Saturday, March 1, 2014
On Wednesday, the Supreme Court decided 7-2 that the victims of Allen Stanford’s Ponzi scheme could pursue state law class action claims against those who allegedly aided and abetted him (.pdf) – most notably, the law firms of Chadbourne & Park and Proskauer Rose. But the opinion still leaves several questions unanswered, and it’s impossible not to read Troice without trying to tea leaf the Justices’ inclinations in Halliburton.
[Read more after the jump]
The Troice cases concerned the scope of the Securities Litigation Uniform Standards Act (SLUSA), which precludes state-law class actions based on misrepresentations and omissions made “in connection with” purchases or sales of “covered” securities. “Covered” securities are, essentially, mutual funds and securities traded on a national exchange. The Court was called upon to determine the contours of what it means to make a misstatement “in connection with” with these securities.
In the Stanford Ponzi Scheme, investors were sold certificates of deposit that were, essentially, worthless. These were certainly securities, but they were not “covered” securities – they did not trade on a national exchange. The nub was that investors were sold on the CDs with the lie that the CDs would be backed by “covered” securities, purchased by the bank that issued the CDs. The question before the Court was whether these statements – concerning the assets backing the securities that the investors purchased – were made “in connection with” covered securities as envisioned by SLUSA, so as to preclude the plaintiffs’ class action lawsuit. This was a critical question because if SLUSA precluded plaintiffs’ state law claims, they’d have no federal claims to fall back on – federal law does not permit aiding and abetting claims by private plaintiffs. Therefore, for these plaintiffs and these defendants, it was state law, or nothing (at least if they wanted to proceed as a class, rather than individually).
The crux of the issue is that the “in connection with” language of SLUSA mirrors the scope of conduct prohibited under Section 10(b) of the Securities Exchange Act – only that statute, of course, applies to all securities, not merely covered securities. The Court had previously held that SLUSA’s “in connection with” language should be construed as broadly as Section 10(b)’s “in connection with” language. See Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit (2006). Therefore, at least with respect to covered securities, misstatements prohibited by Section 10(b) necessarily cannot form the basis of a state law class action claim due to SLUSA; conversely, with respect to covered securities, misstatements that can form the basis of a class action claim under SLUSA necessarily are not prohibited by Section 10(b).
This posture already put the Troice plaintiffs in an unenviable position; even the Justices most sympathetic to their plight were necessarily going to be wary of a ruling that constricts the ability of the SEC to bring claims under Section 10(b). Not in this particular case – because no matter what else, the Stanford scheme involved the sale of the CDs, which are securities (just, not securities covered by SLUSA) and thus indisputably subject to Section 10(b) – but in some hypothetical future case involving lies about covered securities, where the particular investors targeted were not sold securities of any kind.
The Supreme Court navigated this tricky issue by adopting a new rule regarding the scope of SLUSA and – by extension – the scope of Section 10(b). The Court held that the Troice plaintiffs’ claims were not precluded by SLUSA, because a misstatement or omission is made “in connection with” a (covered) security only if it is “material to a decision by one or more individuals (other than the fraudster) to buy or to sell” a (covered) security. Here, no one – other than the fraudster bank – claimed to be buying or selling or holding covered securities; therefore, the misstatements were not made in connection with a covered security, and SLUSA did not preclude the claims.
Note the Court’s careful phrasing: The Court did not hold that the plaintiff-victim of the scheme had to be the individual, other than the fraudster, to decide whether to buy or sell based on the misrepresentation. This may have been at least partly a reference to Dabit, where the plaintiffs, a group of Merrill Lynch brokers, claimed that Merrill’s false research reports prompted them to give bad advice to their clients, who lost money on their investments, and then terminated their relationships with the brokers.
The Court then attempted to demonstrate that all past cases construing the scope of Section 10(b) had fallen within the scope of its new rule with – it must be said – somewhat mixed success. In particular, the insider trading case of United States v. O’Hagan (1997) seems far removed from a rule premised on whether, as the Court put it, someone other than the fraudster “took,  tried to take,  divested themselves of,  tried to divest themselves of, or  maintained an ownership interest in” a security. The Court only managed to fit O’Hagan into its new framework by casting it as a case where the “victims” were “members of the investing public” generally harmed by the insiders’ advantage – which takes a rather broad view of who the “other” person is who must trade in order to find the necessary connection between the fraud and the security.
