US Supreme Court restricts the extra-territorial application of US securities legislation

In a decision of great significance to non-US issuers and their shareholders, the US Supreme Court has clarified and restricted the extra-territorial application of the anti-fraud provisions of US federal securities laws.

On 24 June 2010, the US Supreme Court issued its much anticipated decision in the case of Morrison v National Australia Bank. In Morrison, the Supreme Court considered for the first time the application of US securities anti-fraud legislation in a "foreign-cubed" securities action, that is, one in which: (i) a foreign (ie, non-US) plaintiff sues (ii) a foreign issuer in respect of (iii) shares listed on a foreign exchange.

In its decision, the Supreme Court has replaced the former subjective "conduct" and "effects" test with a more objective "transactional" test, under which section 10(b) of the Securities Exchange Act 1934, as amended (the "Exchange Act") and Rule 10b-5 thereunder will apply only in connection with: (i) the sale or purchase of a security listed on a US exchange; or (ii) the sale or purchase of any other security in the US. The Supreme Court’s new test focuses on the location of the transaction in question, rather than where the alleged fraud occurred.

This transactional test significantly restricts the application of section 10(b) of the Exchange Act, such that private plaintiffs will have great difficulty claiming subject matter jurisdiction to bring a foreign-cubed securities action before the US federal courts. Further, US shareholders will face similar difficulties bringing claims that relate to the acquisition of securities registered on a non-US exchange if the purchase or sale took place outside of the US. The holding is likely to reverse the recent trend of non-US shareholders seeking redress in US courts for alleged fraud taking place outside the US, as in the recent In re Vivendi Universal case.

Facts

The defendant, National Australia Bank ("NAB") is a bank incorporated in Australia with its headquarters in Melbourne. Its shares are listed on the Australian Securities Exchange, together with the stock exchanges of London, Tokyo and New Zealand.

The relevant plaintiffs were Australian residents who purchased ordinary shares of NAB outside the US, and who sought to represent a class of non-US purchasers who acquired such shares at allegedly inflated prices.

The plaintiffs brought an action against NAB, and a number of its officers and directors, in the Southern District of New York alleging violations of the anti-fraud provisions of the Exchange Act. The claim centred on statements made by NAB in Australia, in respect of a US subsidiary called HomeSide Lending which is based in Florida. The plaintiffs alleged that "HomeSide knowingly used unreasonably optimistic valuation assumptions or methodologies" and made materially false and misleading public statements concerning HomeSide’s profitability and financial condition with respect to its profit contributions to NAB. The plaintiffs argued that the central aspect of the alleged fraud was HomeSide’s manipulation of information in Florida and that the statements made by NAB in Australia merely consisted of inserting HomeSide’s incorrect statements into the public filings.

The New York Court dismissed the claims of the non-US plaintiffs for lack of subject matter jurisdiction on the basis that the alleged fraud had an insufficient connection to the US.

The decision of the Court of Appeals for the Second Circuit

The non-US plaintiffs appealed the portion of the judgment dismissing their claims for lack of subject matter jurisdiction to the Court of Appeals for the Second Circuit. The defendants, supported by a number of third parties who filed briefs as amici curiae, urged the Court of Appeals to adopt a bright-line rule that there should be no subject matter jurisdiction in foreign-cubed securities actions.

The Court of Appeals declined to adopt a bright-line rule. Instead, it affirmed the application of the "conduct" and "effects" test it had developed to determine whether the court has subject matter jurisdiction, in light of the fact that the Exchange Act’s anti-fraud provisions are silent as to its extra-territorial application. That test required the court to consider: (i) whether the wrongful conduct occurred in the US; or (ii) whether the wrongful conduct had a substantial effect in the US or on US citizens. In Morrison, the plaintiffs relied only on the conduct component of the test.

Applying the "conduct" and "effects" test, the Court of Appeals reasoned that the US courts did not have subject matter jurisdiction, finding that: (i) although some conduct had occurred in the United States, Australia was "the heart of the alleged fraud"; (ii) there was a "striking absence" of any allegation that the alleged fraud affected US investors or capital markets in the US; and (iii) there was a "lengthy chain of causation" between the US contribution to the alleged misstatements and the harm to investors.

In rejecting a bright-line rule urged by the defendants, the Court of Appeals held that declining jurisdiction in all foreign-cubed securities actions would conflict with the goal of preventing the export of fraud from the US. It also held that the potential conflict between US securities laws and those of other countries does not justify the adoption of a blanket prohibition on such suits by private plaintiffs, as anti-fraud enforcement objectives are broadly similar worldwide.

