Nasdaq Stock Market can rely on legal protections afforded exchange operators to avoid paying damages to firms that lost money on Facebook Inc., the former chief executive officer of the American Stock Exchange said.
The second-largest equity venue’s status as a self- regulatory organization means it will probably be spared liability for technology breakdowns and bad decisions in the May 18 initial public offering, said Neal Wolkoff, a lawyer who also ran ELX Futures LP. Nasdaq OMX Group Inc., the parent company, proposed setting aside $40 million to compensate firms after delayed orders and confirmations left brokers and fund managers unsure of how many shares they owned in the $16 billion IPO.
“Rules that are specific to the unique regulatory roles played by exchanges may well insulate Nasdaq from facing the consequences of significant damages,” according to Wolkoff. The safeguards will withstand arguments 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,” he said.
At least one investor has sued Nasdaq and brokers Knight Capital Group Inc. and UBS AG said they are considering lawsuits. Industry losses tied to delays and malfunctions that slowed the confirmation of trades in the IPO may be close to $200 million, Knight Chief Executive Officer Thomas Joyce said June 7. CNBC said the total for UBS alone may be $350 million.
Phillip Goldberg, an investor in Maryland, said in a lawsuit filed in Manhattan federal court that Nasdaq OMX “badly mishandled” orders placed through an online Charles Schwab Corp. account. He is seeking to represent a class of investors who lost money.
Robert Madden, a spokesman for Nasdaq OMX, declined to comment, as did Christiaan Brakman, a spokesman for UBS, and Kara Fitzsimmons of Knight.
“The reason for immunity is you don’t want a regulator to be worried about getting sued when they make decisions,” Thomas Hazen, a professor at the University of North Carolina at Chapel Hill’s School of Law and author of a seven-volume treatise on securities regulation, said in a phone interview. “You want the regulator or market to make decisions they think is best for the marketplace.”
To win a lawsuit against a self-regulatory organization, “you’d have to show they were acting in bad faith,” Hazen said. “That’s a very, very tough lawsuit to win.”
Nasdaq shares have lost 5.6 percent since May 17 when Facebook shares were priced by underwriters. They rose 1.3 percent to $21.72 yesterday. Facebook, whose stock sale was the biggest IPO ever by a technology company, has fallen 28 percent.
The owner of the largest social networking website was scheduled to open at 11 a.m. New York time on May 18 when trading was delayed by a design flaw in Nasdaq’s IPO auction mechanism. Fixing it blocked order updates and cancellations sent to the exchange over 19 minutes from being included in the first public trade, or cross, at 11:30 a.m., and prevented confirmations from being immediately distributed to brokers.
The malfunctions spurred confusion among securities firms, market makers, asset managers and individual investors, who didn’t know whether they owned shares and couldn’t cut losses. UBS was left with a larger Facebook stake than it meant to buy after repeatedly entering an order that wasn’t confirmed, CNBC said June 8. Switzerland’s largest bank said the loss isn’t material and declined to quantify it.
The exchange’s liability in private lawsuits will depend on whether it was acting “in its SRO role” when it decided to continue with trading after uncovering technical flaws, and then choosing not to halt the stock, Wolkoff wrote in a blog post this week. He said in a phone interview that managing the IPO process for a public company is a “key aspect of what an exchange is about,” making it likely that immunity will apply.
“The role of an exchange is an adjunct to the role of the banker, but the exchange gets the market value of the stock to be published based on the buy and sell interest it receives,” Wolkoff said in the interview.
Facebook was priced at $38 the day before shares began changing hands. Nasdaq’s IPO auction price was $42, a level Nasdaq OMX CEO Robert Greifeld told reporters on May 20 was “proper with respect to volume and price.” Facebook closed at $38.23 on May 18.
The cap on Nasdaq’s liability stemming from technology errors and malfunctions it causes is $3 million, according to the exchange’s rules. Nasdaq raised the limit last year from $500,000 after a malfunction in April with its automated quotation system led to losses by market makers. Greifeld said in a conference call on July 27 that the April mishap was the first such error in his eight years at the helm of the company and he didn’t expect another for the next eight.
