White Paper on the Martin Act for the Partnership for New York City

I. Executive Summary

More than ninety years ago, when New Yorkers first considered state legislation to regulate the securities markets, Governor Alfred E. Smith cautioned that New York is “the financial center of the world,” and that, “[i]n framing laws and in administering government, it is therefore of prime importance that legitimate business should be safeguarded, protected and encouraged, to the end that we maintain our financial, commercial and industrial supremacy.”1

This central concern animated the State’s enactment in 1921 of New York’s first statutory regulation of securities fraud, popularly known as the Martin Act. The policymakers who drafted the statute understood that fraud undermines the integrity of the market to the detriment of all investors, not only those investors that are actually defrauded. These policymakers understood also, however, that any regulatory regime risks tarring the honest broker with the stain of the swindler, and that too broad a brush could irreparably damage the primacy of New York as the world financial capital. Mindful of this danger, the architects of the Martin Act sought to strike a balance. They empowered the State Attorney General to take civil action against speculators who preyed on retail investors with promises of lavish returns from oil fields, mining projects, land developments and new companies that were worthless or fake. At the same time, they explicitly refrained from creating the kind of all-encompassing disclosure and regulatory regime at the state level that would overburden legitimate securities firms and companies looking to raise capital. The drafters considered this restraint vital to assure that undue state regulation would not cause these legitimate firms to take their business elsewhere – to the detriment of the state economy.

Amid the Great Depression, the U.S. Congress recognized the need for nation-wide regulation of these matters and enacted the Securities Act of 1933 and the Securities Exchange Act of 1934, which, as amended, continue to govern the national securities markets today. At the same time, New York policymakers remained committed to the Martin Act’s original balance at the state level, while investing the Attorney General with more weapons to battle truly fraudulent activity in boiler rooms and Ponzi schemes.

The Partnership for New York City is concerned that in recent years –when both New York and the United States need to be more competitive than ever – the use of the Martin Act has made it more challenging for New York to remain competitive as a global financial center. In particular, three key features of the Martin Act have effectively allowed the New York Attorney General to regulate the securities markets on

1 Governor’s Message to the Legislature Transmitting Report of the Special Committee Appointed by the Governor to Provide Proper Supervision and Regulation in Connection with Securities Offered to the Public Investment, LEGIS. DOC. NO. 81, at 8 (1920) (available from New York Legislative Service) [hereinafter Governor’s Message].

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a national level with powers that exceed those available to federal regulators at the Securities and Exchange Commission (“SEC”).

First: The Martin Act is untethered to its original purpose: deterring and punishing fraudulent schemes. The statute does not require the Attorney General to prove that a defendant acted with the intent to defraud in order to establish that the defendant is either guilty of a criminal misdemeanor or liable in a civil action. The Martin Act does not recognize any defense premised on the defendant’s good faith or reasonable diligence, even an affirmative defense on which the defendant would bear the burden of proof.

Second: The Martin Act applies to almost any transaction in securities made on an exchange located in New York. This territorial scope permits the New York Attorney General to prosecute conduct on a nationwide level, which makes enforcement unpredictable for firms that list their securities on New York exchanges but conduct their business elsewhere.

Third: The Martin Act gives the Attorney General what the courts have called “inquisitorial” investigative powers, which may be used to investigate conduct prior to the filing of a lawsuit. The Attorney General has virtually absolute discretion over how to use these powers – including over whether an investigation is secret or public. Further, those at whom the Attorney General directs these powers do not have some of the protections that are afforded them in other proceedings. As such, companies targeted by the Attorney General have very little leverage to defend themselves in the face of what is often a well-publicized investigation that precedes the filing of any actual lawsuit in a court of law.

These three features of the Martin Act permit the Attorney General of New York to regulate the securities markets on a nationwide basis using investigative powers that exceed those of the SEC, and to do so without having to marshal the same proof required by the federal securities laws. Unlike the applicable federal securities laws, a company (or individual) may be guilty of or liable for “fraud” under the Martin Act even if the company (or person) can prove no intent to deceive. All too often, this results in companies agreeing to pay out-sized settlements and to accept restrictive regulatory burdens even when no evidence exists that their employees acted with fraudulent intent.

This shadow regime conflicts with national priorities. Over the last two decades, confronting growing competitive pressures from other global financial centers, Congress has repeatedly tried to streamline and balance American securities laws. Recognizing, for example, that the crushing costs of discovery in private securities cases may coerce defendants into punitively expensive settlements even when they have strong defenses, Congress enacted several protections for defendants, including raising the pleading requirements to allege fraudulent intent, an element that the Attorney General does not have to allege or prove at all in a Martin Act proceeding. Likewise, recognizing the costs of overlapping, at times duplicative, multi-jurisdictional regulation, Congress on two occasions has limited the states’ power to regulate securities

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transactions, largely confining them to investigating the kinds of fictitious or worthless securities at which the Martin Act was originally targeted.

The Partnership for New York City believes that the Martin Act in its current form undermines the competitiveness of New York (and thus the United States) as a global financial center, and thus threatens the engine of our state economy. Data confirm this view. For example, a 2007 report issued by Mayor Bloomberg and Senator Schumer found that financial industry leaders’ concerns about a fragmented, unpredictable and unbalanced U.S. securities regulation regime undermined New York’s competitiveness as a financial center.2 Explaining why London was a more attractive location for their business, these industry leaders cited the problems with securities enforcement that are part and parcel of the current Martin Act enforcement regime.3

Since then, the competition has grown stiffer still. New York’s advantage in the Global Financial Centers Index over its nearest competitors – Hong Kong and Singapore – has been more than halved in the past five years alone.4 Financial professionals expect emerging financial centers – not just Singapore and Hong Kong but also Shanghai, Sao Paulo, Beijing, and Mumbai, among others – to grow more than New York in the years ahead.

The potential costs of these trends are enormous. New York’s securities

industry contributes 1 of every 12 jobs in New York State, and 1 of every 7 jobs in New York City, as well as $2.8 billion, or 7 percent, of state tax revenues and $8.7 billion, or 14 percent, of city tax revenues. New York State also has more than double the securities industry jobs than any other state.5

To protect our state and national economy, the Partnership for New York

City recommends that the Attorney General restore balance to the Martin Act by bringing actions only when: (1) the Attorney General can prove that the defendant acted with an intent to defraud or recklessly; and (2) a significant part of the allegedly fraudulent conduct took place in New York or the conduct has caused substantial harm to New York residents or companies. This will harmonize the Martin Act with securities regulatory regimes nationwide, and will focus the Attorney General’s resources where they belong, namely, on truly fraudulent activity in this State.

2 See generally Sustaining New York’s and the US’ Global Financial Services Leadership, available at http://www.nyc.gov/html/om/pdf/ny_report_final.pdf, at 73-94 (Jan. 22, 2007) [hereinafter Sustaining New York]. 3 See id. 4 Compare id., with The Global Financial Centres Index 1, available at http://217.154.230.218/NR/rdonlyres/0C0332C0-4CE5-4012-9AF7-2CF98A32E618/0/BC_RS_GFCI07_FR.pdf, at 7 (Mar. 2007) [hereinafter Global Financial Centres Index 1], with The Global Financial Centres Index 12, available at http://www.longfinance.net/Publications/GFCI%2012.pdf, at 11 (Sept. 2012) [hereinafter Global Financial Centres Index 12]. 5 THOMAS P. DINAPOLI, NEW YORK STATE COMPTROLLER, REPORT 9-2013, THE SECURITIES INDUSTRY IN NEW YORK CITY (Oct. 2012), available at https://www.osc.state.ny.us/osdc/rpt9-2013.pdf.

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The Office of the Attorney General should also use its discretion to bring Martin Act cases only when federal regulators have not already commenced an investigation or filed a lawsuit. Where the Attorney General learns through investigatory cooperation that the SEC is pursuing an investigation or enforcement action, the Attorney General should let these efforts take their course before continuing its own investigation or filing its own action under the Martin Act. At the very least, the Attorney General should not file a Martin Act case where the SEC has already filed a civil enforcement action. This will avoid duplicative regulatory proceedings that waste resources and taxpayer dollars that could be used to investigate other activity, and that multiply costs for companies already responding to a regulatory inquiry into the very same conduct.

Finally, the Partnership for New York City recommends that the State Legislature consider amending the Martin Act to require the Attorney General, in seeking to establish criminal or civil liability, to prove that a defendant acted with intent to defraud investors, thereby bringing the Martin Act into line with national policies aimed at the very same balance that the Act’s authors sought to strike.

II. History of the Martin Act

In order to understand the problems with the way the Martin Act is being used today, it is critical to understand what problems the Act’s authors were trying to combat and why they believed the Act was the best way to solve them. The elected officials and legal advisors who drafted and enacted the Act shared a central goal: deterring the sale of essentially worthless or fictitious securities and other predatory investment opportunities while preserving New York’s status as a global financial capital. Though the securities markets of 1921 may bear little resemblance to our highly globalized and automated financial markets, this balance remains relevant and should continue to guide the Act’s application today.

