap agreements in New York, and therefore engaged in domestic transactions in other securities within the scope of § 10(b). But the court rejected this narrow reading of Morrison as inconsistent with the Supreme Court’s intention to curtail the extraterritorial application of § 10(b). To allow this Rule 10b-5 action to go forward, reasoned the district judge, would extend extraterritorial application of the Exchange Act’s antifraud provisions to virtually any situation in which one party to a swap agreement is located in the United States and thus contravene the Supreme Court’s intent to avoid interference with foreign securities regulation.
Rule 10b-5 applies with equal force to securities and securities-based swap agreements. Although the Exchange Act did not originally contemplate § 10(b) protection for purchasers of derivative instruments such as swaps, Congress expanded the statute in 2000 in order to make explicit that § 10(b) applies to securities-based swap agreements.
But these securities-based swap agreements did not qualify as domestic transactions in other securities under the Supreme Court’s new transactional test. The Supreme Court has routinely emphasized the importance of economic reality in determining whether derivative instruments fall within the ambit of federal securities regulations. Since the economic value of securities-based swap agreements is intrinsically tied to the value of the reference security, noted the court, the nature of the reference security must play a role in determining whether a transnational swap agreement may be afforded the protection of § 10(b).
Since the swaps executed by the hedge funds were the functional equivalent of trading the underlying VW shares on a German exchange, reasoned the court, the economic reality is that the swap agreements are essentially transactions conducted upon foreign exchanges and markets, and not domestic transactions meriting the protection of the antifraud rule.