Factual Background
Stanford’s Ponzi scheme involved the sale of approximately $7 billion in certificates of deposit (CDs) issued by Stanford International Bank (“SIB”) to more than 25,000 people over fifteen years. SIB falsely represented that the CDs were backed by liquid investments. In reality, however, SIB used a portion of the proceeds from the CD sales to cover interest payments and redemptions, while Stanford spent the remainder on personal luxuries and speculative ventures.
Upon discovery of the fraud and collapse of the scheme, the United States Government, through the Department of Justice and the Securities and Exchange Commission (“SEC”), brought successful enforcement actions against Stanford and his associates under Section 10(b) and Rule 10b-5 of the Exchange Act, which prohibit fraud “in connection with the purchase or sale of any security,” not just “covered securities.”
The plaintiffs in Chadbourne — private purchasers of the CDs — likewise sought recovery for the devastating losses that they suffered from certain third-party defendants, including investment advisers, law firms, and insurance brokers, for helping to perpetrate the fraud or concealing the scheme from regulators. However, under the Supreme Court’s prior decisions in Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) and Central Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994), Section 10(b) does not create a private right of action against such “secondary actors” or “aiders and abettors” of securities fraud. Accordingly, the plaintiffs asserted their claims under state law.
Proceedings Below
The Northern District of Texas dismissed the plaintiffs’ claims at the pleading stage in all four cases, concluding that SLUSA’s preclusion provision applied because, although the CDs were not “covered securities,” the alleged fraud involved misrepresentations that the uncovered CDs were backed by SIB’s ownership of nationally-traded securities. On appeal, the Fifth Circuit reversed the District Court’s decision, finding that such misrepresentations regarding SIB’s holdings in covered securities did not trigger SLUSA because they were not “more than tangentially related” to the “heart, crux, and gravamen” of the alleged fraud, which was the misrepresentation that the uncovered CDs “were ‘a safe and secure’ investment that was preferable other investments for many reasons.” Thereafter, the defendants filed petitions for certiorari, which the Supreme Court granted.
Majority Opinion
Upholding the Fifth Circuit’s ruling, the Supreme Court concluded that the scope of SLUSA’s preclusion provision “does not extend further than misrepresentations that are material to the decision by one or more individuals (other than the fraudster) to purchase or sell a covered security.” The Court cited several factors in support of this finding. First, the Court observed that this interpretation is consistent with SLUSA’s application to “covered securities.” Second, the Court reasoned that SLUSA’s use of the phrase, “material fact in connection with the purchase or sale,” suggests that the connection must matter. That is, the alleged fraud should significantly impact the decision of someone besides the individual perpetrating the fraud to purchase or sell a covered security, not an uncovered one. Third, the Court acknowledged that its decisions interpreting the “in connection with” language under both SLUSA and the Exchange Act have “involved victims who took, who tried to take, who divested themselves of, who tried to divest themselves of, or who maintained an ownership interest in financial instruments that fall within the relevant statutory definition.” Fourth, the Court noted that its interpretation is consistent with both the Exchange Act and the Securities Act of 1933, as “[n]othing in [those] statutes suggests their object is to protect persons whose connection with statutorily defined securities is more remote than words such as ‘buy,’ ‘sell’ and the like, indicate.” And fifth, the Court indicated that a broader interpretation of the “in connection with” requirement would impinge upon state efforts to protect against ordinary state-law frauds.
The Court then addressed two counterarguments raised by the defendants and the Government. First, with regard to the defendants’ contention that the Court has consistently read the “in connection with” language broadly, the Court explained that this reading applied to cases where, unlike the alleged fraud at issue, the false statement was “material” to another individual’s decision to “purchase or sell” a statutorily defined “security” or “covered security.” Second, as to the Government’s argument that a narrow interpretation of SLUSA’s preclusion provision would additionally limit the scope of the SEC’s enforcement powers under Section 10(b), which uses the identical “in connection with” language, the Court pointed out that the SEC had already brought a successful enforcement action against Stanford and SIB, as the Government’s authority under Section 10(b) applies more broadly to “a wide range of financial products beyond those traded on national exchanges,” including the CDs sold by SIB.
Applying its holding to the complaints in each of the four class actions, the Court determined that, at most, they alleged misrepresentations regarding the ownership of covered securities by “the fraudster, not the fraudster’s victim.” Thus, the Court concluded that “there is not the necessary ‘connection’ between the materiality of the misstatements and the statutorily required ‘purchase or sale of a covered security.”
As a final point, the Court rejected the District Court’s additional finding that SLUSA’s preclusion provision applied because at least one of the plaintiffs had purchased the CDs by using the proceeds from the sale of covered securities contained in an investment retirement account (“IRA”) portfolio. Rather, the Court agreed with the Fifth Circuit’s determination that “these sales constituted no relevant part of the fraud but rather were incidental to it.”
Concurrence
In light of his disagreement with the notion that the statutory phrase “in connection with” is subject to a “broad interpretation,” Justice Thomas authored a concise concurring opinion commending the majority’s application of “a limiting principle to the phrase ‘in connection with’ that is consistent with the statutory framework and design of” SLUSA.
Dissent
Writing for the dissent, Justice Kennedy, joined by Justice Alito, expressed concern that the Court’s “narrow interpretation” of SLUSA’s language would limit the SEC’s enforcement powers under Section 10(b) and subject secondary actors to increased state-law claims. Accordingly, the dissent urged a broader reading of the “in connection with” requirement consistent with the Court’s precedents instructing that “[t]he key question is whether the misrepresentation coincides with the purchase or sale of a covered security or the purchase or sale of the securities is what enables the fraud.” Under this standard, the dissent found it irrelevant that Stanford and SIB, as opposed to the fraud victims, held an ownership interest in the covered securities, noting that “[t]he very essence of the fraud was to induce purchase of the CDs on the (false) promise that investors should rely on SIB’s special skills and expertise in making market investments in covered securities on their behalf.”
Implications of Chadbourne
Chadbourne not only resolves a Circuit split regarding the scope of SLUSA’s preclusion provision but also marks a significant victory for the plaintiffs’ bar by permitting defrauded investors otherwise foreclosed from seeking redress under the federal securities laws to bring state-law aiding and abetting claims against secondary actors where the alleged fraud involves the purchase or sale of uncovered securities. While the decision raises some concerns that the Court’s narrowed interpretation of SLUSA’s “in connection with” language will apply with equal force to Section 10(b) and will subject third-party advisers to increased liability under state law, the majority opinion makes clear that such concerns are unfounded, as the Court’s holding is limited to state-law class actions involving only uncovered securities. As such, the SEC’s enforcement powers remain undisturbed, while SLUSA still precludes plaintiffs from bringing state-law class actions against secondary actors based upon their indirect participation in the transaction of securities traded on national exchanges.