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From Securities Regulation Daily, October 7, 2013

U.S. Supreme Court hears oral argument on SLUSA preclusive effect on Stanford Ponzi scheme cases

By Jim Hamilton, J.D., LL.M

The U.S. Supreme Court heard oral argument in a case reviewing an interpretation by the Fifth Circuit Court of Appeals of the scope of the preclusive effect of the federal Securities Litigation Uniform Standards Act (SLUSA), which precludes most state-law class actions in which the plaintiffs allege misrepresentations in connection with the purchase or sale of a covered security. (Chadbourne & Parke, LLP v. Troice; Willis of Colorado Inc. v. Troice; Proskauer Rose LLP v. Troice, October 7, 2013).

Background. The case arose from a multi-billion-dollar Ponzi scheme run by Allen Stanford and various entities that he controlled, including a bank that issued fixed-return certificates of deposit (CDs) that the bank falsely claimed were backed by safe, liquid investments. In fact, the claimed investments did not exist, and the bank had to use new CD sales proceeds to make interest and redemption payments on pre-existing CDs.

After the fraud was discovered, two groups of Louisiana investors filed suits in state court against a number of Stanford companies and employees claiming violations of Louisiana law. The defendants removed the Louisiana cases to federal court, and all of the actions were ultimately transferred to the Northern District of Texas, which dismissed the complaints as precluded under SLUSA. The district court held that, while the CDs themselves were not “covered securities,” the plaintiffs had nevertheless alleged misrepresentations made in connection with transactions in covered securities because the bank said that it invested its assets in highly marketable securities issued by stable governments and strong multinational companies. The district court found that the bank led the plaintiffs to believe that the CDs were backed, at least in part, by investments in SLUSA-covered securities.

Fifth Circuit ruling. The Fifth Circuit reversed, deeming the references to the bank portfolio being backed by covered securities to be merely tangentially related to the heart the defendants’ fraud. Misrepresentations about the investments were only one of a host of misrepresentations, reasoned the appeals court, which also observed that, because the CDs promised a fixed rate of return, they were not tied to the success of any of the bank’s purported investments in covered securities within the meaning of SLUSA.

SLUSA impact. Justice Elena Kagan noted that somebody, but not necessarily the victim of the fraud, has to have had some transaction in the market. It is the kind of misrepresentation that would affect someone in making transactions in the covered market. She asked Paul Clement, who was arguing on behalf of the petitioners, how this would do that.

Mr. Clement said that the whole point of this fraud was to take a non-covered security and to imbue it with some of the positive qualities of a covered security, the most important of which being liquidity. In addition, if you look at the sort of underlying brochures that were used to market this, he continued, that is really what this fraud was all about. These CDs were offered as being better than normal CDs because we can get you your money whenever you need it.

Justice Samuel Alito queried whether it mattered that there apparently is not an allegation that there actually were any purchases or sales of covered securities. The statute says “in connection with the purchase or sale of a covered security.” He did not see an allegation that they actually were purchased or sold and asked whether that matters.

Mr. Clement said that it did not because a line should not be drawn that basically says if you buy different securities than you were supposed to or you sell fewer than you were supposed to, that is covered, but if you are a Madoff and simply lie about the whole thing, and there never were any securities purchases at all, that's somehow better. You cannot somehow have a better fraud that’s immune from the SEC just because you completely made the whole thing up, and there were no transactions at all, he contended.

Justice Antonin Scalia said that he had assumed that the purpose of the securities laws was to protect the purchasers and sellers of the covered securities. There is no purchaser or seller of a covered security involved here, he noted, adding that it is a purchaser of not-covered securities who is being defrauded, if anyone. Somewhat rhetorically, the justice asked why the federal securities law would protect that person.

Mr. Clement noted that the federal securities laws apply to non-covered securities as well as covered securities and that the real question here is SLUSA’s coverage because Rule 10b-5 applies to non-covered securities. The Court is well over the bridge about not requiring that it be the plaintiff’s own purchases or sales that are what the inquiry focuses on, he said.

