FULL TEXT Opinion in Barclays High Frequency Trading Case

August 27, 2015

Last year, Michael Lewis published "Flash Boys: A Wall Street Revolt" and literally set Wall Street on edge with his thesis that high-frequency trading ("HFT") was ruining the markets by providing unfair advantages to its practitioners at the expense of investors who were relying upon the relatively snail-paced movement of non-HFT data. Lewis's book prompted a number of lawsuits against stock exchanges and dark pools where HFT was purportedly harming investors.  

One highly publicized lawsuit became a multidistrict litigation ("MDL") that wound up before the United States District Court for the Southern District of New York ("SDNY"). The defendants in the MDL were Barclays PLC, Barclays Capital, Inc, BATS Global Markets, Inc., Chicago Stock Exchange, Inc., Direct Edge ECN,LLC, NASDAQ Stock Market LLC, NASDAQ OMX BX, Inc, New York Stock Exchange, LLC, and NYSE Arca. 

On August 26, 2015, Judge Jesse Furman published his 51-page Opinion and Order in In Re: Barclays Liquidity Cross and High Frequency Trading Litigation (Opinion and Order, SDNY, 14-md-02589, August 25, 2015). The BrokeAndBroker.com Blog presents this important ruling in FULL-TEXT.

Bill Singer's Comment: Personally, I do not "like" Furman's decision; on the other hand, there are many things in life I do not like and that is not and should not be the acid test when it comes to the serious business of our court system. To Furman's credit, he has crafted an impressive Opinion replete with detailed background content and a patient effort to place the issues and rulings within the appropriate context. Regardless of this decision's fate on appeal, the judge is to be credited for a compelling intellectual exercise in drafting his Opinion in a manner that meticulously presents the issues, the disputes, and his rationale. 

Although this federal opinion constitutes a victory for Barclays, that company still faces a pending New York State lawsuit: 

For a prescient and excellent discussion of HFT, watch this 2013 video featuring the insights of market pundit Shah Gilani: 

The Claims

As more fully explained in the Opinion and Order, there were two baskets of claims: one against the exchanges and the other against Barclays. As explained by Judge Furman [Ed: footnote omitted]:


The SDNY Plaintiffs contend that the Exchanges violated the Exchange Act by engaging in a manipulative scheme in which they enabled HFT firms to exploit ordinary investors trading on the Exchanges in return for which the HFT firms directed their considerable trading activity to the Exchanges. (SDNY Pls.' Mem. 7-8). The essence of the alleged scheme is as follows. Motivated by the need to increase trading volume, and therefore revenue, and recognizing that the HFT firms represented a large - and growing - share of total trading volume, the Exchanges began "catering" their business operations to the needs of the HFT firms. (Id. at 6-7). Specifically, they began offering products, such as proprietary feeds and co-location, whose primary value was to shave minute fractions of a second off the time it takes to receive and respond to information from the Exchanges. (Id. at 8-10). Such services are valuable only to HFT firms, as only they stand to profit from very small decreases in the time it takes to respond to information regarding activity on the Exchanges; in any case, the Exchanges priced the services at such "exorbitantly high" rates that they were worthwhile only for HFT firms and thus "de facto" limited to those firms. (Id. at 8-10, 34). In addition, Plaintiffs contend that the Exchanges worked with HFT firms to design order types that would allow the traders to further exploit their speed advantage over ordinary investors. (Id. at 10-11). Making matters worse, the Exchanges either did not disclose many of these order types to ordinary investors or marketed them exclusively to HFT firms, so that the ordinary investors were unaware of their existence. (See id. at 11-12). Case 1:14-md-02589-JMF Document 50 Filed 08/26/15 Page 12 of 51 13

Through these actions, the Exchanges enabled the HFT firms to amass a significant speed advantage over ordinary investors and to employ trading strategies that exploited that speed advantage to the detriment of ordinary investors. The SAC details the various strategies that HFT firms used to exploit Plaintiffs as a result of this scheme. The specifics of those strategies are not relevant here. Instead, it suffices to say that each of the strategies depended on the HFT firms' ability to recognize Plaintiffs' trading behavior and, in a fraction of a second, react to that behavior in a manner that permitted the HFT firms to trade ahead of Plaintiffs, thereby making a small profit and causing Plaintiffs to trade at less favorable prices than they would have otherwise. (SAC ¶¶ 237-251). In enabling the HFT firms to execute those strategies, the SDNY Plaintiffs allege, the Exchanges' actions "rigged the[] markets in favor of HFT firms." (SDNY Pls.' Mem. 7)

