Morrison’s Impact on Institutional Investors

The following post comes to us from Jeffrey P. Mahoney, General Counsel at the Council of Institutional Investors, and is based on the executive summary of a CII white paper prepared by Christian J. Ward and J. Campbell Barker, available in full here.

American securities law is at an important crossroads, and the direction it takes will affect investors well into the future. For decades, federal securities law protected U.S. domiciled and citizen investors against fraud affecting the securities they purchased, even if purchased on foreign markets. Under the longstanding conduct and effects tests, the antifraud provisions of U.S. securities law covered all conduct that injured American investors. Fraudsters could not escape a private right of action for securities fraud by consummating a transaction abroad.

The U.S. Supreme Court’s June 2010 ruling in Morrison v. National Australia Bank [1] changed the landscape for U.S. investors. In Morrison—a dispute about the territorial reach of the antifraud provisions of U.S. securities law—the Supreme Court rejected four decades of federal court jurisprudence applying the conduct and effects tests and adopted a new rule that focuses narrowly on the location where securities were purchased and sold. Under prior law, if the fraud involved conduct in the United States or had an effect in the United States, victims had a private right to bring suit. Under Morrison’s new test, so long as the fraud relates to securities that trade only on foreign exchanges or other foreign platforms, no amount of harm to American investors triggers the antifraud protection of U.S. securities law, even if investors submitted their orders from the United States.

Morrison thus alters the risk profile of foreign investments, stripping institutional and other private investors of the significant protection previously afforded by federal securities law. After Morrison, Congress restored the conduct and effects tests as the jurisdictional limit of antifraud actions brought by the Securities and Exchange Commission (SEC) and the Department of Justice (DOJ), but it has so far not created a corresponding private right of action.

The current state of U.S. securities law presents significant concerns for institutional investors. Those investors are among America’s largest shareowners, and many routinely invest according to modern portfolio theory, which requires diversification of investments for the greatest return at the most responsible level of risk. In the global economy, diversification requires substantial investment in foreign stocks and other foreign securities. Accordingly, U.S. institutional investors have significant foreign equity holdings.

Reliance on government action alone to recover American investors’ losses from transnational securities fraud is insufficient. The SEC is underfunded and overburdened, and private causes of action recover far more for defrauded investors than does the government. Thus, courts and the SEC itself have recognized that a private right of action is a vital tool for deterring and combating securities fraud. That is particularly true with respect to fraud involving complex international transactions, which can be among the most difficult to investigate.

Extending the private right of action to all securities fraud that affects U.S. investors, regardless of where the securities transaction settles, best comports with investors’ expectations and allows recovery for domestic harm. Investors buying and selling securities from the United States reasonably expect protection for fraud affecting them, even if the trade occurs on an overseas exchange. And the benefits of restoring a private right of action for fraud in connection with foreign securities transactions outweigh the costs.

In addition to permitting greater recoveries for defrauded investors, a private right of action promotes more efficient capital markets by enhancing investors’ confidence in the truth of financial disclosures. That, in turn, improves capital allocation and fosters higher growth. And it is not at all clear that a private right of action would engender any more substantive conflict between the securities laws of the United States and those of other countries than would Morrison’s transactional test or that it would upset international comity.

Importantly, restoring a private right of action for fraud in connection with foreign transactions would be more in sync with the reality of today’s global markets than Morrison’s transactional test. In the capital markets today, an investor may not even know whether a transaction is routed through a domestic exchange or a foreign one. A private right of action relieves American investors from the burdens—and probable loss of substantive and procedural protections—involved in using foreign courts to litigate over domestic losses.

Further, Congress should consider a new private right of action extending to foreign investors (those who are not U.S. citizens or domiciled in the United States) who purchased their shares on a foreign stock exchange. Policing domestic conduct that plays a clear and direct part in causing a foreign injury can promote ethical conduct in a way that benefits all investors. Moreover, many transnational securities frauds involving foreign-traded securities injure both domestic and foreign investors, meaning that domestic investors would have a private right of action if the effects test is restored.

Securities law already allows injured investors to bring a private right of action for fraud in connection with domestic transactions. Restoring the scope of the private right of action to encompass all fraud that harms U.S. investors does no more than afford them the protection of their own country’s laws. And doing so will have far-reaching net benefits. Congress should adopt an effects test to define the territorial reach of the Section 10(b) private right of action. Congress should also clarify the nature and extent of domestic conduct required to allow foreign investors to sue defendants over the foreign sale of stock. All investors will benefit from these reforms.

Endnotes

[1] Morrison v. National Australia Bank Ltd., 130 S. Ct. 2869 (2010).
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