Corporate Governance

Morrison, Tourre, and the Misguided Interpretation of Rule 10b-5 (Part 1)

By J Robert Brown Jr.

We are discussing Morrison v. National Australia Bank, 130 S. Ct. 2869 (June 24, 2010), the Supreme Court case holding that Rule 10b-5 did not have extraterritorial effect and the misreading of the decision by the lower courts. 

As we have previously discussed on this Blog, the Supreme Court lacks meaningful expertise on issues implicating the federal securities laws. The Court doesn't deal enough with the securities laws to gain its own expertise and most of the Justices did not work in the area before joining the bench. The Court often avoids disruptive opinions by tracking the analysis provided by the Solicitor General.  This occurred, for example, in O'Hagan.  Of course, this approach doesn't always work.  When the Solicitor General files a brief without the input of the SEC, the agency with the most expertise on the securities laws, the result can be uneven analysis that is then borrowed by the Court.  Stoneridge falls into this category.

When, however, the Court disregards the Solicitor General and branches off on its own, the lack of expertise is telling.  In those circumstances, the Court is largely stuck with the arguments of the parties and amici, arguments that will likely be structured in a manner designed to win the case rather than ensure conformity with the securities laws.  The results can result in unpredictable consequences that are in fact inconsistent with the federal securities laws. 

This occurred in connection with Morrison.  The Court disregarded the position of the Solicitor General.  As a result, it blazoned a new path.  The result has been confusion among the lower courts and effective repeal of the antifraud provisions in circumstances that would probably shock most investors and legislators. 

How did this happen?  Justice Scalia first found that a presumption against extraterritorial jurisdiction applied.  Unable to find any source demonstrating that Congress intended for the provision to be applied in an extraterritorial fashion, he concluded that Section 10(b) did not.  The concurring opinion written by Justice Stevens disagrees with this approach but Justice Scalia makes a reasonable case for the interpretation.

It is what follows that sows the seeds of confusion.  To the extent that extraterritorial application described transactions wholly outside the US, the holding would have generated little functional change in the law.  The conduct and effects test used by the lower courts in determining extraterritorial application would have excluded those transactions from US jurisdiction.  Thus, as the Court noted:  'the presumption against extraterritorial application would be a craven watchdog indeed if it retreated to its kennel whenever some domestic activity is involved in the case.'

In considering the impact of domestic conduct on jurisdiction, the five Justice majority had a serious problem.  The alleged fraud committed by NAB arguably occurred in the US.  Some of the alleged behavior that made up the fraud took place in Florida.  To uphold dismissal of the case against NAB, the Court had to find a way to conclude that Rule 10b-5 did not extend to the fraudulent conduct by NAB that occurred in the US.  The Court could have done so much the way one of the concurring opinions suggested by concluding that the behavior in Florida was not sufficient to result in territorial application. To do so, however, would have to some degree resurrected the conduct/effects test.

Instead, the Court opted to exempt entirely any consideration of the fraudulent behavior in determining jurisdiction.  The Court did so by relying on the language in Section 10(b).  See Section 10(b), 15 USC 78j(b).  The section extended the prohibition on fraud to "any security registered on a national securities exchange or any security not so registered.'  In what would be incorrectly characterized as a transactional test, the Court interpreted the language to mean that jurisdiction over actions under Section 10(b) extended only to 'transactions in securities listed on domestic exchanges, and domestic transactions in other securities.'

We will pick up this thread in the next post.

For primary materials on SEC v. Tourre, go to the DU Corporate Governance web site.  For primary materials on Morrison v. NAB, go to the DU Corporate Governance web site.?

Full post as published by The Race to the Bottom on February 17, 2011 (boomark / email).