Citadel Sec., LLC v. Chi. Bd. Options Exch., Inc.

• Decision Date: 11 December 2015
• Docket Number: 14–3071.,Nos. 14–2912,s. 14–2912
• Citation: 808 F.3d 694
• Parties: CITADEL SECURITIES, LLC, et al., Plaintiffs–Appellants, v. CHICAGO BOARD OPTIONS EXCHANGE, INC., et al., Defendants–Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

808 F.3d 694

CITADEL SECURITIES, LLC, et al., Plaintiffs–Appellants,

v.CHICAGO BOARD OPTIONS EXCHANGE, INC., et al., Defendants–Appellees.

Nos. 14–2912

14–3071.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 12, 2015.

Decided Dec. 11, 2015.

Stephen Bedell, Attorney, David B. Goroff, Attorney, Ellen M. Wheeler, Attorney, Foley & Lardner LLP, Chicago, IL, for Plaintiffs–Appellants. Paul E. Greenwalt, III, Attorney, Paul E. Dengel, Attorney, Schiff Hardin LLP, Terrence Patrick Canade, Attorney, Locke Lord Edwards LLP, David J. Chizewer, Attorney, Goldberg Kohn Ltd., Chicago, IL, Douglas R. Cox, Attorney, Gibson, Dunn & Crutcher LLP, Washington, DC, Douglas W. Henkin, Attorney, Milbank, Tweed, Hadley & McCloy, New York, N.Y., for Defendants–Appellees.

Before BAUER, FLAUM, and MANION, Circuit Judges.

FLAUM, Circuit Judge.

Plaintiffs Citadel Securities, LLC, et al., sued defendants Chicago Board Options Exchange, Inc., et al., in Illinois state court, seeking to recover fees they claim were improperly charged to and paid by plaintiffs to defendants under defendants' "payment for order flow" programs. Defendants removed the case to federal district court. The district court dismissed the case for lack of subject matter jurisdiction based on plaintiffs' failure to exhaust administrative remedies. Plaintiffs appeal the district court's dismissal of the case as well as the denial of their motion to remand. We affirm.

I. Background

Defendants are national securities exchanges registered with the U.S. Securities and Exchange Commission ("SEC").¹ They operate as self-regulatory organizations ("SROs") that regulate markets in conformance with securities laws under the Securities Exchange Act of 1934, 15 U.S.C. §§ 78a et seq. (1934) ("Exchange Act"). The Exchange Act requires exchanges to adopt rules governing the conduct and administration of the exchanges and their members. See 15 U.S.C. §§ 78f(b), 78s(b). Specifically, the rules of the exchange must "provide for the equitable allocation of reasonable dues, fees, and other charges among its members and issuers and other persons using its facilities." § 78f(b)(4). The SEC has broad authority to amend the rules of SROs. See § 78s(c).

Plaintiffs are securities firms and members of the defendant exchanges.² They operate as "market makers" under the exchanges' rules. Market makers compete for customer order flow by displaying buy and sell quotations for particular stocks.

Between at least January 2004 and June 2011, each defendant charged "payment for order flow" ("PFOF") fees. PFOF is an arrangement by which a broker receives payment from a market maker in exchange for sending order flow to them. These fees are imposed to attract order flow to a market, thereby increasing liquidity in that market. Each defendant exchange imposes PFOF fees on a market maker when a trade is made for a "customer"; however, these fees are not imposed for proprietary "house trades," where a firm trades on its own behalf.

Defendants have adopted rules creating the PFOF programs, as required under the Exchange Act. According to the SEC, the rules creating the PFOF programs are "designed to ensure that market makers that may trade with customers on the exchange contribute to the cost of attracting that order flow." Competitive Developments in the Options Markets, 69 Fed.Reg. 6,124, 6,129 (Feb. 9, 2004).

We briefly note the origins of PFOF fees in order to place this case in historical context. PFOF fees recently became commonplace due to the advent of "multiple listing." See id. at 6,128 –29. Until 1999, most actively traded options were listed on only one exchange. Id. In 1989, the SEC adopted Exchange Act Rule 19c–5, which promoted the listing of options on more than one exchange, enhancing competition among options exchanges. Id. at 6,125. The SEC has noted that PFOF "arrangements principally benefit intermediaries in the first instance, which may or may not pass on those benefits to their customers." Id. at 6,128. The SEC has also expressed concern that PFOF fees may create a conflict of interest between exchanges' own interests as profit-making entities and their regulatory responsibilities. Id. at 6,130.

