Nasdaq Safeguards in Facebook Seen as Focus of Regulators
Nasdaq OMX Group Inc. (NDAQ)’s handling of Facebook Inc. (FB)’s initial public offering has already led to lawsuits and may cost brokers $100 million. What Securities and Exchange Commission officials will want to know is whether the market operator put the public’s interest first.
“Their interest is twofold: to make sure that sufficient safeguards are in place to ensure that mistakes won’t happen in the future, and to make sure that decisions were not made that are not in the public interest,” 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 yesterday.
The $16 billion IPO of the largest social networking company, founded in 2004 by Harvard University student Mark Zuckerberg, was supposed to be a victory for Nasdaq OMX, chosen by Facebook over rival NYSE Euronext. The debut was anything but, with the first day of trading on May 18 marred by delays, mishandled orders and investor uncertainty.
A review by the SEC that has yet to be completed shows technical failures precipitated the trading issues, not a violation of industry rules, the Wall Street Journal said yesterday, citing people familiar with the matter who it didn’t name.
“We continue to review issues related to the IPO and have drawn no conclusions,” John Nester, an SEC spokesman, said in an e-mail yesterday. Joseph Christinat, a Nasdaq OMX spokesman, declined to comment, as did Ashley Zandy, a spokeswoman for Menlo Park, California-based Facebook.
Nasdaq OMX Chief Executive Officer Robert Greifeld acknowledged that a “poor design” in software put the opening auction that set the price for the first traded shares into a loop that delayed its completion. Executives of the company, which operates the Nasdaq Stock Market, “believed they had the right solution” as they worked to start trading, Eric Noll, the executive vice president for transaction services, said in a statement provided by spokesman Robert Madden on May 22.
SEC officials will examine whether New York-based Nasdaq OMX took enough care setting up and testing the IPO auction, when it became aware of the breakdowns and how much it knew as they were occurring, Harris said. Examiners would need proof of malfeasance to conclude Nasdaq OMX was guilty of more than bad judgment or bad luck, according to Thomas Hazen, a professor at the University of North Carolina at Chapel Hill’s School of Law and author of a seven-volume treatise on securities regulation.
“There’d have to be some pretty strong evidence for the SEC to suspect real wrongdoing,” he said in a May 29 phone interview. “This was supposed to be a showcase IPO for Nasdaq. But finding evidence to show they prematurely opened up trading is a different matter.”
If warranted, the most likely SEC sanction against Nasdaq OMX would be a fine, according to Hazen. While securities laws allow for more, including revoking an exchange’s registration, investors would lose out by such a drastic response, making it unlikely, he said.
Facebook shares, which rose as high as $45 on the day of their debut, have lost 33 percent since their first public trade at $42. Nasdaq OMX is down 5.2 percent from its May 17 close and reached a seven-month low of $21.80 on May 24.
Phillip Goldberg, an investor in Maryland, said in a lawsuit filed in Manhattan federal court that Nasdaq OMX “badly mishandled” orders placed through an online Charles Schwab Corp. account. He is seeking to represent a class of investors who lost money. Morgan Stanley (MS), Goldman Sachs Group Inc., JPMorgan Chase & Co. and other underwriters along with Facebook were sued separately by investors who say they were misled in the purchase of the stock.
“Everybody who’s run an exchange has had some technology issues that have disrupted fair and orderly trading,” Neal Wolkoff, former chairman and chief executive officer of the American Stock Exchange and ex-CEO at ELX Futures LP, said in a May 24 phone interview from South Orange, New Jersey. “If it interferes with just and equitable trading, you really have to consider what the options are, rather than just limping through it. An exchange has broad latitude.”
Bats Global Markets Inc., the Lenexa, Kansas-based exchange operator that competes with NYSE Euronext and Nasdaq OMX, halted trading and then called off its own IPO on March 23 when a malfunction in its auction system kept the first transaction from being published properly.
No action such as halting a stock or canceling trades is likely to be “applauded by everyone,” said Wolkoff, who also was a chief operating officer of the New York Mercantile Exchange. “Making a decision in the Facebook case wouldn’t have been easy, and I’m not saying what would have been the right decision for Nasdaq. But they had choices.”
