The SEC, FINRA, the States, and much more
The history of securities regulation and federal securities law is well beyond the scope of this work, and the reader is commended to any one of a number of books in the area. One of the best-known, and often cited treatises on the topic is Loss and Seligman, Securities Regulation, a multi-volume treatise on the subject, published by Little Brown & Co in New York City. A single-volume version is also available and can be ordered online.
For purposes of this article, it is sufficient to note that the federal securities laws are in reality a myriad of rules and regulations of 55 different regulatory agencies, including the Securities Commission in each of the fifty States, the District of Columbia, Puerto Rico and Guam, as well as the Securities and Exchange Commission, the Financial Industry Regulatory Authority, and any of the regional exchanges of which he or his firm is a member.
The complex regulatory landscape governing the securities industry can be likened to a convoluted maze of similar and sometimes overlapping regulations. In practice, this intricate web of rules and agencies can be daunting to navigate, leading to a level of regulatory oversight that might seem overwhelming. This multifaceted system, consisting of numerous regulatory bodies, serves as a stark reminder that the assistance of an experienced securities attorney is often the key to success. One recent experience shows the practical problem – one of my broker-dealer clients received investigative requests from the SEC, FINRA, and the NYSE for the same event, at roughly the same time. Fortunately, we were able to convince the regulators to let one of them conduct the review.
Each regulatory body or agency is responsible for monitoring specific aspects of the industry, addressing various facets of compliance, investor protection, and market integrity. Some of these agencies are highly diligent in their oversight, meticulously monitoring market activities and enforcing regulations to ensure a fair and transparent marketplace. However, not all agencies exhibit the same level of vigilance, which can create inconsistencies and challenges for securities professionals.
The sheer size and number of these regulatory entities can, in and of itself, pose challenges for securities professionals. The vastness of the regulatory landscape means that professionals in the securities industry must contend with a plethora of rules, reporting requirements, and compliance standards. Staying abreast of these evolving regulations and ensuring strict adherence can be a formidable task.
Furthermore, the diverse goals and objectives of the various regulatory bodies can sometimes lead to conflicting interests or interpretations of the rules. This can result in overlap or ambiguity in the regulatory framework, further complicating the compliance efforts of those working within the securities industry.
The presence of numerous regulatory bodies can also entail a significant administrative burden, as securities professionals must dedicate considerable time, resources, and expertise to navigate this regulatory morass effectively. Failure to do so can result in legal and financial repercussions, making it imperative for professionals in the securities industry to establish robust compliance measures and keep a close watch on evolving regulations.
In summary, the existence of a multitude of regulatory agencies, each with its own set of rules and objectives, creates a complex and often challenging environment for securities professionals. The sheer size and scope of this regulatory landscape can be a source of frustration and complexity, underlining the need for a comprehensive understanding of the regulatory framework and a proactive approach to compliance in the securities industry.
Mark J. Astarita is a nationally known securities attorney with over 30 years of experience representing investors and financial professionals across the country in regulatory investigations, arbitration, and litigation. If you have a securities law question, call 212-509-6544
Leaving the specifics of the regulations to later chapters, it is sufficient to note that the vast majority of securities regulations are aimed at one goal “to promote fair and full disclosure of all material information relating to the markets, and to specific securities transactions, including all aspects of market trading, as well as the financing and reporting by public companies.” While it may seem at times that specific regulations go well beyond such goals, that is the true goal of the regulatory scheme, and an underlying principle that should guide every market professional in his dealings with the industry, and the public, for, while no simple method of compliance is guaranteed, a policy of full disclosure will prevent most regulatory mishaps, certainly on the retail side of the business.
Federal Securities Statutes
The federal securities laws are comprised of a series of statutes, which in turn authorize a series of regulations promulgated by the government agency with general oversight responsibility for the securities industry, the Securities and Exchange Commission.
The two main federal statutes are the Securities Act of 1933 and the Securities Exchange Act of 1934. Generally speaking, the ’33 Act governs the issuance of securities by companies, and the ’34 Act governs the trading, purchase, and sale of those securities. Each has a wealth of regulations promulgated by the Securities and Exchange Commission, as well as regulations adopted by FINRA and the various states
Links and descriptions of the various federal and state statutes and rules are available in Securities Regulations, Statutes, and Rules.
The ’33 Act governs the initial issuance and registration of securities, as opposed to the Securities Exchange Act of 1934 which governs financial reporting, the various stock exchanges, and the registration of people involved with the sale of securities.
These disclosure policies are the set of rules and regulations governing the activities of entities that have control of investor’s funds.
The full text of the 1934 Act, primarily governs the purchase and sale of securities, securities brokerage firms, and securities exchanges.
The 1934 Act is not a model of clarity, and the SEC has historically used its authority under the Act to fill gaps in the law. It has also exercised its authority to issue regulations that clarify and supplement the law and is often accused of creating regulations by litigation, rather than the required federal rule-making process.
Companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. These reports are available to the public through the SEC’s EDGAR database.
The Securities Exchange Act also governs the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the election of directors and the approval of other corporate action. This information, contained in proxy materials, must be filed with the Commission in advance of any solicitation to ensure compliance with the disclosure rules. Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which holders are asked to vote.
The Securities Exchange Act requires disclosure of important information by anyone seeking to acquire more than 5 percent of a company’s securities by direct purchase or tender offer. Such an offer often is extended in an effort to gain control of the company. As with the proxy rules, this allows shareholders to make informed decisions on these critical corporate events.
The securities laws broadly prohibit fraudulent activities of any kind in connection with the offer, purchase, or sale of securities. These provisions are the basis for many types of disciplinary actions, including actions against fraudulent insider trading. Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.
Registration of Exchanges, Associations, and Others
The Act requires a variety of market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis.
The exchanges and the Financial Industry Regulatory Authority (FINRA) are identified as self-regulatory organizations (SRO). SROs must create rules that allow for disciplining members for improper conduct and for establishing measures to ensure market integrity and investor protection. SRO proposed rules are subject to SEC review and published to solicit public comment. While many SRO-proposed rules are effective upon filing, some are subject to SEC approval before they can go into effect.
The Investment Company Act of 1940 was signed into law by President Roosevelt in 1940. It was created to protect investors from unscrupulous managers and companies. The Investment Company Act, which regulates mutual funds and other investment companies, make specific disclosures regarding their management, fees, investment objectives, risks, performance, and expenses to the public.
The Investment Adviser’s Act provides the rules and regulations regarding the conduct of and disclosures by registered investment advisers. Generally speaking, and there are exceptions, an investment adviser is a person or entity who provides investment advice for compensation. The SEC typically regulates investment advisers that have assets under management in excess of $100,000,000. Investment advisers that do not meet this threshold generally are regulated by the states.
Both the SEC and the states may require certain advisers to hedge funds, venture capital funds, and other private funds that are not required to be registered to instead file reports with them.
In 1996 Congress amended the Investment Advisers Act of 1940 to require that the SEC establish a readily accessible electronic process to respond to public inquiries about investment advisers and their disciplinary information. The SEC created the Investment Adviser Public Disclosure website and database, which is available and searchable by the public
This Act applies to debt securities such as bonds, debentures, and notes that are offered for public sale. Even though such securities may be registered under the Securities Act, they may not be offered for sale to the public unless a formal agreement between the issuer of bonds and the bondholder, known as the trust indenture, conforms to the standards of this Act.
The Securities Investor Protection Act of 1970 was created by Congress in response to a number of failures of some brokerage firms in the 1960s. A significant problem was created as the cash and securities customers that were held at these firms were lost, or tied up in lengthy bankruptcy proceedings. In addition to mounting customer losses and the subsequent erosion of investor confidence, Congress was concerned with a possible “domino effect” involving otherwise solvent brokers that had substantial open transactions with firms that failed.
Congress enacted the SIPA in reaction to this growing concern. The goal was to prevent the failure of more brokerage houses, restore investor confidence in the capital markets, and upgrade the financial responsibility requirements for registered brokers and dealers. Securities Investor Protection Corp. v. Barbour, 421 U.S. 412, 414 (1975).
Congress designed the SIPA to apportion responsibility for carrying out the various goals of the legislation to several groups. Among them are the SEC, various securities industry self-regulatory organizations, and SIPC. The SIPA was designed to create a new form of a liquidation proceeding. It is applicable only to member firms and was designed to accomplish the completion of open transactions and the speedy return of most customer property.
SIPA establishes a Securities Investor Protection Corporation, commonly known by the acronym “SIPC”. SIPC is a non-profit membership organization, whose members include all brokers or dealers who are members of a national securities exchange or are otherwise registered as brokers or dealers under 15 U.S.C. A, § 78o (b). Unless a broker or dealer falls within one of the exceptions contained in 78ccc(a)(2)(B), membership in SIPC is mandatory.
SIPC’s main function is to step in to liquidate a broker or dealer when customers’ assets are in danger and to protect a customer up to a total amount of $50,000 represented by proven claims to cash and securities expected to be in the hands of the broker or dealer. But no more than $20,000 represented by claims to cash can be recovered under the protective plan of SIPC, though the claim to securities may exceed this limit.
National Securities Markets Improvement Act of 1996 amended Section 15(h) of the Securities Exchange Act of 1934. The Act made federal law controlling in certain aspects of the regulation of broker-dealers, such as record-keeping, financial standards, and operating requirements. In addition, the NSMIA amended the Securities Act of 1933 so that certain types of securities are no longer subject to state registration laws. However, offers and sales must still be registered, market participants must still register per a stateâ€™s blue skies laws, and fraud laws are still available as causes of action for individual investors.
