The topic of high frequency trading has dominated the business headlines since the late March publication of Michael Lewis’s new book, “Flash Boys: A Wall Street Revolt.” The SEC, the U.S. Department of Justice and the Federal Bureau of Investigation have confirmed that they are investigating high frequency trading, as has the New York Attorney General. With all this media attention and regulatory scrutiny, it was perhaps inevitable that the one of the consequences of these events would include a securities suit.
On April 18, 2014, plaintiffs lawyers’ filed a securities class action lawsuit in the Southern District of New York against 42 defendants including fourteen brokerages, sixteen securities exchanges and twelve high-speed traders. The roster of defendants includes the major exchanges, such as the NYSE and NASDAQ, as well as trading platforms such as the BATS Global Markets; major banks, such as BofA, UBS and Barclays; and a long list of trading firms large and small. The complaint does not name any individuals as defendants.
The lawsuit, filed by the City of Providence, Rhode Island, is brought on behalf of an ambitious putative class; the action purports to be brought on behalf of all public investors “who purchased and/or sold shares of stock in the United States between April 18, 2009 and the present (the “Class Period”) on a registered public stock exchange (the “Exchange Defendants”) or a United States-based alternate trading venue and were injured as a result of the misconduct.” And yes, the complaint (which can be found here) contains multiple references to Michael Lewis’s book.
Interestingly, the complaint not only purports to be filed on behalf of a plaintiff class, but it also purports to be filed against a defendant class as well. The Brokerage Firm Defendants and High Frequency Trader defendants named in the complaint purportedly are sued both individually and as representatives of a defendant class consisting of all (1) financial firms whose brokerage divisions placed bids or offers and/or transacted for members of the Plaintiff Class on stock exchanges or alternative trading venues during the class period: (2) financial firms that operated alternative trading venues for the anonymous trading of bids and offers and trading by brokers to members of the Plaintiff Class during the class period; and (3) financial firms that engaged in high frequency trading during the class period.
The complaint traces the history of securities trading in the United States since the early 70’s to try to explain the “bold new world” that characterizes current securities trading, a world that now includes “high frequency trading,” which the complaint defines as “a type of algorithmic trading” involving “the use of sophisticated technological tools and algorithms to rapidly trade securities.”
According to the plaintiff’s lawyers’ April 18, 2014 press release (here), the complaint alleges that defendants “engaged in a scheme and wrongful course of business whereby the Exchange Defendants, together with a defendant class of the brokerage firms entrusted to fairly and honestly transact the purchase and sale of securities on behalf of their clients … and a defendant class of sophisticated high frequency trading firms … engaged in conduct that was designed to and did manipulate the U.S. securities markets and the trading of equities on those markets, diverting billions of dollars annually from buyers and sellers of securities to the defendants.”
The complaint alleges that certain market participants received material, non-public information so that they could use the informational advantage obtained to manipulate the U.S. securities market. The Exchange Defendants and those defendants that controlled alternate trading venues allegedly demanded and received substantial kickback payments in exchange for providing the High Frequency Trader defendants access to material trading data via preferred access to exchange floors and/or through proprietary trading products.
In exchange ‘hundreds of millions of dollars” in payments, the Brokerage Firm Defendants allegedly provided access to their customers’ bids and offers, and directed their customers’ trades to stock exchanges and alternate trading venues that the Brokerage Firm Defendants knew had been rigged and were subject to informational asymmetries as a result of defendants’ scheme and wrongful course of business. The Brokerage Firm Defendants allegedly sold “special access” to material data, including orders made by the investing public so that the high frequency trader defendants could then trade against them using the informational asymmetries and other market manipulation.
The complaint alleges that the defendants’ alleged conduct deprived investors of the “market integrity” on which all securities buyers and sellers rely, as a result of which the plaintiff and the plaintiff class have been “victimized by what can fairly be characterized as a crooked crap game.” (Citations omitted).
The complaint alleges three substantive claims. The first, asserted against all defendants, alleges violation of Section 10(b) of the Exchange Act and Rue 10b-5 thereunder. The second, filed only against the Exchange Defendants, alleges violation of Section 6(b) of the Exchange Act. (Section 6 of the Exchange Act provides for the existence of National Securities Exchanges and specifies certain requirements for the existence, including in particular a requirement that the exchanges operate in a fair and equitable manner). Count III, filed against the Brokerage Firm Defendants and the High Frequency Trading, alleges violations of Section 20A of the Exchange Act. (Section 20A specifies the liabilities to contemporaneous traders for insider trading.) The complaint seeks compensatory damages, equitable restitution, forfeiture and other injunctive or equitable relief.
Discussion
This massive, sprawling lawsuit is nothing if not ambitious. Between the purported plaintiff class that includes everyone that traded in the U.S. securities marketplace during the last five years and an encyclopedia of defendants (including a purported defendant class) that includes just about every one of the financial firms that makes up the U.S. securities marketplace, this lawsuit basically tries to encompass the entire private U.S. securities arena and everything and everyone in it.
The plaintiffs’ lawyers’ ambition includes not only the size of their undertaking, but also the novelty of some of their approaches. I am very curious to know whether or not there is any history of private civil litigation under Section 6 of the Exchange Act and whether or not any other litigants have successfully pursued claims against the securities exchanges based on this statutory provision.
