Newton v. Merrill Lynch

Opinions of the United
1997 Decisions States Court of Appeals
for the Third Circuit
6-19-1997
Newton v. Merrill Lynch
Precedential or Non-Precedential:
Docket 96-5045
Follow this and additional works at: http://digitalcommons.law.villanova.edu/thirdcircuit_1997
Recommended Citation
"Newton v. Merrill Lynch" (1997). 1997 Decisions. Paper 135.
http://digitalcommons.law.villanova.edu/thirdcircuit_1997/135
This decision is brought to you for free and open access by the Opinions of the United States Court of Appeals for the Third Circuit at Villanova
University School of Law Digital Repository. It has been accepted for inclusion in 1997 Decisions by an authorized administrator of Villanova
University School of Law Digital Repository. For more information, please contact Benjamin.Carlson@law.villanova.edu.
Filed June 19, 1997
UNITED STATES COURT OF APPEALS
FOR THE THIRD CIRCUIT
No. 96-5045
KENNETH E. NEWTON; MLPF&S CUST. BRUCE ZAKHEIM
IRA FBO BRUCE ZAKHEIM
v.
MERRILL, LYNCH, PIERCE, FENNER & SMITH, INC.;
PAINEWEBBER INC.; DEAN WITTER REYNOLDS
(D.C. No. 94-cv-05343)
JEFFREY PHILLIP KRAVITZ
v.
DEAN WITTER REYNOLDS, INC.
(D.C. No. 95-cv-00213)
MLPF&S Cust. FPO -- Bruce Zakheim IRA FBO Bruce
Zakheim, Jeffrey Phillip Kravitz, and Gloria Binder,
Appellants
ON APPEAL FROM THE
UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF NEW JERSEY
Argued October 24, 1996
Before: STAPLETON and NYGAARD, Circuit Judges, and
MAZZONE,* Senior District Judge.
_________________________________________________________________
*Honorable A. David Mazzone, United States District Court for the
District of Massachusetts, sitting by designation.
(Opinion filed June 19, 1997)
NORMAN S. POSER, ESQUIRE
(Argued)
Brooklyn Law School
250 Joralemon Street
Brooklyn, NY 11201
KAREN L. MORRIS, ESQUIRE
(Argued)
Morris & Morris
1105 North Market Street
Suite 1600
Wilmington, DE 19801
Attorneys for Appellants
MATTHEW D. ANHUT, ESQUIRE
JONATHAN N. EISENBERG,
ESQUIRE (Argued)
Kirkpatrick & Lockhart
1800 Massachusetts Avenue, N.W.
Washington, DC 20036-5891
Attorneys for Appellee Merrill Lynch,
Pierce, Fenner & Smith, Inc.
JOSEPH A. BOYLE, ESQUIRE
Kelley, Drye & Warren
5 Sylvan Way
Parsippany, NJ 07054
BRUCE COOLIDGE, ESQUIRE
ROBERT B. McCAW, ESQUIRE
(Argued)
Wilmer, Cutler & Pickering
2445 M Street, N.W.
Washington, DC 20037-1420
Attorneys for Appellee
PaineWebber, Inc.
2
FRANK M. HOLOZUBIEC, ESQUIRE
Kirkland & Ellis
153 East 53rd Street
Citicorp Center
New York, NY 10022
Attorney for Appellee
Dean Witter Reynolds
RICHARD H. WALKER, ESQUIRE
ERIC SUMMERGRAD, ESQUIRE
SUSAN F. WYDERKO, ESQUIRE
JACOB H. STILLMAN, ESQUIRE
Mail Stop 6-6
Securities & Exchange
Commission
450 Fifth Street, N.W.
Washington, DC 20549
Attorneys for Amicus Curiae,
Securities & Exchange Commission
OPINION OF THE COURT
NYGAARD, Circuit Judge.
The issue on appeal is whether the over-the-counter
customer order execution practices of several large stock
brokers constituted securities fraud. The district court
concluded that these practices were not fraudulent and
granted summary judgment in favor of the defendants. We
will affirm.
I.
