This article reviews the relevant case law and examines whether, under prevailing legal precedents, exchange-traded funds ("ETFs"), mutual funds or other investment vehicles may track the same basket of stocks that make up an index without obtaining (or paying for) a license.
Index providers have long argued that they have an intellectual property right in the basket of stocks and other components that comprise their indexes. Based on their considerable success in defending this right, they limit the number of ETFs and other financial products that track their indexes by entering into exclusive and restrictive licensing agreements with product developers. These agreements have become a central part of the industry's business model, and they collectively represent tens, if not hundreds, of millions of dollars in annual revenues.1
A recent ruling by the United States Court of Appeals for the Second Circuit, however, has thrown these rights-and this business model-into question. In Dow Jones & Co. v. International Securities Exchange, Inc.2 ("ISE"), the court found that index providers do not have the right to restrict the listing of options based on ETFs that track their indexes.
Although the ISE ruling dealt narrowly with options, the court left open a much larger question: whether index providers have any right to prevent use of their indexes for financial products. It may seem obvious that they do, but a careful reading of recent case law suggests that the courts may be ready to bring the period of exclusive and restrictive index licensing agreements to an abrupt end.
Background: The Tort Of Misappropriation
Misappropriation is a doctrine found in common law, and it is not easy to define. To illustrate this doctrine, courts frequently cite a 1918 United States Supreme Court case called International News Service v. Associated Press ("International News Service").3 In that case, the Associated Press ("AP") sought an injunction to prevent the International News Service ("INS") from distributing to INS's customers, commercially and for profit, news that had been gathered and published by AP. The district (or trial-level) court granted the injunction, and the appellate court affirmed. The Supreme Court upheld the injunction as well, finding that AP and INS were "competitors in business" and that INS had engaged in unfair competition by transmitting news it had appropriated from AP "for commercial use, in competition with [AP] . . . ." 4 [Emphasis added.]
For reasons that are beyond the scope of this article, the decision in International News Service is no longer binding on individual states. But to the extent that the doctrine of misappropriation survives in New York, the site of the recent ISE ruling, the basic reasoning of International News Services has been adopted nonetheless. In particular, the requirement of direct competition between the defendant accused of misappropriation and the product or service offered by the plaintiff has been recognized by the Court of Appeals for the Second Circuit within the last ten years as a requirement of New York law.5
Misappropriation Of An Index: The COMEX Case
We start our discussion of the scope of intellectual prop property rights that index providers have in their indexes with District Judge Milton Pollack's 1982 decision in Standard & Poor's Corp. v. Commodity Exchange, Inc.6 ("COMEX"). In COMEX, Standard & Poor's ("S&P") sought both a preliminary and permanent injunction7 restraining Commodity Exchange, Inc. ("Comex") from selling futures contracts "based on the use of the S&P's name or the S&P 500 Stock Index."8
The facts of COMEX were as follows. Comex wished to trade futures contracts on its exchange, and to that end, sought a license from S&P to use the S&P 500 Index. S&P refused to grant Comex a license. Instead of abandoning the idea, relying on some other index or creating a new index, Comex decided to proceed without a license. The exchange applied to the Commodities Futures Trading Commission for permission to sell contracts based on what it called the "Comex 500 Stock Index," which "would use the same 500 stocks and the same method of computation as the Standard & Poor's 500 Stock Index."9 S&P opposed the application and sued for an injunction.10
After a hearing, the court found that S&P would likely succeed on its misappropriation claim. S&P was a long-standing and trusted provider of various informational services to the financial community, largely through the sale of copyrighted publications. S&P licensed the use of its 500 index to other data disseminating organizations. S&P also licensed the index to the Chicago Mercantile Exchange for index futures trading, the same activity that Comex intended to engage in.
The court found that the S&P 500 Index was "developed and maintained by S&P at considerable expense and effort," and that while the S&P disseminated the list of constituent stocks and the formula used to calculate the index, "the actual minute to minute and day-to-day calculations depend upon certain inputs determined solely and exclusively by S&P based on special calculations and determinations known only to S&P. . . . [T]he exact numerical values of the Index cannot be calculated by Comex or any other third party without S&P's direct participation . . . ." 11
In controlling the index, S&P permitted some uses and rejected others based on its perception of how the use would affect S&P's reputation.
