Extraterritoriality Occupies Second Circuit in 2014: Part I, Section 10(b)

Seldom has there been a more acerbic rejection of a Circuit-specific body of law than the Supreme Court’s reversal of the Second Circuit’s rulings on the extraterritoriality of section 10(b) of the Securities and Exchange Act of 1934 and its administrative handmaiden, SEC Rule 10b–5, in Morrison v. National Australia Bank, 561 U.S. 247 (2010). Morrison, in turn has inspired a plethora of Second Circuit cases dealing with extraterritoriality in multiple contexts.

Post-Morrison cases reflect an ever-expanding theme in plaintiff business litigation-convincing American courts to take up causes of action with a greater or lesser foreign connection. As Justice Scalia wryly noted in Morrison:

“While there is no reason to believe that the United States has become the Barbary Coast for those perpetrating frauds on foreign securities markets, some fear that it has become the Shangri-La of class-action litigation for lawyers representing those allegedly cheated in foreign securities markets.”

Although the main thrust of the Second Circuit’s readjustment to Morrison has been in section 10(b) cases, other contributions in diverse fields should be noted, including Liu v. Siemens, No. 11-397-cv (2d Cir. 08/14/14) [Dodd-Frank Act's Anti-Retaliation Provision], European Community v. RJB Nabisco, No. 11-4275-cv (2d Cir. 08/20/14) [RICO], and SIPC v. Bernard L. Madoff Investment Securities, No. 12-mc-115 (JSR) (SDNY 07/06/14) [bankruptcy]. These will be covered in a subsequent article.

Morrison was intended to add a significant gloss on section 10(b), encoded in 15 U. S. C. 78j(b). Section 10(b) prohibits “the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement any manipulative or deceptive device or contrivance in contravention of [SEC] rules and regulations.”

Morrison involved a foreign bank’s purchase of a Florida mortgage servicer. The Bank, whose shares were never listed on an American exchange, subsequently wrote down the shares of the Florida firm, leaving dissatisfied investors in the Florida firm to claim that it had manipulated financial models to make the company’s mortgage-servicing rights appear more valuable than they really were. Moreover, the investors claimed that the deep-pocket Bank were aware of this manipulation.

The Southern District of New York trial court dismissed the section 10(b) claim for lack of subject-matter jurisdiction under Federal Rule of Civil Procedure 12(b)(1) and the Second Circuit affirmed the dismissal. The Supreme Court affirmed, but the five-justice majority gave the Second Circuit a scolding for “a threshold error” in its analysis.

“[T]he extraterritorial reach of §10(b) [does not] raise a question of subject-matter jurisdiction” and therefore this issue cannot be decided under Rule 12(b)(1), Rather, “what conduct [section] 10(b) prohibits . . . is a merits question” which can be determined only by statutory analysis. The Supreme Court interpreted section 10(b) under the canon of construction that unless a contrary intent appears, a statute is meant to apply only within the territorial jurisdiction of the United States.

The Second Circuit had created a misreading of section 10(b) when it held in Leasco Data Processing Equip. Corp. v. Maxwell, 468 F. 2d 1326 (2d Cir. 1972) that “the presumption against extraterritoriality apples only to matters over which the United States would not have prescriptive jurisdiction.” As Congress had prescriptive authority over securities fraud, the Second Circuit erroneously concluded that “if Congress had thought about the point,” it would have wanted 10(b) to apply extraterritorially.

The error was extended when the Second Circuit formalized its analysis, creating an “effects test” based on whether the wrongful conduct had a substantial effect in the United States or upon United States citizens, and a “conduct test,” whether the wrongful conduct occurred in the United States.” (SEC v. Berger, 322 F. 3d 187 (2d Cir. 2003))

The Supreme Court found at the practical level that the tests were needlessly confusing and had led to conflicting Circuit results. On the theoretical level, the Second Circuit had never established a “textual or even extratextual basis for these tests.” Rising to metaphorical heights, the Supreme Court found that the Berger tests, rather than a mighty oak grown from the Leasco Data acorn, were the creation of an undesirable “botanically distinct tree.” The issue was what jurisdiction Congress in fact thought about and conferred rather than divining what Congress would have wished if it had addressed the problem.

