The decision thwarts a planned regulatory effort to study how exchanges’ pricing creates conflicts of interest for stockbrokers that may harm investors.
Photo: Colin Ziemer/Associated PressWASHINGTON—Judges for a federal appeals court handed stock exchanges a victory on Tuesday by ruling their regulator can’t order them to experiment with trading fees.
The decision from the U.S. Court of Appeals for the District of Columbia Circuit thwarts a planned regulatory effort to study how exchanges’ pricing creates conflicts of interest for stockbrokers that may harm investors. A panel of the appeals court said the program would have been an “unprecedented action that clearly exceeded the SEC’s authority under the Exchange Act.”
At issue in the case was the dominant pricing system used by exchanges, which charges fees for some trades while giving brokers rebates for other orders. The SEC has said the system, known on Wall Street as “maker-taker,” could distort brokers’ choice of where to send investors’ orders, since brokers generally pay the fees and keep the rebates.
“Nothing in the Commission’s rule-making authority authorizes it to promulgate a ‘one-off’ regulation…merely to secure information that might indicate to the SEC whether there is a problem worthy of regulation,” a majority of the panel wrote in its decision.
The ruling is the second court win this month over the SEC for exchanges such as New York Stock Exchange parent Intercontinental Exchange Inc. A panel of the D.C. Circuit ruled in early June that regulators can’t allow challenges to some fee increases after they have taken effect, in a separate legal battle over the cost of market data sold by exchanges.
Tuesday’s ruling may further chill the SEC’s appetite for drawn-out fights with the exchanges, which have been at odds with the agency during the Trump administration.
The SEC under Chairman Jay Clayton has repeatedly challenged how exchanges make money, a confrontation it hasn’t sought with any other major market participant, such as hedge funds or investment banks. Exchanges believe the friction stems from Mr. Clayton’s decision to hire a top staff director, Brett Redfearn, who criticized exchanges when he previously worked at JPMorgan Chase & Co.
“We accept the decision of the D.C. Circuit and appreciate the guidance it provides,” Mr. Clayton said in a statement. “I expect the Commission will move forward with its efforts to improve and modernize our National Market System, including to ensure that it best serves the interests of our long-term Main Street investors.”
The measure struck down Tuesday would have required exchanges to set up a pilot program to test trading with lower fees and rebates. The experiment would have lasted at least one year. For one group of stocks, rebates would have been completely eliminated. The SEC approved the rule requiring the test in 2018.
In approving the experiment, the SEC didn’t answer whether the current system of trading fees harms investors. Instead, it reasoned that a pilot program would allow regulators to assess whether the complaints about conflicts of interest are justified.
That, the judges said Tuesday, was the problem.
“Even if the commission has authority to seek data from regulated parties, it does not follow that the commission may ‘shock’ the market,” Judge Harry Edwards wrote in the court opinion.
NYSE, Nasdaq Inc. and exchange operator Cboe Global Markets Inc. sued the SEC to block the rule in 2019.
Mr. Redfearn helped develop the pilot program, although the SEC had studied “maker-taker” for years before he arrived to run its Trading and Markets division.
Money managers such as T. Rowe Price Group Inc. have long complained that, under the maker-taker system, brokers may route their orders to venues that pay the highest rebate, instead of the exchange where investors are likely to get the best price and most efficient execution.
Rebates have been a feature of Wall Street for more than two decades. Exchanges argue that they make markets function more smoothly by rewarding brokerages and traders for posting price quotes for shares. NYSE, Nasdaq and Cboe together paid nearly $2.4 billion in rebates last year, according to an analysis of their regulatory filings by Equity Research Desk, a research firm.
The SEC’s proposed pilot divided Wall Street. Its supporters included asset managers that oversee trillions of dollars of investor funds, such as Fidelity Investments and Vanguard Group. Critics included exchanges, high-speed trading firms and a number of publicly traded corporations including Procter & Gamble Co. and Home Depot Inc.
The pilot’s foes raised concerns that it would harm investors by damaging the liquidity of U.S. stocks and widening bid-ask spreads—the difference between the buying and selling price of a stock. When those spreads widen, investors pay more to buy and sell stocks.
The judges agreed. “If implemented, the Pilot Program would have serious, market-altering effects,” the majority of the panel wrote. “It is not merely a benign quest for data, as the commission appears to suggest.”
A trade group consisting of the three exchange operators welcomed the court ruling. “The Transaction Fee Pilot was a mistake that if put into place would have brought many unknown consequences for the investing public and the companies that list on the exchanges,” the Equity Markets Association said.
Some investors expressed disappointment with the court ruling. “It’s extremely frustrating for us,” said Mehmet Kinak, global head of systematic trading at T. Rowe Price Group Inc., a longtime proponent of the pilot project. “It would have been interesting to see where the liquidity would go and where brokers would route if they were unconflicted. Unfortunately, the conflict between the SEC and the exchanges crowded out their ability to push this through.”
Write to Dave Michaels at dave.michaels@wsj.com and Alexander Osipovich at alexander.osipovich@dowjones.com
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