Judge Pollack found that Comex's plan to sell the contracts would "improperly . . . misappropriate the property of [S&P]."12 He also concluded that, were Comex allowed to begin selling the futures contracts while the case was pending, it was likely that irreparable harm would result. First, S&P might be harmed because: a) it might lose revenues it otherwise would have earned under its agreement with the Chicago Mercantile Exchange, in an amount difficult to calculate; and, b) it would lose control of its marks, name and index, which "even if only tarnished . . . cannot be restored to their full value."13 Second, and more critically, Judge Pollack found that the public could be harmed if trading in the contracts was allowed and then abruptly brought to a halt if the permanent injunction was granted later.
In sum, Judge Pollack granted the preliminary injunction based both on the possibility of irreparable harm if the preliminary injunction was not granted and the likelihood that S&P would eventually succeed on the merits and win a permanent injunction. This was a critical success in the index providers' defense of their intellectual property rights.
Judge Pollack's grant of a preliminary injunction was appealed to the Court of Appeals for the Second Circuit and affirmed. However, the Second Circuit steered clear of deciding anything about the merits (or likely merits) of the claim of misappropriation. Instead-and this is an important point that is easily missed-without deciding the merits of the case at all, the Second Circuit affirmed the preliminary injunction based on the possible harm to the public, which it found likely if trading in the contracts were abruptly halted.
CBOT And The Greater Good
Competing neck-and-neck with COMEX as the index providers' favorite intellectual property decision is the 1983 Illinois Supreme Court decision in Board of Trade of the City of Chicago v. Dow Jones & Co.14 ("CBOT"). The underlying facts in CBOT were similar to those in the COMEX case, but the procedural posture was different. As a result, the merits of the dispute were squarely ruled upon. The Board of Trade of the City of Chicago ("Board of Trade") sought a declaration that its offering of a commodity futures contract utilizing the Dow Jones Industrial Average as the underlying commodity would not violate any legal or proprietary rights of Dow Jones & Company ("Dow Jones"). The Board of Trade won at the trial level, but its victory was reversed on appeal.15
Dow Jones was a provider of financial information, such as its Dow Jones Industrial Averages, which it disseminated in a variety of ways including "teleprinters" and "cathode ray-tube receivers." (Just as the technology has evolved markedly since 1983, so too has the use of indexes as the basis for investment products!) Those interested in stock market news could subscribe to Dow Jones's transmissions. One subscriber was the Board of Trade. Dow Jones was not selling futures contracts at that time or licensing others to do so; thus, it neither offered nor licensed a product in direct competition with the proposed contracts.
The Board of Trade wanted to become a market for stock index futures. To that end, it spent two years developing its own index to be used as a basis for futures contracts. In the end, however, it appeared unlikely that trading in such contracts would be approved by industry regulators unless the contracts "were based on widely known and well-established stock market indexes."16 As a result, the Board of Trade sought approval to trade contracts based on the Dow Jones averages.
The Board of Trade's expert described the purpose of the contracts as a means of hedging against the so-called "systematic" risk that stock prices might decline.17 The idea- familiar to all of us today-is that, instead of selling their shares and incurring capital gains and other costs, investors could reduce or avoid systematic risk (and defer taxes and other costs) by purchasing index-based futures contracts at a much lower price.
The court sought to balance the possible economic and social consequences of ruling in favor of Dow Jones against those of ruling in favor of the Board of Trade. On the one hand, the court reasoned, if the Board of Trade was allowed to go forward with the contracts as proposed, "it appears unlikely that an adverse decision will cause [Dow Jones] to cease to produce its averages." On the other hand, holding that the Board of Trade's proposed use of the averages was a misappropriation might "stimulate the creation of new indexes perhaps better suited to the purpose of 'hedging' against the 'systematic' risk present in the stock market."18
In the end, a majority of the court ruled in favor of Dow Jones, finding that the societal interest in encouraging the creation of new indexes was the consideration that tipped the scales. In ruling for Dow Jones, the court gave an expansive reading to the concept of misappropriation first described in International News Service , because it ruled in favor of Dow Jones despite the fact, explicitly found, that the Board of Trade's proposed use of the averages "is not in competition with the use [Dow Jones] presently makes of [the averages]."19
The court's ruling in favor of Dow Jones, and particularly its expansive reading of what constitutes an actionable "misappropriation," was the subject of a spirited dissent. For the reasons outlined below, we believe that this dissent, rather than the majority opinion, may be followed by other courts that are not bound by either COMEX or the majority in CBOT.
