Relational Enforcement of Stock Exchange Rules

Abstract

Stock exchanges, as regulating entities supervised by the Securities and Exchange Commission (SEC), have wielded their rulemaking power on various corporate governance issues, ranging from the independent board committee requirement adopted in 2003 to the board diversity requirement approved in 2021. Simultaneously, as for-profit corporate entities, major stock exchanges have been competing against each other to attract and retain more companies. This dual status of stock exchanges—as regulators and as profit-driven entities—brings into question the stock exchanges’ incentive to enforce their own rules against listed companies. What happens if a listed company violates stock exchange rules? As the first study that offers an analysis of original hand-collected data on 838 enforcement actions by stock exchanges in 2019, this Article finds that (1) stock exchanges’ detection of noncompliance is mostly on the failure to meet mechanical criteria, such as the $1.00 minimum stock price requirement; (2) listed companies tend to self-report violations of corporate governance requirements before the stock exchanges detect them; and (3) even after noncompliance is detected, stock exchanges tend to extend cure periods and rarely impose the only substantive sanction for stock exchange rule violations: delisting. Focusing on stock exchanges’ corporate governance requirements for listed companies, our analysis of S&P 1500 companies’ board composition data shows that despite this low likelihood of detection and enforcement, most companies diligently comply with the stock exchanges’ requirements. This Article argues that this curious coexistence of lax enforcement and diligent compliance can be explained as an extension of the relational contract theory to the relationship between a regulator and a regulated. Competition among stock exchanges makes a long-term, interactive relationship between stock exchanges and their listed companies valuable to both sides. The fact that the stock exchanges’ enforcement mechanism relies on a single, drastic measure of terminating the relationship (i.e., delisting) and that listed companies’ noncompliance hardly triggers delisting incentivize cooperative compliance between the regulator and the regulated. Such “relational enforcement” of stock exchange rules indicates that where there is an extended regulatory relationship that offers a substantial benefit to the regulated entity, diligent compliance can be expected even in the absence of rigorous, formal policing.