AuthorPagliuso, Shiri

United States federal securities laws, in part, protect investors from fraudulent and deceptive practices affecting domestic securities markets. (1) Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5 thereunder prohibit fraud in connection with the purchase or sale of securities. (2) The extraterritorial reach of Section 10(b) is an area of longstanding judicial uncertainty and courts were previously inconsistent in their application of federal securities laws to foreign transactions. (3) The United States Supreme Court responded to this widespread confusion in Morrison v. Nat'l Austl. Bank, where it held that Section 10(b)'s application is limited to securities listed on domestic exchanges and domestic transactions in other securities, establishing what is coined as the transactional test. (4) Despite the Court's attempt to clarify the law, the meaning of the phrase "domestic transactions in other securities," has created additional confusion and resulted in a circuit split. (5) In SEC v. Morrone, (6) the First Circuit, joining two sister circuits, adopted the "irrevocable liability" test for purposes of determining which domestic securities transactions satisfy the second prong of the Morrison transactional test, subjecting them to federal securities laws. (7)

The defendants, Jonathan Morrone ("Morrone"), Paul Jurberg, ("Jurberg"), Brett Hamburger ("Hamburger"), and Anthony Orth ("Orth"), were executives of Bio Defense, a U.S. corporation that manufactured machines to detect letters containing anthrax. (8) In 2008, Hamburger introduced Bio Defense to Agile Consulting ("Agile"), a Cyprus-based company that targeted investors in Europe and charged high fees for investor funds it raised. (9) Bio Defense began working with Agile without disclosing Agile's fees to its investors. (10) If Agile's efforts in targeting investors proved fruitful and an investor agreed to purchase stock, Morrone would send a cover letter and stock subscription agreement to Hamburger in Spain. (11) Hamburger would forward the stock subscription agreement to the investor, who would then return the executed agreement. (12) However, the agreement itself became binding only after Bio Defense counter-signed the investor-executed stock subscription agreement. (13)

In the course of this business venture, Bio Defense raised around $3.3 million, of which almost $2.5 million was paid to Agile, and received numerous complaints from investors about Bio Defense's solicitation practices. (14) The SEC filed a complaint against Bio Defense, Morrone, Jurberg, Hamburger, and Orth, alleging violations of the SEC's Rule 10b-5. (15) Morrone and Jurberg were alleged to have violated Rule 10b-5 by substantially participating in a scheme to defraud investors and making materially false and misleading statements in the offer or sale of securities. (16) At trial, the United States District Court of Massachusetts granted summary judgment in favor of the SEC. (17)

The defendants appealed, arguing that the federal securities laws should not apply to their conduct targeting international investors and urged the court to follow the Second Circuit's application of the Morrison transactional test. (18) The First Circuit declined to extend its inquiry further than its analysis of the defendants' irrevocable liability, concluding that the Exchange Act does not focus on the place where the deception originated, but upon purchases and sales which occur in the United States. (19) The First Circuit ultimately concluded that the defendants were subject to the federal securities laws because they incurred irrevocable liability in the United States based on (1) the subscription agreements for Bio Defense stock, signed by Bio Defense in Boston, which stated that the company had "no obligation until Bio Defense executes and delivers to the purchaser a signed copy," and (2) the issuance of shares from Boston to investors in Europe by Morrone and Jurberg. (20)

The Securities Act and Exchange Act seek to provide investors with information on securities and prevent deceptive practices in the securities market. (21) While the Exchange Act's provisions are clearly intended to regulate securities transactions in the secondary market, issues have arisen in determining whether the Exchange Act applies to transactions involving foreign countries. (22) Delineating the Exchange Act's extraterritorial application has led courts to develop a series of tests that attempt to answer this question. (23)

