In a decision issued this week, Roland v. Green, -- F.3d --, 2012 WL 898557 (5th Cir. Mar. 19, 2012), the U.S. Court of Appeals for the Fifth Circuit addressed an issue of first impression—the scope of the preclusion provision of the Securities Litigation Uniform Standards Act (“SLUSA”). Recognizing the current split among circuits, the court adopted the “tangentially related” test. Under this standard, for a plaintiff’s state law class action lawsuit alleging fraud to be properly removable to federal court and precluded under SLUSA, the allegations must be more than “tangentially related” to transactions in “covered securities.” This ruling defines the breadth of SLUSA and allows class action plaintiffs to maintain their state law claims if their allegations are only tangentially related to the purchase or sale of covered securities.

Background

In 1995, Congress passed the Private Securities Litigation Reform Act (the “Reform Act”) to address perceived abuses in securities class actions by, among other reforms, imposing heightened pleading standards in class action lawsuits involving federal claims and nationally-traded securities. To avoid the Reform Act’s effects, plaintiffs began filing class action securities lawsuits under state law and in state court. To stem this shift, Congress enacted SLUSA, which provides defendants with a vehicle to remove to federal court state law class action lawsuits alleging fraud. Under SLUSA’s preclusion provision, “[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)(1)(A). To effectuate this, SLUSA mandates that “[a]ny covered class action brought in any State court involving a covered security . . . shall be removable to the Federal district court” and subject to dismissal. §78bb(f)(2).

The Roland case arises out of several state law class actions related to the multi-billion dollar Stanford ponzi scheme. The plaintiff investors allegedly purchased fraudulent CDs from Stanford International Bank (the “Bank”). When the Ponzi scheme collapsed, the plaintiffs filed class action suits in state court. The defendants sought removal to federal court on the basis that SLUSA precluded the state court from entertaining the suits. The federal district court found that the plaintiffs’ claims were precluded under SLUSA because even though the Bank’s CDs were not themselves covered securities, they were purportedly backed by “covered securities.”

Fifth Circuit Opinion

The Fifth Circuit recognized that the appropriate inquiry under SLUSA was whether the alleged fraudulent scheme was “in connection with” a transaction in a covered security. Because the scope of the SLUSA “in connection with” language was one of first impression for the court, it turned to Supreme Court precedent, Congressional intent, and rulings by other circuits to formulate its standard for analyzing the connection of claims to the purchase or sale of covered securities.

There is a split among the circuits in defining the “connection” requirement between the alleged fraud and a transaction in covered securities. The Sixth and Eleventh Circuits resolved that the standard is met when the fraudulent scheme “depends on” transactions in covered securities. The Seventh Circuit preferred “involving,” meaning more than a “but for” relationship. While the Second Circuit determined that the allegations must “necessarily involve” or “rest on” the covered securities.

The Fifth Circuit stressed the importance of enacting a standard that applies the “connection” requirement seriously, but does not construe the term “in connection with” so broadly as to encompass every common-law fraud that involves covered securities. The Fifth Circuit adopted the Ninth Circuit’s test from Madden v. Cowen & Co., 576 F.3d 957 (9th Cir. 2009), which states that a misrepresentation is “in connection with” the purchase or sale of securities if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related. Thus, if the allegations regarding fraud are more than tangentially related to (real or purported) transactions in covered securities, then they are properly removable and precluded under SLUSA. The court suggested that this standard was less stringent than formulations previously used by some of the other circuits.

Applying this standard to the plaintiffs’ allegations in Roland, the Fifth Circuit determined that references to the Bank’s portfolio being backed by “covered securities” were merely “tangentially related” to the heart, crux, or gravamen of the defendants’ fraud. The heart of the fraudulent scheme was the representation that the CDs were a “safe and secure” investment. That the CDs were marketed with some vague references to the Bank’s portfolio containing instruments that might be SLUSA-covered securities was tangential to the schemes allegedly advanced by the defendants. The court bolstered this conclusion by drawing distinctions between the present case and the Madoff feeder fund cases. Unlike the Madoff plaintiffs who invested in feeder funds as an indirect means of investing in covered securities, the plaintiffs in the Roland case had not deposited money in the Bank for the purpose of purchasing covered securities. Also, this case had multiple layers of separation between the CDs and any security the Bank purchased.

Because the Fifth Circuit found that the purchase or sale of securities (or representations about them) was only “tangentially related” to the fraudulent scheme alleged by the class action plaintiffs, it held that SLUSA did not preclude plaintiffs from using their state class actions to pursue their recovery.

Conclusion

Despite being a “less stringent” standard, the court reversed the district court’s decision and revived the state law class actions. Nevertheless, this standard ultimately defines the breadth of SLUSA. In order to invoke the SLUSA preclusion provision, litigants must heed the Fifth Circuit’s new standard: if the allegations regarding fraud are more than “tangentially related” to (real or purported) transactions in covered securities, then the claims are properly removable and also precluded under SLUSA.

For more information, please visit the Securities Class Action Defense and Shareholder Litigation page of the Haynes and Boone, LLP website, or contact one of the attorneys below. You may also view the alert in the PDF linked below.

PDF - Fifth_Circuit_SLUSA.pdf