INTRODUCTION I. OVERVIEW II. THE ORIGINS OF THE FRAUD-ON-THE-MARKET CLASS ACTION A. The Development of a Claim for Damages for Corporate Misstatements Where the Issuer Does Not Trade 1. The illegality of corporate misstatements 2. Private right of action 3. Presumption of reliance on the integrity of the market and the possibility of class actions a. The traditional reliance requirement b. The fraud-on-the-market theory of reliance c. Availability of class actions B. Lessons from the History of the Two Causes of Action 1. Differences in injury and setting 2. Open process by which the courts develop the cause of action III. UNDERSTANDING THE SOCIAL FUNCTIONS OF FRAUD-ON-THE-MARKET CLASS ACTION LIABILITY A. Fairness-Based Compensation Rationales 1. The ex ante perspective 2. The ex post perspective B. The Risk-Reallocation-Based Compensation Rationale C. The Investor Protection Deterrence Rationale D. Deterring Misstatements to Promote Corporate Governance and Liquidity 1. The rationale for mandatory disclosure 2. Deterring misstatements makes mandatory disclosure more effective at promoting transparency 3. Greater transparency contributes to better corporate governance 4. Greater transparency contributes to liquidity IV. USING FIRST PRINCIPLES TO DETERMINE THE APPROPRIATE TRANSNATIONAL REACH OF FRAUD-ON-THE-MARKET ACTIONS A. Policy Concerns Arguably Justifying Imposition of Liability 1. The illusory compensation concern 2. Deterring misstatements to promote corporate governance and liquidity, and the scope of U.S. interest a. Corporate governance b. Liquidity c. The limits of U.S. interest 3. Enhancing global welfare by facilitating foreign-issuer bonding 4. Assuring that only high-transparency issuers trade on U.S. exchanges B. Policy Considerations Otherwise Implicated by Imposition of Liability. 1. Pro rata distribution of benefits to shareholders 2. Promoting the efficient functioning of secondary trading markets through undistorted issuer and investor choices of venues 3. Advantages of resolving similar claims in one place C. Convergence on a Simple Rule 1. Statement of the rule 2. Derivation from the seven policy concerns 3. Effect of the rule on global and U.S. economic welfare 4. Operational considerations V. COMPETING ALTERNATIVES: RETURN TO THE CONDUCT/EFFECTS TEST A. The Origins of the Conduct/Effects Test 1. Schoenbaum 2. Leasco 3. Bersch 4. Vencap 5. Distillation into the conduct/effects test framework B. Comparing Application of the Conduct/Effects Test to Traditional Fraud and to Fraud-on-the-Market Actions 1. Traditional reliance-based fraud actions a. Effects test b. Conduct test 2. Fraud-on-the-market actions a. Effects in the United States b. Conduct in the United States C. Resulting Pre-Morrison Case Law 1. Conduct test 2. Effects test D. Evaluation VI. COMPETING ALTERNATIVES: THE MORRISON TEST AND COMMENTATOR PROPOSALS A. Need for a Serious Assessment B. The Reach of the Test 1. Foreign issuers with no securities listed on a U.S. exchange a. Claims based on purchases in the U.S. OTC market b. Claims based on the purchase order being placed in the United States 2. Foreign issuers with securities listed on a U.S. exchange a. Purchases executed on the U.S. exchange--ADRs b. Purchases executed on the U.S. exchange--issuers listing their underlying common shares on a U.S. exchange c. Purchases executed abroad--issuers listing their underlying common shares on a U.S. exchange d. Purchases abroad--issuers listing only ADRs on a U.S. exchange C. Evaluation D. Proposals of Other Commentators VII. IMPLEMENTATION A. The Courts B. The SEC C. Congress CONCLUSION INTRODUCTION
Fraud-on-the-market class actions allow buyers in secondary securities markets to recover losses that they incur from purchasing at prices inflated by misstatements of the issuing corporation. These actions, based on alleged violations of section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, (1) give rise to the bulk of all the damages paid out in settlements and judgments pursuant to private litigation under the U.S. securities laws. (2) With securities trading becoming globalized, (3) foreign issuers became increasingly frequent targets of such actions, with one in six being against a foreign issuer in 2009 compared to only one in fifteen a decade earlier. (4) Two of the seven largest payouts in the history of private U.S. securities litigation were made in settlements of suits against foreign-issuer defendants: Nortel Networks (over $2 billion) and Royal Ahold, NV (over $1 billion). (5) A judgment estimated in the press to be worth over $9 billion, an amount larger than any payout yet made in any U.S. securities case, was rendered in early 2010 against another foreign corporation, Vivendi. (6)
The law behind these actions against foreign issuers has since been thrown into flux, however, with the Supreme Court's decision in Morrison v. National Australia Bank Ltd. (7) and Congress's response to Morrison in provisions of the subsequently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act. (8) The Morrison case and the congressional reaction to it put the United States at a critical moment of decision. We face the fundamental question of whether, as a matter of good policy, it is ever appropriate that a foreign issuer be subject to the U.S. fraud-on-the-market class action damages liability regime, and, if so, by what kinds of claimants and under what circumstances.