The CBOT Dissent
The judges in CBOT split four to three, with the slim majority ruling in favor of Dow Jones. The dissenting judges in CBOT took a far narrower view of what constituted misappropriation than the majority, balanced the economic and social factors differently than the majority, and would have affirmed the trial court decision allowing the Board of Trade to sell the contemplated futures contracts without a license from Dow Jones.
To be clear: the CBOT majority decision is the law of Illinois and binds the lower courts of that state. Broadening out, however, neither the COMEX decision nor the CBOT decision binds a federal or state court when considering the merits of a misappropriation claim under New York law. Both decisions are what is known as "persuasive" authority, which can be followed or rejected by any court not deciding Illinois law. Likewise, the dissenting opinion in CBOT is also persuasive authority, and could be followed by a court if it found the reasoning more convincing.
The dissenting judges in CBOT argued that the majority had usurped the legislative function and "broadly expanded the tort of misappropriation in Illinois" by ignoring the requirement that, to misappropriate intellectual property, the use must be in "direct competition" with the person who created that property.20 Since Dow Jones was in the business of disseminating information, and not in the business of selling futures contracts or other securities, it did not compete with the Board of Trade. Even if Dow Jones were to seek to license its name for use in connection with futures contracts (which it had not done and did not intend to do at the time of the CBOT decision), the dissent said it would not satisfy the competition requirement. In the view of the dissent, the majority had balanced the social and economic factors in the wrong direction: "The majority errs, in part, because it has failed to place enough emphasis on the unfettered access to ideas in the public domain, a privilege which is essential to our free market economy."21
The dissenters did not suggest that the Board of Trade could use Dow Jones's name for its product or claim an affiliation with Dow Jones. Instead, they only argued that the Board of Trade could use the stocks in the Dow Jones averages as the basis for its contracts. The dissenters would have affirmed the trial court decree, which would not have prevented Dow Jones "from licensing its name to sponsor a stock market futures index in competition with the one to be offered by the Board of Trade."22 The trial court decree would also have required the Board of Trade to disclaim any affiliation with or sponsorship by Dow Jones. The right of Dow Jones to grant or withhold its endorsement of a product was something the dissenters sought to protect, even as they opined that the makeup of the index should be available for non-competitive use by the Board of Trade.
Archipelago And Golden Nugget: The Index Providers' Position Weakens
In the COMEX and CBOT cases, decided in the early 1980s,23 the index providers did very well. The index provider's initial defeat in the trial court in CBOT was reversed on appeal, and while the dissent in CBOT had interesting arguments, those arguments lost.
In Nasdaq Stock Market, Inc. v. Archipelago Holdings, LLC24("Archipelago"), decided in 2004, the outcome was very different. There, the index provider lost on its misappropriation claim at the trial level, and the decision was not reviewed on appeal
In Archipelago, Nasdaq Stock Market, Inc. ("NASDAQ") sued the Archipelago Exchange, LLC ("Arca Exchange") alleging misappropriation, among other claims, for facilitating the trading of shares in the Nasdaq-100 Trust Series 1 ETF (called QQQ) without a license. NASDAQ sought money damages and an injunction preventing Arca Exchange from continuing to facilitate the sale of QQQ shares.
The court dismissed the claim, reasoning that NASDAQ did not have any protectable interest in the QQQ shares held by investors. The court's argument relied heavily on the Court of Appeals for the Ninth Circuit's decision in Golden Nugget, Inc. v. American Stock Exchange, Inc.25 ("Golden Nugget"). In Golden Nugget, the plaintiff, a corporation listed on the New York Stock Exchange, brought a misappropriation claim against the American Stock Exchange and the Options Clearing Corporation for trading options on Golden Nugget stock without its permission. The Ninth Circuit rejected Golden Nugget's claims on the ground that Golden Nugget had no property or other protectable interest in the Golden Nugget common stock held by shareholders.
