Argument analysis: Ghost of Madoff hangs over state securities class actions

Allen Ferrell is the Greenfield Professor of Securities Law at Harvard Law School.

The specter of Bernie Madoff hovered over oral arguments Monday.  This was appropriate to the occasion, as the Court was preoccupied with metaphysics:  What does it mean for a misrepresentation to be “in connection with” a purchase or sale?  The question that came up repeatedly was essentially, whether the lawyers arguing on both sides “agree that Madoff committed Rule 10b-5 securities fraud when he represented that he was purchasing securities on behalf of investors when in fact he purchased nothing.”  According to at least one reading of the plaintiffs’ allegations, Stanford Investment Bank arguably acted like Madoff.  The bank falsely represented to investors that they were buying an instrument (certificates of deposit) that were in some sense backed by securities — securities that did not exist (like Madoff’s securities purchases that never happened).  The answer to this question is critical because if the answer is yes – Madoff did commit Rule 10b-5 securities fraud – and, yes – the alleged facts here are analogous to the Madoff situation – then it follows that the Securities Litigation Uniform Standards Act (SLUSA) precludes the state actions. Recall that SLUSA uses the same “in connection with” language that Section 10b does.

To be sure, there were some counters to the Madoff trap set for the plaintiffs (respondents at the Court) (besides the unpalatable argument that Madoff did not commit Rule 10b-5 securities fraud).  To this end, the plaintiffs proposed several distinctions: (1) Stanford Investment Bank did not represent that the certificates of deposit were backed in some sense by the securities it claimed it had (in part, because the certificates of deposit promised a fixed return rather than a return contingent on the value of the securities); (2) Stanford Investment Bank was not a broker-dealer but a bank; (3) the misrepresentation does not have a negative effect on public confidence in the markets in the way that Madoff-type fraud does; and (4) there was no purchase (or promised/represented purchase) by the plaintiffs of a “covered security” – they purchased a certificate of deposit, which everyone agrees is not a “covered security.”  Whether these distinctions are sufficient to distinguish this case from the Madoff situation is the question.

The fourth distinction seemed to garner the most interest from the Justices. The defendants (the petitioners before the Court) attempt to counter this distinction by arguing that in effect the plaintiffs, by virtue of Stanford International Bank’s misrepresentation, thought they were buying exposure (or perhaps even an interest) in the covered securities – and in this way one is led back to the merits of the first distinction.  Justice Scalia went even beyond this fourth distinction, suggesting that there must be an actual purchase or sale (not just a representation of a purchase that is in reality nonexistent) for the “in connection with” a purchase or sale language to be satisfied.  After all, Justice Scalia asked rhetorically, does the statute say “promised purchase”?  But this position must face its own Madoff question: suppose a future Madoff promises to invest clients’ money in securities but just embezzles the money?  There is no actual purchase or sale of a security in this scenario. Does that mean there is no 10b-5 securities fraud in this situation?  And note that there would be 10b-5 securities fraud if our future Madoff did go to the bother of purchasing at least some securities (just one?).  Maybe our future Madoff should go whole hog in his fraudulent enterprise so as to make sure he doesn’t engage in any purchases or sales whatsoever.  Unlike some hypotheticals, this fraud scenario is not just a possibility but unfortunately a certainty.

But against the onslaught of the Madoff question, the defendants faced their own awkward question, albeit one without the same emotional oomph.  Suppose, the Chief Justice asked, that someone lied on a home loan application – for example, falsely stating that they own securities which will serve as collateral (or, to introduce a “purchase,” that they will purchase securities to serve as collateral).  Does this fall under the ambit of Rule 10b-5, i.e., is it “in connection with” a purchase or sale of a security? This  seemed to strike the Justices as a strained result. Has there ever been such a case?  One possible answer, not fully developed at oral argument, is “no,” but for reasons having to do with other requirements of Rule 10b-5 other than the “in connection with” language.

Immanuel Kant warned that “[m]etaphysics is a dark ocean without shores or lighthouse, strewn with many a philosophic wreck.” In all likelihood, the Court will likely avoid this fate by not taking too seriously an inquiry into what having a “connection” with a purchase or sale “really” means. One safe route the Court could well take is to issue a narrow opinion addressing this specific type of situation and then quickly moving on without lingering too long. Absent a strong, clear distinction from the Madoff scenario, the Court could well lean in favor of finding the requisite “connection.”

[Disclosure:  The law firm of Goldstein & Russell, P.C., whose attorneys contribute to this blog in various capacities, serves as counsel to the respondents in the case.  However, the author of this post is neither affiliated with the firm nor involved in the case.]