Let me begin by calming the nerves of anyone who thinks "foreign-cubed" is a long-forgotten high school algebra equation. I promise there will be no math in this column. "Foreign-cubed" refers to a securities class action brought in the United States by (1) foreign investors, against (2) a foreign issuer, regarding securities purchased or sold on (3) a foreign exchange or a foreign securities market. Plaintiffs in foreign-cubed actions seek to bring their claims in the U.S. courts to take advantage of relatively liberal U.S. class action law and the potentially larger damage awards here than in their home countries. 

Foreign-cubed litigation gained notoriety earlier this year when the U.S. Supreme Court heard a prime example of such a case, Morrison v. National Australia Bank. The Morrison case highlights the myriad legal and public policy questions raised by foreign-cubed cases, and a surprising proposal made by the SEC may offer a workable solution. 

In Morrison, Australian investors sued the National Australia Bank (NAB) for losses suffered through trading on the ASX, an Australian exchange. The plaintiffs allege that fraudulent financial reporting by the bank artificially inflated its stock price, which later dropped when the fraud finally was revealed. The investors claim that the fraud took place in the United States, through intentionally misleading financial statements prepared by the bank’s Florida subsidiary, thereby implicating U.S. law. The bank argues that any potential wrongdoing took place in Australia, where the financial statements were compiled and reviewed, and that the case should be thrown out of the U.S. courts.

Like most foreign-cubed cases, the original Morrison plaintiff class included both U.S. and foreign investors. Courts generally agree with the common sense notion that claims by U.S. investors who purchased securities on a U.S. exchange should be subject to U.S. law, even though the defendant may be a non-U.S. resident. Courts often utilize something called the "effects test" to determine whether the United States has enough of an interest in a case for domestic law to apply–when the fraudulent activity has an effect on domestic investors purchasing securities on domestic exchanges, then the courts allow U.S. law to be used to protect U.S. citizens and markets. 

In Morrison, the named plaintiff was a U.S. investor who purchased the bank’s ADRs on the New York Stock Exchange. NAB never questioned U.S. jurisdiction over Morrison’s own case, but his claim was dismissed early in the proceedings on other grounds. That left only foreign plaintiffs complaining about losses on a foreign exchange. With no U.S. investors or exchanges any longer involved, the effects test did not apply. 

That left the courts with the job of determining whether the allegedly fraudulent conduct in Florida was significant enough to warrant the United States’ exercise of its jurisdiction. That determination is typically called the "conduct test," where courts evaluate how much of the conduct contributing to the fraud actually occurred in the United States. Nationally, judicial interpretations of the conduct test have been inconsistent. The two lower courts that heard Morrison interpreted the conduct test to mean that U.S. jurisdiction exists "if activities in this country were more than merely preparatory to a fraud and culpable acts or omissions occurring here directly caused losses to investors abroad." Not exactly a clear or easy standard for courts to follow. Both lower courts then concluded that the conduct in Florida was "merely preparatory" and ultimately was not the "direct" cause of the fraudulent activity. 

The Supreme Court must now evaluate the lower courts’ application of the conduct test and weigh the competing public policy concerns.  The Supreme Court will be asked to consider whether the conduct test was the proper standard, or whether the lower courts should have applied some other method of determining whether U.S. jurisdiction was warranted.  If the Court decides that the conduct test was the right test, then it will have to determine whether the lower courts properly interpreted and applied the conduct test.

Both sides believe they have strong public policy arguments in their favor, and both presented suitably eloquent legal arguments to the Supreme Court. Plaintiffs’ supporters asserted that when an issuer lists its securities on a U.S. exchange, subject to stringent U.S. disclosure requirements, investors have a heightened level of confidence that leads to an increase in the issuer’s stock price. Confidence that U.S. law protects shareholders attracts more investors to the U.S. markets, which in turn benefits the U.S. economy. Thus, they argued that if the Supreme Court rules that foreign-cubed claimants are not entitled to the protection of U.S. law, foreign investors may flee from our markets, taking much-needed capital with them. Moreover, the U.S. courts’ dismissing foreign-cubed cases would embolden international criminals to commit fraud in the United States, knowing that they likely will not be subject to U.S. legal action. 

