Typically, offshore funds are not subject to regulation under the U.S. securities regulations as long as they are not sold to U.S. citizens or residents. Offshore funds were not liable for fraud under §10(b) of the Securities Exchange Act unless they met the standards for the "conduct or effects" test. The test focused on:
- Whether the wrongful conduct occurred in the United States; and
- Whether the wrongful conduct had a substantial effect in the United States or upon United States citizens.
The "conduct or effects" test was rejected in Morrison v. Nat'l Austl. Bank Ltd. in 2010. The court established a new transactional test that stated that §10(b) and Rule 10b-5 do not apply extraterritorially, but only apply to "transactions in securities listed on domestic exchanges and domestic transactions in other securities." The court stated that domestic transactions should focus on the purchase and sale of securities. The case did not specifically define the term "domestic transactions," however, because the parties to the case were foreign and the dispute occurred outside the United States.
In Absolute Activist v. Ficeto, decided on March 1, 2012, the 2nd Circuit Court of Appeals expanded on the Morrison test to determine whether offshore hedge funds and other non-U.S. financial firms will be considered to be within the fraud statute when they are not listed on domestic exchanges. The court expanded the meaning of "domestic transactions," holding that a "domestic transaction" occurs if:
- The parties incurred irrevocable liability within the United States; or
- Title was transferred within the United States.
In order for a hedge fund to claim that a "domestic transaction" occurred, it has to show that the purchaser incurred irrevocable liability within the United States to take and pay for a security, or that the seller incurred irrevocable liability within the United States to deliver a security. A party will incur irrevocable liability when both parties have mutually agreed to purchase and sell securities, and the parties are required to follow through with the obligation. Also, if the sale of the security and title was transferred within the United States, the hedge fund will meet the burden of proving a "domestic transaction."
The court also noted a number of other factors which may be relevant but do not necessarily prove that purchase or sale was a "domestic transaction." These factors include the location of the broker, the identity of the security, the citizenship or residency of the purchaser and seller, and whether the defendants engaged in at least some conduct within the United States.
An offshore hedge fund must decide if it wants to be protected under the federal securities laws. Depending upon its determination, a hedge fund will have to carefully structure its transactions to be included or excluded from the transactional test if the transactions do not involve securities listed on domestic exchanges. It will also be important that future offshore hedge funds that want to allege fraud ensure that the complaint specifically pleads that the alleged fraud involved "domestic transactions." Merely making a conclusory allegation that that transaction took place in the United States will not be sufficient to state a claim.
Page Perry, LLC provides legal and compliance services to investment advisers, broker-dealers, registered representatives, hedge funds and issuers of securities, among others. Our regulatory practice group assists financial service providers with the complex issues that arise in the course of their businesses, including compliance with federal and state laws and rules.