In Schwab v. E*TRADE, Judge Koeltl sent packing a proposed class action plaintiff who was sure E*TRADE misrepresented how they processed his stock trades, but failed to give the detail necessary to make his point.
Brokers like E*TRADE are paid are paid commissions by their customers, and also are paid rebates by the market makers and exchanges that execute their customers’ securities trades. These rebates, known as payments for order flow, are perfectly legal, although heavily regulated. Brokers also owe a duty of best execution to their customers, which means they must try to get their customers the best price for each stock sale or purchase available under prevailing market conditions. Needless to say, there is a lurking conflict of interest between a broker’s duty of best execution to his customer, and the amount of the rebate a broker can collect from the market maker he directs to execute his customer’s trade.
Mr. Schwab alleged that E*TRADE directed his stock transactions to market makers that paid E*TRADE the biggest rebate, not those that offered the best price. E*TRADE countered that it discloses to its customers that it takes rebates into account in choosing where it directs its customers’ trades, along with cost to the customer, speed and level of service. But Schwab claimed that E*TRADE misrepresented its practices because it actually directed trades to maximize the rebates it received, and that the customer-friendly reasons were merely window dressing. Schwab alleged that E*TRADE generated hundreds of millions of dollars at its customers’ expense by prioritizing its rebates and business relationships over its duty of best execution.
To plead a securities fraud claim, Schwab had to show that he relied on E*TRADE’s false statement that it fulfilled its duty of best execution. But Schwab merely claimed that he “would” have used another broker if he had known that E*TRADE was prioritizing rebates over best execution. That’s not specific enough, according to Judge Koeltl. Schwab didn’t even claim that he read E*TRADE’s best execution disclosures, or that he “was aware with any sort of particularity– whether by reading, hearing or otherwise– of any of the challenged misstatements when he traded with E*TRADE.”
Schwab also failed to show that E*TRADE’s misstatements were made with scienter, that is, an intent to deceive—a necessary element of a securities fraud claim. Schwab had to show that E*TRADE’s executives had a motive to deceive their customers, such as by selling their own shares at a profit, or that they recklessly ignored information about E*TRADE’s conduct.
Schwab alleged only that the senior executives “must have known” and ignored that E*TRADE was prioritizing its rebates over its duty of best execution based on E*TRADE’s own internal reviews of its best execution practices, and third-party industry studies, as well as an older regulatory fine. But merely pointing to a job title is not enough to establish scienter without a “particularized allegation to suggest that [the CEO] knew at any point that E*TRADE was delivering something less than best execution.”
According to Judge Koeltl, Schwab made “no allegation about [the CEO’s] role in monitoring any of these items (let alone that he acted recklessly in fulfilling any such duty) beyond the allegation that he was CEO. ” And since obtaining rebates from market makers and exchanges is legal, the pursuit of rebates alone “is the type of generic profit motive that is insufficient to establish scienter.”
Judge Koeltl dismissed the complaint without prejudice to renewal, and the opinion is a careful lesson on how (or how not) to plead securities fraud.
Hat tip to Bethany Clarke for her assist on this post.