On February 26, 2014, the U.S. Supreme Court ruled in Chadbourne & Parke LLP v. Troice et al. that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) does not preclude class action lawsuits asserting state law claims in connection with the notorious Ponzi scheme perpetrated by Allen Stanford and the Stanford International Bank. The decision turns on an interpretation of the meaning of the phrase “in connection with” as used in SLUSA and other federal securities laws.

SLUSA forbids securities class actions asserting claims under state law that allege a misrepresentation or omission of a material fact “in connection with” the purchase or sale of a covered security, where “covered security” means securities traded on a national exchange.

Investors in “uncovered” securities – CDs issued by Stanford International Bank – filed class action lawsuits asserting state law claims against various parties, including insurance brokers and law firms, alleging that they assisted Stanford International Bank in conducting or concealing its Ponzi scheme. According to the plaintiffs’ allegations, an important part of the fraudulent scheme was a false representation that money deposited with the Bank would be invested in safe and liquid securities – which would include “covered securities” – when in fact only a small percentage of the funds were invested in covered securities and the remainder were diverted to other uses including repaying earlier investors, paying for Allen Stanford’s elaborate lifestyle, and making speculative real estate investments. Defendants argued that since investments in the “uncovered” CDs were procured by false assurances that the funds would be invested in covered securities, the misrepresentation was “in connection with” the purchase or sale of a covered security and thus class actions based on state law could not be maintained.

Defendants’ argument was not without support, because in prior cases the Supreme Court has interpreted the phrase “in connection with” very broadly in construing federal securities laws. For example, in SEC v. Zandford, 535 U. S. 813 (2002), the court held that a stockbroker who promised to conservatively invest customers funds in the stock market but then sold the securities and pocketed the proceeds had committed fraud “in connection with” the purchase or sale of securities. In Chadbourne, the Securities and Exchange Commission filed an amicus brief urging the Court to adopt a broad definition of “in connection with” and to find SLUSA applicable.

Nevertheless, the Supreme Court (7-2) concluded that in this case the alleged fraudulent misrepresentations were not sufficiently connected to the purchase or sale of a covered security to come within the ambit of SLUSA. In reaching this result, the Court enunciated the following rule:

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.”

As the dissent (by Justice Kennedy) points out, the requirement that there be a decision to buy or sell securities by a person other than the one accused of fraud is hard to reconcile with prior Supreme Court precedent. The Court reasoned that the facts of Zandford satisfied this test because the sales were of securities owned by the defrauded customers. However, the customer in that case did not make or direct the sales and in fact was unaware that they were occurring, and thus cannot be said to have made a decision to buy or sell securities. The rule is also hard to reconcile with United States v. O’Hagan, 521 U.

S. 642 (1997), which adopted the misappropriation theory of insider trading. In O’Hagan, the Court held  that the defendant committed fraud “in connection with” a securities transaction when he misappropriated confidential information and used it to profit from purchasing stock. It stated that “the fiduciary’s fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities… This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information.” Id., at 656. It does not appear that in O’Hagan there was a decision to purchase or sell securities by  anyone other than the one accused of fraud.

It is not surprising that on the specific facts of the Chadbourne case the Court found the connection between the fraud and the trading of covered securities to be too attenuated to invoke SLUSA. However, the language used by the Court to define “in connection with” is awkward, hard to reconcile with past precedent, and may give rise to continuing controversies over the scope and application of the phrase as it is used elsewhere in the securities laws.