Two-Sided Loyalty - Exploring The Boundaries of Fiduciary Duties of Market Makers - Dolgopolov 2012

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A TWO-SIDED LOYALTY?: EXPLORING THE BOUNDARIES OF FIDUCIARY DUTIES OF MARKET MAKERS

STANISLAV DOLGOPOLOV ABSTRACT This Article explores the boundaries of fiduciary duties of market makers established by the federal courts and evaluates these boundaries in the light of the changing economics and institutional framework of providing liquidity in securities markets and the current regulatory agenda. Given a variety of business models and trading strategies employed by these market participants in order to provide liquidity and their potentially multiple roles in securities markets, this Article identifies various factors set by the federal courts suggesting the existence of a fiduciary duty. The Article also considers whether certain practices of market makers integral to the function of providing liquidity may give rise to a fiduciary duty and examines corresponding potential consequences. TABLE OF CONTENTS INTRODUCTION ...................................................................................................... 32 I. THE REACH OF FIDUCIARY DUTIES TO THE FUNCTION OF PROVIDING LIQUIDITY ................................................................................................... 35 II. VARIOUS FACTORS SUGGESTING THE EXISTENCE OF A FIDUCIARY DUTY ......... 46 III. CERTAIN PRACTICES OF MARKET MAKERS INTEGRAL TO THE FUNCTION OF PROVIDING LIQUIDITY THAT MAY GIVE RISE TO A FIDUCIARY DUTY ......... 51 IV. THE SIGNIFICANCE OF THE CHANGING ECONOMICS AND INSTITUTIONAL FRAMEWORK OF PROVIDING LIQUIDITY IN SECURITIES MARKETS AND THE CURRENT REGULATORY AGENDA ........................................................ 54 V. SEVERAL LEGAL ISSUES RELEVANT TO MARKET MAKERS WITH RESPECT TO THEIR REGULATORY ENVIRONMENT AND CIVIL LIABILITY ......................... 60 CONCLUSION ......................................................................................................... 63
J.D. (the University of Michigan), M.B.A. (the University of Chicago), B.S.B.A. (Drake University), member of the North Carolina State Bar. The author thanks Henry G. Manne for his guidance in life and Vladislav Dolgopolov, Christal Phillips, Larry E. Ribstein, and Sandra Zeff for their help, comments, and expertise.
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INTRODUCTION The federal courts have repeatedly encountered the controversy regarding the nature of fiduciary duties1 owed to individual market participants by market makers,2 entities that formally or informally provide liquidity in securities markets under different names, such as specialists, dealers, designated market makers, or liquidity providers, in exchange for revenues from bid-ask spreads and, in some cases, liquidity rebates offered by trading venues.3 One issue in the case law and concomitant public policy analysis is whether a fiduciary duty attaches to the function of providing liquidity as such. An intertwined issue addresses heightened duties, such as a fiduciary duty, of securities firms that serve as market makers in addition to their other functions. These issues are exemplified by the recent high-profile controversy relating to Goldman Sachss involvement in numerous structured finance transactions, notably the ABACUS 2007-AC1 deal,4 as the firm had repeatedly
For a selective mix of general sources on fiduciary duties, see TAMAR FRANKEL, FIDUCIARY LAW (2010); Robert Cooper & Bradley J. Freedman, The Fiduciary Relationship: Its Character and Economic Consequences, 66 N.Y.U. L. REV. 1045 (1991); Frank H. Easterbrook & Daniel R. Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425 (1993); Larry E. Ribstein, Fencing Fiduciary Duties, 91 B.U. L. REV. 899 (2011); Robert H. Sitkoff, The Economic Structure of Fiduciary Law, 91 B.U. L. REV. 1039 (2011); D. Gordon Smith, The Critical Resource Theory of Fiduciary Duty, 55 VAND. L. REV. 1399 (2002). Also compare FRANKEL, supra, at 10607 (designating the duty of loyalty, which includes [t]he duty to follow and abide by the directives of entrustment, [t]he duty to act in good faith in performing fiduciary services, [t]he duty not to delegate the fiduciary services to others, [t]he duty to account and disclose relevant information to the entrustors, and [t]he duty to treat entrustors fairly, and the duty of care as two broad categories of fiduciary duties), with Ribstein, supra, at 899 (arguing that [t]he fiduciary duty is appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good faith and fair dealing, and to refrain from misappropriation), and with Smith, supra, at 1402, 1409 (asserting that the duty of loyalty . . . is the essence of fiduciary duty and that, [u]nlike the duty of care, the fiduciary duty of loyalty is distinctive). 2 See, e.g., United States v. Finnerty, 474 F. Supp. 2d 530 (S.D.N.Y. 2007); United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887 (S.D.N.Y. Sept. 6, 2006); Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469 (N.D. Ill. Oct. 24, 1990). 3 For an analysis of market making, which stresses the impact of high-frequency trading, see MICHAEL DURBIN, ALL ABOUT HIGH-FREQUENCY TRADING passim (2010). For additional recent sources on market making, see Concept Release on Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594 passim (Jan. 14, 2010); GETCO EUROPE LTD., A MODERN MARKET MAKERS PERSPECTIVE ON THE EUROPEAN FINANCIAL MARKET REGULATORY AGENDA (2010), available at http://www.getcollc.com/images/uploads/Final_EU_Paper.pdf; Peter Chapman & James Ramage, In Search of Market Makers, TRADERS MAG., Nov. 2010, at 30. 4 For the basic facts and different perspectives on this controversy, see Wall Street and the Financial Crisis: The Role of Investment Banks: Hearing Before the Permanent Subcomm. on Investigations of the S. Comm. on Homeland Sec. & Governmental Affairs, 111th Cong. (2011); Goldman Sachs Grp., Inc., Current Report (Form 8-K) (May 3, 2010), available at http://www2.goldmansachs.com/our-firm/investors/financials/archived/8k/pdf-attachments/05-031
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pointed to its market maker status in order to shield itself from liability.5 As articulated by Lloyd C. Blankfein, Goldman Sachss Chairman and CEO, In our market-making function, we are a principal. We represent the other side of what people want to do. We are not a fiduciary. We are not an agent.6 In turn, Gary Cohn, the firms President and Chief Operating Officer, provided the following public policy rationale: Markets would not work, if market makers were a fiduciary. What would a market maker do if he had a buyer and seller simultaneously approach him? . . . He cant be a fiduciary to one and not the other. He cant be a fiduciary to both.7 This defense has not remained uncontested: Goldman was not acting as primarily a market maker responding to client demand when it originated and sold [certain structured finance securities] [but] as an underwriter, placement agent, or broker-dealer, aggressively soliciting its clients to purchase [certain] products that senior management wanted to eliminate from its inventory.8 This counterargument echoes several decisions of
10-8k-doc.pdf; Complaint and Demand for Jury Trial, SEC v. Goldman, Sachs & Co., No. 10-CV3229 (BSJ), 2010 U.S. Dist. LEXIS 119802 (S.D.N.Y. July 20, 2010), available at http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf; Consent of Defendant Goldman, Sachs & Co., SEC v. Goldman, Sachs & Co., No. 10-CV-3229 (BSJ), 2010 U.S. Dist. LEXIS 119802 (S.D.N.Y. July 20, 2010), available at http://www.sec.gov/litigation/litreleases/ 2010/consent-pr2010-123.pdf. For academic commentary, see Steven F. Davidoff et al., Computerization and the ABACUS: Reputation, Trust, and Fiduciary Duties in Investment Banking, J. CORP. L. (forthcoming) available at http://ssrn.com/abstract=1747647; Andrew F. Tuch, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs (John M. Olin Ctr. for Law, Econ. & Bus., Harvard Law Sch., Fellows Discussion Paper No. 37, 2011), available at http://ssrn.com/abstract=1809271. 5 See MAJORITY & MINORITY STAFF OF THE PERMANENT SUBCOMM. ON INVESTIGATIONS OF THE S. COMM. ON HOMELAND SEC. & GOVERNMENTAL AFFAIRS, 112TH CONG., WALL STREET AND THE FINANCIAL CRISIS: ANATOMY OF A FINANCIAL COLLAPSE 61013 (Comm. Print 2011), available at http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf [hereinafter SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS]. 6 Lloyd C. Blankfein, Chairman & CEO, Goldman Sachs Grp., Inc., Testimony at the First Public Hearing of the Financial Crisis Inquiry Commission 27 (Jan. 13, 2010), http://fcicstatic.law.stanford.edu/cdn_media/fcic-testimony/2010-0113-Transcript.pdf [hereinafter Blankfeins FCIC Testimony]. 7 Tom Braithwaite & Francesco Guerrera, Goldman Lobbies Against Fiduciary Reform, FIN. TIMES, May 12, 2010, at 4. 8 SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS, supra note 5, at 615. A blue-ribbon commission, probably having the Goldman Sachs controversy in mind, similarly pointed to potential conflicts for underwriters of mortgage-related securities to the extent they shorted the products for their own accounts outside of their roles as market makers. NATL COMMN ON THE CAUSES OF THE FIN. & ECON. CRISIS IN THE UNITED STATES, THE FINANCIAL CRISIS INQUIRY REPORT 212 (2011), available at http://www.gpoaccess.gov/fcic/fcic.pdf. One important point, however, is that the synthetic nature of some of the securities in question required Goldman to find both long and short investors, who were making opposite bets in what amounts to a zero sum investment. Thomas J. Moloney et al., Fiduciary Duties, Broker-Dealers and Sophisticated Clients: A Mis-Match That Could Only Be Made in Washington, 3 J. SEC. L. REG. & COMPLIANCE 336, 340 (2010).
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the federal courts that analyzed various factors pointing to the existence of a fiduciary duty owed by market makers due to multiple roles played by such firms and the nature of the relationship between the parties in question.9 On the other hand, a natural concern is whether some of these factors cover practices that may be essential to the function of providing liquidity. Given the complexity and multi-faceted nature of fiduciary relationships, which arise in a variety of contexts under fact-intensive scenarios, crafting a concise theoretical underpinning for the existence of a fiduciary duty with respect to various functions performed by market makers in securities markets is a difficultif not near-futiletask. After all, [f]iduciary obligation is one of the most elusive concepts in Anglo-American law.10 Yet, at least in the context of commercial relationships, a fiduciary duty perhaps could be thought of as a contractual device that minimizes transaction costs.11 The authors simplified synthesis of the existing thicket of approaches to identifying and categorizing fiduciary relationships12 is that such duties must be based on a relationship of trust and confidence, a reliance on external expertise and discretion, and an undertaking to act on behalf of and in the best interest of the other party. A mere existence of superior knowledge and specialization, a hypothetical that captures the reality of securities markets, is insufficient by itself.13 This Article explores the boundaries of fiduciary duties of market makers established by the federal courts. Part I traces the chronological development of the case law, which indicates the lack of a general fiduciary duty for performing market making services as such. Part II identifies various factors set by the federal courts suggesting the existence of a fiduciary duty owed by market
9
See, e.g., Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828 (N.D. Ill. 2010); Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S. Dist. LEXIS 8065 (S.D.N.Y. June 14, 1993). 10 Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 879. 11 For recent academic debates on the contractual nature and efficiency of fiduciary relationships, see Arthur B. Laby, The Fiduciary Obligation as the Adoption of Ends, 56 BUFF. L. REV. 99 (2008); Ribstein, supra note 1; Sitkoff, supra note 1; Leonard I. Rotman, Is Fiduciary Law Efficient? A Preliminary Analysis (n.d.) (unpublished manuscript) (on file with author), available at http://ssrn.com/abstract=1485853. See also Graham v. Mimms, 444 N.E.2d 549, 555 (Ill. App. Ct. 1982) (The law of fiduciary obligations facilitates commercial efficiency by imposing a duty of loyalty on fiduciaries, thereby relieving the parties to such relationships of the obligation of, in every case, individually negotiating contracts which specify the fiduciarys duties in a large number of hard-to-anticipate situations.) (citing Victor Brudney & Robert Charles Clark, A New Look at Corporate Opportunities, 94 HARV. L. REV. 997, 999 (1981)). 12 See, e.g., FRANKEL, supra note 1, at 442; Thomas Lee Hazen, Are Existing Stock Broker Standards Sufficient? Principles, Rules, and Fiduciary Duties, 2010 COLUM. BUS. L. REV. 710, 72227; Ribstein, supra note 1, at 90103; L.S. Sealy, Fiduciary Relationships, 1962 CAMBRIDGE L.J. 69, 7479; Smith, supra note 1, at 142331. 13 See Hazen, supra note 12, at 724.
