two-sided loyalty - exploring the boundaries of fiduciary duties of market makers - dolgopolov 2012
Post on 29-Jul-2015
79 Views
Preview:
TRANSCRIPT
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
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.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
32 UC Davis Business Law Journal [Vol. 12
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 Sachs’s involvement in numerous structured finance
transactions, notably the ABACUS 2007-AC1 deal,4 as the firm had repeatedly
1
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 106–07
(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 MAKER’S 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/05-03-
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 33
pointed to its market maker status in order to shield itself from liability.5 As
articulated by Lloyd C. Blankfein, Goldman Sachs’s 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 firm’s 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 can’t be a fiduciary to one and not the
other. He can’t 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-CV-
3229 (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 610–13 (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://fcic-
static.law.stanford.edu/cdn_media/fcic-testimony/2010-0113-Transcript.pdf [hereinafter
Blankfein’s 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.” NAT’L COMM’N 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
34 UC Davis Business Law Journal [Vol. 12
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
difficult—if not near-futile—task. 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 author’s 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 fiduciary’s 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 4–42; Thomas Lee Hazen, Are Existing Stock Broker
Standards Sufficient? Principles, Rules, and Fiduciary Duties, 2010 COLUM. BUS. L. REV. 710,
722–27; Ribstein, supra note 1, at 901–03; L.S. Sealy, Fiduciary Relationships, 1962 CAMBRIDGE
L.J. 69, 74–79; Smith, supra note 1, at 1423–31. 13
See Hazen, supra note 12, at 724.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 35
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 court’s 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 issuer’s 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 find—with the exception of thinly
traded / illiquid securities—because 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
36 UC Davis Business Law Journal [Vol. 12
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 be—nothing 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 specialist’s 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
Id. at *44. 17
Id. at *45. 18
Id. at *46 (internal citation omitted). 19
Id. at *46–47. 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 *3–8 (S.D.N.Y. June 14, 1993). 22
Id. at *31.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 37
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
broker’s 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 dual-
roles, 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 investor’s order to buy or buying
the stock and holding it in their own account to fill an investor’s
order to sell.26
23
Id. at *32–33 (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), aff’d in part, rev’d 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 York’s 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.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
38 UC Davis Business Law Journal [Vol. 12
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
customer’s 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
Id. at 61–62 (quoting the applicable rules of the NYSE). 28
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
*16–17 (S.D.N.Y. Oct. 2, 2006) (reserving this issue); United States v. Bongiorno, No. 05 Cr. 390
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 39
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 organization—but perhaps
largely as a face-saving measure—had some interest in imposing the fiduciary
standard on the NYSE specialists in some form. To the author’s 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 *21–23 (S.D.N.Y. May 1, 2006) (same); In re NYSE
Specialists, 405 F. Supp. 2d at 306–08 (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 332–33 (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]
specialist’s 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. COMM’N, 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 142–43. 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] specialist’s fiduciary duties to unexecuted limit orders on the
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
40 UC Davis Business Law Journal [Vol. 12
like description of the applicable standard: “Whether acting as brokers or dealers,
specialists are required to hold the public’s 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 standard—when “the fiduciary agrees to act as a principal’s ‘alter
ego,’ rather than assuming the standard arm’s length stance of traders in a
specialist’s 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 agency’s 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 Specialist’s 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 specialist’s 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 customer’s 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 41
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 party’s
interests, Defendant here was expected to execute orders for both
buyers and seller [sic]—two masters as it were—and presumably
there was an expectation that Defendant would not place one
customer’s demands over another’s. Instead, Defendant’s 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 Defendant”41 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
Id. at *13. 39
Id. at *14. 40
Id. at *16–17. 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
42 UC Davis Business Law Journal [Vol. 12
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 specialist’s 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 prosecution’s 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 firm’s and his pockets”47:
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 firm’s 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 buyer’s expectations are clear: for a
[preset] commission, the real estate broker will act as the buyer’s
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 discrimination—including interference with execution and
mishandling—of 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 543–44 (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 *4–5 (N.D. Ill. Mar. 26, 2010); Last Atlantis Capital LLC v. Chi. Bd. Options Exch., 455
F. Supp. 2d 788, 791–92 (2006).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 43
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 one’s
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
51
Last Atlantis, 455 F. Supp. 2d at 791. 52
Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *24–26. 53
Id. at *24, 26–28. 54
Id. at *24–25 (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 transactions—that 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
44 UC Davis Business Law Journal [Vol. 12
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 arm’s-length’s, and this conclusion invokes a
more general principle that “[t]he arm’s-length relationship of parties in a
business transaction is, if anything, antithetical to the notion that either would
58
Id. at 842 n.10. 59
Id. at 844. 60
Id. at 831–32. 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 *10–11 (N.D. Ill. June 6, 2011). 62
Additional legal issues—and perhaps gaps in the existing decisions—lurking 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.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 45
owe a fiduciary relationship to the other.”63 Another key point was the
