On July 10, 2017, Judge John G. Koeltl of the United States District Court for the Southern District of New York dismissed a putative securities fraud class action against E*TRADE Securities LLC (“E*TRADE”), E*TRADE Financial Corporation (“E*TRADE Financial), and one current and one former officer of E*TRADE Financial. Schwab v. E*TRADE Fin. Corp., No. 16-cv-05891 (S.D.N.Y. July 10, 2017). Plaintiff alleged that E*TRADE misled its clients by falsely representing that it would execute orders consistent with its duty of “best execution,” which requires it to use “reasonable diligence” to obtain the most favorable price for a customer under “prevailing market conditions.” Plaintiff brought claims under Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) and Rule 10b-5 thereunder, as well as control person claims under Section 20(a) of the Exchange Act. The Court granted defendants’ motion to dismiss, holding that plaintiff failed to adequately plead reliance or scienter, and also failed to plead culpable participation sufficient to state a control person claim.
Plaintiff alleged that rather than fulfill its duty of “best execution,” E*TRADE pursued an order routing strategy designed to maximize payments for order flow (“PFOF”) received from venues under the “maker-taker” model. According to plaintiff, E*TRADE was locked into providing order flow to venues regardless of best execution considerations, based on “predetermined routing agreements” between E*TRADE and the venues. Under these agreements, E*TRADE agreed to route a certain percentage of its orders to a venue in exchange for that venue’s PFOF. Plaintiff alleged that, as a result, E*TRADE’s clients obtained prices that were less favorable than had the company followed best execution practices, citing third-party industry and academic studies that concluded that a broker-dealer’s strategy of obtaining the greatest PFOF tends to “interfere” with best execution. Accordingly, plaintiff alleged that during the class period, orders placed with E*TRADE received worse prices than would have been received had E*TRADE honored its “best execution” promise.
Plaintiff argued that it was entitled to the presumption of reliance articulated by the United States Supreme Court in Affiliated Ute. The Court explained, however, that the gravamen of plaintiff’s claim was that E*TRADE’s disclosures made it seem like PFOF and reciprocal business arrangements were only two factors among many considered in making order routing determinations, rather than decisive factors as alleged by plaintiff. Because the alleged omissions were “simply the flip side of the affirmative misstatements,” plaintiff could not invoke Affiliated Ute. Without the benefit of that presumption, plaintiff did not plead reliance with particularity. The Court held that plaintiff, “[a]mazingly, failed to clear [the pleading] threshold” of reasonable reliance because its allegations were entirely conclusory and failed to show with any sort of particularity that that plaintiff was aware — whether by reading, hearing, or otherwise — of any of the challenged misstatements when trading with E*TRADE.
The Court further found that the Section 10(b) and Rule 10b-5 claims should independently be dismissed for failing to sufficiently plead scienter. The Court noted that a plaintiff “cannot allege scienter by merely pointing to [a defendant’s] job title,” but that plaintiff’s conclusory scienter allegations boiled down to the individual defendants being in senior roles at E*TRADE Financial and did not contain the “connective tissue … that would lead to a compelling and cogent inference of scienter.” The Court similarly rejected plaintiff’s allegations of scienter with respect to unidentified individuals within the corporate defendants because those allegations failed to “establish that someone whose intent could be imputed to the corporate defendants acted with scienter.” Finally, as to plaintiff’s “core operations” doctrine pleadings, the Court applied the majority rule among courts within the Second Circuit and held that such allegations could provide only a “supplementary, but not an independent, means to plead scienter.”
Having found that plaintiff failed to plead a primary violation of the Exchange Act, the Court dismissed plaintiff’s control person claims under Section 20(a). Independently, the Court found that plaintiff failed to allege culpable participation on the part of the individual defendants. Stating that culpable participation requires “something more than negligence” and that the weight of well-reasoned authority within the Second Circuit requires allegations “at least approximating recklessness,” the Court found that plaintiff failed to make such a showing for either individual defendant.
This decision highlights that courts are wary of attempts by plaintiffs to recast misrepresentation claims as omission claims in order to avoid having to plead reliance and will carefully examine scienter allegations to require particularized pleading connecting the defendant to the representation by reasons other than mere status.
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