Wednesday, October 19, 2016

Allegations of unsuitable sales of reverse convertibles precluded by SLUSA

By Rodney F. Tonkovic, J.D.

State law claims alleged in a complaint against a seller of convertible notes were precluded by SLUSA and must be dismissed, a district court has found. The court found that the majority of the claims sounded in fraud, and the alleged misrepresentations and omissions were made "in connection with the purchase or sale of a covered security" (Luis v. RBC Capital Markets, LLC, October 13, 2016, Nelson, S.).

Risky notes. The complaint alleges that RBC Capital Markets, LLC improperly marketed and sold proprietary reverse convertible notes to the seven investor plaintiffs. The notes at issue were a form of bond, consisting of a high-yield, short-term note of the issuer linked to the performance of an unrelated reference asset. The notes were riskier than a traditional bond, however, and an investor could lose all of the principal investment and be left with only a depreciated asset. When the notes declined precipitously in value, the investors brought this suit on behalf of a putative class of "several thousand," alleging fraud under state and common law.

In essence, the complaint alleged that RBC sold inherently risky notes to retirees who did not understand the nature of the investments and who had told RBC that they were risk-adverse. Because reverse convertible notes are so risky, the investors maintained, RBC had a duty to market them only to those who fully understood and accepted the risks. Instead, RBC hid the risk and pushed the notes on investors who were unwilling to engage in risky options trading. The investors alleged that they relied on RBC's misrepresentations and omissions in purchasing the notes, and brought seven claims under state law, including common law fraud, fraudulent concealment, and violation of two provisions of the Minnesota Securities Act.

SLUSA. RBC contended that the complaint must be dismissed because each claim was barred by SLUSA, and the court agreed. There was no dispute that, under the SLUSA, the action was a "covered class action" based on state law. The court then found that the complaint generally alleged misrepresentations and omissions of material fact by RBC. While the investors pleaded claims for common law negligence, breach of fiduciary duty, and breach of contract, there was no avoiding the fact that the majority of the claims sounded in fraud, and explicitly required allegations of material misrepresentations and omissions, the court said.

The court then concluded that RBC’s alleged misrepresentations and omissions were made "in connection with the purchase or sale of a covered security." First examining whether the notes were covered securities, the court looked at Securities Act Section 18(b)(1)(C), which declares a security to be "covered" if it is "a security of the same issuer that is equal in seniority or that is a senior security to a security described in subparagraph (A) or (B)." This section, the court noted, has never been addressed by a federal court. The court determined that the notes met every element of subsection (C): the notes were "securities" issued by Royal Bank of Canada, the “same issuer” of a security described in subparagraph (A), and were of at least equal seniority to Royal Bank of Canada's common stock. Ultimately, the court declined to narrow the plain language of the statute, and concluded that this interpretation was in keeping with the purpose and scope of SLUSA.

Finally, the court found that RBC's alleged misconduct was "in connection with" the purchase of covered securities. The investor's own allegations, the court said, repeatedly states that RBC’s misrepresentations and omissions directly induced their purchase of the notes. The court accordingly found that the claims were indeed precluded by SLUSA and dismissed the complaint without prejudice.

The case is No. 16-cv-00175.

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