Relational Enforcement of Stock Exchange Rules

Stock exchanges in the United States, most notably the New York Stock Exchange and Nasdaq, serve multiple roles at the same time. As regulators of their listed companies, they set various listing requirements, ranging from quantitative listing criteria (eg minimum trading price) to disclosure (eg timely filing of periodic reports) to corporate governance (eg majority independent board, mandatory board committees, and board diversity). Simultaneously, as for-profit corporate entities, major stock exchanges have been competing against each other to attract and retain more companies. This dual status of stock exchanges—as regulators and as profit-driven entities—brings into question the stock exchanges’ incentive to enforce their own rules against listed companies. Given this background, by examining original hand-collected data on 838 enforcement actions by US stock exchanges in 2019 and practitioner interviews, our Article (forthcoming in The Brigham Young University Law Review) explores the enforcement and compliance pattern of stock exchange rules. What happens if a listed company violates stock exchange rules? If stock exchanges do not enforce their rules rigorously, how well do listed companies comply with the rules? Is it desirable for stock exchanges to enforce the rules and delist companies proactively?

As the first study that offers an empirical analysis of enforcement actions by US stock exchanges, our Article finds that (1) stock exchanges’ detection of noncompliance is mostly on the failure to meet mechanical criteria, such as the $1.00 minimum stock price requirement; (2) listed companies tend to self-report violations of corporate governance requirements before the stock exchanges detect them; and (3) even after noncompliance is detected, stock exchanges tend to extend cure periods and rarely impose the only substantive sanction for stock exchange rule violations: delisting. Particularly for corporate governance rules, our finding reveals that enforcement actions by exchanges are rare, and in those rare enforcement actions, the punishments are almost always light. Yet, our analysis of S&P 1500 companies’ board composition data shows that most companies diligently comply with the stock exchanges’ requirements despite this low likelihood of detection and enforcement, with an extremely low rate of noncompliance.

Our Article argues that this curious coexistence of lax enforcement and diligent compliance can be explained as an extension of the relational contract theory to the relationship between a regulator and a regulated. Both the exchange and the listed company establish a long-term relationship with each other, and much discretion regarding the future of the relationship, particularly given the changing nature of the stock market, is reserved for both parties. In this dynamic, listed companies’ strong compliance can be a way to establish bonds of trust with the exchange and to signal their commitment to preserving and increasing the exchange’s reputational capital. The exchange’s discretion in imposing a draconian penalty (ie delisting) further serves to deter opportunistic behavior, even if such penalty is rarely, if ever, imposed.

Furthermore, the competition among stock exchanges creates a balance of push-pull factors for stock exchange rule enforcement. At first glance, as asserted by critics of industry self-regulation, the stock exchanges’ pursuit of profits and the presence of a competitor can potentially lead to lax enforcement, as they may lower their standards to attract more issuers. Simultaneously, such collusion concerns are counterbalanced by the exchanges’ reputational concerns and the SEC oversight. Relaxing their enforcement level too much can risk destroying the reputational capital of the major exchanges, and conspicuous collusion may also invite SEC intervention. Such ‘relational enforcement’ of stock exchange rules indicates that where there is an extended regulatory relationship that offers a substantial benefit to the regulated entity, diligent compliance can be expected even in the absence of rigorous, formal policing.

Geeyoung Min is an Assistant Professor of Law at the Michigan State University College of Law.

Kwon-Yong Jin is an Associate at Wachtell, Lipton, Rosen & Katz. This post and the Article referenced in this post represent the authors’ views only and do not represent the views of Wachtell, Lipton, Rosen & Katz.