by T. GormanPosted on Posted in SECActions

Following the crash of the market for auction rate securities in early 2008, regulators as well as private litigants brought a series of suits against the brokerage houses which sold the securities. Typically the suits claimed that sells had misrepresented the risks in the market claiming, for example, that the securities were “the same as a money market fund” without describing the risks or telling investors that in the fall of 2007 cracks began to appear in the markets as they spiraled to a crash. The SEC and the NY AG settled a series of enforcement actions tied to the sale of these markets.

In litigation regulators and private plaintiffs have not been as successful. The SEC lost an ARS case against Morgan Keegan & Co. on summary judgment. SEC v. Morgan Keegan & Co., Inc., Civil Action No. 1:09-cv-1965 (N.D. Ga. Opinion dated June 28, 2011)(here). The New York AG lost an action against Charles Schwab & Co. on a motion to dismiss. The People of the State of New York v. Charles Schwab & Co., Index No. 453388/2209 (N.Y. Sup. Ct.)(here). Private plaintiffs such as Ashland, Inc. also failed. could not sustain claims centered on the ARS market. Ashland, Inc. v. Oppenheimer & Co., No. 10-5305 (6th Cir. July 28, 2011)(here)(affirming dismissal but describing narrow class of cases that have been successful).

Even when private plaintiffs are backed by the SEC, as in Wilson v. Merrill Lynch & Co., No. 10-1528 (2nd Cir. Decided Nov. 14, 2011), the claims have not been sustained. In that case Colin Wilson brought a class action against Merrill Lynch for those who purchased auction rate securities between March 25, 2003 and February 13, 2008. The complaint centered on allegations of market manipulation rather than nondisclosures. Plaintiffs claimed that Merrill manipulated the clearing rates — the rate set at the periodic auctions –through its supporting bids which sent a false signal to the market about the price and liquidity of the securities. As the markets began to deteriorate in the summer of 2007 Merrill prevented auction failure with its bids. By the fall however the broker began withdrawing its support from some auctions. On February 13, 2008 Merrill and all other major dealers withdrew from the ARS markets which subsequently collapsed. Prior to that time Merrill had described the markets as safe and liquid, according to the complaint.

The district court dismissed the case. That court concluded that the disclosures Merrill made regarding the markets were adequate, although Mr. Wilson purchased his securities on-line. On appeal the Second Circuit requested the views of the SEC. The agency filed a letter brief supporting reversal of the district court’s decision (here). The Circuit Court affirmed the ruling of dismissal.

Plaintiffs told the Second Circuit that Merrill’s disclosures were false and misleading because they stated that the firm may routinely submit support for individual auctions when, in fact, the broker supported every auction. In addition, the firm knew that there was insufficient investor demand and that the bids were submitted to create a false impression of demand.

The Second Circuit found there was no dispute that Merrill disclosed it routinely placed orders in the market for several purposes including too prevent auction failure. Those disclosures also stated that “the fact that an auction clears successfully does not mean that an investment in the securities involves no significant liquidity or credit risk . . “ While plaintiffs argue that in reality Merrill had a policy of placing support bids in every auction to prevent failure, the complaint is inconsistent in the view of the Second Circuit. Some allegations in the complaint support plaintiffs’ contention. Others are much more limited and qualified. These inconsistencies on this central point are critical and undercut plaintiffs’ arguments on appeal.

While plaintiffs’ also claim that Merrill knew the market was “unsustainable,” that knowledge post dates the purchase by Mr. Wilson. When read together, the allegations of the complaint “do not support the inference that Merrill knew, at the time of Wilson’s purchase, that the ARS market was certain to fail in the absence of intervention.” (emphasis original).

