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Lawyers faced off on Jan. 18 in the first U.S. Supreme Court securities litigation case to be heard under the leadership of Chief Justice John G. Roberts Jr. In Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, No. 04-1371, the issue being contested is the reach of the Securities Litigation Uniform Standards Act (SLUSA), and whether it pre-empts class action claims by “holders” of securities as opposed to “purchasers or sellers.” In Dabit, the Supreme Court will interpret the “in connection with” language in SLUSA, and reconcile that interpretation with its previous decisions, including the court’s decision over a quarter of a century ago in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). From the arguments, it appears likely that the high court will refuse to permit “holder” cases to proceed in state courts. Congress passed the Private Securities Litigation Reform Act in 1995 in response to the perceptions of widespread abusive practices in federal securities litigation, including the routine filing of “cookie cutter” complaints after a drop in a stock’s price without regard to an issuer’s culpability and with only a “faint hope” that later discovery might lead to a “plausible cause of action”; the targeting of “deep pocket defendants” without regard to culpability solely for settlement value; discovery practices designed to impose “massive costs,” making it more economic for defendants to settle than to litigate; and the manipulation by plaintiffs’ lawyers of people they purport to represent. See Joint Explanatory Statement of the Committee of Conference, H.R. Conf. Rep. No. 104-369, 104th Cong., 1st Sess. 31 (1995) at 31-32. To deter such practices, the reform act altered the judicial playing field for plaintiffs, imposing rigorous new standards for pleading causes of action under the securities laws and mandating dismissal of any complaint that fails to measure up. See 15 U.S.C. 78u-4, 78u-5, 77z-1, 77z-2. Initially, the reform act was unable to accomplish its intended purposes. While Congress sought in 1995 to deter the filing of baseless and abusive securities class actions, the practical effect of the reform act was instead to shift much of the burden onto the state courts. Seemingly proving the notion that sometimes when Congress closes a door it opens a window, plaintiffs responded to the reform act by migrating to the state courts with allegations of violations of state law. Plaintiffs sought to circumvent the barriers of the stricter pleading standard and mandatory discovery stay imposed by the reform act. This was hardly the result intended by Congress, and so, in 1998, it sought to close the window it unintentionally opened for such claims with the passage of SLUSA. SLUSA broadly prohibits state law “covered class actions” involving nationally traded “covered securities.” SLUSA provides that “[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 either “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security” or “that the defendant used or employed any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.” 15 U.S.C. 78bb(f)(1). The conference committee observed that “since the passage of the Reform Act, plaintiffs’ lawyers have sought to circumvent the Act’s provisions by exploiting differences between Federal and State laws.” H.R. Conf. Rep. No. 105-803, 105th Cong., 2d Sess. (1998). The purpose of the statute “is to prevent plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than in Federal, court.” Id. at 13. In order to fulfill its purpose, SLUSA provides, therefore, for the removal, and subsequent dismissal, of any “covered class action.” 15 U.S.C. 78bb(f)(1). History of ‘holder’ claims More than three decades ago, the Supreme Court rejected attempts by a plaintiff to assert a “holder” lawsuit in Blue Chip Stamps. The court held that only actual purchasers or sellers of securities had standing to bring a claim under � 10(b)/Rule 10b-5 of the Securities Exchange Act of 1934. The plaintiff in that case attempted to bring a claim based on the fact that he was dissuaded from purchasing securities because of an overly pessimistic prospectus. The Supreme Court rejected that attempt and instead adopted the purchaser/seller requirement because of its concern that “vexatious litigation” could result from permitting a claim based on unsupported or uncorroborated oral testimony from a plaintiff that he/she would have purchased or sold a security. In Dabit, the 2d U.S. Circuit Court of Appeals revisited the Blue Chip Stamps rejection of holder claims in the context of the reach of SLUSA’s pre-emption and removal provisions. 395 F.3d 25 (2d Cir. 2005). The court was asked to determine whether SLUSA “preempts claims that do not allege that putative class members purchased or sold particular securities in reliance upon the defendant’s alleged misconduct” but instead allege that they held securities that were bought before the purported fraud started. In other words, the 2d Circuit was confronted with a holder suit in which a plaintiff claims to have held a security instead of selling it because he or she was misled by the defendants’ fraudulent acts. The 2d Circuit determined that the “in connection with” language in SLUSA should be afforded the same interpretation as the “in connection with” language in � 10(b) and Rule 10b-5. Based on that conclusion, it held that SLUSA did not pre-empt holder claims because the “in connection with” language in � 10(b)/ Rule 10b-5 only applied to purchasers or sellers as held in Blue Chip Stamps. The 2d Circuit expressed the view that its interpretation and holding was consistent with every other circuit court that had considered the issue, citing to decisions from the 8th, 9th and 11th circuits. In the fall of 2005, the U.S. Supreme Court agreed to review the 2d Circuit’s ruling, particularly in light of a 7th Circuit ruling that appears directly at odds with Dabit. Oral argument The oral arguments suggest, not surprisingly, that the Supreme Court justices viewed