The Securities Act of 1933 was the first major piece of securities industry regulation, which was brought about largely as a result of the stock market crash of 1929. Other laws also were enacted to help prevent another meltdown of the nation's financial system, such as the Securities Exchange Act of 1934, which will be discussed next.
The Securities Act of 1933 regulates the primary market. The primary market consists exclusively of transactions between issuers of securities and investors. In a primary market transaction, the issuer of the securities receives the proceeds from the sale of the securities. The Securities Act of 1933 requires nonexempt issuers, typically corporate issuers, to file a registration statement with the Securities Exchange Commission (SEC). The SEC will review the registration statement for a minimum of 20 days. During this time (known as the cooling-off period), no sales of securities may take place. If the SEC requires additional information regarding the offering, the SEC may issue a deficiency letter or a stop order that will extend the cooling-off period beyond the original 20 days. The cooling-off period will continue until the SEC has received all of the information it has requested. The registration statement—formally known as an S1—is the issuer's full-disclosure document for the registration of the securities with the SEC.
While the SEC is reviewing the securities' registration statement, a registered representative is very limited as to what they may do with regard to the new issue. During the cooling-off period, the only thing a registered representative may do is obtain indications of interest from clients by providing them with a preliminary prospectus, also known as a red herring. The term red herring originated from the fact that all preliminary prospectuses must have a statement printed in red ink on the front cover stating: “These securities have not yet become registered with the SEC and therefore may not be sold.” An indication of interest is an investor's or broker dealer's statement that they may be interested in purchasing the securities being offered. The preliminary prospectus must be delivered in hard copy to all interested parties. The preliminary prospectus contains most of the same information that will be contained in the final prospectus, except for the offering price and the proceeds to the issuer. All information contained in a preliminary prospectus is subject to change or revision.
All purchasers of new issues must be given a final prospectus before any sales may be allowed. The final prospectus serves as the issuer's full-disclosure document for the purchaser of the securities. If the issuer has filed a prospectus with the SEC and the prospectus can be viewed on the SEC's website, a prospectus will be deemed to have been provided to the investor through the access equals delivery rule. Once the issuer's registration statement becomes effective, the final prospectus must include:
The SEC reviews the issuer's registration statement and the prospectus but does not guarantee the accuracy or adequacy of the information. The SEC disclaimer must appear on the cover of all prospectuses. It states: “These securities have not been approved or disapproved by the SEC nor have any representations been made about the accuracy or the adequacy of the information.”
Financial relief for misrepresentations made under the Securities Act of 1933 is available for purchasers of any security that is sold under a prospectus that is found to contain false or misleading statements. Purchasers of the security may be entitled to seek financial relief from any or all of the following:
Issuers may use forward-looking statements to provide details about its future prospects to purchasers. These forward-looking statements must be identified by key words such as expect, predict, estimate, anticipate, or potential. These words are used so that the reader clearly understands that the statements are management's projections.
The Securities Exchange Act of 1934 was the second major piece of legislation that resulted from the market crash of 1929. The Securities Exchange Act regulates the secondary market that consists of investor-to-investor transactions. All transactions between two investors that are executed on any of the exchanges or in the over-the-counter market are secondary market transactions. In a secondary market transaction, the selling security holder receives the money, not the issuing corporation. The Securities Exchange Act of 1934 also regulates all individuals and firms that conduct business in the securities industry. The Securities Exchange Act of 1934:
One of the biggest components of the Securities Exchange Act of 1934 was the creation of the SEC. The SEC is the ultimate securities industry authority and is a direct government body. Five commissioners are appointed to five-year terms by the president and each must be approved by the Senate. No more than three commissioners may be from any one political party. The SEC is not a self-regulatory organization (SRO) or a designated examining authority (DEA). A self-regulatory organization is one that regulates its own members such as the NYSE or FINRA. A designated examining authority is one that inspects a broker dealer's books and records and also can be the NYSE or FINRA. All broker dealers, exchanges, agents, and securities must register with the SEC. All exchanges are required to file a registration statement with the SEC that includes the articles of incorporation, bylaws, and constitution. All new rules and regulations adopted by the exchanges must be disclosed to the SEC as soon as they are enacted. Issuers of securities with more than 500 shareholders and with assets exceeding $5,000,000 must register with the SEC, file quarterly and annual reports, and must solicit proxies from stockholders. A broker dealer who conducts business with the public must register with the SEC and maintain a certain level of financial solvency known as net capital. All broker dealers are required to forward a financial statement to all customers of the firm. Additionally, all employees of the broker dealer who are involved in securities sales, have access to cash and securities, or who supervise employees must be fingerprinted.
