On June 24, 2010, the U.S. Supreme Court in Morrison et al. v. National Australia Bank Ltd. et al. ruled that § 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 10b-5 promulgated thereunder — the antifraud provisions of the Exchange Act — apply only to cases involving either the purchase or sale of securities listed on U.S. securities exchanges or the purchase or sale of any other securities in the U.S. In so holding, the Court overruled more than 40 years of precedent established by the federal circuit courts concerning extraterritorial application of the Exchange Act.
Although its holding comes in the context of a private securities class action, under the logic of the decision, the SEC’s power to bring enforcement actions relating to non-domestic securities transactions could also be limited. However, proposed financial reform legislation would preserve the SEC’s enforcement jurisdiction in fraud cases and also calls for a study by the SEC concerning the extent to which private rights of action should extend to extraterritorial claims.
The petitioners in Morrison were shareholders of National Australia Bank (“National”), one of Australia’s largest banks, whose Ordinary Shares — what in the U.S. would be called “common stock” — were not traded on a U.S. securities exchange. National’s Ordinary Shares were traded on Australia’s primary securities exchange, on other foreign securities exchanges and as American Depository Receipts (“ADRs”) on the New York Stock Exchange.1 The petitioners were Australian citizens whose stock purchases occurred in Australia.
In 1998, National purchased HomeSide Lending, a U.S. mortgage servicing company, and in public filings between 1998 and 2001, it “touted the success” of this business. Beginning in 2001, however, National began a series of write-downs of the value of the HomeSide business, which it attributed to the effects of interest rate fluctuations. Plaintiffs alleged however, that senior executives of HomeSide, acting from company headquarters in Florida, had intentionally manipulated its financial models to pump up earnings. By 2001, National wrote down $2.2 billion of HomeSide’s assets, which caused National’s share price to fall. Plaintiffs, purporting to represent a class of foreign purchasers, sued National and HomeSide for alleged violations of § 10(b) and Rule 10b-5.
Applying a conduct-and-effects test established by the Second Circuit to determine whether § 10(b) applied extraterritorially, the District Court dismissed the case and the Second Circuit, applying the same test, affirmed. Although the Supreme Court unanimously affirmed dismissal of the action, the Court explicitly and forcefully rejected the Second Circuit’s long-standing test.
Presumption Against Extraterritoriality
The Court’s opinion, delivered by Justice Scalia, relied on the “longstanding principle of American law that legislation of Congress, unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States.”2 This principle rests on the perception that Congress ordinarily legislates with respect to domestic matters, not foreign matters.3 The Court relied on its 1991 decision in EEOC v. Arabian American Oil Co. (Aramco), which rejected extraterritorial application of Title VII of the Civil Rights Act of 1964 on such grounds.4
The Court observed that nothing in the text of § 10(b) suggests that it applies abroad. Thus, while the lower court’s § 10(b) jurisprudence “point[ed] the way to what Congress would have wished,” or “would have wanted if it had thought of the situation before the court,” in the view of the Court, no such jurisprudence replaced the presumption against extraterritoriality.5
Rejection of the Second Circuit Conduct-and-Effects Test
The Court’s decision considered and firmly rejected the Second Circuit's complex conduct-and-effects test, adopted by other circuits with minor variations, for determining whether extraterritorial jurisdiction existed in particular cases. The Second Circuit’s version considered, “(1) whether the wrongful conduct occurred in the United States, and (2) whether the wrongful conduct had a substantial effect in the United States or upon United States citizens.” 6
Justice Scalia pointed to the inconsistent application of the test. For instance, the Second Circuit applied the conduct test differently depending on whether the harmed investors were Americans or foreigners. And while, generally, the conduct test was satisfied when a defendant’s activities in the United States were more than “merely preparatory,” this analysis required courts to distinguish between mere preparation and using the United States as a “base” for fraudulent activities in foreign countries.
The Court’s opinion concluded that the unpredictable application of § 10(b) “demonstrate[d] the wisdom of the presumption against extraterritoriality.” By applying this presumption in all cases, Justice Scalia asserted, Congress can legislate with more predictable effects. The Court considered and rejected arguments that three other provisions of the Exchange Act suggested that Congress intended to apply the statute extraterritorially.
The Court also rejected arguments for a modified version of the Second Circuit test advanced in an amicus brief by the Solicitor General (expressing the views of the SEC) that, the government argued, would serve a number of purposes, including “achieving a high standard of business ethics in the securities industry, ensuring honest securities markets and thereby promoting investor confidence, and preventing the United States from becoming a ‘Barbary Coast’ for malefactors perpetrating frauds in foreign markets.”
The Court concluded by establishing a seemingly bright-line test: “Section 10(b) reaches the use of a manipulative device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.”
