In McDaniel v. Wells Fargo Investments, LLC, Nos. 11-17017, 11-55859, 11-55943, 11-55958, 2013 WL 1405949 (9th Cir. Apr. 9, 2013), the United States Court of Appeals for the Ninth Circuit affirmed the dismissal of four class action lawsuits filed by employees against brokerage firms Wells Fargo, Bank of America, and Morgan Stanley. In separate lawsuits, the employees alleged that the brokerage firms' policies prohibiting employees from opening outside self-directed trading accounts violates Section 450(a) of the California Labor Code, which prohibits employers from forcing its employees to patronize his or her employer. The Ninth Circuit held that the California statute is preempted by the Section 15(g) of the Securities Exchange Act of 1934 (the "1934 Act"), 15 U.S.C. § 78o(g), which requires brokerage firms to take measures reasonably designed to prevent employees from engaging in insider trading. This case of first impression in California reassures brokerage firms that compliance with the securities laws will not violate California labor laws.
Section 15(g) of the 1934 Act requires brokerage firms to adopt policies "reasonably designed, taking into consideration the nature of such broker's or dealer's business, to prevent the misuse of . . . nonpublic information by such broker or dealer or any person associated with such broker or dealer." As the court explained, breaches of this duty are punished harshly, including sanctions and civil penalties in the amount of three times the profit gained or loss avoided as a result of the employee misconduct.
The Securities and Exchange Commission ("SEC") relies upon the securities exchanges (e.g., the New York Stock Exchange) to enforce Section 15(g). The exchanges are vested with the authority to promulgate their own rules that, once approved by the SEC, have the force of law. The exchanges thus have adopted rules requiring brokerage firms to adopt policies to ensure compliance with the Act.
Each of the brokerage firms in this case adopted policies generally prohibiting their financial advisors from opening self-directed trading accounts outside the firm. The reason given by the firms for doing so is to monitor employee activity to ensure that employees are not engaging in insider trading, and thus ensure compliance with Section 15(g) of the 1934 Act.
Section 450(a) of the California Labor Code provides that no employer "may compel or coerce any employee . . . to patronize his or her employer . . . in the purchase of any thing of value." The employees here argued that the brokerage firms are violating this provision of California law by forcing them to open self-directed trading accounts inside their firm. According to the employees, they would rather open accounts outside the firm because the trading fees are lower.
The brokerage firms moved to dismiss, arguing that the California statute is preempted by the securities law. The United States District Courts for the Northern and Central Districts of California granted defendants' motions and dismissed the complaints. The employees appealed.
After consolidating the cases on appeal, the Ninth Circuit affirmed. As an initial matter, the Court rejected the brokerage firms' argument that when Section 450 is enforced against their policies prohibiting self-directed trading accounts outside their firms, the statute loses its character as a labor law and takes on the nature of a securities regulation. The Court explained that Section 450 regulates the labor market which is an area traditionally of state concern, and therefore, there is a presumption that Congress did not intend to preempt Section 450. However, that was not the end of the Court's analysis.
The Court next turned to whether Section 450 of the California Labor Code presents an "obstacle" to the accomplishment of a significant objective of the securities laws. The Court concluded that it does. According to the court, Section 15(g) of the 1934 Act calls on the brokerage firms to decide "for themselves how to best monitor their employees' trading, suggesting that individually tailored policies serve as an important means for achieving the Act's basic goal of reducing insider trading." Where federal law grants an actor a choice and the state law would restrict that choice, the state law is preempted if preserving that choice is a significant regulatory objective. Accordingly, the Court held that Section 450 is preempted by the 1934 Act because the state statute would restrict the brokerage firms' discretion on how to best monitor and prevent insider trading by its employees.
The employees also argued that even if Section 450 of the California Labor Code did impede the firms' discretion, they could still comply with Section 450 by offering free in-house accounts. The Ninth Circuit did not agree. It held that the plain language of Section 450 forbids mandatory free accounts just as it forbids paid ones. According to the Court, Section 450 not only prohibits forced purchases from the employer, but also prohibits forced purchases from any third party. Thus, free accounts would still violate Section 450 because it would force employees to purchase a thing of value (e.g., a brokerage account) through their employer.
Accordingly, the Court affirmed the dismissals of the lawsuits by the district courts, reassuring brokerage firms that may keep and/or implement policies which restrict their employees from opening outside self-directed trading accounts without running afoul of the California Labor Code.
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