Supreme Court to Decide International Reach of US Federal Securities Laws

The Supreme Court will decide the extraterritorial reach of the US federal securities laws in what appears to be the first foreign cubed case to ever reach the Court. The Court agreed to review a Second Circuit panel ruing that the US federal securities laws did not apply to foreign investors alleging fraudulent statements by a foreign issuer when the conduct in the US was merely preparatory to the fraud and the acts directly causing loss to investors occurred outside the US. The panel described itself as an American court, not the world’s court, which cannot expend resources resolving cases that do not affect Americans or involve fraud emanating from America. Morrison v. National Australian Bank, Ltd., CA-2, Dkt. No. 08-1191.

Foreign investors alleged that a US subsidiary sent false financial information to its Australian parent company, which in turn created and distributed public filings incorporating the false statements. The main issue before the court was what conduct comprised the heart of the alleged fraud. The appeals panel concluded that actions taken by the parent company in Australia were significantly more central to the fraud, and more directly responsible for harming investors, than the alleged manipulation at the US subsidiary. The parent was the public company with oversight over all corporate operations and the duty to file accurate financial statements to the outside world.

The rapid globalization of financial markets in recent years has cast into stark relief issues surrounding the international reach of US securities laws. Since the federal securities laws are silent on their international reach, federal courts developed tests, including the conduct test, which focuses on the nature of the conduct within the US as it relates to carrying out the alleged fraudulent scheme

A three-way split has developed among the federal Circuit Courts of Appeal as to the proper scope of jurisdiction when conduct within the US results in fraud in connection with a transaction outside the US. The predominant difference among the Circuits is the degree to which the US-based conduct must be related causally to the fraud and the resulting harm to justify the application of the federal securities laws.The Third, Eighth and Ninth Circuits have held that jurisdiction may be exercised when conduct within the US furthered the alleged fraud The Second, Fifth and Seventh Circuits have established a more restrictive test, holding that jurisdiction may be exercised only when conduct occurring within the US directly caused the alleged losses. Finally, the District of Columbia Circuit has adopted the most stringent test, holding that jurisdiction is proper only when the fraudulent statements or misrepresentations originate in the United States, are made with scienter and in connection with the purchase or sale of securities, and directly cause the harm to those who claim to be defrauded, even if reliance and damages occur elsewhere.

On the Supreme Court’s invitation, SEC counsel and the U.S. Solicitor General filed an amicus brief while the Court considered whether to take the case. The brief urged the Court to let the dismissal of the fraud action against an Australian bank stand. While the government lawyers stated that the Second Circuit erred in characterizing the issue as one of subject matter jurisdiction, they believed that the court was correct in holding that the suit should not proceed.

But earlier, in an amicus brief in the Second Circuit, the SEC argued that US courts had jurisdiction since the information that made the statements in Australia false was generated in the US with the expectation that it would be distributed to foreign investors.

The SEC urged the Second Circuit to adopt a test under which the antifraud provisions of the securities laws would apply to transnational frauds that result exclusively or principally in overseas losses if the conduct in the US is material to the fraud’s success and forms a substantial component of the fraudulent scheme. The test proposed by the Commission is an articulation of the conduct test and describes when an injury is considered to be sufficiently directly caused by US conduct to support jurisdiction, reflecting the fact that the Court has upheld jurisdiction even though the last event in effectuating the fraudulent scheme did not occur in this country

A related purpose underlying the conduct test is ensuring international reciprocity. By extending US securities laws to prohibit fraudulent conduct in the US that injures overseas investors, explained the SEC, the US can reasonably expect other countries’ laws to offer comparable protection to prevent fraudulent conduct overseas that is directed towards US investors

A key phrase in the SEC’s proposed test is that the conduct in the US be "material to the fraud’s success." According to the SEC, the materiality inquiry would ensure that the domestic conduct was an integral link in the chain of events in the transnational fraud leading to the overseas investors’ losses. The SEC pointed out that the use of the term “materiality” for the jurisdictional inquiry under its proposed conduct test should not be confused with the different concept of “materiality” as an element of a fraud violation.The Commission believes that its proposed test sufficiently addresses concerns that an over-extension of US securities laws to foreign corporations whose shares trade overseas may discourage their investment in the United States. This concern must be balanced against the principle that the US should not be used as a base for engaging in fraudulent conduct that may injure foreign investors. The proposed standard strikes the proper balance by affording jurisdiction only where the conduct in the US constitutes a substantial portion of the fraud that is material to the success of the scheme.

In an amicus brief in the Second Circuit filed by the US Chamber of Commerce and the securities industry, it was argued that giving broad extraterritorial effect to federal securities fraud class action would reduce cross-border investment and deter foreign companies from accessing U.S. markets. For example, in this case, contended SIFMA, an Australian company listed on an Australian exchange with virtually all of its shareholders outside the United States faces the possibility of protracted litigation in the U.S. courts for alleged misstatements made to those non-U.S. investors.The industry brief goes on to assert that no Congressional mandate or judicial precedent requires opening U.S. courts to these foreign-cubed securities class actions brought by foreign plaintiffs against foreign issuers based on the purchase or sale of securities in foreign countries. On the contrary, contended the brief, principles of comity and effective judicial administration favor the resolution of these actions in the courts of other countries.

In its brief, the industry argued that the application of US securities regulation to fundamentally foreign disputes raises a host of policy concerns. For example, it risks weakening core principles of comity, as well as creating a reciprocal risk of exposing U.S. companies to securities litigation in virtually any jurisdiction in which they have a subsidiary, even if their shares are traded exclusively by US investors. The securities industry also raised the risk of arbitrariness and inequity, with different companies subject to different liability regimes dependent solely on tenuous factors arising out of the location of business operations or other considerations unrelated to the investor protection objectives of the U.S. securities laws.

As the Supreme Court reviews the extraterritorial reach of the federal securities laws, House draft legislation would provide for the transnational reach of the antifraud provisions of the Securities Act and the Exchange Act. The Investor Protection Act passed the Financial Services Committee and could be voted on by the full House in December as part of overall financial reform. There is currently no companion provision in the Senate draft legislation, the Restoring American Financial Stability Act.

Section 215 of the Investor Protection Act would amend both the 1933 and 1934 Acts to provide that US district courts have jurisdiction over violations of the antifraud provisions that involve a transnational fraud if there is 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.

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