On March 27, 2019, the Supreme Court issued its decision in Lorenzo v. SEC, holding that those who disseminate false or misleading statements to potential investors with the intent to defraud--even if they are not the author or "maker" of the statement--can be found to have violated subsections (a) and (c) of Rule 10b-5 and related provisions of the federal securities laws. Lorenzo v. SEC, 587 U.S.___, 2019 WL 1369839 (Mar. 27, 2019).
Lorenzo is noteworthy because it could be seen as expanding potential liability under Rule 10b-5 and may be used by civil plaintiffs to try to resuscitate exposure for third-party actors who were thought to be outside the ambit of Rule 10b-5 after earlier decisions in Janus Capital Group, Inc. v. First Derivative Traders, 564 U.S. 135 (2011) and Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994).
In Central Bank, the Court held that there is no private right of action for aiding and abetting a Rule 10b-5 violation by someone else. In Janus, the Court held that only the "maker" of a statement--one who has "ultimate authority" over the statement's content and whether to communicate it--can be liable for violations of subsection (b) of Rule 10b-5. These decisions had helped limit the scope of 10b-5 cases in recent years. In a ruling that goes further than what many hoped Janus suggested, the Court in Lorenzo held that "dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule
10b-5... even if the disseminator did not `make' the statements and consequently falls outside subsection (b) of the Rule."
The facts of the case were not sympathetic. Francis Lorenzo, an investment banker at Charles Vista, LLC, sent an email to two potential investors concerning one of Charles Vista's clients, Waste2Energy Holdings, Inc. ("W2E"). Lorenzo's email touted certain claimed protections for the potential investment, including W2E having $10 million in assets, which Lorenzo knew to be inaccurate. The emails were written by and sent at the request of Lorenzo's boss, but in the email, Lorenzo told the potential investors to call him with any questions, listing his name and title as "Vice President--Investment Banking."
On appeal from administrative proceedings before the SEC, the D.C. Circuit held that, although Lorenzo's statements were false or misleading and had been made with the requisite mental state, Lorenzo could
not be liable for violating subsection (b) of Rule
Supreme Court Creates Uncertainty about the Reach of "Scheme" Liability under Rule 10b-5 Page 1
Delaware Court of Chancery Holds Forum Selection Provisions Requiring Claims under the Securities Act of 1933 to Be Brought in Federal Court Are "Ineffective and Invalid" Page 4
Supreme Court Declines to Decide Standard of Liability for Alleged Tender Offer Misstatements and Omissions under Exchange Act 14(e) and Whether There Is a Private Right of Action Page 6
A New Era of Extraterritorial SEC Enforcement Actions Page 8
Fried Frank Securities Litigation Update Copyright 2019. Fried, Frank, Harris, Shriver & Jacobson LLP. All rights reserved. Attorney Advertising. Prior results do not guarantee a similar outcome.
Lorenzo is noteworthy because it could be seen as expanding potential liability under Rule 10b-5 and may be used by civil plaintiffs to try to resuscitate exposure for third-party actors who were thought to be outside the ambit of Rule 10b-5 after earlier decisions in Janus and Central Bank.
10b-5 because, under Janus, Lorenzo was not the "maker" of the statements. Lorenzo v. SEC, 872 F.3d 578 (D.C. Cir. 2017). Rather, Lorenzo's boss retained "ultimate authority" over the statements' content. But the D.C. Circuit concluded that Lorenzo nonetheless could be liable for violating subsections (a) and (c) of Rule 10b-5, which do not require that a defendant "make" a statement to impose liability.
The Supreme Court granted certiorari "to resolve disagreement about whether someone who is not a `maker' of a misstatement under Janus can nevertheless be found to have violated the other subsections of Rule 10b-5 and related provisions of the securities laws, when the only conduct involved concerns a misstatement."
the Rule. For purposes of the appeal, it was undisputed that the statements were false and sent with the requisite scienter.
Lorenzo had urged that these sections should not reach his conduct:
This is so, he says, because the only way to be liable for false statements is through those provisions that refer specifically to false statements. Other provisions, he says, concern "scheme liability claims" and are violated only when conduct other than misstatements is involved. Thus, only those who "make" untrue statements under subsection (b) can violate Rule 10b-5 in connection with statements.
