Following the March 31, 2014 release of Flash Boys by Michael Lewis, an all-too-familiar story is playing out on Wall Street, this time focusing on high frequency trading (“HFT”). As in past financial scandals, the publicity surrounding HFT has fueled a growing wave of regulatory activity followed by investor lawsuits, and could result in significant claims under financial institution insurance policies. To date, these matters have arisen in the US, but similar investigations and lawsuits may eventually spread to other jurisdictions. This article discusses HFT practices, the regulatory response, investor lawsuits and the potential impact on financial institution insurers.
High Frequency Trading practices
HFT involves the use of technological tools and computer algorithms to rapidly trade securities. In order to capture small profits on a large volume of trades, traders utilise trading models and computer programs to move in and out of positions in fractions of a second. This allows HFT firms to make enormous profits with virtually no risk.
Proponents contend that HFT benefits securities markets by increasing liquidity and leveling the playing field. Regulators and investors, however, allege that HFT firms often employ HFT with other strategies to electronically manipulate securities markets and obtain improper gains, including “front-running”, “trading ahead”, “latency and rebate arbitrage”, “co-location”, “pinging”, “spoofing” or “layering”, and “contemporaneous trading.” While not all of these practices are illegal, they may constitute violations if used to manipulate the markets.
Regulatory investigations and actions
Long before Flash Boys, HFT was the subject of regulatory scrutiny. In early-2009, analysts questioned whether HFT firms had an unfair advantage, and the SEC considered the need for tighter controls on HFT.
On May 6, 2010, US stock markets lost and then recovered hundreds of points, all within a few minutes. Regulators later determined that HFT firms exacerbated the price declines and some commentators blamed HFT as the cause. This so-called “flash crash” further increased regulators’ interest in HFT.
Following Flash Boys, authorities further increased their scrutiny of HFT and particularly the use of privately- owned alternative stock trading platforms called “dark pools.” In March 2014, New York Attorney General Eric Schneiderman (the “NYAG”) announced an investigation into HFT practices as part of his “insider trading 2.0” initiative, and shortly after issued subpoenas to HFT firms regarding dark pools. The FBI and CFTC are also examining HFT practices, and the SEC has disclosed that it has multiple ongoing investigations into dark pools. Congress has held a number of hearings on HFT, and new HFT regulations are expected.
On June 25, 2014, the NYAG announced that he had filed fraud charges against Barclays for alleged misrepresentations it made to clients trading in its dark pool. The NYAG contends that Barclays reassured those clients that it would protect them from predatory HFT while it actively sought to attract such traders to its dark pool.
At least three other European banks, UBS, Deutsche Banc and Credit Suisse, have reported that the NYAG is examining their dark pools.
Private civil lawsuits
Predictably, HFT quickly caught the attention of the plaintiffs bar in the spring of 2014. Investors have already filed an increasing number of lawsuits across the US against exchanges, brokerage firms and HFT firms.
On April 18, 2014, the City of Providence filed an ambitious lawsuit (the “Providence Action”) on behalf of a massive plaintiff class against 16 stock exchanges, 14 brokerage firms and 12 HFT firms in the Southern District of New York (“SDNY”). The court later consolidated three similar lawsuits with the Providence Action.
Many of the allegations in the initial complaints closely tracked Flash Boys. The plaintiffs essentially alleged that by utilising non-public information and manipulating the securities markets through HFT, the defendants diverted billions of dollars from investors. The complaint described various types of manipulative, self-dealing and deceptive conduct, and alleged that the defendants paid each other kick-backs.
On September 2, 2014, five lead plaintiff institutional investors filed an amended complaint in the Providence Action. The amended complaint dropped many of the defendants, but named Barclays and seven stock exchanges. The allegations focus on the exchanges and Barclays’ operation of its dark pool. According to the amended complaint, the defendants “paved the way” and incentivised the illicit activity of high frequency traders, allowing them to “prey on less sophisticated investors.” The lead plaintiffs seek to represent a broad class of investors who traded on the defendant exchanges or in Barclay’s dark pool between April 18, 2009 and the present.
The amended complaint asserts causes of action for violations of §§10(b) and 6(b) of the Exchange Act and SEC Rule 10b-5, and seeks, among other things, unspecified compensatory damages, restitution, disgorgement and forfeiture of illicit fees.
At the pleading stage of the Providence Action, the plaintiffs will need to overcome significant hurdles. Motions to dismiss are due on October 31, 2014, and the defendants will likely argue for dismissal on a number of grounds. For example, the defendants may argue that the amended complaint does not allege actionable misrepresentations or omissions as many of the practices were disclosed or otherwise known to investors. Also, the defendants may argue that their conduct was not manipulative and the plaintiffs have not sufficiently pled fraudulent intent as many of the alleged practices are not prohibited under applicable regulations, have been approved by the SEC, and benefit the markets and investors. Further, statute of limitation defences may apply as much of the alleged conduct occurred at an early date and may have been known to investors. With respect to the §6(b) claim, the defendants may argue that there is no private right of action under that provision.
If the amended complaint survives a motion to dismiss, the plaintiffs will have other significant challenges before trial, including class certification and the defendants’ summary judgment motions. In particular, the plaintiffs may not be able to demonstrate that common class-wide issues predominate over individual issues with respect to the broad plaintiff class. Also, it may be difficult for the plaintiffs to prove causation and damages.
Investors have filed additional securities class actions against Barclays, as well as separate lawsuits against stock exchanges for securities law violations, breach of contract, common law fraud, aiding and abetting, constructive trust, unjust enrichment and violations of the Sherman Antitrust Act and the Commodity Exchange Act.
Plaintiffs will likely file new lawsuits in the wake of regulatory actions and further disclosures about HFT practices, and continue to test different theories of liability and damages in various courts across the US.
Potential impact on insurers
Financial institutions and exchanges targeted by HFT regulatory investigations and investor lawsuits may seek insurance coverage under D&O, Professional Indemnity and other policies. While these matters are in their preliminary stages and the ultimate exposure is difficult to predict, those entities might seek reimbursement of significant defence costs and sizeable settlements or judgments.
Depending, of course, on the particular circumstances and contract terms, a number of coverage defences may arise. For example, in view of the early regulatory activity, coverage defences may arise relating to the timing of the conduct and the insured’s prior knowledge, including whether the claim was first made in the policy period, whether notice was timely and whether the insured disclosed HFT risks in the underwriting of the policy. As many of the lawsuits seek disgorgement or restitution and allege fraud, whether the claims allege insurable “Loss” or are barred by public policy may be significant issues.
Further, the HFT matters may trigger a number of policy exclusions, including with respect to, among other things, dishonest or fraudulent acts, improper personal gain or advantage, professional services, regulatory claims, notice to prior insurers and prior wrongful acts. Finally, additional coverage issues may arise with respect to other insurance clauses and allocation of costs between covered and uncovered loss or parties.
In view of the potential exposure and related coverage claims, financial institution insurers should closely track developments with respect to HFT litigation, regulatory actions and new regulations.