When a publicly listed for-profit exchange handles the initial public offering or
IPO of a legendary company, should it be held responsible for investors’ losses
if the offering goes badly because of trading glitches caused by the exchange’s
technology?
Intuitively, the answer appears
to be yes, because companies of all stripes have had to compensate victims who
suffered losses caused by the corporation’s negligence. However, since 1934 the securities markets have
operated in large part as surrogates for the federal regulator, the Securities
and Exchange Commission, in maintaining fair and orderly markets and upholding
principles of just and equitable principles of trade. When they operate under the mantle of surrogate
of the SEC, exchanges are called Self-Regulatory Organizations, or SROs, and
they are given wide latitude to act, or not act, in the best interests of the
investing public. The courts have held
that SROs when performing the quasi-governmental role as an SRO in regulating
the marketplace have the right to be protected, just as the regulator would be,
from lawsuits and damages resulting from a regulatory decision under a doctrine
called “absolute immunity.” In re NYSE Specialists Securities Litig.,
503 F. 3d 89, 90-91 (2d Cir. 2007); Mandelbaum v. New York Mercantile
Exchange, 894 F. Supp. 676 (SDNY 1995).
The question of whether Nasdaq was acting in its SRO role
when it made various decisions surrounding the Facebook IPO may determine
whether it will face the consequences of having to repay angry investors their
losses – now totaling hundreds of millions of dollars - or be able to escape
from any court imposed damages.
The basic details of what went wrong with the launch of the
Facebook IPO have been broadly reported: the opening was delayed from the
announced time, and after the first print was published by Nasdaq , investors
and brokers began complaining that they did not know if their orders had been
executed.
The opening of trading in the IPO of Facebook shares went
awry quickly because of technology failures, and questionable decision-making
in the face of those technology issues.
In the days that followed the IPO several companies revealed that they
and their customers had suffered losses of about $200 million. This weekend UBS upped the ante for injury
caused by Nasdaq’s handling of the IPO by revealing a whopping loss of an
additional $350 million above what had been reported earlier by other market
participants.
Nasdaq has apologized several times, and acknowledged the
specific technical glitches that created that first day havoc (a “race condition” where the matching engine
never enters a stable state was the root of the electronic havoc). Nasdaq has proposed a compensation pool of
approximately $40 million, about a third of which would be paid in cash and two
thirds in reduced or waived fees for future business. The exchanges that compete with Nasdaq have derided
this offer serving up another helping of negative press to reinforce the view
of Nasdaq as something of a bumbler. The
competing exchanges complain, and with some justification, that using a
compensation pool as a way to lock customers into using your market, thus helping
your own market share numbers at the expense of your competitors, is against
the SEC’s rules for fair and competitive markets.
Normally, when a public company performs badly in its
business and causes damages to the public or other companies the question of
liability is one of calculating the damages and determining whether the misstep
was the result of intentional misconduct where punitive damages might apply, or
negligence where the company must repay the injured person for the harm it
caused. Certainly no one in this matter
claims that Nasdaq intended to botch the Facebook IPO, but botched it was. Leaving a marketplace full of investors and
brokers wondering for hours whether they bought stock or not while the market
was gyrating wildly is a failure by a market operator to perform its basic
function.
Securities and futures exchanges operate in a strangely
different world from other corporations, and thinking that normal rules of
liability apply to them can be misleading to the extreme. Under normal rules of liability, Nasdaq could
be facing damage claims of more than $500 million because investor losses can
be tied directly to its systems failure. However, under the rules governing exchanges
it is quite possible that Nasdaq will escape any liability, or at least
significant liability, because it benefits from the legal doctrine of “absolute
immunity” in performing the regulatory functions it must perform as a surrogate
of the SEC. If Nasdaq was acting in its
capacity as a regulatory body when it was making decisions about the Facebook
IPO in order to protect the public
interest, then Nasdaq will be able to say that it is absolutely immune from
paying damages, even if its decisions were flawed.
Nasdaq realized early on that something was amiss with the
technology supporting the Facebook IPO.
It tried to assign an opening price manually while fixing what it
believed to be the bug causing the problem.
Nasdaq was empowered to halt the
market under its own Rule 4120(a)(7), and cancel all trades that had occurred
prior to the halt (remember the BATS IPO where BATS experienced system problems
handling its own IPO after the market had started to trade, and reversed course
to cancel all trades in order to preserve a fair and orderly marketplace). Or, Nasdaq could have halted the market,
resolved the issues, and confirmed all trades occurring before the halt, and
then moved forward with new trades.
Should Nasdaq have been in doubt about actions it could have taken in
the face of a halt, Nasdaq could have relied on Section 19 (b)(3)(B) of the ‘34
Act and implemented an emergency rule without prior public notice or SEC
approval in order to maintain “fair and orderly markets.”
In hindsight, notwithstanding the misguided criticism heaped
on BATS after its IPO fizzled, a trading halt could have resolved the technical
issues before too much damage was caused.
Yes, a halt during the biggest IPO of recent years would have been embarrassing,
but not on the scale of 500 million reasons to be chagrined. BATS, by contrast, chose to be embarrassed
over flubbing its own IPO rather than risking the consequences of a technology
failure during its IPO. Nasdaq on the
other hand decided to plow forward, thinking at the time that its actions would
solve the problems and preserve a fair and orderly market and just and
equitable principles of trade. In
hindsight, plowing forward only made matters worse, sowing confusion among
investors and maximizing the losses that they incurred as systems issues
plagued investors and the exchange during the day.
However, at the time it made its decision, Nasdaq officials
believed that the best course for them to take to protect the interests of the
market was to issue an opening price manually, fix the technology issues on the
fly, and continue with public trading of Facebook shares. With 20/20 hindsight that may not have been
the wisest or best decision. However, if
Nasdaq made the decision not to halt as the best means to provide the public
with a fair and orderly market, then
Nasdaq can claim that it acted in its capacity as a Self-Regulatory
Organization to provide and protect a fair and orderly market, and were thus
protected by the absolute immunity doctrine that applies to exchanges
performing quasi-governmental regulatory actions.
I expect that the question of absolute immunity for exchange
actions taken during the Facebook IPO will receive much attention from the
courts. Arguments will be made that
Nasdaq acted primarily in its corporate interests, or that a for-profit
exchange does not deserve the protection of the absolute immunity doctrine that
arose when exchanges were not-for-profit membership owned organizations;
instead its shareholders should bear the risk of loss. Those arguments have some appeal, and may
prevail ultimately as the inevitable cases go through the courts. But, rules that are specific to the unique regulatory
roles played by exchanges may well insulate Nasdaq from facing the consequences
of significant damages from its handling of the Facebook IPO.
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