Crossing the Rubicon: The Consequences of National Securities Exchanges Suing the SEC

Posted on by Chloe Schwarz

In 2019, the three largest American stock exchange groups, New York Stock Exchange (NYSE), Nasdaq, and Cboe (formerly known as the Chicago Board Options Exchange) sued their regulator, the Securities and Exchange Commission (SEC).1 The lawsuit was over the SEC’s Transaction Fee Pilot.2 The novelty of suing one’s own regulator was not lost on the exchanges. In a Wall Street Journal article titled “We’re Suing the SEC to Protect the Stock Market,” NYSE President Stacey Cunningham wrote that the exchange didn’t look forward to suing its regulator but had “no choice but to ask for judicial relief.”3 Despite the potential consequences, legal and otherwise, of suing their own regulator, the exchanges were prepared for battle. As NYSE’s then Head of Transactions Michael Blaugrund explained, “it’s a very serious decision to cross the Rubicon.”4 This blog post starts by providing background on the SEC’s Transaction Fee Pilot and the subsequent lawsuit brought by the exchange groups. Then a discussion on the legal merits of the lawsuit and the exchanges’ potential ulterior motives follows. Finally, the blog concludes by considering the consequences and impact of these lawsuits.  

Background

In the U.S., exchanges generally charge fees or provide rebates for trades executed on their venues, depending on whether orders “make” or “take” liquidity.5 An order that makes liquidity adds share volume to an exchange, and an order that takes liquidity removes volume at the venue.6This pricing model has led to controversy in the industry over potential conflicts of interest between broker-dealers and their customers, as broker-dealers route orders to the exchanges on their behalf. Broker-dealers are expected to achieve the best executions for their clients. The concern is that they are routing to the exchanges that provide the highest rebates (which is generally not passed onto the client) instead of getting the best execution.7 Even if a broker-dealer routes to an exchange with the best quoted price, the execution can be detrimental to clients in other ways. For example, the order could have a higher likelihood of execution at a different exchange that offers lower rebates.8

At the end of 2018, the SEC adopted Rule 610T of Regulation NMS to implement the Transaction Fee Pilot.9 The SEC adopted the Pilot to study the effects that the fee and rebate pricing model had on broker routing, execution quality, and overall market quality.10 The study separated stocks into three groups. The first group was the control group that operated under current rules, the second group removed rebates, and the third group lowered the fee exchanges could charge.11

The Exchanges Sue the SEC Over the Transaction Fee Pilot

NYSE, Nasdaq, and Cboe were all strongly opposed to the Pilot. They argued that incentives such as rebates were necessary to encourage orders to be sent on-exchange and to compete with the benefits of trading off-exchange.12 The exchanges also argued that the Pilot would be implementing governmental price controls and would further complicate the market.13 The exchanges’ lawsuit claims that the Transaction Fee Pilot exceeds the SEC’s statutory authority under the Exchange Act14 and that this type of “one-off” regulation is costly and does not guarantee the SEC will find a problem worth regulating.15

In reviewing the case, the D.C Circuit applied the two-step Chevron deference doctrine to determine whether the Commission had authority to implement the Transaction Fee Pilot16 Under step one of Chevron, a court decides whether Congress spoke directly to the question at issue.17 In this case, there was no direct congressional authorization for the SEC to implement the Pilot. Under step two of Chevron, a court decides if the agency acted based on a reasonable interpretation of the statute.18 The Court found that the SEC failed here, too, because the Pilot was adopted without a regulatory agenda.19 The Court also found that the SEC violated Section 23 of the Exchange Act, which forbids the SEC from adopting a rule that would unnecessarily burden competition.20 Without direct delegated authority or a regulatory agenda, the Court held that the SEC exceeded its rulemaking authority when it adopted Rule 610T.21

One of the D.C. Circuit Court’s strongest arguments is that the Pilot would burden competition and impose “significant, costly, and disparate regulatory requirements.”22 The Transaction Fee Pilot’s obligations applied only to the national securities exchanges, excluding ATSs (Alternative Trading Systems), i.e., dark pools, from the rules. This not only further complicated compliance with the Pilot but also gave the dark pools a potential competitive advantage with pricing over the exchanges. Although it is worth noting that ATSs are under a differently regulatory regime than the exchanges and are not subject to access fee caps pursuant to Rule 610.

In its opinion, the D.C. Circuit heavily focused on what it considered the SEC’s lack of regulatory agenda. The goal of the Pilot was to review the fee model system employed be the exchanges.23  Since the SEC did not have the data necessary to determine the best course of action, it designed the Pilot to gain a better understanding of the potential issues with the exchange pricing model.24. The data was then to be used in determining what, if any, changes (i.e., new permanent rules) should be made to this regulatory regime.25 The Court’s opinion also takes issue with the fact that the data provided by the Pilot “may or may not indicate to the SEC whether there is a problem worthy of regulation.”26 The Court found the Pilot to be an impermissible use of the SEC’s rulemaking authority because the goal of the study, however, was to implement temporary ‘rules’ that applied to three separate groups and then use the data gathered to determine whether further regulation was necessary.

Ulterior Motives Behind the Lawsuit?

Before discussing the consequences of this lawsuit and subsequent decision, it is important to consider the exchanges’ motives. Although the exchanges said to be acting in the interest of investors and the stability of the market, some industry participants contend that the exchanges had improper profit-related motives.27 Exchanges like the NYSE, which are for-profit entities, make money not by matching buyers and sellers at the best price but by selling market data and connectivity services at their venues.28 An exchange’s revenues from selling these products are directly related to the exchange’s market share, and market share is driven by the exchange paying rebates to brokers who route to its venue.29 Since the Pilot was aimed at studying the potential detrimental impacts of rebates, the exchanges arguably saw it as a threat to their lucrative business model. Without rebates, the exchanges could lose market share and ultimately revenue. The possibility that this litigation was in some way motivated by profit-seeking behavior is cause for concern.

Second, the exchanges’ lawsuit is unique in that the exchanges themselves have regulatory capabilities. The Securities and Exchange Act of 1934 made national securities exchanges self-regulatory organizations (SROs)30, with oversight by the Securities and Exchange Commission.31 For many years, the exchanges were not-for-profit, member-owned organizations.32 However, this self-regulatory authority raised interesting questions with the demutualization of the exchanges in the early 2000s.33 Exchanges no longer solely have the role of matching buyers and sellers. These for-profit companies found new revenue sources to fulfill their fiduciary responsibility to shareholders, such as the market data and connectivity products mentioned previously. What does it mean for an SRO to sue its regulator? Moreover, what does it mean for them to sue their regulator and win?

More Lawsuits to Come

One serious consequence of this lawsuit is that is has paved the way for more of its kind. In February 2021, just two years after the initial suit, the exchanges sued the SEC again, this time over changes to the equities market data infrastructure.34 The new SEC rules at issue in this recent suit update and expand the content of market data and establish a de-centralized consolidation model in which competing consolidators collect, consolidate, and disseminate market data to the public.35 Like the previous lawsuit, the exchanges’ more recent legal action seems to be at least in part motivated by profit at the expense of the public. Under the current market data model, the exchanges provide certain quote and trade information to the public through exclusive Securities Information Processors (SIPs).36 In addition to this “core” data, the exchanges also sell proprietary, depth-of-book market data to market participants.37 Several market participants have found the high prices charged for this proprietary data to be monopolistic and abusive, which compelled a regulatory response.38

Given how valuable the current data infrastructure is to the exchanges’ bottom-line, we may question whether these recent suits are examples of frivolous or meritorious litigation. While the possibility that exchanges are suing the SEC for purely financial reasons is alarming, at the same time, however, we want to ensure the SEC is acting within its Congressionally delegated authority. If the SEC oversteps these legal bounds, even for the benefit of the market, it is unlawful, and the exchanges’ suits have legal merit even if they are motived by profit-seeking behavior. These considerations will be important to evaluate in future litigation.

Conclusion

One consequence of the exchanges’ lawsuits is that, at the very least, they have begun to chip away at the novelty of suing one’s regulator. As it currently stands, the lawsuits have been infrequent and are manageable. If these types of lawsuits become more commonplace, frivolous or merely obstructionist in nature, we will have to consider whether burdensome litigation could present a roadblock to the SEC’s effective regulation of the financial markets.

