In Chadbourne & Parke LLP v. Troice, Nos. 12-79, 12-86 and 12-88, 2014 U.S. LEXIS 1644 (U.S. Feb. 26, 2014), the Supreme Court of the United States resolved a split in the circuits regarding whether alleged misrepresentations were made “in connection with the purchase or sale of a covered security” for purposes of the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), 15 U.S.C. § 78bb(f)(1)(A).  The Court held that a “misrepresentation or omission of a material fact” is made “in connection with the purchase or sale of a covered security” only if the misrepresentation is “material” to the plaintiff’s decision to buy or sell that covered security.  This decision narrows the scope of removal and preclusion of state law securities fraud class actions by the federal courts under SLUSA.

Plaintiffs were private investors who brought state law class claims against defendant firms and individuals in Louisiana and Texas state courts, alleging that defendants had assisted Stanford International Bank (the “Bank”) and Alan Stanford (“Stanford”) in perpetrating a fraud on the plaintiffs.  Stanford had run a multibillion dollar Ponzi scheme through which he and his affiliates sold to plaintiffs Bank certificates of deposit (“CDs”).  The CDs were debt assets that promised a fixed rate of return.  Plaintiffs expected Stanford to use the money it received to buy assets and invest in publicly traded securities.  Instead, Stanford used the money to repay old debts, live a lavish lifestyle and finance speculative real estate ventures.

Defendants removed the state law class actions to federal court and sought dismissal under SLUSA.  SLUSA generally authorizes the removal to federal court and dismissal of state law class actions that allege misrepresentations or misleading omissions in connection with the purchase or sale of “covered securities.”  SLUSA adopts the definition of “covered security” in the Section 18 of the Securities Act of 1933, 15 U.S.C. § 77r, as one that is “listed, or authorized for listing, on [various national stock exchanges]” or one that is “issued by an investment company that is registered . . . under the Investment Company Act of 1940.”

The United States District Court for the Northern District of Texas granted defendants’ motion to dismiss, concluding that plaintiffs’ claims were precluded under SLUSA.  The district court acknowledged that the CDs were not “covered securities” under SLUSA because the CDs were not “traded nationally [or] listed on a regulated national exchange.”  However, the district court noted that each complaint alleged that the fraud included misrepresentations that the Bank held significant holdings in covered securities, which made the CDs more secure.  The district court thus held that this provided the necessary “connection” between plaintiffs’ state law fraud claims and “transactions in covered securities,” and that the claims were therefore precluded by SLUSA.

The United States Court of Appeals for the Fifth Circuit reversed.  The Fifth Circuit agreed with the district court’s determination that the complaints described misrepresentations about covered securities.  The Fifth Circuit held, however, that the “heart” of the allegedly fraudulent scheme centered on representations that the uncovered CDs were safe and secure.  The Fifth Circuit held the falsehoods concerning the covered securities were too “tangentially related” to the “crux” of the fraud to be sufficiently “in connection with” the purchase or sale of a covered security for purposes of SLUSA.

The Supreme Court affirmed.  The Court first noted that SLUSA focuses on transactions in covered securities, not uncovered securities.  The Court also observed that the pertinent phrase of SLUSA, “material fact in connection with the purchase or sale,” suggests a connection between the misrepresentation or omission and a purchase or sale that “matters.”  The Court determined that a connection “matters” where the misrepresentation makes a “significant difference to a person’s decision to purchase or sell a covered security,” but not an uncovered security.  Plaintiffs’ complaints alleged misrepresentations regarding the Bank’s ownership of covered securities, but did not allege misrepresentations in connection with the “purchase or sale of a covered security” by plaintiffs.  Thus, the complaints did not provide the necessary “connection” between the materiality of the misstatements and the “purchase or sale of a covered security.”

The Court also noted that its interpretation of the “in connection with” language in SLUSA should not significantly impair the SEC’s enforcement powers for violations of Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”), 15 U.S.C. § 78j(b), because the definition of “security” under the Exchange Act is broader than that of “covered security” under SLUSA.

The Court’s decision in Chadbourne would appear to limit SLUSA to cases where plaintiffs allegedly purchased, sold or held (see Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71 (2006)) “covered securities.”  Class actions where plaintiffs allegedly purchased, sold or held uncovered securities, even if covered securities are lurking in the background, may proceed in state court.