Escaping Secondary Liability: the Ever-Increasing Scope of SLUSA


Just imagine: in a split second, your hard-earned lifesavings, and the financial security that accompanied it, vanishes. You have just discovered that you are the victim of a Ponzi scheme. Furious, you pledge to take action against every last party responsible for defrauding you.  Of course, having just lost all of your savings, you are not in any financial position to engage in expensive litigation. A class action is your only hope in pursuing your cause, as your targets may include the large banks or law firms that facilitated the Ponzi schemer’s actions.  In the past, as a means to pursue actions against them, you might have been able to rely on secondary liability, under your state’s blue sky statutes.  Unfortunately, due to recent developments in securities class action law, many of the actors who might have been held accountable under the doctrine of secondary liability may now be beyond your reach.

On October 7, the Supreme Court heard oral argument in Proskauer Rose LLP v. Troice, a case stemming from the seven billion dollar Ponzi scheme perpetrated by “Sir” Allen Stanford.  This case concerns the scope of the preclusion provision under the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), which was designed by Congress to fill in the perceived gaps left under the Private Securities Litigation Reform Act of 1995 (“PSLRA”). PSLRA’s objective is “to combat abusive and extortionate securities class actions” by implementing “uniform standards” and heightened pleading requirements for securities fraud class actions brought in federal courts. In order to avoid the PSLRA’s requirements, plaintiff’s attorneys began filing their federal securities fraud class actions in state court.

In response, Congress enacted SLUSA to prevent plaintiffs from circumventing PSLRA. This was achieved by means of a preclusion provision that either removes to federal court or dismisses outright any “class action based upon the statutory or common law of any State or subdivision there-of . . . by any private party alleging a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.’’  In the simplest of terms, “covered securities” are those that are traded on a national exchange. The issue to be decided in Proskauer Rose LLP is what standard should determine whether a particular allegation was “in connection with” the purchase or sale of a covered security.

Intuitively, one might think that in order for SLUSA to apply, the complaint must allege that an actual sale took place, or that actual covered securities must be involved in the transaction. This makes sense for two reasons. First, SLUSA’s plain language supports this interpretation. As the respondents argued in Proskauer Rose LLP, Congress could have made the law applicable to any misstatement “relating to” or “about” covered securities, but it did not. Further, in contrast to rule 10(B) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), wherein Congress criminalized deceptive practices “in connection with the purchase or sale of any security” Congress specifically limited SLUSA to “covered” securities.  Second, Congress’s express purpose in passing SLUSA was to stabilize and protect the integrity of the national securities markets. Specifically, Congress expressed concern that spurious litigation was having a chilling effect on the ability of companies to make projective statements, forced companies to settle to retain investor confidence, and deterred qualified investors from sitting on company boards. Thus, it seems reasonable that a complaint alleging fraudulent conduct in connection with the purported—as opposed to actual— sale of uncovered securities that have no bearing on the national securities markets would not be subject to preclusion under SLUSA. These conclusions make the Second Circuit’s recent decision in Trezziova v. Kohn difficult to understand.

In Trezziova, the court held that a class action brought on behalf of investors in certain foreign feeder funds—which, unbeknownst to the investors, had funneled most of the invested funds into Bernie L Madoff Securities— was precluded by SLUSA from bringing various state-law causes of action. Consequently, the plaintiffs in Trezziova were unable to pursue their state law claim of aiding and abetting in breach of fiduciary duty against JP Morgan Chase (“JPMorgan”) and the Bank of New York Mellon (“BNY”), the banks at which the Madoff securities were held. Even though these plaintiffs had purchased “non-covered” securities (the foreign feeder funds), and even though Madoff Securities “may not have actually executed their pretended securities trade,” the court found SLUSA applicable. In defense of its decision, the court pointed out that JP Morgan and BNY’s liability was based on their alleged assistance of the Madoff Securities’ Ponzi scheme, which did purport to trade in covered securities, and not on any action directed towards the plaintiffs.  The court also cited to Instituto De Prevision Militar v. Merrill Lynch in asserting that no actual purchase or sale need occur to satisfy SLUSA’s “in connection with” requirement.

