Wednesday, June 17, 2020

Court vacates SEC’s NMS transaction fee pilot

By Anne Sherry, J.D.

The D.C. Circuit Court of Appeals struck down an SEC pilot program to randomly assign certain stocks into test groups with different fee and rebate structures. Agreeing with the exchanges that challenged the program, the court said that the Commission exceeded its statutory authority by instituting the test merely to “shock the market” to determine whether additional regulation was needed. One concurring judge wrote that while the SEC needed to do more to stake a position on why there is a problem and how the rule would help address it, the agency does have the authority to conduct experimental pilots even without specific authorization from Congress (New York Stock Exchange LLC v. SEC, June 16, 2020, Edwards, H.).

Rule 610T. The SEC adopted the transaction fee pilot on December 19, 2018, 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. Created under New Rule 610T of Regulation NMS, the pilot intended to subject exchange transaction-fee pricing, including "maker-taker" fee-and-rebate pricing models, to new temporary pricing restrictions across three test groups. The pilot would have lasted for a maximum of two years with a potential one-year sunset period and applied to all NMS stocks and equities exchanges. Absent the pilot program, exchanges are subject to a $0.0030 per share fee cap on orders against a protected quotation.

SEC lacked delegated authority. Applying an analysis under Chevron (U.S. 1984), the court granted the petitions for review filed by the NYSE and other exchanges. Step one of Chevron is to decide “whether Congress has directly spoken to the precise question at issue.” The SEC allowed that it lacked express authority to adopt Rule 610T but argued that it had implied authority under the Exchange Act and was entitled to deference under step two. However, the court reasoned that step two does not come into play if the agency acted in excess of its statutory authority. Nothing in the Exchange Act authorizes such an “aimless, one-off” regulation that imposes costs and burdens just to gather data to identify if there is a problem that needs fixing. Furthermore, Exchange Act Section 23 prohibits the SEC from adopting a rule “that would impose a burden on competition not necessary or appropriate in furtherance of [the Act’s] purposes.” The SEC never made a determination that the regulatory requirements of the pilot program—as distinguished from the goal of data collection—were necessary or appropriate to maintain fair and orderly markets.

The appeals court stressed repeatedly that the pilot is a “one-off” regulation designed to gather data. “Normally, unless an agency’s authorizing statute says otherwise, an agency regulation must be designed to address identified problems,” the court wrote. The pilot program lacked support from any regulatory agenda describing the problems it was meant to address. While the SEC identified maker-taker fees and rebates as a subject of disagreement among stakeholders, it did not take a side in those debates, identify any shortcomings in existing rules, or propose rules that might address any perceived problems. The transaction fee pilot, instead, was intended to shock the market to collect data so that the SEC could consider whether regulation was necessary. “This was an unprecedented action that clearly exceeded the SEC’s authority under the Exchange Act,” the court wrote. In contrast, the SEC’s tick size pilot program was also an experimental rule, but it followed from a Congressional command to study the impacts of the tick size.

The SEC relied heavily on a 1973 Supreme Court opinion, Mourning, to support its argument that the pilot was permissible because it was “reasonably related” to the purposes of the SEC’s enabling legislation. But Michigan v. EPA, decided after Mourning, makes clear that a “necessary or appropriate” provision in an enabling statute does not necessarily empower the agency to make rules that are not otherwise authorized. Another Supreme Court opinion indicates that the “reasonably related” language in Mourning means little post-Chevron. Instead, Mourning applies only when the court determines that Congress did delegate authority for the agency action. Here, the SEC lacked that delegated authority.

Concurrence. While the tone of the majority opinion is that the SEC was clearly in the wrong—it even quotes from the petitioners’ brief in whole to illustrate the problems with the pilot—concurring Judge Pillard wrote separately to say that it was a close case. The SEC does have statutory authority to engage in experimental action and has a history of conducting pilot programs even without congressional action. The problem here is that the agency also must evaluate whether the burdens of the rule are necessary and appropriate, which it did not do. Despite nearly 10 years of studying the issue, the SEC failed to take a side and, moreover, devoted only three lines of its 104-page rule to identifying the problem that the pilot program was supposed to resolve.

The SEC also made no assessment of whether the fee structure or its effects are harming investors. Even if it lacks evidence to that point, the Commission still needs a basis for action that is consistent with its mandate. Judge Pillard suggests that on remand the SEC “must stake a position that there is a problem within its regulatory ambit that it has sufficient reason to think exists and that—at least without contrary evidence accessible through its planned informational intervention—it has grounds to believe continuing the status quo will do more harm than good.”

The case is No. 19-1042.