Fraud on the Global Market: U.S. Courts Don’t Buy It; Subject-Matter Jurisdiction In F-Cubed Securities Class Actions

Julie B. Rubenstein

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The ability of publicly available information to affect stock prices and the globalization of the world’s economies has ushered in an era of transnational securities fraud.  The United States, with its unique class-action mechanism, has become an increasingly attractive forum not only for U.S. investors seeking to recoup their losses against foreign defendants but also for foreign investors seeking to vindicate their own rights in American courts.  Consequently, U.S. courts must grapple with difficult questions regarding whether to hear claims by foreign plaintiffs involving transactions that are predominantly foreign—a question that U.S. courts traditionally view as one of subject-matter jurisdiction (though this characterization has, from time to time, been questioned).  The note on which this editorial is based examines how courts decide whether to exercise subject-matter jurisdiction over the claims of foreign purchasers in an increasingly common form of securities class action called the “F-cubed” (short for “foreign-cubed”) action—that is, a class action brought against a foreign issuer on behalf of a class that includes foreign investors who transacted on a foreign exchange.

Federal securities laws are currently silent as to their extraterritorial application, leaving a growing mess of lower-court precedent addressing how to apply a pair of judicially created jurisdictional tests: the “effects test” and the “conduct test.”  Under the effects test, courts focus their attention on the impact of foreign conduct on U.S. investors and markets.  By contrast, courts applying the conduct test focus their attention on the extent and nature of the defendant’s U.S.-based conduct and whether such conduct was part of a fraudulent scheme resulting in losses to investors abroad.  Although the circuits differ on precisely how to apply the conduct test, the Second Circuit’s approach provides that the U.S.-based conduct must (1) be more than merely preparatory to the fraud and (2) directly cause the plaintiff’s loss.

Although articulating the effects and conduct tests is easy, recent cases demonstrate that their application is anything but straightforward. Another possibility, however, is that courts bungle what would otherwise be a straightforward application of the tests by focusing on the wrong factors, a digression that easily leads to counterintuitive outcomes.  A comparison of two recent F-cubed cases, In re National Australia Bank Securities Litigation1 (NAB) and In re Alstom SA Securities Litigation,2 illustrates the unpredictability with which courts apply the tests.  In NAB, plaintiffs alleged a fraudulent scheme whereby the defendant’s Florida-based subsidiary falsified the value of its future cash flow and then sent the data to the defendant-bank in Australia, where personnel incorporated the information into statements and filings disseminated to the public.  Likewise, in Alstom, the plaintiffs alleged a fraudulent scheme whereby the defendant incorporated into its financial statements fraudulent results that were based on the underreporting of costs on railcar construction projects at a wholly owned subsidiary located in New York.  Despite these nearly identical facts, the NAB court and the Alstom court reached divergent outcomes.  In NAB, the district court dismissed for lack of subject-matter jurisdiction the claims of non-U.S. residents who purchased their NAB shares abroad.  The district court held, and the Second Circuit agreed, that the domestic conduct was merely a link in the chain of an alleged overall securities fraud scheme that culminated abroad.  Treating the effects test and conduct test as two parts of the same test, the Second Circuit allowed the place of compilation of the public statements (Australia), rather than the place of improper conduct (Florida), to determine jurisdiction.  On the other hand, the Alstom court held the effects test to be wholly inapplicable as a source of subject-matter jurisdiction over the claims of F-cubed plaintiffs, a holding that stands in contrast to the Second Circuit’s characterization in NAB of the subject-matter inquiry as “binary.”3  As for the conduct test, the Alstom court retained subject-matter jurisdiction over F-cubed claims as to the railcar-construction fraud.  The Alstom court  reasoned that the fraudulent underreporting of costs occurred in the United States—specifically, in the New York office of the defendant’s subsidiary: “The false documents may have been sent to Alstom headquarters in France and incorporated into the Company’s financial reports, but[] . . . the mailing of the fraudulent documents for publication outside of the United States does not render the conduct in the United States any less of a cause of plaintiffs’ losses.”4  Thus, although the Second Circuit in NAB allowed the place of compilation of the public statements to determine jurisdiction, the Alstom court focused on the place of improper conduct.  As NAB and Alstom illustrate, courts do not apply the effects and conduct tests predictably.  Rather, courts manage to reach opposite outcomes, even in cases involving comparable claims and facts.

