Fourth Amendment Challenges to the Consolidated Audit Trail
Posted on Nov 12, 2024Shane Rooney
Introduction to the Consolidated Audit Trail (CAT)
In 2010, the Securities and Exchange Commission (SEC) proposed Rule 613, which directed self-regulatory organizations (SROs) under its supervision - national securities exchanges and FINRA - to "act jointly in developing a national market system (‘NMS’) plan to develop, implement, and maintain a consolidated order tracking system, or consolidated audit trail” for certain securities.[1] According to the SEC, a consolidated audit trail (CAT) was needed to create a comprehensive market surveillance system that would allow the SROs and the SEC to effectively monitor and regulate trading activity across multiple markets.[2] For decades, the SROs and the SEC relied on fragmented audit trails, which required a time-consuming and frequently unsuccessful process to compile data from disparate SROs and broker-dealers.[3] The impetus for Rule 613 was the 2010 Flash Crash, when financial markets unexpectedly dropped around 5% in a short period.[4]
The SROs collaborated to create a plan (“CAT NMS Plan”) to implement the CAT according to Rule 613’s requirements.[5] Under the CAT NMS Plan, they established CAT NMS, LLC, a joint entity responsible for overseeing the creation, implementation, and maintenance of the CAT system. [6] Relevant to the Fourth Amendment discussion, the CAT NMS Plan requires participating exchanges to record certain order details in a centralized data repository, including customer IDs for the individuals placing an order, the order date and terms.[7]
Fourth Amendment Challenge to the CAT
In April 2024, two individual plaintiffs filed a class-action complaint in the Western District of Texas alleging, among other things, that the CAT violated their Fourth Amendment rights against unlawful search and seizure.[8] To support their claim, the plaintiffs argue that the investor information collected by the CAT qualifies as “papers” under the Fourth Amendment, thereby warranting constitutional protection.[9]
To support their argument that CAT investor information counts as “papers” under the Fourth Amendment, the plaintiffs point to Supreme Court precedent suggesting that financial records may be considered “papers.”[10] On closer look, however, the cases they cite offer only tenuous support for their claim that investor records in the CAT repository are protected. Plaintiffs cite both FTC v. American Tobacco and Boyd v. United States for the proposition that the Supreme Court has previously “found ‘financial papers’ to be protected” by the Fourth Amendment.[11] American Tobacco, however, does not suggest that all financial records are “papers” protected by the Fourth Amendment. All that American Tobacco held was that the FTC could not compel companies to produce business records related to an investigation without showing that those documents were relevant to the FTC’s investigation.[12] Far from holding that all financial records are papers, the holding actually suggests that some kinds of financial records (i.e., records related to a government investigation) may not fall under the Fourth Amendment’s protections.
Boyd likewise does not suggest that the investor data collected by the CAT is protected under the Fourth Amendment. In Boyd, the Court held that the government could not compel the production of a company’s invoices for use against it in a criminal proceeding.[13] While Boyd offers more support for the plaintiffs’ claim, plaintiffs gloss over a critical difference between the financial information in Boyd and the data collected by the CAT: the invoices in Boyd were in the defendant’s possession. The CAT repository’s investor information, however, is provided to CAT NMS LLC by the exchanges, not the individuals who place the orders.[14] Therefore, even if the CAT investor information could count as “papers” under the Fourth Amendment, the “papers” are not the property of individual investors, rendering the holding in Boyd inapplicable. Instead, the investor data in the CAT repository should be analyzed under the Katz reasonable expectation of privacy test and the third-party doctrine.
Katz and the Third-Party Doctrine Defeat Plaintiffs' Claims
The CAT likely does not violate investors’ Fourth Amendment Rights under the Katz test and the third-party doctrine. In Katz v. United States, the Supreme Court held that the Fourth Amendment protects individuals’ privacy from government intrusion if that individual (i) has a subjective expectation of privacy and (ii) that expectation is one that society is prepared to recognize as reasonable.[15] The third-party doctrine, first articulated in United States v. Miller as a corollary to the Katz test, asserts that people have no reasonable expectation of privacy in information that they voluntarily turned over to third parties.[16]
The investor information collected by the CAT NMS LLC is analogous to the bank records at issue in Miller, so the third-party doctrine defeats the plaintiffs’ claims. In Miller, the Supreme Court held that the defendant had no reasonable expectation of privacy in his bank records because he voluntarily disclosed that information to a third party–the bank.[17] The investor information the CAT collects are financial records that are not any more sensitive than an individual’s bank records. In addition, investors must voluntarily disclose their order information to a broker/stock exchange in order to make the order. Unlike the private invoices in Boyd, the investor information in the CAT repository must be publicly disclosed to exchanges and brokers every time an investor makes a trade in the covered securities. The parallels between the information the CAT collects and the information at issue in Miller thus suggest that the third-party doctrine applies to the CAT as well.