The Court disagreed, describing the relevant securities laws as "includ[ing] both a general proscription against fraudulent and deceptive practices and, out of an abundance of caution, a specific proscription against nondisclosure even though a specific proscription against nondisclosure might in other circumstances be deemed surplusage." The Court's "conviction [wa]s strengthened by the fact that we here confront behavior that, though plainly fraudulent, might otherwise fall outside the scope of the Rule." In other words, the Court was not comfortable giving a pass to an obvious fraudster by finding that Rule 10b-5 could not reach him.
The Court recognized that applying subsections (a) and (c) of Rule 10b-5 to the dissemination of alleged misstatements "may present difficult problems of scope in borderline cases," such as where the individual is only "tangentially involved in dissemination." But because "Lorenzo d[id] not challenge the appeals court's scienter finding,"-- that is, because it was settled that Lorenzo actively intended to deceive investors--the Court found it "difficult to see how his actions could escape the reach of those provisions."
The dissent expressed concern that the Court's Lorenzo decision would render its Janus decision
"a dead letter." Janus involved a mutual fund
In the Court's decision, Justice Breyer (writing for a 6-2 majority) reasoned that the language of subsections (a) and (c) of Rule 10b-5 are sufficiently broad to include within their scope the dissemination of false or misleading information with the intent to defraud. The Court held that, by sending emails he knew to contain materially false statements, Lorenzo "employ[ed]" a "device," "scheme," and "artifice to defraud" within the meaning of subsection (a) of the Rule. By the same conduct, he "engage[d] in a[n] act, practice, or course of business" that "operate[d]... as a fraud or deceit" under subsection (c) of
In a ruling that goes further than what many hoped Janus suggested, the Court in Lorenzo held that "dissemination of false or misleading statements with intent to defraud can fall within the scope of subsections (a) and (c) of Rule 10b-5... even if the disseminator did not `make' the statements and consequently falls outside subsection (b) of the Rule."
2 fried frank securities litigation update | spring 2019
advisor that was legally distinct from the fund that issued the challenged prospectus, and thus was not the "maker" of the challenged statements, despite having participated in the preparation of those statements. But the Lorenzo ruling reads Janus as saying "nothing about the Rule's application to the dissemination of false or misleading information" and, accordingly, the Court reasoned that "Janus would remain relevant (and preclude liability) where an individual neither makes nor disseminates false information."
The Court also was not persuaded by Lorenzo's argument that finding him liable under subsections (a) and (c) of Rule 10b-5 would "erase or at least weaken what is otherwise a clear distinction between primary and secondary (i.e., aiding and abetting) liability." The Court observed that it is "hardly unusual for the same conduct to be
a primary violation with respect to one offense and aiding and abetting with respect to another." The Court characterized its decision in Central Bank as recognizing "the need for a clean line between conduct that constitutes a primary violation of Rule 10b-5 and conduct that amounts to a secondary violation." But the Court concluded that its latest guidance--that "[t]hose who disseminate false statements with intent to defraud are primarily liable under Rules 10b-5(a) and (c)... even if they are secondarily liable under Rule 10b-5(b)"--does not blur this clean line.
It remains to be seen whether the Court's Lorenzo decision in fact opens the door to broader claims against non-"makers" that some thought dead after Central Bank and Janus. Certainly we expect industrious plaintiffs to try to assert claims against non-"makers" of a statement on the grounds that they nonetheless
were part of a "scheme or artifice to defraud" under Rule 10b-5(a) or "engaged in a[n] act or practice... [that] would operate as a fraud" under Rule 10b-5(c).
Of course, any claim under Rule 10b-5(a) and (c) must still include factual allegations that provide a "strong inference" that the defendant acted with an intent to defraud. And the Court made clear that the prohibition of aiding and abetting liability delineated in Central Bank remains in effect. But if and when the market turns down and shareholders look for problems and deep-pocketed participants to blame, we would not be surprised to see an attempted resurgence of 10b-5 claims against collateral participants on the grounds that Lorenzo endorsed primary liability alternatives under subsections (a) and (c) of the Rule and limited the "maker" requirement only to claims under subsection (b).
