E*Trade Best Execution Case Reaches Federal Appeals Court

October 30, 2018

In a recent federal lawsuit, we're on the third version of the Complaint and facing yet another motion to dismiss. As the parties wend their way from the United States District Court for the Southern District of New York to the United States Court of Appeals for the Second Circuit, Defendant E*TRADE contests allegations that it had violated the duty of best execution.  Is the third time the charm? Do you get a third bite of the apple? 

Case In Point

Plaintiff/Appellant Craig L. Schwab appeals to the United States Court of Appeals for the Second Circuit ("2Cir") following the January 22, 2018, Opinion and Order of the United States District Court for the Southern District of New York ("SDNY"), which granted Defendants-Appellees' motion to dismiss Schwab's Third Amended Complaint ("TAC") for failure to state a claim pursuant to Federal Rule of Civil Procedure 12(b)(6). Craig L. Schwab, Individually and on Behalf of All Others Similarly Situated,  Plaintiff/Appellant, v E*Trade Financial Corporation, E*Trade Securities LLC, Paul T. Idzik, David Herbert, Roger A. Lawson, and Karl A. Roessner, Defendants/Appellees
(Summary Order, United States Court of Appeals for the Second Circuit, October 26, 2018) http://www.brokeandbroker.com/PDF/SchwabEtrade2Cir.pdf 

SIDE BAR: Federal Rules of Civil Procedure Rule 12. Defenses and Objections: When and How Presented; Motion for Judgment on the Pleadings; Consolidating Motions; Waiving Defenses; Pretrial Hearing
. . .

(b) How to Present Defenses. Every defense to a claim for relief in any pleading must be asserted in the responsive pleading if one is required. But a party may assert the following defenses by motion:

(1) lack of subject-matter jurisdiction;

(2) lack of personal jurisdiction;

(3) improper venue;

(4) insufficient process;

(5) insufficient service of process;

(6) failure to state a claim upon which relief can be granted; and

(7) failure to join a party under Rule 19.

A motion asserting any of these defenses must be made before pleading if a responsive pleading is allowed. If a pleading sets out a claim for relief that does not require a responsive pleading, an opposing party may assert at trial any defense to that claim. No defense or objection is waived by joining it with one or more other defenses or objections in a responsive pleading or in a motion.

E*TRADE Defendants

In setting the cast of characters, we have the following in the roles of Defendant/Appellant:
  • E*TRADE Financial provides brokerage and related products and services to retail investors;
  • E*TRADE Securities LLC ("E*TRADE"), a wholly-owned subsidiary of E*TRADE Financial, a registered broker-dealer, and the primary provider of brokerage products and services to E*TRADE Financial's customers. Over 95% of E*Trade's customer orders are "non-directed,"  for which the firm chooses the venue for an order's routing for execution.
  • Paul T. Idzik was Chief Executive Officer and a director at E*TRADE Financial from 2013 to 2016; and
  • Karl A. Roessner was the Executive Vice President and General Counsel at E*TRADE from 2009 up until 2016, at which point he became Chief Executive Officer.
Best Execution

Plaintiff Schwab was a customer of E*TRADE, who alleged that:

[B]etween July 12, 2011 and July 22, 2016 ("the Class Period"), E*TRADE violated the duty of best execution, which requires broker-dealers to "use reasonable diligence to ascertain the best market for the subject security and buy or sell in such market so that the resultant price to the customer is as favorable as possible under prevailing market conditions." Financial Industry Regulatory Authority Rule 5310(a)(1).Schwab's allegations of misconduct center on two main points: (1) that E*TRADE entered into agreements with third parties that resulted in E*TRADE's failing to deliver best execution; and (2) that E*TRADE focused on the maximization of revenues rather than on delivering best execution to its clients . . .

Page 3 of the 2Cir Order

Six-Point Test

SDNY dismissed Plaintiff Schwab's Section 10(b) claim because he had failed to adequately plead scienter and reliance upon the Defendant s' allegedly deceptive acts. SDNY cited a six-point test that requires an alleged violation of Section 10(b) or Rule 10b-5 to plead:
  1. a material misrepresentation (or omission),
  2. scienter,
  3. a connection with the purchase or sale of a security,
  4. reliance,
  5. economic loss, and
  6. loss causation.
Affiliateed Ute Citizens' Preumption

Plaintiff/Appellant relied exclusively upon a so-called "presumption of reliance" that is available when there is an omission of material fact by one who has a duty to disclose that is set forth in Affiliated Ute Citizens v. United States, 406 U.S. 128, 153-54 (1972) https://supreme.justia.com/cases/federal/us/406/128/ 2Cir distinguished Affiliated Ute as applying to cases "involving primarily a failure to disclose, where a defendant both (1) had a duty to disclose and (2) omitted a material fact." Page 5 of the 2Cir Order.

