Foreign Issuers Fear Global Class Actions

John C. Coffee Jr.
The National Law Journal
June 14, 2007

A series of recent reports by blue-ribbon bodies have warned that the U.S. capital markets are losing their competitiveness and that foreign firms fear entering the U.S. market. But the reasons given in these studies for this fear usually describe only the complaints and frustrations of domestic U.S. firms. Talk instead to a sophisticated foreign issuer today, and you will hear a very different concern; it is not the Sarbanes-Oxley Act, accounting problems or the Securities and Exchange Commission. Rather, it is fear that listing on a U.S. exchange exposes the foreign issuer to potentially bankrupting securities liabilities if its stock price were to decline sharply. This liability would be owed not simply to U.S. investors, but, more importantly, to a much larger worldwide class of foreign shareholders who acquired their shares outside the United States.

In the new vernacular, such a class of foreign purchasers who bought a foreign issuer's securities on a foreign exchange is now known as an "f-cubed class," and recent examples of securities class actions predominantly composed of such f-cubed plaintiffs would include Royal Ahold, Royal Dutch Shell, Parmalat, Nortel Networks and Vivendi. See, e.g., In re Vivendi Universal S.A. Sec. Litig., 241 F.R.D. 213 (S.D.N.Y. 2007); Royal Dutch/Shell Transp. Sec. Litig., 380 F. Supp. 2d 509 (D.N.J. 2005); In re Royal Ahold N.V. Sec. & ERISA Litig., 351 F. Supp. 2d 334 (D. Md. 2004).

TWO FACTORS PRESENT FOREIGN ISSUERS WITH A QUANDARY

Two factual generalizations explain the dimensions of the problem: First, foreign issuers that enter the United States typically list only a small proportion of their shares on a U.S. exchange through the mechanism of American depository receipts (ADRs), often only 1 percent or 2 percent of their total outstanding shares. Second, the securities class action is not available as a practical matter elsewhere in the world, with the possible exceptions of Canada and Australia. The impact of these twin facts is to present the foreign issuer that is considering entering the U.S. market with an extraordinary imbalance between the costs and benefits of listing. If it lists in the United States, it will likely boost its stock price modestly and obtain access to lower-cost capital. But it will now face the prospect that, if its stock price falls suddenly, it will become potentially liable to a worldwide class of investors who could not otherwise feasibly sue it collectively.

This risk is not theoretical; both Royal Ahold and Nortel Networks have recently settled class actions in U.S. courts for more than $1 billion each, and Royal Dutch Shell has agreed to pay more than $400 million to foreign investors in a settlement class action in the Netherlands in the hopes of escaping a global class action in the United States. That other foreign issuers continue to list here may suggest that they still do not yet accurately understand the risks involved.

But why are U.S. courts willing to certify a global class that consists predominantly of f-cubed plaintiffs? The answer is not that the federal securities laws require this result. In fact, they are largely silent on their extraterritorial application. Indeed, a few district courts have found that they lack subject-matter jurisdiction in cases primarily involving f-cubed plaintiffs. See In re National Australia Bank Sec. Litig., 2006 U.S. Dist. Lexis 94162 (S.D.N.Y. Oct. 25, 2006); Bleckner v. Daimler-Benz A.G., 410 F. Supp. 2d 266 (D. Del. 2006).

Doctrinally, to establish subject-matter jurisdiction over the claims of f-cubed plaintiffs, the plaintiffs attorneys must allege both that truly fraudulent conduct, not merely preparatory activities, occurred in the United States, and that this fraudulent conduct directly caused the losses of the foreign plaintiffs. But this requirement to show fraudulent conduct in the United States may only lead to creative pleading. Moreover, on a motion to dismiss, all contested facts must be construed in favor of the plaintiffs. Thus, in the Royal Dutch Shell case, the critical accounting decisions were reached outside the United States, but the plaintiffs stressed that they were explained to securities analysts within the United States. If this suffices to satisfy the conduct test, then most foreign corporations will be subject to a global class action.

