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Monday
Jun072010

The Declining Regulatory Role of the Stock Exchanges 

The NYSE is a for profit public company.  It has had that status since 2006.  See Exchange Act Release No. 53382 (Feb. 27, 2006).  As with all for profit corporations, the board has traditional fiduciary obligations that require it to act in the best interests of shareholders and to maximize profits.  At the same time, however, the NYSE retains a regulatory function.  At the moment of demutalization, the Exchange was responsible for broker-dealer oversight, surveillance, and listing standards, among other things.

The need to profit maximize potentially conflicts with the regulatory function.  Delisting a company or evicting a broker might adversely affect profits.  Both the SEC and the NYSE were aware of this tension at the time of demutalization.  One possibility would have been to remove all regulatory functions from the exchange, perhaps transferring them to the SEC or another self regulatory model.  Some countries have done this.  The other possibility, and the one ultimately selected, was the retnetion of regulatory responsibilities but with creation of a separate body within the NYSE designed to insulate the function from the profit making motives of the holding company. 

This was done through the creation of NYSE Regulation, a New York non-proft.  Although a subsidiary, , all directors on NYSE Regulation must be "independent" of the holding company's management.  While directors of the holding company can sit on the NYSE Regulate board, they must remain a minority of the board.  (Two of the eight directors of NYSE Regulation are also directors on the holding company).  The CEO of NYSE Regulation reports only to that board.  These requirements are ensconced in the bylaws of NYSE Regulation. 

Despite these prophylactic measures, some commentators at the time of demutalization remained concerned that the for-profit structure was inconsistent with regulatory functions.  A commentator raised concern about funding, questioning "whether NYSE Regulation will have to generate sufficient sanctions and penalties to fund its own operations, or, alternatively, whether NYSE Group and New York Stock Exchange LLC will be willing to adequately fund NYSE Regulation's expenses without regard to the impact on NYSE Group's 'bottom line.'"  Exchange Act Release No. 53382 (Feb. 27, 2006).

Nonetheless, the Commission allowed the NYSE to retain its regulatory function.  Since then, however, the NYSE has given up its regulatory functions at a rapid pace.  The merger between the NASD and the NYSE broker-dealer oversight function saw the consolidation of member regulation in the hands of FINRA.  See Exchange Act Release No.  56148 (July 26, 2007).  The transaction left the NYSE with some modest broker-dealer oversight responsibilities (mostly enforcement of NYSE only rules), surveillance responsibilities, and oversight of listing standards.  See Id. n. 13 ("Following the closing of the Transaction, NYSE Regulation will continue to oversee market surveillance and listed company compliance at the NYSE and NYSE Arca."). 

The next shoe to drop was the transfer of surveillance functions to FINRA.  In a press release dated May 4. 2010, FINRA and the NYSE announced that FINRA would assume "responsibility for performing the market surveillance and enforcement functions currently conducted by NYSE Regulation."  There was a compelling logic to the decision.  With much of the trading of NYSE stocks taking place off the exchange, surveillance by the NYSE of its own activities was capturing less and less of the market.

Nonetheless, the reality is that the latest transfer (once approved by the Commission) leaves that NYSE with only one significant regulatory function:  Listing standards.  Listing standards are critical components of the governance process.  Indeed, the market reforms likely to emerge from Congress will continue to use listing standards as a way of strengthening governance, particularly with respect to compensation committees of the board.

The time has come to reconsider whether the NYSE ought to spin off this remaining regulatory function.   How might that come to pass?  Perhaps the functions could be transferred to the Commission.  Indeed, this process is already underway.  In the financial reform legislation, the Commission is largely given the authority to define critical terms such as independent director (for the compensation committee) and independent compensation consultant.  In other words, listing standards will increasingly be written not by the NYSE but by the Commission.

The NYSE is a for profit company.  It deserves to engage in profit making activities without the constraints of regulatory obligations that can conflict with this goal.  

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