New York's Highest Court Decides Important Martin Act Preemption Question

At the end of 2011, the New York Court of Appeals handed down Assured Guaranty (UK) Ltd. v. J.P. Morgan Investment Management, Inc., an important decision that could have a broad impact on securities litigation in New York state and federal courts.[1] The case presented New York's highest court with an opportunity to resolve a significant and unsettled issue in New York securities law—whether the Martin Act, New York's securities statute, preempts private common-law tort claims arising from securities transactions. On December 20, 2011, the Court of Appeals held that the Martin Act does not preempt common-law claims, contrary to numerous federal and state court decisions that had held such claims were precluded.

The Martin Act

The Martin Act (the "Act") is New York's "blue sky" law, so called because these laws were designed to stop schemes involving fraudulent securities "which have no more basis than so many feet of 'blue sky.'"[2] The Act prohibits "[a]ny fraud, deception, concealment, suppression, false pretense or fictitious or pretended purchase or sale" in "the issuance, distribution, exchange, sale, negotiation or purchase … of any securities or commodities."[3] In 1960, the Act was amended to also cover fraudulent practices in the offering of condominiums and cooperatives.[4]

Widely considered the most severe blue sky law in the country, the Martin Act grants the New York Attorney General extraordinarily broad power to investigate and prosecute suspected violators of its antifraud provisions. The Act, for instance, contains no scienter requirement. The Attorney General need not prove a defendant's intent to defraud or deceive to recover civil damages. The Act was used to great effect by former New York Attorney General Eliot Spitzer in a series of lawsuits against banks and investment firms. New York Governor Andrew Cuomo continued to use the Martin Act against financial institutions during his tenure as New York Attorney General.

Private Securities Claims and the Martin Act

The Martin Act does not expressly provide a private right of action for claims that fall within the Attorney General's enforcement authority. Some courts initially allowed private litigants to bring claims pursuant to the Act.[5] That practice stopped when the New York Court of Appeals held, in CPC International Inc. v. McKesson Corp.,[6] that only the Attorney General can bring an action under the Act, because "an implied private action is not consistent with the legislative scheme underlying the … Act." The CPC decision set the Martin Act apart from other states' blue sky laws, the majority of which had been held to provide an implied private right of action.[7] While dealing with private actions under the Martin Act itself, the CPC decision left open the question of the extent to which the Martin Act, under the doctrine of preemption, precluded common law claims asserted in New York securities cases.

Martin Act Preemption

Following CPC, many state and federal courts in New York held that the Martin Act preempts private common law claims based on facts that would also allow the New York Attorney General to bring an action under the Act. An exception was made for common law fraud, which requires proof of deceitful intent, an additional element not required by the Act.

For example, a line of condominium and cooperative cases in New York state court found that common law negligence, breach of fiduciary duty, and constructive fraud claims were preempted by the Martin Act, because allowing the claims "would effectively permit a private action under the … Act, which would be inconsistent with the Attorney-General's exclusive enforcement powers thereunder."[8]

In Independent Order of Foresters v. Donaldson, Lufkin & Jenrett, the Southern District of New York applied these real estate cases to the securities context, holding that "[a]ny claim that is covered by the Martin Act is … not actionable by a private party," and dismissed common law claims for negligence and breach of fiduciary duty.[9] The Second Circuit reached a similar result in Castellano v. Young & Rubicam Inc.,[10] relying on the New York state court real estate cases to dismiss a common law breach of fiduciary duty claim. Although the courts were not uniform on the issue, the majority of federal courts within the Second Circuit have followed Foresters and Castellano in finding Martin Act preemption of nonfraud tort claims.[11]

Until this past December, the New York Court of Appeals had not directly addressed the issue. The closest it came was in Kerusa Co. LLC v. W10Z/515 Real Estate LP,[12] where the court dismissed a common law fraud claim involving a condo development because it was based entirely on disclosure requirements imposed solely by the Martin Act. The Kerusa court held that, on those facts, a common law fraud claim based on a defendant's failure to comply with the Martin Act cannot be meaningfully distinguished from a private right of action under the Act.[13] However, the Court of Appeals did not address the question of whether plaintiffs could bring a common law cause of action that was premised on facts that would support a valid Martin Act claim by the Attorney General, but whose elements were not based on the particular requirements of the Act itself. Certain decisions by the New York Appellate Division, New York's intermediate appellate court, had rejected arguments for such broad preemption, finding that private common law claims "may rest upon the same facts that would support a Martin Act violation … as long as they are sufficient to satisfy traditional rules of pleading and proof."[14]

Assured Guaranty

In Assured Guaranty, the plaintiff brought negligence and breach of fiduciary duty claims against an investment manager for investing funds in mortgage-backed securities. The trial court dismissed the claims, finding that they were preempted by the Martin Act. The Appellate Division, First Department, reversed. Construing Kerusa narrowly, the Appellate Division held that a private common law claim is not preempted by the Act unless it also "cast[s] what is clearly an obligation under the … Act as a common-law cause of action."[15] The court was persuaded by the New York Attorney General's amicus brief, which asserted that "there is nothing in the act or its legislative history, despite a number of amendments, that indicates any intention [by] the Legislature to replace common-law causes of action," and that allowing common law claims furthers the purpose of the Act, which is to combat fraud in securities transactions.[16] The court also cited as persuasive Anwar v. Fairfield, a decision by Southern District of New York Judge Marrero, which criticized the Foresters and Castellano decisions for reading the early state court real estate cases too broadly.[17]

The Appellate Division applied the same reasoning in CMMF, LLC v. J.P. Morgan Investment Management Inc.,[18] decided the same day as Assured Guaranty. In CMMF, the trial court declined to find common law negligence and breach of fiduciary duty claims preempted by the Martin Act, and the Appellate Division affirmed, voicing its opposition to the majority federal court view. These cases appeared to settle the issue, at least in the New York state courts. Even after the Appellate Division's decision in Assured Guaranty was handed down, however, the dissonance continued in the federal courts. In one case, another judge in the Southern District found that common law claims were still preempted by the Martin Act.[19] In doing so, the court followed Castellano without addressing the comprehensive analysis of this issue in Anwar, and noted that the Appellate Division's decision in Assured Guaranty was not the "last word" on the subject because the New York Court of Appeals had not addressed the issue.[20]  

Meanwhile, the bank defendant moved for leave to further appeal the First Department's decision in Assured Guaranty to the New York Court of Appeals, noting this conflict among the state and federal courts on Martin Act preemption, and the Court of Appeals' failure to address the issue directly. The Appellate Division granted the bank defendant leave to further appeal, setting the preemption question up for decision by New York's highest court.