Opinion analysis: Scope of federal preclusion of state law actions
on Feb 28, 2014 at 12:19 pm
In the recently decided Chadbourne & Parke v. Troice decision, the Supreme Court – in an opinion by Justice Breyer – held that federal law does not preclude the state-law-based actions (filed in Louisiana and Texas) filed against those who allegedly assisted in some capacity (including insurance brokers and law firms) in the fraudulent sales of Stanford International Bank certificates of deposit. More specifically, the Court held that these actions did not allege “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security” – the relevant language that, if applicable, would result in preclusion under the Securities Litigation Uniform Standards Act of 1998.
Before delving into the Court’s analysis, two important facts are worth highlighting: (1) the certificates of deposit in question promised rates of return far in excess of those enjoyed by typical U.S. certificates of deposit; and (2) the Bank allegedly made false statements to the effect that the Bank held significant holdings of “highly marketable securities issued by stable governments [and] strong multinational companies,” holdings which supposedly made the certificates of deposit (and their promised rate of return) secure. Not surprisingly, the plaintiffs allege that these misstatements were an integral part of the fraudulent scheme, as they were important in their decision to purchase the certificates of deposit. Indeed, this last point is barely worth mentioning as the connection (a word that will loom large in my discussion in a moment) between the credibility of a promise to provide above-market rates of return and the creditworthiness of the promisor – i.e., the Bank – is obvious.
The Court rests its decision on the simple and undisputed fact that the certificates of deposit are not “covered securities.” (In sharp contrast, the highly marketable securities presumably purchased by the Bank in significant quantities would include “covered securities.”) As a result, the Bank’s misstatements were not made “in connection” with a “covered security.” Rather, the victims of the fraud were tricked into purchasing non-covered securities. Q.E.D., one might say.
Of course, one can readily grant the Court’s premise that the Bank’s misstatements were made “in connection” with the sale of the certificates of deposit and, indeed, that this is central to the plaintiffs’ theory of the case. But this by itself simply does not imply that the Bank’s misstatements were not also made “in connection” with the purchase of highly marketable securities, which are “covered securities.” Here, the Court flatly states that if the “only party who decides to buy or sell a covered security as a result of a lie is the liar, that is not a ‘connection’ that matters.” The Court repeats statements to this effect throughout the opinion. But why doesn’t this connection matter? Without a satisfactory answer, these statements are simply a legal conclusion rather than an explanation.
The Court, to be fair, attempts to provide some explanation. The Court argues that the securities laws are concerned with “transactions that lead to the taking or dissolving of ownership positions.” Here, the ownership position that is subject to federal preclusion is “covered securities” and not certificates of deposit. On a similar note, the Court states, “no person actually believed he was taking an ownership position [in covered securities].” Rather, the owner of the “covered securities” in this case was the Bank. (Elaborating on this point, the Court notes that, “[a]t most, the complaints allege misrepresentations about the Bank’s ownership of covered securities – fraudulent assurances that the Bank owned, would own, or would use the victims’ money to buy for itself shares of covered securities.)
One preliminary comment on all this is that the Court’s own test for preclusion of state-law-based actions does not actually turn on whether there was a transaction “taking or dissolving” an ownership position in a covered security. As the Court makes quite clear in the opinion (as it must), if an investor “tries” to take a position in a covered security (say, Bernie Madoff falsely represents that he purchasing IBM stock for the investor, but simply pockets the money), such an investor could not bring a state law action, because the “in connection” requirement would be satisfied. The Court’s analysis is not quite as crisp as it might appear.
More importantly, if the allure of the certificates of deposit did substantially turn on the value of the presumed holdings of highly marketable securities, why shouldn’t this count in terms of taking an “ownership position” in a covered security? To illustrate the point, suppose that the Bank’s highly marketable securities were the sole asset of a fund, with the fund issuing certificates (along with some equity) with high promised rates of return. While the owners of the certificates would not hold legal title to the covered securities, they would nevertheless be beneficial owners of much of the income generated by those securities. The owners of the certificates in this hypothetical are entitled to some portion of the cash flows generated by the covered securities, just as they would be entitled to the cash flows if they directly held title to the covered securities. Indeed, as a group the holders of the certificates and of the equity would have actually the same economic stake as direct holders of the underlying covered securities. For this reason, the Court’s distinction could potentially end up being formalistic.
A more sympathetic reading of the Court’s reasoning is that one must inevitably draw a line between state-law-based actions that are precluded and those that are not, with such a line inevitably being somewhat arbitrary. Indeed, Justice Thomas wrote a short concurring opinion to make essentially this point. And, to be sure, there is much truth in this.
The dissent by Justice Kennedy (joined by Justice Alito) focuses on the importance of the Bank’s misstatements to the investors in the Bank’s certificate of deposits. The dissent points out, quite accurately, that “the very essence of the fraud was to induce purchase of the [certificates of deposit] on the (false) promise that investors should rely on [the Bank]’s special skills and expertise in making market investments in covered securities on their behalf.” This fact, in conjunction with prior Court precedent that the “in connection” language should be given a broad construction, formed the primary basis for the dissent’s disagreement with the majority.
Disclosure: Goldstein & Russell, P.C., whose attorneys work for or contribute to this blog in various capacities, serves as counsel to the respondents in this case.