The SEC must generally approve rules and rule changes by self-regulatory organizations, which are referred to as SROs. According to this SEC web page, there are 37 active SROs. The volume of rule filings submitted for approval is high. In 2016, the NYSE alone made 91 rule filings. Whether or not you agree with the result, the SEC takes this responsibility seriously, as demonstrated by its denial of two proposed bitcoin exchange traded funds.

But a recent decision by the United States Court of Appeals for the District of Columbia Circuit paints a different picture. Susquehanna International Group, LLP, et al., v. SEC involved a rule change by the Option Clearing Corporation to permit the OCC to increase its capital. Two nonshareholder exchanges and a market participant sought judicial review of the SEC’s approval of the rule. Reviewing the rule under the Administrative Procedure Act, the Court found the SEC’s approval was arbitrary and capricious, unsupported by substantial evidence, and otherwise not in accordance with law.

The primary reason the Court gave for reaching its conclusion was the SEC effectively abdicated its responsibilities under the Administrative Procedure Act to the OCC. According to the Court, the SEC’s approval order reflects little or no evidence of the basis for the OCC’s own determinations — and few indications that the SEC even knew what that evidence was.

For example, the Court noted:

The Order’s shortcomings are apparent in its discussion of whether the Plan pays dividends to shareholder exchanges at a reasonable rate. That is a central issue: if the dividend rate represents an unnecessary windfall for shareholders, as Petitioners argue, then the Plan may run afoul of the Exchange Act’s prohibitions by unnecessarily or inappropriately burdening competition, harming the interests of investors and the public, or unfairly discriminating against nonshareholders and clearing members . . . The SEC found that the Plan heeds those statutory prohibitions because the dividends represent a reasonable return on the shareholders’ capital contribution . . .

Why did the SEC find the return reasonable? The Order says only that the Plan is “designed to set the dividends . . . at a level that [OCC’s] Board, with the assistance of independent outside financial experts, has determined to be reasonable for the cost and risks associated” with the shareholders’ obligations . . .

That explanation raises more questions than it answers. Who were those independent experts? How does the SEC know they were independent? What analysis did they and OCC’s Board perform? How did they measure the “level” of the dividends? How did they measure the “cost and risks”? And how did they determine that the dividend level was reasonable for the associated cost and risks? The Order is silent on all counts. Instead, the SEC candidly admits that it simply “rel[ied] on the Board’s analysis” of “the rate of return the Stockholder Exchanges were receiving for their capital investment” . . . That is, to decide whether the dividend level was reasonable, the SEC took OCC’s word for it.

While perhaps the OCC’s plan merited more scrutiny by the SEC, if the decision is carried to extremes it could have a negative effect on the ability of the SEC to approve SRO rules. Must the SEC independently verify every aspect of a proposed rule change, many of which are routine? The inability of the SEC to approve rule changes in a timely manner could impair the efficient conduct of an SRO’s business, stifle innovative technologies, and impair capital formation and investor protection.