Unleashing a Wall Street Watchdog

How a 1920s law meant to protect investors was manipulated to protect big banks and investment firms—until now.
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How a 1920s law meant to protect investors was manipulated to protect big banks and investment firms—until now.
(Illustration by Mark McGinnis)

(Illustration by Mark McGinnis)

No one doubts that the Great Recession has been the worst economic crisis in this country since the Great Depression. By whatever yardstick — the near collapse of the banking system, the 8.8 million jobs lost between 2008 and 2010 — no downturn in the intervening 80 years comes close. The crisis has forced a fundamental rethinking of the financial system, a conversation that is now centered on the 2010 reforms known as the Dodd-Frank Act. But the 2,319 pages of legislation do not hold all of the answers. If the regulators who are responsible for enforcing the hundreds of new rules are not up to the task, even the most elegant financial architecture is simply a Potemkin village.

Herein lies one of the great dilemmas of the new financial order. Even under the best of circumstances, government regulators such as the Securities and Exchange Commission, which is responsible for policing the markets and protecting investors, cannot do it all. And these are not the best of circumstances.

Although the SEC was the crown jewel of federal regulators for the first decade after its creation in 1934, its recent track record is appalling. SEC officials had no inkling that Enron had cooked its books a decade ago because no one in Washington had even looked at Enron’s financial statements for several years before its collapse. Although the SEC was the primary regulator of Bear Stearns and Lehman Brothers, it was so far out of its league that then-Treasury Secretary Henry Paulson didn’t even bother to include the SEC in many of the key discussions when Bear Stearns disintegrated in March 2008 and Lehman Brothers followed six months later. Perhaps most galling of all, the SEC repeatedly ignored warnings that Bernie Madoff’s investment business was actually a Ponzi scheme.

These failures came before the new financial reforms, of course. But there is little evidence that much has changed. Certainly Jed Rakoff, a federal trial judge in New York who is known for his dramatic interventions in important cases, doesn’t think so. In late 2009, Rakoff was so disgusted with the SEC’s handling of allegations that Bank of America had failed to disclose an agreement to pay, after it acquired Merrill Lynch, up to $5.8 billion in bonuses to Merrill executives, that he refused to approve a proposed settlement. The proposed fine, Rakoff concluded, was “inadequate, in that $33 million is a trivial penalty for a false statement that materially infected a multibillion-dollar merger. But since the fine is imposed not on the individuals putatively responsible but on the shareholders, it is worse than pointless: it further victimizes the victims.” A year later, Rakoff dressed down the SEC again, rejecting an SEC settlement with Citigroup because it, like the earlier settlement, did not require the company to admit that it had misbehaved in any way.

The SEC’s defense of these settlements is hardly reassuring. SEC officials claim that the agency had no choice; it does not have the resources to aggressively pursue more than a few enforcement actions, so churning out settlements that do not require any admission of guilt can be its best option. The SEC’s budget isn’t shrinking. It has risen from roughly $515 million in 2002 to more than $1.1 billion last year. But this is nowhere near the resources it needs to genuinely police the markets. And the SEC’s recent requests for budget increases have been swatted down by Republican lawmakers, even though the agency has enormous new responsibilities under the financial reforms. More responsibility without more money means that the SEC’s track record may get worse, not better.

If investors can’t count on the SEC, what can they count on? The answer may start with self-help by the investors themselves — if they are allowed. Odd as it sounds, this could depend on a controversial, 91-year-old New York securities law known as the Martin Act whose scope was recently debated in New York’s highest court.

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New York is only one of 50 states, of course, but its laws have always had outsized importance. Because the New York Stock Exchange, NASDAQ, and the biggest banks and accounting firms are all in New York, the most important securities cases often apply New York law. Most defendants in these cases are based in New York, and they usually insist, using “choice of law” arguments, that New York state laws be applied (the Martin Act applies to any security bought in or sold from New York).

Enacted in 1921, the Martin Act was one of the last of a wave of state securities laws that purported to crack down on manipulators who might bilk gullible investors by selling them securities backed by nothing more than the clear blue sky — hence their label, “blue sky laws.” Manipulators did indeed roam the earth in this era. But in most states, so did powerful local banks that saw the growing securities markets as a serious threat: if companies could raise money by selling stocks or bonds, they wouldn’t need to rely on bank loans. By imposing tedious disclosure obligations and the threat of regulatory scrutiny, the blue sky laws not only discouraged fraud, they also slowed down the banks’ competition. It wasn’t an accident that New York was late to this game. In most states, local banks were extremely influential, and bogging down the securities industry had limited local consequences. In New York, the home of Wall Street, the priorities were reversed.

As originally enacted, the Martin Act hardly even qualified as a blue sky law. Unlike other state blue sky laws, it did not require that a seller of stocks or bonds even provide — much less obtain state approval of — a prospectus or other disclosure document before a sale. It did little more than authorize the state attorney general’s office to investigate potential wrongdoing and to ask for an injunction insisting that wrongdoers knock it off. No wonder even the Investment Bankers Association sent Governor (and subsequent Democratic presidential nominee) Al Smith a letter praising the legislation. The Martin Act passed the Assembly by a unanimous vote.

Over time, however, the acorn became a wide oak, thanks to both judicial interpretation and subsequent legislative expansion. New York courts construed the act’s key terms in the most sweeping fashion possible. Nearly anything could be a “security,” for instance, not only stocks and bonds but even bags of silver coins or fake Salvador Dali lithographs. In 1955, then-Attorney General Jacob Javits persuaded New York lawmakers to add criminal penalties to the law, and, as he put it in a letter to the governor, “to bring within the condemnation of the statute any false promise which tends to deceive.” By prohibiting any false promise, and not requiring actual fraud as a condition of liability, these amendments made the Martin Act far broader than almost any other securities law in the country.

At least for the New York attorneys general (like, most famously, Eliot Spitzer). The implications of the Martin Act for lawsuits brought by defrauded investors themselves is a very different story. This story, which has been quietly developing outside the media spotlight and was the focus of the recent debate in New York’s highest court, may determine whether, as we climb out of the crisis, there is adult supervision on Wall Street.

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To understand the stakes, we need only appreciate a simple — and repeatedly underappreciated — truth: private litigation has always been a necessary supplement to regulatory oversight. Regulators have never been able to do it all on their own. This is true of both federal and state regulators. Because both federal and New York lawmakers forgot this truth when they enacted their securities laws, investors have long been forced to fight for a place at the table — their own table, since investors are the ones that the securities laws are supposed to protect.

The key federal securities laws (the second of which created the SEC) were enacted in 1933 and 1934, in the midst of the Great Depression. Because the reformers who drafted the federal securities laws assumed that the SEC could do it all, they authorized the agency to enforce key antifraud provisions, without saying anything about whether investors themselves could sue if defrauded. In 1946, a federal trial court held that there was an “implied” right of action for private lawsuits in the federal securities laws. Other courts followed, and the Supreme Court eventually agreed. Investors have supplemented SEC enforcement with their own lawsuits ever since.

Not surprisingly, the defendants in these cases weren’t happy. For decades, corporate lobbying organizations such as the Chamber of Commerce and Business Roundtable have campaigned vigorously for restrictions on investors’ right to sue. In the 1970s, the groups achieved considerable success in the Supreme Court, which handed down rulings prohibiting investors from suing if the fraud was accidental, or if a company’s lies caused investors to hold their stock rather than sell it.

In the 1990s, Congress tightened the screws. Thanks to the Private Securities Litigation Reform Act of 1995, plaintiffs are now required to state the damning facts “with particularity”—but are not permitted to ask for documents or to question corporate decision-makers until after a court decides whether to let the case go forward. This catch-22 makes it far more difficult for investor lawsuits to succeed. (Subsequent legislation also forestalls any securities class actions under state law with 50 or more class members.)

Advocates of the restrictions claim that many investor lawsuits are “strike suits” that have no merit but may garner a private settlement from a corporation without going to court. The real winner in these cases is the lawyer, the reasoning goes, not the investors, since the cases are often brought on behalf of millions of investors, each of whom has a small stake in the corporation and will receive only a tiny amount from a settlement. The lawyers, by contrast, can make millions. To be sure, dubious lawsuits have indeed sometimes slipped through the cracks. But corporate executives would have far less to fear if the private right of action were abolished. Even the most fervent critics of securities fraud litigation seem to acknowledge this much. Surely, even critics seem to concede, Bank of America should have at least as much to fear if it defrauds its shareholders as McDonald’s does when one of its customers spills a hot cup of coffee on herself.

