The word “security” is a term of art that describes an ownership or economic interest in a company. This term includes common investments, like stocks and bonds, but it can also refer to more complex investments, like promissory notes and “call” and “put” options.
The United States is home to the largest and most sophisticated financial markets in the world. Each year, stock markets like the New York Stock Exchange and the Nasdaq, and equity derivatives markets such as the Chicago Board Options Exchange and Chicago Mercantile Exchange, collectively draw trillions of investment dollars from investors across the world as they trade securities.
One explanation for the fact that the United States serves as a global investment center is its robust system of “securities regulation.” In our first module, we’ll explore the regulatory framework of securities law by learning about what is meant by securities regulation. We’ll introduce key terms in the field, the most important topics in securities regulation and finally, we’ll learn about the entities that enforce these laws.
A basic understanding of terminology related to securities regulation is necessary before exploring the field.
We’ll begin by defining the term investor, who is someone who buys or sells securities. The term “retail investor” typically refers to one who buys securities from a broker. Someone who purchases small amounts of stock from time to time would likely be considered a retail investor. On the other hand, an “institutional investor” typically refers to a large entity, such as an insurance company, union, bank or mutual fund, that invests large sums of money to purchase securities.
Next is the broker-dealer, which is a company that is in the business of buying and selling securities for others. Their customers call them to buy or sell stock. For example, investment firms such as JP Morgan and Merrill Lynch are broker-dealers. People who work for broker dealers are typically called “brokers.”
On the other side of a securities transaction is an issuer of securities, which is a company that has created, or “issued”, the securities. It can be a corporation, a limited liability company or other business entity. For example, Apple, Inc., is an issuer.
An underwriter is a company that buys securities from issuers with the goal of reselling them to other investors. For example in an initial public offering, the issuer will sell securities to the underwriter, who will then sell them to the public at-large. Large investment banks like Goldman Sachs often act as underwriters.
A company that issues publicly traded securities must have a board of directors, who are responsible for appointing the officers of the company. Officers are the senior-most personnel at a company. Some examples of officers include:
- the chief executive officer;
- the chief financial officer;
- the general counsel;
- the chief compliance officer; and
- the chief risk officer.
Finally, there is an outside auditor. This is typically an accounting firm that reviews the company’s financial records to ensure that information provided to the public is accurate and compliant with Generally Accepted Accounting Principles. Outside auditors, as opposed to inside accountants employed by the company, bring objective expertise to a critical aspect of public reporting-the financial condition of the company.
Prior to the Great Depression, the United States did not have a robust federal system of securities regulation. In the 1920s, states had lackadaisical approaches to regulating securities. As a result, many companies and promoters were not truthful or forthcoming regarding negative company information.
Investors were tempted by promises of rags to riches transformations. Approximately $50 billion in new securities were offered during the decade. Due in large part to overselling and fraudulent practices, however, half of these securities ultimately became valueless or almost valueless. In October 1929, the stock market crashed and public confidence in the United States capital markets plummeted.
The federal government enacted a new regulatory regime to restore investor confidence in legitimate companies and to prevent misconduct. We’ll begin with the first major law, the Securities Act of 1933.
The Securities Act of 1933
The Securities Act of 1933 is typically referred to as the “Securities Act” or the “‘33 Act.” The overarching goal of the Securities Act is to enable investors to make informed investment decisions by requiring full disclosure of all important information concerning the issuer and its business. It accomplishes this goal in several ways.
First, the Securities Act broadly defines “securities” to include all forms of ownership in a company. It also broadly defines “selling” and “offering to sell” securities to include any means by which someone might try to get an investor to buy a security.
Second, the Securities Act requires the issuer of securities to affirmatively disclose important financial information through registration statements and prospectuses. These documents are filed with the Securities and Exchange Commission and made public once they are final. Investors, analysts and the market at large can then absorb and analyze this information before making investment decisions. Additionally, the Securities Act prohibits the sale of securities unless they have been properly registered and the required disclosures have been made.