NAB’s supporters countered that subjecting an issuer in a foreign-cubed case to potential U.S. securities liability will cause foreign companies to delist from U.S. exchanges and to cease their U.S. business operations, which could devastate the U.S. economy. They argued that United States involvement in foreign-cubed cases would frustrate foreign governments’ efforts to enforce their own securities laws, and would allow foreign plaintiffs to circumvent the laws of their home countries by forum-shopping for plaintiff-friendly regulatory regimes. Several nations filed briefs with the Supreme Court in support of NAB’s position, including Great Britain, France and, appropriately, Australia. 

The SEC, on behalf of the U.S. government, has also taken an active role in Morrison, but its position took a peculiar turn as the case worked its way to the Supreme Court. In the lower courts, the SEC supported the plaintiffs, arguing that the conduct in Florida was substantial enough to warrant U.S. jurisdiction. That viewpoint surprised no one, as the SEC would understandably wish to have jurisdiction to bring its own legal action against similar frauds in the future. 

At the Supreme Court, however, the SEC reversed its position and surprisingly supported NAB. The SEC’s new and more nuanced argument supports the dismissal of Morrison, while simultaneously advocating for SEC jurisdiction over similar cases in the future. The SEC reasoned that for private lawsuits, such as a class action by investors in a foreign-cubed case, something similar to the version of the conduct test used by the lower courts in Morrison should apply. Under that test, the SEC agreed with the courts below that the Morrison claim should not be tried in the United States because the plaintiffs cannot show that their losses were "directly" caused by any fraudulent activity that took place in Florida. 

However, the SEC also proposed a new, more relaxed version of the conduct test for determining whether the type of fraud alleged in Morrison violates Section 10(b) of the Exchange Act. The SEC believes that such fraud violates Section 10(b) if "significant conduct material to the fraud’s success occurs in the United States." The SEC’s test may be just as subjective and difficult to apply as the "more than merely preparatory" and "direct cause" interpretations used by the lower courts in Morrison, but it seems clear that the SEC’s "significant and material" standard would lower the bar in applying U.S. jurisdiction for enforcement actions by the SEC. 

The SEC maintained that the alleged fraudulent conduct by NAB in Florida meets the "significant and material" test, which would allow for an enforcement action against NAB. Moreover, the SEC argued that applying different standards to private lawsuits than to SEC enforcement actions would address the competing public policy concerns presented by the parties and their amicus curiae supporters. 

Addressing the concerns of those siding with the Morrison plaintiffs, the SEC argued that a more lenient jurisdictional standard for SEC enforcement actions would provide assurance to foreign investors that the SEC could protect against U.S.-based fraud. Thus reassured, foreign investors would continue to invest in foreign companies listed on U.S exchanges and in foreign companies with U.S. subsidiaries, saving the U.S. markets and U.S. economy from ill effects. The SEC’s solution also would tend to deter potential fraudsters from engaging in unsavory conduct in the United States, because they would fear the enforcement might of the SEC. 

On the other hand, Morrison’s dismissal also would ease the public policy concerns of NAB’s supporters. Secure that the United States would not grab jurisdiction over a foreign-cubed private class actions like Morrison, foreign issuers would continue to list securities on U.S. exchanges and to operate U.S. subsidiaries. Foreign investors could not circumvent issuer-friendly regulatory regimes in their home countries by bringing securities cases in the more investor-friendly environment of the United States. 