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makers, given a variety of business models and trading strategies employed by these market participants in order to provide liquidity and their potentially multiple roles in securities markets. Part III considers whether certain practices of market makers integral to the function of providing liquidity, such as payment for order flow, may give rise to a fiduciary duty and examines corresponding potential consequences. Part IV analyzes the significance of the changing economics and institutional framework of providing liquidity in securities markets and the current regulatory agenda for fiduciary duties of market makers. Part V analyzes several legal issues relevant to market makers with respect to their regulatory environment and civil liability. The Article concludes by evaluating the overall position of the federal courts on the issue of fiduciary duties of market makers and the prospects for its future application. I. THE REACH OF FIDUCIARY DUTIES TO THE FUNCTION OF PROVIDING LIQUIDITY The basic inquiry is whether a market maker, assuming away its other roles in securities markets, owes a fiduciary duty to individual market participants by the virtue of occupying a pivotal position as a liquidity provider. Turning to the chronological analysis of this matter, probably the earliest relevant case, which addressed alleged securities fraud in connection with transactions in limited partnership interests, concluded that [t]he plaintiffs cannot bootstrap a general fiduciary duty from the limited duty imposed on market makers by Rule 10b-5.14 The first detailed analysis of fiduciary duties of market makers appeared in the case addressing the events in the aftermath of the Black Monday of October 19, 1987, when several market makers in equity index options did not trade but allegedly should have or allegedly traded at inflated and grossly exaggerated prices.15 The starting point of the courts analysis was an assertion that [f]iduciary responsibilities are not lightly inferred [as] [t]hey arise from a
14
In re Longhorn Sec. Litig., 573 F. Supp. 255, 272 (W.D. Okla. 1983). On the other hand, an even earlier case suggest[ed] that the sole dealer and market maker in an issuers commercial paper may be held to a higher standard in the context of disclosure obligations and fiduciary duties. Assoc. Randall Bank v. Griffin, Kubik, Stephens & Thompson, Inc., 3 F.3d 208, 213 (7th Cir. 1993) (interpreting Sanders v. John Nuveen & Co., 619 F.2d 1222 (7th Cir. 1980)). This decision raises a potential issue whether a sole market maker might be considered a fiduciary. However, such liquidity providers are becoming harder to findwith the exception of thinly traded / illiquid securitiesbecause even trading venues with one designated market maker often have other de facto market makers or coexist with other trading venues transacting in the same security. Furthermore, another case, which offers a distant analogy, refused to link the monopoly status of a public utility and the existence of a fiduciary duty owed to its customers. County of Suffolk v. Long Island Lighting Co., 728 F.2d 52, 63 (2d Cir. 1984). 15 Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *1-2 (N.D. Ill. Oct. 24, 1990).
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very narrow class of relationships.16 The court concluded that, [w]hether they trade or not, [market makers] do not owe fiduciary duties to investors.17 Drawing on the economic nature of market making and the difference between the roles of brokers and market makers, the court offered the following justification: Market makers match buyers and sellers and may, when there are price discontinuities or a temporary disparity between supply and demand, have a duty (though not necessarily owed to investors, as opposed to the Exchange) to stand against the market and trade on their own accounts. Brokers, as opposed to market makers, are agents and may be fiduciaries, though even then, only when trading on discretionary accounts in which the broker determines which investments to make. But market makers are not fiduciaries for investors even in the sense that brokers may benothing in the complaint alleges that market makers advise or influence investors or hold or spend money for them. Nor does the complaint allege that there is any pre-existing relation of trust between market makers and investors.18 The court also stated that the [p]laintiffs have alleged nothing which would clearly distinguish these dealings from arms length business transactions, and for that reason their allegation that market makers owe investors fiduciary obligations is insufficient.19 Finally, the court stated that the plaintiffs add[ed] nothing to an allegation of normal trust other than the existence of [federal securities law and rules of the options exchange and the clearinghouse].20 A later case involved an attempt to cancel a sell order for put options on shares of an airline company, which was placed through a third-party brokerage firm, but this order was in fact executed for the specialists account after the release of news relating to the collapse of a takeover deal for another major player in the airline industry.21 On the other hand, the specialist did disclose that he took the trade as a principal.22 In its analysis of the alleged breach of fiduciary duties by the specialist, the court made the following observation: The specialist has fiduciary obligations closely resembling, if not identical to, those of a broker [because] [a]s broker, the specialist
16 17
Id. at *44. Id. at *45. 18 Id. at *46 (internal citation omitted). 19 Id. at *4647. 20 Id. at *47. 21 Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S. Dist. LEXIS 8065, at *38 (S.D.N.Y. June 14, 1993). 22 Id. at *31.
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holds and executes orders for the public on a commission basis. When he does so, he is an agent and has a fiduciary obligation to his principal, the purchaser or seller of stock. . . . An aspect of a brokers fiduciary duty is to refrain from transactions that are adverse to the interests of his or her customer.23 In other words, the analysis hinged on the dual role played by some market makers rather than the very function of providing liquidity. With the exception of a dictum that the market maker status, the role that the defendant in fact had not played, implicate[s] broader fiduciary duties,24 the next group of cases on the issue of fiduciary duties of market makers dealt with the high-profile controversy over the conduct of specialists on the floor of the New York Stock Exchange (NYSE).25 The specialists role, in contrast to the role of market makers in pure dealer markets, was characterized by a certain duality of functions: Specialists are responsible for maintaining a two-sided auction market by providing an opportunity for public orders to be executed against each other. In order to do so, they serve dualroles, acting as both agent and principal. Once an order has been received, the specialist, acting as agent, is required to match the open order to buy with an open order to sell within the same price range. Specialists generally receive no compensation for filling orders as agents. When there are no matching orders to sell and orders to buy, specialists are permitted to trade on a principal basis by either selling the stock from their own proprietary account to fulfill the investors order to buy or buying the stock and holding it in their own account to fill an investors order to sell.26
Id. at *3233 (quoting Note, The Downstairs Insider: The Specialist and Rule 10b-5, 42 N.Y.U. L. REV. 695, 697 (1967)). 24 Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 980 (10th Cir. 1996). 25 For the basic facts of this tenacious controversy, which went much deeper than the issue of fiduciary duties of the NYSE specialists, see In re NYSE Specialists Sec. Litig., 405 F. Supp. 2d 281 (S.D.N.Y. 2005), affd in part, revd in part, 503 F.3d 89 (2d Cir. 2007), remanded to 260 F.R.D. 55 (S.D.N.Y. 2009). For academic commentary, see Emil J. Bove III, Institutional Factors Bearing on Criminal Charging Decisions in Complex Regulatory Environments, 45 AM. CRIM. L. REV. 1347 (2008); J. Scott Colesanti, Not Dead Yet: How New Yorks Finnerty Decision Salvaged the Stock Exchange Specialist, 23 ST. JOHN J. LEGAL COMM. 1 (2008); Nan S. Ellis et al., The NYSE Response to Specialist Misconduct: An Example of the Failure of Self-Regulation, 7 BERKELEY BUS. L.J. 102 (2010). 26 In re NYSE Specialists, 260 F.R.D. at 61.
23
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Furthermore, the NYSE place[d] a negative obligation on specialists, prohibiting purchases or sales of any security in which such specialist, is registered . . . unless such dealings are reasonably necessary to permit such specialist to maintain a fair and orderly market [and] prohibit[ed] proprietary trading, with limited exceptions, when the specialist has knowledge of any particular unexecuted customers order to buy (sell) such security which could be executed at the same price.27 More specifically, the NYSE specialists were accused of the following wrongdoings in connection with their status as market makers: (i) interpositioning in violation of the Specialist Firms negative obligation, in which a Specialist Firm steps in the way of matching orders of public sellers and/or buyers of stock to generate riskless profits to the detriment of [other market participants]; (ii) trading ahead or front-running, in which Specialist Firms take advantage of their confidential knowledge of public investors orders . . . and trade for their own account as principals before completing orders placed by public investors; (iii) freezing the book, in which a Specialist Firm freezes its Display Book on a stock so it can first engage in trades for its own account prior to entering and then executing public investors orders . . . .28 As the scandal began to unfold, a class action lawsuit prominently featured the allegation that the NYSE specialists are fiduciaries to public investors.29 In fact, several decisions of the federal courts specifically addressed the issue of fiduciary duties owed by the NYSE specialists to public customers, i.e., potentially all market participants on the NYSE, including customers of all brokers and direct access traders,30 although in some instances this issue was reserved or viewed as preempted.31 An intriguing fact is that several specialist
27 28
Id. at 6162 (quoting the applicable rules of the NYSE). Id. at 64. 29 Complaint and Demand for Jury Trial, CalPERS v. NYSE, Inc., No. 03 Civ. 9968, para. 4 (S.D.N.Y. Dec. 16, 2003), available at http://securities.stanford.edu/1029/NYSE03-01/20031215_ f01c_CPERS.pdf. For the background information on the consolidation of different lawsuits and the appointment of two lead plaintiffs, see In re NYSE Specialists, 405 F. Supp. 2d at 287. 30 See United States v. Finnerty, 474 F. Supp. 2d 530 passim (S.D.N.Y. 2007); United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887 passim (S.D.N.Y. Sept. 6, 2006). 31 See, e.g., United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist. LEXIS 72119, at *1617 (S.D.N.Y. Oct. 2, 2006) (reserving this issue); United States v. Bongiorno, No. 05 Cr. 390
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firms entangled in this controversy had made public statements as to their fiduciary status.32 In addition to the plaintiffs in civil litigation and the prosecution in criminal trials of several employees of the investigated specialist firms, the U.S. Securities and Exchange Commission (SEC) as the securities regulator and the NYSE itself as a self-regulatory organizationbut perhaps largely as a face-saving measurehad some interest in imposing the fiduciary standard on the NYSE specialists in some form. To the authors knowledge, the SEC never used the word fiduciary in connection with this scandal, although this position had been articulated on other occasions with respect to exchange specialists more generally, which were seen as agents entrusted with public customers orders.33 On the other hand, the regulatory agency crafted a fiduciary(SHS), 2006 U.S. Dist. LEXIS 24830, at *2123 (S.D.N.Y. May 1, 2006) (same); In re NYSE Specialists, 405 F. Supp. 2d at 30608 (holding that the fiduciary duty-based claim is preempted by the Securities Litigation Uniform Standards Act of 1998). 32 See In re NYSE Specialists, 405 F. Supp. 2d at 33233 (two specialists having made nearly identical public statements that, [a]s agent, the specialist assumes the same fiduciary responsibility as a broker and as an agent, a specialist assumes the same fiduciary responsibility as a broker). 33 As far back as 1936, the SEC adopted the position asserting the existence of the [exchange] specialists fiduciary obligation to buyers and sellers whose orders he has accepted for execution, pointed to his special knowledge and superior bargaining power in trading for his own account, and considered essential . . . that the dealer functions of the specialist be subjected to stringent control. SEC. & EXCH. COMMN, REPORT ON THE FEASIBILITY AND ADVISABILITY OF THE COMPLETE SEGREGATION OF THE FUNCTIONS OF DEALER AND BROKER 63 (1936). In a later administrative adjudication relating to the American Stock Exchange, the regulatory agency asserted that, because the exchange specialist functions as a broker executing orders entrusted to him by other brokers on behalf of their customers . . . he is in a position of trust and confidence with his customers and obligated within the terms of his agency to the strict standards of loyalty, disclosure and fair dealing required of fiduciaries. Re, Re & Sagarese, Exchange Act Release No. 6900, 41 S.E.C. 230, 231 (Sept. 21, 1962). An in-depth study of securities markets conducted by the SEC similarly concluded that [t]he [exchange] specialist who holds an order is a subagent in a fiduciary relationship with his principal, the customer who originated the order. REPORT OF SPECIAL STUDY OF SECURITIES MARKETS OF THE SECURITIES AND EXCHANGE COMMISSION, H.R. DOC. NO. 88-95, pt. 2, ch. VI, at 58 (1963) (footnote omitted). While the study maintained that the fiduciary relationship with the ultimate customer entails [that] [a]s an agent, [the exchange specialist] has a duty to act solely for the benefit of his principal in all matters within the scope of his agency, it also recognized that this market participant represents many customers on opposite sides of the market [and] deals for his own account in competition with, and often adversely to, his customers. Id. at 14243. In a more recent statement, the regulatory agency maintained that the exchange specialist has a fiduciary obligation to orders on the book. Order Approving Proposed Rule Change of the Midwest Stock Exchange, Inc. Relating to a Pilot Program for Stopped Orders in Minimum Variation Markets, Exchange Act Release No. 30,189, 57 Fed. Reg. 2621, 2622 (Jan. 14, 1992). In another statement, the SEC asserted that the exchange specialist is a fiduciary when acting as agent for a limit order. Order Approving Proposed Rule Change by the Philadelphia Stock Exchange Relating to the New Electronic Trading Platform, Phlx XL, Exchange Act Release No. 50,100, 69 Fed. Reg. 46,612, 46,621 (July 27, 2004). A somewhat more restrictive statement pointed to the [exchange] specialists fiduciary duties to unexecuted limit orders on the
