On November 19, 2018, the CBOE defendants filed a motion to dismiss the Consolidated Amended Complaint. That complaint, as well as an overview of the VIX index itself, were the subject of previous posts in this stirring series, and can be found at the following links:
The VIX is Fixed?! A Preview of the Tricks
The VIX is Fixed?! A Complaint is Remixed
Once you’ve caught up on all the (alleged) trixing and fixing, it’s time to take a closer look at the CBOE Defendants’ arguments in favor of nixing this vexatious VIX suit. While the majority of their argument is given over to refutation of Plaintiffs’ Rule 10b-5 claim, the seventy-two-page brief also covers Plaintiffs’ averred failure to state a claim under the Commodities Exchange Act (“CEA”), the purported preemption of Plaintiffs’ negligence claim, a general refutation of Plaintiffs’ aiding-and-abetting claim, and an overall argument against this manipulation’s very existence.
Cboe Options, the exchange on which SPX and VIX options are traded, is a registered “national securities exchange” under the Securities Exchange Act (“SEA”). Cboe Options further has status as a “self-regulatory organization” (“SRO”), which means that it must comply with the provisions of the Act, and enforce compliance with its members. SROs are subject to oversight and control by the SEC, and the SEC has broad powers to sanction SROs that fail to meet their statutory obligations. Like other SROs, the Cboe Option’s responsibilities under the Act and related SEC supervision come with what Defendants’ describe as an “important corollary:” Cboe Options is “immune from suit for conduct falling within the scope of the SRO’s regulatory and general oversight functions.” This immunity does not make Defendants unaccountable, they insist – it merely vests the SEC, rather than private plaintiffs, with the authority to hold them accountable for their failure to carry out their regulatory responsibilities.
In order for this regulatory immunity to apply, the claims made by the Plaintiffs must relate to the proper functioning of the regulatory system. Defendants insist that they do so relate, noting that Plaintiffs allege that Cboe Options should have designed the SOQ process differently to better guard against manipulation, and then should have policed the market more effectively to root out the manipulation that the do assert occurred. Both tasks—guarding against and responding to manipulation—are what Defendants describe as “core regulatory and oversight functions of an exchange.” Specifically, they point to 15 U.S.C. § 78f(b)(5), which requires an exchange to have and enforce rules “designed to prevent fraudulent and manipulative practices.” Defendants also point to NYSE Specialists, a decision which emphasized the fact that a plaintiff’s “own characterization of [its] claims” can “implicitly concede that the [exchange] was acting within the realm of [its] oversight powers.”
Defendants further object to what they describe as Plaintiff’s efforts to “circumvent” regulatory immunity. The first of these is proprietary products: Plaintiffs suggest that immunity does not extend to the initial design of products susceptible to manipulation. This cannot survive, Defendants insist, because Cboe’s regulator, the SEC, specifically approved the offering of VIX options, including the protested surveillance procedures. The crux of Plaintiffs’ claims, Defendants argue, is that Cboe Options should have either stopped listing the product with the flawed settlement mechanism, or pursued disciplinary action—it is Cboe’s performance as a regulator within the existing system, not how that system was initially designed, that is the source of Plaintiff’s injuries. Second, Plaintiffs point to statements by Cboe Options that, allegedly, “promoted VIX Options and VIXX Futures as an accurate and reliable means for investors to take positions on market volatility.” Defendants argue that allegations of fraud based on these statements are also barred by regulatory immunity because such statements could only be found to be false if Defendant’s market-policing efforts were deficient—and those judgments are exactly what is protected by regulatory immunity. Plaintiffs also raise Cboe Option’s status as a “profit-seeking entity,” which Defendants claim to “irrelevant to immunity” under NYSE Specialists, which held that “[importing] a motive element to absolute immunity. . . would be incomparable with the doctrine’s purpose.”
Defendants also argue that Plaintiffs’ claim is precluded by the Securities Exchange Act because they seek to impose liability based on Cboe Options rules that the SEC approved. This is not appropriate, Defendants insist, because the Supreme Court has recognized that a regulator’s approval of conduct may preclude plaintiffs from bringing a suit under federal law based on the same conduct. In support of this theory, Defendants cite that court’s decision in Providence, where SCOTUS declined to extend immunity to the activities at issue, but noted as a “distinct potential ground for dismissal” circumstances under which a “plaintiff challenges actions of an SRO that are in accordance with the rules approved by the SEC, the challenge may be precluded because it would conflict with Congress’s intent that the SEC…make the rules regulating those markets.” It may be the case that “may” is the operative word in that, quote, however, and the Providence court declined to resolve the issue as it had not been briefed by the parties. Defendants go on to note that the CFTC and SEC issued a join order concerning the VIX Index, and, to do so, reviewed “the calculation and methodology” of the Cboe’s volatility indexes, concluding that VIX futures “show not be readily susceptible to manipulation because of the composition, weighting, and liquidity of the [SPX] options” in the VIX Index.
