Showdown Over SLUSA: An Update
By J. Christian Word & Gregory A. Harris

On March 21, 2006, less than a year after its groundbreaking loss causation decision in Dura Pharmaceuticals v. Broudo,¹ the Supreme Court ruled in the Dabit case,² resolving a split between the Second and Seventh Circuits over the scope of the Securities Litigation Uniform Standards Act (“SLUSA”).³ At issue in Dabit was whether SLUSA preemption applies to so-called “holders” claims, brought by those whose purported injury stems from their decision to retain—rather than to buy or sell—their allegedly overvalued securities.⁴

The Supreme Court’s unanimous ruling in Dabit is noteworthy in two respects. First, it closes a loophole through which plaintiffs’ counsel attempted to undermine the uniformity imposed by Congress via the Private Securities Litigation Reform Act (“PSLRA”)⁵ and SLUSA. Second, it represents a clear victory for the Seventh Circuit’s Judge Easterbrook, whose spirited opinion in Kircher v. Putnam Funds Trust (“Putnam Funds II”)⁶ sharply criticized the Second Circuit’s interpretation of the Supreme Court’s landmark decision in Blue Chip Stamps, which limited private 10b-5 actions to situations in which the plaintiffs were fraudulently induced to purchase or sell securities.⁷

Interestingly, the Dabit ruling resolves only one of the two SLUSA related splits between the Second and Seventh Circuits. As discussed in our first article on this topic, Judge Easterbrook’s decisions in the Putnam Funds litigation opened a “double split.”⁸ While Dabit answered the question of whether SLUSA preempts state law claims in cases where the plaintiff neither purchased nor sold covered securities, it does not resolve the second dispute: whether a district court’s decision to remand an action removed to federal court under the auspices of SLUSA is appealable. The Supreme Court will consider this second issue in a separate matter, scheduled for oral argument on April 24, 2006.9

Background of the Second Circuit’s Dabit Decision

Respondent Shadi Dabit, a former Merrill Lynch broker, filed the underlying class action in the United States District Court for the Western District of Oklahoma on behalf of himself and all other former or current brokers who, while employed by Merrill Lynch, purchased certain stocks for themselves and for their clients between December 1, 1999, and December 31, 2000. Dabit alleged that Merrill Lynch manipulated the prices of these stocks by disseminating misleading research, and that, as a result, the class members were induced to retain the allegedly overvalued securities. As explained by the Court:

Dabit’s theory was that Merrill Lynch used its misinformed brokers to enhance the prices of its investment banking clients’ stocks: The research analysts, under management’s direction, allegedly issued overly optimistic appraisals of the stocks’ value; the brokers allegedly relied on the analysts’ reports in advising their investor clients and in deciding whether or not to sell their own holdings; and the clients and brokers both continued to hold their stocks long beyond the point when, had the truth been known, they would have sold.¹⁰

Rather than rely on the federal securities laws, Dabit invoked the district court’s diversity jurisdiction and advanced his claims under Oklahoma state law. Merrill Lynch moved successfully to dismiss Dabit’s claim on the grounds that SLUSA preempts state-law claims alleging “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.”

After his initial complaint was dismissed, Dabit filed an amended complaint that omitted all references to purchases. Thus, the plaintiff class was transformed into a group of “holders” who “owned and continued to own” the securities in question. Dabit then argued that such a class, asserting nothing more than “holders” claims, was not subject to SLUSA preemption because the statute specifically referenced claims made “in connection with the purchase or sale of a covered security.” The district court disagreed, granting Merrill Lynch’s renewed motion to dismiss.

