Issues
Whether, as the seventh circuit held earlier this month and in direct conflict with the decision below, SLUSA preempts state law class action claims based upon allegedly fraudulent statements or omissions brought solely on behalf of persons who were induced thereby to hold or retain (and not purchase or sell) securities?
The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) preempts state law class action suits that allege misrepresentation “in connection with the purchase or sale” of securities. In a state class action suit against Merrill Lynch for issuing biased recommendations of certain stocks, Respondent Dabit attempted to escape the preemption of SLUSA by filing a holder suit — alleging that he held and refrained from selling stocks based on Merrill Lynch’s misrepresentations, expressly avoiding any references to purchases or sales of stocks. The court must resolve a conflict between the Second Circuit’s decision in this case, holding that such holder claims are not preempted by SLUSA and can be brought in state courts, and a recent seventh circuit decision that held otherwise. This case will be closely watched by the corporate community, as allowing holder suits in state court would allow a new class of plaintiffs to sue corporations and also expose corporations to litigation in the more unpredictable and less experienced (with respect to securities class actions) state courts.
Questions as Framed for the Court by the Parties
Whether, as the seventh circuit held earlier this month and in direct conflict with the decision below, SLUSA preempts state law class action claims based upon allegedly fraudulent statements or omissions brought solely on behalf of persons who were induced thereby to hold or retain (and not purchase or sell) securities?
Facts
In 2000, New York Attorney General Eliot Spitzer (“Spitzer”) investigated Merrill Lynch, a global financial services firm, for allegedly issuing biased investment recommendations and illegitimately hyping up stocks to obtain business. Dabit v. Merrill Lynch, 395 F.3d 25, 28 (2d cir. 2005), cert. Granted, 126 S.Ct. 34 (2005). Spitzer subsequently reached a settlement with Merrill Lynch, but the investigation nevertheless prompted over 150 private class action suits against Merrill Lynch in federal and state courts. See Brief for Petitioner at 9.
Shadi Dabit (“Dabit”), a former Merrill Lynch broker, commenced one of these class action suits in the Western District of Oklahoma, alleging that Merrill Lynch made misrepresentations that induced him and other brokers to purchase and hold stocks of forty-eight internet and technology companies. See Brief for Petitioner at 11. Dabit claims that if he “had been advised of the true facts, he would have sold them and advised his clients to sell them well before the … stocks dramatically declined in value.” Id. The district court dismissed Dabit’s initial complaint, reasoning that class action suits alleging misrepresentations in connection with the purchase of nationally traded securities must be filed in federal court, as mandated by SLUSA. See id. Attempting to circumvent this dismissal, Dabit amended his complaint to remove the reference to the purchase of securities. Instead, the amended complaint alleged that Merrill Lynch induced him and other brokers “to continue to hold” the securities in question. See id. At 12–13. Nevertheless, the district court dismissed the suit as preempted by SLUSA. See Dabit v. Merrill Lynch, 395 F.3d at 28. The Second Circuit reversed, finding “no clear indication” from either the text or the legislative history of SLUSA that it was intended to preempt claims stemming from merely holding securities, as opposed to claims directly linked to a purchase or sale. See id.
Analysis
Dabit filed a class action suit in state court against Merrill Lynch, alleging that the company made misrepresentations and wrongfully induced him to hold certain stocks that later faltered. Merrill Lynch seeks dismissal of the suit on the grounds that it is preempted by SLUSA, which amended the securities exchange act of 1934 (“1934 Act”) to declare that class action suits alleging misconduct “in connection with the purchase or sale” of securities are to be heard exclusively in federal courts. See Dabit v. Merrill Lynch, 395 F.3d at 28. On the contrary, Dabit argues that his suit eludes the preemption of SLUSA because his claims merely allege damages as a result of being induced to hold — not buy or sell — stocks. The court will resolve this case by engaging in statutory interpretation: looking to the plain meaning of SLUSA’s text, the interpretation of the “in connection with” requirement in other sections of the 1934 Act, most notably in §10(b) and its corresponding SEC Rule 10b-5. The court will also likely consider congress’ intent in passing SLUSA.
Congress enacted SLUSA in 1998 as a means of closing the “federal flight” loophole that allowed class action plaintiffs to bring their suits in state courts rather than in federal courts and avoid the more stringent requirements for federal securities litigation of the Private Securities Litigation Reform Act of 1995 (“PSLRA”). See Dabit v. Merrill Lynch, 395 F.3d at 32. The heightened requirements of the PSLRA were designed to curb “strike suits,” meritless suits filed against corporations only because their share prices dropped in order to draw settlements. See id.