Failure to Plead Elements of Rule 10b-5
Next up, Defendants argue that Plaintiffs have failed to make allegations sufficient to adequately plead the elements of a claim under Rule 10b-c. Looking first at fraudulent acts, Defendants claim that Plaintiffs have not adequately alleged any misleading statements, nor have they adequately alleged culpable failures in disclosure. The statements cited by Plaintiffs are not, Defendants argue, misleading or inaccurate in any way: “most describe the basic properties of the VIX Index and the opportunities that VIX derivatives offer . . . .” Not only are these statements not all that different from what the SEC has itself said about VIX derivatives, but none of these statements, Defendants insist, either states or implies that VIX derivatives are immune from third party manipulation—nor would any “sophisticated investor” take such statements to provide that type of assurance.
Plaintiffs also allege that Cboe Options “published the wrong, manipulated prices to the market,” and that these prices constituted materially misleading statements. Defendants argue that these allegations are deficient for two reasons: one, Plaintiffs do not identify a statement in which the Cboe defendants warranted that the final settlement values were free of manipulation; and, two, even if a manipulated settlement value could constitute a false statement, Plaintiffs allege only general facts, and do not provide any details to suggest that each, or any particular, VIX settlement was manipulated. All the allegations Plaintiff make are made on the basis of aggregate data, and they therefore fail to state with particularity any reason to believe that individual statements corresponding to a final settlement value were false.
With respect to failure to disclosure, Plaintiffs argued that Cboe Options made a culpable omission insofar as it knew of (or recklessly disregarded) systematic manipulation, and committed fraud through it’s failure to disclose that fact. While Defendants conceded that an allegation of fraud based on non-disclosure can stand when there exists a duty to speak, they argue that such a duty simply did not exist. First, Rule 10-b imposes a duty not to “omit to state a material fact in order to make the statements made . . . not misleading.” Relying on Matrixx Initiatives, Defendants interpret this statementt mean that a duty not to tell “half-truths” only arises when there is some affirmative statement made that is materially misleading absent further disclosure. This raises a further issue of particularity, as Defendants claim that Plaintiffs failed to allege any specific, misleading half-truths—against, they say, the only statements identified in the complaint concern general properties of the VIX derivatives, and are characterized as misrepresentations, not half-truths, and are generally “too vague to be actionable.” Defendants then go on to point out that the duty to disclose only arises when a “fiduciary or similar relationship of trust” exists. In this case, Plaintiffs do not–and, according to Defendants, cannot—allege that Cboe Options owes them any fiduciary duty.
Defendant’s brief now shifts to the second element, scienter. Under the PSLRA, Plaintiffs must “state with particularity facts giving rise to a strong inference that defendants acted wit the required state of mind.” The required state of mind is one with an intent to deceive, and, Defendants posit, Plaintiffs have failed to meet this standard. One of Plaintiff’s central arguments in support of scienter is their unfettered access to the raw data required to appropriately identify the manipulation they alleged, together with their consistent engagement in “market surveillance.” This is insufficient, Defendants argue, for three reasons. First, Plaintiffs never allege that any official responsible for making the misleading statements would have “had reason to analyze the trading data, or, indeed, would have had the technical capacities to do so.” This is necessary under the corporate scienter rule, Defendants argue, because someone who actually spoke for the defendant must hold the intent to deceive as to the alleged manipulation. Second, Plaintiffs’ scienter theory based on access to trade data assumes that a competent observer would be able to recognize manipulation. This is both inaccurate, Defendants say, and contrary to Plaintiffs’ own assertions that no one suspected manipulation prior to the publication of an academic paper in May 2017. They point specifically to Plaintiff’s request that the statute of limitations be tolled on the grounds that even a reasonably diligent person would not have had cause investigate the possibility of manipulation – though it is worth pointing out that Plaintiffs made such assertions from the perspective of an investor, not as an entity with unlimited access to the relevant data.
Plaintiffs further argued that Cboe’s economic interest in the VIX derivatives also supported an inference of scienter. Defendants dispute this on the grounds that “allegations of a generic motive to protect the company are an insufficient basis for inferring the requisite scienter,” and, further, that the importance of the VIX derivatives simply provides a greater motive to “aggressively police” any manipulation – not to turn a blind eye to it. Defendants insist that, under FRE 407, Plaintiffs also cannot infer scienter from the Cboe’s subsequent measures, nor can they use it to infer that prior standards were deficient. A similar argument applies, Defendants say, to any reliance on the disciplinary proceedings brought by Cboe Options with respect to VIX options.
