1. IX. Regulation of Trading and Securities Markets

2. A. Background and Early Regulation The primary purpose of government regulation of competitive markets is to prevent market failure or collapse. Proponents of regulation argue that financial markets, left unregulated, will tend towards loss of competition, stability, efficiency and credibility, leading to individuals and firms withdrawing from participation. Senator Edmund Muskie, in his 1970 introduction of what was to become the Securities Investor Protection Act to the Senate stated: The economic function of the securities markets is to channel individual institutional savings to private industry and thereby contribute to the growth of capital investment. Without strong capital markets it would be difficult for our national economy to sustain continued growth: indeed, the state of U.S. capital market development, more advanced than that of any other industrial country, is an important contributing factor in the rapid economic growth this country has experienced. Securities brokers support the proper functioning of these markets by maintaining a constant flow of debt and equity instruments. The continued financial wellbeing of the economy thus depends, in part, on public willingness to entrust assets to the securities industry."

3. Regulatory Approaches Regulatory approaches around the world can be strikingly different, despite the coordination efforts of global organizations. Securities regulatory authorities tend to take some combination of two basic approaches to designing a regulatory system: Rules-based approaches and Principles-based approaches.

4. Rules- and Principles-based Regulatory Approaches Rules-based approach, where authorities set forth specific and detailed prescriptive rules to which securities markets participants must adhere. – Regulatory authorities taking this approach often focus on risk, where the authority considers whether there is a potential market failure that needs to be addressed and conducts an analysis to determine how to address the problem given the constraint of limited resources. – Rules-based regulation is frequently implemented as a preventative mechanism. – This approach seeks to clarify exactly what activities are and are not permitted. Principles-based approach, where authorities set forth a small number of regulatory objectives and principles, authorities and firms’ officers more judgment in ensuring that policy objectives are being fulfilled. – Tends to be more outcome-oriented – Encourages innovation by the regulated. Seems to work best in self-regulated environments when regulators and firms already have strong relationships. – Seems to work best in self-regulated environments when regulators and firms already have strong relationships.

5. Rhetorical Questions Suppose that the IRS had a principles based approach to seeking fair, appropriate and adequate amount of taxes from each taxpayer? What would be the tax collection impact of Principles-based taxed regulation?

6. B. U.S. Securities Market Legislation: The Foundation Beginning in the 1930s, a series of regulatory acts were proposed to prevent or mitigate market failures such as the Great Crash of 1929. Such sweeping legislation was made possible, in part due to overwhelming Democratic majorities having been elected to both houses of Congress and the election of President Roosevelt in 1932. 25 days after his inauguration in 1933, President Roosevelt asked Congress for a new law that would “put the burden of telling the whole truth on the seller” of securities, and, referring to the caveat emptor rule generally preferred in business circles, added: “Let the seller also beware.” Business leaders were in poor position to effectively protest this imposition of regulation at the height of the Great Depression.

7. The Securities Act of 1933 The Securities Act of 1933, sometimes called the "Truth in Securities Law“ Deals primarily with new issues of securities. – The Act requires that issuers and underwriters provide financial and other significant information concerning securities offered for public sale. – The Act prohibits deceit, misrepresentations, and other fraud in the sale of securities. – Unlike most of the "Blue Skies Laws" that focused on the merits of securities, the Securities Act focused on making reliable information available to prospective investors in securities. Its major provisions are as follows: – All primary issues must be registered with an appropriate government agency (later to be the Securities Exchange Commission or S.E.C.). – The registration will include proper statements and documentation. – A prospectus must accompany each new issue. This prospectus must contain a complete and accurate accounting of the firm's condition, risks and prospects and state how the proceeds of the new issue will be used. – Small and private issues are exempt from the registration provisions. In addition, a more recently (1982) instituted S.E.C. Rule 415 (shelf registration) allows up two years for securities to actually be issued after completing the S.E.C. registration process. – Firms, officers of firms and underwriters are prohibited from making false statements regarding their new issues, and may be criminally liable for doing so.