Sarbanes-Oxley is a federal statute that was adopted as a reaction to a number of corporate and accounting scandals in the late 1990s and early 2000s. This Act amended numerous securities and investment statutes and created new or expanded requirements for all U.S. public company boards, management, and public accounting firms. There are also a number of provisions of the Act that also apply to privately held companies, such as the willful destruction of evidence to impede a federal investigation. The Act covers the responsibilities of a public corporationâ€™s board of directors, adds criminal penalties for certain misconduct, and requires the SEC to create regulations to define how public corporations are to comply with the law.
Dodd-Frank was enacted on July 21, 2010. The law was a reaction to the turmoil of the late 2000s and made changes that affected virtually all federal financial regulatory agencies and almost every part of the nation’s financial services industry.
The Act is categorized into 16 titles and it requires that regulators create 243 rules, conduct 67 studies, and issue 22 periodic reports.
For those brave souls who wish to jump right into it, the regulations under each Act are on the Web and we have provided links to the statutes and rules here, as well as at Securities Rules and Regulations. As stated elsewhere, be sure to consult an attorney before relying on those rules, and the text and the interpretations of those rules are in a constant state of flux.
Securities regulation forms the foundation of a well-functioning financial market. Regulatory bodies such as the Securities and Exchange Commission (SEC) in the United States play a crucial role in overseeing securities offerings, disclosures, and market activities. By enforcing regulations, they aim to maintain market confidence and foster investor trust. In addition to the SEC, FINRA plays a significant role in the oversight of financial professionals and their firms and has its own series of regulations. Finally, each State has its own securities regulatory body, and its own rules and regulations.
This collection of rules and regulations is an attempt to ensure compliance with securities laws and to protect the securities markets. Key components of these securities regulations include:
Registration and Reporting Obligations
Market participants must comply with registration and reporting obligations to provide transparency and accountability. This includes filing necessary disclosures, financial statements, and periodic reports with regulatory authorities.
Anti-Money Laundering (AML) and Know Your Customer (KYC) Measures
To combat illicit financial activities, securities compliance necessitates the implementation of robust AML and KYC measures. These measures help identify and mitigate the risk of money laundering, terrorist financing, and other fraudulent activities.
Insider Trading and Market Abuse
Securities compliance also involves strict regulations against insider trading and market abuse. Market participants must adhere to rules that prohibit the use of non-public information for personal gain, ensuring fair and equal opportunities for all investors.
Investor Protection and Disclosure Requirements
Investor protection is a cornerstone of securities compliance. Market participants must provide accurate and timely information to investors, enabling them to make informed investment decisions. This includes disclosing material facts, risks, and conflicts of interest associated with securities offerings.
Researching Investment Rules and Regulations
Those of you searching for federal securities law are well advised to start by reading a treatise on the subject, rather than the statutes themselves since the statutes are only the start of the climb into securities laws.
Secondary Sources and Collections
The SEC’s Office of Investor Education and Advocacy has issued a number of useful resources for investors. The SEC’s website offers a variety of free educational and informational resources, including investor bulletin boards, guides, and publications, as well as a searchable database of SEC no-action letters.
The Commission’s investor publications include:
- For Seniors – Protect Yourself Against Investment Fraud
- Mutual Funds – A Guide for Investors
- Questions You Should Ask About Your Investments
- Saving and Investing – A Roadmap To Your Financial Security Through Saving and Investing
Section 10b-5 and Rule 10b-5
The most well-known federal securities law is Rule 10b-5, promulgated pursuant to Section 10b of the 34 Act. The Rule is the most often used Rule in the area of securities law, and almost every securities fraud case involves, in one way or another, Rule 10b-5.
Rule 10b-5, and Section 10b are known as the Anti-Fraud provisions of the 34 Act, and most federal regulations flow from this rule. The rule has been the subject of extensive litigation, and later revisions to this article will address some of the significant aspects of those matters, including insider trading, market manipulation, fraud in connection with public offerings and takeovers, and fraud in connection with dealings with customers.
Federal Securities Law Court Decisions
The laws relating to insider trading have come predominately from the federal courts, not Congress.
For example, the federal securities laws relating to insider trading are almost exclusively from the federal courts, including:
SEC v. Texas Gulf Sulphur Co. (1971) -The court stated that anyone in possession of inside information must either disclose the information or refrain from trading.
Dirks v. Securities and Exchange Commission (1983). The Supreme Court held that those who receive inside information from an insider are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information.
