Although the Securities Exchange Act of 1934 ("Exchange Act") lays out a comprehensive registration process and reporting scheme, the Act makes it clear that the Securities and Exchange Commission ("SEC") does not single-handedly ensure industry compliance. All securities exchanges must register with the SEC under Section 5 of the Exchange Act. Section 6 lays out the requirements for registration, including a requirement that all exchanges adopt a regulatory regime for their members, in the form of exchange rules.
Every exchange has such a set of rules that apply to any market participant who trades on that stock exchange. Congress, however, realized that leaving the complete substance of stock exchange rules up to the discretion of the stock exchanges presented the classic problem of the “fox guarding the chicken coop,” which could result less-than-vigilant regulation. Thus, Section 6 of the Exchange Act prescribes the standards and regulatory objectives that security exchange (i.e. self regulatory organization, or SRO) rules should fulfill. Through the rulemaking process, SROs must establish standards to prevent fraud and market manipulation and promote "just and equitable principles of trade," as well as provide for disciplinary actions against exchange members who violate federal securities law. SRO rules also address fee structures for brokers.
Section 6 gives the securities industry substantial power to supervise itself under the SEC's watchful eye. This provision provides for upfront regulation by the SEC, which establishes the goals and targets of regulation by prescribing the content of SRO rules. The SEC also regulates at the back end to ensure that the exchanges fulfill their statutory duties in enforcing the rules and monitoring their members. The actual process of rulemaking and enforcement against members is left to the securities exchanges.
The SEC has the power to ensure that the exchanges fulfill their regulatory responsibilities on an ongoing basis. Under Section 19 of the Exchange Act, the SEC can take enforcement actions against SROs that violate rules of good practice and fail to police and discipline their members. Despite having the power to review any disciplinary actions that an SRO takes, the SEC rarely reverses SRO’s disciplinary actions. In addition, Section 19 requires securities exchanges to receive SEC approval for any rule changes. In contrast to disciplinary action, rulemaking by SROs is often treated with less deference by the SEC, reflecting the SEC's use of industry-wide standards to indirectly regulate SRO members. Deliberations on proposed rules take place through a public notice and comment period. Interested parties ranging from individual investors to large corporations comment on the desirability or language of a proposed rule or an amendment. The SEC and SRO may modify the rules accordingly.
In addition to securities exchanges, broker-dealer firms who must register under the Exchange Act can only transact in the over the counter market (i.e. securities traded outside of an exchange) if they are members of a registered securities association. (See Exchange Act §§ 5(b)(8) and 5(b)(9).) Given that the vast majority of securities are traded over-the-counter and that a securities association can require its members to trade only with other members, this provision effectively require almost all broker-dealers to register with a securities association. A securities association in turn must develop rules of conduct and good practices for its members and must discipline members for violations of its own rules and federal securities laws. A securities association's rules address ethical behavior and duties of brokers towards their clients. The rules also address more specific problems, such as behavior by brokers that results in market manipulation, such as trading on short term changes in price. Securities association rules also prohibit violations of duties to individual clients by recommending unsuitable investments, trading excessively in a customer's account, or trading without authorization from a customer. A securities association can take disciplinary actions against its members. Although the SEC has statutory power to review disciplinary actions, it rarely overturns those decisions.
Until recently, each securities exchange constituted an SRO. The New York Stock Exchange (NYSE) was the largest and most well-known. In contrast, the sole securities association registered with the SEC was the National Association of Securities Dealers (NASD). In July 2007, the SEC approved the merger of NASD and the regulatory operations of the NYSE to form the Financial Industry Regulatory Authority (FINRA). The goal was to create a single efficient regulatory body that saved costs for members and protected investors effectively by combining the regulatory operations of the two SROs. FINRA has undertaken a process to consolidate the rules from each SRO. FINRA also provides a single forum where investors can seek arbitration for claims that they have against broker-dealer firms and the firms’ employees.
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