Supreme Court Rules That Federal Law Pre-empts State Law Securities Fraud Class Actions By Holders

By Sheppard, Mullin, Richter & Hampton LLP
May 10, 2006

On March 21, 2006, the Supreme Court in Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71 (2006), ruled that the Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) pre-empts “covered class actions” purportedly brought under state law on behalf of persons who neither purchased or sold securities, but instead claim that they were defrauded into refraining from purchasing or selling securities. In doing so, the Supreme Court reaffirmed long-standing policy considerations underlying the application and interpretation of the federal securities laws which recognize that “litigation under Rule 10b-5 presents a danger of vexatiousness different in degree and in kind from that which accompanies litigation in general.”

SLUSA provides that “[n]o covered class action” based on state law and alleging “a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security . . . may be maintained in any State or Federal court by any private party.” The Second Circuit held that SLUSA only pre-empted state law securities fraud class action claims brought by plaintiffs who themselves purchased or sold securities. The Seventh Circuit, in contrast, held that SLUSA pre-empted all state law securities fraud class action claims, including those brought by plaintiffs who did not purchase or sell securities.

Justice Stevens, writing for a unanimous Supreme Court, agreed with the Seventh Circuit’s broader view of SLUSA pre-emption. The Court held that the Second Circuit improperly conflated the “in connection with” requirement, which is contained in SLUSA, Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, with the so-called “Birnbaum rule,” a rule first established in Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952), and later adopted by the Supreme Court in Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), limiting private rights of action under Section 10(b) and Rule 10b-5 to plaintiffs who actually purchased or sold securities. The Court’s endorsement of the Birnbaum rule, Justice Stevens wrote, was based not upon an interpretation of the “in connection with” language of the statute, but rather upon “policy considerations” necessitating safeguards to prevent abuses attendant to this judicially created private right of action. Justice Stevens reiterated those thirty-year-old “policy considerations” without reservation, noting, for example, Congress’ much more recent attempts to address the same abuses in the Private Securities Litigation Reform Act of 1995 and SLUSA. The Court explained further that Supreme Court precedents have established that the “in connection with” requirement means merely that the alleged “fraud ‘coincide’ with a securities transaction—whether by plaintiff or by someone else.”

The immediate effect of the Court’s decision in Merrill Lynch is to eliminate a small but growing number of state law class action lawsuits brought by holders of securities alleging that they were defrauded into retaining their shares. The decision, however, does not affect such lawsuits brought by fifty or fewer plaintiffs; indeed, the Supreme Court all but invited prospective plaintiffs to proceed in that manner. Finally, the decision made clear that the Birnbaum rule, while still the law of the land, rests on a somewhat ephemeral policy-based foundation, subject more to shifting political winds than statutory interpretation or jurisprudence.

For further information, please contact John Stigi at (213) 617-5589.