Self-regulatory organizations (SROs) play an enormous role in financial markets. The Financial Industry Regulatory Authority (FINRA) oversees the brokerage industry, while the National Futures Association (NFA) covers the futures markets. Securities clearing firms, derivatives clearinghouses, the Municipal Securities Rulemaking Board (MSRB), and exchanges, such as the New York Stock Exchange (NYSE), are all SROs. Modern markets would collapse if SROs were suddenly unable to play their critical roles.
While we often think about systemic risk emerging from within the financial system or from some regulatory or legislative mistake, the post-Trump era Supreme Court also poses systemic risk to markets. If a Supreme Court decision suddenly invalidates some critical SRO or SRO rule, financial markets could collapse, either from the lack of critical market infrastructure or from legal uncertainty.
Even though this risk might have once seemed unlikely, changes to the Supreme Court’s composition and evolving constitutional doctrines now mean that SROs face significant risk from judicial scrutiny. Once-moribund constitutional doctrines have resurged under the current Supreme Court, effectively changing the risk landscape for SROs.
This is not to say that the Supreme Court would intend to touch off a financial crisis. Rather, extending current lines of precedent runs the risk of making SROs untenable. The Supreme Court may even attempt to take what it sees as a modest step by invalidating a single SRO rule. Yet depending on the SRO rule at issue, judicial intervention could still trigger a cascade of consequences. Consider the impact from a Supreme Court decision invalidating some MSRB rule and creating uncertainty about municipal bond offerings. If many financial institutions suspended municipal bond offerings to resolve uncertainty, a restriction in municipal debt offerings could lead to layoffs, defaults, and correlated insurance and derivatives payouts.
Even a small risk of a judicially induced financial crisis must be managed because the potential economic consequences loom so large. Given the scale of the possible consequences, modest interventions aimed at reducing the likelihood of a sudden disruption in SRO functioning appear justified.
Modern SROs Play Vital Roles
Understanding how SROs have evolved from their origins as private clubs to de facto arms of federal law enforcement helps illuminate the risk they now face from evolving Constitutional law. Critically, modern SROs differ significantly from the private clubs Congress co-opted with the 1934 Securities and Exchange Act.
SROs serve as the primary beat cops in nonbank financial regulation. At their current resource levels, federal regulators simply could not oversee markets without SROs standing ready on the front lines. SROs police their own members, but they also enforce federal law. Without them, much federal law enforcement would disappear from financial markets.
Yet SROs occupy an uneasy place within the U.S. constitutional framework. Courts have classified them as “private-sector” regulators while also affording them absolute immunity when exercising their regulatory functions. In most instances, SROs have been able to act to police members and oversee markets without being bound by the constitutional restraints that apply to ordinary branches of government. This means that SROs have not been required to provide due process or protection against self-incrimination when enforcing their rules, or federal law.
At the same time, federal law gives SROs their power. Federal law requires industry members to join SROs. It allows SROs to govern entire industries because lawfully operating within the industry requires being a member of an SRO. This gives SROs extraordinary powers to demand answers and information from enforcement targets. Anyone who refuses to comply and cooperate with an SRO may be summarily expelled from the industry.
SROs now enforce vague rules that would likely be deemed unenforceable if promulgated by traditional regulatory agencies. Notably, FINRA requires its members to “observe high standards of commercial honor and just and equitable principles of trade.” These types of vague rules have been lauded as serving useful purposes because they allow SROs to capture objectionable conduct without needing to incur significant costs in attempting to precisely define impermissible conduct.
At the same time, SRO rules may not be entirely their own. The Securities and Exchange Commission (SEC) has possessed the power to enact and modify rules from SROs under its jurisdiction since the 1970s. If the SEC were to formally inscribe its preferred rules into an SRO’s rulebook, the statute even goes so far as to say that SEC-written rules would be “considered for all purposes of this chapter to be part of the rules of” the SRO.
This power raises real constitutional questions. Could the SEC shed its constitutional restraints by compelling an SRO to change its rules to do something that the SEC could not? The existence of this power also means that SRO rules are today enacted against the backdrop of the SEC’s power to modify SRO rules. SEC officials may be able to drive SROs to enact their preferred rules through informal requests.
