The United States Supreme Court issued a significant ruling that may present challenges to the Securities and Exchange Commission in pursuing some federal securities fraud claims and may open up some defendants to costly state court class actions.
On February 26, 2014, in Chadbourne & Parke LLP v.
Troice et al.,1 the Supreme Court narrowed the
definition of "in connection with" as that term is used
in the Securities Litigation Uniform Standards Act of 1998 (SLUSA).
SLUSA bars state law class actions in which the plaintiff alleges a
misrepresentation or omission "in connection with the purchase
or sale of a covered security." The plaintiffs in a state law
class action had alleged that they purchased certificates of
deposit (uncovered securities) based on the misrepresentations that
the certificates of deposit were backed by purchases and sales of
covered securities. The Supreme Court held that a material
misrepresentation is "in connection with" the purchase or
sale of a covered security only if it makes a significant
difference to someone's (other than the fraudster's)
decision to purchase or sell a covered security.2
Because the certificates of deposit purchased by the class were not
"covered securities," the 7-2 majority concluded that
there was not a sufficient "connection" between the
misrepresentations (which related to the fraudster's
purported purchase or sale of securities) and any purchase or sale
of covered securities by the aggrieved
investors.3 As a result, SLUSA did not bar the
state class action from continuing.
Although the Court interpreted the "in connection with"
requirement of SLUSA, the same "in connection with"
language appears in the key antifraud provisions of Section 10(b)
and Rule 10b-5 of the Securities Exchange Act of 1934. Accordingly,
the decision will have implications for both application of the
restrictions imposed by SLUSA and the reach of the antifraud
provisions of the 1934 Act.
The Decision
At issue in Chadbourne were four consolidated class
actions involving plaintiffs who purchased certificates of deposit
in the Stanford International Bank as part of former financier and
cricket magnate Allen Stanford's multibillion-dollar Ponzi
scheme.4 These certificates of deposit were not traded
on a national exchange or issued by an investment company. The
plaintiffs alleged they were told that Stanford International Bank
backed the certificates of deposit with nationally traded
securities, making the certificates of deposit more
secure.5 The four class actions alleged that the
defendants (investment advisers, insurers, and law firms) helped
Stanford carry out or conceal the fraud from
regulators.6
SLUSA is a federal statute that precludes state law class actions
alleging (1) misrepresentation or omission of material fact in
connection with the purchase or sale of a covered security; or (2)
use of any manipulative or deceptive device or contrivance in
connection with the purchase or sale of a covered
security.7 Covered securities are limited to those
traded on a national exchange or issued by an investment
company.8 The Court evaluated whether SLUSA precluded a
state law class action based on misrepresentations relating to
covered securities where the victims purchased certificates of
deposit, but did not themselves directly purchase covered
securities.9
The Court, in a 7-2 decision, narrowly interpreted the "in
connection with" requirement in SLUSA, holding that "[a]
fraudulent misrepresentation or omission is not made 'in
connection with' such 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 sell a
'covered security.'"10 The
misrepresentations at issue concerned Stanford International
Bank's purchase or sale of covered securities—the
victims did not purchase or sell covered securities. Consequently,
there was not a sufficient "connection" between the
misrepresentations and the purchase or sale of covered
securities.11 Justice Breyer, writing for the majority,
gave several reasons for the decision:
- the focus of SLUSA is on transactions involving covered securities;12
- a natural reading of SLUSA reveals that preclusion applies only when a misrepresentation is material to a decision to purchase or sell a covered, as opposed to uncovered, security;13
- prior cases alleging fraud in connection with purchase or sale of a security have all involved victims "who maintained an ownership interest in financial instruments that fall within the relevant statutory definition";14
- such a limit is consistent with the underlying statutes, the Securities Act of 1933 and the Securities Exchange Act of 1934, which evince a focus on "transactions involving the statutorily relevant securities";15 and
- a broader interpretation of the connection would interfere with and limit a state's ability to address violations of state law frauds.16
Implications
As Justice Kennedy observed in the dissent, this new
approach may restrict the Securities and Exchange Commission (SEC)
and civil litigants in their ability to use the antifraud
provisions of the federal securities laws, as well as expose
defendants to costly state law litigation. The new
"ownership" rule, for instance, may pose challenges to
the SEC where the vehicle in which victims invest is not itself a
security under the federal securities laws, though that vehicle
invests in securities.17 And though the facts presented
by the Stanford matter were unusual—investors purchasing
"uncovered securities" based on misrepresentations
regarding "covered securities"—the dissent notes
that fraudulent practices "constantly vary,"18
and that it is difficult to predict how this narrowing may
frustrate enforcement efforts in the future.
Additionally, Chadbourne arguably represents a departure
from prior Supreme Court jurisprudence. In decisions such as
SEC v. Zandford,19 Merrill Lynch, Pierce,
Fenner & Smith Inc. v. Dabit,20 and U.S. v.
O'Hagan,21 the Court focused the "in
connection" inquiry on whether the misrepresentation or
omission "coincided" with a purchase or sale.
Chadbourne requires, in addition, that the
misrepresentation or omission cause someone other than the
fraudster to purchase or sell a security. As the dissent
observes, it is difficult to reconcile this new requirement with
precedent such as O'Hagan, in which the entity
"defrauded" was not the other party to the trade, but the
fraudster's principal from whom confidential information was
misappropriated.22 It will be interesting to see whether
Chadbourne cabins the SEC in future insider trading cases,
particularly where it might seek to expand the reach of the
misappropriation theory.
*Mark Cahn and Michael Mugmon are partners and Laura Schwalbe is a senior associate at Wilmer Cutler Pickering Hale and Dorr LLP. Mr. Cahn, while serving as General Counsel for the SEC, was one of the authors of the amicus curiae brief filed by the Solicitor General and the SEC asking the US Supreme Court to deny the petitions for a writ of certiorari in the instant case. The views expressed by Mr. Cahn in this article are his own.
1 Chadbourne & Parke LLP v. Troice et
al., Nos. 12-79, 12-86, 12-88, slip op. (U.S. Feb. 26, 2014),
available at http://www.supremecourt.gov/opinions/13pdf/12-79_h3ci.pdf.
The companion cases are Willis of Colorado Inc. et al. v.
Troice et al. and Proskauer Rose LLP v. Troice et
al.
2 Id. at 8-9.
3 Id. at 18-19.
4 Id. at 5.
5 Id. at 7, 18.
6 Id. at 6-7.
7 15 U.S.C. § 78bb(f).
8 15 U.S.C. § 78bb(f)(5)(E).
9 Chadbourne, slip op., at 8.
10 Id.
11 Id. at 18-19.
12 Id. at 9.
13 Id.
14 Id. at 9-10 (emphasis in original).
15 Id. at 11.
16 Id. at 12-13.
17 Chadbourne, slip op., at 16-17 (Kennedy, J.
dissenting).
18 Id. at 11.
19 535 U.S. 813, 820 (2002).
20 547 U.S. 71, 85 (2006).
21 521 U.S. 643, 658 (1997).
22 Chadbourne, slip op., at 9-12 (Kennedy, J.
dissenting).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.