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City of Providence v. BATS Global Markets, Inc.

United States Court of Appeals, Second Circuit

December 19, 2017

City of Providence, Rhode Island, Employees' Retirement System of the Government of the Virgin Islands, Plumbers and Pipefitters National Pension Fund, Lead Plaintiffs-Appellants,
v.
BATS Global Markets, Inc., Chicago Stock Exchange Inc., Direct Edge ECN, LLC, NYSE Arca, Inc., NASDAQ OMX BX Inc., New York Stock Exchange LLC, Nasdaq Stock Market, LLC, Defendants-Appellees, State-Boston Retirement System, Plaintiff-Appellant, Great Pacific Securities, on Behalf of Itself and All Others Similarly Situated, Plaintiff, American European Insurance Company, James J. Flynn, Harel Insurance Company Ltd., Dominic A. Morelli, Consolidated-Plaintiffs, Barclays Capital Inc., Barclays PLC, and Does, 1-5, inclusive, Defendants.

          Argued: August 24, 2016

         August Term, 2016

         Appeal from the United States District Court for the Southern District of New York. Nos. 14-md-2589, 14-cv-2811 - Jesse M. Furman, Judge.

         We consider in this class action whether plaintiffs have sufficiently pled that several national securities exchanges engaged in manipulative or deceptive conduct in violation of § 10(b) of the Securities Exchange Act of 1934, 15 U.S.C. § 78j(b), and Securities and Exchange Commission Rule 10b-5, 17 C.F.R. § 240.10b-5. The lead plaintiffs, institutional investors who traded on the defendant stock exchanges during the class period, allege that the exchanges misled them about certain products and services that the exchanges sold to high-frequency trading firms, which purportedly created a two-tiered system that favored those firms at the plaintiffs' expense. We conclude that we have subject matter jurisdiction over this case, the defendant exchanges are not entitled to absolute immunity, and the district court erred in dismissing the complaint under Federal Rule of Civil Procedure 12(b)(6). We therefore VACATE the district court's judgment entered in favor of the defendants-appellees and REMAND for proceedings consistent with this opinion.

          Joseph D. Daley (Andrew J. Brown, David W. Mitchell, Samuel H. Rudman, Patrick J. Coughlin, Vincent M. Serra, on the brief), Robbins Geller Rudman & Dowd LLP, San Diego, CA and Melville, NY; Joseph F. Rice, William H. Narwold, Ann K. Ritter, David P. Abel, Donald A. Migliori, Rebecca Katz, Motley Rice LLC, Mount Pleasant, SC and New York, NY; Christopher J. Keller, Joel H. Bernstein, Michael W. Stocker, Labaton Sucharow LLP, New York, NY for Lead Plaintiffs- Appellants.

          Douglas R. Cox (Scott P. Martin, Michael R. Huston, Alex Gesch, Rajiv Mohan, on the brief), Gibson, Dunn & Crutcher LLP, Washington, DC for Defendants-Appellees NASDAQ OMX BX Inc. and Nasdaq Stock Market, LLC; Douglas W. Henkin, J. Mark Little, Baker Botts LLP, New York, NY and Houston, TX for Defendants-Appellees New York Stock Exchange LLC and NYSE Arca, Inc.; Seth L. Levine, Christos G. Papapetrou, Levine Lee LLP, New York, NY for Defendant-Appellee Chicago Stock Exchange Inc.; James A. Murphy, Theodore R. Snyder, Joseph Lombard, Murphy & McGonigle, P.C., New York, NY and Washington, DC for Defendants-Appellees BATS Global Markets, Inc. and Direct Edge ECN, LLC.

          Sanket J. Bulsara, Deputy General Counsel, Michael A. Conley, Solicitor, Dominick V. Freda, Assistant General Counsel, Jacob R. Loshin, Securities and Exchange Commission Washington, DC, for amicus curiae Securities and Exchange Commission.

