Opinion ID: 2140882
Heading Depth: 1
Heading Rank: 2

Heading: Preemption Analysis As Applied to Plaintiff's Common-Law Agency Causes of Action

Text: Preemption analysis must begin with a description of the nature of plaintiffs' causes of action and whether they represent colorable claims from which liability could be imposed. In this Court, as before the Appellate Division, plaintiffs have abandoned their statutory and common-law claims based on the per se illegality of defendants' receipt of order flow payments. Instead, plaintiffs rely exclusively on allegations in their identical complaints that Schwab and Fidelity violated their common-law agency relationships with customers comprising the putative plaintiff classes. Specifically, they allege that Schwab and Fidelity breached their common-law duties, owed to each member of the plaintiff classes, of undivided loyalty under which they were limited to acting in any stock transaction solely in the interest of each firm's principal. Plaintiffs allege that the acceptance by defendants of order flow payments, which they characterize as kickbacks, violated the agency relationship with each class member because customers' orders were accepted and routed without full and frank disclosure of each defendant's dual role in the transaction, which disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its stark significance (Complaints ¶ 8). Plaintiffs aver that defendants' disclosures to the members of the class were inadequate (rendering their dual role and self-dealing actionable) in failing to inform the class members prior to the execution of any transaction that [defendants] would be receiving a kickback, let alone the amount thereof (Complaints ¶ 9 [emphasis added]). They allege that the disclosure on the customers' confirmation statements (in compliance with then rule 10b-10 [a] [7] [iii]), that remuneration was received and would be further described upon request, falls far short of the full and frank disclosure required by law ( id. ). Plaintiffs' allegations of the standard of disclosure which must be made by an agent, having a personal interest in the principal's transaction prior to the execution of the transaction, has support in New York agency law precedents. Indeed, plaintiffs plead verbatim this Court's articulation of an agent's obligation to make a full and complete disclosure of any conflict of interest in a transaction conducted for the principal: Disclosure    indefinite and equivocal does not set the agent free to bargain for his own account or for the account of a corporation which acts through him alone. If dual interests are to be served, the disclosure to be effective must lay bare the truth, without ambiguity or reservation, in all its stark significance  ( Wendt v Fischer , 243 N.Y. 439, 443 [Cardozo, J.] [emphasis supplied]; see also , TPL Assocs. v Helmsley-Spear, Inc. , 146 AD2d 468). In such conflict of interest situations, the Restatement (Second) of Agency states that advance disclosure by the agent is required of all facts which the agent knows or should know would reasonably affect the principal's judgment whether to consent to the agent's dual role (Restatement [Second] of Agency § 390, and comment a , at 208-209). Thus, facially, plaintiffs have pleaded actionable claims under New York common-law agency principles, and similar claims could have been brought in the courts of other States who subscribe to the views of the Restatement (Second) of Agency. And a jury could have found against Schwab or Fidelity under these principles because no specific pretransaction disclosure of defendants' receipt of order flow payments was made, nor of the dollar amounts of such payments to be received in the transaction, which disclosure might have affected the judgment of the customers. Upon the basis of the legislative history of the 1975 amendments to the Securities Exchange Act and the history of SEC's implementing regulations applicable to order flow payment disclosure, we are convinced that permitting the courts of each State to enforce the foregoing common-law agency standards of disclosure on the practice of order flow payments in civil damage actions would unavoidably result in serious interference with the accomplishment and execution of the full purposes and objectives of Congress ( Hines v Davidowitz , supra , 312 US, at 67), in enacting the 1975 amendments, and would directly conflict with SEC regulations limiting the disclosure requirements regarding receipt of order flow payments to less exacting, posttransaction information on customer confirmation statements and disclosure of general policies of the broker on initial and annual customers' account statements. As we have shown, the 1975 amendments to the Securities Exchange Act were intended to give the SEC the power administratively to develop a coherent and rational regulatory structure to correspond to and to police effectively the new national market system (Sen Rep No. 94-75, at 2, op. cit. , 1975 US Code Cong & Admin News 181). Among the goals of Congress in that legislation was to spark the creation of such a national market system for security trading, which would assure more economically efficient execution of securities transactions and promote greater competition among all securities industry players, including competition between exchange markets and markets other than exchange markets (Pub L 94-29, § 7, 89 US Stat, at 111-112, codified at 15 USC § 78k-1 [a] [1] [C]). The SEC was directed administratively to promote those goals. Congress also recognized that its objectives would require SEC regulation of disclosures regarding security transactions, including the fairness and usefulness of the form and content of such information ( id. , 89 US Stat, at 115, codified at 15 USC § 78k-1 [c] [1] [B]). Acting pursuant to that delegated authority, the SEC fashioned customer disclosure requirements applicable to the receipt of order flow payments in 1977 under the original rule 10b-10, and in 1994 by amendments to rule 10b-10 and the adoption of new rule 11Ac1-3. In each instance, the agency determined the nature and extent of the disclosure requirements, based on an interest-weighing, cost/benefit analysis. In applying the former rule 10b-10 disclosure requirements to order flow payments and in specifically addressing the practice in its 1994 rule making on the subject, the SEC recognized that order flow payments further the purposes of Congress by enhancing more efficient and less costly execution of customers' orders and by promoting competition for order executions among