Thao Do and James Walker ()
On Feb. 26, 2014, the U.S. Supreme Court decided Chadbourne & Parke v. Troice,1 holding by a 7-2 vote that the Securities Litigation Uniform Standards Act of 1998 (SLUSA) does not preclude state law class actions where the plaintiffs allege that they purchased uncovered securities that the defendants misrepresented were backed by securities listed on a national exchange. The court found that the victims of Allen Stanford’s multibillion dollar Ponzi scheme could pursue state law class action claims against numerous individuals and companies—including attorneys, accountants, brokers and investment advisers—for allegedly aiding and abetting a Ponzi scheme. On April 14, 2014, in one of the first applications of Troice, Judge Thomas P. Griesa ruled that a group of Madoff securities investors who suffered losses in Madoff’s Ponzi scheme were permitted to add state law claims to the previously filed class action complaint in In re: Tremont Securities Law, State Law and Insurance Litigation.2
Griesa’s reversal in Tremont demonstrates the significance of Troice to lawyers and other third-party advisors (who may have increased exposure to secondary liability in securities-related litigation under state law causes of action) and to class action litigants (who now may have more opportunities to pursue state law claims alongside federal securities law claims). This article discusses (i) the implications of Troice for third-party advisors with respect to aiding and abetting claims in class actions and (ii) how law firms can limit increased exposure to third-party liability.
Brighter Line Announced in ‘Troice’ Increases Exposure of Lawyers to Third-Party Liability. Prior to Troice, SLUSA3 required that class action plaintiffs asserting fraud that somehow related to “covered securities” (i.e., a security that is listed or authorized for listing on a national securities exchange or a security issued by an investment company) bring claims solely under federal securities law. Troice clarified that, with respect to SLUSA, (i) the connection with a covered security cannot be remote and must result in an investor’s decision to buy or sell an ownership interest in a covered security,4 and (ii) if covered securities are not involved, plaintiffs are free to pursue state law fraud claims.
The impact of Troice is particularly significant because of differences in state and federal law pleading standards. Secondary actors, shielded from suit under federal law, may be expressly contemplated as potential defendants under state statutes.5 Pleading and proof requirements typically are lower under state law,6 and “securities” are defined more broadly under state law than under federal law.7 Even when a state’s blue sky laws prohibit private actions, other common law claims—such as negligent misrepresentation, conspiracy to defraud, and possibly aiding and abetting fraud—can form the basis of asserting liability against lawyers and other third-party actors.8
Tremont demonstrates how Troice may lead to an increase in state law class action claims against professional service advisers who provide services in connection with uncovered securities transactions.9 In Tremont, the court granted a motion to dismiss state law claims against Tremont Group Holdings, a hedge fund accused of misrepresenting the method and extent to which its investors’ funds were placed with Madoff. Upon reconsideration, Griesa concluded that the investors did not purchase an ownership interest in a “covered security,” but rather purchased limited partnership interests in Tremont’s funds, which are not “covered securities,” and therefore investors could pursue state law claims. Moreover, investors were given 14 days to file a motion to add KPMG, the auditor of Tremont’s feeder funds, as a defendant.
The significance of Griesa’s reversal is tempered by the open question as to whether courts will decide, nonetheless, that the “in connection with” requirement is satisfied even when “it is undisputed that the only securities involved in any transactions carried out by the plaintiffs were uncovered securities.”10 For example, in In re Herald, Primeo, and Thema Securities Litigation,11 the Second Circuit accepted the lower court’s conclusion that although plaintiffs’ investment in interests in feeder funds were not “covered securities” (and thus analogous to the limited partnership investments in Tremont), SLUSA preclusion still applied because liability against the banks was premised on the feeder funds’ investment in Madoff Securities and Madoff Securities’ fraud in its trading of “indisputably covered securities.”12 On petitions for rehearing, the Second Circuit distinguished vague promises that Stanford had significant holdings in covered securities in Troice from the Herald plaintiffs, who had tried to take “an ownership position in the statutorily relevant securities.”13 Shortly after the Second Circuit’s issuance of Herald, the First Circuit considered allegations that several defendants misrepresented a certain fund’s percentage of holdings in certain covered and uncovered securities, finding that “the link between the misrepresentations alleged and the covered securities in the Fund’s portfolio is simply too fragile to support a finding of SLUSA preclusion under Troice.”14 Instead, any investment of assets in covered securities was incidental, and at least 75 percent of assets would be invested in uncovered securities.15 The First Circuit distinguished Herald, noting that, in Herald, the “Madoff funds were marketed primarily as vehicles for exposure to covered securities” and “the victims of the fraud had intended to take an ownership interest in covered securities.”16
Law Firm Risk Management “Best Practices.” Notwithstanding Herald, Griesa’s reversal in Tremont and the First Circuit’s holding in Hidalgo-Velez demonstrate that secondary actors with deep pockets (such as law firms) should enhance risk management policies with respect to their clients:
Know Your Clients. Law firms need to develop procedures to sufficiently vet clients. For new clients, a firm should run profile checks and Internet searches, and inquire further into any questionable events uncovered in the client’s past (for example, an SEC securities charge). The firm should not accept the engagement without obtaining comfort as to any issues uncovered.
