During the past few years, several U.S. courts have addressed an increasingly important and controversial topic: When can foreign investors use U.S. courts and U.S. securities laws to pursue investment fraud claims? About two months ago, the Second Circuit issued an important decision on this subject. In Morrison v. National Australia Bank Ltd., 547 F.3d 167 (2d Cir. 2008), the Second Circuit affirmed a decision by the Southern District of New York finding that it lacked subject matter jurisdiction over securities fraud claims asserted under United States federal law by foreign purchasers of securities of a foreign issuer, National Australian Bank (NAB), where the purchase was made on foreign securities exchanges. Cases of this type are sometimes called “foreign-cubed” or “f-cubed” cases. Although the decision itself was a victory for the defendant, in reaching its result the court declined to adopt a “bright-line” test that had been gaining favor with some commentators. Under that bright-line test, courts would lack subject-matter jurisdiction in fcubed cases.  

Rather than accept the bright-line test, the Second Circuit applied the traditional conduct and effects tests to evaluate subject-matter jurisdiction. Based on the facts of the specific case before it, the court held that conduct by the NAB outside the United States was “significantly more central” to the alleged fraud than conduct occurring at NAB’s subsidiary within the United States.  

As a result of the court’s approach, the evaluation of subject matter jurisdiction in cases in the Second Circuit (including New York) will turn on the facts of each individual case, leaving open the possibility that U.S. courts may exercise subject matter jurisdiction over future “f-cubed” cases.  

The Conduct And Effects Tests  

Although this brief memo is not the place for an extended discussion of the conduct and effects tests, it is useful to begin with a brief summary of their purpose. Courts in the United States will tend to exercise jurisdiction where significant conduct has occurred here, or where conduct, if outside the United States, has significant effects here. The rationale for this rule is that the United States has a legitimate police-power interest in both (a) preventing improper conduct from occurring here even if its effects are elsewhere, and (b) protecting people here from improper conduct occurring elsewhere.  

Decision  

The NAB is a bank incorporated under the laws of Australia and headquartered in Melbourne, Australia. In 2000, its Australian operations accounted for approximately 55% of its assets and revenues. Its 1.5 billion ordinary shares traded on the Australian Securities Exchange, the London Stock Exchange, the Tokyo Stock Exchange, and the New Zealand Stock Exchange. The NAB also issued American Depositary Shares (ADRs) that traded on the New York Stock Exchange.  

In February 1998, the NAB acquired HomeSide, a company headquartered in Jacksonville, Florida that serviced mortgage loans in exchange for fees. Following the acquisition, HomeSide became a wholly-owned subsidiary of NAB. In 1999, HomeSide accounted for approximately 5.4% of NAB’s profits, and in 2000, 4.1% of NAB’s profits.  

The litigation arose out of the accounting for Mortgage Servicing Rights (MSRs) belonging to HomeSide. HomeSide used a valuation model to calculate the present value of future mortgage servicing fees, booked the resulting asset on its balance sheet, and amortized the value of the asset over its expected life.  

HomeSide then sent its financial results to NAB, which incorporated them into company-wide financial statements and disseminated those financial statements to the investing public. NAB’s financial statements presented HomeSide’s numbers both as stand-alone numbers discussing the performance of HomeSide and as part of NAB’s consolidated company-wide financial numbers.  

In 2001, NAB disclosed that the value of HomeSide’s servicing rights was overstated. In July 2001, NAB disclosed a $450 million write-down due to a recalculation in the value of HomeSide’s MSR. In September 2001, NAB announced a second write-down of $1.75 billion relating to the value of MSR and goodwill.  

Four plaintiffs brought suit in the Southern District of New York, alleging violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5. The court dismissed the claims asserted by three of the plaintiffs, who purported to represent a class of foreign purchasers of NAB securities, for lack of subject matter jurisdiction. It dismissed the claims asserted by the fourth plaintiff, who purported to represent a class of domestic purchasers of ADRs, for failure to state a claim. The foreign purchasers appealed.  

The Second Circuit affirmed. While it acknowledged that the Securities Exchange Act was silent as to whether its provisions applied to transactions taking place outside of the United States, the court invoked the traditional conduct and effects tests developed by the Second Circuit to evaluate the extraterritorial application of the federal securities laws. Id. at 170-71.  

Under the conduct test, subject matter jurisdiction exists 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.” Id. at 171. In other words, courts 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.” Id. at 173.  

Applying this test, the Second Circuit held that NAB’s conduct was “significantly more central to the fraud and more directly responsible for the harm to investors” than HomeSide’s accounting practices. Id. at 176. NAB – not HomeSide – made the allegedly false and misleading statements at issue. While HomeSide was an operational subsidiary whose “mandate was to run its business well and to make money,” NAB was responsible for reporting to shareholders and the financial community. Id. “Ensuring the accuracy of such statements is much more central to the responsibilities of NAB’s corporate headquarters, which issued the statements, than to those of HomeSide, which did not.” Id. The Court further suggested that absent a public statement from HomeSide, its conduct was more akin to aiding and abetting, which was insufficient to trigger liability under Section 10(b). See Id.

