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Options Market Makers Sue Exchanges Alleging Overcharges

Chicago Board Options Exchange
A U.S. flag is displayed as traders work on the floor of the Chicago Board Options Exchange (CBOE) in Chicago. Photographer: Tim Boyle/Bloomberg

May 23 (Bloomberg) -- Citadel Securities LLC and three other market makers sued the biggest options exchanges, claiming they were wrongly charged fees on trades over a seven-year period.

The companies sued Chicago Board Options Exchange LLC and four more exchanges saying they systematically overcharged or wrongly assessed fees on trades from January 2004 to June 2011.

The exchanges knew by late 2012 that one of their members had been mis-marking requests to buy and sell options as originating with public customers, when in fact they were coming from professionals, according to the complaint filed yesterday in state court in Chicago.

“This isn’t a situation where they’re saying you messed up my trade and therefore I lost money, they’re saying you charged me for something you shouldn’t have charged me for,” James J. Angel, a professor of finance at Georgetown University, said in a phone interview. “They thought they were trading against the retail mom and pops, and now it turns out two things: one, they were mischarged, and two, it wasn’t even a customer order.”

When confronted, “the exchanges simply asserted that they have no responsibility and cannot be held liable for improperly overcharging fees,” according to the market makers’ complaint.

Pricing Incentives

The case centers on pricing incentives adopted by securities exchanges over the past decade and a half, as technical advances and regulatory reform squeezed profits in stock and options trading and the number of markets multiplied.

Among those are systems that reward brokers for bringing orders from individuals and charge others for the privilege of executing against them.

The defendants in the lawsuit include International Securities Exchange LLC, the NYSE Euronext-owned NYSE Arca electronic options exchange and NYSE Amex exchange and Philadelphia Stock Exchange operated by the NASDAQ OMX Group.

Gail Osten, a spokeswoman for the Chicago Board Options Exchange, today declined to comment on the allegations.

Molly McGregor, a spokeswoman for ISE, declined to comment on the suit. Rich Adamonis, a spokesman for NYSE Euronext, and Rob Madden, a Nasdaq spokesman, also declined to comment on it.

The exchange-member firm that allegedly incorrectly marked orders as originating from public customers when they had come from broker dealers and other professionals during the time in question wasn’t named in the complaint. The firm was assessed almost $6.4 million in penalties and an unspecified amount of transaction fees, the plaintiffs said.

Goldman Agreement

According to a letter of consent published on the CBOE website in September 2012, Goldman Sachs Group Inc. agreed to pay $6.75 million to eight U.S. exchanges to settle claims over the way it handled options trades from January 2004 through May 2010.

The New York-based securities firm mislabeled certain options orders as originating with customers instead of brokers or market makers, according to the document. Goldman Sachs was censured by the exchanges, and neither admitted nor denied wrongdoing. Michael DuVally, a Goldman Sachs spokesman, declined to comment on yesterday’s lawsuit.

Joining Citadel in the case are Chicago-based Ronin Capital LLC, San Francisco-based Group One Trading LP, Susquehanna Investment Group and Susquehanna Securities.

Restitution Sought

The market-maker plaintiffs said they seek recovery or restitution of all “payment for order flow” and other fees that were inappropriately charged by the exchanges. The plaintiffs also asked for an accounting of the fees improperly charged and a declaration that the exchanges are required to abide by their own rules regarding the fees.

Exchanges are afforded immunity for actions taken as part of their regulatory duties. The doctrine arose when stock and options markets were nonprofit organizations owned by their member firms. The shield protects them from lawsuits related to the exercise of powers delegated by the U.S. Securities and Exchange Commission and prevents financial losses that could jeopardize institutions seen as vital to the U.S. economy.

“Exchanges have extremely limited liability in these sorts of cases,” Andrew Stoltmann, a securities lawyer in Chicago, said in an e-mail. “It is always an uphill climb roping in an exchange. The contracts between exchanges and securities firms are highly tilted in favor of the exchange. Liability will likely be extremely hard to establish here.”

17.2 Million Traded

Option trading in the U.S. is spread among 11 markets. An average of 17.2 million traded daily in the U.S. in January, the second-highest number for the first month of a year, according to Options Clearing Corp.

The volume represents an 8.2 percent increase from the average last year. Options trading fell in 2012 to a daily average of 15.9 million contracts from a record of 18.1 million in 2011, data from the Chicago-based OCC show.

Katie Spring, a spokeswoman for Citadel, didn’t immediately respond to phone and e-mail messages seeking comment on the lawsuit.

David Pollard, a spokesman for Susquehanna, didn’t respond to a phone call seeking comment. A voice-mail message left at Group One Trading’s main office number wasn’t returned.

The case is Citadel Securities LLC v. Chicago Board Options Exchange Inc., 13CH13246, Cook County Circuit Court, Chancery Division (Chicago).

To contact the reporters on this story: Andrew Harris in the Chicago federal courthouse at aharris16@bloomberg.net; Whitney Kisling in New York at wkisling@bloomberg.net

To contact the editors responsible for this story: Michael Hytha at mhytha@bloomberg.net; Lynn Thomasson at lthomasson@bloomberg.net

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