Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc.

• Decision Date: 30 January 1998
• Docket Number: No. 96-5045,FPO-B,96-5045
• Citation: 135 F.3d 266
• Parties: Fed. Sec. L. Rep. P 90,130 Kenneth E. NEWTON; MLPF & S Cust. Bruce Zakheim IRA FBO Bruce Zakheim v. MERRILL, LYNCH, PIERCE, FENNER & SMITH, INC.; PaineWebber Inc.; Dean Witter Reynolds. Jeffrey Phillip KRAVITZ v. DEAN WITTER REYNOLDS, INC. MLPF & S Cust.ruce Zakheim Ira FBO Bruce Zakheim, Jeffrey Phillip Kravitz, And Gloria Binder, Appellants.
• Court: U.S. Court of Appeals — Third Circuit

Page 266

135 F.3d 266

Fed. Sec. L. Rep. P 90,130

Kenneth E. NEWTON; MLPF & S Cust. Bruce Zakheim IRA FBO Bruce Zakheim v. MERRILL, LYNCH, PIERCE, FENNER & SMITH, INC.; PaineWebber

Inc.; Dean Witter Reynolds.

Jeffrey Phillip KRAVITZ v. DEAN WITTER REYNOLDS, INC.

MLPF & S Cust. FPO-Bruce Zakheim Ira FBO Bruce Zakheim,

Jeffrey Phillip Kravitz, And Gloria Binder, Appellants.

No. 96-5045.

United States Court of Appeals, Third Circuit.

Argued Oct. 24, 1996.

Reargued En Banc Oct. 29, 1997.

Decided Jan. 30, 1998.

Irving Morris, Karen L. Morris (Argued), Abraham Rappaport, Seth D. Rigrodsky, Morris and Morris, Wilmington, DE, for Appellants.

Matthew D. Anhut, Jonathan N. Eisenberg, Kirkpatrick & Lockhart, Washington Joseph A. Boyle, Kelley, Drye & Warren, Parsippany, NJ, Bruce Coolidge, Robert B. McCaw (Argued), Wilmer, Cutler & Pickering, Washington, DC, for Appellee PaineWebber, Inc.

DC, for Appellee Merrill, Lynch, Pierce, Fenner & Smith, Inc.

Frank M. Holozubiec, Kirkland & Ellis, New York City, for Appellee Dean Witter Reynolds.

Richard H. Walker, Eric Summergrad, Susan F. Wyderko, Jacob H. Stillman, Securities & Exchange Commission, Washington, DC, for Amicus Curiae Securities & Exchange Commission.

Before: STAPLETON and NYGAARD, Circuit Judges, and MAZZONE, ^* District Judge.

Reargued En Banc Oct. 29, 1997.

Before: SLOVITER, Chief Judge, BECKER, STAPLETON, MANSMANN, GREENBERG, SCIRICA, NYGAARD, ALITO, ROTH and LEWIS, Circuit Judges.

OPINION OF THE COURT

STAPLETON, Circuit Judge.

I.

Plaintiff-Appellants are investors who purchased and sold securities on the NASDAQ market, the major electronic market for "over-the-counter" securities, during the two year period from November 4, 1992 to November 4, 1994 ("the class period"). The defendants are NASDAQ market makers. NASDAQ is a self-regulating market owned by the National Association of Securities Dealers ("NASD"), subject to oversight by the Securities and Exchange Commission ("SEC").

An "over-the-counter" market like NASDAQ differs in important respects from the more familiar auction markets, like the New York and American Stock Exchanges. The NYSE and AMEX markets are distinguished by a physical exchange floor where buy and sell orders actually "meet," with prices set by the interaction of those orders under the supervision of a market "specialist." In a dealer market like NASDAQ, the market exists electronically, in the form of a communications system which constantly receives and reports the prices at which geographically dispersed market makers are willing to buy and sell different securities. These market makers compete with one another to buy and sell the same securities using the electronic system; NASDAQ is, then, an electronic inter-dealer quotation system.

In a dealer market, market makers create liquidity by being continuously willing to buy and sell the security in which they are making a market. In this way, an individual who wishes to buy or sell a security does not have to wait until someone is found who wishes to take the opposite side in the desired transaction. To account for the effort and risk required to maintain liquidity, market makers are allowed to set the prices at which they are prepared to buy and sell a particular security; the difference between the listed "ask" and "bid" prices is the "spread" that market makers capture as compensation.

The electronic quotation system ties together the numerous market makers for all over-the-counter securities available on NASDAQ. All NASDAQ market makers are required to input their bid and offer prices to the NASD computer, which collects the information and transmits, for each security, the highest bid price and lowest ask price currently available. These prices are called the "National Best Bid and Offer," or NBBO. The NASD computer, publicly available to all NASDAQ market makers, brokers and dealers, displays and continuously updates the NBBO for each offered security.

