Life after SLUSA: what is the fate of holding claims? The pre-emptive force of the 1998 legislation should not upset the long-held balance in the U.S. federal system by trumping all state actions.

• Author: Rose, Amanda M.

IN AN EFFORT to protect corporations from abusive litigation, Congress passed the Private Securities Litigation Reform Act (Reform Act or PSLRA) in 1995, which made federal securities fraud class actions harder to maintain on a variety of fronts. One unforeseen consequence of the act was an increase in the filings of securities fraud actions in state courts, where plaintiffs could avoid the new, tougher federal standards. In 1998, Congress attempted to close this loophole with the Securities Litigation Uniform Standards Act (SLUSA), which pre-empts under the federal Constitution's supremacy clause certain state law securities fraud class actions.

SLUSA's effect is now being revealed. One noticeable trend has been the rise of so-called "holding claims"--that is, claims brought by non-transacting shareholders claiming damage because corporate misrepresentations induced them to hold their stock. Because the federal courts have held that these claims fall outside SLUSA's preemptive scope, they have become an attractive alternative for plaintiffs' lawyers. Although state holding claims have the potential to undermine the goals of the 1995 Reform Act, they rightly remain within the purview of state court jurisdiction, and Congress should not wield its pre-emption power in this arena.

1995 REFORM ACT

The 1995 Private Securities Litigation Reform Act (1) was passed after intense lobbying efforts persuaded Congress to take action to curb securities fraud "strike suits," meritless suits brought by class action plaintiffs' lawyers to extort settlement and attorneys' fees. (2) The joint explanatory. statement of the conference committee stated, "The private securities litigation system is too important to the integrity of American capital markets to allow this system to be undermined by those who seek to line their own pockets by bringing abusive and meritless suits." (3)

The Reform Act responded to these perceived abuses by creating certain procedural barriers that make it more difficult to sustain securities fraud class actions in federal court. It heightened pleading standards required to state a private federal securities fraud claim, for instance, by raising the standard for pleading scienter, and it imposed a discovery stay during the pendency of a motion to dismiss, thus preventing plaintiffs from using discovery to satisfy pleading requirements. The act also created a safe harbor for forward-looking statements either accompanied by meaningful cautionary language or made without actual knowledge of their falsity.

But while the Reform Act severely curtailed the ability to maintain strike suits in federal court, it did nothing to address similar suits brought in state courts based on state blue sky laws or common law. Corporate lobbies, particularly Silicon Valley technology firms, which are especially susceptible to strike suits because of their volatile stock prices, returned to Capitol Hill. (4) They argued that plaintiffs' lawyers were evading the restrictions created by the Reform Act and undermining its purpose by filing securities fraud actions in state rather than federal court. Particularly, it was contended, parallel litigation in state courts allowed plaintiffs to circumvent the federal discovery stay and that the migration of suits to state courts all but eviscerated the Reform Act's safe harbor for forward-looking statements. (5)

Congress responded by enacting SLUSA, (6) which preempts under the supremacy clause certain state law securities fraud claims by allowing automatic removal to federal court, followed by dismissal. "By steering most securities fraud cases to the federal courts, SLUSA intended to `prevent plaintiffs from seeking to evade the protections that federal law provides against abusive litigation by filing suit in state, rather than federal, court.'" (7)

SCOPE OF SLUSA

The act itself provides only general guidance as to the precise scope of SLUSA's pre-emptive force. According to its text, it applies to all "covered class actions" based on state law claims that allege (1) a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security or (2) that the defendant used or employed any manipulative or deceptive device or other contrivance in connection with the purchase or sale of a covered security.

15 U.S.C. [section] 77p(f)(2)(A) defines a "covered class action" as:

(i) any single lawsuit in which--

(I) damages are sought on behalf of more than 50 persons or prospective class members, and questions of law or fact common to those persons or members of the prospective class, without reference to issues of individualized reliance on an alleged misstatement or omission, predominate over any questions affecting only individual persons or members; or

(II) one or more named parties seek to recover damages on a representative basis on behalf of themselves and other unnamed parties similarly situated, and questions of law or fact common to those persons or members of the prospective class predominate over any questions affecting only individual persons or members, or

(ii) any group of lawsuits filed in or pending in the same court and involving common questions of law or fact, in which--

(I) damages are sought on behalf of more than 50 persons; and

(II) the lawsuits are joined, consolidated, or otherwise proceed as a single action for any purpose.

SLUSA then excludes certain claims from its pre-emptive scope, most notably derivative suits and class actions based on a tender or exchange offer.

Because SLUSA provides for automatic removal, it is left exclusively to the federal courts, when entertaining plaintiffs' motions for remand and defendants' motions for dismissal, to decide the act's preemptive scope. These courts have interpreted SLUSA's language as imposing four conditions for pre-emption: (1) the claim is based on state law; (2) the claim concerns a covered security; (3) the underlying suit is a covered class action; and (4) the plaintiff alleges untrue, manipulative, or deceptive statements or omissions in connection with the purchase or sale of a covered security. (8)

The fourth condition--identity of the claim--presents the most challenging issues and is discussed below. The first and second are relatively straightforward and unproblematic, (9) but the third has given rise to some dispute. In Gibson v. PS Holdings Inc., for example, the plaintiff contended that his representative action did not meet SLUSA's definition of a "covered class action" because his amended complaint sought only equitable injunctive relief. Although granting remand on other grounds, the U.S. District Court for the Southern District of California rejected this argument:

Under plaintiff's theory, a class action plaintiff could file a state court complaint seeking only injunctive and declaratory relief, avoid removal, to federal court, pursue massive discovery in state court, then amend its complaint at a later date to add a prayer for compensatory damages. To avoid circumvention of the Reform Act, the structure and legislative history of the Uniform Standards Act suggest that district courts should construe the "covered class action" definition broadly to avoid giving effect to such attempts at manipulation. (10) Other courts confronted with this issue have followed the Gibson approach. (11)

By what criteria will a court evaluate a challenged claim for purposes of the fourth condition for SLUSA preemption? Because SLUSA closely tracks of the language of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, courts have looked to case law interpreting Rule 10b-5 for guidance in this area. In Burns v. Prudential Securities, the U.S. District Court for the Northern District of Ohio explained:

Because SLUSA was enacted just two years ago, there is little federal case law construing the meaning of the phrases "misrepresented or omitted material fact" and "use of manipulative or deceptive device or other contrivance." ... This language does, however, have special significance in the area of securities law. Section 10(b) of the Securities Act ... bars the use of "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of any security, a prohibition that mirrors [SLUSA]. Pursuant to [section] 10(b), the Securities and Exchange Commission promulgated Rule 10b-5, the chief private remedy for fraud. Rule 10b-5 includes a subsection that is substantially the same.... Given these resemblances, the considerable body of [section] 10(b) and Rule 10b-5 jurisprudence offers guidance in construing [SLUSA]. (12) The Burns court proceeded to evaluate the plaintiffs' complaint to determine if it alleged the requisite elements to prevail on a claim of securities fraud under Section 10(b) or Rule 10b-5, under which the plaintiff has the burden of establishing (1) a material misrepresentation or omission, (2) made with scienter, (3) on which the plaintiff reasonably relied, and (4) which proximately caused the plaintiff's injury. The plaintiff class in Burns consisted of current and former clients of Prudential Securities, a brokerage firm. The gravamen of the their complaint was that a Prudential broker "intentionally, knowingly and/or recklessly" liquidated their accounts without their approval, and that Prudential was therefore liable on state law claims of conversion, breach of contract, breach of fiduciary duty, and negligent supervision.

The court, granting the plaintiffs' motion for remand, explained that for "unauthorized trading to constitute a violation of the Securities Act, there must be specific proof that the unauthorized trading was part of a larger scheme to defraud." Because the plaintiffs had not alleged facts suggesting that the broker's conduct involved any "element of deception"--facts necessary to meet the scienter requirement of Rule 10b-5--removal under SLUSA was improper.

The outcome in Burns is...