SUPREME COURT RULES ON REACH OF SECURITIES FRAUD STATUTE AND VIABLITY OF F-CUBED CLASS ACTIONS

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1 SUPREME COURT RULES ON REACH OF SECURITIES FRAUD STATUTE AND VIABLITY OF F-CUBED CLASS ACTIONS By: Bryan Erman 1 The United States Supreme Court recently held, in Morrison v. National Australia Bank, Ltd. ( NAB ), that Section 10(b) of the Securities and Exchange Act ( Exchange Act ) does not apply to stock transactions occurring outside of the United States, even when the fraud at issue occurred in the United States and the fraud s effect was felt in domestic markets. The decision resolves a disagreement among courts and commentators over the reach of United States securities laws. The Court s opinion also signals an end to so-called F-cubed securities fraud claims claims brought against foreign issuers by foreign investors that bought or sold stock on foreign exchanges. Section 10(b) and its companion SEC Rule, 10b-5, prohibit untrue statements or omissions of material fact, fraud, deceit, or any scheme or device to defraud in connection with the purchase or sale of a security. 2 Section 10(b) represents one of the most widely litigated securities statutes, and the frequency of class actions attempting to use Section 10(b) to assert claims on behalf of foreign investors or investors in stock issued by foreign companies has rapidly increased. 3 At issue in NAB was when, if at all, Section 10(b) could be applied to investors or issuers of stock outside of the United States. The common stock of NAB, the largest bank in Australia at the time, was traded on Australian and other foreign exchanges, but not in the United States. 4 In 1998, NAB bought HomeSide Lending, Inc. ( HomeSide ), a Florida-based mortgage 1 Bryan Erman is an associate at Carrington, Coleman, Sloman, & Blumenthal, L.L.P. in Dallas U.S.C. 78j(b) (2009); 17 C.F.R b-5 (2009). 3 See Julie B. Rubenstein, Fraud on The Global Market, 95 CORNELL L. REV. 627, 629 (2010) (citing studies demonstrating the increase in class actions that include foreign investors and that target foreign issuers). 4 NAB, 561 U.S., 1 (2010).

2 servicing company. 5 After NAB touted the value of HomeSide s assets in both financial statements and other public statements, NAB announced a $450 million write-down of HomeSide s assets on July 5, 2001 and the value of its stock declined. 6 A class of plaintiffs that included Australian investors sued under Sections 10(b) and 20(a) of the Exchange Act, alleging that NAB, HomeSide, and their executives failed to disclose the true value of HomeSide s assets. 7 The fraud alleged by plaintiff involved a scheme whereby HomeSide executives in Florida intentionally overvalued the company s assets and provided the misleading valuations to NAB in Australia to be incorporated in its financial statements. The United States District Court for the Southern District of New York dismissed the plaintiffs securities fraud claims, and the Second Circuit affirmed, holding that the plaintiffs claims lacked sufficient connection to the United States to justify application of United States securities laws. 8 Importantly, however, the Second Circuit held that foreign purchasers could sue under Section 10(b) if the conduct complained of and the effects of the fraud had a sufficient connection to the United States. 9 According to the Second Circuit, courts must look to whether the harm was perpetuated here or abroad and whether it affected domestic markets and investors. 10 Therefore, while the claims in NAB lacked a sufficient connection to the United States, the Second Circuit would allow other Section 10(b) claims involving foreign issuers or foreign investors if enough of the fraud or the fraud s effect occurred in the United States. Other courts had applied varying formulations of the test for determining whether securities laws applied to transactions occurring partially outside of the country. As the Seventh 5 Id. at Id. at 2. 7 Id. at In re Nat l Austl. Bank Sec. Litig., No. 03 Civ (BSJ), 2006 WL , *8 (S.D.N.Y. Oct. 25, 2006); Morrison v. Nat l Austl. Bank Ltd., 547 F.3d 167, 177 (2d Cir. 2008) ( Morrison ). 9 Morrison, 547 F.3d at Id.

