Corporate Governance

Morrison, Tourre, and the Misguided Interpretation of Rule 10b-5 (The Non-Transactional Transactional Test) (Part 2)

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.

The test employed by the Court, however, was confusing, not the least because it was described as transactional when, at best, that was only partially true.  Much like the registration provisions of the securities laws which exempt not only transactions (Section 4) but also types of securities (Section 3), Morrison had elements of both.  The reference to domestic sales was transactional.  Only the location of the transaction mattered.  But the reference to securities listed on a US stock exchange was not.  That reference sought to apply Rule 10b-5 to a type of security, those traded on a US exchange.

This suggests that any transaction in a security traded on the NYSE would result in application of Rule 10b-5.  If all that mattered was the type of security (US exchange traded), the antifraud provisions would apply even if the transaction took place entirely outside the United States and involved foreign investors.  This interpretation is compelled by the plain language of the opinion.  To the extent securities traded on a US exchange was somehow meant to apply only to exchange transactions in the United States, the analysis would have been swallowed by the portion of the test that captured all domestic transactions, irrespective of the type of security.    

The two tests together require a straightforward analysis.  First, is the security involved listed on a US stock exchange?  If so, nothing else matters.  It makes no difference that the security is also listed on a foreign stock exchange or that the investors were located outside the US or that the fraud occurred in another country.  Moreover, the test would presumably extend to shares sold overseas in a private placement.  While those shares would not be immediately tradable on a US exchange, they would nonetheless constitute transactions in securities listed on domestic exchanges.  Moreover, they would also likely be traded over the exchange once any limitations on transferability expired.

The second test looks only to the location of the transaction.  The test turns not on the nature of the security (whether a  domestically issued security, a security listed on a foreign exchange, or an ADR) but on the place where the sale occurred.  Determining where first requires proof of when.  Here there is a relatively developed body of law.  Section 3 of the Exchange Act defines a purchase includes 'any contract to buy, purchase or otherwise acquire.'  15 USC 78c(a)(13); see also Blue Chip Stamps v. Manor Drug Stores, 421 US 723, 751 (1975) (noting that under statute purchase includes 'contractual rights or duties to purchase').  The terms "purchase" and "sale" are defined in the Exchange Act.  See 15 USC 78c(13) & (14).

Assuming a purchase or sale, the analysis would shift to the location.  Presumably a sale would seem to occur if the irrevocable commitment to purchase or sell occurred in the US.  As a practical matter, these transactions would most often involve US investors.  As a legal matter, however, the identity of the investor would not matter (except as a factor in determining where the transaction occurred). 

The test had some uncomfortable aspects.  While fraud committed in the US was not sufficient to establish jurisdiction, a trade entirely conducted outside the US could trigger jurisdiction under the antifraud provisions if the stock happened to be traded on Nasdaq or the NYSE.  Indeed, one can imagine that Justice Scalia would have preferred a test that limited jurisdiction exclusively to domestic transactions.  But the language referring to transactions in shares traded on a domestic stock exchange came directly from Section 10(b), the source of his test, so there was little he could do about it.  

For primary materials on SEC v. Tourre, go to the DU Corporate Governance web site.  For primary materials on Morrison v. NAB, including the many amicus briefs filed in the case, go to the DU Corporate Governance web site.?

Full post as published by The Race to the Bottom on February 18, 2011 (boomark / email).