Continuous Client Vetting. Client vetting should not be a one-time event. Instead, a law firm should assess continually its dealings with a client through successive transactions and interactions with a client’s personnel when questions arise concerning the client’s conduct. Questions that a law firm should repeatedly ask itself include:
• How aggressively does the client push the interpretation of restrictions under the securities laws?
• Does the client ask or expect its attorneys to push the bounds of lawful conduct?
• Has the client responded appropriately to pushback from its lawyers?
• Is the client forthcoming with pertinent information, or does the client instead habitually omit information pertinent to the determination of the appropriate legal advice?
• Has the client developed a pattern of behaving in a way that is unpredictable or otherwise unsettling?
• Carefully define the scope of the engagement. Claims that class action plaintiffs may sustain against third-party law firms should be limited to professional services provided within the scope of the representation, provided the firm did not, through its actions, expand the contemplated engagement. Carefully defining the scope of an engagement in a written engagement letter, which may include an explicit exclusion of work that will not be performed by the firm, can be an important tool in defending malpractice claims based on services not contemplated in the representation.17 In addition, clearly marking the termination of a specific engagement—for example, indicating that you are sending the final invoice relating to a particular matter (even where the firm concurrently represents the client in other matters and hopes to continue to do so)—may be critical to establish the period from which the statute of limitations for any potential claims begins to toll.18
• Identify Red Flags in Transactional Matters. Client instructions can substantially limit a law firm’s overall assessment of a transaction. This is especially true when the client wants its lawyers to serve merely as a scrivener on the transaction. By the time the client engages its lawyer, the client may have already finalized the structure and terms of the transaction and may instruct its lawyer that the lawyer’s role is only to draft the transaction documents. Or a client may instruct its lawyer not to perform any due diligence (since the client is performing the legal due diligence itself) and to draft the transaction documents only. These scenarios are common in the current corporate climate, where clients tend to bring the legal work in house in order to save the company outside legal fees and expenses. Nonetheless, even where the scope of the law firm’s representation would limit any ability to look behind the transaction where possible, lawyers need to pay attention to red flags and make an assessment of the client and the transaction.
• Exercise Caution in Making Representations on Behalf of Clients in Government Investigations. Attorneys representing clients in regulatory and white-collar proceedings need to avoid making representations about the client without sufficient knowledge of the underlying facts. Exercising care before making representations about a client’s conduct is the lesson learned by the lawyer in Troice, who represented that there was no fraud at Stanford, but subsequently had to disaffirm his statements when he learned information that made his prior statements either untrue or incomplete. Making a representation about a client without sufficient knowledge of the facts may not only harm the client’s credibility with the government investigator, but also may require the lawyer to disaffirm prior statements and risk disciplinary action, a malpractice claim, and/or exposure to third-party liability.
Troice clarified that when securities trading on national exchanges are not involved, plaintiffs are free to pursue state law fraud claims, and therefore may pursue aiding and abetting claims against third-party advisors under state law. Troice should serve as a wake-up call for third-party advisors, such as law firms and accounting firms, to assess their risk management policies and practices.
1. 134 S. Ct. 1058 (2014).
2. No. 08-11117 (TPG), 2014 WL 1465713 (S.D.N.Y. April 14, 2014).
3. SLUSA precludes state law class actions by private litigants that allege a “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”
4. Investors can obtain relief under state laws “when the fraud bears so remote a connection to the national securities market that no person actually believed he was taking an ownership position in that market.” Troice, 134 S. Ct. at 1070.
5. See, e.g., Tex. Rev. Civ. Stat. Ann. Art. §§581-33(A) and 581-33(F) (West, 2003). Civil litigants also may file primary and aiding and abetting claims under the Texas Stock Fraud Act, which prohibits false representations (but not omissions) in the actual conveyance of stock, rather than any other form of security. Tex. Bus. & Com. Code Ann. §27.01.