Pages 12 - 13 of the Opinion and Order

A. The SDNY Plaintiffs' Claims Against Barclays

The SDNY Plaintiffs contend that Barclays perpetrated a manipulative or fraudulent scheme to exploit ordinary investors trading in its dark pool. (SDNY Pls.' Mem. 68-69). The alleged scheme consisted of two broad components. First, Barclays allegedly disclosed to HFT firms important, otherwise non-public information regarding transactions in the dark pool. For example, it provided at least some HFT firms with the "logic" of the servers operating the dark pool, which enabled those firms to refine their aggressive trading strategies. (SAC ¶ 278; see also Am. Compl. ¶ 62). Second, Barclays either failed to establish or actively undermined various protections for ordinary investors using its dark pool. For example, Barclays allegedly overrode its Liquidity Profiling product - so that certain HFT firms would appear less aggressive and, therefore, would not be blocked by investors that sought to block aggressive firms from trading against them in the dark pool. (SDNY Pls.' Mem. 14; SAC ¶ 277). Similarly, the SDNY Plaintiffs allege that Barclays provided services - including co-location7  - that could be used effectively only by HFT firms. (SDNY Pls.' Mem. 71; SAC ¶ 278). Despite taking those actions to benefit the HFT firms - thereby enabling them to exploit ordinary investors - Barclays nevertheless represented that its dark pool was safe and that the SDNY Plaintiffs were not at risk of being exploited by HFT firms. (Id. ¶¶ 269-74). As a result of these actions, the SDNY Plaintiffs allegedly traded on worse terms in the dark pool than they would have in a "fair and unmanipulated market." (SDNY Pls.' Mem. 14; SAC ¶ 279).

These allegations fail to state a claim for at least two independent reasons. First, as they did with respect to the Exchanges, the SNDY Plaintiffs fail to adequately plead that Barclays committed any manipulative acts. As noted, a manipulative act is one that sends "a false pricing signal to the market" and therefore does not reflect the "natural interplay of supply and demand." ATSI, 493 F.3d at 100; see Ernst & Ernst, 425 U.S. at 199 (observing that the term  "'manipulative' . . . connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities"). The SDNY Plaintiffs' do not allege any actions by Barclays that meet that definition. For example, one of the SDNY Plaintiffs' principal allegations is that Barclays overrode the Liquidity Profiling assessments of certain HFT firms. (SDNY Pls.' Mem. 14; SAC ¶ 277). But the SDNY Plaintiffs do not explain how such overrides themselves could have affected the price at which securities traded in the dark pool. The same goes for the allegations regarding co-location and information regarding the logic of the servers operating the dark pools. Although these actions may have made it easier for HFT firms to trade ahead of ordinary investors, the SDNY Plaintiffs do not explain how the actions themselves could have affected, much less artificially affected, the prices at which securities traded in the dark pool. See Stoneridge, 552 U.S. at 161.

Pages 30 -31 of the Opinion and Order

The Question for the Court

In granting the Defendants' motions to dismiss, Judge Furman admonishes that he will not be dragged into a public policy debate but has put on his judicial blinders and considered the case solely from the perspective of what the law provides. That's not always an easy task, particularly given the existence of so many activist courts, but to his credit, Furman appears to have stuck to his guns. As he noted: 

Now pending are three motions by Defendants, largely pursuant to Rule 12(b)(6) of the Federal Rules of Civil Procedure, to dismiss the claims of Plaintiffs in all five cases (collectively, "Plaintiffs"). Significantly, the motions do not call upon the Court to wade into the larger public debates regarding high-frequency trading or the fairness of the U.S. stock markets more generally. That is, Lewis's book may well highlight inequities in the structure of the Nation's financial system and the desirability for, or necessity of, reform. For the most part, however, those questions are not for the courts, but for commentators, private and semi-public entities (including the stock exchanges), and the political branches of government, which - as Plaintiffs themselves observe - have already taken up the issue. . . .

