Breaking News

Securities law’s overseas reach

At about 11 a.m. on Monday, the Supreme Court will hear one hour of oral argument in Morrison, et al., v. National Australia Bank, Ltd., et al. (08-1191).  Arguing for the overseas investors will be Thomas A. Dubbs of the New York City firm of Labaton Sucharow.  Representing the private Australian bank and others sued in the case will be George T. Conway III, of Wachtell, Lipton, Rosen & Katz in New York City.  Appearing for the U.S. government, as amicus supporting the bank and others, will be Matthew D. Roberts, an assistant to the U.S. Solicitor General, with ten minutes of time.  Justice Sonia Sotomayor is not taking part in judging the case.


The securities fraud law — a key provision of the Securities Exchange Act — has been in force for three-quarters of a century, but the Supreme Court has never ruled on whether it can be enforced against trans-national fraud.  Every U.S. Circuit Court has faced the issue, but there is wide disagreement about its reach.  Now, with investing — and fraud — an increasingly multi-national activity, the Supreme Court will attempt to sort out the conflict in a case involving an Australian bank with a U.S. subsidiary, based in Florida, that serviced home mortgages.  It is not an issue in the case, but the subsidiary eventually got caught up in the sub-prime mortgage meltdown in the U.S. economy, and got absorbed by a troubled financial institution.  Three Australian investors who claimed fraud remain in the case.  The case has attracted a broad international following.


When Congress passed the Securities Exchange Act in 1934, it said nothing at all about whether its anti-fraud provisions would apply to investment deals that took place at least partly outside the United States.  Only one thing remains clear to this day: if a fraudulent deal arose and was carried out entirely overseas, the Act does not apply.  The usual assumption is that, unless Congress says otherwise, a U.S. law applies only inside the country.  Investors in this country and abroad, however, have sought over the years to extend the law’s reach beyond America’s borders.  A number of lawsuits, for example, have been filed in U.S. courts by foreign investors who claimed they were defrauded by Bernard Madoff’s “Ponzi” scheme, which they say was “exported” to foreign soil.  Federal courts thus have attempted to work out what Congress might have intended, had it thought about it. They have not agreed on an answer.

Much of the focus in the federal courts has been on ways to apply the test most often used — that is, the “conduct” test, an inquiry into whether there has been significant conduct inside the U.S., as part of an alleged international fraud.

Some of the lower courts, while imagining that Congress would have wanted the law to reach fraud that did harm to investors or markets within the U.S., have urged Congress to step in and fill the gap in the Act’s language.  In the absence of a response from Congress, every Circuit Court in the U.S. has taken on the issue, searching for a formula for applying the bare language of the Act’s Section 10(b). That section makes it illegal for anyone, using the instruments of interstate commerce, a market, or the mail, to employ “any manipulative or deceptive device or contrivance” that would harm investors or “the public interest.”

In the Second Circuit Court, based in New York and thus the country’s busiest court in securities cases, this is the formula: “We look to whether the harm was perpetrated here or abroad and whether it affected domestic markets and investors.  This binary inquiry calls for the application of the ‘conduct test’ and the ‘effects test.’  We ask: (1) whether the wrongful conduct occurred in the United States, and (2) whether the wrongful conduct had a substantial effect in the United States or upon United States citizens.  Where appropriate, the two parts of the test are applied together because an admixture or combination of the two often gives a better picture of whether there is sufficient United States involvement to justify the exercise the exercise of jurisdiction by an American court.”

In this case, the Second Circuit was asked to apply only the “conduct” test.  That led it to rule that the Act’s 10(b) did not apply, thus it upheld a federal judge’s dismissal of the specific fraud claim.

(It should be noted, in passing, that while the case retains the name of a U.S. investor, Robert Morrison, in its title, his claim was dismissed by a federal judge for a failure to claim that he suffered any damages.  As the case went through the Circuit Court, and as it now unfolds in the Supreme Court, three Australians continue the case, but the title remains unchanged.)

