Originally prepared by Deepa Sarkar of the Cornell Law School Securities Law Clinic.
Self Regulatory Organization (SRO)
Although the Securities Exchange Act of 1934 ("Exchange Act") lays out a comprehensive registration process and reporting scheme, the Act itself makes it clear that the Securities and Exchange Commission ("SEC") is not single-handedly ensuring industry compliance. All securities exchanges must register with the SEC under Section 5 of the Exchange Act. Section 6 then 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. However, Congress was well aware that leaving the complete substance of stock exchange rules up to the discretion the stock exchanges presented the classic problem of the fox guarding the chicken coop., and could result less-than-vigilant regulation. Thus, Section 6 of the Exchange Act prescribes the standards and regulatory objectives that security exchange (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 principals of trade", as well as provide for disciplinary actions against of exchange members who violate federal securities law. SRO rules also address fee structures, or the way that brokers can be compensated for their services.
Although brief, Section 6 gives the securities industry the substantial responsibility of supervising itself under the SEC's watchful eye. These provisions provide for up-front regulation by the SEC, which establishing the goals and targets of regulation by prescribing the content of SRO rules. The SEC also regulates at the back end, by ensuring the exchanges fulfill their statutory duties to enforce the rules and monitor their members. However, the actual process of rulemaking and enforcement against members is left up the securities exchanges. The SEC has the power to ensure that the exchanges fulfill their regulatory responsibilities on an ongoing basis. Under Section 19, 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 a SRO takes, it is rare for the SEC to reverse SRO disciplinary actions. In addition, Section 19 of the Exchange Act requires securities exchanges to get SEC approval for any rule changes, with the SEC retaining the right to disapprove 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, and 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 (securities traded outside of an exchange) if they are members of a registered securities association (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 means that, in reality, almost all broker-dealers must 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 the 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 the statutory power to review disciplinary actions, it rarely overturns those decisions.
Until very recently, securities exchanges each constituted SROs, with the New York Stock Exchange (NYSE) being the largest and most well-known. In contrast, the sole securities association registered with the SEC was the National Association of Securities Dealers (NASD). However, 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 hope was that combining the regulatory operations of the two SROs would create a single, more efficient regulatory body that both saved costs for members and more effectively protected investors. The rules from each SRO are currently in the process of being harmonized. FINRA also provides a single forum where investors can seek arbitration for claims that they have against broker-dealer firms and their employees.