Why are federal courts so ready to accept that subject-matter jurisdiction exists in the case of f-cubed plaintiffs when the statute is silent? Here, one must go back to some critical 2nd U.S. Circuit Court of Appeals decisions written by Judge Henry Friendly in the mid-1970s. See Bersch v. Drexel Firestone Inc., 519 F.2d 974 (2d Cir. 1975), and IIT v. Vencap, 519 F.2d 1001 (2d Cir. 1975). In the latter Vencap case, which involved f-cubed plaintiffs but in a context in which the principal and controlling defendant was an American, Friendly developed the rationale that Congress would not have wanted the "United States to be used as a base for manufacturing fraudulent securities devices for export, even when these are peddled only to foreigners." 519 F.2d at 1017. His reasoning was essentially that a good neighbor does not allow fraudulent schemes to be perpetrated within its borders, even though directed against individuals in a neighboring jurisdiction. A close reading of this decision inclines one to believe that Friendly was primarily seeking to affirm the authority of the SEC to prosecute such a case, and was also concerned that the American principal defendant would have been likely beyond the reach of other jurisdictions.

Two years later, the 3rd Circuit picked up on Friendly's "good neighbor" rationale and extended it in a case involving an SEC enforcement action. Announcing, a bit rhetorically, that Congress would not have wanted the United States "to become a Barbary Coast, as it were, harboring international securities pirates," it reasoned in SEC v. Kasser, 548 F.2d 109, 116 (3d Cir. 1977), that if the United States would prosecute frauds affecting foreigners on its turf, then foreign governments would be more likely to reciprocate and prosecute frauds organized within their borders but directed at U.S. individuals. Thirty years later, this optimistic hope largely remains unfulfilled.

In short, the common rationale of both the 2nd and 3rd circuits in the two key decisions that have most shaped the law on global class actions is that the United States should be a good neighbor. Three observations seem pertinent about this rationale: First, Friendly's rationale works much better as a justification for public enforcement than for private enforcement. The Vencap decision essentially affirmed a preliminary injunction that kept defendants from liquidating an insolvent investment trust and that appointed a receiver -- in short, a provisional measure until the facts could be sorted out. Second, a key fact in the Vencap decision's acceptance of broad subject-matter jurisdiction was the existence of an American controlling shareholder that probably could not have been held accountable in a European court; this is a rare fact pattern, which was hardly present in the more recent cases in which leading European corporations were sued in the United States. Third, and most importantly, the obligation to be a "good neighbor" sometimes requires prudence and restraint, not hyperactive zeal. Although a good neighbor may properly be concerned that its borders not be used to shelter a fraud against its neighbor's citizens, it should also be cautious in not interfering unduly or obtrusively in a domestic dispute that is simply none of its business.

Inevitably, when a U.S. court certifies an f-cubed class, it exposes the foreign issuer to the vagaries of the U.S. jury system. Juries are rarely used in civil trials in the rest of the world, and the result is to change the balance of advantage in litigation profoundly. In this sense, the United States may not be protecting the citizens of foreign jurisdictions as a good neighbor, as much as it is disruptively exposing foreign corporations to a litigation environment in which plaintiffs arguably have undue leverage.

CERTIFY FOREIGN CLASSES ONLY IN TWO INSTANCES

What then would be the fairer compromise? Normally, U.S. courts should certify only a class of individuals, both foreign and domestic, who purchased on U.S. markets. This would reduce both the leverage of the plaintiffs attorneys and also the inherent threat today in a U.S. listing for a foreign issuer. A class of f-cubed plaintiffs should be certified only when two exceptional facts are present: First, a critical defendant would otherwise escape the plaintiffs' reach, as in Vencap, and, second, the jurisdiction of incorporation of the foreign issuer would clearly recognize and enforce the U.S. court's judgment. If it would not, the U.S. court is poaching and hardly being a "good neighbor."

Today, the United States' foreign neighbors must fear that a global class action in a U.S. court may threaten the solvency of even their largest companies and could have an adverse impact on the interests of local constituencies, including labor, creditors and local communities. This may explain the alacrity with which the Netherlands courts earlier this year accepted a seemingly unprecedented settlement class agreed to by Royal Dutch Shell and a consortium of European investors. In any event, Robert Frost famously observed that "good fences make good neighbors." Respect for traditional principles of comity may be the first rule for the good neighbor.

Understandably, Europe has doubts about U.S. courts serving as securities policemen for the world. From the European perspective, the global class action resembles another instance of U.S. legal imperialism. Against this backdrop, a series of putative global class actions, both those certified and those rejected, should reach appellate courts later this year. The SEC should consider intervening as an amicus in these cases to clarify for federal courts the real costs to the U.S. economy of assuming a role as securities policeman to the world.

John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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