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11/20/97 ROBERT ORMAN ET AL. v. CHARLES SCHWAB &

November 20, 1997

ROBERT ORMAN ET AL., APPELLANTS,
v.
CHARLES SCHWAB & COMPANY, INC., ET AL., APPELLEES.



Appeal from the Appellate Court, First District, Cook County. CASE NUMBERS: AC1-94-2277, AC1-94-3423, AC1-94-3424, TR93CH7365, TR94CH1446, TR94CH1448. TRIAL JUDGE: Hon. Edward C. Hofert, Hon. Arthur L. Dunne.

The Honorable Justice Heiple delivered the opinion of the court.

The opinion of the court was delivered by: Heiple

The Honorable Justice HEIPLE delivered the opinion of the court:

At issue is whether Illinois breach of fiduciary duty and breach of contract claims arising out of a broker's retention of order flow payments are implicitly preempted because such claims would stand as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress in enacting the Securities Exchange Act of 1934 (15 U.S.C. § 78a et seq. (1994)). The plaintiffs in the three class action lawsuits consolidated for review sued the broker-defendants for retaining order flow payments, which they contend runs afoul of Illinois agency law. The trial court granted defendants' motions to dismiss plaintiffs' complaints on the ground that their claims were preempted by the Securities & Exchange Act of 1934, and the appellate court affirmed ( Orman v. Charles Schwab & Co., 285 Ill. App. 3d 937, 676 N.E.2d 241, 221 Ill. Dec. 720). This court allowed plaintiffs' petition for leave to appeal (166 Ill. 2d R. 315). For the reasons expressed below, we affirm.

ANALYSIS

The plaintiffs in these consolidated class actions assert the rights of a putative nationwide class of customers of defendants, Charles Schwab & Company, Inc., Quick and Reilly, Inc., and Olde Discount Corporation, discount securities brokerage firms which plaintiffs retained to execute their securities transactions. The gravamen of plaintiffs' complaints is that the defendants violated Illinois agency and/or contract law when they failed to remit to plaintiffs order flow payments received in executing plaintiffs' securities transactions. Order flow payments consist of both monetary and nonmonetary remuneration paid to a dealer by a market maker in exchange for the dealer's routing a customer's orders through the market maker. As plaintiffs observe, brokers are their customers' agents and as such owe them certain fiduciary duties. See Martin v. Heinold Commodities, Inc., 117 Ill. 2d 67, 76-77, 109 Ill. Dec. 772, 510 N.E.2d 840 (1987). Under traditional agency law, an agent who makes a profit in connection with transactions conducted on behalf of the principal is under a duty to remit that profit to the principal absent an agreement to the contrary. Janes v. First Federal Savings & Loan Ass'n, 57 Ill. 2d 398, 410, 312 N.E.2d 605 (1974), quoting Restatement (Second) of Agency § 388 (1958). Plaintiffs' complaints allege breach of fiduciary duty and breach of contract premised upon defendants' failure to remit the order flow payments they received to the plaintiffs. *fn1

Defendants counter that the Securities Exchange Act of 1934 (Exchange Act) (15 U.S.C. § 78a et seq. (1994)) implicitly preempts plaintiffs' state-law claims. The preemption doctrine is rooted in the supremacy clause of the United States Constitution, which mandates that "the Laws of the United States *** shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding." U.S. Const., art. VI, cl. 2. An act of Congress or regulatory law promulgated thereunder may supersede the statutory, regulatory or common law of any state where such "[is] the clear and manifest purpose of Congress." Cipollone v. Liggett Group, Inc., 505 U.S. 504, 516, 120 L. Ed. 2d 407, 422, 112 S. Ct. 2608, 2617, quoting Rice v. Santa Fe Elevator Corp., 331 U.S. 218, 230, 91 L. Ed. 1447, 1459, 67 S. Ct. 1146, 1152 (1947). A congressional act can either expressly or implicitly preempt a state cause of action. Freightliner Corp. v. Myrick, 514 U.S. 280, 287, 131 L. Ed. 2d 385, 392, 115 S. Ct. 1483, 1487 (1995). Here defendants urge that plaintiffs' state claims relating to order flow payments are implicitly preempted by the Exchange Act because they "stand[ ] as an obstacle to the accomplishment and execution of the full purposes and objectives of Congress," as manifested in the language, structure and underlying goals of the statute at issue. See Hines v. Davidowitz, 312 U.S. 52, 67-68, 85 L. Ed. 581, 587, 61 S. Ct. 399, 404 (1941).

Determining whether plaintiffs' state-law claims are implicitly preempted by the Exchange Act requires an understanding of the Exchange Act's history and the evolution of order flow payments. Congress enacted the Exchange Act in 1934 to regulate the various aspects of the securities industry; its implementing agency, the Securities and Exchange Commission (SEC), is responsible for adopting regulations which foster capital formation, facilitate competition and protect investors in the vastly complex array of markets that constitute the securities industry. Congress subsequently enacted amendments to the Exchange Act in 1975 (1975 Amendments) to cure "the securities industry's languor in the face of great changes and opportunities." S. Rep. No. 94-75, at 1, reprinted in 1975 U.S.C.C.A.N. 179, 180. Concerned with the misallocation of capital, widespread inefficiencies, and undesirable and potentially harmful fragmentation of trading (S. Rep. No. 94-75, at 1, reprinted in 1975 U.S.C.C.A.N. 179, 180), the 1975 Amendments called upon the SEC to develop a "National Market System" which would facilitate the "economically efficient execution of securities transactions" and "fair competition among brokers and dealers, among exchange markets, and between exchange markets and markets other than exchange markets." 15 U.S.C. §§ 78k-1(a)(1)(C)(i), (a)(1)(c)(ii) (1994).

