Securities Regulation
Professor William C. Tyson, Fall 2005
Topic 1—Introduction
A. History of Securities Regulation: “Of Bubbles and Giants”
1. The Securities Act of 1933 did not spring full grown from the brow of any New Deal Zeus… It followed a generation of state legislation and several centuries of legislation in England.”
a. Britain’s South Sea Bubble: bursting of the bubbles led to Bubble Act of 1720
b. U.S. stock market crash of 1929, followed by the Great Depression led to federal securities laws.
i. Point: financial cycles
B. Economic and Policy Rationales for Securities Regulation
1. From an economic standpoint, why do we have Sec. Reg.?
a. Wealth maximization entails economic efficiency which requires correcting market imperfections
i. Asymmetry of information: one party to a transaction (the seller) has all the information about the item (e.g., stock, car), but the putative buyer has a lack of information, and thus the transaction, which may be advantageous transaction, may not occur. Therefore, if we can eliminate this market imperfection, we can improve wealth maximization. One way to do this is through regulation, forcing the party w/ knowledge to disclose the information he has to the other party.
C. Federal Securities Law: 7 organic federal securities laws (this course concerns the first two)
1. Securities Act of 1933 (hereinafter “SA 33”) requires episodicdisclosure.
a. Regulates the distribution of securities (2 types of securities to raise capital)
i. Debt security: bonds (loans→bonds→interest)
ii. Equity security : stocks (investment→stock→dividends)
b. Two-fold purpose:
i. Disclose ALL relevant information concerning the value of the securities sold so that investors can make an informed decision
ii. To prevent fraudin the offer & sale of securities.
2. Securities Exchange of 1934 (hereinafter EA 34) requires continuous disclosure(through periodic disclosures à annual, quarterly reports)
a. Regulates post-distribution trading (Tender offers, insider trading, proxy solicitations
3. Public Utility Holding Company Act of 1935
a. Registration and regulation of public utility holding companies
b. Designed to correct abuses in the financing of public utility companies
c. Requires SEC approval before issuance of securities or changing their financial structure
d. Some feel the Act should be repealed, since it is no longer needed: we previously needed it when we had elaborately-tiered holding companies w/ much abuse.
i. e.g., PECO is a holding company for PECO Electric.
4. Trust Indenture Act of 1939
a. Regulates public offering of DEBT (not equity) securities in tandem with SA 33.
b. If the transaction is for < $5M, you don’t have to comply
c. Trust indenture: A document stating the terms under which a bond is issued; a contract b/w a selling company and the trustee (who plays the role of safeguarding rights and interest of purchasers of debt securities being sold to the public). There can’t be any conflict of interest b/w trustee and the issuer.
5. Investment Company Act of 1940
a. Regulation requirements and regulations for publicly-owned companies that invest in securities
i. Investment company: e.g., mutual fund
1. Caveat!: each mutual fund is a separate company and must be registered accordingly
ii. Industrial company: generally provides services or makes goods
b. Open-end investment company: redeemable securities (most common)
i. If you own a security, you can redeem it at any time.
ii. Typically, the company will continuously offer new funds to the public to cover the cost of redeeming securities.
iii. An investor usually purchases shares in the open market from mutual fund. May occasionally offer new securities to the public.
iv. Each mutual fund is separate and must register w/ SEC
c. Closed-end investment company: non-redeemable securities (must sell securities to market place to get you money back; cannot sell back to company)
d. Hedge funds: exempt from the ICA for two reasons
i. Fewer than 100 members
ii. Made up of sophisticated investors
6. Investment Advisers Act of 1940
a. Investment advisor: not a broker dealer
i. Sole function: to provide financial advice. They do not involve transaction of securities.
ii. Sets up and sponsors mutual funds and gives advice to investment companies
iii. Regulated by SEC and must register w/ SEC
b. Now SEC requires regulation and registration of hedge fund investment advisor even though the hedge fund itself is exempt; this opens up to scrutiny the entire operation of the hedge fund.
7. Securities Investor Protection Act of 1970
a. Set non-profit organization: Securities Investor Protection Corporation (SIPC)
i. Receives funding from:
1. Assessments on the members (most securities firms must belong to the SIPC)
2. $1B line of credit from the gov’t
ii. SIPC helps customers when a securities firm fails, providing up to:
1. $500K per account coverage but
2. $100K per account max for cash.
iii. Customers deposit money w/ a broker dealer firm:
1. Covered up to $500K (up to $100K in cash and additional $400K in securities) unless you put up no cash in which case you are covered for $500K in securities.