As Justice Stevens noted in his concurrence, Morrison eliminated what had been the law in the Second Circuit for nearly four decades and had been created only because “[t]he text and history of §10(b) are famously opaque on the question of when, exactly, transnational securities frauds fall within the statute’s compass.”

Morrison required that section 10(b) extend only to transactions in securities listed on domestic exchanges and domestic transactions in other securities. Therefore the entire Second Circuit jurisprudence on the extraterritorial application of section 10(b), including Leasco Data and Berger, was summarily thrown out.
The Circuit quickly reoriented its approach in section 10(b) cases to accommodate Morrison.

For example, in US v. Vilar, Nos. 10-521-cr(L), 10-580-cr(CON), 10-4639-cr(CON) (2d Cir. 2013), it held that the criminal penalties of section 10(b) did not apply extraterritorially. The Second Circuit began by reiterating Morrison:

“The presumption against extraterritoriality is a method of interpreting a statute, which has the same meaning in every case. The presumption against extraterritoriality is not a rule to be applied to the specific facts of each case.”

Finding in section 10(b) no essential difference in the reach of civil or criminal liability, the Court held that a criminal defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with a security listed on an American exchange, or a security purchased or sold in the United States. The Court upheld the convictions, however, based on the record showing fraud in connection with a domestic purchase or sale of securities.

Absolute Activist Value Master Fund v. Ficeto, 677 F.3d 60 (2d Cir. 2012) holds that a transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.

In Absolute Activist, a foreign investor had placed a buy order on a US exchange but the trade was entirely transacted off-shore. The location of the broker could be relevant to the extent that the broker carries out tasks that irrevocably bind the parties to buy or sell securities, but the location of the broker alone does not necessarily demonstrate where a contract was executed.

With regard to transactions not on a foreign exchange, “facts concerning the formation of the contracts, the placement of purchase orders, the passing of title, or the exchange of money” may be relevant to determining whether irrevocable liability was incurred in the United States, but the Second Circuit has never held “that the placement of a purchase order, without more, is sufficient to incur irrevocable liability, particularly in the context of transactions in foreign securities on a foreign exchange.” To sufficiently allege a domestic securities transaction in securities not listed on a domestic exchange, a plaintiff must allege facts suggesting that irrevocable liability was incurred or title was transferred within the United States.

In City of Pontiac Policemen’s & Firemen’s Ret. Sys. v. UBS, No. 12‐4355‐cv (2d Cir. 05/06/14), the Second Circuit considered whether Morrison applied to the situation where foreign‐issued securities purchased on foreign exchanges, but cross‐listed on a domestic exchange. Plaintiffs alleged UBS accumulated and overvalued $100 billion in residential mortgage backed securities and collateralized debt obligations. The accumulation of these mortgage‐related assets was allegedly made without disclosure to shareholders and were contrary to its representations as to risk.

The case was dismissed under Rule 12(b) because Morrison barred application of section 10(b) to situations where foreign investors purchased UBS stock on a foreign exchange even if UBS stock was available on a US exchange. Section 10(b) was concerned with the location of the securities transaction and not the location of an exchange where the security may have been dually listed.

On August 15, 2014, in Parkcentral v. Porsche, No. 11-397-cv (2d Cir. 08/15/14), the Circuit held that domestically-based swap agreements which, through allegedly fraudulent statements of the defendants primarily in Germany, were insufficient to create extraterritoriality.

A securities‐based swap agreement is a separate and distinct financial instrument from the security it references. Securities‐based swap agreements are designed to roughly replicate the economic effect of owning the referenced share of stock for one counterparty, and shorting the referenced share of stock for the other counterparty, without either party taking an actual ownership interest in the reference security.

