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(Article from Securities Law Alert, April 2015)

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In its April 23, 2015 decision, the Second Circuit addressed “the scope of the Securities Litigation Uniform Standards Act of 1998 (‘SLUSA’), . . . which bars the maintenance of certain state-law-based class actions alleging falsity in connection with transactions in . . . ‘covered securities.’” In re Kingate Mgmt. Ltd. Litig., 2015 WL 1839874 (2d Cir. 2015) (Leval, J.). The Second Circuit determined that “SLUSA requires courts . . . to inquire whether an allegation is of [fraudulent] conduct by the defendant, or by a third party.” The court held that “claims of false conduct in which the defendant is not alleged to have had any complicity are not” “subject to SLUSA’s prohibition”(emphasis in the original). The Second Circuit also held that “[i]f the allegation [of fraudulent conduct by the defendant] is extraneous to the complaint’s theory of liability, it cannot be the basis for SLUSA preclusion.”

Background

Plaintiffs brought suit in the Southern District of New York alleging a multitude of state law-based claims against various defendants affiliated with Kingate Global Fund and Kingate Euro Fund (the “Funds”), two “feeder funds” for Bernard L. Madoff Investment Securities. In March 2011, the Southern District of New York dismissed plaintiffs’ claims on SLUSA grounds. The court “concluded that because some allegations in the complaint involved material misstatements in connection with the purchase or sale of a covered security, the [c]omplaint should be dismissed in its entirety.” Plaintiffs appealed.

Second Circuit Finds Plaintiffs’ Claims Satisfy SLUSA’s “in Connection with” Requirement

The Second Circuit began its analysis by determining whether plaintiffs’ claims satisfied “SLUSA’s requirement that the false conduct be ‘in connection with’ a transaction in ‘covered securities.’” The court explained that in In re Herald, 753 F.3d 110 (2d Cir. 2014), it had previously interpreted the Supreme Court’s decision in Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058 (2014),[1] to find that SLUSA precluded claims brought by plaintiffs who had invested in offshore funds based on the expectation that the funds would then invest the proceeds in S&P 100 stocks. The Herald court distinguished Troice because there, plaintiffs “were not seeking, directly or indirectly, to purchase covered securities.” Herald, 753 F.3d 110. The Herald plaintiffs, however, had made “attempted investments in covered securities, albeit through feeder funds.”

The Second Circuit found that the Kingate plaintiffs, “like the Herald plaintiffs, [had] purchased the uncovered shares of the offshore Funds, expecting that the Funds were investing the proceeds in S&P 100 stocks, which are covered securities.” Kingate, 2015 WL 1839874. The court therefore determined that SLUSA’s “in connection with” requirement was met.

Second Circuit Holds SLUSA Preclusion Applies Only to Claims Alleging False Conduct by the Defendant

The Second Circuit then considered “the meaning of SLUSA’s ambiguous use of the word ‘alleging’” insofar as SLUSA precludes covered class actions “alleging . . . [false conduct] in connection with the purchase or sale of a covered security.” The court found that “the history and the purposes of this provision all favor interpreting it to apply to state law claims predicated on conduct by the defendant that is specified in SLUSA’s operative provisions referencing the anti-falsity proscriptions of the 1933 and 1934 Acts” (emphasis in the original). The court  reasoned that “[s]uch allegations would be subject to the [Private Securities Litigation Reform Act (‘PSLRA’)] if pleaded as a private securities claim,” and therefore “[c]ouching [those claims] as state law claims would escape the PSLRA’s limitations.” The Second Circuit explained that “[i]nterpreting SLUSA to apply” “whenever a falsity in connection with a transaction in a covered security is a necessary predicate of the plaintiffs’ claim, even where the falsity is not chargeable to the defendant and the claim could not have been brought under the federal securities laws . . . would bar state law claims in a manner unrelated to SLUSA’s purposes.” 

