Today’s Argument in Merrill Lynch v. Dabit

Private securities fraud actions brought under Section 10(b) of the 1934 Act and its corresponding Rule 10b-5 serve as a valuable supplement to government enforcement actions. At the same time, the availability of the class action mechanism and liberal discovery rules have created a risk of “strike” suits, in which plaintiffs advance meritless claims with the hopes of obtaining lucrative settlements.

Congress has struggled to strike a proper balance between the interest in allowing private securities fraud actions and the countervailing interest in combating “strike” suits. In 1995, Congress passed the Private Securities Litigation Reform Act (“PSLRA”) with the purpose of readjusting the balance in favor of combating meritless claims, but that legislation resulted in an increase in state-court class actions based on state-law claims. Through the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), Congress sought to preempt a broad swath of state-law claims in order to develop uniform national standards and ensure that the objectives of PSLRA are fully achieved.

The Court will hear oral arguments today in Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Shadi Dabit, No. 04-1371, a case in which the Court will be asked to determine whether SLUSA preempts state-law class action claims brought on behalf of persons who held or retained, but did not purchase or sell, securities based upon allegedly fraudulent statements or omissions.

Respondent Dabit was a broker at the financial services firm of petitioner Merrill Lynch, Pierce, Fenner & Smith, Inc. (“Merrill Lynch”). Dabit brought a class action suit in federal court, alleging that Merrill Lynch had violated state law by willfully distorting its stock recommendations and breaching both the covenant of good faith and fair dealing implied in the brokers’ employment contracts and its fiduciary duties to its brokers. His complaint, which was amended to exclude individuals who had “purchased” stocks, defined the class as including those brokers who “suffered damages as a result of owning and holding . . . [Merrill Lynch] Stocks” during the relevant time period. The class definition also included those brokers “who suffered damages as a consequence of the loss of clients due to [Merrill Lynch’s] wrongful actions.”

The district court determined that the holding and lost-fee claims in Dabit’s amended complaint were preempted by SLUSA. On appeal, the Second Circuit vacated and remanded (the opinion can be found here). The Second Circuit recognized that SLUSA preempts state-law class action claims alleging a “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” However, since private parties who neither purchased nor sold securities lack standing to bring suit pursuant to Section 10(b) and its Rule 10b-5 under the Supreme Court’s 1975 decision in Blue Chip Stamps v. Manor Drug Stores, the court reasoned that SLUSA should not be interpreted to preempt state holding claims. Instead, the court found that Congress intended to import the “settled standing rule along with the ‘in connection with’ phrase as a substantive standard.” As such, the court concluded that claims of non-purchasers and non-sellers were exempted from preemption. The court also relied on an “assumption that the historic police powers of the states were not to be superseded by the federal act unless that was the clear and manifest purpose of Congress.” Since SLUSA spoke in general terms about preemption but did not specifically mention non-purchaser/non-seller claims, Congress had not manifested an intent to preempt those claims.

Because the Seventh Circuit had reached the opposite conclusion in a 2005 opinion by Judge Easterbrook, the Supreme Court granted certiorari to resolve the circuit conflict.

Jay B. Kasner of New York will argue on behalf of petitioner Merrill Lynch, while David C. Frederick of Washington, D.C. will argue on behalf of respondent Dabit and all others similarly situated. Deputy Solicitor General Thomas Hungar will argue on behalf of the United States as an amicus curiae in support of Merrill Lynch. The briefs of the parties are available here. The brief of the United States is available here.

In an effort to deter frivolous securities litigation, PLSRA adopted numerous procedural safeguards, including heightened pleading standards for federal securities claims and sanctions for frivolous litigation. Substantively, PLSRA adopted a safe harbor for forward-looking statements. Notably, however, PLSRA did not eliminate or address state-law claims of non-purchasers and non-sellers. In Merrill Lynch v. Dabit, the Supreme Court must determine whether the broad language of SLUSA, which was intended primarily to advance the objectives of PLSRA, nevertheless preempts such claims.

Respondent Dabit opens his brief by describing the important role that states have historically played in regulating the securities industry. For more than a century, state law has permitted recovery by investors who have suffered losses in the value of their stock holdings from misconduct. Thus, Dabit invites the Court to adopt a presumption against preemption. He argues that Merrill Lynch and its amici exaggerate the need for uniformity in the securities industry, and that any such need does not justify disregarding the traditional presumption against preemption.

Dabit further contends that, within the context of private securities litigation under § 10(b) and Rule 10b-5, the phrase “in connection with the purchase or sale” has a settled judicial interpretation: Under the Court’s decision in Blue Chip, a private party does not assert a claim “in connection with the purchase or sale of any security” unless that party alleges that the defendant’s act or omission was in connection with her own purchase or sale. Since SLUSA applies to private securities litigation, Dabit asserts that it should be interpreted in accordance with the Court’s cases construing Section 10(b) and Rule 10b-5 in such suits. Dabit further argues that such an interpretation is most consistent with Congress’s purpose in passing SLUSA, which he argues was solely to preempt those cases that could have been brought under federal law.

Petitioner Merrill Lynch first argues that the plain language of SLUSA preempts state law class actions “by any private party” alleging deception or misrepresentation “in connection with the purchase or sale of a covered security.” Thus, Merrill Lynch asserts that Congress intended to preempt claims based on the defendant’s alleged conduct and not on the identity of class action plaintiffs. The relevant inquiry, then, is whether the defendant is alleged to have made a “misrepresentation or omission of a material fact in connection with” any “purchase or sale of a covered security.” Dabit had alleged that Merrill Lynch made misrepresentations that inflated a company’s publicly traded share price, and such inflation can only occur if there is trading in the company’s shares. Such trading constitutes a purchase or sale; thus, Dabit’s holding claim is included in the scope of SLUSA’s preemptive language.

Merrill Lynch makes two additional arguments: First, Merrill Lynch argues that the Court’s decision in Blue Chip sought solely to limit private party standing, and did not touch upon the substantive scope of Section 10(b), which SLUSA intended to incorporate. Second, Merrill Lynch contends that Dabit’s interpretation of SLUSA would undermine the purpose of SLUSA since the Court in Blue Chip declined to grant non-purchasers and non-sellers standing to bring private suits under Section 10(b) and Rule 10b-5 precisely because those suits are the most likely to be unmeritorious.

The United States argues, in part, that the Second Circuit conflated the question of the conduct alleged with the question of whether there is standing. Since Dabit concedes that his is a covered class action, and that misrepresentations are being alleged, the only issue is whether the alleged misrepresentation was made “in connection with a purchase or sale.” Because Dabit alleges that the misrepresentations arose in connection with someone’s purchase or sale, it is irrelevant to the substantive scope of § 10(b) – and hence the preemptive scope of SLUSA – that Dabit did not himself purchase or sell.

In addition, the United States argues that the Second Circuit was wrong to apply a presumption in favor of non-preemption. Citing the Court’s 2000 decision in United States v. Locke, the United States contends that the “‘assumption’ of nonpre-emption is not triggered when the State regulates in an area where there has been a history of significant federal presence.” The United States challenged Dabit’s attempt to focus narrowly on the longstanding history of holding claims under state law, and instead asserted that the Court should focus on the fact that Congress is active in regulating the securities industry generally.