          Before: Walker, Cabranes, and Lohier, Circuit Judges.

          John M. Walker, Jr., Circuit Judge

         We consider in this class action whether plaintiffs have sufficiently pled that several national securities exchanges engaged in manipulative or deceptive conduct in violation of § 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"), 15 U.S.C. § 78j(b), and Securities and Exchange Commission ("SEC") Rule 10b-5, 17 C.F.R. § 240.10b-5. The lead plaintiffs, institutional investors who traded on the defendant stock exchanges during the class period, allege that the exchanges misled them about certain products and services that the exchanges sold to high-frequency trading ("HFT") firms, which purportedly created a two-tiered system that favored those firms at the plaintiffs' expense. We conclude that we have subject matter jurisdiction over this case, the defendant exchanges are not entitled to absolute immunity, and the district court erred in dismissing the complaint under Federal Rule of Civil Procedure 12(b)(6). We therefore VACATE the district court's judgment entered in favor of the defendants-appellees and REMAND for proceedings consistent with this opinion.

         BACKGROUND

         The lead plaintiffs filed this class action for securities fraud against seven national securities exchanges (collectively, "the exchanges"), including BATS Global Markets, Inc., the Chicago Stock Exchange Inc., the Nasdaq Stock Market, LLC, and the New York Stock Exchange LLC ("NYSE").[2] The exchanges are all registered with the SEC as self-regulatory organizations ("SROs")-non- governmental entities that function both as regulators and regulated entities. As regulated entities, they 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. See 15 U.S.C. § 78c(a)(26); id. § 78f(b)(1); see also S. Rep. No. 94-75 (1975), reprinted in 1975 U.S.C.C.A.N. 179, 1975 WL 12347, at *23.

         The complaint alleges that the defendant exchanges manipulated market activity in their capacities as regulated entities, in violation of § 10(b) and Rule 10b-5. In particular, plaintiffs contend that the exchanges developed products and services that give HFT firms trading advantages over non-HFT firms and the investing public, sold those products and services at prices that ordinary investors could not afford, and failed to publicly disclose the full or cumulative effects that the products and services have on the market.

         I. National Securities Exchanges

         Prior to 1975, the national securities exchanges operated independently from one another such that stocks listed on one registered exchange might trade at a different price on a different exchange. To mitigate this problem, Congress amended the Exchange Act in 1975 to mandate the creation of a unified "national market system" ("NMS"). See 15 U.S.C. § 78k-1(a). Congress conferred on the SEC broad authority to oversee the SROs' "planning, developing, operating, or regulating" of the national market system. Id. § 78k- 1(a)(3)(B).

         The SEC then promulgated a series of regulations, culminating in 2005 with Regulation NMS, "to modernize and strengthen the national market system . . . for equity securities." Regulation NMS, 70 Fed. Reg. 37, 496, 37, 496 (June 29, 2005) (codified at 17 C.F.R. § 242.600 et seq.) [hereinafter "Regulation NMS"]). The SEC emphasized that a national market system must "meet the needs of longer-term investors" because any other outcome would be "contrary to the Exchange Act and its objectives of promoting fair and efficient markets that serve the public interest." Id. at 37, 500 (noting the Exchange Act's "core concern for the welfare of long-term investors who depend on equity investments to meet their financial goals"). The SEC distinguished such long-term investors from short- term speculators who hold stock "for a few seconds." Id. In furtherance of these objectives, the SEC required that the exchanges distribute core market data on "terms that are fair and reasonable" and "not unreasonably discriminatory." 17 C.F.R. § 242.603(a)(1), (2). The SEC also required that exchanges and brokers accept the most competitive "bid" or "offer" price posted at any trading venue, to ensure that investors would receive the best prices, and that the exchanges inform the investing public of the national best "bid" and "offer" price by displaying it on their consolidated data feeds. See id. §§ 242.601-603.