fried frank securities litigation update | spring 2019
Delaware Court of Chancery Holds Forum Selection Provisions Requiring Claims under the Securities Act of 1933 to Be Brought in Federal Court Are "Ineffective and Invalid"
In a December 2018 decision, Vice Chancellor Laster of the Delaware Court of Chancery held that forum selection provisions in three companies' certificates of incorporation requiring claims under the Securities Act of 1933 (the "Securities Act") to be brought only in federal court are "ineffective and invalid" under Delaware law. Sciabacucchi v. Salzberg, C.A. No. 2017-0931-VCL, 2018 WL 6719718, at *3 (Del. Ch. Dec. 19, 2018). Vice Chancellor Laster held that Delaware corporations lack the power to require claims arising under the Securities Act to be brought in federal court because such claims are "external matters" that arise under the federal securities laws.
The decision in Sciabacucchi, combined with the increased frequency with which plaintiffs are bringing Securities Act claims in state court in the wake of Cyan, Inc. v. Beaver County Employees Retirement Fund, 138 S.Ct. 1061 (2018), increases the risk that companies will face overlapping securities class actions that cannot be consolidated in a single court. Nothing in Sciabacucchi, however, affects the validity of forum selection provisions in the certificate of incorporation or bylaws of a Delaware corporation that require claims concerning the "internal affairs" of a corporation, such as stockholder derivative suits or fiduciary duty claims, to be litigated in a specified forum, which remains a valuable tool to prevent multi-forum litigation involving those types of claims.
Federal forum selection clauses for claims under the Securities Act had become an increasingly popular tool for companies proceeding with an IPO to include in their certificate of incorporation in the wake of the Supreme Court's decision in Cyan. In Cyan, the Supreme Court held that state courts have concurrent jurisdiction, without the possibility of removal, over class actions asserting Securities Act claims. Delaware corporations prior to and with increased frequency following the Cyan decision had adopted provisions in their bylaws or certificates of incorporation restricting
the ability of stockholders to litigate claims under the Securities Act in federal court.
Sciabacucchi involved a challenge to charter provisions adopted by three companies: Blue Apron Holdings, Inc., Roku, Inc., and Stitch Fix, Inc. The challenged charter provisions purported to require any cause of action arising under the Securities Act to be brought in federal court and stated that purchasing or acquiring an interest in the corporation would be deemed notice and consent to the forum selection provision. The plaintiff sought a declaratory judgment that these forum selection provisions were invalid.
In addressing the validity of forum selection provisions for Securities Act claims, Vice Chancellor Laster relied on then-Chancellor Strine's decision in Boilermakers Local 154
Ret. Fund v. Chevron Corp., 73 A.D.3d 934 (Del. Ch. 2013). Boilermakers held that Section 109(b) of the Delaware General Corporation Law (the "DGCL") permits a Delaware corporation to "adopt a forum-selection bylaw for internal affairs claims." Id. at 952. By contrast, the court in Boilermakers held that bylaws containing forum selection provisions for external disputes such as contract or tort claims against the corporation would be invalid because such bylaws would concern "external matters" rather than "the rights and powers of the plaintiff stockholder as a stockholder." Id. Following the Boilermakers decision, the Delaware General Assembly in 2015 adopted Section 115 of the DGCL, which allows a certificate of incorporation or bylaws to include forum selection provisions as to "any or all
internal corporate claims."
The decision in Sciabacucchi, combined with the increased frequency with which plaintiffs are bringing Securities Act claims in state court in the wake of Cyan, increases the risk that companies will face overlapping securities class actions that cannot be consolidated in a single court.
4 fried frank securities litigation update | spring 2019
In Sciabacucchi, the court held that a claim under the Securities Act "resembles a tort or contract claim brought by a third-party plaintiff who was not a stockholder at the time the claim arose," and is thus "an external claim that falls outside the scope of the corporate contract." Sciabacucchi, 2018 WL 6719718, at *18. In support of that determination, the court explained that a claim under the Securities Act "does not turn on the rights, powers, or preferences of the shares, language in the corporation's charter or bylaws, a provision in the DGCL, or the equitable relationships that flow from the internal structure of the corporation." Id. at *1. The court further emphasized that a Securities Act claim "does not arise out of or relate to the ownership of the share, but rather from the purchase of the share," and that at the time of the purchase "the purchaser is not yet a stockholder and does not yet have any relationship with the corporation that is governed by Delaware corporate law." Id. at *17. Rather, a claim under the Securities Act arises under federal law.
