NOTE: The following commentary by Neal L. Wolkoff was originally published on his blog.
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.