May the holders of American Depository Receipts (ADRs) reflecting ownership of shares in a Japanese corporation bring a shareholder derivative action on behalf of that corporation? Both US and Japanese law provide for shareholder derivative actions. However, the US Court of Appeals for the Ninth Circuit has held in Batchelder v Kawamoto [July 15 1998] that under Japanese law on ADRs, the holder of the ADRs did not have standing to bring the derivative action.
The plaintiff, Harry Batchelder, owned 1,246 ADRs, each representing 10 shares of stock in Honda Motor Company, the Japanese automobile company. The ADRs were issued by Morgan Guaranty Trust Company of New York acting as depository. By purchasing the ADRs Batchelder was able to invest in the Japanese company.
Batchelder brought the present action alleging that the directors of Honda Japan breached their fiduciary duties by failing to protect the company from bribery and kickback schemes perpetrated by certain employees of Honda's American subsidiary. The directors of Honda's American subsidiary were also named in the suit in what is known as a double derivative action, ie an action brought by a shareholder of a parent company on behalf of that corporation to enforce a cause of action in favour of the subsidiary company.
Honda maintained that Batchelder did not have standing to bring either derivative action because under Japanese law shareholders and not holders of ADRs may bring derivative actions. Batchelder purchased his ADRs under a deposit agreement with Morgan Guaranty and Honda Japan. The deposit agreement contained a choice of law clause which read:
"This Deposit Agreement and the [American Depository] Receipts and all right hereunder and thereunder and provisions hereof and thereof shall be governed by and construed in accordance with the laws of the State of New York, United States of America. It is understood that notwithstanding any present or future provision of the laws of the State of New York, the rights of holders of Stock and other Deposited Securities, and the duties and obligations of the Company in respect to such holders, as such, shall be governed by the laws of Japan."
The Ninth Circuit held that under the second sentence of this choice of law clause, Japanese law governs the rights of holders of ADRs in Honda Japan. While Article 267 of the Japanese Commercial Code allows for a derivative action in the name of a Japanese company, the Ninth Circuit found, on the basis of expert testimony, that only shareholders have rights under Article 267 and dismissed the case.
Batchelder argued that he was never given a copy of and never consented to the deposit agreement. In response, the Ninth Circuit quoted a number of SEC releases to the effect that: "[T]he deposit agreement constitutes the contract between the issuer of the deposited securities, the depository and the holders of ADRs. ADR holders are deemed to have agreed to all terms in the deposit agreement by their acceptance and holding ADRs."
The holding in Batchelder may seem inequitable because the plaintiff did not have his day in court. However, the case is significant in that it upholds the validity of choice of law clauses in financial contracts.