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The United States Supreme Court heard arguments earlier this month in three important securities cases regarding the preemptive scope of the federal securities laws. At issue is the meaning of the phrase “in connection with the purchase or sale of a covered security” under the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”). The Supreme Court’s decision will impact the preclusive effect of SLUSA on future state-court class actions that bear some relationship to nationally traded securities.

The related cases of Chadbourne & Park LLP v. Troice, Willis of Colorado v. Troice, and Proskauer Rose v. Troice arise from the far-flung Ponzi scheme allegations against R. Allen Stanford and affiliated entities. According to the plaintiffs, Stanford International Bank (“SIB”) and other defendants participated in Stanford’s alleged fraudulent scheme by selling certificates of deposit (“CDs”) to the plaintiffs and fraudulently 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 allege, the CDs were backed by illiquid investments or no investments at all. The plaintiffs filed state-court class action lawsuits against various defendants, including law firms, alleging violations of state securities laws.

The defendants removed these suits to federal court, where plaintiffs’ claims were dismissed as preempted by federal law. Under SLUSA, “covered class actions” are automatically removable, and “[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.” 15 U.S.C. § 78bb(f) (emphasis added). Although the federal district court acknowledged that the CDs themselves were not “covered securities” under SLUSA, it found that the plaintiffs’ claims were nevertheless precluded by the statute because the plaintiffs had alleged they were induced to purchase the CDs by fraudulent representations that those CDs were backed by instruments that qualify as “covered securities.” Thus, according to the district court, the alleged fraud was “in connection with the purchase or sale of a covered security” under SLUSA.

On appeal, the United States Court of Appeals for the Fifth Circuit reversed. Following an exhaustive review of Supreme Court and circuit court precedent regarding the meaning of the phrase “in connection with” – language taken directly from Section 10(b) of the Securities Exchange Act of 1934 – the appellate court held: “[W]e find 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.” Accordingly, the Fifth Circuit held that the “in connection with” requirement was not satisfied and the plaintiffs’ claims not precluded by SLUSA.

The defendants appealed the Fifth Circuit’s ruling, and the Supreme Court heard oral arguments in the related cases on October 7. When asked to provide a standard upon which the Court should decide the case, counsel for the defendant-petitioners stated, “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 [satisfied].” Under this test, SLUSA would apply and preclude the plaintiffs’ claims because SIB “promised to purchase” various types of marketable securities to back the CDs. Conversely, counsel for the plaintiff-respondents suggested that the Court should adopt the following test: “[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.” Under this test, SLUSA would not preclude the plaintiffs’ claims because the CD purchasers were to have no direct interest in the purported “covered securities” backing the CDs.

Counsel for the petitioners faced challenges from a number of Justices, with Chief Justice Roberts asking skeptically: "If I'm trying to get a home loan and they ask [] what assets you have and I list a couple of stocks and, in fact, it’s fraudulent, I don’t own them, that’s a covered transaction, that’s a 10(b)(5) violation?" Justice Kagan also challenged petitioners’ counsel to articulate a “market effect” of the alleged wrongdoing, stating, “[i]n all of our cases, there’s been something to say when somebody can ask the question: How has this affected a potential purchaser or seller in the market for the relevant securities? And here there’s nothing to say.”

Although it received scant attention during oral arguments, also at issue in two of the cases is the question of whether SLUSA’s preclusive effect should apply to allegations that parties “aided and abetted” SLUSA-covered securities fraud when those parties themselves did not make direct misrepresentations about the purchase or sale (such as outside counsel for the issuer).

The Court’s decision on these issues will be an important one. SLUSA was enacted to stem the tide of private securities class actions being filed in state court in order to avoid the heightened pleading standards of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). A ruling for the defendant-petitioners in Chadbourne will further limit the scope of claims that can be brought in state court and will subject claims such as those attempted by the CD purchasers here to the PSLRA’s strict requirements. A ruling for the plaintiff-respondents, on the other hand, could lead to more creative class action filings in state court.

If you have questions about this pending matter or securities-related litigation in general, please contact one of the Securities Class Action Defense and Shareholder Litigation attorneys listed below: