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The SROs and Due Process
Traders Magazine Online News, December 11, 2008
As discussed in prior articles, the constitutional legitimacy of the SEC and other independent administrative agencies depends in large part on the "due process" of their actions. The Fifth Amendment of the US Constitution states, in part, that "no person shall . . . be deprived of life, liberty or property, without due process of law."
In interpreting the meaning of "due process," as it pertains to an administrative agency, the Supreme Court has examined whether due process has been satisfied when an agency engages in rule-making, judging and enforcement, which correspond to the three principal powers of government: Legislative, judicial and executive. Due process is satisfied when agencies make rules after the public has been provided notice of proposed rule-making and an opportunity to make comments. In agency judicial hearings, a defendant must have adequate notice and an opportunity to be heard, which includes the important rights to obtain the advice of counsel, to present evidence and to examine adverse witnesses. The SEC's enforcement authority is limited to civil procedures, but even so, the Division of Enforcement is required to conduct investigative and prosecutorial activities in a manner that protects the rights of the accused.
So far, neither the courts nor the SEC has been willing to subject self-regulatory organizations (SROs) to the Constitutional requirements of due process.
When federal securities law was created in the 1930s, Congress initially viewed the concept of self-regulatory organizations as a good way to make the securities industry pay for its own regulation. In a time of economic hardship, this avoided having the strapped public taxpayer foot the bill for the regulation of an industry viewed by many as composed of fat cats.
In the 1930s, the New York Stock Exchange was a private company owned by its members. So, to achieve self-regulation, all Congress needed to do is require that the New York Stock Exchange create rules for its members. To make sure that these rules would be appropriate, the New York Stock Exchange, and all other national securities exchanges, were required to obtain the SEC's approval for these rules. And, SROs were required to establish a system for enforcing these rules.
To make sure that this self-regulatory scheme covered the entire industry, every broker-dealer was required to become a member of some SRO. This covered all of the broker-dealers that were members of exchanges, but something needed to be done to cover over-the-counter brokers and dealers. So, the National Association of Securities Dealers, Inc. (NASD) was established for that purpose, initially with federal subsidy. It soon became self-supporting, like the exchanges.
This neat and tidy method of regulating the securities industry at little cost to the public purse left open the question of the character of an SRO. If it is a regulator, then its actions should be subject to all of the due process rights guaranteed to protect life, liberty and property under the Constitution. If it is a membership organization, then its relationship with members is contractual. The whole idea of a contract is that you give up some property, and in the case of an employee, some liberty, in exchange for other benefits. Under the Constitution, people are free to contract as they will, subject to occasional considerations of public policy. You can't lawfully contract for murder, for example.
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