The SEC's responsibilities included implementing regulations to "assure the prompt, accurate, reliable, and fair collection *** [and] distribution *** of information with respect to *** transactions in such securities and the fairness and usefulness of the form and content of such information." 15 U.S.C. § 78k-1(c)(1)(B) (1994). In 1977, the SEC exercised its authority and adopted Rule 10b-10, a "uniform rule applicable to all who wish to effect transactions for or with investors" which "adjusted regulatory requirements to eliminate those for which compliance costs appear to be disproportionate to the practical benefits of investor protection thereby obtained." (Securities Confirmations Proposed Rule, SEC Exchange Act Release No. 12806, reprinted in 41 Fed. Reg. 41,432, 41,432 (1977)). In pertinent part, Rule 10b-10 required that a broker-dealer disclose on a customer's confirmation statement "whether any other remuneration has been or will be received and that the source and amount of such other remunerations will be furnished upon written request." 17 C.F.R. § 240.10b-10(a)(7)(iv) (1997). Rule 10b-10 was in addition to section 28(a) of the 1975 Amendments, which provided in pertinent part:

"The rights and remedies provided by this chapter shall be in addition to any and all other rights that may exist at law or in equity *** . Nothing in this chapter shall affect the jurisdiction of the securities commission (or any agency or officer performing like functions) of any state over any security or any person insofar as it does not conflict with the provisions of this chapter or the rules and regulations thereunder." 15 U.S.C. § 78bb(a) (1994).

Thus Congress and the SEC achieved the appropriate balance between necessary regulation and free market forces in advancing the National Market System.

Substantively, the 1975 Amendments contained a variety of provisions intended to increase the number of market participants, develop competitors to the traditional stock exchanges and utilize emerging technology to increase competition between the exchanges and market makers for retail customer order flow. Market 2000: An Examination of Current Equity Market Developments, Market Regulation Division, Securities and Exchange Commission 5-6 (1994). It was hoped that "if market makers in a particular market center have reasonable expectations that they will receive a greater amount of [customer] order flow if they make markets which are consistently better in terms of price, depth or ease of execution *** they will be more likely to compete aggressively thereby providing a better and more efficient" National Market System. Development of a National Market System, Exchange Act Release No. 34-15671, Fed. Sec. L. Rep. (CCH) par. 81,572 (1979). Toward this end, the 1975 Amendments abolished fixed commission rates in order to increase competition within and between securities markets. See 15 U.S.C. § 78(e)(1) (1994).

The 1975 Amendments have been successful, prompting market makers to develop and utilize nontraditional markets such as the over-the-counter (OTC) market and the NASDAQ to effectuate trades, which has in turn has increased customer options with respect to how and at what prices they trade securities. Integral to the market makers' ability to attract steady streams of customer order flow for traditional and nontraditional markets has been the practice of paying "order flow payments." Generally speaking, payment for order flow is the practice of market makers or exchange specialists compensating brokerage firms for directing customer orders to them for execution. The order flow payment practice evolved in the early 1980s and typically includes both monetary and nonmonetary remuneration to broker-dealers in exchange for their routing their customers' transactions through the market makers. *fn2 When the practice of order flow payments evolved, the National Association of Securities Dealers took the position that the practice was governed by Rule 10b-10, the 1977 all-purpose provision requiring that broker-dealers disclose on a customer's confirmation statement whether any other remuneration has been or will be received and that the source and amount of such other remunerations will be furnished upon written request. 17 C.F.R. § 240.10b-10(a)(7)(iv) (1997). See, e.g., National Association of Securities Dealers Notice to Members, NTM No. 85-32 (1985) (Rule 10b-10 applies to "payments received by a retail firm from a market maker in return for their directing order flow to the market maker").

As evidenced by the instant plaintiffs' persistent references to order flow payments as "kickbacks," the practice has its detractors. See generally Note, The Perils of Payment for Order Flow, 107 Harv. L. Rev. 1675 (May 1994). The SEC, sensitive to the various concerns raised by the practice, has studied its impact on both markets and consumers since as early as 1984. See SEC Release No. 34-33026, reprinted in 58 Fed. Reg. 52,934, 52,935 (1993). After a thorough and comprehensive study of order flow payments, with input from participants industrywide, the SEC acknowledged arguments that order flow payments produced economic benefits to customers, including: (1) lower unit costs; (2) increased retail brokerage firm revenue; (3) lowered commissions; (4) more expeditious executions; (5) enhanced customer services; (6) increased competition from automated execution systems and related practices; (7) increased competition between wholesale dealers and exchanges and vertically integrated firms; and (8) reduced execution costs in all markets, including the exchanges. SEC Release No. 34-33026, reprinted in 58 Fed. Reg. at ...


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