Exchanges Prevail in Flash Boys-Inspired Suits

The practice of high frequency trading has been a hot-button issue of late, thanks in part to Michael Lewis’ 2014 book Flash Boys: A Wall Street Revolt, which examines the rise of this phenomenon throughout U.S. markets.  Several class action lawsuits have alleged that various private and public stock and derivatives exchanges entered into agreements and received undisclosed fees to favor high frequency traders (“HFTs”), conferring timing advantages that damaged other market participants.  Two courts have recently addressed the merits of claims for damages against such exchanges and both ruled that plaintiffs failed to state a claim for relief.

High frequency trading involves the use of sophisticated computers and algorithms to make high-speed trades (without human direction) to take advantage of small changes in securities prices before other market participants.  Leveraging technological superiority, high frequency traders sometimes enter into co-location agreements, whereby they pay a fee to place their computers in the same facility as an exchange’s servers.  This affords access to market price data through “direct feeds” milliseconds faster than other market participants, who are located at a greater physical distance from the exchange.

In the last year, some putative classes of investor plaintiffs challenged the use of direct data feeds and co-location agreements in civil lawsuits against the exchanges.  These plaintiffs alleged that the exchanges’ provision of such information and services to the HFTs violated various federal statutes and regulations (including the Commodity Exchange Act (“CEA”) and the Securities Exchange Act of 1934), causing artificial prices, price fluctuations, and losses to other market participants.

Two courts have recently addressed the merits of these allegations.  The Southern District of New York took up the issue in August in In re Barclays Liquidity Cross & High Frequency Trading Litig., No. 14-2589, 2015 WL 5052538 (S.D.N.Y. Aug. 26, 2015).  The Court dismissed the wide-ranging securities fraud and manipulation claims against seven stock exchanges (including the New York Stock Exchange, NASDAQ and the Chicago Stock Exchange), finding that “merely enabling a party to react more quickly to information” does not constitute a manipulative act in violation of securities laws, particularly “where the services at issue are publicly known and available to any customer willing to pay.”

Earlier this month, in Braman v. The CME Group, Inc., the Northern District of Illinois followed suit, dismissing multiple claims related to high frequency trading brought against several Chicago-based derivatives exchanges.  Case No. 14-2646, 2015 WL 7776871 (N.D. Ill. Dec. 3, 2015).  The Braman plaintiffs alleged that the exchanges had entered into “clandestine incentive agreements” with HFTs “to create a two-tiered marketplace that disadvantages the American public and all other futures marketplace participants” and, in so doing, engaged in manipulation and fraud in violation of the CEA.  With respect to plaintiffs’ market manipulation claims, the court found that “‘the [artificial] effect was caused by the HFT firms’ trades themselves, not by the Exchanges’ provision of [data and services] to the HFT firms,’” and thus the exchanges had not caused the effect on price.  With respect to defendants’ allegedly fraudulent representation that all market participants received information through “one pipe”—that is, a “single data feed,” the court ruled that the statements were “technically true.”  The court dismissed all claims, including plaintiffs’ claims under the federal antitrust laws.

While high frequency trading is likely to remain controversial and HFTs may face increased legal and regulatory scrutiny, as the Braman and In re Barclays decisions demonstrate, without more, exchanges are not likely to be held liable in civil class action lawsuits for facilitating the trading of HFTs through co-location agreements.