Hidalgo-Vélez v. San Juan Asset Management, Inc.: Defining When Mixed Investments are “in connection with” Covered Securities under the SLUSA

In Hidalgo-Vélez v. San Juan Asset Mgmt., Inc., No. 13-1574, 2014 BL 191862 (1st Cir. July 9, 2014), previously discussed here, the First Circuit Court of Appeals held that the district court “impermissibly extended” the scope of the Securities Litigation Uniform Standards Act of 1998 (the “SLUSA”) when it granted defendant’s motion to dismiss and denied plaintiff’s motion to remand.

Plaintiffs are investors who filed a covered class action in a Puerto Rico court against the Puerto Rico & Global Income Target Maturity Fund (the “Fund”), its officers and directors, investment advisors, sales agent, and independent auditor (collectively, the “Defendants”) alleging misrepresentation in violation of Puerto Rico law. According to the complaint, the prospectus used to solicit the investors outlined that the Fund would primarily invest in specialized notes. It also stated that no more than 25% of the Fund’s assets would be invested in securities sold by a single issuer. Despite these representations, plaintiffs alleged that nearly 75% of the Fund’s assets were invested in notes issued by one issuer, Lehman Brothers. The notes significantly diminished in value and the Fund was forced to liquidate.

Plaintiffs filed suit alleging misrepresentation in violation of Puerto Rico law. Defendants removed the case to federal district court, claiming the case fell within the purview of the SLUSA and moved to dismiss.  The district court found that the mixed investment satisfied the "in connection with" requirement because the prospectus envisioned a quarter of the Fund's assets being invested into "covered securities." Therefore, the district court granted Defendants' motion to dismiss for failure to state a claim based on the SLUSA preclusion.

The SLUSA applies to a covered class action based on state law allegations of “fraud or misrepresentation in connection with the purchase or sale of a covered security.” Romano v. Kazacos, 609 F.3d 512, 518 (2nd Cir. 2010). A “covered security” is typically “traded nationally and listed on a regulated national exchange,” but it can also be “issued by an investment company registered under the Investment Company Act of 1940.”

The First Circuit found that this case involved allegations of misrepresentations that induced the plaintiffs to invest.  The specialized notes, which constituted the majority of the prospective investment, were “uncovered securities” under SLUSA while the remaining quarter would be invested in "covered securities." The court had to determine whether an investment of a quarter of the Fund's assets in covered securities sufficiently established that the mixed transaction was subject to the SLUSA.

Courts considering whether a mixed investment is governed by the SLUSA look to the extent to which plaintiffs sought an ownership interest in covered securities. Factors that demonstrate intent to invest in covered securities include the primary purpose of the transaction as represented to the solicited investors, the covered securities weight in the promised mix of investments, and the surrounding nature of the alleged misrepresentations. 

The First Circuit found that the prospectus envisioned only a relatively small portion of the Fund would be invested in covered securities. The covered securities were ancillary to the primary purpose of the transaction—to purchase and acquire an ownership interest in uncovered securities. Plaintiffs did not intend to gain ownership interest in covered securities, and the small potential investment did not motivate them to enter into the transaction. Therefore, the alleged misrepresentations and surrounding circumstances were too tangential to justify extending the SLUSA.

Accordingly, the First Circuit reversed and remitted the case to the district court with instructions to remand to the Puerto Rico Court of First Instance.

A previous post discussing this case’s removal to federal court can be found here.

The primary materials for this case can be found on the DU Corporate Governance website.

Shannon Moran