The Extraterritorial Reach of Section 10(b): a Wolf Hunt Off Wall Street

• Publication year: 2022

The Extraterritorial Reach of Section 10(b): A Wolf Hunt Off Wall Street

Radley Gillis

THE EXTRATERRITORIAL REACH OF SECTION 10(B): A WOLF HUNT OFF WALL STREET

Abstract

Born to combat the market effects of the Great Depression, the Securities Exchange Act of 1934 protects American investors and maintains American confidence in the U.S. securities market. These objectives are largely accomplished through the imposition of liability from Section 10(b) of the Securities Exchange Act and the SEC's Rule 10b-5. These federal laws impose civil and criminal penalties for domestic insider trading and securities fraud violations. Because Section 10(b) and Rule 10b-5 only apply domestically, when securities violations occur both within the United States and abroad, the reach of federal law becomes questionable, leaving federal courts with a complex issue.

To resolve this issue, the Second Circuit created a Conduct and Effects test that left federal courts with a subpar solution to determine when Section 10(b) may apply extraterritorially. The test developed for over forty years and was widely accepted until the Supreme Court, in Morrison v. National Australia Bank, Ltd., brought Section 10(b)'s extraterritorial reach to a screeching halt in 2010. Ushering in a fundamental shift in securities law, Justice Scalia abrogated the Second Circuit's Conduct and Effects test and purported to provide a clear Transactional test that avoided interference with foreign securities regulation. But the Court missed the mark, and instead created two new issues for the circuit courts of appeals. First, the Transactional test created an ambiguity that resulted in a sharply divided split among the First, Second, Third, and Ninth Circuit Courts. Second, the simultaneous enactment of the Dodd-Frank Act prompted a question of whether Congress partially abrogated the Court's decision in Morrison and reinstated the Conduct and Effects test.

In the wake of this circuit split comes uncertainty among the lower courts, threats to stare decisis, plaintiffs avoiding a defendant-friendly Second Circuit by forum shopping, and strains on international comity. To resolve the split, this Comment sets forth a factor-balancing test that determines whether the foreign elements of a transaction overcome the domestic elements to render Section 10(b) inapplicable to the conduct. This Spectrum test provides a flexible, but narrowly tailored, framework that can adapt to a rapidly evolving and

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globalizing securities market. It provides courts with a workable and consistent analysis that will facilitate the development of Section 10(b) jurisprudence.

Table of Contents

Introduction..........................................................................................439

I. A New Deal..................................................................................441

A. Combatting the Great Crash ................................................... 442
B. Securities Act of 1933 and Securities Exchange Act of 1934 .... 444

1. Section 10(b) of the Securities Exchange Act of 1934 ........ 445
2. Rule 10b-5 ........................................................................446
3. Private Actions Versus Public Actions............................... 447

II. Section 10(b)'s Rally Abroad...................................................447

A. The Effects Test ...................................................................... 448
B. The Conduct Test.................................................................... 449

III. A Halt in Extraterritorial Reach ..........................................450

A. Morrison v. National Australia Bank, Ltd................................451
B. Dodd-Frank Wall Street Reform and Consumer Protection Act......................................................................... 455

1. The Tenth Circuit—SEC v. Scoville .................................. 456
2. Congress Failed to Extend Section 10(b)'s Scope for Public Actions..............................................................................457

IV. Volatility in the Circuits.........................................................459

A. The Second Circuit Takes on Morrison.................................... 460

1. The Irrevocable Liability Test ...........................................460
2. The So Predominantly Foreign Test .................................. 462

B. The Other Side of the Circuit Split .......................................... 467

1. The Third Circuit—United States v. Georgiou ...................468
2. The Ninth Circuit—Stoyas v. Toshiba Corp.......................470
3. The First Circuit—SEC v. Morrone................................... 472

V. IPO of the Spectrum Test...........................................................476

A. Spectrum Test Framework ...................................................... 477
B. Spectrum Test in Action .......................................................... 481

1. Application to Parkcentral ................................................. 482
2. Application to Morrone.....................................................484