Page 2 of the Opinion and Order

Absolute Immunity

An interesting and important aspect of the Opinion and Order is its discussion of the "absolute immunity" afforded to self-regulatory organizations. As more fully set forth by Judge Furman:

B. Absolute Immunity

Next, the Exchanges argue that, even if the Court has jurisdiction, Plaintiffs' claims are barred by the doctrine of absolute immunity. (See Exchanges' Mem. 24-36). It is well established "that an SRO and its officers are entitled to absolute immunity from private damages suits in connection with the discharge of their regulatory responsibilities." Standard Inv. Chartered, Inc. v. Nat'l Ass'n of Sec. Dealers, Inc., 637 F.3d 112, 115 (2d Cir. 2011) (quoting DL Capital Grp., 409 F.3d at 96). That is because the Exchanges "perform[] a variety of regulatory functions that would, in other circumstances, be performed by the SEC - an agency [that] is accorded sovereign immunity from all suits for money damages." DL Capital Grp., 409 F.3d at 97. Thus, "in light of [the Exchanges'] special status and connection to the SEC," they are, "out of fairness[,] . . . accorded full immunity from suits for money damages" when taking action pursuant to this special status. Id. (internal quotation marks omitted).

As in other contexts, absolute immunity provides an SRO with "protection not only from liability, but also from the burdens of litigation, including discovery, and should be 'resolved at the earliest possible stage in litigation.'" In re Facebook, Inc., IPO Sec. & Derivative Litig., 986 F. Supp. 2d 428, 448, 452 (S.D.N.Y. 2013) (quoting Hunter v. Bryant, 502 U.S. 224, 227 (1991), and citing other cases). The party seeking that protection bears the burden of establishing its entitlement to absolute immunity. See, e.g., D'Alessio v. N.Y. Stock Exch., Inc., 258 F.3d 93, 104 (2d Cir. 2001). Such immunity "is of a rare and exceptional character," Standard Inv. Chartered, 637 F.3d at 115 (internal quotation marks omitted), and must therefore be evaluated on a caseby-case basis, see, e.g., DL Capital Grp., 409 F.3d at 97, using a functional test that examines the "nature of the function performed," Forrester v. White, 484 U.S. 219, 229 (1988). Specifically, an SRO "'is entitled to immunity from suit when it engages in conduct consistent with the quasigovernmental powers delegated to it pursuant to the Exchange Act and the regulations and rules promulgated thereunder.'" DL Capital Grp., 409 F.3d at 97 (quoting D'Alessio, 258 F.3d at 106). Or put another way, "so long as the 'alleged misconduct falls within the scope of the quasi-governmental powers delegated to the [exchange],' absolute immunity attaches." In re NYSE Specialists Sec. Litig., 503 F.3d 89, 96 (2d Cir. 2007) (quoting D'Alessio, 258 F.3d at 106).

Significantly, the motive or reasonableness of the actions in question is irrelevant to the analysis. See, e.g., id. at 95-96; accord Bogan v. Scott-Harris, 523 U.S. 44, 54 (1998) (holding that whether a government official is absolutely immune "turns on the nature of the act, rather than on the [official's] motive or intent"). Instead, "the decision to extend absolute immunity depends 'upon the nature of the governmental function being performed.'" DL Capital Grp., 409 F.3d at 99 n.4 (quoting D'Alessio, 258 F.3d at 104-05). Thus, the fact that the Exchanges in this case are now for-profit corporations does not, by itself, deprive them of absolute immunity. See, e.g., id.; cf. NYSE Specialists, 503 F.3d at 91 & n.1 (holding that the defendant exchange was entitled to absolute immunity even though it was "no longer a nonprofit corporation, following a merger which commenced after the filing of [the] lawsuit"). For similar reasons, and as the SDNY Plaintiffs conceded at oral argument (Tr. 33-34), it does not matter if an Exchange, in performing a regulatory function, is also motivated by the desire for profit or some other business purpose. Cf. Weissman v. Nat'l Ass'n of Sec. Dealers, 500 F.3d 1293, 1298-99 (11th Cir. 2007) (holding that an SRO is not protected by absolute immunity for actions that have no regulatory dimension and relate solely to the SRO's business interests). Instead, the sole question is whether the alleged misconduct falls within the scope of the quasi-governmental powers delegated to the Exchanges - in which case absolute immunity applies - or outside the scope of those powers - in which case it does not. (See Exchanges' Reply Mem. 7 ("[A]bsolute immunity applies to SRO activities that are incident to their regulatory functions, but not to exclusively non-regulatory functions.")).