The investors, pursuing a class-action remedy, had bought stock on the Australian Stock Exchange of that country’s largest bank, National Australia Bank. Its stock is traded on other country’s markets, but not in the U.S.   (Some of its indirect-interest instruments — “depositary receipts” — are traded on the New York Stock Exchange.)  A subsidiary of the Bank, formerly called HomeSide Lending Inc., based in Jacksonville, Fla., collected mortgage payments from homeowners, made payments to investors in mortgage-backed securities and to insurance companies, and it paid taxes. It made collections based upon rights to service the underlying mortgages.

Initially, HomeSide made significant profits.  But through errors or miscalculations in its accounting, based upon estimates of where mortgage interest rates would go, HomeSide misjudged the revenue it would get.  The Bank, as a result, had to make a more than $3 billion write-down on book value.  (That led the Bank to sell the subsidiary to Washington Mutual, Inc., a company that landed some seven years later in the midst of the sub-prime mortgage fracas in the U.S., and wound up with its banking assets being taken over by J.P. Morgan Chase & Co., and bankruptcy.)

After the massive write-downs, the Bank’s stock price plummeted in Australia and elsewhere.  The miscalculations had been reported in financial statements the Bank had made in Australia to regulators there.  The investors, in their class-action claims, argued that the Bank, HomeSide, and four officers made false and misleading statements in filings with the U.S. Securities and Exchange Commission, especially regarding HomeSide’s financial health. They claimed that HomeSide had falsified its financial data in Florida, giving the scheme a close link to the U.S.

The Bank and the others sued asked the District Court to dismiss the case, arguing that the U.S. stock fraud law did not reach the transaction, claiming it occurred mainly in Australia with little or no impact in the U.S.   The chain between anything that happened in Florida and what happened abroad was too disconnected, they contended.  The District Court dismissed the case, and the Second Circuit agreed.   It said the scheme mainly involved actions or inaction by the Bank, and ruled that there was essentially no impact on U.S. investors or U.S. markets.  (Recall that American investor Robert Morrison was out of the case at that point.)

The three Australian investors filed their petition for review in the Supreme Court on March 22 last year.  Focusing primarily on what the petition said was a three-way split in the Circuit Courts on the trans-national application of Section 10(b), the investors raised three questions: whether the fraud provision applies to “transnational frauds” with links to the U.S., whether the Court would resolve the split, and whether the Second Circuit should have adopted the views the SEC had laid out in an amicus brief — that is, whether the scheme was furthered by “material and substantial conduct” in the U.S.

The Bank and others sued argued in response that there was no conflict among the Circuit Courts, that the decision below was bound by its special facts, and that the mix of circumstances was novel and unusual.  The only lower court ruling in disagreement on the core issue, the brief in opposition contended, was a District Court decision approving a settlement.

After examining the case initially, the Supreme Court asked the U.S. Solicitor General to provide the federal government’s views.  Solicitor General Elena Kagan urged the Court to deny review.  While saying that the Circuit Courts “have not been entirely uniform” on the core issue, she contended that the Australian investors had failed to show that their lawsuit would be allowed to go forward in any other Circuit Court.  Kagan, however, went on to discuss at some length a standard for applying Section 10(b) that might make it reach some trans-national frauds.  The law, she said, should not be limited to transactions in which domestic conduct is the predominant factor.  It is sufficient, she suggested, if a scheme involved significant conduct within the U.S. that was “material” to the success of the fraud.

Seeking to answer the Solicitor General, the Australian investors’ lawyers argued that their lawsuit, in fact, would have gone forward under the tests laid out in three other Circuit Courts — the Third, Eighth and Ninth.  Joining in urging the Court to grant review was the National Association of Shareholder and Consumer Attorneys, arguing that “the reach of the United States securities laws has become increasingly important as news stories break almost daily about frauds of international scope.”

The Supreme Court, obviously sensing that it was time for some guidance, turned aside the Solicitor General’s suggestion and granted review last November 30, with new Justice Sonia Sotomayor, a former Second Circuit judge, recused.  (She was not on the Circuit Court panel that decided this case.)

Briefs on the Merits

Relying on the language of Section 10(b), the Australian investors contended that “a federal violation occurs whenever a fraud is committed in connection with the purchase or sale of any security,” if any one of three conditions is met: using an instrument of commerce, or the U.S. mail, or any national securities market — to carry on a securities fraud.  Since the word “or” separates those three, the merits brief argued, any one is sufficient.  In this case, they noted, their lawsuit claimed that the Bank had engaged in fraud through interstate commerce in the U.S., and through the use of U.S. mail.  Focusing solely on whether a U.S. securities market was involved (which it was not), the Circuit Court simply dropped the other basis for applying Section 10(b), the brief argued.

