The law governing securities evolves constantly to keep pace with changes in the industry. Regulatory agencies like the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) F/K/A National Association of Securities Dealers (NASD) enforce various rules and regulations designed to promote fair and full disclosure of material facts related to financial markets and individual securities transactions. This guide provides a surface-level overview of the securities laws in the United States and what those laws mean for you.
Important Terms in Securities Law
A security is an intangible financial instrument that entitles its owner to claims of ownership on assets and earnings of the issuer or the voting power that accompanies the claims. Securities exist in the form of:
- Treasury stocks,
- Certificates of interest,
- Collateral trust certificates,
- Transferable shares,
- Investment contracts,
- Voting trust certificates,
- Certificates of deposit for a security; or
- A fraction, undivided interest in mineral rights.
Stock markets in the United States collect trillions of dollars on investments through the securities trade.
The individuals buying or selling securities are referred to as investors. The term “retail investor” refers to an individual who typically purchases securities from a broker and, in most cases, does not purchase a large quantity of securities. The term “institutional investor,” on the other hand, often refers to a company investing large sums of money in securities.
The company buying and selling securities for investors is known as a broker-dealer. Firms like Morgan Stanley and Merrill Lynch employ brokers to serve clients by buying and selling securities on their behalf.
History of Federal Securities Law
Prior to the Great Depression, the United States lacked an expansive securities regulation at the federal level. As a result, companies falsified and misrepresented financial information without fear of consequences. During the 1920s, the stock market expanded rapidly as the U.S. economy grew and stock prices reached record highs. Between August 1921 and September 1929, the Dow increased by 600%. Excitement surrounding the stock market fueled retail investors to get involved. Many retail investors purchased stocks “on margin,” meaning they only paid a small portion of the stock price and borrowed the remaining amount from a bank or broker. Despite the audacity of the claim, many believed that stock prices would continue rising forever. In early September 1929, stock prices started to decline. Not yet alarmed, many investors saw an opportunity to buy into the stock market at a lower price.
The Stock Market Crash of 1929
On October 18, 1929, stock prices decreased more significantly. October 24 signaled the first day of panic among investors. Known as “Black Thursday,” a record 12,894,650 shares were traded throughout the day. On October 28, the Dow suffered a record loss of 38.33 points, or 12.82%.
The following day—”Black Tuesday”— held more devastating news for investors as stock prices dropped even more. 16,410,030 shares were traded on the New York Stock Exchange in a single day. The 1929 stock market crash resulted in billions of dollars lost and signaled the beginning of the Great Depression.
In the wake of the crash, the U.S. Senate formed a commission responsible for determining the causes. The investigation uncovered a wide range of abusive practices within banks and bank affiliates and spurred public support for banking and securities regulations. As a result of the findings, Congress passed the Banking Act of 1933, the Securities Act of 1933, and the Securities Exchange Act of 1934. New York County Assistant District Attorney Ferdinand Pecora finalized the final report and conducted hearings on behalf of the commission and was later selected as one of the first commissioners of the SEC.
Federal Securities Laws and Regulations
The American banking systems suffered significantly in the wake of the stock market crash, as approximately one in three banks closed their doors permanently. Following the crash, the U.S. government imposed tighter rules and regulations on the financial industry. As securities evolve, regulatory agencies are responsible for imposing up-to-date regulations to protect investors.
Banking Act of 1933
The Banking Act of 1933 (the Banking Act), implemented by Congress on June 16, 1933, signaled the start of many changes in the securities industry. First, the Banking Act established the Federal Deposit Insurance Corporation (FDIC), created to provide deposit insurance to depositors in United States depository institutions in an effort to restore the public’s trust in the American banking system.
Four sections of the Banking Act—referred to as the Glass-Steagall legislation—addressed the conflicts of interest uncovered by Ferdinand Pecora during his investigation into the stock market crash of 1929. The Glass-Steagall legislation sought to limit the conflicts of interests created when commercial banks are allowed to underwrite stocks and bonds. In the previous decade, banks put their interest in promoting stocks and bonds to their own benefit, rather than considering the risks placed on investors. The new legislation banned commercial banks from:
- Dealing in non-governmental securities for customers;
- Investing in non-investment grade securities on behalf of the bank itself;
- Underwriting or distributing non-governmental securities; and
- Affiliation or employee sharing with companies involved in such activities.
On the other side, the legislation prohibited investment banks from accepting deposits from customers.
Deterioration and reinterpretation of Glass-Steagall provisions
The separation of commercial and investment banks proved to be a controversial topic throughout the financial industry. Only two years after passing the Banking Act, Senator Carter Glass—the namesake of the provisions—sought to repeal the prohibition on commercial banks underwriting securities, stating that the provisions had unduly damaged securities markets.