A. Blue Sky Laws

Between 1897 and 1913, rising incomes among a rapidly expanding middle class, along with a strong agricultural sector, quadrupled the American public’s savings, a “new source of capital that could be tapped effectively by means of public securities issuance.” 6 In the early years of the twentieth century, access to the securities markets thus expanded from professional investors to retail investors with far less experience.7

Many of these new investors purchased traditionally safe so-called “blue chip” securities with low but reliable returns, such as railroad and municipal bonds. Many others, uninitiated and unsophisticated, became prime targets for promises of far greater returns from investments, typically in natural resources and land development, that were particularly attractive at a time of high inflation. Unlike traditional securities

6 Jonathan R. Macey & Geoffrey P. Miller, Origin of the Blue Sky Laws, 70 TEX. L. REV. 347, 353-354 & n.22 (1991). 7 See id.

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issued by large financial institutions and traded on major securities exchanges, these get-rich-quick prospects were sold using the tools of a burgeoning mass marketing industry: “face-to-face solicitation, newspaper advertisements, and mass mailings.”8 They were “‘hyped’ by sales puffery” to anyone on a mailing list “in exciting, vibrant tones, stimulating the imaginations of wishful investors with tales of earth-shaking inventions, new projects, and vast wealth.”9

“The public’s growing appetite for speculative securities sparked intense public concern about fraudulent promotions.”10 Financial industry authorities and public figures alike became alarmed that retail investors were committing their savings to investments in oil fields, mining projects, and land developments that were either fictitious or so speculative as to be worthless.11 In popular parlance, many of these securities were said to have “no more basis than so many feet of ‘blue sky.’”12

At the time, no state or federal statutes specifically governed the sale of securities. As public reports of losses from bogus securities mounted, so, too, did calls for legislation “to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines, and other like fraudulent exploitations.”13 These statutes became known as Blue Sky laws because they were “aimed at promoters who ‘would sell building lots in the blue sky in fee simple.’”14

Kansas passed the first of these Blue Sky laws in 1911. The Kansas law required any firm selling securities in Kansas to obtain a license and file with the Banking Department copies of the securities, any contracts for their sale, descriptions of expected returns, and reports of the firm’s financial condition. Based on these submissions, the banking commissioner had discretion to prohibit the sale of any securities that he concluded were “unfair, unjust, inequitable or oppressive,” did not represent “honest business,” or did not “promise a fair return.” As such, the Kansas law became the model for so-called “merit regulation.”15

Reports of the Kansas legislation “quickly sparked efforts to regulate the sale of speculative securities in other states.”16 In 1912, Arizona and Vermont adopted laws modeled on the Kansas statute, and nine more states followed the next year. Nearly a dozen other states enacted Blue Sky laws that required licensing and registration with state regulators but did not empower them to reject securities on the merits.17 In 1917,

8 Id., at 353-54. 9 Id. 10 Id. at 355-59. 11 Id. 12 Hall v. Geiger-Jones Co., 242 U.S. 539, 550 (1916). 13 Id. 14 1 L. LOSS & J. SELIGMAN, SECURITIES REGULATION 36, 31-43 (3d ed.1998) (quoting Mulvey, Blue Sky Law, 36 CAN. L. TIMES 37 (1916)). 15 See generally Rick A. Fleming, 100 Years of Securities Laws: Examining a Foundation Laid in the Kansas Blue Sky Law, 50 WASHBURN L.J. 583 (2011); see also Origin of the Blue Sky Laws, supra note 6, at 359-64; 1 L. LOSS, J. SELIGMAN, & T. PAREDES, SECURITIES REGULATION, at 53-54 (4th ed. 2006). 16 Origin of the Blue Sky Laws, supra note 6, at 377. 17 Id. at 377-380; LOSS, ET AL., supra note 15, at 54.

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the U.S. Supreme Court upheld several Blue Sky laws against constitutional challenge.18 By 1920, some 33 states had enacted Blue Sky laws,19 and by 1934, 47 of the 48 states, plus the territory of Hawaii had Blue Sky laws on the books.20

B. Origins of the Martin Act

New York approached legislation somewhat more deliberately because of its unique place in the American financial landscape. While New York shared other states’ concerns about fictitious securities and bogus schemes, unlike most other states, New York was equally concerned that anti-fraud measures could inhibit legitimate investment activity that powered the state’s economy.

On September 25, 1919, Governor Smith appointed a Special Committee to Provide Proper Supervision and Regulation in Connection with Securities Offered to the Public Investment to study the issue and make recommendations. The Special Committee was comprised of prominent figures in private banking, the legal profession, and representatives of the investing public.21 In his letter appointing the Special Committee, Smith made clear that any legislation should be directed to “a prevention of the evil of issuing and offering for sale to the investing public, of worthless securities and securities of doubtful value.”22

The Special Committee found that the “evils” at issue fell “into two classes”:

1. The initial issuance of securities to the public in this or some other State, which are either worthless or have so little value that those purchasing them at the prices for which they are offered immediately sustain a severe loss.

2. The negotiation and sale by swindlers of worthless securities to individuals.23

After studying the Blue Sky laws of other states, corresponding with officials in these states, and holding hearings with the New York District Attorney’s Office and various industry associations, the Special Committee issued its report in December 1919. Despite some disagreement in approach – three members of the Special Committee issued a minority report24 – the members of the Special Committee agreed that any legislative solution needed to deter fraud without compromising New York’s preeminent position as a financial center.

18 See Merrick v. Halsey & Co., 242 U.S. 568 (1917); Caldwell v. Sioux Falls Stock Yards Co., 242 U.S. 559 (1917); Hall, supra note 12, 242 U.S. 539. 19 See State v. Gopher Tire & Rubber Co., 177 N.W. 937, 938 (Minn. 1920). 20 LOSS, ET AL., supra note 15, at 58. 21 Governor’s Message, supra note 1, at 5. 22 Id. 23 See id. at 5. 24 Id. at 5-6, 17-18.

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Echoing Governor Smith, the majority wrote that “New York is today the financial center of the world” and that, “[i]n framing laws and in administering government, it is therefore of prime importance that legitimate business should be safeguarded, protected and encouraged, to the end that we maintain our financial, commercial and industrial supremacy.”25 In a similar vein, the majority found that, “[i]n adopting any legislation which frankly will tend to restrict legitimate business in the hope of preventing fraud, New York State must proceed intelligently and should not adopt any legislation in which the restriction upon business is out of proportion to the benefit which might thereby be attained.”26 The minority agreed that legislation “should be framed . . . with a view to preserving as much freedom as possible for legitimate business enterprises,” and that this was “especially important in the case of New York State which is the center where capital is mainly mobilized for service in all parts of the country.”27

The members of the Special Committee disagreed on how to strike this balance. The minority proposed a licensing and disclosure regime similar to the British Company Act and to regulatory schemes enacted by many Western states. Draft legislation appended to the minority report became the basis for a bill in the Legislature.28 The Committee’s majority opposed the licensing and disclosure proposal, rejecting the British model. England, they wrote, “is a country with a single financial centre, whereas New York State is one State of a union, and can neither legislate as to the issuance of securities in other States, nor afford to drive capital into other States.”29 To avoid that result, the Committee recommended legislation granting the Banking Department and the Attorney General concurrent jurisdiction to investigate fraudulent securities.30

Opposing the minority view, the Association of the Bar of the City of New York elaborated on the risk that legislation would undermine New York’s supremacy as a financial center:

The United States, if not the whole world looks to New York State for capital and the development of national resources, industries and inventions. New York State has become a great financial centre of the World . . . . The capitalist who is urged to advance large sums of money is not likely to invest his money in New York if such investment is made burdensome, while other States and countries afford more favorable opportunities for investment. Any law which places oppressive burdens on those who are asked to invest their capital tends to drive capital, from the State enacting such a law, into other States and countries. The Legislature should be scrupulously

25 Id. at 8. 26 Id. 27 Id. at 20. 28 Id. at 20-24. 29 Governor’s Message, supra note 1, at 12. 30 Id. at 12-14.

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careful in attempting a remedy for an alleged evil not to create thereby a greater evil.31

The majority view prevailed in the Legislature, and its proposal became the basis for legislation introduced by Assemblyman Louis H. Martin, whose name became associated with the Act. The core of the Martin Act was its “majestic, one sentence sweep” empowering the Attorney General to investigate fraud, broadly defined.32 The Act’s opening sentence provided that, “[w]henever it shall appear to the attorney-general” that any person or company “is employing or is about to employ any device, scheme or artifice to defraud or for obtaining money or property by means of any false pretense, representation or promise” in connection with any transaction in securities, the Attorney General could “require” the person or company to testify in his office under oath.33 The Act also empowered the Attorney General to bring a civil action for an injunction barring a person or company from engaging in practices the Attorney General believed operated as a fraud.34

Recognizing that the Martin Act embodied the balance that animated the Special Committee’s work, the City Bar Association called the law “an excellent remedy for the evils which it has been attempted to meet by means of so-called blue-sky laws, but which, unfortunately, have been so framed as to give rise to abuses as serious as those sought to be obviated.”35

C. Later Amendments

Since 1921, the State Legislature has amended the Martin Act several times to give the Attorney General additional powers to prosecute fraud,36 some of which are germane to how the law operates today.

