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Guice v. Charles Schwab & Co., 89 N.Y.2d 31 (Oct. 17, 1996).

SECURITIES LAW - ORDER FLOW PAYMENTS - FEDERAL PREEMPTION

SECURITIES EXCHANGE COMMISSION REGULATIONS PREEMPT STATE LAW IN THE CASE OF ORDER FLOW PAYMENTS, WHICH HAVE BEEN ANALYZED BY THE SECURITIES EXCHANGE COMMISSION TO BE A COST BENEFICIAL PRACTICE.

[SUMMARY] | [ISSUE & DISPOSITION] | [AUTHORITIES CITED] | [COMMENTARY]

SUMMARY

Plaintiffs, former retail customers of Defendant's "discount" stock brokerage houses, objected to Defendant's receipt of "order flow" payments, a common practice in the securities industry by which retail security broker-dealers route customers' orders for execution to wholesale dealers in exchange for monetary or other remuneration. Characterizing the payments as "kickbacks" that were accepted without full and frank disclosure of the broker's dual role in the transaction, Plaintiffs initiated civil damages actions against Defendants. Plaintiffs initially alleged a violation of the common-law agency duty of loyalty and the per se illegality of the practice of accepting order flow payments as a form of commercial bribery and a violation of a broker's duty to obtain the "best execution" of customers orders. The complaint was subsequently certified as a class action on behalf of all similarly situated clients who used defendants' brokerage services during the 1990-94 putative period and limited to allegations of breach of common-law agency principles.

The Supreme Court granted Defendants' motions to dismiss, concluding that Plaintiffs' causes of action were preempted by the Securities Exchange Act of 1934, as amended in 1975, and the SEC Regulations promulgated thereunder. The Appellate Division reinstated Plaintiffs' common-law causes of action, reasoning that federal law was not a bar to determining the adequacy of disclosure of information regarding order flow payments. The Appellate Division remitted for determination of the remaining grounds for defendants' motions to dismiss and certified to the Court of Appeals the question whether the modification order was properly made.

ISSUE & DISPOSITION

Issue

Whether civil damage claims based on common law agency standards of disclosure in the practice of order flow payments are preempted by SEC regulations promulgated under the Securities Exchange Act of 1934, as amended.

Disposition

Yes. SEC regulations preempt state law in the case of order flow payments, which have been analyzed to be a cost beneficial practice.

AUTHORITIES CITED

Cases Cited by the Court

  • Doctor's Assocs., Inc. v. Casarotto, _U.S._, 64 U.S.L.W. 4370 (1996).
  • Freightliner Corp. v. Myrick, _ U.S. _, 115 S.Ct. 1483 (1995).
  • International Paper Co. v. Ouellette, 479 U.S. 481 (1987).
  • Capital Cities Cable, Inc. v. Crisp, 467 U.S. 69 (1984).
  • Le Roy v. Great W. United Corp., 443 U.S. 173 (1979).
  • Gordon v. New York Stock Exch., 422 U.S. 659 (1975).
  • Hines v. Davidowitz, 312 U.S. 55 (1941).
  • Dahl v. Charles Schwab & Co., 545 N.W.2d 918 (Minn. 1996), cert. denied, No. 96-99, 1996 WL 411501 (Oct. 7, 1996).
  • Evangelist v. Fidelity Brokerage Servs., Inc., 643 N.Y.S.2d 332 (N.Y. App. Div. 1996).
  • Guice v. Charles Schwab & Co., 214 A.D.2d 53 (N.Y. App. Div. 1995).