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like description of the applicable standard: Whether acting as brokers or dealers, specialists are required to hold the publics interests above their own and, as such, are prohibited from trading for their dealers accounts ahead of pre-existing customer buy or sell orders that are executable against each other.34 Undoubtedly in coordination with the SEC, the NYSE used the identical language in its own proceedings,35 and it went even further, reminding its specialists, in the context of the impermissibility of trading ahead, that they have a fiduciary duty to orders entrusted to them as agent[s].36 In Hunt, a criminal case in which the prosecution alleged that the defendant specialist owed fiduciary obligations to the NYSE and its public customers,37 the court focused on the narrow set of circumstances giving rise to the fiduciary standardwhen the fiduciary agrees to act as a principals alter ego, rather than assuming the standard arms length stance of traders in a
specialists limit order book. Order Granting Approval to Proposed Rule Change of the Philadelphia Stock Exchange, Inc. Relating to the Treatment of PACE Orders, Exchange Act Release No. 39,548, 63 Fed. Reg. 3596, 3599 (Jan. 13, 1998). 34 Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1896 (Mar. 30, 2004); see also N.Y. Stock Exch., Inc., Exchange Act Release No. 51,524, 85 SEC Docket 517, 518 (Apr. 12, 2005) (making the same statement). Analyzing the regulatory agencys public statements, one commentator argued that, on the specific question of interpositioning, the SEC has made clear . . . that it holds the Specialist to a fiduciary duty when acting as either principal or agent. Colesanti, supra note 25, at 26. 35 See, e.g., Fleet Specialist, Inc., Exchange Hearing Panel Decision 04-49, at 6 (N.Y. Stock Exch. Mar. 29, 2004), available at http://www.nyse.com/pdfs/04-049.pdf. 36 Mkt. Surveillance Div., N.Y. Stock Exch., Member Educ. Bulletin No. 2004-12, at 1 (Dec. 23, 2004), available at http://apps.nyse.com/commdata/PubeduMemos.nsf/0/85256F340070DCAD852 56F73005E408D/$FILE/Microsoft%20Word%20-%20Document%20in%202004-12.pdf. On the other hand, the NYSE had occasionally used the word fiduciary with respect to its specialists even before this controversy. See, e.g., Mkt. Surveillance Div., N.Y. Stock Exch., Info. Memo No. 94-45, at 1 (Sept. 14, 1994), available at http://apps.nyse.com/commdata/PubInfoMemos.nsf/0/852 56FCB005E19E885257108006C2D8B/$FILE/Microsoft%20Word%20-%20Document%20in%20 94-45.pdf (stating that [a]gency orders on the book must be appropriately represented in accordance with the Specialists fiduciary responsibilities). Other trading venues had also articulated the existence of certain fiduciary duties owed by exchange specialists, but, typically, the scope of such duties was not defined very broadly. See, e.g., Notice of Filing and Immediate Effectiveness of Proposed Rule Change by the Boston Stock Exchange, Inc. Relating to the Execution Guarantee Rules, Exchange Act Release No. 50,904, 69 Fed. Reg. 78,065, 78,067 (Dec. 21, 2004) (the Boston Stock Exchange pointing to the specialists fiduciary duties of best execution); Notice of Filing of a Proposed Rule Change by the Philadelphia Stock Exchange, Inc. Relating to the Automatic Execution of Booked Customer Limit Orders, Exchange Act Release No. 47,657, 68 Fed. Reg. 18,717, 18,720 (Apr. 10, 2003) (the Philadelphia Stock Exchange stating that, [o]nce a customer limit order is booked, a fiduciary responsibility devolves upon the specialist to execute such an order at the best price available, subject to the customers limit price, when the order becomes marketable). 37 United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *12 (S.D.N.Y. Sept. 6, 2006).
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market.38 A key conclusion was that a position of public trust [occupied by the NYSE specialists] is not directly analogous to a fiduciary duty to specific customers.39 The court also employed a detailed analysis of market making as a means of aggregating orders of different types in an impersonal market: While specialists may have an obligation to maintain the market economy, they do not owe the public a fiduciary duty, and therefore an alleged breach of fiduciary duty cannot serve as a basis for security fraud. Rather than represent one partys interests, Defendant here was expected to execute orders for both buyers and seller [sic]two masters as it wereand presumably there was an expectation that Defendant would not place one customers demands over anothers. Instead, Defendants task was to facilitate the flow of market forces as a quasi-neutral party. Defendant here was not responsible for making trades for customers in the traditional broker sense; instead he acted as a catalyst, bringing buyers and sellers together to complete deals. . . . [S]pecialists have no loyalty to buyers or sellers, as they execute orders for both, and further, they often do not know the identity of those for whom they execute buys and sells.40 Finally, the court concluded that the lack of fiduciary duties also follows from the fact that public customers did not compensate Defendant41 and stressed that specialists do not exercise discretionary authority on behalf of the trading public.42 In another case, the same court noted the pivotal role of the allegation that the NYSE specialists owe a fiduciary duty to public customers in the context of criminal liability under federal securities law: [E]ven assuming that the Government demonstrated that [the defendant specialist] was a thief who stole from public customers, his conviction for securities fraud cannot be sustained absent a showing that he also violated a fiduciary duty.43 Turning to the relevant precedents, the court concluded that the only case to have squarely addressed this issue held that specialists do not owe a fiduciary duty to their public customers [and] that specialists serve two masters, both the buyer and the seller,
38 39
Id. at *13. Id. at *14. 40 Id. at *1617. 41 Id. at *18. 42 Id. 43 United States v. Finnerty, 474 F. Supp. 2d 530, 543 (S.D.N.Y. 2007). On the flip side, a mere breach of fiduciary duty without any deception, misrepresentation, or nondisclosure does not give rise to liability under the Securities Exchange Act of 1934 and Rule 10b-5. Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977).
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and thus have no loyalty to buyers or sellers, as they execute orders for both.44 Furthermore, the court also agreed with the significance of the fact that the NYSE specialists do not receive compensation from public customers.45 The court even considered irrelevant the defendant specialists deposition testimony admitting that he owed a fiduciary duty to public customers: A fiduciary duty does not arise out of mere admission, where, as here, the case law points to the contrary.46 The court also rejected the prosecutions analogy with a rogue real estate broker who instead of putting the buyer and seller together and letting them trade with each other . . . buy[s] the apartment for himself [and] sell[s] it to the buyer for the [maximum amount] that the buyer was willing to pay, and then . . . put[s] [the difference] in his firms and his pockets47: The real estate broker works for one side, the buyer or the seller, not both, while the specialist executes orders for both sides. The real estate broker does not act as a principal, while the specialist regularly trades for his firms proprietary account. The real estate broker has a fiduciary duty to the party he is representing, while the specialist does not. The real estate broker is entitled to a commission, while the specialist earns no fee for executing public orders. . . . The apartment buyers expectations are clear: for a [preset] commission, the real estate broker will act as the buyers agent, on a fiduciary basis, solely as a broker and not as a principal. The expectations of the specialists [sic] customers are substantially different. . . . 48 Ultimately, the court concluded that the issue of the existence of a fiduciary duty was one for the jury, but the jury was never asked to decide the issue.49 Another series of decisions addressed the conflict between options market makers and direct access customers, which possess informational and technological advantages compared to other market participants, stemming from the alleged discriminationincluding interference with execution and mishandlingof such customers orders by market makers.50 The plaintiffs also described themselves as market participants implementing arbitrage trading
44
Finnerty, 474 F. Supp. 2d at 54344 (quoting United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *17 (S.D.N.Y. Sept. 6, 2006)). 45 Id. at 544 n.10. 46 Id. at 543. 47 Id. at 547. 48 Id. 49 Id. at 544. 50 Last Atlantis Capital LLC v. AGS Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS 29175, at *45 (N.D. Ill. Mar. 26, 2010); Last Atlantis Capital LLC v. Chi. Bd. Options Exch., 455 F. Supp. 2d 788, 79192 (2006).
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strategies which attempt to take advantage of price discrepancies of options.51 The key issue was whether an options specialist owed a fiduciary duty to customers of third-party brokers,52 and the court noted the lack of precedents pointing to such a duty and the existence of the case law suggesting the opposite result.53 The court also proceeded cautiously with defining the boundaries of the fiduciary standard: Under some circumstances, a broker or dealer will have a fiduciary duty to a particular customer. That duty, however, is not based on ones status as a dealer. A fiduciary relationship arises only when the dealing [sic] between the customer and the dealer presuppose a special trust or confidence.54 The court also rejected the relevance of the cases presented in support of attaching a fiduciary duty because they did not involve options specialists and in all of those cases the defendant . . . had direct dealings with the investors.55 Overall, the court concluded that the plaintiffs have failed to provide sufficient evidence of a special relationship of trust or confidence.56 In another decision relating to the same controversy, the court once again attacked the plaintiffs arguments: [P]laintiffs argue that defendants actively solicited orders from plaintiffs by generating quotes which plaintiffs could access via the Exchanges order routing and execution system. . . . Providing quotes is a basic part of the specialists job, and the quotes are disseminated by the Exchanges through their systems. I do not view the generation of quotes as actively solicit[ing] customers, but rather simply part of the role played by the specialists in making markets.57
Last Atlantis, 455 F. Supp. 2d at 791. Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *2426. 53 Id. at *24, 2628. 54 Id. at *2425 (quoting Congregation of the Passion, Holy Cross Province v. Kidder Peabody & Co., Inc., 800 F.2d 177, 182 (7th Cir. 1986)). 55 Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *24 n.9. Both cases cited by the court that were used by the plaintiffs to support their position, Kurz v. Fidelity Management & Research Co., 556 F.3d 639 (7th Cir. 2009), and Wsol v. Fiduciary Management Associates, Inc., 266 F.3d 654 (7th Cir. 2001), involved the allegations that the respective investment advisers were directing orders to their favored brokers in exchange for kickbacks. Of course, the investment adviser status confers an independent fiduciary duty. See, e.g., Fidelity Mgmt. & Research Co., Investment Advisers Act Release No. 2713, Investment Company Act Release No. 28,185, 2008 SEC LEXIS 507, at *12, 14 (Mar. 5, 2008) (Under Section 206 of the [Investment] Advisers Act [of 1940], an investment adviser has a fiduciary duty to seek best execution for its clients securities transactionsthat is, to seek the most favorable terms reasonably available under the circumstances [and] a fiduciary duty to disclose all material conflicts of interest to its advisory clients.). 56 Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *25. 57 Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828, 843 (N.D. Ill. 2010).
