The New York Court of Appeals, New York’s highest court, recently held that New York’s Martin Act does not preclude private investors from bringing common law tort claims such as breach of fiduciary duty or negligence arising out of the sale of securities. Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management, 2011 N.Y. Slip Op. 9162, 2011 N.Y. LEXIS 3658 (2011). In so doing, the Court rejected the assumption of numerous federal and state courts, which had reasoned that the Martin Act’s lack of a private right of action necessarily preempted private common law claims based on conduct covered by the Martin Act. While it remains to be seen what effect the Court’s decision will ultimately have, the ruling opens up an avenue for pursuing securities-related claims in New York state courts that may be attractive to investors seeking to avoid the heightened pleading standards applicable to federal securities claims.

The Martin Act

The Martin Act is New York’s “blue sky” law. Essentially, it prohibits misrepresentation in connection with the offering or sale of securities within or from New York. The Martin Act is particularly potent because civil enforcement actions under the Act do not require any showing of either a defendant’s intent to deceive, known as scienter, or reliance by an investor on the defendant’s alleged misrepresentation. Although it was first passed in 1921, the Martin Act recently gained prominence as the weapon of choice for former New York Attorney General Eliot Spitzer, who used the threat of civil claims under the Martin Act to negotiate a series of large settlements against financial institutions.  

Although the Martin Act grants New York’s Attorney General broad investigative and prosecutorial powers that exceed those of most state regulators, the New York Court of Appeals held in 1987 that it does not provide for a private right of action. CPC International Inc. v. McKesson Corp., 70 N.Y.2d 268 (1987). Following that decision, a number of courts (including the Southern District of New York and the Second Circuit) concluded that the Martin Act effectively precluded non-fraud common law causes of action based on allegations of conduct that would have violated the Martin Act, reasoning that allowing private plaintiffs to bring such claims would effectively allow them to circumvent the lack of a private right of action in the Martin Act itself. See, e.g., Independent Order of Foresters v. Donaldson, Lufkin & Jenrett, 919 F. Supp. 149 (S.D.N.Y. 1996); Castellano v. Young & Rubicam, Inc., 257 F.3d 171 (2d Cir. 2001). Common law claims sounding in fraud were permitted, however, on the grounds that fraud claims required a showing of scienter and thus were neither covered nor preempted by the Martin Act.  

The Lower Court Proceedings

Against this background, Assured Guaranty (UK) Ltd. (“Assured”) commenced an action against J.P. Morgan Investment Management Inc. (“J.P. Morgan”) asserting causes of action for breach of fiduciary duty, gross negligence and breach of contract. The gravamen of the complaint was that J.P. Morgan mismanaged the investment portfolio of Orkney Re II PLC (“Orkney”), an entity whose obligations Assured had guaranteed. Assured alleged that J.P. Morgan had invested Orkney’s assets heavily in high-risk securities, such as subprime mortgage-backed securities, and failed to diversify the portfolio or advise Orkney of the true level of risk. The complaint also alleged that J.P. Morgan had improperly made investment decisions in favor of Orkney’s largest shareholder, which was a client of J.P. Morgan.  

J.P. Morgan moved to dismiss the complaint on the grounds that the breach of fiduciary duty and gross negligence claims were preempted by the Martin Act. The trial court granted the motion to dismiss the complaint in its entirety, holding that the breach of fiduciary duty and gross negligence claims fell “within the purview of the Martin Act and their prosecution by plaintiff would be inconsistent with the Attorney General’s exclusive enforcement powers under the Act.” New York’s intermediate appellate court reversed and reinstated the breach of fiduciary duty and gross negligence claims. The appellate court concluded that there was “nothing in the plain language of the Martin Act, its legislative history or appellate level decisions in [New York] that supports defendant’s argument that the Act preempts otherwise validly pleaded common law causes of action.” J.P. Morgan appealed the appellate decision to the New York Court of Appeals.

The Court of Appeals’ Decision

On appeal, J.P. Morgan argued that the Martin Act preempted Assured’s common law claims because the Martin Act vested the Attorney General with exclusive authority over the fraudulent securities practices that were covered by the statute. Permitting common law claims that overlapped with the Martin Act, J.P. Morgan argued, would interfere with the Attorney General’s exclusive authority.  

In making this argument, J.P. Morgan relied on Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. Partnership, 12 N.Y.3d 236 (N.Y. 2009). In Kerusa, the plaintiff had asserted a common law fraud claim based on allegedly material omissions from an offering plan for a condominium development that had been filed with the Attorney General as required under the Martin Act. The New York Court of Appeals had held that such a claim was preempted by the Martin Act because it could not be meaningfully distinguished from a private right of action. The court in Kerusa had based its decision, however, on the fact that the alleged misconduct consisted solely of the defendant’s failure to comply with the Martin Act’s requirement, and thus the claim would not have existed absent the Act. Kerusa left open the question of whether a common law claim that alleged conduct violative of the Martin Act would be preempted when that conduct also independently constituted a common law violation.

The Court of Appeals ultimately rejected J.P. Morgan’s argument that the Martin Act preempted independent common law claims that were not based solely on that statute. The court determined, first, that there was nothing in either the text of the Martin Act or its legislative history that reflected any attempt to preclude common law claims that existed prior to its passage. Had the legislature intended to preclude such claims, the court noted, that significant step should have been reflected in the statute or its legislative history.  

Moreover, the Court of Appeals reasoned, policy considerations weighed against expanding Martin Act preemption to common law claims with a legal basis independent of the statute. It noted that the New York Attorney General had filed an amicus brief in support of Assured’s position, and argued that allowing private common law claims would assist, rather than detract from, the purposes of the Martin Act, combating fraudulent practices in securities transactions.  

Conclusion

The Court’s decision has the potential to increase significantly the number of claims arising out of securities transactions filed against financial institutions in New York, and to shift some of that litigation to state courts. Common law claims such as breach of fiduciary duty and negligence do not require a showing of a defendant’s intent to deceive, and thus are easier for plaintiffs to prosecute and more likely to survive a motion to dismiss. Moreover, asserting such claims in New York state courts may be an attractive alternative for plaintiffs seeking to avoid the heightened pleading standards that normally apply to securities claims filed in federal court. While the federal SLUSA statute will continue to mandate that securities class actions be filed in federal court, the sheer size of many securities transactions in New York raises the prospect that institutional and other high net worth individual plaintiffs may find it worthwhile to bring common law claims directly. In short, financial institutions may find it advisable to become more familiar with New York’s common law jurisprudence and to ensure that they are taking the appropriate compliance measures to ensure that they minimize their exposure to such claims.