In 1932, the Legislature augmented the Attorney General’s power to bring

a civil action for an injunction against a person or company that had violated the Act. As originally enacted, the Act permitted the Attorney General to seek an injunction against only the specific practices alleged to be misleading. The 1932 amendment authorized the Attorney General to bar the violator from selling any securities of any kind in the state, not only the securities involved in the violation.37

31 Committee on the Amendment of the Law of the Association of the Bar of the City of New York, Memorandum on Senate Bill, Pr. No. 140, Int. No. 138 & Assembly Bill, Pr. No. 9, Int. 9 (available from New York Legislative Service), at 107-108. 32 LOSS, ET AL., supra note 15, at 164. 33 Martin Act, ch. 649, § 352 (1921) (current version at N.Y. GEN. BUS. LAW. § 352 (2012)). 34 Id., § 353. 35 Committee on the Amendment of the Law of the Association of the Bar of the City of New York, Memorandum on Assembly Bill, Pr. No. 1932, Int. No. 1540 (available from New York Legislative Service), at 360-61 [hereinafter Memorandum on Assembly Bill]. 36 See L. 1923, c. 600; L. 1925, c. 239; L. 1926, c. 617; L. 1927, c. 365; L. 1932, c.213; L. 1935 c.271; L. 49, c. 525; L. 1955, c. 553; L. 1958, c. 750; L. 1959, c. 692; L. 1960, c. 961r; L. 1980, c. 316; L. 1982, c. 146. 37 Martin Act, ch. 213 § 533 (1932) (current version at N.Y. GEN. BUS. LAW. § 352 et seq. (2012)).

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In 1955, on the recommendation of Attorney General Jacob K. Javits, the Legislature made its most significant amendments to the Martin Act. In a letter to Governor W. Averell Harriman and the state’s legislative leadership, Javits reported that the sale of fictitious and highly speculative securities to retail investors continued despite the Attorney General’s powers under the Martin Act:

In the last year the number of firms specializing in the retail distribution of such speculative securities has mushroomed. Most of them do their selling on the telephone out of what are familiarly known in the trade as “Boiler Rooms.” They employ salesmen of dubious reputation who resort to gross misrepresentations, false promises and other fraudulent and deceptive practices in order to sell their gullible prospects. They concentrate their efforts in the sale of issues of securities which are exempt from registration under the Securities and Exchange Act.

In particular, Javits described schemes very similar to the sales of “blue sky” that Governor Smith and his Special Committee had targeted three decades earlier: speculators touting “the development of oil” and the “future economic prospects of uranium.”38

Javits’s proposal led to two major changes to the Act. First, the

amendments made it a criminal misdemeanor to violate the Martin Act. Previously, the Act had merely empowered the Attorney General to file a civil action for an injunction. Second, the amendments clarified that the definition of “fraudulent conduct” prohibited by the Act included “[a]ny representation or statement which is false” even where the “person who made such representation or statement . . . did not have knowledge concerning the representation or statement made.”39 This amendment codified prior judicial rulings (discussed below) that the Act did not require the Attorney General to prove that a defendant acted with fraudulent intent.

In 1976, the Legislature amended the Act again to enable the Attorney General, in a civil action, not only to enjoin alleged wrongdoing but also to obtain restitution “of any moneys or property obtained directly or indirectly by an such fraudulent practice” that violated the Act.40

In 1982, the Legislature strengthened the Act’s criminal penalties for intentional and egregious violations. The 1982 amendment made it a class E felony to engage in an intentional ongoing scheme to defraud or to intentionally defraud ten or more persons.41 Although a felony conviction would thus require proof of fraudulent

38 Jacob K. Javits, N.Y. State Attorney General, Memorandum to the Governor on Assembly Int. 3448 Pr. 3734 (Apr. 7, 1955), in 1955 Amendment Bill Jacket (available from New York Legislative Service). 39 L. 1955, c.533, § 532-c (1955) (current version at N.Y. GEN. BUS. LAW. § 352 et seq. (2012)). 40 L. 1976, c.559 § 1 (current version at N.Y. GEN. BUS. LAW. § 352 et seq. (2012)). 41 L. 1982, c. 146 (1982) (current version at N.Y. GEN. BUS. LAW. § 352 et seq. (2012)).

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intent, the Attorney General retained the earlier-provided power to bring misdemeanor charges without proving such fraudulent intent.42

In writing to Governor Hugh L. Carey in support of this amendment, Attorney General Robert Abrams noted that it would “help protect the investing public” from the same “evils” targeted by the Martin Act and Javits’s 1955 amendments, namely, “boiler rooms, Ponzi schemes, insider trading, pyramid schemes, fictitious transactions and other artifices to defraud the investing public.”43

III. The Martin Act Today

History, then, teaches that the architects of the Martin Act and its key amendments intended for the Act to be used primarily to deter schemes involving fictitious or essentially worthless securities that prey on unsophisticated retail investors. Equally clear from the Act’s history is that the Legislature, Governors, Attorneys General, and leading members of the bar took great care to assure that anti-fraud measures did not impede the markets for legitimate securities.

Unfortunately, adherence to this objective has been uneven. In recent times, the expanded use of the Martin Act has undermined the delicate balance that the architects of the Martin Act intended – and created an uncertain and unpredictable regulatory regime that imposes enormous costs on businesses and firms. Indeed, several key features of the Martin Act have permitted the Attorney General to establish a more unpredictable and less balanced securities regulatory regime in New York than exists at the federal level or in some of the emerging financial centers with which this State must compete. To understand why this is so, it is necessary to analyze three key features of the Act, especially in comparison to national policy on securities regulation.

A. The Martin Act Punishes Unintentional Conduct

The potential effects of an Attorney General’s decision to file a Martin Act claim are of no small severity. If the Attorney General concludes that a sufficient basis exists to allege a violation of the Martin Act, the Attorney General may file a civil action seeking an award of restitution, monetary damages, an award of attorneys’ fees, and an injunction barring the defendant from continuing the practice that allegedly violates the Act as well as from selling any securities in the state.44 Misdemeanor charges, carrying a prison term of up to a year, are also an option.45 Not only are these penalties stiff, but defendants face the prospect of damaging reputational injury.

At the same time, however, the requirements for the Attorney General to impose these consequences are minimal. The Attorney General need prove only two meaningful elements to prove a violation: that the person or company made a false or

42 Letter from Attorney General Robert Abrams to Governor Hugh L. Carey, May 25, 1982 (available from New York Legislative Service). 43 Id. 44 N.Y. GEN. BUS. L. § 353. 45 N.Y. GEN. BUS. L. § 352-c (4); N.Y. GEN. BUS. L. § 359-g(2)

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misleading statement46 and that the statement was material.47 The Attorney General need not demonstrate that a defendant intended to deceive or mislead any investor in order to prove civil or misdemeanor charges. In fact, the Attorney General does not have to prove anything at all about the defendant’s intent. Nor does the law recognize a defense that a defendant acted in complete good faith or upon due diligence, including any affirmative defense as to which the defendant would bear the burden of proof.

Since the Act’s inception, the New York courts have held that, as used in the Act, “[t]he words ‘fraud’ and ‘fraudulent practices’” should “be given a wide meaning so as to include all acts, although not originating in any actual evil design or contrivance to perpetuate fraud or injury upon others, which do by their tendency to deceive or mislead the purchasing public come within the purpose of the law.”48

The New York courts continued to cite and follow this interpretation even after the Legislature made it a crime to violate the Martin Act. As the leading commentator on the Martin Act has noted, “a long line of cases has consistently established the principle that neither scienter nor intent need to be alleged or proven to sustain civil liability in general, or misdemeanor criminal culpability” under the Martin Act.49 Former Attorney General Abrams and numerous commentators have uniformly understood this case law to mean that the Martin Act contains no intent requirement at all.50 The Martin Act creates a strict liability crime.

