On July 9, 2014, the US Court of Appeals for the First Circuit in Hidalgo-Velez v. San Juan Asset Management, Inc. ordered an action remanded to state court where an investment fund's stated objective was to invest at least 75% of its assets in securities not covered by the Securities Litigation Uniform Standards Act of 1998 (SLUSA) (No. 13–1574, (July 9, 2014)).

Investors in a Puerto Rican investment fund company filed a putative class action against the fund and its agents in a Puerto Rico court. They alleged that the investment fund did not comply with the policies promised in the prospectus used to solicit investors. The prospectus promised that the fund would invest at least 75% of its assets in a particular type of specialized note and that it would invest no more than 25% of its assets in securities issued by a single issuer. Instead, the fund invested 75% of its assets in notes sold by a single issuer, Lehman Brothers. The Lehman notes soon lost most of their value and the fund adopted a plan of liquidation.

The defendants removed the action to federal district court, asserting that the suit fell within the domain of SLUSA. The district court denied the plaintiff's motion to remand and granted the defendants' motion to dismiss the action based on SLUSA's preclusion provision. The plaintiffs then appealed.

The First Circuit vacated the dismissal, reversed the denial of the remand motion and ordered the action returned to the Puerto Rico court. The circuit court ruled that the misrepresentations at issue were not made "in connection with" transactions in securities covered by SLUSA. There was no dispute that the plaintiffs purchased uncovered securities. However, the defendants argued that the fund's intended investments included up to 25% covered securities.

Applying the US Supreme Court's recent decision in Chadbourne & Parke LLP v. Troice, the First Circuit held that SLUSA precludes a claim that misrepresentations induced a purchase of uncovered securities "only if the circumstances of the purchase evince an intent to take an ownership interest in covered securities" (134 S. Ct. 1058 (2014)).

Here, the court viewed the possibility that the fund might invest up to 25% of its assets in covered securities as incidental to the fund's primary purpose, which was to invest at least 75% of its assets in specialized notes not covered by SLUSA. Therefore, the link between the misrepresentations and the covered securities was too attenuated to bring the complaint within the realm of SLUSA.

The court rejected defendants' argument that this was a "feeder fund" case in which the plaintiffs invested in funds that directly or indirectly acquire covered securities. The court distinguished this case from In re Herald, a case involving funds that fed into the Bernie Madoff ponzi scheme (Nos. 12–156–cv (L), 12–162 (Con.), (2d Cir. 2013)). There, Madoff primarily marketed his funds as vehicles for investing in covered securities and it was clear the victims had intended to take an ownership interest in covered securities, so the US Court of Appeals for the Second Circuit ruled that it fell within the "in connection with" requirement of SLUSA and the claim was precluded. Here, in contrast, any ownership interest in covered securities was secondary at best.

Practitioners involved in SLUSA-related litigation should look to the primary purpose of the fund in question and whether covered securities predominate in the promised mix of investments when arguing whether or not a claim is precluded by SLUSA.