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From: New York Law Publishing
Time: 5:48:23 PM
In an article written by Martin Flumembaum and Brad S. Karp for the New York Law Journal on July 22, 1998 a rather schoolarly work indicated what kind of treatment the regulation would have in the 2nd Circuit.
Broker-Dealers, Excessive Markups and Enforcement
IN RECENT MONTHS, the Securities and Exchange Commission and the National Association of Securities Dealers have stepped up enforcement efforts in the area of broker-dealers that charge excessive markups. Those efforts, by and large, have focused on over-the-counter securities and, in particular, broker-dealers that operate in the NASDAQ small-cap market. But the concept of excessive markups, and the obligation of broker-dealers to charge customers fair and reasonable prices, extends to the sale of all securities.
In this month's column, we discuss a significant ruling in which the United States Court of Appeals for the Second Circuit addressed for the first time what constitutes an excessive markup in the context of municipal securities.
The markup on a security represents the difference between the price a broker-dealer charges its customer and the "prevailing market price." Central to determining the reasonableness of a markup is determining the prevailing market price. The prevailing market price generally means the price at which broker-dealers trade with each other -- i.e., the current inter-dealer market. But where a broker-dealer is not a marketmaker, the prevailing market price generally is based on the broker-dealer's cost in actual transactions closely related in time to its retail sales.
In Grandon v. Merrill Lynch & Co.,1 the Second Circuit, in an opinion written by Judge Joseph M. McLaughlin and joined by Judge John M. Walker Jr. and District Judge Robert W. Sweet of the Southern District of New York (sitting by designation), vacated and remanded a district court's dismissal of a securities fraud complaint alleging that a broker-dealer had charged (undisclosed) excessive markups, ruling that a broker-dealer has a duty to disclose markups on municipal bonds where those markups are deemed "excessive."
In 1994 and 1995, in three separate transactions, plaintiffs bought three sets of municipal bonds from registered broker-dealer Merrill, Lynch, Pierce, Fenner & Smith Inc. In 1996, plaintiffs brought an action against Merrill Lynch in the United States District Court for the Southern District of New York, alleging that Merrill Lynch had charged excessive markups on these transactions of 4.6 percent, 6.3 percent and 3.7 percent to 9.74 percent, respectively.
Plaintiffs asserted that Merrill Lynch committed securities fraud by: (i) charging excessive markups by imposing inflated prices and fees; (ii) failing to disclose either the "true market price" of the bonds or the amount of the markups; and (iii) making implied misrepresentations or omissions by sending plaintiffs confirmation statements without disclosing the prevailing market prices or the amount of fees charged. Plaintiffs also asserted pendent state law claims for breaches of contract and fiduciary duty.
Merrill Lynch moved to dismiss the complaint. The district court granted Merrill Lynch's motion to dismiss, on the ground that Merrill Lynch was not required to disclose the markups. Although the district court believed the size of the markups was significant and presumed reliance on the part of plaintiffs, it nonetheless held that Merrill Lynch had no statutory or regulatory duty to disclose the markups. Because the district court determined that Merrill Lynch was under no such affirmative duty to disclose, it also concluded that the firm had not acted with scienter in failing to disclose the markups.
The district court did not address whether Merrill Lynch had made fraudulent misrepresentations or omissions in the confirmation statements sent to plaintiffs; nor did it address Merrill Lynch's alternative argument that plaintiffs had not satisfied the stringent pleading requirements Fed. R. Civ. P. 9(b). Refusing to exercise pendent jurisdiction over the state law claims, the district court dismissed the complaint in its entirety.
In reviewing the lower court's decision de novo, the Second Circuit only addressed plaintiffs' contention that Merrill Lynch had a duty to disclose the "true market price" of the municipal securities and that it had failed to make the required disclosure. Because the court ruled that Merrill Lynch had a duty to disclose any excessive markups, it did not address plaintiffs' contention that Merrill Lynch had made implied, material misrepresentations by not disclosing the markups in its confirmation statements.
Duty to Disclose
Liability under §10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 promulgated under it, is established by demonstrating that: (i) in connection with the purchase or sale of a security; (ii) the defendant, acting with scienter; (iii) made a material misrepresentation or (where there exists a duty to speak) a material omission, or used a fraudulent device.2 Where a material omission is alleged, a duty to disclose arises where "one party has information that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them."3
Because there are few federal regulations governing the municipal securities market, investors of municipal securities enjoy "substantially less protection" than do investors in the "regular securities market."4 It is well-settled that a broker-dealer operating in the regular securities market commits fraud in violation of §10(b) and Rule 10b-5 by charging customers excessive markups without proper disclosure. As noted above, the markup on a security represents the difference between the price charged and the prevailing market price, which generally is the price at which dealers trade with one another. An excessive markup is one that bears "no reasonable relation to the prevailing market price."5
The Municipal Securities Rulemaking Board -- the SEC-supervised, primary regulatory authority in the municipal securities market6 -- has expressly refused, because of the "heterogeneous" nature of the municipal securities market, to adopt a specific percentage guideline for what constitutes a reasonable markup. Instead, the MSRB has stated that the goal of protecting customers from unfair prices "can be achieved through other means." These "other means" include MSRB Rule G-30,7 which requires that prices charged by a municipal securities dealer be "fair and reasonable, taking into consideration all relevant factors."