Finally, the Securities Act prohibits misrepresentations in registration statements and prospectuses used when offering securities to the public, and it holds issuers, underwriters and others who are responsible for these documents accountable to investors for any misrepresentations.
Despite its breadth, the law doesn’t require the registration of all securities. For example, private offerings to a limited number of people or institutions or certain “small” offerings and bonds issued by federal, state or municipal governments do not have to be registered.
The Securities Exchange Act of 1934
The second law we’ll introduce is The Securities Exchange Act of 1934, known as the “Exchange Act” or “‘34 Act.” Congress designed it to complement the Securities Act of 1933. The Exchange Act embodies two primary purposes. First, it ensures that securities transactions are regulated uniformly throughout the United States. Second, it fosters transparent, fair and orderly markets. The Exchange Act accomplishes these goals in several ways.
First, the Exchange Act created the Securities and Exchange Commission. The SEC is the primary regulator of securities transactions in the United States. The Exchange Act endows the SEC with broad authority over all aspects of the securities industry. This includes the power to register, regulate and oversee issuers, brokerage firms and exchanges. It also includes the power, when authorized by Congress, to enact specific, technical rules to accomplish Congress’ broader objectives.
Second, The Exchange Act requires public companies to issue annual reports (called “Form 10-Ks”) and quarterly reports (called “Form 10-Qs”) to keep the investing public informed as to the current state of the company. These reports must disclose the company’s current financial status, business outlook and major risks as they exist at the time.
Third, the Exchange Act broadly prohibits fraud in connection with any purchase or sale of securities. The anti-fraud provisions in the Securities Act are limited to the initial public offering stage and the actors involved in bringing a security to the public. The Exchange Act, by contrast, prohibits fraud in subsequent “secondary market” transactions, such as those that occur on an exchange. For example, if a company was truthful in its initial public offering documents, several years pass, and then the company misrepresents its revenues in an annual report, the Exchange Act antifraud provisions would apply.
Fourth, the Exchange Act prohibits company insiders and those who gain access to confidential information from trading on that “inside information,” also known as “insider trading.” The purpose of this prohibition is to ensure broad investor confidence and mitigate fear that the other side is buying or selling the stock due to access to nonpublic information.
Finally, the Exchange Act prohibits certain officers, directors, large shareholders and other “insiders” from engaging in “round trip” transactions (e.g., buying and then selling a stock) within a short time period, including the “short swing profit” rule, which prohibits stock sales by insiders for profit within certain time ranges of important corporate announcements. These provisions assume that the insider has access to superior information and may consciously-or subconsciously-desire to take advantage of that information.
Subsequent Federal Securities Legislation
The Investment Company Act of 1940
Many investors, particularly retail investors, invest in mutual funds and other index-based products, rather than individual stocks. For this reason, Congress enacted the Investment Company Act, which regulates mutual funds and other companies that invest in securities for others. It requires these companies to disclose their investment objectives and financial conditions, and to minimize conflicts of interest.
The Investment Advisers Act of 1940
Some investors do not pick and choose their own investments, but rather rely on advisers to guide their investment decisions. The Investment Advisers Act of 1940, often referred to as the “Advisers Act,” regulates companies and individuals who charge clients for investment advice. It requires advisers to register with the SEC if they have at least $100 million in assets under management or advise a registered investment company.
The Sarbanes-Oxley Act of 2002
The Sarbanes-Oxley Act of 2002 was enacted in the wake of the bursting of the Internet Bubble, which led to a stock market decline in the early 2000s. Poor accounting practices and overzealous officers led to gross exaggerations of company performance. Large companies like Enron engaged in fraudulent activities. The Sarbanes-Oxley Act instituted many reforms to correct these financial statement abuses.
The first major accomplishment of the Sarbanes-Oxley Act is to require CEOs and CFOs to attest to the truthfulness of statements in annual and quarterly reports. It makes them personally liable for any misrepresentations in these documents. The law embraces the concept that, by holding individual officers personally responsible, there will be more incentives to report truthfully and completely on matters such as revenues, expenses and business risks.
