Are “Flash Boys Lawsuits” Frivolous? Not Quite; said the Court of Appeals for the Second Circuit.

By Ricardo Lesperance

When Michael Lewis published Flash Boys: A Wall Street Revolt, his exposé on how Wall Street movers and shakers use High Frequency Trading (HFT) to rip riskless profits at the expense of unsuspecting investors, it created such sensational business headlines that it was inevitable Securities lawsuits would follow. The claims in “Flash Boys” were so fantastical, that they even prompted the SEC, the U.S. Department of Justice, the FBI and the New York Attorney General to scrutinize and investigate HFT practices. These regulators wanted to confirm whether in fact, public exchanges were providing superior information to high frequency traders, allowing the latter to front-run orders, execute trades and pocket the spread between bids and offers, risk free. The brouhaha and public scrutiny even prompted Goldman Sachs which prominently features in Lewis’ novel to consider the possibility of shutting down its "dark pool" - the anonymous trading venue that allegedly provides high frequency traders their unfair advantage. Ultimately, that did not happen. On the contrary,

last summer, Goldman Sachs launched a new “dark pool” called Sigma X2 - or “Sigma X-squared” and hired exchange operator Nasdaq Inc. to run it. One could argue that by floating the idea of potentially shutting down its dark pool, Goldman placed itself in a position to claim the moral high ground in the HFT controversy and be seen as the last Investment Bank with a conscience left on Wall Street.

Shortly after “Flash Boys” came out, a group of investors including the City of Providence, Rhode Island, the Plumbers and Pipefitters National Pension Fund, and Great Pacific Securities, filed a lawsuit against several exchanges claiming violation of §10(b) of the Securities Exchange Act of 1934. The suit alleged that Barclay, the New York Stock Exchange (NYSE), NASDAQ, BATS Exchange and the Chicago Board Options Exchange, misled the Plaintiffs about certain products and services that the exchanges sold to HFT firms. More specifically, the Plaintiffs argued that the Defendants fraudulently “. . . created ‘hide and light’ orders that allow traders to place orders that remain hidden from the ordinary bid-and-offer listings on the individual exchange until a stock reaches a particular price, at which point the hidden orders emerge and jump the queue ahead of other investors’ orders”.[1] In Plaintiffs’ opinion the Defendants’ practice of not fully and adequately disclosing the full functionality of these order types to all market participants

“. . . caused measurable harm to investors including, inter alia, increased opportunity costs from unexecuted fill orders, adverse selection and price movement bias on executed fill orders, and increased execution costs.[2] ”

Through such manipulative conduct, the Defendants diverted billions of dollars annually from ordinary investors and into the pocket of Wall Street’s high frequency traders, the lawsuit alleged.

On August 26, 2015, Judge Jesse M. Furman of the Southern District of New York dismissed the “Flash Boys Lawsuit” in its entirety, by invoking the doctrine of absolute immunity. Judge Furman declared that under the Securities Exchange Act of 1934, Self-Regulating Organizations (SROs) such as Defendants are “. . . absolutely immune from suits based on their creation of complex order types and provision of proprietary data feeds, both of which fall within the scope of the quasi-governmental powers delegated to the Exchanges”.[3]

Following that ruling, the Plaintiffs filed an appeal. In a unanimous December 19, 2017 decision, the United States Court of Appeals for the Second Circuit vacated the district court’s decision, reversed the dismissal of the action and remanded the case for further proceedings. In an amicus curiae brief to the Appellate Court, the SEC stated that “. . . the securities laws do not divest the district court of subject matter jurisdiction over this case”, and that the Commission believed the Defendants “are not entitled to absolute immunity from suit for the challenged conduct.”[4]

Agreeing with both the Plaintiffs and the SEC, the Appellate Court rejected the Defendants’ argument that their SRO status provides them with absolute immunity. Writing for the court, Judge John M. Walker, Jr. stated, “. . . the plaintiffs challenge exchange actions that are wholly divorced from the exchanges’ role as regulators. Plaintiffs allege that the exchanges violated §10(b) and Rule 10b-5 when they intentionally created, promoted, and sold specific services that catered to HFT firms and disadvantaged investors who could not afford those services”.[5] The Court went on to say that in providing these products and services, the Defendants did not “effectively stand in the shoes of the SEC, and therefore are not entitled to the same protections of immunity that would otherwise be afforded to the SEC”.[6]

In addition to the “absolute immunity” ruling, the district court had also concluded that the Plaintiffs did not assert a claim on which relief could be granted since it failed to sufficiently alleged that the exchanges (1) engaged in acts that manipulated market activity and (2) committed "primary" violations of Rule §10(b). The Appellate Court disagreed. Quoting Gurary v Winehouse, Judge Walker said the essence of Rule 12(b)(6) in this case is the “deception of investors into believing that prices at which they purchase and sell securities are determined by the natural interplay of supply and demand, not rigged by manipulations”.[7] The Judge argued, the Plaintiffs clearly laid out how for a fee, the Defendants “rigged the market” by allowing HFT firms to access market data at a faster rate, obtain non-public information, front-run ordinary investors’ trades, and deprive the Plaintiffs of the best available prices, as the Defendants knowingly continued to create a false appearance of market liquidity.[8]

The Appellate Court ultimately determined that the district court erred in dismissing the case. The manipulative and deceptive conducts alleged in the complaint are forbidden by the Exchange Act. For the lower court to hold that the Defendants’ conduct at best rose to mere aiding-and-abetting for which the law provides no relief does not withstand scrutiny. The Plaintiffs do not just assert that the Defendants simply “facilitated” the conduct. On the contrary what the Plaintiffs vociferously argued is that the Defendants were co-participants who benefited handsomely to the tune of hundreds of millions of dollars from the manipulative and deceptive conduct. Therefore, the complaint does sufficiently plead a violation of the Exchange Act and of Rule 10b-5 for which relief can be granted.

One thing these “Flash Boys Lawsuits” highlight is that the financial market is vulnerable to what amounts to “permissible manipulation”. There are deficiencies in the market that can be and perhaps are being exploited by rogue players, at the expense of average investors. More disturbing perhaps, is the apparent impotence of regulators against the ingenuity of algorithmically-armed high frequency traders. Although it was encouraging that the SEC opted to lend its support to the Plaintiffs by filing an amicus curiae brief on their behalf, it is doubtful that intervention did much to instill investor confidence in the agency’s ability to continue to regulate the securities industry. In this rapidly changing landscape of capital investment, a phenomenon that is fueled by the availability of an array of exotic products and superior technological innovations, it is not in the best interest of the SEC to appear passive or to be playing second fiddle to the court, in the face of apparent violations of securities laws. It is hard to predict how this particular “Flash Boys” case will end and how long it will linger through the justice system. However, if Michael Lewis is ultimately proven right, schemes like HFT will not do much to enhance Wall Street’s less-than-stellar reputation in the eyes of average investors.

[1] In re Barclays Liquidity Cross & High Frequency Trading Litig., No. 14-MD-2589 (JMF), 2015 U.S. Dist. LEXIS 113323 (S.D.N.Y. Aug. 26, 2015).

[2] City of Providence, Rhode Island v. Bats Global Markets, In., 878 F.3d 36, 52 Fed. Sec. L. Rep. P 99,937

[3] In re Barclays Liquidity Cross & High Frequency Trading Litig., No. 14-MD-2589 (JMF), 2015 U.S. Dist. LEXIS 113323 (S.D.N.Y. Aug. 26, 2015).

[4] Brief of the Securities and Exchange Commission as Amici Curiae Supporting Appellants, City of Providence, Rhode Island v. Bats Global Markets, In., 878 F.3d 36 (no. 15-3057)

[5] City of Providence, Rhode Island v. Bats Global Markets, In., 878 F.3d 36, 48 Fed. Sec. L. Rep. P 99,937

[6] Id.

[7] Id. at 50

[8] Id. at 49