The concluding days of the Supreme Court’s term may prove to be the most significant for securities regulation. While all eyes are turned to Capital Hill and the financial reform legislation, this week the Court is expected to hand down its decision in Free Enterprise Fund v. PCAOB, No. 08-861. The High Court’s ruling is expected to determine whether a key reform crafted in the ashes of Enron and other financial debacles will survive. The viability of The Public Company Accounting Oversight Board, created to oversee the auditing profession as part of the Sarbanes-Oxley Act of 2002, is at stake.

The Court’s decision last week in Morrison v. National Australia Bank Ltd., No. 08-1192 (June 24, 2010) will have a significant impact on SEC enforcement. Morrison is the Second Circuit’s “foreign cubed” decision. Each of the Justices agreed that the case was properly dismissed by the district and circuit courts. There is, however, a sharp divergence over the reasoning supporting that conclusion and its impact.

National Australia Bank Ltd was the largest bank in Australia. Its shares are traded on the Australian Stock Exchange and other foreign exchanges and its ADRs are listed on the NYSE. In February 1998, the bank brought HomeSide Lending, Inc., a mortgage servicing company headquartered in Florida. From 1998 through 2001, National’s annual reports and other public documents touted the success of HomeSide’s business. Unfortunately, the financial results at HomeSide were manipulated by its officers, according to the complaint. A group of Australian shareholders brought suit in New York against the bank, HomeSide and the officers alleging violations of Exchange Act Section 10(b). The action was dismissed by the district court for lack of jurisdiction. The Second Circuit affirmed.

The Supreme Court also agreed the suit was properly dismissed, but for different reasons, in an opinion written by Justice Scalia, and joined by Chief Justice Roberts and Justices Kennedy, Thomas and Alito. At the outset, the Court corrected an error by the Second Circuit which has been made by several other circuits. The question of the extraterritorial reach of Section 10(b) does not concern the power of the court to hear the case. Clearly the Exchange Act gives the court that authority in its jurisdictional sections. Rather, the issue to be decided is whether the plaintiffs are entitled to relief. The question is thus not one which is properly viewed under Rule 12(b)(1), but Rule 12(b)(6). While the Second Circuit’s analysis is, in this regard, incorrect, dismissal is, nevertheless, the correct remedy, the Court held.

Justice Scalia, writing for the Court, crafted his analysis around two key points. First, he stated that it is a “longstanding principle of American law that legislation of Congress, unless a contrary intent appears, is meant to apply only within the territorial jurisdiction of the United States.” Slip. Op. at 5 (citations and internal quotations omitted). The principle is a presumption or canon of construction, not a limit on the ability of Congress to legislate. Following this principle, when the statute “gives no clear indication of an extraterritorial application, it has none.” Id. at 6.

Second, the text of Section 10(b) does not suggest that it was intended to apply abroad. To the contrary, the plain language of the Section does not give any suggestion that Congress intended it to have any extraterritorial application. Accordingly, it has none. This means that Section 10(b) “reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed on an American stock exchange, and the purchase or sale of any other security in the United States.” Id. at 24.

In reaching this conclusion, Justice Scalia reviewed the evolution of the Second Circuit’s jurisprudence regarding the extraterritorial application of Section 10(b). Under those rulings, now followed by other circuits, jurisdiction would be predicated on either “some effect on American securities markets or investors or significant conduct in the United States.” Id. at 6. That theory, Justice Scalia noted, is built on the notion of determining how Congress would have applied the Section to a particular transaction. The decisions have been criticized for being unpredictable and at times inconsistent. They also fail to give deference to the key rule of construction regarding the application of congressional enactments abroad and are not rooted in the text of the statute.

Justice Stevens, in an opinion joined by Justice Ginsburg, concurred with the Court’s conclusion, but not its reasoning. After reviewing the Second Circuit’s jurisprudence in this area, which he termed the “north star” of Section 10(b) jurisprudence, Justice Stevens concluded that the Court’s critique of “judge made rules” in this area such as those of the Second Circuit is misplaced. “This entire area of law is replete with judge-made rules, which give concrete meaning to Congress’ general commands.” Slip Op. at 3. Indeed, Congress has invited an expansive role for judicial elaboration in this area by writing open-ended statutes. That fact has been confirmed over the years by both the Congress and the SEC.

Furthermore, the Court’s main criticism of the Second Circuit’s approach – that it disregarded the so-called presumption against extraterritoriality – is incorrect. It is the Court which has misapplied that presumption Justice Stevens noted. That presumption is only a rough rule of thumb, not in inflexible precept. Its application here ignores the real question which is what type of effects in the U.S. must be present.

In a footnote, Justice Stevens raises what is clearly a fundamental issue for the SEC and its enforcement program, noting: “The Court’s opinion does not, however, foreclose the Commission from bringing enforcement actions in additional circumstances, as no issue concerning the Commission’s authority is presented by this case.” Id. at 11, n. 12.

Justice Stevens is clearly correct in noting that Morrison is a private action, not an SEC enforcement case. Private actions do of course differ significantly from Commission enforcement actions. To the extent SEC enforcement actions are based on Section 10(b) however, Justice Stevens’ comment is probably more a wish than reality. The Court’s Morrison holding is predicated squarely on the text of Section 10(b). While the opinion authored by Justice Scalia does not mention SEC enforcement actions, in rejecting the Second Circuit’s approach to the issue, it cites two SEC enforcement actions.

The result in Morrison, and its potential impact on SEC cases, differs little in this regard from that of earlier Court decisions construing the Section. In Central Bank of Denver v. First Interstate, 511 U.S. 164 (1994) for example, the High Court concluded in a private damage action that Section 10(b) did not provide a right of action which includes aiding and abetting. That ruling was based on the text of the Section. To preserve the ability of the SEC to bring actions based on aiding and abetting, Congress had to amend the Exchange Act to correct for Central Bank and restore the Commission’s authority.

Similarly, when the Court concluded that Section 10(b) requires proof of scienter, it was in a private damage action and based on the text of the statute. Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). When the Second Circuit concluded that Hochfelder did not apply in Commission enforcement actions, the Supreme Court quickly reversed the decision. Aaron v. SEC, 446 U.S. 680 (1980). The fact is the text of Section 10(b) is the same whether it is the predicate for a private damage case or a Commission enforcement action. Morrison delimits the reach of that text. There should thus be no doubt that Morrison, like Central Bank and Hochfelder, will constrict the reach of SEC enforcement.