8. The Securities Exchange Act of 1934 The Securities Exchange Act of 1934 was primarily intended to improve information availability and to prevent price manipulation. Whereas the Securities Act of 1933 dealt mainly with primary issues, the Securities Exchange Act of 1934 dealt mainly with secondary markets, accomplishing: – Established the S.E.C. as the nation's primary federal securities regulatory authority – Provided for annual and other periodic reporting by public companies – Limited insider trading activity – Provided rules for proxy solicitation – Required registration of exchanges – Provided for credit regulation: Regulations T (for brokerage firms) and U (for non-broker lenders) permit the Board of Governors of the Federal Reserve to set margin requirements. Since 1974, investors have been required to post 50% margin (deposit or collateral) when purchasing stock on margin. FINRA Rule 2520 permits pattern day traders 25% initial margin requirements (subject to a $25,000 account equity balance). – Subjected institutions to the Net Capital Rule, imposing limits on broker-dealer debt-to-net capital ratios. Certain exceptions were made in 2004 to five of the largest institutions, all of which were bankrupted, merged or otherwise suffered significant financial distress in the financial market crisis of 2008. – Prohibited securities price manipulation

9. Prohibited Activities Wash Sales Corners Churning Pools Fraud Inside Trading

10. Insider Trading Illegal insider trading: the execution of transactions on the basis of material non- publicly available information. No comprehensive statutory definition as to precisely what constitutes impermissible insider trading or even what constitutes an insider. Regulators generally rely on several statutes to enforce prohibitions on insider trading. o The Securities Exchange Act bans inside trading of a tender offer target except by the bidder o The Act prohibits trading any public security using “any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” o SEC Rule 10b-5 prohibits “any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.” o The 1934 Act does not specifically mention insider trading, but broad court interpretations of the word "fraud" to include breach of the personal obligation of an insider to maintain confidentiality o A 1980 Supreme Court decision (Chiarella v. United States) narrowed the definition of an insider to be one who maintains a relationship of trust and confidence with shareholders.

11. 1980s Insider Trading Legislation The Insider Trading Sanctions Act of 1984, which authorized penalties for illegal insider trading equal to three times the illegally obtained profits plus forfeiture of the profits. The Insider Trading and Fraud Act of 1988 was intended to help define exactly what constitutes an insider and to increase penalties for illegal insider trading activity.

12. D. Deregulation, Corporate Scandals and the Financial Crisis of 2008 Wendy Gramm, as Chair of the CFTC, in 1989 and 1993 exempted a number of swaps and derivative instruments from regulation. These exemptions were broadened by the Gramm-Leach-Bliley Act. The Federal Reserve Board reinterpreted the Glass-Steagall Act several times during the 1980s and 90s so as to ultimately permit bank holding companies to earn up 25% of their revenues from investment banking activities.

13. The Financial Modernization Act of 1999 The Financial Modernization Act of 1999, also known as the Gramm- Leach-Bliley Act contributed to the consolidation of the financial services industries, allowing for the formation of "mega-banks.” The Act was motivated by: – increased foreign competition – recognition that the financial industries have transformed since the 1930s – modern risk management techniques. This act formally permitted commercial banks, investment banks and insurance companies to consolidate, repealing the most important provisions of the Glass-Steagall Act. While many combinations had already occurred before passage (usually through subsidiaries), their legality was questionable. The pending combination of Citigroup (commercial banking) and Travelers (insurance, investment banking and stock brokerage) into the world's largest financial institution accelerated and contributed to passage of this Act. Mergers that would have been impossible prior to passage might have masked severe operating and financial difficulties, forestalling some inevitable failures. The Act was not replaced with or accompanied by significant regulatory oversight.

14. The Commodity Futures Modernization Act of 2000 Exempted most over-the-counter non-agricultural derivatives (e.g., CDOs and CDSs) and transactions between “sophisticated parties” from regulation under the Commodity Exchange Act (CEA) or as “securities” under other federal securities laws. The Act excluded most over-the-counter energy trades from CFTC oversight and financial derivatives from SEC and CFTC oversight. These exemptions formed the so-called “Enron Loophole” that contributed to massive fraud and the failure of the Enron company in addition to the role that credit default swaps would play in the 2008 financial crisis. The Act sought to resolve disputes between the SEC and CFTC concerning overlapping jurisdictions. Allowed for single equity futures (futures contracts on shares of a single firm's stock). The Act led to retail trading of these contracts in 2003.

