On August 27, 2015 Judge Jesse Furman of the Southern District of N.Y. dismissed plaintiffs’ claims in the consolidated high frequency trading (“HFT”) class action lawsuit In re Barclays Liquidity Cross and High Frequency Trading Litigation.[1] Coming after Judge Katherine Forrest’s similar order in Lanier v. BATS[2] in April, these dismissals likely spell the end of attempts of private plaintiffs to sue the exchanges over their alleged facilitation of abusive HFT activity.[3] The cases ran into two insurmountable barriers. The first is that many of the practices that the plaintiffs complained of were specifically approved by the SEC. The second is that, given the current state of the law, it is difficult to plead facts sufficient to survive a motion to dismiss where the exchanges appear to be mere facilitators of the actions of others, not primary actors in an alleged fraud. The dismissals however leave investors, financial institutions, academics, and above all regulators with an important open question: what, if anything, should be done about the seemingly inevitable creation of a two-tiered market where HFT trades ahead of others by means of co-location and private data feeds?

Judge Furman’s order presents a nuanced treatment of the consolidated cases before him. He first determined that while preemption doctrine did not prevent his court from hearing these claims, as SROs the exchanges were entitled to immunity concerning their provision of complex order types as well as proprietary data feeds (though not co-location).[4] Formulating order types and providing subscribers with data feeds are actions on the part of the exchanges that are regulatory in nature. Moreover, all order types and data provision plans are approved in advance by the SEC.

Judge Furman then evaluated the defendants’ motion to dismiss on the basis of FRCP Rule 12(b)(6), failure to state a claim upon which relief can be granted. He emphasized that manipulative scheme claims under federal securities law are subject to the heightened pleading standards under FRCP Rule 9(b), and that they require primary violations on the part of defendants—under Central Bank of Denver,[5] aiding and abetting will not suffice. Plaintiffs here failed to allege primary violations, but instead showed merely “that the Exchanges aided and abetted the HFT firms’ manipulations of the market price.”[6] In addition, plaintiffs’ claims under Exchange Act Section 6(b) failed because of the overwhelming weight of authority that, after the 1975 amendments, Section 6(b) does not provide a private right of action.[7] While Judge Furman dismissed all claims, plaintiff Great Pacific was granted leave to amend its complaint.

Judge Furman’s ruling echoes the earlier dismissal in Lanier v. BATS, with one difference: instead of finding immunity based on their status as SROs, Judge Forrest determined that plaintiffs’ state law claims were preempted by federal securities law. The Lanier plaintiffs made the novel argument that the exchanges were guilty of breach of contract under New York state law for providing “Preferred Data Customers” with proprietary data feeds. Plaintiffs claimed that these feeds breached their own subscriber contracts for stock information from the Consolidated Quote System, the Consolidated Tape System, the Nasdaq UTP System, and the OPRA System. All the subscriber agreements reference the relevant plans under which the data provision services receive information from the participating exchanges, and all include language indicating that the plans will abide by Regulation NMS Rule 603’s requirement that SROs distribute quotation and transaction information on “terms that are fair and reasonable”[8] and “not unreasonably discriminatory.”[9]

Judge Forrest stated that because this argument converts alleged violations of federal regulations into state law breach of contract claims, it amounts to “legal alchemy.”[10] Since the SEC explicitly approved of both co-location and the proprietary data feeds, this would lead to conflict between state and federal law. Under federal preemption doctrine then Judge Forrest determined that her court lacked subject matter jurisdiction.[11] Moreover, even if all of the allegations contained in the complaint were true, the plaintiffs failed to state a claim for which relief can be granted.[12] Delay in the transmission of data is inevitable, and such timing disparities do not mean that the exchanges are in breach of contract.

