In re Nyse Specialists Securities Litigation

Decision Date18 September 2007
Docket NumberDocket No. 06-1038-cv.
Citation503 F.3d 89
PartiesIn re NYSE SPECIALISTS SECURITIES LITIGATION. California Public Employees' Retirement System, and Empire Programs, Inc., Lead Plaintiffs-Appellants, v. New York Stock Exchange, Inc., Defendant-Appellee.<SMALL><SUP>*</SUP></SMALL>
CourtU.S. Court of Appeals — Second Circuit

Eric Alan Isaacson (William S. Lerach, Mark Solomon, Byron S. Georgiou, William J. Doyle II, Tami Falkenstein Hennick, Lucas F. Olts, on the brief), Lerach Coughlin Stoia Geller Rudman & Robbins LLP, San Diego, CA; and Christopher Lovell, Imtiaz A. Siddiqui, on the brief, Lovell Stewart Halebian LLP, New York, NY, for Lead Plaintiffs-Appellants.

Debra M. Torres, Fried, Frank, Harris, Shriver & Jacobson LLP, New York, NY, for Defendant-Appellee.

Before: JACOBS, Chief Judge, LEVAL and SOTOMAYOR, Circuit Judges.

SOTOMAYOR, Circuit Judge:

Lead plaintiffs-appellants California Public Employees' Retirement System ("CalPERS") and Empire Programs, Inc. ("Empire") (collectively "Lead Plaintiffs") appeal from a judgment of the United States District Court for the Southern District of New York (Sweet, J.), In re NYSE Specialists Secs. Litig., 405 F.Supp.2d 281 (S.D.N.Y.2005) ("In re NYSE Specialists"), granting defendant-appellee New York Stock Exchange, Inc.'s (the "NYSE" or the "Exchange") motion to dismiss Lead Plaintiffs' claims that the NYSE failed to regulate and provide a fair and orderly market and their claim under Rule 10b-5, 17 C.F.R. § 240.10b-5, that the NYSE made misrepresentations about the integrity of its market, upon which Lead Plaintiffs relied in trading on the NYSE. Lead Plaintiffs argue that the district court erred in finding that the NYSE is entitled to absolute immunity because, having abandoned its regulatory role to maintain a fair and orderly market, the NYSE was not acting consistently with the quasi-governmental powers delegated to it when it permitted and encouraged misconduct and fraud on its trading floor. Lead Plaintiffs further contend that the district court erred by finding that they lacked standing under Rule 10b-5 to bring suit against the Exchange for purported misrepresentations about its integrity and internal operations, upon which Lead Plaintiffs relied in trading on the NYSE. For the reasons to be discussed, we affirm the judgment of the district court as to the NYSE's absolute immunity for its alleged regulatory failures, but vacate the district court's ruling that Lead Plaintiffs lacked standing under Rule 10b-5 and remand for further proceedings consistent with this opinion.


Because this appeal challenges the grant of a motion to dismiss, we must take the facts alleged in the complaint as true, drawing all reasonable inferences in Lead Plaintiffs' favor. See Port Washington Teachers Ass'n v. Bd. of Educ. of Port Washington Union Free Sch. Dist., 478 F.3d 494, 498 (2d Cir.2007). Taken in this light, the facts are as follows.

The NYSE is registered with the Securities and Exchange Commission ("SEC") as a national securities exchange pursuant to section 6 of the Exchange Act, 15 U.S.C. § 78f. As a registered exchange, the NYSE is deemed by the Exchange Act a self-regulatory organization ("SRO"), see 15 U.S.C. § 78c(a)(26), which means that the Exchange "has a duty to promulgate and enforce rules governing the conduct of its members." Barbara v. N.Y. Stock Exch., Inc., 99 F.3d 49, 51 (2d Cir.1996). We have previously noted that the SEC has delegated to the NYSE "substantial authority . . . to regulate [its] own conduct and that of [its] members." MFS Secs. Corp. v. N.Y. Stock Exch., 277 F.3d 613, 615 (2d Cir.2002).

The NYSE and the Specialist Firms

According to the complaint, the NYSE was at all times relevant to the action (the "Class Period") a nonprofit corporation, charged with overseeing the world's largest stock exchange, which lists over 2,800 publicly traded companies.1 The NYSE is organized under the principle that investors in the companies traded on its floor, whether individual or institutional, are entitled to equal opportunities to interact and receive the best prices available on their trades. Because the Exchange itself does not execute the actual trading in these 2,800 companies, it facilitates this auction market by funneling trades through seven Specialist Firms (the "Specialist Firms" or the "Firms"), which are charged with managing "the stocks assigned to them to create a fair, competitive, orderly and efficient market." Consolidated Compl. ¶ 37.

