Preemption in the Securities Industry: A Diminished Standard?

By Szydlowski, Anthony E. | St. John's Law Review, Winter 2000 | Go to article overview

Preemption in the Securities Industry: A Diminished Standard?


Szydlowski, Anthony E., St. John's Law Review


How should the power between the governments of the states and the United States be divided? The federalist structure created by our founding fathers seemed to achieve an effective balance,1 and the states' ratification of the Consititution temporarily remedied this controversy. Nearly 200 years later, a comfortable balance between state and federal government has yet to be discerned. Today, the states retain much of their sovereign power, but Congress, pursuant to its power under the Supremacy Clause,2 may preempt a field of law, explicitly or implicitly. Historically, the Supreme Court has expressed a presumption against preemption3 absent a "clear and manifest purpose of Congress."4

In the securities industry, the battle for regulation supremacy is manifested by conflicts between the Securities and Exchange Commission (SEC) and state blue-sky laws. The SEC is a regulatory agency created pursuant to the Securities Exchange Act (the "Exchange Act") as a supplement to state blue-sky laws.5 Its primary purpose was, and is, to protect the investing public by ensuring that investors are provided with full disclosure of all material information prior to engaging in securities transactions.6 SEC rules were traditionally subjected to the same presumption against preemption as any other federal law.7 Recent decisions, however, threaten to destroy state sovereignty in the securities industry without the required showing of congressional intent to do so. Guice v. Charles Schwab & Co.,8 exemplifies a recent trend of faulty judicial analyses applying the Supreme Court standard for preemption to the securities industry.

In Guice, the New York Court of Appeals held plaintiffs' state law claims, alleging violations of common law fiduciary duties, to be implicitly preempted by federal law.9 Specifically, the Court addressed Rule 10b-10,10 promulgated by the SEC pursuant to the 1975 amendments of the Securities Exchange Act of 1934.11 Guice involved a practice "known in the securities industry as `order flow payments.'"12 The practice of payments for order flow ("POF") consists of retail securities broker-dealers sending their customers' orders to market makers in return for monetary or sometimes non-monetary remuneration.15 The plaintiffs in Guice included former retail customers of one of the defendants, Charles Schwab & Co. ("Schwab"),14 a " 'discount' stock brokerage house [that],... charge[s] reduced commissions for effecting securities transactions . . . on behalf of customers who have already decided upon what securities to buy or sell."15

In Guice, defendant, Schwab, indisputably complied with the disclosure requirements of Rule 10b-10.16 Nevertheless, plaintiffs' alleged that defendant's receipt of remuneration for order flow was the equivalent of "kickbacks"17 and their failure to disclose such amounts constituted a breach of fiduciary duty under common law agency principles.18 Additional allegations included breach of contract,19 violations of New York criminal law prohibiting commercial bribery20 and violations of The Martin Act, a New York statute regulating the conduct of securities brokers.21 Schwab successfully moved to dismiss in the Supreme Court.22 The motion to dismiss was based primarily on two United States Constitutional grounds. First, Schwab argued that plaintiffs' common law cause of action violated the Commerce Clause.23 Second, Schwab argued that under the Supremacy Clause,24 plaintiffs' other claims were preempted by Rule 10b-10.25

On appeal, the Appellate Division reinstated all of plaintiffs' claims concluding that a common law tort action was neither inconsistent nor in conflict with the federal regulatory scheme.26 Thus, the Appellate Division ruled that preemption was absent because "Congress had passed no statute dealing directly with order flow payments and... the SEC had not promulgated any final regulations regarding the receipt of order flow payments."27 The Appellate Division remanded the case to the Supreme Court to decide defendant's remaining motions for dismissal,28 but the Appellate Division also granted Schwab leave to appeal, to the New York Court of Appeals, for a determination of whether the Appellate Division's modification order was proper. …

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