With those standards in mind, the Court turns to the three practices of the Exchanges that the SDNY Plaintiffs challenge in this case: co-location services, the proprietary data feeds, and complex order types. (See SDNY Pls.' Mem. 7-11). Whether absolute immunity applies to the provision of co-location services is easily answered. It does not. Notably, although the Exchanges frame absolute immunity as a dispositive defense with respect to all of the SDNY Plaintiffs' claims (see Exchanges' Mem. 29 (stating that "the Exchanges' immunity for proprietary feeds and co-location is dispositive"), their memorandum of law does not actually seek to justify the application of immunity to the provision of co-location services, let alone support such a result. (See id. at 26-29). The Exchanges have thus abandoned any argument for absolute immunity based on their provision of co-location services. And, even if they had not, it is hard to see how the provision of co-location services serves a regulatory function or differs from the provision of commercial products and services that courts have held not to be protected by absolute immunity in other cases. See, e.g., Weissman, 500 F.3d at 1298 (holding that an exchange was not absolutely immune for "tout[ing], market[ing], advertis[ing] and promot[ing]" a particular equity because doing so did not involve the "performance of regulatory, adjudicatory, or prosecutorial duties" for which the SRO stood "in the stead of the SEC"); Facebook, 986 F. Supp. 2d at 452 (denying absolute immunity with respect to an exchange's design of software and promotion of its ability to facilitate an initial public offering). The Exchanges, therefore, are not immune from suit based on the provision of co-location services.

By contrast, the Exchanges are absolutely immune for their creation of complex order types. As noted, the order types permitted by an Exchange define the ways in which traders can interact with that Exchange. See Exchange Act Release No. 34-74032, 2015 WL 137640, at *2 ("Order types are the primary means by which market participants communicate their instructions for the handling of their orders to the exchange."). By establishing a defined set of order types, the Exchanges police the ways in which users of an exchange are able to interact with each other. See id. In so doing, the order types establish a framework by which buyers of stocks are matched with sellers. The creation of new order types - including complex ones - thus plainly "relates to the proper functioning of the regulatory system," for which the Exchanges enjoy absolute immunity. NYSE Specialists, 503 F.3d at 96 (quoting D'Alessio, 258 F.3d at 106); see also DL Capital Grp., 409 F.3d at 95 (stating that the "regulatory powers and responsibilities" that Congress delegated to stock exchanges include the duty "to develop, operate, and maintain" their markets, "to formulate regulatory policies and listing criteria" for the markets, "and to enforce those policies and rules, subject to the approval of . . . the SEC"). It is thus unsurprising that new or modified order types are among the Exchanges' rules that the SEC reviews under Exchange Act Section 6(b), 15 U.S.C. § 78f(b), to ensure that they, among other things, prevent "fraudulent and manipulative acts and practices." See, e.g., Exchange Act Release No. 34-69419, 78 Fed. Reg. 24,449, 24,453 (Apr. 25, 2013); Exchange Act Release No. 34-63777, 76 Fed. Reg. 5630, 5634 (Feb. 1, 2011).

Pages 15 - 19 of the Opinion and Order

In finding that absolute immunity applies to the cited conduct, Judge Furman explained that [Ed: footnote omitted]:

In sum, the Court concludes that the Exchanges are absolutely immune from suit based on their creation of complex order types and provision of proprietary data feeds, both of which fall within the scope of the quasi-governmental powers delegated to the Exchanges. That conclusion is reinforced by the fact that the SEC has ample authority and ability to regulate those activities and address any improprieties by the Exchanges; the Second Circuit has instructed that a court evaluating a claim of absolute immunity should "consider 'whether there exist alternatives to damage suits against the [the potentially immune entity] as a means of redressing wrongful conduct' if absolute immunity applies." NYSE Specialists, 503 F.3d at 101 (quoting Barrett v. United States, 798 F.2d 565, 571 (2d Cir. 1986)). Here, as in NYSE Specialists, "[t]he alternatives [to a suit for damages] are manifold," with the principal alternative seeking to invoke the SEC's "formidable oversight power to supervise, investigate, and discipline the [Exchanges] for any possible wrongdoing or regulatory missteps.'" Id. The upshot - that the SDNY Plaintiffs may not proceed with their claims with respect to the complex order types and proprietary data feeds - "'may be harsh,' but Congress nevertheless saw fit to delegate to SROs certain regulatory powers for which they 'enjoy freedom from civil liability when they act[] in their regulatory capacity,' even where the SROs 'act in a capricious, even tartuffian manner which causes enormous damage.'" Facebook, 986 F. Supp. 2d at 459 (quoting Sparta Surgical Corp. v. Nat'l Ass'n of Sec. Dealers, Inc., 159 F.3d 1209, 1215 (9th Cir. 1998)) (internal alterations omitted).

Page 23 of the Opinion and Order

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