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E-MailThe following post comes to us from Jonathan C. Dickey, partner and Co-Chair of the National Securities Litigation Practice Group at Gibson, Dunn & Crutcher LLP, and is based on a Gibson Dunn publication.
On February 26, 2014, the Supreme Court decided Chadbourne & Parke LLP v. Troice, 571 U.S. ___ (2014), ruling by a 7-2 vote that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) does not bar state-law securities class actions in which the plaintiffs allege that they purchased uncovered securities that the defendants misrepresented were backed by covered securities. The decision is the first in which the Court has held that a state-law suit pertaining to securities fraud is not precluded by SLUSA, suggesting that there are limits to the broad interpretation of SLUSA’s preclusion provision that the Court has recognized in previous cases. While Chadbourne leaves many questions unanswered concerning the precise contours of SLUSA preclusion, and could encourage plaintiffs to pursue securities-fraud claims under state-law theories, the unusual facts in Chadbourne could limit the reach of the holding and provide defendants with avenues for distinguishing more typical state-law claims in other cases.
Chadbourne arose out of a multibillion dollar Ponzi scheme run by Allen Stanford and several of his companies. Stanford and his associates sold the plaintiffs certificates of deposit (“CDs”) issued by his bank and then used the money for their personal gain. Although these CDs were not covered securities under SLUSA, the defendants misrepresented that they were backed by highly marketable securities that were covered by the Act. After the plaintiffs learned of the fraud, they brought state-law class actions against alleged participants in Stanford’s scheme.
The district court dismissed the actions under SLUSA, which precludes state-law securities class actions alleging “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) (emphasis added). According to the district court, the misrepresentation that the CDs were backed by covered securities provided a sufficient “connection” for purposes of SLUSA. The Fifth Circuit reversed, concluding that this falsehood was too “tangentially related” to the “crux” of the fraud to trigger SLUSA’s bar. Slip op. at 8.
The Supreme Court affirmed the Fifth Circuit in an opinion by Justice Breyer. The Court held that in order to satisfy SLUSA’s “connection” requirement, a misrepresentation must be “material to a decision by one or more individuals (other than the fraudster) to buy or sell a ‘covered security.'” Id. Because the plaintiffs had alleged only “fraudulent assurances that [Stanford’s] Bank owned, would own, or would use the victims’ money to buy for itself shares of covered securities,” there was not a “connection” between a material misstatement and the “purchase or sale of a covered security.” Id. at 18-19.
Several considerations supported the Court’s conclusion. First, the Court explained that its interpretation fit with “the Act’s basic focus” on “transactions in covered securities.” Id. at 9. Second, it reasoned that “the phrase ‘material fact in connection with the purchase or sale’ suggests a connection that matters,” and that did not include a scheme in which “the only party who decides to buy or sell a covered security as a result of a lie [was] the liar.” Id. Third, the Court noted that its relevant precedents dealt with victims who “took, tried to take, or maintained an ownership position in the statutorily relevant securities.” Id. at 10. Fourth, it reasoned that its interpretation was “consistent” with the focus of the Securities Exchange Act of 1934 and the Securities Act of 1933 on transactions involving “ownership positions.” Id. at 11. Finally, the Court concluded that a broader interpretation of “connection” would serve only to “limit the scope of protection under state laws that seek to provide remedies to victims of garden-variety fraud,” which was not the objective of SLUSA. Id. at 13.
In his dissenting opinion, Justice Kennedy (joined by Justice Alito) criticized the majority for adopting “a new approach” to securities fraud that “constricts essential protection for our national securities markets.” Slip op. at 3 (Kennedy, J., dissenting). According to the dissent, the Court’s approach limits the SEC’s ability to prosecute “frauds like the one here,” id. at 11, and “introduces confusion in the enforcement of securities laws,” id. at 18.
In response to the dissent’s accusations, the majority took pains to limit the scope of its ruling. It harmonized Chadbourne with its earlier decisions and expressly declined to modify its ruling in Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006), where the Court held that SLUSA precluded a state-law class action alleging that the defendant’s fraudulent manipulation of stock prices was material to and “‘co[i]ncide[d]’ with” third-party securities transactions and induced the plaintiffs to hold artificially inflated stock. Slip op. at 8-9 (quoting Dabit, 547 U.S. at 85 (some alteration in original)). And the majority in Chadbourne insisted that its interpretation would not “significantly curtail the SEC’s enforcement powers” because “the term ‘security’ under § 10(b) covers a wide range of financial products beyond” the types of securities covered by SLUSA, including the CDs at issue in the case. Id. at 15.
Chadbourne serves to remind that the preclusive reach of SLUSA, while broad, is not all-encompassing, and that some state-law suits pertaining to securities fraud will be permissible. Read together, Chadbourne and Dabit indicate that the Court will continue to apply a textualist approach to SLUSA preclusion, and will endeavor to harmonize SLUSA with the private right of action recognized under Section 10(b) of the 1934 Act. In general, cases that could be brought under Section 10(b) will be precluded by SLUSA; that is the mechanism by which Congress sought to avoid evasion of the PSLRA. Only when there is a textual difference between the statutes (as in the differential definitions of “security” and “covered security” at issue in Chadbourne), or when a case falls within one of SLUSA’s express exceptions, should such a divergence occur.
