Created right 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” aimed to instill confidence in the financial markets after decades of manipulation and fraud.
Regulations administered by the SEC apply to non-exempt securities. However, Rule 10b-5 is known as the anti-fraud “catch-all” rule that applies to all types of securities and participants. If the SEC can prove a fraudulent act occurred, they can come after you, regardless of who or what you are.
Broker-dealers are defined and regulated in the Securities Exchange Act of 1934. By definition, a broker-dealer is a firm in the business of trading securities for itself or for the account of others. Broker-dealers can act in an agency or principal capacity in any given trade and make money helping their customers buy and sell securities. You’ve probably heard of the big broker-dealers out there. Fidelity, TD Ameritrade, Wells Fargo, and Charles Schwab are examples of these types of firms.
To maintain a certain level of transparency, the Securities Exchange Act of 1934 requires broker-dealers to disclose certain documents to their customers. First, a balance sheet and net capital computation must be provided to customers on a semi-annual basis. Both disclose a firm’s assets and liabilities in pursuit of finding 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 collecting a short swing profit.
Short sales are prohibited to prevent insiders from betting against the companies they run. Regulators know that it’s difficult to build a successful company, but fairly easy to destroy one. Preventing short sales by insiders removes any incentive to work against the company’s best interests.
A short swing profit is defined as any profit made on a security held for six months or less. If an insider makes a short swing profit on their company’s stock, they are required to return the profit back to the issuer (their company). This rule was written to create an incentive for insiders to invest for long-term purposes.
The Act of 1934 also regulates penny stocks, which are defined as non-listed stocks trading under $5 per share. Penny stocks usually come from lesser-known and smaller companies. Due to their size and lack of business history, penny stocks often present a significant amount of risk to the investor. The lower the stock price, generally the riskier the investment.
When financial firms and professionals solicit penny stock business from customers, there are additional rules in place that must be followed. First, customers must be provided with a risk disclosure statement going over the risks of investing in penny stocks. Risks include a lack of information in the market, high price volatility, and lack of liquidity. Penny stocks are traded less often than larger company stocks, which drives much of this risk.
Customers purchasing penny stocks must always receive monthly account statements. Normally, customers receive quarterly statements. Due to the risks involved with penny stocks, it’s best if a customer monitors their account frequently.
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 go through a suitability discussion that covers the customer’s investment objectives, risk tolerance, goals, and financial background. Once this information is gathered, the financial professional can only make the recommendation if it fits the customer’s situation. After going through this discussion, the financial professional will document everything in the suitability statement, which the customer must sign.
Today, suitability determinations must be completed in most cases. If you did what Jordan Belfort did today, you and your supervisors would face fines, penalties, and possible removal from the industry. However, there is an exception if a customer is “established."
An established customer is defined as either:
A customer with an account open for at least one year with the firm, or
A customer with three completed separate unsolicited penny stock trades (on their own)
When either of these is met, the financial firm and professional can avoid the suitability statement requirements.
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