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In two sets of cases this term, the U.S. Supreme Court is set to decide questions that could significantly alter securities litigation on behalf of large groups of investors under both federal and state law.
Stanford Ponzi Scheme Cases
In a trio of cases argued together in October, the court will determine the scope of the Securities Litigation Uniform Standards Act of 1998 (SLUSA). The three cases—Proskauer Rose v. Troice, No. 12-88; Chadbourne & Parke v. Troice, No. 12-79; and Willis of Colorado v. Troice, No. 12-86—all arise out of a Ponzi scheme perpetrated by R. Allen Stanford. Stanford, operating through various corporate entities, sold certificates of deposit issued by Stanford International Bank (SIB). Stanford’s marketing apparatus sold the CDs by promising high rates of return and assuring potential investors that behind the CDs stood a portfolio of safe investments, including the stocks and debt securities of creditworthy and successful governments and corporations. In fact, the Stanford entities owned no such securities and operated a Ponzi scheme. In February 2009, the U.S. Securities and Exchange Commission brought a civil enforcement action against various Stanford entities, and Stanford’s scheme collapsed.
Aggrieved investors soon filed suit against the Stanford entities and many other parties on a variety of theories. The Troice plaintiffs sued SIB’s insurance brokers—Willis of Colorado—based on Texas Securities Act violations, aiding and abetting Texas Securities Act violations, and civil conspiracy, asserting that Willis had misled them by representing that SIB had appropriate insurance coverage and risk management protections. The investors also sued Stanford’s legal counsel—Proskauer Rose and Chadbourne & Parke—for aiding and abetting and civil conspiracy, asserting that they had both obstructed the SEC from investigating Stanford by misleading the SEC about its authority to do so. These investors further claimed generally that, without the services and imprint of legitimacy conveyed by his insurance brokers and lawyers, Stanford could not have operated the Ponzi scheme. The investors sought to proceed as a class action under Texas law.
The defendants moved to dismiss on the theory that SLUSA precluded the investors’ claims. SLUSA provides that “no 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.”
The district court concluded that SLUSA applied and required dismissal of the investors’ claims. In particular, the court agreed that (1) because the Stanford Ponzi scheme operated by misrepresenting that the CDs sold to the investors were backed by “covered securit[ies]” (those traded on national exchanges), and (2) because the investors had sold “ covered securit[ies]” to purchase the worthless Stanford CDs, the investors’ claims alleged a misrepresentation or material omission “ in connection with” the trading of “covered securit[ies].”
The U.S. Court of Appeals for the Fifth Circuit reversed. The court acknowledged the tension between two principles established by the Supreme Court’s interpretation of the “in connection with” language elsewhere in the federal securities laws in SEC v. Zandford, 535 U.S. 813 (2002). First, “in connection with” should be construed broadly to encompass any fraud that “coincide[s]” with a transaction in covered securities. Second, “ in connection with” should not “be construed so broadly as to convert every common-law fraud that happens to involve securities into a violation of Section 10(b)” of the Securities Exchange Act of 1934. A later case, Merrill Lynch, Pierce, Fenner & Smith v. Dabit, 547 U.S. 71 (2006), extended the same interpretation to the same language in SLUSA.
After surveying appellate courts’ divergent approaches to reconciling these principles, the Fifth Circuit concluded 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.” The court concluded that the alleged misrepresentations of Stanford’s representatives did not satisfy either of these two standards. The court further concluded that the fact that the investors sold covered securities in order to purchase the CDs did not bring their claims within SLUSA. Accordingly, the Fifth Circuit held that the investors could pursue their state-law claims against Stanford’s insurance brokers and legal counsel.
The Supreme Court heard oral argument on the cases in October 2013. At that argument, many of the justices expressed concern about whether an opinion interpreting SLUSA’s language narrowly might limit the SEC’s ability to enforce other provisions of the securities laws, such as Section 10(b) of the Securities Exchange Act. Interestingly, though, the parties and justices seemed to agree on one fundamental point: The Fifth Circuit’s opinion should not be affirmed as written. Even the investors—prevailing parties below—advocated deciding the case on narrower grounds than the Fifth Circuit employed. The investors asked the court to hold that Stanford’s fraud only involved the purchase and sale of non-covered securities—the worthless CDs—which the SEC may regulate but which do not constitute the “covered securit[ies]” governed by SLUSA. Thus, even if the court affirms the Fifth Circuit’s result, some critique of the Fifth Circuit’s analysis of the statute appears likely.
In Halliburton v. Erica P. John Fund, No. 13-317, the justices will decide whether to overrule one of the court’s key securities law decisions, Basic v. Levinson, 485 U.S. 224 (1988). That case established a presumption of investor reliance on material lies/omissions in the securities context: the “fraud-on-the-market theory.” This presumption gave plaintiffs in securities class actions an easier road to class certification by obviating the need for each investor to prove his or her individual reliance on the misrepresentation. Now, the Supreme Court appears poised to eliminate the presumption or, at the very least, limit its application.
The fraud-on-the-market theory relies on the efficient-market hypothesis, an academic theory positing that, at any given time, the market price of an efficiently traded security reflects all material information then known to the market. In the years since Basic, scholars have extensively studied the efficient-market hypothesis. Many have criticized it, and others have tested it empirically with widely varying results. Nonetheless, the efficient-market hypothesis undergirding Basic has remained the law for 25 years.
The justices, however, have foreshadowed their disenchantment with Basic. Last term, in Amgen v. Connecticut Retirement Plans and Trust Funds, 133 S. Ct. 1184 (2013), four of the justices agreed that the court should revisit Basic. It remains unclear whether those four justices can find a fifth vote to overturn Basic.
A decision to overrule Basic would work a significant change in the standards for securities class actions. If each investor must show his or her own individual reliance on alleged misrepresentations, a court is much more likely to reject class certification and conclude that unique issues overwhelm any other common issues. The result would be far fewer certifications of securities class actions and, in turn, far fewer initial filings of such actions.
The court may not go so far as to overturn Basic. The justices have also agreed to hear the case on a narrower question: whether a defendant may rebut the Basic presumption with evidence that any misrepresentations had no actual effect on the price of its stock. This “safety valve” may provide the court with a basis to narrow Basic if five justices cannot agree to overturn it completely. Even this limitation would work a substantial change in the world of securities litigation, and the case will be closely watched by plaintiffs and defense lawyers alike.
Stephen A. Miller practices in the commercial litigation group at Cozen O’Connor’s Philadelphia office. Prior to joining Cozen O’Connor, he clerked for Justice Antonin Scalia on the U.S. Supreme Court and served as a federal prosecutor for nine years in the Southern District of New York and the Eastern District of Pennsylvania.
Joshua N. Ruby also practices in the commercial litigation group at the firm in Philadelphia. He graduated from the University of Chicago and Harvard Law School, and clerked for three judges at the federal and state levels.