Further, not only does the Attorney General not have to prove that a defendant intended to defraud any investor, but the Attorney General also does not have to prove that “anyone was, in fact, defrauded.”51 By its express terms, the Martin Act provides that it is a crime to make a misleading statement “regardless of whether the issuance, distribution, exchange, sale, negotiation or purchase [of a security] resulted.”52

46 N.Y. GEN. BUS. L. § 352-c. 47 The New York courts have adopted a standard formulated by the United States Supreme Court as to when information is material, namely, if “there was a substantial likelihood that the information would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” State of New York v. Rachmani Corp., 71 N.Y.2d 718, 726 (1988). 48 People v. Federated Radio Corp., 244 N.Y. 33, 38-39 (1926). 49 ORESTES J. MIHALY & DAVID J. KAUFMANN, MCKINNEY’S CONSOLIDATED LAWS OF NEW YORK ANNOTATED (1996); see also, e.g., Rachmani Corp., 71 N.Y.2d at 725 n.6; People v. Lexington Sixty-First Assocs., 38 N.Y.2d 588, 595 (1976); People ex rel. Cuomo v. Greenberg, 95 A.D.3d 474, 484 (1st Dep’t. 2012); People v. Am. Motor Club, 179 A.D.2d 277, 283 (1st Dep’t. 1992); People ex rel. Cuomo v. Charles Schwab & Co., Inc., No. 453388/2009, 2011 WL 5515434, at *7 (N.Y. Sup. Ct. Oct. 24, 2011); People v. Morris, No. 0025/09, 2010 WL 2977151, at *22 (N.Y. Sup. Ct. July 29, 2010); State v. Justin, 779 N.Y.S.2d 717, 739 (Sup. Ct. 2003). 50 Letter from Attorney General Robert Abrams to Governor Hugh L. Carey, May 25, 1982 (available from New York Legislative Service); ROBERT J. ANNELLO, 4C N.Y. PRAC., COM. LITIG. IN NEW YORK STATE COURTS § 90:17 (3d ed.); Frank C. Razzano, The Martin Act: An Overview, 1 J. BUS. & TECH. L. 125, 128 n. 21, 129 (2006); Robert A. McTamaney, New York’s Martin Act: Expanding Enforcement in an Era of Federal Securities Regulation, 18(5) WASHINGTON LEGAL FOUNDATION, LEGAL BACKGROUNDER, at 3 (2003). 51 Razzano, supra note 50, The Martin Act: An Overview, at 125. 52 N.Y. GEN. BUS. L. § 352-c(1).

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Thus, the Attorney General does not have to prove that any investor relied on the alleged misstatement.53

In sum, while the Martin Act was enacted to prevent swindlers from

cheating retail investors out of their savings with bogus promises about fictitious securities, the Martin Act, in its current form and application, punishes innocent mistakes and malicious frauds alike.

B. The Reach of the Act Is National

The second key feature of the Martin Act is that it essentially applies nationwide.

By its terms, the Act applies to “the issuance, exchange, purchase, sale, promotion, negotiation, advertisement, investment advice or distribution within or from this state, of any . . . securities.”54 “Accordingly, so long as some nexus exists between a securities transaction and New York, the Martin Act applies.”55 The mere involvement of a New York broker has been held sufficient to trigger application of the Act.56 And the Act can be invoked in connection with transactions involving investors who have no connection to New York, so long as the securities were sold “within or from” the state.57 Thus, as one commentator has noted, the Act’s “territorial reach is arguably satisfied in virtually every case involving a publicly traded security because the New York Stock Exchange is located in New York, the [NASDAQ] is headquartered in New York, and business transactions are routinely negotiated and financed in New York.”58

In sum, a statute that the Legislature intended to protect the primacy of New York’s financial markets creates a disincentive for companies and businesses to take advantage of New York’s financial markets, and arguably of the United States’ financial markets.

C. The Act Gives the Attorney General Unbridled “Inquisitorial” Power

The third key feature of the Act is that it gives the Attorney General broad “inquisitorial” investigative powers.59

“The extremely broad investigative power conferred upon the Attorney General by the Martin Act is evidenced by the fact that the statute affords him not one but

53 See People ex rel. Cuomo v. Merkin, 907 N.Y.S.2d 439 (Sup. Ct. 2010); State of New York v. Sonifer Realty Corp., 212 A.D.2d 366, 367 (1st Dep’t 1995). 54 N.Y. GEN. BUS. L. § 352(1). 55 Charles Schwab & Co., Inc., 2011 WL 5515434, at *6. 56 State v. Samaritan Asset Mgmt. Serv., Inc., 874 N.Y.S.2d 698, 704 (Sup. Ct. 2008). 57 See People ex rel. Cuomo v. H&R Block, Inc., 58 A.D.3d 415, 416 (1st Dep’t 2009); People ex rel. Spitzer v. Telehublink Corp., 301 A.D.2d 1006 (3d Dep’t 2003). 58 Wendy Gerwick Couture, White Collar Crime’s Gray Area: The Anomaly of Criminalizing Conduct Not Civilly Actionable, 72 ALB. L. REV. 1, 20-21 (2009). 59 In re Am. Res. Council, Inc., 10 N.Y.2d 108, 113 (1961); see also Gonkjur Assocs. v. Abrams, 88 A.D.2d 854, 856 (1st Dep’t 1982).

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two means of pursuing his investigative goals: confidential investigations conducted under compulsion of subpoena (§352) and public investigations conducted pursuant to court order (§§ 354 and 355).”60

Under Section 352, whenever it appears to the Attorney General that any person has engaged or is about to engage in any violation of the Act, the Attorney General can require the suspected defendant to “file with him a statement in writing under oath” as to the relevant facts.61 And some courts have held that the Attorney General has this subpoena power even after an action has been commenced.62

The Attorney General also has great leverage to enforce subpoenas under Section 352. The Attorney General does not have to move any court to compel any response to such a subpoena. Rather, the Attorney General may prosecute the failure to “obey the command of a subpoena” as a misdemeanor.63 Further, if the Attorney General decides to pursue a civil action to enjoin a defendant from selling securities in the state, the failure to respond to a subpoena to the Attorney General’s satisfaction is prima facie evidence that a target has engaged in the alleged fraudulent practices, which alone, without more, supplies a court with a basis to bar the alleged wrongdoer from selling securities in the state.64

That is not all. A witness testifying in response to a Section 352 subpoena does not have a right to the assistance of counsel while testifying before the Attorney General.65 Nor does the witness have a right to a transcript or recording of the testimony.66 To the contrary, it is a crime for the witness to divulge to anyone other than an attorney what transpired during the testimony. In fact, one commentator has observed that “[t]he secrecy of confidential hearings conducted by the Attorney General pursuant to the Martin Act has . . . been held to be absolute in its entirety.”67 But the street is one-way only: the case law uniformly holds that the Attorney General “has the authority to decide whether the information he gathers as part of his investigation should be kept secret or public.”68 The choice is for the Attorney General alone to make; the Attorney General may opt to keep some or all of the evidence a secret,69 or he may elect to disclose the information at a time, place, and manner of his own choosing.70

60 MIHALY & KAUFMANN, supra note 49, at 36. 61 N.Y. GEN. BUS. L. § 352. 62 MIHALY & KAUFMANN, supra note 49, at 36; see also Grandview Dairy, Inc., 76 A.D.2d 776, 777 (1st Dep’t 1980). 63 N.Y. GEN. BUS. L. § 352; see also MIHALY & KAUFMANN, supra note 49, at 37. 64 N.Y. GEN. BUS. L. § 353(1). 65 See First Energy Leasing Corp. v. Attorney-General, 68 N.Y.2d 59, 64 (1986). 66 See, e.g., Abrams v. Alliance for Progress, Inc., 519 N.Y.S.2d 533 (Sup. Ct. 1987); Gutterman v. Lefkowitz, 400 N.Y.S.2d 667 (Sup. Ct. 1977). 67 N.Y. GEN. BUS. L. § 352(5); see also MIHALY & KAUFMANN, supra note 49, at 38. 68 People v. Thain, 874 N.Y.S.2d 896, 901 (Sup. Ct. 2009); see also In re Marcus, 248 N.Y.S. 291 (Sup Ct. 1931, aff’d, 232 A.D. 731 (1st Dep’t 1931). 69 Thain, 874 N.Y.S.2d at 920. 70 Sittniewski v. Decker, 134 Misc.2d 177, 178, 509 N.Y.S.2d 1019 (Sup. Ct. 1986), aff’d, 140 A.D.2d 965, 529 N.Y.S.2d 639 (4th Dep’t 1988).

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Further, Section 354 empowers the Attorney General to conduct his entire investigation in public. Under this Section, the Attorney General may obtain, without notice to the witness or to a defendant, a judicial order requiring a witness to testify under oath at a public hearing. The Attorney General may obtain such an order upon no weightier a showing than “his information and belief that the testimony of such person or persons is material and necessary” to a Martin Act investigation.71

The Attorney General’s power to conduct a public pre-suit investigation is

daunting. The injury alone, in the absence of any claims being filed in a court of law, can have severe consequences, even if the Attorney General never pursues legal action or proves a violation. As one commentator has explained, “[t]he shock value and potential business damage of having a criminal investigation conducted in public gives the Attorney General awesome power.”72 It “affords vast tactical advantages” and “all but guarantees that sufficient evidence is available before the decision is taken formally to initiate the proceedings, and guarantees that maximum public relations pressures will be imposed on potential defendants, resulting in settlements which have been secured not only pre-judgment, but pre-filing.”73

Magnifying this concentration of power is that the Attorney General is the

only securities regulator in the United States—state or federal—with exclusive authority to bring both civil and criminal actions for violations of the securities laws.74 Every other state has a securities commissioner that is independent from the state’s Attorney General and has primary if not exclusive authority to enforce Blue Sky laws.75 Likewise, on the