Vice Chancellor Laster also concluded that forum selection provisions for Securities Act claims are invalid based on "first principles." Sciabacucchi, 2018 WL 6719718, at *2. Because incorporation entails an exercise of the state's sovereign authority, the state can regulate the corporation's internal affairs through its corporation law. By contrast, Delaware cannot use its corporate law to regulate external relationships or to exercise authority beyond its territorial jurisdiction. Therefore, Vice Chancellor Laster concluded that Delaware cannot assert authority over claims that "do not arise out of internal corporate relationships," such as the Securities Act claims at issue. Id. at *21. Some commentators have suggested that the decision in Sciabacucchi may be indicative of how Delaware courts would rule on provisions requiring shareholders to arbitrate federal securities claims.
Following the resolution of the plaintiff's pending fee request in the Court of Chancery, it is expected that the defendants will file an appeal with the Delaware Supreme Court.
The court held that a claim under the Securities Act "resembles a tort or contract claim brought by a third-party plaintiff who was not a stockholder at the time the claim arose," and is thus "an external claim that falls outside the scope of the corporate contract."
fried frank securities litigation update | spring 2019
Supreme Court Declines to Decide Standard of Liability for Alleged Tender Offer Misstatements and Omissions under Exchange Act 14(e) and Whether There Is a Private Right of Action
In 2018, a panel of the Ninth Circuit held that negligence, not scienter, is the standard of liability for Exchange Act 14(e) claims of misstatement or omission in tender offers. Varjabedian v. Emulex Corp., 888 F.3d 399 (9th Cir. 2018). The Ninth Circuit's decision created a circuit split by departing from the prior conclusion reached by six other circuits (the Second, Third, Fifth, Sixth, Eighth, and Eleventh Circuits) that 14(e) requires a showing of scienter.
In seeking certiorari, the defendants in Emulex argued that the Ninth Circuit decision was wrong and that, if the Court upheld the Ninth Circuit's negligence standard for 14(e), the Court should consider whether a private right of action exists under 14(e) under recent Supreme Court analysis of when to imply a private right of action. The Supreme Court granted certiorari and heard oral argument on April 15, 2019. One week later, the Court dismissed the writ of certiorari as improvidently granted in a one line order, thereby ending the case. Emulex Corp. v. Varjabedian, No. 18-459, 2019 WL 1768137 (U.S. Apr. 23, 2019).
While it is always difficult to discern why the Court declined to decide a case in this fashion, the oral argument transcript suggests that the Court may have been hesitant to adjudicate the alternative issue of whether there should be a private right of action at all under 14(e). That hesitation may have stemmed, at least in part, from the plaintiffs' contention that the defendants had not preserved that issue in the lower courts by making clear that they were challenging longstanding Ninth Circuit authority recognizing an implied private right of action for 14(e) claims by shareholders of target companies. See generally Plaine v. McCabe, 797 F.2d 713, 717 & n. 7 (9th Cr. 1986).
The legal arguments by both sides were convoluted, which perhaps reflected the complexities of divergent rulings by the Supreme Court over many years since the Williams Act was adopted in 1969. When Congress wrote the Williams Act, which added 14(e) to the Exchange Act, Supreme Court decisions preSandoval (Alexander v. Sandoval, 532 U.S. 275 (2001)) trended in the direction of implying private rights of actions. During that same period, some lower courts had held that negligence was the standard for liability under SEC Rule 10b 5. Later, the Supreme Court ruled that Rule 10b-5 could not create a negligence liability standard for violations of Exchange Act 10(b), and so liability under Rule 10b-5 can only be found under the scienter standard applied to 10(b). Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Separately the Court also ruled that negligence is the liability standard for the SEC to obtain injunctive relief under Securities Act 17(a)(2) or (3) but scienter is required for an SEC action under Exchange Act 10(b). Aaron v. SEC, 446 U.S. 680 (1988).