         II. High Frequency Trading Firms

         In the years following the SEC's promulgation of Regulation NMS, the use of high-frequency trading rose dramatically in the U.S. stock markets. According to the plaintiffs, HFT firm transactions now account for nearly three-quarters of the exchanges' equity trading volume. 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. The firms employ various trading strategies that rely on their ability to process and respond to market information more rapidly than other users on the exchanges. Relevant to this appeal, the plaintiffs allege that the firms engage in predatory practices, such as repeatedly "front-running" other market participants: 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.

         III. Proprietary Data Feeds, Co-Location Services, and Complex Order Types

         The defendant exchanges in this case operate as for-profit enterprises that generate most of their revenue from the fees they charge for trades and the sale of market data and related services for those trades. The exchanges compete with one another to increase the trading volume on their particular exchanges. Plaintiffs contend in this case that the exchanges created three products and services for "favored" HFT firms-proprietary data feeds, co-location services, and complex order types-to provide these firms with more data at a faster rate than the investing public and thereby to attract HFT firms to trade on their exchanges.

         a. Proprietary Data Feeds

         Under Regulation NMS, each exchange must transmit certain information concerning trades on that exchange to a central network where the information is consolidated and then distributed. 17 C.F.R. § 242.603. This consolidated data feed provides basic real-time trading information, such as the national best bid and offer for a given stock. At issue in this case is the exchanges' provision to firms of additional, costly proprietary data feeds that include more detailed information regarding trading activity. At the most detailed and expensive level, a proprietary data feed may provide data on every bid and order for a given stock on an exchange. Furthermore, although the exchanges are prohibited from releasing data on the proprietary feeds earlier than the data on the consolidated feed, see Regulation NMS, at 37, 567, the proprietary data generally reach market participants faster because, unlike the consolidated data, they do not need to be aggregated. See Regulation NMS, 70 Fed. Reg. at 37, 567.

         The SEC has "authoriz[ed] the independent distribution of market data outside of what is required by the [NMS] Plans, " so long as such distribution is "fair and reasonable" and "not unreasonably discriminatory." Id. at 37, 566-67. Applying this standard, the SEC has approved various exchanges' proposals to offer proprietary feeds. See, e.g., Self-Regulatory Organizations; New York Stock Exchange LLC; Order Approving Proposed Rule Change to Establish Fees for NYSE Trades, 74 Fed. Reg. 13, 293 (Mar. 26, 2009). At the same time, it has instituted enforcement proceedings against exchanges for providing proprietary data feeds that are not in compliance with SEC rules. See, e.g., N.Y. Stock Exch. LLC, Exchange Act Release No. 34-67857, 104 SEC Docket 2455, 2012 WL 4044880 (Sept. 14, 2012) (settled action).

         According to plaintiffs, because these proprietary feeds are cost prohibitive for ordinary investors like plaintiffs, HFT firms receive more information at a faster rate and so are able trade on information earlier, which allows them to successfully "front-run" other market participants. Plaintiffs allege that, as a result, ordinary investors are greatly disadvantaged.

         b. Co-Location Services

         Some exchanges also rent space to investors to allow them to place their computer servers in close physical proximity to the exchanges' systems. This proximity helps to reduce the "latency" period-the amount of time that elapses between when a signal is sent to trade a stock and a trading venue's receipt of that signal. As with proprietary feeds, the SEC also regulates co-location services. Under the Exchange Act, the terms of co-location services must not be unfairly discriminatory and the fees must be equitably allocated and reasonable. See 15 U.S.C. § 78f(b)(4), (5). The SEC has approved the terms of particular co-location services as consistent with the Exchange Act, see, e.g., Self-Regulatory Organizations; the Nasdaq Stock Mkt. LLC; Order Approving a Proposed Rule Change to Codify Prices for Co-Location Servs., Exchange Act Release No. 34-62397, 98 SEC Docket 2621, 2010 WL 2589819 (June 28, 2010), ...


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