In light of this unpredictability—and in light of their success in establishing jurisdiction under the conduct test relative to the effects test—F-cubed plaintiffs have sought new arguments to bolster their position in support of subject-matter jurisdiction.  Thus, F-cubed plaintiffs have proposed that a fraud-on-the-global-market theory ought to establish reliance and satisfy the conduct test in cases involving cross-border transactions in much the same way that the traditional fraud-on-the-market theory operates to create a rebuttable presumption of reliance, as established in Basic Inc. v. Levinson.5  No doubt, this argument draws on the efficient-market hypothesis, which the F-cubed plaintiffs have expanded into the global arena.  To link misrepresentations in the United States with effects on securities prices abroad, F-cubed plaintiffs argue that information publicly available in one country will affect the price of the issuer’s securities in other countries as well.  In re AstraZeneca Securities Litigation6 is a particularly illustrative case.  A typical F-cubed class action, AstraZeneca involved claims under section 10(b) of the Securities Exchange Act of 19347 and Rule 10b-58 promulgated thereunder against AstraZeneca, a U.K.-based pharmaceutical company, with the plaintiffs alleging that an anticoagulant drug developed by AstraZeneca was not as safe or effective as the company’s statements suggested and that AstraZeneca did not disclose certain risks associated with the drug to the public.  The plaintiffs argued that the court had subject-matter jurisdiction over the claims of F-cubed members of the class on the basis of the conduct test.  As to the first prong of the conduct test, the plaintiffs alleged that several misrepresentations and misstatements occurred in the United States.  To satisfy the second prong of the conduct test, the plaintiffs invoked the fraud-on-the-market doctrine with a global twist: they argued that AstraZeneca stock traded in an efficient global market, shown by allegations that the stock prices on all three exchanges tracked one another during the relevant period, and that, because analysts at major brokerage firms whose reports were publicly available followed AstraZeneca, the market for AstraZeneca’s securities promptly digested current information and reflected such information in AstraZeneca’s stock price on each exchange on which it traded.  Thus, even if foreign purchasers had not relied directly on AstraZeneca’s alleged misstatements, fraudulent misstatements or omissions made in the United States would necessarily affect the price of AstraZeneca stock on foreign exchanges and harm individuals who purchased their shares abroad.  The court rejected these arguments.  Despite finding that the plaintiffs had satisfied the first prong of the conduct test by adequately alleging that AstraZeneca’s U.S. conduct was more than merely preparatory to the fraud, the court rejected the plaintiffs’ suggestion that a fraud-on-the-global-market theory was sufficient to satisfy the second prong.  Accordingly, the court dismissed for lack of subject-matter jurisdiction the claims of foreigners who acquired AstraZeneca stock on foreign exchanges.  The court noted simply:

Courts that have rejected a global fraud-on-the-market theory have not done so because they believe the theory does not hold true on a global level, but rather because of a concern that allowing foreign purchasers on foreign exchanges to plead reliance in this manner would extend the jurisdictional reach of the United States securities laws too far.9

Thus, the court’s decision turned on its concern about jurisdictional overreach.  The question of how far U.S. securities laws ought to reach is no doubt a valid inquiry.  Nevertheless, the court misdirected this concern by expressing it in response to plaintiffs’ fraud-on-the-global-market argument, an argument the plaintiffs made to satisfy the second prong of the conduct test (the “direct causation” prong).  By finding that the plaintiffs satisfied the first prong (the “more than merely preparatory” prong), the court ought to have allayed any concern it had about jurisdictional overreach.  That is, after finding that the U.S. conduct was sufficient to satisfy the first prong, the court should have moved to the second prong and considered the fraud-on-the-global-market argument free of any worry about jurisdictional overreach.  By using jurisdictional overreach as a response to the plaintiffs’ fraud-on-the-global-market argument, the court simply permitted itself to dismiss the argument without considering it at all.