52
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The court also pointed that the defendant did not receive[] compensation from plaintiffs [and] had [no] direct communications with [them].58 Relying on the precedent set in Finnerty, the court dismissed the relevance of public statements by some of the defendants that they were fiduciaries and asserted that the question of whether or not these defendants were fiduciaries does not rest on whether or not they believed themselves to be (or whether plaintiffs believed them to be).59 Despite the possibility of classifying the defendant specialists as agents, the court also declined to impose on these market participants some inherent duty of best execution in the absence of express representations.60 In its most recent ruling on the controversy, the court stated that its prior decisions do not conclusively foreclose a claim for breach of fiduciary duty based on an agency theory [which was waived earlier by the plaintiffs] . . . [but the] breach of fiduciary duty claims based on special trust are, however, clearly foreclosed.61 Overall, with the exception of several tangential objections, the federal courts have employed a narrow reading of the fiduciary standard and consistently declined to recognize a fiduciary duty owed by market makers to individual market participants. The federal courts have distinguished the largely impersonal and somewhat mechanical nature of providing liquidity from more personalized and discretionary aspects of providing brokerage services. The existing approach also dismissed the relevance of alleged expectations of plaintiffs as to the fiduciary status of defendants, which the federal courts perceived as unjustified or one-sided, and even declined to put too much weight on the use of the word fiduciary by defendants themselves.62 Another common thread was the refusal to classify transactions of market makers in their capacity as providers of liquidity as anything other than arms-lengths, and this conclusion invokes a more general principle that [t]he arms-length relationship of parties in a business transaction is, if anything, antithetical to the notion that either would
Id. at 842 n.10. Id. at 844. 60 Id. at 83132. Although narrow in its scope, the duty of best execution, which is typically applicable to brokers, undoubtedly has a fiduciary nature. One key ruling stated that the duty of best execution predates the federal securities laws [and] has its roots in the common law agency obligations of undivided loyalty and reasonable care that an agent owes to his principal and pointed to its fiduciary nature. Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270 (3d Cir. 1998). 61 Last Atlantis Capital LLC v. ASG Specialist Partners, No. 04 C 397, 2011 U.S. Dist. LEXIS 60380, at *1011 (N.D. Ill. June 6, 2011). 62 Additional legal issuesand perhaps gaps in the existing decisionslurking here are whether the expectations of plaintiffs were reasonable and whether the fiduciary status was assumed by defendants as a contractual representation. One decision, however, briefly touched on the issue of expectations in the context of the fiduciary standard, but it declined to apply this standard to the defendant specialist. United States v. Finnerty, 474 F. Supp. 2d 530, 547 (S.D.N.Y. 2007). Furthermore, there seems to be little evidence that the fiduciary status of market makers was actively sought ex ante by any plaintiff.
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owe a fiduciary relationship to the other.63 Another key point was the recognition of the inherentand indelibleconflict of being a fiduciary to both buyers and sellers, and, indeed, it is difficult to translate a fiduciary duty into specific trading instructions for any market makers business model of buying low and selling high.64 Furthermore, unlike the SEC, the federal courts held that even agency-like features of the trading mechanism in questionmost notably with respect to the NYSE specialistsdo not give rise to a fiduciary duty in the absence of explicit compensation for these agency functions. The underlying public policy issue pertains to the effect of the fiduciary standard on liquidity of securities markets, although this dimension has not been clearly articulated by the federal courts. The refusal to attach a fiduciary duty to the function of providing liquidity avoids potential difficulties with evaluating the reasonableness of transaction prices and the size of bid-ask spreads, as a form of compensation to market makers, given their assumption of risk, exposure to competitive forces, and limited exercise of discretion. This approach similarly avoids an ex post scrutiny of information that was or should have been in the possession of the market maker in question. With respect to the function of providing liquidity as such, a powerful argument is that, [i]f a market maker were required to perform extensive due diligence on each security in which it was asked to execute a transaction, and to update disclosures every time it bought or sold securities, real-time, liquid markets could not exist.65 These legal risk
Dopp v. Teachers Ins. & Annuity Assn, No. 91 Civ. 1494 (CSH), 1993 U.S. Dist. LEXIS 13980, at *15 (S.D.N.Y. 1993); see also Pan Am. Corp. v. Delta Air Lines, Inc., 175 B.R. 438, 511 (S.D.N.Y. 1994) ([W]hen parties deal at arms length in a commercial transaction, no relation of confidence or trust sufficient to find the existence of a fiduciary relationship will arise absent extraordinary circumstances.). 64 This conflict stands in contrast to situations in which conflicts of fiduciary duties arise only in certain circumstances or are attributed to different functions performed by the fiduciary in question. See Arthur B. Laby, Resolving Conflicts of Interest in Fiduciary Relations, 54 AM. U. L. REV. 75 passim (2004) (analyzing situations in which a securities firm performs different functions, such as offering brokerage services and engaging in underwriting activities); Steven L. Schwarcz, Fiduciaries with Conflicting Obligations, 94 MINN. L. REV. 1867 passim (2010) (focusing on situations in which fiduciary duties are owed to different classes of securities with conflicting interests caused by unfavorable market conditions). In the context of market making, it would be problematic to apply mechanisms in which fiduciaries may attempt to envision what the parties [with conflicting interests] would have agreed upon had they been asked [or] resort to general principles of law and precedent, such as maximizing the fairness to each party, and the impact of the fiduciaries decisions on the parties. FRANKEL, supra note 1, at 178. 65 Letter from Gregory K. Palm, Exec. Vice President & Gen. Counsel, Goldman Sachs Grp., Inc., to Philip N. Angelides, Chairman, Fin. Crisis Inquiry Commn 5 (Mar. 1, 2010), available at http://www2.goldmansachs.com/our-firm/on-the-issues/march-10-letter.pdf. On the other hand, in a scenario resembling the Goldman Sachs controversy, informational asymmetries may be caused by a market makers involvement in the creation of the security in question. See Robert B. Thompson, Market Makers and Vampire Squid: Regulating Securities Markets After the Financial Meltdown, 89 WASH U. L. REV. 323, 342 (2011) (When the market maker becomes involved in
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factors are likely to be detrimental to liquidity if the fiduciary standard is applicable to market makers, especially given the stringency of the remedy for breaching a fiduciary duty in the context of two-sided trading.66 II. VARIOUS FACTORS SUGGESTING THE EXISTENCE OF A FIDUCIARY DUTY Despite the general principle that no fiduciary duty is attached to the function of providing liquidity alone, the federal courts have discussed various factors that suggest the existence of a fiduciary duty owed by market makers in the context of multiple roles played by such securities firms and the nature of the relationship between the parties in question.67 While these factors typically stem from a specific function performed by a securities firm, a fiduciary duty owed to other market participants may also emerge for a reason outside of an ordinary range of business activities, such as a market makers access to and use of inside information.68
the creation of inventory, not just obtaining it on the market, there are additional asymmetrical incentives that can distort the market-making function.); Steven Drucker & Christopher Mayer, Inside Information and Market Making in Secondary Mortgage Markets, at i (Jan. 6, 2008) (unpublished manuscript) (on file with author), available at http://www4.gsb.columbia.edu/null/ download?&exclusive=filemgr.download&file_id=16547 (Instead of acting as unbiased market makers, underwriters [of prime mortgage-backed securities] appear to exploit access to better information and models to their own advantage.). 66 As one commentator observed, In the event of the fiduciarys breach of duty, the principal is entitled to an election among remedies that include compensatory damages to offset any losses or to makeup any gains forgone owing to the fiduciarys breach, or to disgorgement by the fiduciary of any profit accruing to the fiduciary owing to the breach. The former is a standard measure of make-whole compensatory damages; the latter is a restitutionary remedy arising in equity in the form of a constructive trust that prevents unjust enrichment. Sitkoff, supra note 1, at 1048 (footnotes omitted). 67 It also appears that being a fiduciary to other market participants, such as in the capacity of the lead plaintiff status in a securities class action, does not necessarily preclude a securities firm from functioning as a market maker, but this status imposes a duty to deal . . . in good faith [as] the general duty of the fiduciary to disclose all relevant information to the person to whom the duty is owed when the fiduciary deals with that person. In re Seeburg-Commonwealth United Litig., No. 69 Civ. 5736, 1975 U.S. Dist. LEXIS 14185, at *8 (S.D.N.Y. Jan. 24, 1975). The workability of this standard for a market maker is of course problematic. 68 For a discussion of fiduciary duties owed to other market participants that is acquired as a result of access to privileged information or tipping by insiders, see Dirks v. SEC, 463 U.S. 646 (1983). In fact, some recent empirical evidence suggests the existence of exploitation of inside information by certain market makers linked to their board representation. See H. Nejat Seyhun, Insider Trading and the Effectiveness of Chinese Walls in Securities Firms, 4 J.L. ECON. & POLY 369 (2008). On the other hand, unlike the classical theory of insider trading in Dirks, the misappropriation theory addresses the issue of fiduciary duties owed to the source of information rather than other market participants. See United States v. OHagan, 521 U.S. 642 (1997). An
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One factor is a potential overlap of the roles of a dealer acting as a liquidity provider and a broker owing a fiduciary duty to specific customers in certain situations. This combination raises a serious problem: Acting as a dealer . . . is anathema to the fiduciary obligation owed to a customer and presents a classic conflict of interest. . . . When acting as a dealer, the firm seeks to buy low and sell high precisely what the customer seeks. It is hard to see how any dealer can act in the best interest of his customer when trading with her.69 One concern is whether such an overlap necessarily emerges, and this situation is exemplified by the assertion of the leadership of Goldman Sachs in the context of the scrutinized structured finance transactions that the firm was not a broker at all [but solely] a principal.70 Another consideration is that the scope of fiduciary duties owed by brokers is somewhat ambiguous on both federal and state levels,71 but when the hurdle is met, any distinction between omissions and misrepresentations is illusory in the context of a broker who has a fiduciary duty to her clients.72
interesting historical fact pertaining to the adoption of the Securities Acts Amendments of 1964 is that in the course of the discussion of corporate directorships held by representatives of brokerdealers, one controversial point of view considered market makers access to inside information as aiding them, if not being essential, in providing liquid markets. See Note, Section 16(d) Exemption for Market Makers: The Meat Axe Applied to a Rule of Thumb!, 60 NW. U. L. REV. 367, 37576 (1965); see also 110 CONG. REC. 17, 92627 (1964). 69 Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 BUS. LAW 395, 425 (2010). For an early analysis of this problem, see William O. Douglas & George E. Bates, Stock Brokers as Agents and Dealers, 43 YALE L.J. 46 (1933). An even earlier treatise stated that, [u]nder a well-established rule of the law of agency, the broker who receives an order from a customer to buy or sell securities, cannot, in execution of the order, buy the securities from or sell them to himself, irrespective whether or not there is any evidence of bad faith on his part. DOUGLAS CAMPBELL, THE LAW OF STOCKBROKERS 29 (1st ed. 1914). 70 Blankfeins FCIC Testimony, supra note 6, at 28. A similar issuealso highly relevant for todays securities marketsis the ambiguity with respect to the overlap and respective boundaries of the terms customer, client, and counterparty. See SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS, supra note 5, at 17, 608 n. 2692. 71 See Arthur B. Laby, Fiduciary Obligations of Broker-Dealers and Investment Advisers, 55 VILL. L. REV. 701 passim (2010); see also SEC v. Pasternak, 561 F. Supp. 2d 459, 499 (D.N.J. 2008) (To determine the existence of a fiduciary relationship in federal securities fraud actions, district courts generally look to state law.); Laby, supra, at 712 (Understanding the duties imposed on brokers by . . . Sections 10 and 15 [of the Securities Exchange Act of 1934] requires an analysis of the state law of fiduciaries.). Summarizing the state of the law as of the early 20th century, one treatise remarked that, [i]nasmuch as the broker in his transactions for a customer is dealing with property belonging to the customer, which is intrusted to him in a confidential capacity, his agency is fiduciary in character. CAMPBELL, supra note 69, at 1314. 72 SEC v. Zandford, 535 U.S. 813, 823 (2002).