In Emulex, the plaintiffs contended that the language of 14(e) is modeled on Securities Act 17(a)(2 & 3) and on Rule 10b-5 (as it was understood pre-Ernst & Ernst) and so negligence should be the liability standard. In the plaintiffs' view, the circuit courts that found scienter to be the standard under 14(e) were ignoring the similarity of the language of Exchange Act 14(e) to Securities Act 17(a) (2 & 3) and instead focused on the Supreme Court's holding in Ernst & Ernst that scienter is the standard for Exchange Act 10(b) and thus Rule 10b-5 liability. The Emulex defendants contended that the analogy to Rule 10b 5, other textual clues, and principles of statutory construction lead to the conclusion that the 14(e) liability standard is scienter.
The United States submitted a brief in support of neither party and sought to split the difference, arguing that the 14(e) liability standard should be negligence (which would
allow the SEC to use that standard in
The Supreme Court's decision to end the proceedings without a decision leaves the law regarding Exchange Act 14(e) tender offer claims unsettled.
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pursuing claims) but that there is no implied private right of action. Amici also raised the issue of whether the 14(e) standard should be consistent with liability standards under 14(a) (for misstatements in proxy materials often used to effect acquisitions).
The practical effect of the Supreme Court's lack of decision could be significant to businesses undergoing tender offers whether or not the tender offer is hostile. Both the tenderor and the tenderee could face liability regardless of whether the tender offer succeeds. In the Ninth Circuit, where the 14(e) standard now is negligence, it will be easier for securities class action plaintiffs to assert claims whenever a tender offer occurs and soon afterwards there are share price declines. The SEC can also use the negligence standard for its enforcement actions in the Ninth Circuit. And so long as the Supreme Court does not examine whether a private right of action under 14(e) even should exist, the lower courts will continue to have to grapple with difficult issues of liability and damages for tender offer claims brought by shareholders of target companies.
The outcome is disappointing because the issue of whether the 14(e) standard of liability is
negligence or scienter was well-preserved below. The Supreme Court could have chosen to assume, without deciding, the existence of a private right of action and ruled on the liability standard issue. The Supreme Court had done exactly that in an earlier 14(e) decision. Piper v. Chris-Craft Indus., Inc., 430 U.S. 1, 42 & n. 28 (1977) (holding tender offerors do not have a claim under 14(e) without deciding whether shareholders of the target company have an implied right of action under 14(e)). Had the Supreme Court followed that past practice, practitioners, corporate executives, shareholders, and the SEC at least would have had a clear, nationwide answer on the 14(e) liability standard issue.
The Supreme Court's decision to end the proceedings without a decision leaves the law regarding Exchange Act 14(e) tender offer claims unsettled. Because 14(e) claims are much less common than 10(b) claims, there are significantly fewer opportunities to obtain appellate rulings and, ultimately, Supreme Court guidance. It could be several years before another 14(e) case raising either the issue of the standard of liability or the existence of a private right of action or both
issues reaches the Supreme Court again.
It could be several years before another 14(e) case raising either the issue of the standard of liability or the existence of a private right of action or both issues reaches the Supreme Court again.
fried frank securities litigation update | spring 2019
A New Era of Extraterritorial SEC Enforcement Actions
In a recent decision, U.S. Securities and Exchange Commission v. Scoville, the United States Court of Appeals for the Tenth Circuit became the first Circuit Court to opine on the scope of the SEC's extraterritorial enforcement authority under the Dodd-Frank Act. Departing from the United States Supreme Court's 2010 opinion in Morrison v. National Australia Bank Ltd., the Tenth Circuit held that Congress, in enacting the Dodd-Frank Act, "affirmatively and unmistakably" expressed its intent to apply the SEC's enforcement authority under Section 17(a) of the Securities Act of 1933 ("Section 17(a)") and the antifraud provisions of the Securities and Exchange Act of 1934, including Section 10(b) ("Section 10(b)"), extraterritorially.
SEC v. Scoville expands the scope of the SEC's enforcement authority beyond the limitations imposed by Morrison, returning to the so-called "conduct-andeffects" test to determine extraterritoriality. This departure creates uncertainty about the scope of the SEC's enforcement authority and additional risk
for foreign entities and individuals.