Citing a decision earlier this Term (Union Pacific v. Locomotive Engineers, 08-604), the investors’ brief said that “the lower courts are without authority to disclaim the subject matter jurisdiction that Congress has given them.”

The Bank’s brief on the merits relied on three broad arguments, the net effect of which would be that the courts simply had no business filling in the gap that Congress had left in the Securities Exchange Act.  First, the brief contended that allowing this particular lawsuit to go forward would unleash “claims of hundreds of thousands of investors who have no connection to the U.S. or to U.S. securities markets.” Second, it argued that federal courts for four decades have been disregarding the principle that a U.S. law does not reach beyond American shores unless Congress very explicitly says that it does.  That principle, it asserted, goes all the way back to Chief Justice John Marshall and the Charming Betsy ruling in 1804.  And, finally, the brief advanced a foreign policy plea: extending this law overseas would intrude on the “sovereign authority” of other nations.

The federal government, now fully involved in the case, renewed its argument that Section 10(b) should reach trans-national securities fraud when “significant conduct material to the fraud’s success occurs in the United States.”  The Court should not narrow the Section below that standard, the Solicitor General argued, because that “would risk permitting the United States to become a base for orchestrating securities frauds for expert.  That approach would erode ethical standards in the securities industry and undermine investor confidence, and it could lead to diminished protections for United States citizens targeted by foreign fraudsters.”

Still, the Solicitor General said, when that standard has been met, it should be the SEC that should undertake an enforcement action.  Merely because there has been a claimed violation of Section 10(b), she added, a private individual such as an investor would not have enough basis for pursuing a private lawsuit.  For such a lawsuit to go forward, the government brief insisted, the investor should have to prove “a direct causal link between the violation and his own economic injury.”  That, the brief spelled out, would require proof that the injury was “a direct result of the component of the fraud that occurred in the United States.”  The lawsuit by the Australian investors, the brief concluded, would not meet that standard, and thus was rightly dismissed.

Amicus Briefs

The friends-of-court filings in the case, numerically, lean heavily against the Australians’ lawsuit, and against an expansive reading for Section 10(b) for trans-national frauds.  The raw count is 14 to 3.  Among those siding with the Australian bank are the governments of its own country, as well as those of Britain and France, a host of international securities and other business organizations, and assorted professors (and law students) of law and finance.  Supporting the Australian investors are a group representing Australian investors in general, plus a trio of investment funds in the Netherlands, Scotland and England, and several international pension funds.


The Court has perhaps three ways to approach the case.  First, it could focus explicitly on the language of the Securities Exchange Act, ignoring policy factors and concluding simply that the text dictates either that there simply is no extra-territorial reach because the words are not there, or that the words do reach any fraud that involves one of the means spelled out in the law.  Second, it could look to some policy considerations, as the Solicitor General and others have suggested, and give the Act a compromise reading so that it sometimes reached trans-national frauds.  And, third, it could focus on the fact that this specific lawsuit at issue is one by private investors, and rule that, whatever the law might mean for purposes of SEC’s enforcement powers, it does not allow private lawsuits to target trans-national frauds.

There may be variations on those approaches, but the Court does seem to be fairly closely divided now between blocs that seek to focus on the specific words of federal laws or, alternatively, to look to other guides for congressional intent.  There is also a strong and perhaps emerging bloc within the Court that is skeptical to creating new private rights to sue under federal statutes that do not explicitly authorize such claims.  Whether the Court will be moved by the specter of the Bernard Madoff episode, creating the image of the U.S. as a cradle of global scandal, seems doubtful unless policy considerations become dominant in the review.  To some degree, if the Court is inclined to trust the SEC and the Solicitor General, it might well embrace the somewhat straddling approach that they have put forward.

In any event, it does appear that the Court is poised, at least, at least to begin answering a question that has eluded a uniform approach in the lower courts.   A final ruling is expected by late spring or early summer.