71 N.Y. GEN. BUS. L. 354; First Energy Leasing Corp., 68 N.Y.2d at 64. In this regard, “[t]he courts have given Section 354 of the Martin Act the widest possible application.” Kaufmann, McKinney’s Consolidated Laws of New York Annotated, at 39; see also Razzano, supra note 50, at 130. In fact, Justice Cardozo recognized decades ago that the Attorney General can require a public hearing “almost upon mere request.” Matter of Ottinger v. State Civ. Serv. Comm’n, 240 N.Y.435, 439 (1925); see also In re Am. Res. Council, Inc., 10 N.Y.2d at 111. And, even after the Attorney General has commenced a public proceeding and required the testimony of witnesses, the Attorney General can continue to investigate in secret by subpoenaing other witnesses under Section 352. See Matter of Abrams, 611 N.Y.S.2d 422, 425 (Sup. Ct. 1994). 72 ANNELLO, supra note 50, at § 90:17. 73 McTamaney, supra note 50, at 3. 74 MIHALY & KAUFMANN, supra note 49, at 11. 75 See, e.g., ALA. CODE § 8-6-15 (2012); ALASKA V STAT. § 45.55.905 (2012); ARIZ. REV. STAT. ANN §§ 44-1822 (2012); ARK. CODE. ANN. §§ 23-42-201 (2012); CAL. CORP. CODE § 25531 (2012); COLO. REV. STAT. § 11-51-601 (2012); CONN. GEN. STAT. §§ 26b-26, 36b-27 (2012); DEL. CODE. ANN. §§ 73-401, 73-403 (2012); D.C. CODE § 31-5606.01 (2012); FLA. STAT. § 517.201 (2012); GA. CODE. ANN. §§ 10-5-70 (2012); HAW. REV. STAT. § 485A-602 (2012); IDAHO CODE ANN. § 30-14-602 (2012); 815 Ill. COMP. STAT. ANN. 5/11 (2012); IND. CODE § 23-19-6-3 (2012); IOWA CODE § 502.602 (2012); KAN. STAT. ANN. § 17-12a602 (2012); KY. REV. STAT. ANN. § 292.460 (2012); LA. REV. STAT. ANN. § 51:711 (2012); ME. REV. STAT. §§ 16602, 16603 (2012); MD. REV. STAT. § 11-701 (2012); MASS. GEN. LAWS ch. 110A § 407 (2012); MICH. COMP. LAWS § 451.2602 (2012); MINN. STAT. §§ 80A.79 (2012); MISS. CODE ANN. §§ 75-71-602 (2012); MO. REV. STAT. § 409.6-602 (2012); MONT. CODE. ANN § 30-10-304 (2012); NEB. REV. STAT. § 8-1115 (2012); NEV. REV. STAT. § 90.620(1) (2012); N.H. REV. STAT. § 421-B:22(1) (2012); N.J. STAT. ANN. § 49:3-68(a) (2012); N.M. STAT. ANN. § 58-13C-602(a) (2012); N.C. GEN. STAT. ANN. § 78A-57(b) (2012); N.D. CODE. § 10-04-16.1 (2012); OHIO REV. CODE. § 1707.23 (2012); OKLA. STAT. ANN. § 1-602(A)(1) (2012); OR. REV. STAT. § 59.245 (2012); PA. STAT. § 1-509 (2012); R.I. GEN. STAT. § 7-11-601(a) (2012); S.C. CODE § 35-1-602 (2012); S.D. CODE § 47-31B-602 (2012); TENN. CODE. ANN. § 48-2-

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federal level, the SEC cannot bring criminal charges. While the SEC can share information and work with the Department of Justice, the Department cannot use an SEC civil investigation as a stalking horse for a criminal investigation and the Department has independent authority over whether to file criminal charges.76 In contrast, the Attorney General need not consult with any other agency before openly invoking the possibility of criminal charges to exert leverage in a nominally civil investigation.

The Martin Act thus gives a single state official enormous discretion to

regulate securities firms – precisely the state of affairs under the original Kansas Blue Sky law that New York sought to avoid. IV. These Features Give the Attorney General Unparalleled Power

These features of the Act give the Attorney General unparalleled power to regulate the national securities markets. Indeed, the Act has had far more punitive consequences than its architects intended. Whereas Attorney General Javits envisioned that the 1955 amendments would “conform our statutes with similar provisions contained in the laws of the more progressive States and the Federal Government,” the reality today is that the Attorney General may prosecute conduct that the federal securities laws do not prohibit and that our system of justice has not permitted the law to punish.

A. The American Legal System Generally Disfavors Unintentional Criminal Liability

The Attorney General’s power to prosecute conduct as criminal “fraud,” even when the defendant did not intend to mislead anyone, is inconsistent with foundational principles of our legal system. While the Attorney General’s Office generally forbears from using this power to charge individuals or companies with misdemeanor violations, the specter that the Attorney General could do so casts a shadow over civil actions and investigations. By invoking the possibility that defendants in civil actions or subjects of investigations could face criminal charges as well, the Attorney General can exert leverage over defendants who assert an aggressive defense. As such, notwithstanding the fact that the Attorney General’s power to prosecute violations of the Martin Act as strict liability crimes is more often recognized than exercised, that power has tremendous consequences for those the Attorney General elects to pursue.

Our system of law has long frowned on the existence of such power. The

principle that a defendant should not be punished criminally for an unintentional act was well-established at English common law in the eighteenth century.77 From its beginnings, American jurisprudence, too, has recognized that “the prosecution of good faith defendants under strict liability laws appears to conflict with the most fundamental 118 (2012); TEX. ANN. STAT § 581-28 (Vernon 2012); UTAH CODE ANN. § 61-1-19 (2012); VT. STAT. ANN. 9 § 5602 (West 2012); VA. CODE ANN. § 13.1-518) (2012); WASH. REV. CODE § 12.20.370 (West 2012); W. VA. CODE § 32-4-407 (2012); WIS. STAT. ANN. § 551.602 (2012); WYO. STAT. § 17-4-119(a) (2012). 76 See, e.g., United States v. Scrushy, 366 F. Supp. 2d 1134 (N.D. Ala. 2005); United States v. Parrott, 248 F. Supp. 196 (D.D.C. 1965). 77 4 WILLIAM BLACKSTONE, COMMENTARIES *21.

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principles of just punishment.”78 Indeed, the U.S. Supreme Court has consistently required evidence of some culpable intent even when a criminal statute is silent on the question.79 The Court has permitted convictions without a showing of intent only for violations of statutes intended to protect the public from severe physical danger, such as laws regulating narcotics, prescription drugs, contaminated food, and highly toxic acids.80

Lawyers assessing the 1955 amendment criminalizing violations of the Martin Act recognized the danger of extending the Act’s criminal proscriptions to unintentional misstatements. The New York City Bar Association said at the time that the amendment “may give rise to unease because it does not contain the usual statutory requirement that criminal acts be ‘willfully’ or ‘knowingly’ committed.”81 For these reasons, the City Bar expressed concern that “[t]he result could be that one forecasts at his peril” and that “a securities salesman might find himself saddled with criminal liability for a careless but innocent misstatement of an immaterial fact.”82

The City Bar, however, believed this risk was minimal because, in its

view, “the intent of the bill appears to sanction criminal liability only for obviously intentional or irresponsible acts.”83 The City Bar was confident that the courts would effectuate this intent by invoking the well-established principle strongly disfavoring prosecution of unintentional acts. This belief that “courts will generally construe criminal statutes strictly” persuaded the City Bar to conclude that “these objections are not sufficient to . . . to disapprove the bill.”84 Instead, the City Bar observed that, whereas other “states have much more restrictive and far reaching ‘Blue Sky’ or securities laws than New York,” the “bill provides an additional measure of public protection by creating higher standards of conduct for those dealing in securities and commodities without imposing the sweeping regulation which in some states reduces the flexibility of the securities distribution system.”85

As set forth above, however, the courts did not interpret the Act as the

City Bar anticipated. Accordingly, as the law currently stands, the Attorney General has the power to prosecute violations of the Martin Act as criminal misdemeanors even if the violators did not act with any intent to defraud. And even if the Attorney General rarely (if ever) invokes his power to prosecute unintentional violations of the Martin Act as criminal violations, his authority to do so gives him enormous leverage to dictate terms to those parties under civil investigation.

78 Laurie L. Levinson, Good Faith Defenses: Reshaping Strict Liability Crimes, 78 CORNELL L. REV. 401, 427 (1993). 79 See, e.g., Staples v. United States, 511 U.S. 600 (1994); United States v. U.S. Gypsum Co., 438 U.S. 422 (1978); Morissette v. United States, 243 U.S. 246 (1952). 80 See United States v. Park, 421 U.S. 658 (1975); United States v. Int’l Minerals & Chem. Corp., 402 U.S. 558 (1971); United States v. Dotterweich, 320 U.S. 277 (1943); United States v. Balint, 258, 250 (1922). 81 Comm. On State Legislation, Memo. No. 124, 7 N.Y. City B.A. Bull. 421, 423 (Apr. 21, 1955). 82 Id. 83 Id. 84 Id. 85 Id.

