In recent years, the SEC has faced scrutiny of its actions under the arbitrary-and-capricious standard of the Administrative Procedure Act (APA), which requires the Commission to adequately justify its rules. In particular, critics have questioned the SEC’s economic analysis of new rules, especially its approach to cost-benefit analysis (CBA). A recurring concern is how the SEC incorporates qualitative factors into its justifications. One such factor is fairness, which the SEC has invoked to support trading restrictions in areas such as insider trading, high-frequency trading, and short selling. In a new article, I examine short-selling regulation to highlight inconsistencies in how the SEC support fairness-based restrictions in the stock market and to offer recommendations on how the SEC should invoke fairness as a policy justification for trading restrictions.

The SEC typically includes fairness considerations in its CBA, arguing that certain trading restrictions protect ordinary investors from exploitation by more sophisticated investors, thereby enhancing people’s perception of market fairness, fostering greater willingness to participate in the securities markets, promoting capital formation, market stability, and improving allocative efficiency. This approach suggests that, on a formal level, the SEC considers fairness as a determinant of market efficiency within its efficiency regulatory paradigm, as grounded in Section 3 of the Exchange Act.

Scholars, however, have noted that the SEC provides no empirical evidence showing that new rules actually deliver these benefits effectively enough to justify their costs. This lack of evidence also exists in the regulation of short selling, particularly in the adoption of the so-called Alternative Uptick Rule, which was adopted in the wake of the 2008 financial crisis. The rule restricts short selling when a stock’s price declines by at least 10 percent in a single day and was adopted in response to concerns that unrestricted short selling undermined investor confidence, defined as investors’ perceptions of the fairness of financial markets. As my article demonstrates, however, the SEC fell short of adequately demonstrating how the rule would enhance investors’ perceptions of fairness and thus investor confidence.

My article provides a framework for how the SEC can more rigorously justify fairness-based trading restrictions. It contends that, because providing those justifications is difficult, the SEC should explain how the restrictions are consistent with fair markets. Codified in Section 2 of the Exchange Act, the principle of fair markets can support restrictions not only on trading practices that result in unfair prices but also on trading practices that create either undue advantages or lawful advantages that allow sophisticated investors to get richer at the expense of individual investors–without creating any meaningful social value.

This framework rests on two different notions of fairness. In securities regulation, fairness may operate either as a determinant of market efficiency under the efficiency regulatory paradigm, or as an independent regulatory principle under the public values regulatory paradigm. Fairness as a determinant of market efficiency refers to the concept of perceived fairness. By contrast, fairness as an independent regulatory principle refers to the concept of fairness as a regulatory principle that must be implemented on its own terms. The latter concept stems from the fact that multiple provisions of the securities laws, notably Section 2 of the Exchange Act, require the SEC to ensure fairness in the securities markets. Therefore, though one could question whether fairness should be a relevant regulatory principle in the regulation of securities markets, fairness is a regulatory principle codified in the securities laws that the SEC must weigh against the principle of market efficiency.

Using fair markets as a justification for trading restrictions, however, presents problems, which short selling helps illustrate. First, it requires interpreting market fairness in accordance with the norms of statutory interpretation. Second, it involves balancing fair markets with market efficiency, ensuring that the two complement each other. The justification for short selling restrictions is rooted in the interpretation of the principle of fair markets. If this principle is narrowly understood as granting the SEC authority solely to ensure fair prices – defined as efficient prices – then such restrictions might lack any basis. The financial literature consistently demonstrates that short selling enhances price accuracy by preventing overpricing, which can contribute to market bubbles, and improves market liquidity.

However, if fair markets under Section 2 of the Exchange Act are interpreted to encompass distributive fairness, then rules like the Alternative Uptick Rule can clearly be justified. Indeed, the rule restricts short selling that does not significantly enhance price accuracy and liquidity, such as after a sharp decline in a stock’s price. In that scenario, short selling consumes market liquidity and accelerates stock-price declines, making the resulting wealth transfer from long holders to short sellers unsupportable.

The SEC should adopt a more coherent approach when invoking fairness as a policy justification, especially given the heightened scrutiny by courts and interest groups of its rulemaking rationales. The SEC should either (a) invoke perceived fairness as a determinant of market efficiency and empirically demonstrate the benefits of new rules based on their impact on perceived fairness and market efficiency; or (b) explicitly invoke fairness as an independent regulatory principle and explain how the new rules align with the statutory interpretation of fair markets, thereby justifying them despite certain costs. When the SEC is unable to support a rule as enhancing perceived fairness and investor confidence, it should present qualitative, fairness considerations in a separate section of its proposing and adopting releases. A separate qualitative analysis would allow the SEC to articulate fairness-based justifications without conflating them with efficiency arguments, reducing ambiguity and strengthening the agency’s ability to defend fairness-based rules under judicial review.

Giovanni Patti is the associate director of SEED Research at the NYU Pollack Center for Law & Business. This post is based on his new article, “Fairness and the SEC’s Competing Regulatory Paradigms” available here.