The plaintiff’s purported use here of a defendant class action is also interesting. The attempt to name a defendant class is not a new concept. Claimants have attempted to use this kind of procedural vehicle in a number of other kinds of lawsuits, ranging from patent litigation to product liability litigation against fire arms manufacturers. Still, as noted on the Class Action Countermeasures blog (here), defendant class actions are “rare beasts” because of definitional and procedural problems surrounding their use. Here, the 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.
Another challenge the plaintiffs may face has to do with the very subject of their lawsuit. For all of the adverse publicity surrounding high frequency trading, it is not (in and of itself) illegal – though of course, front-running, insider trading and other practices are or can be. However, it is a tall order to try to contend that everyone engaged in high frequency trading employed prohibited practices. Moreover, high frequency trading has its defenders. According to some, the presence of high frequency trading helps to narrow the gaps between bid and ask prices, which helps to reduce trading costs – a possibility that may highlight the kind of challenges the plaintiffs will face in pursuing these claims and in trying to show that all of the members of the purported plaintiff class were in fact damaged. As one author put it, high frequency trading may be “mysterious and secretive, but not at all evil.”
And of course the plaintiff will face the hurdles that any private securities plaintiff faces – overcoming the heightened pleading standard under the PSLRA, presenting sufficient allegations of scienter as to each of the defendants – except that here all of those hurdles are magnified by the sheer number and diversity of the defendants involved.
If nothing else, this lawsuit looks like a full employment act for the securities defense bar. The dozens of defense law firms that will be involved undoubtedly will count on riding this baby for years. (Which of course underscores another aspect of the plaintiff’s lawyers’ audacity in brining this suit; that is, they are going to have to carry this massive lawsuit, which will be fiercely litigated for years, before they will realize any possibility of a recovery.)
Whenever there is massive new event-driven litigation like this I am asked what the litigation means for the D&O insurance industry. Here, I think this event means a variety of things. Many of the larger financial institution defendants are either self-insured, carry large self-insured retentions or only carry so-called Side A only insurance programs (which would not be triggered here). The involvement of these larger financial institution defendants in this lawsuit will have only a limited impact on the D&O marketplace.
Many of the other defendants, especially the smaller brokerage and trading firms, are likely to carry more traditional D&O insurance programs (although an interesting question is whether these claims would trigger their D&O insurance programs or the E&O insurance programs – or even perhaps both). The carriers insuring these other defendants are at a minimum going to be looking at some huge defense fee bills. Maybe not enough to change the overall marketplace, but maybe enough to substantially affect the D&O (and E&O) marketplace for these kinds of financial firms.
The real wild-card here, for the insurance carriers as well as for everyone else involved, is whether this case will get through to the point where there is a settlement or settlements, and importantly for insurance purposes, whether by that point there have been developments in the ongoing governmental investigations that might affect the availability of coverage (e.g., whether or not there have been any criminal guilty pleas or other admissions that might trigger coverage exclusions). In other words, at this early stage, it is far too early to try to conjecture how it might all play out. However, for better or worse, we will get to have the experience of watching this case unfold in the months ahead.
Many readers will recall that Michael Lewis spoke at the PLUS International Conference in Orlando last November. He was an engaging and entertaining speaker and he left the impression that he is an interesting, likeable person. Although it seems likely that this lawsuit will be referred to as the “high frequency trading securities lawsuit,” I kind of hope in an acknowledgement of Lewis that the lawsuit is known as the “Flash Boys lawsuit.” (I recognize that the defendants probably wouldn’t like that very much.)
Dinner at Edwin’s: On Saturday night, my wife and I joined another couple for dinner at a new and unusual restaurant in Shaker Square in Cleveland called Edwin’s. It is a high-end, white table cloth restaurant serving fine French food. The food was excellent, and the service was well-intentioned and enthusiastic, if not always perfect. But what made the meal interesting is Edwin’s mission:
Edwin’s Leadership & Restaurant Institute is a unique approach at giving formerly-incarcerated adults a foundation in the hospitality industry while providing a support network necessary for a successful reentry. Edwin’s goal is to enhance the community of Cleveland’s vulnerable neighborhoods by providing its future leaders. Our mission is to teach a skilled trade in the culinary arts, empower willing minds through passion for the hospitality industry and prepare students for a successful transition into the world of business professionals.
In recent years, there have been a string of restaurants in Shaker Square that have tried valiantly but failed. In fact, one of our favorite after-theater restaurants, the Wine Grotto, used to be located in the space now occupied by Edwin’s. For many reasons, it could be a tough road for Edwin’s, too. But you just really want to see a project like this succeed. It was great to see that the restaurant was crowded and the large staff was busy. It makes such a difference to meet the staff members and to get a glimpse of the challenges they face – and of how hard they are willing to work to overcome the challenges.
The True Story of the Koy Panyee Southern Thailand Youth Soccer Club: A friend sent me a link to the video embedded below. The video tells the true story of how a group of boys figured out how they could find a place to play soccer in their water-surrounded floating fishing village in Thailand. The video is entertaining, heart-warming and inspiring. Do yourself a favor and take a couple of minutes to watch this video.