3 Circuit noted, [a]lthough the circuits... seem to agree that there are some transnational situations to which the antifraud provisions of the securities laws are applicable, agreement appears to end at that point. 11 Generally, however, most courts allowed Section 10(b) to be applied to some foreign transactions, and looked to whether the fraudulent conduct occurred in the United States or the fraud affected domestic markets to determine when Section 10(b) applied. The tests employed by these courts have commonly been referred to as the conduct and effects tests. 12 Therefore, the question the Supreme Court set out to address in NAB was when, if at all, Section 10(b) applied to transactions occurring outside of the United States. In an opinion written by Justice Antonin Scalia, the Court held that the reach of Section 10(b) was limited to securities traded on United States exchanges and other domestic transactions not involving foreign exchanges. 13 In doing so, the Court concluded that the Second Circuit s test, and any other test that would extend the reach of Section 10(b) to purchases and sales of stock outside of the United States, were improper. Central to the Court s decision was 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. 14 The Court held that, if the statute does not indicate any foreign application, it has none. 15 Applying this principle, the Court determined that there was no indication that Congress intended that Section 10(b) apply to transactions occurring outside of the United States. The 11 Kauthar SDN BHD v. Sternberg, 149 F.3d 659, 665 (7th Cir. 1998). 12 See, e.g., In re China Life Sec. Litig., No. 04 Civ. 2112(TPG), WL , *9 (S.D.N.Y. Sept. 3, 2009). 13 Justices Roberts, Kennedy, Thomas and Alito joined in the opinion written by Justice Scalia. Justices Breyer, Stevens, and Ginsburg filed opinions concurring in the Court s judgment. Justice Sotomayor, who was on the Second Circuit (but not the panel that decided the case) when NAB was before that court, took no part in the decision. 14 NAB, 561 U.S. at 5 (internal quotations omitted). 15 Id. at 6.

4 Court rejected the arguments of the plaintiffs and the Solicitor General that references throughout the Exchange Act indicated Congress desire that Section 10(b) be applied abroad. 16 Specifically, the plaintiffs and the Solicitor General argued that Section 10(b) covers the use of any means or instrumentality of interstate commerce and that interstate commerce is defined in the Exchange Act as trade between any foreign country and any State. 17 Citing its previous holding finding that references to foreign commerce in statutes do not authorize application outside of the United States, the Court concluded that the general reference to international commerce in the Exchange Act did not overcome the presumption against foreign application. 18 The Court held that there is no affirmative indication in the Exchange Act that 10(b) applies extraterritorially, and we therefore conclude that it does not. 19 Relying on the Second Circuit s conduct and effects tests, Plaintiffs had argued that the claims at issue did not actually require foreign application of Section 10(b) because HomeSide and its executives had engaged in fraudulent activity in Florida. The Court also rejected this argument, holding that the presumption against foreign application of statutes cannot be circumvented by alleging some connection to the United States. The Court held that the proper inquiry in determining whether Section 10(b) applied to a transaction was where the purchase or sale of securities occurred, not where the deceptive conduct emanated or where the effects were felt. 20 Accordingly, only transactions in securities listed on domestic exchanges and domestic transactions in other securities are covered by Section 10(b). 21 The Court declined to explain 16 Id. at U.S.C. 78j(b) and 78c(a)(17) (2009). 18 Id. at (citing EEOC v. Arabian Am. Oil Co., Inc. v. Filardo, 366 U.S. 281, 285 (1949)). 19 Id. at Id. at Id. at 18.

5 what constitutes a domestic transaction in stock not listed on a United States exchange. Given the Court s emphasis on where the transaction occurred, however, these transactions would likely need to involve purchases or sales occurring in the United States to be covered by Section 10(b). Because the Australian plaintiffs had purchased the NAB stock on exchanges outside of the United States, the Court held Section 10(b) did not apply to their transactions. 22 The Court s decision will have a significant effect on the increasingly frequent F-cubed securities class actions. After the decision in NAB, only investors that bought or sold stock in the United States can bring claims under Section 10(b). Therefore, it appears that Section 10(b) will not reach stock transactions where the purchase or sale occurred abroad, regardless of how much of the fraud occurred in the United States or how much the effect of the fraud is felt domestically. 22 Id. at 24.

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