Supreme Court rules state-law fraud class actions not barred by federal securities law because alleged scheme did not involve buying, selling ‘covered securities’

by Jim Orr

The basic purpose of the Securities Exchange Act and the Securities Act is to ensure honest securities markets and thereby promote investor confidence. For example, Section 10(b) of the Securities Exchange Act of 1934 forbids the use of “any manipulative or deceptive device or contrivance” “in connection with the purchase or sale of any security.” Securities and Exchange Commission Rule 10b–5 similarly forbids the use of any “device, scheme, or artifice to defraud” (including the making of “any untrue statement of a material fact” or any similar “omi[ssion]”) “in connection with the purchase or sale of any security.” The Supreme Court has read § 10(b) and Rule 10b–5 as providing injured persons with a private right of action to sue for damages suffered through those provisions’ violation. See, e.g., Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 730 (1975).

However, federal law also provides some protection for securities issuers (as well as the investment advisers, accountants, and brokers who help them sell financial products) from class-action lawsuits. Specifically, the Securities Litigation Uniform Standards Act of 1998 forbids the bringing of large class actions “based upon the statutory or common law of any State” in which the plaintiffs allege a misrepresentation in connection with “the purchase or sale of a covered security.”

In Chadbourne & Parke LLP v. Troice, — S.Ct. —-, 2014 WL 714697 (U.S. February 26, 2014) four groups of investors alleged that Allen Stanford and several of his companies ran a multibillion dollar Ponzi scheme. Essentially, Stanford and his companies sold the plaintiffs certificates of deposit in Stanford International Bank. The plaintiffs were private investors who bought the Bank’s certificates of deposit. The certificates were debt assets that promised a fixed rate of return. The plaintiff investors expected that Stanford International Bank would use the money it received to buy highly lucrative assets. But instead, Stanford and his associates used the money provided by new investors to repay old investors, to finance an elaborate lifestyle, and to finance speculative real estate ventures. The investors filed civil class actions under state law, contending that the defendants helped Allen Stanford and his companies perpetrate the Ponzi scheme by falsely representing that “uncovered securities” (the certificates of deposit in Stanford International Bank) that plaintiffs were purchasing were backed by “covered securities.”

The defendants in each of the cases moved to dismiss the complaints. The defendants argued that the class actions were precluded by the Securities Litigation Uniform Standards Act of 1998 (the “Litigation Act”). The Litigation Act forbids the bringing of large securities class actions based upon violations of state law. It says that plaintiffs may not maintain a class action “based upon the statutory or common law of any State” in which the plaintiffs allege “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”

The Litigation Act defines “covered security” narrowly. It is a security that “satisfies the standards for a covered security specified in paragraph (1) or (2) of section 18(b) of the Securities Act of 1933.” § 78bb(f)(5)(E). And the relevant paragraphs of § 18(b) of the 1933 Act define a “covered security” as “[a security] listed, or authorized for listing, on a national securities exchange,” § 77r(b)(1) (or, though not relevant here, as a security issued by an “investment company,” § 77r(b)(2)). The Litigation Act also specifies that a “covered security” must be listed or authorized for listing on a national exchange “at the time during which it is alleged that the misrepresentation, omission, or manipulative or deceptive conduct occurred.” § 78bb(f)(5)(E).

The District Court recognized that the certificates of deposit themselves were not “covered securities” under the Litigation Act because they were not “‘traded nationally [or] listed on a regulated national exchange.” The District Court nonetheless granted the motions to dismiss. Because the lawsuits alleged that the fraud included misrepresentations that the Bank maintained significant holdings in “ ‘highly marketable securities issued by stable governments [and] strong multinational companies,’ and that the Bank’s ownership of these “covered” securities made investments in the uncovered certificates more secure, the court concluded that this circumstance provided the requisite statutory “connection” between the plaintiffs’ state-law fraud claims, and “transactions in covered securities.” Accordingly, the District Court dismissed the class actions under the Litigation Act.

All four sets of plaintiffs appealed and the Fifth Circuit reversed. The Fifth Circuit court held that the alleged falsehoods about the Bank’s holdings in covered securities were too tangentially related to the crux of the fraud to trigger the Litigation Act. Defendants in the four class actions sought review by the Supreme Court. After agreeing to hear the case, the Supreme Court has affirmed the Fifth Circuit and reinstated the class actions. Chadbourne, 2014 WL 714697.

The issue for the Supreme Court was to determine the scope of the Litigation Act’s phrase “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” If this phrase applied to the plaintiff’s asserted class actions, the Litigation Act precludes the claims and they must be dismissed. If the phrase did not apply, the plaintiffs could pursue their state-law-based class actions.

The plaintiffs did not allege they purchased or sold “covered” securities. Rather, the plaintiffs alleged they purchased “uncovered” securities (certificates of deposit that are not traded on any national exchange). Although plaintiffs alleged the defendants falsely stated the uncovered securities were backed by covered securities, the plaintiffs did not allege that the defendants’ misrepresentations led anyone to buy or to sell (or to maintain positions in) covered securities. The Supreme Court held that, under these circumstances, the Litigation Act does not apply. Thus, the class actions are not barred and the plaintiffs may purse their state-law claims.