Yet for more than a decade, a seemingly idiosyncratic interpretation of the Martin Act effectively removed most investors’ right to sue. Case after case has been thrown out. These run the gamut from Barron v. Igolnikov — where the U.S. District Court for the Southern District of New York threw out a class-action suit holding a Swiss bank liable for gross negligence (among other state-level violations) in allocating money to Madoff feeder funds to — perhaps most sensationally — a case in which real estate and publishing magnate Mortimer Zuckerman’s CRT Investments Limited sued former GMAC chairman J. Ezra Merkin’s Gabriel Capital Corporation, and several accounting firms, over $40 million in losses stemming from Madoff investments. Ironically, even to argue for a motion to dismiss, you have to assume the facts in the case are correct. But in all of these cases and many more, it didn't matter.

It was this interpretation of the Martin Act that quietly worked its way through the New York courts.

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In late 2008, J.P. Morgan Investment Management Inc. was sued in New York state court for gross negligence and breach of fiduciary duty. The company was accused of investing a considerable portion of a client’s assets in subprime mortgage securities and, allegedly, had not properly diversified the portfolio. J.P. Morgan insisted, as have dozens of defendants accused in civil courts of financial wrongdoing, it wasn’t obligated to defend against the allegations: because the claims were similar to the kinds of misbehavior prohibited by the Martin Act, J.P. Morgan argued, the claims must be dismissed.

There are two rather remarkable steps to this argument. The first is an assumption that investors do not have the same right to bring private lawsuits under the Martin Act that they have under the federal securities law. Because they are prevented from suing under the Martin Act, according to the second and far more radical step in the reasoning, investors also cannot bring any claims that resemble Martin Act allegations.

The New York attorney general’s office filed “friend of the court” briefs objecting to this defense both in the lower courts and when the case, known as Assured Guaranty (UK) Ltd. v.  J.P. Morgan Investment Management Inc., reached New York’s highest court last year. (In New York’s confusingly labeled system of state courts, the lowest court is known as the Supreme Court and the Court of Appeals is New York’s highest court.) The attorney general's principal argument was simply that its office needed the help of private litigants. We “cannot take sole responsibility for policing the securities marketplace for fraud and deceptive conduct,” the AG’s office wrote, and it warned the court that  J.P. Morgan’s “preemption" argument served to “reduce the protection afforded to investors and the securities markets, and would thus directly contravene the legislative goal embodied in the Martin Act.”

Given the limitations of governmental enforcement, these arguments seem to be no-brainers. But by the time the Assured Guaranty case was argued, the AG’s office and the private plaintiff who brought the case were fighting a distinctly uphill battle.

Back in the 1960s, early Martin Act decisions assumed that these investors would be permitted to bring a private right of action, just as they could under the federal securities laws. In a 1965 case involving both federal and Martin Act claims, a federal trial judge predicted that although the “Blue Sky Laws of New York have no express private civil liability provisions of any kind … if the New York courts were presented with a civil action under [the Martin Act] as here presented, they would” permit it.

Two decades later, New York’s highest court cast cold water on this prediction. Although it acknowledged that private lawsuits would further the act’s “broader statutory purpose,” the court refused — in a 1987 case called CPC Int'l. v. McKesson Corp. — to interpret the Martin Act as giving private investors this authority. If private investors wanted the right to sue, they needed to make the case in Albany, by persuading New York’s legislators to add this authority to the statute. Current New York Attorney General Eric Schneiderman proposed legislation that would have done just this before he became the AG, but the legislation has languished since he left the legislature.

Having persuaded the courts to deny a private right of action, the defendants in these cases continued to press their advantage in a string of cases whose outcomes firmly established that the Martin Act preempted private litigation, even if the private litigation was based on other claims, the theory later advanced by J.P. Morgan. Under this theory, the Martin Act would act like a black hole: any allegation that came sufficiently close to the kinds of claims covered by the Martin Act would get sucked in and destroyed.

