Supreme Court To Resolve Circuit Split On State-Law Securities Claims

A circuit split has developed, with some circuits holding that state law claims in "holding" cases are not barred by SLUSA, while at least one other holds that they are.

A resolution of this split will immediately affect numerous cases pending against mutual fund companies and variable annuity issuers, particularly those sued in dozens of cases alleging damages resulting from market-timing activities.

Generally, SLUSA preempts state law class claims alleging fraud in connection with the purchase or sale of registered securities. Creative plaintiffs' class action lawyers have tried to avoid SLUSA preemption by alleging that the class they represent suffered damages as a result of "holding" stock during the class period rather than from purchasing or selling it.

In three circuits, such a plaintiff class is permitted to assert state law claims–for instance, for common law fraud or violation of state deceptive practices legislation–even though a purchaser subjected to the same conduct during the class period would be limited to federal law claims only. If the Supreme Court adopts the Second Circuit's position in Dabit, then securities firms, mutual fund companies and variable annuity issuers–and their professional liability insurers–will face a stream of "holder" lawsuits that will be costly to defend or settle.

Legislative Background

In 1995, Congress enacted the Private Securities Litigation Reform Act to curtail "strike suits"–non-meritorious class actions alleging some violation of securities law brought in the hope that defendants would settle quickly, rather than absorb the potentially overwhelming costs of extensive discovery, or risk an adverse judgment at trial. PSLRA imposes heightened pleading requirements and stays discovery pending a motion to dismiss.

After enactment of PSLRA, Congress found plaintiffs' lawyers thwarted the purpose of the statute by filing "frivolous and speculative lawsuits in state court, where essentially none of the Reform Act's procedural or substantive protections against abusive suits are available."

With the Securities Litigation Uniform Standards Act of 1998, Congress established federal courts as the exclusive venue for most securities class action lawsuits. SLUSA was intended to "prevent plaintiffs from seeking to evade the protections that federal law provides against abusive litigation by filing suit in state, rather than federal, court."

SLUSA states that "no class action based on the statutory or common law of any state…may be maintained in any federal or state court by any private party alleging untrue statements or omissions of material fact in connection with the purchase or sale of a covered security." Covered securities specifically include securities traded on national exchanges or issued by registered investment companies, such as mutual fund shares and variable annuities. The defendant in a "covered class action" can remove it to federal court and move to dismiss all non-federal claims.

Dabit Limits SLUSA Preemption

The plaintiffs in Dabit asserted state law claims in several class action lawsuits alleging Merrill Lynch had issued biased research and investment recommendations designed to garner investment banking business. Plaintiffs omitted any reference to the purchase or sale of securities, but rather alleged they were harmed as "holders" of securities.

Senior Judge Milton Pollak dismissed plaintiffs' claims as "squarely within SLUSA's ambit."

On appeal, the sole issue before the Second Circuit was whether SLUSA preempted state law claims that do not allege putative class members purchased or sold securities in reliance on the defendant's alleged misconduct. Plaintiffs argued their claims were not preempted because they were not based on misrepresentations made "in connection with" a purchase or sale, as the language of SLUSA required.

On appeal, all parties–and the Securities and Exchange Commission–agreed that the court, in construing the "in connection" requirement of SLUSA, should be guided by prior case law interpreting the nearly identical language in Section 10(b) of the Securities Exchange Act of 1934. They differed, however, as to whether the court should apply the purchaser-seller limitation the Supreme Court held applies to Section 10(b) claims in Blue Chip Stamps v. Manor Drug Stores. That case holds that a private plaintiff can maintain a claim for violation of Section 10(b) only if the plaintiff actually purchased or sold the security; mere holders have no claim for violation of the statute.

Reviewing SLUSA's legislative history, the Second Circuit concluded that "Congress sought only to ensure that class actions brought by plaintiffs who satisfy the Blue Chip purchaser-seller rule are subject to federal securities laws." Accordingly, it held that Blue Chip Stamps limits SLUSA preemption to those claims where the complaint alleges the plaintiff purchased or sold the security. The court ruled that certain of plaintiffs' claims satisfied the Blue Chip Stamps requirement, and thus were preempted, but others did not.