The fact that the SEC supported plaintiffs claims did not persuade the Circuit Court to reverse the dismissal. The Commission presented two key legal propositions. First, in some circumstances disclosure can prevent a false signal from being sent to the market, thereby undercutting a market manipulation claim. Second, disclosure of a potential risk is insufficient when in fact the risk is much greater and/or is a known certainty. The Court agreed with each point. Nevertheless, it did not agree with the Commission’s conclusions. While the parties disputed the amount of deference that should be given to the views of the agency, the Second Circuit held that “we are unable to agree with the SEC’s application of the legal principles governing Merrill’s disclosures even under the generous standard of deference that Wilson urges . .. we find the complaint to be inconsistent as to how Merrill placed support bids . .. and view other allegations of the complaint as incompatible with the notions that every auction would fail in the absence of Merrill’s intervention or that Merrill knew by July 2007 that the ARS market was unsustainable.”

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by T. GormanPosted on Posted in SECActions

The Securities Litigation Uniform Standards Act of 1998 or SLUSA was passed to prevent a class action plaintiff from circumventing the stringent pleading requirements of the Private Securities Litigation Reform Act by filing in state court. The Third, Sixth and Ninth Circuits have developed different approaches to the application of SLUSA. The Seventh Circuit recently disagreed with the approach of the Ninth Circuit, but concluded that under the approach of the Sixth or one approaching that of the Third, an action brought in state court centered on a claimed breach of fiduciary duty tangled with a misrepresentation claim was properly dismissed under the Act. Brown v. Calamos, No. 11-1785 (7th Cir. Decided Nov. 10, 2011).

Plaintiff brought a state court class action centered on a claim that an investment adviser breached its fiduciary duty by redeeming auction market preferred stock or AMPS to placate banks and brokers important to other funds in the family. The suit was brought on behalf of the owners of the common stock of Calamos Convertible Opportunities and Income Fund, a closed-end investment fund. The defendants are the adviser, the fund and the parent’s board of trustees.

AMPS are preferred shares in the fund. They payed an interest rate recomputed at short intervals at auctions. The auctions gave the AMPS shareholders liquidity. The funds from the purchase of the preferred shares are pooled with the money from the common shareholders. The AMPS were essentially a kind of non-redeemable bond which gave the fund inexpensive financing. When the auctions failed the AMPS shareholders demanded redemption. The investment adviser redeemed the shares although there was no obligation. This reduced the liquidity of the fund and its leverage. Additional money was borrowed but at a higher interest rate.

The complaint claims that the redemption constituted a breach of fiduciary duty and that it was undertaken to maintain relations with investment bankers which were essential to other funds managed by the adviser. It also contains a disclaimer which specifies that it does not contain a fraud claim. Following removal the district court dismissed the case under SLUSA.

SLUSA prohibits securities class actions of more than 50 members based on state law alleging a misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security. A covered security is one traded nationally and listed on a regulated national exchange. Once a case is removed from state court the district court has two options. First, if the case falls within the ambit of SLUSA the court must grant a motion to dismiss. This is an adjudication on the merits. If however the suit is not within the purview of the statute then it must be remanded to state court. In that event the district court has no jurisdiction to hear the case.

Three approaches have evolved to the application of SLUSA. Under the literalist approach of the Sixth Circuit if the complaint can be interpreted as containing a misrepresentation and the other requirements of the Act are met, it must be dismissed. The Third Circuit, in contrast, has concluded that if a misrepresentation or material omission is not essential to the success of the plaintiff’s claim, it is not a bar to the suit. The Ninth Circuit takes an intermediate approach which permits the complaint to be dismissed but without prejudice. Plaintiffs can then file an amended complaint in state court without the misrepresentation.

In this case the Seventh Circuit concluded that the suit was properly dismissed. The approach of the Ninth Circuit is contrary to the Act the Court found. The plaintiff here however “must lose even under a looser approach than the Sixth Circuit’s (not the Ninth Circuit’s approach, however, but one close to the Third Circuit’s), whereby suit is barred by SLUSA only if the allegations of the complaint make it likely that an issue of fraud will arise in the court of the litigation – as in this case. The allegation of fraud would be difficult and maybe impossible to disentangle from the charge of breach of the duty of loyalty that the defendants owed their investors.” Under these circumstances, and despite the disclaimer in the complaint, the suit is barred by SLUSA.

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