On June 16, 2020, the U.S. Court of Appeals for the District of Columbia Circuit held that the Securities and Exchange Commission (“SEC”) lacks the authority to administer a two-year pilot program designed to review the fees and rebate structure used by U.S. stock exchanges.  As discussed in our previous article, major U.S. exchanges, such as New York Stock Exchange, CBOE,  Global Markets, and Nasdaq sought review to challenge the pilot program.  In New York Stock Exchange LLC  v. SEC, No. 19-1042 (D.C. Cir. Jun. 16, 2020), the Court sided with the exchanges, holding that the SEC exceeded its authority by creating a program whose thrust was merely to test whether the current pricing structure was problematic.

The program was launched in December 2018 when the SEC issued Rule 610T, whose objective was to analyze the effects of the “maker taker” and “taker maker” models used by domestic exchanges.  Under the “maker taker” model, exchanges pay rebates to “makers” of liquidity, essentially trading firms, that post an offer to buy or sell a security at a given price.  At the same time, the exchanges charge fees to “takers” of the liquidity—investment firms—that accept the maker’s offer.  The exchanges generate revenue by pocketing the difference between the fees they charge and the rebates they provide.

Conversely, other exchanges that utilize the “taker maker” model charge makers a fee and pay takers a rebate.  Under the Rule 610T pilot program, the SEC limited transaction fees and rebates for certain securities in order to ascertain if the restrictions would encourage broker-dealers to execute trades that best match their customer’s investment profile, and deter the pursuit of trades that paid smaller fees or earned rebates.  Further, the SEC sought to determine if listings would increase if the fees charged to access the exchange were lowered.

Despite the SEC’s legitimate intentions, the Court held the SEC cannot implement a rule merely to test whether the current system has flaws.  The Court characterized the SEC’s implementation of the program as “an unprecedented action that clearly exceeded the SEC’s authority under the Exchange Act.”  Further, the Court noted the SEC adopted the program without any regulatory agenda. The Court stated that the pilot program would impose disproportionate regulatory requirements on affected parties because the SEC was unsure if the current system actually created conflicts of interest for broker-dealers.  In the Court’s view, Rule 610T was not a response to a clearly identified problem but a tool to test the SEC’s unfounded suspicions about the current structure.  The Court required the SEC to consider other alternatives before it could implement Rule 610T.  Accordingly, the Court vacated the rule and ordered the SEC to conduct further proceedings consistent with the Court’s opinion.

Significantly, the Court did not address the specific requirements the SEC must meet before implementing a testing program  Nonetheless, the decision suggests that the SEC should, at a minimum, be prepared first to establish that a particular deficiency or problem exists so as to justify the need for regulatory action.