The 1st U.S. Circuit Court of Appeals has just lent its weight – in a ruling issued on Monday in Securities and Exchange Commission v. Morrone – to appellate precedent that, in essence, instructs issuers of unusual securities on how to evade U.S. securities laws.
If the securities are not traded on domestic exchanges, all sellers have to worry about, under the test that now prevails in the federal circuits, is where the transfer of “irrevocable liability” from the issuer to the investor takes place. If that transfer happens outside of the U.S., then federal securities laws don’t apply.
There is an important caveat to the rule. The SEC can still go after issuers engaged in foreign transactions, thanks to a provision in the Dodd-Frank Wall Street Reform Act. But issuers seem to be insulated from liability to investors under federal securities laws as long as they don’t finalize sales within the borders of the U.S.
The irrevocable liability test emerged, of course, after the U.S. Supreme Court’s 2010 decision in Morrison v. National Australia Bank Ltd(130 S.Ct. 2869). As you surely recall, Morrison restricted the extraterritorial reach of U.S. securities laws, holding that the laws apply only to securities listed on U.S.-based exchanges and to “domestic transactions” in other securities.
The justices did not provide a specific definition for so-called domestic transactions. In 2012, the 2nd Circuit stepped into the breach in Absolute Activist Value Master Fund Ltd v. Ficeto (677 F.3d 60), which focused on the location of the final transfer of the security – or irrevocable liability – from seller to investor. A transaction was domestic, according to the Absolute Activist test, if that transfer took place in the U.S.
The 2nd Circuit added an additional complication to its test in 2014’s Parkcentral Global Hub Ltd v. Porsche Automobile Holdings SE (763 F.3d 198), ruling that even if irrevocable liability is transferred in the U.S., U.S. laws don’t extend to “predominantly foreign” claims. Other circuits – including the 1st Circuit in Monday’s decision in the Morrone case – have declined to adopt Parkcentral’s reasoning. But the 3rd, 9th and, now, 1st Circuits have all agreed with the 2nd Circuit that the test for a domestic transaction centers on where irrevocable liability shifted from the seller to the investor.
The case decided on Monday by 1st Circuit Judges Sandra Lynch, Kermit Lipez and Rogeriee Thompson involved executives at a Massachusetts-based company called Bio Defense Corp. Bio Defense, which was founded in 2001 after a spate of mailings containing anthrax, was purportedly in business to sell equipment to decontaminate the mail. It ended up selling fewer than a dozen of its MailDefender machines in six years of operation, but it somehow managed to raise nearly $25 million in stock sales to private investors over those same six years.
Between 2008 and 2010, after regulators in Texas and Massachusetts cracked down on Bio Defense’s stock sales to U.S. investors, the company pitched its securities to European investors through call centers in Spain and Portugal. The SEC sued the company and several executives in 2012 for, among other things, selling unregistered securities. Because of the statute of limitations, the case ended up being restricted to securities sales to international investors.
The defendants, as you would expect, argued that those sales were not domestic transactions so, under Morrison, were not subject to U.S. securities laws. (The transactions at issue in the Bio Defense case preceded the Dodd-Frank provision I already mentioned, which was intended to ensure that the Supreme Court’s Morrison decision did not restrict SEC enforcement actions.)
The 1st Circuit sided with the SEC, just a month after the case was argued. The appeals court had not previously defined domestic transactions but held that the 2nd Circuit’s Absolute Activist test correctly focused on the location of the sale of the security. In the Bio Defense case, wrote Lynch in the 1st Circuit opinion, company executives finalized sales to their European investors in Boston, where the subscription agreements were signed and executed.
The court affirmed summary judgment for the SEC, which did not respond to my email query on the ruling. The two Bio Defense executives who brought the appeal were represented by Steven Kaplan of Rosenfeld & Kaplan, who also did not respond to my email.
On its own, the Bio Defense case is an anachronism. As the 1st Circuit noted, there are few remaining SEC cases involving securities transactions that predate the Dodd-Frank provision confirming the commission’s enforcement authority over international trades. Morrison simply isn’t much of a factor in SEC cases.
But I’ve noticed Morrison figuring prominently in private litigation against cryptocurrency defendants based outside of the U.S. I’ve told you, for instance, about the crypto exchange Binance citing Morrison earlier this year as its centerpiece argument for the dismissal of an investor class action in federal court in Manhattan. The crypto defendants Block.one and HDR Global Trading Ltd have also homed in on Morrison in dismissal motions in investor class actions in Manhattan, arguing that investors can’t show, under the Absolute Activist test, that defendants transferred irrevocable liability to them in the U.S.
Those arguments may not prevail, of course. In 2018, U.S. District Judge Richard Seeborg of San Francisco rejected Morrison arguments by the Tezos cryptocurrency enterprise (2018 WL 429334) in an investor class action. The Tezos defendants cited the irrevocable liability test, which had just been adopted by the 9th Circuit, to argue that the final transfer of digital assets took place outside of the U.S.
The judge held, however, that key elements of the name plaintiff’s deal took place on computers and servers in the U.S. The Tezos class action settled for $25 million in 2020.
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