Corporate Governance

Morrison, Tourre, and the Misguided Interpretation of Rule 10b-5 (Protecting Foreign Exchanges) (Part 3)

By J Robert Brown Jr.

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

So Morrison dictated that that applicability of Rule 10b-5 depended upon the type of security (traded on a domestic stock exchange) or the location of the trade (domestic transaction).  The straightforward analysis was, however, confused by the emphasis in the opinion on the need to avoid interference with foreign stock exchanges. 

In concluding that Rule 10b-5 applied to shares listed on a US stock exchange, Justice Scalia relied on language in the Exchange Act that referred to listed securities.  See Section 30, 15 USC 78dd.  This affirmative decision to emphasize securities listed in the US, he divined, was designed to prevent US law from regulating foreign stock exchanges.  As he noted:  "Nothing suggests that this national public interest pertains to transactions conducted upon foreign exchanges and markets."  To do otherwise created the "probability of incompatibility with the applicable laws of other countries."  Id.

Yet the conflict proposed by the Court is not at all clear.  Some sections of the Exchange Act, such as the requirement that stock exchanges receive SEC approval, would interfere with the regulatory system applicable to foreign exchanges.  But Section 10(b) and  Rule 10b-5, the provisions as issue in Morrison, are an entirely different matter.  They essentially prohibit lying, a form of behavior presumably either not countenanced by foreign exchanges or, at most, not within their regulatory bailiwick.  Thus, it is difficult to see how the provisions could cause the "incompatibility" raised by Justice Scalia. 

The Court did eventually identify aspects of Rule 10b-5 that it deemed likely to cause the requisite incompatibility.  As the majority described:  

• And the regulation of other countries often differs from ours as to what constitutes fraud, what disclosures must be made, what damages are recoverable, what discovery is available in litigation, what individual actions may be joined in a single suit, what attorney's fees are recoverable, and many other matters.

But most of these attributes are not embedded in Section 10(b) or Rule 10b-5.  Matters such as fees or discovery or joinder were not dictated by Section 10(b) (and therefore considered by Congress in adopting the provision) but by the rules of civil procedure or other sources outside the securities laws.  Moreover, many of the concerns that arise from damages or fees (or class actions) developed long after the adoption of the Exchange Act and therefore could not have been considered by Congress.

To the extent that Section 10(b) can be said more generally to regulate disclosure, even this is not likely to cause incompatibility with regulation by foreign stock exchanges.  Disclosure is not a task ordinarily left to foreign stock exchanges.  They may (but usually do not) regulate disclosure.  See The Role of the Stock Exchange in Corporate Governance, OECD Study, 2009, at 5 ('Monitoring of ongoing disclosure requirements is also not typically the sole purview of exchanges. Given that at least some aspects of disclosure regimes are not based on stock exchange rules but on legislation or regulatory authority rules (i.e., in the area of takeovers or accounting standards), exchanges may have a minor role in enforcing non-compliance. More often than not, the thrust of exchanges' responsibility in the enforcement function lies in their capacity to monitor market developments and bring cases to the attention of securities regulators.').  

More importantly, the antifraud provisions only regulate disclosure to the extent that they prohibit misstatements.  There is no foreign stock exchange that authorizes misstatements.  And, while Rule 10b-5 may sometimes require more disclosure than what is mandated by a country's securities laws, more disclosure (as opposed to less disclosure) presumably does not directly conflict with those laws.  The securities laws in other countries most likely permit disclosure beyond what is required. 

In other words, Congress was not concerned about the risk of incompatibility with foreign exchanges.  Given the lack of global trading at the time, it is likely Congress never gave a thought to the impact of the antifraud provisions on foreign exchanges. This can be seen from the actual language of Section 10(b).  By extending Section 10(b) to securities traded in the US, Congress potentially captured foreign securities listed on a foreign exchange that happened to be purchased or sold in the US. 

Congress was concerned not about protecting foreign exchanges but about protecting US investors.  It did so by applying the antifraud provisions to trades on US listed companies and trades that occurred in the US.  The two tests, back in 1934, would likely have captured most trades by US investors.  There is nothing in Section 10(b) that suggests Congress intended to exempt all trades in securities listed on foreign exchanges, including those that took place in the US.  

Yet lower courts have read into the language an intent to exempt foreign securities even if the trade occurs in the United States.  We will explore these opinions in subsequent posts.

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

Full post as published by The Race to the Bottom on February 21, 2011 (boomark / email).