The Securities Exchange Act of 1934
The Securities Exchange Act of 1934, like the other big 4 securities acts, has a name that tells you what it does: it regulates the securities exchanges and the exchanging (trading) of securities that have already been issued. It is also known as the people act, because it deals mainly with the people who trade issued securities and the places where that trading happens.
The Securities Exchange Act of 1934 created the SEC, and gave Reg T to the Federal Reserve Board. It defines and deals with brokers and dealers, along with the registration requirements of representatives working for them.
Brokers and dealers
Broker-dealers are in the business of executing securities transactions either for their own account (as a dealer, in a principal capacity) or for others (as a broker, in an agency capacity). Brokers earn a commission for introducing buyers and sellers and take on minimal risk, since they never own the security being traded. Dealers earn markups and markdowns by buying and selling from their own inventory, and take on more risk, since the value of that inventory can drop. To transact interstate business, a broker-dealer must register with the SEC under the Securities Exchange Act of 1934, and must separately seek membership with any SRO (self-regulatory organization, such as FINRA) whose rules apply to its business - FINRA, for example, is the body that writes and enforces the firm-quote and backing-away rules covered below. Registration applications must be amended whenever previously reported information becomes inaccurate, and an SEC-registered firm must also file regular reports on its financial condition and operations. These are its FOCUS reports (SEC Form X-17A-5, required by Rule 17a-5): they include the firm’s net capital computation and are filed with FINRA through its eFOCUS system, at least every quarter. As always, registration doesn’t imply approval.
Firm quotes
Market makers are member firms that promise to “always be willing to make a market”. What that means is they will always provide a quote, a price they are willing to buy the security for, a price they are willing to sell the security for, along with the quantity they are willing to buy and sell at those prices. Failing to honor a firm quote is referred to as backing away - a serious violation that can cost a market maker its status, sometimes permanently. Market makers honor their quotes even when the market has moved against them.
A firm quote is the most common type of quote we see and think of. It is firm, it is binding, and violating it, refusing to transact at that price, is backing away.
A workout quote is a non-firm quote for illiquid securities. The terms, such as settlement, price, etc, need to be negotiated, or “worked out”, between the 2 parties, before the transaction can commence.
A subject quote is a non-firm price indication: the firm isn’t obligated to trade at that price unless and until it’s confirmed.
A nominal quote is a non-firm price indication given purely for informational purposes - it isn’t an offer to trade at all. Nominal quotes are sometimes called “around” or “looks like” quotes.
Example: Reading a quote
A market maker quotes a stock 35-36 (3x7): bid $35 (size 300 shares), ask $36 (size 700 shares). The bid is what the market maker will pay, and what a retail investor could sell at; the ask is what the market maker will sell for, and what a retail investor could buy at; the size shows the number of round lots (100 shares each) available at each price.
Rule 10b-18 - Purchases of certain equity securities by the issuer and others
An affiliated purchaser is a person acting in concert with the issuer to acquire the issuer’s securities, or an affiliate tied to the issuer’s purchases by control: the affiliate controls the issuer’s purchases, its own purchases are controlled by the issuer, or its purchases and the issuer’s are under common control. What counts is control of the purchases, not control of the company. A broker-dealer isn’t an affiliated purchaser just for executing the purchases, and neither is an officer or director just for taking part in the decision to authorize them.
Rule 10b-18 purchases are restricted by conditions on broker selection, timing, price, and volume - for example, the pre-close blackout window depends on whether the security has an ADTV of $1million or more and a public float of $150m or more. The full set of safe harbor conditions these purchases must satisfy to avoid anti-manipulation liability is detailed below.
10b-18 safe harbor conditions
If the following conditions are met, then the purchases associated with Rule 10b-18 will not be deemed to have violated the anti-manipulation provisions.
- One broker or dealer - Purchases under this rule must be effected from or through only one broker or dealer in a single day, provided that the one-broker-or-dealer condition doesn’t apply to purchases that are not solicited by or on behalf of the issuer or its affiliated purchasers, and when multiple affiliated purchasers of the issuer want to purchase on the same day, all affiliated purchasers must use the same broker or dealer.
- Time of purchases - Rule 10b-18 purchases must not be
- Opening purchase reported in the consolidated system
- Effected during the 10 minutes before the scheduled close of primary trading in the principal market or in the market where the purchase is effected, provided the security has an ADTV of $1m or more, and a public float value of $150m or more.
- Effected during the 30 minutes before the close of less actively traded securities.
- Price of purchases - Purchases under this rule may not be effected at a price higher than:
- For securities quoted and reported in the consolidated system, the highest independent bid or the last independent transaction price reported there, whichever is higher.