The Securities Act of 1934 gave the authority to the Federal Reserve Board (FRB) to regulate the extension of credit by broker dealers for the purchase of securities by their customers. The following is a list of the regulations of the different lenders and the regulation that gave the FRB the authority to govern their activities:
The Public Utilities Holding Company Act of 1935 regulates all companies that are in business to provide retail distribution of gas and electric power. Because the companies are regulated by this act, their securities are exempt from state registration requirements.
The Maloney Act of 1938 was an amendment to the Securities Exchange Act of 1934 that allowed the creation of the NASD. The NASD, now part of FINRA, is the self-regulatory organization for the over-the-counter (OTC) market and its purpose is to regulate the broker dealers who conduct business in the OTC market. FINRA has four major bylaws. They are the:
The Trust Indenture Act of 1939 requires that corporate bond issues in excess of $5,000,000 dollars that are to be repaid during a term in excess of one year issue a trust indenture for the issue. The trust indenture is a contract between the issuer and the trustee. The trustee acts on behalf of all of the bondholders and ensures that the issuer is in compliance with all of the promises and covenants made to the bondholders. The trustee is appointed by the corporation and is usually a bank or a trust company. The Trust Indenture Act of 1939 only applies to corporate issuers. Both federal and municipal issuers are exempt.
The Investment Advisers Act of 1940 regulates industry professionals who charge a fee for the advice they offer to clients. The Investment Advisers Act sets forth registration requirements for advisers as well as disclosure requirements relating to the adviser's:
The Investment Advisers Act of 1940 prohibits an investment adviser from disclosing client information to a third party without the client's consent unless the adviser is required or compelled to disclose the information by law.
The Investment Company Act of 1940 regulates companies that are in business to invest or reinvest money for the benefit of its investors. The Investment Company Act sets forth registration requirements for the three types of investment companies. They are:
FINRA member firms will seek to increase their business and exposure through the use of both retail and institutional communications. There are strict regulations in place in order to ensure all communications with the public adhere to industry guidelines. Some communications with the public are available to a general audience and include:
Other types of communications are offered to a targeted audience. These communications include:
FINRA Rule 2210 replaces the advertising and sales literature rules previously used to regulate member communications with the public. FINRA Rule 2210 streamlines member communication rules and reduces the number of communication categories from six to three. The three categories of member communication are:
Retail communication is defined as any written communication distributed or made available to 25 or more retail investors in a 30-day period. The communication may be distributed in hard copy or in electronic formats. The definition of a retail investor is any investor who does not meet the definition of an institutional investor. Retail communications now contain all components of advertising and sales literature. All retail communications must be approved by a registered principal prior to first use. The publication of a post in a chat room or other online forum will not require the prior approval of a principal so long as such post does not promote the business of the member firm and does not provide investment advice. Additionally, generic advertising will also be exempt from the prior approval requirements. All retail communication must be maintained by the member for three years. If the member firm is a new member firm, which has been in existence for less than 12 months based on the firm's approval date in the central registration depository or CRD, the member must file all retail communications with FINRA 10 days prior to its first use unless the communication has been previously filed and contains no material changes or has been filed by another member such as investment company or ETF sponsor. Member firms that have been established for more than 12 months may file retail communications with FINRA 10 days after the communication is first used. Investment companies, ETF sponsors, and retail communications regarding variable annuities must be filed 10 days prior to first use. If the communication contains nonstandardized performance rankings. Should FINRA determine that a member firm is making false or misleading statements in its retail communications with the public, FINRA may require the member to file all of its retail communications with the public with the association 10 days prior to its first use.
