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IV. Regulation of Trading and Securities Markets.

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1 IV. 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 approach, where authorities set forth specific and detail prescriptive rules to which securities markets participants must adhere. – Securities 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. – Principles-based approach, where authorities set forth a small number of regulatory objectives and principles, granting regulatory authorities and firm operating and compliance officers more judgment in ensuring that policy objectives are being fulfilled.

4 Pre-1930s Securities Regulation: The Background Securities market regulation, with some notable exceptions, is primarily a fairly recent phenomenon. There were exceptions: – Under King Edward I in 1285, broker licensure was instituted after the finding that English brokers provided less satisfactory service than their Italian counterparts. – The Brokers Act of 1696 required stock brokers to be licensed and limited the number of these licenses to 100. – The 1720 Bubble Act passed in Britain provided for the issuance of security prospectuses and prohibited certain types of trading fraud, but was ultimately repealed in – The Companies Act of 1844 provided once again for company issuances of prospectuses, and the Companies Act of 1867 along with subsequent legislation provided for specific details in those prospectuses. – This 19th century British legislation, based largely on full disclosure of material information, served as an important conceptual foundation to 1930s U.S. securities legislation.

5 Early U.S Securities Legislation Securities legislation activity in the U.S. was very slow to start. – Massachusetts enacted one of the earliest securities regulations in 1852, requiring railroad companies to certify that responsible parties had subscribed to their stock. – The Constitution of the State of California signed in 1879 prohibited the sale of stock on margin. – At the Federal level, Congress passed and then quickly repealed the Anti-Gold Futures Act of 1864, intending to restrict trading in gold and exchange contracts. – Congress attempted to regulate agricultural futures trading with the Future Trading Act of 1921, but this Act was found by the U.S. Supreme Court to be unconstitutional. – In the early 1900s, several states passed limited legislation to regulate securities markets. These earlier laws sought to prevent issuance of securities that were considered to be unfair or did not promise a "fair return." Securities were potentially subject to merit tests. – For example, in response to numerous incidents of brokers having sold worthless securities of sham companies, Kansas enacted a securities law in 1911 requiring registration of brokers and securities. – These worthless securities were said to be backed by nothing but the blue skies of Kansas." – This state legislation was considered to be the first of the state Blue Sky Laws intended to regulate securities markets. – Prior to the 1930's, most regulation of U.S. securities markets were provided by these so-called Blue Sky Laws. The precise meaning and origin of the term "Blue Sky Laws" is somewhat unclear.

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 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 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 – Prohibited securities price manipulation

9 Additional Major Depression-Era Legislation The Banking Acts of 1933 (Glass Steagall) was motivated by the failure of thousands of banks. Glass Steagall sought to restore faith in the banking system and prevent a similar crisis. There were 3 main features: – FDIC was created to provide federal insurance on bank deposits (subject to a current $250,000 ceiling). – It imposed restrictions on the activities of commercial banks. It prevented commercial banks from underwriting securities, to trade with the public (excepting certain U.S. government and municipal bonds and real estate loans) and owning risky securities. Much of this provision was relaxed by court decisions, regulators and the Gramm-Leach-Bliley Act of – The Act placed regulations on bank interest rates (Reg Q), though most of these provisions were relaxed in the 1980s. The Commodity Exchange Act of 1936 provided for regulation of commodities and futures trading markets by the Department of Agriculture and required all futures and commodity options to be traded on organized exchanges. The Maloney Act of 1938 provided for the self-regulation of the Over the Counter markets, leading to the establishment of the National Association of Securities Dealers (N.A.S.D., which merged into FINRA approximately 70 years later). The Trust Indenture Act of 1939 provided that issuers of bonds must clearly specify purchaser rights in a trust indenture, provide bond trustees with periodic financial reports, and that the trustee not impair its right or willingness to sue the issuing corporation. The Investment Companies Act of 1940 extended the Securities Act and the Securities and Exchange Act to investment companies such as mutual funds. This Act provided that investment companies must: – avoid fraudulent practices – fully disclose financial statements – distribute prospectuses – publish statements outlining goals, which will not be changed without appropriate process. – limit issuance of debt – follow uniform accounting procedures – operate the fund to benefit its owners, not managers. The Investment Advisers Act of 1940 requires advisors and certain investment institutions who provide clients with paid investment advice to register with the S.E.C.

10 Sarbanes-Oxley The Sarbanes-Oxley Act of 2002 (SOX) was enacted after a wave of corporate scandals including Enron, WorldCom 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. Among the highlights of this Act are: – the creation of a five-member Public Company Accounting Oversight Board (PCAOB) to oversee public auditing firm practices (Section I) – the requirement for CEOs and CFOs to personally certify the accuracy of their firms periodic reports – restricting public accounting firms from providing non-auditing services contemporaneously with auditing services to prevent certain conflicts of interest (Section II) – limiting company loans to directors and officers (Subsection 402) – prohibitions of share trading by officers and directors during certain blackout periods – the requirement 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. – requirement that firms to disclose material off-balance sheet transactions and relationships – prohibitions on unfair allocations of securities in the IPO process – prohibitions on misleading research reports issued by financial advisors and advisory services – requirements for publicly traded firms to have independent directors with financial expertise serve on their audit committees.

11 D. Deregulation, Corporate Scandals and the Financial Crisis of 2008 Wendy Gramm (wife of Senator Phil 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. 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. – 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. The Commodity Futures Modernization Act of 2000 exempted most over-the-counter non-agricultural derivatives and transactions between sophisticated parties from regulation under the Commodity Exchange Act (CEA) or as securities under other federal securities laws. This 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, particularly with respect to certain types of contracts including single equity futures (futures contracts on shares of a single firm's stock). The Act led to retail trading of these contracts in 2003.