The facts of this case are set forth thoroughly in the
district court's opinion, In re Merrill Lynch Securities Litig.,
911 F. Supp. 754 (D.N.J. 1995). Succinctly stated, plaintiffs
are investors who purchase and sell so-called "over the
counter" securities which are traded on a computerized
price quotation system known as NASDAQ. They claim that
the peculiarities of this market have given securities dealers
3
an opportunity--upon which they have capitalized--to
inflate their profit margins at the expense of customers,
resulting in inferior execution prices vis-a-vis other dealers
who have access to superior, privately quoted prices. These
practices, plaintiffs allege, violated the defendants' duty of
best execution, but were never disclosed by the dealers,
thus amounting to a securities fraud under section 10 of
the Securities Exchange Act of 1934, 15 U.S.C. § 78j(a) and
Rule 10-b5 promulgated thereunder, 17 C.F.R. § 240.10b-5.
The NASDAQ, which is now the second-largest securities
market in the United States, is different from the New York
and American Stock Exchanges, because it is a dealer-
created, rather than an auction, market. In an auction
market, buy and sell orders actually "meet" on the
exchange floor, with prices being set by the continuous
interaction of those orders, under the supervision of market
"specialists." This type of market has traditionally been
used for widely traded securities.
Dealer markets, on the other hand, rely on "market
makers" to set prices and maintain the liquidity of
securities. This system arose out of literal, over-the-counter
trading of stocks that were not as widely traded as those
listed on the NYSE or AMEX. In a dealer market, each
market maker decides the prices at which it will buy and
sell a security; the difference between the listed "ask" and
"bid" prices is known as the "spread," from which the
market maker is compensated for its efforts and risk.
Under that system, of course, as long as timely, accurate
information is available regarding each market maker's
prices, orders will naturally gravitate towards the dealer
with the most favorable prices, and this will establish a
single, albeit two-price, market for each security traded.
NASDAQ (which stands for National Association of
Securities Dealers Automated Quotation) is the information
system that relays market makers' pricing information to
buyers and sellers. NASDAQ quotes the National Best Bid
and Offer--known in the industry as the "NBBO"--price for
every stock on the system.
Because of recently created sources of additional, non-
public pricing information, however, the NBBO may no
4
longer always be counted upon to display the "best" price.
Systems such as SelectNet and Instinet, which are not
available to all investors or even to all dealers, may be
quoting a more favorable price than the NBBO at any given
moment. Appellants allege that, not only were better prices
displayed in many instances, but that the defendant
dealers knew such prices were available, yet continued to
book their orders at the inferior, NBBO price at the same
time that they were trading at the more favorable price for
their own accounts.
In addition, in many instances dealers are able to obtain
more favorable prices by "crossing" the customer's order
with the order of another customer. For example, assume
that a dealer quotes an "ask" price of $32 1/4 and an "bid"
price of $32 for shares of XYZ Corporation. A customer
places an order to purchase 100 shares, but, unbeknownst
to him, the dealer has an outstanding limit order from
another customer to sell at 32 1/8. That dealer could
simply cross the two orders and execute the trade at 32
1/8, saving the customer $12.50. The dealer would not
incur any market risk on such a transaction. Appellants
allege that it is a fraud for the defendant dealers to
continue to execute trades at the NBBO price,
appropriating the full "spread" as a fee for their services.
The district court granted summary judgment to
defendants, for two principal reasons. First, it held that
defendants made no actionable misrepresentations,
because the duty of best execution is ill-defined and there
is no widely accepted view that execution of trades at the
NBBO price fails to satisfy that duty; thus, it would be
improper to find that defendants omitted or concealed
material facts. 911 F. Supp. at 771. Second, the court held
that, even if defendants omitted information, they could
not, as a matter of law, have acted with the requisite
scienter. Id. at 772.
II.
A.
To make out a securities fraud claim under § 10 of the
Securities Act of 1934 and Rule 10b-5, plaintiffs must
5
show: (1) a misrepresentation or omission of a material fact
in connection with the purchase or sale of a security; (2)
scienter on the part of the defendant; (3) reliance on the
misrepresentation; and (4) damage resulting from the
misrepresentation. Sowell v. Butcher & Singer, Inc., 926
F.2d 289, 296 (3d Cir. 1991). Although the district court
held that there was no misrepresentation or omission of a
material fact, we will assume, without deciding, that the
trading practices here constituted an otherwise actionable
misrepresentation, because we conclude that the district
court correctly decided that scienter was lacking as a
matter of law, and appellants' securities law claims fail on
that basis alone.
The element of scienter has been defined as "a mental
state embracing intent to deceive, manipulate or defraud."
Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12, 96 S.