Given the interconnectedness of today’s securities markets, the fraud-on-the-global-market theory should be a viable argument.  The Basic Court, relying upon the traditional fraud-on-the-market theory, stated: “The modern securities markets, literally involving millions of shares changing hands daily, differ from the face-to-face transactions contemplated by early fraud cases, and our understanding of Rule 10b-5’s reliance requirement must encompass these differences.”10  Why, then, should our understanding of Rule 10b-5’s reliance requirement not take into account the fact that securities transactions now involve the cross-border exchange of millions of shares every day?  In fact, to assume that the reasoning in Basic does not extend to an efficient worldwide market for a particular issuer’s stock is illogical.  The current financial crisis proves that the market effect of information disseminated in the United States is not restricted to U.S. securities markets.  News that Lehman Brothers would fail leaked on a Sunday, a day when markets around the world were closed.  Global markets reacted to the news upon opening the very next morning, and Lehman’s demise turned out to be a trigger for a global financial crisis.  In today’s interconnected world, information travels rapidly and can affect securities prices around the globe, no matter where that information is disseminated.  Courts, however, by dismissing the claims of F-cubed plaintiffs for lack of subject-matter jurisdiction, ignore the global nature of the securities markets.

One problem with the almost systematic rejection of the fraud-on-the-global-market doctrine is that any rule restricting the doctrine to domestic markets creates a logical logjam.  Courts—and defendants, for that matter—in F-cubed actions routinely concede the courts’ subject-matter jurisdiction over the claims of three distinct investor groups: (1) U.S. residents who purchased their shares on a U.S. exchange; (2) non-U.S. residents who purchased their shares on a U.S. exchange; and (3) U.S. residents who purchased their shares on a foreign exchange.  Thus, courts accept that the fraud-on-the-market theory suffices to establish reliance for some investors whose claims arise from foreign transactions (for example, those in Group 3, U.S. residents purchasing abroad).  This reasoning puts courts in the illogical position of finding that the global market is efficient for U.S. purchasers but not for many foreign purchasers.  Yet, as one commentator points out, “if the market in the issuer’s securities is in fact an efficient, global market, then the jurisdiction plaintiffs seek to establish over only a subset of claims based on foreign transactions . . . should—under the conduct test—be established over all claims based on foreign transactions.”11  The only way out of this seemingly illogical position would be for the court to cut off such claims by U.S. purchasers for failure to establish reliance, but this approach would no doubt fly in the face of Basic and would, moreover, ignore the realities of today’s efficient securities markets.  More troubling than the courts’ dismissal of a valid economic theory, though, is their tendency to do so because of concerns about jurisdictional overreach. Cases like AstraZeneca illustrate a common fear among U.S. courts that allowing foreign purchasers on foreign exchanges to plead reliance through the fraud-on-the-global-market theory would extend the jurisdictional reach of the federal securities laws too far.  As discussed above, this concern is properly addressed not by considering fraud-on-the-global-market, but by considering the defendant’s U.S.-based conduct.  Furthermore, the AstraZeneca court’s conclusion makes little sense for the F-cubed plaintiff who pleads direct reliance.  If pleading reliance through the fraud-on-the-global-market theory would extend the reach of the federal securities laws too far, then why is the same not true if the plaintiff pled reliance the old-fashioned way?  Why would the securities laws apply to a foreign purchaser on a foreign exchange who read and directly relied on a defendant’s statements but not to a foreign purchaser on a foreign exchange who took advantage of the presumption of reliance afforded to him by Basic?  U.S. courts have yet to address this question.