The new theory might have been laughed out of court were it not for another of the Martin Act’s quirks. In 1960, the legislation was amended to bring “purchasers in offerings of cooperative and condominium units” within its scope. Once the courts descended into the morass of New York City co-ops and condos, seemingly crazy arguments suddenly began to make a lot more sense.

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The recent history is recounted in a case, Anwar v. Fairfield Greenwich Ltd., that arose from Bernie Madoff’s Ponzi scheme. Plaintiffs sued four hedge funds under both federal and state law after learning that the funds had invested “the overwhelming majority” of the plaintiff’s money in Madoff’s scheme. The hedge funds responded, in now-familiar fashion, by insisting that the state law claims must be dismissed due to their similarity to Martin Act claims.¬

In the opening section of his opinion in the Anwar case, Judge Victor Marrero, a federal trial court judge in New York with a soft spot for the popular paleontologist Stephen Jay Gould, acknowledged that the hedge funds had numerous precedents on their side. But these cases were the “unwitting perpetuation of error,” much like the repeated, mistaken description of an early horse as “the size of a fox terrier” that Gould recounted in his book Bully for Brontosaurus. It all started, according to Marrero, with a 1996 federal trial court case that slightly but decisively mischaracterized a string of New York state court cases. The federal court, in a case called Independent Order of Foresters v. Donaldson, Lufkin & Jenrette Inc., was led astray by the New York judges’ struggles to apply the Martin Act to the endless skirmishes over co-op fees, condominium conversion projects, and the like. The plaintiffs in these cases alleged that their co-op or condominium had misled them or had breached a fiduciary duty. In each case, the New York court had concluded that the claim was really an attempt to pursue a private right of action under the Martin Act. If the courts permitted the plaintiffs to sue, they would essentially be allowing private rights of action under the Martin Act, which New York’s highest court had forbidden in its 1987 McKesson decision.

This, Judge Marrero concluded, is the point at which the Foresters judge unleashed what Marrero has characterized as a fox terrier into the case law. In place of an earlier court’s innocuous statement that there was “no implied private cause of action for violation of the antifraud provisions” of the Martin Act, Foresters held that there is “no private right of action for claims covered by the Martin Act.” By substituting “covered by” for “violation of,” Foresters invited subsequent courts to kick out not only claims based on the Martin Act, but any claim that was in some way similar to a Martin Act claim. “Based on the lone paragraph of analysis from Foresters,” Judge Marrero concluded, “Martin Act preemption quickly went viral. … Like biology textbooks propagating the curious and outdated comparison of the Eohippus to a ‘fox terrier,’ other courts adopted Foresters’ holding to dismiss a host of common law causes of action, without questioning its conclusion or probing deeply enough into the sources or soundness of its analysis” — and often using the same language.

Since the Martin Act is designed to “prevent all kinds of fraud,” as an earlier case put it, the sweeping interpretation of the prohibition of private rights of action seriously undermines the policies behind the act. Judge Marrero refused to dismiss the plaintiffs' state law claims in his Madoff-related case, and urged other courts to do likewise.

Whether they would heed Judge Marrero’s call was, however, an altogether different question. Federal courts once could offer authoritative interpretations of state law, but since 1938, when the U.S. Supreme Court rejected the view that judges simply “find” the law, that has ceased to be the case. State court judges who found Judge Marrero’s excursus into paleontology refreshing, and his analysis persuasive, might be influenced by the 44-page opinion. But his ruling had no precedential effect. For state courts, the ultimate authority is New York’s highest court. And off to the highest court the Assured Guaranty case went, after the Appellate Division granted leave to appeal on February 17, 2011.

The case arrived in the Court of Appeals after conflicting lower court rulings. After the trial court had kicked out the plaintiff’s claims as expected, the Appellate Division stunned many observers by taking the same tack in Assured Guaranty that Judge Marrero took in Anwar, rejecting J.P. Morgan’s attempt to hide behind the Martin Act shield. Although the Appellate Division ruling attracted little media attention, insiders knew well what was at stake. In a client memo, the white-shoe firm Arnold & Porter warned that “unless overruled by New York’s Court of Appeals,” the decision “threatens to upset what had become increasingly settled expectations that securities-type claims cannot be brought” in New York courts. The decision was particularly important, the memo pointed out, given the difficulty of bringing federal securities law actions under current law. Adopt a broad rule of preemption, and corporate defendants like Arnold & Porter’s clients would have much less to worry about from private lawsuits; uphold the lower court ruling, and plaintiffs would begin relying much more on state law claims. A client would be far more vulnerable.

