The extraterritorial reach of Rule 10b-5 and its applicability to insurance-linked securities

Law firm Willkie Farr & Gallagher have published a client memo which pertains to insurance-linked securities and the rules regarding fraud under the Securities Exchange Act of 1934 Section 10(b) and particularly Rule 10b-5. Willkie Farr & Gallagher recently bolstered their ILS and reinsurance legal team with the hire of a number of partners from Dewey & LeBoeuf who brought significant ILS and catastrophe bond transactional experience with them.

According to the client memo, some decisions in U.S. courts have limited the extraterritorial reach of Rule 10b-5. Rule 10b-5 is the main antifraud remedy for investors under U.S. securities laws against participants in an ILS (including cat bond) offering. Damages can be sought under Section 10(b) and this includes its sub-rule 10b-5. Willkie Farr & Gallagher notes that as ILS and cat bonds are offered and sold using exemption from registration rules it means that the main sections of the Securities Act of 1933 which relate to fraud do not apply. So Rule 10b-5 has been seen as the important one for securities such as ILS for any fraudulent claims.

Willkie Farr & Gallgher explain Rule 10b-5 succinctly as:

Rule 10b-5 makes it unlawful for any person, directly or indirectly in connection with the purchase or sale of any security, to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made not misleading. In order to establish a claim under Rule 10b-5, an investor must demonstrate that the defendant (i) made a misstatement or omission of a material fact, (ii) in connection with the purchase or sale of a security, (iii) with the requisite scienter (i.e., an intent to deceive or reckless disregard for the truth), (iv) upon which the investor justifiably relied, (v) that proximately caused (vi) the investor’s economic loss.

A U.S. Supreme Court decision in a case known as ‘Morrison v. National Australia Bank’ in 2010 has, says Willkie Farr & Gallagher, significantly limited the extraterritorial reach of Rule 10b-5. The court’s decision essentially limited application of the Section 10(b) rules to transactions either listed on domestic exchanges or domestic transactions in other securities. As Willkie Farr & Gallagher note, insurance-linked securities and catastrophe bonds have both onshore and offshore components generally, in fact it is very rare for an ILS to be issued out of the U.S.

Another more recent case ion March 2012 almost resulted in a clarification of this but actually when you read the memo it doesn’t seem all that much clearer. The ‘Absolute Activist’ case attempted to clarify cases where there are domestic transactions in offshore listed securities, but the opinion of Willkie Farr & Gallagher seems to suggest that it’s not clear yet how these will be treated under Rule 10b-5 now.

The memo continues to say that they don’t advise changes to the structure and marketing of ILS transactions in an attempt to be outside the territorial reach of Rule 10b-5. In fact they rightly note that proper documentation, transparent offering documents, good legal counsel and a continuing commitment to full disclosure of the risks involved in an ILS transaction are the best way to ward off any claims of fraud.

Willkie Farr & Gallagher do note two ways that participants in an ILS or cat bond offering may be able to decrease the likelihood that sales to investors outside the U.S. are considered domestic and thus within scope of Rule 10b-5. They note that often the securities in an ILS transaction transfer from one party to another a number of times before reaching the investor, thus transferring title. They say that the first transfer is likely the most important and the one that would be considered under Rule 10b-5 so suggest that offering the resulting securities in book-entry form through Euroclear or Clearstream outside of the U.S. may be a solution. A number of cat bond transactions have used these clearing houses before with no ill effects. They also suggest that the indenture trustees hold the security certificates at a branch outside the U.S. Neither of these suggestions are typical of the majority of ILS and cat bond transactions but Willkie Farr & Gallagher say they have seen them used in successful transactions before.

The memo concludes that exactly what these two cases means for sponsors and the initial purchasers of ILS and cat bonds is still a judicial work in progress and so, as ever, there will be some doubt as to exactly how cases would be treated. However they suggest that the mitigating methods they highlight in the memo may provide some assistance in the event of needing to defend a claim of fraud.

We’re not legal experts at Artemis so we suggest you read the memo from Willkie Farr & Gallagher in full and contact them or speak to your own legal experts to understand how this could affect you as either a sponsor or participant in an ILS or cat bond transaction.