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| WHILE YOU WERE CELEBRATING, THE LEGAL LANDSCAPE FOR INVESTORS CHANGED FOR THE BETTER By Robert Y. Lewis |
Two legal developments during the otherwise slow holiday weeks significantly changed the legal landscape to the benefit of investors wronged by securities issuers, brokers and investment advisors. Both of these developments (one a state court decision and the other a new federal regulation) reflect the recognition that our securities markets are in need of more robust and smarter policing to protect investors and the economy at large. I. Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc. – Breathing Life Into Private Investor Claims by Limiting the Preemptive Reach of the Martin Act On December 20, 2011, the New York Court of Appeals (the highest court in the state) issued a ruling in Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management Inc., 2011 WL 6338898 (N.Y., Dec., 20, 2011), that gives investors the right to successfully bring an action against issuers, advisors and brokers on legal theories that do not require proof of intentional wrongdoing. As explained below, the decision moved the law of New York (the financial center of the world) into closer alignment with the law in the majority of American states.
A. The Martin Act and Preemption Jurisprudence: How Far Does Martin-Act Preemption of Common-Law Claims 1. The Martin Act Gives the Attorney General Robust Enforcement Powers The ruling in Assured Guaranty (UK) Ltd. concerns the Martin Act, which is New York’s securities fraud law, commonly referred to as the “blue sky law.” As originally passed in 1921, the Act gave the New York Attorney General the power to investigate and seek to enjoin fraudulent practices in the marketing of stocks, bonds and other securities within and from New York. As the Court of Appeals explained in the earlier case of CPC Intl. v. McKesson Corp, 70 N.Y.2d 268 (1987), the Act was designed “to create a statutory mechanism in which the Attorney General would have broad regulatory and remedial powers to prevent fraudulent securities practices by investigating and intervening at the first indication of possible securities fraud.” Importantly, the Martin Act has been interpreted not to require the Attorney General in a civil action to show scienter or intentional fraud. State of New York v. Rachmani Corp., 71 N.Y.2d 718, 725 n.6 (1988). The New York legislature subsequently strengthened the Martin Act by adding criminal sanctions (GBL §352-c), the imposition of which also does not require proof of scienter or intentional wrongdoing (People v. Landes, 84 N.Y.2d 655, 660 (1994)), and by giving the Attorney General the right to seek monetary restitution for victims (GBL § 353[3]). 2. But the Martin Act Does Not Give Victims a Private Right of Action While giving the Attorney General very robust enforcement authority, the Martin Act makes no mention of any right by victims themselves to bring claims for compensation, injunctive relief, or any other remedy. And in 1987, the Court of Appeals expressly held that no private right of action was implied under the Martin Act. CPC Intl., 70 N.Y.2d at 276-277 (1987). Nor has the state legislature seen fit to amend the Act to add an express private right of action. In this regard New York is in the minority. The majority of states have blue sky laws that expressly give investors a private right of action, and they often provide for the award of attorney’s fees to a prevailing investor. 3. Hurdles Investors Face under Federal Securities and Common Law Claims Lacking a private right of action under the Martin Act, investors who are victims of wrongdoing perpetrated in or from New York have relied instead on state common-law actions or federal securities claims. These claims faced two significant hurdles, however. The federal securities claims carried relatively shorter statues of limitations and heightened pleading and proof requirements. And the state common-law claims routinely faced arguments from defendants that the Martin Act, which assigned the task of policing the securities markets to the Attorney General, not the victims themselves, preempted such private common-law claims. Lower state and federal courts issued inconsistent rulings on this preemption argument. Then, in 2009, the Court of Appeals held that the Martin Act did in fact preempt common law claims by a purchaser of condominium apartments predicated on the sponsor’s failure to disclose various construction and design defects in the offering plan, which disclosures are specifically required by the Martin Act, but would not be required without it. See Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. Partnership, 12 N.Y. 3d 236(2009). B. The Assured Guaranty Decision – Breathing Life Into Private Investor Claims In Assured Guaranty (UK) Ltd., the Court of Appeals took up the issue whether to extend Kerusa preemption to negligent representation and breach of fiduciary duty claims which, although similar to and perhaps even in part overlapping Martin Act claims, did not, unlike in Kerusa, depend on the Martin Act for their very existence. 