High Court Eyes Advisor Liability
A U.S. Supreme Court decision on a Ponzi scheme lawsuit includes some new clarity for investment advisors who sell securities that are not traded on a national exchange.
Those types of securities are called “uncovered securities.”
The new clarity has to do with circumstances where investment advisors (and other professionals) could become subject to state-level class-action lawsuits for selling uncovered securities but misrepresenting that the products are backed by covered securities.
It’s a fine point, but one with potential big dollar impact for financial professionals who may get entangled in such lawsuits.
The high court’s case, Chadbourne & Parke LLP v. Troice et al, was handed down on Feb. 25, and interested parties are still sorting through the various elements.
Some investors alleged that they had been misled in a multibillion Ponzi scheme during the mid-2000s. They filed civil class actions under state law, charging that Allen Stanford and several of his companies sold them certificates of deposit (CDs) in Antigua-based Stanford International Bank. They alleged that the sellers had falsely represented that uncovered securities — the CDs — were backed by covered securities (i.e., securities traded on a national exchange).
According to the high court’s summary of the Ponzi scheme, the CD investors had expected that the bank would use the money it received to buy highly lucrative assets. But instead, the court said, money from new investors was used “to repay old investors, to finance an elaborate lifestyle, and to finance speculative real estate ventures.”
The federal government went after Allen Stanford and his companies in 2009 and the case went to trial. In 2012, Stanford was sentenced to 110 years in prison and required to forfeit $6 billion.
Meanwhile, at the state level, the investors brought civil class-action lawsuits focused on suing the firms and individuals whom the investors claimed had helped “perpetrate the fraud” in a material way. The defendants, which included “investment advisors,” insurance brokers and law firms, fought the charges vigorously, so the cases made their way through the court system and on to the U.S. Supreme Court, where they were consolidated into one.
A 1998 federal law, the Securities Litigation Uniform Standards Act (SLUSA), was on center stage in the high court’s decision.
SLUSA forbids the bringing of large securities class actions in the states when there are claims of “misrepresentation[s] or omission[s] of a material fact in connection with the purchase or sale of a covered security.” The court’s task was to determine if SLUSA prohibits the class-action lawsuits originally filed.
In a 7-2 decision, the high court ruled that SLUSA “does not preclude the plaintiffs’ state-law class.” The effect will be to “permit victims of this (and similar) frauds to recover damages under state law,” the court wrote.
But the court also said its decision “does not [sic] limit the Federal Government’s authority to prosecute ‘frauds like the one here.’”
Could the high court’s decision open the door to abusive or frivolous class-action lawsuits at the state level against investment advisors and others who would otherwise not be subject to state class actions?
The two dissenting justices — Anthony Kennedy and Samuel Alito — did raise the point, and Justice Stephen Breyer, writing for the majority, addressed it as follows.
The dissenting justices correctly pointed out that that the federal securities laws have another purpose, beyond protecting investors, Justice Stephen Breyer wrote. “Namely, they (the laws) also seek to protect securities issuers [sic], as well as the investment advisers, accountants, and brokers who help them sell financial products, from abusive class-action lawsuits.”
Both the Private Securities Litigation Reform Act (PSLRA) and SLUSA were enacted in service of that goal, he continued.
“By imposing heightened pleading standards, limiting damages, and pre-empting state-law suits where the claims pertained to covered securities, Congress sought to reduce frivolous suits and mitigate legal costs for firms and investment professionals that participate in the market for nationally traded securities.”
But Breyer also wrote that, "We fail to see, however, how our decision today undermines that objective. The dissent worries our approach will ‘subject many persons and entities whose profession it is to give advice, counsel and assistance in investing in the securities markets to complex and costly state-law litigation.’
“To the contrary, the only [sic] issuers, investment advisers, or accountants that today’s decision will continue to subject to state-law liability are those who do not sell or participate in selling securities traded on U. S. national exchanges.
Only time will tell whether the ruling will be interpreted in such a way as to make other investment advisors, accountants and brokers around the country suddenly subject to abusive or frivolous class actions. But given the tight parameters outlined by the court — i.e., that aggrieved investors allege they purchased uncovered securities from sellers (advisors, etc.) who misrepresented to the investors that the uncovered securities were backed by covered securities — such an outcome seems doubtful.
Still, the decision is a cautionary reminder for advisors to ensure that the representations they make about what they are selling to investors are accurate.
As for the defendants in the suit, Bruce Ballentine, vice president-senior credit officer at Moody’s, termed the decision “credit negative” for them because it extends broad litigation of the matter and will entail ongoing costs and an allocation of management time.
This is a “significant contingent exposure” that will likely take years to resolve, Ballentine predicted in the current issue of Moody’s Credit Outlook.
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