In a case of far reaching importance to the international securities markets, the US Supreme Court held in Morrison v. National Australia Bank Ltd., U.S., No. 08-1191 (decided June 24, 2010) that the principal antifraud provisions of the US securities laws, Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, apply only to transactions in securities that take place in the United States or transactions in securities listed on a US securities exchange. The Court stated that these key provisions do not have extraterritorial application since Section 10(b) lacks an explicit statement of extraterritorial effect. In so holding, the Court overruled a substantial line of prior Federal Court of Appeals’ cases that had allowed claims under Rule 10b-5 if the facts involved either substantial wrongful conduct in the United States or wrongful conduct that had a substantial effect in the United States or on US citizens. The so-called “conduct-and-effects” test had been established in numerous cases involving foreign securities transactions. Eliminating those tests substantially limits the extraterritorial scope of Rule 10b-5 and has broad implications for the international securities markets.
In National Australia Bank, plaintiffs, who were Australian residents, had alleged violations of Rule 10b-5 based on purchases of ordinary shares of National Australia Bank (“NAB”) in Australia. Plaintiffs alleged numerous misstatements (including some originating in the United States) regarding a failed US mortgage business purchased by NAB in Florida. NAB’s American Depositary Receipts (ADRs) were listed on the NYSE but its ordinary shares were not.
National Australia Bank was expected to decide the legitimacy of so-called “foreign cubed” cases (i.e., cases against non US defendants involving foreign purchasers of non US securities in transactions abroad). However, the rule announced in National Australia Bank has far broader application than such “foreign cubed” cases and also applies to US plaintiffs bringing actions based on non US securities transactions. The broadly stated holding of the case is that Section 10(b) and Rule 10b-5 have no extraterritorial effect and apply only to transactions in securities listed on domestic exchanges and to other securities transactions that take place in the United States. The Court made no effort to analyze the distinction between NAB’s stock and ADRs or US and foreign purchasers in its holding. The Court seemed most swayed by the fact that the transactions in the NAB shares took place abroad. The Court mentioned only in passing that NAB had listed ADRs and that NAB was a reporting company under the Exchange Act and therefore would naturally expect to be subject to US antifraud rules with respect to its public statements. Nor did the Court mention that ADRs are generally regarded by investors as substantially equivalent to a purchase of the underlying ordinary shares.
Given the Court’s focus on limiting extraterritorial application of the statute, it would appear that the new test would also disallow Rule 10b-5 claims by a US plaintiff purchasing securities abroad of any issuer whether domestic or foreign where the securities are not listed in the United States. Justice Stevens’s concurring opinion states that the Court’s holding would in fact bar a claim by an American investor who buys shares overseas in a company listed only on a non US exchange.
ADRs and Convertible Securities; Multiple Listed Securities. Purchasers of ADRs in the United States and purchasers of listed ADRs through the facilities of a US exchange will continue to be covered by Rule 10b-5. Purchases outside the United States of GDRs or convertible securities that are not listed on a US exchange will not be covered by Rule 10b-5 whether or not the underlying common stock or other equity securities are US listed. The case leaves unclear the circumstances under which securities traded on both US and foreign exchanges will be covered. An important interpretive question is whether the phrase “transactions in securities listed on a domestic exchange” covers overseas off-exchange transactions in listed securities or transactions on a foreign exchange in securities which have US and one or more other secondary or primary foreign listings. Justice Scalia’s opinion appears to assume that Rule 10b-5 would not apply to any transactions on foreign exchanges regardless of whether the securities are also listed on a US exchange. This has significant implications for many issuers with multiple exchange listings. For example, common stock of many large Canadian corporations is listed in both the United States and in Canada, as Canadian companies generally do not use the ADR structure followed by many other foreign issuers. Based on the Court’s clear intent to limit the extra-territoriality of Rule 10b-5, it is possible and even likely that National Bank of Australia will be read to exclude purchases and sales on a Canadian exchange of common stock that is also listed on a US exchange from the antifraud provisions of Section 10(b). Interpreted in that manner, the new rule would further substantially limit the application of Rule 10b-5 in international transactions.
