Two-Sided Loyalty - Exploring the Boundaries of Fiduciary Duties of Market Makers - Dolgopolov 2012

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A TWO-SIDED LOYALTY?: EXPLORING THE BOUNDARIES OF

FIDUCIARY DUTIES OF MARKET MAKERS

STANISLAV DOLGOPOLOV∗

ABSTRACT

This Article explores the boundaries of fiduciary duties of market makers

established by the federal courts and evaluates these boundaries in the light of the

changing economics and institutional framework of providing liquidity in

securities markets and the current regulatory agenda. Given a variety of business

models and trading strategies employed by these market participants in order to

provide liquidity and their potentially multiple roles in securities markets, this

Article identifies various factors set by the federal courts suggesting the existence

of a fiduciary duty. The Article also considers whether certain practices of market

makers integral to the function of providing liquidity may give rise to a fiduciary

duty and examines corresponding potential consequences.

TABLE OF CONTENTS

INTRODUCTION ...................................................................................................... 32

I. THE REACH OF FIDUCIARY DUTIES TO THE FUNCTION OF PROVIDING

LIQUIDITY ................................................................................................... 35

II. VARIOUS FACTORS SUGGESTING THE EXISTENCE OF A FIDUCIARY DUTY ......... 46

III. CERTAIN PRACTICES OF MARKET MAKERS INTEGRAL TO THE FUNCTION OF

PROVIDING LIQUIDITY THAT MAY GIVE RISE TO A FIDUCIARY DUTY ......... 51

IV. THE SIGNIFICANCE OF THE CHANGING ECONOMICS AND INSTITUTIONAL

FRAMEWORK OF PROVIDING LIQUIDITY IN SECURITIES MARKETS AND

THE CURRENT REGULATORY AGENDA ........................................................ 54

V. SEVERAL LEGAL ISSUES RELEVANT TO MARKET MAKERS WITH RESPECT TO

THEIR REGULATORY ENVIRONMENT AND CIVIL LIABILITY ......................... 60

CONCLUSION ......................................................................................................... 63

∗ J.D. (the University of Michigan), M.B.A. (the University of Chicago), B.S.B.A. (Drake

University), member of the North Carolina State Bar. The author thanks Henry G. Manne for his

guidance in life and Vladislav Dolgopolov, Christal Phillips, Larry E. Ribstein, and Sandra Zeff for

their help, comments, and expertise.


32 UC Davis Business Law Journal [Vol. 12

INTRODUCTION

The federal courts have repeatedly encountered the controversy regarding

the nature of fiduciary duties1 owed to individual market participants by market

makers,2 entities that formally or informally provide liquidity in securities

markets under different names, such as “specialists,” “dealers,” “designated

market makers,” or “liquidity providers,” in exchange for revenues from bid-ask

spreads and, in some cases, liquidity rebates offered by trading venues.3 One

issue in the case law and concomitant public policy analysis is whether a

fiduciary duty attaches to the function of providing liquidity as such. An

intertwined issue addresses heightened duties, such as a fiduciary duty, of

securities firms that serve as market makers in addition to their other functions.

These issues are exemplified by the recent high-profile controversy

relating to Goldman Sachs’s involvement in numerous structured finance

transactions, notably the ABACUS 2007-AC1 deal,4 as the firm had repeatedly

1

For a selective mix of general sources on fiduciary duties, see TAMAR FRANKEL, FIDUCIARY

LAW (2010); Robert Cooper & Bradley J. Freedman, The Fiduciary Relationship: Its Character

and Economic Consequences, 66 N.Y.U. L. REV. 1045 (1991); Frank H. Easterbrook & Daniel R.

Fischel, Contract and Fiduciary Duty, 36 J.L. & ECON. 425 (1993); Larry E. Ribstein, Fencing

Fiduciary Duties, 91 B.U. L. REV. 899 (2011); Robert H. Sitkoff, The Economic Structure of

Fiduciary Law, 91 B.U. L. REV. 1039 (2011); D. Gordon Smith, The Critical Resource Theory of

Fiduciary Duty, 55 VAND. L. REV. 1399 (2002). Also compare FRANKEL, supra, at 106–07

(designating the duty of loyalty, which includes “[t]he duty to follow and abide by the directives of

entrustment,” “[t]he duty to act in good faith in performing fiduciary services,” “[t]he duty not to

delegate the fiduciary services to others,” “[t]he duty to account and disclose relevant information

to the entrustors,” and “[t]he duty to treat entrustors fairly,” and the duty of care as two broad

categories of fiduciary duties), with Ribstein, supra, at 899 (arguing that “[t]he fiduciary duty is

appropriately construed as one of unselfishness, as distinguished from lesser duties of care, good

faith and fair dealing, and to refrain from misappropriation”), and with Smith, supra, at 1402, 1409

(asserting that “the duty of loyalty . . . is the essence of fiduciary duty” and that, “[u]nlike the duty

of care, the fiduciary duty of loyalty is distinctive”). 2

See, e.g., United States v. Finnerty, 474 F. Supp. 2d 530 (S.D.N.Y. 2007); United States v.

Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887 (S.D.N.Y. Sept. 6, 2006); Spicer v.

Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469 (N.D. Ill. Oct. 24,

1990). 3

For an analysis of market making, which stresses the impact of high-frequency trading, see

MICHAEL DURBIN, ALL ABOUT HIGH-FREQUENCY TRADING passim (2010). For additional recent

sources on market making, see Concept Release on Equity Market Structure, Exchange Act

Release No. 61,358, 75 Fed. Reg. 3594 passim (Jan. 14, 2010); GETCO EUROPE LTD., A MODERN

MARKET MAKER’S PERSPECTIVE ON THE EUROPEAN FINANCIAL MARKET REGULATORY AGENDA

(2010), available at http://www.getcollc.com/images/uploads/Final_EU_Paper.pdf; Peter

Chapman & James Ramage, In Search of Market Makers, TRADERS MAG., Nov. 2010, at 30. 4

For the basic facts and different perspectives on this controversy, see Wall Street and the

Financial Crisis: The Role of Investment Banks: Hearing Before the Permanent Subcomm. on

Investigations of the S. Comm. on Homeland Sec. & Governmental Affairs, 111th Cong. (2011);

Goldman Sachs Grp., Inc., Current Report (Form 8-K) (May 3, 2010), available at

http://www2.goldmansachs.com/our-firm/investors/financials/archived/8k/pdf-attachments/05-03-


Ed. 1] A Two-Sided Loyalty? 33

pointed to its market maker status in order to shield itself from liability.5 As

articulated by Lloyd C. Blankfein, Goldman Sachs’s Chairman and CEO, “In our

market-making function, we are a principal. We represent the other side of what

people want to do. We are not a fiduciary. We are not an agent.”6 In turn, Gary

Cohn, the firm’s President and Chief Operating Officer, provided the following

public policy rationale: “Markets would not work, if market makers were a

fiduciary. What would a market maker do if he had a buyer and seller

simultaneously approach him? . . . He can’t be a fiduciary to one and not the

other. He can’t be a fiduciary to both.”7 This defense has not remained

uncontested: “Goldman was not acting as primarily a market maker responding to

client demand when it originated and sold [certain structured finance securities]

[but] as an underwriter, placement agent, or broker-dealer, aggressively soliciting

its clients to purchase [certain] products that senior management wanted to

eliminate from its inventory.”8 This counterargument echoes several decisions of

10-8k-doc.pdf; Complaint and Demand for Jury Trial, SEC v. Goldman, Sachs & Co., No. 10-CV-

3229 (BSJ), 2010 U.S. Dist. LEXIS 119802 (S.D.N.Y. July 20, 2010), available at

http://www.sec.gov/litigation/complaints/2010/comp-pr2010-59.pdf; Consent of Defendant

Goldman, Sachs & Co., SEC v. Goldman, Sachs & Co., No. 10-CV-3229 (BSJ), 2010 U.S. Dist.

LEXIS 119802 (S.D.N.Y. July 20, 2010), available at http://www.sec.gov/litigation/litreleases/

2010/consent-pr2010-123.pdf. For academic commentary, see Steven F. Davidoff et al.,

Computerization and the ABACUS: Reputation, Trust, and Fiduciary Duties in Investment

Banking, J. CORP. L. (forthcoming) available at http://ssrn.com/abstract=1747647; Andrew F.

Tuch, Conflicted Gatekeepers: The Volcker Rule and Goldman Sachs (John M. Olin Ctr. for Law,

Econ. & Bus., Harvard Law Sch., Fellows’ Discussion Paper No. 37, 2011), available at

http://ssrn.com/abstract=1809271. 5

See MAJORITY & MINORITY STAFF OF THE PERMANENT SUBCOMM. ON INVESTIGATIONS OF THE S.

COMM. ON HOMELAND SEC. & GOVERNMENTAL AFFAIRS, 112TH CONG., WALL STREET AND THE

FINANCIAL CRISIS: ANATOMY OF A FINANCIAL COLLAPSE 610–13 (Comm. Print 2011), available at

http://hsgac.senate.gov/public/_files/Financial_Crisis/FinancialCrisisReport.pdf [hereinafter

SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS]. 6

Lloyd C. Blankfein, Chairman & CEO, Goldman Sachs Grp., Inc., Testimony at the First Public

Hearing of the Financial Crisis Inquiry Commission 27 (Jan. 13, 2010), http://fcic-

static.law.stanford.edu/cdn_media/fcic-testimony/2010-0113-Transcript.pdf [hereinafter

Blankfein’s FCIC Testimony]. 7

Tom Braithwaite & Francesco Guerrera, Goldman Lobbies Against Fiduciary Reform, FIN.

TIMES, May 12, 2010, at 4. 8

SENATE STAFF, WALL STREET AND THE FINANCIAL CRISIS, supra note 5, at 615. A blue-ribbon

commission, probably having the Goldman Sachs controversy in mind, similarly pointed to

“potential conflicts for underwriters of mortgage-related securities to the extent they shorted the

products for their own accounts outside of their roles as market makers.” NAT’L COMM’N ON THE

CAUSES OF THE FIN. & ECON. CRISIS IN THE UNITED STATES, THE FINANCIAL CRISIS INQUIRY

REPORT 212 (2011), available at http://www.gpoaccess.gov/fcic/fcic.pdf. One important point,

however, is that the synthetic nature of some of the securities in question “required Goldman to

find both long and short investors, who were making opposite bets in what amounts to a zero sum

investment.” Thomas J. Moloney et al., Fiduciary Duties, Broker-Dealers and Sophisticated

Clients: A Mis-Match That Could Only Be Made in Washington, 3 J. SEC. L. REG. & COMPLIANCE

336, 340 (2010).



the federal courts that analyzed various factors pointing to the existence of a

fiduciary duty owed by market makers due to multiple roles played by such firms

and the nature of the relationship between the parties in question.9 On the other

hand, a natural concern is whether some of these factors cover practices that may

be essential to the function of providing liquidity.

Given the complexity and multi-faceted nature of fiduciary relationships,

which arise in a variety of contexts under fact-intensive scenarios, crafting a

concise theoretical underpinning for the existence of a fiduciary duty with respect

to various functions performed by market makers in securities markets is a

difficult—if not near-futile—task. After all, “[f]iduciary obligation is one of the

most elusive concepts in Anglo-American law.”10 Yet, at least in the context of

commercial relationships, a fiduciary duty perhaps could be thought of as a

contractual device that minimizes transaction costs.11 The author’s simplified

synthesis of the existing thicket of approaches to identifying and categorizing

fiduciary relationships12 is that such duties must be based on a relationship of

trust and confidence, a reliance on external expertise and discretion, and an

undertaking to act on behalf of and in the best interest of the other party. A mere

existence of superior knowledge and specialization, a hypothetical that captures

the reality of securities markets, is insufficient by itself.13

This Article explores the boundaries of fiduciary duties of market makers

established by the federal courts. Part I traces the chronological development of

the case law, which indicates the lack of a general fiduciary duty for performing

market making services as such. Part II identifies various factors set by the

federal courts suggesting the existence of a fiduciary duty owed by market

9

See, e.g., Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828 (N.D. Ill.

2010); Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S.

Dist. LEXIS 8065 (S.D.N.Y. June 14, 1993). 10

Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J.

879, 879. 11

For recent academic debates on the contractual nature and efficiency of fiduciary relationships,

see Arthur B. Laby, The Fiduciary Obligation as the Adoption of Ends, 56 BUFF. L. REV. 99

(2008); Ribstein, supra note 1; Sitkoff, supra note 1; Leonard I. Rotman, Is Fiduciary Law

Efficient? A Preliminary Analysis (n.d.) (unpublished manuscript) (on file with author), available

at http://ssrn.com/abstract=1485853. See also Graham v. Mimms, 444 N.E.2d 549, 555 (Ill. App.

