Securities Regulation Daily Cboe, others immune from suit where policing of order flow fees was part of regulatory duties
Wednesday, October 24, 2018

Cboe, others immune from suit where policing of order flow fees was part of regulatory duties

By Mark S. Nelson, J.D.

A federal judge in Chicago held that the monitoring of payment for order flow (PFOF) fees imposed by multiple exchanges on their market maker members was part of the exchanges’ regulatory functions under the Exchange Act and, thus, the market makers could not pursue a law suit claiming a right to restitution or rescission of fees alleged to have been improperly assessed. The decision was the latest development in a series of attempts by the market maker plaintiffs to persuade the courts and the SEC that they had been wronged by the exchanges (Citadel Securities LLC v. Chicago Board Options Exchange, Inc., October 23, 2018, Gettleman, R.).

PFOF is a competitive business with costs. Market makers who are exchange members often pay broker-dealers to send order flow their way. Generally, PFOF is supposed to improve liquidity and provide benefits to investors. However, exchanges also attempt to ensure that market makers pay their fair share of the costs that arise from the process of creating order flow. As a result, Cboe, Inc., and other exchanges, imposed fees on market makers for "customer" trades but refrained from imposing such fees on proprietary or "house trades." The suit arose from the exchanges’ alleged failure to monitor whether member broker-dealers properly marked orders as "customer orders" or "proprietary orders." The market makers claimed that many orders were mislabeled and resulted in fees they should not have had to pay.

Over a nearly five-and-a-half-year period, the market makers filed suit twice in Illinois only to see their cases removed to federal court where they once voluntarily dismissed their suit and, on a second occasion, failed to persuade the district court not to dismiss the case (failure to exhaust administrative remedies), a decision that was later affirmed by the Seventh Circuit. The market makers then sought an administrative remedy before the Commission but were again rebuffed because the Commission held that it lacked jurisdiction to hear a purely private suit; the Seventh Circuit affirmed when Cboe filed a petition for review.

The market makers tried one more time by filing a new complaint seeking a declaratory judgment regarding the PFOF fees, an accounting, and further alleging breach of contract and promissory estoppel while also asking for restitution and rescission. The question for the court was whether the underlying claim that the exchanges failed to monitor the marking of PFOF orders for purposes of imposing fees was a regulatory function that made the exchanges immune from suit.

Preemption or immunity. Before the district court once again, the market makers had argued that the monitoring of fees was an operational function separate from the exchanges’ regulatory functions. Specifically, the market makers cited the Second Circuit’s decision in City of Providence for the proposition that an exchange cannot assert regulatory immunity when it acts like a regulated entity. The City of Providence had alleged that numerous exchanges misled it and other investors about the high-frequency trading services the exchanges offered to some firms and which allegedly disadvantaged City of Providence.

However, the district court in Chicago said the gist of what the market makers suing Cboe and other exchanges had alleged was that the exchanges violated their own SEC-approved rules. According to the court, that meant that either the suit was preempted by law or the exchanges enjoyed immunity. The district court favorably cited a decision by the D.C. Circuit holding that persons contesting the accuracy of test results for the Series 7 broker examination could not bring a common law suit against the National Association of Securities Dealers, the precursor to the Financial Industry Regulatory Authority, Inc. The penultimate paragraph from the D.C. Circuit case stated: "Whether analyzed under preemption doctrine or a theory of regulatory immunity, the result is the same: plaintiffs cannot raise a common law complaint against defendants based on duties arising under the Exchange Act."

The case is No. 16-cv-09747.

Attorneys: Ellen M. Wheeler (Foley & Lardner LLP) for Citadel Securities LLC, Ronin Capital, LLC and Susquehanna Securities. Paul E. Dengel (Schiff Hardin LLP) for Chicago Board Options Exchange, Inc. Terrence Patrick Canade (Locke Lord LLP) and Amir Cameron Tayrani (Gibson, Dunn & Crutcher LLP) for NASDAQ OMX PHLX f/k/a Philadelphia Stock Exchange, Inc. David Joel Chizewer (Goldberg Kohn) and Douglas W. Henkin (Baker Botts L.L.P.) for NYSE Arca, Inc. f/k/a Pacific Exchange, Inc.

Companies: Citadel Securities LLC; Ronin Capital, LLC; Susquehanna Securities; Susquehanna Investment Group; Chicago Board Options Exchange, Inc.; International Securities Exchange, LLC; NASDAQ PHLX, LLC; NYSE ARCA, Inc.; NYSE MKT, LLC

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