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From Securities Regulation Daily, December 17, 2013

NASDAQ must defend certain securities fraud and negligence claims in Facebook IPO litigation, other claims dismissed on immunity grounds

By Amanda Maine, J.D.

A federal court granted motions to dismiss some negligence and securities fraud claims against NASDAQ relating to its role in Facebook’s initial public offering because NASDAQ acted in its regulatory capacity and was covered by self-regulatory organization (SRO) immunity. Other negligence and fraud claims could proceed, however, because NASDAQ was acting as a business and not in the public interest and was not therefore protected by immunity (In the Matter of Facebook Inc IPO Securities and Derivative Litigation, December 12, 2013, Sweet, R.).

Background. Facebook commenced its IPO on May 18, 2012. Trading on NASDAQ was set to open at 11:00 a.m., with a display-only period (DOP) occurring for 15 minutes starting at 10:45 a.m. A market maker had approached Facebook’s lead underwriter to extend the DOP to 11:05 a.m., which NASDAQ did. A delay of 10 seconds occurred, and ensuing attempts to calculate price/volume figures resulted in new problems. Cancellations escalated, forcing even more calculations. NASDAQ officials met to discuss issues relating to the Facebook IPO, but decided against halting trading. System failures had caused thousands of orders to remain “stuck” and unexecuted. The offering price to the public was $38.00 per share at opening, but closed at $31.00. Several "stuck" orders were prevented from selling due to the design error, which did not generate trade confirmations. The offline matching process did not execute any orders, and some investors were unable to close positions until trading began following Monday at inferior prices. In later SEC proceedings, NASDAQ was censured and ordered to pay $10 million to settle charges relating to the disruptions. Several investors brought securities fraud and negligence claims against NASDAQ and some of its executives, contending that their orders to purchase or sell Facebook stock were not properly executed or confirmed because of systems issues experienced by NASDAQ on the day of the Facebook IPO.

SRO immunity for technology negligence claims. The defendants argued that the plaintiffs’ claims arise out of NASDAQ’s actions within the scope of its regulatory responsibilities, and are therefore precluded under SRO immunity. The court addressed this contention in regards to the technology negligence claims and the claims relating to NASDAQ’s decision not to halt trading in Facebook securities.

The technology negligence claims related to the design, testing, and touting of NASDAQ’s software. According to the court, the defendants mischaracterized the technology negligence claims as arising from the commencement of the trading in Facebook and from NASDAQ’s decisions to proceed with and not to halt trading in Facebook. Instead, the technology negligence claims focus solely on the design, promotion, and inadequate testing of NASDAQ’s technology software prior to the offering, the court stated. They are not “regulatory actions,” such as suspending trading, banning traders, or carrying out disciplinary actions under its mandate to protect investors.

Instead, the court explained, actions regarding software design before an IPO or promotion of that software before trading commences are considered private, non-regulatory actions, and remain subject to liability. The court warned that allowing exchanges to be immune from decisions about the promotion and design of business systems implemented to increase trading volume would allow unrestrained motives for profit to go unchecked. “[T]he regulatory functions of NASDAQ…do not cloak NASDAQ's independent negligence in failing to adequately design and test its software with retroactive immunity,” the court held.

SRO immunity for halting trade negligence claims. In contrast, NASDAQ’s decision not to halt trading or cancel the impacted trades (the “halting trade negligence claims”) is protected by SRO immunity, according to the court. The court disagreed with the plaintiffs’ assertion that the decision was not regulatory because NASDAQ and its officers had treated the system failures as business issues and not issues reserved for the regulatory arm of the Exchange. To the contrary, the court stated, the capacity to suspend trading is a “quintessentially regulatory function,” and the decision was therefore protected by SRO immunity.

SRO immunity for securities fraud claims. In addition to the negligence claims, the plaintiffs’ also alleged that the defendants’ statements during both the pre-class period (prior to the IPO) and during the class period (during the IPO) were allegedly false and misleading in violation of the federal antifraud securities laws. The pre-class period statements, according to the complaint, touted and detailed the purported reliability and the speed of NASDAQ’s technology and trading platform capabilities, while omitting that prior testing had revealed significant systems limitations. None of these omissions, the court stated, related to NASDAQ’s statutorily delegated responsibility to protect investors; instead, the misleading statements were intended to secure the Facebook IPO, which serviced its own business, and not the government’s. This non-regulatory conduct by NASDAQ is not covered by SRO immunity, the court held.