Allowing holder suits under state law would not reopen the identical “federal flight” loophole that was closed by the SLUSA. The “federal flight” loophole, as identified by congress in passing the SLUSA, allowed class action plaintiffs who had the choice to file suit in federal court, to instead bring their actions in state court. See Dabit v. Merrill Lynch, 395 F.3d at 36. Holder suits were never permitted under the federal securities rule 10b-5, therefore, allowing holder suits under state law does not create federal flight, but rather it creates a new option for class action plaintiffs in state courts that was previously impossible. See id. Regardless of this difference, both loopholes challenge congress’ intent to raise the bar for securities litigation to a uniform, nationwide standard.
SLUSA does not expressly define the phrase “in connection with the purchase or sale,” and the supreme court has yet to interpret the phrase in the context of SLUSA. See Dabit v. Merrill Lynch, 395 F.3d at 34. Merrill Lynch argues that the broad wording used in the first part of the SLUSA provision — stating that “[n]o covered class action based upon the statutory or common law of any state … may be maintained in any state or federal court by any private party,” expresses its broad preemptive scope and therefore the SLUSA should cover holder class actions. See Brief for Petitioner at 20–21. However, the broad wording used in the first part of the SLUSA provision only tangentially affects the reading of the “in connection with” requirement, which is at the heart of this matter. More on point, the identical “in connection with” phrase used in SLUSA has been extensively interpreted in the context of another part of the 1934 Act, specifically, §10(b) and its corresponding SEC Rule 10b-5.
As a default rule, courts recognize that identical language used in different parts of the same statute is intended to have the same meaning. See Brief for Petitioner at 24. §10(b) and Rule 10b-5 play the critical role of creating a private right of action for misrepresentation “in connection with the purchase or sale of any security,” and the bounds of this “in connection with” requirement have been well explored through litigation. See Dabit v. Merrill Lynch, 395 F.3d at 34. Both Merrill Lynch and Dabit make arguments that analogize interpretations of §10(b) of the 1934 Act.
Merrill Lynch points to the generally broad interpretation given to the “in connection with” requirement of §10(b), and argues for a similarly broad preemptive scope for SLUSA. In interpreting §10(b) of the 1934 Act, the Court has long established that there need not be an identifiable purchaser or seller of the actual securities transaction for the SEC to bring a securities fraud suit as long as the fraud “touches upon” a securities transaction by someone at issue. See Brief for Petitioner at 19. This includes situations as in SEC v. Zandford, 535 U.S. 813 (2002), where the misconduct did not directly affect the trading decision of a stockholder but merely coincided with the purchase or sale of securities. See id. At 25. Merrill Lynch argues that holder claims, as in this case where a stockholder alleges he was wrongfully induced to hold his stock as it fell in price, are within the scope of the “in connection with” requirement as defined by Zandford, since such claims necessarily coincide with purchases and sales of securities that cause the decrease in value. See id.
On the other hand, Dabit, and the Second Circuit, think that limitations on the private right to sue under Rule 10b—5 should apply conversely to restrict the preemptive scope of SLUSA. In Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 754–55 (1975), the Court recognized a judge-made rule that limited private enforcement rights under rule 10b-5 to actual purchasers or sellers of the securities in question, eliminating private holder claims for that purpose. See Dabit v. Merrill Lynch, 395 F.3d at 37. Therefore, while under Zandford, 535 U.S. at 813, an identifiable purchaser or seller is not required for an sec-enforced action, only actual purchasers or sellers may bring a private securities fraud action. The second circuit concluded that congress wrote the words “in connection with the purchase or sale” into SLUSA with full knowledge of this Blue Chip purchaser-seller requirement for private actions. According to the second circuit’s logic, since SLUSA preempts only those claims that could have been brought under §10(b) and Rule 10b-5, SLUSA only preempts claims by purchasers or sellers, not holder claims.
