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From Securities Regulation Daily, April 22, 2016

Court dismisses allegations of market manipulation against Philadelphia exchange, market makers

By Kevin Kulling, J.D.

A federal court in Pennsylvania has dismissed a class action complaint that alleged the Philadelphia Stock Exchange and several market makers engaged in market manipulation and conspired to deprive investors of dividends the investors expected to receive. The court held that the exchange was shielded by immunity, while claims against the market makers failed to state a claim for fraud (Rabin v. NASDAQ OMX PHLX LLC, April 21, 2016, McHugh, G.).

Theory of complaint. The class action complaint was filed on behalf investors who claimed they suffered damages when market makers on the options market of the Philadelphia Stock Exchange (NASDAQ OMX PHLX) allegedly manipulated options in advance of dividend payments on underlying stock and exchange traded funds for their personal benefit to the detriment of all other options investors during the class period.

The complaint alleged that market makers damaged other writers of call options by executing among themselves pre-arranged manipulative matched options trades on an underlying security immediately prior to the date for that security's dividend payment. The result was that the market makers improperly obtained dividends that would have been paid to investors in the class. The complaint alleged that the market makers improperly used their privileged regulatory status as market makers to make the manipulative trades.

I. Stephen Rabin, the investor who brought the complaint, alleged that the market makers manipulated the options clearing system. By way of example, Rabin claimed he was injured as a result of manipulation of the options contracts in Pfizer, Inc. Rabin said that the market makers inflated the size of the options open interest pool for Pfizer stock by flooding the market with over a million additional option contracts one day before the ex-dividend date of common stock. The result of the manipulation was to ensure that the bulk of dividend payments would be directed to the market makers rather than to Rabin and other class members.

SRO immunity. The claim against the Philadelphia exchange, which is a self-regulatory organization (SRO) registered with the SEC, was dismissed on immunity grounds. In analyzing SRO immunity, the court looked at fee caps created by the exchange. The exchange allegedly created a cap on fees that market makers must pay for trading on the market. The cap made the massive options trades feasible because without the cap the trades would be too expensive to make money and the exchange enacted the fee cap specifically to enable the market makers to deprive plaintiff of expected dividends, according to the complaint.

But the court determined that enacting the fee cap was a regulatory function. The exchanges regulate trading, and that must include regulating fees that should or should not be paid for certain transactions, the court said. The fee cap was nothing like a product that the exchange developed and marketed. The fact that the exchange earned a profit on the volume of trading that was facilitated by the fee cap was not enough to render the establishment of the cap commercial as opposed to regulatory activity, the court said. The regulatory activity was immune, according to the court.

Sufficiency of 10(b) claim. The court concluded that Rabin also failed to establish all the elements needed for a successful fraud allegation against the remaining market maker defendants.

The court said that the alleged conduct did not fall within the definition of manipulation that applies to claims brought under Section 10(b)’s implied right of action. The conduct must involve price manipulation, the court said.

Here, the complaint did not allege that defendants injected false information into the market. Fundamentally, the complaint claimed that the defendants abused the advantages conferred on them as market makers by regulations and OCC practices. Rabin claimed that by making dividend plays the defendants created the false impression of market activity.

But the court did not agree with Rabin’s characterizations. The court said that it was not persuaded that the market activity generated by the market makers was false.

Manipulation requires the injection of false information into a market or the creation of a false impression of supply and demand. Rabin did not allege manipulation that meets the definition.

Reliance, scienter not established. The court said that the plaintiff failed to adequately allege reliance or that the market makers possessed scienter. It was equally plausible, the court said, that the market makers believed they were engaging in a completely legal trading strategy.

The court said that fraudulent scienter requires more than intentional conduct. It requires willful intention to engage in wrongful conduct in the inception of the act.

The case is No. 15-cv-00551.

Attorneys: David J. Stone (Bragar Wexler Eagel & Squire, PC) for I. Stephen Rabin. Stephen J. Kastenberg (Ballard Spahr LLP) for Nasdaq OMX PHLX LLC and Nasdaq OMX Group, Inc. David C. Bohan (Katten Muchin Rosenman LLP) for Bedrock Trading Ltd. Christopher M. Hohn (Thompson Coburn) for Bluefin Trading, LLC.

Companies: Nasdaq OMX PHLX LLC; Nasdaq OMX Group, Inc.; Bedrock Trading Ltd.; Bluefin Trading, LLC

MainStory: TopStory ExchangesMarketRegulation FraudManipulation PennsylvaniaNews

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