12 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 the year, Countrywide Financial Corporation, one of the largest banks in the U.S. was seeking shelter and Northern Rock in the U.K. was on the brink of failure. The financial system took a significant blow in March 2008 when Bear Stearns, one of the largest investment banks in the U.S., collapsed, to be rescued by JP Morgan Chase with backing from the Federal Reserve. The special lending facilities of the Federal Reserve opened the discount window to investment banks to prevent an industry-wide collapse. IndyMac Bank F.S.B., another major depository institution failed in July However, the crisis fell into full swing in September 2008 when 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. See Sections § 2(g) and (h) of the Commodity Futures Modernization Act of 2000 and Cravath, Swaine and Moore [2001].

13 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. – This enabled the largest investment banks to substantially increase their debt, both increasing their risk of failure and enabling them to invest more heavily in riskier assets. – In many respects, relaxation of this Act was consistent with the spirit with the Basel II Accord. – Riskier assets were to be discounted more deeply than safer assets. – The rule requires broker dealers to limit their debt-to-net capital ratios to 12-to-1. Broker dealers qualifying for exemptions under this 2004 relaxation were to be 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-to-equity ratios exceeding 30-to-1. – Four of these five firms failed or were bailed out between 2007 and Regulation NMS was adopted by the U.S. SEC in 2005 intending to modernize the regulatory structure of U.S. equity markets. – An important provision of this regulation is the Order Protection Rule (Rule 611, also known as the trade-through rule). This rule requires markets to maintain policies to ensure the execution of trades at their best prices. – The regulation sought to reduce spreads by allowing for sub-penny pricing on certain transactions and to improve public access to market data. 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.

14 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 Responding to the Financial Crisis of , Congress passed major reform intended to: – promote the financial stability of the United States by improving accountability and transparency in the financial system – to end "too big to fail – to protect the American taxpayer by ending bailouts – to protect consumers from abusive financial services practices. This 848 page act was intended to promote financial stability and consumer protection, and extended well beyond securities trading. Among the important reforms affecting traders are: – Providing for the establishment of the Financial Stability Oversight Council (FSOC) to supervise systemic risk, promote market discipline and respond to threats to financial stability. The council is chaired by the U.S. Treasury Secretary, comprised of 10 voting members and 5 nonvoting members. – Providing new rules for transparency, independence and accountability for credit rating agencies – Creating the Office of Credit Ratings – Providing for the Volcker Rule, regulating and limiting banks, their affiliates and non-bank financial institutions supervised by the Fed with respect to proprietary trading, investment in and sponsorship of hedge funds and private equity funds. – Authorizing the Federal Reserve Board or FSOC to supervise activities of clearing agents – Providing for regulatory authority over swaps between the SEC (security-based swaps) and the CFTS (all other swaps) – Rather than mandate that all swap contracts be traded on exchanges, Dodd-Frank provided 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. – Requiring 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 As of early 2012, many provisions of the Dodd-Frank Act are awaiting finalization and implementation. For example, rules governing trading in the $601 trillion swaps market are expected to be completed in early Implementation of the Volcker Rule is expected to be pushed back from its original deadline of July 21, However, many of the larger U.S. banks had already sold or closed proprietary trading desks by summer of 2011.

15 F. Government Oversight of Self- Regulation: The S.E.C. and C.F.T.C. The U.S. securities regulatory system might be characterized as a cooperative coordination of industry, state and federal systems serving as complementary components under U.S. Federal authority. 1930's securities legislation provided for some degree of self-regulation in securities markets. While FINRA, exchanges and other markets and self-regulatory organizations (SROs) themselves 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. 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 – Similar pursuits by this state office led to a $1.4 billion settlement with 10 of the world's leading brokerage firms for fraudulent and/or exaggerated or unwarranted statements in analyst reports.

16 The S.E.C. The U.S. 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, orderly, and efficient markets and to facilitate capital formation, particularly in the business sectors. The SEC seeks to ensure that firms and organizations raising money by selling securities to investors disclose certain essential facts about these securities prior to their sale and while they are held. The SEC also 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 members of the SEC including its chair to staggered 5-year terms. – No more than 3 can belong to any one political party. – The Commission is comprised of five 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.

17 The CFTC The Commodity Futures Trading Commission (CFTC) was created as an independent agency in 1974 after the enactment of the Commodity Futures Trading Commission Act to regulate U.S. commodity futures and option markets. In a manner similar to the SEC, the CFTC has 5 commissioners including its Chair appointed by the president to staggered 5-year terms, with no more than 3 from any one political party. Its mission is to protect market participants and the public from fraud, manipulation, and abusive practices related to futures and options, and to foster open, competitive, and financially sound markets. The CFTC maintains a number of essential offices and divisions: – The CFTC Office of the General Counsel, represents the Commission in appellate litigation and certain trial-level cases, and advises the Commission on the application and interpretation of the Commodity Exchange Act and other administrative statutes. – The Office of the Executive Director formulates and implements the management and administrative functions of the CFTC and the agency's budget. – The Division of Clearing and Risk oversees derivatives clearing organizations (DCOs), the clearing of swaps, futures, and options on futures, and market participants that may pose risk to the clearing process. – The Division of Market Oversight is responsible for fostering markets that accurately reflect supply and demand for the underlying commodity and are free of abusive trading activity, oversees trade execution facilities, and performs market surveillance, market compliance, and market and product review functions. – The Division of Enforcement investigates and prosecutes alleged violations. – The Office of the Chief Economist provides economic support and advice to the Commission.

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