Applying the Blue Chip rule to SLUSA creates dissonance because it is arguably contrary to the spirit of SLUSA itself. Rule 10b-5’s “in connection with” language is used as a requirement to bring a suit, but the SLUSA uses the identical “in connection with” language conversely as a means to preempt suits under state law. Therefore, while the Blue Chip rule was designed to curb shareholder litigation, if grafted into SLUSA, the rule would limit the preemptive scope of SLUSA and open up more room for shareholder litigation under state law. Merrill Lynch also points out that the Blue Chip rule is a judicially crafted limitation, which was not based upon statutory construction of §10(b) as expressly recognized by the Blue Chip court, and therefore, Merrill Lynch argues that the rule should not be imported in the meaning of SLUSA. See Brief for Petitioner at 30.
Discussion
The securities industry and corporate community desire both a reversal of the Second Circuit’s ruling and the Court to find that holder class actions are preempted by SLUSA. This result would reinforce the uniformity of securities litigation nationwide and protect corporations from vexatious shareholder litigation. They argue that this result was also the original intent of congress in enacting legislation to create a uniform and stringent standard for securities litigation.
In passing the Private Securities Litigation Reform Act in 1995 (“PSLRA”), which increased the pleading standards for securities litigation, congress set out to curb the growing tide of meritless class actions filed against corporations virtually whenever their share prices significantly dropped. See Dabit v. Merrill Lynch, 395 F.3d at 32. Most of these so-termed “strike suits” were initiated largely to force settlement from the corporations, which seek to avoid legal costs and public scrutiny.See id. Following the PSLRA, plaintiffs flocked to state courts to avoid the PSLRA requirements, so congress enacted the SLUSA to force plaintiffs to bring their claims in federal courts and to create a nationwide uniform standard for securities litigation. See id. Congress recognized that class action plaintiffs would likely enjoy favorable, or at least unpredictable, treatment under state law that may include the possibility of punitive damages, extended discovery, more theories of recovery, and longer statutes of limitations. See Brief of Securities Industry Association and Bond Market Association as amici curiae at 9 [hereinafter “Brief of SIA ”]. Moreover, these factors increase the leverage of class action plaintiffs to force settlements. Eliminating the possibility for holder suits under state law would reinforce the uniformity and higher standard for securities litigation promulgated by the PLSRA and SLUSA, reducing the threat corporations face from shareholder class actions.
On the other hand, a decision in favor of Dabit would allow states to pass laws granting causes of action to shareholders who were misled to continue to hold stock, but did not actually purchase or sell. This would open the door for a new class of plaintiffs to sue, since federal courts have held that shareholders who were merely induced to hold stock but did not buy or sell have no claim. See Brief of SIA at 10. Moreover, these plaintiffs could proceed with their claims in state court and avoid the more stringent procedural requirements of federal securities litigation. While allowing state law holder class actions would give aggrieved shareholders an avenue to seek redress, it also revives concerns over meritless “strike suits” that prompted congress to enact the PLSRA in the first place in 1995. See Dabit v. Merrill Lynch, 395 F.3d at 32. However, the potential burdens to corporations which would result from this new right of action are likely contrary to the spirit of congress’ intent in passing SLUSA and would likely prompt a swift reaction from congress.
Shareholders may be split on which outcome they would prefer in this case. Litigious shareholders would hope a decision finding that holder class actions can proceed under state law, as they would benefit from bringing class actions in a more favorable environment, with fewer requirements, a local judge and jury, and more theories under which to recover damages. On the other hand, shareholders may also be in favor of closing this avenue around the SLUSA and national standards for securities litigation, since having to defend and potentially settle shareholder class actions is costly for corporations and will have a negative impact on the price of the shareholder’s stock.
Conclusion
In deciding this case, the Court will resolve a glaring conflict between the second and seventh circuits and determine whether “holder suits” under state law are suits “in connection with the sale or purchase” of securities and are, therefore, preempted by SLUSA. In its exercise of statutory interpretation, the Second Circuit applied the Blue Chip purchaser-seller rule restricting the ability of some parties to bring lawsuits, but did so conversely – in a manner that restricted the scope of SLUSA’s preemption and opened up the possibility for state holder class actions. While it is a technically valid argument, the Second Circuit’s application of the Blue Chip rule produces a result contrary to the spirit of the SLUSA and congress’ intent to ensure uniform and stringent standards for securities litigation nationwide. Therefore, it is likely that the Court will reverse the Second Circuit and close the door for holder class actions under state law. Failing this, congress will likely be quick to take action to reinforce the SLUSA.
Written by:
Euwyn Poon
Acknowledgments
Additional Resources
- Wex, securities