Class action plaintiffs' counsel can be expected to use the decision as a drafting guide in crafting claims to avoid SLUSA preemption, so long as it remains the law. (The Eighth and Eleventh Circuits also hold SLUSA does not preempt "holder" claims.)

Seventh Circuit's Kircher: Split Emerges

Four months after Dabit was decided, the Seventh Circuit's decision in Kircher v. Putnam Funds Trust created a circuit split.

The plaintiffs had asserted state-law claims against mutual fund defendants, alleging harm resulting from the pricing practices that market-timing arbitrageurs could exploit. Plaintiffs defined the putative class to include only those who held shares in the defendant's funds during the class period, and had neither purchased nor sold the shares during the period. The Seventh Circuit addressed whether SLUSA preempted the claims.

Judge Frank Easterbrook began from the same premise as Dabit–that is, that the language of SLUSA should be construed to have the same scope as the nearly identical language in Section 10(b) of the Exchange Act. However, the court declined to hold that the purchaser-seller requirement for private Section 10(b) claims announced in Blue Chip Stamps limits the scope of SLUSA. Instead, the Seventh Circuit held that SLUSA preempts state law "holder" claims.

Judge Easterbrook reasoned that the Blue Chip Stamps requirement was not based on the statutory language but rather was a judicially-created limitation to an implied private right of action. The rationale for such a limitation does not exist under SLUSA, because Congress expressly preempted private claims to create uniformity in national securities markets.

Unlike Dabit, Kircher holds that SLUSA "is as broad as Section 10(b) itself" and that limitations on private causes of action should not limit the statute's scope.

"It would be more than a little strange," the court wrote, "if the Supreme Court's decision to block private litigation by non-traders became the opening by which that very litigation could be pursued under state law, despite the judgment of Congress (reflected in SLUSA) that securities class actions must proceed under federal securities laws or not at all."

The Supreme Court will soon decide whether to reverse Dabit and adopt the rule in Kircher, giving broader effect to SLUSA preemption.

Why Kircher is Correct

Reversing Dabit and adopting Kircher is consistent with the move toward uniform standards in the national securities markets.

Dabit is based on the model for securities litigation that existed before SLUSA changed the landscape.

Beginning in 1934 with the Exchange Act, and continuing well into the 1990s with PSLRA, Congress was concerned with striking a balance between federal and state litigation of securities-based claims. The Supreme Court followed Congress' lead, and thus in cases like Blue Chip Stamps found itself limiting the scope of securities claims under the Exchange Act. Plaintiffs who failed to state a claim–for example, they weren't a purchaser or seller–could pursue their claims under state law.

With SLUSA, Congress departed from the course of prior legislation by completely preempting all state law class claims involving securities traded in the national securities markets and forcing plaintiffs to assert such claims (if at all) under federal law. Just as securities markets had become increasingly subject to national and even global standards, class action lawsuits were made subject to a single set of laws established by the federal government.

By attempting to fasten the purchaser-seller requirement of Blue Chip Stamps onto the framework of SLUSA, the court in Dabit weakens the whole structure.

Dabit allows plaintiffs whose allegations fail the purchaser-seller test to evade SLUSA, assert state-law claims and avoid the restrictions of PSLRA, such as the heightened pleading requirements and discovery stay.

History suggests that even a trickle of such suits soon develops into a flood. One need only look to the many "market-timing cases" currently pending in the District of Maryland, where plaintiffs have amended numerous suits to assert "holding" claims. Even unmeritorious state-law claims may provide powerful leverage for extracting settlements from defendants who wish to avoid the risk and cost of litigation.

Daniel McNeel Lane Jr. is a partner for Akin Gump Strauss Hauer & Feld LLP in the San Antonio office.

"History suggests that even a trickle of such suits soon develops into a flood. One need only look to the many 'market-timing cases'…, where plaintiffs have amended numerous suits to assert 'holding' claims."

Daniel McNeel Lane Jr.

If there is art:

Buy, Sell, or Hold? If the Supreme Court upholds a decision allowing a securities class action to proceed for "holders" of securities, a stream of state-law cases targeting securities firms, mutual fund companies and variable annuity issuers could follow.