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Turning to the applicable case law, one court distinguished the market making and brokerage functions and offered some guidance on the reach of the fiduciary standard: Brokers, as opposed to market makers, are agents and may be fiduciaries, though even then, only when trading on discretionary accounts in which the broker determines which investments to make.73 In that respect, an inquiry may address whether the defendant in question advise[s] or influence[s] investors or hold[s] or spend[s] money for them.74 Another case extended the reach of the fiduciary standard to market makers that serve as commission-based brokers for public customers.75 Overall, the fiduciary status for a broker is not necessarily easily attainable. For instance, while scrutinizing the actions of an employee of a broker-dealer that also functioned as a market maker by matching orders and risking its own capital,76 the court made the following observation: [The defendants] customers purposefully did not relinquish control over their orders [and] testified that they would break up, or dole out, their orders to maintain control over the trade. . . . The fact that [the defendant] could exercise discretion as to time and price on a not-held order does not necessitate a finding of a fiduciary relationship, particularly in light of [the] limitations posed by his customers specific instructions.77 In a key administrative adjudication, the SEC employed an approach to the overlap of the market making and brokerage functions similar to the position
Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *46 (N.D. Ill. Oct. 24, 1990); see also de Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293, 130809 (2d Cir. 2002) ([A]bsent an express advisory contract, there is no fiduciary duty on part of broker-dealer unless the customer is infirm or ignorant of business affairs.) (quoting Robinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 337 F. Supp. 107, 113 (N.D. Ala. 1971)); Pasternak, 561 F. Supp. 2d at 506 (The crux of a fiduciary relationship [between the brokerdealer and the customer] is the relinquishment of control and discretion by the customer.); United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *15 (S.D.N.Y. Sept. 6, 2006) ([S]tockbrokers generally do not owe a fiduciary duty unless a customer has delegated discretionary trading authority to that broker.). 74 Spicer, 1990 U.S. Dist. LEXIS 14469, at *46. 75 Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S. Dist. LEXIS 8065, at *3233 (S.D.N.Y. June 14, 1993). 76 Pasternak, 561 F. Supp. 2d at 48588. 77 Id. at 506. A subsequent proceeding before the securities industrys self-regulatory organization also declined to apply the fiduciary standard to the securities firm in question and even refused to classify it as a broker in these circumstances because the firm as a wholesale market maker, did not maintain customer accounts for the institutions with which it dealt [and] therefore did not act as a broker or agent for institutional customers [who] understood [that their orders] would be executed by [the firm], as a dealer, on a principal-to-principal basis. Dept of Mkt. Regulation v. Leighton, No. CLGO50021, 2010 FINRA Discip. LEXIS 3, at *11016 (N.A.C. Mar. 3, 2010).
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of the federal courts.78 The regulatory agency affirmed a censure by the National Association of Securities Dealers (NASD) of a broker-dealer that, while serving as a market maker, failed to execute customers limit order for the sale of stock even though it sold shares of that security for its own account at prices above the limit price, and customer was not informed that member would give its own position priority.79 Just as the NASD, the SEC based its decision on the fact that the securities firm as a broker was an agent of its customers and, therefore, a fiduciary.80 The regulatory agency also referred to an earlier case that involved a brokerage firm functioning as a market maker that executed a large transaction for its own account rather than the clients: A broker-dealers determination to execute an order as principal or agent cannot be a means by which the broker may elect whether or not the law will impose fiduciary standards upon him in the actual circumstances of any given relationship or transaction.81 Relying on this adjudication, one court declared that, [a]lthough [a fiduciary duty] might grow out of broker / dealers role as agent, the duty does not disappear when the role of principal is assumed.82 Ultimately, Hutton triggered a chain of regulatory initiatives,83 but the SEC had not articulated any theory of a broader fiduciary
E.F. Hutton & Co., Exchange Act Release No. 25,887, 41 SEC Docket 414 (July 6, 1988). Hutton was in fact preceded by two rule-making actions, as opposed to fact-intensive administrative adjudications, that articulated the SECs position that market makers in general owe a fiduciary duty to customers. The term customer was not clarified, but the context of these statements is probably more consistent with the presence of a preexisting brokerage relationship rather that the applicability to all counterparties. See Order Approving Proposed Rule Change of the Chicago Board Options Exchange, Inc., Exchange Act Release No. 24,666, 52 Fed. Reg. 25,679, 25,680 n.10 (June 30, 1987) (stating that market makers [are expected to] execute customer market orders in a manner consistent with their fiduciary obligations to their customers in the context of handling market and marketable limit orders by brokers); Unlisted Trading Privileges in Over-the-Counter Securities, Exchange Act Release No. 22,412, 50 Fed. Reg. 38,640, 38,649 n. 90 (Sept. 16, 1985) (stating that exchange specialists and OTC market makers are still subject to fiduciary obligations to seek best execution for their customers orders in the context of intermarket trading linkages). 79 Hutton, 41 SEC Docket at 414. 80 Id. at 41417, 425. Even the decision of the NASDs Board of Governors was described as an eagerness to expand a market makers obligations to conform with a broadly stated and somewhat featureless conception of broker-dealer fiduciary duties. Gregory A. Hicks, Defining the Scope of Broker and Dealer DutiesSome Problems in Adjudicating the Responsibilities of Securities and Commodities Professionals, 39 DEPAUL L. REV. 709, 725 (1990). For another analysis of Hutton from the perspective of fiduciary duties, see Easterbrook & Fischel, supra note 1, at 43031 & n. 1213. 81 Hutton, 41 SEC Docket at 41516 (quoting Opper v. Hancock Sec. Corp., 250 F. Supp. 668, 675 (S.D.N.Y. 1966)). 82 In re Merrill Lynch Sec. Litig., 911 F. Supp. 754, 768 (D.N.J. 1995). 83 While approving the NASD rule that built on Hutton, the SEC stated that it strongly believe[d] that the ban on trading ahead [applicable to market makers] should [also] be applied to . . . member-to-member trades, i.e., to transactions with both their own and other members customers. Order Approving Proposed Rule Change by the NASD Relating to Handling of
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duty owed by a market maker to market participants other than its own customers in connection with these developments. Another related factor is the existence of compensation in addition to actual transaction prices, which may point in the direction of an agency relationship meeting the fiduciary standard.84 The court in Hunt made the following observation: While compensation may, in certain circumstances, impose fiduciary duties on the individual receiving payment, Defendant here generally received no compensation for executing trades on an agency basis. Therefore, as public customers did not compensate Defendant, he did not in turn owe them a duty under this theory.85 The Finnerty court cited this decision with approval: [U]nlike the broker context, public customers do not compensate specialists, and thus, no fiduciary duty is owed to the public customers under that theory.86 An analogous observation was made in a controversy dealing with options trading, given the possibility that financial remuneration in the form of specialist guarantees and brokerage commissions in exchange for handling public orders as an agent could have been made: [A]ny compensation the defendant specialists received was not from plaintiffs.87 One court also emphasized the importance of direct communications between the defendant specialists and plaintiffs [as an indication of] a special relationship or trust . . . in the context of considering whether or not defendants
Customer Limit Orders, Exchange Act Release No. 34,279, 59 Fed. Reg. 34,883, 34,885 (July 29, 1994). Shortly thereafter, the regulatory agency proposed a broad limit order protection rule applicable to market makers with respect to their own customers and customers of other NASDAQ members. Customer Limit Orders, Exchange Act Release No. 34,753, 59 Fed. Reg. 50,866 (proposed Sept. 29, 1994). The SEC withdrew the proposed rule when the NASD prohibited NASDAQ members from accept[ing] and hold[ing] an unexecuted limit order from its own customer or from a customer of another member . . . from trading ahead of the customers limit order . . . for its own market-making account at prices that would satisfy the customers limit order. Order Approving Proposed Rule Change by the NASD Relating to Limit Order Protection and Nasdaq, Exchange Act Release No. 35,571, 60 Fed. Reg. 27,997, 27,997 (May 22, 1995). Being true to the chosen course, the regulatory agency subsequently required displaying customer limit orders in addition to market makers quotes. Order Execution Obligations, Exchange Act Release No. 37,619A, 61 Fed. Reg. 48,290, 48,290 (Sept. 6, 1996). 84 Also compare Ribstein, supra note 1, at 902 (arguing that [a] fiduciary relationship differs from the broader category of agency relationships), with Laby, supra note 71, at 721 (analyzing the position that [o]ne would expect a broker acting as an agent to be held to a fiduciary standard and pointing out that every version of the Restatement of Agency classifies an agency relationship as a fiduciary one). Perhaps this issue can be framed in terms of the scope of a fiduciary duty owed by a broker, i.e., its reach beyond the duty of best execution. 85 United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *18 (S.D.N.Y. Sept. 6, 2006) (citation omitted). 86 United States v. Finnerty, 474 F. Supp. 2d 530, 544 n.10 (S.D.N.Y. 2007). 87 Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828, 843 (N.D. Ill. 2010).
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were fiduciaries of plaintiffs.88 Furthermore, [h]ad plaintiffs put forward evidence of a more direct solicitation, perhaps through letters or telephone calls, [the court] would be more inclined to agree with them that defendants actively solicit[ed] them as clients.89 Although not in the context of the fiduciary standard, another court also noted that the prosecution had identified no way in which [the defendant specialist] communicated anything to his customers, let alone anything false.90 Another factor considers certain characteristics of the securities market in question. There is a continuum between an impersonal and transparent trading venue with a large number of buyers and sellers open to the public, which ensures its liquidity, and an informal market in relatively illiquid securities, which mostly operates through direct solicitations and preexisting relationships, as well as associated duties. For instance, one court pointed to the role . . . stemming from the relationship between the parties . . . comparable to that of a fiduciary [for] market makers who were actively involved in encouraging the market for the stock through personal solicitations and receipt of commissions.91 On the other end of the spectrum, the existence of a fiduciary duty is less likely when a market maker on a public market act[s] as a catalyst, bringing buyers and sellers together to complete deals92 and [p]rovid[es] quotes [which] are disseminated by the Exchanges through their systems.93 III. CERTAIN PRACTICES OF MARKET MAKERS INTEGRAL TO THE FUNCTION OF PROVIDING LIQUIDITY THAT MAY GIVE RISE TO A FIDUCIARY DUTY While market making as such does not create a general fiduciary duty owed to other market participants, certain trading strategies and arrangements that may be viewed as integral to the function of providing liquidity potentially expose market makers to liability or at least create nontrivial risks and costs of litigation. One illustration is the practice of payment for order flow (PFOF), which is defined as the practice in the securities industry of brokers receiving payments from market makers or exchange specialists for having directed a volume of transactions to such market makers or exchange specialists for
Id. at 844 n.14. Id. at 844 n.15. 90 United States v. Finnerty, 533 F.3d 143, 14849 (2d Cir. 2008). 91 In re Towers Fin. Corp. Noteholders Litig., No. 93 Civ. 0810 (WK) (AJP), 1995 U.S. Dist. LEXIS 21147, at *60 (S.D.N.Y. Sept. 20, 1995) (interpreting Affiliated Ute Citizens v. United States, 406 U.S. 128, 15253 (1972)). 92 United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *17 (S.D.N.Y. Sept. 6, 2006). 93 Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828, 843 (N.D. Ill. 2010).
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execution of the orders placed by investors.94 In one controversy, the court had to evaluate the following PFOF-related allegation: Plaintiffs also argue that [a]ll defendants solicited public customer orders by participating in Exchange-sponsored [PFOF] programs pursuant to which each defendant received the proceeds from marketing fees collected by the Exchanges that were then used to pay certain broker-dealer firms . . . that were selected by the defendants in exchange for their agreement to route public customer orders to the defendants at their respective Exchanges.95 In one of its decisions on this controversy, the court made a rather disputable statement that [t]here is no evidence that [the defendant specialist] sought plaintiffs as customers, nor is there evidence that [the defendant specialist] made payments to broker-dealers in an attempt to secure more public customers.96 Yet, PFOF programs serve the role of securing additional order flowand hence attracting more traderson the level of individual market makers and even trading venues,97 as many securities are cross-listed. Overall, PFOF programs are
Gilman v. BHC Sec., Inc., No. 94 Civ. 1133 (AGS), 1995 U.S. Dist. LEXIS 18682, at *3 (S.D.N.Y. Dec. 18, 1995), revd, 104 F.3d 1418 (2d Cir. 1997). One court further described PFOF programs as a type of volume discountin either cash or in-kind servicesby which market makers (who actually execute securities transactions) reward brokers for having directed business to them. Gilman, 104 F.3d at 1420. An early analysis of the origins of this practice similarly observed that the value in order flow is derived from the aggregation of small orders, which in turn allows market makers to profit from the dealers turn [i.e., the bid-ask spread], to more easily trade in and out of positions, and to make use of information reflected in order flow regarding market sentiment. PAYMENT FOR ORDER FLOW COMM., INDUCEMENTS FOR ORDER FLOW: A REPORT TO THE NASD BOARD OF GOVERNORS 23 (1991). For an analysis of the practice of PFOF from the standpoint of asymmetric information, see Stanislav Dolgopolov, Insider Trading, Informed Trading, and Market Making: Liquidity of Securities Markets in the Zero-Sum Game, 3 WM. & MARY BUS. L. REV. (forthcoming Feb. 2012) (manuscript at 22 & nn.5859) (on file with author). 95 Last Atlantis, 2010 U.S. Dist. LEXIS 117680, at *44 n.12; see also Last Atlantis Capital LLC v. ASG Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS 29175, at *21 (N.D. Ill. Mar. 26, 2010) (quoting the plaintiffs allegation that the defendant specialist actively solicited customers by, inter alia, directing monetary payments to certain brokerage firms in exchange for their agreements to direct customer orders to the Exchanges at which [it] was a designated specialist). 96 Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *22 (emphasis added). 97 See, e.g., Proposed Amendments to Rule 610 of Regulation NMS, Exchange Act Release No. 61,902, 75 Fed. Reg. 20,738, 20,74041 (proposed Apr. 14, 2010) (Many exchanges also charge a payment for order flow or marketing fee to market makers that trade with customer orders on the exchange. The exchange then makes the proceeds from such fees available . . . to collectively fund payment for order flow to brokers directing order flow to the exchange.) (footnote omitted).
