Client Alert
“Foreign-Cubed” Securities Fraud Actions — by Foreign Plaintiffs against Foreign Issuers Based on Foreign Stock Purchases — Can Fall Within Subject Matter Jurisdiction of U.S. Federal Courts Under Appropriate Facts
October 29, 2008
On October 23, 2008, in a case of first impression, the U.S. Court of Appeals for the Second Circuit considered the question of whether a securities fraud complaint brought by foreign plaintiffs against foreign issuers based on foreign stock purchases — a set of circumstances sometimes dubbed a “foreign-cubed securities case” — could be heard by a U.S. federal court. Morrison v. National Australia Bank Ltd., 07-0583-CV. While the Second Circuit rejected this particular case on its facts, it declined to adopt any bright-line rule precluding subject matter jurisdiction in any foreign-cubed case where the wrongful conduct had no effect in the United States. Rather, it held that defendants seeking to challenge subject matter jurisdiction in such cases must continue to do so on a case-by-case basis, looking to the specific facts of each particular case.
The Morrison Case
The three plaintiffs at issue in Morrison (the “Foreign Plaintiffs”) had bought “ordinary shares” (the equivalent of American common stock) of the National Australia Bank, an Australian corporation (“NAB”). While those shares traded on a number of foreign exchanges — the Australian Securities Exchange, the London Stock Exchange, the Tokyo Stock Exchange and the New Zealand Stock Exchange — they did not trade in the United States, and the Foreign Plaintiffs purchased their shares abroad.1
Prior to the Foreign Plaintiffs’ purchases, NAB had acquired a United States corporation, HomeSide Lending, Inc. (“HomeSide”), a mortgage service provider headquartered in Jacksonville, Florida. NAB later discovered that HomeSide had engaged in accounting practices that resulted in an overstatement of the company’s financial results. Specifically, HomeSide had calculated the present value of the fees its mortgage servicing business would generate in the future, and booked that amount as an asset. NAB later revealed that the interest assumptions in HomeSide’s valuation model were incorrect and resulted in an overstatement of the value of HomeSide’s servicing rights. As a result of that disclosure, NAB’s ordinary shares fell dramatically in value, and litigation ensued.
Although they had purchased their shares abroad, the Foreign Plaintiffs brought suit in federal district court in Manhattan, alleging violations of the federal securities laws, including Section 10(b) of the Securities and Exchange Act of 1934 and Rule 10b-5 thereunder. The Foreign Plaintiffs claimed that HomeSide had falsified the pertinent data in Florida, and then sent the data to NAB in Australia, where NAB personnel disseminated it via public filings and statements, and that in reliance upon the misleading statements by NAB, they had purchased NAB shares to their detriment.
The “Usual Rules”
The District Court had dismissed the case for lack of subject matter jurisdiction. In analyzing the issue on appeal, the Second Circuit recognized that while the case presented a novel fact pattern — “a set of (1) foreign plaintiffs . . . suing (2) a foreign issuer in an American court for violations of American securities laws based on securities transactions in (3) foreign countries” (emphasis in original) — the “usual rules still apply.”
Those “usual rules,” as established by prior Second Circuit opinions, dictated that subject matter jurisdiction would exist over extraterritorial claims only if “activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad.”2 In applying this test, the court must “identify which action or actions constituted the fraud and directly caused harm . . . and then determine if that act or those actions emanated from the United States.”
Bright-Line Rule Rejected
The Second Circuit acknowledged that its usual approach to determining subject matter jurisdiction of extraterritorial claims, which involved “determining what is central or at the heart of a fraudulent scheme versus what is ‘merely preparatory’ or ancillary,” could be difficult to apply. Seizing upon that difficulty, the defendants urged the Court to adopt a different standard, a “bright-line” rule precluding the exercise of subject matter jurisdiction in any “foreign-cubed” case where the conduct had no effect within the United States. To do otherwise, they contended, would result in a “parade of horribles,” foremost among them the risk that permitting such actions in the United States would bring our securities laws into conflict with those of other jurisdictions.
The Second Circuit rejected this argument. It concluded that the potential conflict between United States and foreign laws was not a significant obstacle in the case of anti-fraud provisions. As opposed to more specific rules — such as registration requirements, which vary greatly from country to country — the court found that anti-fraud provisions are “broadly similar as governments and other regulators are generally in agreement that fraud should be discouraged.” Moreover, the Court noted that to decline jurisdiction over all foreign-cubed securities fraud actions could render the United States a safe haven for securities cheaters, so long as they victimized only foreign shareholders.
Applying the “Usual Rules” to the Facts
Addressing the “usual rules” under the facts of this case, the Foreign Plaintiffs argued that it was the alleged accounting manipulation by HomeSide — in Florida — that formed the heart of the fraud, and therefore that the Court should uphold jurisdiction. The Second Circuit disagreed. It concluded that “the actions taken and the actions not taken by NAB in Australia were, in our view, significantly more central to the fraud and more directly responsible for the harm to investors than the manipulation of the numbers in Florida.” For that reason, and also because of the lengthy chain of causation between HomeSide’s actions and the statements that reached investors, as well as the lack of any apparent effect of NAB’s conduct on America or American investors, the Second Circuit determined that subject matter jurisdiction was lacking. Thus, although the Foreign Plaintiffs had succeeded in avoiding a bright-line rule foreclosing their foreign-cubed claim altogether, they still failed to satisfy the Court that exercising subject-matter jurisdiction was proper under the particular facts here.
Conclusion
By rejecting a bright-line rule, the Second Circuit left in place its well-established jurisprudence for addressing the subject matter jurisdiction of extraterritorial claims. Thus, even in a foreign-cubed case — one involving foreign plaintiffs, foreign issuers and foreign stock purchases — defendants must attack subject matter jurisdiction on a case-by-case basis. Morrison makes clear, however, that courts in the Second Circuit will not hesitate to grant motions to dismiss where its test for establishing jurisdiction has not been met.
1. While NAB did have American Depository Receipts (“ADRs”) which traded in the United States, and a fourth plaintiff brought suit based on his purchase of such ADRs, the district court dismissed that plaintiff’s claims for failure to allege damages. Because that dismissal was not challenged on appeal, the Second Circuit’s opinion dealt only with the claims of the Foreign Plaintiffs.
2. While the “usual rules” also include a second element to be established in addition to the “conduct test” — whether the wrongful conduct had a substantial effect in the United States or upon United States citizens — the Foreign Plaintiffs in Morrison relied only upon the “conduct” component of the test, and accordingly the Second Circuit did not address the “effects” component of the test.
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