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B. The Martin Act is Stricter than the Federal Securities Laws

Adopted at a time when no federal regulatory scheme existed and amended at times when local boiler room practices often fell below the federal radar, the Martin Act also imposes liability for conduct that is legal under the current federal regulatory scheme.86

1. Federal Regulation by the SEC

The SEC is empowered with enforcement of the federal securities laws, including, among other provisions, Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act.87 At a minimum, these laws require the SEC to prove that the defendant acted negligently, and in many cases they require the SEC to prove that the defendant acted either recklessly or with the intent to defraud.

Section 17(a) of the Securities Act makes it “unlawful in the offer or sale of any securities . . .

(1) to employ any device, scheme, or artifice to defraud, or

(2) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or

(3) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.88 To prove a violation of Section 17(a)(2) or 17(a)(3), the SEC must prove

that the defendant acted negligently.89 To prove a violation of Section 17(a)(1), the SEC must prove that the defendant acted with scienter.90 This means that the SEC must demonstrate that a defendant acted recklessly, with willful disregard of the truth, or with an intent to defraud.91

86 See, e.g., Samuel W. Buell, What is Securities Fraud? 61 DUKE L.J. 511, 559 n. 172 (2011); Razzano, supra note 50, at 18. 87 See 15 U.S.C. §77t; 15 U.S.C. § 78u. 88 15 U.S.C. § 77q. 89 See Aaron v. SEC, 446 U.S. 680, 697 (1980); SEC v. Morgan Keegan & Co., Inc., 678 F.3d 1233, 1244 (11th Cir. 2012); SEC v. Shanahan, 646 F.3d 536, 545 (8th Cir. 2011); SEC v. Wolfson, 539 F.3d 1249, 1256 (10th Cir. 2008); SEC v. Seghers, 298 F.App’x 319, 327 (5th Cir. 2008); SEC v. Ficken, 546 F.3d 45, 47 (1st Cir. 2008); Weiss v. SEC, 468 F.3d 849, 855 (D.C. Cir. 2006); SEC v. Hughes Capital Corp., 124 F.3d 449, 453, 454 (3d Cir. 1997). 90 See Aaron, 446 U.S. at 697. 91 See Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 318 n.3 (2007) (noting that “[e]very Court of Appeals that has considered the question has held that a plaintiff may meet the scienter requirement by showing that the defendant acted intentionally or recklessly” but continuing to reserve decision on whether recklessness is sufficient).

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Section 10(b) of the Exchange Act prohibits essentially the same conduct in connection with securities traded on a national exchange.92 To show a violation of Section 10(b), the SEC must prove that the defendant acted with scienter.93

Even if the SEC proves that the defendant acted negligently or with

scienter under Section 17(a) and/or Section 10(b), the SEC nonetheless may obtain only an enumerated set of remedies and penalties. The SEC may obtain an injunction ordering the defendant not to continue the alleged fraudulent or misleading practice;94 an order requiring the defendant to disgorge any profits from the violation;95 and capped civil penalties.96 The SEC, however, cannot recover other types of damages or pursue criminal penalties.

Contrasting these federal regulations with the Martin Act etches the

problem in sharp relief. Unlike the SEC, the Attorney General is not required to prove even that the defendant acted negligently to impose the penalties of the Martin Act. Also unlike the SEC, the Attorney General may obtain remedies that include not only an injunction but damages and restitution of any investments in the securities at issue.97 And, unlike the SEC, which must refer its evidence to an independent government agency, the Attorney General has the power to threaten and pursue criminal penalties at its discretion.

2. Federal Class Actions

While it may be appropriate that regulators do not have to prove all of the elements that private litigants do, federal law provides for remedies commensurate with the level of proof required. Though SEC has to prove less than private litigants, it cannot obtain the large damage awards that private litigants can if they can satisfy additional requirements. But quite the opposite is true under the Martin Act: the Attorney General has to prove less than federal law requires either the SEC or private litigants to prove, but the Attorney General can obtain the same kinds of large damage awards that are only available to private litigants who must make a more rigorous evidentiary showing.

Federal civil class actions brought under Section 10(b) of the Exchange Act provide the best illustration. Plaintiffs in these class actions may typically obtain monetary damages equal to the decline in the value of plaintiffs’ stock attributable to the corrective disclosure of the defendant’s false statement.98 Plaintiffs often claim billions of dollars in such damages, and it is not uncommon for defendants to pay tens or

92 15 U.S.C. § 78j. 93 Aaron, 446 U.S. at 691. 94 15 U.S.C. § 77t(b); 15 U.S.C. §78u(a)(d)(1). 95 See, e.g., SEC v. Curshen, 372 F.App’x. 872, 883 (10th Cir. 2010) (“[T]he SEC is entitled to disgorgement upon producing a reasonable approximation of [Defendant’s] ill-gotten gains” when defendant violated §§ 17(a) and 10(b)”.); SEC v. Calvo, 378 F.3d 1211, 1217 (11th Cir. 2004) (same). 96 15 U.S.C. §77t(d); 15 U.S.C. §78u(3). 97 See Kerusa Co. LLC v. W10Z/515 Real Estate Ltd. P’Ship, 12 N.Y.3d 236, 244 (2009); Greenberg, 95 A.D.3d at 481; N.Y. GEN. BUS. L. § 353(3); N.Y. EXEC. L. 63(12). 98 See generally In re Omnicom Grp., Inc. Sec. Litig., 597 F.3d 501 (2d Cir. 2010).

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hundreds of millions of dollars to settle such claims.99 However, plaintiffs face a high hurdle in such cases – and one that, as set forth below, Congress has made even higher out of concern that securities litigation had become unbalanced.

To sustain a class action complaint under Section 10(b)(5), claimants must plead with specificity, and then prove by a preponderance of the evidence, that in making an allegedly material misleading statement of fact, or omitting material information:

(a) defendants acted with scienter, that is, with the intent to defraud or recklessly as to whether the statement was misleading;

(b) the plaintiffs relied on the alleged misstatements; and

(c) that this reliance caused them actual monetary damages.100

Not so under the Martin Act. The Attorney General need not demonstrate bad intent, reliance, or causation – the rudimentary elements of any claim for fraud at common law. Yet the Attorney General is nevertheless authorized to seek damages under the Martin Act, and has done so, in amounts comparable to those sought by nationwide private class plaintiffs.

Even the most stringent provisions of the federal securities laws impose greater hurdles to proving liability than does the Martin Act. Under Section 11 and Section 12 of the Securities Act, plaintiffs alleging claims for false statements in a registration statement or prospectus in connection with the issuance of securities need not prove either scienter or negligence.101 Nevertheless, except for the issuer, others involved in the registration statement or prospectus such as financial advisors and accountants are not liable under these Sections if they can establish by a preponderance of the evidence that they acted with reasonable care and due diligence and, despite these good faith actions, could not have known that any statement was misleading.102 This defense at least gives many defendants an ability to defend against inadvertent disclosure errors by establishing their reasonable efforts and good faith. No such defense exists under the Martin Act.103

99 See generally Ellen M. Ryan & Laura E. Simmons, Securities Class Action Settlements: 2011 Review and Analysis, Cornerstone Research (2012), available at http://securities.stanford.edu/Settlements/REVIEW_1995-2011/Settlements_Through_12_2011.pdf. 100 Erica P. John Fund, Inc. v. Halliburton Co., 131 S.Ct. 2179, 2184 (2011). 101 See, e.g., Herman & MacLean v. Huddleston, 459 U.S. 375, 382 (1983); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 208 (1976); In re Morgan Stanley Info. Fund Sec. Litig., 592 F.3d 347, 359-60 (2d Cir. 2010); Miller v. Thane Int’l, 519 F.3d 879, 886 (9th Cir. 2008); In re Suprema Specialties, Inc. Sec. Litig., 438 F.3d 256, 269-70 (3d Cir. 2006). 102 See 15 U.S.C. § 77k(b); 15 U.S.C. § 77l(a). 103 See Note 50, supra.

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V. The Attorney General Has Become a Shadow National Regulator With Nationwide Post-Hoc Rule-Making Power

The tremendous breadth of the Martin Act, coupled with the unprecedented inquisitorial powers of the New York Attorney General, permits the Attorney General to act as a shadow national securities regulator. This system risks undermining the uniformity, predictability, and balance essential to preserving the competitiveness of American financial markets.

Given the minimal proof requirements under the Martin Act and the potential threat of criminal prosecution for unintentional conduct, companies under investigation often have few alternatives other than to agree to settlements of large dollar amounts accompanied by broad-ranging conduct reforms. As the SEC’s former Director of Enforcement has noted, “the prospect of being charged with fraud, even civilly, creates very high stakes for securities-industry participants—indeed, so high, that state regulators may find themselves in a position to dictate dramatic changes in conduct to settling parties. In short, they will have the leverage to effect rule changes through enforcement.”104

The Martin Act enables the Attorney General to effect these post hoc rules through settlements involving conduct legal under federal law and, in many instances, with only a tenuous connection to New York. By imposing change through litigation, the Attorney General re-writes – after-the-fact and on a national level – securities rules that no regulatory body in New York State has the authority to otherwise impose in advance. This kind of “policy making through litigation discussed in a closed conference room is not healthy for the U.S. capital markets, and not good for investors.”105 Indeed, for two reasons, the Attorney General’s recent enforcement “is not an ideal strategy for rule-making.”106

A. Regulation by Settlement Undermines National Priorities

The first problem with the Attorney General’s power to regulate the securities markets through settlements is that it supplants national efforts to re-balance American securities regulation.