94
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integral to the chosen model of providing liquidity despite potential conflicts of interest and other problems that this model may entail.98 In a later decision, the court question[ed] how . . . a [PFOF] program indicates a connection or relationship between defendants and plaintiffs, as plaintiffs too-brief description of it shows a connection, at most, between defendants and the order entry firms.99 However, this issue was left open because the plaintiffs argument on this point [was] waived as undeveloped.100 Indeed, it is a stretch to suggest that some duty owed by an order flow-selling broker to its customers is somehow transferred to an order flow-buying market maker when they enter into a payment arrangement presumably negotiated at arms-length. A similar controversy involved a clearing broker that settled and cleared trades and performed certain other functions for retail brokers, and the clearing broker in turn directed orders submitted through retail brokers to market makers in exchange for PFOF.101 The court suggested in its dictum that the clearing broker did not owe a fiduciary duty to customers of the retail broker,102 and one can infer the insulation of a market maker from the fiduciary standard by analogy.
For recent criticisms of the continuing existence of PFOF programs, see Letter from David M. Battan, Exec. Vice President, Interactive Brokers Grp. LLC, to Florence Harmon, Acting Secy, U.S. Sec. & Exch. Commn 2 (Sept. 8, 2008), available at http://www.sec.gov/comments/srnysearca-2008-75/nysearca200875-4.pdf (arguing that [p]ayment for order flow reduces competition); Letter from Robert R. Bellick, Managing Dir., Wolverine Trading, LLC, to Nancy M. Morris, Secy, U.S. Sec. & Exch. Commn 4 (Sept. 10, 2008), available at http://www.sec.gov/comments/sr-nysearca-2008-75/nysearca200875-5.pdf (arguing that the practice of accepting PFOF calls into question whether a broker is fulfilling its fiduciary duties to its customers [and that] brokers can simply make mindless routing decisions and reap the benefits of PFOF rebates); Letter from Eric J. Swanson, SVP & Gen. Counsel, BATS Exch., Inc. to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 4 (Apr. 21, 2010), available at http://www.sec.gov/comments/s7-02-10/s70210-146.pdf (arguing that the historical practice of payment for order flow . . . is opaque, subject to little effective regulatory oversight, and . . . only benefits certain market participants). But see Letter from Janet M. Kissane, Senior Vice President Legal & Corp. Secy, NYSE Euronext, to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 6 (June 18, 2010), available at http://www.sec.gov/comments/s7-09-10/s70910-16.pdf [hereinafter NYSEs Fee Cap Letter] (arguing that [the] level [of PFOF amounts] has been established in a highly competitive market environment based on the value of that order flow to liquidity providers). 99 Last Atlantis, 2010 U.S. Dist. LEXIS 117680, at *44 n. 12. 100 Id. 101 Gilman v. BHC Sec., Inc., 104 F.3d 1418, 142324 (2d Cir. 1997). 102 Gilman v. BHC Sec., Inc., No. 94 Civ. 1133 (AGS), 1995 U.S. Dist. LEXIS 18682, at *10 (S.D.N.Y. Dec. 18, 1995). Given the remoteness of the defendant from the ultimate customers, this scenario is different from more common cases in which retail brokers are alleged to have violated their common law fiduciary obligations to their customers by participating in PFOF programs. Francis J. Facciolo, When Deference Becomes Abdication: Immunizing Widespread Broker-Dealer Practices from Judicial Review Through the Possibility of SEC Oversight, 73 MISS. L.J. 1, 49 (2003).
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Overall, there is some ambiguity as to whether certain practices of market makers integral to the function of providing liquidity may give rise to a fiduciary duty. In addition to being a deviation from the thrust of the doctrine insulating market making as such from the fiduciary standard, this ambiguity may have adverse consequences for the liquidity of securities markets. Furthermore, debates about various costs and benefits associated with different business models of providing liquidity may be ultimately decided in the courtroom rather than by the forces of competition.103 Given the complexity of various payment / inducement structures for market making, if PFOF programs are scrutinized in the context of fiduciary duties, then other mechanisms, such as liquidity rebates,104 might also seem suspect. IV. THE SIGNIFICANCE OF THE CHANGING ECONOMICS AND INSTITUTIONAL FRAMEWORK OF PROVIDING LIQUIDITY IN SECURITIES MARKETS AND THE CURRENT REGULATORY AGENDA Looking forward at potential litigation, it is important to analyze the significance of the changing economics and institutional framework of providing liquidity, which are influenced by technological advances and the evolving roles, obligations and privileges, and even boundaries of market makers. Another pivotal factor is the focus of the current regulatory agenda on the scope of fiduciary duties of broker-dealers.
103
See, e.g., Letter from John A. McCarthy, Gen. Counsel, Global Elec. Trading Co., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 4 (June 23, 2010), available at http://www.sec.gov /comments/s7-09-10/s70910-25.pdf [hereinafter GETCO Letter] (describing the competition between two separate and very distinct market structuresthe maker-taker model and the PFOF model in options markets in the context of the proposed cap on access fees); see also NYSEs Fee Cap Letter, supra note 98, at 3 (arguing that [e]ach of these business models [including the PFOF model] targets a particular type of market participant or order flow, earning a larger piece of the business from those target segments and forcing competing exchanges to find innovative ways to win that business back, ultimately driving down costs for all market participants). 104 Under the maker-taker model of providing liquidity, liquidity rebates are paid for submitting passive orders and funded by fees charged for submitting aggressive orders. A liquidity rebate is effectively akin to an option premium paid to the option writer, who displays limit orders in the book. Letter from Chi-X Europe Ltd to the Comm. of Eur. Sec. Regulators 11 (Apr. 30, 2010) available at http://www.esma.europa.eu/index.php?page=response_details&c_id=158&r_id=5369. For a further description of the maker-taker model and liquidity rebates, see Concept Release on Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 369899, 3707 08 (Jan. 14, 2010). Interestingly, the maker-taker model is sometimes attacked for similar reasons as PFOF programs. See Letter from U.S. Sen. Edward E. Kaufman to Mary L. Shapiro, Chairman, U.S. Sec. & Exch. Commn att., at 6 (Aug. 5, 2010), available at http://www.sec.gov/comments/s7 -27-09/s72709-96.pdf ([M]aker-taker pricing creates inherent conflicts of interests. Because they are not required to pass along rebates to their customers, brokers might be inclined to direct order flow to the trading venue offering the lowest transaction costs, but not necessarily the best order execution.).
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If anything, imposing a general fiduciary duty on market makers makes even less sense in the rapidly evolving financial marketplace transformed by the emergence of high-frequency trading,105 as it is increasingly problematic to identify a relationship of trust and confidence. In many securities markets, liquidity is now provided by a wide range of market participants and in different forms,106 as [t]he democratisation of market making is now a reality.107 One manifestation of this trend is the spread of the maker-taker model of providing liquidity, described as a structure that rewards any participant that provides liquidity and charges those who consume liquidity,108 and this model even makes it possible to be a one-sided provider of liquidity. Overall, the lines between market making and proprietary trading, such as statistical arbitrage, are becoming increasingly blurry,109 which once again emphasizes the arms-length character of such transactions.110 The existence of a fiduciary duty attached to the function of providing liquidity in a high-speed trading environment may also create a host of problems tied to such sensitive issues to market makers as
For a selective mix of general sources on high-frequency trading, see DURBIN, supra note 3; EDGAR PEREZ, THE SPEED TRADERS: AN INSIDERS LOOK AT THE NEW HIGH-FREQUENCY TRADING PHENOMENON THAT IS TRANSFORMING THE INVESTING WORLD (2011); Peter Gomber et al., HighFrequency Trading (Mar. 2011) (unpublished manuscript) (on file with author), available at http://ssrn.com/abstract=1858626; Thierry Rijper et al., Optiver Holding B.V., High Frequency Trading (Dec. 2010) (unpublished manuscript) (on file with author), available at http://optiver.com/corporate/hft.pdf. 106 A similar architecture of securities markets was envisioned a long time ago in Fischer Black, Toward a Fully Automated Stock Exchange (pts. 1 & 2), FIN. ANALYSTS J., JulyAug. 1971, at 28, FIN. ANALYSTS J., Nov.Dec. 1971, at 24. 107 Letter from Paul ODonnell, Chief Operating Officer & Anna Westbury, Head of Compliance and Regulatory Affairs, BATS Trading Ltd., to the Comm. of Eur. Sec. Regulators 2 (Apr. 30, 2010), available at http://www.esma.europa.eu/index.php?page=response_details&c_id=158&r_id =5370. 108 GETCO Letter, supra note 103, at 5. 109 See Letter from Manoj Narang, Chief Exec. Officer, Tradeworx, Inc., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn app. at 9 (Apr. 21, 2010), available at http://www.sec.gov/comments/s7-02-10/s70210-129.pdf. 110 On the other hand, the countervailing factor is that certain financial institutions affiliated with commercial banks are prohibited from engaging in proprietary trading and allowed to participate in market-making-related activities . . . to the extent that any such activities . . . are designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties by the so-called Volcker Rule. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 619, 124 Stat. 1376, 1620, 1624 (2010). Of course, distinguishing market making from proprietary trading is a challenging task. See FED. STABILITY OVERSIGHT COUNCIL, STUDY & RECOMMENDATIONS ON PROHIBITIONS ON PROPRIETARY TRADING & CERTAIN RELATIONSHIPS WITH HEDGE FUNDS & PRIVATE EQUITY FUNDS 2225 (2011), available at http://www.treasury.gov/ initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.p df.
