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Focus: US courts' extraterritorial reach in securities fraud cases reinstated

5 August 2010

In brief: The recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act extends the extraterritorial jurisdiction of the US federal courts for claims brought by the US Securities and Exchange Commission and the Department of Justice to enforce federal securities laws in relation to overseas conduct and partially overturns the recent decision of the US Supreme Court in Morrison v NAB. Partner Annette Hughes and Lawyer Dora Banyasz report.

This is the second in a series of Focus articles examining in detail particular aspects of the Dodd-Frank Wall Street Reform and Consumer Protection Act and its effect on Australian companies. The first discussed new disclosure laws for resources companies. The remaining articles will examine such issues as the impact of the legislation on banking regulation, corporate governance, executive remuneration, and consumer protection.

How does it affect you?

  • Australian companies that are not listed on the US stock exchange may be the subject of enforcement action by the US Securities and Exchange Commission (the SEC) and the Department of Justice (the DOJ) under the Securities Exchange Act of 1934 (the Exchange Act) in respect of conduct occurring outside the US and involving foreign investors.
  • Federal courts will have the jurisdiction to hear such actions where the conduct has a foreseeable substantial effect within the US, or where significant steps in furtherance of the violation occur within the US.
  • The meaning of 'foreseeable substantial effect' and 'significant steps in furtherance of the violation' is uncertain. The way in which these thresholds are interpreted and applied will need to be monitored to understand in what circumstances an SEC or DOJ action can be brought.
  • The decision in Morrison v NAB continues to apply to private actions, including class actions. This means that private litigants may only pursue claims alleging securities fraud in relation to the sale of, or purchase of, shares in the US or of securities listed on an American domestic stock exchange. Even this aspect of the case is under review, though, as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) requires the SEC to study the benefits and impacts of such actions within 18 months.

Introduction

On 24 June 2010, the US Supreme Court, in Morrison v NAB, ruled that plaintiffs could only pursue claims alleging securities fraud under the Exchange Act for the sale or purchase of shares in the US or of securities listed on an American domestic stock exchange (the so-called 'transactional' test). This restriction applied equally to the enforcement activities of the SEC and the DOJ under the Exchange Act (however, the decision did not touch on, and therefore did not alter, the powers of the SEC or the DOJ to bring proceedings under the Securities Act of 1933 (the Securities Act)). The decision in Morrison v NAB overturned decades of jurisprudence and dramatically limited the extraterritorial reach of US federal securities laws.

The Dodd-Frank Act was signed into law by President Obama on 21 July 2010. The Act overturns part of the decision in Morrison v NAB by expressly creating federal court jurisdiction over actions brought by the SEC or DOJ alleging securities fraud involving extraterritorial conduct.

Impact of the Act on SEC & DOJ enforcement activity

The changes are implemented through section 929P of the Dodd-Frank Act, which amends s22 of the Securities Act and s27 of the Exchange Act.

The Dodd-Frank Act establishes that extraterritorial jurisdiction applies for an action instituted by the SEC alleging a violation of s17(a) of the Securities Act or the antifraud provisions of the Exchange Act which involves:

  • 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
  • conduct occurring outside the United States that has a foreseeable substantial effect within the United States.

The federal courts' jurisdiction is therefore limited to violations of these kinds – that is, foreign frauds involving a significant amount of domestic conduct or effect. This marks a partial return to the conduct and effects tests used by the lower courts before the Morrison v NAB decision, and does away with the 'transactional' test established by the Supreme Court in relation to SEC actions. It is difficult to say with any certainty how this new conduct and effects test will be applied, for, as the Supreme Court noted in its decision, these tests 'were not easy to administer' and decisions of the lower courts had 'produced a proliferation of vaguely related variations' of its application.

Private actions

The Dodd-Frank Act requires the SEC to conduct a study to determine the extent to which private rights of action under the Exchange Act should also be permitted and governed by the conduct and effects test. The study is required to:

  • consider the scope of such a private right, in particular whether it should be limited to institutional investors or apply to all private actors;
  • analyse the costs and benefits of extending extraterritorial jurisdiction for private rights of action, and;
  • determine the implications of such jurisdiction for international comity.

The SEC has until 21 January 2012 to report its findings and make recommendations to the relevant House and Senate committees. Until such time, the Morrison v NAB decision continues to apply to private claimants, including class actions.

Conclusion

Companies not listed on the US stock exchange should be aware of this partial return to the pre-Morrison v NAB liability exposures and manage risk accordingly. They should also ensure that they stay abreast of further potential legislation reinstating private rights of action in securities fraud cases and follow developments that may shed light on what conduct or effects may subject them to the long reach of the US courts under the Dodd-Frank Act.

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