Is There No Judicial Love For Penny Stocks Under Morrison?

In response to the question “How do cases end up in law school text books,” one of my law school professors stated matter-of-factly, “Either because of bad lawyering or bad judging.”  Without opining on said professor’s hypothesis, a recent court decision, Absolute Activist Value Master Fund Ltd. v. Homm et. al., reminded me of the professor’s conclusion.

The Homm decision was an early Christmas gift to Homm and his merry band of domestic and international defendants – not only was it short, 11 pages, it was also sweet in that the judge, relying on the Supreme Court’s Morrison v. National Australia Bank decision, dismissed the plaintiffs’ case in its entirety.   Securities law practitioners and the blogosphere are well aware of the tremendous implications of the Morrison decision, which has severely restricted the scope of  Section 10(b) securities fraud claims.

Although the defendants in Homm, following the procedural path chosen by the Supreme Court,  moved to dismiss the complaint for failure to state a claim under Rule 12(b)(6) of the Federal Rules of Civil Procedure , Judge George B. Daniels of the United States District Court for the Southern District of New York dismissed all of the plaintiffs’ claims on the ground of lack of subject matter jurisdiction under Rule 12(b)(1). Subject-matter jurisdiction refers to whether the court in which the case has been filed has the legal authority or power i.e., the jurisdiction,  to even look at the allegations to determine if they may have merit (e.g Judge Judy’s court does not have subject matter jurisdiction over terrorism cases).

Morrison did not hold that U.S. district courts may never exercise subject matter jurisdiction to decide the merits of Section 10(b) claims involving the purchase of securities traded on foreign exchanges or in foreign countries. Rather, the Supreme Court, per Justice Scalia, applied a legal doctrine known as the presumption of non-extraterritoriality to set new limiting standards that district court judges must consider if a defendant claims that the complaint filed against it does not properly support a securities fraud claim under Section 10(b).  Specifically,  Morrison held that because Congress did not explicitly state that Section 10(b) should apply extraterritorially, the scope of Section 10(b) securities fraud claims should be restricted by a “transactional test” to claims that a defendant has used a manipulative or deceptive device or contrivance only in connection with either (1) “the purchase or sale of a security listed on an American stock exchange”, or (2) “the purchase or sale of any other security in the United States.”  While these standards, particularly the second, are subject to differing interpretations,  some legal commentators read Morrison to limit the scope of a Section 10(b) claim to exclude all foreign security trades, irrespective of whether the purchaser was a US citizen or whether some aspects of the purchase or sale transaction occurred within the US.

In the Homm case, plaintiffs were investment funds organized in the Cayman Islands, i.e. foreign plaintiffs.  Defendants, except for the broker-dealer underwriter of the securities at issue, were all foreign and the defendants had legal authorization to manage the investment decisions of the plaintiffs.   The securities at issue were penny stocks of U.S. companies, but the securities traded in over-the-counter markets such as the Pink Sheets and OTCBB. In the complaint, the plaintiffs alleged that the defendant underwriter first sold plaintiffs shares in the penny stocks through a Securities and Exchange Commission (“SEC”) registered offering.  After acquiring the shares in the offering, plaintiffs, upon defendants’ direction and control, bought more of those shares in the open market to move the price upward while those same defendants sold their own personal shares in what’s known as a pump-and-dump scheme.

In dismissing the plaintiff investments funds’ case for lack of subject-matter jurisdiction, the district court stated:

“Plaintiffs are based in the Cayman Islands.  Defendants, with the exception of Ficeto and Hunter, are foreign nationals.  The corporations that issued the Penny Stocks were registered with the SEC, however, their shares were not traded on a domestic exchange.  Instead, the fraudulent scheme alleged involved private offerings (i.e. the ‘PIPE’ transactions) in which the Funds were caused to purchase the illiquid shares directly from the companies through private placements.  At no point were the shares released to the general market.  In face, the entire ‘market’ alleged was the trading by and between the Funds.  The Funds were based in the Cayman Islands and managed in Europe.

The plain language of the ‘transaction test’ established in Morrison precludes this action from moving forward.  Simply put, accepting the allegations of the amended complaint as true: (1) there was no sale of a security listed on an American Exchange as the PIPE (i.e., private placement) transactions involved “Penny Stocks” that were purchased ‘directly from the company,’ and (2) no transaction occurred in the United States.”

In the above passages, the judge appears aware that the allegations state that plaintiffs bought the penny stocks via private placements from domestic companies registered with the SEC.  Upon those facts, one would expect that prong number 2 of the Morrison test, the “purchase or sale of any other security in the United States”, has been met such that the plaintiff had stated a valid claim under Section 10.  However, this court was not moved:

“The instant case involves foreign investors suing foreign and domestic defendants regarding private transactions in securities that were not listed on a United States domestic exchange.  This appears to be precisely the type of case the Supreme Court had in mind when it issued Morrison.  Permitting this case to move forward on the theory that any trade routed through the United States meets the Morrison standard would be the functional antithesis of Morrison’s directive.  By all accounts, Plaintiffs took great pains to avoid regulations imposed by federal securities laws that apply to domestic market transactions.  It would be illogical, and inconsistent with Morrison to allow them to seek redress in this Court.” (Emphasis added)

Query whether the presence in Homm of Cayman Island-based plaintiffs dealing in penny stocks may have justified the result reached. However, we do not believe it should have been at the cost of a ruling on subject matter jurisdiction that could preclude future plaintiffs, including those defrauded in the purchase of more “substantive” securities than penny stocks, from having their allegations receive review in the district court under Rule 12(b)(6) to determine if they state an actionable Section 10(b) claim. The question that will most likely be answered on appeal is whether this court has reached beyond even the highly restrictive limits of Morrison under any analysis.