In any event, the Court’s refusal to limit its rule to victims leaves the scope of its holding unclear. For example, in U.S. Mortg., Inc. v. Saxton, 494 F.3d 833 (9th Cir. 2007), the plaintiffs alleged that they invested in real estate ventures based in part on their review of the defendant’s SEC filings, which turned out to be false. Even though the plaintiffs had not purchased any securities at all, the Ninth Circuit held that the plaintiffs’ state law fraud claims were precluded by SLUSA. In the Ninth Circuit’s view, the defendants’ SEC filings were unquestionably statements made in connection with transactions in covered securities, even if those transactions were not the basis of the alleged fraud.
The Troice holding apparently leaves the Ninth Circuit’s ruling intact – after all, certainly someone bought or sold securities in reliance on the Saxton defendants’ false SEC filings, even if that fact had nothing to do with the plaintiffs’ allegations. But given how common it is even for non-securities investors to rely on SEC filings when making business decisions (cf. The Cost of Securities Fraud by Prof. Urska Velikonja), this would seem to have the potential to create just the sort of interference with garden variety state law fraud claims that the Court believed Congress was trying to avoid when crafting SLUSA. Plus, in the context of Section 10(b), a really broad array of statements may be deemed to have been made in connection with a security - including product advertisements. See In re Carter-Wallace Sec. Litig., 220 F.3d 36 (2d Cir. 2000). Surely, SLUSA does not preclude consumer product claims. So, Troice does not solve these problems.
It’s also very unclear whether claims by investors in Madoff feeder funds are precluded by SLUSA (as many courts, up until now, have held). The feeder funds were various hedge funds that placed all, or part, of their assets under Madoff’s control (directly or indirectly, through another fund). The investors in such funds purchased only uncovered securities – hedge fund shares – but the money ultimately went to Madoff, who purportedly purchased covered securities on various investors’ (as well as the funds’) behalf. The difference between Madoff and the Stanford scheme is that in the Stanford scheme, investors were told that the bank that issued the CDs – the fraudster – would buy covered securities for its own account; individuals who placed their money with Madoff, however, were told that Madoff was purchasing securities for them directly, to be held in customer accounts. In other words, in Madoff’s fraud, there were individuals for whom the fraud was “material to a decision … (other than the fraudster) to buy or to sell” covered securities.
That said, feeder fund investors’ claims are not predicated on Madoff’s misstatements (directly), but are predicated on the statements of the funds themselves. Assuming that Madoff’s misstatements to the funds are the relevant ones for the purposes of the Troice analysis (which courts have sometimes held, see In re Herald, Primeo, & Thema Sec. Litig., 730 F.3d 112 (2d Cir. 2013); Barron v. Igolnikov, 2010 U.S. Dist. LEXIS 22267 (S.D.N.Y. Mar. 10, 2010)), then under Troice, the class claims of investors in Madoff feeder funds – who did not themselves take, or try to take, or “maintain an ownership interest in” covered securities – are precluded by SLUSA, because the funds in which they invested – or the funds in which those funds invested – were told that Madoff would be buying covered securities directly on behalf of (some) fund.
Of course, investors in funds exposed to Madoff’s fraud often alleged both that the feeder funds were themselves complicit in Madoff’s scheme – which would apparently make Madoff’s purported purchases on the funds’ behalf not relevant to determining SLUSA preclusion, according to the Troice rule – and that the funds negligently failed to detect the fraud – in which case, purchases purportedly made on the funds’ behalf would result in SLUSA preclusion.
If these seem like distinctions without a difference, well, that’s exactly the point made by the dissenters, Justices Kennedy and Alito. They believed that Section 10(b) – and thus, SLUSA’s preclusive scope – does not distinguish between fraudsters who falsely promise investors to buy and sell securities on the investors’ behalf, versus fraudsters who sell investors other products that are backed by the promise to buy and sell securities.
