United States: Emerging Issues in Securities Litigation: The Seventh Circuit’s recent interpretations of CAFA and SLUSA favor defendants in purported securities class actions*

Originally published March 26, 2009

Keywords: securities litigation, Seventh Circuit, CAFA, SLUSA, securities class actions, PSLA, Class Action Fairness Act, purchase sale, breach of contract, securities fraud

Two recent decisions from the United States Court of Appeals for the Seventh Circuit add to the growing arsenal of arguments available to defendants in securities class actions who wish to litigate in federal court, with the attendant protections of the Private Securities Litigation Reform Act. In the first, the court held that the non-removal provision of the Securities Act of 1933 is no impediment to removal under the Class Action Fairness Act. In the second, the court held that a purported "breach of contract" case was removable to federal court under the Securities Litigation Uniform Standards Act because the case clearly involved alleged misrepresentations or omissions "in connection with" the purchase or sale of securities. To read our May 2007 article about the removability of securities cases under CAFA and SLUSA, click here to see "Removal of Class Actions Filed in State Court Alleging Federal Securities Violations".

Securities class actions are removable under CAFA notwithstanding the non-removal provision of the 1933 Act.

On January 5, 2009, the Seventh Circuit parted with the Ninth and held that the Class Action Fairness Act of 2005, 28 U.S.C. §§ 1332(d), 1453, and 1711-1715 ("CAFA"), permits the removal of securities fraud class actions despite a provision in the Securities Act of 1933 prohibiting the removal of such cases from state court.

As Mayer Brown reported in May 2007, there is an increasing trend of federal securities class actions being filed in state court, where plaintiffs hope to avoid the strict pleading requirements of the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4 et seq. Defendants have responded by removing those cases to federal court under the Securities Litigation Uniform Standards Act, 15 U.S.C. §§ 77p(c) & 78bb(f), ("SLUSA"), where applicable, and under CAFA, a statute that expands jurisdiction based on diversity of citizenship for certain class actions. CAFA also loosens the rules on removability; it allows removal "without regard to whether any defendant is a citizen of the State in which the action is brought, except that such action may not be removed by any defendant without the consent of all defendants." 28 U.S.C. § 1453(b).

CAFA, however, contains certain exceptions to removability. Section 1453(d)(3), for example, states that the removal provision is inapplicable to any class action that "solely involves . . . a claim that relates to the rights, duties (including fiduciary duties), and obligations relating to or created by or pursuant to any security . . . and the regulations issued thereunder." (Another provision, section 1332(d)(9)(c), precludes original jurisdiction in identical cases.) One question for defendants seeking removal of securities cases under CAFA has been how broadly the courts would construe this so-called "securities exception."

The Second Circuit answered that the exception should be narrowly construed, so that it would prevent removal only of class-action disputes "over the meaning of the terms of a security." Estate of Pew v. Cardarelli, 527 F.3d 25, 33 (2d Cir. 2008). On the far end of the spectrum, without addressing the securities exception, the Ninth Circuit recently held that no securities claims could be removed under CAFA. Luther v. Countrywide Home Loans Servicing, LP, 533 F.3d 1031, 1034 (9th Cir. 2008). The Court concluded that section 22(a) of the Securities Act of 1933, which provides that "no case" arising under the federal securities laws "shall be removed to any court of the United States," trumps CAFA's expanded removability provision. The court relied on a canon of statutory construction instructing that the specific should control the general. The Luther court distinguished Cardarelli by noting that the federal non-removal provision was not implicated by that case's state-law claims.

The Seventh Circuit has now entered the fray and taken a position opposite that of the Ninth Circuit. In Katz v. Girardi, 55 F.3d 558 (7th Cir. 2009), the court held that section 22(a) of the 1933 Act is no impediment to the removal of securities class actions under CAFA. Plaintiffs, who had contributed real property to the Archstone real estate investment trust in exchange for shares, sued Archstone and a number of other players in connection with Archstone's merger into the Tishman-Lehman Partnership. The shareholders were offered either cash or shares in the new entity, that, according to plaintiffs, had fewer tax benefits than their original units. Plaintiffs allege that this transaction amounted to fraud. The defendants removed the case to federal court under CAFA, but the district court remanded it. Following the reasoning of the Ninth Circuit in Luther, the district court concluded that the specific non-removal provision in the 1933 Act could not be superseded by the general removal provisions of CAFA.

