SEC ENFORCEMENT TRENDS 2011: THE SUPREME COURT, DODD-FRANK AND THE REACH OF SEC ENFORCEMENT
This is the fifth in a series of articles that will be published periodically analyzing the direction of SEC enforcement.
The focus of SEC enforcement in the coming months is a function of its constricted and later expanded authority. Last year that authority contracted in the wake of the Supreme Court’s decision in Morrison v. National Australia Bank Ltd., 130 S.Ct. 2869(2010). Later congress effectively overruled Morrison as to the SEC and DOJ and expanded their authority. A warning from the SEC in a Section 21(a) report in view of the congressional action may suggest a key focus for SEC enforcement in the future.
In Morrison the Supreme Court agreed with the Second Circuit that a shareholder suit based on Exchange Act Section 10(b) should be dismissed. The complaint had been brought by Australian shareholders of the bank. It alleged fraud based largely on transactions which occurred in the U.S. subsidiary that impacted the books and records of the parent company and thus the share price on the Australian exchange. The district court dismissed the complaint for lack of jurisdiction based on long standing Second Circuit jurisprudence which has been largely followed in other circuits.
While the Supreme Court agreed that the case was properly dismissed, it differed as to the rationale. Justice Scalia, writing for the Court, began by noting that the question to be resolved is not one concerning the authority of the district court to hear the case. The Exchange Act confers jurisdiction on the court to hear a securities fraud suit. Rather, the issue is whether the conduct is within the scope of Section 10(b).
In this case that question centers on whether Section 10(b) has extraterritorial reach. When considering if a U.S. statute has extraterritorial reach, the beginning point is the long standing presumption that legislation by Congress is meant to apply only within the territorial jurisdiction of the U.S. unless there is a contrary intent according to the Court. Here there is none. Accordingly, Section 10(b) is limited to conduct which occurs on U.S. exchanges and within the country.
Since Morrison delimited the reach of Section 10(b) it impacts not only private damage actions but also SEC enforcement cases. The immediate result of the decision is to limit the reach of SEC enforcement. This point is illustrated by the Moody’s Investor Services, Inc. Section 21(a) Report. Exchange Act Release No. 62802 (Aug. 31, 2010).
The Report arises out of an enforcement investigation which centered on a new model the firm developed to rate constant proportion debt obligations or CPDOs, a kind of special purpose vehicle marketed in Europe. After rating the instruments the firm discovered an error in the metrics. The firm chose not to acknowledge the error until after a May 2008 Financial Times article exposed it. By that point however Moody’s had registered with the SEC as a NRSRO. In its registration papers the firm detailed its core principles which were not followed when rating the CPDOs.
The Commission declined to bring an enforcement action, citing uncertainty regarding its jurisdiction. While the Report does not cite Morrison, it seems clear that the Court’s ruling influenced the prosecutorial decision.
The Release however concludes with a warning that in the future such conduct may result in an enforcement action: “The Commission notes that, in recently enacted legislation, Congress has provided expressly that federal district courts have jurisdiction over Commission enforcement actions alleging violations of the antifraud provisions . . . involving ‘conduct within the United States that constitutes significant steps in furtherance of the violation, even if the securities transaction occurs outside the United States that has a foreseeable substantial effect within the United States.’”
The Commission’s warning that in the future it will scrutinize conduct is the international markets is well grounded. Dodd-Frank effectively overruled Morrison as to the SEC and the Department of Justice, giving both additional enforcement authority and perhaps a mandate. Specifically, the Act provides that the antifraud provisions extend in SEC and DOJ actions to any conduct within the U.S. that constitutes “significant steps in furtherance of the violation” even where the securities transaction is not in the U.S. and involves only foreign investors. The extension also covers any conduct outside the US. that has a foreseeable, substantial effect in the United States.
Morrison, the Moody’s Report and Dodd-Frank give definition to the scope of SEC enforcement in the near and far term. Enforcement actions stemming from pre-Morrison conduct will be limited by the Supreme Court’s decision as the Moody’s Report makes clear. In contrast, investigations and cases based on post-Dodd-Frank conduct may have the broader, more international reach consistent with the authority give to the agency by the Congress as the Moody’s Report warns.
Next: SEC Enforcement in court