Other Sources Cited by the Court

  • Francis J. Facciolo & Richard L. Stone, Avoiding the Inevitable: The Continuing Viability of State Law Claims in the Face of Primary Jurisdiction and Preemption Challenges Under the Securities Exchange Act of 1934, 525 Colum. Bus. L. Rev 640 (1995).
  • Payment for Order Flow, Exchange Act Release No. 34-33026 (Oct. 6, 1993), reprinted in 58 Fed. Reg. 52,934 (1993).
  • Securities and Exchange Act of 1934, 15 U.S.C. § 78 et seq. (1934).
  • Senate Committee on Banking, Housing and Urban Affairs, S. Rep. No. 94-75, 94th Cong., 1st Sess. 1, reprinted in 1975 U.S.C.C.A.N. 179.
  • Securities Confirmations Proposed Rule, Exchange Act Release No. 12806 (Sept. 16, 1976), reprinted in 41 Fed. Reg. 41432 (1976).
  • Securities Confirmations, Exchange Act Release No. 34-13508 (May 5, 1977), reprinted in 42 Fed. Reg. 25318, codified as amended at 17 C.F.R. § 240.10b-10[a][7][iv].
  • Restatement (Second) of Agency § 390 (1957).

COMMENTARY

State of the Law Before Guice v. Charles Schwab & Co.

In Wendt v. Fischer, the New York Court of Appeals held that when an agent conducts a transaction for the principal, the agent has an obligation to fully and completely disclose any conflict of interest between the agent and the principal. 243 N.Y. 439 (N.Y. 1926). Prior to the Court's decision in Guice, the broker's required level of disclosure to the consumer regarding the receipt of order flow payments was unclear.

Similarly, the Restatement (Second) of Agency calls for full and complete disclosure. Restatement (Second) of Agency § 390. The agent is required to disclose all of the information that the agent knows or should know would be considered important to the principal when determining whether to consent to the agent's dual role. Id. at 390 cmt a (1958).

Effect of Guice on Current Law

The court holds that federal legislation and administrative agency regulations preempt the state common law in cases where the federal agency after extensive cost benefit analysis, intends, its regulations to be the only standard. In effect the court holds that once a federal regulatory agency has determined what the appropriate standard should be, any higher, state-imposed standard will be preempted under the doctrine of implied conflict preemption. The 1975 amendments to the Securities Exchange Act and the subsequent regulations created by the SEC were of such a nature as to preempt the states from imposing any additional common law duties to disclose information regarding order flow payments.

Stating that preemption is ultimately a question of congressional intent, the court outlines various ways in which federal law may preempt state law. The preemptive effect of federal legislation may be shown through express language in the federal statute. It may also be implied if the federal legislation is so comprehensive that it is clear that Congress wished it to occupy the entire field of its subject matter. Furthermore, the court emphasizes that federal administrative agency regulations may also preempt state law when their purpose is to effectuate Congressional intent.

The opinion details the Congressional reasons for the 1975 amendments. The court states that there is a need "to remove impediments to and perfect the mechanisms of a national market system for securities and a national system for clearance and settlement of securities transactions." In accordance with this goal, the SEC adopted Rule 10b-10 in 1977, which imposed various disclosure requirements. However, the SEC also recognized that these requirements should be adjusted to take into consideration situations where compliance costs are disproportionate to the practical benefits to the investor.

In 1993 the SEC reviewed the proposed expansion of disclosure requirements for order flow payments. Employing a cost benefit analysis, the SEC imposed several additional disclosure requirements but flatly rejected eliminating order flow payments. It concluded that the practice benefitted the securities industry because it lowered execution costs, enhanced competition, and did not violate the broker's best execution obligations. The court emphasizes that the Defendants here had complied with the SEC disclosure requirements as applied to order flow payments.

Plaintiff relied on New York agency law precedent which requires that when dual interests are involved, effective disclosure "must lay bare the truth, without ambiguity or reservation." Wendt v. Fischer, 243 NY 439 at 443. The court states that Plaintiffs have an actionable claim under New York law and that a jury might find that Defendants did not disclose adequately to meet the legal standard.

The court, however, concludes that if it allowed various state courts to impose liability on national brokerage houses for failure to meet stricter state common law agency disclosure standards for order flow payments, it would defeat the Congressional purpose of allowing the SEC to regulate a coherent national market system. The court cites precedent showing that federal legislation preempts state regulation when that regulation adversely affects the ability of a federal administrative agency to regulate according to Congressional objectives.

The court goes further to state that state civil actions based on common law agency principles conflict with Congressional intent in a second respect. The SEC, acting within its rule making authority, determined that order flow payments increase the efficiency of the market and placed limited disclosure requirements on these payments. By imposing further disclosure or risk of civil liability on these payments, brokers may abandon them altogether, thereby increasing the cost and directly undermining the Congressional objective of efficient execution of orders.