Ct. 1982) (“The law of fiduciary obligations facilitates commercial efficiency by imposing a duty

of loyalty on fiduciaries, thereby relieving the parties to such relationships of the obligation of, in

every case, individually negotiating contracts which specify the fiduciary’s duties in a large

number of hard-to-anticipate situations.”) (citing Victor Brudney & Robert Charles Clark, A New

Look at Corporate Opportunities, 94 HARV. L. REV. 997, 999 (1981)). 12

See, e.g., FRANKEL, supra note 1, at 4–42; Thomas Lee Hazen, Are Existing Stock Broker

Standards Sufficient? Principles, Rules, and Fiduciary Duties, 2010 COLUM. BUS. L. REV. 710,

722–27; Ribstein, supra note 1, at 901–03; L.S. Sealy, Fiduciary Relationships, 1962 CAMBRIDGE

L.J. 69, 74–79; Smith, supra note 1, at 1423–31. 13

See Hazen, supra note 12, at 724.



makers, given a variety of business models and trading strategies employed by

these market participants in order to provide liquidity and their potentially

multiple roles in securities markets. Part III considers whether certain practices of

market makers integral to the function of providing liquidity, such as payment for

order flow, may give rise to a fiduciary duty and examines corresponding

potential consequences. Part IV analyzes the significance of the changing

economics and institutional framework of providing liquidity in securities

markets and the current regulatory agenda for fiduciary duties of market makers.

Part V analyzes several legal issues relevant to market makers with respect to

their regulatory environment and civil liability. The Article concludes by

evaluating the overall position of the federal courts on the issue of fiduciary

duties of market makers and the prospects for its future application.

I. THE REACH OF FIDUCIARY DUTIES TO THE FUNCTION OF PROVIDING LIQUIDITY

The basic inquiry is whether a market maker, assuming away its other

roles in securities markets, owes a fiduciary duty to individual market participants

by the virtue of occupying a pivotal position as a liquidity provider. Turning to

the chronological analysis of this matter, probably the earliest relevant case,

which addressed alleged securities fraud in connection with transactions in

limited partnership interests, concluded that “[t]he plaintiffs cannot bootstrap a

general fiduciary duty from the limited duty imposed on ‘market makers’ by Rule

10b-5.”14

The first detailed analysis of fiduciary duties of market makers appeared

in the case addressing the events in the aftermath of the “Black Monday” of

October 19, 1987, when several market makers in equity index options “did not

trade but allegedly should have” or allegedly traded at “inflated and grossly

exaggerated prices.”15 The starting point of the court’s analysis was an assertion

that “[f]iduciary responsibilities are not lightly inferred [as] [t]hey arise from a

14

In re Longhorn Sec. Litig., 573 F. Supp. 255, 272 (W.D. Okla. 1983). On the other hand, an

even earlier case “suggest[ed] that the sole dealer and market maker in an issuer’s commercial

paper may be held to a higher standard” in the context of disclosure obligations and fiduciary

duties. Assoc. Randall Bank v. Griffin, Kubik, Stephens & Thompson, Inc., 3 F.3d 208, 213 (7th

Cir. 1993) (interpreting Sanders v. John Nuveen & Co., 619 F.2d 1222 (7th Cir. 1980)). This

decision raises a potential issue whether a sole market maker might be considered a fiduciary.

However, such liquidity providers are becoming harder to find—with the exception of thinly

traded / illiquid securities—because even trading venues with one designated market maker often

have other de facto market makers or coexist with other trading venues transacting in the same

security. Furthermore, another case, which offers a distant analogy, refused to link the monopoly

status of a public utility and the existence of a fiduciary duty owed to its customers. County of

Suffolk v. Long Island Lighting Co., 728 F.2d 52, 63 (2d Cir. 1984). 15

Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *1-2

(N.D. Ill. Oct. 24, 1990).



very narrow class of relationships.”16 The court concluded that, “[w]hether they

trade or not, [market makers] do not owe fiduciary duties to investors.”17 Drawing

on the economic nature of market making and the difference between the roles of

brokers and market makers, the court offered the following justification:

Market makers match buyers and sellers and may, when there are

price discontinuities or a temporary disparity between supply and

demand, have a duty (though not necessarily owed to investors, as

opposed to the Exchange) to stand against the market and trade on

their own accounts. Brokers, as opposed to market makers, are

agents and may be fiduciaries, though even then, only when

trading on discretionary accounts in which the broker determines

which investments to make. But market makers are not fiduciaries

for investors even in the sense that brokers may be—nothing in

the complaint alleges that market makers advise or influence

investors or hold or spend money for them. Nor does the

complaint allege that there is any “pre-existing relation of trust”

between market makers and investors.18

The court also stated that the “[p]laintiffs have alleged nothing which would

clearly distinguish these dealings from arms length business transactions, and for

that reason their allegation that market makers owe investors fiduciary

obligations is insufficient.”19 Finally, the court stated that the plaintiffs “add[ed]

nothing to an allegation of ‘normal trust’ other than the existence of [federal

securities law and rules of the options exchange and the clearinghouse].”20

A later case involved an attempt to cancel a sell order for put options on

shares of an airline company, which was placed through a third-party brokerage

firm, but this order was in fact executed for the specialist’s account after the

release of news relating to the collapse of a takeover deal for another major

player in the airline industry.21 On the other hand, the specialist “did disclose that

he took the trade as a principal.”22 In its analysis of the alleged breach of

fiduciary duties by the specialist, the court made the following observation:

The specialist has fiduciary obligations closely resembling, if not

identical to, those of a broker [because] “[a]s broker, the specialist

16

Id. at *44. 17

Id. at *45. 18

Id. at *46 (internal citation omitted). 19

Id. at *46–47. 20

Id. at *47. 21

Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S. Dist.

LEXIS 8065, at *3–8 (S.D.N.Y. June 14, 1993). 22

Id. at *31.



holds and executes orders for the public on a commission basis.

When he does so, he is an agent and has a fiduciary obligation to

his principal, the purchaser or seller of stock.” . . . An aspect of a

broker’s fiduciary duty is to refrain from transactions that are

adverse to the interests of his or her customer.23

In other words, the analysis hinged on the dual role played by some market

makers rather than the very function of providing liquidity.

With the exception of a dictum that the market maker status, the role that

the defendant in fact had not played, “implicate[s] broader fiduciary duties,”24 the

next group of cases on the issue of fiduciary duties of market makers dealt with

the high-profile controversy over the conduct of specialists on the floor of the

New York Stock Exchange (“NYSE”).25 The specialists’ role, in contrast to the

role of market makers in “pure” dealer markets, was characterized by a certain

duality of functions:

Specialists are responsible for maintaining a two-sided auction

market by providing an opportunity for public orders to be

executed against each other. In order to do so, they serve dual-

roles, acting as both “agent” and “principal.” Once an order has

been received, the specialist, acting as agent, is required to match

the open order to buy with an open order to sell within the same

price range. Specialists generally receive no compensation for

filling orders as agents. When there are no matching orders to sell

and orders to buy, specialists are permitted to trade on a

“principal” basis by either selling the stock from their own

proprietary account to fulfill the investor’s order to buy or buying

the stock and holding it in their own account to fill an investor’s

order to sell.26

23

Id. at *32–33 (quoting Note, The Downstairs Insider: The Specialist and Rule 10b-5, 42

N.Y.U. L. REV. 695, 697 (1967)). 24

Arst v. Stifel, Nicolaus & Co., 86 F.3d 973, 980 (10th Cir. 1996). 25

For the basic facts of this tenacious controversy, which went much deeper than the issue of

fiduciary duties of the NYSE specialists, see In re NYSE Specialists Sec. Litig., 405 F. Supp. 2d

281 (S.D.N.Y. 2005), aff’d in part, rev’d in part, 503 F.3d 89 (2d Cir. 2007), remanded to 260

F.R.D. 55 (S.D.N.Y. 2009). For academic commentary, see Emil J. Bove III, Institutional Factors

Bearing on Criminal Charging Decisions in Complex Regulatory Environments, 45 AM. CRIM. L.

REV. 1347 (2008); J. Scott Colesanti, Not Dead Yet: How New York’s Finnerty Decision Salvaged

the Stock Exchange Specialist, 23 ST. JOHN J. LEGAL COMM. 1 (2008); Nan S. Ellis et al., The

NYSE Response to Specialist Misconduct: An Example of the Failure of Self-Regulation, 7

BERKELEY BUS. L.J. 102 (2010). 26

In re NYSE Specialists, 260 F.R.D. at 61.



Furthermore, the NYSE

place[d] a negative obligation on specialists, prohibiting

“purchases or sales of any security in which such specialist, is

registered . . . unless such dealings are reasonably necessary to

permit such specialist to maintain a fair and orderly market [and]

prohibit[ed] proprietary trading, with limited exceptions, when the

specialist “has knowledge of any particular unexecuted

customer’s order to buy (sell) such security which could be

executed at the same price.”27

More specifically, the NYSE specialists were accused of the following

wrongdoings in connection with their status as market makers:

(i) “interpositioning” in violation of the Specialist Firms’

“negative obligation,” in which a Specialist Firm “steps in the

way” of matching orders of public sellers and/or buyers of stock

to generate riskless profits to the detriment of [other market

participants]; (ii) “trading ahead” or “front-running,” in which

Specialist Firms take advantage of their confidential knowledge of

public investors’ orders . . . and trade for their own account as

principals before completing orders placed by public investors;

(iii) “freezing the book,” in which a Specialist Firm freezes its

Display Book on a stock so it can first engage in trades for its own

account prior to entering and then executing public investors’

orders . . . .28

As the scandal began to unfold, a class action lawsuit prominently

featured the allegation that the NYSE specialists are “fiduciaries to public

investors.”29 In fact, several decisions of the federal courts specifically addressed

the issue of fiduciary duties owed by the NYSE specialists to public customers,

i.e., potentially all market participants on the NYSE, including customers of all

brokers and direct access traders,30 although in some instances this issue was

reserved or viewed as preempted.31 An intriguing fact is that several specialist

27

Id. at 61–62 (quoting the applicable rules of the NYSE). 28

Id. at 64. 29

Complaint and Demand for Jury Trial, CalPERS v. NYSE, Inc., No. 03 Civ. 9968, para. 4

(S.D.N.Y. Dec. 16, 2003), available at http://securities.stanford.edu/1029/NYSE03-01/20031215_

f01c_CPERS.pdf. For the background information on the consolidation of different lawsuits and

the appointment of two lead plaintiffs, see In re NYSE Specialists, 405 F. Supp. 2d at 287. 30

See United States v. Finnerty, 474 F. Supp. 2d 530 passim (S.D.N.Y. 2007); United States v.

Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887 passim (S.D.N.Y. Sept. 6, 2006). 31

See, e.g., United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist. LEXIS 72119, at

*16–17 (S.D.N.Y. Oct. 2, 2006) (reserving this issue); United States v. Bongiorno, No. 05 Cr. 390



firms entangled in this controversy had made public statements as to their

fiduciary status.32 In addition to the plaintiffs in civil litigation and the

prosecution in criminal trials of several employees of the investigated specialist

firms, the U.S. Securities and Exchange Commission (“SEC”) as the securities

regulator and the NYSE itself as a self-regulatory organization—but perhaps

largely as a face-saving measure—had some interest in imposing the fiduciary

standard on the NYSE specialists in some form. To the author’s knowledge, the

SEC never used the word “fiduciary” in connection with this scandal, although

this position had been articulated on other occasions with respect to exchange

specialists more generally, which were seen as agents “entrusted” with public

customers’ orders.33 On the other hand, the regulatory agency crafted a fiduciary-

(SHS), 2006 U.S. Dist. LEXIS 24830, at *21–23 (S.D.N.Y. May 1, 2006) (same); In re NYSE

Specialists, 405 F. Supp. 2d at 306–08 (holding that the fiduciary duty-based claim is preempted

by the Securities Litigation Uniform Standards Act of 1998). 32

See In re NYSE Specialists, 405 F. Supp. 2d at 332–33 (two specialists having made nearly

identical public statements that, “[a]s agent, the specialist assumes the same fiduciary

responsibility as a broker” and “as an agent, a specialist assumes the same fiduciary responsibility

as a broker”). 33

As far back as 1936, the SEC adopted the position asserting the existence of “the [exchange]

specialist’s fiduciary obligation to buyers and sellers whose orders he has accepted for execution,”

pointed to “his special knowledge and superior bargaining power in trading for his own account,”

and considered “essential . . . that the dealer functions of the specialist be subjected to stringent

control.” SEC. & EXCH. COMM’N, REPORT ON THE FEASIBILITY AND ADVISABILITY OF THE

COMPLETE SEGREGATION OF THE FUNCTIONS OF DEALER AND BROKER 63 (1936). In a later

administrative adjudication relating to the American Stock Exchange, the regulatory agency

asserted that, because the exchange specialist “functions as a broker executing orders entrusted to

him by other brokers on behalf of their customers . . . he is in a position of trust and confidence

with his customers and obligated within the terms of his agency to the strict standards of loyalty,

disclosure and fair dealing required of fiduciaries.” Re, Re & Sagarese, Exchange Act Release No.

6900, 41 S.E.C. 230, 231 (Sept. 21, 1962). An in-depth study of securities markets conducted by

the SEC similarly concluded that “[t]he [exchange] specialist who holds an order is a subagent in a

fiduciary relationship with his principal, the customer who originated the order.” REPORT OF

SPECIAL STUDY OF SECURITIES MARKETS OF THE SECURITIES AND EXCHANGE COMMISSION, H.R.

