Posner Surveys SLUSA Decisions, Refrains From Adopting Sister Circuit Standards
Susan M. Greenwood | Bloomberg Law
n an opinion by Honorable Richard A. Posner, the U.S. Court of Appeals for the Seventh Circuit affirmed dismissal of an action for breach of fiduciary duty pursuant to the Securities Litigation Uniform Standards Act of 1998 (SLUSA). The Seventh Circuit reviewed SLUSA decisions by its sister circuits, but did not specifically align itself with any of their approaches.
Putting Future Business before Current Shareholders
As the Seventh Circuit explained, plaintiff represents owners of Calamos Convertible Opportunities and Income Fund (Fund) common stock. Because the Fund is a closed-end investment fund, it functions like a corporation and stockholders cannot “cash out” their position by redeeming their shares. In addition to common stock, the Fund issued auction market preferred stock (AMPS), whose interest rate was recomputed through an auction process held at short intervals. The Fund then invested the monies from its common stock and AMPS sales. After payment of expenses, including interest to AMPS holders, the common stockholders enjoyed the earnings from the Fund’s investments. The common stockholders also benefitted from low AMPS interest rates as the invested monies generated a much higher rate of return than the interest due on AMPS. Indeed, the Fund highlighted the benefit of the lack of a maturity date on the AMPS—in effect, the Fund could continue to finance its investments at low cost in perpetuity.
The 2008 financial crisis, however, destroyed the AMPS market. While the Fund did not have a duty to redeem the AMPS, it did so anyway “at a price above market value.” According to plaintiff, the Fund and its investment adviser Calamos Advisors “wanted to curry favor with the investment banks and brokerage houses that were facing lawsuits both from regulatory agencies and from disappointed customers who had purchased the AMPS thinking that their investment would always be liquid.” Banks and brokers, the Court continued, marketed the numerous investment funds under Calamos Advisors management. Moreover, banks and brokers similarly would market any future funds. Thus, said the Court, “the parent sold its child (actually one of its 20 children) — the Calamos Convertible Opportunities and Income Fund — down the river, in breach of its fiduciary obligations to the fund’s common shareholders, in order to placate banks and brokers.” Meanwhile, the Fund replaced its lost stream of revenue from AMPS sales with funds borrowed at higher rates and shorter terms, increasing its risk exposure. Accordingly, plaintiff alleged breach of fiduciary duty—for choosing to placate banks and brokers over the well-being of the common stockholders—in a state court action that subsequently was removed to federal court and dismissed under SLUSA.
Breach of Fiduciary Duty or Securities Fraud?
“The question presented by this appeal,” the Seventh Circuit declared, “is whether the judge was correct to find that the plaintiff’s complaint alleged the misrepresentation or omission of a material fact in connection with the purchase or sale of a covered security and that therefore SLUSA forbade the suit.” Although the complaint contained an “emphatic” disclaimer against securities fraud, the Court found both an alleged misrepresentation—”that the AMPS would never be redeemed”—and an omission—”that the fund might at any time redeem AMPS on terms unfavorable to the common shareholders because motivated [sic] by the broader concerns of the entire family of 20 Calamos mutual funds.”
The Seventh Circuit noted that under the Sixth Circuit’s “literalist approach to SLUSA,” the inquiry would end with the discovery of a misstatement or omission in connection with the sale of a security.” The Third Circuit, however, favors judging whether the misrepresentation or omission “is inessential to the plaintiffs’ success.” An inessential allegation, the Court continued, is an extraneous allegation. However, allegations that “while not a necessary element of the plaintiff’s cause of action could be critical to his success in the particular case,” result in SLUSA preclusion. A third approach, followed by the Ninth Circuit, “allows the removed suit to be dismissed without prejudice, thus permitting the plaintiff to file an amended complaint that contains no allegation of a misrepresentation or misleading omission and so cannot be removed under SLUSA.”
Calling the Ninth Circuit approach “doubtful,” the Seventh Circuit reasoned that a plaintiff who amends his or her complaint to remove the offending allegations “might be allowed by a state court to reinsert fraud allegations in the course of a litigation” “[a]nd then SLUSA’s goal of preventing state-court end runs around limitations that the Private Securities Litigation Reform Act has placed on federal suits for securities fraud would be thwarted.” In any event, the Court stated that “the district court has no authority to consider whether the removed suit has merit . . . [o]nce it decides that SLUSA either is or is not a bar to the suit, the court has finished; either way it has no further business with the case.”
The Seventh Circuit was unsympathetic to attorneys who may add the problematic allegation “out of an anxious desire to leave no stone unturned — a desire that ha[s] induced momentary forgetfulness of SLUSA.” It reasoned: “But a lawyer who files a securities suit should know about SLUSA and ought to be able to control the impulse to embellish his securities suit with a charge of fraud.”
Left with a choice between the approach of the Third or Sixth Circuits, the Court made no definitive decision, but observed that “[t]he plaintiff in the present case must lose even under a looser approach than the Sixth Circuit’s (not the Ninth Circuit’s approach, however, but one closer to the Third Circuit’s) . . . .” As the Seventh Circuit explained, plaintiff’s “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.” Indeed, “without the allegation that the Calamos Convertible Opportunities and Income Fund misrepresented the characteristics of its capital structure, a charge of breach of loyalty might not be plausible.” According to the Seventh Circuit, Calamos Advisors’ interest in protecting all of the Calamos family of funds is not a breach of loyalty, particularly as the board of trustees exceeded the independent director requirementestablished by the Investment Company Act of 1940. Further, the Court said, the trustees comprise a unitary board whose “responsibility may require [it] to make tradeoffs to the disadvantage of investors in one of the funds for the sake of the welfare of the family as a whole.” However, the introduction of misstatements and omissions changes the nature of the breach of loyalty making the case “plausible.” Finding that the “fraud allegations may be central to the case,” the Seventh Circuit concluded that “[t]he suit is therefore barred by SLUSA under any reasonable standard.”
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