The Archipelago court treated the shares in an ETF as though they were shares of common stock in a corporation being sold in the secondary market. This was so despite the fact that the prices in the secondary market for QQQ shares cannot be set without reference to the index created by NASDAQ, as "the Index is publicly available information and those who use it to set the price for the QQQ shares are investors,"26 not the exchanges that facilitate trading in such shares. Interestingly, NASDAQ relied upon COMEX and CBOT for its arguments, but the court, reading those cases narrowly, held that they were inapplicable because "the defendants have not copied the Index or created a product-such as a futures contract-that is linked to the index."27 The court also made a point of noting that the Second Circuit had not reached the merits of the claim in COMEX. It follows, although not stated by the Archipelago court, that the Second Circuit's decision in COMEX does not stand for the proposition that copying an index or creating a product based on an index is an actionable misappropriation.
The Latest Pronouncement: The ISE Case
Less than two years after the decision in Archipelago, the Second Circuit had occasion to look closely at COMEX and CBOT in the ISE case. Following Archipelago's lead, the court construed those decisions narrowly.
In ISE, decided in June 2006, the Second Circuit ruled on what it characterized as a "narrow and highly specific question," which was "whether an options exchange, by creating, listing, and facilitating the trading of options on shares of an [ETF] designed to track a proprietary market index, misappropriates intellectual-property rights of the creator of the index."28 The court affirmed the lower court's ruling that there was no misappropriation.
The Second Circuit's opinion is interesting as much for what was decided as for what was not decided. Reversing the usual procedure, let's look first at the issues that were not reached.
The index providers in question were McGraw- Hill (Standard & Poor's) and Dow Jones. Each claimed that it had "invested time, money and intellectual creativity into the creation and maintenance of its indexes," which "gives it an intellectual-property right in the index itself, as well as the ETF that tracks this index, and in options on shares of such an ETF."29 The court expressly did not reach the merits of these claims, however, and did not endorse the index providers' view of their intellectual property rights:
We assume, for purposes of this decision-though we do not reach this issue - that each of the plaintiffs possesses an exclusive intellectual - property right in the index it created and in the ETF which has been structured to duplicate the index.30
Not surprisingly, the index providers cited COMEX and CBOT as precedent in support of their position.31 Rather than take the expansive reading of those precedents, however, the Second Circuit found that COMEX and CBOT did not apply and relied instead on Golden Nugget and Archipelago.
The court went even further in distancing itself from the index providers' reliance on their favored precedents. With respect to COMEX, the court disparaged the index providers' contention that the Second Circuit's ruling favored their position: "the [Second Circuit's] ruling [in COMEX], expressed in three separate opinions, reached no conclusion as to the merits." 32 The court also made clear that, for the Second Circuit at least, the question of whether CBOT was decided correctly remains open:
Like COMEX, [CBOT] involved a defendant's attempt to create index futures that would allow investors to speculate directly on the value of an index copied from the DJIA. Even if this constitutes misappropriation-and we express no view on this matter-it would not affect the outcome of the case before us, in which plaintiffs have licensed the creation of ETFs and the sale of their shares to the public, and ISE is simply creating a mechanism for trading those shares.33 [Emphasis added.]
By relying on Golden Nugget and Archipelago, the court declined the opportunity to treat ETF shares differently from common stock of an individual company. Equally significant, the court made clear that it viewed the issues determined in COMEX and CBOT-such as the scope of an index provider's intellectual property interest in the index itself-as an open question.
Leaving these questions open, the court ruled in ISE that, even if index providers have the intellectual property right in their indexes that they claim (and this appears to be a substantial "if "), selling options on vehicles that trade like stocks, whose creation has been licensed by the index providers, is not an actionable misappropriation.
Beyond ISE: What's Next ?
It doesn't take much reading between the lines to see what is coming: a direct challenge to the notion that index providers have the right to limit the creation of investment products (like ETFs and mutual funds) that openly utilize information that has been publicly disseminated by index providers to determine the securities that they invest in. The sole proviso is that the product developers disclaim any affiliation with the index provider in question.