Ct. 1375, 1381 n.12 (1976). Scienter can also be
established by a showing of recklessness, which is defined
as "an extreme departure from the standards of ordinary
care, . . . which presents a danger of misleading . . . that
is either known to the defendant or is so obvious that the
actor must have been aware of it." Healey v. Catalyst
Recovery, Inc., 616 F.2d 641, 649 (3d Cir. 1980) (quoting
Sundstrand v. Sun Chemical Corp., 553 F.2d 1033, 1045
(7th Cir. 1977)). The recklessness standard comprehends
actions very close to intentional conduct; mere indifference
to the consequences of a statement is not sufficient.
Healey, 616 F.2d at 649.
Appellants assert, nevertheless, that the record before the
district court contained sufficient evidence from which a
rational factfinder could infer scienter. The district court
disagreed, opining that because the duty of best execution
is not "established," but ambiguous, the failure to disclose
that all orders were being executed at the NBBO price could
not, as a matter of law, have involved scienter. We agree.
Appellants attempt to refute the district court's reasoning
by arguing that "the absence of a regulation prohibiting a
specific practice does not mean such practice cannot be
considered fraudulent." Specifically, they rely on our
decision in Ettinger v. Merrill Lynch, Pierce, Fenner & Smith,
6
Inc., 835 F.2d 1031 (3d Cir. 1987), which they assert is
"directly on point." We are not persuaded.
It is true that Ettinger involved a securities firm that
failed to disclose excessive markups, but there the
similarity to this case ends. The dealer in Ettinger argued
that its compliance with Rule 10b-10 insulated it from a
material misrepresentation attack under Rule 10b-5, and
we held simply that such compliance did not preclude a
10b-5 action. Id. at 1036. Moreover, Ettinger involved a
markup practice that both the SEC and the courts had
already condemned--the duty in that instance, unlike here,
was clear. See id. at 1033. And finally, scienter was not
even an issue in Ettinger. It had been waived in the district
court. Id. at 1036 n.7. Ettinger is inapposite.
Appellants also cite several cases which allegedly stand
for the proposition that violations of § 10(b) can occur when
a broker-dealer fails to execute customer orders at the best
possible price. Two of those cases, however, involved
execution practices that no reasonable dealer could have
possibly believed proper. See Barnett v. United States, 319
F.2d 340, 345 (8th Cir. 1963) (excessive mark-ups of
between 25 and 67% not disclosed; customer order never
executed at advertised price, while dealer was trading same
security for its own account at superior price); Opper v.
Hancock Securities Corp., 250 F. Supp. 668, 673 (S.D.N.Y.),
aff'd, 367 F.2d 157 (2d Cir. 1966) (dealer claimed to be
searching unsuccessfully for buyer to purchase customer's
stock, while at the same time trading in that same stock
profitably for its own account). Three other cases interpose
a third-party dealer in the transaction, thus increasing the
customer's expense; this practice had already been
condemned by long-standing judicial and regulatory
authority. See Sinclair v. SEC, 444 F.2d 399, 400 (2d Cir.
1971); In re Delaware Management Co., 43 SEC 392, 399-
400 (1967); In re Hoit Rose & Co., 1969 SEC LEXIS 244
(1969).1
_________________________________________________________________
1. Indeed, the only authority appellants are able to cite with facts similar
to the present case is an unpublished district court opinion in
typescript, Lesko v. Merrill Lynch, Pierce, Fenner & Smith, Inc., No. C78-
1740 (N.D. Ohio June 22, 1979), in which the court opined, with very
little analysis, that a deliberate policy of sending all orders to the AMEX
rather than "seeking the best price in the available markets" stated a
claim for securities fraud. That court did not discuss scienter, and is
thus inapposite, whatever its relative persuasiveness.