Intuitional communication is defined as any written communication distributed or made available exclusively to institutional investors. The communication may be distributed in hard copy or in electronic formats. Institutional communications do not have to be approved by a principal prior to first use so long as the member has established policies and procedures regarding the use of institutional communications and has trained its employees on the proper use of institutional communication. Institutional communication is also exempt from FINRA's filing requirement but like retail communications it must be maintained by a member for three years. If the member believes that the institutional communication or any part thereof may be seen by even a single retail investor the communication must be handled as all other retail communication and is subject to the approval and filing requirements as if it was retail communication. An institutional investor is a person or firm that trades securities for his or her own account or for the account of others. Institutional investors are generally limited to large financial companies. Because of their size and sophistication, fewer protective laws cover institutional investors. It is important to note that there is no minimum size for an institutional account. Institutional investors include:
Correspondence consists of electronic and written communications between the member and up to 25 retail investors in a 30 calendar-day period. With the increase in acceptance of email as business communication, it would be impractical for a member to review all correspondence between the member and a customer. The member instead may set up procedures to review a sample of all correspondence, both electronic and hard copy. If the member reviews only a sample of the correspondence, the member must train their associated people on their firm's procedures relating to correspondence and must document the training and ensure the procedures are followed. Even though the member is not required to review all correspondence, the member must still retain all correspondence. The member should, where practical, review all incoming hard copy correspondence. Letters received by the firm could contain cash, checks, securities, or complaints.
Neither an investment adviser nor a broker dealer is deemed to have a place of business in a state where it does not maintain an office simply by virtue of the fact that the publicly available website established by the firm or one of its agents is accessible from that state so long as the following conditions are met:
The content of any website must be reviewed and approved by a principal prior to its first use and must be filed with FINRA within 10 days of use. If the firm or its agent updates the website and the update materially changes the information contained on the website, the updates must be reapproved by a principal and refiled with FINRA. As changes are made to the website each version is subject to the filing requirements and the firm will often have various versions of the site archived to comply with the retention requirement. The website may use the FINRA logo so long as the use is only to demonstrate that the firm is a FINRA member and a hyperlink to the FINRA website is included in close proximity to the logo.
A blind recruiting ad is an ad placed by the member firm for the specific purpose of finding job applicants. Blind recruiting ads are the only form of advertising that does not require the member's name to appear in the ad. The ads may not distort the opportunities or salaries of the advertised position. All other ads are required to disclose the name of the member firm, as well as the relationship of the member to any other entities that appear in the ad.
Generic advertising is generally designed to promote firm awareness and to advertise the products and services generally offered through the firm. Generic ads will generally include:
A tombstone ad is an announcement of a new security offering coming to market. Tombstone ads may be run while the securities are still in registration with the SEC and may only include:
Tombstone ads must include:
All advertising and sales literature is required to be approved by a principal of the firm prior to its first use. A general security principal (Series 24) may approve most advertising and sales literature. Any advertising or sales literature relating to options must be approved by a registered option principal or the compliance registered options principal. Research reports must be approved by a supervisory analyst.
From time to time, broker dealers will use testimonials made by people of national or local recognition in an effort to generate new business for the firm. If the individual giving the testimonial is quoting past performance relating to the firm's recommendations, it must be accompanied by a disclaimer that past performance is not indicative of future performance. If the individual giving the testimony was compensated in any way, the fact that the person received compensation must also be disclosed.
Should the individual's testimony imply that the person making the testimony is an expert, a statement regarding their qualifications as an expert must also be contained in the ad or sales literature. Research prepared by outside parties must disclose the name of the preparer.
If a member firm or investment adviser advertises free services to customers or to people who respond to an ad, the services must actually be free to everyone and with no strings attached.
The practice of providing so-called free lunch seminars presents several unique compliance concerns. Firms that sponsor seminars that are marketed to investors as educational workshops often provide attendees with a “free lunch” as a way to help market the seminar and state that “no investment products will be offered or sold” at the seminar. However, firms who sponsor these seminars clearly intend to establish a business relationship with the attendees. The firms may try to get the attendees to open an account either at the seminar or during a follow-up solicitation to offer investment products. Firms who sponsor so-called free lunch seminars must ensure that strict compliance procedures are followed by the agents who lead the seminars. Without strict compliance to conduct and disclosures rules NASAA considers “free lunch” seminars a prohibited practice. Of particular concern are seminars that are marketed to seniors.