Dabit as a statutory construction case, and, thus, whether the 2d Circuit is affirmed or reversed likely will turn on the phrase “in connection with the purchase or sale of a covered security.” As argued by Merrill Lynch’s counsel, Congress could have, if it wanted, injected a purchaser or seller requirement into SLUSA. Instead, Congress chose broader language, perhaps in recognition of the demonstrated ingenuity of the plaintiffs’ bar in response to its prior actions. The United States, through the deputy solicitor general, as amicus curiae in support of Merrill Lynch, observed that the 2d Circuit’s analysis would essentially give two different and irreconcilable interpretations to the “in connection with” language depending on the identity of the plaintiff-a holder action falls within that language for enforcement purposes under several Supreme Court precedents, but not for private civil actions. In response to questions posed by Justice Ruth Bader Ginsburg about the purchaser/seller limitation imposed under Blue Chip Stamps, the deputy solicitor general also noted that, prior to the passage of the reform act, there was no significant history of state class action holder claims. The reform act essentially resulted in the filing of these new type of cases as plaintiffs tried to evade the reforms attempted by Congress. The respondent’s counsel agreed that holder actions fell within � 10(b)/Rule 10b-5 for enforcement purposes but not civil litigation. The respondent’s counsel, however, argued that the Supreme Court did not need to be concerned about an interpretation of the same language in two different ways, but only needed to understand what Congress intended with the passage of SLUSA. Counsel argued that Congress only intended to stop the migration of cases from federal court to state court; since the Blue Chip Stamps decision in 1975, holder actions could not be filed in federal court, so those claims were untouched by SLUSA. Justice Antonin Scalia noted the counterintuitive nature of that argument since holder claims lend themselves to more abuse than purchaser/seller claims. He also questioned whether the Securities and Exchange Commission’s interpretation of the statute disagreeing with the 2d Circuit’s opinion should be given some level of deference. The respondent’s counsel, however, emphasized that there was a difference between a claim by would-be buyers (as was the case in Blue Chip Stamps) and one by would-be sellers. In the first situation, a person claims that he or she would have bought but for the fraud, while in the second scenario, a person presents a claim that he or she would have sold but for the fraud. The respondent’s counsel argued that a holder nonseller claim is not a “speculative” assertion and has been recognized for centuries as a fraud-by-forbearance tort claim. Roberts followed up on that response and asked whether holder claims were, in essence, just an attempt to “cash in on the fraud” because the underlying complaint is that the holder did not get to sell his or her stock at an inflated value. Other justices also seemed to have concerns with the respondent’s argument. Justice Stephen G. Breyer noted that a potential problem with the 2d Circuit decision was that the plaintiffs’ bar would always be able to file a holder action and avoid the protections in federal court, which would render SLUSA an ineffective statute. Ginsburg reiterated this concern, questioning whether Congress really would have wanted a “more plaintiff-friendly” action like holder claims to survive in state court. In closing, Merrill Lynch’s counsel stressed that an affirmation of the 2d Circuit’s decision could result in the filing of holder cases with every new securities class action. Such cases would then affect the reform act’s safe-harbor provisions, as companies would then be concerned with its forward-looking disclosures as being too pessimistic such that a potential plaintiff can assert that he or she would have purchased the stock if the company was not so negative in its own outlooks. Probable outcome Based on the line of questioning of some of the justices, the Supreme Court could be seen as leaning toward reversing the 2d Circuit’s decision. This would seem to be a rational result, since the Supreme Court has already interpreted the same “in connection with” language broadly in the context of SEC enforcement actions, and also because SLUSA was enacted precisely to prevent plaintiffs from avoiding the reach of the reform act by filing state-law class action claims in state court. Despite the respondent’s argument regarding the differences between a would-be-purchaser action and a would-be-seller action, it is undeniable that SLUSA was intended to plug the holes in the reform act so that the act’s goal of curbing meritless strike suits could be achieved. As was apparently recognized during the recent argument by several justices, and also as held by the Supreme Court more than 30 years ago in the Blue Chip Stamps decision, holder cases are one of the types of securities claims most subject to abuse, as anyone can claim subjectively not to have sold a security at a particular period of time. A majority of justices, therefore, will likely find it hard to believe that Congress intended to allow such claims to proceed in state court and not be pre-empted by SLUSA. The express purpose of SLUSA “is to prevent plaintiffs from seeking to evade the protections that Federal law provides against abusive litigation by filing suit in State, rather than in Federal, court.” Because holder claims are clearly disfavored, it would hardly be a surprise if they ultimately are found by the Supreme Court to be pre-empted by SLUSA. John A. Reding and Peter M. Stone are partners, and Edward Han is an associate, at Paul, Hastings, Janofsky & Walker, where they are members of the securities litigation and enforcement practice group. Reding and Han are resident in the firm’s San Francisco office, and Stone, in the Costa Mesa, Calif., office.

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