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Second Circuit Parses Preclusion

April 29, 2015

Last week, Second Circuit Judge Pierre N. Leval, writing for a three-judge panel, resolved at least some of the questions concerning the preclusive reach of the Securities Litigation Uniform Standards Act (“SLUSA”). SLUSA was adopted in order to close what some perceived to be a loophole in the federal securities laws. It precludes state‐law‐based class actions brought on behalf of at least 50 persons and that allege conduct referencing the anti‐falsity provisions of the Securities Act of 1933 or the Securities Exchange Act of 1934. Although the basic premise of SLUSA is clear, its outer limits are not, and the Second Circuit, in In re Kingate Management Limited Litigation, addressed those limits.

In that case, investogavelrs in two British Virgin Island mutual funds filed a class action suit against the officers, directors, and managers of the funds, as well as the funds’ auditors, a consultant, and the funds’ administrator, for alleged breaches of contract and fiduciary duty, negligence, and fraud. The funds were feeder funds for Bernard L. Madoff Investment Securities LLC. They lost the vast majority of their assets when the Madoff Ponzi scheme was exposed. According to the complaint, defendants undertook obligations to evaluate and monitor Madoff and to audit the funds’ financial statements. Defendants, however, failed to do so and thereby caused the investors’ losses.

The district court concluded that because some of plaintiffs’ allegations involved material misstatements in connection with the purchase or sale of a covered security, the complaint should be dismissed in its entirety. But the Second Circuit disagreed noting that when applying SLUSA, a court must first inquire whether an allegation is of conduct by the defendant, or by a third party. Only claims stemming from the falsity-based conduct of the defendant is subject to SLUSA preclusion.

For example, if plaintiffs of a stockbroker hired an accountant to audit their accounts and the accountant did so negligently, failing to uncover the stockbroker’s fraud in handling the accounts, plaintiffs’ negligence based lawsuit would fall outside of SLUSA’s reach. The accountant isn’t alleged to have engaged in fraud and the federal securities laws are not involved.

SLUSA also requires courts to inquire whether the allegation is necessary to or extraneous to liability under the state law claims. If the allegation is extraneous to the complaint’s theory of liability, it cannot be the basis for SLUSA preclusion.

In announcing this standard, the Court noted two caveats and a limitation. First, plaintiffs cannot evade SLUSA by camouflaging their allegations. If the success of a class action claim depends on a showing that the defendant committed false conduct conforming to SLUSA’s specifications, the claim will be subject to SLUSA, even if the plaintiff is asserting liability under a state law theory.

Second, SLUSA may apply even if no private right of action exists for the underlying violation of the Securities Act or the Securities Exchange Act.

The limitation on the Second Circuit’s standard concerns how the plaintiff drafts the complaint. SLUSA will apply even if the complaint does not allege a “covered security,” that is, a security listed on a national exchange or issued by a registered investment company. Where a state law class‐action claim charges the defendant with liability based on conduct violative of the anti‐falsity provisions of the Securities Act or the Securities Exchange Act, SLUSA may apply.

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