The Second Circuit also cited two additional factors supporting the district court’s decision: 1) the “striking absence of any allegation that the alleged fraud affected American investors or America’s capital markets,” a factor that “weighs against our exercise of subject matter jurisdiction”; and 2) the “lengthy chain of causation” between HomeSide’s conduct and the alleged harm to investors. Id. With respect to causation, the court noted that “while HomeSide may have been the original source of the problematic numbers, those numbers had to pass through a number of checkpoints manned by NAB’s Australian personnel before reaching investors.” Id. at 176-77.  

The Second Circuit conceded that determining “what is central or at the heart of a fraudulent scheme versus what is ‘merely preparatory’ or ancillary can be an involved undertaking.” Id. at 174. But it declined to adopt a per se rule establishing that United States courts lack subject matter jurisdiction over f-cubed cases. It rejected the argument that domestic conduct alone – in the absence of any effect on the U.S. markets of American investors – could never be enough to warrant subject matter jurisdiction.  

The court cited the “goal of preventing the export of fraud from America,” noting that “those who operate from American soil should not be given greater protection from American securities laws because they carry a foreign passport or victimize foreign shareholders.” Id. at 175. The court further stated that “we are leery of rigid bright-line rules because we cannot anticipate all the circumstances in which the ingenuity of those inclined to violate the securities laws should result in their being subject to American jurisdiction.”  

A much stronger case would exist, for example, for the exercise of subject matter jurisdiction in a case where the American subsidiary of a foreign corporation issued fraudulent statements or pronouncements from the United States impacting the value of securities trading on foreign exchanges. Id.  

The Second Circuit also cited its prior decision in SEC v. Berger, 322 F.3d 187 (2d Cir. 2003). There, it had held that subject matter jurisdiction existed with respect to activities of an offshore investment company organized under the laws of the British Virgin Islands. After the company suffered more than $300 million in losses, its single active director, working in New York, created fraudulent account statements concealing those losses and ordered the fund administrator in Bermuda to distribute them to investors. “The critical factor was that the conduct that directly caused loss to investors – the creation of the fraudulent statements – occurred in New York.” Morrison v. Nat’l Australian Bank, 547 F.3d at 173-74.  

But the Second Circuit also stated 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.” Id. at 175. It held that the “‘conduct test’ balances these competing concerns adequately and we decline to place any special limits beyond the ‘conduct test’ on ‘foreign-cubed’ securities fraud actions.” Id.  

Significance  

The Second Circuit decision means that it will continue to be difficult for plaintiffs to plead subject matter jurisdiction in f-cubed cases. Absent a specific public statement made or prepared in the United States, fraud at a U.S. subsidiary should be deemed ancillary to a public statement by a foreign issuer, even if that statement depends on information provided by the subsidiary.  

However, by declining to adopt a bright-line rule, the Second Circuit left an element of uncertainty in f-cubed cases. The conduct and effects tests endorsed by the court are highly fact-specific inquiries, and it is not always easy to predict when a particular fact situation will support subject matter jurisdiction. With respect to the conduct test, the Second Circuit articulated two scenarios in which subject matter jurisdiction may exist. But there may be other scenarios in which courts will conclude that the “central” conduct in an f-cubed case occurred in the United States.  

Under the conduct test, foreign plaintiffs must also plead facts establishing that U.S.-based conduct “directly caused” their losses. The Second Circuit in Morrison v. Nat’l Australia Bank suggested that U.S.-based conduct could satisfy the conduct test if it “impact[ed] the value of securities trading on foreign exchanges.” But the Second Circuit did not clarify what foreign plaintiffs must plead to establish such an impact.  

In a recent decision in the Southern District of New York, foreign plaintiffs urged the court to adopt a global “fraud-on-the-market” theory to establish that allegedly fraudulent statements made in the United States by a foreign issuer influenced the price of the issuer’s shares on foreign exchanges. Among other things, the plaintiffs alleged that a U.S. subsidiary of the foreign issuer created misleading press releases and that the issuer made misleading statements at medical conferences in the U.S., filed a misleading Annual Report with the SEC, and held meetings with analysts and investors in the United States. The court found that the alleged conduct was “more than merely preparatory to the fraud” and accordingly met the first prong of the conduct test. But because the court rejected the global fraud-on-the-market theory, it held that plaintiffs had failed to establish that the U.S.-based conduct had “directly caused” their losses. In re AstraZeneca Sec. Litig., 559 F.Supp.2d 453 (S.D.N.Y. 2008)  

The AstraZeneca court conceded that plaintiffs had raised a “valid” argument, noting that “the price of AstraZeneca stock on foreign markets did move in alignment with the U.S. stock price throughout the class period, as is natural in a global economy.” Id. at 466. But it observed that:  

Courts that have rejected a global fraud-on-the-market theory have not done so because they believe the theory does not hold true on a global level, but rather because of a concern that allowing foreign purchasers on foreign exchanges to plead reliance in this manner would extend the jurisdictional reach of the United States securities laws too far. Id. at 466.

