Created shortly after the Securities Act of 1933, the Securities Exchange Act of 1934 regulates the secondary market and its participants (financial professionals). The “Act of 1934” was designed to restore confidence in the financial markets after decades of manipulation and fraud.
The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) and gave it the authority to regulate and supervise the financial markets.
SEC regulations generally apply to non-exempt securities. However, Rule 10b-5 is known as the anti-fraud “catch-all” rule because it applies to all types of securities and all participants. If the SEC can prove a fraudulent act occurred, it can pursue enforcement action regardless of who committed it or what security was involved.
Broker-dealers are defined and regulated under the Securities Exchange Act of 1934. A broker-dealer is a firm in the business of trading securities for its own account or for the account of others. Broker-dealers can act in an agency or principal capacity in a given trade and earn compensation by helping customers buy and sell securities. You’ve probably heard of large broker-dealers such as Fidelity, TD Ameritrade, Wells Fargo, and Charles Schwab.
To support transparency, the Securities Exchange Act of 1934 requires broker-dealers to provide certain documents to customers. A balance sheet and a net capital computation must be provided on a semi-annual basis. These documents disclose a firm’s assets and liabilities and are used to evaluate its net worth.
The Securities Exchange Act of 1934 also regulates insiders (affiliates), which we first learned about in the primary market chapter. An insider is an officer, director, or 10% shareholder of a publicly traded company. Insiders are prohibited from selling their company stock short and from keeping a short swing profit.
Short sales are prohibited for insiders to prevent them from betting against the companies they manage. Regulators recognize that it’s difficult to build a successful company but relatively easy to damage one. Prohibiting insider short sales removes an incentive to act against the company’s best interests.
A short swing profit is any profit made on a security held for six months or less. If an insider earns a short swing profit on their company’s stock, they must return the profit to the issuer (their company). This rule is intended to encourage insiders to invest with a longer-term focus.
The Act of 1934 also regulates penny stocks, defined as non-listed stocks trading under $5 per share. Penny stocks are often issued by smaller, lesser-known companies. Because these companies may have limited operating history and less publicly available information, penny stocks often involve significant investor risk. In general, the lower the stock price, the riskier the investment.
When firms and financial professionals solicit penny stock transactions, additional rules apply. Customers must receive a risk disclosure statement describing the risks of investing in penny stocks. These risks include limited information in the market, high price volatility, and lack of liquidity. Penny stocks tend to trade less frequently than larger-company stocks, which contributes to these risks.
Customers purchasing penny stocks must also receive monthly account statements. In many other situations, customers receive quarterly statements. Because penny stocks can be volatile and illiquid, more frequent statements help customers monitor their positions.
Suitability statements are also required when soliciting a penny stock purchase. A solicitation occurs when a financial professional recommends a securities transaction to a customer.
Financial professionals must conduct a suitability discussion covering the customer’s investment objectives, risk tolerance, goals, and financial background. After gathering this information, the professional may recommend the transaction only if it fits the customer’s situation. The professional then documents the discussion in a suitability statement, which the customer must sign.
Before this rule existed, some brokers made broad penny stock recommendations to customers who couldn’t afford the risk. For example, in The Wolf of Wall Street, Jordan Belfort’s character solicited penny stock sales from nearly any potential customer willing to listen (warning: explicit language). In many cases, the trades were not suitable, but they were pushed to generate broker compensation.
Today, suitability determinations are required in most cases. If you engaged in the same kind of conduct today, you and your supervisors could face fines, penalties, and possible removal from the industry. However, there is an exception for an “established” customer.
An established customer is defined as either:
If either condition is met, the firm and financial professional may avoid the suitability statement requirements.
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