Nasdaq OMX Group Inc., the second- biggest U.S. stock exchange owner, revamped its proposal to compensate brokers that lost money in the public debut of Facebook Inc. (FB), boosting the payout to $62 million cash.
The amendment, which follows criticism from Wall Street market makers and exchanges about the original plan, increases the compensation pool from $40 million and does away with a proposal to credit most of the money through reduced trading costs, according to a submission with the Securities and Exchange Commission. Member brokers who accommodated customers for losses will get paid first, it said.
“It’s an attempt by Nasdaq to show that they recognize that their clients are very unhappy,” Larry Harris, a professor of finance and business economics at the University of Southern California in Los Angeles and a former chief economist at the SEC, said in a phone interview. “Clearly, making it all-cash is more palatable for regulators and for competitors.”
Delays and malfunctions on the Nasdaq Stock Market were the first signs of trouble in the May 18 Facebook initial public offering that burned investors, spurred losses on Wall Street and prompted lawsuits against the company, its exchange and the underwriters. At yesterday’s close of $28.76, the stock remains down 24 percent from the price set by underwriters, although it has recovered from its low of $25.87 in June.
“We deeply regret the problems encountered during the initial public offering of Facebook,” Nasdaq OMX Chief Executive Officer Robert Greifeld said in a press release yesterday. “We failed to meet our own high standards based on our long history of providing outstanding technology to our members and exchange customers. We have learned from this experience and we will continue to improve our trading platforms.”
In May, Greifeld acknowledged “poor design” in software put the opening auction that set the price for the first traded shares into a loop that delayed its completion.
The exchange operator is submitting its updated payment accommodation plan to the SEC in a filing dated July 23. The public will be able to comment and the SEC must approve it before implementation. Nasdaq OMX said yesterday it expects all compensation will be provided within six months.
“This proposal reflects Nasdaq’s effort to identify the categories of investors and members that Nasdaq’s system difficulties caused objective, discernible harm, and the type and scope of such harm, and to propose an objectively reasonable and regulatorily balanced plan for accommodating exchange members and their investor customers for such harm,” the exchange wrote in the filing.
Nasdaq said it made this decision despite the “liability protections” for claims of financial loss it possesses as a regulated exchange. The cap on Nasdaq’s liability stemming from technology errors and malfunctions it causes is $3 million, according to the exchange’s rules.
Among securities firms expected to seek recompense is Knight Capital Group Inc. (KCG) The Jersey City, New Jersey-based broker and market-making firm reported second-quarter earnings last week that fell 79 percent, including a $35.4 million loss related to the Facebook IPO.
“We have been in reasonably consistent dialogue with Nasdaq,” CEO Thomas Joyce said during a July 18 conference call following the earnings report. “We’re going to be all eyes and ears waiting to watch and read and hear about what they suggest in their filing.”
Citadel LLC, the Chicago-based investment firm run by Ken Griffin, lost as much as $35 million in its market-making unit, according to a person with knowledge of the firm.
Facebook was sold by underwriters at $38 on May 17. The pricing of the first public transaction, a trade known as the IPO cross, took a half hour longer than Nasdaq OMX planned the next morning. About 30 minutes after that, the market owner reported an issue confirming trades from the opening auction with the brokerages that had placed orders.
Order updates and cancellations totaling 30 million shares were submitted into the auction as a technical issue was being repaired between 11:11 a.m. and 11:30 a.m. New York time, Greifeld told reporters on May 20. About half may involve “some level of dispute,” he said.
Nasdaq OMX said in a May 21 notice that the 30 million shares didn’t participate in the IPO cross. An error prevented execution reports for the shares that entered the auction, as well as those that were ignored, from being sent immediately to brokerages, the company said. Nasdaq said in its filing with the SEC that it decided not to halt trading between 11:30 a.m and 1:50 p.m., when the confirmations were disseminated to the exchange’s member firms despite the uncertainty faced by investors and brokers who didn’t know the status of orders.
“Nasdaq believed that the system issues would be resolved promptly,” the exchange told the SEC. “Moreover, after 11:30 a.m. there was an orderly, liquid and deep market in FB stock, with active trading on all markets. Halting trading on a market- wide basis in these circumstances would have been unprecedented and, in Nasdaq’s view, unjustified.”
The exchange said that in its “regulatory judgment,” the market conditions after the stock began changing hands “did not warrant a halt of trading.” It also said that market participants “would reasonably have had certain expectations for the execution or non-execution of their orders.”
Some orders submitted before 11:30 a.m. received executions at prices different from the $42 IPO cross, causing buyers to pay more and sellers to receive less than they should have, Nasdaq OMX said in a May 21 notice. A portion of those deemed ineligible for the IPO auction were later re-entered into the market by Nasdaq’s systems, the exchange said.
Nasdaq said its system errors may have benefited some investors. Buy orders priced at $42 and above and submitted between 11:11 a.m. and 11:30 a.m. weren’t completed in the cross and may have purchased stock at a lower price at 1:50 p.m. when they entered the market, the exchange wrote in its filing.
The payment program Nasdaq announced on June 6 said the plan would cover three kinds of orders placed during the IPO cross: sales priced at $42 or less that weren’t executed; purchases priced at $42; and certain types of sell orders that should have participated in the cross and were entered into the market at 1:50 p.m. New York time on the day of the offering, receiving less than $42.
Orders eligible would only include those submitted before 11:30 a.m. that were disadvantaged by Nasdaq’s technical error and those in which the member firm was uncertain of the outcome of the trade request. Orders that don’t qualify for compensation include “losses that are attributed to execution message delays when in fact an outcome was already certain,” Eric Noll, the executive vice president for transaction services at Nasdaq OMX, said in a webcast on June 6.
Nasdaq added a fourth category yesterday: certain orders to buy shares above $42 that received executions in the cross and that had attempted to cancel the requests before 1:50 p.m. The claims in this category will be reduced by 30 percent in calculating the trading loss, Nasdaq said.
Firms seeking compensation will have a week after the SEC approves Nasdaq’s plan to submit their request, the exchange said. The Financial Industry Regulatory Authority will assess the “eligibility and value” of members’ claims based on the standards Nasdaq laid out.
Payments will be made in two stages to give priority to brokers who reimbursed customers for their losses. Nasdaq will pay member firms for the amount they gave their customers to compensate for direct trading losses as the exchange defines them. If the total amount exceeds $62 million, the payments will be prorated.
Payments to firms that suffered proprietary trading losses will follow those distributed in the first tranche. The payouts will be conditioned on the broker agreeing to release Nasdaq of claims for losses related to the Facebook IPO. Nasdaq said it was requiring this “to avoid the disruption and expense of unnecessary litigation,” despite its immunity. The company cited the Air Transportation Safety and System Stabilization Act that required a release by people who received compensation related to the terrorist attacks on Sept. 11, 2001.
“If the losses from the wholesalers are legitimate, then they won’t be happy with this number,” former SEC chief economist Harris said about Nasdaq’s proposed $62 million fund. “Computing losses is often very contentious. It may end up being litigated, in which case we may find out in five years what the true losses were.”
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