The Changing Regulatory Role of the SROs

Self regulatory organizations play an important role with respect to corporate governance.  Primarily through the mechanism of listing standards, they impose a number of requirements on pubic companies, whether the need for certain board committees or the requirement that a majority of the board consist of independent directors.

The main SROs in the governance area are the NYSE, Nasdaq, and FINRA.  The NYSE and Nasdaq are "for profit" organizations, while FINRA is a Delaware non-profit.  The structure matters.  As for profit companies, the two exchanges have both a legal duty to profit maximize on behalf of shareholders and a legal duty to protect the securities markets, primarily by enforcing listing standards and other legal requirements. 

We note this in part because the courts are having to wrestle with the consequence of the change in status of the SROs.  Courts have traditionally given SROs immunity for actions taken as part of their regulatory function.  See California Public Employees' Retirement System v. NYSE, 503 F.3d 89 (2nd Cir. 2007) (written by Judge Sotomayor).  In the pre-profit maximization era, most of what the SROs did was regulatory.  As a result, the approach translated into a complete immunity from private law suits. 

With the advent of for profit activity, however, the two exchanges are more likely to engage in activity designed to promote commercial rather than regulatory activity.  The result has been a greater struggle by the courts to decide when immunity applies and when it does not.  Thus in Weissman v. NASD, 500 F.3d 1293 (11th Cir. 2007) (en banc) (a case involving activity by Nasdaq, then owned by the NASD), the court allowed a case against an SRO to go forward. 

All of this brings us to Standard Investment Chartered v. NASD, 637 F.3d 112 (2nd Cir. 2011).  The case arose out of the merger between the NASD and the broker-dealer regulatory function of the NYSE.  Plaintiff challenged the proxy solicitation involving a bylaw amendment.  The change was necessarily to effectuate the merger.

The court noted that the merger was a regulatory function and entitled to immunity.  The proxy solicitation, however, was "incidental" to the regulatory function. As the court reasoned:

• The question confronting the court, however, was whether the proxy solicitation regarding amendments to the bylaws, which was incident to the consolidation, also constituted an exercise of NASD's regulatory function. On this point, the district court explained that, "[a]lthough the shareholder vote for which the proxy statement  was issued did not constitute a vote on the regulatory consolidation itself, the approval of the by-law amendments was not only a necessary prerequisite to the completion of that consolidation, but also was promoted as such in the proxy itself." Id. The district court further noted that "amendment of the by-laws itself falls within the parameters of NASD's statutory rule-making authority." Accordingly, as the district court correctly concluded, the proxy solicitation, which was the only vehicle available to NASD for amending its bylaws, was plainly "incident to the exercise of regulatory power," sand therefore an activity to which immunity attached.

The court emphasized that regulatory role of the SEC in the process.

• We also believe that it is significant that  NASD cannot alter its bylaws without approval from the SEC, that the SEC is authorized to develop its own procedure for receiving input on new rules from those affected by any proposed changes, . . . and that the SEC retains discretion to amend the rules of any SRO, . . . The statutory and regulatory framework highlights to us the extent to which an SRO's bylaws are intimately intertwined with the regulatory powers delegated to SROs by the SEC and underscore our conviction that immunity attaches to the proxy solicitation here.

While the court emphasized the broad role of the Commission, the test itself ("incident to the exercise of regulatory power") did not seem to require it.  Thus, the court's analysis was narrow but the test actually adopted was very broad.  The test will make it even more difficult for courts to separate regulatory from non-regulatory actions. 

The Supreme Court may get an opportunity to weigh in on the matter.  Plaintiffs in the case have filed for cert.  The issue is:

• Are SROs entitled to absolute immunity for unlawful conduct that is ‘‘incident to’’ their regulatory powers but does not involve performance of any regulatory duty on behalf of the government.

Whether or not the Court takes the case, the issue will continue to surface.  It may well provide another reason why some of the SROs (the stock exchanges, for example), ought to reconsider their role as regulators.