District Court Dismisses Auction Rate Securities Claims under Pennsylvania Securities Act, Permits Breach of Fiduciary Duty and Negligence Claims to Proceed against Broker-Dealer

The U.S. District Court for the Eastern District of Pennsylvania recently dismissed claims under the Pennsylvania Securities Act (“PSA”). In doing so, the court expressed its view of the requirements for pleading securities claims under the PSA.

Fulton Fin. Advisors, N.A. v. NatCity Invs., Inc., No. 09-4855, 2013 U.S. Dist. LEXIS 148025 (E.D. Pa. Oct. 15, 2013), involved the sale of securities known as auction rate securities (“ARS”). Generally, when issued by municipalities or student loan entities, ARS take the form of debt instruments known as auction rate certificates. Conversely, when issued by a closed-end mutual fund, ARS take the form of preferred stock known as auction preferred shares. At issue in Fulton was the former, which had been issued by student loan entities.

ARS are usually structured to have long-term maturities, but the interest rates are reset at periodic intervals through dutch auctions. Ideally, investors see a higher yield on their investments in ARS than they would through certain other types of high liquidity investments. In addition, at least in theory, ARS are liquid, assuming that there are sufficient bidders to establish a clearing rate at the dutch auctions. If there are not sufficient bidders, however, the auctions fail, and the ARS cannot be sold. In this event, the investor cannot liquidate the securities and instead receives the maximum interest rate, which generally tends to be low in order to permit the issuer of the ARS to obtain a high-quality, investment-grade rating on its ARS. This was the issue in Fulton.

Fulton was an institutional investor who had an investment account with NatCity. NatCity recommended ARS to Fulton, who was seeking “only the highest quality and safest debt investments.” In addition to acting as Fulton’s securities broker, NatCity acted as a contractual broker-dealer (“CBD”) (and possibly underwriter) for issuers of ARS. On the transactions on which NatCity was CBD, it earned a yearly fee in the amount of .25 percent of the value of the transactions. For other ARS transactions on which NatCity was not the CBD, NatCity earned a portion of the CBD’s fee for directing Fulton to the CBD, who was the only party that could submit buy and sell orders at the auctions. NatCity allegedly did not disclose that it earned fees from these transactions to Fulton. Through its transactions with NatCity, Fulton held $175 million in ARS.

Because of the lucrative fees that were generated from the sale of ARS, NatCity allegedly became a secret “guarantor” of the success of the auctions. More specifically, in order to maintain the impression that the market for ARS was operating efficiently, NatCity allegedly made proprietary bids at auctions to preserve the market for ARS, a fact that allegedly was not known to Fulton. When the financial markets later began to collapse, however, so did the market for ARS. As a consequence, Fulton was left with illiquid securities for which it was receiving maximum interest rates that were below market rates. Fulton alleged that NatCity’s conduct in connection with the ARS violated sections 1-402 (market manipulation), 1-401 (sales and purchases), and 1-403 (prohibited broker-dealer transactions involving fraud or deception) of Pennsylvania’s securities laws, as well as gave rise to various common law causes of action. In support of these allegations, Fulton relied on regulatory decisions issued by the SEC and other state regulatory bodies, including a FINRA consent letter in which NatCity conceded that it had not made adequate disclosures to its customers regarding the investments. Fulton further alleged that NatCity owed it a fiduciary duty since it had superior knowledge and expertise in ARS markets.

Turning to these allegations and the corresponding claims, the court began by stating that Rule 9(b) not only applied to fraud claims under federal statutes, but also extended to fraud claims under state law. In so holding, the court expressly rejected Fulton’s argument that the pleading standard should be relaxed under In re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1418 (3d Cir. 1997), which recognized that a lesser standard may be imposed where the information at issue is uniquely within the control of the defendant. According to the court, insofar as NatCity’s alleged manipulation of the market for ARS was a matter of public information, Rule 9(b) applied. (AUTHOR’S NOTE: the PSLRA did not apply since no federal securities claims were asserted by Fulton).

Upon identifying the applicable pleading standard, the court next evaluated the sufficiency of the allegations in the complaint in regard to Fulton’s securities claims under the PSA. The allegations were extensive and will not be recounted here, but they were essentially two-fold. First, Fulton alleged that NatCity falsely manipulated the market for ARS without the knowledge of Fulton, thereby causing Fulton to purchase ARS at an inflated price that it would not have paid had the market not been manipulated. Second, Fulton alleged that NatCity used insider information to divest itself of the ARS that it had purchased, all the while continuing to recommend the ARS as investments to Fulton without disclosing the increased risk attributable to the imminent market collapse. In its defense, NatCity argued that Fulton had failed to identify any particulars of its alleged manipulation of the markets, particularly in regard to when, who, and where the proprietary bids were placed. The court agreed with NatCity that the pleading standard under Rule 9(b) was not satisfied. Essentially, the court held that there were insufficient facts pleaded to support the generalized allegations in the complaint pertaining to NatCity’s involvement with underwriters and other CBDs to manipulate the markets.