The challenge could be based on a claimed lack of direct competition between the product developers and the index providers, or, even more fundamentally, on the contention that an index provider does not have the expansive intellectual property interest in the index itself that it claims to have. An ETF or mutual fund could also argue that it was entitled to proceed without a license because it is "not copying" or "not linked" to the index. Perhaps the best candidates for the "not copying" or "not linked" arguments are investment vehicles that depart from the index, or at least grant the fund manager discretion to do so.
For more than two decades, index providers have limited the creation of index-based financial products by granting or withholding licenses for their indexes, and by asserting misappropriation claims. We see a trend against the restriction of the use of indexes and the extraction of substantial licensing fees based on an intellectual property right in the basket of stocks and other components that comprise the index. We expect the practice of restrictive licensing of indexes for use by mutual funds or ETFs to be squarely challenged in the courts very soon. There are a number of grounds upon which such a challenge could proceed, and there are good reasons to think it would prevail.
- Consider that the index licensing fees for just one ETF - the Standard and Poor's Depository Receipts 1, or SPDR (AMEX: SPY) - will total approximately $20 million in 2006 alone, based on current asset counts. This figure was arrived at by considering the publicly disclosed index licensing fees (0.035 percent-based on SPDR Prospectus, January 7, 2006) and the net assets in the fund at the time of publication ($57 billion-based on Amex data).
- Dow Jones & Co. v. Int'l Sec. Exch., Inc., 451 F.3d 295 (2d Cir. 2006).
- Int'l News Serv. v. Associated Press, 248 U.S. 215 (1918).
- Id. at 239.
- Nat'l Basketball Assoc. v. Motorola, Inc., 105 F.3d 841, 845 (2d Cir. 1997) (to succeed in misappropriation claim, plaintiff must show, inter alia, that "the defendant is in direct competition with a product or service offered by the plaintiffs; and . . . the ability of other parties to free-ride on the efforts of the plaintiff or others would so reduce the incentive to produce the product or service that its existence or quality would be substantially threatened.").
- Standard & Poor's Corp. v. Commodity Exch., Inc., 538 F. Supp. 1063 (S.D.N.Y. 1982) aff'd 683 F.2d 704 (2d Cir. 1982).
- A preliminary injunction, which lasts while the case is pending, differs from a permanent injunction, which continues even after the case ends.
- 538 F. Supp. at 1065.
- Id. at 1064.
- Id. at 1065.
- Id. at 1067.
- Id. at 1065.
- Id. at 1071.
- Board of Trade of the City of Chicago v. Dow Jones & Co., 456 N.E.2d 84 (Ill. 1983).
- Board of Trade of the City of Chicago v. Dow Jones & Co., 439 N.E.2d 526 (Ill. App. Div. 1982) aff'd 456 N.E.2d 84 (Ill. 1983).
- CBOT, 456 N.E.2D at 86.
- Compare systematic risk to "non-systematic" risk, such as labor strikes or changes in consumer attitudes that may devalue a specific company. Non-systematic risk can be controlled by diversification, while systematic risk cannot. Id.
- Id. at 89.
- Id. at 90.
- Id. at 91.
- Id. at 92.
- COMEX and CBOT were decided more than a decade before ETFs hit the market; index-based mutual funds were in their infancy.
- Nasdaq Stock Market, Inc. v Archipelago Holdings, LLC, 336 F. Supp. 2d 294 (S.D.N.Y. 2004).
- Golden Nugget, Inc. v. American Stock Exchange, Inc., 828 F.2d 586 (9th Cir. 1987).
- Archipelago, 336 F. Supp. 2d at 303.
- ISE, 451 F.3d at 297.
- Id. at 302.
- While McGraw-Hill, plaintiff-appellant, cited McGraw-Hill Companies, Inc. v. Vanguard Index Trust, 139 F. Supp. 2d 544 (S.D.N.Y. 2001), aff'd 27 Fed. Appx. 23 (2d Cir. 2001) ("Vanguard"), the Second Circuit did not rely upon that case and found it unworthy of mention in its opinion. Br. and Special App. for Pl.-Appellant at 53, 58. Presumably, the Second Circuit took the view, as we do, that Vanguard concerned only the interpretation of the existing license agreement between the parties and did not opine on the scope of the index provider's intellectual property rights in the make up of the index.
- ISE, 451 F.3d at 305 n.12.
- Id. at 305.