SEC vs. Materia (1984), a case where the “insider” was represented by New York Securities Lawyer Mark Astarita and his partner, is the case that first introduced the misappropriation theory of liability for insider trading. Materia, a financial printing firm proofreader, and clearly not an insider was found to have determined the identity of takeover targets based on proofreading tender offer documents in the course of his employment. After a three-week trial, the district court found him liable for insider trading, and the Second Circuit Court of Appeals affirmed holding that the theft of information from an employer, and the use of that information to purchase or sell securities in another entity, constituted fraud in connection with the purchase or sale of a security. This was the first use of the misappropriation theory of insider trading, expanded insider trading liability to corporate â€œoutsidersâ€ and was eventually adopted by the Supreme Court.
United States v. Carpenter (1986) -the court found liability for a trader who received information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of â€œHeard on the Streetâ€ columns appearing in the Journal.
The Court stated in Carpenter: â€œIt is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principal for any profits derived therefrom.â€
United States v. O’Hagan (1997). The Supreme Court adopted the misappropriation theory of insider trading from SEC vs. Materia. O’Hagan was an attorney whose law firm was representing a company that was considering a tender offer O’Hagan used this inside information by buying call options on the target’s stock.
The Supreme Court held in O’Hagan that a person commits fraud â€œin connection withâ€ a securities transaction and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. When an employee or former employee engages in securities fraud while working at the company, the misappropriation theory may be used to hold the employer liable for the employee’s acts.
In 2000, the SEC enacted SEC Rule 10b5-2, which defined trading on the basis of inside information as any time a person trades while aware of material nonpublic information. It is no longer a defense for one to say that one would have made the trade anyway. The rule also created an affirmative defense for pre-planned trades known as 10b-5 plans.
Morgan Stanley v. Skowron, (2013) The New York federal court held that a hedge fund’s portfolio manager engaging in insider trading in violation of his company’s code of conduct, which also required him to report his misconduct, must repay his employer the full $31 million his employer paid him as compensation during his period of faithlessness. The court called insider trading the “ultimate abuse of a portfolio manager’s position”. The judge also wrote: “In addition to exposing Morgan Stanley to government investigations and direct financial losses, Skowron’s behavior damaged the firm’s reputation, a valuable corporate asset.
United States v. Newman (2014), the United States Court of Appeals for the Second Circuit cited the Supreme Courtâ€™s decision in Dirks, and ruled that for a tippee (a person who used the information they received from an insider) to be guilty of insider trading, the tippee must have been aware not only that the information was insider information, but must also have been aware that the insider released the information for an improper purpose (such as a personal benefit). The Court concluded that the insiderâ€™s breach of a fiduciary duty not to release confidential information ”in the absence of an improper purpose on the part of the insider” is not enough to impose criminal liability on either the insider or the tippee.
State Securities Laws
While the SEC directly, and through its oversight of FINRA and the various Exchanges, is the main enforcer of the nation’s securities laws, each individual state has its own securities regulatory body, typically known as the state Securities Commissioner. A list of state securities commissioners, and their addresses, is available in our Guide to State Securities Regulators.
The various state securities regulators have most of their impact in the area of registration of securities brokers and dealers and in the registration of securities transactions. For further information on the state regulatory scheme, and its impact on market participants, see Introduction to the Blue Sky Laws.
Common Law and the Securities Markets
In addition to the varied securities rules and regulations enacted by statute, there is a large body of case law, and decisions by judges, which impact severely on the securities industry. Briefly, there is the concept of common law fraud, and in theory, if perchance a particular act did not fall within the scope of the federal securities laws, the actor may still be subject to a fraud claim under the common law. In some states, and in certain circumstances stock brokers may be considered to be fiduciaries to their customers. That is, they are expected to conduct themselves with a higher degree of care than would the ordinary person. Additionally, the common law notions of contract and negligence also find their way into the securities laws, for each purchase and sale of a security is, in reality, a contract, and each transaction between market participants, whether in the financing of an IPO, or in the customary stock purchase with a broker, can involve issues of negligence law. For an example of how the common law interfaces with the securities laws and securities transactions, see Customer Disputes.
Federal Securities Law Violations
Later versions of this document will include a discussion of the various types of securities law violations that occur under federal law, including insider trading, market manipulation, fraudulent financial statements, and similar topics.
Louis Loss has long been the top author in the area of federal securities law and securities regulations. Loss’ treatise is a staple in every securities attorney’s library. His single-volume version, Fundamentals of Securities Regulation is an excellent resource for the layman, as well as for the attorney who does not practice securities law every day. Follow the link, and you can order it online, at a discount, from Amazon.com.
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Mark Astarita is a nationally recognized securities attorney, who represents investors, financial professionals and firms in securities litigation, arbitration and regulatory matters, including SEC and FINRA investigations and enforcement proceedings.
He is a partner in the national securities law firm Sallah Astarita & Cox, LLC, and the founder of The Securities Law Home Page - SECLaw.com, which was one of the first legal topic sites on the Internet. It went online in 1995 and is updated daily with news, commentary and securities law related links.