DOC. NO. 88-95, pt. 2, ch. VI, at 58 (1963) (footnote omitted). While the study maintained that the

“fiduciary relationship with the ultimate customer entails [that] [a]s an agent, [the exchange

specialist] has a duty to act solely for the benefit of his principal in all matters within the scope of

his agency,” it also recognized that this market participant “represents many customers on opposite

sides of the market [and] deals for his own account in competition with, and often adversely to, his

customers.” Id. at 142–43. In a more recent statement, the regulatory agency maintained that the

exchange specialist has a “fiduciary obligation to orders on the book.” Order Approving Proposed

Rule Change of the Midwest Stock Exchange, Inc. Relating to a Pilot Program for Stopped Orders

in Minimum Variation Markets, Exchange Act Release No. 30,189, 57 Fed. Reg. 2621, 2622 (Jan.

14, 1992). In another statement, the SEC asserted that the exchange specialist is a fiduciary “when

acting as agent for a limit order.” Order Approving Proposed Rule Change by the Philadelphia

Stock Exchange Relating to the New Electronic Trading Platform, “Phlx XL,” Exchange Act

Release No. 50,100, 69 Fed. Reg. 46,612, 46,621 (July 27, 2004). A somewhat more restrictive

statement pointed to “the [exchange] specialist’s fiduciary duties to unexecuted limit orders on the



like description of the applicable standard: “Whether acting as brokers or dealers,

specialists are required to hold the public’s interests above their own and, as such,

are prohibited from trading for their dealers’ accounts ahead of pre-existing

customer buy or sell orders that are executable against each other.”34

Undoubtedly in coordination with the SEC, the NYSE used the identical language

in its own proceedings,35 and it went even further, reminding its specialists, in the

context of the impermissibility of “trading ahead,” that they “have a fiduciary

duty to orders entrusted to them as agent[s].”36

In Hunt, a criminal case in which the prosecution alleged that the

defendant specialist owed “fiduciary obligations to the NYSE and its public

customers,”37 the court focused on the narrow set of circumstances giving rise to

the fiduciary standard—when “the fiduciary agrees to act as a principal’s ‘alter

ego,’ rather than assuming the standard arm’s length stance of traders in a

specialist’s limit order book.” Order Granting Approval to Proposed Rule Change of the

Philadelphia Stock Exchange, Inc. Relating to the Treatment of PACE Orders, Exchange Act

Release No. 39,548, 63 Fed. Reg. 3596, 3599 (Jan. 13, 1998). 34

Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1896 (Mar. 30,

2004); see also N.Y. Stock Exch., Inc., Exchange Act Release No. 51,524, 85 SEC Docket 517,

518 (Apr. 12, 2005) (making the same statement). Analyzing the regulatory agency’s public

statements, one commentator argued that, “on the specific question of interpositioning, the SEC

has made clear . . . that it holds the Specialist to a fiduciary duty when acting as either principal or

agent.” Colesanti, supra note 25, at 26. 35

See, e.g., Fleet Specialist, Inc., Exchange Hearing Panel Decision 04-49, at 6 (N.Y. Stock

Exch. Mar. 29, 2004), available at http://www.nyse.com/pdfs/04-049.pdf. 36

Mkt. Surveillance Div., N.Y. Stock Exch., Member Educ. Bulletin No. 2004-12, at 1 (Dec. 23,

2004), available at http://apps.nyse.com/commdata/PubeduMemos.nsf/0/85256F340070DCAD852

56F73005E408D/$FILE/Microsoft%20Word%20-%20Document%20in%202004-12.pdf. On the

other hand, the NYSE had occasionally used the word “fiduciary” with respect to its specialists

even before this controversy. See, e.g., Mkt. Surveillance Div., N.Y. Stock Exch., Info. Memo No.

94-45, at 1 (Sept. 14, 1994), available at http://apps.nyse.com/commdata/PubInfoMemos.nsf/0/852

56FCB005E19E885257108006C2D8B/$FILE/Microsoft%20Word%20-%20Document%20in%20

94-45.pdf (stating that “[a]gency orders on the book must be appropriately represented in

accordance with the Specialist’s fiduciary responsibilities”). Other trading venues had also

articulated the existence of certain fiduciary duties owed by exchange specialists, but, typically, the

scope of such duties was not defined very broadly. See, e.g., Notice of Filing and Immediate

Effectiveness of Proposed Rule Change by the Boston Stock Exchange, Inc. Relating to the

Execution Guarantee Rules, Exchange Act Release No. 50,904, 69 Fed. Reg. 78,065, 78,067 (Dec.

21, 2004) (the Boston Stock Exchange pointing to “the specialist’s fiduciary duties of best

execution”); Notice of Filing of a Proposed Rule Change by the Philadelphia Stock Exchange, Inc.

Relating to the Automatic Execution of Booked Customer Limit Orders, Exchange Act Release

No. 47,657, 68 Fed. Reg. 18,717, 18,720 (Apr. 10, 2003) (the Philadelphia Stock Exchange stating

that, “[o]nce a customer limit order is booked, a fiduciary responsibility devolves upon the

specialist to execute such an order at the best price available, subject to the customer’s limit price,

when the order becomes marketable”). 37

United States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *12 (S.D.N.Y.

Sept. 6, 2006).



market.”38 A key conclusion was that “a position of public trust [occupied by the

NYSE specialists] is not directly analogous to a fiduciary duty to specific

customers.”39 The court also employed a detailed analysis of market making as a

means of aggregating orders of different types in an impersonal market:

While specialists may have an obligation to maintain the market

economy, they do not owe the public a fiduciary duty, and

therefore an alleged breach of fiduciary duty cannot serve as a

basis for security fraud. Rather than represent one party’s

interests, Defendant here was expected to execute orders for both

buyers and seller [sic]—two masters as it were—and presumably

there was an expectation that Defendant would not place one

customer’s demands over another’s. Instead, Defendant’s task

was to facilitate the flow of market forces as a quasi-neutral party.

Defendant here was not responsible for making trades for

customers in the traditional broker sense; instead he acted as a

catalyst, bringing buyers and sellers together to complete

deals. . . . [S]pecialists have no loyalty to buyers or sellers, as they

execute orders for both, and further, they often do not know the

identity of those for whom they execute buys and sells.40

Finally, the court concluded that the lack of fiduciary duties also follows from the

fact that “public customers did not compensate Defendant”41 and stressed that

“specialists do not exercise discretionary authority on behalf of the trading

public.”42

In another case, the same court noted the pivotal role of the allegation that

the NYSE specialists owe a fiduciary duty to public customers in the context of

criminal liability under federal securities law: “[E]ven assuming that the

Government demonstrated that [the defendant specialist] was a thief who stole

from public customers, his conviction for securities fraud cannot be sustained

absent a showing that he also violated a fiduciary duty.”43 Turning to the relevant

precedents, the court concluded that “the only case to have squarely addressed

this issue held that specialists do not owe a fiduciary duty to their public

customers [and] that specialists serve two masters, both the buyer and the seller,

38

Id. at *13. 39

Id. at *14. 40

Id. at *16–17. 41

Id. at *18. 42

Id. 43

United States v. Finnerty, 474 F. Supp. 2d 530, 543 (S.D.N.Y. 2007). On the flip side, a mere

breach of fiduciary duty without “any deception, misrepresentation, or nondisclosure” does not

give rise to liability under the Securities Exchange Act of 1934 and Rule 10b-5. Santa Fe Indus.,

Inc. v. Green, 430 U.S. 462, 476 (1977).



and thus ‘have no loyalty to buyers or sellers, as they execute orders for both.’”44

Furthermore, the court also agreed with the significance of the fact that the NYSE

specialists do not receive compensation from public customers.45 The court even

considered irrelevant the defendant specialist’s deposition testimony admitting

that he owed a fiduciary duty to public customers: “A fiduciary duty does not

arise out of mere admission, where, as here, the case law points to the contrary.”46

The court also rejected the prosecution’s analogy with a rogue real estate broker

who “instead of putting the buyer and seller together and letting them trade with

each other . . . buy[s] the apartment for himself [and] sell[s] it to the buyer for the

[maximum amount] that the buyer was willing to pay, and then . . . put[s] [the

difference] in his firm’s and his pockets”47:

The real estate broker works for one side, the buyer or the seller,

not both, while the specialist executes orders for both sides. The

real estate broker does not act as a principal, while the specialist

regularly trades for his firm’s proprietary account. The real estate

broker has a fiduciary duty to the party he is representing, while

the specialist does not. The real estate broker is entitled to a

commission, while the specialist earns no fee for executing public

orders. . . . The apartment buyer’s expectations are clear: for a

[preset] commission, the real estate broker will act as the buyer’s

agent, on a fiduciary basis, solely as a broker and not as a

principal. The expectations of the specialists [sic] customers are

substantially different. . . . 48

Ultimately, the court concluded that “the issue of the existence of a fiduciary duty

was one for the jury, but the jury was never asked to decide the issue.”49

Another series of decisions addressed the conflict between options market

makers and direct access customers, which possess informational and

technological advantages compared to other market participants, stemming from

the alleged discrimination—including interference with execution and

mishandling—of such customers’ orders by market makers.50 The plaintiffs also

described themselves as market participants “implementing arbitrage trading

44

Finnerty, 474 F. Supp. 2d at 543–44 (quoting United States v. Hunt, No. 05 Cr. 395 (DAB),

2006 U.S. Dist. LEXIS 64887, at *17 (S.D.N.Y. Sept. 6, 2006)). 45

Id. at 544 n.10. 46

Id. at 543. 47

Id. at 547. 48

Id. 49

Id. at 544. 50

Last Atlantis Capital LLC v. AGS Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS

29175, at *4–5 (N.D. Ill. Mar. 26, 2010); Last Atlantis Capital LLC v. Chi. Bd. Options Exch., 455

F. Supp. 2d 788, 791–92 (2006).



strategies which attempt to take advantage of price discrepancies of options.”51

The key issue was whether an options specialist owed a fiduciary duty to

customers of third-party brokers,52 and the court noted the lack of precedents

pointing to such a duty and the existence of the case law suggesting the opposite

result.53 The court also proceeded cautiously with defining the boundaries of the

fiduciary standard: “Under some circumstances, a broker or dealer will have a

fiduciary duty to a particular customer. That duty, however, is not based on one’s

status as a dealer. A fiduciary relationship arises only when the dealing [sic]

between the customer and the dealer presuppose a special trust or confidence.”54

The court also rejected the relevance of the cases presented in support of

attaching a fiduciary duty because they did not “involve options specialists and in

all of those cases the defendant . . . had direct dealings with the investors.”55

Overall, the court concluded that the “plaintiffs have failed to provide sufficient

evidence of a special relationship of trust or confidence.”56

In another decision relating to the same controversy, the court once again

attacked the plaintiffs’ arguments:

[P]laintiffs argue that defendants “actively solicited” orders from

plaintiffs by generating quotes which plaintiffs could access via

the Exchanges’ order routing and execution system. . . . Providing

quotes is a basic part of the specialists’ job, and the quotes are

disseminated by the Exchanges through their systems. I do not

view the generation of quotes as “actively solicit[ing]” customers,

but rather simply part of the role played by the specialists in

making markets.57

51

Last Atlantis, 455 F. Supp. 2d at 791. 52

Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *24–26. 53

Id. at *24, 26–28. 54

Id. at *24–25 (quoting Congregation of the Passion, Holy Cross Province v. Kidder Peabody &

Co., Inc., 800 F.2d 177, 182 (7th Cir. 1986)). 55

Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *24 n.9. Both cases cited by the court that were

used by the plaintiffs to support their position, Kurz v. Fidelity Management & Research Co., 556

F.3d 639 (7th Cir. 2009), and Wsol v. Fiduciary Management Associates, Inc., 266 F.3d 654 (7th

Cir. 2001), involved the allegations that the respective investment advisers were directing orders to

their favored brokers in exchange for kickbacks. Of course, the investment adviser status confers

an independent fiduciary duty. See, e.g., Fidelity Mgmt. & Research Co., Investment Advisers Act

Release No. 2713, Investment Company Act Release No. 28,185, 2008 SEC LEXIS 507, at *12,

14 (Mar. 5, 2008) (“Under Section 206 of the [Investment] Advisers Act [of 1940], an investment

adviser has a fiduciary duty to seek best execution for its clients’ securities transactions—that is, to

seek the most favorable terms reasonably available under the circumstances [and] a fiduciary duty

to disclose all material conflicts of interest to its advisory clients.”). 56

Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *25. 57

Last Atlantis Capital LLC v. ASG Specialist Partners, 749 F. Supp. 2d 828, 843 (N.D. Ill.

2010).



The court also pointed that the defendant did not “receive[] compensation from

plaintiffs [and] had [no] direct communications with [them].”58 Relying on the

precedent set in Finnerty, the court dismissed the relevance of public statements

by some of the defendants that they were fiduciaries and asserted that “the

question of whether or not these defendants were fiduciaries does not rest on

whether or not they believed themselves to be (or whether plaintiffs believed

them to be).”59 Despite the possibility of classifying the defendant specialists as

agents, the court also declined to impose on these market participants some

inherent duty of best execution in the absence of express representations.60 In its

most recent ruling on the controversy, the court stated that its prior decisions “do

not conclusively foreclose a claim for breach of fiduciary duty based on an

agency theory [which was waived earlier by the plaintiffs] . . . [but the] breach of

fiduciary duty claims based on ‘special trust’ are, however, clearly foreclosed.”61

Overall, with the exception of several tangential objections, the federal

courts have employed a narrow reading of the fiduciary standard and consistently

declined to recognize a fiduciary duty owed by market makers to individual

market participants. The federal courts have distinguished the largely impersonal

and somewhat mechanical nature of providing liquidity from more personalized

and discretionary aspects of providing brokerage services. The existing approach

also dismissed the relevance of alleged expectations of plaintiffs as to the

fiduciary status of defendants, which the federal courts perceived as unjustified or

one-sided, and even declined to put too much weight on the use of the word

“fiduciary” by defendants themselves.62 Another common thread was the refusal

to classify transactions of market makers in their capacity as providers of

liquidity as anything other than arm’s-length’s, and this conclusion invokes a

more general principle that “[t]he arm’s-length relationship of parties in a

business transaction is, if anything, antithetical to the notion that either would

58

Id. at 842 n.10. 59

Id. at 844. 60

Id. at 831–32. Although narrow in its scope, the duty of best execution, which is typically

applicable to brokers, undoubtedly has a fiduciary nature. One key ruling stated that the duty of

best execution “predates the federal securities laws [and] has its roots in the common law agency

obligations of undivided loyalty and reasonable care that an agent owes to his principal” and

pointed to its fiduciary nature. Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d

266, 270 (3d Cir. 1998). 61

Last Atlantis Capital LLC v. ASG Specialist Partners, No. 04 C 397, 2011 U.S. Dist. LEXIS

60380, at *10–11 (N.D. Ill. June 6, 2011). 62

Additional legal issues—and perhaps gaps in the existing decisions—lurking here are whether

the expectations of plaintiffs were reasonable and whether the fiduciary status was assumed by

defendants as a contractual representation. One decision, however, briefly touched on the issue of

expectations in the context of the fiduciary standard, but it declined to apply this standard to the

defendant specialist. United States v. Finnerty, 474 F. Supp. 2d 530, 547 (S.D.N.Y. 2007).

Furthermore, there seems to be little evidence that the fiduciary status of market makers was

actively sought ex ante by any plaintiff.



owe a fiduciary relationship to the other.”63 Another key point was the

recognition of the inherent—and indelible—conflict of being a fiduciary to both

buyers and sellers, and, indeed, it is difficult to translate a fiduciary duty into

specific trading instructions for any market maker’s business model of buying

low and selling high.64 Furthermore, unlike the SEC, the federal courts held that

even agency-like features of the trading mechanism in question—most notably

with respect to the NYSE specialists—do not give rise to a fiduciary duty in the

absence of explicit compensation for these agency functions.

The underlying public policy issue pertains to the effect of the fiduciary

standard on liquidity of securities markets, although this dimension has not been

clearly articulated by the federal courts. The refusal to attach a fiduciary duty to

the function of providing liquidity avoids potential difficulties with evaluating the

reasonableness of transaction prices and the size of bid-ask spreads, as a form of

compensation to market makers, given their assumption of risk, exposure to

competitive forces, and limited exercise of discretion. This approach similarly

avoids an ex post scrutiny of information that was or should have been in the

possession of the market maker in question. With respect to the function of

providing liquidity as such, a powerful argument is that, “[i]f a market maker

were required to perform extensive due diligence on each security in which it was

asked to execute a transaction, and to update disclosures every time it bought or

sold securities, real-time, liquid markets could not exist.”65 These legal risk

63

Dopp v. Teachers Ins. & Annuity Ass’n, No. 91 Civ. 1494 (CSH), 1993 U.S. Dist. LEXIS

13980, at *15 (S.D.N.Y. 1993); see also Pan Am. Corp. v. Delta Air Lines, Inc., 175 B.R. 438, 511

(S.D.N.Y. 1994) (“[W]hen parties deal at arms length in a commercial transaction, no relation of

confidence or trust sufficient to find the existence of a fiduciary relationship will arise absent

extraordinary circumstances.”). 64

This conflict stands in contrast to situations in which conflicts of fiduciary duties arise only in

certain circumstances or are attributed to different functions performed by the fiduciary in

question. See Arthur B. Laby, Resolving Conflicts of Interest in Fiduciary Relations, 54 AM. U. L.

REV. 75 passim (2004) (analyzing situations in which a securities firm performs different

functions, such as offering brokerage services and engaging in underwriting activities); Steven L.

Schwarcz, Fiduciaries with Conflicting Obligations, 94 MINN. L. REV. 1867 passim (2010)

(focusing on situations in which fiduciary duties are owed to different classes of securities with

conflicting interests caused by unfavorable market conditions). In the context of market making, it

would be problematic to apply mechanisms in which “fiduciaries may attempt to envision what the

parties [with conflicting interests] would have agreed upon had they been asked [or] resort to

general principles of law and precedent, such as maximizing the fairness to each party, and the

impact of the fiduciaries’ decisions on the parties.” FRANKEL, supra note 1, at 178. 65

Letter from Gregory K. Palm, Exec. Vice President & Gen. Counsel, Goldman Sachs Grp.,

Inc., to Philip N. Angelides, Chairman, Fin. Crisis Inquiry Comm’n 5 (Mar. 1, 2010), available at

http://www2.goldmansachs.com/our-firm/on-the-issues/march-10-letter.pdf. On the other hand, in

a scenario resembling the Goldman Sachs controversy, informational asymmetries may be caused

by a market maker’s involvement in the creation of the security in question. See Robert B.

Thompson, Market Makers and Vampire Squid: Regulating Securities Markets After the Financial

Meltdown, 89 WASH U. L. REV. 323, 342 (2011) (“When the market maker becomes involved in



factors are likely to be detrimental to liquidity if the fiduciary standard is

applicable to market makers, especially given the stringency of the remedy for

breaching a fiduciary duty in the context of two-sided trading.66

II. VARIOUS FACTORS SUGGESTING THE EXISTENCE OF A FIDUCIARY DUTY

Despite the general principle that no fiduciary duty is attached to the

function of providing liquidity alone, the federal courts have discussed various

factors that suggest the existence of a fiduciary duty owed by market makers in

the context of multiple roles played by such securities firms and the nature of the

relationship between the parties in question.67 While these factors typically stem

from a specific function performed by a securities firm, a fiduciary duty owed to

other market participants may also emerge for a reason outside of an ordinary

range of business activities, such as a market maker’s access to and use of inside

information.68

the creation of inventory, not just obtaining it on the market, there are additional asymmetrical

incentives that can distort the market-making function.”); Steven Drucker & Christopher Mayer,

Inside Information and Market Making in Secondary Mortgage Markets, at i (Jan. 6, 2008)

(unpublished manuscript) (on file with author), available at http://www4.gsb.columbia.edu/null/

download?&exclusive=filemgr.download&file_id=16547 (“Instead of acting as unbiased market

makers, underwriters [of prime mortgage-backed securities] appear to exploit access to better

information and models to their own advantage.”). 66

As one commentator observed,

In the event of the fiduciary’s breach of duty, the principal is entitled to an

election among remedies that include compensatory damages to offset any

losses or to makeup any gains forgone owing to the fiduciary’s breach, or to

disgorgement by the fiduciary of any profit accruing to the fiduciary owing to

the breach. The former is a standard measure of make-whole compensatory

damages; the latter is a restitutionary remedy arising in equity in the form of a

constructive trust that prevents unjust enrichment.

Sitkoff, supra note 1, at 1048 (footnotes omitted). 67

It also appears that being a fiduciary to other market participants, such as in the capacity of the

lead plaintiff status in a securities class action, does not necessarily preclude a securities firm from

functioning as a market maker, but this status imposes “a duty to deal . . . in good faith [as] the

general duty of the fiduciary to disclose all relevant information to the person to whom the duty is

owed when the fiduciary deals with that person.” In re Seeburg-Commonwealth United Litig., No.

69 Civ. 5736, 1975 U.S. Dist. LEXIS 14185, at *8 (S.D.N.Y. Jan. 24, 1975). The workability of

this standard for a market maker is of course problematic. 68

For a discussion of fiduciary duties owed to other market participants that is acquired as a

result of access to privileged information or tipping by insiders, see Dirks v. SEC, 463 U.S. 646

(1983). In fact, some recent empirical evidence suggests the existence of exploitation of inside

information by certain market makers linked to their board representation. See H. Nejat Seyhun,

Insider Trading and the Effectiveness of Chinese Walls in Securities Firms, 4 J.L. ECON. & POL’Y

369 (2008). On the other hand, unlike the “classical” theory of insider trading in Dirks, the

“misappropriation” theory addresses the issue of fiduciary duties owed to the source of information

rather than other market participants. See United States v. O’Hagan, 521 U.S. 642 (1997). An



One factor is a potential overlap of the roles of a dealer acting as a

liquidity provider and a broker owing a fiduciary duty to specific customers in

certain situations. This combination raises a serious problem:

Acting as a dealer . . . is anathema to the fiduciary obligation

owed to a customer and presents a classic conflict of interest. . . .

When acting as a dealer, the firm seeks to buy low and sell high—

precisely what the customer seeks. It is hard to see how any dealer

can act in the “best interest” of his customer when trading with

her.69

One concern is whether such an overlap necessarily emerges, and this situation is

exemplified by the assertion of the leadership of Goldman Sachs in the context of

the scrutinized structured finance transactions that the firm was “not a broker at

all [but solely] a principal.”70

Another consideration is that the scope of fiduciary duties owed by

brokers is somewhat ambiguous on both federal and state levels,71 but when the

hurdle is met, “any distinction between omissions and misrepresentations is

illusory in the context of a broker who has a fiduciary duty to her clients.”72

interesting historical fact pertaining to the adoption of the Securities Acts Amendments of 1964 is

that in the course of the discussion of corporate directorships held by representatives of broker-

dealers, one controversial point of view considered market makers’ access to inside information as

aiding them, if not being essential, in providing liquid markets. See Note, Section 16(d) Exemption

for Market Makers: The Meat Axe Applied to a Rule of Thumb!, 60 NW. U. L. REV. 367, 375–76

(1965); see also 110 CONG. REC. 17, 926–27 (1964). 69

Arthur B. Laby, Reforming the Regulation of Broker-Dealers and Investment Advisers, 65 BUS.

LAW 395, 425 (2010). For an early analysis of this problem, see William O. Douglas & George E.

Bates, Stock “Brokers” as Agents and Dealers, 43 YALE L.J. 46 (1933). An even earlier treatise

stated that, “[u]nder a well-established rule of the law of agency, the broker who receives an order

from a customer to buy or sell securities, cannot, in execution of the order, buy the securities from

or sell them to himself, irrespective whether or not there is any evidence of bad faith on his part.”

DOUGLAS CAMPBELL, THE LAW OF STOCKBROKERS 29 (1st ed. 1914). 70

Blankfein’s FCIC Testimony, supra note 6, at 28. A similar issue—also highly relevant for

today’s securities markets—is the ambiguity with respect to the overlap and respective boundaries

of the terms “customer,” “client,” and “counterparty.” See SENATE STAFF, WALL STREET AND THE

FINANCIAL CRISIS, supra note 5, at 17, 608 n. 2692. 71

See Arthur B. Laby, Fiduciary Obligations of Broker-Dealers and Investment Advisers, 55

VILL. L. REV. 701 passim (2010); see also SEC v. Pasternak, 561 F. Supp. 2d 459, 499 (D.N.J.

2008) (“To determine the existence of a fiduciary relationship in federal securities fraud actions,

district courts generally look to state law.”); Laby, supra, at 712 (“Understanding the duties

imposed on brokers by . . . Sections 10 and 15 [of the Securities Exchange Act of 1934] requires an

analysis of the state law of fiduciaries.”). Summarizing the state of the law as of the early 20th

century, one treatise remarked that, “[i]nasmuch as the broker in his transactions for a customer is

dealing with property belonging to the customer, which is intrusted to him in a confidential

capacity, his agency is fiduciary in character.” CAMPBELL, supra note 69, at 13–14. 72

SEC v. Zandford, 535 U.S. 813, 823 (2002).



