By an 8-0 vote, the United States Supreme Court has closed a potential "escape hatch" for plaintiff investors and attorneys seeking to maintain and litigate class action securities fraud lawsuits based on state law, rather than federal law. In Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, No. 04- 1371, 2006 WL 694137 (U.S. March 21, 2006), the Court ruled that investors may not file or maintain class action litigation predicated on state law claims that the investors were fraudulently induced to "hold" their securities. More than 30 years ago, the Supreme Court had barred similar claims in lawsuits governed by federal law.
The Supreme Court’s opinion reversed a January 2005 federal Court of Appeals decision. The Court of Appeals had ruled that plaintiff investors could avoid the exacting standards applicable to class action securities fraud lawsuits governed by federal law by alleging that investors were fraudulently induced to "hold" their securities, rather than to "purchase" or "sell" their securities. While seemingly technical in nature, this distinction was viewed by the plaintiffs’ bar as a ready means of averting the high threshold for class action lawsuits subject to federal law.
Prior to 1995, most securities fraud lawsuits were filed in federal court. Once the suits were filed, the plaintiffs and their counsel routinely used discovery at the outset of the litigation to try to unearth favorable facts, and to attempt to extract early settlements, due to the significant cost and burden of such discovery. As the Supreme Court stated in the Dabit case, Congress expressly found that securities fraud defendants were subject to "nuisance filings, targeting of deep-pocket defendants, vexatious discovery requests, and ‘manipulation by class action lawyers of the clients whom they purportedly represent.’"
To curb these abuses, Congress enacted the Private Securities Litigation Reform Act of 1995 ("PSLRA"), which, among other things, authorizes a stay of discovery pending the resolution of motions to dismiss, provides heightened pleading standards for most cases, and mandates the imposition of sanctions for frivolous litigation. In 1998, after plaintiff investors began turning to state courts to avoid the PSLRA, Congress enacted the Securities Litigation Uniform Standards Act of 1998, which provided, among other things, that investors generally cannot maintain, in either federal court or state court, most types of class action securities fraud cases based on state law, and which allege fraud "in connection with the purchase or sale" of a security.
As a result of these two statutes, plaintiff investors who sought damages related to their "purchases" or "sales" of securities were required to file their lawsuits in federal court, subject to the PSLRA’s tough standards, and a heightened prospect of dismissal before discovery could begin. At the same time, as previously mentioned, the plaintiffs could not file securities "holding" claims under federal law, because the Supreme Court has long barred such claims.
Spotting a potential loophole, some plaintiffs began filing state law securities fraud "holding" lawsuits. By doing so, the plaintiffs and their counsel sought: (i) to create an expansive new vehicle for class action litigation predicated on generalized allegations that members of a large plaintiff class would have sold their securities but for an alleged fraud (and thereby lacking the objective "purchase" or "sale" requisite for federal securities fraud litigation); and (ii) to return to the pre-1995 days when plaintiffs could file class action lawsuits subject to varying and potentially relaxed pleading standards, and could commence immediate discovery.
In the Dabit decision, an unanimous Supreme Court put an immediate end to this strategy. The Supreme Court ruled that a broad interpretation of the phrase "in connection with the purchase or sale" was warranted to prevent state law class action "holding" lawsuits. Consequently, such lawsuits may no longer be filed or maintained. Noting that "class actions brought by holders pose a special risk of vexatious litigation," the Supreme Court said that its decision was appropriate to avoid "undercut[ting] the effectiveness of the 1995 Reform Act"; to eliminate the prospect of "parallel class actions proceeding in state and federal court, with different standards governing claims asserted on identical facts;" and to promote Congress’ preference for "national standards for securities class action lawsuits involving nationally traded securities."
As stated in the Dabit opinion, "federal law, not state law, has long been the principal vehicle for asserting class-action securities fraud claims." The Supreme Court’s decision preserves that principle, helping to ensure that defendants to class action securities fraud litigation will receive the benefit of the rigorous national standards applicable to such cases.
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