The United States Supreme Court to Decide Whether Victims of Ponzi Schemes Can Bring State-Law Class Actions Against Defendants Who Aid and Abet Fraud

            An important decision on the ability of Ponzi scheme victims to use class action lawsuits to recoup their losses is expected from the U.S. Supreme Court.  At the opening of the current term, the Court heard oral argument in the case Proskauer Rose, LLP v. Troice, a consolidated appeal of a decision by the U.S. Court of Appeals for the Fifth Circuit involving claims by victims of the infamous multi-billion dollar Ponzi scheme perpetrated by Allen Stanford. 

In the Proskauer cases, the plaintiffs filed class action lawsuits in Louisiana state court against various defendants, including brokerage firms, insurance companies and law firms, for their alleged role in Stanford’s massive Ponzi scheme.  At the heart of his fraud, Stanford arranged for affiliates to sell certificates of deposit issued by the Stanford International Bank that were represented to pay above-market returns and which were falsely characterized as being backed by safe, liquid investments.  According to an earlier lawsuit filed by the SEC against Stanford, “[f]or almost 15 years, SIB represented that it consistently earned high returns on its investment of CD sales proceeds. . .In fact, however, SIB had to use new CD sales proceeds to make interest and redemption payments on pre-existing CDs, because it did not have sufficient assets, reserves and investments to cover its liabilities.” 

The investors’ lawsuits against the defendants alleged that, by their actions, the brokerage firm, insurers and law firms aided and abetting Stanford’s Ponzi scheme and misrepresented the validity of the CDs.  The lawsuits were filed in state court and alleged state-based claims, and the defendants removed the cases to U.S. District Court on the basis of the Securities Litigation Uniform Standards Act (“SLUSA”). 

            SLUSA was enacted in the wake of the Private Securities Litigation Reform Act (“PSLRA”), which Congress passed in response to the purported “rampant nuisance filings [of securities litigation], targeting deep-pocket defendants [and] vexatious discovery requests.”  The PSLRA restricted recoverable damages and attorneys’ fees and, importantly, imposed strict pleading requirements on class action securities lawsuits.  In order to avoid the PSLRA’s challenges, plaintiffs began filing securities class action lawsuits in state courts, alleging only state-based causes of action.  Congress responded to these efforts “to frustrate the objectives of the PSLRA” by enacting SLUSA, which provides for removal and dismissal of a state-based class action lawsuit that alleges a misrepresentation or omission of material fact “in connection with” the purchase or sale of a covered security. 

            At issue before the Supreme Court in Proskauer is the proper test to be used to determine the “in connection with” requirement of SLUSA where the CDs, which were admittedly not covered securities, were represented to be backed by fictitious securities.  The Fifth Circuit identified the proper test from the defendant-oriented perspective, and held that “fraud is ‘in connection with’ the purchase or sale of securities if there is a relationship in which the fraud and the stock sale coincide or are more than tangentially related.”  The court determined that “the heart, crux and gravamen” of the scheme was the representation that the CDs were a “safe and secure” investment because of its backing by other securities.  The court held that the representations about the purchase or sale of securities were only tangentially related to the fraudulent scheme, and thus were not “in connection with” such transactions.  As such, the Fifth Circuit concluded that SLUSA did not apply, and the cases should be remanded to the state court. 

            The U.S. Supreme Court’s anticipated decision has the potential to broadly affect the ability of Ponzi scheme victims to recoup their losses.  Typically, the individuals who perpetrate the fraudulent schemes have wasted the money entrusted to them, and the investors’ best chance to recover their losses is by establishing the liability of others who aided and abetted the fraud, or otherwise made the scheme possible in violation of state-law duties.  Victims of recent Ponzi schemes, including one that lead to the collapse of Peregrine Financial Group and another perpetrated by Scott Rothstein in Miami, may be directly impacted by the Court’s decision.  If the Supreme Court reverses the Fifth Circuit opinion, it will expand the reach of “in connection with” to imaginary securities with the effect of radically curbing investors’ ability to recover damages for losses suffered in Ponzi schemes.

