How Close a “Connection” is Required to File a State-Law Securities Fraud Class Action Lawsuit?

BY ERIN FITZGERALD — On October 7, 2013, the Supreme Court heard oral argument in Chadbourne & Parke LLP v. Samuel Troice, in which the Court is expected to clarify the scope of preclusion under the Securities Litigation Uniform Standards Act (“SLUSA”) of state-law securities fraud class actions.  Chadbourne, representing three consolidated cases arising from the R. Allen Stanford Ponzi scheme, specifically focuses on SLUSA’s provision that precludes class actions based on state law that involve “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” A covered security is a security traded on a national exchange or issued by a federally registered investment company.

In 1995, Congress enacted the Private Securities Litigation Reform Act (“PSLRA”) to address issues like nuisance filings, targeting of specific clients, and client manipulation in class action suits. The PLSRA made it significantly more difficult to bring securities class actions in federal court, which led plaintiffs’ attorneys to avoid federal forums and instead file class actions in state court.

In 1998, Congress enacted SLUSA, including 15 U.S.C. § 78bb(f)(1)(A), which bars plaintiffs from bringing a class action on behalf of more than 50 persons under state law alleging misrepresentations “in connection with” the purchase or sale of a covered security. SLUSA prevented plaintiffs from avoiding PSLRA requirements by filing essentially federal class action fraud suits in state courts.

In 2006, the Supreme Court in Merrill Lynch v. Dabit emphasized a broad scope for the “in connection with” requirement. The Court held that securities fraud claims brought by those who never purchased or sold a covered security satisfy the “in connection with” requirement if the underlying allegations of fraud “coincide” with a covered securities transaction by the plaintiff or someone else. Still, courts are divided about how broad the scope should be for the “in connection with” requirement.

Chadbourne stems from the alleged Ponzi scheme perpetrated by R. Allen Stanford and his entities. One of these entities, the Antigua-based Stanford International Bank, issued fixed-return certificates of deposits (“CDs”) purchased by investors through their individual retirement accounts (“IRAs”). The bank allegedly represented that the CDs were backed by liquid securities, including SLUSA-covered securities, and would be safe investments generating above-market returns.

However, instead of investing the funds generated by the CD sales to acquire the promised securities, the bank allegedly used the proceeds to make interest and redemption payments on pre-existing CDs. After the fraud was uncovered in 2009, the investors filed suit, alleging violations of Texas and Louisiana state common law and securities laws against the issuing bank. The investors argued that SLUSA did not apply because the fraud was “in connection with” the sale of CDs, which were never registered or nationally traded and, therefore, not “covered securities” for SLUSA purposes. However, the United States District Court for the Northern District of Texas held that the lawsuit was precluded by SLUSA.  The court held that dismissal was appropriate because the alleged fraudulent scheme coincided with and depended upon the sale of SLUSA covered securities.

The United States Court of Appeals for the Fifth Circuit reversed and held that SLUSA did not preclude the case from moving forward because the investors’ allegations were only “tangentially related” to securities trades covered by SLUSA. The Fifth Circuit found that that “the heart, crux, and gravamen of [the] allegedly fraudulent scheme” involved the representation that the CDs were a “safe and secure investment.”

In January 2013, the Supreme Court granted the defendants’ petition for writ of certiorari. At issue was whether SLUSA precludes a state law class action where plaintiffs are induced to invest in securities that are not covered by SLUSA, but where the underlying fraudulent scheme involves the purchase or sale of covered securities. On October 7, the Supreme Court heard oral argument.

During oral argument before the Supreme Court, counsel for the investors argued that the case was precluded by SLUSA and should be dismissed because the CD transactions “clearly included material misrepresentations about transactions in covered securities.” Counsel for the investors strongly asserted that “it was material to this fraud to make representations about purchases of covered securities. Without those representations that we’re going to take their money and we’re going to reinvest it . . . in covered securities, nobody’s going to give their money to a bank in Antigua.” Thus, to the investors, there were not only “misrepresentations [from the bank] about covered securities transactions,” but more specifically, “false promises to purchase covered securities for Plaintiffs’ benefit.”

When asked by Justice Kennedy how counsel for the investors would write the test to determine whether SLUSA applies, counsel responded that “the 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 required.” Justice Sotomayor further asked how broad the word “benefit” should be. Counsel for the United States, arguing briefly in support of the investors’ interpretation of SLUSA, responded that “benefit” should not be “restricted merely to ownership of the securities themselves.” Moreover, a “purported, intended, consummated” purchase should be sufficient to implicate SLUSA protection. Counsel for the United States argued that if this type of purchase is not implicated by SLUSA protection, then “egregious frauds would go unremedied.”

In response, counsel for the respondents argued that SLUSA does not preclude its cause of action and that the case should be allowed to proceed with litigation. Counsel argued that there was no misrepresentation “in connection with a covered security” because Stanford International Bank (“SIB”) did not purchase any “covered securities” in connection with the sale of the CDs: “SIB never sold any securities at all. It only sold CDs.” Counsel asked the Court to adopt a rule “that a false promise to purchase securities for one’s self in which no other person will have an interest is not a material representation in connection with the purchase or sale of covered securities.” Counsel argued that the while the definition of “in connection with” has to be “flexible,” there must also be “some limit” to this definition. Though not an “easily administered one,” the limit is those frauds that the “Court has recognized would have an effect on the regulated market.”

If the Court affirms the Fifth Circuit’s decision and decides that the case is not precluded by SLUSA, the scope of SLUSA would be narrowed. The narrower scope would permit more state-law claims based on investment vehicles that are not covered securities themselves, but whose performance implicates covered securities, such as investment funds that invest in nationally traded equities, options, or debt instruments.

By contrast, if the Court reverses the Fifth Circuit and adopts a broader test to determine the “in connection with” requirement, financial services defendants may have greater success in in dismissing class action lawsuits based on violations of state law. Thereafter, investors would be forced to file federal security lawsuits, which would be subject to stricter pleading requirements imposed by the PSLRA.

The victims of the Stanford fraud are anxiously hoping that the Court will affirm and give them a chance at vindication.

Leave a Reply

Your email address will not be published. Required fields are marked *