Do the Exchanges Think They Are Immune From Investor Lawsuits?
Do you recall the 2014 class-action lawsuit filed by several plaintiffs, including Providence, Rhode Island, against the major stock exchanges and the Barclays Dark pool in the wake of Flash Boys? It had been dismissed by Judge Furman in August 2015 on the grounds that:
“Exchanges, as self-regulatory organizations, are “absolutely immune from suit based on their creation of complex order types and provision of proprietary data feeds.” He said Congress has decided that the exchanges are to be regulated by the Securities and Exchange Commission.”
With regard to Barclays, Judge Furman ruled that not enough evidence was presented that Barclays was misleading investors about interaction in its dark Pool, LX. Since its dismissal, Barclays has received the largest SEC fine for a dark pool in history for misleading investors, despite Judge Furman’s November 2015 ruling.
Since Judge Furman’s Providence Rhode Island lawsuit dismissal, the plaintiffs’ lawyers have picked up a new plaintiff or two, and have filed a 48 page appeal.
Key to this appeal, and what we would like to highlight for you today, is section B, and particularly pages 10-12, which hammer home the argument that Exchanges selling co-location is a commercial decision – not to be protected by SRO immunity. While the Exchanges claim that colocation is one critical method they use to fulfill their regulatory responsibility, the defendants point out that this is not true:
The District Court Recognized that Co- Location Services Are Undeserving of Immunity
Even the district court recognized that the Exchanges’ co-location services warrant no immunity protection. SPA17. Those extraneous services serve no regulatory function; indeed, “it is hard to see” how they differ from “the provision of commercial products and services” that have been deemed unprotected. SPA18.
The district court’s holding was correct. Co-location is nakedly commercial conduct that exists solely to generate additional revenues for the Exchanges, and has nothing to do with SROs acting as quasi- regulatory overseers.
Defendants have conceded as much elsewhere. Co-location is, by Defendant NYSE’s admission to the SEC, “completely voluntary,” while NASDAQ has acknowledged that co-location “‘exists to advance … competition’” for order flow “‘among exchanges and non-exchange markets.’” MDL-CD26:36 (quoting Exchanges’ SEC filings). In fact, two of the Exchanges do not even maintain their own co-location centers, but provide the service through an unregulated third party. Id. That third party, in turn, has explained that co-location is simply an “infrastructure tool and is not a trading practice.”5 Plainly, co-location is far-removed from the “performance of regulatory, adjudicatory, or prosecutorial duties in the stead of the SEC.” Weissman v. NASD, 500 F.3d 1293, 1298 (11th Cir. 2007).
Struggling against this reality, Defendants insist that co-location services are “one critical method” they use to fulfill their “regulatory responsibility.” Def. Bf. at 37. But that’s not true; their core regulatory responsibilities, summed up, are to: (i) “prevent fraudulent and manipulative … practices”; (ii) “promote just and equitable principles of trade”; (iii) “remove impediments to and perfect” the “free and open market”; and (iv) “protect investors and the public interest.” 15 U.S.C. §78o-3(b)(6). And the Exchanges fulfill those responsibilities by, inter alia, participating in the consolidated feed – which data stream, available to all investors, Congress intended “‘would form the heart of the national market system.’” JA239:¶45.
But the high-priced co-location services do the opposite – they promote manipulative practices, close off free-and-open markets, and actually hurt investors and the public interest by making ordinary traders “pay higher prices for stocks.” JA272:¶109. It is absurd to suggest that, “in other circumstances,” the co-location services would “be performed by a government agency” like the SEC. Barbara, 99 F.3d at 59.
Seeking a lifeline from the SEC’s oversight of exchange rules associated with co-location services, Defendants imply that the agency has given its stamp of approval to the practice. Def. Bf. 37-38.
But Congress has cautioned against reading SEC “approval” into its oversight. See, e.g., 15 U.S.C. §78z (Exchange Act §26 specifies that a filed statement or report does not mean it is “true and accurate on its face,” or that the SEC has passed on the security’s merits); see also In re Facebook, Inc., IPO & Sec. & Derivative Litig., 986 F. Supp. 2d 428, 451 n.11 (S.D.N.Y. 2013) (“‘SEC approval … is not the sine qua non of SRO immunity; engaging in regulatory conduct is.’”).
Finally, while Defendants point out that the SEC has rejected a “synchronize[d]” data delivery requirement (Def. Bf. 38), they omit that in the same release, the SEC also warned that SROs or broker-dealers are prohibited “from transmitting data to a vendor or user any sooner than [they] transmit the data to a Network processor.” Regulation NMS, 70 Fed. Reg. 37496, at 37567 (June 29, 2005). That is precisely what occurs with co-location – as Defendant BATS implicitly acknowledged before a Senate subcommittee in 2014. JA265:¶95.
And just in case anyone has any doubt regarding the advantages of co-location, sold by the stock exchanges to the highest bidder, here is a blog post published yesterday by Hewlett Packard – a maker of advanced computer servers. Here are a few excerpts:
“Positioning their equipment just a few feet of cable away from exchange servers enables HFT firms to capture the most up-to-date market pricing a few milliseconds before the rest of the investing community. This real-time insight into market dynamics offers traders a distinct advantage as they are able to analyze and react to the current state of the market long – actually, a few of milliseconds – before everyone else.”
“Co-location has become a lucrative proposition for exchanges, who charge HFT firms exorbitant rental rates for low-latency positions in their data centers. This insatiable demand for data center space is the primary reason why many stock exchanges are rapidly expanding the size of their data centers. For example, while the old New York Stock Exchange building was only 46,000 square feet, the new data center in New Jersey sprawls over 400,000 square feet.”
“Co-location is an essential component of infrastructure strategy as firms seek to exploit microsecond latency advantages to help them succeed in today’s increasingly competitive financial markets.”
Please read that red highlighted section in the above paragraph, written by Hewlett Packard, as well as the red highlighted paragraph in the Providence Appeal earlier in this note. They are making the exact same point.
While the stock exchanges have convinced Judge Furman that colocation is a trading practice, and not an infrastructure tool, which makes the practice not legally immune from investor litigation, they certainly have not convinced Hewlett Packard, whose computer servers line exchange data centers.
Are stock exchanges immune from investor colocation lawsuits? We all will see soon enough.