Merrill Lynch v. Dabit: The Case of the Scorned Broker and the Death of the State Securities Fraud Class Action Suit

• Author: Melanie P. Goolsby
• Pages: 227-256

Merrill Lynch v. Dabit: The Case of the Scorned Broker and the Death of the State Securities Fraud Class Action Suit¹

Page 227

Melanie P. Goolsby: I wish to thank Vice Chancellor Glenn G. Morris for his invaluable assistance and guidance throughout the drafting of this casenote. I also thank my husband Drake for his patience and support.

I Introduction

In a news conference on Tuesday, April 8, 2002, New York Attorney General Eliot Spitzer announced that his office had been conducting a nine month investigation into an investment analysis conducted by Merrill Lynch analysts.² Spitzer alleged that Merrill

Lynch analysts had produced misleadingly positive assessments of stocks so that the investment banking arm of Merrill Lynch could secure fees from selling stock and advising on mergers. The New York Attorney General pointed to Merrill Lynch email messages that referred to the same stocks subject to rosy assessments as "piece[s] of junk" and "powder keg[s] as evidence to support his accusations."³ At the time of the announcement, Wall Street observers hinted that conflicts of interest and biased recommendations permeated the entire industry.⁴ Indeed, approximately one month later Spitzer announced that he had expanded the scope of his investigation to include Switzerland's UBS AG and Credit Suisse Group.⁵ Merrill Lynch quickly negotiated a $100 million settlement with Spitzer that outlined a series of reforms designed to eliminate the alleged conflicts of interest.⁶ Other Wall Street investment banks mimicked the Page 228 reforms outlined in the settlement, including Credit Suisse First Boston.

The damage, however, was already done. Shadi Dabit, a former Merrill Lynch broker, filed a class action suit against his former employer alleging breach of fiduciary duty and the covenant of fair dealing on behalf of current and former Merrill Lynch brokers.⁷ Dabit pointed to Merrill Lynch's misleading analyst reports as the cause for his and his clients' decision to hold their securities beyond the point when they would have sold had they known the truth.⁸ Rather than relying on federal securities law, Dabit anchored his claim on Oklahoma state law which, according to Dabit's interpretation, recognized a securities fraud holding claim.

Dabit's choice was shrewd given the changing legal landscape of private securities fraud class action suits. Compared to state regulation, federal securities law imposes strict jurisprudential standing requirements and heightened pleading standards.⁹

Conversely, state securities regulation is less stringent given that some states recognize securities fraud holding claims,¹⁰ which are grounded in tort theories of fraudulent inducement.¹¹

Nevertheless, the Securities Litigation Uniform Standards Act of 1998 ("SLUSA") stands as a formidable obstacle to the viability of state securities fraud claims. If a court determines that the plaintiffs' state law holding claim falls within SLUSA's Page 229 preemptive scope, the statute functions to invalidate the plaintiffs' state law claim.¹² Once the action is removed to federal court, the plaintiffs' cause of action is dismissed altogether since federal securities law does not recognize analogous holding claims. Prior to the United States Supreme Court's decision in Dabit, a split had emerged among the federal courts of appeals regarding whether SLUSA's preemptive scope reached class action suits premised on state securities fraud holding claims. The Supreme Court resolved this conflict among the federal appellate circuits in March of 2006 when it held that SLUSA preempts state securities fraud holding claims.¹³

In a time where forty-one percent of investors identify "dishonesty" as the main issue facing the securities industry¹⁴ and defrauded shareholders may expect to receive only around six percent of their claimed losses against even solvent companies,¹⁵ it is an appropriate moment to reevaluate the regulatory state of the securities markets and explore legal methods to restore investor confidence. This casenote addresses the extent to which state law holding claims fall within SLUSA's preemptive scope. Part II examines the background of the federal securities law, Congress's recent efforts to amend the original SEC Act, and the specific provisions in SLUSA. Part III of this casenote considers federal circuit decisions concerning SLUSA preemption of state law holding claims and identifies the majority and minority rules that have resulted from a split among the circuits. Finally, Part IV addresses the United States Supreme Court's opinion in Merrill Lynch v. Dabit, which recognized that SLUSA's preemptive scope reaches securities fraud holding claim class action suits. Furthermore, Part IV also examines some remaining questions surrounding SLUSA, including whether the statute should be construed as a statute of complete preemption and whether the Page 230Court's interpretation of SLUSA has any collateral impact on the SEC's enforcement authority.

II Federal and State Securities Laws and Congress's Blurring of the Lines

To appreciate the magnitude of Congress's action in passing SLUSA in 1998, it is important to understand the relationship between the federal and state regimes prior to 1998. Congress intended to supplement and reinforce state securities laws when it first enacted the 1933 and 1934 Acts. However, after recent federal legislative steps, federal and state securities laws have existed in an increasingly precarious dichotomy. This Part discusses the background regarding SLUSA preemption of state securities fraud holding claims by examining the federal securities laws and the implicit private right of action under Section 10(b) and Rule 10b-5, the various common law theories that have been used in state courts for securities fraud, and Congress's most recent legislative steps to shift the balance between federal and state securities fraud causes of action.

A Federal Securities Laws and Section 10(b)

Although the Securities and Exchange Act of 1934 does not explicitly provide a private right of action for securities fraud, Section 10(b) of the 1934 Act has been judicially interpreted to provide such a private right of action.¹⁶ The language of Section 10(b) provides that "[i]t shall be unlawful for any person . . . to use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe."¹⁷ A private right of action under Section 10(b) was judicially inferred as early as 1946.¹⁸ Given its unique Page 231 jurisprudential origin, the private right of action under Section 10(b) of the 1934 Securities Exchange Act has been appropriately described as a "judicial oak that has grown from a legislative acorn."¹⁹

Because a private right of action under the 1934 Act has been judicially inferred, the United States Supreme Court has taken steps to restrict the use of Section 10(b) as a private remedy. The Court adopted the purchaser/seller standing rule in its decision in Blue Chip Stamps v. Manor Drug Stores as a means of restricting the circumstances in which plaintiffs could use Section 10(b) as a private cause of action.²⁰ The plaintiff in Blue Chip Stamps alleged that he and the other members of the class failed to purchase shares issued by Blue Chip Stamp Co. as part of a reorganization plan due to their reliance on a false and misleading prospectus.²¹ Before the Court reached its final disposition of the case, it recited the history of the standing rule. The purchaser/seller standing rule was born of a Second Circuit opinion written by Judge Augustus Hand that reasoned since both Section 10(b) and Rule 10b-5 addressed fraud "in connection with the purchase or sale" of covered securities, the plaintiff class in a Rule 10b-5 private action was limited to actual purchasers and sellers.²²

In adopting the purchaser/seller standing rule, the Court found that such a limitation on the plaintiff class would avoid the use of Section 10(b) as a private tool for vexatious or strike suits²³ and would thus promote judicial economy.²⁴ The Court, however, was careful to explicitly state that the purchaser/seller standing requirement in regard to private rights of action was not required Page 232 by the language of Section 10(b)²⁵ and that the standing requirement in no way affected the enforcement authority of the SEC under Section 10(b) and Rule 10b-5.²⁶ The Court did note that the adoption of the standing rule would deprive otherwise deserving plaintiffs of a federal cause of action,²⁷ but stated in a footnote that the same plaintiffs were free to pursue applicable remedies for nonpurchasers and nonsellers under state law.²⁸

More recently, the Court has addressed the required nexus between the purchase...