Recently, the U.S. Supreme Court limited the scope of the preemption of state law class actions afforded by the Securities Litigation Uniform Standards Act of 1998 (SLUSA) in Chadbourne & Parke LLP v. Troice, No. 12-79 (U.S. Feb. 26, 2014).
Congress enacted SLUSA three years after it passed the Private Securities Litigation Reform Act (PSLRA) to prevent class action plaintiffs from using state courts and state law remedies to avoid the PSLRA’s heightened pleading and proof requirements for securities fraud claims. SLUSA prohibits plaintiffs alleging fraud “in connection with the purchase or sale of a covered security” from pursuing a class action based on state law.
SLUSA defines a “covered security” as a security traded on a national exchange or issued by an investment company, consistent with Section 18(b) of the Securities Act of 1933. Prior to its decision on February 26, 2014, the Court previously held that SLUSA’s preemption of state law class actions extends to all suits in which the alleged fraud “coincide[s]” with a transaction involving covered securities, regardless of who purchased the covered securities. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 85 (2006).
Allen Stanford’s Ponzi Scheme
Chadbourne arose from the Ponzi scheme masterminded by Allen Stanford. One of Stanford’s corporate entities, Stanford International Bank (SIB), sold the plaintiffs certificates of deposit, which SIB promised were backed by a portfolio of assets that included SLUSA-covered securities. Plaintiffs filed class actions under state law alleging that various professional firms made material misrepresentations and omissions of fact, and aided and abetted Stanford’s scheme. Each suit alleged that the fraud included misrepresentations concerning SIB’s investments in SLUSA-covered securities.
Although the CDs were not covered securities, the district court nevertheless dismissed the state law claims because the alleged fraud had a sufficient nexus to SLUSA-covered securities to be preempted by SLUSA. The U.S. Court of Appeals for the Fifth Circuit reversed that decision. It held that SLUSA preemption did not apply because the misrepresentations concerning the SLUSA-covered securities were too tangential to the overall scheme to be considered as “in connection with” the purchase or sale of SLUSA-covered securities. Rather, the “heart, crux, and gravamen” of the alleged fraud was the representation that the CDs were a safe and secure investment.
The Majority Opinion
By a 7-2 margin, the Court affirmed the Fifth Circuit decision and ruled that SLUSA did not preempt the plaintiffs’ state law claims. The Court began by confirming the outer boundaries of when a fraud is committed “in connection with” a securities transaction: “A fraudulent misrepresentation or omission is not made ‘in connection with such a ‘purchase or sale of a covered security’ unless it is material to a decision by one or more individuals (other than the fraudster) to buy or sell a covered security.” Thus, the fraud at issue must involve a misrepresentation that made a significant difference in a person’s decision to purchase a covered security, not an uncovered security.
The Court ruled that the connection is not established when the only party deciding whether to purchase or sell a covered security is the fraudster (here, SIB), because “that is not a ‘connection’ that matters.” Because SIB was the alleged fraudster and its statements concerned its own purchases, and not those of investors, the representations were not made “in connection with” a transaction involving SLUSA-covered securities. The Court explained that this analysis was consistent with prior decisions, such as Dabit, because those earlier cases involved victims who either purchased or divested an ownership interest in instruments that met the relevant statutory definition. The Court found that expanding the reach of SLUSA preemption to include fraud directed at purchasers of uncovered securities would unduly interfere with state law remedies intended to provide relief to victims of “ordinary” state law frauds.
The U.S. Solicitor General filed an amicus brief on behalf of the Department of Justice and the SEC seeking reversal of the Fifth Circuit decision. The Court has previously ruled that the “in connection with” language of SLUSA and the parallel “in connection with” language in Section 10(b) of the Securities Exchange Act are interpreted in a similar manner. The government was thus concerned that limiting the scope of the SLUSA exemption would potentially hinder its antifraud enforcement efforts. Responding to these concerns, the Court noted that Section 10(b) covers a wide range of financial products, including uncovered securities. The Court also reasoned that its limitations on the “in connection with” requirement would not have changed the outcome of any reported decision, including the SEC’s action against SIB.
In dissent, Justice Anthony Kennedy, writing on behalf of himself and Justice Samuel Alito, argued that the majority’s opinion was inconsistent with the Court’s prior decisions, which did not suggest that a victim, rather than the fraudster, must purchase or sell an ownership interest in a security for the transaction to be subject to the federal securities laws. He noted that the purpose of SIB’s fraud was to induce investors to trust SIB’s acumen in investing in SLUSA-covered securities, and that such a fraud is similar to other federal securities frauds perpetrated by intermediaries and investment advisors. The dissent further questioned whether the majority’s formulation would turn a previously straightforward inquiry into a complex consideration of the nature of the ownership interest obtained by the investor victim.
Implications for Securities Litigation and Enforcement
Chadbourne goes against the trend of Supreme Court decisions imposing higher standards on securities plaintiffs, but whether it will open the door to more securities class actions remains to be seen. Purchasers of unregistered securities – who typically acquire such securities in a private transaction or an exempt offering – are more likely to file individual actions seeking redress rather than a class action, which is the only type of action subject to SLUSA preemption. Nonetheless, Chadbourne does add another weapon to a securities plaintiff’s arsenal, and both issuers and professional service providers should be cognizant of this additional litigation risk with respect to uncovered securities.
Chadbourne may have unintended consequences with respect to SEC enforcement initiatives. The “ownership interest” test formulated in Chadbourne for SLUSA presumably also is applicable to the “in connection with” requirement under Section 10(b) , and the majority did not suggest otherwise. Thus, Chadbourne may limit the types of fraud that the SEC may pursue, and in particular, may pose challenges to the SEC’s enforcement authority with respect to intermediaries and pooled investment vehicles (such as hedge funds or mutual funds). When an individual or entity makes an investment through such vehicles, a court may need to closely review whether in fact the investor actually purchased an interest in the covered security. This may require divining the rights provided to an investor under corporate law, and may limit the SEC’s ability to bring an enforcement action.