Securities law often relies on stock exchanges and other self-regulatory organizations (SROs) to create rules that structure markets. The SEC reviews and must approve these rules if the agency finds they meet certain statutory requirements. SROs file over a thousand rule proposals a year, with most flying under the radar.

The SRO rulemaking process is newly in the spotlight after a recent decision from the U.S. Court of Appeals for the Fifth Circuit. The court’s decision last month in Alliance for Fair Board Recruitment v. SEC (AFBR) vacated the SEC’s order approving the stock exchange NASDAQ’s board diversity rule.

Other observers have focused on how that decision changes listed firms’ obligations. This post focuses instead on higher-order implications about SRO rulemaking. In doing so, it draws from a forthcoming article that uses computational methods to look at every SRO rule change filing from 2000 through 2023, or just under 32,000 in all.

In AFBR, the Fifth Circuit found that NASDAQ’s proposed rule – essentially a disclosure requirement for listed companies – was insufficiently tied to the Securities Exchange Act’s statutory purposes. To begin, the majority held that promotion of “disclosure” is not, by itself, enough to justify an SRO rule. To the Fifth Circuit, efforts to use SRO rules to reduce information asymmetries and empower investors may no longer be justified on that basis alone and may need to be connected more concretely to the Exchange Act’s other core investor-protection and public-interest purposes.

The majority also faulted the SEC for not connecting the rule to three asserted purposes. Without evidence that it was unethical to have less “diversity as Nasdaq would prefer,” the rule couldn’t further “just and equitable principles of trade.” Nor was board diversity related to market microstructure purposes of the 1975 national market system amendments to the Exchange Act. And as the majority would not credit an evidentiary link between board diversity and corporate governance or investor protection, the rule could not be related to the “public interest” either. Practically speaking, the SEC’s historical practice in relying on general appeals to the act’s broad aims may no longer suffice.

AFBR sends a noisy signal for future SRO rulemakings not haunted by culture-war vibes. The majority opinion deems diversity-related disclosures unacceptable as too-far removed from concrete, narrow investor-protection and antifraud purposes identified when the relevant Exchange Act provisions were amended in 1975. The majority opinion essentially tells the SEC that stock exchanges can’t adopt listing rules unless they fit into a cramped, Ye Olde vision of the Exchange Act that ignores modern economic reality. Understood this way, the decision is less about Exchange Act Section 19(b) and more about the country’s most socially conservative court wanting to return our regulatory framework to a sepia-toned era when power flowed differently in markets.

Whether or not you credit this story (as I largely do), there is another way in which AFBR may be overdetermined. It may be a product not just of the Fifth Circuit’s hostility to anti-subordination approaches to labor markets for corporate leadership, but also of the modern judiciary’s general suspicion toward the SEC. In this latter respect, AFBR echoes the D.C. Circuit’s 2017 decision in Susquehanna Int’l Grp. v. SEC, in which the court vacated the SEC’s approval of an SRO rule change. That decision was not prompted by the rule’s political or cultural resonance, but by the SEC’s failure to make findings that the statutory factors were met based on evidence. Instead, the commission relied uncritically on the SRO’s characterization of the evidence. Susquehanna indicates what happens when the SEC’s analysis is too deferential or cursory, a line of reasoning that also led the Fifth Circuit to fault the agency here.

Of course, the vast majority of SRO rule-change proposals are less controversial than NASDAQ’s board diversity rule; most fly under the radar entirely. Consider empirical evidence of how SRO filings of rule-change proposals have evolved between 2000 and 2023, based on a dataset of every Federal Register notice during this period. What I find is a process that has come to resemble a “firehose” of SRO rules.

In the middle of this period, Dodd-Frank Section 916 altered the SEC’s role under Exchange Act Section 19(b)(3) with respect to a large category of SRO rules. The rules now go “immediately effective” upon filing unless the SEC affirmatively intervenes within two months to disapprove them as inconsistent with the Exchange Act’s purposes. Dodd-Frank’s reform flipped the burden, making it easier for SROs to implement rules without extensive public input or rigorous SEC review. Over time these immediately effective rules have come to dominate the SRO rulemaking process. The rulemaking process may allow exchanges to set policies that shape the market in ways that escape meaningful scrutiny and oversight from other market participants, the SEC, and the public.

Suppose AFBR’s approach to SRO rulemaking is not a “ticket good for one ride only,” limited to “board diversity.” Understood that way, it is likely to shape how the SEC reviews immediately effective rules under Section 19(b)(3), if not push it to reassess the review model entirely. If courts demand tighter evidentiary connections between proposed SRO rules and concrete Exchange Act purposes, the SEC may feel pressure to scrutinize SRO proposals more thoroughly, even those otherwise eligible to go “immediately effective.”

Another implication of AFBR is to encourage SRO rulemaking with a conceptual nexus to securities fraud. This pushes us further toward Bloomberg columnist Matt Levine’s mantra of “everything is securities fraud.” Yet we should not want second-best policymaking in which every other regulatory concern must be smuggled in through the diplomatic pouch of “securities fraud.” This framing privileges social concerns from the perspective of capital, diminishing the interests of other stakeholders. In doing so, it also gives the SEC and SROs new powers on the sly. Do we trust non-state actors like NASDAQ to do right by society if we are to aggrandize their jurisdiction by trying to make corporate board diversity a problem of securities fraud?