How the United States answers this question will have important effects on where the shares of the world's issuers trade, who invests in them, and what these issuers disclose to the public. Fear of fraud-on-the-market suits, for example, appears to have been the single most important deterrent in recent years to foreign issuers offering or listing their shares in the United States. (9) More fundamentally, the United States' decision concerning the reach of these suits will have a significant impact around the world on both the overall efficiency of securities trading and the quality and cost of corporate governance. The decision will also materially affect U.S. economic relations with other countries. (10) This Article goes back to first principles to look at the basic policy concerns that are implicated by the reach of fraud-on-the-market class actions. The resulting analysis suggests a simple, clear rule likely to both maximize U.S. economic welfare and, by also promoting global economic welfare, foster good foreign relations. The American law based class action fraud-on-the-market liability regime, I conclude, should not as a general matter be imposed upon any genuinely foreign issuer, even where the purchaser making the claim is a U.S. investor purchasing the share in a U.S. market or where significant conduct contributing to the misstatement occurs in the United States. An issuer is genuinely foreign if it has its economic center of gravity as an operating firm outside the United States. (11) The only exception would be a foreign issuer that has agreed, as a form of bonding, to be subject to the U.S. liability regime, in which case all such claims against the issuer should be allowed, regardless of the nationality and residence of the purchasing plaintiff, the place where she executes the transaction, and the place or places where conduct contributing to the misstatement occurs.
A claim of injury based on a secondary market securities purchase at a price inflated by the issuer's misstatement has potential connections with particular countries along a number of dimensions. In addition to the nationality of the issuer, these dimensions would include the nationality and the residence of the purchaser, the place where the purchase order was executed, the place of each of the exchanges where the security is listed, and the place or places where conduct relating to the misstatement occurred. The concern here is with a claim that is connected with more than one country in terms of these different dimensions. Consider each country that has such a connection with the claim and that under its law has a cause of action would arise if the claim had instead been entirely domestic. Such a country is faced with deciding whether to still include the claim within the reach of its cause of action despite the claim's foreign elements. The issue is which connection or connections with other countries, if any, will nevertheless allow the claim to remain within the reach of the country's cause of action.
Until very recently, development of the U.S. approach to the reach of its fraud-on-the-market class action was, by default, entirely the province of the lower federal courts. Congress had not specified the reach of section 10(b), the statute whose violation gives rise to the cause of action. The language of section 10(b) makes no distinctions between the United States and elsewhere in the world with respect to any of these dimensions of connection. Read literally, it authorizes the SEC to promulgate rules that govern the whole world. (12) The SEC had not spoken either: the language of Rule 10b-5 is as sweeping as that of the underlying statute in terms of its possible reach, (13) and the SEC has not promulgated any other rules relevant to determining the reach of the Rule. The Supreme Court also had not addressed the issue.
The approach developed by the lower courts was that in transnational situations, the prohibitions of section 10(b) and Rule 10b-5 reached conduct, and their violation could be the basis of a fraud-on-the-market cause of action under either of two circumstances: where conduct in connection with the violation occurred in the United States (the "conduct test"), or where effects from the violation were experienced in the United States (the "effects test"). (14) The nature and importance of the conduct or effects necessary to satisfy these tests were subject to a variety of different, often vague, formulations. Overall...