The story of the American stock market dates back hundreds of years. Suffice to say that the symbol of the financial industry as a whole and the largest stock market in the world – the New York Stock Exchange – was founded in 1792. The breakthrough towards modern regulation started after the market meltdown during the Great Depression. As a result the US Securities Act was adopted in 1933. Before the Act, primary placement investors received minimum information and the securities could have been bought on margin. The Act established a detailed information disclosure for investors, filing of a special form, the Registration Statement, to the Securities and Exchange Commission (created in 1934) for public securities sales and forbade the purchase of primary placement securities on margin.
Therefore, the essence of the Act is that a detailed information disclosure is required while trading securities in the open market and in case the securities are not exempt or an exempt transaction, a principal’s approval is mandatory. For example, according to the Act, trading in government and municipal securities serves as an exception and as such is regulated separately. The same refers to short-term commercial paper and bank notes. For example, placement within one state is regulated by the state not by the federal law, private placements are limited to a number of investors as well as securities placement of less than $ 5 M does not require long-lasting and expensive underwriting for prospect preparation, filing and the commission approval.
The Securities Act was adopted at the end of 1933 followed by the Securities and Exchange Act of 1934. Just like the Act of 1933 regulates the issuance of new securities, the Act of 1934 regulates the turnover of already issued securities. Prior to the Act of 1934 manipulating the market was a usual practice and was legal. Surplus credits for securities purchase were generally used; public companies did not have strict standards of financial reports, companies’ officials made use of insider information for personal gain.
As a result of adopting the Securities and Exchange Act of 1934, manipulating the market was considered fraud and became punishable by law and insiders were forbidden to use non-public significant information to gain a profit or generate a loss. Stock exchanges were required to be registered with the Securities and Exchange Commission, created by the Act. The Act also implemented broker-dealer regulation. They, as well as the stock exchange, were required to be registered with the Commission. Special requirements for brokers were implemented as well such as, capital stock requirements, client securities custody regulations, information disclosures, etc.
The Investment Company Act was adopted in 1940. An investment company is a company whose core activity is investing into securities. There are two main types of investment companies today: mutual funds and closed type investment companies. Mutual funds are the most popular, they buy and sell shares themselves for the price evaluated based on the net assets per share. The second, trade on stock exchange like usual corporations.
Broker-dealer regulations in the States are stricter than those for management companies. First of all, brokers should be registered with the US Securities and Exchange Commission. In practice, they are regulated by FINRA (Financial Industry Regulatory Authority) – an institution, formed as a result of merging the New-York Stock Exchange Compliance Department with NASDAQ. Hundreds of legislative acts concerning investment and banking business regulation were adopted before and after the creation of FINRA. A broker-dealer is required to have at least 2 principals possessing the Series 24 (General Securities Principal), a principal possessing the Series 27 (Financial and Operations Principal). They must follow anti-money laundering legislation, observe the rules of storing information about clients and their activity, file net assets cost calculations in regards to it sufficiency to SEC monthly, hold an annual audit, etc. The number of requirements seems endless.
An investment company, according to the US Law, should have $100,000.00 USD of minimum net assets, be managed by a registered investment advisor and cannot purchase securities on margin. On top of that, 40% of the Board members should be independent of the company. Violating the Investment Company Act is punishable by a fine of $10,000.00 or more and/or imprisonment for up to 5 years.
In 1940, together with the Investment Company Act, the Investment Advisor Act was adopted. An investment advisor is a company which gives advice regarding selling and purchasing stock in any form and receiving compensation for such services. Today, investment advisors (i.e. management companies) managing over $100,000,000 USD of assets are regulated by the Act of 1940 and must be registered with the Securities and Exchange Commission. Companies managing fewer assets are regulated by State legislation and must get approval by the Secretary of State.
Representatives (individuals) of a management company managing any asset volume are required to be licensed, passing the Series 65 examination (Uniform Registered Investment Advisor). Some states require representatives to obtain the Series 63 (Uniform Securities Agent Laws). Possessing these licenses is one of the many conditions for registering a managing company on both the Federal and State levels. Detailed information regarding the requirements for a management company and its activities are disclosed in the regulatory notes which are the basis for passing the Series 65 and 63. To illustrate: the examination for the Series 65 lasts 3 hours and includes 130 questions. Around 70% of the questions concern economics, investments, portfolio management and 30% refer to US securities legislation. As of the date of writing this article, one is required to answer 94 questions correctly.
A broker representative who sells securities and contacts potential clients is required to possess the Series 7 (General Securities Registered Representative) while a representative participating in investment and banking structures should possess the Series 79. The Series 7 examination lasts 6 hours, including a 30-minute break. The questions cover securities, the stock market, options, clients’ accounts, underwriting, taxes, investment companies, regulations, analysis, etc.
Therefore, the basis of US stock market regulation is the Securities Act of 1933, the Securities and Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisor Act of 1940.
Other important acts include the Trust Indenture Act of 1939. It refers to issuing corporate bonds over $5M USD in 12 months with a max maturity of 9 month. The Act was adopted to insure better protection for corporate bondholders. It obligates the issuer to appoint a trustee acting in the interests of the bondholders and is responsible for the issuer to fulfill the issuance contract.
After the default of broker-dealer companies in the 1960’s, the Securities Investor Protection Act was adopted in 1970. The Act tightened the financial regulations of a broker-dealer and the Securities Investor Protection Corporation was created as a result. In essence, SICP is an independent insurance company which, in case of a broker-dealer’s bankruptcy, guarantees the return of up to $500,000 USD to the client. However, the return of cash cannot be more than $100,000 USD (equal to the FDIC in the banks which, at the moment is at $250,000. This amount will fluctuate again in the near future). Indemnity refers to securities, but does not refer to, for instance, products and futures which are not securities according to the US Legislation. The source of financing for SIPC are broker-dealers’ membership payments to the SIPC.
One of the latest regulatory acts in market regulation was the Sarbanes Oxley Act of 2002. Due to numerous corporate scandals, the requirements for companies’ reports were tightened, the managers’ responsibility for presenting credible information to the investors increased, the Corporate Management Code was implemented, the auditors’ activity was limited, etc.
One of the significant Acts adopted in the US since the Great Depression was the Dodd-Frank Act of 2010. The Act came as a result of Congress’ reaction to the 2008 crisis. It aimed at improving financial industry stability through greater transparency of records especially, of commercial banks. Nevertheless, along with the banks, the Act implemented regulation of hedge-funds, management and insurance companies, credit agencies and broker-dealers.
Today, we can confidently say that since the beginning of the 20th century, regulatory acts adopted in the US tightened the responsibility for the US markets and its participants. This will become a continuous trend for the foreseeable future. However, this has started to tire market participants. On the other hand, shareholders’ protection is the strongest it has ever been in the US. Yet, there is obviously no golden mean for both sides today.