all markets, with demonstrated beneficial results for individual investors. Permitting the courts of each State to impose civil liability on national securities brokerage firms, such as Schwab and Fidelity, for failure to meet more stringent common-law agency standards of disclosure of receipt of order flow payments (rather than the Federally mandated uniform specific disclosure on posttransaction confirmation statements and general disclosure on new customer account statements and annual statements, under the SEC's amended rule 10b-10 and rule 11Ac1-3) would inevitably defeat the congressional purpose of enabling the SEC to develop and police that coherent regulatory structure for a national market system. Securities broker-dealers, confronted with the risk of nationwide class action civil damage liability, including restitution of commissions and punitive damages  as plaintiffs seek here  would be impelled to tailor their disclosures to each State's common-law agency jurisprudence, and the carefully crafted SEC disclosure requirements would have little, if any, influence. [7] Surely, [i]t is unlikely  to say the least  that Congress intended to establish such a chaotic regulatory structure ( International Paper Co. v Ouellette , supra , 479 US, at 497). When, thus, a State's regulation, through the imposition of common-law tort liability or otherwise, adversely affects the ability of a Federal administrative agency to regulate comprehensively and with uniformity in accordance with the objectives of Congress, then the state law may be pre-empted even though `collision between the state and federal regulation may not be an inevitable consequence' ( Schneidewind v ANR Pipeline Co. , 485 US 293, 310, quoting Northern Gas Co. v Kansas Commn. , 372 US 84, 91-92). State civil actions based upon common-law agency doctrine would thwart the objectives of Congress in a second respect. As already noted, the SEC determined that the practice of order flow payments brings about constructive results furthering the goals of Congress in the 1975 amendments to the Securities Exchange Act. It also found that stricter disclosure requirements than those ultimately adopted under its rules might be unworkable or costly out of all proportion to possible benefits to investors. Thus, the SEC rejected proposals for more exacting disclosure, anticipating that, at the least, the increased cost of such disclosure would be passed onto customers in higher commissions or to market makers in higher fees for order routing  outcomes clearly counterproductive to congressional objectives of economically efficient execution of orders, lower execution costs and vigorous competition among OTC and exchange markets. At worst, onerous stricter disclosure costs plus the threat of lawsuits all around the country, based on breach of common-law agency relationships, would likely result in many brokerage firms abandoning acceptance of order flow payments altogether, an even more drastic undermining of congressional objectives. Thus, for these reasons, we agree with the Minnesota Supreme Court's conclusion in Dahl v Charles Schwab & Co. (545 NW2d 918, 925, cert denied ___ US ___, 117 S Ct 176 [Oct. 7, 1996]), that these likely deleterious if not ruinous effects upon a securities industry practice the SEC, under its delegated securities industry supervisory powers has determined will further the policies of Congress, are alone sufficient to require preemption ( see , Capital Cities Cable v Crisp , 467 US 691, 707-708, supra ). Put another way, the SEC, acting reasonably within its rule-making authority, adopted a policy, incorporated in regulations, of permitting the practice of order flow payments and not unduly inhibiting the practice by oppressive disclosure requirements. These goals and policies of the SEC are antithetical to threshold limitations placed on order flow payment practices in the form of severely, if not prohibitively, burdensome additional disclosure requirements imposed by application of each State's common-law of agency in civil damage actions ( Doctor's Assocs. v Casarotto , 517 US ___, ___, 116 S Ct 1652, 1657 [May 20, l996]). We reject plaintiffs' contention that there is no preemption here because compliance with State common-law disclosure standards under agency doctrine would not prevent compliance with SEC regulatory disclosure requirements, and because greater disclosure promotes the same investor-protection purposes of the Federal regulations. Even if the goals of Federal and State law are the same, [a] state law also is pre-empted if it interferes with the methods by which the federal statute was designed to reach this goal ( International Paper Co. v Ouellette , 479 US, at 494, supra ). The stricter standards of order flow payment disclosure which may be required under State common-law agency principles inevitably will supplant the disclosure rules of the SEC on the same subject and come to dominate the relationship between broker and customer, since the broker would not be able to avoid civil liability for acceptance of order flow payments merely by complying with Federal regulations. Unquestionably, however, State common-law standards for disclosure when an agent has a financial stake in a transaction effected on behalf of a principal are set generally, and would be applied to broker-dealer receipt of order flow payments, without engaging in the policy choices and balancing of the competing legitimate interests of investors, exchange and non-exchange markets and other participants in the securities industry, that the SEC was charged by Congress to perform and that are involved in regulation of order flow payments. Thus, although both State common-law actions and Federal regulations may promote broker-dealers' disclosure to customers, State enforcement of agency law standards of disclosure cannot help but upset the policy-based delicate balance Congress directed the SEC to achieve in the regulatory regime envisaged under the 1975 amendments to the Securities Exchange Act. Here, as in International Paper Co. v Ouellette ( supra ) (where State common-law nuisance actions also threatened to upset a Federally designed, legislative/regulatory interest-weighing cost/benefit approach), [i]t would be extraordinary for Congress, after devising an elaborate [balanced regulatory] system that sets clear standards, to tolerate common-law suits that have the potential to undermine this regulatory structure ( id. , 479 US, at 497; see also , Gordon v New York Stock Exch. , 422 US 659, 688-690; Darling v Mobil Oil Corp. , 864 F.2d 981, 987-988).