Lawsuits Reveal Risks Lurking Below Surface of Dark Pools Law360, New York (September 04, 2014, 10:34 AM ET) ‐‐

Lawsuits Reveal Risks Lurking Below Surface Of Dark Pools Law360, New York (September 04, 2014, 10:34 AM ET) ‐‐

In the ongoing debate surrounding high‐frequency stock trading, private trading platforms called “dark pools” have recently been thrust into the spotlight. A civil lawsuit by the New York attorney general (NYAG) and two investor class actions portend an increasing number of lawsuits against brokerages that operate dark pools. Dark pools are privately owned stock trading platforms, operated primarily by large brokerages, where investors David Beehler Thomas Berndt can buy and sell stock with greater anonymity than public exchanges like the Nasdaq or New York Stock Exchange. Unlike public exchanges, dark pools do not publish investors’ buy and sell orders and do not publicly announce trading prices until after execution. Dark pools were initially touted as a “safe” way for institutional investors to trade large blocks of stocks without tipping the market of their intent and potentially moving market prices. The NYAG estimates that dark‐pool trading accounts for “over 40 percent of all U.S. equities trades.”[1]

Inextricable from the current debate concerning dark pools is the larger issue of high‐frequency trading. Since the March 2014 publication of Michael Lewis’ best‐selling book, Flash Boys,[2] high‐frequency trading has become a flashpoint issue among both investors and regulators. High‐frequency trading is made possible by the proliferation of electronic stock trading and the increase in the number of public and private trading venues, which has led to small, temporary price differences between the venues. High‐frequency traders use ultra‐fast computer connections to exploit these price differences, a practice referred to as “slow‐market (or latency) arbitrage.”

In his book, Lewis illustrates how high‐frequency traders take advantage of large institutional investors seeking to trade large blocks of stock. Such orders are often too voluminous to fill on any one exchange and must be routed in smaller chunks to numerous exchanges. Because orders are electronically routed to exchanges through data lines (often fiber optic cable), the various chunks of a large order will arrive at the various exchanges at slightly different times, often only fractions of a second apart. Lewis details how this small window provides high‐frequency traders enough time to detect the presence of the large order and trade against it on the exchanges it has not yet reached.

Lewis likens this practice to “front running,” an illegal practice by which a stockbroker uses its knowledge of unexecuted customer orders to trade the same securities for its own account before executing the customer orders, thereby benefiting from the price movement caused by the customer orders.

Lewis also details how dark pools are feeding grounds for high‐frequency traders to prey on slower investors. According to Lewis, “a customer’s stock market order, inside a dark pool, [is] fat and juicy prey.”[3] Lewis speculates how high‐speed traders could take advantage of the slow speed by which activity within the dark pool is transmitted to the public exchanges.[4]

For example, high‐speed traders could place small buy and sell orders inside a dark pool on every stock listed in order to detect certain trading patterns indicative of a large order.[5] Once the high‐speed trader detects a large order for a particular stock within a dark pool, the trader could trade that stock in the opposite direction on the public exchanges, where the prices have not yet changed to reflect the activity within the dark pool.[6] Emphasizing how long it takes information from within a dark pool to reach the public exchanges, Lewis quotes a Wall Street insider as saying “[y]ou could front‐run an order in a dark pool on a bicycle.”[7]

Dark Pools Come Under Increased Scrutiny

Dark pools have recently come under increased scrutiny by both regulators and investors. On June 25, 2014, as part of its Insider Trading 2.0 initiative, the NYAG sued Barclays for misrepresentations regarding its dark pool.[8] The NYAG suit spurred two investor class actions against Barclays based on the operation of its dark pool. In July, Credit Suisse, Deutsche Bank and UBS all disclosed that U.S. regulators were investigating their respective dark pools.[9]

The NYAG’s suit alleges that, from 2011 to the present, Barclays “embarked on a business strategy to dramatically increase the market share of its dark pools, with the goal of making it the largest dark pool in the United States.” According to the complaint, “Barclays accomplished this through a series of false statements to clients and the investing public about how, and for whose benefit, Barclays operates its dark pool.”

The complaint alleges that, contrary to Barclays’ claim that it implemented special safeguards to protect clients from what Barclays described as “aggressive,” “predatory” or “toxic” high‐frequency trading in its dark pool, “Barclays has operated its dark pool to favor high‐frequency traders” and “has actively sought to attract such traders to its dark pool, and ... given them advantages over others trading in the pool.” The NYAG’s complaint asserts counts for securities fraud under New York’s Martin Act and Executive Law § 63(12).

Barclays responded to the NYAG’s complaint on July 24, 2014, by filing a motion to dismiss. Barclays’ motion argues that “the Complaint fails to identify any fraud — establishing no material misstatements, no identified victims, and no actual harm.” Barclays characterizes clients of its dark pool as “highly sophisticated traders and asset managers” whose investment decisions are based on “detailed execution data, not on the glossy marketing brochures or quotes from magazine articles the NYAG cites.” Barclays further argues that the Martin Act is limited to actions for fraud in the purchase or sale of “securities,” and does not apply to the marketing and operation of “alternative trading platforms” such as Barclays’ dark pool. According to Barclays, regulating alternative trading platforms is the province of the U.S. Securities and Exchange Commission, and not the NYAG.

The NYAG Lawsuit Spurs Two Investor Class Actions

The NYAG suit has spurred two investor class actions. On July 28, 2014, Barbara Strougo filed a class action complaint against Barclays PLC, its former CEO Bob Diamond, current CEO Antony Jenkins, former Finance Director Chris Lucas, and current Finance Director Tushar Morzaria.[10] Strougo seeks to

represent herself and a class “consisting of all those who purchased or otherwise acquired Barclays ADSs, and options contracts to purchase or sell such ADSs, [between Aug. 2, 2011, and June 25, 2014].” The complaint asserts counts for violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (the “Exchange Act”). Strougo alleges that she and other owners of Barclays’ ADS were damaged when Barclays’ ADSs fell 7.38 percent the day after the NYAG announced its suit.

On July 31, 2014, Great Pacific Securities filed an investor class action against Barclays PLC, Barclays Capital Inc. and other unnamed defendants involved in the operation and marketing of Barclays’ dark pool.[11] The complaint is filed on behalf of Great Pacific Securities and “[a]ll persons and entities who, [from Jan. 1, 2011, to the present], were clients of Barclays and whose trades were submitted for potential execution in the [Barclays dark pool] and suffered harm as a result.”

The complaint states claims for concealment, unfair competition under California Bus. & Prof. Code § 17200, and false advertising under California Bus. & Prof. Code § 17500. Great Pacific Securities alleges that it and other investors were damaged when Barclays shared detailed information regarding orders in its dark pool with high‐frequency traders, who were then able to trade ahead of the investors, causing them to receive less favorable prices than they would have otherwise received.

While the pending dark‐pool investigations and lawsuits seek to ensure investors are adequately apprised of the extent of high‐frequency trading in dark pools, they do not seem to directly address the larger issue of whether high‐frequency trading in itself is illegal. This is perhaps an intentional strategy, as high‐ frequency trading is a polarizing issue: detractors characterize it as fraud while proponents argue that it provides desirable liquidity. By focusing on Barclays’ marketing of its dark pool, the current suits seek redress for investors harmed by high‐frequency trading without having to address the desirability of high‐ frequency trading itself.

One suit, filed on April 18, 2014, by the city of Providence, Rhode Island, confronts high‐frequency trading directly.[12] The complaint alleges that tactics used by high‐frequency traders, such as “electronic front‐ running” and “slow‐market (or latency) arbitrage,” constitute securities fraud. Additionally, the complaint alleges that exchanges committed securities fraud by selling high‐frequency traders special access to market data. Lastly, the complaint alleges that brokerages received kickbacks in exchange for routing their customers’ orders to trading venues they knew were “rigged” in favor of high‐frequency traders.[13]

Specifically, as to dark pools, the complaint alleges that brokerages place customer orders in dark pools and “leave them sitting there,” while prices on the broader market continue to change. This allows high‐ frequency traders and the brokerages’ own proprietary traders time to wait for price changes outside of the dark pool and then extract a profit by arbitraging the real‐time market price against the dark‐pool customer’s stale order price.[14]

The city of Providence seeks to represent itself and a sprawling class of “all public investors who purchased and/or sold shares of stock listed on a U.S.‐based exchange or alternate trading venue between April 18, 2009, and the present and were injured thereby,” asserts claims under Sections 6(b), 10(b), and 20(A) of the Exchange Act against various high‐frequency trading firms, exchanges and brokerages.

On its face, the city of Providence’s suit seems to present more challenging issues, both legally and evidentiary, than the other pending dark‐pool suits, which have their own challenges. However, the city’s lawsuit, if successful, would change the fundamental nature of how stocks are traded. In contrast, the other pending dark‐pool suits may lead brokerages to consider more fulsome or accurate disclosures of

the extent of high‐frequency trading in their dark pools, but seem less likely to rid dark pools or the larger market of high‐frequency trading. Nonetheless, by shining a critical light on high‐frequency trading within dark pools, the current lawsuits may very well evolve into a larger fight against high‐frequency trading — a fight that could lead to broad market reform.

—By David W. Beehler and Thomas F. Berndt, Robins Kaplan Miller & Ciresi LLP

David Beehler is a partner in Robins Kaplan's Minneapolis office and heads the firm’s financial industries group. He is also a member of the firm's executive board.

Thomas Berndt is an associate in the firm's Minneapolis office and practices in the firm’s financial industries group.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

[1] Complaint, Schneiderman v. Barclays Capital Inc., No. 4511391/2014 (N.Y. Sup. Ct. July 24, 2014).

[2] Michael Lewis, Flash Boys: A Wall Street Revolt (W.W. Norton & Co. 2014).

[3] Lewis, supra at 123.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Schneiderman v. Barclays Capital Inc., No. 451391/2014 (N.Y. Sup. Ct.).

[9] Max Colchester, John Letzing, & Eyk Henning, Deutsche Bank, UBS Sucked Into Dark‐Pools Trading Probe, THE WALL STREET JOURNAL, July 30, 2014.

[10] Strougo v. Barclays PLC, 14‐cv‐5797‐SAS (S.D.N.Y. 2014).

[11] Great Pacific Securities v. Barclays PLC, 8:14‐cv‐01210‐DDP‐SH (C.D. Cal. 2014).

[12] City of Providence v. BATS Global Markets Inc., 14‐cv‐2811‐JMF (S.D.N.Y.).

[13] Complaint at 2.