Second Circuit Ruling Stuns Major Stock Exchanges

MANHATTAN (CN) – The New York Stock Exchange, NASDAQ and other major stock exchanges are not immune to claims they cheated investors by giving high-speed traders special access to stock market information, allowing them to manipulate the markets and make billions at the expense of ordinary investors, the Second Circuit ruled Tuesday.

Providence, Rhode Island and other institutional investors claim in a 57-page lawsuit that the scheme began after the onset of the global economic crisis.

The defendant exchanges, including the Chicago Stock Exchanges and BATS Global Markets, used “devices, contrivances, manipulations and artifices to defraud in a manner that as designed to and did manipulate the U.S. securities markets and the trading of equities on those markets,” Providence, et al. say in the complaint.

Among the devices were allowing preferred traders “to place their computer servers in close physical proximity to the exchanges’ systems,” the Second Circuit wrote.

This, almost unbelievably, allows favored traders to profit off of the infinitesimal time period linked to the speed of electricity — nearly the speed of light — because their machines are closer to the markets’ machines that send the information.

The plaintiffs claim the major stock exchanges received substantial kickbacks for providing high-frequency traders preferential access to trading data via proprietary trading products.

The predatory practices allegedly extended to defendant Barclays PLC, which is accused of selling special access to material data, including orders made by it and the plaintiff class so that the high frequency trading firms could trade against them using the competitive advantages they had put in place.

The lawsuit was filed after financial journalist Michael Lewis’s new book, “Flash Boys,” made national news with its claim that the markets are rigged for and by high-frequency traders.

A federal judge dismissed the investors’ claims, finding that the exchanges are entitled to absolute immunity with regard to regulations enacted pursuant to their delegated quasi-governmental powers.

But the Second Circuit on Tuesday found that the investors’ claims do not challenge regulatory conduct.

“We agree with the exchanges and the district court that disseminating market data is a critical function for which exchanges have various responsibilities under Regulation NMS and, more generally, that the exchanges have numerous obligations to ensure fair and orderly securities markets,” Second Circuit Judge John M. Walker Jr. wrote for the three-judge panel.

“But the provision of co‐location services and proprietary data feeds does not relate to the exchanges’ regulatory function and does not implicate the SROs’ need for immunity.”

Co-location services refers to the favored placement of defendants’ receiving computers.

While the exchanges did not hide the existence of proprietary data feeds from ordinary investors, it is not clear to what extent the exchanges disclosed the cumulative effect such services would have on the market, the court found.

“We think that such allegations sufficiently plead that the exchanges misled investors by providing products and services that artificially affected market activity,” Walker said.

This win for ordinary investors over the interests of high-frequency traders follows closely on a November victory in which the Second Circuit ruled that investors may sue Barclays for failing to provide promised protections against high-frequency traders on its dark pool exchanges.

Defendants include Direct Edge ECN and Barclays Capital Inc.

Plaintiffs includes the retirement systems of Boston and the Virgin Islands, the Plumbers and Pipefitters National Pension Fund, American European Insurance Company, et al.

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