6. See, e.g., id. §581-33(F)(2). The Texas Securities Act (TSA) arguably provides wide latitude to pursue third-party aiding and abetting actions, curbed only by the narrow view Texas courts have taken on third-party liability. See, e.g., Navarro v. Grant Thornton, 316 S.W.3d 715, 726-27 (Tex. App. Houston [14th Dist.] 2010) (accounting firm did not render substantial assistance to primary violators simply by providing accounting services and auditing financial statements); Willis v. Marshall, No. 08-11-00207, 2013 WL 1758862, at *12 (Tex. App. El Paso, 2013) (same); Frank v. Bear, Stearns & Co., 11 S.W.3d 380 (Tex. App. Houston [14th Dist.] 2000) (underwriters could not be liable as aiders and abettors because plaintiffs could not show that underwriters knew of securities law violation at the time plaintiffs purchased the securities).
7. For example, under the TSA, the term “security” or “securities,” in addition to stock in a company, may include a limited partnership interest, collateral trust certificate, equipment trust certificate, preorganization certificate or receipt, subscription or reorganization certificate, note, bond, debenture, mortgage certificate or other evidence of indebtedness, any form of commercial paper, certificate in or under a profit sharing or participation agreement, certificate or any instrument representing any interest in or under an oil, gas or mining lease, fee or title, or any certificate or instrument representing or secured by an interest in any or all of the capital, property, assets, profits or earnings of any company, investment contract, or any other instrument commonly known as a security, whether similar to those herein referred to or not. The term applies regardless of whether the “security” or “securities” are evidenced by a written instrument. Tex. Rev. Civ. Stat. Ann. Art. §581-4(A) (West, 2003).
8. For example, New York’s Martin Act does not permit a private right of action for any claim covered under the Act, see, e.g., Assured Guaranty (UK) v. J.P. Morgan Inv. Mgmt., 18 N.Y.3d 341, 351(2011), but the Martin Act will not preclude a private litigant from pursuing non-fraud common law claims, the elimination of which is not expressly mentioned or contemplated in the Act. Id. at 351-52.
9. The reversal in Tremont will not necessarily open the floodgates for state law claims because courts continue to grapple with the “ownership interest,” “in connection with,” and “covered securities” components of the standard announced in Troice. See, e.g., In re Harbinger Capital Partners Funds Investor Litigation, 2014 U.S. Dist. LEXIS 64504 (S.D.N.Y. April 30, 2014) (interpretation of “ownership interest” and “in connection with” in Troice was unclear, and decision on a motion for reconsideration deferred pending the Second Circuit ruling in one of several pending matters); In re Kingate Management Limited Litigation, No. 11-1397 (April 12 , 2011) (appeal of a lower court dismissal of state law claims based on the lower court’s conclusion that state law claims against banks, managers, consultants, advisers, auditors and administrators of the funds were precluded under SLUSA because the underlying claims—relating to the investment of plaintiffs’ capital with Madoff—involved fraudulent conduct in connection with a “covered security”).
10. Hidalgo-Velez v. San Juan Asset Management, et al., No. 13-1574, 2014 WL 3360698, at *6 (1st Cir. July 9, 2014).
11. No. 12-156(L), 12-162(Con), 2014 WL 2199774 (2d Cir. May 28, 2014).
12. Trezziova v. Kohn (In re Herald), 730 F. 3d 112, 118 (2d Cir. 2013) (internal quotes omitted).
13. Id. at *2 (internal quotations omitted).
14. Hidalgo-Velez, 2014 WL 3360698 at *7.
17. See, e.g., Ableco Finance v. Hilson, Ippolito and Paul, Hastings, Janofsky & Walker, Index No. 650618/2009 (N.Y. July 28, 2010) (failure to limit the scope of a representation to advising on an acquisition and negotiating a loan permitted plaintiff to sustain malpractice claim allegations based on law firm’s alleged failure to advise client on defective lien and bankruptcy-related risks).
18. See, e.g., Red Zone v. Cadwalader, Wickersham & Taft, 2013 N.Y. Slip Op. 32074 (N.Y. Aug. 27, 2013) (claim of malpractice in drafting of side letter fee agreement fell within three-year statute of limitations, even where conduct took place almost six years before lawsuit and last bill was issued almost four years before lawsuit, because absent a communication terminating the prior representation, the “continuous representation” doctrine extended representation to one year before filing when defendant last provided advice to the client on the side letter issue ); Red Zone v. Cadwalader, Wickersham & Taft, Sup. Ct., N.Y. County, May 5, 2014, Schweitzer, J., index no. 650318/2011 (amended judgment ordering defendant law firm to pay plaintiff $17.2 million on malpractice claim), aff’d, 2014 WL 2765973 (1st Dep’t. June 19, 2014).