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From Securities Regulation Daily, May 29, 2013

NASDAQ Censured, Must Pay Record $10 Million to Settle SEC Charges Over Facebook IPO

By Mark S. Nelson, J.D.

The SEC today announced that The NASDAQ Stock Market, LLC (NASDAQ) and NASDAQ Execution Services, LLC (NES) have agreed to settle charges that they violated the Exchange Act and their own rules in dealing with trading disruptions during Facebook’s May 2012 initial public offering (IPO). The SEC censured NASDAQ and NES, ordered them to stop engaging in the charged conduct, and required both firms to take remedial actions. NASDAQ must pay a $10 million civil monetary penalty, which the SEC said is the largest fine ever paid by an exchange. Under the settlement, NASDAQ and NES neither admitted nor denied the SEC’s findings (Release No. 34-69655, May 29, 2013).

In a press release, George S. Canellos, Co-Director of the SEC’s Division of Enforcement, said “[t]his action against NASDAQ tells the tale of how poorly designed systems and hasty decision-making not only disrupted one of the largest IPOs in history, but produced serious and pervasive violations of fundamental rules governing our markets.”

According to Daniel M. Hawke, Chief, SEC Enforcement Division, Market Abuse Unit, the SEC focused its investigation of the Facebook IPO on NASDAQ’s systems design and the firm’s response to trading disruptions. “Too often in today’s markets, systems disruptions are written off as mere technical ‘glitches’ when it’s the design of the systems and the response of exchange officials that cause us the most concern,” said Mr. Hawke.

Background. The SEC’s order instituted cease and desist proceedings against NASDAQ and NES just over one year since one of the largest IPOs ever involving the social media company Facebook. According to the SEC, NASDAQ conducted pre-IPO testing of its systems and later announced that the Facebook display only period (DOP) would occur between 10:45 a.m. and 11:00 a.m. on May 18, 2012.

Next, the SEC said that by 10:58 a.m a large market-making broker-dealer had approached the lead underwriter of the Facebook IPO about getting the DOP extended. NASDAQ extended the DOP by 5 minutes in response to the underwriter’s request.

Trading in Facebook was to begin at 11:05 a.m., but instead began at 11:05:10 a.m. because a 10-second randomization delay feature had not been removed from NASDAQ’s systems. Facebook trading should have started immediately at 11:05 a.m. under NASDAQ Rule 4120. The ensuing attempts to repeatedly calculate price/volume figures led to new problems as cancellations escalated, forcing even more recalculations.

Senior NASDAQ officials soon called a “Code Blue” meeting to discuss the Facebook issues. As events unfolded, NASDAQ was initially unable to deliver confirmations for IPO cross orders. NASDAQ also violated its own Rule 4757 regarding price/time priority for certain “stuck” orders that NASDAQ (and its members) initially did not know had been erroneously left out of the cross. Related issues forced two halts in Zynga trading.

Violations. Although the SEC determined that it would not be in the public interest to impose limits on NASDAQ’s activities and that disruptions related to Facebook’s IPO did not constitute an emergency, the SEC still found numerous violations.

According to the SEC’s order, NASDAQ violated Exchange Act Section 19(g)(1) by failing to comply with its own rules that require execution of equally priced or better priced trading interest for 35,000 Facebook orders and 365 Zynga orders. NASDAQ’s inability to deal with its error account resulted in an error position involving 3 million Facebook shares valued at $129 million which produced a $10.8 million profit when the positions were closed through trading via NES.

The SEC separately charged that NASDAQ violated Rule 201(b) of Regulation SHO because its SHO Through application was disabled on nine trading days resulting in the failure of 4,400 short sales to meet the price test. NASDAQ’s disabling of the Trade Through application also violated related Regulation NMS Rule 611 because NASDAQ did not enforce its trade through polices on the affected trading days.

Lastly, the SEC charged that NES violated the net capital rule in Exchange Act Section 15(c)(3) and Rule 15c3-1. The violation arose from mishandling of the error account regarding Facebook trades, which resulted in a $26.5 million net capital deficiency.

Remedies. The SEC’s order censured NASDAQ and NES for their roles in trading disruptions that hit Facebook and Zynga orders during Facebook’s IPO. The SEC also ordered both firms to cease and desist from engaging in the charged conduct and ordered NASDAQ to pay a record civil monetary penalty of $10 million.

Additionally, NASDAQ’s CEO must certify in writing to the SEC that NASDAQ and NES have taken the prescribed remedial actions. These actions include amending NASDAQ Rule 4120 to provide for a randomization interval at the end of the DOP in the IPO cross and to provide for an underwriter DOP extension request. NASDAQ also must make technical enhancements to its trading technologies (including IPO/halt crosses), deploy change management software, and create a quality assurance organization that reports to the senior vice president, market systems, at NASDAQ OMX. NES must revise its supervisory procedures to ensure compliance with net capital rules.

Companies: Facebook; NASDAQ Execution Services, LLC; The NASDAQ Stock Market, LLC; Zynga

MainStory: TopStory Enforcement ExchangesMarketRegulation IPOs SecuritiesOfferings

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