In a significant decision favorable to defendants in securities fraud lawsuits, Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 126 S. Ct. 1503 (2006), the United States Supreme Court has unanimously decided to close a loophole that plaintiffs' lawyers have used to bring securities fraud lawsuits in state court. This loophole existed as a result of how some appellate courts had interpreted the language of the Securities Litigation Uniform Standards Act of 1998 (SLUSA).

This Update summarizes the key elements of the Supreme Court's decision.

The Securities Litigation Uniform Standards Act of 1998

SLUSA requires class action lawsuits based on alleged misrepresentations or omissions made "in connection with the purchase or sale" of a publicly traded security to be brought in federal court, where defendants enjoy the protections of the Private Securities Litigation Reform Act of 1995. Relying on a literal reading of SLUSA, some plaintiffs' lawyers have brought class action securities lawsuits in state court by filing suit on behalf of only those shareholders who relied on the alleged fraud by holding their securities instead of selling them. Based on these plaintiffs' status as "holders" of securities, rather than purchasers or sellers, their lawyers had argued that their claims are not subject to SLUSA because they are not asserting claims relating to "the purchase or sale" of a security.

Courts of Appeal Had Interpreted SLUSA Inconsistently

Prior to the Supreme Court's ruling in Dabit, the intermediate courts of appeal had reached different conclusions about whether SLUSA applies to securities claims brought on behalf of a so-called "holder" class. The Second Circuit, which heard the Dabit case before it was appealed to the Supreme Court, had embraced the argument that holder class actions are not subject to SLUSA because they do not involve claims asserted "in connection with the purchase or sale" of a security. Other circuit courts had reached the opposite conclusion.

The Supreme Court Resolved This Conflict in Dabit

In order to resolve this conflict, the Supreme Court reviewed the background and text of SLUSA, as well as the policy considerations that had motivated Congress to enact that statute.

Supreme Court Reviewed Reform Act and SLUSA. Congress passed SLUSA three years after the Reform Act. Both statutes were intended to prevent what Congress perceived as abusive practices by plaintiffs' lawyers, including "nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests, and 'manipulation by class action lawyers of the clients whom they purportedly represent.'" In order to curb these abuses, the Reform Act, among other things, requires plaintiffs to plead fraud allegations with specificity, imposes an automatic discovery stay while a motion to dismiss the complaint to test the sufficiency of the fraud allegations is pending, limits damages that can be recovered and imposes sanctions for frivolous claims.

Unintended Consequence Created Loophole. The protections created by SLUSA and the Reform Act, however, had an unintended consequence—plaintiffs' lawyers started filing state‑law class action lawsuits in order to avoid the Reform Act's limitations. In reaction to this "shift from federal to state courts," and in order to prevent plaintiffs' lawyers from using state-law class action securities lawsuits "to frustrate the objectives of the Reform Act," Congress passed SLUSA to require that all class action securities fraud claims be brought in federal court. Once again, however, SLUSA had unintended consequences. Before SLUSA, only one state-law class action asserting claims on behalf of a "holder" class had ever been filed. After SLUSA, plaintiffs' lawyers grasped upon "holder" class action claims as a novel way to attempt to avoid both SLUSA and the Reform Act.

Supreme Court's Decision in Dabit Closed Loophole. Consistent with the policies that motivated Congress to pass SLUSA in the first place, the Supreme Court has now closed this loophole. The implications of this decision are broader than its direct result—a prohibition on state-law "holder" class action lawsuits. Among other things, the Dabit decision sends the message to trial courts that SLUSA should be interpreted broadly to achieve Congress's goal that class action securities fraud lawsuits be maintained in federal court and therefore subject to the Reform Act. For corporations and their officers, directors and advisors who may someday face a securities fraud lawsuit, this is good news.

Additional Information

You can find the full text of the Supreme Court's decision at http://www.supremecourtus.gov/opinions/05pdf/04-1371.pdf. You can find discussion of other recent court decisions, laws, regulations and rule proposals of interest to public companies on our website.