Dabit appealed to the Second Circuit, which ultimately vacated the district court’s judgment, finding that the claims asserted by “holders” do not allege fraud “in connection with the purchase or sale” of securities, and thus fall outside SLUSA’s ambit.¹¹ The Second Circuit acknowledged, but ultimately rejected, Merrill Lynch’s argument—bolstered by an SEC amicus brief—that the phrase “in connection with the purchase or sale” has been interpreted broadly in other contexts, and that Congress’ intent in enacting SLUSA was to impose a uniform, rigorous standard on all private securities class actions. In support of its reasoning, the Second Circuit pointed to the Supreme Court’s 1975 Blue Chip Stamps v. Manor Drug Stores decision, which limited private 10b-5 actions to buyers and sellers. As the Second Circuit reasoned, if “holders” were not entitled to bring actions under Rule 10b-5 because they were not injured “in connection with a purchase or sale,” holders also should be excluded from SLUSA, which used the same “in connection with” language. Congress “borrow[ed] language with a settled judicial interpretation in the context of private damages actions, and such borrowing implicates the strong presumption that Congress is aware of and approves that construction.”¹²

Merrill Lynch successfully petitioned the Supreme Court for a writ of certiorari.

The Seventh Circuit’s Putnam Funds II Decision Challenges the Second Circuit

While Merrill Lynch’s petition was pending, the Seventh Circuit’s Judge Easterbrook issued his Putnam Funds II decision, which directly challenged the Second Circuit’s reasoning in Dabit. Specifically, Judge Easterbrook argued that the Second Circuit had both misinterpreted Blue Chip Stamps and ignored a trio of subsequent Supreme Court decisions indicating that Blue Chip Stamps did not truncate the overall scope of Section 10(b) and Rule 10b-5.¹³

Under Judge Easterbrook’s interpretation, Blue Chip Stamps simply represents a judicial constraint on a judicially- created right of action (the right of private parties, as opposed to government entities, to bring Rule 10b-5 claims). Judge Easterbrook pointed to language in Blue Chip Stamps indicating that the Supreme Court desired to confine such private actions to situations where litigation was apt to do more good than harm, noting the Justices’ observation that “anyone can say that a failure to trade bore some relation to what the issuer did (or didn’t) disclose, but that judges and juries would have an exceedingly hard time knowing whether a given counterfactual claim (‘I would have traded, if only ...’) was honest.”¹⁴ Thus, in Judge Easterbrook’s formulation, Blue Chip Stamps represented the Supreme Court’s decision to limit private securities actions to harms arising out of actual trading (which narrows the affected class and simplifies proof), while leaving other securities offenses—including “holders” claims—to public prosecutors.

The Supreme Court Favors the Seventh Circuit— and Uniformity

The Supreme Court’s Dabit decision represents a complete vindication of Judge Easterbrook’s reasoning. Justice Stevens clarified that Blue Chip Stamps was not an attempt to define the phrase “in connection with the purchase or sale,” but rather a more limited holding that private litigants in federal securities actions lack standing to bring suit under Rule 10b-5 unless they can show that they engaged in a transaction as a result of the alleged misrepresentation. The Dabit decision endorses a liberal reading of the actual “in connection with” language, noting the Court generally has “espoused a broad interpretation” of the phrase.¹⁵ “The requisite showing ... is deception in connection with the purchase or sale of any security, not deception of an identifiable purchaser or seller.”¹⁶ Justice Stevens also noted that Congress’ intent in enacting SLUSA was to eliminate precisely the sort of “wasteful, duplicative litigation” that would result from allowing “holders” claims to proceed in state court.¹⁷ Justice Stevens underscores the importance of SLUSA with a telling fact also noted by Judge Easterbrook: prior to the PSLRA, there was “essentially no securities class action litigation in state court.”¹⁸ After the PSLRA was enacted, with its stringent pleading requirements for federal securities actions, there was a temporary decline in federal securities class actions accompanied by a corresponding increase in state court filings.¹⁹ Moreover, the vast majority of these new cases were being filed in conjunction with nearly identical federal court actions—often by the same plaintiffs’ firms. SLUSA was enacted to foreclose this transparent “endrun” around the PSLRA—a goal that would be frustrated by allowing state-law “holders” claims to go forward.²⁰