Beginning in the 1960s, banks began lobbying Congress to allow them to enter the municipal bond market.
In the 1970s, large banks argued that the Glass-Steagall provisions were preventing them from being competitive with foreign securities firms. The Federal Reserve Board reinterpreted Section 20 of the Glass-Steagall provisions to allow banks to have up to 5% of gross revenues from investment banking business. Soon after, the Federal Reserve Board voted to loosen regulations under the Glass-Steagall provisions after hearing arguments from Citicorp, J.P. Morgan, and Bankers Trust. The newly eased regulations permitted banks to handle several underwriting businesses, including commercial paper, municipal bonds, and mortgage-backed securities. The Federal Reserve Board indicated that it planned on increasing the limit to 10% in the near future in an attempt to increase competition.
Federal Reserve Chairman Alan Greenspan—appointed by President Ronald Reagan in 1987— favored deregulation of the securities industry as a way to help American banks compete with foreign securities firms. Greenspan’s appointment signaled the beginning of the end for Glass-Steagall legislation.
Financial Services Modernization Act of 1999
The Financial Services Modernization Act of 1999, also known as the Gramm-Leach-Bliley Act (GLBA), repealed part of the Glass-Steagall provisions, removing barriers in the market for banking companies, securities companies, and insurance companies that prohibited any single institution from acting as any combination of a commercial bank, investment bank, or insurance company.
The GLBA failed to give the SEC or any other regulatory agency authority to regulate the large investment bank holding companies. The justification for the GLBA revolved around investors’ ability to have both a savings and investment account with the same financial institution. The GLBA resulted in numerous consolidations among financial institutions.
The GLBA implemented the “financial privacy rule” requiring financial institutions to provide each customer with a privacy notice when the consumer relationship is established and on an annual basis thereafter. The notice must explain the information being collected about the customer, where the information will be shared, how the information is used, and how the institution is protecting that information.
The Securities Act of 1933
The Securities Act of 1933, referred to as the Securities Act, represents an integral part of United States securities regulation. This Act regulates offers and sales of securities in the United States. The Securities Act requires companies offering securities to file a registration statement containing information about itself, the securities it is offering, and the offering itself. The information required in a registration statement includes:
- Past performance of the business;
- Audited financial statements;
- Executive compensation information;
- Risks of the business; and
- Information about the officers and managers of the company issuing the stock.
The Securities Act aimed to ensure that investors of securities received complete and accurate information about the security itself prior to investing. The company issuing the stocks is held strictly liable if any of the information contained in the registration statement is false or misleading.
The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 (the Exchange Act) governs the trading, purchasing, and selling of securities. After implementing the Securities Act, Congress determined that a regulatory body was needed to enforce those regulations. Therefore, Congress created the SEC and charged the body with administering and enforcing federal securities laws.
The Exchange Act gave the SEC broad powers to regulate the securities industry, allowing it to bring civil charges against individuals and companies found violating securities laws. The Exchange Act empowered the SEC to register, regulate, and oversee the nation’s securities self-regulatory organizations (SROs), which include:
- The New York Stock Exchange;
- The NASDAQ Stock Market; and
- The Financial Industry Regulatory Authority (FINRA).
The Exchange Act also authorized the SEC to require that companies offering publicly traded securities submit periodic reports.
With the Exchange Act, Congress authorized the SEC to promulgate rules to help regulate securities transactions. Since the passage of the Exchange Act, new rules surrounding the securities industry have, for the most part, been implemented by the SEC.
Section 10(b) & 10(b)-5
Section 10(b) of the Exchange Act prohibits fraudulent activity of any kind in connection with the offer, purchase, or sale of securities. Section 10(b)-5 provides the basis for many forms of disciplinary actions, including insider trading.
In numerous opinions, the Supreme Court outlined the six elements that must be alleged by a plaintiff to win a rule 10(b)-5 claim, including:
- The defendant made a “material misrepresentation or omission”;
- The defendant acted with “scienter,” or a “wrongful state of mind”;
- The material misrepresentation or omission was made “in connection with the purchase or sale of a security;
- The plaintiff relied upon the material misrepresentation or omission;
- The plaintiff suffered an economic loss as a result of the fraud; and
- The plaintiff can prove that the fraudulent misrepresentation or omission caused the plaintiff’s economic loss.
The PSLRA, discussed below, heightened the pleading standard for plaintiffs filing securities lawsuits.
Investment Company Act and Investment Advisers Act
The Investment Company Act, implemented on August 22, 1940, required organizations primarily engaged in investing and trading stocks to provide full disclosure about investment objectives and minimize conflicts of interest.