Conclusion.............................................................................................486

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Introduction

Federal securities laws protect American investors from securities fraud, insider trading, and other deceptive practices.¹ In the context of a rapidly evolving and globalizing securities market,² determining the reach of that protection can be difficult.³ When a securities transaction occurs, it may occur solely inside the United States, or it may involve parties abroad.⁴ But when the transaction occurs both inside and outside the United States, it raises a complex issue for federal courts due to the common law presumption against extraterritoriality. This canon of construction presumes that when Congress legislates, it does so for domestic matters as opposed to foreign matters unless Congress clearly indicates otherwise.⁵

In 2010, the Supreme Court determined that the Securities Exchange Act of 1934 does not overcome the presumption against extraterritoriality, and it does not apply extraterritorially.⁶ Consequently, the Court gave a Transactional test to determine when a transaction is domestic in order to impose liability for violations of Section 10(b) of the Securities Exchange Act.⁷ The Court did not provide guidance in applying the Transactional test,⁸ which naturally gave rise to a split among the First, Second, Third, and Ninth Circuit Courts of Appeals.⁹

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Congress then added to the chaos by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act. Because the Dodd-Frank Act was passed nearly simultaneously with the Morrison v. National Australia Bank Ltd. decision's release,¹⁰ another ambiguity arose causing the circuit courts to question whether Congress partially abrogated Morrison and reinstated the Conduct and Effects test.¹¹ Several crucial issues arise from the circuit courts' interpretations of Morrison, including inconsistent decisions,¹² strains on international comity,¹³ threats to stare decisis,¹⁴ and forum shopping.¹⁵

This Comment addresses the extraterritorial reach of Section 10(b) of the Securities Exchange Act of 1934 as well as the U.S. Securities and Exchange Commission's ("SEC") Rule 10b-5 and provides a new framework for the analysis to resolve these respective issues. In Part I, this Comment discusses the social and economic background¹⁶ that the Securities Exchange Act was legislated against. Part II introduces Section 10(b)'s initial extraterritorial application and the development of the Conduct and Effects test. Part III analyzes the Morrison decision and the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Part IV evaluates the circuit courts'

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split in the application of the second prong of Morrison's Transactional test. Finally, Part V argues for the implementation of the Spectrum test¹⁷ to resolve the split, and demonstrates its application to existing fact patterns adjudicated by the First and Second Circuits. While the SEC punted on the issue in 2012,¹⁸ the Spectrum test provides a flexible and consistent framework that can adapt to a rapidly evolving and globalizing securities market.

I. A New Deal

Dancing, prohibition, gangsters, and economic prosperity are staples of the American era famously known as the Roaring Twenties.¹⁹ During the Roaring Twenties, social mores evolved and public expectations of women changed.²⁰ It became socially acceptable for women to dress promiscuously, smoke, drink, and dance vivaciously in public.²¹ Throughout this era, dance halls filled and new dance styles proliferated.²² Contemporaneously, alcohol consumption increased, despite the alcohol prohibition by the 18th Amendment to the U.S. Constitution.²³ Americans were not deterred by the prohibition and resorted to a black market for alcohol.²⁴ Famous gangsters, like Al Capone, bootlegged

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alcohol through organized crime and were revered as heroes by the public for their defiance against the government.²⁵

The American economy flourished.²⁶ New household products entered the market, the number of Americans that owned automobiles rose, and ordinary people invested in stocks.²⁷ The stock market rapidly expanded, and stock prices rose to historic levels.²⁸ Optimistic speculation in the market reigned, and hundreds of millions of shares of stock were financed by bank loans, which were expected to be repaid by the anticipated profits from the stock transactions.²⁹ Anticipated profits fell short, however, preventing lenders from recovering loan amounts and shattering confidence in the U.S. economy.³⁰

In 1929, the United States faced the Great Crash and, soon after, the Great Depression, eviscerating the success of the Roaring Twenties.³¹ These historic events led President Franklin Delano Roosevelt to organize the New Deal.³² The Securities...