The courts held, however, that the allegedly misleading statements by the defendants during the class period were incidental to NASDAQ’s regulatory functions and are subject to SRO immunity. The plaintiffs had argued that during the IPO, the defendants concealed the known technological errors NASDAQ was receiving and failed to disclose the magnitude of those problems. NASDAQ’s statements generated profit and advanced its business interest, and therefore cannot be protected as regulatory functions, the plaintiffs contended. The court, while acknowledging that these allegations were essential for pleading securities fraud, found that they were irrelevant to the issue of SRO immunity. The class period statements involve real time announcements of NASDAQ’s actions “regarding its regulatory decisions” to suspend, resume, or cancel trading. Being incidental to its regulatory function, the statements made by NASDAQ during the IPO are shielded by SRO immunity, according to the court.

Motions to dismiss. Given the above, the court granted the defendants’ motions to dismiss the halt trading negligence claims and the securities fraud class period statement claims on grounds of immunity. However, the motions to dismiss the technology negligence claims and the pre-class period securities fraud claims were denied. Regarding the technology negligence claims, the court found that the plaintiffs sufficiently alleged that NASDAQ had a duty to design and test its systems to ensure they could handle Facebook’s opening day trading, and that its failure to fulfill this duty proximately caused the damages alleged by the plaintiffs.

Regarding the pre-class period statements, the court found that the plaintiffs adequately alleged that the defendants had (1) made misstatements or omissions of material fact; (2) with scienter; (3) in connection with the purchase or sale of securities; (4) upon which plaintiffs relied; and (5) that plaintiffs' reliance was the proximate cause of their injury. The court rejected the defendants’ argument that the statements were vague, forward-looking statements of optimism, but involved the representation of existing facts about NASDAQ’s reliability. The failure to correct the misleading statements constituted a material omission because the correct information could have impacted a reasonable investor’s decision to participate in the Facebook offering, the court stated.

In addition, the plaintiffs adequately pleaded scienter under the Private Securities Litigation Reform Act because the allegations, which include an insider’s purported knowledge about NASDAQ’s faulty system, demonstrate that the defendants knew or should have known they need to correct prior statements to render them not materially misleading. The defendants' failure to adequately test and monitor their systems, in light of the anticipated trade volumes and their statements claiming ensured reliability, constitutes scienter, the court held. In addition, plaintiffs met the reliance element because reliance is presumed in actions involving “primarily a failure to disclose.” Finally, the complaint adequately details how the plaintiffs’ damages were caused by their “inability to trade on a fair and functioning system” and were within the "zone of risk concealed" by the defendants, the court held.

The case is No. MDL 12-2389.

Attorneys: Andrew J Entwistle (Entwistle & Cappucci LLP) for Avatar Securities, LLC. Christopher Lovell (Lovell Stewart Halebian Jacobson LLP), Douglas G. Thompson (Finkelstein,Thompson & Loughran), Jacob H. Zamansky (Zamansky & Associates LLC) for Meredith Bailey, Dmitri Bougakov, Ryan Cefalu, First New York Securities L.L.C. Lorrain Chin is pro se. Darryl M. Bloodworth (Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, PA), Margaret Osborne Padilla (Ballard Spahr LLP) for The NASDAQ Stock Market L.L.C., NASDAQ OMX Group, Inc., Barclays Capital Inc., Facebook, Inc. Andre G. Bouchard (Bouchard, Margules & Friedlander, P.A.), Samantha Harper Knox (Davis Polk & Wardwell LLP) for Goldman, Sachs & Co.; J.P. Morgan Securities LLC., Merrill Lynch Pierce Fenner & Smith Inc., Morgan Stanley & Co, Inc., Allen & Company LLC., BMO Capital Markets Corp.

Companies: Avatar Securities, LLC; First New York Securities L.L.C.; The NASDAQ Stock Market L.L.C.; NASDAQ OMX Group, Inc.; Barclays Capital Inc.; Facebook, Inc.; Goldman, Sachs & Co.; J.P. Morgan Securities LLC.; Merrill Lynch Pierce Fenner & Smith Inc.; Morgan Stanley & Co, Inc.; Allen & Company LLC; BMO Capital Markets Corp.

MainStory: TopStory IPOs DirectorsOfficers ExchangesMarketRegulation FraudManipulation SecuritiesOfferings NewYorkNews

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