In the Morrison v. National Australia Bank ("NAB") case, the U.S. Supreme Court has held that Section 10(b) of the Exchange Act applies only to transactions in securities listed on U.S. exchanges and to U.S. transactions in other securities. The 8-0 decision (Justice Sotomayor did not participate) authored by Justice Scalia thus rejects the use of the conduct/effects test to determine the extraterritorial application of the U.S. anti-fraud securities laws.
In NAB, the court considered a so-called "foreign-cubed" securities case - i.e., a securities class action brought against a foreign issuer by foreign investors who purchased their securities on a foreign exchange. The Second Circuit applied its existing "conduct test" for determining the extraterritorial application of Section 10(b) and held that the plaintiffs needed to adequately allege that "activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad." The court found that this test was not met in NAB because the locus of the fraudulent activity, including the issuance of the false statements, was in Australia.
On appeal, the Supreme Court reached the same result, but took a notably different approach.
First, the Court found (contrary to the Second Circuit and other lower federal courts) that the extraterritorial application of Section 10(b) does not "raise a question of subject-matter jurisdiction." Instead, it is an issue of "what conduct Section 10(b) prohibits, which is a merits question."
Second, it is a longstanding principle that Congressional legislation, "unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States." The fact that the "Exchange Act is silent as to the extraterritorial application of Section 10(b)" does not give courts license to speculate as to what Congress would have wanted. In the absence of any "affirmative indication" that Section 10(b) applies extraterritorially, the Court concluded "that it does not."
Finally, the Court addressed the plaintiffs' contention that even if Section 10(b) does not apply extraterritorially, there was sufficient deceptive conduct in the U.S. to make it a "domestic" case. Although the Court agreed that applying the presumption against extraterritorial application may require analysis, the presumption "would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case." The Court found that the focus should be on the location of the securities transaction, not "the place where the deception originated." Accordingly, it is "only transactions in securities listed on our domestic exchanges, and domestic transactions in other securities, to which Section 10(b) applies."
Notes on the Decision
(1) Although technically a unanimous decision, the concurrence written by Justice Stevens (and joined by Justice Ginsburg) effectively acted as a dissent. The justices urged affirmance on the grounds set forth in the Second Circuit's opinion.
(2) The Court's bright-line rule would appear easy to apply. One can envision fact patterns, however, that might make it difficult to assess whether a securities transaction is "domestic" (i.e., has taken place within the United States).
(3) While the decision does not discuss whether it applies to the SEC, there is no principled reason why the Court's construction of Section 10(b) would not extend beyond private plaintiffs. Congress has been considering a codification of the extraterritorial application of Section 10(b). By indirectly limiting the scope of the SEC's authority, the Court may have improved the prospects for such legislation.
(4) The Court showed some sympathy for the argument that the extraterritorial application of Section 10(b) will encourage suits of questionable merit and compromise the ability of foreign countries to regulate their own securities markets. To wit: "While there is no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets, some fear that it has become the Shangri-La of class action litigation for lawyers representing those allegedly cheated in foreign securities markets."
The U.S. Supreme Court is going to address the issue of materiality in securities fraud cases, albeit in the limited context of actions based on a drug company's nondisclosure of "adverse event" reports.
Yesterday, the Court granted cert in the Matrixx Initiatives, Inc. v. Siracusano (9th Circuit) case. In Matrixx, the Ninth Circuit found that a drug company can be liable for failing to disclose adverse event reports (i.e., reports by users of a drug that they experienced an adverse event after using the drug) even if those reports were not statistically significant. The First, Second, and Third Circuits, however, have held that statistical significance is required to make the nondisclosure of the reports material. The Court will resolve the circuit split.
SCOTUSBlog has links to the cert petition papers. Although the question presented is narrow, the case may have wider ramifications if the Court offers guidance on its general materiality standard. Matrixx will be heard in the October term.
In Freudenberg v. E*TRADE Financial Corp., 2010 WL 1904314 (S.D.N.Y. May 11. 2010), the plaintiffs alleged that E*TRADE had fraudulently concealed the high risk nature and deterioration of the company's mortgage portfolio. The court's decision, which denies the defendants' motion to dismiss, addresses a couple of interesting topics.
(1) Rule 10b5-1 stock trading plans - The utility of a Rule 10b5-1 stock trading plan in defeating the inference of scienter caused by large stock sales varies widely. (The 10b-5 Daily's most recent post on the topic, with links to other relevant posts, can be found here.) In the E*TRADE case, the individual defendants had entered into their plans during the class period. In other words, they allegedly "were already aware of the Company's mortgage exposure time bombs" when they decided to sell shares. Under these circumstances, the court declined to find that any inference of scienter created by the stock sales was dispelled.
(2) Announcement of SEC investigation - On the last day of the class period, E*TRADE announced additional mortgage losses , withdrew its guidance, and disclosed that the SEC has commenced an investigation. The company's stock price declined significantly. The court found that the announcement of the SEC investigation, which was "linked to the purportedly fraudulent misconduct," was within the "zone of risk" concealed by E*TRADE's alleged misrepresentations. As a result, it was "akin to a corrective disclosure" and could be used to adequately plead loss causation. (A post by The 10b-5 Daily on a contrary decision can be found here.)
Holding: Motion to dismiss denied.
Under the collective scienter theory, it is possible for a plaintiff to adequately plead scienter with respect to a corporate defendant even where the plaintiff is unable to adequately plead scienter with respect to any individual corporate employee who made a false statement. There is a circuit split on the issue, with the Second Circuit and Seventh Circuit adopting the theory and the Fifth Circuit rejecting the theory. That leaves a lot of room for district courts in other circuits to come to their own conclusions.
In City of Roseville Employees' Retirement System v. Horizon Lines, Inc., 2010 WL 1994693 (D. Del. May 18, 2010), the court considered the potential liability of the corporate defendants (Horizon and a wholly-owned subsidiary) for making false statements related to a price fixing conspiracy. Certain of the corporate defendants' officers had already plead guilty to price fixing. The court declined to apply the collective scienter theory, finding that the Third Circuit's rejection of group pleading (i.e., the presumption that the senior officers of a company are collectively responsible for any misrepresentations contained in the company's public statements) made the appellate court unlikely to adopt collective scienter. Instead, the court followed the Fifth Circuit's requirement that there must be "a showing that at least one individual officer who made, or participated in the making of, a false or misleading statement did so with scienter."
The officers who had plead guilty to criminal charges were not alleged to have made any public statements on behalf of the corporate defendants. Nevertheless, the plaintiffs argued that these officers "participated" in the making of the statements because the corporations must have obtained the false data from them. As a result, the plaintiffs argued, the scienter of these officers should be imputed to the corporations. The plaintiffs provided no facts to support their assertion about the source of the false data and the court declined to find that corporate scienter had been adequately established.
Holding: Complaint dismissed with prejudice as to certain defendants.