The Seventh Circuit, unconvinced by the district court and Luther, vacated the decision. It began by noting that the 1933 Act's non-removal provision is incompatible with CAFA's jurisdiction and removal provisions. However, the court determined that it was unnecessary to consult canons of statutory construction, which are "just doubt resolvers," because CAFA itself specifically addresses its applicability to securities cases (55 F.3d at 562). Claims that are listed in section 1453(d) – including certain securities claims – are not removable, and those listed in section 1332(d)(9) cannot support original jurisdiction. This leaves "no doubt" about how the CAFA and securities laws fit together, and the non-removability provision must yield to CAFA. Id. Because the Luther court did not acknowledge these provisions of CAFA, the Seventh Circuit explained: "We therefore disagree with Luther and hold that securities class actions covered by [CAFA] are removable, subject to the exceptions in § 1332(d)(9) and § 1453(d)." Id.

Although the Seventh Circuit rejected a general rule that securities cases are not removable under CAFA, it did not decide whether the Katz case itself was removable. The court determined that Katz's complaint raised several inconsistent theories and ultimately might not implicate the federal securities laws. Accordingly, the court of appeals remanded to the district court for an evidentiary hearing at which the plaintiffs' theories could be clarified and the district court could determine whether the securities exception applies, blocking removability. The Seventh Circuit did not take a position on the Second Circuit's narrow interpretation of the securities exception in Cardarelli, although it noted that neither party had disavowed it.

It remains to be seen, then, whether the Seventh Circuit will agree with the Second that the securities exception does not block the removability of the typical securities fraud class action. But potential defendants can draw some comfort from the court's rejection of a strict rule prohibiting removal of securities class actions under CAFA. The reactions of the other federal appellate courts to the divide between the circuits on this issue will be a development to follow closely.

A "breach of contract" case alleging a violation of best-execution duties is removable under SLUSA because the underlying allegations clearly involve securities fraud.

In Kurz v. Fidelity Management & Research Co., 556 F.3d 639 (7th Cir. 2009), the Seventh Circuit affirmed the district court's judgment denying plaintiffs' motion to remand their purported "breach of contract" case to state court. The plaintiffs sued two Fidelity entities, alleging that they were third-party beneficiaries of contracts between Fidelity and broker Jeffries Co., which the plaintiffs said guaranteed "best execution" of trades. Best execution, as the Seventh Circuit explained, is "the optimal combination of price, speed, and liquidity for a securities trade." Id. at 640. The plaintiffs, a class of former investors in Fidelity funds, alleged that Jeffries bribed Fidelity employees to send them more business. This scheme, according to plaintiffs, violated the duty of best execution because traders were selected not for their ability to provide best execution, but because of their enticements. They brought suit in Illinois state court.

Fidelity argued that the alleged misconduct of its employees—and in particular, its failure to disclose that misconduct to investors—implicated the securities laws, and not any common-law breach of contract theory. It therefore removed the case to federal court under SLUSA, which provides at 15 U.S.C.§ 78bb(f) that a "covered class action" cannot be maintained under state law in state or federal court by a party alleging "a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security"; moreover, any such case brought in state court is removable to federal court. The district court agreed that the gist of the plaintiffs' complaint was that Fidelity failed to communicate facts to investors that related to its ability to provide best execution. Accordingly, the district court denied plaintiffs' motion to remand the case to state court.

On appeal, Mayer Brown defended the district court's ruling for Fidelity. The defendants urged the Seventh Circuit to look through the labels used in the complaint and hold that the plaintiffs' best-execution claims are quintessential securities fraud claims. In support, the defendants noted that the SEC had investigated the exact same facts under the Investment Advisers Act and the Investment Company Act. The defendants also argued that best-execution claims are necessarily "in connection with" the purchase or sale of securities, as required for SLUSA to apply. The Seventh Circuit agreed on each point, and it noted that although a "genuine" breach of contract claim would not be removable, it was clear in this case that "[t]he promise—if there was any independent of the NASD's rules—was made by Fidelity's employees to Fidelity itself." Id. at 642. It was simply not plausible to parlay that promise into a contract entered into for the benefit of this class of former investors. On the other hand, the securities laws were a perfect fit—provided, of course, that there was a timely complaint making the required allegations of scienter and loss causation, among others. This was not true for the Kurz plaintiffs. Instead, the plaintiffs had a "bad securities fraud claim," Id., and it could not proceed in state court as a purported class action for breach of contract.

Footnote

^{* Update to "Removal of Class Actions Filed in State Court Alleging Federal Securities Violations" White Paper, May 2008.}

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