Each security listed for trading on the NYSE is assigned to a particular Firm. To execute purchases and sales of a particular security, buyers and sellers must present their bids to buy and offers to sell to the specific Specialist Firm assigned to that security. The primary method of trading on the Exchange occurs through the NYSE's Super Designated Order Turnaround System, which transmits orders to buy and sell to the Specialist Firm electronically. The orders appear on a special electronic workstation often referred to as the "display book." Each Specialist Firm has a computerized "display book" at its trading post that permits the Firm to execute orders for the market.

By acting as either the agent for investors or principal for itself in the sale and purchase of the individual securities to which they are each assigned, the Firms are required to make and display continuous two-sided quotations that accurately reflect prevailing market conditions in order to maintain a liquid and continuous two-sided public auction. When acting as agent, the Specialist Firms match the orders of buyers and sellers, whose bids and offers appear on the display book, and thus ensure the timely execution of trades at the best available price. When acting as principal, the Specialist Firms

[a]re permitted to execute, in certain limited circumstances, trades on a "principal" or "dealer" basis, when required to do so to maintain a fair and orderly market. In such circumstances, such as if there were no matching orders to sell and orders to buy, the specialist was permitted to execute an investor's order to buy stock by selling the stock from the specialist's proprietary account, or "inventory" of stock, to the investor. Additionally, the specialist was permitted to execute an investor's order to sell stock by buying that stock and holding the stock in the investor's inventory.

In re NYSE Specialists, 405 F.Supp.2d at 290.

The substantial powers of, and the near-total control exercised by, the Specialist Firms over any given stock on the NYSE create an opportunity to manipulate the market for self-gain. The complaint alleges that "[t]he Specialist Firm is constantly in a position to trade for its own proprietary accounts while in possession of material non-public information regarding the supply and demand for a given stock, in part through its knowledge of existing but unexecuted" orders. Consolidated Compl. ¶ 52.2 Cognizant of this risk, the Exchange has promulgated internal rules that govern the conduct of Specialist Firms, including rules that require the Firms to "adhere to the principles of good business practice," NYSE Rule 401(a), and rules that prohibit any Firm from trading on its own account unless it is reasonably necessary to maintain a fair and orderly market, see, e.g., NYSE Rule 104(a) ("No [Specialist Firm] shall effect on the Exchange purchases or sales of any security in which such [Firm] is registered, for any account in which [it] . . . is directly or indirectly interested, unless such dealings are reasonably necessary to permit such [Firm] to maintain a fair and orderly market . . . ."). Thus, Lead Plaintiffs allege that the rules require the Firms to act as principal only in the limited situations where doing so is necessary to maintain a fair and orderly market.

Lead Plaintiffs allege that during the Class Period, the Specialist Firms actively took advantage of their unique position to self-deal and that the NYSE neglected or abandoned its regulatory duties and oversight of the Specialist Firms by permitting and in some cases encouraging blatant self-dealing. Through "wide-ranging manipulative, self-dealing, deceptive and misleading conduct," the Firms and the Exchange allegedly violated several sections of the Exchange Act, SEC rules, and the NYSE's own rules and regulations. In the complaint, Lead Plaintiffs alleged five types of misconduct, the first four of which involve the NYSE either turning a blind eye to, or actively encouraging, the Firms' self-dealing:

"Interpositioning," whereby a Specialist Firm prevented the normal agency trade between matching public orders and instead interposed itself between the matching orders in order to generate profits for itself.

"Trading ahead," in which a Specialist Firm undertook trades for its own account before undertaking trades for public investors. Because the Specialist Firm knew how the public investors' orders would impact the stock price, it used this confidential knowledge to its own commercial advantage.

"Freezing the book," whereby a Specialist Firm froze its display book for a given stock in order to engage in trades for its own account first before undertaking any orders for public investors.

• Manipulating the "tick," whereby a Specialist Firm changed the price of the stock to affect principal trades.

The fifth type of misconduct alleged by Lead Plaintiffs involves the effort to conceal evidence of the Specialist Firms' malfeasance, in which the NYSE actively sought to help the Firms skirt or violate the securities laws by, inter alia, falsifying reports, tipping off Specialist Firms to impending investigations, and covertly encouraging misconduct. This wide-ranging fraudulent scheme allegedly resulted in hundreds of millions of dollars in illicit profits for the Firms and the NYSE.

The SEC Report and Enforcement Actions Against the NYSE and Specialist Firms

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