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Court Finds No Subject Matter Jurisdiction in “Foreign-Cubed” Cases

By Karen L. Stevenson, Litigation News Associate Editor – January 16, 2009

For the first time addressing “foreign-cubed” securities claims, the Second Circuit in Morrison v. National Australia Ltd. Bank [PDF] has given guidance to what it has called “the vexing question of the extraterritorial application of the securities laws.”

In its recent opinion this fall, the appellate court affirmed a ruling by the U.S. District Court for the Southern District of New York that it lacked jurisdiction over claims brought under American securities laws by foreign investors who bought shares of National Australia Bank on a foreign exchange.

“Foreign-Cubed” Cases
A foreign-cubed case involves foreign plaintiffs suing foreign issuers in a U.S. court for violations of U.S. securities laws based on transactions in foreign countries. The application of U.S. securities laws to foreign-based transactions is vexing for courts because of the potential to generate conflicts with other countries.

In its opinion, the Second Circuit observed that “we are an American court, not the world’s court, and we cannot and should not expend our resources resolving cases that do not affect Americans or involve fraud emanating from America.”

However, the Second Circuit refused to bar foreign-cubed claims altogether. Instead, it held that determining subject matter jurisdiction over foreign-cubed claims requires a fact-specific examination in each case.

“Foreign claimants will continue to assert claims in U.S. courts against foreign-domiciled companies—particularly in connection with the onslaught of subprime and credit-crisis related litigation that increasingly implicates foreign domiciled, as well as U.S.-based companies,” notes Barrie L. Brejcha, Chicago, cochair of the Section of Litigation Securities Litigation Committee.

Background of the Case
In Morrison, National Australia Bank Ltd. (NAB) acquired an American mortgage servicing company headquartered in Florida. The plaintiffs alleged that the American affiliate calculated fees it expected to generate from mortgage servicing in the future using a valuation model that overstated its earnings. As a result, it is alleged that NAB took a $450 million write-down, and the price of the bank’s shares plummeted.

Foreign investors sued in the Southern District of New York alleging violations of Sections 10(b) and 20(a) of the Securities and Exchange Act of 1934 arising from materially false and misleading statements regarding the American affiliate’s profitability and contribution to NAB’s financial condition. The district court dismissed the claims for lack of subject matter jurisdiction, and the Second Circuit affirmed.

Second Circuit Ruling
The court rejected a bright line rule analysis and instead applied a “conduct test” in Morrison. It held that the alleged accounting manipulation at a U.S. subsidiary of NAB was merely preparatory to the alleged fraud. While Title 15 of the United States Code is silent as to its extraterritorial application, the court reasoned that “it is consistent with the statutory scheme to infer that Congress would have wanted to ‘redress harms perpetrated abroad which have a substantial impact on investors or markets within the United States.’”

Therefore, the court stated the “usual rules” apply when determining whether subject matter jurisdiction exists over foreign-based transactions. That is, courts must examine whether: (1) the wrongful conduct occurred in the U.S. and (2) whether the conduct had a substantial effect in the U.S. or on U.S. citizens. Commonly referred to as the “conduct test” and “effects test,” the two components may, where appropriate, be applied together. The NAB investors, however, relied solely on the conduct component in asserting subject matter jurisdiction.

Conduct Test
Under the conduct test, jurisdiction exists over foreign-cubed claims only if “the defendant’s conduct in the United States was more than merely preparatory to the fraud, and particular acts or culpable failures to act within the United States directly caused losses to foreign investors abroad.”

The Second Circuit concluded that in the case of NAB, the creation of allegedly false revenue figures by the American affiliate did not constitute the essential fraud. Rather, the court noted the attenuated chain of causation between the American affiliate’s actions and statements that ultimately reached investors: “the numbers had to pass through numerous checkpoints manned by NAB’s Australian personnel before reaching investors.” These facts and “the complete lack of any effect on America or Americans” led the court to conclude it lacked subject matter jurisdiction.

In clarifying the “conduct test,” the Second Circuit, however, explicitly rejected the D.C. circuit’s characterization of that test as requiring that domestic conduct comprise all the elements necessary to establish a violation of Rule 10b-5.

Exceptional Cases
Nonetheless, the Second Circuit acknowledged that there will be circumstances in which it would be appropriate to exercise subject matter jurisdiction over foreign-cubed claims. “Declining jurisdiction over all foreign-cubed securities fraud actions would conflict with the goal of preventing the export of fraud from America,” the court stated.

What does Morrison mean for the future? “To say that the ‘floodgates” will now be open as a result of the Morrison case may be premature,” opines Zesara C. Chan, San Francisco, codirector of the Section’s Substantive Areas of Litigation Division.

“The decision still supports a fact-based, case-by-case approach and the ‘conduct and effects’ test. Plaintiffs will still need to show that the alleged wrongful conduct had the required nexus in the United States,” Chan notes.

Keywords: Morrison v. National Australia Ltd. Bank, securities law, foreign cubed case, Second Circuit, internationalization


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