On Wednesday of last week, the Supreme Court of the United States issued a 7-2 decision affirming a Fifth Circuit ruling permitting four state-law class actions to proceed against two New York law firms and others in a matter stemming from a $7 billion Ponzi scheme orchestrated by Allen Stanford. The scheme involved the sale of bogus certificates of deposit by Stanford’s bank, Stanford International Bank, based in Antigua. Stanford was sentenced in 2012 and is serving 110 years in prison.
Investors in this scheme brought suit against two law firms, Chadbourne & Parke LLP and Proskauer Rose LLP, an insurance brokerage, Willis Group Holdings Plc, a financial services firm, SEI Investments Co, and an insurance company, Bowen, Miclette & Britt. The investors, as four sets of plaintiffs, filed civil class actions under state law contending that these defendants assisted Stanford in perpetrating the Ponzi scheme by falsely representing that uncovered securities (the bogus certificates of deposit) that plaintiffs were purchasing were backed by covered securities. The District Court dismissed these four cases under the Securities Litigation Uniform Standards Act of 1998 (the “Litigation Act” or “Act”).
The Litigation Act prohibits plaintiffs from bringing securities class actions under state law in matters in which plaintiffs claim “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” 15 U.S.C. 78bb(f)(1). The Litigation Act defines a “covered security” to mean “only securities traded on a national exchange.” 78bb(f)(5)(E). The District Court held that the “Bank’s misrepresentation that its holdings in covered securities made investments in its uncovered securities more secure provided the requisite ‘connection’ (under the Litigation Act) between the plaintiffs’ state-law actions and transactions in covered securities.” The Fifth Circuit reversed that decision determining that the connection between the Bank’s misrepresentations regarding its holdings in covered securities and the fraud was too tenuous to trigger the Litigation Act. The Supreme Court agreed with the Fifth Circuit holding that the plaintiffs are not precluded for their state-law class actions under the Litigation Act.
Because the Supreme Court has previously held that “aiding and abetting” claims cannot be made under federal law, the plaintiffs in these class action suits are eager to pursue state law remedies against these law firms and other companies that had secondary roles in their transactions with Stanford. In Central Bank, N.A. v. First Interstate Bank, N.A., 511 U.S. 164 (1994), the Supreme Court held that “Section 10(b) [of the Securities Exchange Act of 1934 (‘Exchange Act’)] does not support aiding and abetting liability stating that the “the statute prohibits only the making of a material misstatement (or omission) or the commission of a manipulative or deceptive act.” The Court would not impose Section 10(b) liability on a third party that did not itself commit a deceptive act. The Court decided that knowing about the primary violation was not enough to turn a third party (like a law firm) into a violator. Further, more recently, in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 153, 155, 166 (2008), the Court held that a private right of action does not apply to suits against “secondary actors” who had no “role in preparing or disseminating” a stock issuers fraudulent “financial statements.” Based on the holdings of Central Bank and Stoneridge, if the defendants in the four class actions were able to block the plaintiffs’ state-law claims, the defendants could not be held liable for their roles in Stanford’s fraudulent transactions.
The Supreme Court’s Conclusion
Writing for the majority, Justice Breyer stated that the Court based its conclusion on five factors that it deemed supportive of the contention that “misrepresentation of a material in fact in connection with the purchase or sale of a covered security” only extends to misrepresentations that are material to the decision-making of those (other than the fraudsters) to purchase or sell a covered security (as opposed to an uncovered secured). The factors cited by the Supreme Court supporting this conclusion are:
This is “consistent with the Act’s basic focus on transactions in covered, not uncovered securities.”
The plain language of the Act supports this conclusion. The Act states a “material fact in connection with the purchase or sale” and the Court interprets that the “connection” here between the material fact and the purchase or sale is a “connection that matters.” There must be an impact on an individual’s choice to buy or sell a covered security, not an uncovered security.
In securities cases where the Supreme Court has found there to be the requisite connection between the fraud and the purchase or sale under the Act, there have been “victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintained an ownership interest in financial instruments that fall within the relevant statutory definition.”
The Supreme Court viewed the Act in light of the Securities Exchange Act of 1934 and the Securities Act of 1933 regarding those engaged in securities transactions that result in the taking of ownership positions and which make it illegal to deceive an individual when she is doing so. The Court recognized that the purpose of these statutes is to protect investor confidence. Nothing in any of these statutes endeavors to protect those “whose connection with the statutorily defined securities is more remote than buying or selling.”
The Supreme Court expressed wariness in applying a broader statutory interpretation than necessary as such broad interpretation of the “connection” could interfere with the various states’ efforts “to provide remedies for victims of ordinary state-law frauds.” The Court recognizes that the Litigation Act seeks to avoid that outcome, allowing the individual states authority over matters primarily of state concern.
The Defendants’ and Government’s Argument for Broad Interpretation
First, the defendants and the Government staged a precedence argument, pointing out that the Supreme Court has suggested that the phrase “in connection with” be given broad interpretation. However, the Court disagreed stating that in all cases in which the Court found the requisite connection between the misrepresentation and the sale or purchase, the security involved was “a statutorily defined ‘security” or “covered security.’” The Court states that is could not find any case in which it ruled involving “a fraud ‘in connection with’ the purchase or sale of a statutorily defined security in which the victims did not fit” into the relevant statutory definition.
Next, the Government expressed concern that narrowly interpreting the Litigation Act would diminish the SEC’s authority under the Securities Exchange Act, which uses the same “in connection with the purchase or sale” language. The Supreme Court disposed of this contention by stating that the authority of the SEC and Department of Justice covers all “securities,” not just those traded on national exchanges. The Court pointed out that the SEC successfully prosecuted Stanford based on his Bank’s fraudulent sales of certificates of deposit, which are “securities” even if they are not “covered securities.”
Two Justices Dissent
Joined by Justice Alito, Justice Kennedy wrote the dissent, stating that because these investors purchased the certificates of deposit based on the false statements that these certificates of deposit were backed by covered securities there was requisite connection between the misrepresentation and the purchase or sale of a covered security. The dissent stresses that, in light of the precedent, even though those cases dealt with much less complex transactions, if the fraud depends on the purchase or sale of securities or the promise to do so, the connection is made. Therefore, these class actions under state law must be precluded by the Litigation Act. The dissent cautions that the majority opinion creates a new rule that departs from the precedent. Furthermore, agreeing with the Government, Justice Kennedy wrote that the Court’s decision will negatively impact the SEC’s enforcement authority as it is inconsistent with Congress’s intent and “casts doubt on the applicability of federal securities law to cases of serious securities fraud.”
Conclusion and Consequences
The Supreme Court held that the requisite “connection” between the materiality of the misrepresentations and the required “purchase or sale of a covered security” was not made in this case. Therefore the Litigation Act did not preclude the plaintiffs’ class action suits under state law. There is no allegation that the material misrepresentations were “in connection with” the buying or selling of covered securities. The Court held that “at most, they allege misrepresentations about the Bank’s ownership of covered securities. But the Bank is the fraudster, not the fraudster’s victim; nor is it some other person transacting in covered securities.”
The holding of this case allows these class actions based on state law against various law firms and others to go forward, widening the net of those potentially liable for the consequences of Stanford’s Ponzi scheme. Furthermore, this decision leaves questions as to the purported narrowness of the interpretation of the Litigation Act. As Ponzi schemes become more sophisticated and complex, involving varying schemes and players, it will be interesting to see how courts apply the Court’s interpretation.