The recent decision of the Second Circuit in NAB12 did not bring clarity to these questions.  In November 2009, the Supreme Court granted certiorari to review NAB.  Thus, the Supreme Court will finally address the arbitrariness with which U.S. courts apply the effects and conduct tests in F-cubed class actions.  Whether the Court adopts the approach of the Second Circuit or whether it announces an entirely different standard remains to be seen.  For example, the Court could choose to adopt a transaction-based approach, limiting subject-matter jurisdiction under the antifraud provisions to claims arising out of transactions on U.S. markets; but such an approach would exclude from a putative class any U.S. citizens who happened to purchase their shares abroad.  Arguably the globalization of securities markets has resulted in an increased need for investor protection.  Denying class membership to American investors, then, is not ideal.  Instead, the Court could adopt the approach of the NAB and AstraZeneca courts and require dismissal only of the claims of foreigners purchasing on foreign exchanges.  As discussed above, however, this approach completely ignores the global nature of today’s securities markets.  Furthermore, this approach fails to take seriously the premise of Basic v. Levinson.  In an efficient market—any efficient market—publicly available information determines securities prices.  If the market for a particular issuer’s securities is an efficient one, it does not stop being efficient simply because certain investors happen to be non-U.S. residents or happen to have purchased their shares on a non-U.S. exchange.

Ultimately, this editorial and the note on which this editorial is based attempt to show that the fraud-on-the-global-market doctrine is a logical extension of the traditional fraud-on-the-market theory and that, where  an efficient worldwide market for an issuer’s securities exists, the doctrine ought to satisfy the second prong of the conduct test.  Nevertheless, more than logic is at play, and when the Supreme Court tackles NAB, it will likely take a fresh look at the question of how far the securities laws should apply.  In doing so, it need not choose between extending the reach of the securities laws too far and denying the economic validity of the fraud-on-the-global-market doctrine.  If the Court retains the two-pronged conduct test, it ought to address any concerns about jurisdictional overreach as it considers the defendant’s U.S.-based conduct.  If the Court finds the U.S.-based conduct sufficient—using whatever standard it deems appropriate, whether that is the Second Circuit’s “more than merely preparatory” test or an alternative approach—this finding should appease any worry about extending the reach of the securities laws too far.  Free of any such concern, the Court should then consider the fraud-on-the-global-market argument in connection with the conduct test’s second prong.  As I have attempted to show, the fraud-on-the-global-market doctrine is a viable theory given the interconnectedness of today’s securities markets, and the Supreme Court ought to accept this doctrine as a way to satisfy the conduct test’s “direct causation” prong.

Acknowledgments:

Copyright © 2010 Cornell Law Review.

Julie B. Rubenstein is a 2010 J.D. candidate at Cornell Law School.

This Legal Workshop Editorial is based on Ms. Rubenstein’s Student Note: Julie B. Rubenstein, Note, Fraud on the Global Market: U.S. Courts Don’t Buy It; Subject-Matter Jurisdiction in F-Cubed Securities Class Actions, 95 CORNELL L. REV. 627 (2010).

  1. No. 03-6537, 2006 WL 3844465 (S.D.N.Y. Oct. 25, 2006) (NAB I); 547 F.3d 167 (2d Cir. 2008) (NAB II).
  2. 406 F. Supp. 2d 346 (S.D.N.Y. 2005).
  3. NAB II, 547 F.3d at 177.
  4. In re Alstom SA Sec. Litig., 406 F. Supp. 2d 346, 396 (S.D.N.Y. 2005).
  5. 485 U.S. 224 (1988).
  6. 559 F. Supp. 2d 453 (S.D.N.Y. 2008).
  7. 15 U.S.C. §78 (2006).
  8. 17 C.F.R. §240/10b-5 (2009).
  9. AstraZeneca, 559 F. Supp. 2d at 466.
  10. Basic, 485 U.S. at 243–44.
  11. Hannah L. Buxbaum, Multinational Class Actions Under Federal Securities Law: Managing Jurisdictional Conflict, 46 COLUM. J. TRANSNAT’L L. 14, 47–48 (2007).
  12. 547 F.3d 167 (2d Cir. 2008).

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