Chapter 19

• Jurisdiction: United States

Chapter 19 International Securities Fraud

In this chapter, we discuss primarily securities actions in the United States against foreign companies with foreign shareholders and whose stock is traded on foreign exchanges (the so-called F-cubed companies).

Extraterritoriality Background

For many years, federal courts never addressed the issue of the extraterritorial application of the U.S. laws. Although there was a generally understood presumption that unless Congress explicitly specified otherwise, the laws of the United States did not apply extraterritorially, it was not until Kook v. Crang, 182 F. Supp. 388 (S.D.N.Y. 1960), that a federal court explicitly applied that presumption to a case under the 1934 Act. However, by 1968, the federal courts had carved out an exception to that presumption because they concluded that extraterritorial application of the securities laws was necessary "to protect American investors." Schoenbaum v. Firstbrook, 405 F.2d 200 (2d Cir.), modified en banc 405 F.2d 215 (2d Cir. 1968). By 1975, that carve-out was made even more explicit in Bersch v. Drexel Firestone Inc., 519 F.2d 974 (2d Cir. 1975). Foreign transactions would be covered by the U.S. securities laws if the foreign transactions were "directly caused" by "acts (or culpable failures to act) within the United States." Bersch at 993. The notion was that until Congress decided to act, federal courts could fill in the gap in the hope that "by finding jurisdiction" for frauds occurring abroad, "we may encourage other nations to take . . . reciprocal action against fraudulent schemes aimed at the United States from foreign sources." SEC v. Kasser, 548 F.2d 109 (3d Cir. 1977).

The "conduct" test seemed fairly clear. It required that "only domestic conduct constituting the relied-upon misrepresentations sufficed." See Morrison, 561 U.S. 247 (2010), Brief for Respondents, p. 5. In Bersch, the lower court found that domestic conduct constituted an "essential link" in the fraud that had taken place in the United States. The Second Circuit reversed because the statements at issue were made abroad and reached their victims abroad. Thus, Section 10(b) would apply only when "all the elements of a defendant's conduct necessary to establish a violation" occurred in the United States, that is, when the misrepresentations were made in the United States.

This was a bright-line test (the so-called "location of the lies" test) but it did not last long. Soon, other courts focused on the materiality of the domestic acts and conflated the "conduct" test with a separately articulated "effects" test. As a result, the law became, as the National Australian Bank's counsel, George Conway, argued in Morrison, "a collection of conclusions" and a set of "potentially incompatible statements of applicable rules" that were essentially impossible to apply in a consistent and predictable fashion. As a result, the filing of the so-called "F-cubed" cases expanded greatly, "generating excessive levels of conflict with other countries."¹

Against this background, the Supreme Court rejected the "conduct and effects" test in the Morrison case and concluded that the issue was not one of jurisdiction but one of extraterritorial application of the U.S. laws. In other words, a return to the pre-1968 law. Whether the "new" test turned out to be a bright-line test or easy application remains to be seen. This issue is apparently still alive and well, at least insofar as it applies to private cases.

Class Certification Issues

Rule 23 and Supreme Court decisions provide that absent class members are bound by the result and are precluded from suing again. That is one reason why they must receive notice that complies with the requirements for due process. But what if some of the class members are foreigners? Will a judgment (in favor of the defendant) be given preclusive effect in other countries? Why does this matter? What is the correct test? Is it "near certainty" or "more likely than not"? In In re Vivendi Universal S.A. Securities Litigation, 2007 WL 861147 (S.D.N.Y. Mar. 22, 2007), the district court held that class certification is permissible so long as the "plaintiffs are able to establish a probability that a foreign court will recognize the res judicata effect of a U.S. class action judgment." However, Bersch v. Drexel Firestone, Inc., 519 F.2d 974 (2d Cir. 1975), held that an American court should abstain from entering a judgment against a foreign company when it is a "near certainty" that a foreign court might not recognize or enforce it. Recall that Rule 23 requires that a class notice must advise putative class members about "the binding effect of a class judgment on members." How could that be done if it is even a "possibility" that the judgment might not be held by a foreign court to be "binding" on class members? It should be understood that the "binding" that we are talking about here is the "binding" effect of a judgment in favor of the defendant foreign corporation in its home country. There is no question that a foreign member of a class that lost its case could not sue again in an American court; the question of interest, however, is whether that class member could sue again in a foreign court that does not recognize the binding res judicata effect of the U.S. judgment. Because there are very few bilateral treaties mandating such recognition, there is no satisfactory answer to that question.