7
As the district court recognized, the most instructive case
on the issue of scienter is Platsis v. E.F. Hutton & Co., 946
F.2d 38 (6th Cir. 1991). There, a broker failed to disclose its
production credits, spreads or markups, while at the same
time it was profiting from customer transactions against its
own inventory. The district court found, after trial, that
defendants had acted with scienter, but the court of
appeals reversed because there was no established
regulatory duty to disclose and intent to deceive could not
thus be established by omission. Here, as in Platsis, the
dealers were under no established duty to execute trades at
other than the NBBO price or to disclose their execution
practices. Indeed, it appears that the industry as a whole
used the NBBO to satisfy the duty of best execution. Under
the reasoning of Platsis, then, which we adopt, there was
no scienter. Accord Shivangi v. Dean Witter Reynolds, Inc.,
825 F.2d 885, 889 (5th Cir. 1987) (failure to disclose sales
compensation did not involve scienter when no court or
regulator had ever held that information material and there
was no evidence that its disclosure was normal industry
practice).2
On the other hand, in Chasins v. Smith, Barney & Co.,
438 F.2d 1167 (2d Cir. 1970), a broker failed to disclose
that it was making a market in certain securities it strongly
recommended, and then sold, to plaintiff. Although scienter
was not directly at issue in Chasins, the court did opine
that all brokerage firms had followed the same practice and
had never thought such disclosure was required. Moreover,
the SEC had never prosecuted any firm for this violation.
_________________________________________________________________
2. The district court and appellees maintain that this circuit already
follows a Platsis-like rule. In Christidis v. First Pennsylvania Mortgage
Trust, 717 F.2d 96 (3d Cir. 1983), plaintiffs sued an accounting firm,
alleging that it fraudulently failed to preparefinancial statements in
accordance with generally accepted accounting principles. Although
scienter as such was not an issue, we affirmed the dismissal of the
complaint for lack of particularity in pleading fraud under Fed. R. Civ.
P. 9(b). Id. at 100. We do not read Christidis as itself adopting the
proposition that failure to disclose cannot involve scienter where there is
no clear duty to do so and the practice at issue is common in the
industry. It was simply a case involving the pleading standard for
allegations of fraud. Nevertheless, we think that Platsis is persuasively
reasoned and we adopt it here.
8
Indeed, as here, the practice at issue in Chasins was later
addressed by regulation. Id. at 1171 n.5.
Nevertheless, we decline to apply Chasins to this fact
pattern. First, the holding there did not address scienter.
See Architectural League v. Bartos, 404 F. Supp. 304, 315
(S.D.N.Y. 1975) ("All that . . . Chasins holds . . . is that
failure to disclose market-maker status was . . . the
omission of a material fact. The omission of a material fact,
without more, does not violate Rule 10b-5. All other
elements, including scienter, must be proven[.]"). Second, in
Chasins, appellant's contention that nobody thought
disclosure was required was demonstrably false, having
been impeached by appellant's own witness. 438 F.2d at
1171. That is not the case here. Finally, and most
importantly, in Chasins the dealer was strongly
recommending that the customer buy certain securities in
which the dealer itself was making the market. The dealer
thus had an undisclosed conflict of interest of major
proportions; to the extent that the customer followed its
"advice," the dealer made more money. See Simon v. Merrill
Lynch, Pierce, Fenner & Smith, Inc., 482 F.2d 880, 885 (5th
Cir. 1973) (distinguishing Chasins on this basis); Batchelor
v. Legg & Co., 52 F.R.D. 553, 557 (D. Md. 1971) (similar).
We therefore hold that, where defendants are under no
affirmative legal duty to disclose their order execution
practices and those practices are widely followed within the
securities industry, as a matter of law there is no scienter
when defendants fail to disclose those practices.
B.
In this case, although it appears on the surface that
appellants have adduced evidence that the nondisclosures
at issue here were not common industry practice, closer
examination reveals that contention to be unsupported.
Appellants first cite the deposition testimony of Paul M.
Lacy, a retired securities trader, for the proposition that
"other broker-dealers do not execute customer orders with
exclusive reference to the NBBO." His testimony supports
nothing. Mr. Lacy retired before the beginning of the class
period (November 1992), and therefore cannot offer any
9
competent, firsthand testimony about industry practices as
they existed at the times material to this litigation. Of even
greater significance, Lacy did not even testify about the
practices of other securities dealers in general or even his
former firm in particular, but testified only about his own
practices as a trader within that firm.
Appellants also rely on proposed SEC rules on order
execution as confirmation of Lacy's testimony [A 609]. See
Order Execution Obligations, 60 Fed. Reg. 52,792 (1995) (to
be codified at 17 C.F.R. pt. 240) (proposed Oct. 10, 1995).
That document recites that traders use "a variety of
systems and procedures" to satisfy best execution. Id. at
52,794. If traders use a variety of systems, however, that
bolsters the district court's conclusion that there was no
clear duty to supplement the NBBO price and that failure
to disclose the practice of executing all trades at the NBBO
price could not have involved scienter.