Turning to the applicable case law, one court distinguished the market making

and brokerage functions and offered some guidance on the reach of the fiduciary

standard: “Brokers, as opposed to market makers, are agents and may be

fiduciaries, though even then, only when trading on discretionary accounts in

which the broker determines which investments to make.”73 In that respect, an

inquiry may address whether the defendant in question “advise[s] or influence[s]

investors or hold[s] or spend[s] money for them.”74 Another case extended the

reach of the fiduciary standard to market makers that serve as commission-based

brokers for public customers.75 Overall, the fiduciary status for a broker is not

necessarily easily attainable. For instance, while scrutinizing the actions of an

employee of a broker-dealer that also functioned as a market maker by matching

orders and risking its own capital,76 the court made the following observation:

[The defendant’s] customers purposefully did not relinquish

control over their orders [and] testified that they would break up,

or dole out, their orders to maintain control over the trade. . . . The

fact that [the defendant] could exercise discretion as to time and

price on a not-held order does not necessitate a finding of a

fiduciary relationship, particularly in light of [the] limitations

posed by his customers’ specific instructions.77

In a key administrative adjudication, the SEC employed an approach to

the overlap of the market making and brokerage functions similar to the position

73

Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *46

(N.D. Ill. Oct. 24, 1990); see also de Kwiatkowski v. Bear, Stearns & Co., Inc., 306 F.3d 1293,

1308–09 (2d Cir. 2002) (“[A]bsent an express advisory contract, there is no fiduciary duty on part

of broker-dealer ‘unless the customer is infirm or ignorant of business affairs.’”) (quoting

Robinson v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 337 F. Supp. 107, 113 (N.D. Ala. 1971));

Pasternak, 561 F. Supp. 2d at 506 (“The crux of a fiduciary relationship [between the broker-

dealer and the customer] is the relinquishment of control and discretion by the customer.”); United

States v. Hunt, No. 05 Cr. 395 (DAB), 2006 U.S. Dist. LEXIS 64887, at *15 (S.D.N.Y. Sept. 6,

2006) (“[S]tockbrokers generally do not owe a fiduciary duty unless a customer has delegated

discretionary trading authority to that broker.”). 74

Spicer, 1990 U.S. Dist. LEXIS 14469, at *46. 75

Mkt. St. Ltd. Partners v. Englander Capital Corp., No. 92 Civ. 7434 (LMM), 1993 U.S. Dist.

LEXIS 8065, at *32–33 (S.D.N.Y. June 14, 1993). 76

Pasternak, 561 F. Supp. 2d at 485–88. 77

Id. at 506. A subsequent proceeding before the securities industry’s self-regulatory

organization also declined to apply the fiduciary standard to the securities firm in question and

even refused to classify it as a broker in these circumstances because the firm “as a wholesale

market maker, did not maintain customer accounts for the institutions with which it dealt [and]

therefore did not act as a broker or agent for institutional customers [who] understood [that their

orders] would be executed by [the firm], as a dealer, on a principal-to-principal basis.” Dep’t of

Mkt. Regulation v. Leighton, No. CLGO50021, 2010 FINRA Discip. LEXIS 3, at *110–16

(N.A.C. Mar. 3, 2010).



of the federal courts.78 The regulatory agency affirmed a censure by the National

Association of Securities Dealers (“NASD”) of a broker-dealer that, while

serving as a market maker, “failed to execute customer’s limit order for the sale

of stock even though it sold shares of that security for its own account at prices

above the limit price, and customer was not informed that member would give its

own position priority.”79 Just as the NASD, the SEC based its decision on the fact

that the securities firm as a broker was an agent of its customers and, therefore, a

fiduciary.80 The regulatory agency also referred to an earlier case that involved a

brokerage firm functioning as a market maker that executed a large transaction

for its own account rather than the client’s: “A broker-dealer’s determination to

execute an order as principal or agent cannot be ‘a means by which the broker

may elect whether or not the law will impose fiduciary standards upon him in the

actual circumstances of any given relationship or transaction.’”81 Relying on this

adjudication, one court declared that, “[a]lthough [a fiduciary duty] might grow

out of broker / dealers’ role as agent, the duty does not disappear when the role of

principal is assumed.”82 Ultimately, Hutton triggered a chain of regulatory

initiatives,83 but the SEC had not articulated any theory of a broader fiduciary

78

E.F. Hutton & Co., Exchange Act Release No. 25,887, 41 SEC Docket 414 (July 6, 1988).

Hutton was in fact preceded by two rule-making actions, as opposed to fact-intensive

administrative adjudications, that articulated the SEC’s position that market makers in general owe

a fiduciary duty to “customers.” The term “customer” was not clarified, but the context of these

statements is probably more consistent with the presence of a preexisting brokerage relationship

rather that the applicability to all counterparties. See Order Approving Proposed Rule Change of

the Chicago Board Options Exchange, Inc., Exchange Act Release No. 24,666, 52 Fed. Reg.

25,679, 25,680 n.10 (June 30, 1987) (stating that “market makers [are expected to] execute

customer market orders in a manner consistent with their fiduciary obligations to their customers”

in the context of handling market and marketable limit orders by brokers); Unlisted Trading

Privileges in Over-the-Counter Securities, Exchange Act Release No. 22,412, 50 Fed. Reg. 38,640,

38,649 n. 90 (Sept. 16, 1985) (stating that “exchange specialists and OTC market makers are still

subject to fiduciary obligations to seek best execution for their customers’ orders” in the context of

intermarket trading linkages). 79

Hutton, 41 SEC Docket at 414. 80

Id. at 414–17, 425. Even the decision of the NASD’s Board of Governors was described as an

“eagerness to expand a market maker’s obligations to conform with a broadly stated and somewhat

featureless conception of broker-dealer fiduciary duties.” Gregory A. Hicks, Defining the Scope of

Broker and Dealer Duties—Some Problems in Adjudicating the Responsibilities of Securities and

Commodities Professionals, 39 DEPAUL L. REV. 709, 725 (1990). For another analysis of Hutton

from the perspective of fiduciary duties, see Easterbrook & Fischel, supra note 1, at 430–31 & n.

12–13. 81

Hutton, 41 SEC Docket at 415–16 (quoting Opper v. Hancock Sec. Corp., 250 F. Supp. 668,

675 (S.D.N.Y. 1966)). 82

In re Merrill Lynch Sec. Litig., 911 F. Supp. 754, 768 (D.N.J. 1995). 83

While approving the NASD rule that built on Hutton, the SEC stated that it “strongly believe[d]

that the ban on trading ahead [applicable to market makers] should [also] be applied to . . .

member-to-member trades,” i.e., to transactions with both their own and other members’

customers. Order Approving Proposed Rule Change by the NASD Relating to Handling of



duty owed by a market maker to market participants other than its own customers

in connection with these developments.

Another related factor is the existence of compensation in addition to

actual transaction prices, which may point in the direction of an agency

relationship meeting the fiduciary standard.84 The court in Hunt made the

following observation: “While compensation may, in certain circumstances,

impose fiduciary duties on the individual receiving payment, Defendant here

‘generally received no compensation for executing trades on an agency basis.’

Therefore, as public customers did not compensate Defendant, he did not in turn

owe them a duty under this theory.”85 The Finnerty court cited this decision with

approval: “[U]nlike the broker context, public customers do not compensate

specialists, and thus, no fiduciary duty is owed to the public customers under that

theory.”86 An analogous observation was made in a controversy dealing with

options trading, given the possibility that “financial remuneration in the form of

specialist guarantees and brokerage commissions in exchange for handling public

orders as an agent” could have been made: “[A]ny compensation the defendant

specialists received was not from plaintiffs.”87

One court also emphasized the importance of “direct communications

between the defendant specialists and plaintiffs [as an indication of] a ‘special

relationship or trust’ . . . in the context of considering whether or not defendants

Customer Limit Orders, Exchange Act Release No. 34,279, 59 Fed. Reg. 34,883, 34,885 (July 29,

1994). Shortly thereafter, the regulatory agency proposed a broad limit order protection rule

applicable to market makers with respect to their own customers and customers of other NASDAQ

members. Customer Limit Orders, Exchange Act Release No. 34,753, 59 Fed. Reg. 50,866

(proposed Sept. 29, 1994). The SEC withdrew the proposed rule when the NASD prohibited

NASDAQ members from “accept[ing] and hold[ing] an unexecuted limit order from its own

customer or from a customer of another member . . . from trading ahead of the customer’s limit

order . . . for its own market-making account at prices that would satisfy the customer’s limit

order.” Order Approving Proposed Rule Change by the NASD Relating to Limit Order Protection

and Nasdaq, Exchange Act Release No. 35,571, 60 Fed. Reg. 27,997, 27,997 (May 22, 1995).

Being true to the chosen course, the regulatory agency subsequently required displaying customer

limit orders in addition to market makers’ quotes. Order Execution Obligations, Exchange Act

Release No. 37,619A, 61 Fed. Reg. 48,290, 48,290 (Sept. 6, 1996). 84

Also compare Ribstein, supra note 1, at 902 (arguing that “[a] fiduciary relationship differs

from the broader category of agency relationships”), with Laby, supra note 71, at 721 (analyzing

the position that “[o]ne would expect a broker acting as an agent to be held to a fiduciary standard”

and pointing out that every version of the Restatement of Agency classifies an agency relationship

as a fiduciary one). Perhaps this issue can be framed in terms of the scope of a fiduciary duty owed

by a broker, i.e., its reach beyond the duty of best execution. 85


Sept. 6, 2006) (citation omitted). 86

United States v. Finnerty, 474 F. Supp. 2d 530, 544 n.10 (S.D.N.Y. 2007). 87


2010).



were fiduciaries of plaintiffs.”88 Furthermore, “[h]ad plaintiffs put forward

evidence of a more direct solicitation, perhaps through letters or telephone calls,

[the court] would be more inclined to agree with them that defendants ‘actively

solicit[ed]’ them as clients.”89 Although not in the context of the fiduciary

standard, another court also noted that the prosecution had “identified no way in

which [the defendant specialist] communicated anything to his customers, let

alone anything false.”90

Another factor considers certain characteristics of the securities market in

question. There is a continuum between an impersonal and transparent trading

venue with a large number of buyers and sellers open to the public, which ensures

its liquidity, and an informal market in relatively illiquid securities, which mostly

operates through direct solicitations and preexisting relationships, as well as

associated duties. For instance, one court pointed to “the role . . . stemming from

the relationship between the parties . . . comparable to that of a fiduciary [for]

‘market makers’ who were actively involved in encouraging the market for the

stock through personal solicitations and receipt of commissions.”91 On the other

end of the spectrum, the existence of a fiduciary duty is less likely when a market

maker on a public market “act[s] as a catalyst, bringing buyers and sellers

together to complete deals”92 and “[p]rovid[es] quotes [which] are disseminated

by the Exchanges through their systems.”93

III. CERTAIN PRACTICES OF MARKET MAKERS INTEGRAL TO THE FUNCTION OF

PROVIDING LIQUIDITY THAT MAY GIVE RISE TO A FIDUCIARY DUTY

While market making as such does not create a general fiduciary duty

owed to other market participants, certain trading strategies and arrangements that

may be viewed as integral to the function of providing liquidity potentially

expose market makers to liability or at least create nontrivial risks and costs of

litigation. One illustration is the practice of payment for order flow (“PFOF”),

which is defined as “the practice in the securities industry of brokers receiving

payments from market makers or exchange specialists for having directed a

volume of transactions to such market makers or exchange specialists for

88

Id. at 844 n.14. 89

Id. at 844 n.15. 90

United States v. Finnerty, 533 F.3d 143, 148–49 (2d Cir. 2008). 91

In re Towers Fin. Corp. Noteholders Litig., No. 93 Civ. 0810 (WK) (AJP), 1995 U.S. Dist.

LEXIS 21147, at *60 (S.D.N.Y. Sept. 20, 1995) (interpreting Affiliated Ute Citizens v. United

States, 406 U.S. 128, 152–53 (1972)). 92


Sept. 6, 2006). 93


2010).



execution of the orders placed by investors.”94 In one controversy, the court had

to evaluate the following PFOF-related allegation:

Plaintiffs also argue that “[a]ll defendants solicited public

customer orders by participating in Exchange-sponsored [PFOF]

programs pursuant to which each defendant received the proceeds

from ‘marketing’ fees collected by the Exchanges that were then

used to pay certain broker-dealer firms . . . that were selected by

the defendants in exchange for their agreement to route public

customer orders to the defendants at their respective

Exchanges.”95

In one of its decisions on this controversy, the court made a rather disputable

statement that “[t]here is no evidence that [the defendant specialist] sought

plaintiffs as customers, nor is there evidence that [the defendant specialist] made

payments to broker-dealers in an attempt to secure more public customers.”96

Yet, PFOF programs serve the role of securing additional order flow—and hence

attracting more traders—on the level of individual market makers and even

trading venues,97 as many securities are cross-listed. Overall, PFOF programs are

94

Gilman v. BHC Sec., Inc., No. 94 Civ. 1133 (AGS), 1995 U.S. Dist. LEXIS 18682, at *3

(S.D.N.Y. Dec. 18, 1995), rev’d, 104 F.3d 1418 (2d Cir. 1997). One court further described PFOF

programs as “a type of volume discount—in either cash or in-kind services—by which market

makers (who actually execute securities transactions) reward brokers for having directed business

to them.” Gilman, 104 F.3d at 1420. An early analysis of the origins of this practice similarly

observed that “the value in order flow is derived from the aggregation of small orders,” which in

turn allows market makers “to profit from the dealer’s turn [i.e., the bid-ask spread], to more easily

trade in and out of positions, and to make use of information reflected in order flow regarding

market sentiment.” PAYMENT FOR ORDER FLOW COMM., INDUCEMENTS FOR ORDER FLOW: A

REPORT TO THE NASD BOARD OF GOVERNORS 23 (1991). For an analysis of the practice of PFOF

from the standpoint of asymmetric information, see Stanislav Dolgopolov, Insider Trading,

Informed Trading, and Market Making: Liquidity of Securities Markets in the Zero-Sum Game, 3

WM. & MARY BUS. L. REV. (forthcoming Feb. 2012) (manuscript at 22 & nn.58–59) (on file with

author). 95

Last Atlantis, 2010 U.S. Dist. LEXIS 117680, at *44 n.12; see also Last Atlantis Capital LLC

v. ASG Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS 29175, at *21 (N.D. Ill. Mar. 26,

2010) (quoting the plaintiffs’ allegation that the defendant specialist “actively solicited customers

by, inter alia, directing monetary payments to certain brokerage firms in exchange for their

agreements to direct customer orders to the Exchanges at which [it] was a designated specialist”). 96

Last Atlantis, 2010 U.S. Dist. LEXIS 29175, at *22 (emphasis added). 97

See, e.g., Proposed Amendments to Rule 610 of Regulation NMS, Exchange Act Release No.

