Judge Allows Class Action Against 7 Specialist Firms

(CN) - The nation's largest public pension fund was granted class-action certification in its lawsuit against seven New York Stock Exchange "specialist firms," including Bear Wagner Specialists and SIG Specialists. The California Public Employees' Retirement System (CalPERS) accused the firms' traders of defrauding them out of millions of dollars over a five-year period.

U.S. District Judge Robert W. Sweet in Manhattan appointed CalPERS and Market Street Securities as class representatives. CalPERS manages 1.5 million California employees, retirees and their families. As of 2007, its portfolio was valued at more than $243 billion.

The SEC filed cease-and-desist proceedings against the seven firms in 2004, which each firm settled by agreeing to pay more than $240 million in penalties and disgorgement.

Investors filed the class action in 2003 and named the NYSE as a defendant. Judge Sweet dismissed the NYSE from the suit in December 2005 on the grounds that the exchange was immune from being sued over its regulatory decisions, due to its self-regulatory status as delegated by the SEC. The 2nd Circuit upheld that part of the ruling in an opinion written by Judge Sonia Sotomayor, President Obama's recent Supreme Court nominee.

However, Judge Sweet allowed the claims against the specialists firms to proceed. These firms are LaBranche; Spear, Leeds & Kellogg Specialists; Van der Moolen Specialists; Fleet Specialist; Bear Wagner Specialists; SIG Specialists; and Performance Specialist Group.

The plaintiffs accused the firms of regularly trading for their own profit before handling orders from clients. The specialists allegedly gave preferential treatment to orders by brokers on the floor over orders sent to the exchange's electronic order entry system, known as SuperDOT.

The defendants are accused of using a slew of "illegal and manipulative practices," including front running, in which the firms used their confidential knowledge of the investors' orders to trade for their own accounts before completing clients' orders.

CalPERS bought and sold almost 3 billion shares of NYSE-listed stock between 1998 and 2003. Market Street bought and sold more than 280 million shares during that same period.

As part of the investigation, the Department of Justice and NYSE created a computer algorithm to identify transactions where specialists traded ahead of public orders, positioned themselves between orders and traded for their own personal accounts before trading for clients.

Judge Sweet denied the defendants' motion to strike the opinion of an expert witness for CalPERS, which agreed with the "general methodology" of the algorithm, but said it failed to catch many instances of illegal trading. CalPERS insisted that its modified "surveillance software" can identify the firms' illegal conduct without a trade-by-trade review.

"A disagreement with an expert is not a legitimate basis on which to strike that expert's opinion," Sweet wrote.

The judge said the plaintiffs satisfied the class-action requirements because "each class member's claim arises from the same course of events, and each class member makes similar legal arguments to prove the defendants' liability."

However, the specific factors would vary from class member to class member and trade to trade, Sweet said, making it a "Herculean task" involving hundreds of millions of trades.

Failed hedge fund Sea Carriers Corp., a member of the class, claimed in a separate 2007 antitrust lawsuit that the "defendants exploited their exclusive control over order execution and publication of the data relating to order execution to create, maintain and conceal the existence of two distinct submarkets on the New York Stock Exchange: a dominant, insider submarket comprised of trades executed for the benefit of those members of the NYSE who operate on the floor of the exchange; and an inferior, outsider submarket comprised of SuperDOT trades."

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