Justices limit investor class action suits

Ambiguity in law on fraud cleared up


The Supreme Court, clearing up an ambiguity in the law, ruled yesterday in favor of limiting class action lawsuits filed by investors who allege that they were misled into holding on to risky stocks that they otherwise would have sold.

Stockholders tricked into holding their shares are subject to the same rules that govern those who were duped into buying or selling stocks, the court ruled.

The ruling, which favors defendant Merrill Lynch, "is of great significance to all publicly traded companies and financial services firms," said Merrill attorney Jay Kasner, because it "closes an enormous loophole" in the laws covering such litigation.

The spur for the fraud suit against Merrill was New York Attorney General Eliot Spitzer's highly publicized 2002 investigation into whether Merrill and other brokerages had curried favor with big investment-banking clients by having their analysts praise certain stocks.

Wall Street was embarrassed by the investigation when it became known, for example, that one analyst had referred in a private e-mail to a certain company's stock as a "piece of crap" while continuing to publicly recommend the stock as an attractive investment.

Spitzer's investigation generated a number of class action lawsuits by investors who claimed that they had lost money because of analysts' misleading statements.

Recent litigation has highlighted a rift over the way one phrase in the law should be interpreted.

In 1998, Congress, moving to stem what had become a flood of class action securities lawsuits with little merit, passed legislation restricting such claims. Under the law, investors who allege that they have been defrauded "in connection with the purchase or sale" of securities must file their class action suits in federal court. (Plaintiffs' attorneys often prefer state courts, which sometimes permit broader legal claims.)

The 1998 law was silent on investors who held on to their shares because of fraudulent statements.

The Merrill case was filed by a former Merrill broker who claimed, in the words of Justice John Paul Stevens, that Merrill's misleading analyst research led him and others "to hold their stocks long beyond the point when, had the truth been known, they would have been sold."

Like a growing number of such plaintiffs, the former broker brought his class action claim under state rather than federal law.

Lower courts have been divided on whether stockholders claiming to have been defrauded should have access to state courts or whether they were barred from state courts by the law that covers defrauded buyers and sellers.

Last year, the 7th U.S. Circuit Court of Appeals in Chicago ruled that such class action claims should be restricted to federal courts. But in the Merrill case, another federal appeals court ruled the opposite way.

Several states filed on behalf of the plaintiff when the case went to the high court, arguing that states' rights to protect their citizens shouldn't be pre-empted. The Securities Industry Association trade group and the Bush administration back Merrill's view.

Stevens, writing for the entire court, said yesterday that the distinction between people who hold on to stock and people who buy or sell shares is irrelevant.

In either instance, Stevens wrote, the misconduct the plaintiff is alleging is "fraudulent manipulation of stock prices." And such behavior, he said, "unquestionably qualifies as fraud "in connection with the purchase or sale" of securities, even if the investor simply held the shares.

The case was remanded to the lower court.

James P. Miller writes for the Chicago Tribune.

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