United States: Wall Street Banks, Stock Exchanges and High Frequency Trading Firms Hit With Securities Fraud Class Action

Last month, the City of Providence, Rhode Island filed a first-of-its-kind class action against Wall Street banks, securities exchanges and brokerage firms over alleged violations of federal securities laws stemming from the defendants' involvement in so-called "high-frequency trading" (HFT).  HFT has been subject of heightened focus since numerous regulators launched investigations into the practice, which some claim distorts stock market prices at the expense of the investing public.  In simplified terms, HFT is when traders utilize complex computer algorithms to move in and out of securities positions within fractions of a second.  As Michael Lewis explains in Flash Boys: A Wall Street Revolt, there are dozens of venues for trading stock (including public exchanges and private trading venues known as "dark pools"), which are situated at varying physical distances away from the originating order.  An order to buy or sell might therefore take longer (albeit milliseconds or even microseconds) to reach one exchange versus another.  According to Lewis and the City of Providence, HFT firms pay the exchanges for the right to place their computer servers as close to the exchanges' matching engines as possible, giving them "nearly instantaneous" access to key data about the investor's order, including its intention to buy or sell, its price sensitivity or margin requirements.  With that data in hand, HFT firms then employ complex computer code to race to other exchanges, transact, and then fulfill the investor's order.  This not only prevents the investor from obtaining the best price available when it sent the order, but also causes the market to move—in the blink of an eye—in a direction that causes the damage to the investor.

In the complaint, Providence represents a purported class of public investors who traded stock in U.S. exchanges or dark pools between April 18, 2009 and the present and suffered loss because of HFT.  The suit features an ambitious roster of defendants, including every SEC-registered national stock exchange (the Exchange Defendants), the 14 largest U.S. brokerage firms (the Brokerage Defendants) and 12 high frequency trading companies (the HFT Defendants).  Plaintiffs allege the Brokerage Defendants and HFT Defendants represent a "class" of defendants comprising "hundreds" of unidentified brokers and traders allegedly complicit in the scheme.

The complaint tracks the history of securities trading since the 1970's, depicting a "bold new world" in which sophisticated traders play "cat-and-mouse games" to gain clues about the investing public's trading intentions and exploit that information to gain a market advantage.  According to the plaintiffs, a 2007 SEC regulation called "Reg NMS" (or "national market system")—which requires exchanges and brokers to execute customers' orders at the most competitive price posted at any U.S. trading venue that displayed price quotes—may be partly to blame.  While Reg NMS was designed to promote investor confidence by ensuring customers received the best possible price, it spurred the proliferation of new exchanges, all competing to entice new customer order flow by offering that best price.  This fostered fragmentation of the stock market, boosting HFT firms' ability to exploit latency times and jump out ahead of the investing public.  Because of this, plaintiffs say, HFT has exploded—it accounts for 73% of all equity bids and orders volume on the market today.

In particular, plaintiffs allege the defendants engaged in the following manipulative HFT practices:

  • "electronic front-running" – where, in exchange for kickback payments, the HFT Defendants are provided early notice of investors' intentions to transact by being shown initial bids and offers placed on exchanges and other trading venues by their brokers, and then race those bona fide securities investors to the other securities exchanges, transact in the desired securities at better prices, and then go back and transact with the unwitting initial investors to their financial detriment;
  •  "rebate arbitrage" – where the HFT and Brokerage Firm Defendants obtain kickback payments from the securities exchanges without providing the liquidity that the kickback scheme was purportedly designed to entice;
  • "slow-market (or latency) arbitrage" – where the HFT Defendants are shown changes in the prices of a stock on one exchange, and pick off orders sitting on other exchanges, before those exchanges are able to reach and replace their own bid/offer quotes accordingly, which practices are repeated to generate billions of dollars more a year in illicit profits than front-running and rebate arbitrage combined;
  • "spoofing" – where the HFT Defendants send out orders with corresponding cancellations, often at the opening or closing of the stock market, in order to manipulate the market price of a security and/or induce a particular market transaction; and
  • "layering" – where the HFT Defendants send out waves of false orders intended to give the impression that the market for shares of a particular security at that moment is deep in order to take advantage of the market's reaction to the layering of orders.

While the HFT Defendants and the Brokerage Defendants allegedly profited to the tune of billions of dollars by trading against investors using their informational advantage, the Brokerage Defendants also allegedly received kickbacks for directing their customers' orders to certain exchanges and dark pools the Brokerage Defendants knew were "rigged" due to "informational asymmetries" caused by HFT.  The Exchange Defendants also allegedly received payments for allowing the HFT Defendants to place their servers in close proximity to the exchanges' matching engines (a practice known as "co-location"), giving the HFT Defendants a sneak preview of key customer trading data.

The suit includes three substantive counts: (1) Violation of §10(b) of the Securities Exchange Act and Rule 10b-5 promulgated thereunder (against all Defendants); (2) Violation of §6(b) of the Securities Exchange Act (against the Exchange Defendants); and (3) Violation of 20A of the Securities Exchange Act (against the Brokerage Firm Defendants and the HFT Defendants).

Plaintiffs will face a number of legal obstacles to victory, in particular, the definitional problems surrounding their depiction of the Brokerage and HFT Defendants as a "defendant class."  Plaintiffs appear to have lumped the Brokerage and HFT Defendants together in alleging they all engaged in similar illicit conduct, yet fail to allege specific fraudulent conduct by any particular defendant.  As one writer has pointed out, "Plaintiffs will struggle to overcome some obvious problems with the seeming shapelessness of the defendant class and the problems associated with having class representatives that did not volunteer for the role."

Plaintiffs may have a particularly hard time proceeding under §6(b), which does not appear to create a private right of action.  Section 6(b) requires all nationally-registered exchanges to enact rules designed to promote the Exchange Act's purposes—to prevent fraudulent and manipulative practices—but does not specify whom may enforce violations of this requirement.  The plaintiffs allege they are the "direct intended beneficiaries of" and collectedly relied on §6, perhaps foreshadowing their argument that §6 contemplates a private right of action.

Plaintiffs will also have to overcome the heightened pleading standards of the Private Securities Litigation Reform Act, which requires plaintiffs to allege sufficient facts to create a "strong inference" of fraudulent intent against each defendant.  That is no easy task considering the laundry list of defendants included in the suit.  Also, proving the defendants engaged in HFT is not the same as proving they committed fraud; as some have written, HFT is not always predatory and may even benefit the market in unseen ways.

Expect the HFT debate to continue gaining traction in the months ahead.  The New York Stock Exchange, for its part, has already paid millions to the SEC to settle charges of HFT abuse.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions