SEC: Stock exchanges not immune from high-frequency-trading suit

December 8, 2016

To match Special Report SEC/INVESTIGATIONSSeven stock exchanges should not be immune from a lawsuit accusing them of providing nonpublic data to high-frequency-trading firms to the detriment of other investors, the Securities and Exchange Commission has told a federal appeals court.

In a Nov. 28 friend-of-the-court brief filed with the 2nd U.S. Circuit Court of Appeals, the agency argues that the lower court judge incorrectly ruled that the stock exchanges have “absolute immunity” from the suit.

The judge ruled the exchanges were immune from the plaintiffs’ claims because of their status as self-regulatory organizations. Self-regulatory organizations have absolute immunity for actions falling within their regulatory and general oversight functions under the Securities Exchange Act of 1934, 15 U.S.C.A. § 78c(a)(26).

According to the SEC, the challenged actions are not part of the exchanges’ regulatory functions. Absolute immunity should only extend to the exchanges’ membership regulation and not to the operation of their own markets or to their products and services.

Dark pools’ and high-frequency trading

High-frequency trading uses advanced computer systems to make trades with proprietary algorithms at rapid speeds to take advantage of market inefficiencies.

The suit stems from Barclays Plc’s liquidity cross-trading venue, also known as a “dark pool,” where investors can make trades and monitor market positions.

Investors in the trading venue claim Barclays and seven stock exchanges, including Nasdaq, the New York Stock Exchange, BATS Global Markets and the Chicago Stock Exchange, violated federal securities laws and engaged in a manipulated scheme with high-frequency-trading firms.

According to the suit, the exchanges failed to disclose that they provided HFT firms with nonpublic information, leaving other investors in the dark pool at the risk of exploitation.

The exchanges and Barclays also gave perks such as preferential order routing, data feeds and trade priority to the HFT firms in exchange for fees, the suit said.

These perks cost other traders billions of dollars while benefiting the high-frequency traders, the plaintiffs alleged.

Absolute immunity

U.S. District Judge Jesse Furman of the Southern District of New York granted a defense motion to dismiss the suit last year. In re Barclays Liquidity Cross & High Frequency Trading Litig., 126 F. Supp.3d 342 (S.D.N.Y. 2015).

He held that the exchanges are immune from the key claims of the suit because the allegedly fraudulent activities fall within their actions as self-regulatory organizations.

Even if the exchanges were not immune from suit, Judge Furman said, the plaintiffs failed to show their conduct was manipulative.

He also dismissed the claims against Barclays, saying the investors failed to show they relied on statements by the bank that affected the prices of securities they traded.

The plaintiffs are appealing the decision as it pertains to the exchanges.

Business-centric or regulatory function?

According to the plaintiffs’ initial Jan. 7 brief to the 2nd Circuit, the exchanges’ activities are not related to their regulatory functions because they are business-centric.

The exchanges countered in their April 7 brief that their conduct is protected from suit.

“The challenged conduct concerns the exchanges’ regulatory responsibilities to develop, oversee and operate their markets,” their brief said.

Membership regulation

The 2nd Circuit panel asked for the SEC’s take on the case in an August order. The agency responded with a brief supporting the plaintiffs, saying immunity should only apply to membership regulation.

“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,” the brief says.

The SEC argues immunity should not extend to the defendants’ alleged actions related to the operation of their markets or the sale of products and services and not a regulatory function.

“When an exchange is operating its own market and engaging in its own conduct pursuant to commission regulation, it is acting as a regulated entity — not a regulator of others,” the brief says.

City of Providence et al. v. BATS Global Markets et al., No. 15-3057, amicus brief filed (2d Cir. Nov. 28, 2016).

Related filings on Westlaw:

Reply brief: 2016 WL 2620070
Appellees’ brief: 2016 WL 1399571
Appellants’ brief: 2016 WL 164375