Plaintiffs allege that between 2004 and 2011 defendants charged PFOF fees on millions of orders not properly subject to those fees. They claim that a broker-dealer—which remains unidentified, is referred to by the parties only as the "Subject Firm," and is not a defendant in this case—incorrectly marked plaintiffs' stock option orders, resulting in payment of PFOF fees in contravention of various exchange rules. Upon discovering the Subject Firm's errors, defendants entered into stipulations and letters of consent whereby the Subject Firm paid them penalties and all previously uncollected transaction fees due on non-customer orders. Plaintiffs seek restitution or recovery from defendants of all fees that were allegedly mischarged.

Plaintiffs sued defendants in the Circuit Court of Cook County, Illinois. Defendants then removed the case to federal district court. Plaintiffs moved to remand to state court, claiming that no federal question was presented. The district court denied plaintiffs' motion to remand, finding that jurisdiction under § 78aa was proper.

Defendants then moved to dismiss for: lack of subject matter jurisdiction based on failure to exhaust administrative remedies, absolute immunity, lack of private right of action, and failure to state a claim. On August 4, 2014, the district court found that plaintiffs had failed to exhaust their administrative remedies and dismissed the case without prejudice for lack of subject matter jurisdiction. Plaintiffs appeal.

II. Discussion

A. Failure to Exhaust Administrative Remedies

We first turn to plaintiffs' argument that the district court erred in dismissing the suit. In general, we review de novo a district court's grant of a motion to dismiss for lack of subject matter jurisdiction. Shawnee Trail Conservancy v. U.S. Dep't of Agric., 222 F.3d 383, 385 (7th Cir.2000). However, the district court based its dismissal on plaintiffs' failure to exhaust administrative remedies. We have held that "the decision to require exhaustion as a prerequisite to bringing suit is a matter within the discretion of the trial court and may be disturbed on appeal only when there has been a clear abuse of discretion." Id. at 389 (citation and internal quotation marks omitted). We "accept as true all well-pleaded factual allegations and draw reasonable inferences in favor of the plaintiff[s]." Capitol Leasing Co. v. F.D.I.C., 999 F.2d 188, 191 (7th Cir.1993).

The district court observed that the Exchange Act provides a comprehensive administrative review process for decisions rendered by exchanges. The court explained that final rulings issued by an exchange are subject to administrative review by the SEC. Looking to the terms of the statute, the district court also noted that an aggrieved party dissatisfied with the SEC's determination can obtain further review from a federal appellate court. Ultimately, the district court concluded that plaintiffs had failed to demonstrate that they have no meaningful administrative remedy.

Plaintiffs present two main arguments on appeal. First, they argue that because defendants acted outside of their regulatory function and solely in their private capacity as for-profit entities, there is no need for exhaustion of remedies before the SEC. Second, plaintiffs argue that exhaustion is not required because the SEC cannot provide adequate relief.

1. Application of the Exhaustion Requirement

We agree with the district court that plaintiffs seek to enforce defendants' own rules promulgated under the Exchange Act. Plaintiffs claim that PFOF fees serve purely a private function and are not created pursuant to any regulatory authority, thus the exhaustion requirement does not apply. We are not convinced by this argument. Section 78s(h)(1) authorizes the SEC to "censure or impose limitations upon the activities, functions, and operations of" a national security exchange if it "finds, on the record after notice and opportunity for hearing, that [the exchange] has violated or is unable to comply with any provision of this chapter, the rules or regulations thereunder, or its own rules or without reasonable justification or excuse has failed to enforce compliance...." Id. (emphasis added).

Given that the plain language of the Exchange Act calls for SEC review of plaintiffs' allegations of improper PFOF fees, the district court did not abuse its discretion in holding that plaintiffs are required to exhaust administrative remedies. There is little question that the PFOF fees are imposed pursuant to defendants' own rules: Defendants announced the PFOF fees as "proposed rule changes" published in the Federal Register.³ The fees became effective upon announcement and remained in place because the SEC did not take any action to abrogate them. See § 78s(b)(3)(A)(ii). Consequently, PFOF fees are rules with which defendants must comply, subject to SEC enforcement.

Moreover, we are not persuaded by the case law plaintiffs present to show that rules imposing PFOF fees fall outside of defendants' regulatory function. Plaintiffs rely heavily on In re Facebook, Inc., IPO Sec. & Derivative Litig., 986 F.Supp.2d 428, 452–53 (S.D.N.Y.2013), where the district court acknowledged changes wrought by the widespread transformation of financial exchanges from non-profit mutual companies to for-profit, publicly listed organizations (known as "demutualization"). Specifically, the court identified the potential for conflict between exchanges' profit motive and their regulatory duties. Id. at 453. The Facebook court raised important concerns about the application of "blanket protection for exchanges when they fail to exercise due care in their pursuits of profit," but it did so in the context of questions raised about SRO immunity. Id. at 453–54. The Facebook court held that...