Second, the Sarbanes-Oxley Act created the Public Company Accounting Oversight Board. This regulatory body ensures that outside auditors are thorough and follow Generally Accepted Accounting Principles when they sign off on information given to investors concerning a company’s financial condition. The Board is charged with registering auditing firms and investigating and penalizing misconduct.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
Finally, we arrive at the Dodd-Frank Wall Street Reform and Consumer Protection Act, referred to as “Dodd-Frank,” which was signed into law after the Financial Crisis of 2008. Many perceived that large financial institutions and complex, opaque securities derivatives products had combined with other market forces (such as the housing market bubble) to create a perfect financial storm.
Dodd-Frank reshaped the regulatory oversight of financial institutions by prohibiting them from engaging in certain types of trades and from undergoing “stress tests,” and by requiring more robust internal corporate governance.
Dodd-Frank also created a program to encourage members of the public to report violations of the securities laws to the SEC. People who give worthwhile tips are eligible to recover a portion of the penalties or fines recouped by the government in an enforcement action. Frequently, they are company insiders who observe or are directed to commit infractions, investors who have been defrauded, or outsiders whose analysis of public information reveals fraud.
Securities Industry Regulators
There are several entities involved in the regulation of securities. First and foremost is the Securities Exchange Commission, the primary securities regulator in the United States. It consists of five presidentially-appointed Commissioners who serve staggered five-year terms. The mission of the Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. To help the Commissioners, the SEC has several departments and offices.
- The Division of Corporate Finance: ensures compliance with the registration and prospectus requirements for newly-issued securities as well as the periodic reporting requirements of publicly traded companies.
- The Division of Investment Management: oversees investment companies, financial advisers, and other specific investment products. Investments such as mutual funds, electronically traded funds (“ETFs”), and variable insurance products fall under this division’s auspices.
- The Division of Enforcement: investigates potential violations of the federal securities laws. When the Division of Enforcement believes that a violation has occurred, it will prosecute a civil action to recover fines, penalties and disgorgement of profits.
If the SEC believes that a violation of the securities laws has occurred, it may prosecute a civil matter in one of two forums. It may proceed in a United States District Court, in which case the alleged violation is decided by a jury in proceedings overseen by a federal judge. The SEC may also proceed in an “in-house” forum before an Administrative Law Judge, who can make decisions for the agency. The ALJ’s decision may be appealed to the Commissioners. The decision of the Commission may be appealed to a United States Court of Appeals and ultimately to the Supreme Court.
The second enforcer of securities regulations laws is the United States Department of Justice, which handles criminal prosecution for securities violations. The DOJ has created a “Securities and Financial Fraud Unit” that addresses these criminal matters. Criminal prosecutions under the federal securities laws are brought in the federal courts.
In addition to federal regulation, there is a patchwork of state regulators that govern securities transactions that occur within the state. State securities laws are often referred to as “blue sky laws.” This term is believed to have been coined in the early 1900s for stocks that had “as much value as a patch of blue sky.”
Private industry groups also engage in regulatory oversight. These are often referred to as “self-regulatory organizations.” For example, the Financial Industry Regulatory Authority (often referred to as “FINRA”) oversees the relationship between brokers and investors.
As we have seen, Congress has enacted numerous laws to regulate securities and has authorized the SEC to pass regulations to further the broad legislative provisions. If it believes a statutory provision or one of its rules has been violated, the SEC (or, in serious matters, the DOJ) will prosecute the violator. Decisions on whether a violation has occurred are reviewed by the United States District Court, then the Court of Appeals, and potentially the Supreme Court. In addition to determining whether a violation has occurred, the courts may also decide how to interpret a provision in one of the securities laws or whether the SEC properly exercised, or exceeded, its authority in adopting a rule to further Congress’ purpose.
In our second module on Securities Regulation, we’ll discuss the difference in regulating instruments such as stocks, bonds and promissory notes.
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