Plaintiffs allege that technological advances made it feasible during the class period for the defendant market makers to execute orders at prices quoted on private on-line services like SelectNet and Instinet and that those prices were frequently more favorable to their investor clients than the NBBO price. According to plaintiffs, the defendants regularly used these services and knew that prices better than NBBO were often available through them. Even though they knew that their investor clients expected them to secure the best reasonably available price, plaintiffs say, the defendants executed plaintiffs' orders at the NBBO price when they knew that price was inferior and when they, at the same time, were trading at the more favorable price for their own accounts. In this way, they were able to inflate their profit margins at the expense of their investor clients. This practice is alleged to violate section 10 of the Securities Act of 1934, 15 U.S.C. § 78j, and Rule 10b-5 promulgated thereunder, 17 C.F.R. § 240.10b-5.

The plaintiffs also charge defendants with two other violations of section 10 and Rule 10b-5. Market makers who simultaneously hold a market order for both sides of a transaction may obtain more favorable prices than the NBBO by "crossing" these in-house orders. Transactions handled in this way are executed within the spread, giving both the purchaser and seller a better price. Similarly, a customer order can be matched by a market maker with an in-house limit order on the other side of the transaction. Since a limit order specifies a particular price at which to execute a transaction, matching another customer order at that price may beat the currently displayed NBBO quote for that security. Plaintiffs allege that the failure of the defendants to execute orders of their clients in these ways when feasible constitutes a fraudulent practice because, by executing at the NBBO rather than matching customer orders, the defendants capture the full market "spread" as a fee for their services without incurring any actual risk in the transaction.

II.

The defendants filed a motion to dismiss for failure to state a claim upon which relief could be granted. At the direction of the district court, this motion was converted into a motion for summary judgment, which was ultimately granted. See In re Merrill Lynch Securities Litigation, 911 F.Supp. 754 (D.N.J.1995). The district court rested its decision on two principal grounds. First, the court determined that the defendants made no misrepresentation. Though recognizing that the defendants, by accepting plaintiffs' orders, impliedly represented that they intended to execute those orders in conformity with the "duty of best execution," the court considered the scope of this duty sufficiently ill-defined that execution at the NBBO could not, as a matter of law, be found inconsistent with the duty. The court concluded that in the face of uncertainty about the scope of defendants' duty of best execution, holding them liable would be "highly imprudent." 911 F.Supp. at 771. Second, the court held that, even if defendants made a material misrepresentation, they could not, as a matter of law, have acted with the requisite scienter.

To state a claim for securities fraud under § 10 of the Securities Act of 1934 and Rule 10b-5, plaintiffs must demonstrate: (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. See Sowell v. Butcher & Singer, Inc., 926 F.2d 289, 296 (3d Cir.1991). Because plaintiffs have demonstrated that a genuine issue of material fact exists as to the elements of their securities fraud claim, we will reverse the district court.

III.

The parties agree that a broker-dealer owes to the client a duty of best execution. They further agree that a broker-dealer, by accepting an order without price instructions, impliedly represents that the order will be executed in a manner consistent with the duty of best execution and that a broker-dealer who accepts such an order while intending to breach that duty makes a misrepresentation that is material to the purchase or sale. The parties differ, however, on whether a trier of fact could conclude from this record that the implied representation made by the defendants included a representation that they would not execute at the NBBO price when prices more favorable to the client were available from sources like SelectNet and Instinet.

As we explain hereafter, this difference can be resolved only by determining whether, during the class period or some portion thereof, it was feasible for the defendants to execute trades through SelectNet and Instinet when prices more favorable than the NBBO were being quoted there. This is a matter concerning which the record reflects a material dispute of fact. If such prices were reasonably available and the defendants, at the time of accepting plaintiffs' orders, intended to execute them solely by reference to the NBBO, they made a material misrepresentation in connection with the purchase or sale of the securities involved. If a finder of fact could infer, in addition, that the defendants' implied representation was knowingly false or made with reckless indifference, it would follow that summary judgment for the defendants was inappropriate.

The duty of best execution, which predates the federal securities laws, has its roots in the common law agency obligations of undivided loyalty and reasonable care that an agent owes to his principal. ¹ Since it is understood by all that the client-principal seeks his own economic gain and the purpose of the agency is to help the client-principal achieve that objective, the broker-dealer, absent instructions to the contrary, is expected to use reasonable efforts to maximize the economic benefit to the client in each transaction.

The duty of...