Because securities‐based swap agreements do not involve the actual ownership, purchase, or sale of the reference security, domestic securities laws describe swaps as transactions in which the counterparties agree to make certain transfers without also conveying a current or future direct or indirect ownership interest. Instead, the parties agree to exchange payments calculated by applying the change in price of the reference security to a pre‐determined “notional amount” set by the parties. The agreement to a notional amount is the basis for either party’s profit and securities‐based swap agreements are essentially wagers on changes in the price of the reference securities.

The swap agreements were made in the US with reference to European stock. Defendant was not a party to any securities‐based swap agreements and did not participate in the market for such swaps in any way. The Circuit began with the conceptual problem of whether the swap agreements, executed and performed in the US, were a domestic transaction not only necessary for section 10(b) but also sufficient “to justify the application of § 10(b) to otherwise foreign facts . . . “

Holding that Morrison dealt with an indisputedly domestic transaction and therefore never reached the issue of whether “application of § 10(b) will be deemed domestic whenever such a [domestic] transaction is present and that the Supreme Court would not:
“require courts to apply the statute to wholly foreign activity clearly subject to regulation by foreign authorities solely because a plaintiff in the United States made a domestic transaction, even if the foreign defendants were completely unaware of it.”

The Circuit noted the deleterious effect of such a rule, as it would inevitably place section 10(b) in conflict with the regulatory laws of other nations. Such a rule “would subject to U.S. securities laws conduct that occurred in a foreign country, concerning securities in a foreign company, traded entirely on foreign exchanges, in the absence of any congressional provision addressing the incompatibility of U.S. and foreign law nearly certain to arise.”

The Circuit, observing that “the fact that the transaction was domestic might well be deemed sufficient to compel the conclusion that the invocation of § 10(b) is also domestic” in any given case, in this case “the claims in this case are so predominantly foreign as to be impermissibly extraterritorial.” Only when “the defendants are alleged to have sufficiently subjected themselves to the statute” will a section 10(b) action be allowed to proceed.

The opinion concluded with a riposte to Morrison.

“The conclusion we have reached on these facts cannot, of course, be perfunctorily applied to other cases based on the perceived similarity of a few facts. We do not purport to proffer a test that will reliably determine when a particular invocation of § 10(b) will be deemed appropriately domestic or impermissibly extraterritorial . . . [C]ourts must carefully make their way with careful attention to the facts of each case and to combinations of facts that have proved determinative in prior cases, so as eventually to develop a reasonable and consistent governing body of law on this elusive question.”

The Circuit made a rather pointed comment on the Morrison “bright-line” rule.

“We have neither the expertise nor the evidence to allow us to lay down, in the context of the single case before us, a rule that will properly apply the principles of Morrison to every future § 10(b) action involving the regulation of securities‐based swap agreements in particular or of more conventional securities generally. Neither do we see anything in Morrison that requires us to adopt a ‘bright‐line’ test of extraterritoriality when deciding every § 10(b) case.”

A disinterested observer might conclude that Morrison itself as a bright-line test of extraterritoriality which would seem to eliminate any labored consideration of “the facts of each case and to combinations of facts that have proved determinative in prior cases, so as eventually to develop a reasonable and consistent governing body of law” as the Second Circuit now recommends in Parkcentral.

Indeed, it seems that Parkcentral returns us to discarded Berger “effects test,” whether the wrongful conduct had a substantial effect in the United States or upon United States citizens, and the Berger “conduct test,” whether the wrongful conduct occurred in the United States. The extended Parkcentral discussion of the facts of the transaction and its effects reminds us that Morrison may have been right about Berger being “unpredictable and difficult to administer.” To make extensive reference to the pleaded facts as it did in Parkcentral exposes the Second Circuit to a second reversal on the extraterritoriality of section 10(b).

More by | James Ching James Ching , Law.com Contributor
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