D&O underwriters are increasing their scrutiny of US American Depository Receipts (ADRs), following recent cases that point to likely increased class action exposure for foreign companies.
Recent legal cases in the US have shown foreign companies with ADRs – derivative securities issued by a depositary bank – may be more exposed to securities class action litigation than previously thought.
In particular, a recent ruling by the Court of Appeals for the Ninth Circuit in Stoyas v Toshiba Corphas created some uncertainty regarding the applicability of US securities laws to unsponsored ADRs, according to Edward Kirk, partner in the New York office of Clyde & Co.
Shareholders are filing record numbers of securities class actions against non-US issuers, despite the US Supreme Court’s 2010 ruling in Morrison v National Australia Bank, which limited the extraterritorial reach of the Securities and Exchange Act. In each of the past two years, the number of securities class actions against foreign companies was double the 1997 to 2017 annual average of 24. Many of those actions involve ADRs, according to Mr Kirk.
“After Morrison, the number of filings against foreign companies was expected to drop, but this did not happen. In fact, the number of new securities class actions against foreign companies has doubled, in line with a substantial increase in US shareholder class action litigation overall,” he told CRE. “Plaintiff attorneys appear to be targeting companies with ADRs trading in the US, including unsponsored ADRs,” he added.
There are two basic types of ADRs. Sponsored ADRs are issued on behalf of a foreign company. Unsponsored ADRs are issued by a depositary bank often without the involvement, participation or consent of the foreign company whose stock underlies the ADRs.
There are also three levels of ADR. ADR Level II and III are traded on a US exchange. Issuers have to file with the Securities and Exchange Commission (SEC) and are subject to US securities laws and therefore exposed to US securities class actions. ADR Level I are traded over the counter and no filings are made with the SEC.
Courts applying Morrisonto securities class actions involving ADRs have consistently found that US securities law applies to ADRs listed on a US registered exchange. But ADRs traded on over-the-counter markets – which are not registered securities exchanges except, potentially, where a foreign issuer sponsored or otherwise took affirmative steps to make its ADRs available to US investors – have tended to escape the rules. But the Toshibadecision looks like it might change things.
“Following Morrison, D&O underwriters had previously believed that foreign companies with unsponsored ADRs were safe from US litigation. However, the Toshibadecision suggests this might not be the case and that at least in the Ninth Circuit, courts may find that the US Exchange Act applies to unsponsored ADRs,” said Mr Kirk.
Given that the US Supreme Court decided not to hear the Toshibaappeal, the Ninth Circuit opinion on Toshibastands and is the law in district courts under its jurisdiction. The US government indicated in a brief submitted by its solicitor general that it agrees with the decision on Toshiba.
“This is an extremely concerning development for non-US companies and their directors and officers, as they could be hauled into US courts by US purchasers of the unsponsored ADRs. US securities claims are the most severe category of D&O claim, so this is a significant change in exposure for these companies,” said Stephanie Pestorich Manson, head of directors and officers (D&O) at Marsh JLT Specialty in the UK.
There have been other noteworthy ADR I cases since Morrison, including separate securities class action lawsuits filed against Tesco, VW and Daimler in various US courts.
These cases have been watched very closely, according to Catherina MacCabe of Lloyd’s insurer Beazley. US securities class action exposure is the biggest driver of D&O claims and has a significant impact on underwriting appetite, strategy and premiums, she said.
“The D&O market has historically assumed issuers of ADR I were not subject to US securities laws and were not exposed to US class actions. Recent cases indicated issuers of sponsored ADR I may, in certain circumstances, be subject to US securities laws, but the general belief was still that this is not the case for issuers of unsponsored ADR I,” said Ms MacCabe.
However, if unsponsored ADRs were subject to US securities law, underwriters could apply rate increases, reduce capacity and/or increase retentions, she said.
Some insurers have begun to adjust pricing to reflect this new risk, according to Ms Pestorich Manson. D&O programmes for companies with exposure to US securities litigation are typically priced at multiples of companies that do not have US exposure, she pointed out.
Ms Pestorich Manson explained that D&O insurers did not expect clients with Level 1 ADRs – and certainly not unsponsored ADRs – to be subject to US securities litigation after the 2010 US Supreme Court decision on Morrison. “The insurance market has consistently differentiated these clients from US traded clients and deploys capacity and pricing very differently on accounts that are US traded and those which are not,” she said.
“To date, we have not seen companies with ADR Level I exposure being re-rated to be equivalent to those with direct listings or ADRs listed on national exchanges, but insurers are taking the exposure more seriously,” the broker added.
“Some insurers are looking more carefully at capacity and pricing on companies with Level 1 ADR exposure. The most common changes at this early stage are primary insurers requiring US securities retentions where insureds may not have such retentions, or increasing those retentions where they are considered low, and some carriers are changing ‘any one claim’ limits to aggregate limits,” she added.
Foreign companies with US exposures have faced shrinking capacity, increased rates and higher deductibles, in particular for foreign filers with ADR II, ADR III or full US listing, according to Ms MacCabe. “The market has not yet hardened to the same extent for ADR I issuers. Toshibacould, and most probably will, change that,” she said.
At the very least, D&O underwriters are likely to seek more information from non-US companies regarding their involvement in securities transactions in the US, said Mr Kirk. “Insurers will want to examine the types of securities foreign companies have in the US, including swaps and ADRs, sponsored or unsponsored,” he said.
However, theToshibadecision may not “open the floodgates” to securities class actions against foreign companies with unsponsored ADRs in the US as some commentators have anticipated, according to Mr Kirk. The case explored whether the Securities Exchange Act applies to unsponsored ADRs, but not the liability of foreign issuers, which would be the next step in successful litigation, he added.
“Even if a court found that the securities laws applied to unsponsored ADRs, plaintiffs would still have a high hurdle to overcome to establish liability – they must also plead and prove a connection between material misrepresentations or omissions and the purchase or sale of the ADRs in the US. So, ultimately, Toshiba may not substantially increase the exposure of foreign companies whose securities back unsponsored ADRs,” said Mr Kirk.
According to Ms Pestorich Manson, given the small number of US ADR holders compared to an entire company’s shareholder base, the additional exposure is likely limited to a small group of shareholders and therefore a concern for primary or low excess insurers rather than entire large insurance towers.
The focus on ADRs comes against the backdrop of a hardening market for D&O insurance. Nearly all buyers of D&O insurance are experiencing changes in terms and conditions, according to Ms Pestorich Manson. While some segments are only seeing changes in rate, others are facing significantly restricted capacity and they cannot purchase the desired limits at any price, she said.
“All US listed companies, wherever domiciled, are facing a challenging marketplace. Insureds in the pharmaceutical and technology sectors are experiencing reducing capacity and [rate] increases, while private companies seeking to IPO are facing some of the most challenging market conditions,” said Ms Pestorich Manson.