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July 11, 2012

What Exchanges and Kings Have in Common

It must be good to be a king. Sitting in your castle, taxing peasants and silencing opponents. Laughing it up with the court jesters and courtesans, while drinking quarts of whatever it is kings drink. (Scotch? Wine? Gravy?) But perhaps better than holding court would be the courts you avoid, because as king, you could never find yourself a defendant in a civil or criminal court.[IMGCAP(1)]

Going back to 13th-century England, the Crown has been immune from lawsuits, in a common-law doctrine known as "sovereign immunity." In America, sovereign immunity applies to the government and its entities. You can't sue the post office for losing a package, and you can't sue the USDA for labeling "pink slime" as meat. Recently, the ancient doctrine of sovereign immunity has become part of traders' conversations, as broker-dealers learned that they can't sue exchanges for errors, even really big ones, like botching the opening cross of a very large IPO. 

Why would an exchange qualify for sovereign immunity? Aren't they for-profit companies like Microsoft or Walmart? Yes, they are. For the past six years, the New York Stock Exchange and Nasdaq have been for-profit companies that exist to make money for their shareholders. Yet they have also been deemed by courts to be quasi-governmental entities, dating back to the 1934 Exchange Act, in which Congress delegated some regulatory responsibilities to the exchanges. But even after the exchanges "demutualized," their quasi-governmental status was still upheld in courts. For example, in a September 2007 court decision (Calpers v. NYSE, Second Circuit), an appeals court dismissed a suit against the NYSE, finding the exchange "stands in the shoes of the SEC" and therefore even if misconduct had occurred, "absolute immunity" applies.

Absolute immunity is a pretty cool thing to have. It's like being a legal superman. Bullets like "gross negligence" and "willful misconduct" just bounce off you. Imagine life if your actions had no consequences. You could spend your days dropping things from balconies and leaving banana peels on the sidewalk. Yes, life would be sweet, at least for you. For those around you, though, life may be a bit less sweet. Economists refer to situations with a lack of consequences for negative actions as creating "moral hazard." Kids hopefully learn that if they send a baseball through the neighbor's window, they're going to have to pay for it. Tell the kid it's not his problem, and you've created moral hazard, along with a lot of future broken windows.

To avoid broken windows where possible, society should be stingy about bestowing immunity on organizations. So why are exchanges treated like kings and granted sovereign immunity? Unlike in the past, today every exchange except BATS outsources all or most of its regulatory responsibilities to the Financial Industry Regulatory Authority. It is beyond a stretch to call Nasdaq or Arca a branch of government, even if they do still have some regulatory tasks. [Editor's note: Mathisson was on the board of BATS from 2007 to 2010.]

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