In re Merrill Lynch Securities Litigation

• Decision Date: 15 December 1995
• Docket Number: Civ. No. 94-5343 (DRD).
• Citation: 911 F. Supp. 754
• Parties: In re MERRILL LYNCH, et al. SECURITIES LITIGATION.
• Court: U.S. District Court — District of New Jersey

911 F. Supp. 754

In re MERRILL LYNCH, et al. SECURITIES LITIGATION.

Civ. No. 94-5343 (DRD).

United States District Court, D. New Jersey.

December 15, 1995.

COPYRIGHT MATERIAL OMITTED

Karen Morris, Morris & Morris, Wilmington, DE, Paul Dillon, Greenberg, Dauber & Epstein, Newark, NJ, for Plaintiffs.

Bruce Coolidge, Wilmer, Cutler & Pickering, Washington, DC, Joseph A. Boyle, Kelley, Drye & Warren, Parsippany, NJ, for Defendant Painewebber, Inc.

Jonathan Eisenberg, Kirkpatrick & Lockhart, Washington, DC, New York City, Brian F. Amery, Bressler, Amery & Ross, Florham Park, NJ, for Defendant Merrill Lynch, Pierce, Fenner & Smith, Inc.

Frank A. Holozabiec, Kirkland & Ellis, New York City, Jonathan L. Goldstein, Hellring, Lindeman, Goldstein & Siegal, Newark, NJ, for Defendant Dean Witter Reynolds Inc.

OPINION

DEBEVOISE, Senior District Judge.

This is a class action in which the complaint charges defendant brokerage firms with securities fraud in violation of Section 10 of the Securities Exchange Act of 1934 and Rule 10-b promulgated thereunder, as well as breach of fiduciary duty and unjust enrichment under state law. Defendants moved to dismiss the complaint for failure to state a claim upon which relief can be granted. At the direction of the court defendants' motion was converted into a motion for summary judgment. Defendants were requested to supply by way of affidavit and supporting documents information relating to each transaction which they conducted on behalf of each of the plaintiff class representatives during the class period. In addition, each party was requested to submit information about market practices and regulatory requirements or advisories concerning transactions such as those which were the subject of the complaint. For the reasons given below, defendants' motion for summary judgment is granted.

I — PLAINTIFF'S ALLEGATIONS

Defendants in this case, Merrill Lynch Pierce Fenner & Smith, Inc. ("Merrill Lynch"), PaineWebber, Inc. ("PaineWebber") and Dean Witter Reynolds, Inc. ("Dean Witter"), are "integrated broker/dealer" brokerage companies that transact trades both as agents and as principals. Plaintiffs Bruce Zakheim IRA FBO Bruce Zakheim ("Zakheim"), a Merrill Lynch customer, Gloria Binder ("Binder"), a Painewebber customer, and Jeffrey Phillip Kravitz ("Kravitz"), a Dean Witter customer retained defendants to either conduct trades on their behalf or to trade with them directly in various over-the-counter ("OTC") securities.

The gravamen of plaintiffs' complaint is as follows:

1) As agents, defendants relied exclusively on the National Best Bid and Offer ("NBBO"), a price quotation representing the best bid and best offer of any OTC market maker in a particular security on the two-sided NASDAQ market, to fulfill their duty to execute their customers' market orders¹ at the best available price, despite the availability of better prices from a number of sources of liquidity. Those sources included SelectNet², Instinet³, in-house limit orders, in-house market orders, and the SOES limit order file.⁴ Plaintiffs contend that by failing to take advantage of these other sources and by failing to disclose such neglect, defendants breached a fiduciary duty they owed to plaintiffs by dint of the broker/customer relationship that existed between them. Amended and Consolidated Class Action Complaint ("Amended Complaint") ¶¶ 25-32, 46-49.

2) As principals, defendants not only failed to execute plaintiffs' market orders at the best available price but also employed a number of fraudulent devices to secretly accrue profits for themselves. Failure to disclose both the accrual of such profits and the practice of failing to execute at the best available price, according to plaintiffs, amounted to fraud, Amended Complaint ¶ 42, and a further violation of defendants' fiduciary duty. Amended Complaint ¶ 48. Moreover, defendants were unjust enriched by the accrual of secret profits. Amended Complaint ¶¶ 50-53.

The parties agree that all the transactions in question here were executed by defendants, either as agents or principals, at prices that were equivalent to the NBBO at the time of each transaction. Amended Complaint ¶ 28; Memorandum of Law In Support of Defendants' Motion to Dismiss the Amended Complaint at 7-8; Reply in Support of Defendants' Motion To Dismiss The Amended Complaint at 2; Declaration of Hugh Quigley ¶ 10; Affidavit of Robert Slane ¶ 9; Affidavit of Thomas Dwyer ¶¶ 6-8.

