2nd CIRCUIT AFFIRMS THAT A DOMESTIC TRANSACTION IS A NECESSARY ELEMENT TO MAINTAIN A SECTION 10(b) FRAUD CLAIM

On January 25, 2021, in the matter of Cavello Bay Reinsurance Ltd. v. Stein the U.S. Court of Appeals for the Second Circuit sought to clarify how geographic restraints affect U.S. lawsuits regarding foreign securities transactions. The Court held that the transactions at issue are “predominantly foreign,” and thus do not fall under regulation of Section 10(b) of the Securities Exchange Act.

In this case, a private securities transaction between two parties where the plaintiff-buyer, based and incorporated in Bermuda, bought shares from the defendant-seller, who is based in New York but incorporated in Bermuda. Plaintiff alleged that the Defendant made material misrepresentations regarding management fees associated with the securities. The investment portfolio, which is the subject of the transaction, consists of U.S. insurance-related assets and is managed by a Delaware portfolio manager. The defendant-seller and its CEO acted entirely out of their New York headquarters. Such actions included the following:

● Defendant pitched the investment portfolio to Plaintiff’s parent company based in Bermuda by calling via phone from New York;

● The Power-Point presentation that contains the alleged misrepresentations to the buyer was emailed from New York;

● The draft subscription agreement to the buyer was sent from New York;

● The deal was countersigned in New York; and

● The deal agreement was mailed back to Bermuda, where the title was transferred from New York.

There are two primary rule sources regarding securities fraud in the U.S. securities law — Section 10(b) of the Exchange Act of 1934 and SEC Rule 10b-5. Under the law, parties are prohibited from making “any untrue statement of material fact” or engaging in any activity that “would operate as a fraud or deceit . . . in connection with the purchase or sale of any security.” Under U.S. law, a transaction must be identified as “domestic” in order to apply U.S. securities law. Generally, the standard in determining whether a transaction is “domestic” is identifying if the “meeting on the minds” happened in U.S. territory. However, strictly applying this rule can be extremely difficult in transactions involving cross-border activities.

In 2010, the U.S. Supreme Court created a standard to determine if a security transaction is sufficiently domestic to render it subject to regulation under Section 10(b) in Morrison v. Nat’l Austl. Bank Ltd. The Second Circuit further expanded upon the Morrison decision by finding that (1) unless the security is listed on a domestic exchange, a domestic transaction is a necessary element of a 10(b) claim, and (2) even with the presence of a domestic transaction, the claims must not be “so predominantly foreign” as to be impermissibly extraterritorial. These tests were laid out in Absolute Activist Value Master Fund Ltd. v. Ficeto and Parkcentral Global HUB Ltd. v. Porsche Automobile Holdings SE.

In Cavello, the District Court granted the defendant’s motion to dismiss on two grounds: (1) the transaction was not “domestic” under the test applied in Absolute Activist, and (2) the claims are “so predominantly foreign” that the transaction could not be found to be domestic under Parkcentral.

In affirming the lower court’s decision, the Second Circuit held only that the claims “are so predominantly foreign” under Parkcentral that they could not be “domestic.” The place of the transaction and the “meeting of the minds” was too difficult to determine given the nature of this transaction. The court found that the “domestic transaction” rule operates as a threshold requirement. The review must then continue and focus on the transaction itself rather than the surrounding circumstances. While some of the conduct and communication surrounding the transaction occurred domestically, that court found that was not enough. The claims were based on a private agreement for a private offering between a Bermudan investor and a Bermudan issuer. The purchaser of the agreement had made the purchase in a way that avoids U.S. regulation, and thus the expense and taxation of the United States. Such an agreement that is designed to avoid U.S. laws cannot later claim that such a transaction is then subject to them. The designation of New York law in the contract was insufficient to establish this as a domestic transaction subject to 10(b) regulation.

Conclusion

Engaging in securities transactions with foreign entities or conducting cross-border actions is a complex matter. The decision in Cavello further clarifies that circumstances surrounding a transaction that may determine if such a transaction is regulated by or beyond the reach of U.S. securities laws. The test to determine whether or not a matter is subject to U.S. law will focus primarily on the nature of the transaction itself. An agreement that is structured to avoid the costs and taxation of U.S. law cannot then later attempt to subject it to regulation of U.S. securities laws.

If you have questions related to securities transactions or financial advisors, feel free to contact me.