A recent Supreme Court opinion, Chadbourne & Parke LLP v. Troice, addresses the viability of class action state-law claims arising from fraudulent securities transactions. This was an opportunity for the Court to limit state-law liability, particularly for secondary actors, based on a federal securities litigation reform statute that precludes certain state court class action suits. In an opinion delivered by Justice Stephen Breyer, however, the Court read the statute narrowly, allowing potentially broad liability for securities fraud premised on state law.

The Securities Litigation Uniform Standards Act of 1998 (SLUSA) prohibits large securities class actions based upon state statutory or common law where the plaintiffs allege “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” A “covered security” is defined (as relevant to the issues in Chadbourne) as only securities traded on a national exchange. (SLUSA was part of legislative reform to address perceived abuses in class action litigation involving nationally traded securities.) The issue in Chadbourne was whether the SLUSA prohibition applies in a case where the plaintiffs alleged that they purchased uncovered securities based on the defendants’ misrepresentations that these uncovered securities would be backed by covered securities.

Chadbourne involved the Ponzi scheme of Allen Stanford. Stanford and his companies sold plaintiffs certificates of deposits —“uncovered securities”—in Stanford International Bank. They did so based on misrepresentations that the bank would use the plaintiffs’ money to buy highly lucrative assets such as marketable securities, which would have been “covered securities.” In reality, however, Stanford misused the plaintiffs’ funds. He was convicted of numerous crimes, received a lengthy prison sentence, and was required to forfeit $6 billion; the U.S. Securities and Exchange Commission won an enforcement action against Stanford and his companies, resulting in a $6 million civil penalty.

The investors in Chadbourne filed class actions under state law against so-called secondary actors—investment advisers, service providers, insurance brokers, and two major law firms—alleging that they helped Stanford Bank perpetrate the fraud. If SLUSA applied to the misrepresentations to the plaintiffs, these actions would be precluded. At issue before the Supreme Court was the breadth of SLUSA’s phrase “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security”— that is, whether it extends “further than misrepresentations that are material to the purchase or sale of a covered security.”

The Court held that a misrepresentation or omission is not in connection with 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 to sell a ‘covered security.’” The Court provided several reasons for its interpretation:

  • SLUSA focuses on transactions in covered securities—that is, principally those traded on a national exchange—not uncovered securities.
  • A “natural reading” of SLUSA suggests “a connection that matters.” The Court explained that this is a connection where the misrepresentation makes a significant difference to an investor’s decision to buy or sell a covered security, not an uncovered one.
  • The Court’s precedents support its interpretation: every case where it found a fraud to be “in connection with” a purchase or sale of securities 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” (original emphasis).
  • The interpretation requiring securities transactions that lead to taking or dissolving an ownership interest is consistent with the underlying regulatory statutes (the Securities Exchange Act of 1934 and the Securities Act of 1933).
  • Interpreting SLUSA’s “connection” requirement more broadly “would interfere with state efforts to provide remedies for victims of ordinary state-law frauds.”

The Court rejected two principal arguments advanced by the defendants and the government. First, it disagreed with the contention that its precedents supported a broad interpretation of the language “in connection with.” The Court explained that all of the precedents concerned a false statement “that was ‘material’ to another individual’s decision to ‘purchase or s[ell]’ a statutorily defined ‘security’ or ‘covered security.’”

Second, responding particularly to the government’s concern that a narrow interpretation will curtail regulatory actions, the Court emphasized that its holding will not limit the SEC or U.S. Department of Justice in bringing enforcement proceedings or criminal charges. The Court stated: “When the fraudster peddles an uncovered security like the CDs here, the Federal Government will have the full scope of its usual powers to act.” The Court underscored that, while not constraining government enforcement, its holding “also preserve[s] the ability for investors to obtain relief under state laws when the fraud bears so remote a connection to the national securities market that no person actually believed he was taking an ownership position in that market.” (original emphasis)

Justice Anthony Kennedy, joined by Justice Samuel Alito, dissented. To the dissent, the “key question,” based on the Court’s precedents, “is whether the misrepresentation coincides with the purchase or sale of a covered security or the purchase or sale of the securities is what enables the fraud.” The dissent argued that Stanford’s actions came within this standard: “The fraudster in this litigation misrepresented that he would purchase nationally traded securities. That misrepresentation was made ‘in connection with the purchase or sale’ of the promised securities because it coincided with them.”

The dissent disagreed with the Court’s narrow reading of the “in connection with” requirement, asserting that the language—based on prior cases—should be given a broad construction. As a consequence, the dissent believed that the plaintiffs’ state-law cases should be precluded. The dissent also asserted that the Court’s interpretation introduces confusion into the securities laws and may (despite the Court’s contrary emphasis) “narrow[] and constrict[] essential protection for our national securities markets,” even inhibiting the SEC and litigants “from using federal law to police frauds and abuses” that harm the national securities markets.

Chadbourne clarifies that the door remains open, despite SLUSA, for disgruntled investors to bring class action state-law claims arising from securities fraud where the fraud involving the investor is deemed attenuated to national securities markets and the investor does not take a direct ownership position in securities on that market. In other words, if a plaintiff-investor alleges misrepresentations that are not material to a purchase-or-sale decision by the plaintiff of a national-market security, the plaintiff will be able to pursue state-law claims related to the fraud.

This may prove significant because fraudulent securities schemes often take many forms, and investors—such as those in Chadbourne—may assert that they were misled into acquiring or selling investments through circumstances that did not fall within Chadbourne’s narrow reading of the “in connection with”/“covered security” language. SLUSA will not stand in the way of class actions based on violations of state law brought on this basis.

The viability of state-law claims in the securities world is especially significant for secondary players in securities transactions—such as investment advisers, insurers, brokers, accountants and, of course, lawyers. Securities plaintiffs often assert that secondary actors (who are not secondarily liable in private federal suits under Section 10(b)) participated or enabled a fraudulent investment scheme, giving rise to common law claims sounding in fraud, breach of fiduciary duty, aiding and abetting, negligence and negligent misrepresentation, and the like, as well as state statutory claims.

Particularly where a substantial securities fraud occurs, and the fraudster may be judgment-proof, secondary actors are attractive targets to investor-plaintiffs. Where plaintiffs can portray the fraud affecting them as being remote from covered securities, Chadbourne allows plaintiffs to plead and prove claims against these defendants and avoid SLUSA preclusion.

Attorneys in Ballard Spahr’s Securities Enforcement and Litigation Group represent clients in investigations, regulatory proceedings, and litigation involving the SEC, state attorneys general, and state securities regulators. Members of the Group include the attorneys who joined us from the New York City litigation firm Stillman & Friedman, P.C., to form Ballard Spahr Stillman & Friedman LLP.

Copyright © 2014 by Ballard Spahr LLP.
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