61,902, 75 Fed. Reg. 20,738, 20,740–41 (proposed Apr. 14, 2010) (“Many exchanges also charge a

payment for order flow or ‘marketing’ fee to market makers that trade with customer orders on the

exchange. The exchange then makes the proceeds from such fees available . . . to collectively fund

payment for order flow to brokers directing order flow to the exchange.”) (footnote omitted).



integral to the chosen model of providing liquidity despite potential conflicts of

interest and other problems that this model may entail.98

In a later decision, the court “question[ed] how . . . a [PFOF] program

indicates a connection or relationship between defendants and plaintiffs, as

plaintiffs’ too-brief description of it shows a connection, at most, between

defendants and the order entry firms.”99 However, this issue was left open

because the “plaintiffs’ argument on this point [was] waived as undeveloped.”100

Indeed, it is a stretch to suggest that some duty owed by an order flow-selling

broker to its customers is somehow transferred to an order flow-buying market

maker when they enter into a payment arrangement presumably negotiated at

arm’s-length. A similar controversy involved a clearing broker that settled and

cleared trades and performed certain other functions for retail brokers, and the

clearing broker in turn directed orders submitted through retail brokers to market

makers in exchange for PFOF.101 The court suggested in its dictum that the

clearing broker did not owe a fiduciary duty to customers of the retail broker,102

and one can infer the insulation of a market maker from the fiduciary standard by

analogy.

98

For recent criticisms of the continuing existence of PFOF programs, see Letter from David M.

Battan, Exec. Vice President, Interactive Brokers Grp. LLC, to Florence Harmon, Acting Sec’y,

U.S. Sec. & Exch. Comm’n 2 (Sept. 8, 2008), available at http://www.sec.gov/comments/sr-

nysearca-2008-75/nysearca200875-4.pdf (arguing that “[p]ayment for order flow reduces

competition”); Letter from Robert R. Bellick, Managing Dir., Wolverine Trading, LLC, to Nancy

M. Morris, Sec’y, U.S. Sec. & Exch. Comm’n 4 (Sept. 10, 2008), available at

http://www.sec.gov/comments/sr-nysearca-2008-75/nysearca200875-5.pdf (arguing that “the

practice of accepting PFOF calls into question whether a broker is fulfilling its fiduciary duties to

its customers [and that] brokers can simply make mindless routing decisions and reap the benefits

of PFOF rebates”); Letter from Eric J. Swanson, SVP & Gen. Counsel, BATS Exch., Inc. to

Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 4 (Apr. 21, 2010), available at

http://www.sec.gov/comments/s7-02-10/s70210-146.pdf (arguing that “the historical practice of

payment for order flow . . . is opaque, subject to little effective regulatory oversight, and . . . only

benefits certain market participants”). But see Letter from Janet M. Kissane, Senior Vice President

– Legal & Corp. Sec’y, NYSE Euronext, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch.

Comm’n 6 (June 18, 2010), available at http://www.sec.gov/comments/s7-09-10/s70910-16.pdf

[hereinafter NYSE’s Fee Cap Letter] (arguing that “[the] level [of PFOF amounts] has been

established in a highly competitive market environment based on the value of that order flow to

liquidity providers”). 99

Last Atlantis, 2010 U.S. Dist. LEXIS 117680, at *44 n. 12. 100

Id. 101

Gilman v. BHC Sec., Inc., 104 F.3d 1418, 1423–24 (2d Cir. 1997). 102

Gilman v. BHC Sec., Inc., No. 94 Civ. 1133 (AGS), 1995 U.S. Dist. LEXIS 18682, at *10

(S.D.N.Y. Dec. 18, 1995). Given the remoteness of the defendant from the ultimate customers, this

scenario is different from more common cases in which retail brokers “are alleged to have violated

their common law fiduciary obligations to their customers” by participating in PFOF programs.

Francis J. Facciolo, When Deference Becomes Abdication: Immunizing Widespread Broker-Dealer

Practices from Judicial Review Through the Possibility of SEC Oversight, 73 MISS. L.J. 1, 49

(2003).



Overall, there is some ambiguity as to whether certain practices of market

makers integral to the function of providing liquidity may give rise to a fiduciary

duty. In addition to being a deviation from the thrust of the doctrine insulating

market making as such from the fiduciary standard, this ambiguity may have

adverse consequences for the liquidity of securities markets. Furthermore, debates

about various costs and benefits associated with different business models of

providing liquidity may be ultimately decided in the courtroom rather than by the

forces of competition.103 Given the complexity of various payment / inducement

structures for market making, if PFOF programs are scrutinized in the context of

fiduciary duties, then other mechanisms, such as liquidity rebates,104 might also

seem suspect.

IV. THE SIGNIFICANCE OF THE CHANGING ECONOMICS AND INSTITUTIONAL

FRAMEWORK OF PROVIDING LIQUIDITY IN SECURITIES MARKETS AND THE CURRENT

REGULATORY AGENDA

Looking forward at potential litigation, it is important to analyze the

significance of the changing economics and institutional framework of providing

liquidity, which are influenced by technological advances and the evolving roles,

obligations and privileges, and even boundaries of market makers. Another

pivotal factor is the focus of the current regulatory agenda on the scope of

fiduciary duties of broker-dealers.

103

See, e.g., Letter from John A. McCarthy, Gen. Counsel, Global Elec. Trading Co., to Elizabeth

M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 4 (June 23, 2010), available at http://www.sec.gov

/comments/s7-09-10/s70910-25.pdf [hereinafter GETCO Letter] (describing the competition

between “two separate and very distinct market structures—the maker-taker model and the PFOF

model” in options markets in the context of the proposed cap on access fees); see also NYSE’s Fee

Cap Letter, supra note 98, at 3 (arguing that “[e]ach of these business models [including the PFOF

model] targets a particular type of market participant or order flow, earning a larger piece of the

business from those target segments and forcing competing exchanges to find innovative ways to

win that business back, ultimately driving down costs for all market participants”). 104

Under the “maker-taker” model of providing liquidity, liquidity rebates are paid for submitting

“passive” orders and funded by fees charged for submitting “aggressive” orders. A liquidity rebate

“is effectively akin to an option premium paid to the option writer, who displays limit orders in the

book.” Letter from Chi-X Europe Ltd to the Comm. of Eur. Sec. Regulators 11 (Apr. 30, 2010)

available at http://www.esma.europa.eu/index.php?page=response_details&c_id=158&r_id=5369.

For a further description of the maker-taker model and liquidity rebates, see Concept Release on

Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg. 3594, 3698–99, 3707–

08 (Jan. 14, 2010). Interestingly, the maker-taker model is sometimes attacked for similar reasons

as PFOF programs. See Letter from U.S. Sen. Edward E. Kaufman to Mary L. Shapiro, Chairman,

U.S. Sec. & Exch. Comm’n att., at 6 (Aug. 5, 2010), available at http://www.sec.gov/comments/s7

-27-09/s72709-96.pdf (“[M]aker-taker pricing creates inherent conflicts of interests. Because they

are not required to pass along rebates to their customers, brokers might be inclined to direct order

flow to the trading venue offering the lowest transaction costs, but not necessarily the best order

execution.”).



If anything, imposing a general fiduciary duty on market makers makes

even less sense in the rapidly evolving financial marketplace transformed by the

emergence of high-frequency trading,105 as it is increasingly problematic to

identify a relationship of trust and confidence. In many securities markets,

liquidity is now provided by a wide range of market participants and in different

forms,106 as “[t]he democratisation of market making” is now a reality.107 One

manifestation of this trend is the spread of the maker-taker model of providing

liquidity, described as a “structure that rewards any participant that provides

liquidity and charges those who consume liquidity,”108 and this model even

makes it possible to be a “one-sided” provider of liquidity. Overall, the lines

between market making and proprietary trading, such as statistical arbitrage, are

becoming increasingly blurry,109 which once again emphasizes the arm’s-length

character of such transactions.110 The existence of a fiduciary duty attached to the

function of providing liquidity in a high-speed trading environment may also

create a host of problems tied to such sensitive issues to market makers as

105

For a selective mix of general sources on high-frequency trading, see DURBIN, supra note 3;

EDGAR PEREZ, THE SPEED TRADERS: AN INSIDER’S LOOK AT THE NEW HIGH-FREQUENCY TRADING

PHENOMENON THAT IS TRANSFORMING THE INVESTING WORLD (2011); Peter Gomber et al., High-

Frequency Trading (Mar. 2011) (unpublished manuscript) (on file with author), available at

http://ssrn.com/abstract=1858626; Thierry Rijper et al., Optiver Holding B.V., High Frequency

Trading (Dec. 2010) (unpublished manuscript) (on file with author), available at

http://optiver.com/corporate/hft.pdf. 106

A similar architecture of securities markets was envisioned a long time ago in Fischer Black,

Toward a Fully Automated Stock Exchange (pts. 1 & 2), FIN. ANALYSTS J., July–Aug. 1971, at 28,

FIN. ANALYSTS J., Nov.–Dec. 1971, at 24. 107

Letter from Paul O’Donnell, Chief Operating Officer & Anna Westbury, Head of Compliance

and Regulatory Affairs, BATS Trading Ltd., to the Comm. of Eur. Sec. Regulators 2 (Apr. 30,

2010), available at http://www.esma.europa.eu/index.php?page=response_details&c_id=158&r_id

=5370. 108

GETCO Letter, supra note 103, at 5. 109

See Letter from Manoj Narang, Chief Exec. Officer, Tradeworx, Inc., to Elizabeth M. Murphy,

Sec’y, U.S. Sec. & Exch. Comm’n app. at 9 (Apr. 21, 2010), available at

http://www.sec.gov/comments/s7-02-10/s70210-129.pdf. 110

On the other hand, the countervailing factor is that certain financial institutions affiliated with

commercial banks are prohibited from engaging in proprietary trading and allowed to participate in

“market-making-related activities . . . to the extent that any such activities . . . are designed not to

exceed the reasonably expected near term demands of clients, customers, or counterparties” by the

so-called “Volcker Rule.” Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L.

No. 111-203, § 619, 124 Stat. 1376, 1620, 1624 (2010). Of course, distinguishing market making

from proprietary trading is a challenging task. See FED. STABILITY OVERSIGHT COUNCIL, STUDY &

RECOMMENDATIONS ON PROHIBITIONS ON PROPRIETARY TRADING & CERTAIN RELATIONSHIPS WITH

HEDGE FUNDS & PRIVATE EQUITY FUNDS 22–25 (2011), available at http://www.treasury.gov/

initiatives/Documents/Volcker%20sec%20%20619%20study%20final%201%2018%2011%20rg.p

df.



limitations on order cancellation and a minimum order duration,111 which recently

gained attention in regulatory debates.

The evolution of obligations and privileges of market makers also makes

it more problematic to identify a relationship of trust and confidence. “[T]he

dispersal of liquidity across a large number of trading centers of different

types”112 has effectively destroyed the quasi-monopoly franchise enjoyed by

some market makers—often compounded by their privileged position vis-à-vis

other market participants on the same trading venue—in the past.113 Another

pivotal factor is that market makers serving in the capacity of agents or quasi-

agents—especially paid ones—are becoming harder to find.114 The abolition by

some trading venues of the “negative” obligation, i.e., the prohibition of

transactions by a market maker for its own account that are not reasonably related

to the maintenance of “a fair and orderly market,”115 reinforces the incentive to

111

See, e.g., Letter from Stuart J. Kaswell. Exec. Vice President, Managing Dir. & Gen. Counsel,

Managed Funds Ass’n, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 22 (May 7,

2010), available at http://www.sec.gov/comments/s7-02-10/s70210-178.pdf (“Market makers have

always cancelled and refreshed their quotes in response to market movements. . . . If the [SEC]

were to limit cancellations in any way, market participants would be more reluctant to post limit

orders, which would likely result in a widening of spreads and a decrease in liquidity.”); Letter

from Brett F. Mock, Chairman & John C. Giesea, President and CEO, Sec. Traders Ass’n, to

Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 8 (Apr. 30, 2010), available at

http://www.sec.gov/comments/s7-02-10/s70210-170.pdf (“Requiring a minimum duration for

orders is draconian and inconsistent with the operation of efficient markets. . . . Setting an arbitrary

minimum time that an order must be in force will expose the liquidity provider to much greater

risk for which they will require greater compensation in the form of wider spreads.”). 112

Concept Release on Equity Market Structure, Exchange Act Release No. 61,358, 75 Fed. Reg.

