Tag: 34 Act

Do Section 10(b) and Rule 10b-5 Apply Outside of the U.S.?

Spoiler Alert: No, and this applies to civil and criminal matters, according to the Second Circuit.

Link:  U.S. v. Vilar 

Amid a selection of evidentiary and litigation-y claims, the recent 2nd Circuit case of U.S. v. Vilar did have some interesting nuggets for securities professionals.  Looking at an open issue following the U.S. Supreme Court case of Morrison v. National Australia Bank Ltd., the court looked at whether criminal liability under the Securities Exchange Act of 1934 extended to conduct outside the U.S.

Morrison was a civil case that limited Exchange Act Section 10(b) and Rule 10b-5 to domestic transactions in securities.

Background

The defendants were investment managers and advisers managing up to $9 billion before the tech bubble burst.  They offered select clients the opportunity to invest in securities that paid a high, fixed rate of interest, which were backed primarily by high quality, short-term deposits.  However a portion was invested in publicly traded emerging growth stocks.  See where this is going?

The bubble burst and the defendants were not able to meet the interest payments.  They created another investment vehicle and sold it to an investor, using the proceeds to settle a portion of the previous securities and for various personal expenses.  This investor complained to the SEC after demands to return her funds were met with questionable responses.

The defendants were convicted on a variety of securities, mail and wire fraud counts.

The Argument

Relying on Morrison, he defendants argued that their convictions should be reversed since their conduct was extraterritorial, or outside the U.S.

The court agreed and quoted Morrison for the proposition that when a statute gives no clear indication of an extraterritorial application, it has none.  Although Section 10(b) clearly forbids a variety of fraud, its purpose is to prohibit crimes against private individuals or their property, which is the sort of statutory provision for which the presumption against extraterritoriality applies (responding to the government’s examples of cases broadly applying statutes extraterritorially where the victims were government actors).  A statute either applies exterritorially or it does not, and once it is determined that  a statute does not apply extraterritorially, the only relevant question is whether the conduct occurred in the territory of a foreign sovereign.  In such a case, the court’s test is:

A securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.  More specifically, a domestic transaction has occurred when the purchaser has incurred irrevocable liability within the United States to take and pay for a security, or the seller has incurred irrevocable liability within the United States to deliver a security.

The Upshot

The conviction stands.  The conduct at issue was conducted in the United States, with ties to New York and Puerto Rico, which counts for the court’s purposes.

The defendants claimed that they structured the transaction carefully to avoid U.S. jurisdiction.  However, the court declined to “rescue fraudsters when they complain that their perfect scheme to avoid getting caught has failed.”

The Takeaway

The court summarized its conclusion on the relevant (to us) point as follows:

  • Section 10(b) and Rule 10b-5 do not apply to extraterritorial conduct, regardless of whether liability is sought criminally or civilly.
  • A defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with:
    1. a securities listed on a U.S. exchange; or
    2. a security purchased or sold in the United States.

Recent Case Shows How Little The SEC Appreciates The Beauty* Of A Reverse Merger

*Beauty Is in the eye of the stock promoter.
SEC v. Sierra Brokerage, et al.

Many of the arguments in the case are procedural, but the basis of the case involves Tsai, who created shell companies for reverse mergers.  As part of the process, Tsai would distribute the shares to his buddies to spread out the holdings in order to qualify for OTC trading.  Tsai also had stock powers from these people that allowed him to redistribute the shares in the reverse merger.

Tsai’s ability to reclaim the shares at a reduced price constituted “control” over the shareholders in addition to his control over the company and made them all “affiliates.”  According to the SEC and the court, this made him an underwriter and Rule 144 unavailable.  Thus, the distribution was a violation of the registration requirements of the 33 Act.

But wait, there’s more.  His failure to report the shares he controlled via the stock powers was a violation of Section 13(d) and Section 16(a) of the 34 Act (requirements to file Schedule 13Ds and Forms 3, 4 and 5).

If you want to draw broader lessons:

  • Spreading out securities holdings without an effective registration violates the 33 Act
  • The ability to repurchase shares demonstrates control
  • The ability to repurchase shares constitutes beneficial ownership and pecuniary interest for purposes of the Williams Act and Section 16 disclosure and short swing profit rules
  • The SEC still does not like reverse mergers

Can you “profit” from sale of securities you don’t own, can’t vote or can’t sell?

You would think that the answer would be, “No, of course not. What kind of idiot would believe such a thing?”

And the U.S. Court of Appeals for the 2nd Circuit would agree with you.

This case deals with additional fallout from the recent Goldman Sachs insider trading scandal, in this case involving short swing trading under Section 16 of the 34 Act.  Interesting already, right?

The plaintiffs in the case argued that because the defendant, an insider of Goldman Sachs, provided insider trading tips for money to a fund manager about Goldman Sachs while owning a stake in the fund that was trading in Goldman Sachs.  Get it?

The court did, and said:

  1. Getting paid for insider tips is not the same as realizing profits for purpose of Section 16.
  2. Knowing and intending for the tips to be used for insider trading is not the same as controlling the investment decisions over the shares of the fund.
  3. A pecuniary benefit from another person’s trading is not the same as a pecuniary interest for Section 16 purposes as business dealings do not establish beneficial ownership.