Other OTC Securities Sold Abroad. The Court’s ruling will also have a substantial effect not only with respect to corporate debt and equity securities, but also with respect to mortgage backed securities and derivatives purchased in the secondary market outside the United States by any purchaser. As such securities are rarely listed in the United States, overseas transactions in those securities are no longer covered by Section 10(b).
Implications for the International Securities Markets. The Court’s bright line test could lead to substantial changes in the practices of both US and overseas issuers, investment banks and investors. Non US issuers and underwriters have always made an effort, where possible, to avoid application of the US securities laws. National Australia Bank gives those issuers and underwriters a bright line test they can potentially use to avoid Rule 10b-5 liability in international securities transactions. For example, foreign issuers selling non US listed securities to US institutions may insist that those purchasers buy their securities in an offshore transaction by a non US affiliate in an effort to remain beyond the reach of Rule 10b-5. Conversely, large US institutional investors may insist that their Rule 144A purchases be made directly into the United States so that Rule 10b-5 would be applicable to the sale.
Much of the power of Rule 10b-5 has come from the fact that Rule 10b-5 liabilities could not be disclaimed by contract and are applicable regardless of the intentions of the parties. The new bright line test appears to make it a simple matter to avoid the Rule by structuring securities sales so that they take place offshore. Section 30(b) of the Exchange Act allows the SEC to subject to the securities laws, transactions which are designed to evade the Exchange Act and the SEC has done so on a number of occasions. However, given the clarity of the Court’s bright line test, it is difficult to see how the SEC could develop rules which would have much force in distinguishing transactions designed to evade Section 10(b).
Issuers, underwriters and indeed all sellers of securities now have a strong incentive to structure their securities sales as non US transactions. US Institutional investors have a contrary incentive. Foreign private issuers will have a further incentive not to list their securities in the United States. One possible result is that the Rule 144A market could become less favored which could benefit the Regulation S market. Alternatively, the structure of Rule 144A sales may be altered in an effort to avoid application of the Rule.
When Does a Transaction Take Place in the United States? Lower courts will have to define when a purchase or sale (at least as to non US listed securities) takes place in the United States within the meaning of National Australia Bank. Can underwriters do a US road show with extensive US directed selling efforts, but close all sales of securities abroad and thereby avoid application of Rule 10b-5? Is where the money originated in a purchase of securities, or to whom it went in a sale of securities, determinative? Are US residents protected by Rule 10b-5 when they place purchase or sale orders with their brokers from the United States on non US exchanges? As noted above, similar questions may arise in the case of transactions in US listed securities that take place overseas off the facilities of the exchange or on a foreign exchange. National Australia Bank does not fully answer these questions.
Government Enforcement Actions. The Supreme Court’s ruling in National Australia Bank also may subject SEC and the Department of Justice enforcement actions to the Court’s new extraterritoriality test. However, the Financial Regulation Reform bill recently signed into law purports to extend the US Government’s enforcement jurisdiction under Section 10(b) and Rule 10b-5 to:
“(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.”
In National Australia Bank, the Court had found that the issue of extraterritoriality was not a matter of subject-matter jurisdiction but was a question on the merits. Although phrased in terms of jurisdiction, this provision is clearly designed to restore the ability of the SEC and Department of Justice to bring these cases. But it remains an open question whether the legislation will be effective. The Scalia opinion clearly states that as a substantive matter of statutory interpretation, Rule 10b-5 does not have extraterritorial application.
The financial reform legislation also requires the SEC to prepare a study within 18 months of enactment of the bill on the implications of authorizing an explicit legislative private right of action based on the conduct-and-effects test. As a result, even if there is legislative pressure to overrule National Australia Bank (which is by no means assured), it could be some time after that report is received before Congress would even consider that possibility.