Although it hasn't always been the case, the securities
industry in the U.S. today is subject to strict regulations.
It's important for you to know about some of the regulatory
bodies and their rules in order to make sure you stay
well within the limits of the law. Penalties for not
playing by the rules can be stiff and involve both hefty
fines and time in prison. Most of the time, it is individuals
who work on Wall Street or who are insiders at a company
that run afoul of the law. Still, it's a good idea for
even the average investor to know about the legal issues
that exist in the securities world.
The Securities and Exchange Commission was established in 1934 in order to correct some of the problems in the securities industry that had led to the Crash of 1929 and the resulting Great Depression. Before this time, there was no central regulatory agency responsible for enforcing securities legislation (granted, there was not much legislation to enforce). The SEC of today, however, is responsible for enforcing a wide variety of securities laws and ensuring that all market participants are playing by the rules.
The SEC is an independent, quasi-judiciary regulatory agency. It has five commissioners, each appointed for a five year term that is staggered so that one new commissioner is being replaced every year. In order to keep partisan politics to a minimum, no more than three members of the commission can be of a single political party. The commissioners are primarily responsible for enforcing the following pieces of securities legislation:
Securities Act of 1933: Prohibits fraud in the sale of securities and requires proper disclosure of information about public securities to investors.
Securities Exchange Act of 1934: Extends the Securities Act of 1933 to include securities traded on exchanges and over-the-counter markets (see InvestorGuide University: Stock Exchanges).
Investment Advisor Act of 1940: Requires that investment advisors and investment advising firms register with the SEC and adhere to its standards.
Of course, there are other pieces of legislation that the SEC enforces; these are just three of the most important ones. Recently, with the rash of accounting, mutual fund, and analyst scandals, there has been a significant amount of new reform legislation aimed at ensuring fair dealings. Eliot Spitzer, SEC watchdog, uncovered ample evidence in 2002 that analysts were doctoring their reports to win business for their banks' investment arms or to downgrade companies that don't play ball. It is to be hoped that the new regulatory crackdown on such activities will curb the publishing of misleading stock information, but the individual investor should beware.
The job of enforcing regulations is divided between four basic divisions of the SEC. The Division of Corporate Finance is in charge of making sure all publicly traded companies disclose the required financial information to investors (see InvestorGuide University: Income Statements). The Division of Market Regulation oversees all legislation involving brokers and brokerage firms. The Division of Investment Management regulates the mutual fund and investment advisor industries. And finally, the Division of Enforcement enforces the securities legislation and investigates possible violations.
The National Association of Securities Dealers (NASD) is a self-regulatory non-governmental agency that regulates the sales of securities and oversees licenses for brokers and brokerage firms. The NASD investigates complaints against member firms and tries to ensure that all of its members adhere to both its own standards and those laid out by the SEC. The NASD has the power to expel its members from an exchange in the case of wrongdoing (it cannot, however, take legal action against a member other than by reporting it to the SEC). The association is run by a Board that takes half of its representatives from the securities industry and half of its representatives from the public. In total, the NASD oversees more than 5,000 securities firms.
Illegal Insider Trading
Insider trading is illegal when insiders trade on the basis of information that has not been disclosed to the public and that relates somehow to the company's stock. Insiders" are usually the officers of a company, but it can also include officers' relatives or employees of the firm. In fact, anyone who comes across inside information through any means and then trades upon it can be found guilty of insider trading. The SEC, the NASD, and the exchanges carefully regulate the trading activity of insiders in order to curb these abuses.