On March 6, 2018, the United States Securities and Exchange Commission (“SEC”) instituted a settled administrative proceeding against the New York Stock Exchange (“NYSE”), and affiliated national exchanges NYSE American LLC (“American”) and NYSE Arca, Inc. (“Arca”), for allegedly misrepresenting stock prices as “automated,” applying price collars when there was no rule permitting them, failing to maintain sufficient disaster recovery policies, and other conduct in violation of various sections of the Securities Act of 1933 (“Securities Act”), the Securities Exchange Act of 1934 (“Exchange Act”), and various regulations thereunder. This administrative proceeding arose from five separate SEC investigations and culminated in a $14 million fine against the exchanges. See In the Matter of New York Stock Exchange LLC, et al., Admin. Proc. No. 3-18388 (Mar. 6, 2018); see also Press Release, NYSE to Pay $14 Million Penalty for Multiple Violations, Rel. No. 2018-31 (Mar. 6, 2018), https://www.sec.gov/news/press-release/2018-31.
NYSE, American, and Arca are national securities exchanges registered under Section 6 of the Exchange Act. Although the exchanges are considered self-regulating, they nevertheless must file any proposed rule changes with the SEC for approval and must comply with the Securities Act, Exchange Act, and the regulations thereunder. See 15 U.S.C. §§ 19(b) & (g). In particular, Regulation SCI, promulgated under the Exchange Act, requires national exchanges to maintain disaster recovery plans that provide for next-business-day resumption of trading and two-hour resumption of critical systems following wide-scale disruptions. See 17 C.F.R. § 242.1001(a).
According to the SEC, NYSE and American experienced escalating connectivity problems between their trading units and their customers on July 8, 2015, which eventually prevented customers from accessing quotations in a majority of symbols traded on the exchanges. Even though these connectivity problems meant that the impaired quotations were no longer automated, NYSE and American allegedly continued to represent that the quotations were automated, which the SEC concluded constituted a violation of Section 17(a)(2) of the Securities Act.
Separately, the SEC alleged that on August 24, 2015, during unusual market volatility in exchange-traded products, Arca applied price collars to “reopening auctions” that were conducted to resume trading after so-called Limit-Up/Limit-Down (“LULD”) trading pauses. LULD pauses are designed to address market volatility by preventing trades in stocks from occurring outside specified price bands, which are set at a percentage level above and below a specified reference point (usually, the average price of reported transactions over a short period before the LULD pause). Reopening auctions are used to resume trading after the LULD pause is lifted. Yet, by implementing a collar during the reopening auctions on August 24, 2015, Arca caused an imbalance in supply and demand, which the SEC alleged led to additional LULD pauses. The SEC contended that Arca’s price collars “should have been the subject of an effective exchange rule.” Since Arca did not include the collars in its rules, the SEC alleged that Arca violated Section 19(g)(1) of the Exchange Act, which requires national securities exchanges to abide by their own rules. See 15 U.S.C. § 78s(g)(1).
Finally, the SEC contended that, in 2015 and 2016, NYSE and American’s disaster recovery plans were insufficient to comply with the requirements in Regulation SCI. NYSE and American’s plans allegedly relied wholly upon Arca’s backup systems in the event of a wide-scale systems disruption. According to the SEC, under those plans, the Arca backup platform would perform the opening and closing auction for NYSE and American, and would also send all intraday primary market regulatory messages. The SEC found that this was insufficient to comply with the requirements in Regulation SCI that national exchanges have policies reasonably designed to ensure that their systems are sufficiently resilient and secure. See 17 C.F.R. §§ 242.1001(a). In particular, the SEC noted that reliance on Arca’s backup platform effectively meant that all NYSE and American intraday trades would be labeled as Arca trades and would occur pursuant to Arca rules. The SEC noted that this plan was insufficient, among other things, to ensure two-hour resumption of critical systems and next-business-day resumption of trading.
The SEC’s administrative proceeding against the exchanges is notable not only for the high fines levied on national exchanges, but because it is the first-ever charged violation of Regulation SCI. In a press release, Co-Director of the SEC’s Division of Enforcement Stephanie Avakian emphasized this, saying “[f]or retail investors to have confidence in our markets, exchanges must provide accurate information and comply with legal requirements, including being equipped for unexpected market disruptions.” The SEC also appears to have been influenced by the exchanges’ alleged violation of an earlier order prohibiting violations of Section 19 of the Exchange Act, among other things. See In the Matter of New York Stock Exchange, et al., Admin. Proc. No. 3-15860 (May 1, 2014). According to the SEC, the “violation of the prior SEC order was a significant factor in assessing the civil penalties in this matter.”