In sum, the Dabit Court’s unanimous holding significantly benefits issuers and securities litigation defendants. As an initial matter, SLUSA’s promise of national uniformity in securities class actions is advanced by the foreclosure of private “holder” claims, which had been recognized by some states, but not by others. Moreover, the Dabit decision limits plaintiffs’ ability to use state court claims—which are not subject to the PSLRA’s discovery stay—in conjunction with federal securities actions to increase the costs of defense and force settlement of even meritless suits. The Dabit decision also prevents plaintiffs from using state-law “holder” suits as a convenient means of avoiding the much-despised board demand requirements of shareholder derivative suits. Finally, and most importantly, the Dabit decision diminishes the risk of having to defend two (or more) actions arising from the same set of facts, but subject to radically different substantive and procedural requirements that could lead to inconsistent substantive rulings.

The Supreme Court’s Next Step: Resolving the Remaining SLUSA-Related Circuit Split

On April 24, 2006, the Supreme Court will hear an appeal of Judge Easterbrook’s Putnam Funds I decision,²¹ which opened the first, more limited SLUSA-related split between the Second and Seventh Circuits.

Prior to the June 2004 Putnam Funds I decision, the Second and Ninth Circuits issued a trio of cases holding that a district court’s decision to remand an action that had been removed to federal court under SLUSA was not appealable.²² These decisions relied on three Supreme Court cases interpreting 28 U.S.C.A. § 1447(d),²³ which states that “[a]n order remanding a case to the State court from which it was removed is not reviewable on appeal.” While the language in Section 1447(d) is sweeping, the Supreme Court has limited its scope to those cases remanded due either to (1) lack of subject-matter jurisdiction; or (2) irregularities with the procedure of removal. Drawing on the Supreme Court’s holdings, the Second and Ninth Circuits determined that cases removed under SLUSA and subsequently remanded due to lack of subject-matter jurisdiction fall squarely within the ambit of Section 1447(d) and its prohibition of appellate review.

In his Putnam Funds I opinion, Judge Easterbrook argued that the Second and Ninth Circuits erred in not looking beyond the “jurisdictional label” used by the district courts in their remand orders. Although these remand decisions were cast as having been based on a “lack of subject-matter jurisdiction,” Judge Easterbrook argued that this label was incorrect. More precisely, the Putnam Funds I decision holds that when a district court reviews and then remands a case removed to federal court under the auspices of SLUSA, the remand is—despite the language used by the district court—based not on a lack of subject-matter jurisdiction, but rather is a decision on the merits:

We must distinguish between a decision that ‘this court lacks adjudicatory competence’ and a decision that ‘the court has been authorized to do X and having done so should bow out.’ The former implies lack of subject-matter jurisdiction, as [prior Supreme Court decisions] explain; the latter implies the presence of jurisdiction.²⁴

Thus, Judge Easterbrook argued, the Second and Ninth Circuits failed “to recognize the difference between a case that never should have been removed and a case properly removed and remanded only when the federal job is done.”²⁵

Whether the Supreme Court will agree with Judge Easterbrook that the Second and Ninth Circuits “were mesmerized by the word ‘jurisdiction’” remains to be seen. What is clear, however, is that once again the high Court will be faced with an opportunity to further Congress’ express goal of promoting uniformity in private securities litigation. Rejection of the Putnam Funds I decision would limit the ability of securities defendants to seek redress for even a clearly erroneous district court decision to remand an action properly preempted by SLUSA. Adopting Judge Easterbrook’s reasoning, by contrast, would allow conflicting district court decisions on SLUSA to be reviewed and reconciled by the circuit courts of appeals.

Conclusion: The Road Ahead

The Supreme Court has issued two favorable securities litigation rulings in less than a year. The first, Dura, ensures a robust application of the Reform Act’s loss causation requirement, while the second, Dabit, closes a potential loophole in SLUSA’s coverage. The Putnam Funds appeal presents the possibility that the Court will strike a third blow in favor of national uniformity in securities class actions. Should the stars align in this way, the time may be ripe to seek the “holy grail” of the private securities defense bar: a uniform federal scienter pleading standard.