Nasdaq OMX would have had to consider the effect of halting Facebook shares on the social-networking company, said Harris, the USC professor.
“Nasdaq had a responsibility to Facebook as well as to shareholders,” he said. “If they had halted the stock, people might have thought that the problem was with Facebook and not Nasdaq. It’s a delicate issue.”
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 second-largest U.S. equities market owner reported an issue confirming trades from the opening auction with the brokerages that placed them.
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 disseminated immediately to brokerages, the company said.
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 another 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 OMX blamed the trading delay for Facebook on its inability to handle order updates and cancellations that came in as the exchange was trying to complete the IPO cross. That, along with mishandled trade requests, led to confusion among investors, brokers and market makers about the status of millions of orders sent to Nasdaq OMX for the opening cross. The exchange’s systems didn’t distribute execution reports until 1:50 p.m., leaving member firms and customers without information about their orders and unable to cut losses and manage financial risks.
Deciding not to accept order modifications and cancellations after a specified time before the IPO cross is safer for investors, said Robert Schwartz, a professor of finance at Baruch College at the City University of New York, who was on an advisory committee that helped design Nasdaq OMX’s auctions for the start and end of the trading day almost a decade ago. Nasdaq OMX hadn’t experienced a similar problem before with initial offerings, he said.
“It’s wise to have a hard stop like a train schedule so people aren’t trying to get on board when the train is leaving the station,” Schwartz said in a May 23 phone interview. “You also have to build human safeguards into any electronic system. When you have extremely heavy order flow from customers who are far and wide apart, they’ll behave differently than big, sophisticated customers.”
Nasdaq OMX said it would no longer accept “cross-eligible” order modifications after the auction’s final price calculation has begun, the exchange operator said on May 21.
The commission will want Nasdaq OMX to provide its own chronology of events, said Larry Bergmann, who worked at the SEC for more than 30 years starting in 1975, including as associate director in the agency’s division of market regulation.
“An exchange is required to operate a fair and orderly market,” Bergmann, now a partner at Murphy & McGonigle PC in Washington and a member of the exchange board at Direct Edge Holdings LLC, said in a May 25 phone interview. “That’s the No. 1 obligation. From the SEC’s point of view, exchanges are rules-based organizations and the key thing is whether the actions they took are permitted by their rules or fairly implied. I’d think the SEC would also want to look into whether the rules specify that they take certain actions in certain circumstances.”
Losses may total $120 million for the four largest U.S. equity wholesalers, or market-makers that execute orders for individual investors supplied from brokers such as TD Ameritrade Holding Corp. and Charles Schwab. Nasdaq OMX plans to set aside about $13 million to reimburse member firms, pending SEC approval, Greifeld said on May 20.
Knight Capital Group Inc. estimated it lost as much as $35 million trading Facebook because of the malfunction, the Jersey City, New Jersey-based broker said in a May 23 SEC filing. Citadel LLC, the Chicago-based investment firm run by Ken Griffin, lost as much as $35 million on Facebook in its market-making unit, according to a person with knowledge of the firm.
UBS AG lost about $30 million and Citigroup Inc. about $20 million from servicing retail customers through their wholesaling businesses, Dow Jones Newswires reported on May 25.
Nasdaq OMX’s liability stemming from a systems malfunction or trading-systems error is capped at $3 million per month, according to its rules. Greifeld said on May 20 that about $10 million the exchange received from its unanticipated participation in Facebook’s IPO would be added to the fund, if the SEC permits it.
Former SEC Commissioner Roberta Karmel, a professor at Brooklyn Law School, said technology problems and the financial risks they produce can snowball as trading becomes faster and market participants rely more on automation to execute orders.
“You wouldn’t want an exchange to be bankrupted because of a technology problem,” Karmel, author of “Regulation by Prosecution” and co-author of “Demutualization of Stock Exchanges,” said in a May 21 phone interview. “It wasn’t a problem in the past. Now things can go awry quicker and have much greater consequences. It’s another example of speed not necessarily meaning a fairer or more orderly market.”
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