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Relational Enforcement of Stock Exchange Rules

Stock exchanges, as regulating entities designated by the Securities and Exchange Commission (SEC), have wielded their rulemaking power on various issues, ranging from the independent board committee requirement adopted in 2003 to the board diversity requirement proposed in 2020. 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 stock exchanges enforcement actions in 2019, this Article finds that (1) stock exchanges’ detection of non-compliance 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 non-compliance is detected, stock exchanges tend to extend cure periods and rarely impose delisting, the only substantive sanction for stock exchange rule violations. Focusing on corporate governance requirements—a major part of stock exchange rules for listed companies—and examining S&P 1500 companies’ board composition data, we find that despite this low likelihood of detection and enforcement, most companies diligently comply with the stock exchanges’ requirements. 
 
In order to explain this odd coexistence of lax enforcement and rigorous compliance, the Article argues that the stock exchanges’ enforcement mechanism that relies on the single draconian termination of relationship (i.e., delisting) is a unique extension of the relational contract theory to the relationship between a regulator and a regulated. Under this “relational enforcement” of stock exchange rules, the fact that delisting is the only substantive enforcement option makes stock exchanges rely more on listed companies’ self-policing, yet also encourages listed companies’ voluntary self-reporting of non-compliance without the risk of delisting. As such, the 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 policing. Given the recent debate over the merits of industry self-regulation, this Article’s findings and implications can be more broadly applied to other forms of self-regulation and their enforcement/compliance, rendering them particularly relevant.