The opinion of the court was delivered by: DEBEVOISE
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 orders
at the best available price, despite the availability of better prices from a number of sources of liquidity. Those sources included SelectNet
, in-house limit orders, in-house market orders, and the SOES limit order file.
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") PP25-32, 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 P42, and a further violation of defendants' fiduciary duty. Amended Complaint P48. Moreover, defendants were unjust enriched by the accrual of secret profits. Amended Complaint PP 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 P28; 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 P10; Affidavit of Robert Slane P9; Affidavit of Thomas Dwyer PP6-8.
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 P33.
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 PP34-35.
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 P36.
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) 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 P38.
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.
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. An 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 prices are arrived at quickly and efficiently.
To maintain this liquid environment market makers must put their own capital at risk. In order to "foster the risk-taking function of market makers and thereby . . . provide free market incentives to active participation in the flow of orders," Securities Acts Amendments of 1975, Report of the Committee on Banking, Housing and Urban Affairs, S. Rep. No. 75, 94th Cong., 1st Sess. at 12 (1975), market makers are therefore permitted to buy securities at a "bid" price and to sell them at a higher "ask" price, thus creating what is known as a "two-sided" market. Plastis v. E.F. Hutton, No. G86-1030 CA5, 1990 U.S. Dist. LEXIS 4828 (W.D. Mich. Apr. 18, 1990) ("The difference between [the bid and offer] is known as the 'spread,' and represents the market maker's compensation for the transaction."); Investors Research Corp., 1976 SEC LEXIS 2771 (July 19, 1976) ("The spread is [the market maker's] compensation for 'dealing' in a security and risking its capital.").
SEC rules require that any NASDAQ dealer that wishes to hold itself out as a market maker in a particular security must continually report the prices at which it is willing to buy and sell the security. 17 C.F.R. § 240.11Ac1-1(c)(1). Once reported, those quotes must be honored up to the "quotation size" ("the number of shares . . . that [a market maker] is willing to buy at the bid price or sell at the offer price comprising his bid or offer. . ." 17 C.F.R. § 240.11Ac1-1(a)(10)), 17 C.F.R. § 240.11Ac1-1(c)(2).
NASDAQ itself is required to "collect, process and make available . . . the highest bid and lowest offer communicated . . . by each member . . . acting in the capacity of an OTC market maker for each reported security . . ." 17 C.F.R. 240.11Ac1-1(b)(1)(ii). This quotation has come to be known as the National Best Bid and Offer ("NBBO").
In accordance with this obligation, NASDAQ operates a quotation reporting system which disseminates market maker quotes over an electronic communications network. There are three levels to this service:
Level 1 - Displays the best bid and ask quotes, high, low and last prices and volumes. Does not reveal origin of quotes.
Level 2 - Displays the current quotes and the names of the market makers who have entered them.
Level 3 - Displays the same information as Level 2 and also allows market makers to enter and to update their quotes.
Introduced in November, 1990, SelectNet is an on-line service provided by NASDAQ on which subscribers can negotiate trades and execute orders in OTC securities. In addition to price, offers posted by subscribers can specify size, the period during which the offer is "open," (any period up to 99 minutes or an entire day), and whether the price or size of an order is negotiable. Subscribers may also "preference" their orders, that is, an order may be directed at a specific market maker, at all market makers, or at all subscribers. Offers may be accepted, countered or declined. Subscribers who are not market makers may make their offers anonymously. Market makers must identify themselves.
The thrust of the SelectNet service is to provide an electronic alternative to negotiation by telephone. "The system is offered to NASD members to facilitate negotiation of securities transactions through computer automation, rather than relying on telephone communication." Market 2000, An Examination of Current Equity Market Developments, Division of Market Regulation of the SEC, Section IV at 6-7, 1994 SEC LEXIS 135 at *8 (1994) (hereinafter Market 2000).
Institutional Networks, Inc. ("Instinet") is another on-line trading system, similar to SelectNet but differing in two important aspects: 1) it is privately owned and operated; and 2) subscribers, including market makers, may display offers and trade anonymously. Traders, particularly large institutions, may therefore conduct large transactions without any revelation of their identity that might induce market reaction against their interest. Orders are accepted from a minimum of 1000 shares to a maximum of 50,000 shares. Although it conducts trades on behalf of clients, Instinet is not a market maker and therefore does not risk its own capital, charging only a commission for its services. Instinet Corp., SEC No-Action Letter, 1992 WL 672345 (S.E.C.) at *2.
In January, 1989, the SEC introduced the Limit-Order Service, an extension of SOES. The SOES limit book file, as this service came to be known, allows both GTC (good till canceled) and day limit orders of one thousand shares or less to be accepted, stored, and automatically executed when a market maker's quote reaches or exceeds a limit order price. A small customer can therefore be assured of obtaining execution at a given price if the market, in the form of the NBBO, reaches that level.
In-house limit and market orders
Individual integrated firms, functioning as either agents or principals, receive orders to both buy and sell securities in the course of the trading day. When either a limit or market order is received before a "corresponding" order is executed, the possibility exists that the two orders could be matched, or "crossed" at a price midway between them. "Call market" trading systems employed in some foreign countries, e.g., Austria, Belgium, Germany and Israel, as opposed to "continuous" trading systems employed on the United States financial markets (both securities exchanges and the OTC markets), regularly utilize this type of order crossing by periodically batching corresponding offers for simultaneous execution at a single "clearing" price:
"Orders for an issue are revealed to an auctioneer when the market is called. Buy and sell orders are matched at the price that most closely equates the aggregate number of shares offered for sale (at that price and below) with the aggregate number of shares sought for purchase (at that price and above). Then, all market orders to buy and all buy limit orders at the clearing price or higher are executed, as are all market orders to sell and all sell limit orders at the clearing price or lower."
It is the contention of plaintiffs in this action that defendants were obligated to conduct such a call market whenever an outstanding market or limit order remained unexecuted upon receipt of corresponding market order. Amended Complaint PP34-36.
The relationship between a broker/dealer and its customer gives rise to "certain fiduciary obligations." In re E.F. Hutton & Co., Securities Exchange Act Release No. 25887, [1988 Transfer Binder] Fed. Sec. L. Rep. (CCH) P84,303, 89,326 at 89,328 and n.9 (July 6, 1988) (citing Restatement (Second) of Agency P1 (1957)). Amongst those obligations is a duty to execute the customer's order at the best available price. Payment For Order Flow, Exchange Act Release No. 34902 [1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) P85,444, 85,849 at 85,854 n.28. ("Payment for Order Flow Release No. 34902"). That agency obligation, moreover, does not dissolve when the broker/dealer acts in its capacity as a principal. "A broker/dealer's determination to execute an order as a principal or agent cannot be 'a means by which the broker may elect whether or not the law will impose fiduciary standards upon him in the actual circumstances of any given relationship or transaction.'" In re E.F. Hutton at 89,328 (quoting Opper v. Hancock Securities Corp., 250 F. Supp. 668, 675 (S.D.N.Y.), aff'd, 367 F.2d 157 (2d Cir. 1966)). Avoidance of any conflict of interest is central to public confidence in the various markets. "The ...