On July 26, 2016, the SEC filed an enforcement action against Charles Scoville and Traffic Monsoon, LLC (the "Defendants") in the United States District Court for the District of Utah ("Utah District Court"), alleging violations of Section 17(a) and Section 10(b). SEC v. Scoville, 913 F.3d 1204, 1212 (10th Cir. 2010). Scoville was the sole member, manager, and registered agent of Traffic Monsoon, which, according to Scoville, was a "website traffic exchange." Website traffic exchanges sell visits to websites, clicks on advertisement banners, and similar services to drive internet traffic to websites and make websites appear to be more popular than they actually are. Website owners are the typical customers for website traffic exchanges, as search engines generally rank websites based, in part, on the number of visits that they receive.
According to the SEC, Traffic Monsoon was not a bona fide website traffic exchange. Rather, the SEC alleged that Traffic Monsoon was operating as a Ponzi scheme by selling investment contracts called "Adpacks." Adpacks were $50 "bundles" that included 1,000 website visits, twenty clicks on advertisement banners, and a right to share in Traffic Monsoon's profits up to $55 per Adpack.
The Utah District Court found that, while "[s]ome individuals initially purchased Adpacks... to promote their online businesses[,]... for many members, the profits that could be reaped from the Adpacks themselves quickly eclipsed the motive." Id. at 1211. Ninety-eight percent of Traffic Monsoon's sales came from Adpacks, and ninety percent of all Adpacks were sold outside the United States. By the time the SEC initiated its enforcement action, Traffic Monsoon's members had paid $173 million to purchase 3.4 million Adpacks and had purchased approximately 14 million Adpacks (valued at $700 million) by rolling over money earned from earlier Adpacks.
Interestingly, Traffic Monsoon's website disclaimed being a Ponzi scheme in a list of Frequently Asked Questions:
Is TrafficMonsoon a... Ponzi, pyramid scheme, or illegal? What is a Ponzi? ponzis [sic] are investment schemes which offer interest payments... Traffic Monsoon only offers ad services... Yes, you can qualify to share in the sales revenue generated when services are sold by actively viewing other people's websites, but this is not interest... That's not a Ponzi... In conclusion, when looking at pure definitions, Traffic Monsoon is not a ponzi...
SEC v. Traffic Monsoon, LLC, 245 F. Supp. 3d 1275, 1282 (D. Utah 2017).
Utah District Court Decision
In deciding the SEC's motion for a preliminary injunction, the Utah District Court addressed the
scope of the SEC's extraterritorial enforcement authority. As noted above, the Dodd-Frank Act, signed into law less than a month after Morrison, amended the Securities Act of 1933 and Securities Exchange Act of 1934 to provide federal District Courts with extraterritorial jurisdiction over SEC enforcement actions. In respect to the Securities Exchange Act of 1934's antifraud provisions, Section 929P(b) of the Dodd-Frank Act provides:
The district courts of the United States and the United States courts of any Territory shall have jurisdiction of an action or proceeding brought or instituted by the Commission or the United States alleging a violation of the antifraud provisions of this title [15 USCS 78a et seq.] involving--(1) conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States and involves only foreign investors; or (2) conduct occurring outside the United States that has a foreseeable substantial effect within the United States.
15 USCS 78aa(b). Section 929P(b) of the Dodd-Frank Act also provides nearly identical language in connection with Section 17(a).
Notwithstanding that plain language, the Defendants argued that the Dodd-Frank Act did not demonstrate a sufficiently clear intention by Congress to apply Section 17(a) or Section 10(b) extraterritorially because the relevant language from the Dodd-Frank Act focused on jurisdiction. The Supreme Court held
in Morrison that extraterritoriality was a question
8 fried frank securities litigation update | spring 2019
of statutory intent and not jurisdiction. Thus, the Defendants argued that the relevant language in the Dodd-Frank Act had no effect on the extraterritoriality of Section 17(a) or Section 10(b).
The Utah District Court ultimately granted the SEC's motion for a preliminary injunction, holding that the SEC's enforcement authority under Section 17(a) and Section 10(b) applied extraterritorially. The Utah District Court reasoned that "[t]he legal landscape when [the Dodd-Frank Act] was initially proposed and considered by congress is vital to discerning this congressional intent... Indeed, when the final version of DoddFrank was presented to the House and the Senate for approval, congressmen from both chambers expressed their understanding that [the DoddFrank Act] codified the conduct and effects test... Thus, both the legal context... and the legislative history of this provision indicate a legislative intent to apply 17(a) and Sections 10(b) to extraterritorial transactions if the conduct and effects test can be satisfied." Traffic Monsoon, LLC, 245 F. Supp. 3d at 1292-93.