These "relevant factors" include: (i) "the best judgment of the broker, dealer or municipal securities dealer as to the fair market value at the time of the transaction"; (ii) "the expense involved in effecting the transaction"; (iii) "the fact that the broker, dealer or municipal securities dealer is entitled to a profit"; (iv) "the total dollar amount of the transaction"; (v) the availability of the security in the market; (vi) the price or yield of the security; and (vii) the nature of the professional's business.8
The MSRB has expressly recognized that the price charged customers is the single "most important" factor in determining the fairness and reasonableness of the markup. Given the "welter of considerations" identified by the MSRB, the court noted that there is no fixed definition of what constitutes an excessive markup, although permissible markups on municipal bonds are significantly lower than those for equity securities.9
As distinguished from the myriad regulations governing equity securities, no statutory disclosure requirements exist with respect to municipal securities. To protect against unfair pricing, the SEC has brought Rule 10b-5 actions asserting fraud against securities brokers for charging undisclosed, excessive markups on debt securities under a "shingle theory" of liability. This presumes that a dealer has created an implied duty to disclose excessive markups by "hanging out his professional shingle."10
Although not expressly espousing this "shingle theory," the Third and Sixth Circuits have recognized a private right of action under §10(b) and Rule 10b-5 for violating this implied duty to disclose certain markups,11 and the Supreme Court has long interpreted expansively the antifraud provisions of the securities laws.12
The Second Circuit itself has held, in SEC v. First Jersey Sec. Inc.,13 that sales of securities by broker-dealers carry an implied representation that the prices charged are reasonably related to those charged in an open market, and broker-dealers that charge customers retail prices that include an undisclosed, excessive markup violate the securities laws.
Although this principle was announced in the context of an SEC enforcement action regarding markups of over-the-counter securities, the Second Circuit announced in Grandon v. Merrill Lynch that "[t]he time has come ... to extend the First Jersey principles to private actions arising out of excessive markups on municipal bonds. Specifically, we find that there exists an implied duty to disclose markups on municipal securities when those markups are excessive."14
The court continued: "We find that when a broker-dealer breaches this implied duty to disclose excessive markups, the broker-dealer violated §10(b) and Rule 10b-5 ... Finally, we also recognize that a private action under the antifraud provision of §10(b) and Rule 10b-5 exists against broker-dealers who charge undisclosed, excessive markups on municipal bonds."15
Recognizing that it might be unduly burdensome to require broker-dealers to disclose bond markups in every instance and fearful of overreaching into the competitive municipal bond market, the court cautioned that "[i]n assessing whether markups on municipal bonds are, in fact, excessive ... courts should begin with the factors set forth under MSRB Rule G-30."16 Although a "fairness and reasonableness determination" under MSRB Rule G-30 typically will be fact-based, the court stated that a court, in some cases, properly may conclude, as a matter of law, that plaintiffs have not stated a claim for excessive markups.
Finding that there exists a duty to disclose excessive markups on municipal bonds, the Second Circuit reversed the district court's judgment of dismissal. It also remanded for consideration by the district court the issue of whether plaintiffs properly pleaded that Merrill Lynch had impliedly misrepresented in its confirmation statements the prices charged in the bond transactions. Further, the court vacated the lower court's determination that Merrill Lynch had not acted with scienter because it was not bound by any duty to disclose even excessive markups.
Finally, the court directed the district court to address Merrill Lynch's arguments (i) that plaintiffs had failed to plead the basis for determining the "fair market value" at the time of sale or the amount of the markup, as required by Fed. R. Civ. P. 9(b); and (ii) that plaintiffs' claims are barred by the statute of limitations.
The Second Circuit's decision in Grandon opens the door to further enforcement action by the SEC and private actions by plaintiff-investors. Given the fact-intensive nature of the "excessive markup" analysis formulated by the court, these actions likely will survive motions directed at the pleadings. Needless to say, in the wake of the Second Circuit's ruling and the spate of recent enforcement actions, broker-dealers need to shore up their compliance efforts with respect to determining appropriate markups on all types of securities.
(1) 1998 WL 321695 (2d Cir. June 19, 1998).
(2) Id. at *3 (citations omitted).
(3) Chiarella v. United States, 445 U.S. 222, 228 (1980) (internal quotation and citation omitted).
(4) 1998 WL 321695 at *4.
(5) Id. at *5 (citations omitted).
(6) See 15 USC §78o-4(b).
(7) MSRB Rule G-30, MSRB Manual (CCH)
P 3646, at 5157.
(9) 1998 WL 321695 at *6.
(10) Id. at *8 (citations omitted).
(11) See Ettinger v. Merrill Lynch, Pierce, Fenner & Smith Inc., 835 F2d 1031, 1036 (3d Cir. 1987); Bank of Lexington & Trust Co. v. Vining Sparks Sec. Inc., 959 F2d 606, 613 (6th Cir. 1992).
(12) See, e.g., Affiliated Ute Citizens v. United States, 406 U.S. 128, 151 (1972).
(13) 101 F3d 1450, 1469 (2d Cir. 1996), cert. denied, 118 S. Ct. (1997).
(14) 1998 WL 321695 at *9.
(16) Id. at *10.
Martin Flumenbaum and Brad S. Karp are partners at Paul, Weiss, Rifkind, Wharton & Garrison. They specialize in civil and criminal litigation. Danya E. Perry, a litigation associate at the firm, assisted in the preparation of this article.
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