The New York statute that has given Attorneys General the power to take on Wall Street, and catapulted many of them into the governor’s mansion, is about to undergo a radical change if a Southern District judge’s ruling is upheld. In a guest editorial in Westlaw Business Currents, Hall and Johnston of DLA Piper explain the law and recent developments.
Sections 352 and 353 of Article 23-A of New York’s General Business Law (collectively known as the Martin Act) give the Attorney General the power to investigate, regulate, and take action against securities fraud. Since 1987, the courts have held that the Martin Act is the sole province of the Attorney General, and preempts private tort action for securities fraud. The Martin Act differs from most other state securities statues by having a much lower evidentiary requirement. The Martin Act requires only proof of misrepresentation (including omissions) and materiality. It differs from common law fraud and federal securities law by not requiring proof of scienter, reliance, or damages.
This makes the bar for relief much lower than a classic case of fraud, or of securities fraud under SEC Rule 10b-5.
A successful 10b-5 suit requires proof of both transaction causation, that the plaintiff would not have made the investment but for the alleged fraud, and loss causation, that the alleged act or omission caused the loss for which the plaintiff seeks to recover damages. The scienter provision requires that plaintiffs establish either a strong inference of motive and opportunity to commit fraud, or strong circumstantial evidence of misbehavior or recklessness.
Enter Bernie Madoff. Fairfield Greenwich was a Madoff feeder fund which lost $7 billion of its investors’ money, and collected $400 million in fees between 2005 and 2008. After Madoff’s fraud came to light, Fairfield Greenwich was hit with multiple lawsuits alleging gross negligence, breach of fiduciary duty, third-party beneficiary breach of contract and unjust enrichment, among others. Judge Marrero consolidated these lawsuits into a class action suit that came to be known as Anwar v. Fairfield Greenwich.
The filing of the suit was inevitably followed by the motion to dismiss. The defense motion made multiple arguments, foremost among them that the Martin Act preempted private claims. Judge Marrero thought the preemption argument significant enough to merit its own separate opinion.
The judge based his opinion on two main arguments. The first, that rules of statutory construction foreclose preemption, rests on the rule that clear legislative intent is required for a statute to override the common law. He applies this by holding that nothing in the clear language of the Martin Act preempts private action. Marrero’s second argument was that the history of the Martin Act does not support preemption.
Without presuming to question Judge Marrero’s legal reasoning, there is a great deal of precedent to support the opposite view, that the Martin Act does preempt private action. The New York Appellate Division ruled this in CPC Intern v. McKesson Corp. in 1987, holding that the purpose of the statute was to create a statutory mechanism for the New York Attorney General to prevent securities fraud through investigation and intervention. At the federal level, this question was most recently addressed by the 2nd Circuit Court of Appeals in 2001 in Castellano v.Young & Rubicam. In that case, the court devoted only two paragraphs of the opinion to holding that the Martin Act preempted private claims, in deference to the New York Appellate Division.
Leaving aside arguments about legislative intent and federalism, this case has significant public policy implications. Judge Marrero’s ruling, if it stands, opens the door to a huge number of new lawsuits. Plaintiffs would only have to prove that there was a material misstatement somewhere in an offering prospectus, not that they relied on it at all, believed it, or that it caused them any damage. The Martin Act prohibits, among other things, “any promise or representation as to the future which is beyond reasonable expectation or unwarranted by existing circumstances” or any false statement where the person knew the truth, could have found out the truth, didn’t try to learn the truth, or didn’t know. Imagine what the plaintiffs’ bar can do with that.
Given the fact that many prospectuses are often based on unproven assumptions, and unprovable projections, startup companies may meet their investors in court more often than in the boardroom. Companies will have to balance their need for capital against the costs of almost inevitable litigation. Every market crash brings waves of litigation, where courts are called upon to distinguish securities fraud from bad investment decisions. A private right of action, under the Martin Act’s low evidentiary hurdle, will encourage many more lawsuits.
The case is currently pending in front of the U.S. 2nd Circuit. However, if the Appeals Court does uphold this ruling, the judges there should be prepared to hear a lot more securities fraud cases.