Because the Second Circuit had not yet provided guidance on whether the fraud-on-the-market theory should apply to foreign countries, the court held that the foreign plaintiffs had failed to plead reliance on the U.S.-based conduct. Id. The court accordingly dismissed the claims of the foreign purchasers for failure to plead subject matter jurisdiction.  

The Second Circuit’s subsequent decision in Morrison v. Nat’l Australia Bank does not squarely address whether foreign plaintiffs may invoke a global fraud on the market theory to establish causation. At most, language in the decision suggests that U.S.-based conduct can influence the stock price on foreign exchanges. The decision therefore leaves some uncertainly as to how plaintiffs relying on the conduct test can establish that public statements in the U.S. directly caused their losses.  

The Second Circuit addressed only the conduct test, because appellants did not argue jurisdiction under the effects test. The decision therefore leaves an open question as to whether plaintiffs in an f-cubed case could establish subject matter jurisdiction on the basis of effects felt in the U.S. For example, NAB (like many foreign issuers) issued ADRs that were purchased by U.S. investors. Assuming the purchasers of ADRs suffered losses as a result of fraudulent conduct occurring in Australia, could foreign purchasers in an f-cubed action establish subject matter jurisdiction under the effects test?  

Decisions by the Southern District of New York do not provide a clear answer. Some suggest that foreign purchasers could establish subject matter jurisdiction using the effects test provided that domestic purchasers held a substantial percentage of the issuer’s outstanding shares. For example, in In re Nat’l Australia Bank Sec. Litig., No. 03 Civ. 6537(BSJ), 2006 WL 3844465 at *4 (S.D.N.Y. Oct. 25, 2006), the district court held that the foreign investors had not adequately pled jurisdiction under the effects test. First, the lead domestic plaintiff had failed to plead damages. But beyond that, there were not enough domestic investors to warrant jurisdiction over the foreign purchasers under the effects test. “[B]ecause the aggregate value of the ADRs represented a mere 1.1% of NAB’s nearly one-and-a-half billion ordinary shares, any effect on the United States market from the alleged fraud pales in comparison to the effect on the foreign markets.” Id. at *4.  

Similarly, in In re Bayer AG Sec. Litig., 423 F. Supp. 2d 105 (S.D.N.Y. 2005), the court held that purchasers of the securities of Bayer AG, a German issuer, on foreign exchanges had not pled subject matter jurisdiction under the effects test where United States investors held only 8% of Bayer AG’s shares. “Because United States investors held ‘an exceptionally small percentage’ of the total number of shares, Plaintiffs cannot demonstrate a substantial or significant effect upon United States citizens to support jurisdiction over Foreign Purchasers.” Id. at 114.  

Both decisions left open the possibility that if ADRs comprised a larger percentage of the total outstanding shares, then subject matter jurisdiction might be appropriate under the effects test.  

Other decisions by the Southern District of New York hold that foreign investors cannot invoke the effects test as a basis for subject matter jurisdiction because foreign investors, by definition, do not suffer from effects in the U.S. See In re China Life Sec. Litig., No. 04 Civ. 2112 (TPG), 2008 WL 4066919 at *9 (S.D.N.Y. Sep. 3, 2008) (“the basic purpose of applying effects test is to protect American investors”; test “does not provide a basis for allowing claims by foreigners who purchased shares of China Life on the [Hong Kong Stock Exchange]”); In re Parmalat Sec. Litig., 497 F. Supp. 2d 526, 531-32 (S.D.N.Y. 2007) (effects test has “no bearing” on subject matter jurisdiction over claims asserted by foreign plaintiffs); In re Parmalat Sec. Litig., 376 F. Supp. 2d 472, 511 (S.D.N.Y. 2005) (effects test inapplicable to claims “brought by foreigners who purchased Parmalat securities outside the United States”).  

It is worth noting that in each of the cases cited above, the court assessed subject matter jurisdiction separately for foreign and domestic purchasers.1 “Indeed, in the class action context where foreign purchasers have not demonstrated a significant connection to the United States under the conduct and effects tests, it is appropriate to dismiss the claims of foreign purchasers for lack of subject matter jurisdiction and retain the claims of domestic purchasers.” In re Bayer AG Sec. Litig., 423 F. Supp. 2d at 114-15. It is therefore unlikely that foreign purchasers in an f-cubed case could rely on a finding of subject matter jurisdiction in a separately filed case by domestic purchasers to establish jurisdiction under the effects test.  

The Second Circuit decision in Morrison v. Nat’l Australia Bank illustrates the steep pleading hurdle plaintiffs in f-cubed cases face in pleading subject matter jurisdiction. But by declining to adopt a bright-line rule, the court left the door open for foreign plaintiffs armed with theories of subject matter jurisdiction under the conduct or effects tests to bring suit in the Second Circuit.