Enforcement of the securities laws on an equal basis and with a studied appreciation of the impact on national and global markets is an important governmental objective. As the Attorney General’s enforcement of the Martin Act has “moved beyond the mere pursuit of fraudulent conduct within the jurisdictional boundaries of the state of New York,” the Act’s features have permitted the Attorney General to “usurp the SEC’s core regulatory function: dictating regulatory policy for the capital markets” and

104 Remarks of Stephen M. Cutler, Director, Division of Enforcement, U.S. Securities and Exchange Commission, at F. Hodge O’Neal Corporate and Securities Law Symposium, in 81 WASH. U. L. Q. 545, 552 (2003) [hereinafter Remarks of Stephen M. Cutler]. 105 Oxley, Who Should Police the Financial Markets?, N.Y. TIMES (June 9, 2002). 106 Jonathan R. Macey, Wall Street in Turmoil: State-Federal Relations Post-Eliot Spitzer, 70 BROOK. L. REV. 117, 129 (2004).

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“replace[] the SEC as ‘policy czar.’”107 In the words of Representative Michael Oxley, Chairman of the House Committee on Financial Services and a principal architect of the 2002 Sarbanes-Oxley Act’s aggressive reforms, the enforcement approach that the Attorney General began nearly a decade ago represents “a regulatory coup.”108 Such actions are strange in our federal system, for “there is nothing democratic about allowing one state to set national policy.”109 Because “regulated parties will conform their behavior to meet the demands of the strictest regulator with authority over them,” a single state, like New York, “could single-handedly undermine the majority view by intensifying its enforcement policies.”110

For these reasons, Congress has repeatedly “emphasized the goals of efficiency and competitiveness in our capital markets, and has concluded that uniformity in regulation is a pre-requisite to achieving these goals.”111 For example, in 1995, Congress recognized that the asymmetry of securities litigation – that the costs of defending securities actions far outpace the costs of pursuing them – made such litigation potentially unfair, even where intent to defraud is a required element.112 Congress recognized that exorbitant defense costs, including “the threat that the time of key employees will be spent responding to discovery requests” such as demands for testimony, “often force[d] innocent parties to settle frivolous” suits.113 To prevent this, Congress passed the Private Securities Litigation Reform Act (PSLRA) of 1995, which, among other things, increased the pleading standards for scienter applicable to securities class actions and barred plaintiffs from pursuing discovery while a court considers whether to dismiss an action.114 When, following passage of the PSLRA, civil litigants sought to evade the statute by filing their cases in state courts instead of federal courts, Congress acted swiftly to prevent any such attempt to avoid the stricter federal standards, passing the Securities Litigation Uniform Standards Act in 1998, which requires most securities class actions to be litigated in federal courts. 115

More recently, Congress has acknowledged that “the system of dual Federal and state securities regulation has resulted in a degree of duplicative and unnecessary regulation” which was “redundant, costly, and ineffective.”116 Congress found that “this duplicative regulation tends to raise the cost of capital to American issuers of securities without providing commensurate protection to investors or to our

107 Id. at 128. 108 Oxley, Who Should Police the Financial Markets?, supra note 105. 109Amanda M. Rose, The Multienforcer Approach to Securities Fraud Deterrence: A Critical Analysis, 158 U. PA. L. REV. 2173, 2210 (2010). 110 Id. 111 Remarks of Stephen M. Cutler, supra note 104, at 549. 112 Though private litigants had to prove that defendants acted with scienter, under existing law, plaintiffs could allege this element quite easily. As such, courts were reluctant to dismiss securities class actions before trial and plaintiffs could proceed to discovery, with its enormous costs. H.R. Conf. Rep. 104-369, P.L. 104-67 (1995). 113 Id. 114 See generally 15 U.S.C. § 78u-4. 115 H.R. Conf. Rep. 105-803, P.L. 105-353 (1998). 116 H.R. Conf. Rep. 104-864, P.L. 104-290 (1996).

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markets.”117 Accordingly, Congress sought to “eliminate duplicative and unnecessary regulatory burdens while preserving important investor protections by reallocating responsibility over the regulation of the nation’s securities markets in a more logical fashion between the Federal government and the states.” 118

Specifically, Congress tried to achieve this goal “by, as a general rule, designating the Federal government as the exclusive regulator of national offerings of securities.”119 That made sense, because “the SEC is able to bring to its consideration of matters affecting our markets a broader perspective – one informed by national economic and international policy developments – than can any one state.”120 To that end, Congress passed the National Securities Markets Improvement Act (NSMIA) of 1996, which preempted the states from regulating securities registrations and offerings made on a national scale.121 Congress explicitly “preserved the authority of the states to protect investors through application of state antifraud laws” in order “to permit state securities regulators to continue to exercise their police power to prevent fraud and broker-dealer sales practice abuses, such as churning accounts or misleading customers” 122 – i.e., the “evils” that Governor Smith and Attorney General Javits intended to target. At the same time, however, Congress intended NSMIA to apply “both to direct and indirect State action, thus precluding States from exercising indirect authority to regulate the matters preempted” by NSMIA.123

Contrary to this intent, the Attorney General’s enforcement of the Martin Act has only increased since the enactment of the PSLRA and NSMIA, even as to conduct that has nothing to do with fictitious securities or Ponzi schemes.

The Attorney General further routinely investigates conduct that is also under investigation by the SEC or another federal or state agency. Indeed, a review of press releases on the New York Attorney General’s website revealed that, in over 80% of the major securities fraud settlements that the Office announced over the past decade, the SEC or another federal regulator has been involved at some level in the underlying investigation or settlement negotiation.124 Though we are unable to determine from this information whether the investigation was commenced by the SEC or the Attorney General, this duplication is significant, and demonstrates a troubling overlap in the use of regulators’ resources and companies’ expenses in responding to inquiries.

117 Id. 118 Id. 119 H.R. Conf. Rep. 104-290, Pl. 104-290, at 30 (1996). 120 Remarks of Stephen M. Cutler, supra note 104, at 550. 121 See generally Kevin A. Jones, The National Securities Markets Improvement Act of 1996: A New Model for Efficient Capital Formation, 53 ARK. L. REV. 153 (2000); Roberta S. Karmel, Reconciling Federal and State Interests in Securities Regulation in the United States and Europe, 28 BROOK INT’L L. REV. 495, 509-511 (2003). 122 H.R. Conf. Rep. 104-864, P.L. 104-290. 123 H.R. Conf. Rep. 104-290, P.L. 104-290, at 30 (1996) 124 The Partnership reviewed information on the New York Attorney General’s website, http://www.ag.ny.gov, regarding 48 settlements of Martin Act actions from 2002 to the present.

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While in theory regulatory competition should encourage more vigorous enforcement, a former SEC Commissioner has noted that it more “frequently is an unseemly jurisdictional battle fueled by politics” that can “lead to disrespect for the law, as one regulator undermines the laws and regulations of another regulator.”125 Indeed, “a contest to be the most responsive regulator could too easily become a contest to be the most popular but most irresponsible regulator,” which “can have untold costs – to investors to issuers, to financial institutions, to the capital markets, to the justice system, and, ultimately, to our credibility as regulators.”126

B. Regulation by Litigation is Too Unpredictable

The second problem with the Attorney General’s power to regulate the securities markets through settlements in enforcement actions is that it is too unpredictable. Companies deciding whether to embark on new initiatives or to open new lines of business want to know whether these activities are legal, and they employ or retain lawyers to advise them on such questions. The overwhelming majority of law enforcement in this country is implemented in the private corridors of business, in the private exchanges between lawyers and their clients. The more certain a company and its lawyers are about the law, the less likely the company is to forgo profitable activity that turns out to be lawful or to expend resources on safeguards that are, in fact, unnecessary. But two features of the Martin Act make it very difficult for companies and their advisors to know the rules in advance.

First, the Attorney General’s enormous power under the Act gives him great leverage to dictate terms beyond what a company expects. “Perhaps most disturbingly, when rulemaking takes place in the context of an enforcement action, the regulator has such a power advantage over the regulated entity that unjust results are likely to occur.”127 This is especially true under the Martin Act owing to its extraordinary breadth and the powerful threat that the Attorney General will conduct its investigation in the public spotlight.