Appellants likewise refer us to the opinions of a trader
and a former SEC commissioner who believe that the duty
of best execution requires affirmative efforts to supplement
the NBBO with other sources of pricing. See National
Market System: Hearings Before the Subcomm. on
Telecommunications & Finance of the Comm. on Energy &
Commerce, 103d Cong., Serial No. 103-67, at 355 (1993)
(statement of securities dealer Bernard L. Madoff that he
believes it is the obligation of a market maker to achieve
price improvement whenever possible and does so infifty
percent of all trades); Declaration of former SEC
Commissioner Richard Y. Roberts, [A777] ("[i]t would be
inconsistent with the duty of best execution for a broker-
dealer to advantage itself by automatically executing
customer orders at the NBBO when superior prices are
reasonably available"). This evidence, however, is
insufficient.
To prevail on summary judgment, one need not show
that every dealer executes trades at the NBBO price, but
merely that enough dealers do so that the duty to
supplement the NBBO price is ambiguous and scienter is
negated. There is more than ample evidence of that. David
S. Ruder, a former Chairman of the SEC, member of the
NASD board and law professor at Northwestern University,
10
stated by affidavit that trades at the NBBO price satisfied
the duty of best execution and that the general custom and
practice of firms in the industry was to execute at the
NBBO price [A225-27]. T. Grant Callery, General Counsel to
NASD, also stated by affidavit that NASD views the NBBO
price as satisfying the best execution duty [A 458]. Finally,
Hugh Quiqley, a trader at Merrill Lynch, declared that he
had observed the trading practices of every major firm in
the industry and observed that the standard practice was
to trade at the NBBO [A 497].
Finally, while this case was pending on appeal, the SEC
finalized new regulations pertaining to order execution
which address directly the practices at issue here. See
generally Self-Regulatory Organizations; National
Association of Securities Dealers; Order Granting Partial
Approval and Notice of Filing and Order Granting
Accelerated Approval of Amendment No. 1 to Proposed Rule
Change Relating to Implementation of the Commission's
Order Handling Rules, 62 Fed. Reg. 2415 (Jan. 16, 1997).
Under these new rules, which became effective on January
20, 1997, market makers must display a customer's limit
order when the price of that order is superior to the current
NBBO quote. Moreover, any superior prices quoted on
electronic communications networks such as SelectNet and
Instinet must be listed as part of the NBBO price. See SEC
News Release 97-3, New Trading Rules for NASD and the
Exchanges, 1997 WL 21042 (Jan. 20, 1997). By these
regulatory changes, dealers will essentially be required to
eliminate the practices that appellants complain of in this
case. We believe, as did the district court, that the fact that
the Securities and Exchange Commission perceived the
need to address these order execution practices through the
regulatory process indicates strongly, if not conclusively,
that the "duty" to cross orders and to look beyond the
NBBO for pricing information was ambiguous, indeed
speculative, during the class period. Regulatory agencies
would not spend the time, money and effort in
promulgating regulations if the duty it sought to impose
were already clear under established law.3
_________________________________________________________________
3. We do not mean to imply, however, that the duty of best execution is
in any way unenforceable in a private action under § 10(b) of the 1934
11
III.
In sum, the evidence in this record is legally insufficient
for a rational jury to infer that defendants failed to disclose
their "NBBO-only" execution policy knowing that it was
fraudulent not to do so, or that they recklessly ignored
massive evidence suggesting that it was. Accordingly, the
district court correctly found no scienter and properly
entered summary judgment for defendants. We will affirm.
_________________________________________________________________
Act. Where the duty is clear, or where a practice is obviously fraudulent
and not pervasive throughout the securities industry, the mere lack of
regulations directly addressing the practice at issue will not constitute a
bar to such a suit.
12
STAPLETON, Circuit Judge, dissenting:
During the class period, Section 10(b) and Rule 10(b)-5
(hereafter referred to collectively as "Section 10(b)") imposed
upon the defendants a duty not to deliberately mislead
their clients. The plaintiffs allege that, when the defendants
received the plaintiffs' orders, the defendants knew both (1)
that the plaintiffs expected them to execute these orders at
a better price than the NBBO if the opportunity to do so
presented itself, and (2) that the defendants themselves had
no intention of referencing anything other than the NBBO.
The issue for decision is whether the plaintiffs have
produced sufficient evidence from which a trier of fact could
reasonably infer that one or more of the defendants had
this state of mind when they accepted the plaintiffs' orders
for execution. I conclude that they have and that summary
judgment for the defendants is therefore improper.
