[ by Howard Haykin ] Nasdaq's handling of Facebook's IPO last month was botched up because of flawed computers and "technical errors," according to the Exchange.  Regulators suspect it may be something more, which is why the SEC is conducting an investigation into the role of the exchange in the IPO. Regulators want to ascertain whether Nasdaq failed to properly test its trading systems, which broke down during the IPO, and whether it violated rules when it rewrote computer code to jump-start trading. Previous Inquiry. The Facebook investigation comes after a broader inquiry into trading breakdowns and other problems at the nation's largest exchanges, including 2 previously undisclosed cases involving Nasdaq's archrival, the NYSE, the people said.  SEC Enforcement, which has opened more than a dozen related cases, is examining whether exchanges lack adequate controls and favor select investors.  As investor confidence in the market wanes, the worry is that missteps by the exchanges are contributing to the dissatisfaction. Since the financial crisis, investors have seen their portfolios erode, prompting them to flee stocks. Senator Jack Reed (D-RI), who held a hearing this week on the IPO process, noted:  "If exchanges have technical problems, that slows capital formation and erodes the confidence." Yet, while none of the exchanges has been accused of any wrongdoing and the SEC may never take enforcement action, the crackdown represents a significant shift. Traditionally, the agency has been relatively cozy with the industry, which is increasingly under pressure to produce profits since the exchanges became publicly traded companies. Along with the threat of enforcement cases, the SEC has stepped up its inspections of exchanges and introduced several measures to improve the safety of the markets. For example, the agency has approved proposals that would help limit volatility in specific stocks, including circuit breakers that would halt trading. "Cases against exchanges are few and far between, and inevitably a big deal," said Stephen Crimmins, a partner at K&L Gates and a former SEC enforcement official.  Facebook's IPO highlights the problems facing exchanges - and how regulators are finding their responses lacking.  On May 18, its first day of trading, Facebook got off to a rocky start. Nasdaq delayed the start of trading and later flooded the market with shares, adding to investor trepidation.  Nasdaq's lack of communication - and at times, lack of contrition - aggravated the situation, according to documents and executives, bankers and regulators. On a 5/31 call with SEC Chairman Mary Schapiro and other officials, Nasdaq's CEO Robert Greifeld expressed confusion about the SEC's aggressive approach.  "We're regulators, too," said Greifeld, adding "we're all in this together." Yet, the Facebook debacle is not an isolated instance - it comes after a flurry of trading breakdowns.  In March, BATS Global Markets canceled its own IPO after its systems faltered.  Nasdaq last year halted trading in dozens of stocks amid technical problems.  Such experiences echo the so-called flash crash, which occurred on 5/6/10.  On that day, the DJIA plummeted more than 700 points in minutes, before recovering shortly thereafter. In nearly every case, companies blamed technical malfunctions. But regulators say some breakdowns may point to more fundamental issues.  The SEC is also examining whether some exchanges give undue priority to high-frequency trading firms and big institutional investors through its order types and data disclosure. The NYSE is among the most prominent players facing scrutiny from regulators, who have opened 2 investigations into the Big Board, according to people briefed on the matter who spoke on the condition of anonymity because the cases are not public.  The SEC reportedly is examining whether the NYSE violated rules by distributing in-depth stock data to paying clients faster than the public received general information.  That issue was first discovered in the rubble of the flash crash.  The exchange declined to comment, but people close to the exchange have attributed the problem to unintended technical shortcomings. The SEC, which penalized the Direct Edge exchange for having "weak internal controls," is also pursuing the CBOE for not properly policing the markets.  BATS Global Markets acknowledged receiving a request in February from the SEC - the investigation is looking into whether any collaboration between BATS and high-frequency trading firms could hinder competition. Nasdaq represents one of the most prominent cases. On Friday, 5/18, Facebook's debut, Nasdaq's finance team, led by David Ebersman, stood on Morgan Stanley's trading floor surrounded by scores of traders sporting white baseball caps stamped with "Facebook."  The mood was initially festive, but Mr. Ebersman grew anxious, as he turned to the bankers and asked: "Why aren't we starting?"  Nearby, a trader clutched phones to his ears, one with a call to another bank, the other to Nasdaq.  At about 11 a.m., Nasdaq said trading would begin in 5 minutes. After nothing happened, Nasdaq officials phoned SEC trading experts to explain that everything was under control, according to a person briefed on the call. Nasdaq's computers were programmed to accept last-second modifications to orders of Facebook shares. When these trades kept piling in, the system reset the price over and over again. Some orders were not executed - or were placed at prices other than the opening bid of $42. Many traders, who usually receive confirmations in seconds, had no idea how many shares they held. "We were flying blind," said one person at a market-making firm. The SEC is examining why Nasdaq lacked an action plan for navigating such a crisis, including plans to abort the IPO, and whether it failed to follow federal guidelines in running system tests.  Nasdaq did run some 400 tests ahead of the Facebook IPO, and the company used the system in question for more than 5 years. Mr. Greifeld has publicly blamed "design flaws" in the system.  Ultimately, Nasdaq overrode the system manually, switching to a backup server. That move, too, has drawn scrutiny. Exchanges must follow their own strict trading procedures. In this case, Nasdaq changed its procedure on the fly without amending its rules. While the exchange may not have followed the letter of the law, a person close to Nasdaq said that the company had previously used the backup system with approval from regulators.  The exchange declined to comment.  Shares started trading at 11:30 a.m., sending brief applause through Morgan Stanley's trading floor. The Facebook team, which had been hoping for a 5010% jump from the offering price of $38, was relieved when it rose. The team headed to Teterboro Airport to fly back to California.  Then at 1:50 pm ET, a 2nd wave of confusion ripped through Wall Street. Traders saw an unexpected sell order of about 11 million shares.  While some wondered whether a big hedge fund had dumped shares, investors who had been on the fence about buying, backed off, and others sold. Within minutes, Facebook slipped $2, to $40. As it turned out, there was no mystery hedge fund seller.  It simply was the aggregation of trades backed up in the system - which Nasdaq started to process.  It was as if those shares were dumped on the market, according to people with knowledge of the matter. About the same time, some Facebook shares that had ended up in an account at Nasdaq were also sold without warning.  The move may have violated Nasdaq's own rules, which do not explicitly allow the exchange to take a position in the shares of an IPO, according to one of the people. While some analysts have pinned Facebook's woes on Nasdaq, others have blamed the company and its bankers for being too aggressive on the size and price of the offering.  Facebook shares ended that first day at $38.23, a tad higher that where they started.  Two days later, Mr. Greifeld called the IPO "quite successful" over all and said that technical issues had not affected the price. Facebook's management team, which was beginning to grasp the extent of the problems, was livid. Some wondered why Nasdaq had made little effort to keep them apprised on Friday and kept them out of decision-making.  Mr. Greifeld called a senior executive, asking how the exchange could get back into its good graces. The executive erupted. "Bob," the executive said, "You don't understand what a hole you're in." Nasdaq soon aggravated the trading woes. The exchange informed traders it might offer "financial accommodation" for claims filed on Monday. Some investors dumped shares, to prove a loss.  In the first hour of Monday trading, Facebook plunged from $38 to less than $34, swiftly wiping out billions of dollars in market value. For further details, go to:  [Dealbook, 6/21/12].