The other question of interest is whether the American courts could or more properly should exercise jurisdiction over foreign companies in the first place. We know that for decades they have been doing so, but did they have the right to do so? We turn to that question next.

Jurisdiction or Extraterritoriality?

Does a U.S. court have "jurisdiction" over F-cubed companies? Is this a subject matter jurisdiction issue, as the courts have assumed for decades, or do the U.S. securities laws simply not apply abroad?

Bersch v. Drexel Firestone, Inc., 519 F.2d 974 (2d Cir. 1975), established the "conduct and effects" test and held that whether a foreign corporation could be sued in a U.S. court for violating the U.S. securities laws was a questions of "subject matter jurisdiction." The court had jurisdiction if the alleged unlawful conduct took place in the United States (at least beyond merely preparatory activities) or if the conduct occurring overseas has a substantial "effect" inside the United States. That test lasted forty years but the cases were not uniform. Most circuits had weighed in. They all thought that the issue was one of subject matter jurisdiction. The problem with the test was simply that it was very hard to apply. Along came the Morrison case.

Morrison v. National Australia Bank Ltd.²

National Australia Bank was an Australian company whose shares were traded on the Australian Stock Exchange Limited. Only its America Depository Receipts (ADRs) were traded on an American stock exchange. The plaintiffs claimed that a subsidiary, HomeSide Lending, Inc., a Florida company, misstated certain risks to its business model and as a result, National Australian Bank had to write down its investment. The two lower courts dismissed the complaint and affirmed the dismissal because there was no "subject matter jurisdiction." The acts that took place in the United States were "at most, a link in the chain of an alleged overall securities fraud scheme that culminated abroad" that did not meet the conduct test. In re National Australia Bank Securities Litigation, 2006 WL 3844465 (S.D.N.Y. Oct. 25, 2006). The Second Circuit affirmed that judgment. 547 F.3 167 (2008).

The Supreme Court affirmed, but not for the same reasons as the lower courts. Rather, it held that the issue was not one of subject matter jurisdiction at all but was rather a "merits" question, to wit, the extraterritorial reach of Section 10(b). "It is a '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." Morrison, 561 U.S. 247 (2010), citing EEOC v. Arabian Americas Oil Co., 499 U.S. 244, 248 (1991).

Thus, the Supreme Court held that the "conduct and effect" test that had been used for decades was fatally flawed. The Court looked at the statutory text and found no evidence of an intent to extend the securities laws extraterritorially. The Court applied the "presumption against extraterritoriality" and held that Section 10(b) applies "only in connection with the purchase or sale of a security listed on an American stock exchange and the purchase and sale of any other security in the United States." (Query: What does the latter part mean? Why did the Court not say simply "the sale of a security in the United States"?)

The Supreme Court intended to create a bright-line test, but did it? Did the court misspeak? Does the statute apply to transactions outside the United States even if the securities are cross-listed on a U.S. exchange? No, it doesn't, but for a while it looked as if it might. Post-Morrison cases have now clearly rejected that so-called "listing" theory.

In order to see why that is so, it is necessary to read the opinion as a whole. The Court clearly wanted to limit the extraterritorial reach of Section 10(b), and it did so notwithstanding the fact that National Australian Bank had ADRs listed in the United States backed by common shares. Those common shares were "listed" on an American exchange, but they were not tradable on that exchange. Clearly, the Court meant to exclude from the reach of Section 10(b) shares that were listed and tradable on an American exchange.³ But the Court did not say so explicitly.

Much of the post-Morrison litigation concerns the second prong of the test. The "domestic transaction" test is difficult to apply in today's modern, electronic, cross-border world where different components of a transaction occur in different physical...