The fraudulent devices alleged by plaintiffs to have been employed by the defendants in their role as principals, are as follows:

1) Failure to reference sources other than the NBBO when setting prices, as principals, for transactions with retail customers: By setting the price of their transactions as principals with reference exclusively to the NBBO, defendants arbitrarily made parity with the NBBO the de facto standard for best execution. Because prices superior to the NBBO, from the standpoint of the retail customer, were in fact available from other sources of liquidity at the time of those transactions, defendants were able to establish market positions, both long and short, that were, in fact, better, from their standpoint, than those that represented the "best available price" at any given time. By establishing such superior positions, defendants were able to profit from the difference between the NBBO and the best available price. Amended Complaint ¶ 33.

2) Failure to cross in-house market orders: Plaintiffs contend that when defendants received contemporaneous market orders to buy and sell shares in the same stock they systematically failed to execute those orders at a price between the bid and ask, executing each instead at the NBBO quote, thereby appropriating the "spread" between the bid and asked prices on the two-sided NASDAQ market while incurring no risk to themselves. Amended Complaint ¶¶ 34-35.⁵

3) Failure to cross customers' market orders with in-house limit orders: Plaintiffs contend that defendants executed customers' market orders at the NBBO despite having received corresponding "limit" orders in the same security from other customers. Defendants thereby appropriated the "spread" while incurring no risk to themselves. Amended Complaint ¶ 36.

4) Failure to cross customers' market orders with SOES limit orders: executing orders to either sell or buy shares of particular stocks at the NBBO despite the currency of "limit" orders on the SOES limit order file.⁶

5) Re-trading at the inside price on the "same side" of the spread: executing market orders to either sell or buy shares of particular stocks at the NBBO quotes despite better prices being available, and then immediately retrading those same shares at those better prices for defendants' own profits, incurring no risk by trading on the same side of spread. Amended Complaint ¶ 37.

6) Selling order flow: Without knowledge or consent of the customers placing the orders and in exchange for payments ("payment for order flow"), defendants allegedly routed plaintiffs' market orders to other brokers who failed to execute them at the best available price and who used one or more of the above fraudulent devices to secretly accrue profits to themselves. Amended Complaint ¶ 38.

Plaintiffs bring this class action pursuant to Fed.R.Civ.Proc. 23 on behalf of all those persons who placed market orders with Merrill Lynch, PaineWebber or Dean Witter to purchase or sell shares of OTC stock between November 4, 1992 and November 4, 1994.

II-MARKET OPERATION

NASDAO

Over-the-counter trading ("OTC") is, in a sense, the oldest and simplest type of economic exchange: buyer and seller meet outside a formal marketplace, agree on a price and exchange items of economic value. The term derives from a time, long before the advent of computers and electronic communications networks, when some trading in stocks took place in banks where the physical certificates were passed "over-the-counter." Reshaping The Equity Markets, Robert A. Schwartz at 47 (HarperBusiness 1991) hereinafter Schwartz.

In 1971, in an effort to link together geographically dispersed dealers into a single integrated system by exploiting rapidly evolving technologies, Congress created the National Association of Securities Dealers Automated Quotation System ("NASDAQ,", more formally the Nasdaq Market System, Inc.), a subsidiary of The National Association of Securities Dealers ("NASD"). The purpose of the NASDAQ was explicitly delineated in the authorizing legislation:

The securities markets are an important national asset which must be preserved and strengthened ... The linking of all markets for qualified securities through communication and data processing facilities will foster efficiency, enhance competition, increase the information available to brokers, dealers, and investors, facilitate the offsetting of investors' orders, and contribute to best execution of such orders.

15 U.S.C. § 78k-1(a)(1)(A) and (D).

The function of a stock exchange is to provide an environment in which the transfer of capital between enterprises can be accomplished at fair prices for minimal cost. One measure of the success of an exchange in fulfilling that role, known as liquidity, is the rapidity and ease with which such transfers can be effectuated. A marketplace with good liquidity affords buyers and sellers the opportunity to locate counterparts willing to trade a wide range of issues at acceptable prices as quickly and efficiently as possible.

In contrast to traditional markets, where liquidity, and thus efficiency and immediacy, are maintained by monopolist "specialists," liquidity on the NASDAQ is maintained by competing dealers, known as "market makers," who hold themselves out to all comers as ready to buy or sell a security for their own account. By making known the price at which they are willing to transact in a particular stock, NASDAQ market makers create a competitive structure in which fair...