The Supreme Court held that a fraudulent misrepresentation is not made “in connection with” such a “purchase or sale of a covered security” unless it is material to a decision by one or more individuals (other than the fraudster) to buy or to sell a “covered security.” The Court reached this interpretation of the Litigation Act for several reasons. First, the Litigation Act focuses upon transactions in covered securities, not upon transactions in uncovered securities. An interpretation that insists upon a material connection with a transaction in a covered security is thus consistent with the Litigation Act’s basic focus.

Second, the Litigation Act requires the dismissal of a state-law-based class action where a private party alleges a “misrepresentation” “in connection with the purchase or sale of a covered security.” According to the Supreme Court, the phrase “material fact in connection with the purchase or sale” suggests a connection that matters:

And for present purposes, a connection matters where the misrepresentation makes a significant difference to someone’s decision to purchase or to sell a covered security, not to purchase or to sell an uncovered security, something about which the Act expresses no concern.

Id. Further, the Supreme Court noted that the “someone” making that decision to purchase or sell must be a party other than the fraudster. 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.

Third, prior case law supported the Court’s interpretation. Every prior securities case in which the Supreme Court has found a fraud to be “in connection with” a purchase or sale of a security has involved a victim who took, tried to take, or maintained an ownership position in the statutorily relevant securities through “purchases” or “sales” induced by the fraud.

Fourth, the Court felt its interpretation of the Litigation Act was consistent with the underlying regulatory statutes, the Securities Exchange Act of 1934 and the Securities Act of 1933:

The regulatory statutes refer to persons engaged in securities transactions that lead to the taking or dissolving of ownership positions. And they make it illegal to deceive a person when he or she is doing so.


Fifth, the Supreme Court determined that to interpret the necessary statutory “connection” as broadly as suggested by the defendants would interfere with state efforts to provide remedies for victims of ordinary state-law frauds. For example, a broader interpretation would allow the Litigation Act to cover, and thereby to prohibit, a lawsuit brought by creditors of a small business that falsely represented it was creditworthy, in part because it owns or intends to own exchange-traded stock. Similarly, it could prohibit a lawsuit brought by homeowners against a mortgage broker for lying about the interest rates on their mortgages—if, say, the broker (not the homeowners) later sold the mortgages to a bank which then securitized them in a pool and sold off pieces as “covered securities.”

The Court also emphasized that its interpretation would not curtail the SEC’s enforcement powers. Indeed, the term “security” under § 10(b) covers a wide range of financial products beyond those traded on national exchanges, including the Bank’s certificates of deposit at issue in these cases. Thus, frauds like the one at issue will continue to be within the reach of federal regulation because the authority of the SEC and Department of Justice extends to all “securities,” not just to those traded on national exchanges.

Heygood, Orr & Pearson fighting for victims of fraud

The attorneys at Heygood, Orr & Pearson have represented numerous plaintiffs in consumer fraud and consumer class action lawsuits. For example, we have represented individuals who allege they were misled by claims made by Samsung regarding the memory capacity of its Galaxy S4 phone and dozens of consumers who claim they were defrauded into investing in life settlements. In that case, we are challenging Samsung’s attempts to force the case into arbitration based on an arbitration provision buried in a user manual and a health, safety and warranty guide. The issue is likely to be decided by the Federal Ninth Circuit Court of Appeals.

Our law firm has represented clients across the country in class action lawsuits against multimillion dollar companies, making sure that when consumers are hurt by corporate wrongdoing, the companies that do so are held accountable for their actions. Heygood, Orr & Pearson is AV-rated, the highest rating available from Martindale-Hubble, the top law firm rating service. Our partners Michael Heygood, Jim Orr, and Eric Pearson are all Board Certified in Personal Injury Trial Law by the Texas Board of Legal Specialization and have all been voted by their peers as “Super Lawyers” in the state of Texas for several consecutive years.*

Heygood, Orr & Pearson are also very comfortable and experienced with the complex and challenging world of multidistrict litigation. As one example, Michael Heygood and other lawyers at Heygood, Orr & Pearson were designated “Lead Plaintiffs’ Counsel” last year by the federal court that presided over numerous wrongful death lawsuits regarding the Watson fentanyl patch that were consolidated for pretrial purposes in MDL No. 2372 — In re: Watson Fentanyl Patch Products Liability Litigation, before the United States District Court for the Northern District of Illinois.

If you have been a victim of false or misleading business practices, contact the law firm of Heygood, Orr & Pearson for a free consultation so we can help you determine the best way to protect your legal rights and interests. You can reach us by calling our toll-free hotline at 1-877-446-9001, or by following the link to our free case evaluation form located on this site.


Michael Heygood, James Craig Orr, Jr. and Eric Pearson were selected to the Super Lawyers List, a Thomson Reuters publication, for the years 2003 through 2014.

by Jim Orr

Jim Orr is a licensed attorney and a partner at HO&P focusing on business and personal injury litigation. Jim was selected multiple times to the Super Lawyers List and has tried 70+ cases to verdict.