On the topic of reliance, Defendants first argue that Plaintiffs cannot simply assert reliance “upon the fairness of the VIX SOQ process,” because it is not an allegation of any specific, actionable misstatement or omission. Nor should Plaintiffs’ reliance should be presumed under Affiliated Ute, Defendants argue, because Cboe Options had no duty to disclose. The “fraud-on-the-market” doctrine is also inapplicable, say Defendants, because that doctrine assumes that one is investing in the same entity that carry out the market manipulation; because Plaintiffs are investing in VIX derivatives, and not in Cboe Options itself, “even if a Cboe defendant had withheld information about manipulation of [the VIX] markets, Plaintiffs have alleged no reason to believe that “the market’s” belief about whether trading was or was not being manipulated was priced in to the prices at which Plaintiffs bought and sold those derivatives.”
In their final push against the merits of Plaintiffs’ 10b-5 claims, Defendants attack their allegations of loss causation. This point is again tied to the specificity of Plaintiffs’ allegations of misrepresentation; Defendants argue that Plaintiffs have not plausibly alleged that they have suffered a loss as a result of a misrepresentation by Cboe Options because Plaintiffs have not tied any particular statements made by the Cboe defendants to a specific loss suffered by Plaintiffs. Moreover, Plaintiffs’ allegations are not even sufficient to establish loss causation based on manipulation by third parties, or so Defendants say, because Plaintiffs do not allege—either in general or in a particular transaction—that the manipulation about which they complain caused settlement prices to go up or down, and whether such changes would have in fact harmed them. Citing Sonterra Capital Master Fund, Defendants insist that manipulation causing unspecified effects is simply insufficient to state a claim.
Failure to State a Claim Under the CEA
The CEA implicates a different regulatory scheme, but, according to Defendants, Plaintiffs claims fail for much the same reasons. Cboe Futures, like Cboe Options, is a self-regulatory organization. It has duties under the CEA to oversee its markets and enforce standards of conduct. Plaintiffs CEA claims fail, Defendants argue, first because there is no private right of action under § 5, and, second, with respect to claims under § 22, because plaintiffs failed to allege a failure to enforce any specific rule, that such lapse in enforcement caused specific losses, or that such lapse was motivated by bad faith.
With respect to the Section 5 claims, Defendants cite to Sam Wong, a Second Circuit case holding that “wrenching the provisions out of § 5 out of context to create and exchange duty . . . and implying a private right of action…would disregard the framework Congress established” in support of their position that the core principals of § 5 are not enforceable via private cause of action.
On the § 22 claim, Plaintiffs’ claim rests, according to Defendants, on failure to enforce two rules that broadly prohibit fraudulent acts and manipulation of the market. This fails, per Defendants, for a reason we’ve heard repeated often: Plaintiffs failed to provide a factual basis to suggest that a specific order or trade was made with the intent to manipulate VIX futures. Evaluation of a rule violation is only possible when an SRO can evaluate the specific circumstances to determine if enforcement is warranted and if Plaintiff suffered losses, and it is “impossible to evaluate an SRO’s alleged failure to exercise its delegated enforcement powers absent similarly discrete allegations.” Similarly, Defendants point out that, under the CEA, Plaintiffs must allege that their losses were caused by a failure to enforce; without identifying specific instances of enforcement failures, they cannot allege that their asserted losses are the result of such failed enforcement.
Defendants also dispute whether or not Plaintiffs successfully alleged but-for or proximate causation such that they could establish that bringing the enforcement actions would have spared them their unidentified losses. And again, following the same lines, without identifying specific failures of enforcement, Plaintiffs cannot allege that their losses were caused by such failure. Defendants posit that, in order for plaintiff’s losses to have been the but-for result of a failure by Cboe Futures to enforce Rules 601 or 603, the disciplinary hearing that typically arises from such a manipulation would also have had to result in a refund of past transactions. Because plaintiffs do not allege that enforcement would have resulted in such a refund, such enforcement would not have averted Plaintiff’s losses. Defendants also posit, perhaps tenuously, that “there is no plausible causal link between such hypothetical disciplinary proceedings and future market activity.” On proximate causation, Defendants insist that a claim for damages will generally not proceed beyond the “first step” of a multi-link chain of cause and effect; in this instance, that would impose liability on the actual manipulators, not on Cboe Futures, because the “hypothetical deterrence effects” that Cboe’s potential disciplinary actions could have generated are too attenuated to support liability.