  1. N.Y. Stock Exch. LLC v. SEC, 962 F.3d 541 (D.C. Cir. 2020). ↩

  2. Id. at 544. ↩

  3. Stacey Cunningham, We’re Suing the SEC to Protect the Stock Market, Wall St. J. (Feb. 14, 2019, 6:57 PM), https://www.wsj.com/articles/were-suing-the-sec-to-protect-the-stock-market-11550188636. ↩

  4. Nick Baker & Ben Foldy, Top U.S. Exchanges Sue Their Regulator to Block a Test, Bloomberg (Feb. 15, 2019, 5:08 PM), https://news.bloombergtax.com/health-law-and-business/top-u-s-exchanges-sue-their-regulator-to-block-a-proposed-test?context=article-related. ↩

  5. Transaction Fee Pilot for NMS Stocks, 84 Fed. Reg. 5202, 5202 (Feb. 20, 2019) (to be codified at 17 C.F.R. pt. 200, 242) https://www.federalregister.gov/documents/2019/02/20/2018-27982/transaction-fee-pilot-for-nms-stocks. ↩

  6. Id. ↩

  7. Id. at 5244. ↩

  8. Id. at5204. ↩

  9. Press Release, SEC, SEC Adopts Transaction Fee Pilot for NMS Stocks, (Dec. 19, 2018), https://www.sec.gov/news/press-release/2018-298. ↩

  10. Id. ↩

  11. Id. ↩

  12. See Sarah E. Aberg, Where is the Love? Exchanges Sue SEC Over Market Access Fee Pilot Program, Nat’l L. Rev. (Feb. 27, 2019), https://www.natlawreview.com/article/where-love-exchanges-sue-sec-over-market-access-fee-pilot-program. ↩

  13. See id. ↩

  14. N.Y. Stock Exch. LLC v. SEC, 962 F.3d 541 (D.C. Cir. 2020). ↩

  15. Id. at 546. ↩

  16. Id. at 552. ↩

  17. Chevron, U.S.A., Inc. v. NRDC, Inc., 467 U.S. 837, 842 (1984). ↩

  18. Id. ↩

  19. N.Y. Stock Exch. LLC v. SEC, 962 F.3d 554. ↩

  20. Id. at 555. ↩

  21. Id. at 568. ↩

  22. Id. at 553. ↩

  23. Transaction Fee Pilot for NMS Stocks, 84 Fed. Reg. 5202, 5202 (Feb. 20, 2019) (to be codified at 17 C.F.R. pt. 200, 242) https://www.federalregister.gov/documents/2019/02/20/2018-27982/transaction-fee-pilot-for-nms-stocks. ↩

  24. Id. at 5203 ↩

  25. Id. ↩

  26. N.Y. Stock Exch. LLC v. SEC, 962 F.3d 554, 550. ↩

  27. See e.g.,Sal Arnuk & Joe Saluzzi, Themis Trading Comment Letter on the Transaction Fee Pilot, at 5 (Apr. 27, 2018), https://www.sec.gov/comments/s7-05-18/s70518-3516296-162277.pdf. ↩

  28. See John Ramsay, IEX Second Comment Letter on the Transaction Fee Pilot, at 4 (June 27, 2018), https://www.sec.gov/comments/s7-05-18/s70518-3968434-167099.pdf. ↩

  29. Id. ↩

  30. See 15 U.S.C. § 78c(a)(26) (2012). ↩

  31. See id. § 78d(a) (2018). ↩

  32. Andreas M. Fleckner, Stock Exchanges at the Crossroads, 74 Fordham L. Rev. 2541, 2541 (2006). ↩

  33. See id. at 2452. ↩

  34. See Alexander Osipovich, Nasdaq, NYSE Sue SEC to Block Market Data Overhaul, Wall St. J. (Feb. 9, 2021, 8:07 PM), https://www.wsj.com/articles/nasdaq-sues-sec-to-block-market-data-overhaul-11612909321. ↩

  35. Press Release, Sec. & Exch. Comm’n, SEC Adopts Rules to Modernize Key Market Infrastructure Responsible for Collecting, Consolidating, and Disseminating Equity Market Data, (Dec. 9, 2020), https://www.sec.gov/news/press-release/2020-311. ↩

  36. Market Data Infrastructure, 85 Fed. Reg. 16726, 16729 (Mar. 24, 2020) (to be codified at 17 C.F.R. pt. 200, 242, 249). ↩

  37. Id. at 16728-29. ↩

  38. See Dave Michaels & Alexander Osipovich, SEC, Justice Department to Scrutinize Exchanges’ Market Data Business, Wall St. J. (June 22, 2020, 9:30 PM), https://www.wsj.com/articles/sec-justice-department-to-scrutinize-exchanges-market-data-business-11592864481. ↩

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