3594, 3600 (Jan. 14, 2010). This development has also spread beyond equity markets, which is

exemplified by the multiple listing of many options. See Proposed Amendments to Rule 610 of

Regulation NMS, Exchange Act Release No. 61,902, 75 Fed. Reg. 20,738, 20,738 (proposed Apr.

14, 2010). 113

See, e.g., William O. Brown, Jr. et al., Competing with the New York Stock Exchange, 123 Q.J.

ECON. 1679, 1679 (2008) (presenting empirical evidence consistent with the view that the NYSE

specialists possessed market power to charge higher bid-ask spreads); Harold Demsetz, The Cost of

Transacting, 82 Q.J. ECON. 33, 42–45 (1968) (analyzing sources of market power and competitive

forces in the context of the specialist system on the NYSE). 114

See, e.g., Order Approving a Proposed Rule Change To Create a New NYSE Market Model,

Exchange Act Release No. 58,845, 73 Fed. Reg. 64,379, 64,389 (Oct. 24, 2008) (stating that

“designated market makers,” specialists’ replacements on the NYSE, “are no longer subject to the

specialist’s agency responsibilities with respect to orders on the Display Book”); see also Notice of

Filing and Immediate Effectiveness of a Proposed Rule Change for a Pilot Program To Establish a

New Class of NYSE Market Participants That Will Be Referred to as “Supplemental Liquidity

Providers,” Exchange Act Release No. 58,877, 73 Fed. Reg. 65,904, 65,904 (Oct. 29, 2008)

(stating that an additional class of liquidity providers on the NYSE are not to “act on an agency

basis”). 115

See, e.g., Order Approving a Proposed Rule Change To Create a New NYSE Market Model,

73 Fed. Reg. at 64,380. However, the SEC rule applicable to any “specialist” on a securities

exchange “restricting his dealings so far as practicable to those reasonably necessary to permit him



combine market making and proprietary trading. An additional development is

that “changes in the business models of many exchanges and advancements in

technology have eliminated or reduced the value of the special time and place

privileges traditionally enjoyed by specialists and registered market makers.”116

However, given recent debates about balancing obligations and privileges of

market makers, it is feasible that new advantages of these market participants

going beyond favorable pricing and order allocation, such as time and

information advantages,117 will beget a new wave of litigation—perhaps

ultimately futile—invoking the fiduciary theory of liability.118

The existing case law indicates that merely being a professional

participant in securities markets does not create a fiduciary-like duty.119 By

to maintain a fair and orderly market or necessary to permit him to act as an odd-lot dealer” still

remains on the books. Regulation of Specialists, 17 C.F.R. § 240.11b-1(a)(2)(iii) (2011). 116

Letter from Greg Tusar, Managing Dir., Goldman Sachs Execution & Clearing, L.P. &

Matthew Lavicka, Managing Dir., Goldman Sachs & Co., to Elizabeth M. Murphy, Sec’y, U.S.

Sec. & Exch. Comm’n 7 (June 25, 2010), available at http://www.sec.gov/comments/s7-02-

10/s70210-243.pdf. As an illustration, the NYSE recently eliminated the “advance ‘look’ at

incoming orders,” which was previously available to specialists, for designated market makers.

Order Approving a Proposed Rule Change To Create a New NYSE Market Model, 73 Fed. Reg. at

64,389. 117

One example is a proposed regulation to “[h]old every order for a tenth of a second with the

exception of market maker quote updates for products in which the market maker is registered and

has affirmative obligations. There is simply no other measure that can protect market makers

against being picked off.” Thomas Peterffy, Chairman & CEO, Interactive Brokers Grp.,

Comments Before the 2010 General Assembly of the World Federation of Exchanges 6 (Oct. 11,

2010), http://investors.interactivebrokers.com/download/worldFederationOfExchanges.pdf. For a

discussion of the “pick off” concern of market makers caused by “stale” quotes, see Dolgopolov,

supra note 94 (manuscript at 17–19 & n. 46–53). Another example is the suggestion that a set of

market making privileges “might include preferential co-location provisions.” JOINT CFTC-SEC

ADVISORY COMM. ON EMERGING REGULATORY ISSUES, SUMMARY REPORT, RECOMMENDATIONS

REGARDING REGULATORY RESPONSES TO THE MARKET EVENTS OF MAY 6, 2010, at 10 (2011),

available at http://www.sec.gov/spotlight/sec-cftcjointcommittee/021811-report.pdf. 118

The existence of inherent advantages enjoyed by certain market makers was recognized by the

federal courts in the past, but, so far, it has made no visible impact in the debate over the reach of

the fiduciary standard. See, e.g., United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist.

LEXIS 72119, at *4 (S.D.N.Y. Oct. 2, 2006) (“Because of their position, specialists had access to

certain material information—such as advance knowledge of the price parameters of all open

orders—and accordingly were subject to certain rules and obligations to prevent them from taking

unfair advantage of investors.”). In any instance, even if a market maker possesses significant

advantages, it is doubtful that this situation fits the scenario “when one party figuratively holds all

the cards—all the financial power or technical information, for example [indicating that] a

fiduciary relationship has arisen.” Broussard v. Meineke Disc. Muffler Shops, Inc., 155 F.3d 331,

348 (4th Cir. 1998). 119

For instance, one court remarked that “no fiduciary duty, for [Rule] 10b-5 purposes, exists for

broker-dealers simply by virtue of their status as market professionals.” Vannest v. Sage, Rutty &

Co., 960 F. Supp. 651, 656 (W.D.N.Y. 1997) (interpreting Moss v. Morgan Stanley Inc., 719 F.2d

5, 15 (2d Cir. 1983)).



contrast, the current regulatory agenda is influenced by the debates about the

merits of imposing—or rather expanding the scope of—fiduciary duties on

broker-dealers120 and the grant of the rule-making authority to the SEC to

“establish a fiduciary duty for brokers and dealers” by setting “the standard of

conduct applicable to an investment adviser [for] providing personalized

investment advice about securities to a retail customer (and such other customers

as the [SEC] may by rule provide).”121 Furthermore, the regulatory agency was

advised by its own staff “to adopt and implement, with appropriate guidance, the

uniform fiduciary standard of conduct for broker-dealers and investment advisers

when providing personalized investment advice about securities to retail

customers.”122 On the other hand, a securities industry group specifically

cautioned the SEC “to consider the effect of [the fiduciary] standard on investors

and the vibrancy of markets, particularly in the context of broker-dealers’ role as

market makers.”123 Similarly, another industry group warned that “[t]he standard

of care must allow retail clients to have ready access to investments that are sold

on a principal basis” and that, “[i]f retail customers lose access to [the] liquidity

[provided by affiliated market makers], their execution costs will in many cases

120

For a sample of academic commentary, see Kristina A. Fausti, A Fiduciary Duty for All?, 12

DUQ. BUS. L.J. 183 (2010); Hazen, supra note 12; Donald C. Langevoort, Brokers as Fiduciaries,

71 U. PITT. L. REV. 439 (2010); Symposium, Papers on a Fiduciary Duties for Broker-Dealers, 30

REV. BANKING & FIN. L. 119 (2010–11). One academic commentator argued that “a general

fiduciary duty applicable to a broad range of investment banker dealings would leave significant

uncertainty as to the nature of the duties in each specific context” and specifically pointed to the

problem “whether investment bankers [would be able to] participate in market-making, which

inherently involves positions on both sides of the market.” Wall Street Fraud and Fiduciary

Duties: Can Jail Time Serve as an Adequate Deterrent for Willful Violations?: Hearing Before the

Subcomm. of the S. Comm. on the Judiciary, 111th Cong. 146–47 (2011) (prepared statement of

Larry E. Ribstein, Mildred van Voorhis Jones Chair, University of Illinois College of Law). 121

Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 913(g),

124 Stat. 1376, 1828 (2010); see also Arthur B. Laby, SEC v. Capital Gains Research Bureau and

the Investment Advisers Act of 1940, 91 B.U. L. REV. 1051, 1098–1100 & n.402–415 (2011)

(scrutinizing the reach of the statutory text and its legislative history); Ribstein, supra note 1, at

919 & nn. 120–21 (same). Currently, broker-dealers in general are not subject to the fiduciary

standard applicable to investment advisors. See STAFF, U.S. SEC. & EXCH. COMM’N, STUDY ON

INVESTMENT ADVISERS AND BROKER-DEALERS 15–16 (2011), available at http://www.sec.gov/

news/studies/2011/913studyfinal.pdf [hereinafter SEC’S STAFF, SECTION 913 REPORT] (discussing

the scope of the relevant exemptions); see also SENATE STAFF, WALL STREET AND THE FINANCIAL

CRISIS, supra note 5, at 609 (discussing whether the fiduciary standard for an investment adviser

was applicable in the Goldman Sachs controversy). 122

SEC’S STAFF, SECTION 913 REPORT, supra note 121, at 165. But see Tamar Frankel, The

Regulation of Brokers, Dealers, Advisors and Financial Planners, 30 REV. BANKING & FIN. L.

123, 129 (2010–11) (arguing that “it is crucial to impose fiduciary duties on all brokers, etc.

regardless of whether their clients are what we call sophisticated”). 123

Letter from Richard H. Baker, President & CEO, Managed Funds Ass’n, to Elizabeth M.

Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 20 (Sept. 22, 2010), available at http://www.sec.gov/

comments/4-606/4606-2809.pdf.



substantially increase, and markets will lose a significant source of liquidity.”124

An openly pessimistic view on the imposition of the fiduciary standard paints the

following scenario of market making in certain securities:

Broker-dealers would be asked essentially to insure all of the

securities they sell to their customers, as any customer with an

investment loss will seek to capitalise on the inherent conflicts of

interest that will continue to exist for a broker-dealer that not only

sells, but makes markets in and structures, securities.125

Ultimately, the impact of this regulatory agenda, which may potentially

negate the existing decisions of the federal courts with respect to market makers,

will depend on the SEC’s regulatory zeal, the definition of the protected class of

investors, and the statutory interpretation. One telltale sign is that the regulatory

agency’s staff report specifically mentioned the securities industry’s request to

exclude market making from the definition of “personalized investment

advice”126 in the context of the staff’s recommendation that the covered activities

“should not include ‘impersonal investment advice’ as developed under the

[Investment] Advisers Act of 1940.”127 The report also recognized that a different

regulatory treatment of such activities as market making and underwriting

“primarily reflect[s] the different functions and business activities of investment

advisers and broker-dealers . . . and may allow for diversity of products or

services and investor choice.”128 But if market making services are bundled with

“personalized investment advice” as a result of the economies of scope, the 124

Letter from Ira D. Hammerman, Senior Managing Dir. & Gen. Counsel, Sec. Indus. & Fin.

Mkts. Ass’n, to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 10 (Aug. 30, 2010),

available at http://www.sec.gov/comments/4-606/4606-2553.pdf; see also Industry Perspectives of

the Obama Administration’s Financial Regulatory Reform Proposals: Hearing Before the H.

Comm. on Fin. Servs., 111th Cong. 110–11 (2009) (prepared statement of Randolph C. Snook,

Executive Vice President, Securities Industry and Financial Markets Association) (“[W]hen

broker-dealers are not providing personalized securities investment advice to individual

investors . . . for example, when broker-dealers . . . engage in market making . . . there is no cause

for modifying the existing, extensive regulatory regime that governs broker-dealers.”). 125

Moloney et al., supra note 8, at 345. 126

SEC’S STAFF, SECTION 913 REPORT, supra note 121, at 126 n.573. 127

Id. at 127; see also Letter from John Junek, Exec. Vice President & Gen Counsel, Ameriprise

Fin., Inc., to Elizabeth M. Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 2 & n.3 (Aug. 30, 2010),

available at http://www.sec.gov/comments/4-606/4606-2640.pdf (suggesting that the exclusion of

market making from the scope of “personalized investment advice” is consistent with classifying

this activity as “impersonal investment advice” under the Investment Advisers Act of 1940); Letter

from Sarah A. Miller, Exec. Dir. & Gen. Counsel, ABA Sec. Ass’n, and Senior Vice President,

Am. Bankers Ass’n, to Elizabeth Murphy, Sec’y, U.S. Sec. & Exch. Comm’n 3 n.6 (Aug. 30,

2010), available at http://www.sec.gov/comments/4-606/4606-2717.pdf (arguing that the SEC

“was not directed [by the Dodd-Frank Act of 2010] to carry forward the principal transaction

prohibitions of Section 206(3) of the Investment Advisers Act [of 1940]”). 128

SEC’S STAFF, SECTION 913 REPORT, supra note 121, at 104.



impact of regulation may still spill over to market making. This scenario is not

unlikely for certain custom-made securities, but it is probably more applicable to

“sophisticated” rather than “retail” customers.

V. SEVERAL LEGAL ISSUES RELEVANT TO MARKET MAKERS WITH RESPECT TO

THEIR REGULATORY ENVIRONMENT AND CIVIL LIABILITY

The restraint on the application of the fiduciary standard to market

makers interacts with several legal issues relevant to these market participants

with respect to their regulatory environment and civil liability under federal

securities law. These issues also illustrate the potential applicability of certain

restraints, such as other heightened duties, to market makers and raise the

question of the sufficiency of such restraints in the absence of the fiduciary

standard.

