SLUSA And The Delaware Carve Out
The Securities Litigation Uniform Standards Act of 1998 (SLUSA) generally precludes shareholders from bringing a class action securities fraud suit in state court. The Act was passed to prevent an end run around the stringent substantive and pleading requirements of the Private Securities Litigation Reform Act of 1995. SLUSA does have exceptions, however. In Madden v. Cowen & Co., Case No. CV-06-04886 (9th Cir. Feb. 11, 2009), the Ninth Circuit defined the scope of one of those exceptions known as the Delaware carve-out.
The suit arose out of the acquisition of St. Joseph Medical Corp. and its controlled entity, Orange Coast Managed Care Services by FPA Medical Management. Both St. Joseph and Orange were privately held corporations. FPA was publicly traded.
In 1997, the management of St. Joseph and Orange formed a special committee to seek a buyer for the two companies. Cowen was engaged to assist. Eventually Cowen arranged for FPA to acquire the shares of St. Joseph and Orange in an exchange offer. Cowen issued a fairness opinion in connection with the deal. Shortly after the transaction closed, FPA reported poor earnings and its stock price dropped by 75%. Two months, later the company filed for bankruptcy. At the time, its share price was about 0.5% of what it was at the time of the deal with St. Joseph and Orange.
The sixty three shareholders of St. Joseph, a California corporation, and Orange, a Delaware company, filed suit against FPA’s management in California state court. That case was removed under SLUSA after which the district court granted summary judgment in favor of the defendants. The Ninth Circuit affirmed. Subsequently, this suit was brought against Cowen for negligent representations and professional negligence under California law. Defendants removed the action under SLUSA and the district court granted a motion to dismiss.
The Ninth Circuit reversed. SLUSA generally precludes covered class actions from being brought in state court the Circuit Court noted. There are exceptions, however. The Delaware carve-out, Section 16(d) of the Securities Act and Section 28(f) of the Exchange Act were added to SLUSA to “preserve state-law actions brought by shareholders against their own corporations in connection with extraordinary corporate transactions requiring shareholder approval, such as mergers and tender offers, regardless whether the corporations issued nationally traded securities.”
There are five key elements to the Delaware carve-out: 1) the suit must be based on the law of the state in which the issuer is incorporated; 2) it must involve a communication with respect to the sale of the issuers securities; 3) the communication must be made for or on behalf of the issuer or an affiliate; 4) it must be to shareholders of the issuer; and 5) it must concern specified shareholder decisions including a response to a tender offer or an exchange offer. If these elements are met the suit cannot be removed.
Here, the suit clearly falls within the Delaware carve-out. The case is based on California state law where the issuer, St. Joseph, is incorporated and it involves a communication concerning an exchange offer for securities. Accordingly, the carve-out applies, according to the Court.
Defendants claim however, that that St. Joseph is not an issuer within the meaning of the exception. This claim is based on the argument that the word “issuer” in the carve-out means “covered issuer.” The latter is a defined term which generally refers to publicly traded shares. The former is not a defined term. After examining the plain language of the statute, the court concluded that there is nothing which limits the undefined term “issuer” to the scope of the defined term “covered issuer” in the carve-out. Accordingly, the Court rejected the argument and, since the carve-out applies, reversed the lower court.