Justice Scalia replied that, while it doesn't have to be the plaintiff’s, it has to be somebody’s. Chief Justice Roberts remarked that the fraud did not go to the purchase and sales of the covered securities; it went to the CDs.

Responding to Justice Anthony Kennedy’s question on what would be the simplest formulation of the test if the Court were to reverse the Fifth Circuit, Mr. Clement said that the simplest, narrowest way to decide this case is to say that, when there is a misrepresentation and a false promise to purchase covered securities for the benefit of the plaintiffs, then the “in connection with” standard is required.

Elaine Goldenberg, Assistant to the Solicitor General, as amicus curiae supporting the petitioners, said the Government agreed with the narrow formulation that Mr. Clement had given, that the issue in this case is a false promise to purchase covered securities using the fraud victims' money in a way that they are told is going to benefit them, and that is a classic securities fraud.

Justice Kagan asked if the Government could satisfy the test that this kind of representation could affect somebody. It may not have to be the victim of the fraud, but someone else whose decision to buy or sell or hold covered securities could be affected. Ms. Goldenberg said yes, adding that here there is a major effect on investor confidence, specifically with respect to covered securities in several different ways. If people see that lies of the kind here where someone is telling someone else “I am going to buy covered securities” and “it is going to benefit you” are being made, then people are less likely to go to their broker and say “here is some money,” “go out on the market and buy me some securities.”

It is a lie that goes to the mechanism by which the securities markets operate, which involves purchases and sales, she emphasized, and it makes it less likely for people to be willing to believe that when they engage in purchases and sales, that something is really is going to happen, and the person is going to respond.

Chief Justice Roberts pointed out that nobody is suggesting that the SEC cannot take action with respect to the non-covered securities. So, to the extent there is diminished confidence in the securities markets, the SEC has all the tools available to address that. The question is a different one under SLUSA.

Justice Scalia returned to the problem of the text of the statute, that there has been no purchase or sale here.

Thomas Goldstein, for the respondents, asked the Court to write an opinion affirming and adopting the following rule: that a false promise to purchase securities for one’s self in which no other person will have an interest is not a material misrepresentation in connection with the purchase or sale of covered securities. The other side has asked for a rule that has never been advocated by the SEC in any other proceeding and has never been adopted by any court, noted counsel for the respondents. Their theory is that what happened here is that there was a promise to buy covered securities that would be for the benefit of someone else. The plaintiffs bought something that Congress specifically excluded from preclusion under SLUSA, argued Mr. Goldstein.

Justice Kennedy proposed a scenario in which a broker says, “Give me $100,000 and I will buy covered securities” and then just pockets it and and flees and said he did not see how this case is much different.

Mr. Goldstein said that the critical difference is in the definition of “purchase.” The reason that the broker example is securities fraud is that the definition of a purchase includes pledging the stocks. That is really important, and it tracks with the Court's holding that “in connection with” reaches as far as frauds that would have an effect on the regulated market.

If someone tells me, to sell securities and give them the money to buy securities for himself after which I receive a fixed rate of return, I think that is in connection with the purchase and sale of securities, even though it's not legally purchased for my benefit, reasoned Justice Sonia Sotomayor.

Mr. Goldstein argued that the key feature is that you can understand why it is that the market cannot function if your stockbroker is making promises about buying and selling securities. This is a bank in the instant case, he said. A bank that does not issue covered securities in any way because it is a foreign bank; it issues only the non-covered securities that Congress specifically excluded.

Mr. Goldstein concluded that this was not material to any purchase or sale. We have this idea from the National Securities Markets Improvements Act that the states regulate non-covered securities, he contended, and so we are going to say that the preclusive effect of SLUSA does not reach things like the CDs that we leave to state regulation. As such, this case clearly falls within the text of SLUSA as being not precluded, he said.

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