Defendants also argue that Plaintiffs have not adequately alleged bad faith with respect to Cboe Future’s lapse in enforcement. Congress has permitted a cause of action against exchanges for certain regulatory failures in the futures context, but only where an SRO acts in bad faith in it’s failure to perform its regulatory duties. Defendants note that the Second Circuit has found that this requirement is to be “strictly applied,” and thus Plaintiffs’ allegation of bad faith should be held to the particularity requirements of Rule 9(b) – a position the Seventh Circuit supports. To plead bad faith, Plaintiffs would need to allege facts supporting both willful blindness and an ulterior motive in the failure to enforce. This is not, according to Defendants, a bar they have reached. First, Plaintiffs themselves point out that the Cboe Defendants brought disciplinary proceedings with respect to volatility products, including the VIX index; this makes it implausible that the same Defendants were willfully avoiding the truth. Second, citing Zimmerman and Brawer, Defendants explain that, because “mixed motives” are a common feature of SROs—they, or their members, often have an interest in the markets they regulate—an interest in “generating increased trading volumes and revenues” is not sufficient for a claim of bad faith. Even if Plaintiffs have alleged an ulterior motive, Defendants argue, they have not provided sufficient basis for the Court to infer that this ulterior motive was the dominant one.
Plaintiff’s State-Law Negligence Claim Should be Dismissed
Defendants urge dismissal of Plaintiff’s negligence claim on grounds of immunity, preemption, and merit. With respect to immunity, Defendants argue that the same regulatory immunity that they insist barred the federal claims also bars state-law claims. In their favor, they cite a D.C. Cir. case, In re Series 7, which held that “the comprehensive structure set up by Congress is suggestive of both an intent to create immunity for [regulatory] duties, and of an intent to preempt state common law causes of action.”
Defendants also found a supportive case cite for their preemption argument, quoting the Seventh Circuit’s decision in Am. Agric. Movement Inc. for the position that the CEA preempts state-law claims that “bear upon the actual operation of the commodity futures markets.” Based on this, they argue that Plaintiff’s claim that the VIX futures settlement process was susceptible to manipulation would have a direct impact on trading or the operations of a futures market, and is thus preempted. Defendants also argue that Plaintiffs claims concerning options traded on Cboe Options are preempted in a similar manner by the Securities Exchange Act.
Aiding and Abetting under the CEA
Defendants dedicate brief page to Plaintiff’s aiding and abetting claim, which they note “is not clear . . . has anything to do with Cboe,” as it “appears to be charging that the John Does aided each other’s manipulation.” In an abundance of caution, however, Defendants take the time to note that, while Section 22 does create a cause of action against aiders-and-abettors, that is limited to entities “other than a registered entity.” Because Cboe Futures is a registered entity, the claim cannot apply. Defendants also argue that aiding and abetting cannot apply to Cboe Options or Cboe Global either, as Plaintiffs allegedly fail to establish that those entities had the requisite knowledge of the principal’s intent to violate the CEA, nor did they have the individual intent to further that violation. Citing Bosco, Defendants observe that “it would be most unlikely” that Cboe would “want to help an intermediary defraud [their] customers, for scandals such as a fraud can only hurt the Exchange.”
Inadequate Allegations of Manipulation
Finally—yes, really—Defendants argue that a “major defect” cutting across Plaintiff’s claims is their failure to adequately allege that a manipulation has, in fact, occurred. To this end, Defendants note that “price manipulation is a species of fraud” (under In re London Silver Fixing) and therefore subject to the heightened pleading standard of Rule 9(b). Plaintiffs must therefore describe the “who, what, when, where, and how of the fraud” with particularity—and, according to Defendants, have failed to do so. Plaintiffs fail, for example, to identify those responsible for the manipulation, or even the types of market participants responsible. And instead of describing the mechanism for any particular fraud, they “merely allege that two possible mechanisms are consistent with the aggregate data.” For a description of those methods—banging the close and manipulating the zero bid rule—check out our earlier posts in this series. Defendants further argue that Rule 9(b) prohibits Plaintiffs from using the discovery process to remedy this pleading defect.
Defendants then attack Plaintiff’s reliance on the Griffin and Shams paper, noting Griffin’s (disclosed) affiliation with an expert consulting firm that may profit from litigation on the same topics covered by his article, and that the paper itself states (after exploring and debunking several potential alternate explanations for the data) that it “cannot fully rule out all potential explanations without more granular data. Defendants also state that Plaintiffs have overlooked an innocent explanation to the aggregate data on trading volumes: strategy orders, which are routine and permissible, and, because the relate to a market participant’s positions in expiring volatility index derivatives, would explain the observed elevated trading volume.
While Defendants have put forward a strong brief, it will be some time before we know if it offered enough in the mix to defeat this VIX (lawsuit). Watch this space for our forthcoming installments—we’ll provide an update on the discovery motions currently in play next, and, of course, a close look at Plaintiff’s inevitable opposition to this motion.
This post was written by Alexandra M.C. Douglas.
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