15. Sarbanes-Oxley The Sarbanes-Oxley Act of 2002 (SOX) was enacted after a wave of corporate scandals including Enron, WorldCom, Adelphi and Global Crossing in the late 1990's and early 2000's. The Sarbanes-Oxley Act, also known as the Corporate and Criminal Fraud Accountability Act was passed to provide for accounting reform, improved financial reporting, reduced conflicts of interest and increased penalties for securities fraud.

16. Provisions of Sarbanes Oxley Created the Public Company Accounting Oversight Board (PCAOB) to oversee public auditing firm practices (Section I) Required CEOs and CFOs to personally certify accuracy of their firms’ reports Restricted public accounting firms from providing non-auditing services contemporaneously with auditing services to prevent conflicts of interest (Section II) Limited company loans to directors and officers (Subsection 402) Prohibited share trading by insiders during certain “blackout” periods (e.g., IPOs) Required that attorneys representing reporting companies report material violations of law or breaches of contracts to appropriate corporate authorities Subsection 404 of the Act requires that companies prepare assessments of their internal controlling practices along with auditors’ reports on those assessments. Required that firms to disclose material off-balance sheet transactions and relationships Prohibited on misleading research reports issued by financial advisors and advisory services Required publicly traded firms to have independent directors with financial expertise serve on their audit committees.

17. Post-SOX Legislation Another crucial deregulatory action occurred in 2004 when the S.E.C. relaxed the "net capital rule" (Rule 15c3-1) for the five largest investment banks. – The earlier rule required broker dealers to limit debt-to-net capital ratios to 12-1. – Broker dealers qualifying for exemptions were designated as "consolidated supervised entities," or CSEs. – Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns qualified as CSEs, enabling them to maintain debt-equity ratios exceeding 30-to-1. – They substantially increased their debt, both increasing their risk of failure and enabling them to invest more heavily in riskier assets. – Four of these five firms failed or were bailed out between 2007 and 2009. The Credit Rating Reform Act of 2006 was enacted to improve competition in the credit rating industry and to reduce certain conflicts of interest and abuses. – The Act abolished the SEC's authority to designate credit-rating agencies as NRSROs – It allowed any credit-rating agency three years of experience fulfilling certain requirements to register with the SEC as a "statistical ratings organization.“ – The Act sought to curb the practices of sending a company unsolicited ratings along with a bill and packaging ratings with the purchase of consulting and other services.

18. The 2008 Financial Crisis In the summer of 2007, there were increasing reports of troubled mortgages and weakening of the securitized assets and portfolios that contained them. These reports followed on the peak of U.S. housing prices. By the end of 2007, Countrywide Financial Corporation and Northern Rock in the U.K. were on the brink of failure. In May 2008, Bear Stearns was rescued by JP Morgan Chase with backing from the Federal Reserve. The Federal Reserve opened the discount window to investment banks to prevent an industry-wide collapse. IndyMac Bank F.S.B. failed in July 2008. In September 2008, Freddie Mac and Fannie Mae were placed under U.S. government conservatorship, Lehman Brothers filed for Chapter 11 bankruptcy protection, and the U.S. entered its worst recession since the Great Depression.

