Second Circuit Holds That Stock Exchanges Are Not Immune From High-Frequency Trading Suit

By Adam J. Blander

Generally speaking, government entities and officials cannot be sued for actions they perform within the scope of their duties.  The rationale underpinning this “absolute immunity” principle is that the public interest requires government officials to conduct themselves without fear that their decisions could expose them to a damages lawsuit from any unhappy private citizen.  Sometimes, the question arises as to whether non-governmental entities who perform certain governmental functions may still invoke absolute immunity as a defense.  

The United States Court of Appeals for the Second Circuit recently confronted a strain of this question in City of Providence v. BATS Global Markets, Inc., No. 15-3057 (2d Cir. Dec. 19, 2017), in which the plaintiffs, large institutional investors, sued the NASDAQ, the New York Stock Exchange, and several other public stock exchanges for securities fraud in connection with the exchanges’ relationships with high-frequency trading (“HFT”) firms.  Stock exchanges are “non-governmental entities that function both as regulators and regulated entities,” and, as such, register with the Securities and Exchange Commission as “self-regulatory organizations (“SROs”). Op. at 5.  “As regulated entities, [exchanges] are subject to SEC oversight and must comply with the securities laws as well as the exchanges’ own rules; and as regulators, they are delegated the authority by the SEC to oversee and discipline their member broker‐dealers.”  Id.

Some background for those pondering what HFT firms do:  “HFT firms, using sophisticated, computer‐driven algorithms to move in and out of stock positions within fractions of a second, make money by arbitraging small differences in stock prices rather than by holding the stocks for long periods of time” and “employ various trading strategies that rely on their ability to process and respond to market information more rapidly than other users on the exchanges.” Op. at 7. 

The plaintiffs alleged that HFT firms engaged in practices that harmed the public. For example, firms would “front-run” other investors, by “anticipating when a large investment of a given security is about to be made, purchasing shares of the security in advance of the investment, and then selling those shares to the buying investors at slightly increased prices.” Op. at 8. [1] And these practices were made possible by the exchanges, who “developed products and services that give HFT firms trading advantages over non‐HFT firms and the investing public, [and who] sold those products and services at prices that ordinary investors could not afford.” Op. at 5-6. Specifically, exchanges 1) created valuable “proprietary data feeds” for HFT firms, which are comprised of detailed, unconsolidated trading information; 2) rented space to HFT firms in close physical proximity to exchange systems, causing the firms to receive electronic trading signals more rapidly than the general public (a practice known as “co-location”); and 3) developed and sold to HFT firms “complex order types,” which are pre-programmed commands which allow firms to circumvent the default exchange commands on how to process bids and offers. Op. at 8-12.

The plaintiffs asserted that these HFT arrangements—which allegedly enriched the exchanges by several hundred million dollars—were manipulative, and moreover, that the exchanges misled public investors about the cumulative market effects of this predatory “two-tiered” system, putting them at an “informational disadvantage.” Op. at 33. In short,  the exchanges had “rigged the market.”  Op. at 26.

The exchanges moved to dismiss the plaintiffs’ suit, arguing, among other things, that they were immune from liability.  Reversing the lower court’s order of dismissal, the Second Circuit disagreed.  Observing that an SRO is entitled to immunity only when acting “under the aegis” of its regulatory duties—or put another way “when it stands in the shoes of the SEC”—the Court provided a non-exclusive list of examples in which an SRO exercises such immunizing “quasi-governmental powers.” Op. at 19-20.  Such examples include: enforcing security regulations through disciplining violating members or referring them to prosecutors; interpreting securities law regarding stock exchanges; or publicly announcing the cancellation of trades. Op. at 20.  The common denominator in all these examples, the Court noted, is that the SRO “is fulfilling its regulatory role.”  Op. at 20-21.  The conduct alleged by plaintiffs, by contrast, namely, that the exchanges “intentionally created, promoted, and sold specific services that catered [only] to HFT firms” was “wholly divorced from the exchanges’ roles as regulators.”  Op. at 23-24.  Accordingly, the exchanges’ immunity defense failed.  As the Court tersely put it: when an exchange “operate[s] its own market that is distinct from its oversight role, it is acting as a regulated entity—not a regulator.” Op. at 24 (emphasis in original). 

City of Providence should remind us that stock exchanges, despite their “critical function” of “ensur[ing] fair and orderly securities markets,” Op. at 21, are, at the end of the day, private, for-profit businesses not unlike the market participants they regulate.  Reasonable people can debate whether, as a matter of policy, exchanges should be allowed to monetize this critical quasi-governmental function by developing and selling complex products which benefit only a tiny (and exceedingly wealthy) sliver of market participants, provided, of course, that such conduct is not manipulative and is adequately disclosed to the public.  What City of Providence settles, however, is that such conduct constitutes the working of business, not government. Accordingly, exchanges should not expect immunity from lawsuits, either individual or class-wide, which vindicate public investor rights and ensure the stability and integrity of our capital markets system. 

[1] Front-running and other unsavory HFT conduct garnered intense public scrutiny—and litigation—following the 2014 publication of Michael Lewis' Flash Boys.  New York Attorney General Eric Schneiderman has referred to such practices as “Insider Trading 2.0.”