The notion of a Consolidated Audit Trail (“CAT”) arose in the early days of the 21st century, which in 2005 led to the creation of the National Market System when the U.S. Securities and Exchange Commission (“SEC”) adopted regulation NMS as laid out in my Sept. 8, 2020 Blog “SEC Seeks to Increase the Security of Data on the Consolidated Audit Trail National Market System.” The nation’s equity markets were subjected to very serious turmoil in the 2010 “Flash Crash,” (which was years later traced to abusive trading in London on an electronic platform). In the aftermath of the “Flash Crash” Congress directed the SEC to gather information about the operations of capital markets on a close to real time basis, which in turn resulted in the adoption by the SEC in 2016 of the Consolidated Audit Trail National Market System Master Plan (“CAT NMS ”).
On Aug. 29, 2019, the various exchanges (called “Participants” in CAT) scrapped the CAT NMS Master Plan in its entirety and replaced it with a materially revised Plan operated by a limited liability company known as CAT LLC. Subsequent expressions of concern from market participants about the level of data security in the CAT produced a major SEC initiative in August 2020 to identify data security shortcomings and adopt corrective steps. Those data security concerns focused on the potential liability to entities active in trading securities in the capital markets if either customer personal identity information were accessed by third parties OR if other participants gained competitive advantages. The implementation of the CAT also stimulated many expressions of concern about costs especially due to a series of expensive “fits and starts” as operating computer systems firms were chosen, rejected, and replaced.
On June 1, 2022, the Operating Committee for CAT LLC, which is composed of the Participants, proposed a wholesale amendment of the funding model for CAT (the “New Model”). The prior funding model (“Prior Model”) assessed fees based on the volume of electronic messages involved in market transactions. The New Model computes fees based on transaction volume, noting that the Prior Model might well have caused market makers, who typically generate high levels of message traffic, to pay “outsized fees.” In other words, CAT admitted that its proposed system design did not fairly allocate responsibility for operating costs.
Under the Prior Model, Participants would have paid 25% of the total costs; the New Model imposes 33% of total costs on the Participants – that is to say, the Participants were proposing to pay a significantly greater proportion of CAT operating costs. Despite this effort to obtain a substantial level of agreement on funding, the SEC in its Aug. 30, 2022 Release (“Release”) covering the proposed New Model (the “Proposal”) reports that many CAT Members (i.e., the broker/dealers and other parties trading on CAT) seriously questioned, and in most cases opposed, the Proposal for a number of reasons including the following: an alleged lack of transparency about costs, arbitrary decisions about the allocation of cost responsibilities, questions about allocation of responsibility for past development costs (where some substantial percentage of those past costs were caused by questionable management decisions, i.e., Operating Committee errors in the selection and replacement of the CAT computer system operator). These objections are no doubt driven by the fact that the past CAT costs total some $337,688,610.
Perhaps the most vigorous objections to the Proposal came from the Securities Industry and Financial Market Association (“SIFMA”), which describes itself as” the leading trade association for broker-dealers, investment banks, and asset managers operating in the U.S. and global capital markets.” In a June 22, 2022, 11-page letter, SIFMA asserted that it has not been able to participate in the process to determine cost allocations and that the Operating Committee has not provided the Commission or anyone else with sufficient data to allow the SEC “to articulate a satisfactory explanation for its approval of the proposed funding model, as required by the holding in Susquehanna Int’l Grp., LLP v. SEC 866 F 3rd 442 (D.C. Cir. 2017). The SIFMA letter attacked both the cost allocation in the Proposal and the justification for seeking to recover past costs in the magnitude of $337,688,610. It also challenged the bases for computing “past costs.”
Subsequently, in an Oct. 7, 2022 letter, SIFMA continued its attacks on the Proposal specifically noting the failure to justify the cost allocation without taking into account the amount of funding borne by the SIFMA members to support the Financial Industry Regulatory Authority, Inc. (“FINRA”), which itself had filed a letter of objection with the Commission, also dated June 22, 2022, expressing concern about both “the lack of fundamental transparency about cost allocation,” and the probable result of an undue burden on FINRA members. The Oct. 7 letter asserted that the proposed cost allocation was fundamentally unfair and that it would impose unacceptable financial burdens on clearing brokers.
The Release included an SEC Order instituting Proceeding under NMS regulations to determine whether the Proposal should be approved by the Commission, where, as the Order notes, the “burden to demonstrate that an NMS filing is consistent with the [Securities Exchange Act of 1934, as amended] Exchange Act … is on the plan participants that filed … [the Proposal].” Comments were due by Sept. 27, 2022, and rebuttals were due by Oct. 11, 2022. The combination of industry “pushbacks” and issues raised by the Commission in its Order caused the Operating Committee of CAT LLC on Nov. 16, 2022, to submit a letter (the “Partial Amendment”) to the SEC to “propose a partial amendment of” the Proposal. That Partial Amendment was published by the SEC on Nov. 28, 2022, as a Release (the “Partial Amendment Release”) consisting of 42 pages of Partial Amendment Release PLUS 17 pages of “Cumulative Proposed Revisions to CAT NMS Plan.” The Partial Amendment Release requests interested parties to submit comments within 21 days after the publication of the Partial Amendment Release in the Federal Register.