U.S. Supreme Court Enforces Arbitration Provision’s Ban on Class Action Claims

In a ruling that continues a recent trend restricting the use of class action lawsuits to address the collective claims of similarly situated plaintiffs, the United States Supreme Court has ruled that restaurant owners were precluded by an arbitration clause in their American Express agreements from pursing arbitration claims against the financial institution on a class-wide basis.

The plaintiffs in the putative class action case, American Express v. Italian Colors Restaurant, alleged that American Express forced merchants to accept its high-fee credit cards as a condition of accepting the firm’s premium and corporate cards, in violation of federal anti-trust laws.  The merits of the dispute, however, were not addressed because American Express sought to enforce a provision in its service contract that required stores to arbitrate their disputes rather than file lawsuits in court.  Importantly, the standard arbitration clause found in these agreements prohibited the merchants from bringing their claims as a class action on behalf of similarly situated restaurants.  Rather, each vendor was required to pursue its arbitration claim on an individual basis.

The Second Circuit Court of Appeals initially permitted the restaurant owners to bring their case as a class action because the high costs of anti-trust litigation would preclude them from brining individual claims for relief.  According to the plaintiffs, the litigation costs could reach $1 million even though each litigant could expect to recover approximately $40,000.  The federal appellate court agreed that this disparity resulting from the class action waiver provision would effectively preclud the restaurants from “vindicating [their] statutory rights in the arbitral forum.”

The U.S. Supreme Court, however, reversed the Second Circuit’s decision and held that the arbitration provision was enforceable as written.  Justice Antonin Scalia, who authored the 5-3 majority opinion, rejected the lower court’s rationale because the “anti-trust laws do not guarantee an affordable procedural path to the vindication of every claim.”   According to the majority opinion, the large expense of arbitration did not justify weakening the impact of the Federal Arbitration Act’s “core requirement” that arbitration agreements be enforced pursuant to the intent of the parties entering into the contract.  As Justice Scalia explained, “[t]he fact that it is not worth the expense involved in proving a statutory remedy does not constitute the elimination of the right to pursue that remedy.”  The majority concluded that courts must “vigorously enforce” arbitration agreements according to their terms.  Otherwise, the extensive litigation of the merits of a case necessary to allow a court to decide whether to enforce an arbitration agreement “would undoubtedly destroy the prospect of speedy resolution that arbitration in general and bilateral arbitration in particular was meant to secure.”

In her dissent, Justice Elena Kagan was sharply critical of the majority’s decision. She disputed that arbitration should be permitted to be used as a mechanism “easily made to block the vindication of meritorious federal claims and insulate wrongdoers from liability.”  She further wrote, “[t]he monopolist gets to use its monopoly power to insist on a contract effectively depriving its victims of all legal recourse. . .And here is the nutshell version of today’s opinion, admirably flaunted rather than camouflaged:  Too darn bad.” 

Class Action Lawsuit Filed Against FINRA for Violating Brokers' Constitutional Due Process Rights

Block & Landsman joined other firms in filing a class action lawsuit against the Financial Industry Regulatory Authority (FINRA) seeking injunctive relief to stop the regulatory authority from violating the constitutional due process rights of registered representatives. Specifically, FINRA Rule 3010(b)(2), known as the Taping Rule, requires brokerage firms to establish special supervisory procedures, including the tape recording of broker conversations, when they employ more than a specified percentage of representatives who were previously employed by firms that have been expelled or had their registrations revoked for sales practice rule violations (referred to as "disciplined firms").

FINRA's Rule imposes a "guilt-by-association" standard by tainting brokers who worked for a disciplined firm even though the representatives had no involvement in any activity that led to the firm's expulsion or revocation. Even if the registered representatives worked left the firm before the misconduct occurred, they are nonetheless deemed to be "tainted." The special supervisory procedures required of firms that hire enough of these brokers are burdensome and expensive, and can be avoided only by reducing the number of so-called "tainted" brokers. Subsequent employers can avoid having to implement the procedures by reducing the number of affected brokers below a qualifying number.

As a result, brokers who are "tainted" face termination, or the inability to be hired, on the basis of nothing more than their past association with a prior disciplined firm. And FINRA provides no mechanism for a former broker of a disciplined firm to remove the "taint" arbitrarily imposed by FINRA's rule, thereby violating their due process rights and subjecting them to arbitrary termination.