Nasdaq Screwed Up The Facebook IPO To Preserve The Integrity Of The Capital Markets

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Because Nasdaq messed up the Facebook IPO, a bunch of people lost money, and because this is America those people sued,1 and yesterday Nasdaq defended itself in a motion to dismiss, and I guess they're probably right, I don't know, but none of it exactly works as an advertisement for Nasdaq's services. The main argument is:

  • Yes, we screwed up trading in the Facebook IPO.
  • And yes, we broke a bunch of our own rules in doing so.
  • But what we screwed up was one of our most important jobs: "The orderly initiation of secondary market trading after an IPO is one of the most fundamental functions of a national securities exchange."2
  • So you can't sue us!

This ... is probably right? But, still. There's a certain backwardness to a rule that Nasdaq is immune from liability for careless computer programming errors and intentional rule violations, as long as those errors and violations were fundamental.

That rule comes from the notion that Nasdaq, like other securities exchanges, is a "self-regulatory organization" that "stands in the shoes of the SEC" when it makes decisions about trading, and you can't sue the SEC for screwing up regulation, though lots of people want to. And there's a glimmer of sense in that rule:

“After all, the purpose of the immunity is to give governmental officials – or those acting with the express delegation of the government, as with SROs – breathing room to exercise their power without fear that their discretionary decisions may engender endless litigation.” Otherwise, exchanges will “feel constrained in making every decision by the consequences in terms of [their] own potential liability in a suit for damages.” This “breathing room” is critical because exchanges constantly make regulatory determinations that benefit some members or public investors while disadvantaging others. Although often guided by SEC or exchange rules, those decisions frequently require exchanges to apply the broad discretion they are delegated by the SEC.

Similarly, if the exchanges faced potential liability for using crossing engines that don't work due to infinite loops, they would be afraid to build crossing engines that don't work, and then where would we be? Somewhere, probably.

If you want to buy a share of stock you basically tell your computer to go out to some other computers, get the best price, and bring back the stock. Some of those other computers belong to exchanges like Nasdaq, which are I guess immune from liability when their computers break down. Others belong to internalizing dealers, dark pools, ECNs, and other alternative trading systems, who are at least in theory liable for their screw-ups.3 The exchanges have the advantage of confidence in their discretion to do the right thing for markets or whatever. The alternative trading systems have the advantage of, like, having legal-liability incentives not to screw up your order. You could ponder which provides better incentives though the answer is probably "who cares?"4; the legal framework is a lot less important than commercial and reputational concerns. If you screw up too much it hurts your business, whether or not anyone can or does sue you. (Ask BATS!)

Nasdaq's argument does seem a bit anachronistic, though. A rule designed to protect humans who must make difficult decisions about market integrity is being used to protect computers that were just plain programmed dumb. And in fact the scope for human discretion at the exchanges is narrowing, as regulators push them to be more rule-driven. So the SEC went after Nasdaq in its Facebook IPO fine for doing things like extending the pre-cross period at the request of the underwriters, or shorting shares in its error account when trades got screwed up. Those things were not covered by Nasdaq's rules, but they seemed sensible to the human self-regulators at the time, in their discretion. The SEC said: less discretion please.

You can see why they would: for one thing, in an era of computerized trading, getting some humans to sit around jawboning about the right thing to do is probably not the best solution to trading problems. Just get the algorithms right, y'know? For another, the for-profit exchanges who rely on fee-paying business from big traders might not always be exercising their regulatory discretion in a purely regulatory way.5 Remember, for instance, how the SEC recently fined the CBOE for basically running its regulatory division as a business-development/client-service function, complete with helping customers get out of trouble with the SEC. Better, from the SEC's perspective, for exchanges to have clear rules and minimal discretion. But if the future of exchanges involves reducing their regulatory discretion, what's the value of making that discretion immune from legal liability?

In re Facebook, Inc. IPO Securities and Derivative Litigation - Nasdaq Motion to Dismiss [SDNY]
Nasdaq Seeks Dismissal of Facebook Suit [WSJ]

1.Though more cats-and-dogs type people than the people who actually lost a lot of money. Nasdaq members agree not to hold Nasdaq liable for losses, so only one Nasdaq member, First New York, is taking a flyer on this case. Basket cases like UBS and Knight Capital are just suffering in silence.

2.A sampling:

Plaintiffs’ negligence claims arise from NASDAQ’s commencement of trading in Facebook. They are thus directed to “one of the most fundamental functions” of a national securities exchange. ... The SEC’s finding that the initiation of trading after an IPO is “one of the most fundamental functions of a national securities exchange” is dispositive of the Exchange’s entitlement to immunity for claims arising out of the exercise of that function. As this Court has summarized, “‘it is the SRO’s function as a quasi-governmental authority that entitles it to absolute immunity,’” and not “the nature of the plaintiffs’ claims.”

3.I suppose your computer probably signs an indemnity with their computers before trading, so that liability may be mostly theoretical.

4.Though the fact that the exchanges keep fuming against the dark pools etc. might make you wonder.

5.As the Journalputs it:

Nasdaq's stance is likely to fuel a continuing debate over legal protections granted to exchanges. Some brokers and regulators have questioned the approach, noting that stock exchanges are now largely for-profit entities and have outsourced much of the day-to-day regulation of their markets to Finra.

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