The following are some examples of misleading statements that are not allowed to appear in any communications with investors:
The Securities Investor Protection Corporation is a government-sponsored corporation that provides protection to customers in the event of a broker dealer's failure. All broker dealers who are registered with the SEC are required to be SIPC members. All broker dealers are required to pay annual dues to SIPC's insurance fund to cover losses due to broker dealer failure. If a broker dealer fails to pay their SIPC assessment, they may not transact business until it is paid.
All broker dealers are required to maintain a certain level of net capital in order to ensure that they are financially solvent. A broker dealer's capital requirement is contingent upon the type of business that the broker dealer conducts. The larger and more complex the firm's business is, the greater the net capital requirement. Should a firm fall below its net capital requirement, it is deemed to be insolvent, and SIPC will petition in court to have a trustee appointed to liquidate the firm and protect the customers. The trustee must be a disinterested party and, once the trustee is appointed, the firm may not conduct business or try to conceal any assets.
SIPC protects customers of a brokerage firm in much the same way that the FDIC protects customers of banks. SIPC covers customer losses that result from broker dealer failure, not for market losses. SIPC covers customers for up to $500,000 per separate customer. Of the $500,000, up to $250,000 may be in cash. Most broker dealers carry additional private insurance to cover larger accounts, but SIPC is the industry-funded insurance and is required by all broker dealers. The following are examples of separate customers:
| Customer | Securities Market Value | Cash | SIPC Coverage |
| Mr. Jones | $320,000 | $75,000 | All |
| Mr. & Mrs. Jones | $290,000 | $90,000 | All |
| Mrs. Jones | $397,000 | $82,000 | All |
All of the accounts shown would be considered separate customers and SIPC would cover the entire value of all of the accounts. If an account has in excess of $250,000 in cash, the individual would not be covered for any amount exceeding $250,000 in cash and would become a general creditor for the rest. SIPC does not consider a margin account and cash account as separate customers and the customer would be covered for the maximum of $500,000. SIPC does not offer coverage for commodities contracts and all member firms must display the SIPC sign in the lobby of the firm.
All SIPC members are required to obtain a fidelity bond to protect customers in the event of employee dishonesty. Some things that a fidelity bond will insure against are check forgery and fraudulent trading. The minimum amount of the fidelity bond is $25,000; however, large firms are often required to carry a higher amount.
The Securities Acts Amendments of 1975 gave the authority to the MSRB to regulate the issuance and trading of municipal bonds. The MSRB has no enforcement division. Its rules are enforced by other regulators.
The Insider Trading and Securities Fraud Enforcement Act of 1988 established guidelines and controls for the use and dissemination of nonpublic material information. Nonpublic information is information that is not known by people outside of the company. Material information is information regarding a situation or development that will materially affect the company in the present or future. It is not only just for insiders to have this type of information, but it is required for them to do their jobs effectively. It is, however, unlawful for an insider to use this information to profit from a forthcoming move in the stock price. An insider is defined as any officer, director, 10% stockholder, or anyone who is in possession of nonpublic material information as well as the spouse of any such person. Additionally, it is unlawful for the insider to divulge any of this information to any outside party. Trading on inside information has always been a violation of the Securities Exchange Act of 1934, but the Insider Trading Act prescribed penalties for violators, which include:
Information becomes public information once it has been disseminated over public media. The SEC will pay a reward of up to 10% to informants who turn in individuals who trade on inside information. In addition to the insiders already listed, the following are also considered insiders:
Broker dealers who act as underwriters and investment bankers for corporate clients must have access to information regarding the company in order to advise the company properly. The broker dealer must ensure that no inside information is passed between its investment banking department and its retail trading departments. The broker dealer is required to physically separate these divisions by a firewall. The broker dealer must maintain written supervisory procedures to adequately guard against the wrongful use or dissemination of inside information.
