Ruling on the extraterritorial scope of Section 10(b) of the 1934 Act, in 2010 the Supreme Court in Morrison v. National Australia Bank rejected the expansive “conduct and effects” tests, and limited the reach of Section 10(b) to instances in which the security at issue is sold in the U.S. or listed on an American stock exchange. Congress responded by legislatively overruling Morrison with respect to government civil and criminal enforcement actions and ordered the Securities and Exchange Commission “to conduct a study to determine whether private actions under Section 10(b) should be similarly extended.”1
While openly endorsing an expansion of the private right of action under Section 10(b), the SEC Staff declined to make hard and fast recommendations, providing only “options” to extend Section 10(b) private actions extraterritorially and sparking a rare dissent by Commissioner Aguilar. Nonetheless, the SEC staff’s thorough Study (the “Study”) has likely defined the parameters of the debate to come by contrasting concerns for international comity against imperatives of investor protection and the integrity of capital markets. With the debate so defined, the ever-increasing challenges for investor protection presented by the globalization of capital markets may very well dictate the return of at least some limited form of extraterritorial jurisdiction.
Morrison: Bright-Line “Transactional” Test Replaces Expansive “Conduct and Effects” Tests
Morrison concerned a so-called “foreign cubed” (foreign3) securities fraud action in that it involved: (1) foreign investors; (2) a foreign corporation; and (3) the foreign corporation’s securities traded on a foreign stock exchange. Its connection to the U.S. was that — according to the plaintiffs — fraud was perpetrated through false financial data generated in the U.S. by the issuer’s wholly owned U.S. subsidiary. The question addressed by the Supreme Court was whether these alleged facts came within Section 10(b) of the 1934 Act.
Before the Supreme Court’s decision in Morrison, the federal circuit courts of appeal all applied some version of the “conduct and effects” tests to resolve the extraterritorial reach of Section 10(b). Under the conduct and effects tests, such a case would be heard if either a sufficient level of the alleged fraudulent conduct occurred in the U.S. or the alleged fraudulent conduct occurring outside the U.S. caused substantial harmful effects to U.S. interests. Although the conduct and effects tests’ lack of precision led to differences in precisely how lower courts applied them, the overall result was that foreign securities suits were liberally permitted in U.S. courts.
Citing the absence of any “affirmative indication” of extraterritoriality in the language of Section 10(b) and potential concerns for international comity, the Supreme Court rejected the conduct and effects tests in favor of what it described as a bright-line standard — the “transactional” test. Under the transactional test, Section 10(b) does not apply unless it involves “the purchase or sale of a security listed on an American stock exchange, [or] the purchase or sale of any other security in the U.S.” Morrison, 130 S. Ct. 2869, 2888. Subsequent lower court cases have found this standard to be somewhat less self-executing than the Supreme Court majority apparently expected.
In response, Congress passed legislation under the Dodd-Frank Act effectively adopting the conduct and effects tests in Section 10(b) enforcement cases brought by the SEC and Department of Justice. While this extension of the SEC’s extraterritorial authority only applies to Section 10(b), the SEC and its staff seem to have taken a narrow view of Morrison, continuing to exercise extraterritorial jurisdiction under other statutory provisions. For instance, the SEC has sanctioned non-U.S. financial institutions for securities activities with U.S. persons occurring outside the U.S. that involved violations of provisions other than Section 10(b).2 Whether the SEC’s current expansive view of its extraterritorial jurisdiction in regulatory matters will survive judicial scrutiny is also an open question.
With respect to private litigation, Congress ordered the SEC, in Section 929Y of the Dodd-Frank Act, “to conduct a study to determine whether private actions under Section 10(b) should be similarly extended.”3
The SEC Staff Study
On April 11, 2012, the SEC released its staff’s Study. The Study details the state of the law before Morrison and provides a modestly annotated overview of the reasoning of the Morrison decision. For instance, the Study appears to rebut the Morrison Court’s observations that “there is no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets,” noting “[t]o the extent that the Morrison decision can be understood to suggest that the perpetration of securities frauds from the U.S. on investors in other countries is not a significant problem, this view is not supported by the following recent Commission enforcement actions” followed by such recent SEC enforcement actions.4 The Study also details Justice Stevens’ concurrence, joined by Justice Ginsberg, which supported the conduct and effects tests to protect American investors fraudulently induced to purchase a foreign issuer’s securities, though the concurring Justices concluded that the majority’s bar on foreign cubed private damages actions was appropriate.5 The Study then summarizes the experience of lower courts following Morrison, including a laundry list of circumstances in which courts have considered whether a private action under Section 10(b) could be brought (mostly concluding in the negative), conveying the extent to which private actions under Section 10(b) have been narrowed.