Separately, the court also held in the alternative that Fulton had failed to plead scienter either through a showing of conscious misconduct or recklessness. Looking to Section 10(b) of the Securities Exchange Act of 1934 and its implementing rule, Rule 10b-5, the court held that the sections of the PSA that NatCity allegedly had violated required a showing of scienter. As part of its analysis, the court recognized that the law was not settled on this point, particularly to the extent that Section 1-501 has been interpreted as possibly creating a cause of action separate and apart from the private right of action created for violations of Sections 1-401 and 1-403. Nonetheless, because Fulton had asserted claims under these sections as opposed to an independent claim under Section 1-501, the court found that scienter was required. It also concluded that this burden was not met because Fulton had alleged nothing more than a financial motive to commit fraud, which, as the court noted, is inadequate as a matter of law to support an inference of scienter.

After addressing scienter, the court analyzed the issue of reliance, which the court also found was required to state a claim under the sections of the PSA relied upon by Fulton. Additionally, reliance was an element of several of Fulton’s common law claims. NatCity argued that Fulton had failed to plead reasonable reliance because the alleged market manipulation was publicly known before Fulton entered into the transactions in question. In response, Fulton raised a number of arguments, including that it was not required to plead reliance to state its claims under the PSA, that reliance could be presumed under Pennsylvania law, and that its reliance was in any event reasonable, assuming the issue could be resolved on a motion to dismiss. The court rejected these arguments. Consistent with its interpretation of the PSA, the court found that reliance was required to state a claim under the sections of the PSA invoked by Fulton. The same was also true for Fulton’s common law causes of action for negligent misrepresentation and fraud. As for Fulton’s argument that reliance could be presumed, the court concluded that substantive federal law and Rule 9(b) stated otherwise. Finally, with respect to the reasonableness of Fulton’s reliance, the court determined that it could properly resolve the issue on a motion to dismiss, and that Fulton’s reliance in this instance was unreasonable since Fulton was a sophisticated investor who could have learned of the issues that it complained of through an SEC order that was entered the year before it entered into the transactions at issue.

Moving on to Fulton’s common law claims, the court held that Fulton also could not state a claim for negligent misrepresentation under Pennsylvania law because its claim sounded in the nature of omissions rather than affirmative misrepresentations. The court also dismissed Fulton’s aiding and abetting fraud claim for the same reason that it dismissed the other fraud claims-i.e., Fulton had failed to allege specific facts of NatCity’s participation with other CBDs in manipulating the ARS market. Finally, the court dismissed Fulton’s equitable rescission claim, noting that it was not a claim, but a remedy for fraud.

With respect to the negligence and breach of fiduciary duty claims, however, the court reached a different conclusion. Unlike the securities and other fraud claims, these claims were not subject to a heightened pleading standard. Accordingly, in light of the parties’ relationship and the allegation that NatCity had been trading in a manner inconsistent with Fulton’s stated investment objectives, the court concluded that Fulton had properly stated claims for negligence and breach of fiduciary duty.

Several aspects of this decision are worth noting. In discussing reliance, the court noted that Fulton’s claims were omissions-based. This notwithstanding, there was no mention or discussion of the U.S. Supreme Court’s decision in Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 128 S. Ct. 761 (2008), where the court held that, “if there is an omission of a material fact by one with a duty to disclose, the investor to whom the duty was owed need not provide specific proof of reliance.” Ultimately, this would not have affected the fate of the securities law claims under the PSA, but it is notable that this proposition was not analyzed, especially since the court expressly took note of the fraud-on-the-market exception, which, incidentally, was the second exception to pleading reliance that was recognized by the U.S. Supreme Court in Stoneridge.

In addition, when analyzing whether a showing of scienter was required, the court suggested the similarity between Section 9(a)(2) of the 1934 Securities Exchange Act and Section 1-402 of the PSA. On this point, it is worth noting that at least one other federal court has construed the language of Section 9(a)(1), which contains similar language as Section 9(a)(2), as requiring a showing of specific intent above and beyond the recklessness standard that will suffice under Section 10(b). See, e.g., Rockies Fund, Inc. v. SEC, 428 F.3d 1088, 1093 (D. D.C. 2005) (“Whereas [the “for the purpose of” language in] Section 9(a)(1) requires a showing of specific intent, Rule 10b-5 generally requires only ‘extreme recklessness.’ … Extreme recklessness requires a stronger showing than simple recklessness but does not rise to the level of specific intent.”). At least theoretically, this could mean that what is required to plead scienter to state a claim under Section 1-402 could vary depending on whether Section 9(a) or Section 10(b) of the 1934 Securities Exchange Act applies. The court did not even have to consider this issue, however, since it found allegations of scienter lacking entirely.

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