Curbs on SRO liability were developed to keep the member- firm owners of an exchange from having to pay another broker for losses caused by technical breakdowns, according to George T. Simon, a partner at Foley & Lardner LLP and former associate director in the SEC’s division of market regulation. Simon helped restructure the national equities market after the 1975 Securities Acts Amendments, which overhauled rules for exchanges and trading to spur competition and increase price transparency.
Today, since none of the exchanges are member-owned, “one could argue that the premise behind the limited liability is no longer relevant,” Simon said. “On the other hand, these rules are still in effect and courts, except in cases of real abuse, have honored them.”
“If I were a betting person, I’d bet in favor of Nasdaq,” he said.
U.S. courts have upheld the immunity of exchanges and associations of securities dealers for actions related to self- regulatory responsibilities such as monitoring the compliance of brokers with laws and running their markets. Cases brought against the New York Stock Exchange and the National Association of Securities Dealers Inc., which created Nasdaq in 1971, preserved that protection in recent decades.
In 1996, a U.S. appeals court in Barbara v. New York Stock Exchange Inc. upheld a lower court’s decision that NYSE was entitled to immunity for damages stemming from how it conducted disciplinary proceedings. An appeals court upheld another decision in 1998 that Nasdaq’s de-listing of a stock and suspension of trading was subject to immunity in Sparta Surgical Corp. v. National Association of Securities Dealers Inc.
An appeals court in Weissman v. NASD Inc. distinguished between actions taken to carry out an SRO’s obligations and what it called private commercial conduct. In 2007 it affirmed a lower court decision that Nasdaq’s advertising about its listed companies wasn’t subject to its immunity as an SRO. The U.S. Supreme Court in a 1963 case called Silver v. New York Stock Exchange said that NYSE’s role as a self-regulator didn’t exempt it from antitrust laws.
Brokers suing Nasdaq OMX are subject to contracts for trading on the exchange that limit the venue’s liability, said Andrew Stoltmann, a securities lawyer in Chicago who has represented investors in cases alleging securities fraud. Since Nasdaq is experiencing a public relations crisis, the exchange may increase the $40 million in reimbursements and trading discounts it offered brokers, subject to SEC approval, he said.
“If you just look at the contractual agreement between the firms and Nasdaq, that’s going to be hurdle No. 1 that has to be jumped,” Stoltmann said in a phone interview. “There are really limiting clauses in the contracts.”
Nasdaq may have been caught unprepared for the Facebook blunder in part because the exchange wasn’t as used to dealing with technology and systems problems as rival markets, Wolkoff said. The American Stock Exchange, a listing venue mainly for small and mid-size companies, was “overly practiced” at coping with technical malfunctions because it experienced more glitches as it shifted to automated trading in the last decade, he said.
NYSE Euronext, owner of the New York Stock Exchange, bought Amex in 2008 and renamed it NYSE MKT last month.
“We were famous for having technology problems,” said Wolkoff, who left Amex in 2008. “Every exchange has had technology problems. You can’t get so mad at a marketplace because they have a technology issue. But once you have it, how do you deal with it?”
Nasdaq should have delayed the Facebook IPO until it knew for certain trading could occur without mishap, he said. Eric Noll, executive vice president at Nasdaq OMX, said executives at the company “believed they had the right solution” as they worked to start trading on May 18, according to a statement provided by Madden on May 22.
“With the benefit of hindsight they should have halted, solved the problem and recommenced trading,” Wolkoff said. “They had broad latitude to do whatever they viewed as fair for the market. They could have canceled trades from the IPO cross and restarted trading. Or they could have waited until they confirmed everything and then reopened trading so no one was operating in a vacuum of information.”
All exchanges are allowed to declare halts when it’s done to protect investors and the integrity of trading, Wolkoff said.
“When you fix something on the fly, you can get lucky and it can work,” Wolkoff said. “You can also get unlucky -- and the consequences of being unlucky are close to catastrophic.”
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