In a recent decision, the Second Circuit Court of Appeals affirmed the district court’s ruling that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”), 15 U.S.C.A. § 77bb (f), precludes the plaintiffs’ state law claims against Bernard F. Madoff’s banks based on alleged misrepresentations in connection with the purchase or sale of securities. In re Herald, Primeo, and Thema Funds Securities Litigation; Trezziova, et al. v. Kohn, et al., No 12-156, 2013 WL 5046509 (2d Cir. 2013)..

Background

The claims in this lawsuit are part of a larger consolidated class action filed in the Southern District of New York accusing several investment firms of funneling billions of dollars in investor assets to securities firm in furtherance of his fraudulent Ponzi scheme. Madoff is currently serving a 150-year federal sentence for criminal fraud. While serving as Madoff’s “principal banker,” JPMorgan allegedly knew Madoff was violating fiduciary duties and committing fraud but ignored the many “red flags.” BNY Mellon also provided banking services to Madoff and allegedly ignored evidence of the fraud to collect large fees.

In the principal case, three plaintiffs representing a class of foreign investors are suing three foreign (non-US) investment funds, called Herald, Primeo and Thema, which were open only to non-US investors. The foreign plaintiffs also asserted claims against the funds’ respective directors, administrators, custodians, investment managers, auditors, advisors, lawyers and financial intermediaries involved in the investment of plaintiffs’ money in the infamous Ponzi scheme orchestrated by Bernard L. Madoff and Bernard L. Madoff Investment Securities LLC.

Specifically, in the case decided here, two of the three plaintiffs in the consolidated action also asserted claims against JPMorgan Chase & Co., JPMorgan Chase Bank, N.A., J.P. Morgan Securities LLC, J.P. Morgan Securities Ltd. (collectively, “JPM”), and The Bank of New York Mellon (“BNY”), in their roles as bankers to Madoff Securities.

As to JPM, the complaints alleged that, as Madoff Securities’ principal banker, JPM had not only ignored “red flags” of fraud, but “had actual knowledge that [Madoff Securities] was violating its fiduciary duties and committing fraud.” Despite this knowledge, however, JPM allegedly furthered Madoff’s fraud by “funnel[ing] hundreds of millions of dollars to Madoff” and Madoff Securities. The complaint further alleged that, “instead of alerting authorities as they were required to do, . . . the JPMorgan Chase Defendants kept their mouths shut to ensure their own profits at the expense of Plaintiffs and the other members of the Class.”

As to BNY, which also provided banking services to Madoff Securities, the complaints alleged that it similarly “knew that it was providing substantial assistance to the fraud,” but, because it “was collecting such large fees . . . it ignored the evidence of fraud and failed to disclose the fraud.”

In November 2011, the district court judge granted the bank defendants’ Rule 12 (b)(6) motion to dismiss on the grounds that the claims were precluded by SLUSA. See 2011 WL 5928952 (S.D.N.Y. Nov. 29, 2011). Specifically, the district court held that the claims against the bank defendants were all under New York common law and therefore precluded by SLUSA, which compels the dismissal of such claims. On appeal, the investors argued that the district court wrongly confused their purchase of interests in the funds, which were not SLUSA-covered securities, with Madoff’s purported transactions in covered securities—in essence eliding their purchase with Madoff’s scheme. They also contended that their allegations against the two banks did not refer to or mention any SLUSA-covered securities transactions.

The Appeal

SLUSA provides: “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 a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security.” 15 U.S.C. § 78bb(f)(1)(A).

The Second Circuit began its affirmance by discussing the history of SLUSA and its relationship to the Private Securities Litigation Reform Act (PSLRA) as part of a legislative effort to properly balance the need for “transparency and stability” in the securities markets with the need to “combat abusive and extortionate securities class actions.” The court determined that SLUSA must be broadly construed to effectuate the purpose of the legislation, which is to ensure that the national securities markets are “governed by federal securities law” and that claims must be kept out of state courts because “state private securities class action lawsuits would frustrate the purpose of the law.”

Although the plaintiffs purchased interests in foreign feeder funds that all parties agreed are not within the definition of “covered security” as provided by SLUSA, the Second Circuit nevertheless found that the claims were precluded by the statute as a matter of law. The court affirmed the district court on this issue by finding that even though the direct investments were not covered by the SLUSA statute, the claims were barred because the allegations of bank misconduct arose “in connection” with the Madoff securities fraud, which did include a trading strategy involving “covered securities.” In other words, the case hinged on the precise meaning of “in connection with a covered security” and the degree of connection required between the fraud being alleged and the covered security in question. The court found that, although the plaintiffs’ interests in the funds were not themselves securities covered by SLUSA, the underlying claims against JP Morgan and BNY Mellon were based on their roles in assisting Madoff’s securities scheme, not the bank’s relationship with the investors or the investment feeder funds. SLUSA requires attention to “both the pleadings and realities underlying the claims,” and plaintiffs cannot avoid SLUSA by “consciously omitting references to securities or federal securities law.”

The court went on to find that the facts of this case show the necessary connection between Madoff’s fraud and the allegations against the banks and therefore bring it within the ambit of the SLUSA statute.

The court addressed the two specific ways that the plaintiffs tried to insulate themselves from the preclusive effects of SLUSA. First, the plaintiffs alleged that, because Madoff did not in fact execute the fraudulent trades, SLUSA could not apply. In essence, they argued that, because Madoff did not buy the promised securities, the claim against the banks could not be in connection with a covered security since no covered security was purchased. In rejecting this argument, the court, citing an Eleventh Circuit case, Instituto De Prevision Militar v. Merrill Lynch, 546 F.3d 1340, 1352 (2008), held that no actual purchase of securities is needed to support a SLUSA objection. The court also discussed the relationship between the investments in the feeder funds and the Madoff “downstream” fraud.

Ultimately the court was not persuaded by the fact that the plaintiffs in this case did not purchase any covered securities because the alleged liability of the banks in the lawsuit was predicated on their relationship to the Madoff fraud and not to any relationship between the banks and the feeder funds. Since the Madoff fraud undisputedly involved covered securities, the court held that dismissal was proper because SLUSA was applied as a factual basis of the legal claim. The court emphasized that SLUSA requires attention to both the “pleadings and realities” underlying the claims. Because the claim against the two banks was essentially that they were complicit in the Madoff fraud, the court held that the lawsuit was clearly “in connection with a covered security.”

Conclusion

The Second Circuit’s decision in this case is in conflict with similar cases in other circuits. See, e.g., Roland v. Green, 675 F.3d 503 (5th Cir. 2012). The Supreme Court granted certiorari in three consolidated cases to assess when an alleged misrepresentation is “in connection with” a securities transaction under SLUSA. The Supreme Court will address whether SLUSA precludes a state-law class action from alleging a scheme of fraud involving misrepresentations about transactions in SLUSA-covered activities. The case was argued in October 2013 and is yet to be decided by the Supreme Court.