I find the Court’s reasoning highly suspect. First, Instituto does not stand for the broad proposition for which the court adapts it. In Instituto, the plaintiffs alleged that Merrill Lynch aided and abetted a fraud committed by a pension fund company that had embezzled the funds deposited with Merrill Lynch. Plaintiffs argued that Merrill Lynch was liable because its “failure to prevent” the fund’s use of Merrill Lynch’s corporate name and logo had “lur[ed]” the plaintiffs into investing with the fund. The court repeatedly emphasized that it was because the complaint alleged that it was Merrill Lynch’s added credibility that had induced the plaintiffs to invest with the pension fund company that the complaint satisfied SLUSA’s “in connection with” requirement[1]. By contrast, the plaintiffs in Trezziova had no knowledge of JP Morgan’s role, and so could not have been induced into purchasing the feeder funds because of JP Morgan’s actions.

Second, by focusing on JP Morgan’s relationship to what Madoff Securities was purportedly engaged in, the Trezziova court lost sight of the purpose for which SLUSA was enacted. Seemingly, none of the concerns for which PLSRA and SLUSA were enacted are implicated by allowing the plaintiffs in Tressiova to pursue their claim against Merrill Lynch: there is no increased risk for companies that wish make to projective statements, as no one is claiming to have been induced into a transaction from misleading or erroneous information; it is unlikely that banks such as Merrill Lynch would feel compelled to settle, fearing of a loss of investor confidence in the bank, as the financial soundness of the bank is not being targeted; nor would qualified investors, with the possible exception of banks, be deterred from sitting on company boards.  Further, the anxiety felt by potential defendants, who understandably worry about the ability of lay juries to competently decide difficult securities issues such as materiality, scienter, reliance and causation, which no doubt adds pressure to settle, is not present in common law aiding and abetting claims. Moreover, claims similar to those in Trezziova against Merrill Lynch, wherein the plaintiffs do not allege there was any misinformation relating to the potential value of any covered securities, have no conceivable effect on investor confidence in the national markets.  The disconnect between the purpose for which SLUSA was enacted and the Trezziova opinion, and the resulting consequences thereof, are apparent from SLUSA’s legal foundations and legislative history.

Both Congress and the Supreme Court have repeatedly expressed the outer limits of the federal securities laws and the importance of maintaining traditional state police powers. In SEC v. Zandford, the Supreme Court explained that the “in connection with” requirement of § 10(b) of the Securities Exchange Act, upon which SLUSA’s phraseology was modeled, “must not be construed so broadly as to convert every common law fraud that happens to involve securities into a violation of § 10(b).”  Accordingly, as Congress used identical phrasing for § 10(b) and SLUSA, we should presume they “have the same meaning.”  Additionally, Congress made clear that SLUSA would preserve “the appropriate enforcement powers of State securities regulators.”  The SEC itself has recognized the importance of preserving state law claims, as they afford “broader liability than federal law provides, such as aiding and abetting liability in cases of fraud.” Lastly, it should be noted that interpreting SLUSA’s scope broadly, as the court in Trezziova did, would in fact increase the potential for securities regulation, as limiting litigants potential causes of action forces plaintiff’s similar to those in Trezziova to pursue their cause in federal securities courts rather than in state courts. Such a consequence is clearly contrary to SLUSA’s purpose of decreasing securities litigation.

When considering the wide-reaching magnitude of recent Ponzi schemes, the Second Circuit’s push to decrease the availability of secondary liability to the victims of such frauds is troubling. If banks know that they are protected from secondary liability in the event that deposits are used in connection with such schemes, what incentive do they have to make it more difficult for perpetrators to use their services in carrying out their plans? The expanding scope of SLUSA will no doubt make it more convenient for banks to look the other way. Hopefully, the Supreme Court will keep in mind the purpose for which SLUSA was enacted – that is, to protect the integrity of the markets, rather than relieve financial players from responsibility for engaging criminals in their midst.

[1] It was undisputed that the pension fund included covered securities.


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Fordham Journal of Corporate & Financial Law