The SEC’s solution might just work, provided that the SEC actually is vigilant about enforcing U.S. laws against fraudulently activity that affects foreign investors. The policy in favor of private rights of action recognizes that the SEC can’t do it all: directly affected individuals can assist the government’s overall goal of compliance with the securities laws, and increase the total amount of resources applied to the prosecution of fraud claims, if they are allowed to bring their own suits against fraudsters at their own expense. However, forum-shopping is a problem, and the standards applicable to foreign-cubed claims have long been dangerously unclear. Parties to these litigations, including legitimately aggrieved plaintiffs, have spent countless legal dollars arguing over U.S. jurisdiction without ever getting to the merits of their cases. While not without its flaws, the SEC’s proposal in Morrison may be the most equitable solution put forth yet. The Supreme Court will soon provide its solution to the foreign-cubed equation.

Daniel Zinn is a principal of The Nelson Law Firm in White Plains, N.Y. He can be reached at dmzinn@nelsonlf.com 

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com 

At the end of 2008, I wrote a column for Traders Magazine entitled "Regulatory Capture," which argued the need for an investor advocate. An investor advocate is necessary to ameliorate the problem of undue industry influence on regulatory decisions, a disease known as "regulatory capture" that afflicts many government agencies. I am pleased to report that there has been a great deal of progress since that time.

The problem of regulatory capture was described in detail in the 2008 column. In brief, to do its job, the SEC must obtain information from the broker-dealers, exchanges, issuers and investment advisers that it regulates. In turn, the business of these regulated entities will be directly affected by the decisions the SEC makes. As regulated entities feed information to the regulator, they gain access–the regulated have many opportunities to complain about "unnecessary" and "burdensome" regulations, request special rules and exceptions, and influence the course of rulemaking.

The industry’s influence over the SEC’s decision-making is exacerbated because the SEC, like most other government agencies, routinely hires staff from law and accounting firms. And many staffers expect that upon leaving government service, the most promising employment opportunities will be at law and accounting firms whose clients are regulated by the SEC.
 
I have the greatest respect for professionals who decide to take a severe cut in income to devote years of their career to government service. But it is also true that, while these professionals make every effort to represent their new government client wholeheartedly, their views and perspectives are influenced by their experiences representing regulated entities, and they tend to lean in favor of their former clients or employers, consciously or unconsciously. Similarly, I don’t think there is anything wrong with SEC staffers finding jobs in the securities industry. They need to support their families, like everyone else. But, these future employment prospects undoubtedly limit the zeal of staffers to provoke the industry’s ire by aggressive efforts to institute or enforce costly regulations.

Our culture and system of laws recognize that conflicts of interest will always be with us. Rather than trying to abolish them, we usually address conflicts of interest by providing a counterbalance. We try to expose the existence of the conflict of interest; then we try to make sure that there is an unbiased arbiter and, at the very least, provide an opportunity for each party to have an unbiased advocate who will tell their story in a light most favorable to their cause. The idea is that the truth lies somewhere in the middle.

Unfortunately, investors generally don’t hire advocates to represent their positions to the SEC. The big pension funds and other large institutional investors retain lawyers to advocate their views on a handful of issues, such as proxy voting. And retail investors sometimes call the SEC to complain about their brokers or some industry miscreant. But in the process of rulemaking, most rules that may have an enormous impact on investors are promulgated without any input from advocates for investor interests.

Of course, the SEC is charged with protecting the interests of investors, and I believe they try to consider these interests when rules are promulgated. However, the information used to make any particular regulatory decision is almost always generated by the securities industry. There has been no counterbalance on the investors’ side, until recently.

In 2009, the SEC organized an "Investor Advisory Committee." It is composed of people who represent a broad spectrum of investor interests, as well as some members of the securities industry. The Committee includes some law professors and representatives of organizations that advocate the interests of individual and institutional investors. Some members represent labor organizations, which have a great interest in seeing that the retirement funds of their members are invested properly. There are also some members who are employees of exchanges and broker-dealers. 

When this group was first assembled, I wondered whether it would actually try to accomplish any useful purpose, or whether its role would consist of simply applying lipstick to a pig. A recent Webcast of the Committee’s latest meeting left me guardedly optimistic.