1. Facts and Procedural History The plaintiff Assured Guaranty was a guarantor of Ornkey Re II PLC debt. Assured Guaranty alleged that defendant J.P. Morgan mismanaged the investment portfolio of Ornkey, causing Ornkey to fail and Assured Guaranty to have to pay on its guaranty. Assured Guaranty sued J.P. Morgan under common-law causes of action for breach of fiduciary duty, gross negligence and breach of contract. J.P. Morgan moved to dismiss on the grounds that the claims were preempted by the Martin Act. The trial court granted the motion, dismissing the case. The appellate division reversed, rejecting the preemption argument. It reinstated the breach of fiduciary duty and gross negligence claims, and part of the contract claim. 2. The Court of Appeals’ Holding The Court of Appeals agreed with the appellate division. It reasoned that, while the Martin Act did not authorize a private right of action to enforce it, neither did it contemplate the elimination of private common-law claims that existed prior to its enactment. The Court expressly endorsed the view of federal court Judge Marrero of the Southern District of New York, who in a recent case noted that to hold that the Martin Act precludes properly pleaded common-law actions would leave the marketplace “less protected than it was before the Martin Act’s passage, which can hardly have been the goal of its drafters.” Anwar v. Fairfield Greenwich Ltd., 728 F. Supp. 2d 354, 371 (S.D.N.Y. 2010). Thus, after Assured Guaranty it is clear that investor-victims may bring claims that overlap with and might even be cognizable under the Martin Act (if brought by the Attorney General), so long as they were claims that existed at common law before the enactment of the Martin Act. Significantly, this permits claims that have substantially longer statutes of limitations than federal securities law claims and that, like the Martin Act, do not require proof of intentional wrongdoing. The Assured Guaranty decision is welcome relief for investors dealing with New York financial institutions, who for many years have been stymied by Martin Act preemption arguments in their attempts to obtain recompense for wrongdoing. By breathing life into private claimant remedies that do not require proof of intentional wrongdoing, the ruling brings New York into closer (albeit still far from complete) alignment with the majority of states which give investors private rights of action under their blue sky laws. II. The SEC Changes the Definition of “Accredited Investor” by Excluding the Value a Primary Residence in Calculating Net Worth The second significant change in the legal landscape for investors occurred on December 21, 2011, when the SEC, following the mandate of section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, amended its definition of “accredited investor” to exclude the value of a person’s primary residence from the “net worth” calculation. We see this as a welcome protection for investors who on paper have substantial net worth because of the value of their homes, but who are otherwise neither wealthy nor sophisticated. Our federal and state securities laws are grounded in the notion that investors are best protected when they are given accurate information about an investment, including both its risks and rewards. Thus, the law requires that for most large securities offerings, the issuer “register” the securities with the SEC (and the state equivalent) by providing, in public filings, substantial information about the issuer and the particular offering being sold. Investors are entitled to rely on these registration statements in deciding whether and how much to invest, and issuers whose registration statements are materially inaccurate risk exposure to costly private and government securities fraud and related claims. However, complying with these registration requirements is burdensome and expensive. Recognizing this, the law provides a broad set of exemptions from the registration requirement for certain smaller offerings, and several of these exemptions depend (at least in part) on whether some or all of the investors are “accredited”. (See 17 C.F.R. §§ 215 and 501). If the offering qualifies for an exemption, the issuer need not register it, and its disclosure obligations to investors are significantly reduced. The notion is that an “accredited” investor has the financial wherewithal to take on greater risk than non-accredited investors, and is more sophisticated and better able to obtain information about and understand those risks. Therefore, there is less need for regulatory oversight of the investment. Issuers have often relied on a “net-worth” test to establish that the investors buying the securities were “accredited”. Under this test, an investor with a net worth of more than $1 million qualified as “accredited”. (17 C.F.R. § 230.501(5)). With the run up (until 2008) in real estate prices and the growth in home ownership, in recent years many individuals qualified as “accredited” under section 230.501(5), even though they had virtually no liquid assets, substantial debt, and no particular knowledge or experience with investments. In our practice, we have counseled numerous clients who fell victim to unscrupulous private placement issuers exploiting this legal loophole. The loophole has now been closed. An issuer will no longer be able to avoid registration when selling to investors whose “millionaire” or “accredited investor” status depends on the value of their home. Other “accredited investor” tests include the “income” test: Does one’s income exceeds $200,000 in each of the two most recent years, or one’s joint income with one’s spouse exceeds $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year? 17 C.F.R. § 230.501(6). This income test has not been changed.
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