recognition of the inherent—and indelible—conflict 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 maker’s 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 question—most notably
with respect to the NYSE specialists—do 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
63
Dopp v. Teachers Ins. & Annuity Ass’n, 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 Comm’n 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 maker’s 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
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
46 UC Davis Business Law Journal [Vol. 12
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 maker’s 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 fiduciary’s 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 fiduciary’s 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. & POL’Y
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. O’Hagan, 521 U.S. 642 (1997). An
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 47
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 broker-
dealers, 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, 375–76
(1965); see also 110 CONG. REC. 17, 926–27 (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
Blankfein’s FCIC Testimony, supra note 6, at 28. A similar issue—also highly relevant for
today’s securities markets—is 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 13–14. 72
SEC v. Zandford, 535 U.S. 813, 823 (2002).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
48 UC Davis Business Law Journal [Vol. 12
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 defendant’s] 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
73
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,
1308–09 (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 broker-
dealer 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 *32–33 (S.D.N.Y. June 14, 1993). 76
Pasternak, 561 F. Supp. 2d at 485–88. 77
Id. at 506. A subsequent proceeding before the securities industry’s 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.” Dep’t of
Mkt. Regulation v. Leighton, No. CLGO50021, 2010 FINRA Discip. LEXIS 3, at *110–16
(N.A.C. Mar. 3, 2010).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 49
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 customer’s 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 client’s: “A broker-dealer’s 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
78
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 SEC’s 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 414–17, 425. Even the decision of the NASD’s Board of Governors was described as an
“eagerness to expand a market maker’s 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 Duties—Some 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 430–31 & n.
12–13. 81
Hutton, 41 SEC Docket at 415–16 (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
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
50 UC Davis Business Law Journal [Vol. 12
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 customer’s limit
order . . . for its own market-making account at prices that would satisfy the customer’s 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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 51
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 deals”92 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
88
Id. at 844 n.14. 89
Id. at 844 n.15. 90
United States v. Finnerty, 533 F.3d 143, 148–49 (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, 152–53 (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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
52 UC Davis Business Law Journal [Vol. 12
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 flow—and hence
attracting more traders—on the level of individual market makers and even
trading venues,97 as many securities are cross-listed. Overall, PFOF programs are
94
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), rev’d, 104 F.3d 1418 (2d Cir. 1997). One court further described PFOF
programs as “a type of volume discount—in either cash or in-kind services—by 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 dealer’s 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.58–59) (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, 20,740–41 (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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 53
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
arm’s-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.
98
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 Sec’y,
U.S. Sec. & Exch. Comm’n 2 (Sept. 8, 2008), available at http://www.sec.gov/comments/sr-
nysearca-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, Sec’y, U.S. Sec. & Exch. Comm’n 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, Sec’y, U.S. Sec. & Exch. Comm’n 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. Sec’y, NYSE Euronext, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch.
Comm’n 6 (June 18, 2010), available at http://www.sec.gov/comments/s7-09-10/s70910-16.pdf
[hereinafter NYSE’s 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, 1423–24 (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).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
54 UC Davis Business Law Journal [Vol. 12
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, Sec’y, U.S. Sec. & Exch. Comm’n 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 structures—the maker-taker model and the PFOF
model” in options markets in the context of the proposed cap on access fees); see also NYSE’s 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, 3698–99, 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. Comm’n 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.”).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 55
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 arm’s-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
105
For a selective mix of general sources on high-frequency trading, see DURBIN, supra note 3;
EDGAR PEREZ, THE SPEED TRADERS: AN INSIDER’S LOOK AT THE NEW HIGH-FREQUENCY TRADING
PHENOMENON THAT IS TRANSFORMING THE INVESTING WORLD (2011); Peter Gomber et al., High-
Frequency 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., July–Aug. 1971, at 28,
FIN. ANALYSTS J., Nov.–Dec. 1971, at 24. 107
Letter from Paul O’Donnell, 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,
Sec’y, U.S. Sec. & Exch. Comm’n 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 22–25 (2011), available at http://www.treasury.gov/
initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.p
df.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
56 UC Davis Business Law Journal [Vol. 12
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
types”112 has effectively destroyed the quasi-monopoly franchise enjoyed by
some market makers—often compounded by their privileged position vis-à-vis
other market participants on the same trading venue—in the past.113 Another
pivotal factor is that market makers serving in the capacity of agents or quasi-
agents—especially paid ones—are 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
111
See, e.g., Letter from Stuart J. Kaswell. Exec. Vice President, Managing Dir. & Gen. Counsel,
Managed Funds Ass’n, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 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 Ass’n, to
Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 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, 42–45 (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
specialist’s 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
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 57
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 litigation—perhaps
ultimately futile—invoking 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, Sec’y, U.S.