19. E. Dodd-Frank The most significant piece of securities legislation passed since the 1930s was the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010. Responding to the Financial Crisis of 2007-09, Congress passed major reform intended to: – promote the financial stability of the United States by improving accountability and transparency in the financial system – end "too big to fail” – protect the American taxpayer by ending bailouts – protect consumers from abusive financial services practices – limit proprietary trading by depository institutions (the Volker Rule)

20. Dodd Frank, cont. This 848 page act was intended to promote financial stability and consumer protection, Among the reforms are to: – Provide for the Financial Stability Oversight Council (FSOC) to supervise systemic risk, promote market discipline and respond to threats to financial stability. – Provide new rules for transparency, independence and accountability for credit rating agencies – Provide for the Volcker Rule, regulating and limiting banks w.r/t proprietary trading, investment in and sponsorship of hedge funds and private equity funds. – Authorize the Federal Reserve Board or FSOC to supervise clearing agents – Clarify regulatory authority over swaps between the SEC (security-based swaps) and the CFTS (all other swaps) – Provide for the creation of a swap execution facility (SEF), specifically designed to provide for trade transparency, encourage competitive execution, and ensure a complete record and audit trail of trades, all designed to enhance swaps markets. – Require companies selling credit and mortgage-backed products to retain at least 5% of the instruments’ credit risk unless the underlying loans meet certain standards that reduce risk

21. F. Government Oversight of Self- Regulation: The S.E.C. and C.F.T.C. The U.S. securities regulatory system is a cooperative coordination of industry, state and federal systems serving as complementary components. 1930's securities legislation provided for some self-regulation in securities markets. While FINRA, exchanges and self-regulatory organizations (SROs) still play a primary role in regulating and monitoring market, the SEC and other government agencies retain ultimate regulatory powers and play oversight and technical roles in regulatory activity. SROs such as the NYSE regularly pursue actions against insider trading. If markets fail to properly monitor and regulate themselves, the SEC or CFTC can take action, as might state authorities under Blue-Sky laws.

22. Weak Enforcement and Blue Sky Laws In some eras, the SEC has been considered to have been either lax or weak in its enforcement. – Other regulatory authorities such as state attorneys general have pursued enforcement. – State "Blue-Sky" laws, even those predating 1930s legislation, have been used by states attorneys general to pursue abuses. – For example, the former Attorney General of New York, Elliot Spitzer, used the New York 1921 Martin Law prohibiting certain "boiler room" activities and securities fraud to obtain a $100 million settlement from Merrill Lynch & Co. in 2002 related to Enron reports and coverups.

23. The S.E.C. The Securities and Exchange Commission (SEC) was created as an independent agency by the Securities and Exchange Act of 1934 to protect investors, to maintain fair and orderly markets and to facilitate capital formation. The SEC seeks to ensure that firms selling securities disclose essential facts about securities. The SEC seeks to ensure that those who trade securities are dealt with fairly and honestly. The president of the U.S., with advice and consent from the Senate, appoints the 5 SEC members including its chair to 5-year terms. – No more than 3 can belong to any one political party. – The Commission has 5 Divisions and 16 Offices, with headquarters in Washington, DC, and in 11 Regional Offices around the country. The SEC not only investigates regulatory infractions and enforces legislation, it is an essential rule maker itself.

24. I. Privatization of Regulation and Exchange Rules Privatization of regulation is non-government creation and adoption of common guidelines to govern the behavior in markets. The CFA Institute: the "purpose of any self-regulatory group is to keep industry interests aligned with the public interest so as to avoid government intervention and the possibility of more-restrictive regulation." The Maloney Act of 1938 allowing creation of NASD was a significant innovation NASD (now merged into FINRA), the National Futures Association and exchanges themselves act or acted as SROs (Self Regulatory Organizations). They are overseen and perhaps micromanaged by the SEC. OTC (non-public) markets rely on trade associations to prepare uniform contracts and standardized agreements among market participants. For example, in 1987 the International Swaps and Derivatives Association (ISDA), which sets standards for derivative contracts, prepared the then 14-page ISDA Master Agreement. ISDA and its early success was instrumental to the refusal by Congress to regulate derivatives markets in the 1990s.

25. Private and Self Regulation Advantages Advantages of private regulatory bodies or self-regulation in securities markets include: – Market participants have the most intimate knowledge of the markets to be regulated. – The regulatory foci on developing best practices and effective monitoring and enforcement policies are based on economic and reputational self- interest. – Governmental regulatory costs are reduced as they are passed on to the regulated market.