On 30 November 2009 the Supreme Court granted the plaintiffs’ petition for a writ of certiorari to allow them to appeal the decision of the Court of Appeals to the Supreme Court.

The Supreme Court’s decision

Again, a significant number of interested third parties filed amicus curiae briefs to the Supreme Court. These third parties included the US Government, US and international trade, academic and legal bodies and foreign Governments such as those of the United Kingdom, Australia and France.

The US Solicitor General on behalf of the US Government advocated a test which would require the US Courts to examine whether "the fraud involves significant conduct in the United States that is material to the fraud’s success". The plaintiffs strongly supported this test which they argued would provide a unified standard and resolve the split among the judicial Circuits as to the application of the traditional "conduct" and "effects" test.

The defendants, supported by a significant number of amici curiae, urged the Supreme Court to adopt a brightline rule that would limit the persons able to seek remedy under the Exchange Act to those who have purchased or sold securities in the US. A number of amici curiae, including the British Government, further argued that if the Supreme Court allowed the plaintiffs’ appeal, there would be a danger of violating and interfering with relevant laws of other countries which would: (i) evade the remedial procedures of another country on the basis that the US is perceived to be the easiest forum in which to recover damages resulting from alleged securities fraud; and (ii) affect a foreign nation’s ability to regulate independently its own commercial affairs.

The Supreme Court affirmed the Court of Appeals’s dismissal of the plaintiffs’ claim, though not its reasoning. In its decision, the Supreme Court first corrected a "threshold error" by the Court of Appeals, emphasising that the central issue to be decided was not one of subject matter jurisdiction, but of the scope of section 10(b) of the Exchange Act and whether it had extra-territorial application. In doing so, the Supreme Court applied the longstanding principle of statutory interpretation that, absent clear intent to the contrary, a Congressional statute is meant to apply only within the territorial limits of the US. The Supreme Court found no affirmative indication in the Exchange Act that section 10(b) was intended by Congress to have extra-territorial effect.

The Supreme Court held that the focus of the Exchange Act is not on the place where the alleged deception originated, but upon the purchases and sales of securities in the US. The Supreme Court thereby decided that section 10(b) does not seek to punish deceptive conduct, but only deceptive conduct in connection with the sale or purchase of securities listed on a US exchange or other securities sold or purchased in the US. It is only such transactions, the Supreme Court held, that the statute seeks to regulate.

Finally, the Supreme Court noted that countries outside of the United States regulate their domestic exchanges and securities transactions occurring within their territorial jurisdiction. In this regard, the Supreme Court acknowledged the submissions made by the British, Australian and French Governments that a clear test would avoid the potential interference of section 10(b) with non- US securities laws. The Supreme Court suggests that the new transactional test will achieve that result.

Congressional action

In the aftermath of Morrison, the extra-territorial application of the anti-fraud provisions of the Exchange Act will also be affected by ongoing financial sector reform legislation in the US. The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which is expected to be approved by Congress this week before being sent to President Obama for signature into law, would amend the Exchange Act and other US federal securities legislation to grant jurisdiction to US federal courts in enforcement actions brought by regulators including the US Securities Exchange Commission (the "SEC").

The Dodd-Frank Act would specifically authorise SEC enforcement actions where there is "(i) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the violation is committed by a foreign adviser and involves only foreign investors; or (ii) conduct occurring outside the United States that has a foreseeable substantial effect within the United States." The intent of the Congress is to reserve the right for the SEC to pursue enforcement actions even in cases where the Morrison holding would not permit a private claim. The Dodd-Frank Act is currently silent on the extra-territorial application of the anti-fraud provisions for private investor lawsuits.

Comment

In recent years, a growing number of non-US shareholders have sought to bring claims against non-US issuers in the US courts through class action litigation. In particular, the financial crisis has given rise to a significant number of securities class action claims in the US against non-US financial institutions and operating companies for alleged violations of US anti-fraud rules. More recently, class actions have been filed in the US courts against BP by shareholders, including non-US shareholders, alleging that they were misled with regard to BP’s safety and crisis management procedures.

The costs and risks involved in US class action litigation are notoriously high. Non-US issuers will welcome the establishment of the transactional test which not only restricts their potential exposure to those costs and risks, but provides much needed certainty in this area.

Shareholders of non-US issuers may be less pleased with the Supreme Court’s decision as a relatively low cost and low risk route to redress seems to have been closed to them. The Supreme Court’s decision is likely to cause aggrieved shareholders to turn to domestic courts. This will increase the focus once again on the procedures for collective actions in the UK and elsewhere.