The U.S. Court of Appeals for the Eighth Circuit recently reversed and remanded a trial court’s certification of a class under Federal Rule of Civil Procedure 23(b)(3).

In so ruling, the Eighth Circuit concluded that:

  1. Determining economic losses in this case would entail individualized inquiry inconsistent with the predominance requirement of Rule 23; and
  2. Because economic loss could not be presumed, ascertaining which class members sustained injuries meant that individual issues predominated over common ones; and
  3. By defining the class to include only those customers who were harmed by the defendant company’s alleged failure to seek best execution (a so-called “fail-safe class”), the trial court certified a class in which membership depended upon having a valid claim on the merits. Such a class was impermissible because it allowed putative class members to seek a remedy but not be bound by an adverse judgment.

A copy of the opinion in Ford v. TD Ameritrade Holding Corp. is available at: Link to Opinion.

A customer of a company offering brokerage services to retail investors filed suit against the company and two other defendants for securities fraud in federal court. The lead plaintiff was appointed for a group of investors who purchased and sold securities through the company between 2011 and 2014. The plaintiffs alleged that the company’s order routing practices violated the company’s “duty of best execution” by systematically sending customer orders to trading venues that pay the company the most money, rather than to venues that provide the best outcome for customers.

The trial court determined that the plaintiffs’ expert had developed an algorithm that could make automatic determinations of economic loss for each customer. The court thus certified a class consisting of “[a]ll clients of [the company] between September 15, 2011 and September 15, 2014 who placed orders that did not receive best execution, in connection with which the company received either liquidity rebates or payment for order flow, and who were thereby damaged.”

The Eighth Circuit granted the defendants permission to appeal the class certification order. See Fed. R. Civ. P. 23(f). The Appellate Court reviewed the order for abuse of discretion. IBEW Local 98 Pension Fund v. Best Buy Co., 818 F.3d 775, 779 (8th Cir. 2016).

In general, to justify certification of a class in an action for damages, a plaintiff must meet all the requirements of Federal Rule of Civil Procedure 23(a) and satisfy one of the three subsections of Rule 23(b). The trial court here certified a class based on Rule 23(b)(3), which requires that “questions of law or fact common to class members predominate over any questions affecting only individual members, and that a class action is superior to other available methods for fairly and efficiently adjudicating the controversy.”

The plaintiffs alleged that the company violated § 10(b) of the Securities Exchange Act and Rule 10b-5. Section 10(b) forbids the use, in connection with the purchase or sale of a security, of “any manipulative or deceptive device or contrivance in contravention of” regulations promulgated by the SEC for the protection of investors. 15 U.S.C. § 78j(b). The SEC promulgated Rule 10b-5 to enforce § 10(b). Rule 10b-5 prohibits making an untrue statement of material fact or omitting to state a material fact in connection with the purchase or sale of a security. 17 C.F.R. § 240.10b-5(b).

To recover damages for violations of § 10(b) and Rule 10b-5, a plaintiff must prove “(1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation.” Amgen Inc. v. Conn. Ret. Plans & Tr. Funds, 568 U.S. 455, 460-61 (2013).

The Eighth Circuit here determined that the economic loss allegedly caused by the company’s order routing practices was “the difference between the price at which [customers’] trades were executed and the ‘better’ price allegedly available from an alternative trading source.” Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 259 F.3d 154, 178 (3d Cir. 2001). To justify class certification, the Court concluded that the plaintiffs must show that they can establish this type of economic loss for a class of plaintiffs in a manner consistent with the predominance requirement of Rule 23.

In Newton, the Third Circuit affirmed the denial of class certification in a best execution case. Id. at 162. The Third Circuit observed that “[w]hether a class member suffered economic loss from a given securities transaction would require proof of the circumstances surrounding each trade, the available alternative prices, and the state of mind of each investor at the time the trade was requested.” Id. at 187. The alleged injuries arose out of the execution of “hundreds of millions of trades.” Id. at 190. Because “[d]etermining which class members were economically harmed would require an individual analysis into each trade and its alternatives,” the Third Circuit concluded that individual questions were “overpowering.” Id. at 189.

The Eighth Circuit found Newton’s reasoning persuasive.

Here, the plaintiffs’ expert proposed to establish through an algorithm that a better price was obtainable for each executed trade by comparing the trade’s actual price with the National Best Bid and Offer (NBBO) price. The NBBO represents the highest price a buyer was willing to pay, and the lowest price a seller was willing to accept, for a particular stock at a given time. But the Eighth Circuit noted that sometimes a trade fails to execute at the NBBO price through no fault of the broker. For example, volatile or otherwise unusual market conditions can prevent a trade from executing at that price.

The Eighth Circuit also observed that there is no definitive list of unusual market conditions that account for transactions that depart from the best available price. As a result, the Court held that the algorithm’s use of published market data would not identify all legitimate exclusions, and the experts would have to use their own judgment to identify further exclusions on a trade-by-trade basis. A trier of fact would then have to individually determine the appropriateness of particular exclusions.

Furthermore, the Eighth Circuit remarked that the duty of best execution requires that brokers “use reasonable efforts to maximize the economic benefit to the client in each transaction.” Id. at 173. This duty regulates a broker’s process of routing orders for execution but does not guarantee a specific outcome “[b]ecause economic loss cannot be presumed, ascertaining which class members have sustained injury means individual issues predominate over common ones.” Id. at 190.

Therefore, the Eighth Circuit concluded that, despite advances in technology, individual evidence and inquiry was still required to determine economic loss for each class member, precluding class certification under Rule 23(b)(3).

The Eighth Circuit also found an independent problem with the class as defined by the trial court: it was an impermissible “fail-safe class.” The class consisted of “[a]ll clients of [the company] . . . who placed orders that did not receive best execution, in connection with which [the company] received either liquidity rebates or payment for order flow, and who were thereby damaged.” The Court determined that this definition incorporated two contested elements of liability: failure to seek best execution and economic loss.

In the Court’s view, by defining the class to include only those customers who were harmed by the company’s alleged failure to seek best execution, the trial court certified a class in which membership depended upon having a valid claim on the merits.

The Eighth Circuit held that such a class was impermissible because it allowed putative class members to seek a remedy but not be bound by an adverse judgment. Orduno v. Pietrzak, 932 F.3d 710, 716 (8th Cir. 2019). The Court also concluded that fail-safe classes are unmanageable, see Fed. R. Civ. P. 23(b)(3)(D), “because the court cannot know to whom notice should be sent.” Orduno, 932 F.3d at 717.

Accordingly, the Eighth Circuit reversed the trial court’s order certifying a class and remanded for further proceedings consistent with its ruling.