Sec. & Exch. Comm’n 7 (June 25, 2010), available at http://www.sec.gov/comments/s7-02-
10/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 17–19 & n. 46–53). 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 information—such as advance knowledge of the price parameters of all open
orders—and 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 cards—all 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)).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
58 UC Davis Business Law Journal [Vol. 12
contrast, the current regulatory agenda is influenced by the debates about the
merits of imposing—or rather expanding the scope of—fiduciary 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
120
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 (2010–11). 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. 146–47 (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, 1098–1100 & n.402–415 (2011)
(scrutinizing the reach of the statutory text and its legislative history); Ribstein, supra note 1, at
919 & nn. 120–21 (same). Currently, broker-dealers in general are not subject to the fiduciary
standard applicable to investment advisors. See STAFF, U.S. SEC. & EXCH. COMM’N, STUDY ON
INVESTMENT ADVISERS AND BROKER-DEALERS 15–16 (2011), available at http://www.sec.gov/
news/studies/2011/913studyfinal.pdf [hereinafter SEC’S 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
SEC’S 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 (2010–11) (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 Ass’n, to Elizabeth M.
Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 20 (Sept. 22, 2010), available at http://www.sec.gov/
comments/4-606/4606-2809.pdf.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 59
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 SEC’s regulatory zeal, the definition of the protected class of
investors, and the statutory interpretation. One telltale sign is that the regulatory
agency’s staff report specifically mentioned the securities industry’s request to
exclude market making from the definition of “personalized investment
advice”126 in the context of the staff’s 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 124
Letter from Ira D. Hammerman, Senior Managing Dir. & Gen. Counsel, Sec. Indus. & Fin.
Mkts. Ass’n, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 10 (Aug. 30, 2010),
available at http://www.sec.gov/comments/4-606/4606-2553.pdf; see also Industry Perspectives of
the Obama Administration’s Financial Regulatory Reform Proposals: Hearing Before the H.
Comm. on Fin. Servs., 111th Cong. 110–11 (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
SEC’S 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, Sec’y, U.S. Sec. & Exch. Comm’n 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. Ass’n, and Senior Vice President,
Am. Bankers Ass’n, to Elizabeth Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 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
SEC’S STAFF, SECTION 913 REPORT, supra note 121, at 104.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
60 UC Davis Business Law Journal [Vol. 12
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” theory—a 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
129
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 arm’s 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, 1295–96 (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 *14–15 (N.D. Ill. Mar. 26, 2010) (following United States v. Finnerty, 533 F.3d 143 (2d
Cir. 2008)).
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 61
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
132
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, 542–43 (S.D.N.Y. 2007); United
States v. Hayward, No. 05 Cr. 390 (SHS), 2006 U.S. Dist. LEXIS 37108, at *5–6 (S.D.N.Y. June
5, 2006). 135
See, e.g., United States v. Fiore, 381 F.3d 89, 90–91 (2d Cir. 2004); SEC v. Diversified Corp.
Consulting Grp., 378 F.3d 1219, 1223 (11th Cir. 2004); SEC v. Sayegh, 906 F. Supp. 939, 940–41,
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, 318–19 (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 fraud-
on-the-market cases]. . . . If it did, very little fraud would be actionable.”). 139
NYSE Specialists, 405 F. Supp. 2d at 318–19. On the other hand, this conclusion was
somewhat weakened on the appellate level—despite the recognition of the reach of the fraud-on-
the-market doctrine—because 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,
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
62 UC Davis Business Law Journal [Vol. 12
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 issuer’s 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, 77–79
(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, 1168–69 (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, 757–61 (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
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
Ed. 1] A Two-Sided Loyalty? 63
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 specialist’s 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 duty—and the corresponding
litigation-related risks—can 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 masters”—an idealized two-
sided loyalty in arm’s-length transactions—appears 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, 265–66 (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.
12.1DOLGOPOLOVMACROFINAL.DOCX (DO NOT DELETE) 4/3/2012 12:01 AM
64 UC Davis Business Law Journal [Vol. 12
possibly, a fiduciary duty—that 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 today’s securities markets, given such factors as the diminishing, if
not disappearing, role of market makers as “agents” with special privileges—as
opposed to “dealers” in increasingly “democratized” and dispersed markets—and
the automated process of aggregating, matching, and routing orders in a high-
speed 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.
top related