The question of timing disparities is however at the heart of the controversy over HFT, and even though these cases dismiss private plaintiffs’ claims against the exchanges, the SEC and CFTC will still have to grapple with them. While the SEC has so far maintained that as long as data is transmitted from an exchange to its proprietary data feed clients no sooner than it is sent to the Securities Information Processor (or “SIP”) such transmission is permissible,[13] this position is not inevitable. In their forthcoming article The New Stock Market: Sense and Nonsense, Merritt B. Fox, Lawrence R. Glosten, and Gabriel V. Rauterberg point out that, for purposes of insider trading law, the courts and the SEC have focused “on the time at which information reaches end users rather than the time of a public announcement . . . .”[14]

The larger message of these failed class actions then is that they pass the question of fair market microstructure back to the regulators. The core problem here is the creation of a two-tiered market, where certain technologically adept players will be able to trade ahead of most other traders in the market, thereby eking out relatively small, but real, rents. While regulators and the exchanges emphasize that co-location and proprietary data feeds are open to all, practically speaking few institutions possess the technical ability to profit from them. A year and a half after the publication of Flash Boys and the resulting firestorm of controversy, the SEC and FINRA have taken some small steps towards regulating the HFT space.[15] The fundamental question of the fairness of our current trading environment however remains unanswered.

ENDNOTES

[1] In re: Barclays Liquidity Cross and High Frequency Trading Litigation, No. 14-md-02589 (S.D.N.Y. Aug. 26, 2015). This multidistrict litigation consolidated four cases from the Southern District of New York as well as one from the Central District of California: City of Providence, Rhode Island v. BATS Global Markets, Inc., et al., C.A. No. 1:14-02811; American European Insurance Company v. BATS Global Markets, Inc., et al., C.A. No. 1:14-03133; Harel Insurance Co., Ltd. v. BATS Global Markets, Inc., et al., C.A. No-1:14-03608; Flynn, et al. v. Bank of America Corporation, et al., C.A. No. 1:14-04321, and Great Pacific Securities v. Barclays PLC, et al., C.A. No. 8:14-01210.

[2] Harold R. Lanier v. BATS Exchange, Inc., No. 14-cv-3745 (S.D.N.Y. April 28, 2015).

[3] Barbara Strougo v. Barclays PLC, No. 14-cv-05797 (S.D.N.Y. July 28, 2014) remains alive after Judge Scheindlin declined to grant a motion to dismiss on April 24, 2015. Unlike In re: Barclays or Lanier, however, Strougo is a conventional securities fraud class action suit alleging that misstatements caused the value of plaintiffs’ shares to decline. Strougo in large part relies on claims made by N.Y. Attorney General Eric Schneiderman’s lawsuit against Barclays alleging violations of the Martin Act. See New York v. Barclays Capital, Inc., Complaint No. 451391/2014 (June 25, 2014).

[4] See In re: Barclays Liquidity Cross and High Frequency Trading Litigation, No. 14-md-02589 (S.D.N.Y. Aug. 26, 2015) at 17-20.

[5] Central Bank of Denver N.A. v. First Interstate Bank of Denver N.A., 511 U.S. 164 (1994).

[6] See In re: Barclays Liquidity Cross and High Frequency Trading Litigation, No. 14-md-02589 (S.D.N.Y. Aug. 26, 2015) at 27.

[7] Id. at 28.

[8] 17 C.F.R. § 242.603(a)(1).

[9] 17 C.F.R. § 242.603(a)(2).

[10] Lanier v. BATS Exchange, Inc., No. 14-cv-3745 (S.D.N.Y. April 28, 2015), at 22.

[11] See id. at 23-24.

[12] See id. at 24.

[13] See SEC Concept Release on Equity Market Structure, Exchange Act Release No. 34-61358 (Jan. 14, 2010), at 61-62.

[14] Merritt B. Fox, Lawrence R. Glosten & Gabriel V. Rautenberg, The New Stock Market: Sense and Nonsense 53, forthcoming, Duke L. J., available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2580002.

[15] E.g., the SEC has proposed narrowing the Rule 15b9-1 exemption, which allows an exemption from FINRA membership for broker-dealers who trade in off-exchange venues, which would increase the regulatory oversight of firms including HFT shops. See “SEC Proposes Rule to Require Broker-Dealers Active in Off-Exchange Market to Become Members of National Securities Association,” available at http://www.sec.gov/news/pressrelease/2015-48.html. FINRA has proposed registration requirements for individuals developing algorithmic trading strategies; see “Registration of Associated Persons Who Develop Algorithmic Trading Strategies,” FINRA Regulatory Notice 15-05, available at https://www.finra.org/sites/default/files/notice_doc_file_ref/Notice_Regulatory_15-06.pdf.

The preceding post comes to us from Steven McNamara, Assistant Professor of Business Law at the Olayan School of Business, The American University of Beirut.