Last week, the U.S. Supreme Court decided Chadbourne & Parke LLP v. Samuel Troice, 571 U.S. ____ (2014), and allowed state law class actions to proceed against alleged aiders and abettors of Robert Allen Stanford’s massive $7 billion Ponzi scheme. At the same time, according to dissenter Justice Kennedy, the Supreme Court may have limited the enforcement powers of the SEC to combat frauds that touch the U.S. securities markets.

Case Background

In Chadbourne, victims of Stanford’s Ponzi scheme brought state law class actions against third parties who allegedly aided and abetted the scheme. The victims purchased certificates of deposit issued by Stanford’s foreign bank that were purportedly backed by a portfolio of investments, including securities traded on U.S. exchanges. Instead, the money was used to repay old investors, and to finance extravagant lifestyles and speculative real estate deals. The third party defendants moved to dismiss the state law class actions as barred by the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”). Specifically, at issue before the Supreme Court was the reach of SLUSA’s “Preclusion Provision,” which bars state law class actions alleging fraud “in connection with” the purchase or sale of securities traded on a U.S. exchange or issued by a registered investment company (“Covered Securities”).

The Supreme Court Requires "A Connection That Matters"

The Supreme Court found that the state law class actions brought by Stanford’s victims were not barred by SLUSA’s Preclusion Provision because Stanford’s victims did not purchase or sell – or even believe that they were purchasing or selling – ownership interests in Covered Securities. The fact that Stanford’s victims were falsely told that certificates of deposit were backed by the bank’s investments, which included Covered Securities, was not sufficient:

The question before us concerns the scope of [SLUSA’s] phrase “misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” ... Does it extend further than misrepresentations that are material to the purchase or sale of a covered security? In our view, the scope of this language does not extend further... A fraudulent misrepresentation or omission 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.” Slip Opinion at 8.

To satisfy the “in connection with” requirement, the Court held that the connection must be “a connection that matters. And for present purposes [one that] makes a significant difference to someone’s decision to purchase or to sell a covered security....” Id. at 9. The Court further held that “the ‘someone’ making that decision to purchase or sell must be a party other than the fraudster.” Id. Previously, the Court had held that the alleged fraud must merely “touch” or “coincide” with the purchase or sale of a covered security to satisfy the “in connection with” requirement. See Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006); SEC v. Zandford, 535 U.S. 813 (2002). Although the Court did not overrule these important precedents, the Chadbourne decision provides new guidance which arguably narrows the scope of the “in connection with” requirement.

The SEC's Interest

The SEC had an important stake in the Supreme Court’s interpretation of SLUSA’s “in connection with” language because the same language is used in §10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) to define the reach of that Act and, consequently, the SEC’s enforcement power thereunder. The SEC contributed to an amicus curie brief filed by the U.S. Government arguing that a narrow interpretation of SLUSA’s “in connection with” language could hamper its ability to police the U.S. securities markets. The SEC argued that because Stanford’s misrepresentations were about his bank’s own trading and meant to induce victims to believe their certificates of deposit were safe and secure, this should be enough to satisfy the “in connection with” requirement. The Supreme Court majority, however, rejected this argument, adopted a test requiring a “connection that matters” or one that “makes a significant difference,” and found that connection missing in the case at bar.

The SEC also argued that Stanford’s scheme satisfied the “in connection with” requirement despite the fact that neither the defrauded investors nor Stanford actually purchased or sold any ownership interest in any Covered Security. The SEC noted that it had historically prosecuted similar cases under the Exchange Act where fraudsters obtained money by false promises to invest in Covered Securities, but then purchased something else or nothing at all. The Supreme Court majority, however, held that a connection between a misrepresentation and a purchase or sale “matters” only if it is “material to a decision by one or more individuals (other than the fraudster) to buy or to sell....” Slip Opinion at 8 (emphasis added). The majority distinguished and thus preserved the SEC’s ability to go after fraudsters that promise to purchase Covered Securities on behalf of defrauded investors, indicating that the “in connection with” requirement would be satisfied where investors try to obtain an ownership interest in a Covered Security, as opposed to Stanford’s Ponzi scheme, where the investors never believed they would hold any ownership interest in any Covered Security.

The Impact of the Chadbourne Decision

While the majority went to great pains to demonstrate that its decision would not limit the SEC’s enforcement powers, Justice Kennedy expressed a different opinion in his dissent:

[T]oday’s decision, to a serious degree, narrows and constricts essential protection for our national securities markets, protection vital for their strength and integrity. The result will be a lessened confidence in the market, a force for instability that should otherwise be countered by the proper interpretation of federal securities laws and regulations. Dissent at 3.

The SEC clearly would have preferred a broader interpretation of the “in connection with” requirement. However, if the Supreme Court would have agreed with the SEC’s position, Stanford’s victims would have faced dismissal of their state law claims pursuant to the Preclusion Provision of SLUSA, and no possibility of relief under the federal securities laws against alleged Stanford aiders and abettors. The full impact of the ruling, and whether or to what extent Justice Kennedy’s concerns are realized, remains to be seen.

For More Information

The Supreme Court decision may be read in its entirety here: http://www.supremecourt.gov/opinions/13pdf/12-79_h3ci.pdf.