- For securities not in the consolidated system, the highest independent bid or last independent transaction price, whichever is higher, displayed on a national securities exchange or on an inter-dealer quotation system that displays at least 2 priced quotations for the security.
- For all other securities, the highest independent bid obtained from three independent dealers.
- Volume of purchases -
- The total volume of securities purchased under this rule by the issuer and any affiliated purchasers in a single day may not exceed 25% of the ADTV of that security. Once a week, however, the issuer or an affiliated purchaser, instead of purchasing under the 25% of ADTV limit, can effect one block purchase if no other 10b-18 purchases are effected that day and the block is not included when calculating the security’s 4-week ADTV under this section.
Reporting companies
A company becomes a “reporting company” under Section 12(g) of the Securities Exchange Act once it has more than $10 million in total assets and a class of equity securities held of record by 2,000 or more persons, or by 500 or more persons who are not accredited investors. It must then register that class of securities with the SEC and file ongoing reports. This is separate from registering an offering under the Securities Act of 1933, which an issuer must do each time it sells securities to the public, whether or not it is already a reporting company.
Insiders and insider trading
Section 16 insiders
Under Section 16 of the Securities Exchange Act, a reporting company’s insiders are its officers and directors and any person who owns more than 10% of a class of its registered equity securities. Other laws draw the line elsewhere: under the Investment Company Act, for example, owning 5% of a fund makes someone an affiliated person, and owning more than 25% is presumed to be control. A person who becomes a Section 16 insider, through promotion or purchase, must report it to the SEC on Form 3 within 10 days, including how many shares they own. After that, any change in their ownership must be reported on Form 4 within 2 business days. A separate filing has a lower threshold: anyone who becomes the beneficial owner of more than 5% of a class of a reporting company’s voting equity securities must file Schedule 13D with the SEC within 5 business days. Schedule 13D reports a large shareholder’s stake and its purpose; it doesn’t make the holder a Section 16 insider.
Insiders cannot sell the company’s stock short. They also can’t keep “short-swing” profits: any profit from buying and selling (or selling and buying) the company’s stock within less than 6 months has to be returned to the company.
Insider trading
Insider trading is trading on material, non-public information, and it’s prohibited under Rule 10b-5 of the Securities Exchange Act. Material information is information an investor would consider important in making an investment decision; non-public means it hasn’t been released to the public. Whether the CEO likes the color of their new car might be non-public, but it isn’t material; a CFO being fired for embezzling is material, but once it’s announced, it’s public. It has to be both material and non-public to be insider trading. Anyone who learns the information through their work, down to clerical and janitorial staff, can’t trade on it until it has been publicly announced, and trading on it is a violation whether or not a profit is made.
Insiders can’t get around this by having someone else make the trade. Both the tipper, who passes the information on, and the tippee, who trades on it, are liable. If George, the CEO, tells his wife Gloria, who tells her hairdresser Monica, who tells her boyfriend Michael, who tells his mother Michelle, and Michelle then buys or sells, every person in that chain can be charged. Liability follows awareness of the information: a person trades on the basis of inside information only if they were aware of it when they bought or sold (SEC Rule 10b5-1). Someone who never had the information, and simply ends up with a profit from a trade another person chose to make, hasn’t committed insider trading.
Consequences of insider trading
Civil penalties are fines of up to 3 times the profit gained, or loss avoided; there is no minimum. A person who controlled the violator, such as an employer, can be fined up to the greater of 3 times the profit gained or loss avoided, or an inflation-indexed amount that started at $1 million and is roughly $2.6 million today, though the precise number won’t be tested.
Criminal penalties are fines of up to $5 million for individuals and $25 million for corporations, and up to 20 years in prison for the individuals responsible.
Separately, the SEC’s whistleblower program pays people who report securities law violations 10% to 30% of the sanctions collected, in cases where the sanctions exceed $1 million.
Information barriers
Section 15(g) of the Securities Exchange Act requires every broker-dealer to establish, maintain, and enforce written policies and procedures reasonably designed to prevent the misuse of material non-public information by the firm and its associated persons. The barriers those procedures put between departments are called information barriers, or, in older usage, “Chinese walls.”
The basic idea is that material non-public information stays with the people who need it for their jobs. If the investment banking department is working on a client’s merger or offering, that information has to be walled off from the firm’s research, sales, and trading staff, so no one trades on it, or tips anyone else, before it is public. Trading ahead of a customer’s large order is a different violation, front running, which firms also have to prevent.
Restricted list
When a firm has material non-public information about a company, for example because it is underwriting the company’s offering, it puts that company’s securities on a restricted list, and the firm, its employees, and its proprietary trading accounts may not trade them. Securities the firm expects to learn inside information about can go on a watch list, where trading continues but is closely monitored.