Second, regulation by enforcement action “lacks the usual notice and comment period associated with the promulgation of rules. It does not permit participation by all, or even most affected parties.”128 Whereas the SEC makes rules pursuant to a set of substantive and procedural rules that the aggrieved parties can enforce in court, there is no such process employed under the Martin Act and the Attorney General has nearly absolute discretion over investigations and settlements. This lack of transparency is particularly problematic where regulation is entrusted to a single elected official.129

125 Karmel, supra note 121, at 544-45. 126 Remarks of Stephen M. Cutler, supra note 104, at 551. See also generally Jonathan R. Macey, Positive Political Theory and Federal Usurpation of the Regulation of Corporate Governance: The Coming Preemption of the Martin Act, 80 NOTRE DAME L. REV. 951 (2004). 127 Id. 128 Id. 129 Rose, supra note 109, at 2223.

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Without any guidance from the rule-making process, companies and their lawyers can only speculate about the motives, politics, and goals of the Attorney General’s Office and what the Attorney General will demand in a proceeding where he has the upper hand. Running a business based on this uncertainty “can cause significant economic disruption” if regulated companies are “unfairly surprised when regulators advance broad principles in novel ways through enforcement.”130 In fact, regulatory unpredictability can have “some of the very same social costs as securities fraud itself” – for example, “it can increase the cost of capital . . . if fear of liability causes companies to overinvest in precautionary measures or causes financial intermediaries to charge more for their services.”131

VI. The Current Martin Act Enforcement Scheme Harms New York

These are not idle concerns. Evidence exists that the regulatory problems that characterize the current Martin Act regime – uncertainty, inconsistency, and imbalance – have undermined New York’s competitiveness as a global financial center. The 2007 report commissioned by Mayor Michael Bloomberg and U.S. Senator Charles Schumer found that the “second most important factor of competitiveness” among the financial industry leaders it surveyed “was the quality of the legal system.” These leaders cited “the unpredictable nature of the legal system” in the United States as one of the major factors undermining New York’s competitiveness.132 Chief among the major issues they cited:

• The U.S. legal system “is multi-tiered and highly complex”

because it is “divided between state and federal courts” and “uses a variety of enforcement mechanisms, including legal actions by regulators, state and federal attorneys general, plaintiff classes, and individuals.” This “fragmented US approach” was “seen as being more punitive, more public, and more costly, with multiple enforcement actions by national and state regulators and litigators” as well as “the possibility of both criminal and civil penalties in different jurisdictions.”133 This “has the unfortunate side effect of making it harder to manage legal risk in the US than in many other jurisdictions.”134

• The “enforcement efforts and subsequent rulings in the financial services industry have appeared to effectively criminalize conduct that had until then been assumed to be permissible. This caused many market participants to question their understanding of the

130 James J. Park, The Competing Paradigms of Securities Regulation, 57 DUKE L.J. 625, 630-32 (2007); see also Karmel, supra note 121, at 546. 131 Rose, supra note 109, at 2184. 132 Sustaining New York, supra note 2, at 73. 133 Id. at 84. 134 Id. at 77.

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scope of existing law, which in turn led them to adopt costly risk-averse behavior and bear the associated opportunity costs.”135

As Mayor Bloomberg and Senator Schumer concluded, “the highly complex and fragmented nature of our legal system has led to a perception that penalties are arbitrary and unfair,” which “diminishes our attractiveness to international companies.”136

The consequences of this reduced competiveness are clear. Long ago, the

New York City Bar Association noted that “a capitalist who is urged to advance large sums of money is not likely to invest his money in New York if such investment is made burdensome, while other States and countries afford more favorable opportunities for investment. Any law which places oppressive burdens on those who are asked to invest their capital tends to drive capital, from the State enacting such a law, into other States and countries.”137 And this is even truer “in today’s ultra-competitive global marketplace” where “more and more nations are challenging our position as the world’s financial capital.”138

Indeed, there are signs that New York already suffers from reduced

competitiveness. The report commissioned by Mayor Bloomberg and Senator Schumer concluded that, as early as 2006, initial public offerings (IPOs), exchange listings, and the rapidly expanding market in derivatives, among other financial activity, had begun migrating away from the United States, which means away from New York.139 Financial industry leaders reported that they viewed London, and the United Kingdom’s more efficient and predictable regulatory environment, as a more attractive location for their business.140 And New York continues to trail London in the Global Financial Centres Index, a biennial survey of global financial center competitiveness.141

The threat has not abated; it has spread. New York’s advantage in the

Index over its nearest competitors – Hong Kong and Singapore – has been cut by more than half in the past five years.142 The most recent Index found that financial professionals expected that Singapore, Shanghai, Hong Kong, Toronto, Sao Paulo, Luxembourg, Beijing, Moscow, Mumbai, and London, not New York, were the ten financial centers likely to become more significant in the years ahead.143 And more financial professionals expected financial firms to open new offices in Singapore, Hong Kong, London, Shanghai, and Dubai than expected firms to open new offices in New

135 Id. at 78. 136 Id. at ii. 137 Committee on the Amendment of the Law of the Association of the Bar of the City of New York, Memorandum on Assembly Bill, Pr. No. 1932, Int. No. 1540, at 107-108. 138 Sustaining New York, supra note 2, at i. 139 Id. at 40-59. 140 Id. at 73-78. 141 Global Financial Centres Index 12, supra note 4, at 11 (2012). 142 Compare id., with Global Financial Centres Index 1, supra note 4, at 7 (2007). 143 See Global Financial Centres Index 12, supra note 4, at 9.

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York.144 Thus, the Index warned that “London and New York must not believe they are ‘untouchable’,” since “the longer term trend of the leading Asian centres is upward.”

The potential costs of reduced financial competitiveness are enormous.

New York’s securities industry currently contributes to 1 of every 12 jobs in New York State, and 1 of every 7 jobs in New York City, as well as $2.8 billion, or 7 percent, of state tax revenues and $8.7 billion, or 14 percent, of city tax revenues. New York State also has more than double the securities industry jobs than any other state.145

Thus, what Governor Smith noted in proposing the Martin Act remains

true nearly a century later: because “New York is today the financial center of the world,” it is “of prime importance that legitimate business should be safeguarded, protected and encouraged, to the end that we maintain our financial, commercial and industrial supremacy.” 146

VII. Recommendations

The Partnership for New York City is committed to restoring the Martin Act’s intended balance between deterring frauds and preserving New York’s competitive advantage as a financial capital. To accomplish this objective, we must revisit the Martin Act’s roots: (1) the Act was intended to protect retail investors from swindlers selling fictitious securities or securities based on worthless promises; and (2) New York purposefully rejected a comprehensive system of regulation in favor of a more surgical approach focused on fraudulent schemes.

Today, Congress has preempted New York from doing so, because national legislative reform has placed a premium on a single, national system of comprehensive regulation and has rejected a system of dual regulation. Congress has thus limited the states to prosecuting the kinds of fraudulent schemes at which the Martin Act was originally directed.

In recent times, however, the Attorney General has used its residual power for the very purpose of regulating the national securities markets wholesale, even where the conduct at issue has nothing to do with fictitious securities, boiler room operations, or pyramid schemes. New York cannot afford this system any more than it could in 1921; indeed, such a system would be even more costly for New York today given competition from global financial centers in Asia and elsewhere that were hardly on the map nine decades ago.

The Attorney General should enforce the Martin Act in a way that supplements rather than supplants national regulation.

144 Id. at 12. 145 THOMAS P. DINAPOLI, NEW YORK STATE COMPTROLLER, REPORT 9-2013, THE SECURITIES INDUSTRY IN NEW YORK CITY (Oct. 2012), available at https://www.osc.state.ny.us/osdc/rpt9-2013.pdf. 146 Governor’s Message, supra note 1, at 8.

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First, the Attorney General should pursue claims under the Martin Act only when the Attorney General can establish that the defendant acted with intent to defraud or recklessly, which is the prevailing standard for federal cases under federal law and which comports with the Martin Act’s historical objectives.

Second, rather than pursuing claims against defendants nationwide, the Attorney General should pursue claims under the Martin Act only when a significant part of the allegedly fraudulent conduct took place in New York or when the conduct has caused substantial harm to New York residents or companies. Only these changes can harmonize the Martin Act with securities regulatory regimes nationwide, and focus the Attorney General’s resources where they belong: on truly fraudulent activity in this state.

Third, rather than duplicating or piggybacking on federal enforcement, the Attorney General should also use its discretion to bring Martin Act cases only where federal regulators have not already commenced an investigation or filed a lawsuit. While the Attorney General may not always know in the first instance whether federal regulators are pursuing a given matter, the Attorney General’s record of working jointly with federal regulators suggests that the Attorney General will usually learn when the SEC is pursuing an investigation or enforcement action. At the very least, the Attorney General should not file a Martin Act case where the SEC has already filed a civil enforcement action. Duplicating the efforts of federal regulators serves no additional deterrent effect, wastes taxpayer resources that could be used to investigate other activity, and materially increases defense costs for companies who are already facing legal consequences.

Finally, because restoring the Martin Act’s balance is so important to New York’s competitiveness, the Partnership for New York City recommends that the Legislature consider amending the Martin Act to require the Attorney General to prove that a defendant acted with intent to defraud, or, at a minimum, to afford defendants some defense premised on their use of reasonable diligence or good faith.