While analyzing the reach of the fiduciary standard, the federal courts on

several occasions addressed the “shingle” theory—a variation of a heightened

duty, although there is some disagreement among commentators with respect to

the nature of this theory and its overlap with the agency / fiduciary approach129—

and declined to apply this heightened duty to market makers. One court stated

that “specialists do not actively solicit customers, and unlike securities dealers, do

not ‘hang[] out [their] professional shingle.’”130 Another court based its decision

on the precedent that was interpreted as a “reject[ion] [of] the equivalent of the

shingle theory” and a requirement of “a statement or conduct.”131 While the SEC

has effectively endorsed the “shingle” theory with respect to market making

129

Compare Louis Loss, The SEC and the Broker-Dealer, 1 VAND. L. REV. 516, 518 (1948)

(“This [theory] has nothing to do with any agency obligation. . . . [E]ven a dealer at arm’s length

impliedly represents when he hangs out his shingle that he will deal fairly with the public.”), and

Laby, supra note 69, at 427 (“The compromise struck by the shingle theory . . . [which] prohibit[s]

an unreasonable price . . . stops short of requiring a dealer to act as a fiduciary.”), with Roberta S.

Karmel, Is the Shingle Theory Dead?, 52 WASH & LEE L. REV. 1271, 1295–96 (1995) (“The

shingle theory . . . embodies the notion that broker-dealers impliedly represent that they will deal

fairly, but this implied representation is really a legal fiction. At bottom, the shingle theory rests on

the premise that a broker-dealer has fiduciary obligations to its customers.”), and Cheryl Goss

Weiss, A Review of the Historic Foundations of Broker-Dealer Liability for Breach of Fiduciary

Duty, 23 J. CORP. L. 65, 89 (1997) (“[O]ften accompanying the ‘implied representation’ contract

language of the opinions [endorsing the ‘shingle’ theory] is language implying fiduciary

responsibilities, including equitable concepts of unequal relationship, trust and confidence, and full

disclosure.”). 130

United States v. Finnerty, No. 05 Cr. 393 (DC), 2006 U.S. Dist. LEXIS 72119, at *19

(S.D.N.Y. Oct. 2, 2006) (alterations in original) (quoting Grandon v. Merrill Lynch & Co., Inc.,

147 F.3d 184, 192 (2d Cir. 1998). 131

Last Atlantis Capital LLC v. AGS Specialist Partners, No. 04 C 397, 2010 U.S. Dist. LEXIS

29175, at *14–15 (N.D. Ill. Mar. 26, 2010) (following United States v. Finnerty, 533 F.3d 143 (2d

Cir. 2008)).



activities in the past,132 the author is not aware of any case that explicitly

recognized such an application.133 On the other hand, the scope of implied

representations deemed to be made by market makers perhaps remains an open

issue.134

Potential liability of market makers for market manipulation135 does not

require the existence of a fiduciary duty.136 Similarly, the applicability of the

fraud-on-the-market doctrine to market makers137 has no such requirement.138 In

fact, the reach of the fraud-on-the-market doctrine been found to be broader than

just “fundamental” information about underlying companies:

The fraud-on-the-market doctrine is applicable to misstatements

about specific securities as well as misstatements about the

marketplace for those securities. . . . Just as information about a

specific security is reflected in the price of that security, so too is

information about the manner in which transactions would be

completed reflected in the price of securities generally.139

132

See, e.g., Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1895

(Mar. 30, 2004) (arguing that NYSE specialists make “implied representations to public customers

that they [are] limiting dealer transactions to those reasonably necessary to maintain a fair and

orderly market”); Albert Fried & Co., Exchange Act Release No. 15,239, 16 SEC Docket 100, 105

(Nov. 3, 1978) (arguing that “the [NYSE] specialist impliedly represents that he will not take

advantage of his unique position and his customers’ ignorance of market conditions nor exploit

that ignorance to extract unreasonable profits”). 133

Furthermore, one decision suggests that the “shingle” theory only covers conduct that “arise[s]

from affairs entrusted to the broker as a fiduciary, agent, or trustee.” Bissell v. Merrill Lynch &

Co., 937 F. Supp. 237, 247 (S.D.N.Y. 1996). This interpretation most likely excludes the function

of providing liquidity by itself. 134

See, e.g., United States v. Finnerty, 474 F. Supp. 2d 530, 542–43 (S.D.N.Y. 2007); United

States v. Hayward, No. 05 Cr. 390 (SHS), 2006 U.S. Dist. LEXIS 37108, at *5–6 (S.D.N.Y. June

5, 2006). 135

See, e.g., United States v. Fiore, 381 F.3d 89, 90–91 (2d Cir. 2004); SEC v. Diversified Corp.

Consulting Grp., 378 F.3d 1219, 1223 (11th Cir. 2004); SEC v. Sayegh, 906 F. Supp. 939, 940–41,

946 (S.D.N.Y. 1995). 136

See, e.g., United States v. Regan, 937 F.2d 823, 829 (2d Cir. 1991) (“[The] argument that a

fiduciary relationship must exist before liability [for market manipulation] can be found is without

merit.”). 137

See, e.g., In re NYSE Specialists Sec. Litig., 405 F. Supp. 2d 281, 318–19 (S.D.N.Y. 2005). 138

See, e.g., Fry v. UAL Corp., 84 F.3d 936, 938 (7th Cir. 1996) (“The duty not to make

misrepresentations does not depend on the existence of a fiduciary relationship [such as in fraud-

on-the-market cases]. . . . If it did, very little fraud would be actionable.”). 139

NYSE Specialists, 405 F. Supp. 2d at 318–19. On the other hand, this conclusion was

somewhat weakened on the appellate level—despite the recognition of the reach of the fraud-on-

the-market doctrine—because no clear price effect on the relevant securities had been shown:

“[T]he government has attributed to [the defendant specialist] nothing that deceived the public or

affected the price of any stock: no material misrepresentation, no omission, no breach of a duty to

disclose, and no creation of a false appearance of fact by any means.” United States v. Finnerty,



In a related case, in which actions of an options exchange, a

clearinghouse, and options market makers allegedly led to inflated prices, the

reach of the fraud-on-the-market doctrine to market makers was also recognized:

“A successful scheme to charge excessive prices across the market and not to

disclose that fact affects the integrity of market prices as surely as any scheme to

spread false information about corporate prospects that affects the price only of a

single issuer’s stock.”140

Another consideration is that a securities firm in certain situations may be

obligated to disclose its market maker status in order to prevent civil liability.141

The SEC also requires broker-dealers to supply its customers with a written

notification for transactions disclosing “[w]hether the broker or dealer is acting as

agent for such customer, as agent for some other person, as agent for both such

customer and some other person, or as principal for its own account; and if the

broker or dealer is acting as principal, whether it is a market maker in the

security.”142

Finally, market makers must abide by the rules of self-regulatory

organizations, which are approved and sometimes guided by the SEC, that

establish market makers’ trading obligations,143 although these obligations do not

necessarily trigger civil liability under federal securities law with respect to other

market participants.144 On the other hand, in the context of trading obligations of

533 F.3d 143, 151 (2d Cir. 2008). In another reiteration of this controversy, the district court once

again asserted that the fraud-on-the-market doctrine is potentially applicable, as the plaintiffs were

presumed to rely “on an efficient and fair market,” and extended its analysis to “customer

expectation in terms of reliance.” In re NYSE Specialists Sec. Litig., 260 F.R.D. 55, 77–79

(S.D.N.Y. 2009). 140

Spicer v. Chi. Bd. Options Exch., Inc., No. 88 C 2139, 1990 U.S. Dist. LEXIS 14469, at *35

(N.D. Ill. Oct. 24, 1990). 141

See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d 1168, 1168–69 (2d Cir. 1970); Glynwill

Invs., N.V. v. Prudential Sec., Inc., No. 92 Civ. 9267 (CSH), 1995 U.S. Dist. LEXIS 8262, at *13–

15 (S.D.N.Y. June 15, 1996); Shamsi v. Dean Witter Reynolds, Inc., 743 F. Supp. 87, 93 (D. Mass.

1989); see also Carl Wartman, Note, Broker Dealers, Market Makers and Fiduciary Duties, 9

LOY. U. CHI. L.J. 746, 757–61 (1978). 142

Confirmation of Transactions, 17 C.F.R. § 240.10b-10(a)(2) (2011). 143

One recent example is the ban on “stub” quotes by several trading venues as a part of more

stringent quotation standards for market makers in the aftermath of the “Flash Crash” of May 6,

2010, and this measure was passed “in coordination” with the SEC. Order Granting Approval to

Proposed Rule Changes by Several Self-Regulatory Organizations To Enhance the Quotation

Standards for Market Makers, Exchange Act Release No. 63,255, 75 Fed. Reg. 69,484, 69,484

(Nov. 5, 2010). The regulatory agency started “consider[ing] steps to deter or prohibit the use by

market makers of ‘stub’ quotes” on its own shortly after the “Flash Crash.” Examining the Causes

and Lessons of the May 6th Market Plunge: Hearing Before the Subcomm. on Sec., Ins., & Inv. of

the S. Comm. on Banking, Hous., & Urban Affairs, 111th Cong. 54 (2010) (prepared statement of

Mary L. Shapiro, Chairman, U.S. Securities and Exchange Commission). 144

See Finnerty, 533 F.3d at 151 (holding that violations of the rules aimed to prevent

“interpositioning” by market makers “do[] not establish securities fraud in the civil context [under



market makers, the rationale of implied misrepresentations perhaps may serve as

a viable channel for establishing a private right of action.145 For instance, backing

its view with the precedent that addressed implied misrepresentations in the

context of civil liability, the SEC made the following statement:

Specialists impliedly represent to their customers that they are

dealing fairly with the public in accordance with the standards and

practices applicable to specialists, namely, that they are limiting

their dealer transactions to those “reasonably necessary to

maintain a fair and orderly market.” A specialist’s failure to

comply with this implied representation, if done with scienter, can

constitute a violation of the antifraud provisions of the securities

laws.146

CONCLUSION

The federal courts’ unwillingness to identify a broad fiduciary duty owed

by market makers is to be applauded, as this duty—and the corresponding

litigation-related risks—can morph into something dangerous for the liquidity of

securities markets instead of “boosting confidence” into them. The intuitive

rationale about the impossibility of “serving two masters”—an idealized two-

sided loyalty in arm’s-length transactions—appears to be the strongest argument

in favor of this outcome. The thrust of the case law should also serve as guidance

when certain practices of market makers integral to the function of providing

liquidity may be interpreted as giving rise to a fiduciary duty. On the other hand,

in a variety of situations, such as those involving personalized relationships and

relatively illiquid / custom-made securities traded in an informal market, it seems

likely that the federal courts will find the existence of a heightened duty—

Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5] . . . let alone in a criminal

prosecution”); Spicer v. Chi. Bd. of Options Exch., Inc., 977 F.2d 255, 265–66 (7th Cir. 1992)

(holding that violations of the rule requiring market makers to engage in transactions that

“constitute a course of dealings reasonably calculated to contribute to the maintenance of a fair and

orderly market” do not give rise to a private right of action under Section 6(b) of the Securities

Exchange Act of 1934). A more general point is that “[i]t is well established that violation of an

exchange rule will not support a private claim.” In re VeriFone Sec. Litig., 11 F.3d 865, 870 (9th

Cir. 1993). On the other hand, several courts have adopted the position that a private right of action

exists for violations of certain rules of self-regulatory organizations, such as rules designed “to

protect the public.” Cook v. Goldman, Sachs & Co., 726 F. Supp. 151, 156 (S.D. Tex. 1989). 145

See supra note 134 and accompanying text. 146

Fleet Specialist, Inc., Exchange Act Release No. 49,499, 82 SEC Docket 1895, 1900 (Mar. 30,

2004) (relying on Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir.

1998)). One ambiguity raised by this administrative adjudication is that it is not entirely clear

whether civil liability hinges on the violation of the SEC rule or the similarly worded NYSE rule

standing by itself.



possibly, a fiduciary duty—that is, however, tied to something other than the

market maker status by itself.

The imposition of a broad fiduciary duty on market makers makes even

less sense in today’s securities markets, given such factors as the diminishing, if

not disappearing, role of market makers as “agents” with special privileges—as

opposed to “dealers” in increasingly “democratized” and dispersed markets—and

the automated process of aggregating, matching, and routing orders in a high-

speed trading environment. Accordingly, the current regulatory agenda must be

approached from this perspective, and certain concerns relating to market makers

should be addressed through other forms of regulation by the government and

self-regulatory organizations, such as defining the scope of market makers’

obligations and privileges and fine-tuning circuit breakers, and other theories of

civil and criminal liability, such as antifraud law. It is also appropriate to reflect

on more general costs of “over-fiduciarization”: “More broadly applying

fiduciary duties could unnecessarily constrain parties from self-protection in

contractual relationships, impose excessive litigation costs, provide an unsuitable

basis for contracting, and impede developing fiduciary norms of behavior.”147

147

Ribstein, supra note 1, at 899.