Expect the Securities and Exchange Commission to scrutinize offshore activity more aggressively after a recent ruling by a panel of the U.S. Court of Appeals for the Tenth Circuit. On an issue of first impression, a two-judge majority held in S.E.C. v. Scoville, No. 17-4059, ___ F.3d ___, 2019 WL 302867 (10th Cir. Jan. 24, 2019), that the Commission may police extraterritorial misconduct so long as it satisfies the conduct and effects test adopted by Congress in Section 929P(b) of the Dodd-Frank Act. Division of Enforcement attorneys should not rush to renew their passports, however. The majority decided the matter under the test’s conduct prong. That leaves open whether the Commission may pursue cases under the effects prong when targeted misconduct is entirely overseas and involves only overseas securities transactions.
Scoville arose from an SEC enforcement action against an internet advertising company and its principal. The Commission alleged that the defendants were engaged in a Ponzi scheme in violation of Sections 10(b) and 17(a). The scheme allegedly involved the sale of “AdPacks,” which the Commission claimed are securities. Opposing the Commission’s preliminary injunction motion in the district court, the defendants argued that the AdPacks were not securities and, even if they were, most AdPack buyers were offshore, and so beyond the SEC’s reach under Morrison v. National Australia Bank Ltd., 561 U.S. 247 (2010). The district court rejected both arguments.
The court held that the AdPacks were securities under Howey and that Morrison did not bar the SEC’s action. Morrison, a private securities fraud lawsuit under Section 10(b), tossed out the conduct and effects test that lower courts had relied on for 40 years to decide if they had jurisdiction over public and private securities lawsuits involving overseas misconduct or securities transactions. The Supreme Court held that the question was not one of jurisdiction, but of substantive law – did Section 10(b) itself prohibit extraterritorial misconduct. The Court concluded it did not. Citing the presumption against the extraterritorial application of U.S. law, the Court looked to the Exchange Act’s plain language and concluded that Section 10(b) prohibited only misconduct connected to securities bought or sold in the U.S. Since Morrison, courts have applied this so-called transactional test in private securities fraud lawsuits.
In Scoville, the SEC contended that Section 929P(b)’s conduct and effects test controlled, not Morrison’s transactional test. The defendants countered that Section 929P(b) amended the Securities Act’s and Exchange Act’s jurisdictional provisions, not the substantive antifraud provisions that the Supreme Court in Morrison said were key. The district court sided with the SEC. It noted that Congress drafted and was finalizing Section 929P(b) before Morrison was decided, and that it was commonly understood at the time that Section 10(b)’s extraterritorial application was a jurisdictional issue. Given that context, the court held, the jurisdictional amendments overcame the presumption against extraterritoriality.
The appellate panel affirmed the preliminary injunction. Tracing the same path as the district court, the majority held that in Section 929P(b) “Congress ‘affirmatively and unmistakably’ directed that [the antifraud] provisions apply extraterritorially in an enforcement action.” The majority also held that the defendants’ sales and offers to sell AdPacks to overseas buyers satisfied the conduct and effects test because the “conduct within the United States … constitute[d] significant steps in furtherance of the violation of Rule 10b-5 and Section 17(a).”
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Scoville presages more robust SEC enforcement activity of offshore conduct, including offshore securities transactions that have an effect in the U.S. But we question whether the law reaches so far. The conduct prong of the conduct and effects test addresses “conduct within the United States that constitutes significant steps in furtherance of the violation [of the antifraud provisions], even if the securities transaction occurs outside the United States and involves only foreign investors” (emphasis added). The effects prong lacks the italicized language; it addresses only “conduct occurring outside the United States that has a foreseeable substantial effect within the United States.” The absence of the italicized language suggests that Congress intended the effects prong to apply only when extraterritorial misconduct is connected to domestic securities transactions.
The jurisdictional rubber literally hits the road if the Commission can rely on the effects prong to target entirely extraterritorial misconduct involving only offshore securities transactions. Those were not the facts in Scoville, however, and neither the majority’s opinion nor Section 929P(b)’s language plainly supports giving the effects prong such a wide berth. Even on its own facts, Scoville seems a stretch. The district court entered the preliminary injunction on alternative grounds – holding both that Section 929P(b)’s conduct and effects test applied to the SEC’s enforcement of Sections 10(b) and 17(a), and that the defendants’ acts satisfied Morrison’s transactional test. Thus, the appellate panel’s concurring member observed, they could have affirmed under Morrison, a fact that future defendants should bear in mind, especially outside the Tenth Circuit.