What is particularly interesting about these pricing negotiations being carried out in the public eye are both I) the continued support by the Operating Committee of CAT LLC for the New Model and ii) the material adjustments as to how the New Model will work. First, CAT LLC declared that it “continues to believe that the … [New] Model satisfies the applicable requirements of the Exchange Act [i.e., the Securities Exchange Act of 1934, as amended] as well as the funding principles and other requirements of the CAT NMS [Master] Plan.” CAT LLC goes on, rather defensively, to assert that the New Model “would provide reasonable fees that are equitably allocated, not unfairly discriminatory, and do not impose an undue burden on competition, in that the [New] Model reflects a reasonable effort to allocate costs based on the extent to which the different CAT [Members] participate in and benefit from the equities and options markets.” Continuing its defensive posture and apparently seeking to enlist SEC support, CAT LLC goes on:
As the Commission is aware, the Exchange Act does not require CAT LLC to demonstrate that the … [New Model] is superior to any other potential proposal. Instead, CAT LLC must demonstrate that the … [New Model] is consistent with the Exchange Act and the rules and regulations thereunder.
Having tried to make its case, CAT LLC then proposes material amendments to the Proposal specifically focused on the “allocation of fees” and whether those fees are “reasonable.” First, and perhaps most significantly, the Partial Amendment concedes the validity of one of the primary complaints raised by SIFMA; namely, that the New Model would impose unacceptable financial burdens on clearing brokers. Under the Partial Amendment, the responsibility for payment of the CAT fees falls on the executing brokers: on the executing broker for the buyer in the case of purchases and on the executing broker for the seller in the case of sales. CAT LLC then acknowledges that this “may impose an excessive financial burden on clearing firms,” precisely as SIFMA had alleged. It is noteworthy that CAT LLC also cites the request in the SEC Order inviting comments from commenters “why imposing CAT fees only on clearing brokers, instead of on all [Members] is consistent with the Exchange Act and Rule 608 of Regulation NMS, and whether such allocation is an unreasonable burden on competition.”
Second, the Partial Amendment makes a variety of adjustments in the timing of fees and the disclosures as to how those fees are computed. The Partial Amendment restructures the mechanics for calculating fees so that the details of each fee are set out with specifics and not just described as fee categories, and that those fees are cost-based. The Fee Rate for CAT fees will be computed every six months (i.e., twice a year) to allow for cost-based adjustments. In addition, the look-back period for purposes of making trading volume adjustments will be a 12-month, rather than a 6-month, period. CAT fee rates must remain in effect until the Operating Committee approves a new rate and informs the Members of the change. “Additional detail” must be provided regarding “budget technology, legal, consulting, insurance, professional and administration, and public relations costs.” The Operating Committee must establish a reserve equal to not more than 25% of the annual budget. If collected fees exceed CAT costs (including the reserve), the excess must be applied to reduce future fees. Past CAT costs are to be itemized in detail, and the recovery period used to compute those costs cannot be less than 24 months nor more than 60 months.
One can deduce from the scope and tone of the proposed adjustments in the Partial Amendment that CAT LLC was not certain these concessions would prove sufficient to reach an adequate level of acceptance by the Members or the approval of the Commission. The initial operation of the CAT remains pending with ever growing reasons to implement, given the Dec. 14, 2022 action by the Commission proposing fundamental restructurings of the capital markets related to the pricing of trades (fractions of a cent, as opposed to even cent pricing), payment for order flow, and requirements that a greater volume of trades be effected on regulated exchanges. Then, in January 2023, SIFMA sent a third comment letter to the SEC raising several fundamental procedural and substantive objections to the CAT LLC New Model as modified by the Partial Amendment. The points raised in SIFMA’s Jan. 12, 2023, letter (the “January letter”) deserve attention but on one point, SIFMA prevailed without any discussion by the Commission. SIFMA complained that part of the unfairness was the SEC’s release of the Partial Amendment on Nov. 16, 2022, with a comment period of 21 days after the release appeared in the Federal Register. Then on Jan. 20, 2023, without any reference to SIFMA’s January letter, the end date of the comment period was extended from Jan. 27 to March 28, 2023.
In its January letter, SIFMA argued that the changes made by the Partial Amendment were so material that CAT LLC should be required to start again “from scratch,” despite SIFMA noting several adjustments in the Partial Amendment that it supported. SIFMA also argued that CAT LLC proceeded without “meaningfully …[soliciting] industry input.” As to substance, SIFMA strongly objected to the Members being allocated ⅔ of CAT costs, and proposed 50% instead, noting among other points that the proposed allocation gives no credit for “costs incurred by …Members in building their systems to accommodate CAT reporting.” SIFMA also pointed to the allocation of historical costs as unfair and unreasonable, urging that Members not bear any responsibility for costs related to the termination of technology providers as well as any “legal and consulting costs incurred prior to the CAT NMS Plan’s approval in November 2016.” SIFMA insisted that the annual budget be proposed for “public comment” prior to adoption and that the budgeting system should include “an independent cost control mechanism.” SIFMA particularly insisted that technology costs be broken out in fine detail. Finally, SIFMA complained that the Partial Amendment allocates costs tied to the executing brokers without addressing how costs will be allocated when a broker functions not just as an executing broker, but also is a consolidating broker for other firms. In the same vein, SIFMA notes that the Partial Amendment does not discuss “how the CAT Fees for transactions on [Alternative Trading Systems] would be assessed.”
The integrity of the U.S. capital markets needs the continuing oversight capacity that the CAT is expected to provide if CAT LLC and the Members can ever reach agreement on how to pay for it.
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