On August 15, 2014, in a matter of first impression, the Second Circuit Court of Appeals held, in Parkcentral Global Hub Ltd. v. Porsche Auto. Holdings SE, that security-based swaps (SBS) referencing stocks traded exclusively in foreign jurisdictions could not be the basis of liability under Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. § 78j(b)) for statements made in foreign jurisdictions by foreign individuals, despite the fact that the SBS trades themselves took place in the US (No. 11-397-CV L, (2d Cir. Aug. 15, 2014)).

Plaintiffs Parkcentral Global Hub Ltd. (Parkcentral) brought suit against Porsche Auto Holdings SE (Porsche) for substantial losses stemming from allegedly false and misleading statements under Section 10(b) made by Porsche relating to certain shares of Volkswagen AG (VW) that were referenced in a series of SBS that Parkcentral (VW SBS) entered into with various private counterparties in the territorial US.

Porsche's financial arm began to acquire a growing equity stake in, and call options on, the shares of VW (VW shares) while publicly maintaining that it had no interest in acquiring a controlling share of VW. The statements were made in Germany, but in some cases were available either in the US or were made to US investment managers. The VW shares were traded on the Frankfurt Stock Exchange and “international" stock exchanges in Switzerland, Luxembourg, and the UK, but were not traded in the US.

To finance its growing interest in the VW shares, Porsche sold put options on the VW shares. The put options required Porsche to pay the difference between an agreed strike price and the actual stock price if the actual price was below the strike price on an agreed date (for a description of equity put option mechanics, see Practice Note, Equity Derivatives: Overview (US): Puts and Calls). In 2008, the global financial crisis caused the value of the VW shares to fall dramatically, causing Porsche to sustain substantial losses.

In an effort to curb its losses and raise the value of the VW shares, Porsche issued a public statement revealing an intention to gain a controlling 75% stake in VW, along with its existing 74.1% stake. As roughly 20% of the stock was held by the German state Lower Saxony, only 5.9% of the shares were publicly available to the market, some of which were tied up in funds that would or could not sell them. On the other hand, short sellers were obligated to acquire 13% of the outstanding VW shares to return it to the parties from which they had borrowed it. This scenario is commonly referred to as a "short squeeze," under which demand to cover short positions far outweighs the supply of available shares in the market.

Under this short squeeze for the VW shares, the price of the VW shares nearly quintupled. To alleviate this shortage, Porsche agreed to sell 5% of its holdings of the VW shares, at a huge profit. In total, short positions in the VW shares lost a total of $38.1 billion and the stock price eventually returned to its 2007 level.

The VW SBS were so-called synthetic short positions which would increase in value if the value of the VW shares fell (for a description of these mechanics, see Practice Note, Equity Derivatives Overview: Synthetic Short Total Return Swaps (Cash Settled)). Parkcentral therefore incurred substantial losses on the VW SBS due to the sudden and drastic increase in the value of the VW shares. Parkcentral brought suit against Porsche in the Southern District of New York (SDNY) under Section 10(b) for losses incurred on their synthetic short positions as a result of Porsche's statements that misled the public regarding its intention to acquire a controlling interest in VW.

The SDNY Court dismissed the complaint, holding that applying Section 10(b) to this transaction would interfere with foreign securities regulations by impermissibly extending the reach of Section 10(b) extraterritorially. While the transactions were executed in the US, the SDNY Court held, the value of the transactions were reliant solely on securities that were listed and legally transacted abroad.

On appeal, the parties agreed that Section 10(b) applied to SBS to the same extent as it applies to other securities. Parkcentral then argued that, because Section 10(b) protects transactions within the territorial United States and the SBS in question were transacted within the territorial United States, those transactions were protected. Porsche took the position that, since the underlying VW shares were traded exclusively on foreign exchanges, Section 10(b) would not apply to transactions directly involving those specific stocks, and therefore, the VW SBS, based entirely on the VW shares should fall similarly outside the scope of Section 10(b).

The Court sided with Porsche, holding that, in order for Section 10(b) to apply, the relevant actions must not be so predominantly foreign as to be inconsistent with the rule's presumption against extraterritoriality. While the Court refused to create a bright line rule determining that regulatory conflict with a foreign government would prohibit application of Section 10(b) in all cases, it noted that in this case, German officials had already taken action against the defendants for their conduct, which took place entirely abroad, demonstrating a direct regulatory conflict and weighing against application of US securities laws to the conduct in question.

Section 10(b) 15 U.S.C. § 78j(b)) is the antifraud provision of the Exchange Act. The Supreme Court case Morrison v. Nat'l Australia Bank Ltd. established two important rules about the cross-border application of Section 10(b):

(561 U.S. 247, 130 S.Ct. 2869, 177 L.Ed.2d 535 (2010))

While these principles dictate that, for Section 10(b) to apply to a defendant's conduct, a substantial portion of the transaction that causes the loss must be domestic, the Court noted that it was unclear whether the situs of the transaction alone was sufficient for the application of Section 10(b). After examination, the Court concluded that, while having a security transferred domestically was a necessary element for Section 10(b), some portion of the defendant's fraudulent conduct must also have a connection to the US. Several aspects of the Morrison decision supported the conclusion that the domestic nature of a transaction alone was not sufficient to apply Section 10(b) to a defendant's conduct, including:

The Court ultimately stated that it was inappropriate to create prescriptive rules regarding the application of Section 10(b) to extraterritorial cases, instead electing to allow courts to create rules as different fact patterns regarding novel securities arise. Exclusively foreign conduct and conflict with foreign securities laws are factors which may be examined in determining whether the presumption against extraterritorial application of Section 10(b) is violated, but cohesive principles on when Section 10(b) liability should apply to foreign conduct will be determined by subsequent caselaw.

The Court explicitly left open the possibility that SBS transactions could form the basis for liability under Exchange Act Section 10(b). Conceivably, if a plaintiff alleges that a defendant made false or misleading statements about a security that trades on a domestic exchange which causes losses in SBS that reference that security, then the plaintiff may survive a motion to dismiss. If a court determines that no additional requirements for the application of Section 10(b) apply, an issuer could be liable for losses in SBS transactions that the issuer may not even know exist and could potentially impose liability that is greater than the market cap of the issuer itself.

Combined with the "fraud on the market" theory of reliance, which states that reliance on fraudulent statements is presumed because information is immediately integrated into pricing in an efficient market, this case could create a situation in which:

In short, issuers beware. Liability for materially false or misleading statements based solely on synthetic securities is a real possibility, and the amount of that liability may have no relation to the value of the stock outstanding or the issuer itself.

For more information on the fraud on the market theory under Section 10(b), see Article, Expert Q&A on the Fraud on the Market Presumption.

For more information on SBS, see Practice Note, Equity Derivatives: Overview (US).

For more on Section 10(b) liability and its extraterritorial application, see Practice Notes, Liability Provisions: Securities Offerings: Section 10(b) of the Exchange Act and SEC Rule 10b-5 and US Securities Laws: Overview: Extraterritoriality and US Securities Laws.