The recent flurry of litigation surrounding High Frequency Trading raises the question of what defenses may be available to various entities and individuals accused (or who may be accused) of wrongdoing in connection with HFT. This post will focus on one particular practice that has already been targeted in a recent class action — the sale of online brokerage customer “order flow” to HFT firms — and a defense likely to be raised in response: the existence of pre-dispute arbitration agreements pursuant to which investors waive their right to bring class action lawsuits.
The core allegation in the recent class action is that the practice of selling customer “order flow” to HFT firms — through an arrangement in which the HFT firms actually purchase the customers orders from the brokers and then arrange for execution of these orders themselves, whether in their own “dark pools” or on one of the 11 public exchanges — constitutes an illegal manipulative practice because the brokerages are in fact facilitating HFT front-running, failing in their duty of best execution or participating in the levying of an undisclosed “tax” on retail investors. Potential damages could be in the hundreds of millions of dollars. E-Trade alone, for example, for just a single year, generated at least $72 million in order flow sale revenue (which goes almost directly to the bottom line since E-trade incurs virtually no expenses in connection with this revenue other than minimal software costs associated with routing the order flow to the HFT buyer).
But despite the obvious risk to the online brokers from HFT litigation, to date only one significant class action lawsuit appears to have been filed against the online brokers challenging the payment for order flow practice. Why?
The obvious answer is that all customers are required to execute an agreement to arbitrate disputes as a condition of opening a brokerage account. In addition, most, but not all brokers require clients to agree to a class action waiver – a highly controversial provision because many individual claims are too small to bring on a separate basis and are only economically viable as class actions. Payment-for-order-flow litigation is a paradigm case. The harm suffered by any one investor by the sale of the entire pool of all trades to an HFT firm is likely small; it is only by aggregating the hundreds of thousands of individual claims into a single class action that the brokerage/HFT practice could be seriously challenged. And the legal and factual issue in all of these hundreds of thousands of claims would be identical: whether the payment-for-order-flow practice as a whole constitutes a manipulative or otherwise illegal practice.
In this context, the key question is whether a mandatory class action waiver clause in a brokerage customer agreement would be enforceable. At first blush, the issue seems settled. In a pair of recent decisions, ATT Mobility LLC v. Concepcion, 131 S.Ct. 1740 (2011) and American Express v. Italian Colors Restaurant, 133S.Ct. 2304 (2013), the Supreme Court has twice upheld mandatory class action waiver clauses contained in pre-dispute arbitration agreements, first on the grounds that the Federal Arbitration Act (the “FAA”) pre-empted California’s judicial rule regarding the unconscionability of class action waivers in customer contracts, and second on the grounds that the prohibitive cost of individual arbitration in the antitrust context did not constitute a sufficient basis to override Congressional policy favoring arbitration embodied in the FAA and the courts’ duty to enforce contractual agreements as written.
Despite the seeming finality of the Supreme Court’s decisions in Concepcion and American Express, there is reason to believe that a class action waiver in the securities context would fare differently.
First, all of the online brokers are members of the Financial Industry Regulation Authority (“FINRA”), which prohibits the use of mandatory class action waivers in pre-dispute arbitration clauses. FINRA has carefully reviewed the interrelationship between the FAA and the FINRA rules and has concluded that the FAA does not pre-empt the FINRA rules because there is an express “congressional command” in the Securities Exchange Act of 1934 giving the SEC the authority to approve the rules of self-regulatory organizations such as FINRA, including rules relating to arbitration. Because the SEC, acting pursuant to a Congressional mandate, has approve the FINRA rules barring member brokers from imposing class action waivers, FINRA has concluded that the FAA does not pre-empt its rules.
Second, under the Dodd-Frank Act of 2010, Section 921, Congress gave the SEC additional authority to adopt rules limiting the use of pre-dispute arbitration agreements. The SEC has not yet adopted rules pursuant to Dodd-Frank, but Section 921 provides additional evidence that Congress intended to override the harshness of the FAA that, as interpreted by the Supreme Court, allows (one-sided, take-it-or-leave-it) contracts of adhesion to foreclose judicial class actions. While it might be possible to argue that Section 921 of the Dodd-Frank Act supersedes earlier SEC approval of FINRA arbitration rules, it would appear that the better view is that the Dodd-Frank mandate does not conflict with the SEC’s prior limited approval of FINRA’s arbitration rules because Section 921 permits the SEC to go even further and ban pre-dispute arbitration clauses altogether, whether on an individual or class basis. Of course, given the almost visceral antipathy of the current Supreme Court majority to class actions, it is possible the Supreme Court could disagree with the foregoing analysis and state that unless and until the SEC expressly carries out its mandate under Dodd-Frank, the Supreme Court’s prior decisions require pre-dispute arbitration agreements to be enforced as written, whether or not any non-governmental body such as the FINRA has taken a contrary view.
In sum, class-action litigation targeted at on-line brokers’ practice of selling order flow to HFT firms raises the specter of a wave of very significant payment-for-order-flow claims. The brokers’ reliance on a pre-dispute class action waiver as a defense is likely to fail, although a degree of uncertainty remains in light of Supreme Court precedent strongly affirming the enforceability of such waivers in other contexts.