The following post comes to us from Benjamin P. Edwards, Director of the Investor Advocacy Clinic at Michigan State University College of Law.  It is based on his working paper, “Securities Fraud, Federalism, and the Rise of the Disaggregated Class:  The Case for Pruning the State Law Exit Option,” which is available here.

As Professor Coffee and others have recognized, many plaintiffs have secured significant recoveries by opting out of federal securities fraud class actions to pursue their own individual actions.[1]  These opt-out actions have returned substantial sums to investors and usually proceed under state law in state courts.

Why do securities fraud plaintiffs avoid federal court?  Ostensibly aimed at securities fraud class actions, the Securities Litigation Uniform Standards Act (“SLUSA”) broadly defines covered class actions in a way that allows it to sweep many individual actions within its scope.  In particular, SLUSA’s “group of lawsuits” provision effectively dooms many individual securities fraud claims as soon as they enter the federal system.  The provision requires courts to classify individual actions as class actions under SLUSA whenever more than fifty persons’ individual claims arising out of the same securities controversy “are joined, consolidated, or otherwise proceed as a single action for any purpose” in the same court.[2]  In sprawling securities controversies, the federal multidistrict litigation process enables defendants to consolidate related cases into the same court, regularly triggering SLUSA’s application.[3]

Yet is this a bug or a feature?  It would have been far simpler and more direct for Congress to preclude state law fraud claims in federal court.  Still, in enacting SLUSA, Congress sought to channel most securities fraud litigation into federal court and under federal law.  SLUSA’s broadly construed group of lawsuits provision achieves this purpose by forcing many securities fraud plaintiffs to litigate under federal law.

To work around SLUSA’s 50-plaintiff restriction and cost-effectively aggregate lower-value claims, some plaintiffs’ attorneys have begun to deploy a new procedural tactic, something I have dubbed the “disaggregated class.”  Disaggregated classes seek to replicate class actions by filing duplicative state court cases in different state courts, keeping the number of named plaintiffs in each court below SLUSA’s fifty-person threshold.  These disaggregated classes are effectively de facto opt-in class actions (a type of class-action device not permitted under the federal rules).  Although a difficult practice to quantify, the tactic has been used with varying degrees of success in the aftermath of Enron, Worldcom and Madoff.[4]

Implementing the tactic is simple.  When the plaintiffs’ attorney represents more than fifty plaintiffs, she dices them into blocks and files their complaints in different courts.  As the attorney gathers more clients, she files more cases in more locations.

As the securities class action continues to experience death by one thousand cuts, we may soon see increasing numbers of these disaggregated classes.  This trend appears likely because tightening federal law restrictions on securities fraud claims make exiting federal class actions for individualized state law remedies seem increasingly attractive.

Yet this tactic also drives significant public costs.  Spreading duplicative actions across many courts increases the likelihood of inconsistent outcomes, and wastes judicial and party resources.  Over time, it may diminish federal law as the dominant source for private securities liability, frustrating the PSLRA’s objectives.  The state law lawsuits may also drain defendants’ coffers, leaving less for the federal class to recover.

These dynamics show that, much like the PSLRA before it, SLUSA has unintended consequences.  While nothing in SLUSA’s legislative history indicates that Congress intended to drive most individual state law claims out of federal court, the sky has not fallen.  It also seems unlikely that Congress would have endorsed the rise of disaggregated classes.  Because of these dynamics, it would be best to prune the current state-law exit option.

Both SLUSA and the National Securities Markets Improvement Act take it as given that primarily federal law should govern the national securities markets.  Making federal law the primary source for liability gives federal authorities better control over the liability regime and allows liability to be calibrated in pursuit of optimal deterrence.

To the extent Congress desires to remain true to these principles, it should preempt state law in many individual actions as well.  Extending SLUSA’s preclusion into preemption would limit the rise of disaggregated classes.  Yet Congress should proceed cautiously when structuring extended preemption.  The federal securities laws were initially designed to overlay existing state liability regimes.  Despite the national character of today’s securities markets, state laws should not be cavalierly cast aside whenever national market securities are somehow involved.  Rather, I argue that Congress should proceed carefully and prune back disaggregated classes to force securities fraud opt-outs to litigate under the same standards as the federal class.

[1] See John C. Coffee, Jr., Litigation Governance:  Taking Accountability Seriously, 110 Colum. L. Rev. 288, 311 (2010) (explaining that institutional investors are now opting out “on an unprecedented scale” and receiving higher recoveries); Elizabeth Chamblee Burch, Optimal Lead Plaintiffs, 64 Vand. L. Rev. 1109, 1132 (2011) (discussing trend toward opting out).

[2] 15 U.S.C. § 78bb(f)(5)(B)(ii).  See Instituto De Prevision Militar v. Merrill Lynch, 546 F.3d 1340, 1346 (11th Cir. 2008).

[3] See Markey v. Citigroup, Inc., 09 MD 2070 SHS, 2013 WL 6728102, at *5 (S.D.N.Y. Dec. 20, 2013) (recognizing that actions are “proceeding ‘as a single action for any purpose’ within the meaning of SLUSA when they are grouped together as part of an MDL”).

[4] See e.g., Newby v. Enron Corp., 302 F.3d 295, 298 (5th Cir. 2002); In re Worldcom, Inc. Sec. Litig., 02 CIV. 3288 (DLC), 2004 WL 692746 (S.D.N.Y. Apr. 2, 2004); In re WorldCom, Inc. Sec. Litig., 308 F. Supp. 2d 236, 238 (S.D.N.Y. 2004); In re Tremont Sec. Law, State Law, & Ins. Litig., 08 CIV. 11117, 2013 WL 4730263 (S.D.N.Y. Sept. 3, 2013).