2Cir noted that Plaintiff Schwab acknowledged that in contrast with "failure to disclose," E*TRADE made many statements affirming its compliance with best execution obligations -- as such, the apparent basis for Plaintiff's case, namely, the omission of information, was undercut by the numerous examples of affirmative statements on the critical issue of best execution by Defendant. In affirming SDNY, 2Cir distinguishes Affiliated Ute in a manner consistent with its prior Waggoner v. Barclays PLC, 875 F.3d 79, 95 (2d Cir. 2017)    https://www.leagle.com/decision/infco20171106065:

In Waggoner, the defendant operated an alternative trading system. Waggoner, 875 F.3d at 86. The plaintiffs alleged that the defendant had made "numerous statements asserting that [this trading system] was safe" from "aggressive high frequency trading activity" or "predatory traders[]," id. at 87-88, but argued that they were entitled to the Affiliated Ute presumption because the defendant had omitted the truth -- that investors were not in fact adequately protected, id. at 95-96. The Waggoner Court concluded that these purported "omissions" were "simply the inverse of the [p]laintiffs' misrepresentation allegations," because the only thing they omitted was the "truth that the statement misrepresents." Id. at 96. Thus, the plaintiffs' case was one primarily
about misrepresentations, not omissions, and the Affiliated Ute presumption did not apply. Id.

So too here. Just as the Waggoner defendant stated that its alternative trading system was protected from abusive trading practices, E*TRADE repeatedly and specifically affirmed that it complied with the duty of best execution. And just as the plaintiffs in Waggoner argued that the defendant's statements were misleading because they failed to disclose that the system was not actually protected, Schwab argues that E*TRADE's statements were misleading because they failed to disclose that it did not actually comply with the duty. Schwab's omissions claim, like the Waggoner plaintiffs', is "simply the inverse" of a misrepresentation claim; the "only omission is the truth that the statement misrepresents." Id. at 96. 

Moreover, Waggoner determined that Affiliated Ute applies only when the original
rationale for Affiliated Ute is present: when there are "no positive statements," and "reliance as a practical matter is impossible to prove." Id. at 95 (quoting Wilson v. Comtech Telecomms. Corp. 648 F.2d 88, 93 (2d Cir. 1981)). Schwab's TAC alleges that E*TRADE made many affirmative misstatements directly relating to his claims of fraud. As a "practical matter," then in this case "reliance [is not] impossible to prove," id. at 95, and the rationale for the Affiliated Ute presumption does not apply. Schwab therefore failed adequately to plead reliance and his Section 10(b) claim was properly dismissed. Because Schwab's Section 10(b) claim was properly dismissed, moreover, Schwab's Section 20(a) claim also necessarily fails and was properly dismissed. See ATSI Commc'ns, 493 F.3d at 108. 

Page 7 of the 2Cir Order

Bill Singer's Comment

Sure . . . I'l admit it . . . I couldn't stop wondering why a guy named Schwab didn't open his brokerage account with Charles Schwab rather than with some annoying broker-dealer that insists on inserting an asterisk into its name, and then insists on using all capital letters. 

In any event, lemme try to take a crack at explaining the core nuance in the 2Cir's Order.

If you want to prove that a party engaged in 10b(5) fraud, then you normally start off by pointing to a material misstatement, and then you demonstrate that you relied upon that misstatement to your detriment. More simply, you would say that "The Defendant said X. X was a boldfaced lie, but I didn't know X was a lie at the time Defendant said it. Unfortunately, I relied upon Defendant's statement when I invested every penny I had in XYZ stock. As a result, I lost every penny."

You can sort of see how that works, right? Okay, but, now, let's imagine a different set of circumstances.

Defendant had an obligation to tell the truth. The things is, however, that the Defendant didn't say anything. He omitted making a statement. Aha! We come upon that elusive "omission." In such a case, Affiliated Ute says that there is a "presumption" of reliance where the alleged fraud involves an omission. 

Let me restate that: 

You have to prove reliance if you relied upon a statement

You are granted the presumption of reliance if you relied upon an omission

As best I understand the flaw in Schwab's case as enunciated by the 2Cir Order and as set forth in Waggoner, he cited to lots of stuff that the Defendants said -- as in honest-to-goodness statements. All of which prompted 2Cir to arch an eyebrow and refuse to bite down on an inverse-reverse-mirror-image of a statement (which the Court pretty much felt was little more than a dressed-up omission). In fact, 2Cir said that an omission isn't merely an inverse statement.

You can sue someone for making a fraudulent statement. 

You can sue someone for omitting to tell the truth and hence fostering a wrong impression. 

But you can't sue someone of not not saying something if that someone also said something. 

You got all of that?  Really? Okay . . . sure you do.

Let me see if I can pose one more mind-bender:

Imagine if the President of the United States stated that "President Putin says it's not Russia. I don't see any reason why it would be," 

Now imagine if the President of the United States was confronted with video proof of the above statement but he then argued that what he meant to say was that "President Putin says it's not Russia. I don't see any reason why it wouldn't be." 

You could sue someone for fraud based upon the "would" misstatement. 2Cir would likely require you to prove reliance for this misstatement.

You might be able to sue someone for omitting to say the "n't" in the first set of remarks. 2Cir might deem the "n't" issue as an omission and initiate the presumption of reliance set forth in Affiliated Ute Citizens.

On the other hand, if you tried to sue someone for saying the second, corrected set of remarks; namely, the "wouldn't" version, 2Cir might not deem that to be an omission issue but rather a misstatement issue and, hence, the presumption of reliance would not be triggered as promulgated in Waggoner

If he said it, you have to prove reliance. If he didn't say it, you may have the presumption. If he said that what he first said was wrong and then revises it, that's not an omission but a statement, and you can't benefit from the presumption of reliance for an omission that becomes a statement by way of revising the first statement to include what had been previously misstated in the form of an omission.


Then again maybe not. 

Then again, I'll leave it to the folks in the robes to offer a better explanation.