Circuit Court Decision
Following the Utah District Court's decision granting the SEC's motion for a preliminary injunction, Scoville then filed an interlocutory appeal to the Tenth Circuit arguing, inter alia, that Section 17(a) and Section 10(b) did not apply extraterritorially because the Dodd-Frank Act had not abrogated Morrison. The Tenth Circuit's majority opinion found
that Section 17(a) and Section 10(b) applied extraterritorially, holding:
Notwithstanding the placement of the DoddFrank amendments in the jurisdictional provisions of the securities acts, given the context and historical background surrounding Congress's enactment of those amendments, it is clear to us that Congress undoubtedly intended that the substantive antifraud provisions should apply extraterritorially when the statutory conductand-effects test is satisfied.
Scoville, 913 F.3d at 1219. The Tenth Circuit proceeded to apply the conduct-and-effects test set forth in the Dodd-Frank Act to the facts at issue. The Tenth Circuit highlighted that the Defendants housed Traffic Monsoon's servers in the United States and "created and promoted the Adpack[s]" from Utah. Id. The majority opinion viewed the Defendants' conduct as easily meeting the statutory standard, devoting only one paragraph of a forty-three page opinion to applying the conduct-and-effects test.
The concurrence, however, would not have reached the majority's holding regarding extraterritoriality because the alleged conduct was sufficiently domestic to satisfy Morrison. As Judge Briscoe explained, "Traffic Monsoon sold AdPacks via the internet, and the record further demonstrates that Traffic Monsoon made its sales through computer servers based solely in the United States. Under any common sense reading of Morrison and 10(b), Traffic Monsoon made several securities sales in the United States...
SEC v. Scoville expands the scope of the SEC's enforcement authority beyond the limitations imposed by Morrison, returning to the so-called "conduct and effects" test to determine extraterritoriality. This departure creates uncertainty about the scope of the SEC's enforcement authority and additional risk for foreign entities and individuals.
Accordingly, I would affirm because... the SEC sufficiently established that the Defendants sold securities in the United States..." Id. at 1226-27 (Briscoe, J., concurring).
On February 12, 2019, the Tenth Circuit granted, in part, Scoville's motion for a stay pending his filing of a petition for a writ of certiorari with the Supreme Court. In Scoville's motion, he identified two bases for a writ of certiorari: (i) the extraterritorial reach of Section 10(b); and (ii) whether or not a transaction is domestic when foreign parties incur irrevocable liability with respect to the transaction in the United States. Notably, the Tenth Circuit, in granting Scoville's motion to stay, found that its decision in Scoville "decided an important federal question in a way that conflicts with relevant decisions of the United States Supreme Court," and constituted "an important question of federal law that has not been, but should be, settled by the United States Supreme Court." Order Granting Mot. to Stay Pending App. for Cert., SEC v. Scoville, No. 17-4059 (10th Cir.), EFC No. 10626380 (Apr. 18, 2019).
The Conduct-and-Effects Test and Morrison
In the 1960's, Circuit Courts, starting with the Second Circuit's 1968 opinion in Schoenbaum v. Firstbrook, 405 F.2d 200 (2d Cir. 1968), began applying Section 10(b) extraterritorially using a conduct-and-effects test. This pre-Morrison conductand-effects test required either a transaction having substantial effects on the United States or significant conduct based in the United States in furtherance of a fraud.
The Second Circuit's application of the effects test required a fraudulent transaction with "some effect on American securities markets or investors." Morrison v. Nat'l Austl. Bank Ltd., 561 U.S. 247, 258 (2010). The conduct test was driven by the "principle that Congress did not want `the United States to be used as a base for manufacturing fraudulent security devices for export, even when these are peddled only to foreigners.'" Terra Sec. ASA Konkursbo v. Citigroup, Inc.,
