High Court Ponders State-Level Class Action On Securities

Securities law streaked across the stage of the U.S. Supreme Court earlier this month, as lawyers argued in front of the justices about whether certain state securities-fraud class action suits are still valid despite a 1998 federal law intended to curb such disputes at the state level.

The case, Merrill Lynch v. Dabit, is the first securities action to go before the high court this term. The specific issue is whether shareholders who claim they held on to a security—but didn’t purchase or sell it—as a result of a fraudulent statement can seek damages under state law. The 1998 federal law, the Securities Litigation Uniform Standards Act, precludes state class-actions “in connection with the purchase or sale” of securities.

A decision in the case is expected by the end of the court’s term in June.

Lower courts are split on the question. The New York-based 2nd Circuit Court of Appeals ruled in Dabit that SLUSA doesn’t include shareholders who merely hold on to securities. But the 7th Circuit in Chicago reached the opposite conclusion, finding that allowing these suits to proceed in state courts would constitute an impermissible end-run around SLUSA (see decisions in box at right).

Kaplan

Mitchell Kaplan, who chairs the securities litigation practice at Choate, Hall & Stewart in Boston, says he’d be “quite surprised” if the Supreme Court doesn’t reverse the 2nd Circuit. Kaplan notes that the Securities and Exchange Commission has supported the position that SLUSA prohibits state class-actions by securities holders.

“When the SEC—which has been very protective of the rights of investors—comes out and says, ‘This is a misinterpretation of what SLUSA was intended to do’,” Kaplan says, “that’s a fair indicator that you don’t need to bring class actions on behalf of holders of securities to get the benefit that class-action securities litigation can bring to the marketplace.”

The End Of Holder Actions?

Brighton

Robert Brighton, a partner with the law firm Ruden McClosky in Fort Lauderdale, Fla., says much is at stake in the Dabit case. If the court rules in favor of Merrill Lynch, “it will eliminate the ability of private plaintiffs to bring securities fraud claims in state court,” he says. “It would be the regulators who would have to bring these claims.”

Stewart Weltman, a partner with plaintiff class-action firm Cohen, Milstein, Hausfeld & Toll in Chicago, starkly predicts that a decision for Merrill Lynch “will mean the end of holder class actions.”

Weltman

According to Weltman, large institutional investors might still be able to bring their individual cases, but small investor class actions will be removed to federal court—where, he says, based on a 1975 Supreme Court decision, they will be dismissed. “The Dabit case is really about whether small investor-holder will have some remedy when defrauded into holding as opposed to buying a stock,” he says.

Theus

Roma Theus, who represents corporate defendants and is a member of the Defense Research Institute, says the issue is “whether Congress intended to preempt the field to try to preclude specious securities litigation in federal and state court.” In passing SLUSA, Congress was aware that class-action lawsuits “can be vehicles for abuse; they can be used to wring settlements out of corporations where no lawsuit should have been brought at all.”

The Dabit case, argued before the Supreme Court on Jan. 18, was a product of New York Attorney General Eliot Spitzer’s 2002 investigation into alleged conflicts of interest between research analysts and investment bankers. Spitzer’s probe suggested that some research analysts were encouraged to tailor their reports to get business from investment banks.

Seizing upon the information uncovered in the investigation, Shadi Dabit, a former Merrill Lynch broker, filed a purported class-action suit on behalf of shareholders in Oklahoma, claiming that Merrill Lynch had violated state law. Although the suit was actually brought in a federal court based on diversity jurisdiction, it was a state law claim.

OPINIONS

2nd Circuit

...Plaintiffs contend that SLUSA does not preempt their actions because they do not, as SLUSA’s preemption provisions require, allege a misrepresentation or omission “in connection with the

purchase or sale of a . . . security.” We hold that (i) the meaning of “in connection with the

purchase or sale of a . . . security” under SLUSA is the same as that of the nearly identically

phrased term found in § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and its

corresponding Rule 10b-5, 17 C.F.R. § 240.10b-5, (ii) the purchaser-seller rule of Blue Chip

Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), applies as a limit on the preemptive effect of

SLUSA, and (iii) the instant actions present claims alleging misrepresentations “in connection

with” securities transactions and are partly preempted under SLUSA.

Source: U.S. Court Of Appeals For The 2nd Circuit In Shadi Dabit v. Merrill Lynch

7th Circuit

We hold that SLUSA is as broad as §10(b) itself and that

limitations on private rights of action to enforce §10(b) and

Rule 10b-5 do not open the door to litigation about securities

transactions under state law. Plaintiffs’ claims are connected

to their own purchases of securities and thus are blocked by

SLUSA, whose preemptive effect is not confined to knocking

out state-law claims by investors who have winning federal

claims, as plaintiffs suppose. It covers both good and bad

securities claims—especially bad ones. The judgments of the

district courts are reversed, and the cases are remanded

with instructions to undo the remand orders and dismiss

plaintiffs’ state-law claims.

Source: U.S. Court Of Appeals For The 7th Circuit In Kircher And Brockway v. Putnam Fund Trust

The trial judge initially dismissed the suit on grounds that it was preempted by SLUSA. But Dabit amended his complaint to narrow the class of plaintiffs only to those who “owned or held” securities, not those who purchased or sold them. The suit was then transferred to the Southern District of New York, which has established a special litigation panel to hear such cases.

In New York, Dabit’s suit was again dismissed because it was precluded by SLUSA. On appeal, however, the 2nd Circuit held that Dabit’s state-law claims that did not involve the purchase or sale of securities could go forward.

Getting Around SLUSA

Kaplan at Choate, Hall & Stewart says that the 2nd Circuit “got all off track” by finding that the U.S. Supreme Court’s 1975 decision in Blue Chip Stamps v. Manor Drug Stores—which said that only purchasers and sellers of securities have the legal right under federal law to sue for securities fraud—left the door open for securities holders to bring state court class-actions.

Kaplan says plaintiff lawyers only recently started suing on behalf of holders of securities, after Congress forced securities class-actions into federal court—where pleading requirements are heightened and cases can be dismissed before costly discovery takes place. “A bunch of clever people, seeking to get around the requirements of SLUSA and the limitations on securities litigation, said, ‘OK, we’re not going to sue on behalf of purchasers or sellers but we’re going to sue on behalf of holders’,” he says.

According to Kaplan, viable class-action suits are still being brought in federal court, despite the limitations imposed by federal law. “If you’ve got a good claim, you can bring it under the federal securities laws and it can withstand a motion to dismiss,” he says.

Iavarone

But Nicholas Iavarone, who practices with plaintiff law firm Simmons Cooper in East Alton, Ill., says nothing in the language of SLUSA precludes small investors who hold securities from seeking damages in state court.

“To me, the holding claims [like the ones in Merrill Lynch v. Dabit] are really the last place you can go to have relief from these large frauds,” he says. “Small investors can’t really avail themselves of any type of relief in federal court.”

Although Iavarone hopes the Supreme Court will uphold the 2nd Circuit, he wouldn’t “be at all surprised” if the ruling favors Merrill Lynch. “But if [the justices] are true to what they say that they are strict interpreters of the law and they don’t want to expand federal jurisdiction—the 2nd Circuit should be upheld,” he says.

Related opinions and briefs can be found in the box above, right.