Taken collectively, these changes have drawn SROs much closer to government and created a largely symbiotic relationship between the SROs and their federal overseers. Old lines of precedent treating SROs as private organizations may not apply with as much force today because the fundamental relationship between SROs and federal regulators has shifted.
Changing Constitutional Doctrines Put SROs at Risk
SROs have not been the only bodies to shift over time. The current Supreme Court has been transformed by Trump-era appointments. In a series of decisions, the Supreme Court has shown concern for preserving the President’s power to ensure the faithful execution of the laws. This may create problems for SROs because their leadership is ordinarily selected without any government appointments. At least four doctrines should be monitored for risks to SROs: (A) nondelegation doctrine; (B) separation of powers doctrine; (C) Appointments Clause doctrine; and (D) State Action doctrine.
A. Nondelegation Doctrines
Most of the current Supreme Court has recently signaled an interest in reconsidering nondelegation doctrine. Although hot disputes exist over the extent and even existence of the doctrine, it may be broadly defined: nondelegation doctrine draws a line between what Congress may permissibly delegate. A revitalized nondelegation doctrine poses a significant threat to the scope of the administrative state because it may substantially narrow Congress’s ability to delegate issues to regulatory agencies.
Similarly, the private nondelegation doctrine limits Congress’s ability to delegate federal power to private organizations. While this doctrine now seemingly only requires a degree of federal supervision, a Supreme Court concerned with excessive delegation may require more.
B. Separation of Powers
The Supreme Court has issued a string of recent decisions on separation of powers grounds. Much of the existing analysis begins with Free Enterprise Fund, a critical Supreme Court case where Chief Justice Roberts declared for-cause removal protections for members of the Public Company Accounting Oversight Board (PCAOB) unconstitutional. The court has changed significantly since that time and new decisions have extended its reasoning. For example, this June, in Collins v. Yellin, the Supreme Court invalidated removal protections for the head of the Federal Housing Finance Agency (FHFA). In the majority opinion, Justice Alito swiftly rejected a string of attempts to distinguish the FHFA from the PCAOB, including a proposed distinction pointing out how the FHFA operates as a private entity when it acts as a receiver. Justice Alito rejected the proposed distinction because the FHFA must still interpret and apply federal law. As SROs now enforce and necessarily interpret and apply federal law, they may be increasingly vulnerable to challenge.
C. Appointments Clause
The Supreme Court has also shown a renewed interest in the Appointments Clause with recent decisions on SEC-Staff appointed administrative law judges, and patent administrative law judges. One lesson to draw from these precedents may be that the Supreme Court may require some line of authority to the President. This poses a potential problem for SROs because they ordinarily select their own leadership without any direct government appointments.
D. State Action Doctrine
State Action doctrine has long been a concern for SROs. Thus far, they have largely succeeded at being treated as private-sector regulators. If SROs are deemed state actors, they may face a host of new constitutional challenges.
Given the risks faced by SROs, planning for how to deal with the risk of an adverse judicial decision should begin now, and not when the Supreme Court interferes with some financial market utility or key rule. At the very least, SROs should begin to include the risk of an adverse Supreme Court decision in their contingency planning. Having thought through how to respond to these types of events will decrease the chance that a slow response will impact markets. The judicial landscape should also be surveilled for risks so that a sudden decision will not catch SROs and regulators by surprise.
Congress may want to take notice of the risk and enact contingency statutes. Granting statutory authority ahead of time for federal regulators to nationalize or take over SRO responsibilities in the event of an adverse judicial decision will do much good. Markets will likely suffer much less damage if federal regulators swiftly assume control instead of needing to wait for a Congressional fix.
Structural options to mitigate risk also warrant consideration. This may mean either shifting SROs back toward their private club origins or more fully drawing them into government. Leaving them in their awkward middle ground seems likely to draw eventual judicial intervention.
Benjamin Edwards is an Associate Professor of Law at the University of Nevada, Las Vegas, William S. Boyd School of Law.
This post is based on his article, “Supreme Risk” available on SSRN.