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limitations on order cancellation and a minimum order duration,111 which recently gained attention in regulatory debates. The evolution of obligations and privileges of market makers also makes it more problematic to identify a relationship of trust and confidence. [T]he dispersal of liquidity across a large number of trading centers of different types112 has effectively destroyed the quasi-monopoly franchise enjoyed by some market makersoften compounded by their privileged position vis--vis other market participants on the same trading venuein the past.113 Another pivotal factor is that market makers serving in the capacity of agents or quasiagentsespecially paid onesare becoming harder to find.114 The abolition by some trading venues of the negative obligation, i.e., the prohibition of transactions by a market maker for its own account that are not reasonably related to the maintenance of a fair and orderly market,115 reinforces the incentive to
See, e.g., Letter from Stuart J. Kaswell. Exec. Vice President, Managing Dir. & Gen. Counsel, Managed Funds Assn, to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 22 (May 7, 2010), available at http://www.sec.gov/comments/s7-02-10/s70210-178.pdf (Market makers have always cancelled and refreshed their quotes in response to market movements. . . . If the [SEC] were to limit cancellations in any way, market participants would be more reluctant to post limit orders, which would likely result in a widening of spreads and a decrease in liquidity.); Letter from Brett F. Mock, Chairman & John C. Giesea, President and CEO, Sec. Traders Assn, to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 8 (Apr. 30, 2010), available at http://www.sec.gov/comments/s7-02-10/s70210-170.pdf (Requiring a minimum duration for orders is draconian and inconsistent with the operation of efficient markets. . . . Setting an arbitrary minimum time that an order must be in force will expose the liquidity provider to much greater risk for which they will require greater compensation in the form of wider spreads.). 112 Concept Release on Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3600 (Jan. 14, 2010). This development has also spread beyond equity markets, which is exemplified by the multiple listing of many options. See Proposed Amendments to Rule 610 of Regulation NMS, Exchange Act Release No. 61,902, 75 Fed. Reg. 20,738, 20,738 (proposed Apr. 14, 2010). 113 See, e.g., William O. Brown, Jr. et al., Competing with the New York Stock Exchange, 123 Q.J. ECON. 1679, 1679 (2008) (presenting empirical evidence consistent with the view that the NYSE specialists possessed market power to charge higher bid-ask spreads); Harold Demsetz, The Cost of Transacting, 82 Q.J. ECON. 33, 4245 (1968) (analyzing sources of market power and competitive forces in the context of the specialist system on the NYSE). 114 See, e.g., Order Approving a Proposed Rule Change To Create a New NYSE Market Model, Exchange Act Release No. 58,845, 73 Fed. Reg. 64,379, 64,389 (Oct. 24, 2008) (stating that designated market makers, specialists replacements on the NYSE, are no longer subject to the specialists agency responsibilities with respect to orders on the Display Book); see also Notice of Filing and Immediate Effectiveness of a Proposed Rule Change for a Pilot Program To Establish a New Class of NYSE Market Participants That Will Be Referred to as Supplemental Liquidity Providers, Exchange Act Release No. 58,877, 73 Fed. Reg. 65,904, 65,904 (Oct. 29, 2008) (stating that an additional class of liquidity providers on the NYSE are not to act on an agency basis). 115 See, e.g., Order Approving a Proposed Rule Change To Create a New NYSE Market Model, 73 Fed. Reg. at 64,380. However, the SEC rule applicable to any specialist on a securities exchange restricting his dealings so far as practicable to those reasonably necessary to permit him
111
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combine market making and proprietary trading. An additional development is that changes in the business models of many exchanges and advancements in technology have eliminated or reduced the value of the special time and place privileges traditionally enjoyed by specialists and registered market makers.116 However, given recent debates about balancing obligations and privileges of market makers, it is feasible that new advantages of these market participants going beyond favorable pricing and order allocation, such as time and information advantages,117 will beget a new wave of litigationperhaps ultimately futileinvoking the fiduciary theory of liability.118 The existing case law indicates that merely being a professional participant in securities markets does not create a fiduciary-like duty.119 By
to maintain a fair and orderly market or necessary to permit him to act as an odd-lot dealer still remains on the books. Regulation of Specialists, 17 C.F.R. 240.11b-1(a)(2)(iii) (2011). 116 Letter from Greg Tusar, Managing Dir., Goldman Sachs Execution & Clearing, L.P. & Matthew Lavicka, Managing Dir., Goldman Sachs & Co., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 7 (June 25, 2010), available at http://www.sec.gov/comments/s7-0210/s70210-243.pdf. As an illustration, the NYSE recently eliminated the advance look at incoming orders, which was previously available to specialists, for designated market makers. Order Approving a Proposed Rule Change To Create a New NYSE Market Model, 73 Fed. Reg. at 64,389. 117 One example is a proposed regulation to [h]old every order for a tenth of a second with the exception of market maker quote updates for products in which the market maker is registered and has affirmative obligations. There is simply no other measure that can protect market makers against being picked off. Thomas Peterffy, Chairman & CEO, Interactive Brokers Grp., Comments Before the 2010 General Assembly of the World Federation of Exchanges 6 (Oct. 11, 2010), http://investors.interactivebrokers.com/download/worldFederationOfExchanges.pdf. For a discussion of the pick off concern of market makers caused by stale quotes, see Dolgopolov, supra note 94 (manuscript at 1719 & n. 4653). Another example is the suggestion that a set of market making privileges might include preferential co-location provisions. JOINT CFTC-SEC ADVISORY COMM. ON EMERGING REGULATORY ISSUES, SUMMARY REPORT, RECOMMENDATIONS REGARDING REGULATORY RESPONSES TO THE MARKET EVENTS OF MAY 6, 2010, at 10 (2011), available at http://www.sec.gov/spotlight/sec-cftcjointcommittee/021811-report.pdf. 118 The existence of inherent advantages enjoyed by certain market makers was recognized by the federal courts in the past, but, so far, it has made no visible impact in the debate over the reach of the fiduciary standard. See, e.g., United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist. LEXIS 72119, at *4 (S.D.N.Y. Oct. 2, 2006) (Because of their position, specialists had access to certain material informationsuch as advance knowledge of the price parameters of all open ordersand accordingly were subject to certain rules and obligations to prevent them from taking unfair advantage of investors.). In any instance, even if a market maker possesses significant advantages, it is doubtful that this situation fits the scenario when one party figuratively holds all the cardsall the financial power or technical information, for example [indicating that] a fiduciary relationship has arisen. Broussard v. Meineke Disc. Muffler Shops, Inc., 155 F.3d 331, 348 (4th Cir. 1998). 119 For instance, one court remarked that no fiduciary duty, for [Rule] 10b-5 purposes, exists for broker-dealers simply by virtue of their status as market professionals. Vannest v. Sage, Rutty & Co., 960 F. Supp. 651, 656 (W.D.N.Y. 1997) (interpreting Moss v. Morgan Stanley Inc., 719 F.2d 5, 15 (2d Cir. 1983)).
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contrast, the current regulatory agenda is influenced by the debates about the merits of imposingor rather expanding the scope offiduciary duties on broker-dealers120 and the grant of the rule-making authority to the SEC to establish a fiduciary duty for brokers and dealers by setting the standard of conduct applicable to an investment adviser [for] providing personalized investment advice about securities to a retail customer (and such other customers as the [SEC] may by rule provide).121 Furthermore, the regulatory agency was advised by its own staff to adopt and implement, with appropriate guidance, the uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.122 On the other hand, a securities industry group specifically cautioned the SEC to consider the effect of [the fiduciary] standard on investors and the vibrancy of markets, particularly in the context of broker-dealers role as market makers.123 Similarly, another industry group warned that [t]he standard of care must allow retail clients to have ready access to investments that are sold on a principal basis and that, [i]f retail customers lose access to [the] liquidity [provided by affiliated market makers], their execution costs will in many cases
For a sample of academic commentary, see Kristina A. Fausti, A Fiduciary Duty for All?, 12 DUQ. BUS. L.J. 183 (2010); Hazen, supra note 12; Donald C. Langevoort, Brokers as Fiduciaries, 71 U. PITT. L. REV. 439 (2010); Symposium, Papers on a Fiduciary Duties for Broker-Dealers, 30 REV. BANKING & FIN. L. 119 (201011). One academic commentator argued that a general fiduciary duty applicable to a broad range of investment banker dealings would leave significant uncertainty as to the nature of the duties in each specific context and specifically pointed to the problem whether investment bankers [would be able to] participate in market-making, which inherently involves positions on both sides of the market. Wall Street Fraud and Fiduciary Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?: Hearing Before the Subcomm. of the S. Comm. on the Judiciary, 111th Cong. 14647 (2011) (prepared statement of Larry E. Ribstein, Mildred van Voorhis Jones Chair, University of Illinois College of Law). 121 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 913(g), 124 Stat. 1376, 1828 (2010); see also Arthur B. Laby, SEC v. Capital Gains Research Bureau and the Investment Advisers Act of 1940, 91 B.U. L. REV. 1051, 10981100 & n.402415 (2011) (scrutinizing the reach of the statutory text and its legislative history); Ribstein, supra note 1, at 919 & nn. 12021 (same). Currently, broker-dealers in general are not subject to the fiduciary standard applicable to investment advisors. See STAFF, U.S. SEC. & EXCH. COMMN, STUDY ON INVESTMENT ADVISERS AND BROKER-DEALERS 1516 (2011), available at http://www.sec.gov/ news/studies/2011/913studyfinal.pdf [hereinafter SECS STAFF, SECTION 913 REPORT] (discussing the scope of the relevant exemptions); see also SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS, supra note 5, at 609 (discussing whether the fiduciary standard for an investment adviser was applicable in the Goldman Sachs controversy). 122 SECS STAFF, SECTION 913 REPORT, supra note 121, at 165. But see Tamar Frankel, The Regulation of Brokers, Dealers, Advisors and Financial Planners, 30 REV. BANKING & FIN. L. 123, 129 (201011) (arguing that it is crucial to impose fiduciary duties on all brokers, etc. regardless of whether their clients are what we call sophisticated). 123 Letter from Richard H. Baker, President & CEO, Managed Funds Assn, to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 20 (Sept. 22, 2010), available at http://www.sec.gov/ comments/4-606/4606-2809.pdf.
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substantially increase, and markets will lose a significant source of liquidity.124 An openly pessimistic view on the imposition of the fiduciary standard paints the following scenario of market making in certain securities: Broker-dealers would be asked essentially to insure all of the securities they sell to their customers, as any customer with an investment loss will seek to capitalise on the inherent conflicts of interest that will continue to exist for a broker-dealer that not only sells, but makes markets in and structures, securities.125 Ultimately, the impact of this regulatory agenda, which may potentially negate the existing decisions of the federal courts with respect to market makers, will depend on the SECs regulatory zeal, the definition of the protected class of investors, and the statutory interpretation. One telltale sign is that the regulatory agencys staff report specifically mentioned the securities industrys request to exclude market making from the definition of personalized investment advice126 in the context of the staffs recommendation that the covered activities should not include impersonal investment advice as developed under the [Investment] Advisers Act of 1940.127 The report also recognized that a different regulatory treatment of such activities as market making and underwriting primarily reflect[s] the different functions and business activities of investment advisers and broker-dealers . . . and may allow for diversity of products or services and investor choice.128 But if market making services are bundled with personalized investment advice as a result of the economies of scope, the
Letter from Ira D. Hammerman, Senior Managing Dir. & Gen. Counsel, Sec. Indus. & Fin. Mkts. Assn, to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 10 (Aug. 30, 2010), available at http://www.sec.gov/comments/4-606/4606-2553.pdf; see also Industry Perspectives of the Obama Administrations Financial Regulatory Reform Proposals: Hearing Before the H. Comm. on Fin. Servs., 111th Cong. 11011 (2009) (prepared statement of Randolph C. Snook, Executive Vice President, Securities Industry and Financial Markets Association) ([W]hen broker-dealers are not providing personalized securities investment advice to individual investors . . . for example, when broker-dealers . . . engage in market making . . . there is no cause for modifying the existing, extensive regulatory regime that governs broker-dealers.). 125 Moloney et al., supra note 8, at 345. 126 SECS STAFF, SECTION 913 REPORT, supra note 121, at 126 n.573. 127 Id. at 127; see also Letter from John Junek, Exec. Vice President & Gen Counsel, Ameriprise Fin., Inc., to Elizabeth M. Murphy, Secy, U.S. Sec. & Exch. Commn 2 & n.3 (Aug. 30, 2010), available at http://www.sec.gov/comments/4-606/4606-2640.pdf (suggesting that the exclusion of market making from the scope of personalized investment advice is consistent with classifying this activity as impersonal investment advice under the Investment Advisers Act of 1940); Letter from Sarah A. Miller, Exec. Dir. & Gen. Counsel, ABA Sec. Assn, and Senior Vice President, Am. Bankers Assn, to Elizabeth Murphy, Secy, U.S. Sec. & Exch. Commn 3 n.6 (Aug. 30, 2010), available at http://www.sec.gov/comments/4-606/4606-2717.pdf (arguing that the SEC was not directed [by the Dodd-Frank Act of 2010] to carry forward the principal transaction prohibitions of Section 206(3) of the Investment Advisers Act [of 1940]). 128 SECS STAFF, SECTION 913 REPORT, supra note 121, at 104.