Nonetheless, the dissenters’ view is not exactly satisfying, either. Their lengthy appeals to Section 10(b)’s breadth and flexibility in order to protect markets from new and innovative fraudulent schemes ring hollow in light of the fact that the only reason the plaintiffs were resorting to state law claims in the first place was because of the Court’s ever-narrowing reading of Section 10(b)’s scope. For example, the dissenters were part of the majority in Janus Capital Group, Inc. v. First Derivative Traders (2011). That case took an extremely cramped view of Section 10(b) by holding that an investment adviser to a mutual fund – which is technically a separate entity, but practically runs all of the fund’s operations – does not “make” a misstatement, and thus does not violate Rule 10b-5(b), by drafting a false prospectus on the fund’s behalf, to be distributed to the fund’s investors in the fund’s name.
The peculiar aspect of Janus, of course, is its inscrutability with respect to what, exactly, the majority was interpreting. If it was Rule 10b-5(b), it is difficult to square with the majority’s refusal to defer to the views of the SEC, which promulgated the rule (and also, that would make the decision somewhat meaningless, as Rules 10b-5(a) and (c) are worded much more broadly, to prohibit “schemes” and fraudulent “courses of business”). The Court held that its decision was the natural result of its prior holding in Central Bank, N.A. v. First Interstate Bank, N.A. (1994), which was an interpretation of Section 10(b) proper, rather than Rule 10b-5. But if Janus is an exercise in statutory interpretation, it’s an odd one – nowhere does the majority even quote Section 10(b), let alone argue that the defendant’s conduct fell outside of its prohibitions.
Anyway, given the Troice dissenters’ endorsement of Janus’s (apparently) narrow reading of Section 10(b), one cannot help but take their newly expansive view of Section 10(b)’s scope with a grain of salt.
Which brings us to the Halliburton tea leaves. It is no secret that Justices Kennedy and Alito are likely to be sympathetic to the defendants’ argument in Halliburton. Both Justices were among the four who invited a challenge to Basic’s endorsement of the fraud-on-the-market presumption, in light of, as Justice Alito put it in Amgen Inc. v. Connecticut Retirement Plans and Trust Funds (2013), “more recent evidence suggest[ing] that the presumption may rest on a faulty economic premise.”
Which makes this particular paragraph from Justice Kennedy’s Troice dissent so fascinating:
Investor confidence indicates fair dealing and integrity in the markets. It also is critical to achieving an efficient market. The corollary to the principle that insider trading and other frauds have an “inhibiting impact on market participation” is that investor confidence in strong federal regulation to prevent these abuses inspires participation in the market. Widespread market participation in turn facilitates efficient allocation of capital to the Nation’s companies.
Basic is premised on market efficiency. Halliburton and its amici have offered numerous challenges to Basic, based on statutory interpretation and the like, but the main hook – the hook that caused four Justices to invite a reconsideration Basic, and the hook most likely to overcome objections of stare decisis – is the argument that Basic’s economic premise is flawed, that markets are not efficient, and that investors do not rely on market integrity when making investment decisions. Thus, it is telling that Justice Kennedy not only invokes market efficiency in his dissent, but also emphasizes the importance of encouraging investor confidence in market fairness – suggesting, perhaps, that against the current odds, he is not inclined to declare a new legal principle that markets cannot be presumed to be efficient.
Justice Kennedy’s dissent also contains other Halliburton hints. He quotes Dabit’s point that SLUSA makes “federal law, not state law, the principal vehicle for asserting class-action securities fraud claims.” That’s a virtual acknowledgment that – contrary to Halliburton and its amici – Congress has not been “silent” on the issue of the fraud on the market presumption, but instead passed both SLUSA and the PSLRA predicated on the existence of the Section 10(b) class action, which itself depends on fraud on the market.
Finally, Justice Kennedy makes the point – similarly made in Dabit – that SLUSA does not leave investors unprotected, because they may still bring state law claims; they just can’t bring them as a class. Fraud on the market theory, by contrast, is as much a substantive doctrine as it is a procedural mechanism for winning class certification – without it, many investors will lose their claims entirely, because most investors do not “actually” rely on corporate statements, but instead choose index funds and other passive-management techniques (that in turn rely upon market efficiency). These investors rely only on the market – which, Justice Kennedy suggests, is something to be encouraged.
So is the Troice dissent a hint that Halliburton’s argument goes too far, even for Justice Kennedy? Obviously, it’s hard to say, but there are some aspects that the Halliburton plaintiffs should find encouraging.