The Second Circuit clarified that there were “two caveats and a limitation” to its holding that SLUSA only precludes claims alleging fraudulent conduct by the defendant in connection with transactions in covered securities. First, the court found that plaintiffs cannot “evade SLUSA by camouflaging allegations that satisfy this standard in the guise of allegations that do not.” The court explained that “[w]hen the success of a class action claim depends on a showing that the defendant committed false conduct conforming to SLUSA’s specifications, the claim will be subject to SLUSA, notwithstanding that the claim asserts liability on the part of the defendant under a state law theory that does not include false conduct as an essential element – such as breach of a contractual right to fair dealing” (emphasis in the original). The court further stated that  “if the success of a claim depends on conduct specified in SLUSA, and the defendant was complicit in that conduct, the claim is covered by SLUSA even though plaintiffs     . . . artfully avoided using SLUSA’s terms.”

Second, the court ruled that “SLUSA may apply even though there is no private claim . . . for that violation under the 1933 and 1934 Acts.” The court reasoned that while SLUSA “requires an allegation of conduct prohibited by the anti-falsity provisions of the 1933 and 1934 Acts that are referenced in SLUSA,” the statute “does not require an allegation of conduct for which the 1933 and 1934 Acts authorize a private right of action” (emphasis in the original).

Finally, the court recognized that certain “[s]tate law fraud prohibitions . . . are not defined in a manner that refers explicitly to securities transactions, much less to transactions in ‘covered’ securities.” The Second Circuit held that “where a state law class-action claim charges the defendant with liability based on conduct violative of the anti-falsity provisions of the 1933 and 1934 Acts as referenced in SLUSA but does not allege the supplemental status-based elements specified in SLUSA, such as the ‘covered’ status of the relevant security, the court may nonetheless ascertain those facts independently of [ ] plaintiffs’ allegations and apply SLUSA when those facts are present.”

Second Circuit Rules “Peripheral” Allegations of False Conduct Cannot Serve as the Basis for SLUSA Preclusion

The Second Circuit also considered whether “the falsity of the conduct alleged in the complaint” must “be essential to the state law theory of liability” in order for SLUSA preclusion to apply. The court recognized that under “the broadest of interpretations, [the term] ‘alleging’ could mean that SLUSA applies to any claim that includes any reference whatsoever to the false conduct specified in SLUSA, even if the false conduct is completely irrelevant to the state law theory of [ ] defendants’ liability.”

Rejecting this approach, the Second Circuit held that an allegation of fraud “cannot be the basis for SLUSA preclusion” if it is “extraneous to the complaint’s theory of liability.” The court explained that “[a]ny factual assertion in a complaint can be considered an ‘allegation,’ regardless of whether the asserted fact pertains in any way to the defendant or has any role in establishing the defendants’ liability.” Because “[c]omplaints are drafted not only to comply with the legal requirements for setting forth an actionable claim, but also at times for public relations purposes,” they may “include assertions intended for the eyes of the press” that are “unrelated to the legal theory of the complaint.” The Second Circuit therefore found that “SLUSA requires courts to inquire whether [an] allegation is necessary to or extraneous to liability under the state law claims” before determining whether that allegation can serve as the basis for SLUSA preclusion.

Second Circuit Holds Dismissal of the Entire Action Is Not Warranted If SLUSA Precludes Some (But Not All) of Plaintiffs’ Claims

The Second Circuit determined that the district court had erred in dismissing plaintiffs’ entire action after finding that SLUSA precluded some (but not all) of plaintiffs’ claims. The court explained that “[t]he district court was required to conduct [its SLUSA] analysis on a claim-by-claim basis.”

The court found that under longstanding Second Circuit precedent, “only the claims covered by SLUSA’s terms should [have] be[en] dismissed” (citing Dabit v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 395 F.3d 25 (2d Cir. 2005), rev’d on other grounds by Dabit, 547 U.S. 71)). The court stated that this position is “clearly correct” because “SLUSA does not say that a class action containing a claim that falls within the statute’s terms ‘must be dismissed.’” Rather, SLUSA “asserts the very different command – that no covered class action based on the law of any state and including the necessary allegations ‘may be maintained in any State or Federal court by any private party’” (emphasis added by the court). The Second Circuit observed that “[i]f the court dismisses the claims that come within SLUSA’s terms and allows the other claims to proceed,” then “the surviving action which is ‘maintained’ does not include allegations precluded by SLUSA.”

The Second Circuit vacated the district court’s decision, and remanded the action for further proceedings consistent with its opinion.