The Consequences of the NYSE-Deutsche Combination on Listing Standards (Regulatory Alternatives) (Part 8)

We are examining the combination between NYSE Euronext and Deutsche Borse.  The transaction will need to be approved by the SEC.  One way to avoid the SEC's oversight is for the NYSE to get out of the regulatory business.  Should this be considered?

It would certainly free the NYSE from an onerous level of SEC oversight.  The NYSE for example has mandatory limits on stock ownership and voting, restrictions that can't be changed without SEC approval. See Exchange Act Release No. 62032 (May 4, 2010) (“Specifically, no person (either alone or together with its related persons) is entitled to vote . . .  more than 10% of the then outstanding votes entitled to be cast on such matter. . . . In addition, no person (either alone or together with its related persons) may at any time beneficially own shares of stock of NYSE Euronext representing in the aggregate more than 20% of the then outstanding votes entitled to be cast on any matter.”).

Likewise the NYSE can't sell its own assets, at least those associated with the SROs, without SEC approval. See Exchange Act Release No. 53382 n. 64 (Feb. 27, 2006) (“In addition, pursuant to the Operating Agreement of New York Stock Exchange LLC, NYSE Group may not transfer or assign its interest in New York Stock Exchange LLC, in whole or part, to any entity, unless such transfer or assignment is filed with and approved by the Commission under Section 19 of the Act.").

Then there is the risk of liability.  NYSE-Euronext confronts the risk of controlling, aiding and abetting, and "a cause of" liability when the regulated entities fail to perform their regulatory function.  See Exchange Act Release No. 55293 (Feb. 14, 2007) (noting that controlling person of SROs "shall be jointly and severally liable with and to the same extent that the Exchange and NYSE Arca are liable under any provision of the Exchange Act, unless the controlling person acted in good faith and did not directly or indirectly induce the act or acts constituting the violation or cause of action" and also noting possibility of aiding and abetting liability and Commission's authority to bring cease and desist orders against those who are "a cause of" a violation).

This is more than an academic possibility.  The SEC has brought actions against the SROs for failing to adhere to their regulatory mission.  See In re New York Stock Exchange LLC, Exchange Act Release No. 60391 (July 28, 2009) (cease and desist order for "failure to properly detect, investigate and discipline widespread unlawful proprietary trading by specialists on the floor of the NYSE"). 

Removing the regulatory function from the NYSE would free the entity from these restrictions.  Moreover, this has already been occurring.  The NYSE gave up most of its control over broker-dealers in the merger with FINRA. Likewise, much of the surveillance function has been taken over by FINRA.  SeeExchange Act Release No. 56145 (July 26, 2007) (discussing combination of “member regulation operations” from NYSE Group and NASD “ into a single self-regulatory organization;” transaction involved transfer of “member firm regulation and enforcement functions and employees from NYSE Regulation” to FINRA).  See also Exchange Act Release No. 62032 (May 4, 2010) (“The Financial Industry Regulatory Authority ("FINRA") performs some of the regulatory functions contracted out to NYSER pursuant to a separate multi-party regulatory services agreement with FINRA. These regulatory contractual arrangements closely parallel the regulatory arrangements for NYSE Amex that the Commission reviewed and approved in the NYSE Amex Approval Order.").

The remaining duties are modest, with one exception.  NYSE Regulation has four groups, Listed Company Compliance, Regulatory Policy and Management, StockWatch, and Regulation Administration and, at the end of 2010, had only about 50 people.  See Form F-4, at 409.  The only significant function, therefore, is the oversight of listing standards.

Any change in the regulatory scheme would probably have to encompass one of two models.  First would be to give all regulatory responsibility to the Securities and Exchange of Commission (or FINRA).  To some degree, this process is already underway. 

In the realm of listing standards, Congress assigned to the Commission the authority to write rules governing listing requirements for audit and compensation committees of the board.  Moreover, with respect to independent directors, Congress essentially allowed the SEC to define the term with respect to compensation committees by identifying factors that must be considered by the exchange.  

Shifting complete control of listing standards to the Commission would, therefore, hasten a process already underway.  To the extent this continued, it could result in a slow, piece meal process that would gradually deprive the exchanges of the benefits of regulation (the ability to determine the standards) while leaving them with the disadvantages (the SEC's extensive regulatory oversight).

Alternatively, the regulatory function could be mostly, if not entirely, left with NYSE Regulation (and FINRA).  NYSE Regulation could, however, be made entirely independent of the NYSE.  NYSE Regulation would become self funding.  A mechanism would need to be determined for designating directors of NYSE Regulation.  One possibility, which was suggested back in 2006, was to have the SEC appoint directors.  See Exchange Act Release No. 53382 (Feb. 27, 2006) (“This model would require the Commission to appoint directly the members of the entity overseeing NYSE Regulation.”). 

Both of these shifts would probably require legislation.  Moreover, it would be unlikely to happen unless the NYSE supported the change.  It would only occur, therefore, if the NYSE viewed the costs of the regulatory role as outweighing the benefits. 

As a passing note, while the issue of regulatory responsibility has been discussed in the context of NYSE Euronext, the same analysis would apply to any stock exchange that exists as a for profit business, including Nasdaq.