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From Securities Regulation Daily, July 31, 2018

State law securities fraud claims precluded by SLUSA

By Rebecca Kahn, J.D.

"Artful" pleading of state law violations could not take claims out of the ambit of the Securities Litigation Uniform Standards Act of 1998 (SLUSA) when the substance of the claims "plainly alleged fraudulent conduct," a Second Circuit panel ruled. Pleading that a brokerage firm breached its "non-fraud based fiduciary duty of best execution" by choosing traders that paid the highest "kickbacks" to execute clients’ non-directed standing limit orders could not escape SLUSA when "falsity was essential to the claim." The panel joined sister circuits in ruling that "best execution" claims alleging misrepresentations or omissions about kickbacks and executing trades to make the most of such kickbacks satisfied SLUSA by alleging securities claims based on fraudulent conduct. Therefore, dismissal of the claims was affirmed (Rayner v. E*TRADE Financial Corp., July 31, 2018, Livingston, D.).

Alleged conflict of interest. Ty Rayner filed a putative class action against E*TRADE Financial Corporation and E*TRADE Securities LLC (collectively, "E*TRADE") on behalf of clients like himself, who had placed non-directed standing limit orders with E*TRADE. Because these orders were non-directed, E*TRADE retained discretion to choose the trading venue to execute these orders. Rayner asserted that this discretion must be guided by the firm’s duty of best execution and that E*TRADE breached this duty by choosing trading venues that paid the largest "kickbacks" in exchange for order flow. This practice allegedly raised a conflict of interest by incentivizing the firm to choose the most cost-effective trading venues for E*TRADE, but which may not be the most beneficial execution method for its clients. Clients were allegedly harmed when limit orders were routed to trading venues that paid higher kickbacks, because such orders were allegedly "up to 25 percent less likely to be executed" and more likely to "trade when the market price is becoming worse."

Dismissal. The complaint alleged state law claims of breach of fiduciary duty and unjust enrichment and sought declaratory relief. The lower court dismissed for failure to state a claim because each of these claims was based on the same allegation that E*TRADE violated its duty of best execution.

SLUSA. SLUSA precludes private parties from filing a class action based on state law claims alleging that defendants misrepresented or omitted a material fact in connection with the purchase or sale of covered securities. SLUSA is designed to prevent plaintiffs injured by securities transactions from engaging in artful pleading so as to migrate their case to state court in order to evade securities litigation limits (such as PSLRA) designed to block frivolous or abusive suits.

Plaintiff’s arguments. Rayner argued that the case was not precluded by SLUSA because (1) the complaint did not allege that E*TRADE made a misrepresentation or omission, or employed any manipulative or deceptive device; and (2) even if the complaint had alleged fraud, such fraud was not "in connection with" the purchase or sale of covered securities.

Underlying realities. The panel rejected these arguments, emphasizing that SLUSA requires evaluation of both the pleadings and the realities underlying the claims. SLUSA could not be avoided merely by omitting references to securities or to the federal securities law. The gravamen of the complaint was that E*TRADE allegedly made material misrepresentations and omissions to induce clients to execute non-directed, standing limit orders even though E*TRADE had no intention of fulfilling its purported fiduciary obligations. Rayner asserted that his "breach of duty" claim was based on E*TRADE’s breach of a non-fraud based fiduciary duty. But the plaintiffs could not escape SLUSA by"artfully characterizing a claim as dependent on a theory other than falsity when falsity is essential to the claim." The substance of the complaint plainly alleged fraudulent conduct.

"In connection with the purchase or sale of covered securities." E*TRADE’s alleged failure to provide best execution caused Rayner and other E*TRADE clients to purchase and sell securities at unfavorable prices and at lower volumes than expected. The panel noted it was "frivolous" to suggest that negatively influencing the price and quantity at which clients may buy and sell securities would not make a significant difference to someone’s decision to purchase or to sell a covered security. Rayner’s claim amounted to an allegation that E*TRADE’s routing practice fraudulently induced the plaintiffs to purchase and sell securities at less favorable prices and lower volumes than anticipated. Therefore, the lower court had properly dismissed the complaint.

The case is No. 17-1487.

Attorneys: Leslie E. Hurst (Blood Hurst & O’Reardon, LLP) for Ty Rayner. Corey Worcester (Quinn Emanuel Urquhart & Sullivan, LLP) for E*TRADE Financial Corp. and E*TRADE Securities LLC.

Companies: E*TRADE Financial Corp. and E*TRADE Securities LLC

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