No SLUSA Protection Absent Material Connection With Sale/Purchase of Covered Security

by Eversheds Sutherland (US) LLP
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In Chadbourne & Parke LLP v. Troice, the U.S. Supreme Court held on February 26, 2014, that the victims of Allen Stanford’s multibillion-dollar Ponzi scheme can proceed with their claims against law firms, insurance brokers, and a financial services company that allegedly helped perpetuate Stanford’s fraud.  The Court held that the state law claims are not barred by the federal Securities Litigation Uniform Standards Act of 1998 (SLUSA).  (Click here for the opinion.)

The victims of Stanford’s Ponzi scheme purchased bogus certificates of deposit (CDs) issued by Stanford International Bank.  Stanford used the billions of dollars from these CD sales to pay other investors and to support Stanford’s lavish lifestyle.  Stanford’s victims filed four separate state-law class action lawsuits against lawyers, insurance brokers, and financial advisers who provided services to Stanford’s companies.1   

The defendant firms moved to dismiss the state-law class actions under SLUSA, which generally bars state law class actions alleging fraud “in connection with the purchase or sale of a covered security” and permits removal of any such class actions to federal court.  SLUSA defines a “covered security” as one that is traded on a national exchange or issued by a registered investment company.  (This is a narrower definition than the definition of “security” for most purposes under the federal securities laws.)  The bogus CDs at issue in the Stanford litigation were not “covered securities,” because they were not traded on a national exchange or issued by a registered investment company.

The defendant firms nevertheless argued that SLUSA preemption applied, because even though the CDs themselves were not covered securities, the defendants allegedly told the victims that the uncovered CDs were backed by covered securities.  So, defendants argued that the alleged fraud was “in connection with the purchase or sale of a covered security.”  The trial court agreed and dismissed all four class action lawsuits.

The Fifth Circuit reversed on the grounds that the “heart, crux, and gravamen of . . . the allegedly fraudulent scheme was representing . . . that the CDs were a safe and secure investment.”2  The Fifth Court held that these claims were only “tangentially related” to any “covered” securities, and the fact that the CDs were marketed with vague references to covered securities was insufficient to bring the claims within SLUSA.

The Supreme Court affirmed, in a 7-2 opinion authored by Justice Breyer.  The Court held that even though SLUSA “forbids the bringing of large securities class actions based upon violations of state law,” the Stanford victims could proceed with their state law claims because the fraudulent CDs they purchased were not a “covered security.”4  The Court stated that Defendants could not benefit from SLUSA’s protections just because Stanford and his associates told their victims that the non-covered CDs were backed by “covered” securities.  The Court emphasized that there must be a “material connection with a transaction in a covered security” for a defendant to seek SLUSA’s protections.  The fact that the issuer of the uncovered CDs held “covered” securities in its portfolio did not make a “significant difference” to the victims’ investment decisions.  Thus, the Court held that the alleged fraud was not “in connection with the purchase or sale of a covered security.”

Both the Federal Government and the dissenting opinion, authored by Justice Kennedy and joined by Justice Alito, argued that this decision would improperly undercut the enforcement powers of the Securities and Exchange Commission (SEC) and other federal agencies.  In response, the majority noted that Stanford and his associates had been imprisoned and ordered to pay billions of dollars of fines, and such frauds would still be subject to federal regulation, because the SEC and Department of Justice have authority to police all securities, not simply SLUSA-covered ones.  The majority emphasized that neither the Federal Government nor the dissent could point to a single SEC enforcement action that would have been barred by this decision.

In light of this decision, class action defendants invoking SLUSA must be prepared to demonstrate that the plaintiff is alleging fraud or manipulation that has a “material connection with a transaction in a covered security”; otherwise, SLUSA preemption will not be available as a defense..

1 Chadbourne & Parke LLP v. Troice, 571 U.S.__(2014), available at http://www.supremecourt.gov/opinions/13pdf/12-79_h3ci.pdf.

2 Roland v. Green, 675 F.3d 503, 522 (5th Cir. 2012) (citations omitted).

3 Id.

4 Supra note 1.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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