In a concurring opinion, Justice Stevens, joined by Justice Ginsburg, agreed that dismissal of the case was appropriate, but argued that the Second Circuit conduct-and-effects test should not be abandoned. The test, Justice Stevens stated, was well-established, comported with congressional intent in enacting such an “open-ended statute” and, having stood for more than 40 years with the “tacit approval” by Congress and the SEC, was entitled to deference.
Application of the Morrison Decision
As noted above, the test articulated by the Court appears straightforward: Were the securities whose purchase or sale is at issue listed on an American stock exchange? If not, were the securities purchased or sold “in the United States?” In practice, however, this test may not be so simple to apply.
For example, how are purchases of ADRs7 to be treated? In the context of transnational securities transactions, the issue of whether the purchase or sale of securities occurred “in the United States” may not be so easily resolved. Does the purchaser have to be a U.S. citizen or corporation? What if the seller, or issuer, is a U.S. entity but the purchaser resides abroad? Does it matter where the closing occurs, or what law governs? Or if a foreign or U.S. broker is involved? What if a U.S. buyer and a U.S. seller agree to execute a transaction in a foreign market? These questions will be answered only through the process of judicial application of the Morrison decision. Further, while the Morrison decision only addresses Section 10(b) of the Exchange Act, the reasoning may apply to all sections of the Exchange Act, which could have the effect of significantly limiting the SEC’s ability to regulate cross-border activity. Indeed, the reasoning also may apply to other federal securities statutes, such as the Securities Act of 1933, the Investment Advisers Act of 1940 and the Investment Company Act of 1940, that do not explicitly include grants of extraterritorial jurisdiction.
SEC Enforcement Actions
The Court’s decision clearly precludes private parties from bringing § 10(b) actions where the relevant securities were purchased or sold abroad and are not listed on a domestic exchange. The majority opinion does not, however, specifically address SEC enforcement actions. Justice Stevens’ concurring opinion seeks to carve SEC actions out of the ruling on the ground that “they. . .pose a lesser threat to international comity.” However, many SEC enforcement actions are based on the very same statute and rule as private actions — namely, § 10(b) and Rule 10b-5. The view that SEC enforcement actions are unaffected by this ruling appears inconsistent with the majority’s focus on the terms of the statute and the presumption against extraterritorial application.
Congressional Action to Preserve Federal Enforcement Proceedings in Light of the Morrison Decision
A Congressional Conference Committee has just approved legislation under Title IX of the newly renamed Dodd-Frank Act that would establish, in proceedings brought by the SEC or the United States, extraterritorial jurisdiction under the antifraud provisions of the Securities, Exchange, Investment Advisers and Investment Company Acts for “(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” See H.R. 4173, Additional Proposed Amendments to Title IX, p. 20-23 (June 15, 2010), Section 929P(b).
This legislative language would preserve the jurisdiction of the SEC to bring civil enforcement actions, and the U.S. Department of Justice to institute criminal proceedings, alleging violations of these antifraud provisions. The language does not, however, reverse the impact of Morrison on private actions. However, Section 929Y of the proposed Dodd-Frank Act provides that the SEC is to solicit public comment and then conduct a study on the extent to which the conduct-and-effects test applicable to the SEC and DOJ should also be extended to cover private rights of action. The SEC study is to consider whether such extraterritorial rights should be extended to all private actors or just institutional investors, the impact on international comity, economic costs and benefits, and whether a narrower standard should be adopted. Further, the legislative language does not appear to preserve the SEC’s ability to regulate the extraterritorial activities of regulated entities such as broker-dealers and investment advisers.
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1 National’s ADRs on the NYSE represent the right to receive a specified number of National’s Ordinary Shares.
2 EEOC v. Arabian American Oil Co., 499 U.S. 244, 248 (1991) (internal citations and quotations omitted).
3 Smith v. United States, 507 U.S. 197, 204 n.5 (1993).
4 As Justice Stevens pointed out in his concurring opinion in Morrison, the Aramco decision was quickly abrogated by statute.
5 The Court held that the Second Circuit erroneously considered the question of section 10(b)’s extraterritorial reach to raise a question of subject-matter jurisdiction, and held instead that the issue was a “merits question.”
6 SEC v. Berger, 322 F.3d 187, 192-3 (2d Cir. 2003); see Leasco Data Processing Equip. Corp. v. Maxwell, 468 F. 2d 1326 (2d Cir. 1972); see also Schoenbaum v. Firstbrook, 405 F.2d 200 (2d Cir. 1968).
7 One of the original plaintiffs in Morrison was an American who had had purchased National’s ADRs, but his claims were dismissed for failure to allege damages and there was no appeal of that dismissal.
This article was originally published by Bingham McCutchen LLP.