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For those who have followed recent corporate law scandals, it is almost unfathomable that the Martin Act, which gives New York’s AG such sweeping powers to police fraud, also could have given Wall Street an all-encompassing shield. But if Judge Marrero had hewed to the earlier cases, the hedge funds that funneled their clients’ money into the biggest Ponzi scheme in American history would not even have been required to defend their behavior. In Assured Guaranty, J.P. Morgan would not need to explain why, in the words of the New York attorney general’s brief, it invested “heavily in risky securities, particularly those based on subprime and ‘Alt-A’ residential real estate loans,” despite the fact that “J.P. Morgan concluded that it did not desire to hold these same risky securities in its own portfolio.”

Given the limitations of the SEC’s and state attorney generals’ enforcement capabilities, and the obstacles to bringing federal securities fraud claims, upholding those condo and co-op precedents would deprive the many investors who were devastated by the Madoff’s Ponzi scheme and the subprime crisis of their day in court.

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What was New York’s highest court to do? If it followed the growing weight of authority that led executives of Bank of America and other firms to assume they need not worry about private state law litigation, the court would be insulating Wall Street from the investors whose money the firms had handled on the eve of the crisis. But the court could give investors a chance to air their complaints only by thumbing its nose at the many cases that have permitted defendants to use the Martin Act to fend off state law claims.

Faced with this dilemma, Judge Victoria Graffeo, writing on behalf of New York’s Court of Appeals, on December 20, 2011, pursued a narrow question: Did New York lawmakers clearly intend to displace other, similar state law claims when they enacted the Martin Act (or presumably, its major revisions)? “Here,” she wrote, “the plain text of the Martin Act, while granting the Attorney General investigatory and enforcement powers and prescribing various penalties, does not expressly mention or otherwise contemplate the elimination of common-law claims.” Although New York’s high court has ruled both that investors do not have an implied right of action under the Martin Act and that claims that depend upon the Martin Act are likewise precluded, the Martin Act does not prevent investors from bringing other claims under state law. The Martin Act is no help to investors in private litigation, but neither is it a black hole, incinerating any claim that comes close.

One law blogger immediately recognized the importance of the New York decision. In a post titled “Investors Could ‘Occupy’ American Courts,” he speculated that the ruling “could see protestors, some of them backed by union support, bringing their own actions to address wrongs that they see as the heart of the Occupy movement.” “If the courts can be used as an alternative to police excess and fiascoes like the G20,” he wrote, “I interpret it as a small success for our judicial system," later noting that the same unions that have promoted the Occupy movement are major investors through union pension funds; they and other investors are now a little more likely to have redress in the courts.

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Does Assured Guaranty guarantee that private investors will have access to the courts, and supplement enforcement efforts by the SEC and the New York attorney general? Most assuredly not. If even a small portion of the investors whose nest eggs were ruined by subprime mortgages or Madoff’s Ponzi scheme now sue under state law, Wall Street lawyers and lobbyists will start looking for ways to cut off the spigot. As is demonstrated by the accumulated — and, as judges Marrero and Graffeo ruled, erroneous — precedent that Wall Street lawyers helped to quickly and effectively build to protect their clients from private litigation, the financial community has repeatedly and brilliantly used the courts and Congress to shield itself.

The situation is fluid, as the politicians like to say. New York’s highest court has now swept away decades of contrary case law, and unclogged the principal obstacle to private enforcement of the securities laws. For the moment, investors whose advisers loaded up on subprime mortgages or entrusted their money to Bernie Madoff can sue. But whether the courts will still be open next year is anybody’s guess. Given the tumultuous history of the Martin Act — with its shifts from a bland, Wall Street-friendly state securities law to sweeping anti-fraud statute to Wall Street shield — don’t expect New York’s most recent pronouncement to be the last word.

This article appeared in the May-June issue of Pacific Standard under the title “Caveat Pre-Emptor.”