VW suit maps out new route in U.S. courts

The first bondholders' class action against Volkswagen AG and its U.S. subsidiaries could provide a new avenue for U.S. investors to sue foreign companies in U.S. courts.

Law firm Labaton Sucharow on June 20 filed the lawsuit for the $4 billion State-Boston Retirement System on behalf of all bondholders who acquired Volkswagen 144A bonds between May 23, 2014, and Sept. 22, 2015.

Because these bonds — also known as private placements or sophisticated investor bonds — are not subject to the same prohibition on legal action against foreign issuers of securities established by a landmark U.S. Supreme Court ruling in 2010, the Boston pension fund decided to open an avenue of recovery for investors, said firm partner Thomas A. Dubbs, New York.

Mr. Dubbs, who said he is in discussions with more potential public pension plan participants in the lawsuit, advised institutional investors to check their holdings in Volkswagen 144A bonds. “They should determine whether and how they want to participate and potentially obtain a recovery,” he said.

The lawsuit, Boston Retirement System vs. Volkswagen, filed in U.S. District Court in San Francisco, claims Volkswagen raised more than $8 billion in the U.S. capital markets by issuing 144A bonds that were traded at “artificially inflated prices” up to 100% over par value. After the Environmental Protection Agency issued a notice of violation in September disclosing the automaker's emission-testing improprieties, investors lost hundreds of millions of dollars when the bonds' value declined, the lawsuit claims.

The Boston Retirement suit marks the first major legal case to address whether these private debt offerings fall outside the scope of the Supreme Court's 2010 decision in Morrison vs. National Australia Bank Ltd., which prohibits actions in U.S. courts against foreign-bought securities.

Securities lawyers see increasing interest in 144A bonds among foreign companies seeking to raise capital in the U.S. because, as private debt, the bonds fall outside the purview of federal exchange regulators. That makes it is a riskier proposition for investors, who nonetheless like the higher interest rates offered.

The Financial Industry Regulatory Authority in 2014 began publicly disseminating Rule 144A transaction data to bring transparency “to a market that had previously operated in the dark,” it said.

By May 2016, 144A transactions comprised 21.3% of the corporate debt market, up from 18.5% in 2014, with trades of $6.5 billion, up from $3.7 billion in August 2014, according to data from the Securities Industry Financial Markets Association.

Most U.S. investors have been forced to pursue or join lawsuits against foreign issuers in the issuers' home courts because of the Morrison decision.

The decision altered “the risk profile of foreign investments, stripping institutional and other private investors of the significant protection previously afforded by federal securities law,” the Council of Institutional Investors in Washington said in a report after the ruling.

While Congress later restored some jurisdictional powers to the Securities and Exchange Commission and the Department of Justice to pursue violations, it did not create a private right of action.

That's why the $294.1 billion California Public Employees' Retirement System, Sacramento, joined 277 institutional investors from the U.S., Europe, Canada, Australia and Asia seeking e3.2 billion ($3.6 billion) in a case filed in regional court in Germany.

That lawsuit against Volkswagen AG, filed in Braunschweig, Germany, in March by German law firm TISAB, is supported by a legal consortium that includes law firms Kessler Topaz Meltzger & Check LLP, Grant & Eisenhofer PA and DRRT.

The $187.4 billion California State Teachers' Retirement System, West Sacramento, joined a similar lawsuit against Volkswagen filed in Germany on June 21 by Quinn Emanuel Urquhart & Sullivan and funded by Bentham Europe Ltd., which continue to talk to large pension funds and international money managers.

The shift to foreign courts often means investors can no longer be passive.

Under the German legal system, shareholders do not receive a portion of any recovery unless they affirmatively join a case, or opt in.

“Morrison has largely taken away the opportunity to be a passive member of a U.S. class when the securities were purchased on a foreign exchange. Were it not for Morrison, VW would likely have been sued here, and we wouldn't have to go to Germany,” said one public pension fund attorney who declined to be identified.

As the Morrison decision forces investors to look to courts in other countries for relief, the number of cases filed abroad “has really ramped up,” said Darren Check, a partner with Kessler Topaz Meltzger & Check in Radnor, Pa.

“We spend a lot of time talking to institutional investors of all kinds,” Mr. Check said.

Aside from recouping investment losses, CalSTRS officials believe the lawsuit it joined also provides an opportunity to implement much-needed corporate governance reform at Volkswagen, said Brian Bartow, CalSTRS general counsel and chief compliance officer.

“As a long-term shareholder, CalSTRS has serious concerns about Volkswagen's internal controls, governance and oversight by the board,” Mr. Bartow said in a statement.

Boston Retirement's bondholder lawsuit in the U.S. does not promise a wholesale reversal of the need for investors to pursue securities litigation overseas. Moreover, the lack of transparency with 144A bonds has made it hard for investors to win class-action lawsuits because all members of the class have to show they relied on the same offering documents, and there is little legal precedent, legal experts said.

Still, the Volkswagen case in the U.S. could prove to be a turning point, they added, because the company raised significant sums from U.S. investors while flouting American regulations, among other improprieties.

“The pressure that's being put on them by the U.S. litigation creates a dynamic where they are probably best served by looking for a global solution,” said Mr. Dubbs of Labaton Sucharow.

It could also change the appeal of private debt offerings by foreign companies.

As one lawyer familiar with the case said: “If this case is successful, then companies seeking to raise capital in the U.S. may have a lot more to worry about.”