The meeting began with a presentation by Dan Ariely, a behavioral economist and author of the best selling book "Predictably Irrational." Ariely challenged the most basic propositions of the securities laws. Disclosure, in his view, merely confuses investors and recent behavioral studies suggest that the person making disclosure feels liberated to make outrageous claims on the theory that the disclosure has sanctified the process. He also pointed to recent experiments showing that conflicts of interest cannot be cured by disclosure.

Ariely’s research takes aim at some highly venerated sacred cows that serve as the foundations of our securities laws. It will be interesting to see how far the Committee goes in its recommendations to the SEC. There seem to be some fairly simple alternative ways to protect investors that are suggested by Ariely’s research, and these may well find their way into the Committee’s recommendations to the SEC. Others of his suggestions would require us to abandon the notion that "sunlight is the best of disinfectants." An entirely new theory of investor protection would have to be developed to take its place.

Another panel got into a thorough and balanced discussion of the pros and cons of securities arbitration. My experience representing clients in securities arbitration has caused me to loathe the process. Nonetheless, I came away from the panel discussion thinking that doing away with it altogether would probably do more harm than good. A more nuanced approach that improves the fairness of the process is probably the most practical alternative.

The Committee’s discussion of money market funds was particularly interesting. The Committee is generally opposed to the SEC’s recent rule-making proposal, which, among other things, considers whether to do away with a stable net asset value. This proposal would cause the value of a share to vary each day, much like a traditional mutual fund. The Committee thoroughly grilled Robert Plaze from the Division of Investment Management, who provided a lot of information about the thinking of the President’s Working Group on this issue. This discussion demonstrated the Committee’s independence from the SEC and the current administration on a very controversial issue.

The SEC from time to time organizes "blue ribbon" commissions and other committees to focus on certain issues. They generally make some recommendations, which may lead to rulemaking, and then they go away.  In this case, however, it appears that we can be reasonably optimistic that the Investor Advisory Committee will be with us for the long haul. Both the Senate and House version of the recently passed financial service regulatory reform bills require the SEC to establish an Investor Advisory Committee. It would have to be funded and meet at least twice each year. The SEC would be required to consider the Committee’s recommendations, but would not be required to do anything about them.

The Senate bill would go one step further. It would establish an "Investor Advocate," who would be a member of the Investor Advisory Committee. This would be a paid position. The Investor Advocate also would be entitled to retain or employ independent counsel–that is, counsel who would not be part of the SEC Office of General Counsel–and its own research and service staff, as the Investor Advocate deems necessary to carry out the duties of the office.

The Senate bill’s Investor Advocate would have the duties of an ombudsman, assisting retail investors to resolve significant problems with the SEC or FINRA. It would identify areas where investors would benefit from rule changes and problems with financial service providers and investment products, and propose changes to rules and orders that would be helpful to investors. Most importantly, the Investor Advocate would be charged with analyzing the proposed impact on investors of proposed regulations, including changes in FINRA’s rules, and with suggesting changes to the SEC and Congress, including legislation, that would be appropriate to address adverse impact to investors. The SEC would be required to respond to the Investor Advocate’s suggestions. One would expect the "Investor Advocate’s Statement" to become an important part of rule-making proposals.

The Investor Advocate would also be required to make an annual report to Congress on its success in achieving its objectives. Among other things, this report would describe the quality of the SEC’s cooperation and would not be reviewed by the SEC prior to its submission. The Senate clearly intends for the Investor Advocate to be independent of the SEC and provide an independent assessment of the SEC’s effectiveness as a regulatory agency.

A lot depends on who gets appointed Investor Advocate and how seriously they take their responsibilities. But this proposal has a lot of potential. If it survives in conference and becomes law, and the Investor Advocate competently performs its assigned tasks–both very big ifs–the SEC’s decision-making process will never be the same. I would expect the Investor Advocate and the Investor Advisory Committee to provide a strong counterbalance to the influence of industry advocates. 

The days of regulatory capture are numbered.

Stephen J. Nelson is a principal of The Nelson Law Firm in White Plains, N.Y. Nelson is a weekly contributor and columnist to Traders Magazine’s online edition. He can be reached at sjnelson@nelsonlf.com 

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com