On February 26, 2014, the U.S. Supreme Court held that state-law fraud class actions brought against attorneys, insurance brokers, and others arising from Ponzi-scheme claims involving R. Allen Stanford could proceed. In a 7–2 decision in Chadbourne & Parke LLP v. Troice, 571 U.S. ___ (2014), the Court held that such claims were not prevented by the Securities Litigation Uniform Standards Act (SLUSA), a federal law that precludes certain state-law securities class actions in which the alleged fraud was perpetrated “in connection with” the purchase or sale of covered securities. The Court’s decision narrows the extent of the preclusive effect of SLUSA on state-law fraud claims that bear some relationship to nationally traded securities.
SLUSA was enacted in 1998 to stem a rising tide of state-law class actions creatively constructed to avoid the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA). SLUSA provides that “[n]o covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal court by any private party alleging a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” The question of whether an alleged fraud is “in connection with the purchase or sale of a covered security” has been an unsettled one, leading to inconsistent appellate court rulings and the Supreme Court’s arguments in Chadbourne & Parke in October 2013.
The plaintiffs in Chadbourne & Parke alleged that defendants participated in Stanford’s alleged Ponzi scheme through the sale of certificates of deposit (CDs) issued by Stanford International Bank (SIB) while misrepresenting that those CDs would be backed by investments in “highly marketable securities issued by stable governments, strong multinational companies and major international banks.” In reality, the plaintiffs alleged, the CDs were backed by illiquid investments or no investments at all. The district court dismissed these claims as precluded by SLUSA, acknowledging that the CDs purchased by the plaintiffs were not themselves “covered securities” under SLUSA, but nevertheless finding SLUSA preclusion appropriate because the defendants allegedly induced the purchase of the CDs by misrepresenting that the CDs were backed by “covered securities” acquired by SIB. On appeal, the Fifth Circuit reversed, Roland v. Green, 675 F.3d 503, 521 (5th Cir. 2012), finding “the references to SIB’s portfolio being backed by ‘covered securities’ to be merely tangentially related to the heart, crux, or gravamen of the defendants’ fraud.” (Emphasis added.)
During oral arguments before the Supreme Court, the defendants urged that “[t]he simplest, narrowest way to decide this case is to say that when there is a misrepresentation and a false promise to purchase covered securities for the benefit of the plaintiffs, then the ‘in connection with’ standard is [satisfied].” Conversely, counsel for the plaintiffs urged the Court to hold that “a false promise to purchase securities for one’s self in which no other person will have an interest is not a material misrepresentation in connection with the purchase or sale of covered securities.” The plaintiffs’ position prevailed in the 7–2 decision by the Supreme Court.
Supreme Court’s Analysis
The majority opinion, written by Justice Breyer, cited several factors supporting the conclusion that SLUSA’s language – “misrepresentation or omission of material fact in connection with the purchase or sale of a covered security” – does not extend beyond statements material to the decision of a person (“other than the fraudster”) to purchase or sell a covered security.
First, the Court noted that its holding was consistent with SLUSA’s focus on “transactions in covered securities.” The plaintiffs in Chadbourne & Parke purchased uncovered securities (CDs not traded on any national exchange). Second, the Court found that SLUSA’s language suggested a “connection that matters” – meaning the alleged misrepresentation “makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security, something about which [SLUSA] expresses no concern.” Third, the Court noted that its prior interpretations of the “in connection with” language (which appears in both SLUSA and the Securities Exchange Act of 1934) involved “victims’” “ownership interest in financial instruments that fall within the relevant statutory definition,” as contrasted with plaintiffs in Chadbourne & Parke, whose direct ownership was of securities outside SLUSA’s scope. Fourth, the Court found that SLUSA and its underlying regulatory statutes (the Securities Act of 1933 and the 1934 Exchange Act) were intended to protect persons who actually “buy” or “sell” “statutorily relevant securities,” not persons with a “more remote” connection to such securities. Fifth, the Court expressed concern that a broader interpretation of the “in connection with” requirement would “interfere with state efforts to provide remedies for victims of ordinary state law frauds,” such as a suit by creditors against a small business that had claimed credit-worthiness due to its stock investments. The Court noted that “[l]eaving aside whether this would work a significant expansion of the scope of liability under the federal securities laws, it unquestionably would limit the scope of protection under state laws that seek to provide remedies to victims of garden-variety fraud.” The Court found that SLUSA reflected “congressional care to avoid such results.”
The United States had sided with the defendants in Chadbourne & Parke, expressing concern that a narrow interpretation of the “in connection with” requirement in SLUSA risked a similar narrow construction of the phrase in Section 10(b) of the 1934 Exchange Act. The Court dismissed this concern, noting that the enforcement powers of the Securities and Exchange Commission and the Department of Justice extend to all types of securities under Section 10(b) – “a wide range of financial products beyond those traded on national exchanges, apparently including [SIB’s CDs] at issue in these cases.” The Court stated: “[W]e have cast no doubt on the SEC’s ability to bring enforcement actions against Stanford and [SIB]. The SEC has already done so successfully . . . . No one here denies that, for §10(b) purposes, the ‘material’ misrepresentations by Stanford and his associates were made ‘in connection with’ the ‘purchases’ of those [CDs].” “[T]he basic consequence of our holding,” Justice Breyer stated, “is that, without limiting the Federal Government’s prosecution power in any significant way, it will permit victims of this (and similar) frauds to recover damages under state law.”
In a dissenting opinion, joined by Justice Alito, Justice Kennedy expressed concern that the “narrow interpretation of [SLUSA’s] language will inhibit the SEC and litigants from using federal law to police frauds and abuses that undermine confidence in the national securities markets.” Focusing on the attorneys and insurance brokers who were defendants in Chadbourne & Parke, the dissent predicted that the majority opinion “will subject many persons and entities whose profession it is to give advice, counsel, and assistance in investing in the securities markets to complex and costly state-law litigation based on allegations of aiding or participating in transactions that are in fact regulated by the federal securities laws.” Justice Breyer, in the majority opinion, offered a rejoinder to this concern, highlighting “the irony of the dissent’s position [where] federal law would have precluded private recovery in these very suits, because §10(b) does not create a private right of action for investors vis-à-vis ‘secondary actors’ or ‘aiders and abettors’ of securities fraud.”
The decision in Chadbourne & Parke resolves inconsistencies in the lower courts with respect to interpretation of the “in connection with” requirement. It also represents a “win” for the shareholder plaintiffs’ bar which could lead to an increase in creative class action filings under state laws against third parties involved indirectly, peripherally, or tangentially in securities transactions. Such state law claims remain attractive to plaintiffs’ attorneys because they are not subjected to the heightened pleading requirements of the PSLRA. However, the effect of Chadbourne & Parke should be limited to cases involving so-called “uncovered securities” not traded on a national exchange. For “covered securities,” state law claims against third parties should remain subject to SLUSA’s preclusive effect.