Local securities lawyers say a 2nd Circuit ruling defines for the first time the meaning of “domestic transaction” under a test laid out by the U.S. Supreme Court in its landmark 2010 Morrison, et al. v. National Australia Bank Ltd., et al. decision.

In Absolute Activist Value Master Fund Ltd., et al. v. Ficeto, et al., the 2nd U.S. Circuit Court of Appeals held that securities not traded on a domestic exchange can be subject to Section 10(b) of the Securities Exchange Act of 1934 only if the parties incurred irrevocable liability in the United States, or transferred title here.

The case arose in response to Morrison, which created a two-prong transactional analysis test limiting fraud claims to securities listed on domestic exchanges or “domestic transactions in other securities.”

Paul V. Curcio of Adler, Pollock & Sheehan in Providence said the Supreme Court used the term “domestic transaction” without really defining its meaning.

Morrison changed the rules, he said, but left securities lawyers uncertain as to how to properly interpret the case.

“What Absolute Activist does is gives plaintiffs a blueprint to use when they’re dealing with securities that aren’t traded on a U.S. exchange, but would still be subject to federal anti-fraud laws,” he said. “It clarifies portions of Morrison so that you now know what a domestic transaction is for purposes of application of 10(b).”

Until Morrison, questions about whether extraterritorial transactions were covered had been decided under the “conduct or effects” test, said Michael T. Gass, chairman of Choate, Hall & Stewart’s securities litigation group in Boston. The test allowed plaintiffs to file suit if the conduct in question had a substantial effect in the U.S. or occurred within its borders, he added.

Morrison created widespread debate in the securities bar because the court struck down the old test without providing any guidance on how to analyze the new “domestic transaction” prong, Gass said.

“This is such a significant pronouncement from the court because Absolute Activist cleared up the gray area that was out there by providing us with a straightforward definition,” he said. “You’ve got the most highly respected circuit in the securities field articulating, for the first time in the country, a narrow interpretation of what the Supreme Court left unclear in Morrison.”

Decade change

Daniel N. Marx of Foley Hoag said Absolute Activist represents a major change that will reduce the number of cases brought under Section 10(b).

Although determining whether a security is listed on a domestic exchange is simple, the second prong of the test was not as easy to answer, the Boston lawyer said.

“In Morrison, the court established that one way to fall within the extraterritorial reach of Section 10(b) is to be to be engaged in a ‘domestic transaction,’” Marx said. “But the court didn’t have any reason to explore the scope of the phrase since it was so obvious in Morrison that all the facts were exclusive to events that occurred outside the U.S.”

Marx said the bright-line rule established in Absolute Activist means that lawyers analyzing similar jurisdiction questions must now focus on the transaction itself as opposed to the parties’ conduct during the deal.

To survive a motion to dismiss, a Section 10(b) fraud complaint can no longer rely simply on the location of the individuals making the trades or whether the securities were issued by U.S. companies, he said.

“For decades, we applied a ‘conduct and effects’ test, and we kind of got used to it in that there was a body of caselaw we were all familiar with,” Marx said. “It’s been unclear since the Supreme Court’s decision as to whether a complaint satisfies the standards of Morrison. Absolute Activist provides a lot of those answers.”

George J. Skelly of Boston’s Nixon Peabody, predicted that the decision will be felt beyond the 2nd Circuit and will be cited regularly by securities lawyers practicing in the 1st Circuit.

“The 2nd Circuit is the preeminent jurisdiction for securities cases and is widely followed by other circuits,” he said. “The 1st Circuit’s not bound to follow a 2nd Circuit ruling, but they’re very likely to because they have so much experience and are recognized as the court that’s been dealing for a long time with some of the biggest cases in the securities area.”

In addition to cutting down on privately filed suits, Skelly said, the ruling will make it harder for the SEC to bring enforcement actions.

“There was some thought out there that Absolute Activist might have led to a test interpreting domestic transaction much broader,” he said. “But it’s pretty clear the 2nd Circuit followed the direction of where the Supreme Court in Morrison was going by using what looks like a fairly narrow test.”

Instead of filing under Section 10(b), many litigants will now bring claims under Rule 17A of the 1933 Securities Act, a statute that alleges negligence rather than fraud, Skelly said.

“Obviously, if you’re being tried on a claim of negligence, that is less egregious conduct with lower penalties,” he said. “It certainly carries less stigma and is much more favorable to the defendant.”

Bad deal

The plaintiffs were nine Cayman Islands hedge funds that invested in a variety of assets for hundreds of clients around the world, including many in the U.S.

They allegedly incurred $195 million in losses at the hands of a defendant U.S. broker, investment manager and other entities.

The plaintiffs claimed they were victims of a scheme in which the defendants caused the funds to buy shares of thinly capitalized companies in the U.S.

According to the complaint, the defendants secretly invested in the companies and traded the stocks among the funds in a way that artificially inflated their price. The purpose of the scheme, the plaintiffs alleged, was to generate higher fees and commissions.

The plaintiffs filed suit in the Southern District of New York in 2009 under Section 10(b).

Relying on Morrison, U.S. District Court Judge George B. Daniels dismissed the complaint. Although the securities were issued in the United States by U.S. companies, the judge found the plaintiffs failed to establish they were “domestic transactions” under Morrison.

In affirming the ruling, Judge Robert A. Katzmann, writing for the 2nd Circuit panel, said the involvement of a U.S. broker-dealer in and of itself could not form the basis of a claim. He also said it was not enough simply to allege that a security was issued by a U.S. company registered with the SEC.

The judge noted, however, that a buyer or seller located outside the country was not barred from proving a transaction took place in the U.S.

Katzmann said the plaintiffs could not be faulted for failing to allege sufficient facts under Morrison.

“Because there has been significant ambiguity as to what constitutes a ‘domestic transaction in other securities,’ the plaintiffs should have the opportunity to assert additional facts leading to the plausible inference that either irrevocable liability was incurred or that title passed in the United States,” he wrote.