I.
The class period extends from November 4, 1992 to
November 4, 1994. The district court granted summary
judgment to the defendants primarily because the SEC,
during that period, had not explicitly declared that the duty
of best execution included the duty to consult reasonably
available sources other than NBBO. Because resolving that
issue involved considerations within the scope of the SEC's
expertise, the district court believed it would be
inappropriate for the courts to recognize a legal duty to
consult other sources during the class period. Ifind the
district court's approach unacceptable because it
mistakenly equates the SEC's lack of guidance with an
absence of any relevant law.
Our court reaches a somewhat different conclusion. It
finds that the SEC's post-class period decision effectively
eliminating the practices of which the plaintiffs here
complain1 "indicates strongly, if not conclusively, that the
_________________________________________________________________
1. The SEC proposed in 1995, and implemented in 1997, amendments to
the "Quote Rule" which now require market makers to include in the
NBBO any superior price they are quoting on electronic communications
networks like SelectNet or Instinet. See Order Execution Obligations,
13
`duty' to . . . look beyond the NBBO for pricing information
was ambiguous, indeed speculative, during the class
period." Slip Op. at 11. The court then concludes that there
was applicable law during the class period and that it was
established by the way in which a segment of the regulated
profession behaved during that period. Thus, the
defendants are entitled to summary judgment, we are told,
because they have shown "that enough dealers [referenced
only the NBBO during the class period] so that the duty to
supplement the NBBO price [was] ambiguous and scienter
is [therefore] negated." Id. at 10 (emphasis omitted).
I believe that Congress established the principles of law
applicable here when it enacted Section 10(b) and that
these principles were not ambiguous during the class
period. The district court's task was to apply those
unambiguous principles to the circumstances of each
transaction between a plaintiff and a defendant. Because
there are material disputes of fact concerning those
circumstances, I would reverse and remand for further
proceedings.
II.
The relationship between a client and a broker is that of
a principal and an agent. Absent special circumstances, it
is a relationship in which it is understood by all that the
client-principal seeks his own economic gain and the
broker-agent earns his commission by helping the client-
principal achieve that objective. Absent instructions to the
contrary, the broker is thus expected to maximize the
economic benefit to the client in each transaction. Hence,
the duty of best execution.
"[T]he duty of best execution requires a broker-dealer to
seek the most favorable terms reasonably available under
_________________________________________________________________
Exchange Act Release No. 36,310, 60 Fed. Reg. 52972 (Oct. 10, 1995)
("Proposed Rules"); Order Execution Obligations, Exchange Act Release
No. 37,619A, 61 Fed. Reg. 48290 (Sept. 12, 1996) ("Final Rules"). Since
the new NBBO incorporates a far wider range of prices, the possibility of
executing a trade at an inferior NBBO price when better prices are
available on an electronic communications network has been eliminated.
14
the circumstances for a customer's transaction." Proposed
Rules, 60 Fed. Reg. at 52793; U.S. Equity Market Structure
Study, Exchange Act Release No. 30,920, 57 Fed. Reg.
32587, 32595 (July 22, 1992); see generally Restatement of
Agency (2d) § 424 (1958) (stating that agent must "use
reasonable care to obtain terms which best satisfy the
manifested purposes of the principal"). That is, the duty of
best execution requires the defendants to execute the
plaintiffs' trades at the best reasonably available price.2
While there may be uncertainty in any particular situation
as to what prices are reasonably available, the existence of
a broker-dealer's duty to execute at the best of those prices
that are reasonably available is well-established.
The set of prices that are reasonably available to a
broker-dealer is constantly fluctuating. Therefore,
determining what satisfies the duty of best execution is a
highly fact-and-circumstance-sensitive inquiry, with the
scope of the duty evolving over time with changes in
technology and transformations in the structure offinancial
markets. See, e.g., Final Rules, 61 Fed. Reg. at 48322-23.
For example, before the creation of NASDAQ, a broker in an
over-the-counter market satisfied her duty of best execution
by contacting at least three market makers prior to
executing a client's order. See Proposed Rules, 60 Fed. Reg.
at 52793. With the advent of NASDAQ, and the NBBO
computer system providing instant access to the best bid
and offer available nationwide, the standard for satisfying
the duty of best execution necessarily heightened.