2. The analog in banking is FDIC.
D. Related Statutes
1. Bankruptcy Reform Act of 1978 (most recent iteration)
a. Authorizes the SEC to serve as an advisor when there is a substantial public interest to the U.S. Bankruptcy courts.
2. Sarbanes-Oxley Act of 2002: Bill won’t call it as one of the organic federal securities statutes.
a. Addresses the systemic issues in securities market.
i. Sets out the broker-dealer responsibility.
ii. Audit independence provisions (cannot do both audit and consulting)
iii. Independent accounting oversight board.
iv. Corporate governance and responsibility measures
v. Mandatory disclosure requirement: conflict of interest (underwriters are also analysts)
1. Regulation A-C
vi. Deals w/ securities fraud
3. Jurisdictional base: Congress’ interstate commerce and postal clause powers
a. SA 33 and EA 34 only regulate securities transaction that use interstate commerce and mails: after Lopez, they were cautious
i. Art. I. Sec. 8: Commerce Clause—securities transactions usually involve interstate commerce
ii. Postal power: securities usually involve mail
b. CAVEAT: intra state communication or use of mail is covered.
c. Loophole: activity is only regulated if the jurisdictional means are used.
i. i.e., if you sell securities personally, no federal securities laws apply.
4. Federal Securities Code: ALI, ABA, and SEC tried to put all organic securities laws together.
a. Never adopted.
E. Securities Exchange Commission (SEC) (independent nonpartisan agency)
1. History: In 1933, FTC did the work. In 1934, SEC was c
ii. Each exchange is called Self-regulatory Organizations (SRO): each has its own rules
iii. Must be registered and are subject to SEC oversight
b. Over-the-counter (OTC) market:: Securities Association (only 1), aka second market (dealer market)
i. Non-tangible market: just telephones and computers matching buyers & sellers, no auctioneers
ii. Use of intermediary or a broker dealer
iii. NASDAQ (National Association of Securities Dealers, Inc.): only 1 Securities Association that is in charge of all OTC market transaction
1. Subject to SEC oversight
2. SRO: Rules of NASD.
iv. SuperMontage: developed by NASDAQ to compete w/ ECN
v. OTC bulletin Board
c. Securities that are enlisted in NYSE but traded on OTC market (third market transactions)
i. Securities that are listed and can trade on exchange but instead trade on OTC
d. Individual persons or firms, trading w/o assistance of an underwriter
i. Private sales
2. Glass Steagall Act of 1933: Regulated commercial banks
a. IB business was focused on securities transactions (IB underwriting)
b. Underwriting could only be done by securities firms: Banks could not do both commercial and investment banking b/c of the conflict of interest, unless through a subsidiary that accounted for only up to 25% of gross revenue and w/ the ad hoc approval of the Federal Reserve Board.
i. Congress passed a statute prohibiting commercial bank from dealing in securities except gov’t bonds
ii. Policy concern that you don’t want losses in one area (IB) to bring down another (CB)
iii. Federal Reserve Board, which oversees enforcement of Glass Steagall Act allows some banks on ad hoc basis to expand into underwriting and trading (e.g., Bankers’ Trust, Nations’ Bank, and Union Bank but the broker-dealer must be a subsidiary; separately capitalized; w/ not more than 25% of the gross revenues coming from investment banking)
3. Gramm-Leach-Bililey Act of 1999: Significantly dismantled major portion of Glass-Steagall Act.
a. Dismantled the distinction b/w CB and IB: allows one-stop shopping
b. However, there must be a subsidiary so that the liability does not affect the other
c. IBs still can’t deal w/ pension funds.
4. Functional v. consolidated regulation: securities, insurance, and banking.
a. In the U.S., the industry is consolidated, but the regulation is still functional.
i. Banks: regulated by Federal Reserve and the state bank commission
ii. Insurance industry: regulated by certain state insurance commission
iii. Securities: regulated by the feds.
5. Activities of Securities Firms (Merrill Lynch, Goldman Sachs)