The Study then summarizes the arguments presented by 72 comment letters from various interests, including eight foreign governments. Those supporting a continuation of the transaction test and opposed to the conduct and effects tests focused primarily upon potential conflicts with foreign nations’ laws and the legitimate policy choices at variance from the U.S., such as a class action system perceived as “creating incentives for abusive litigation.”6 The European Commission remarked that an “extraterritorial application of the antifraud provisions of the United States’ securities law … where the nexus is stronger with a foreign jurisdiction is liable to violate the E.U.’s and its Member States’ sovereignty, and to impede the proper development of the E.U.’s securities regulations.”7 Supporters of the transactional test also trumpeted its “bright-line standard,” allowing issuers greater predictability with respect to potential liability.8
Supporters of the conduct and effects tests, by contrast, argued that the tests did not “interfere with a non-U.S. sovereign’s ability to independently regulate its own securities market”9 and asserted that international comity may actually be enhanced because all regulators ultimately seek to protect investors.10 Proponents asserted that the conduct and effects tests protect foreign investors as well by “prevent[ing] the U.S. from being used as a manufacturing base for the export of fraud and deceit.”11 Supporters of the conduct and effects tests also pointed to the growing globalization of the capital markets as requiring a more expansive private right of action under Section 10(b). For instance, comments on behalf of pension funds explained that investors are often unaware of, and in fact unable to know, whether an order for cross-listed securities will be executed on a domestic or foreign exchange in light of broker-dealer best execution requirements.12 Others explained that diversification of an investment portfolio is hamstrung if limited to purchasing only ADRs, which may be less liquid and less efficient to trade on American exchanges, especially given that American markets are, globally, the last to open.
The Study’s Options for Congress’ Consideration and Commissioner Aguilar’s Dissent
While standing by its view that the conduct and effects tests (in modified forms) should be applied to private Section 10(b) litigation, the Study makes no formal recommendations for doing so, and instead merely presents options for Congress to consider. The Study’s proposed options largely reflect to various degrees the concerns raised by the comment letters and provide Congress with a menu of possibilities loosely matched to the interests at play. Leaving the ultimate decision on how to proceed with the legislators, the Study advises Congress that “the specific options identified below [are] consistent with the recognized principles of prescriptive jurisdiction — i.e., legislative authority ….” 13
The first option is to codify the conduct and effects tests for private rights of action in much the same way as Congress has already done for actions brought by the SEC or DOJ, with some modifications to “alleviate certain of the potential negative consequences” addressed earlier.14 For example, Congress could narrow the “conduct” test for private litigation so that it only applies if the injury resulted directly from the conduct occurring in the U.S. This is the approach the SEC suggested to the Supreme Court in Morrison and is the one it still favors. Another proposed modification is to limit the conduct and effects tests by requiring that the application of Section 10(b) to foreign issuers be permitted only in the interests of protecting U.S. investors. These variations on the conduct and effects tests would, in the Study’s view, protect investors while alleviating concerns for international comity, though those advantages must be weighed against the costs to issuers faced with defending such actions and general foreign government opposition.15
The second option is to legislate one or more modifications to the transactional test to expand its scope. The Study provides several suggestions for accomplishing this, largely reflecting the various concerns of those dissatisfied with the transactional test, including to allow claims: (1) where the securities at issue are of the same class of securities registered in the U.S.; (2) against intermediaries, such as broker-dealers, that fraudulently purchase or sell U.S. or non-U.S. securities overseas for U.S. investors; (3) where an investor was fraudulently induced to engage in a securities transaction while in the U.S., regardless of where the transaction eventually took place; or (4) if either party made or accepted the offer to buy or sell while in the U.S.
The Study also briefly mentions a third option — do nothing. “Under that approach,” the Study states, “the lower courts would continue to interpret and refine the Supreme Court’s holding in Morrison.”16 This option, and the general failure to make an affirmative recommendation, prompted Commissioner Aguilar to voice dissent. Commissioner Aguilar conveyed “strong disappointment that the Study fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that has resulted, and will continue to result, due to Morrison.”17 In addition, he explained his views about how the Study overstates international comity concerns. The Commissioner made clear his view that, in the interests of protecting investors, Congress should adopt for private Section 10(b) litigation the same standard adopted for SEC and DOJ actions.
Observations and Implications
Although immediate reactions to the SEC staff’s Study have largely focused on its failure to present a single affirmative recommendation to Congress, there is nothing equivocal about the staff’s position regarding its view of the proper extraterritorial scope of Section 10(b) in private litigation. The Study makes plain that the SEC staff continues to support the conduct and effects tests, provided that “the plaintiff’s injury resulted directly from conduct within the U.S.”18 The Study’s emphasis on the numerous scenarios involving fraud found to be outside the scope of the transactional test in the post-Morrison world, its recounting of instances of investor fraud from within the U.S. upon foreign investors and its guidance to Congress indicating that all of the proposed options are within its legislative authority make clear that the SEC staff favors legislative action expanding private rights of action. Its refusal to identify a specific recommended course of legislative action perhaps signals no more than the SEC staff's unwillingness to assume that legislative function.
With the increasing globalization of capital markets, vexing problems regarding the scope of private rights of action under Section 10(b) involving cross-border securities transactions and American participants — both investors and issuers alike — will only multiply in the years to come. Whether a divided Congress is presently capable of, or has an inclination toward, acting upon the options the Study has presented is, of course, an open question. However uncertain the timing and nature of congressional action may be, however, it is clear that the Study framed the nature of the debate. The playing field is staged in favor of expanding the private right of action as the capital markets continue to globalize. The SEC staff’s Study features investor protection and the integrity of markets facing off against concerns for international comity. As globalization accelerates and American investors are increasingly entangled in cross-border securities transactions, it is not unreasonable to conclude that concerns for international comity will ultimately give way.
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This article was originally published by Bingham McCutchen LLP.