Created right after the Securities Act of 1933, the Securities Exchange Act of 1934 regulates the secondary market and the people and firms who participate in it (financial professionals). The “Act of 1934” was designed to restore confidence in the markets after years 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 the anti-fraud “catch-all” rule. It applies broadly to all types of securities and all market participants. If the SEC can prove fraud, it can pursue enforcement action regardless of the security involved or the person committing the act.
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. In a given trade, broker-dealers can act in an agency or principal capacity, and they earn compensation by helping customers buy and sell securities. Large broker-dealers include Fidelity, Wells Fargo, and Charles Schwab.
To support transparency, the Securities Exchange Act of 1934 requires broker-dealers to provide certain financial information to customers. Specifically, a balance sheet and a net capital computation must be provided on a semi-annual basis. These documents show the firm’s assets and liabilities and help assess its financial condition.
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 hard to build a successful company but relatively easy to damage one. Banning 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 that profit to the issuer (the company). This rule encourages 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 can be especially risky. In general, the lower the stock price, the higher the risk.
When firms and financial professionals solicit penny stock transactions, additional rules apply. Customers must receive a risk disclosure statement that explains the risks of penny stocks, including limited market information, high price volatility, and lack of liquidity. Penny stocks often trade infrequently, which contributes to these risks.
Customers who purchase penny stocks must also receive monthly account statements. (For most other securities, statements are typically sent quarterly.) 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 discussion and conclusion are documented 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. If you saw The Wolf of Wall Street, Jordan Belfort’s character solicited penny stock sales from any potential customer willing to listen (warning: explicit language). In many cases, the trades weren’t suitable, but they were pushed to generate commissions.
Today, suitability determinations are required in most situations. If someone followed the same approach today, both the individual and their supervisors could face fines, penalties, and possible removal from the industry. However, there’s an exception when a customer is considered “established.”
An established customer is defined as either:
If either condition is met, the firm and the financial professional can avoid the suitability statement requirements.
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