Notes

1. 544 U.S. 336 (2005).

2. Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. ___, 2006 WL 694137 (March 21, 2006).

3. Pub. L. No. 105-353, 112 Stat. 3227 (1998) (codifi ed in part as 15 U.S.C.A. § 77p and 15 U.S.C.A. § 78bb).

4. Section 101 of SLUSA states that:

No covered class action based upon the statutory or common law of any State or subdivision thereof may be maintained in any State or Federal Court by any private party alleging—

(1) an untrue statement or omission of a material fact in connection with the purchase or sale of a covered security; or

(2) that the defendant used or employed any manipulative or deceptive devise or contrivance in connection with the purchase or sale of a covered security.

(Emphasis added.)

5. Pub. L. No. 104-67, 109 Stat. 737 (1995) (codifi ed as amended throughout 15 U.S.C.A. §78u-4, et seq.).

6. Kircher v. Putnam Funds Trust, 403 F.3d 478 (7th Cir. 2005).

7. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

8. Gregory Harris and J. Christian Word, “Showdown Over SLUSA,” WALL STREET LAWYER, Vol. 9, No. 2, July 2005, at 11.

9. Kircher v. Putnam Funds Trust (05-409), cert. granted January 6, 2006.

10. Dabit, supra note 2, at 2.

11. Dabit v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 395 F.3d 25 (2d Cir. 2005).

12. Id. at 40.

13. See United States v. O’Hagan, 521 U.S. 642, 664 (1997); Holmes v. SIPC, 503 U.S. 258, 284 (1992); United States v. Naftalin, 441 U.S. 768, 774 n.6 (1979).

14. Putnam Funds II, supra note 6, at 483.

15. Dabit, supra note 2, at 12.

16. Id. at 13 (internal citation omitted).

17. Id. at 14.

18. Id. at 15. The Reform Act’s reach was limited to federal claims— a crucial oversight that Congress later explained by noting that “state-court class actions involving nationally traded securities were virtually unknown” at the time the statute was enacted. S. REP. NO. 105-182, at 4 (1998).

19. See H.R. CONF. REP. NO. 105-803, at 14-15 (1998), citing Joseph A. Grundfest & Michael A. Perino, Securities Litigation Reform: The First Year’s Experience: A Statistical and Legal Analysis of Class Action Securities Fraud Litigation under the Private Securities Litigation Reform Act of 1995, Stanford Law School, PLI Order No. B4-7199 (Feb. 27, 1997).

20. Congress found that securities plaintiffs sought “to evade the protections that Federal law provides against abusive litigation by fi ling suit in State, rather than Federal, court,” which “prevented [the PSLRA] from fully achieving its objectives.” Id. at 14.

21. Kircher v. Putnam Funds Trust, 373 F.3d 847 (7th Cir. 2004).

22. See United Investors Life Ins. Co. v. Waddell & Reed, Inc., 360 F.3d 960 (9th Cir. 2004); Spielman v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 332 F.3d 116 (2d Cir. 2003); Abada v. Charles Schwab & Co., 300 F.3d 1112 (9th Cir. 2002).

23. See Quackenbush v. Allstate Ins. Co., 517 U.S. 706 (1996); Things Remembered, Inc. v. Petrarca, 516 U.S. 124 (1995); Thermtron Products, Inc. v. Hermansdorfer, 423 U.S. 336 (1976).

24. Putnam Funds I, supra note 21, at 850.

25. Id. at 851.

About the Author

Christian Word (christian.word@lw.com) is a partner and Greg Harris (greg.harris@lw.com) is a senior litigation associate in Latham & Watkins’ Northern Virginia office. They specialize in securities class action litigation and professional liability defense.