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In March, in Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, No. 04-1371, the U.S. Supreme Court held that securities fraud “holder claims” cannot be asserted as class actions under state law. Although the court’s unanimous 8-0 decision suggests the case was easy, in fact the court reached a profoundly counterintuitive result, for minimal practical benefit: The court’s decision is an ineffective half-measure that does little to eliminate these frivolous claims. Holder claims are claims in which shareholders whose securities holdings have dropped in price allege that they were fraudulently induced to hold on to their securities, rather than sell them earlier, before the price dropped. Because of the “standing” requirement in the federal securities laws, holder claims can only be asserted under state law. To assert a federal securities claim, a plaintiff must allege fraud “in connection with the purchase or sale of any security,” meaning only purchasers and sellers of securities have standing to assert private claims under federal law. In the last few years, state law holder claims have become increasingly common as a result of the spate of corporate fraud scandals and legislation limiting federal securities claims. In Dabit, the Supreme Court considered the scope of the Securities Litigation Uniform Standards Act of 1998 (SLUSA). SLUSA was enacted to close certain loopholes in the previously enacted Private Securities Litigation Reform Act of 1995 (PSLRA), which imposed stringent pleading requirements on federal securities fraud claims. SLUSA prevents parties from avoiding federal law by asserting certain claims under state law. In particular, SLUSA provides that private parties may not assert class actions under state law alleging fraudulent or deceptive conduct “in connection with the purchase or sale of a covered security.” In Dabit, the Supreme court held that SLUSA pre-empts state law holder claims even though holder claims do not appear to be in connection with the purchase or sale of securities and thus cannot be asserted under federal law. This decision seems perverse on its face. SLUSA was intended to prevent plaintiffs from recasting federal securities claims as state claims to avoid the PSLRA. It was not meant to pre-empt suits that could never have been asserted under federal law in the first place. Strained statutory construction The decision was also strained as a matter of statutory construction. The plaintiffs argued that holders, by definition, do not allege fraud “in connection with the purchase or sale” of securities. In rejecting this argument, the court decided that that phrase should have a different meaning in SLUSA than in private causes of action governed by the standing rule described above. The court decided to construe the phrase as it is used in criminal and Securities and Exchange Commission enforcement actions that are not subject to the standing rule. This decision may have been driven more by policy concerns than by a strict attempt at statutory interpretation. Holder claims have long been considered particularly abusive and vexatious. Any stockholder can claim that she would have sold sooner if she had known the truth. But proving when she would have sold-crucial to proving damages with reasonable certainty-is an inherently speculative exercise. In holder claims alleging public misstatements, damages are inherently speculative for another, even more problematic reason. A holder plaintiff claims that he would have sold as soon as he learned the truth about the company. But if the truth had been known to the plaintiff, then the truth would also have been known to the market at large. In that case, the price of the security would have dropped before the plaintiff had a chance to sell. Put differently, in a holder claim involving a public misrepresentation, the plaintiff is asserting his right to sell the security at a fraudulently inflated price. The law should not recognize this claim for a windfall. But eliminating holder claims will require more than merely limiting the procedural devices that holders can employ; it will require conclusive recognition of their inherent substantive defects. Although SLUSA now pre-empts holder claims that are asserted as class actions (defined as claims asserted on behalf of more than 50 plaintiffs), plaintiffs’ lawyers will still be able to cherry-pick shareholders with significant losses and cobble them into smaller related actions or arbitrations. Granted, the damages in these actions will be somewhat less than in the class actions precluded by SLUSA, but defendants will incur considerable legal fees defending them. Once the Supreme Court decided to reach out and decide the case on policy grounds, it should have gone further and taken steps to terminate these cases altogether by noting, even in dictum, their inherent substantive defects. Despite straining to cut down on these claims, the Supreme Court has left it to Congress or the states to sound their death knell. Stephen L. Ascher is a partner at Kronish Lieb Weiner & Hellman in New York, specializing in securities litigation, and Rachel Kane is an associate at the firm.

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