SEC Urges Supreme Court Approval of Significant Domestic Conduct Standard in Applying Extraterritorial Reach of US Securities Laws

Although a Second Circuit panel correctly dismissed a foreign-cubed case, the SEC told the US Supreme Court, the panel erred in treating the limits on the transnational application of the Exchange Act’s antifraud provisions as constraints on its subject matter jurisdiction. The statutory provisions that grant the federal courts jurisdiction over claims arising under Section 10(b) do not make that jurisdiction contingent on any link between the United States and the alleged fraudulent conduct, said the SEC in its amicus brief. Instead, the restrictions on the transnational application of Section 10(b) derive from limits on the scope of the statutory prohibition and the associated private right of action.

The Supreme Court has scheduled oral argument for March 29, 2010 on 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 is reviewing a Second Circuit panel ruling 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. Morrison v. National Australian Bank, Ltd., CA-2, Dkt. No. 08-1191

According to the SEC, the panel was also mistaken in suggesting that a securities fraud must involve predominantly domestic conduct in order to violate Section 10(b). The Commission said that transnational securities fraud violates Section 10(b) if significant conduct material to the fraud’s success occurs in the US. That standard advances Section 10(b)’s goals of ensuring high ethical standards in the securities industry and protecting investors, reasoned the Commission, and conserves American enforcement resources for regulation of conduct that presents substantial domestic concerns. A more restrictive standard for Section 10(b) coverage would risk permitting the US to become a base for orchestrating securities frauds for export, warned the SEC, an approach that would erode ethical standards in the securities industry and undermine investor confidence.

The SEC also said that a statutory violation alone, however, does not entitle a private plaintiff to relief under Rule 10b-5’s implied right of action. That right of action includes additional elements, most significantly a requirement that investors establish a direct causal link between the defendant’s violation and their own economic injury. To satisfy that requirement in a suit alleging transnational securities fraud, investors should be required to prove that their injury was a direct result of the component of the fraud that occurred in the United States. A direct injury requirement reduces the risk of conflict with foreign nations presented by application of Section 10(b)’s private remedy to multinational conduct, argued the SEC, and also alleviates the danger that the resources of US courts will be diverted to redress harms having only an attenuated connection to the US.

Under these standards, concluded the SEC, the investors’ action here was correctly dismissed. The investors alleged that false information was generated in the US with the expectation that it would be transmitted to foreign investors abroad. The US conduct did not directly cause the investors’ injury, however, because the false information reached investors only after it was deliberately incorporated by persons acting abroad into financial statements issued abroad. Accordingly, the investors failed to state a valid claim for relief.

Unfortunately, the text of Section 10(b) sheds little light on when a transnational securities fraud falls within its prohibition. Federal courts have uniformly agreed that Section 10(b) can apply to a transnational securities fraud either when fraudulent conduct has effects in the US or when sufficient conduct relevant to the fraud occurs in the US. Although the courts broadly agree that domestic conduct can be significant enough to trigger coverage under Section 10(b) even when the effects of the fraud are felt elsewhere, noted the Commission, they have not been entirely uniform in their view about how much domestic conduct is necessary.

In the SEC’s view, a transnational securities fraud violates Section 10(b) when the fraud involves significant conduct in the US that is material to the fraud’s success. Under that standard, the US conduct must comprise a significant amount of the conduct constituting a violation and must be integral, rather than ancillary, to the fraud. For example, Section 10(b) would apply when misrepresentations are made in the US, when the fraud is masterminded from the US, or when the transaction that consummates the fraud takes place on US markets. But Section 10(b) would not apply when all that occurs in the US are meetings or communications that are incidental to the fraud.

The SEC posited that this standard strikes the appropriate balance between advancing Section 10(b)’s goals and conserving the limited resources of US enforcement agencies for regulation of securities-related conduct that has a substantial connection to the United States. Moreover, interpreting Section 10(b) to prohibit frauds involving significant and material conduct in the US furthers those goals. It ensures that the US does not become a “Barbary Coast’’ harboring international securities pirates who use the US as a base for manufacturing fraudulent security devices for export. If individuals in the US could peddle frauds to foreign victims with impunity, reasoned the SEC, ethical standards in the domestic securities industry would decline and investors both abroad and at home would lose confidence in US securities markets.

The significant and material domestic component also advances the important purpose of protecting US investors against fraud. Even if a fraud is currently directed at overseas investors, reasoned the SEC, the danger always exists that the wrongdoers will begin targeting domestic investors. In addition, if the US interprets its securities laws to prohibit fraudulent domestic conduct that injures overseas investors, other countries are more likely to offer comparable protection to American investors. Finally, the standard advanced by the SEC avoids international friction that might result if the US attempted to apply its laws to securities-related conduct that has little relationship domestically.

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