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impact of regulation may still spill over to market making. This scenario is not unlikely for certain custom-made securities, but it is probably more applicable to sophisticated rather than retail customers. V. SEVERAL LEGAL ISSUES RELEVANT TO MARKET MAKERS WITH RESPECT TO THEIR REGULATORY ENVIRONMENT AND CIVIL LIABILITY The restraint on the application of the fiduciary standard to market makers interacts with several legal issues relevant to these market participants with respect to their regulatory environment and civil liability under federal securities law. These issues also illustrate the potential applicability of certain restraints, such as other heightened duties, to market makers and raise the question of the sufficiency of such restraints in the absence of the fiduciary standard. While analyzing the reach of the fiduciary standard, the federal courts on several occasions addressed the shingle theorya variation of a heightened duty, although there is some disagreement among commentators with respect to the nature of this theory and its overlap with the agency / fiduciary approach129 and declined to apply this heightened duty to market makers. One court stated that specialists do not actively solicit customers, and unlike securities dealers, do not hang[] out [their] professional shingle.130 Another court based its decision on the precedent that was interpreted as a reject[ion] [of] the equivalent of the shingle theory and a requirement of a statement or conduct.131 While the SEC has effectively endorsed the shingle theory with respect to market making
Compare Louis Loss, The SEC and the Broker-Dealer, 1 VAND. L. REV. 516, 518 (1948) (This [theory] has nothing to do with any agency obligation. . . . [E]ven a dealer at arms length impliedly represents when he hangs out his shingle that he will deal fairly with the public.), and Laby, supra note 69, at 427 (The compromise struck by the shingle theory . . . [which] prohibit[s] an unreasonable price . . . stops short of requiring a dealer to act as a fiduciary.), with Roberta S. Karmel, Is the Shingle Theory Dead?, 52 WASH & LEE L. REV. 1271, 129596 (1995) (The shingle theory . . . embodies the notion that broker-dealers impliedly represent that they will deal fairly, but this implied representation is really a legal fiction. At bottom, the shingle theory rests on the premise that a broker-dealer has fiduciary obligations to its customers.), and Cheryl Goss Weiss, A Review of the Historic Foundations of Broker-Dealer Liability for Breach of Fiduciary Duty, 23 J. CORP. L. 65, 89 (1997) ([O]ften accompanying the implied representation contract language of the opinions [endorsing the shingle theory] is language implying fiduciary responsibilities, including equitable concepts of unequal relationship, trust and confidence, and full disclosure.). 130 United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist. LEXIS 72119, at *19 (S.D.N.Y. Oct. 2, 2006) (alterations in original) (quoting Grandon v. Merrill Lynch & Co., Inc., 147 F.3d 184, 192 (2d Cir. 1998). 131 Last Atlantis Capital LLC v. AGS Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS 29175, at *1415 (N.D. Ill. Mar. 26, 2010) (following United States v. Finnerty, 533 F.3d 143 (2d Cir. 2008)).
129
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activities in the past,132 the author is not aware of any case that explicitly recognized such an application.133 On the other hand, the scope of implied representations deemed to be made by market makers perhaps remains an open issue.134 Potential liability of market makers for market manipulation135 does not require the existence of a fiduciary duty.136 Similarly, the applicability of the fraud-on-the-market doctrine to market makers137 has no such requirement.138 In fact, the reach of the fraud-on-the-market doctrine been found to be broader than just fundamental information about underlying companies: The fraud-on-the-market doctrine is applicable to misstatements about specific securities as well as misstatements about the marketplace for those securities. . . . Just as information about a specific security is reflected in the price of that security, so too is information about the manner in which transactions would be completed reflected in the price of securities generally.139
See, e.g., Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1895 (Mar. 30, 2004) (arguing that NYSE specialists make implied representations to public customers that they [are] limiting dealer transactions to those reasonably necessary to maintain a fair and orderly market); Albert Fried & Co., Exchange Act Release No. 15,239, 16 SEC Docket 100, 105 (Nov. 3, 1978) (arguing that the [NYSE] specialist impliedly represents that he will not take advantage of his unique position and his customers ignorance of market conditions nor exploit that ignorance to extract unreasonable profits). 133 Furthermore, one decision suggests that the shingle theory only covers conduct that arise[s] from affairs entrusted to the broker as a fiduciary, agent, or trustee. Bissell v. Merrill Lynch & Co., 937 F. Supp. 237, 247 (S.D.N.Y. 1996). This interpretation most likely excludes the function of providing liquidity by itself. 134 See, e.g., United States v. Finnerty, 474 F. Supp. 2d 530, 54243 (S.D.N.Y. 2007); United States v. Hayward, No. 05 Cr. 390 (SHS), 2006 U.S. Dist. LEXIS 37108, at *56 (S.D.N.Y. June 5, 2006). 135 See, e.g., United States v. Fiore, 381 F.3d 89, 9091 (2d Cir. 2004); SEC v. Diversified Corp. Consulting Grp., 378 F.3d 1219, 1223 (11th Cir. 2004); SEC v. Sayegh, 906 F. Supp. 939, 94041, 946 (S.D.N.Y. 1995). 136 See, e.g., United States v. Regan, 937 F.2d 823, 829 (2d Cir. 1991) ([The] argument that a fiduciary relationship must exist before liability [for market manipulation] can be found is without merit.). 137 See, e.g., In re NYSE Specialists Sec. Litig., 405 F. Supp. 2d 281, 31819 (S.D.N.Y. 2005). 138 See, e.g., Fry v. UAL Corp., 84 F.3d 936, 938 (7th Cir. 1996) (The duty not to make misrepresentations does not depend on the existence of a fiduciary relationship [such as in fraudon-the-market cases]. . . . If it did, very little fraud would be actionable.). 139 NYSE Specialists, 405 F. Supp. 2d at 31819. On the other hand, this conclusion was somewhat weakened on the appellate leveldespite the recognition of the reach of the fraud-onthe-market doctrinebecause no clear price effect on the relevant securities had been shown: [T]he government has attributed to [the defendant specialist] nothing that deceived the public or affected the price of any stock: no material misrepresentation, no omission, no breach of a duty to disclose, and no creation of a false appearance of fact by any means. United States v. Finnerty,
132
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In a related case, in which actions of an options exchange, a clearinghouse, and options market makers allegedly led to inflated prices, the reach of the fraud-on-the-market doctrine to market makers was also recognized: A successful scheme to charge excessive prices across the market and not to disclose that fact affects the integrity of market prices as surely as any scheme to spread false information about corporate prospects that affects the price only of a single issuers stock.140 Another consideration is that a securities firm in certain situations may be obligated to disclose its market maker status in order to prevent civil liability.141 The SEC also requires broker-dealers to supply its customers with a written notification for transactions disclosing [w]hether the broker or dealer is acting as agent for such customer, as agent for some other person, as agent for both such customer and some other person, or as principal for its own account; and if the broker or dealer is acting as principal, whether it is a market maker in the security.142 Finally, market makers must abide by the rules of self-regulatory organizations, which are approved and sometimes guided by the SEC, that establish market makers trading obligations,143 although these obligations do not necessarily trigger civil liability under federal securities law with respect to other market participants.144 On the other hand, in the context of trading obligations of
533 F.3d 143, 151 (2d Cir. 2008). In another reiteration of this controversy, the district court once again asserted that the fraud-on-the-market doctrine is potentially applicable, as the plaintiffs were presumed to rely on an efficient and fair market, and extended its analysis to customer expectation in terms of reliance. In re NYSE Specialists Sec. Litig., 260 F.R.D. 55, 7779 (S.D.N.Y. 2009). 140 Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *35 (N.D. Ill. Oct. 24, 1990). 141 See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d 1168, 116869 (2d Cir. 1970); Glynwill Invs., N.V. v. Prudential Sec., Inc., No. 92 Civ. 9267 (CSH), 1995 U.S. Dist. LEXIS 8262, at *13 15 (S.D.N.Y. June 15, 1996); Shamsi v. Dean Witter Reynolds, Inc., 743 F. Supp. 87, 93 (D. Mass. 1989); see also Carl Wartman, Note, Broker Dealers, Market Makers and Fiduciary Duties, 9 LOY. U. CHI. L.J. 746, 75761 (1978). 142 Confirmation of Transactions, 17 C.F.R. 240.10b-10(a)(2) (2011). 143 One recent example is the ban on stub quotes by several trading venues as a part of more stringent quotation standards for market makers in the aftermath of the Flash Crash of May 6, 2010, and this measure was passed in coordination with the SEC. Order Granting Approval to Proposed Rule Changes by Several Self-Regulatory Organizations To Enhance the Quotation Standards for Market Makers, Exchange Act Release No. 63,255, 75 Fed. Reg. 69,484, 69,484 (Nov. 5, 2010). The regulatory agency started consider[ing] steps to deter or prohibit the use by market makers of stub quotes on its own shortly after the Flash Crash. Examining the Causes and Lessons of the May 6th Market Plunge: Hearing Before the Subcomm. on Sec., Ins., & Inv. of the S. Comm. on Banking, Hous., & Urban Affairs, 111th Cong. 54 (2010) (prepared statement of Mary L. Shapiro, Chairman, U.S. Securities and Exchange Commission). 144 See Finnerty, 533 F.3d at 151 (holding that violations of the rules aimed to prevent interpositioning by market makers do[] not establish securities fraud in the civil context [under
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market makers, the rationale of implied misrepresentations perhaps may serve as a viable channel for establishing a private right of action.145 For instance, backing its view with the precedent that addressed implied misrepresentations in the context of civil liability, the SEC made the following statement: Specialists impliedly represent to their customers that they are dealing fairly with the public in accordance with the standards and practices applicable to specialists, namely, that they are limiting their dealer transactions to those reasonably necessary to maintain a fair and orderly market. A specialists failure to comply with this implied representation, if done with scienter, can constitute a violation of the antifraud provisions of the securities laws.146 CONCLUSION The federal courts unwillingness to identify a broad fiduciary duty owed by market makers is to be applauded, as this dutyand the corresponding litigation-related riskscan morph into something dangerous for the liquidity of securities markets instead of boosting confidence into them. The intuitive rationale about the impossibility of serving two mastersan idealized twosided loyalty in arms-length transactionsappears to be the strongest argument in favor of this outcome. The thrust of the case law should also serve as guidance when certain practices of market makers integral to the function of providing liquidity may be interpreted as giving rise to a fiduciary duty. On the other hand, in a variety of situations, such as those involving personalized relationships and relatively illiquid / custom-made securities traded in an informal market, it seems likely that the federal courts will find the existence of a heightened duty
Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5] . . . let alone in a criminal prosecution); Spicer v. Chi. Bd. of Options Exch., Inc., 977 F.2d 255, 26566 (7th Cir. 1992) (holding that violations of the rule requiring market makers to engage in transactions that constitute a course of dealings reasonably calculated to contribute to the maintenance of a fair and orderly market do not give rise to a private right of action under Section 6(b) of the Securities Exchange Act of 1934). A more general point is that [i]t is well established that violation of an exchange rule will not support a private claim. In re VeriFone Sec. Litig., 11 F.3d 865, 870 (9th Cir. 1993). On the other hand, several courts have adopted the position that a private right of action exists for violations of certain rules of self-regulatory organizations, such as rules designed to protect the public. Cook v. Goldman, Sachs & Co., 726 F. Supp. 151, 156 (S.D. Tex. 1989). 145 See supra note 134 and accompanying text. 146 Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1900 (Mar. 30, 2004) (relying on Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir. 1998)). One ambiguity raised by this administrative adjudication is that it is not entirely clear whether civil liability hinges on the violation of the SEC rule or the similarly worded NYSE rule standing by itself.
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possibly, a fiduciary dutythat is, however, tied to something other than the market maker status by itself. The imposition of a broad fiduciary duty on market makers makes even less sense in todays securities markets, given such factors as the diminishing, if not disappearing, role of market makers as agents with special privilegesas opposed to dealers in increasingly democratized and dispersed marketsand the automated process of aggregating, matching, and routing orders in a highspeed trading environment. Accordingly, the current regulatory agenda must be approached from this perspective, and certain concerns relating to market makers should be addressed through other forms of regulation by the government and self-regulatory organizations, such as defining the scope of market makers obligations and privileges and fine-tuning circuit breakers, and other theories of civil and criminal liability, such as antifraud law. It is also appropriate to reflect on more general costs of over-fiduciarization: More broadly applying fiduciary duties could unnecessarily constrain parties from self-protection in contractual relationships, impose excessive litigation costs, provide an unsuitable basis for contracting, and impede developing fiduciary norms of behavior.147
147
Ribstein, supra note 1, at 899.

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Ribstein, supra note 1, at 899.

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