The Telephone Consumer Protection Act of 1991 regulates how telemarketing calls are made by businesses. Telemarketing calls that are designed to have consumers invest in or purchase goods, services, or property must adhere to the strict guidelines of the act. All firms must:
The following are exempt from the Telephone Consumer Protection Act of 1991:
Calls may be made prior to 8 AM or after 9 PM to places of business. The time regulation only relates to contacting noncustomers at home.
The National Securities Market Improvement Act of 1996, also known as the Coordination Act, eliminated the duplication of effort among state and federal regulators. Some of the key points of the act include:
The National Securities Market Improvement Act of 1996 ensured that no action by any state or political subdivision could impose laws or requirements upon any broker dealer that differed from or are in addition to those of the Securities Exchange Act of 1934 relating to:
In the early half of the twentieth century, state securities regulators developed their state's rules and regulations for transacting securities business within their state. The result was a nation of states with regulations that varied widely from state to state. The Uniform Securities Act (USA) laid out model legislation for all states in an effort to make each state's rules and regulations more uniform and easier to address. The USA (also known as the Act) sets minimum qualification standards for each state securities administrator. The state securities administrator is the top securities regulator within the state. The state securities administrator may be the attorney general of that state or may be an individual appointed specifically to that post. The USA also:
The USA also sets civil and criminal penalties for violators.
The state-based laws set forth by the Uniform Securities Act are also known as Blue Sky laws.
All member firms must guard against money laundering. Every member must report any currency receipt of $10,000 or more from any one customer on a single day. The firm must fill out and submit a currency transaction report also known as Form 4789 to the Internal Revenue Service (IRS) within 15 days of the receipt of the currency. Multiple deposits that total $10,000 or more will also require the firm to file a currency transaction report (CTR). Additionally, the firm is required to maintain a record of all international wire transfers of $3,000 or greater.
The Patriot Act, as incorporated in the Bank Secrecy Act, requires broker dealers to have written policies and procedures designed to detect suspicious activity. The firm must designate a principal to ensure compliance with the firm's policies and to train firm personnel. The firm is required to file a Suspicious Activity Report for any transaction of more than $5,000 that appears questionable. The firm must file the report within 30 days of identifying any suspicious activity. Anti-money-laundering rules require that all firms implement a customer identification program to ensure that the firm knows the true identity of their customers. All customers who open an account with the firm, as well as individuals with trading authority, are subject to this rule. The firm must ensure that its customers do not appear on any list of known or suspected terrorists. A firm's anti-money-laundering program must be approved by senior management. All records relating to the SAR filing including a copy of the SAR report must be maintained by the firm for 5 years.
The money laundering process begins with the placement of the funds. This is when the money is deposited in an account with the broker dealer. The second step of the laundering process is known as layering. The layering process will consist of multiple deposits in amounts less than $10,000. The funds will often be drawn from different financial institutions; this is also known as structuring. The launderers will then purchase and sell securities in the account. The integration of the proceeds back into the banking system completes the process. At this point, the launderers may use the money to purchase goods and services and they appear to have come from legitimate sources. Firms must also identify the customers who open the account and must make sure that they are not conducting business with anyone on the OFAC list. This list is maintained by the Treasury Department Office of Foreign Assets Control. It consists of known and suspected terrorists, criminals, and members of pariah nations. Individuals and entities who appear on this list are known as Specially Designated Nationals and Blocked Persons. Conducting business with anyone on this list is strictly prohibited. Registered representatives who aid in the laundering of money are subject to prosecution and face up to 20 years in prison and a $500,000 fine per transaction. The representative does not even have to be involved in the scheme or even know about it to be prosecuted.
FinCEN is a bureau of the U.S. Department of the Treasury. FinCEN's mission is to safeguard the financial system and guard against money laundering and promote national security. FinCEN collects, receives, and maintains financial transactions data; analyzes and disseminates that data for law enforcement purposes; and builds global cooperation with counterpart organizations in other countries and with international bodies. FinCEN will email a list of individuals and entities to a designated principal every few weeks. The principal is required to check the list against the firm's customer list. If a match is found the firm must notify FinCEN within 14 calendar days.