Not Just a Private Club: Self Regulatory Organizations as State Actors when Enforcing Federal Law

Sunday, January 1st, 1995 at 12:00 am by Richard L. Stone and Michael A. Perino
Richard L. Stone and Michael A. Perino, Not Just a Private Club: Self Regulatory Organizations as State Actors when Enforcing Federal Law, 1995 Colum. Bus. L. Rev. 453

In the Securities Exchange Act of 1934 (the “Exchange Act”), Congress enacted a comprehensive scheme for regulating the national securities markets. Pursuant to that scheme, the Securities and Exchange Commission (the “Commission”) was given ultimate authority to enforce the newly enacted securities laws against market participants. The Exchange Act also created a prominent enforcement role for national securities exchanges (“Exchanges”), like the New York Stock Exchange (“NYSE”). Congress required these self-regulatory organizations (“SROs”) as a condition for their continued operation to enforce, among other things, compliance by their members with the provisions of the Exchange Act and the rules and regulations promulgated thereunder. The SROs were also given the power to sanction those members the SRO found to have violated federal law.

The power and enforcement responsibilities conferred upon SROs under the Exchange Act raise the issue of whether constitutional protections such as due process and the right against self-incrimination apply in SRO enforcement proceedings when the SRO is enforcing federal law. The answer to that question, however, turns on whether SROs are “state actors” when enforcing federal law. State action is a fundamental prerequisite in cases alleging deprivation of constitutionally protected rights. “(M)ost rights secured by the Constitution are protected only against infringement by governments.” At issue is whether SROs should be subject to the same constitutional limitations as the government when they are acting in the same capacity as the government in enforcing federal law, as required of them by the Exchange Act. Despite the Supreme Court’s extensive jurisprudence on the state action question, the Court has not addressed the issue of whether SROs are state actors. Lower courts have split on the question of whether SROs are state actors.

The purpose of this Article is to explain why SROs should be considered state actors when enforcing federal law. The various Supreme Court precedents discussing the state action issue strongly suggest that when enforcing federal law, as they are required to do under the Exchange Act, SROs are state actors. In that situation, SROs should be subject to the same constitutional limitations as the Commission or any other government agency.

In Section II, the Article first examines the disciplinary responsibility of SROs imposed by the Exchange Act including the powers which the Commission has to coerce enforcement activity on the part of an SRO. Both the statutory and regulatory frameworks are analyzed. This Section then goes on to demonstrate the symbiotic relationship that exists between the Commission and the SROs in the context of SRO rule-making. This analysis examines the Commission’s role in approving rules and its authority to amend SRO rules and require SROs to adopt rules. This analysis is significant because the Commission’s authority in the rule-making area effectively allows the Commission to coerce SRO action, and because it demonstrates the heavily regulated nature of SRO activity.

Section III then applies this analysis to the state action tests the Supreme Court currently employs. The Supreme Court has articulated several distinct tests for determining whether state action exists. This Section addresses two of the more relevant tests: (1) the “coercion” or “encouragement” test; and (2) the “public function” test. The Section explains the history and policy considerations that underlie each of these two tests, and demonstrates that under each of these tests SROs enforcing federal law should be considered state actors.

In Section IV, the Article analyzes lower court decisions that have addressed the general topic of state action in the context of SROs.

Finally, in Section V, the Article concludes that SROs are state actors when they enforce federal law. This conclusion not only follows from the Supreme Court’s extensive state action jurisprudence, but is also bolstered by the common sense argument that a dual system for enforcement of federal securities laws — one providing full constitutional protections and the other providing no such constitutional protections — is illogical. This dual enforcement system, which can lead to outcome determinative results based solely upon the prosecutorial forum, has a recognized historical foundation but is unsupported by current state action jurisprudence.

Author Information

Stone (partner at Cadwalader, Wickersham & Taft in NY); Perino (associate at Cadwalader, Wickersham & Taft)