On October 31, 2014, the US Court of Appeals for the Second Circuit in Pennsylvania Public School Employees' Retirement System v. Morgan Stanley & Co. Inc. held that the district court abused its discretion in limiting the evidence that the appellant could use to establish standing on its fraud claims. The court also dismissed the claims of a state agency for lack of diversity jurisdiction and denied class certification. (Nos. 13-2095, 13-2283, 13-2286 and 13-2287, (2d Cir. Oct. 31, 2014).)

The action arose out of the collapse of a structured investment vehicle (SIV) that had issued several classes of notes initially worth billions of dollars. When the SIV collapsed, a disgruntled investor brought a putative class action alleging common law fraud under New York law. The complaint based federal subject matter jurisdiction on diversity of citizenship under 28 U.S.C. § 1332(a).

The plaintiffs moved for class certification on the common law fraud claims seeking to certify a class of all investors in the SIV who purchased notes during a specified time period. The US District Court for the Southern District of New York denied the motion.

The plaintiffs-appellants, Commerzbank and Pennsylvania Public School Employees' Retirement System (PSERS), then filed an amended complaint. The defendants moved to dismiss and for summary judgment on the fraud-related claims. On the summary judgment motion, the district court limited the 15 named plaintiffs, including the appellants, to a three-page "reliance declaration" to establish reliance of each plaintiff on the alleged misstatements to support a valid fraud claim in New York.

The district court granted summary judgment dismissing Commerzbank's fraud claims. It determined that the reliance declaration did not establish standing to sue because as a subsequent holder of the note, Commerzbank had not shown that it had acquired the original purchaser's fraud claim against the defendants. Commerzbank moved for reconsideration and filed two new declarations explaining the transfer of rights. The court refused to consider the two documents and denied reconsideration.

The district court also dismissed PSERS from the action to preserve its subject matter jurisdiction.

On appeal, the Second Circuit affirmed the dismissal of PSERS's claim. The court found that as an arm of the state of Pennsylvania, PSERS is not a citizen of any state and therefore, it cannot be diverse under 28 U.S.C. § 1332(a). Adopting the "contamination theory" of diversity jurisdiction, the court held that federal subject matter jurisdiction under Section 1332(a)(3) requires complete diversity of all parties and that the supplemental jurisdiction statute, 28 U.S.C. § 1367, cannot be used to establish jurisdiction over the claims of a non-diverse party. The court also rejected PSERS's effort to distinguish plaintiffs added through compulsory joinder under FRCP 19 from plaintiffs added through permissive joinder under FRCP 20 for purposes of diversity.

The Second Circuit affirmed the denial of class certification by finding that the FRCP 23 requirements of numerosity and predominance of common issues were not met. With respect to numerosity, although the class might have over 100 members, the individual stakes of the sophisticated investors weighed in favor of joinder. The Second Circuit also concluded that class-wide reliance was not established as a common issue. In doing so, the court rejected the appellants' "fraud-created-the-market" theory, which asserts that but for the fraud the securities would have been unmarketable. The Second Circuit did not go as far as other circuits that have held that the theory is never viable but found that it cannot apply to state law fraud claims.

Additionally, the Second Circuit held that the district court erred in refusing to consider Commerzbank's additional evidence to establish standing. Although it acknowledged a district court's power to limit the evidence presented, the Second Circuit concluded that the page limits imposed for the summary judgment (three pages for 15 plaintiffs) were arbitrary. The court found that the standing issue was complicated and that the district court should have either:

Finally, the court certified the following two questions to the New York Court of Appeals on whether a trier of fact could find that: