SEC Amicus Brief Raises Uncomfortable Questions About SRO Immunity

December 1, 2016

After Michael Lewis published "Flash Boys," the world awoke to a very dire picture of high frequency trading ("HFT") and its corrosive and corrupting influences on the so-called level playing field that Wall Street so dearly wants to market to the public. The fact is -- and this is coming from a 34-year industry veteran -- there has never been a level playing field in the financial markets. They want you to believe that fairy tale. You may actually believe it. But the truth is that the cards are often marked, the wheels are rigged, the dice loaded, and the House retains the odds (and, yes, there are more than a few professional cheaters who make a nice living operating on the fringe). Sorry to burst your bubble. All of which set the stage for the filing of a number of lawsuits about the fraud perpetrated via HFT and how more than a handful of self-regulatory organizations ("SROs") seemed to have either looked askance or, worse, engaged in complicit behavior.

The HFT Complaint

Given that downer of a preamble, let's turn to a high-profile civil lawsuit filed in the United States District Court for the Southern District of New York ("SDNY"): CITY OF PROVIDENCE, RHODE ISLAND, EMPLOYEES' RETIREMENT SYSTEM OF THE GOVERNMENT OF THE VIRGIN ISLANDS, PLUMBERS AND PIPEFITTERS NATIONAL PENSION FUND, STATE-BOSTON RETIREMENT SYSTEM, Plaintiffs-Appellants, v. BATS GLOBAL MARKETS, INC., CHICAGO STOCK EXCHANGE INC. DIRECT EDGE ECN, LLC, NYSE ARCA, INC., NASDAQ OMX BX INC., NEW YORK STOCK EXCHANGE LLC, THE NASDAQ STOCK MARKET, LLC, Defendants-Appellees (Consolidated Class Action Amended Complaint; SDNY; 14-CV-02811 / September 2, 2014). Consider these allegations from a portion of the "Summary of Allegations" [Ed.: Footnotes omitted]:

1. This securities class action is brought on behalf of public investors who purchased and/or sold shares of stock in the United States between April 18, 2009 and the present (the "Class Period") on a registered public stock exchange generated by defendants (collectively, the "Exchanges") or on the alternative trading venue operated by Barclays PLC identified herein (collectively, the "Defendants"), and were injured as a result of the misconduct detailed herein (the "Class").

2. This case arises out of a scheme and wrongful course of business whereby the Exchanges and Barclays, together with sophisticated high frequency trading ("HFT") firms, employed devices, contrivances, manipulations and artifices to defraud in a manner that was designed to and did manipulate the U.S. securities markets and the trading of equities on those markets, diverting billions of dollars annually from buyers and sellers of securities and generating billions more in ill-gotten kickback payments for Defendants. 

3. Contrary to the duties imposed upon them by law, U.S. Securities and Exchange Commission ("SEC") rules, the Financial Industry Regulatory Authority ("FINRA") and their own rules and regulations, Defendants together with HFT firms participated in the scheme and wrongful course of business complained of herein whereby the Exchanges and Barclays provided certain market participants with material, non-public information and trading advantages so that those market participants could use the advantage obtained to manipulate the U.S. securities markets to the detriment of plaintiffs and the Class. The Exchanges, having evolved from member-owned not-for-profit entities that focused solely on trade-matching to for-profit enterprises with the financial incentive to create an uneven playing field for investors, engaged in and facilitated this unlawful course of conduct by providing HFT firms with complex order types, proprietary data feeds and colocation services that allowed those firms to, inter alia, access enhanced trading information at faster speeds and position their trades to disadvantage plaintiffs and the Class. 

4. Notwithstanding their legal obligations and duties to provide for orderly and honest trading and to match the bids and orders placed on behalf of investors at the best available price, and in direct conflict with their own public statements to their own customers and investors and in breach of their fiduciary duties, the Exchanges and Barclays demanded and received substantial kickback payments in exchange for providing HFT firms access to material trading data via preferred access to exchange floors and enriched data feeds. To satisfy the demands of HFT firms and attract order flow (and thus more fees), the Exchanges designed and implemented hundreds of new complex "order types" - preprogrammed commands traders use to tell the Exchanges how to handle their bids and offers - with the knowledge that those same HFT firms would use these order types to detect investors' trading patterns and trade in front of them to their detriment.

5. Moreover, in an effort to increase their own trading volumes - and therefore revenues - the Exchanges and Barclays encourage HFT firms to exploit their other customers by providing kickback payments to HFT firms for directing their trades to their own trading venues that they and the HFT firms knew were subject to informational asymmetries as a result of Defendants' scheme and wrongful course of business. Additionally, the Exchanges purchased retail and institutional order flow from various retail brokerages in order to provide victims to HFT firms' predatory practices. 

6. Defendants utilized devices, contrivances, manipulations and artifices to defraud, which operated as a fraud and deceit on plaintiffs and the Class in violation of the Securities Exchange Act of 1934 (the "Exchange Act") and SEC rules promulgated thereunder. Defendants' misconduct rigged the market and manipulated the prices at which shares were traded during the Class Period, causing substantial damage to plaintiffs and the Class as a result thereof. . .

Pages 1 - 3 of the Consolidated Amended Complaint

SDNY Opinion and Order

If you followed this high-profile lawsuit, you know that in August 2015 it came crashing down to Earth. As summarized in IN RE: BARCLAYS LIQUIDITY CROSS AND HIGH FREQUENCY TRADING LITIGATION (Opinion and Order; SDNY; 14-MD-2589/August 26, 2015) 

In 2014, author Michael Lewis published a bestselling book titled Flash Boys: A Wall Street Revolt, in which he argued that "high-frequency traders" have been able to gain an unfair advantage in the stock market, in part because stock exchanges and "dark pools" - alternative venues for trading stocks - have enabled those traders to obtain and trade on market data faster than other investors. A litany of lawsuits followed in short succession, asserting various theories of liability. See, e.g., Lanier v. BATS Exchange, Inc., - F. Supp. 3d -, No. 14-CV-3745 (KBF), 2015 WL 1914446 (S.D.N.Y. Apr. 28, 2015) (state-law claims against various stock exchanges); Strougo v. Barclays PLC, - F. Supp. 3d -, No. 14-CV-5797 (SAS), 2015 WL 1883201 (S.D.N.Y. Apr. 24, 2015) (investor suit against the operator of a major dark pool); People ex rel. Schneiderman v. Barclays Capital Inc., 1 N.Y.S.3d 910 (N.Y. Sup. Ct. 2015) (state-law claims against the operator of a major dark pool). This multidistrict litigation ("MDL") proceeding involves a group of cases in that litany. In four cases, originally filed in this District, various investors (collectively, the "SDNY Plaintiffs") bring claims under the Securities Exchange Act of 1934 ("the Exchange Act"), 15 U.S.C. § 78a et seq., against seven stock exchanges - BATS Global Markets, Inc., Chicago Stock Exchange, Inc., Direct Edge ECN, LLC, the NASDAQ Stock Market LLC, NASDAQ OMX BX, Inc., New York Stock Exchange, LLC, and NYSE Arca, Inc. (collectively, "the Exchanges") - as well as Barclays PLC and Barclays Capital Inc. (collectively, "Barclays"), a major financial institution and the subsidiary that operates its "dark pool." In a fifth action, Docket Number 15-CV-168, filed in the United States District Court for the Central District of California and later consolidated here by the Judicial Panel on Multidistrict Litigation (the "JPML"), Plaintiff Great Pacific Securities ("Great Pacific") sues Barclays alleging violations of California state law.

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. (See Second Consol. Am. Compl. Violation Federal Securities Laws (14-CV-2811, Docket No. 252 ("SAC") ¶¶ 280-89 (describing investigations related to high-frequency trading by the United States Congress, the Federal Bureau of Investigation, the Department of Justice, the Commodity Futures Trading Commission, and the Securities and Exchange Commission); Am. Class Action Compl. (15-CV- 168, Docket No. 30) ("Am. Compl.") ¶ 5 (describing actions taken by the New York Attorney General)). More to the point, the only question for this Court on these motions is whether the Complaints in these cases are legally sufficient to survive Defendants' motions. Applying well established precedent from the United States Supreme Court, the United States Court of Appeals for the Second Circuit, and the California Supreme Court, the Court is compelled to conclude that they are not. Accordingly, and for the reasons stated below, Defendants' motions to dismiss are granted, although Great Pacific is granted leave to amend its complaint in 15-CV-168.

Pages 1 -3 of the SDNY Opinion and Order

Notwithstanding SDNY Judge Furman's dismissal of the Complaint, one does sense more than a tad of frustration from the bench. Although Furman may have felt compelled by the law to rule in favor of the Defendants, he did reject the possibility that all was not fair and healthy in our markets and, perhaps, someone (just not the courts) needed to do something:

[L]ewis and the critics of HFT may be right in arguing that it serves no productive purpose and merely allows certain traders to exploit technological inefficiencies in the markets at the expense of other traders. They may also be right that there is a need for regulatory or other action from the SEC or entities such as the Exchanges and Barclays. Those, however, are debates and tasks for others. The Court's narrow task was, instead, to decide whether the Complaints in these cases were legally sufficient to survive Defendants' motions to dismiss. Having concluded that they are not, the Complaints must be and are dismissed. The Clerk of Court is directed to terminate 14-MD-2589, Docket Nos. 7, 15, and 23, and to close all member cases except for 15-CV-168.

Page 51 of the SDNY Opinion and Order

SEC Amicus Curiae Brief

Having lost their case at SDNY, the Plaintiffs have appealed to the United States Court of Appeals for the Second Circuit ("2Cir"). In grappling with its appellate review of the matter, 2Cir requested an Amicus Brief from the United States Securities and Exchange Commission ("SEC").  The resulting brief raises some interesting points but clearly reflects more than a bit of discomfort when one regulator (in this case the SEC) is asked to comment upon the possible failings and immunity from lawsuit of other regulators (in this case various self-regulatory organizations). Clearly, there is an institutional concern or fear of one's words coming back to haunt. CITY OF PROVIDENCE, RHODE ISLAND, EMPLOYEES' RETIREMENT SYSTEM OF THE GOVERNMENT OF THE VIRGIN ISLANDS, PLUMBERS AND PIPEFITTERS NATIONAL PENSION FUND, STATE-BOSTON RETIREMENT SYSTEM, Plaintiffs-Appellants, v. BATS GLOBAL MARKETS, INC., CHICAGO STOCK EXCHANGE INC. DIRECT EDGE ECN, LLC, NYSE ARCA, INC., NASDAQ OMX BX INC., NEW YORK STOCK EXCHANGE LLC, THE NASDAQ STOCK MARKET, LLC, Defendants-Appellees (SEC Amicus Curiae Brief; 2Cir; 15-3057 / November 28, 2016): 

INTRODUCTION AND INTEREST OF AMICUS CURIAE

The Securities and Exchange Commission submits this amicus curiae brief in response to the Court's August 25, 2016 order, asking the Commission to file a brief in this private securities fraud class action "setting forth the SEC's views on whether the district court had subject-matter jurisdiction over the case, and whether defendants-appellees have absolute immunity from suit arising from the challenged conduct." Plaintiffs, who are institutional investors, allege that the defendant national securities exchanges engaged in market manipulation, in violation of Section 10(b) of the Securities Exchange Act and Rule 10b-5, by providing certain customers engaged in "high-frequency trading" with proprietary services that enabled those customers to obtain and utilize market data faster than ordinary investors-thus allegedly disadvantaging ordinary market participants not engaged in high-frequency trading strategies. Specifically, plaintiffs contend that the exchanges provided their customers with co-location services, proprietary data feeds, and complex, electronic order types that, when used in combination, constituted manipulative devices, allegedly profiting high-frequency traders at plaintiffs' expense. JA248 ¶65; JA280 ¶119. They also contend that the defendant exchanges thwarted the congressionally mandated Commission rule-approval process by failing to disclose required information in proposed rule filings for these practices, or failing to file altogether-again to the exclusive benefit of high-frequency trading firms. JA290-JA291 ¶139; JA293 ¶143.

As explained further below, the Commission takes the following positions on the Court's questions:

First, the securities laws do not divest the district court of subject matter jurisdiction over this case. Although Congress created a detailed scheme of administrative and judicial review for challenges to certain actions of self-regulatory organizations ("SROs") like the defendant exchanges, Congress did not authorize the Commission to adjudicate fraud lawsuits against SROs brought by private parties. As this Court recognized in Lanier v. BATS Exchange, Inc., Congress's intent to preclude district court jurisdiction must be "fairly discernible" from "the SEC's scheme of administrative and judicial review." 838 F.3d 139, 147 (2d Cir. 2016). That conclusion cannot be drawn about plaintiffs' Section 10(b) claim.

Second, the defendant exchanges are not entitled to absolute immunity from suit for the challenged conduct. The Commission believes that absolute immunity is properly afforded to the exchanges when they are engaged in their traditional self regulatory functions-in other words, when the exchanges are acting as regulators of their members. Immune activities include the core adjudicatory and prosecutorial functions that have traditionally been accorded absolute immunity, as well as other functions that materially relate to an exchange's regulation of its members. For example, an exchange should be immune when it disciplines its members for misconduct or suspends from trading by its members a security listed on its market. But the Commission believes that immunity does not properly extend to functions performed by an exchange itself in the operation of its own market, or to the sale of products and services arising out of those functions-like the challenged activities at the center of the plaintiffs' allegations. This view is consistent with the historical rationale for the immunity doctrine, as well as with this Court's decisions applying it. And, ultimately, although protecting an exchange from the threat of retaliatory lawsuits when regulating its members is appropriate, the justifications for absolute immunity have less force when an exchange is itself engaged in offering the type of proprietary services challenged by the plaintiffs here.

Despite the inapplicability of immunity to the type of conduct plaintiffs challenge, the Commission believes that where a plaintiff's claims conflict with, or otherwise obstruct, the Commission's regulation of the exchanges, such claims will- and should-fail under the doctrines of preemption and preclusion. Those doctrines would, for example, protect an SRO's conduct when acting in accordance with rules that were subject to Commission oversight and supervision through the applicable statutory scheme. Because of the early stage of this litigation, which limits the record to the complaint, as well as prudential concerns in light of the Commission's own enforcement activities in this area, the Commission takes no position on the outcome of such an analysis in this case. 

Pages 1 - 4 of the SEC Amicus Brief

My my my . . . now isn't that an interesting proposition: Are self-regulatory organizations immune from lawsuit? And not just "immune" but "absolutely immune." Not a lot of wiggle room if you accept that latter proposition. On the other hand, you can just feel the SROs squirming in their seats when they read the SEC's brief and come across this fairly blunt assertion that "Congress did not authorize the Commission to adjudicate fraud lawsuits against SROs brought by private parties." Did not authorize as in you don't have to exhaust your administrative remedies before suing the SROs in court when they engage in fraud.

Then there's that massive moat and castle door that has so long and well served the SROs: If they act as regulators, the courts generously shield them from virtually all lawsuits. Except, the SEC, reiterates its previously stated position that it "believes that immunity does not properly extend to functions performed by an exchange itself in the operation of its own market, or to the sale of products and services arising out of those functions-like the challenged activities at the center of the plaintiffs' allegations." For those of us veteran industry lawyers, that's not much of a news flash even in a Flash Crash case. What's important about that pronouncement is that it is clear and set forth with more force in the body of the Amicus Curiae Brief.  As SROs seem to extend themselves into more non-regulatory functions such as selling data and running advertising and taking on a larger marketing effort, those activities may open some windows and unguarded back-doors through which litigants may file lawsuits against which the doctrine of immunity may not prevail. Imagine how the SROs reacted to reading this:

II. The exchange defendants are not absolutely immune from this suit challenging aspects of the operation of their markets. 

The Court also inquired whether, in the Commission's view, defendants "have absolute immunity from suit arising from the challenged conduct." The exchange defendants assert a broad claim of immunity that would encompass everything they do to "disseminat[e] market information and facilitate[e] trading" on their exchanges  (Appellees' Br. at 29)-including processing orders through the exchanges' electronic systems, selling access to locations near their servers, and selling their own "proprietary" data. Although the Commission believes that absolute immunity plays an important role in the system of self-regulation, it does not believe immunity extends so far. 

Absolute immunity is the strongest form of protection from suit, stronger than the qualified immunity enjoyed by most government officials (see Appellees' Br. 31- 32). Because absolute immunity means that "the victim of an abuse of office may receive no recompense for the injury done," courts have "limited this extraordinary foreclosure of remedies." Austin Mun. Sec., Inc. v. Nat'l Ass'n of Sec. Dealers, Inc., 757 F.2d 676, 687 (5th Cir. 1985). And courts "must be 'careful not to extend the scope of the protection further than its purposes require.'" Weissman v. Nat'l Assn of Sec. Dealers, Inc., 500 F.3d 1293, 1297 (11th Cir. 2007) (en banc) (quoting Forrester v. White, 484 U.S. 219, 224 (1988)). Consequently, this Court has cautioned that, given the "rare and exceptional character" of absolute immunity, "courts must examine [its] invocation . . . on a case-by-case basis," with "the party asserting immunity bear[ing] the burden of demonstrating [an] entitlement to it." In re NYSE Specialists Secs. Litig., 503 F.3d 89, 96 (2d Cir. 2007); see also Antoine v. Byers & Anderson, 508 U.S. 429, 432, 433 n.4 (1993) (immunity should be afforded "quite sparing[ly]"); Butz v. Economou, 438 U.S. 478, 508 (1978) ("a considered inquiry" is required); Regulation Systems Compliance and Integrity, Exchange Act Release No. 73639 (Nov. 19, 2014), 2014 WL 6850916, at *90 n.675 ("The Commission notes that SRO immunity applies only under certain circumstances."). 

Consistent with this Court's pronouncements regarding SRO immunity, as well as with the doctrine's historical precepts, the Commission is of the view that absolute immunity is properly afforded to the exchanges when engaged in their traditional self regulatory functions-where the exchanges act as regulators of their members. Those include the core adjudicatory and prosecutorial functions that have traditionally been accorded absolute immunity, as well as other functions that materially relate to the exchanges' regulation of their members. But we believe that immunity does not properly extend to functions performed by an exchange itself in the operation of its own market, or to the sale of products and services arising out of those functions.

 Pages 20 - 22 of the SEC Amicus Brief