By John M. Jascob, J.D., LL.M.
In oral argument before the D.C. Circuit Court of Appeals, several national exchanges and the SEC debated the Commission’s statutory authority to adopt a rule creating a transaction fee pilot for national market system (NMS) stocks. The NYSE Group, Nasdaq, and Cboe Global Markets have all challenged the legality of the controversial pilot, which is designed to study NMS stocks and the effects that exchange transaction fee and rebate pricing models may have on order routing behavior, execution quality, and general market quality (New York Stock Exchange LLC v. SEC, October 11, 2019).
Created under New Rule 610T of Regulation NMS, the pilot subjects exchange transaction-fee pricing, including "maker-taker" fee-and-rebate pricing models, to new temporary pricing restrictions across three test groups. The pilot, which will last for a maximum of two years with a potential one-year sunset period, applies to all NMS stocks and includes all equities exchanges.
“Reckless experiment.” Arguing on behalf of the NYSE exchanges, Thomas G. Hungar of Gibson, Dunn & Crutcher asserted that the SEC has created an "exogenous shock" to the securities market that threatens to harm investors, reduce liquidity, and unfairly tilt the competitive playing field in a way that harms exchanges and benefits off-exchange, dark venues without advancing any of the objectives of the Exchange Act. Hungar stated that the SEC did not even find that its new rule will do more good than harm, nor did it conclude that the information that it hopes to obtain from the "reckless experiment" will actually benefit investors, strengthen the market, or promote the purposes of the Exchange Act. In the exchanges’ view, the Commission is acting like a doctor who is subjecting his patient to risky open-heart surgery without first using all the available diagnostic tools to find out whether there's anything wrong and without knowing whether anything good will come of the risky experiment.
Noting that the purpose of the new rule is to gather data, Judge Edwards asked whether the exchanges were contending that this was an impermissible purpose under the Administrative Procedure Act (APA). Hungar responded “no,” provided that the agency is able to engage in an experiment that it predicts, based on the record, will reasonably further the Exchange Act. Although a pilot program is not prohibited just because an agency has not been given explicit statutory authority, the Exchange Act does not give SEC a free pass to evade the requirements of the APA, Hungar stated. Moreover, Exchange Act Section 11(a) requires the Commission to find that the rule will carry out the objectives specified by Congress.
Returning to Hungar’s medical analogy, Judge Edwards observed that sometimes the best we can do is exploratory surgery because we are not precisely sure, so we need to take a look. Judge Pillard noted that the exchanges appear to be faulting the SEC for its neutrality on the question of whether the maker-taker system is harmful to the markets and investors. Why, she asked, would pushing the SEC off this position make the agency more in compliance with its statutory obligations? Hungar replied that the fact that the Commission thinks there is a question does not allow it to issue rules that threaten harm to the markets it is supposed to protect. Agencies don't have to predict with certainty, but they do have to predict that it is more likely than not that the rule will do good.
Answering an abstract question that does not achieve any of the objectives of the Exchange Act is not permissible, Hungar continued. And even conceding that the Commission can issue rules that threaten the market, the SEC has not exhausted all alternatives. Although the Commission claims that it lacks data, the SEC has comprehensive authority to demand that information from brokers at its whim, Hungar asserted.
Hungar cited the Albuquerque Study, which found that $6 billion in investor losses resulted from the SEC’s tick size pilot alone. The exchanges believe that the losses to investors from this pilot will be 10 times as great. Moreover, the SEC has no experimental exception under the statute, Hungar contended. If the SEC is permitted to go forward, then a huge truck will be driven through the APA because a new rule will always provide more information about how that rule affects the regulated markets.
SEC’s response. Arguing on behalf of the SEC, Tracey A. Hardin began by stating that the SEC specifically concluded in its adopting release that gathering the necessary data in the pilot would further the purposes of the Exchange Act. Hardin observed that the statute gives the Commission a continuing regulatory responsibility to ensure the efficient operation of the national market system. Here, the SEC is faced with a credible case on both sides of the question of whether the existing fee structure is causing market distortions. Forbidding the rule creating the pilot would put the SEC in a Catch-22 situation where it cannot gather the data needed to determine whether there is market distortion because it does not have the data.
The SEC believes that this informational benefit will further the public interest, Hardin stated. Moreover, there is a regulatory need for this information because there is a fundamental question of whether the status quo is causing market distortions. Although information-gathering is not one of the listed objectives of Exchange Act Section 11(a), engaging in data-driven decision-making is well within the purposes of the Act, Hardin said, and is something which the court itself has indicated that the Commission should be striving to do.
Regarding the availability of other data sources, Hardin said that the Commission specifically went through the existing sources and concluded that ultimately none of the data would reach the question of causality. The pilot is reasonably designed to get to the causality question because fees and rebates and order routing can be jointly determined. Without holding one of those factors constant. Hardin stated, one cannot really know what the causational factor is.
Observing that there are already markets that do not use the maker-taker model, Judge Pillard asked why those markets are not being used as sources of data. Hardin answered that as long as rebates are being paid at other exchanges, this data will not tell us what will happen if no exchange pays rebates. For example, the data will not you tell the effect on spreads across different classes of securities if rebate-sensitive orders can just go next door to another NYSE-sponsored exchange that pays rebates. Many execution-quality questions cannot be answered as long as you have most exchanges paying rebates, Hardin stated.
Regarding the exclusion from the pilot of off-exchange data, Hardin argued that existing data will allow the SEC to track order flow both on- and off-exchange. This is the important question for purposes of this pilot because off-exchange venues are not part of the regulatory scheme that is being tested. For example, they do not charge transaction-based fees and typically do not pay rebates, so none of the other questions the Commission is asking concerning the appropriate regulatory structure for transaction-based fees really apply off-exchange. The pertinent question, Hardin said, is whether the on-exchange regulatory scheme shifts order flow back or forth off-exchange, which is something the SEC can track with existing data. Including off-exchange data would have greatly expanded the scope and cost of the pilot, Hardin concluded.
The case is No. 19-1042.