688 F. Supp. 2d 303, 309 (S.D.N.Y. 2010).
fried frank securities litigation update | spring 2019
As noted above, in Morrison, the Supreme Court repudiated the conduct-and-effect test and held that Section 10(b) did not apply extraterritorially. Morrison involved a "foreign cubed" litigation, that is litigation involving foreign plaintiffs, a foreign defendant, and a foreign securities transaction. In Morrison, the foreign plaintiffs alleged that the National Australian Bank ("NAB") violated Section 10(b) by improperly incorporating a United States subsidiary's (Homeside Lending) allegedly falsified valuations into NAB's public filings. The Supreme Court held that there was no basis for an action under Section 10(b) because the securities at issue were not listed on domestic exchanges or purchased in the United States. As the Supreme Court explained, "[t]he criticisms [of the conductand-effects test] seem to us justified...[and] demonstrate the wisdom of the presumption against extraterritoriality... In short, there is no affirmative indication in the Exchange Act that 10(b) applies extraterritorially, and we therefore conclude that it does not." Morrison, 561 U.S. at 261-266.
After Scoville, foreign entities and individuals
engaging in securities transactions face increased
risk of SEC enforcement actions. The Utah District
Court acknowledged that the Dodd-Frank Act
effectively "codified" the conduct-and-effects test
as it had been applied in the Second Circuit prior
to Morrison. Traffic Monsoon, 245 F. Supp.3d
at 1291. It remains to be seen whether other
Circuit Courts will reach similar conclusions.
However, for the time being, District Courts
(and the SEC) will look to Circuit Courts'
pre-Morrison jurisprudence for guidance regarding the application of the conduct-and-effects test in SEC enforcement actions. Future enforcement actions by the SEC will also provide a helpful interpretative gloss.
One risk created by the effects test is that purely foreign transactions, which arguably influence the price of securities traded on United States exchanges, may be the subject of SEC enforcement actions. For example, in Schoenbaum--an early pre-Morrison case--the plaintiff, an American shareholder of Banff Oil Ltd. ("Banff"), alleged that Banff's treasury shares were fraudulently sold in Canada in violation of Section 10(b). Banff was a Canadian corporation whose common shares, but not its treasury shares, were publicly traded on stock exchanges in the United States and Canada. The Second Circuit in Schoenbaum held that, although the treasury shares were not traded on United States exchanges and were only sold in Canada, Section 10(b) applied extraterritorially to the transaction because the foreign trading of Banff's treasury shares "affected the value of the common shares publicly traded in the United States." Morrison, 561 U.S. at 265. Under Scoville, similar transactions may be subject to SEC enforcement actions.
Likewise, the conduct test can be deployed to reach allegedly fraudulent conduct that takes place in the United States, even where the underlying transaction and any effects are entirely foreign. For example, in SEC v. Kasser (548 F.2d 109 (3d Cir. 1977))--another early pre-Morrison case--the Third Circuit
applied the conduct test to an SEC enforcement action where the sole victim was the Manitoba Development Fund, which was owned by the Province of Manitoba. The Third Circuit in Kasser noted that the case had "little, if any, impact" in the United States, Id. at 112; nonetheless, the SEC charged the defendants with engaging in a Ponzi scheme. The Third Circuit found that the SEC's enforcement action satisfied the conduct test because, inter alia, the SEC alleged that crucial records essential to the fraud were kept in the United States; the New York office of a Swiss Bank was used as a conduit for the transaction; the instrumentalities of interstate commerce were used to further the scheme; negotiations for the fraudulent transaction took place in New York; and one of the investment contracts was executed in New York. Aside from the execution of a contract in New York, none of the relevant facts in Kasser would have been significant under Morrison because the transaction itself was mostly foreign. Scoville increases the risk of SEC enforcement actions for foreign
transactions under similar circumstances.
While Scoville affords the SEC with broad latitude to bring extraterritorial enforcement actions under Section 17(a) and Section 10(b), we do not yet know how the SEC will choose to use that power. The SEC (like any organization) has limited resources and may reasonably decide to focus on domestic matters as a matter of prosecutorial discretion. In assessing regulatory risk for foreign entities and individuals, the SEC's future charging decisions may be as significant as
the Tenth Circuit's decision in Scoville itself.
10 fried frank securities litigation update | spring 2019
James E. Anklam
Samuel P. Groner
Stephen M. Juris
Michael C. Keats
Scott B. Luftglass
William G. McGuinness
Joshua D. Roth
Justin J. Santolli
Peter L. Simmons
James D. Wareham
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