_________________________________________________________________
2. Other terms in addition to price are also relevant to best execution. In
determining how to execute a client's order, a broker-dealer should take
into account order size, trading characteristics of the security, speed of
execution, clearing costs, and the cost and difficulty of executing an
order in a particular market. See, e.g., Payment for Order Flow,
Exchange Act Release No. 33,026, 58 Fed. Reg. 52934, 52937-38 (Oct.
13, 1993). When the plaintiffs state that better "prices" were reasonably
available from sources other than the NBBO, I understand that to mean
that, given an evaluation of price as well as all of the other relevant
terms, the trade would be better executed through a source of liquidity
other than the NBBO (e.g. SelectNet, Instinet, in-house limit orders or
market orders held by the defendants, or limit orders placed by the
public in the Small Order Execution System). Similarly, for convenience,
I use the phrase "best reasonably available price" to mean "best terms."
15
The record reflects a genuine dispute of fact as to
whether prices better than those on the NBBO were
reasonably available from sources other than the NBBO at
the time the defendants executed the plaintiffs' trades at
the NBBO price. There is sufficient evidence from which a
reasonable trier of fact could find, for example, that prices
better than the NBBO were reasonably available on the
SelectNet and Instinet at the very moment that the
defendants chose to execute the plaintiffs' orders at the
NBBO price. The defendants have suggested that consulting
other sources besides the NBBO would have added
substantial expense and delay to the execution of plaintiffs'
orders, more than offsetting any improvements that might
have been available in terms of price. See Tr. Oral Arg. at
28-29. This, however, is clearly a factual dispute, which we
are not permitted to resolve in favor of the defendants at
this juncture.
I believe the evidence is sufficient to allow a reasonable
trier of fact to conclude that, by the time of the class
period, both technology and over-the-counter markets had
developed to a point where it was feasible to maximize the
economic benefit to the client by taking advantage of better
prices than the NBBO.
III.
Recovery for federal securities fraud requires a showing
of deliberate or reckless misrepresentation of a material
fact. The misrepresentation here, according to plaintiffs,
was an implied representation made by the defendants
when they agreed to execute the plaintiffs' orders that they
would maximize the plaintiffs' economic gain in the
transaction. Plaintiffs' orders did not specify the price at
which they were to be executed. It is at least a reasonable
inference, plaintiffs therefore insist, that they would not
have placed these orders with the defendants without an
understanding that the defendants would execute them in
a manner seeking to maximize plaintiffs' economic benefit.
Since the defendants knew of the plaintiffs' profit
motivation, they must have understood that plaintiffs would
expect them to obtain a price more advantageous to the
plaintiffs than the NBBO when one was readily available. If,
16
as plaintiffs allege, the defendants intended not to act in a
manner consistent with this expectation when they
accepted the orders and yet did not so advise plaintiffs, the
defendants can be found to have made an implied
representation that they knew to be false.
In addition to these inferences that can be drawn from an
economic analysis of the plaintiffs' relationship with the
defendants, plaintiffs rely upon evidence showing that
respected members of the brokerage community recognized,
even prior to the class period, that trades were readily
available from sources other than the NBBO and that their
clients expected them to take advantage of those sources
whenever it would benefit the client. See, e.g., Declaration
of Paul M. Lacy [A 718]; Declaration of Junius W. Peake [A
755]; Declaration of Richard Y. Roberts [A 775]. Moreover,
the plaintiffs have shown that the SEC found clear evidence
of a two-tiered market during the class period, in which
NASDAQ market makers routinely traded at one price with
retail clients like the plaintiffs and at a better price for
themselves through quotation services like SelectNet and
Instinet. See Final Rules, 61 Fed. Reg. at 48307-08. They
have further shown that the possibility that the duty of best
execution might require resort to sources other than the
NBBO was being actively debated during the class period
and that that debate ultimately resulted, after the class
period, in a regulation effectively requiring as much. Id.
All of this would allow a reasonable trier of fact to find
that the defendants' misrepresentation--namely, that they
would execute plaintiffs' trades in a manner maximizing
plaintiffs' economic gain--was at least reckless, if not
intentional. See Healey v. Catalyst Recovery of Penn., Inc.,
616 F.2d 641, 649 (3d Cir. 1980) (defining recklessness as
an extreme departure from ordinary care). Certainly, then,
scienter can be found on this record.