Plaintiffs make two arguments for why the third-party doctrine should not apply to the CAT. First, they argue that the third-party doctrine does not apply to property-based searches.[18] However, as discussed above, the information collected by the CAT is not a property-based search because the records are not in the investors’ physical possession. Second, the plaintiffs argue that the Supreme Court’s decision in Carpenter v. United States not to apply the third-party doctrine to people’s cell-site location data means that the third-party doctrine should not apply to the CAT.[19] However, the Court made sure to stress that Carpenter was a narrow holding for retrospective cellphone location data due to the uniquely revealing nature of such data and the fact that information passively collected from cellphones cannot be considered “voluntarily” disclosed to a third party.[20] The information collected by the CAT is fundamentally different from the location data in Carpenter. In contrast, the information collected by the CAT does not reveal nearly the same level of intimate information about an individual’s life as location data, and it is only generated by an investor’s voluntary decision to trade on a national market. So, Carpenter’s narrow third-party doctrine carve-out should not apply, meaning that investors likely have no reasonable expectation of privacy in the trading information collected by the CAT.
Conclusion
The Fourth Amendment challenges are only one of several claims brought by plaintiffs against the CAT.[21] Elsewhere in the Eleventh Circuit, the American Securities Association has made a direct appeal against the CAT, arguing that the SEC lacks the authorization to create the CAT.[22] So, even though the Fourth Amendment challenges are unlikely to succeed, the CAT is not out of the woods yet.
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[1] Consolidated Audit Trail, 75 Fed. Reg. 32556, 32556 (June 8, 2010) (to be codified at 17 C.F.R. Part 242).
[2] Id. at 32557.
[3] Joint Industry Plan; Order Approving the National Market System Plan Governing the Consolidated Audit Trail, 81 Fed. Reg. 84696, 84697–84698 (proposed Nov. 23, 2016).
[4] SEC, Statement Regarding the Order Approving an Amendment to the National Market System Plan Governing the Consolidated Audit Trail (2023), https://www.sec.gov/newsroom/speeches-statements/crenshaw-statement-cat-funding-090623.
[5] 81 Fed. Reg. 84696 at 84697.
[6] Id. at 84699.
[7] Limited Liability Company Agreement of Consolidated Audit Trail, LLC, Article VI §6.3(d), 49–51, https://catnmsplan.com/sites/default/files/2024-08/LLC_Agreement_of_Consolidated_Audit_Trail_LLC-as-of-7.31.24.pdf.
[8] Complaint at 41, Davidson v. Gensler, No. 24-cv-00197 (W.D. Tex.).
[9] Plaintiffs Memorandum in Support of Preliminary Injunction at 28, Davidson v. Gensler, No. 24-cv-00197 (W.D. Tex.).
[10] Id. at 28.
[11] Id. at 28.
[12] FTC v. American Tobacco, 264 U.S. 298, 307 (1924).
[13] Boyd v. United States, 116 U.S. 616, 634–635 (1886).
[14] Limited Liability Company Agreement, supra note 6 at 49.
[15] Katz v. United States, 389 U.S. 347 (1967) (Harlan J. concurring).
[16] United States v. Miller, 425 U.S. 435 (1976). See also Smith v. Maryland, 442 U.S. 735 (1979).
[17] See Miller, 425 U.S. 435 at 444–445.
[18] Plaintiffs Memorandum supra note 8 at 29 (footnote 35).
[19] Id. at 29.
[20] Carpenter v. U.S., 585 U.S.296, 316 (2018).
[21] Complaint, supra note 7.
[22] Opening Brief of Petitioners, American Securities Association v. SEC (11th Cir. 2024) (No. 23-13396).