The court specifically rejects Plaintiffs' arguments that stricter state common law disclosure doctrine can coexist with federal regulations, because both are intended to enhance investor protection. The effect of state liability would be to supplant the disclosure rules of the SEC and disrupt the delicate balance of interests determined by Congress and the SEC.

The savings clause of the Securities Exchange Act, which allows for state securities regulation to the extent that it does not conflict with federal regulations, does not provide the Plaintiff any relief either. The Court holds that there is a conflict between the state common law agency standard and the federal regulations and therefore the savings clause does not apply.

Unanswered Questions

Chief among the questions that are left open by the court is how far the decision will reach. In Guice the issue was the SEC's directive to create, and authority to regulate a national market system for securities. Federal law, by definition is national in scope. In cases where Congress includes a savings clause in the statute, federal law normally serves as a minimum standard. Absent a conflict with federal law, states are usually free to also regulate the area in question. The court acknowledges this principle but interprets the higher standard of New York's common law of agency as directly conflicting with the standard for disclosure set by the SEC. The court does so not because meeting both standards is impossible but because New York's common law standard is an obstacle to achieving the Congressional objective of a national system. Will this type of implied conflict preemption be found only when Congress intends to establish a national system? In our increasingly mobile and interconnected society, it is important to know if such preemption will also be found in other areas regulated by both state and federal governments.

The court's emphasis on the cost benefit analysis done by the SEC suggests that such an analysis is necessary, or at least highly probative, in determining the preemptive effect of such a federal regulation. The court does not, however, directly address the question. Additionally, if such an analysis is required, it is not clear how exhaustive that analysis must be. The court gives complete deference to the SEC's determination of the standard for disclosure concerning order flow payments, and never addresses whether it would do so had the SEC's analysis been less thorough.

If a cost benefit (or similar) analysis is required to give preemptive effect to federal agency regulations, it is unclear who will decide whether the agency has done such an analysis and whether it was adequately done. It seems that such a determination will in all likelihood rest with the courts. This may further undermine the certainty of a savings clause. The savings clause was not enough to sustain state action in Guice. The question remains whether such a clause would be able to support state action in other areas regulated by federal agencies.

Survey of the Law in Other Jurisdictions

The issue whether state common law agency and statutory consumer protection requirements should be extended into the area of order flow payments in securities transactions has only been raised in one state other than New York.

The Supreme Court of Minnesota has addressed the possible preemption of state statutory or common law by federal order flow payment regulation. In Dahl v. Schwab, the Court held that federal securities law regarding "order flow payments" preempted any consent requirements under state common law of agency or state consumer protection statutes. 545 N.W.2d 918 (Minn. 1996). Minnesota agency law requires the principal's consent as well as the agent's full disclosure of facts in situations were the agent may profit. Carlson v. Carlson, 363 N.W.2d 803 (Minn. 1985). The Minnesota Supreme Court stated that if these requirements were imposed, they would result in agents or brokers having to calculate the exact amounts of order flow profits per customer before the aggregate order was executed and that such a requirement might render the order flow payment system unprofitable. Dahl, 545 N.W.2d at 925. The Court found, as the New York Court of Appeals did in Guice, that there should be an implied preemption to state law since it presented an obstacle to the accomplishment of the purpose of federal law. Unlike the New York Court of Appeals, however, the Minnesota Supreme court did not discuss SEC amendments in its preemption analysis. The Minnesota court relied instead on Congress' general intent to allow the SEC to regulate the securities market. The Court reasoned that it was the general Congressional intent to encourage competition and concluded that order flow payments are a useful competitive tool. Dahl, 545 N.W.2d at 925.

Prepared By:

  • Emmy B. Hackett, '98
  • Armando Pastrana, Jr., '98
  • Michael A. Peil, '97
  • Barbara Raben, '98
  • Spencer F. Robert, '98
  • Christopher W. Sprague, '98
  • Michelle L. Sterling, '97