Ninth Circuit Holds That SEC Rules and Related FINRA Rules Trump State Law

May 08, 2013

On April 9, 2013, in McDaniel v. Wells Fargo Investments, LLC, --- F.3d ---, 2013 WL 1405949 (9th Cir. Apr. 9, 2013), the Ninth Circuit Court of Appeals affirmed the dismissal of four class actions brought against broker-dealers by their former employees, holding that federal securities law and related self-regulatory organizations (“SRO”) rules trumped a California statute forbidding forced patronage. In the McDaniel decision, the Ninth Circuit recognized that federal securities laws and related SRO rules were intended to give firms broad flexibility in designing their compliance programs, particularly as they relate to preventing insider trading, and that state laws that restrict that flexibility are preempted.

State Law v. Federal Mandates

Federal securities laws, and related SRO rules, require brokerage firms to take measures reasonably designed to prevent their employees from misusing material, nonpublic information. To meet that obligation, defendants Wells Fargo Investments, Wells Fargo Advisors, Morgan Stanley Smith Barney, and Merrill Lynch, Pierce, Fenner & Smith adopted policies forbidding their financial advisers from opening self-directed accounts outside of their firm. The plaintiff employees brought four separate class actions alleging that, by only permitting the employees to open self-directed trading accounts with their employers, Defendants forced their financial advisers to patronize their employers in violation of California Labor Code § 450(a). Defendants argued that California Labor Code § 450(a) was preempted as it was an obstacle to the accomplishment of a significant objective of federal securities law, namely that brokerage firms adopt policies reasonably designed to detect and prevent insider trading. The federal district courts for the Northern District of California and the Central District of California agreed with Defendants, dismissing those actions and holding that preemption barred plaintiffs’ claims.

In their appeal to the Ninth Circuit Court of Appeals, Plaintiffs argued that the district courts wrongly concluded that California Labor Code § 450(a) conflicts with federal law, because California Labor Code § 450(a) does not pose an obstacle to achieving the goal of preventing insider trading. Rather, Plaintiffs argued that forcing Defendants to comply with California Labor Code § 450(a) merely eliminates one choice of supervisory methods, and that although federal law grants firms a choice of methods, that choice itself is not a “significant objective” of federal law. In the alternative, Plaintiffs argued that, even if broker-dealer discretion in choosing supervisory methods is a significant objective of the federal regulatory scheme, Defendants could avoid violating California Labor Code § 450(a) by simply offering in-house trading accounts free of charge.

Discretion in Implementing Securities Law is Key Element of Laws

The Ninth Circuit rejected Plaintiffs’ arguments, stating that, where federal law grants an actor a choice, state law is preempted if preserving that choice was a significant federal objective. The Court determined that allowing broker-dealers discretion in choosing supervisory methods was a significant federal objective. The plain language of Section 15(g) of the Securities and Exchange Act and SRO rules, the Court found, grant broker-dealers broad flexibility to “decide for themselves how best to monitor their employees’ trading.” The Court noted that Congress recognized that broker-dealers required flexibility in enacting supervisory schemes — “the House Committee on Energy and Commerce went so far as to encourage the very policies that the defendants have adopted.” The Ninth Circuit also rejected Plaintiffs’ argument that offering free in-house trading accounts would allow Defendants to avoid violating California Labor Code § 450(a), stating that the plain language of that section “forbids mandatory ‘free’ accounts just as it forbids paid ones.” 

In upholding the district courts’ rulings, the Ninth Circuit affirmed the broker-dealers’ discretion to choose the supervisory scheme best suited for their business. 

Implications for Firms

For firms with associated persons in California, this ruling will give some welcome relief. As the opinion notes, at least one of the defendant firms had moved to allowing its California employees to hold accounts outside the firm, which are often more difficult and labor intensive to supervise. The court’s decision eliminates that requirement.

In reaching its conclusion, the Ninth Circuit touched on two important issues for member firms. First, the Court recognized that flexibility and discretion in implementing supervisory procedures to prevent insider trading is a fundamental element of the securities laws that cannot be impinged by state law. 

Second, the Court gave the SRO Rules enacted to implement this provision the same preclusive effect as the federal laws themselves. The Court concluded that “Congress has vested FINRA and the NYSE with the power to promulgate rules that, once adopted by the SEC, have the force of law,” and then added (in a footnote), “[f]or that reason, SRO rules are capable of preempting state law.” Id. at *3 and n. 6 (citing Whistler Invs., Inc. v. Depository Trust & Clearing Corp., 539 F.3d 1159, 1168 (9th Cir. 2008)). The extent to which this holding would apply beyond those rules that enforce Section 15(g) is not clear, but the broad wording of the court’s decision lends support to the view that SRO’s rules are entitled to the same deference as federal law.


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This article was originally published by Bingham McCutchen LLP.