The Supreme Court Reviews the Preemption of State Securities Class Actions Under the SLUSA

The Supreme Court Reviews the Preemption of State Securities Class Actions Under the SLUSA

The Securities Litigation Uniform Standards Act of 1988 (SLUSA) was enacted in order to prevent securities law claimants from evading the protections afforded to defendants by the Private Securities Litigation Reform Act (PSLRA).  The PSLRA provides for sanctions for frivolous lawsuits and stricter pleading requirements instituted under Section 10(b) of the Securities Exchange Act of 1934, and its corresponding Rule 10b-5.  The enactment of the SLUSA ensures that the protection of the PSLRA is not circumvented by plaintiffs filing suit in state, rather than in federal court.

Under the SLUSA, a plaintiff is prohibited from bringing a class action under state law alleging a misrepresentation, material omission or deceptive practice “in connection with the purchase or sale of a covered security.”   A “covered” security is defined as one that is “listed, or authorized for listing, in a national securities exchange” or a security issued by an investment company.

The Supreme Court recently addressed the reach of the SLUSA in Chadbourne & Parke LLP v. Troice et al.  In a 7-2 decision, the Court held that the SLUSA does not preclude class actions brought under state securities laws based on purchases or sales of uncovered securities, even if the underlying investments of the uncovered investment vehicle include covered securities.

The case actually involves four consolidated class action cases involving the Stanford International Bank (SIB) Ponzi scheme orchestrated by Allen Stanford wherein the plaintiffs were issued certificates of deposit (CDs) by SIB.  The cases were brought against various law firms, investment advisers and insurance brokers under state law alleging the defendants aided in or concealed Stanford’s scheme.  While the plaintiffs’ CDs were admittedly uncovered securities, they claim they were misled to believe their investments were used to purchase covered securities to ensure the liquidity of their investment.  However, Stanford was using the investors’ funds to pay off other investors and finance his extravagant lifestyle.

The defendants argued that even though the CDs the plaintiffs purchased from SIB were not “covered securities” under the statute, the SLUSA nevertheless precluded the plaintiffs’ state court claims because the investors had been told the CD sales proceeds would be invested in securities of a type that would represent “covered securities” under SLUSA.

However, the Court disagreed and held the SLUSA preemption did not apply as the “in connection with” and “materiality” elements were not satisfied by the allegations, and the plaintiffs could move forward with their state law fraud claim.  According to the Court, the fraudulent misrepresentation or omission must be material, i.e. make a “significant difference” in the plaintiff’s decision to buy or sell a covered security.  The Court reasoned that the misrepresentation by Stanford concerned his bank’s purchase of covered securities and did not concern the plaintiffs’ purchase of the uncovered CDs.

The two dissenting justices, as well as many commentators, view the majority’s decision as a narrow interpretation of the preemption provision that limits the reach of the SLUSA.  The dissent argued the decision is inconsistent with the court’s prior precedent that the “in connection with” requirement only mandates that the fraud “coincide” with the covered security transaction.  In their dissent, they also expressed concern that the majority’s interpretation will expose secondary actors such as accountants, lawyers and investment advisors to liability under state law, despite the protection they are afforded under federal law.

However, the majority does not view their decision as narrowing the scope of the law.  They note that “every securities case in which [the] Court has found a fraud to be ‘in connection with’ a purchase or sale of a security has involved victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintained an ownership interest in financial instruments that fall within the relevant statutory definition.” (emphasis original)   The plaintiffs in this case did not fall within that scope.  The Court further noted that interpreting the law more broadly, “[l]eaving aside whether [it] would work as 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.”

Therefore, while many commentators view the Supreme Court’s decision as drastically limiting the reach of the SLUSA, the effect of Chadbourne & Parke is limited to cases involving “uncovered securities” not traded on a national exchange.   Although the Court’s decision narrows the extent of the preclusive effect of the SLUSA where covered securities are only remotely involved, the protection against frivolous lawsuits where covered securities are the basis of the claim provided under the PSLRA remains intact.