Tuesday, December 20, 2011

Chamber of Commerce Urges SEC Not to Recommend Legislation Altering Supreme Court Ruling on Transnational Securities Fraud

In a letter to the SEC, the US Chamber of Commerce said there is no basis for the Commission to recommend congressional action to alter the US Supreme Court’s ruling in Morrison setting a transactional test for the extraterritorial application of the federal securities laws. In its 2010 ruling in Morrison v. National Australia Bank, the Court found that securities antifraud provisions applied to transactions in securities listed on domestic exchanges, and domestic transactions in other securities. The Chamber noted that the United States should not create a new, extraterritorial private cause of action for securities fraud to overturn the Supreme Court’s decision. The letter references Section 929Y of the Dodd-Frank Act, which directs the SEC to conduct a study to determine the extent to which private rights of action under the antifraud provisions of the Exchange Act should be extended to cover transnational securities fraud.

The Chamber’s review of post-Morrison decisions revealed that the federal courts have been consistently and appropriately applying Morrison. When a transaction occurs in the United States, courts have been permitting claims under the antifraud rule. Conversely, when a transaction occurs abroad, courts have been deferring to the judgment of foreign nations on the appropriate security enforcement mechanisms. Moreover, there is no indication that the application of the principles set forth in Morrison is leaving unsophisticated U.S. investors without a remedy that they believed to have been available or leaving any U.S. investors without protection. To the contrary, said the Chamber, the off-exchange transactions to which Morrison is being applied are highly complex transactions entered into by extremely sophisticated investors able to ascertain the governing remedial laws, which in virtually all cases have been the well-developed laws of key U.S. allies and trading partners.

Following Morrison, courts have concluded that the purchase of securities by foreigners on a foreign market cannot be the basis for a Section 10(b) claim. Similarly, courts have universally extended Morrison’s transactional test to reject also claims where U.S. individuals purchase securities of a foreign issuer on a foreign exchange. In both of these situations, reasoned the Chamber, the investor is purchasing shares on a non-U.S. exchange, and, there is little chance that the investor could mistakenly believe that U.S. laws apply. Moreover, because the foreign exchanges are supervised by sophisticated regulators there is little chance that the investor will be left unprotected.

Although the Supreme Court in Morrison did not explicitly define the phrase domestic transactions, courts have found that the phrase was intended to be a reference to the location of the transaction, not to the location of the purchaser and that the Supreme Court clearly sought to bar claims based on purchases and sales of foreign securities on foreign exchanges, even though the purchasers were American. See In re Vivendi Universal Securities Litigation, (SDNY 2011).

The Chamber also observed that courts have correctly concluded that when a plaintiff purchases the securities issued by a defendant on a U.S. exchange, a Section 10(b) remedy is available against the issuer for fraudulent conduct. This principle applies even when the fraudulent conduct occurs abroad. But when a foreign issuer lists securities on both foreign and domestic exchanges, Section 10(b) extends only to parties to transactions that occur on a U.S. exchange

Swap agreements can replicate other securities transactions, such as purchasing or shorting company stock. These transactions are synthetic in the sense that gains and losses are the product of contracts and the parties need not actually own the underlying security instrument at issue. The economic reality of such swap agreements determines whether it is foreign or domestic for Morrison purposes. Thus, when a swap agreement is functionally indistinguishable from purchasing or shorting stock on a foreign market, it must he treated as a foreign transaction and thus outside the scope of the federal antifraud rule.

Similarly, contracts for difference are another type of synthetic security pegged to an underlying since they are derivative instruments allowing a trader to take a long or short position on an underlying financial instrument without actually owning it.

A federal district court recently concluded that foreign purchases of contracts for difference nonetheless fell within Section 10(b) when the underlying referent is a stock traded on a U.S. exchange. See SEC v. Compania Internacional Financeria SA (SDNY 2011). As with swap-based agreements, the Court looked to the economic reality of the transaction. As the transaction was indistinguishable from the purchase of a U.S. security, and indeed likely caused the provider to purchase U.S. securities, it properly fell within the scope of U.S. regulation.

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