To be sure, as the court's opinion stresses, the
defendants have countered with affidavits of other
respected members of the brokerage community stating
that their practice during the class period was the same as
that of the defendants. This evidence could, of course, be
regarded by a trier of fact as probative of the defendants'
state of mind when they accepted plaintiffs' orders. But
17
these affidavits do no more than raise a material issue of
fact as to whether the defendants knew of the expectation
plaintiffs claim to have had; they do not settle the matter.
At trial, the defendants would certainly be entitled to
argue to the jury that, because of industry practice, they
thought their clients would expect them to execute only at
the NBBO or that they never thought about their clients'
expectations. Moreover, any evidence, derived from
knowledge of industry practice or elsewhere, that the
plaintiffs were generally aware of the defendants' exclusive
reliance on the NBBO would, of course, be quite probative
of whether the plaintiffs had the expectations they claim.
But the court, in elevating the practice of a segment of the
industry to be outcome determinative, loses sight of the fact
that the basis for the duty of best execution is the mutual
understanding that the client is engaging in the trade--and
retaining the services of the broker as his agent--solely for
the purpose of maximizing his own economic benefit, and
that the broker receives her commission because she
assists the client in reaching that goal. Based on this
mutual understanding and the absence of any express
limitations on the brokers' responsibility, a trier of fact
could find that the defendants understood that they were
expected to utilize sources other than the NBBO when a
better price was readily available.
IV.
As I understand the court's analysis, a Section 10(b)
defendant might be granted summary judgment even if her
regular practice violated the duty of best execution, and she
knew or should have known that it violated that duty, so
long as she can identify a sufficient number of other
broker-dealers engaged in the same wrongful conduct to be
able to argue in good faith that the underlying duty was
"ambiguous." I cannot accept an analysis that will produce
such a result.
Even a universal industry practice may still be
fraudulent. See Chasins v. Smith, Barney & Co., 438 F.2d
1167, 1171-72 (2d Cir. 1970) (non-disclosure of widespread
industry practice may still be non-disclosure of material
18
fact); Opper v. Hancock Securities Corp., 250 F. Supp. 668,
676 (S.D.N.Y. 1966) (industry custom may be found
fraudulent, especially on first occasion it is litigated); see
also Vermilye & Co. v. Adams Express Co., 88 U.S. 138,
146 (1874). Indeed, the SEC recently completed an
investigation in which it found that widespread fraud was
occurring in the NASDAQ market during a period
overlapping the class period. See Report Pursuant to
Section 21(a) of the Securities Exchange Act of 1934
Regarding the NASD and the NASDAQ Market (Aug. 8,
1996).
As the court emphasizes, the practice of exclusive
reliance on the NBBO has never been held to be fraudulent
by any court or regulator. But neither is there any statute,
rule, regulation, or interpretation, by the SEC or by a court,
that authoritatively establishes that exclusive reliance on
the NBBO, even when better prices are reasonably
available, satisfies the duty of best execution. Whether the
NBBO exhausted the category of "reasonably available
prices" during the class period has thus never been
expressly determined. But this did not absolve the district
court of the duty to resolve the plaintiffs' securities fraud
claim once it was presented in this suit.
"In the final analysis, ultimate responsibility for
construction and enforcement of the securities laws must
rest with the court." Langert v. Q-1 Corp., Fed. Sec. L. Rep.
(CCH) para. 94,445, at 95,540, 1974 WL 377 (S.D.N.Y. Mar.
15, 1974). The district court was not deprived of this
enforcement authority just because no court or regulator
had previously chosen to exercise such authority with
respect to the practice challenged here. See, e.g., Chasins,
438 F.2d at 1171-72 (finding that defendant's failure to
disclose its market maker status was material omission
under Section 10(b), despite fact that SEC had never
previously held that such disclosure was required).
V.
On the record before us, I believe a reasonable trier of
fact could conclude that the defendants misrepresented
that they would execute the plaintiffs' orders so as to
19
maximize the plaintiffs' economic benefit, and that this
misrepresentation was intentional or reckless because, at
the time it was made, the defendants knew that they
intended to execute the plaintiffs' orders at the NBBO price
even if better prices were reasonably available. A reasonable
trier of fact could find scienter with respect to a material
misrepresentation, as well as the other elements essential
to a Section 10(b) fraud claim. Accordingly, I must
respectfully dissent.
A True Copy:
Teste:
Clerk of the United States Court of Appeals
for the Third Circuit
20