THE REACH OF SECTION 10(b): THE SUPREME COURT AND FOREIGN-CUBED

The Supreme Court agreed to hear the Second Circuit’s “foreign-cubed” decision, Morrison v. National Australia Bank Ltd., Case No. 08-1191. In that case, the circuit court affirmed the dismissal of a securities fraud complaint for lack of jurisdiction, as discussed here. The decision by the Supreme Court could have a significant impact on the reach of the antifraud provisions of the federal securities laws.

Morrison is a securities class action involving the claimed manipulation of the internal books of the U.S. subsidiary of an Australian public company whose ADRs are traded in New York. Respondent National Australia Bank is an Australian company headquartered in Melbourne, Australia. In 1998, the bank acquired Jacksonville, Florida based HomeSide Lending, Inc. Petitioners are non-U.S. shareholders of the bank.

The complaint claims that the defendant Respondents. which includes the bank, HomeSide and certain officers and directors, made false and misleading statements that inflated the price of the bank’s shares. The false statements stem from the claimed manipulation from 1998 to 2001 of the value of HomeSide’s mortgage portfolio. False values for that portfolio were furnished to the bank, whose CEO knew of the manipulation, but permitted the numbers to be incorporated into the public financial statements of the bank. Later, following significant write downs of the mortgage portfolio, the share price dropped significantly.

The court of appeals stated that there are two basic tests to determine whether there is jurisdiction over a suit such as this. First, the conduct test looks to determine whether the wrongful conduct occurred in the United States. Second, the effects test focuses on whether the conduct had substantial effects in the U.S. or on its citizens.

Here, the Second Circuit focused on the conduct at the heart of the claimed fraud. The court concluded that the actions taken and not taken by the bank in Australia were significantly more central to the fraud and more directly responsible for the harm to investors than the manipulation in Florida. In addition, the court concluded that the connection between any misconduct in the United States and the injury petitioners claimed to have suffered is too attenuated. In reaching its conclusion, the court emphasized that there is no allegation of fraud impacting U.S. investors or capital markets.

The Solicitor General, appearing as amicus curiae in a brief with the SEC, urged the high court not to take the case. The solicitor argued that the Second Circuit was correct. At the same time, the brief for the government notes that the Second Circuit, along with others, erroneously concluded that the issue in these cases is jurisdictional. Courts have then considered policy factors to determine if they have jurisdiction since the Exchange Act does not specifically address transnational transactions.

The question in foreign-cubed cases is not jurisdiction, the Solicitor argued. Under the Exchange Act, courts have jurisdiction over actions arising under the statute. Thus, the question is one of statutory construction and whether the conduct falls with the ambit of the statute. Here, the conduct described violates Section 10(b) but the link between the U.S. component of the scheme and Petitioner’s injury is too attenuated to support a private suit. This argument echoes the approach used in part by the Supreme Court in Stoneridge, discussed here. There, the Court focused in part on the reliance element of a damage cause of action to reject arguments about scheme liability without delimiting the reach of Section 10(b) which could impact SEC enforcement cases.

In a footnote, the Solicitor stated that, although the SEC supported Petitioner’s in the circuit court, that was based on existing Second Circuit precedent. Now the SEC has joined the position of the Solicitor.

The Supreme Court’s decision in this case may resolve the transnational reach of the antifraud provisions of the securities laws unless the approach argued by the Solicitor is invoked. That same question however, is pending in Congress. H.R. 3817, The Investor Protection Act of 2009, incorporates the two-part Second Circuit test in Section 215. Accordingly, next year there may be a resolution of a significant issue regarding the ultimate reach of Section 10(b).

THE STATUTE OF LIMITATIONS BEFORE THE SUPREME COURT

Merck & Co. v. Reynolds, Case No. 08-905, argued yesterday before the high court, will resolve an important question regarding the application of the statute of limitations in private securities damage actions. The case focuses on an interpretation of the limitations period added to the securities laws as part of The Sarbanes Oxley Act. Specifically, the issue concerns when the two-year limitation period of 28 U.S.C., § 1658(b)(1) begins. That section provides in part that “an action [for fraud] may be brought not later than the earlier of — (1) “2 years after the discovery of the facts constituting the violation; or (2) 5 years after such violation.”

The question in Merck, discussed here, revolves around the applicability of “inquiry notice.” All of the circuits agree, as did the parties during the oral argument, that the statute of limitations begins to run in a securities fraud damage action when the plaintiff has notice of sufficient facts to state a claim for fraud. The concept of inquiry notice uses an objective test to determine when a plaintiff has sufficient information of possible wrong doing and is on notice of a possible claim. The theory, employed by some circuits, is designed to prevent plaintiffs from sitting on their hands.

The question arises in the context of a securities class action against the drug manufacturer based on alleged false statements about the possible side effects of pain reliever Vioxx. Questions about the drug were raised as early as 1999 when it was introduced. Those same questions surfaced again in a 2001 FDA hearing, in an AMA Journal article later that year and when the FDA cautioned on its website in September 2001 about misleading advertising by the company for the pain killer. Suit was not brought until 2003 however, after clinical trials suggested the drug carried an increased risk of heart attack – the issue which had been raised but denied by the company since 1999 – and the stock price dropped.

The district court dismissed the action as time barred, ruling that by 2001 plaintiffs were on inquiry notice but failed to take any action. The Third Circuit reversed in a 2-1 decision, concluding that plaintiffs were not on inquiry notice until 2003 when they had evidence that the statements by the company about the possible side effects were false.

The arguments before the Supreme Court focused on the statutory language of the Section, if it included the concept of inquiry notice and the question of constructive knowledge by the plaintiff of information about a possible claim. The company argued that inquiry notice put the plaintiff on notice of a possible claim as early as 2003. Since the plaintiff here failed to do so, the claim is time barred.

The notion of whether inquiry notice fit within the contours of the statutory language seemed to trouble the Justices, who returned to the question throughout the arguments. Justice Sotomayor, for example, raised the question just moments into the argument by comparing the language of Section 1658 to that of to Section 13 of the Securities Act. That Section provides in part that an action must be brought within one year “after discovery of the untrue statement … or after such discovery should have been made by the exercise of reasonable diligence … .” The proviso regarding “should have been made” does not appear in Section 1658, suggesting that it does not apply there. This same point was emphasized in a series of questions by Justice Scalia.

Petitioner countered that the concept of inquiry notice and reasonable due diligence is implicit in Section 1658. This contention led to questions about the nature of the inquiry and whether it would create an unworkable standard for the courts. This concept could also lead to situations in which the plaintiff might have to file a complaint before having the necessary facts, Justice Breyer noted. Merck responded by noting that there may be times, such as here, when the plaintiff never has sufficient facts to meet the pleading requirements of the PSLRA. In response to other questions, the company conceded that a plaintiff who makes inquiry would get additional time while emphasizing that in this case there was no inquiry at all.