In what is known as the pre-Morrison era, the Second Circuit developed the "conducts and effects" test to determine the Exchange Act's extraterritorial application. (24) Under this test, courts inquire into whether the wrongful conduct giving rise to a securities law violation (1) occurred in the United States, or (2) had a substantial effect in the United States or upon United States citizens. (25) This test was flexible, and courts typically determined the reach of U.S. securities laws on a case-by-case basis. (26) In Morrison v. National Australia Bank, the Supreme Court introduced a new bright-line test which dictated when Section 10(b) laws apply: (1) in transactions for securities listed on domestic exchanges; and (2) domestic transactions in other securities. (27) Circuit courts struggled to define the second half of the Morrison test--domestic transactions in other securities--due to lack of clarity surrounding the definition of a "domestic transaction." (28)

The Second Circuit first interpreted what constitutes a domestic transaction under Rule 10b-5 in Absolute Activist Value Master Fund Ltd. v. Ficeto, ruling that a transaction is considered domestic when irrevocable liability occurs in the United States. (29) Less than three years later, in Parkcentral Global HUB Ltd. v. Porsche Auto. Holdings SE, the Second Circuit considered the same question of extraterritorial application under a different set of circumstances. (30) The type of security at issue in Parkcentral--a securities-based swap agreement--was unusual because it did not involve the actual ownership, purchase, or sale of the reference security. (31) Thus, differentiating Absolute Activist from Parkcentral, the court decided that it could not apply federal securities laws to this case because the transactions were so "predominantly foreign" that they did not trigger U.S. securities laws. (32)

Since Parkcentral s holding in 2014, the Third and Ninth Circuits have explicitly adopted the irrevocable liability test, but no circuit courts have followed the Second Circuit's "foreign nature" test. (33) In Stoyas v. Toshiba Corp., the Ninth Circuit critiqued Parkcentral as "contrary to ... Morrison itself," and emphasized that the Exchange Act focuses on transactions, not the place where deceptive conduct occurred. (34) The question of whether the Second Circuit intended the predominantly foreign inquiry to extend to other securities transactions, not just securities-based swap agreements, remained open until the Second Circuit's 2021 decision in Cavello Bay Reinsurance Ltd. v. Shubin Stein (35) In Cavello Bay, the Second Circuit held that the predominantly foreign inquiry is one the court must make when deciding whether to apply federal securities laws to a transaction. (36) This decision thus marked a circuit split about whether irrevocable liability is sufficient to apply domestic securities laws to a transaction, or whether an additional inquiry--the predominantly foreign test--is also needed. (37)

In SEC v. Morrone, the First Circuit applied the test adopted by the Third and Ninth Circuits, holding that irrevocable liability was sufficient under Morrison to determine whether Section 10(b) applies and declining to consider whether the transaction was so predominantly foreign so as to evade the reach of federal securities laws. (38) In determining whether irrevocable liability occurred within the United States, the First Circuit referenced the written agreement between the defendants and the investors, which stated that Bio Defense had "no obligation" until Bio Defense "execute[s] and deliver[s] to the Purchaser an executed copy of the agreement." (39) Based on these terms, Bio Defense became irrevocably liable in Boston to deliver the shares to the Purchaser (the investor). (40)

The First Circuit then addressed whether, despite a finding of irrevocable liability, the court should follow the Second Circuit's reasoning in Parkcentral and Cavello Bay and hold that U.S. securities laws do not apply due to the predominantly foreign nature of the transaction. (41) The First Circuit, citing the rulings of its sister circuits, ultimately rejected the arguments made in Parkcentral and Cavello Bay, calling them inconsistent with Morrison (42) The court reasoned that Morrison focused its Section 10(b) analysis on the domestic nature of the securities transaction, and thus no further inquiry as to the transaction's foreign nature is needed. (43) Further, the court stated that holding the transaction to be predominantly foreign would be superfluous. (44)

The First Circuit correctly determined that irrevocable liability alone was sufficient to establish whether a transaction was domestic, and that it was unnecessary to incorporate the predominantly foreign nature test into its analysis. (45) According to the contractual agreement, Bio Defense was obligated to deliver the security to the investor when the stock subscription agreement was counter-signed by Bio Defense. (46) Thus, although irrevocable liability to the investor occurred while the investor was overseas, Bio Defense became liable to perform its end of the bargain upon counter-signing in the United...

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