The staff of the Securities and Exchange Commission (“SEC”) recently released a study on the cross-border scope of the private right of action under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), 15 U.S.C. § 78j(b), and SEC Rule 10b-5, 17 C.F.R. § 240.10b-5, promulgated thereunder. The study, mandated by Congress following the United States Supreme Court’s decision in Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010), outlines a number of legislative options for extending the scope of private actions for international securities fraud that may provide a roadmap for future Congressional action.
While courts have long recognized a private right of action for securities fraud under Section 10(b) of the Exchange Act, the Supreme Court held in Morrison that Section 10(b) does not apply to the purchase or sale of non-U.S.-listed securities outside the United States. Prior to Morrison, federal courts applied Section 10(b) to transnational securities fraud if a sufficient level of conduct occurred in the United States (the “conduct test”) or conduct occurring outside the United States had a foreseeable and substantial effect within the Untied States (the “effects test”). In Morrison, the Supreme Court rejected these tests in favor of a “transactional test,” which limited Section 10(b) to fraud in connection with the purchase or sale of a security listed on a U.S. exchange and the purchase or sale of any other security in the United States.
In response to Morrison, Congress added Section 929P(b) to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which restored the conduct and effects tests for civil and criminal actions brought by the SEC and the Department of Justice (“DOJ”), respectively. With respect to private rights of action, however, Section 929Y of the Dodd-Frank Act required the SEC to solicit public comment and conduct a study to determine the extent to which the conduct and effects tests should apply in such cases.
The study outlines three legislative options for applying the conduct and effects tests to private rights of action for transnational securities fraud. The first is to apply the SEC and DOJ versions of the tests, which (according to the study) “would involve policy trade-offs that could carry significant implications” for investor protection and international comity — a principle of customary international law that recognizes the validity of foreign law.
An alternative approach (and one that the SEC advocated in Morrison) is to narrow the conduct test by imposing a “direct injury requirement,” which would require the plaintiff to show that the injury resulted directly from conduct within the United States. A disadvantage of this approach is that it could pose challenges for international comity because it would allow “foreign investors [to] receive remedies that their governments have determined not to provide . . . .” A second alternative is to limit the conduct and effects tests to U.S. investors, though this would permit “application of Section 10(b) to securities transactions that occur on foreign securities exchanges, which a number of foreign governmental authorities have opposed.”
The study also outlines four options for supplementing and clarifying the transactional test adopted by the Supreme Court in Morrison. The first option is to allow private actions for the purchase or sale of any security that is of the same class of securities registered in the United States. This would provide a bright-line standard based on U.S. registration, but could have the unintended consequence of discouraging foreign issuers from registering in the United States.
A second option is to allow private actions against securities intermediaries (e.g., broker-dealers and investment advisors) that engage in securities fraud while purchasing or selling securities overseas for U.S. investors. District courts interpreting the transactional test under Morrison have held that Section 10(b) no longer applies to such transactions, even in cases where the securities intermediary resided in and engaged in fraudulent conduct in the U.S. or traveled to the U.S. frequently to meet with the U.S. investor.
A third option is to allow private actions for investors who can demonstrate that they were induced to engage in the transaction while in the United States. According to the study, such a “fraud in the inducement” test would not raise international comity concerns because it would require a showing of actual reliance and would therefore preclude use of the “fraud on the market” theory, which “has been a source of criticism from foreign government authorities when it is applied to transnational securities frauds involving overseas transactions.”
A fourth option is to allow private actions if either party to the transaction made or accepted the offer to sell or purchase the securities while in the United States. This would further Morrison’s goal of establishing a bright-line standard for liability by clarifying when an off-exchange transaction takes place.
Apart from noting in passing that the SEC “has not altered its view in support of” the direct injury requirement, the study offers little in terms of specific recommendations. In a sharply worded dissenting statement, SEC Commissioner Luis Aguilar argued that the study “fails to satisfactorily answer the Congressional request, contains no specific recommendations, and does not portray a complete picture of the immense and irreparable investor harm that has resulted” from Morrison.
Although the study identifies a number of policy considerations that Congress may consider in determining whether to enact legislation extending the transnational scope of private actions under Section 10(b), the reluctance of the SEC staff to provide explicit recommendations renders the immediate impact of the study unclear. As noted in the study, “a final option would be for Congress to take no action” at all, in which case lower federal courts would continue to interpret and refine the transactional test under Morrison.