The Investment Advisers Act required registered investment advisers to register with the SEC prior to providing any services.
Employee Retirement Income Security Act of 1974
The Employee Retirement Income Security Act of 1974 (ERISA) established minimum standards for pension plans in private industries. The legislation was enacted to protect the interests of employee benefit plan participants by:
- Establishing standards of conduct for plan fiduciaries;
- Requiring disclosure of financial and other information concerning the plan to beneficiaries; and
- Providing appropriate remedies and access to federal courts.
For purposes of securities law, ERISA applies to investment advisers and other securities professionals who manage or trade in accounts considered subject to ERISA.
ERISA defines three categories of fiduciaries:
- Those who exercise authority or control over the management of plan assets;
- Those who provide investment advice for a fee with respect to plan assets, or have the authority to do so; and
- Those who administer the plan.
Fiduciary duties include acting in the interest of participants and beneficiaries, acting prudently, and adequately diversifying a portfolio to minimize the risk of significant losses.
The fiduciary standard imposed by ERISA only applied to registered investment advisers and typically did not extend to brokers and broker-dealers.
The 1975 Securities Act Amendments
The 1975 Securities Act Amendments charged the SEC with creating a composite quotation system and promoting the development of a national system for the efficient clearance and settlement of securities transactions.
The Amendments also required the SEC to consider the impact any newly implemented regulation would have on competition before enactment.
Private Securities Litigation Reform Act
The Private Securities Litigation Reform Act (the PSLRA), passed in 1995, implemented changes to the process of filing cases under federal securities laws in areas of pleading, discovery, liability, class representation, and award amounts.
The PSLRA barred plaintiffs from filing frivolous securities lawsuits in an effort to use pre-trial discovery as an opportunity to uncover real evidence of fraud. Defending these frivolous claims proved incredibly costly for securities firms, eventually resulting in settlement as a preferred method of resolution. The PSLRA implemented a heightened pleading standard for plaintiffs attempting to file lawsuits, including class actions.
Securities Litigation Uniform Standards Act
As a result of the PSLRA, plaintiffs attempted to avoid federal court altogether to escape the heightened pleading standard. Instead of federal court, plaintiffs took their lawsuits to state courts alleging state-law based securities fraud. Congress conducted a hearing and subsequently passed the Securities Litigation Uniform Standards Act (SLUSA) to prevent securities class action lawsuits brought in front of state courts from frustrating the objectives of the PSLRA.
The SLUSA effectively preempted state law claims arising from plaintiffs that claimed injury based on the prolonged retention of stock due to fraud and claims arising from the fraud-induced purchase or sale of securities.
The Sarbanes-Oxley Act
The Sarbanes-Oxley Act (SOX) implemented and expanded requirements for all United States public company boards, management, and public accounting firms. Following a number of corporate and accounting standards in the early 2000s, lawmakers drafted SOX in an effort to outline:
- The responsibilities of a board of directors for a public corporation;
- Criminal penalties for certain forms of misconduct;
- The SEC’s responsibility to create regulations to define how public corporations are to comply with the law;
- The creation of the Public Company Accounting Oversight Board (PCAOB);
- Standards for auditor independence to limit conflicts of interest;
- Enhanced reporting requirements for financial transactions;
- Codes of conduct for securities analysts, requiring full disclosure of certain conflicts of interest; and
- Increased criminal penalties in connection with white-collar crime and conspiracies.
SOX constituted the most expensive securities legislation passed in the United States since President Franklin D. Roosevelt. Following the enactment of SOX, several other countries implemented SOX-like legislation to strengthen their own financial governance laws.
As a whole, SOX attempted to enhance corporate responsibility, enhance financial disclosures, and combat corporate and accounting fraud.
Dodd-Frank Wall Street Reform and Consumer Protection Act
In 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) into law. Dodd-Frank overhauled financial regulation laws in the aftermath of the Great Recession.
This legislation imposed strict legislation on lenders and banks in an effort to protect consumers and prevent another economic recession.
Dodd-Frank assigned new responsibilities to the FDIC. The legislation created the Consumer Financial Protection Bureau, charged with protecting consumers against abuses involving credit cards, mortgages, and other financial products. The Federal Reserve received new authority to regulate systemically important institutions. The Financial Stability Oversight Council was also formed as a result of Dodd-Frank, a committee responsible for identifying risks that affect the financial industry.
A provision of Dodd-Frank called the Volker rule restricted banks from making certain speculative investments.
Dodd-Frank also created a program designed to encourage members of the public to report securities law violations to the SEC. A whistleblower provision included in Dodd-Frank also encouraged internal securities officers to report violations without fear of retaliation.
The Stop Trading on Congressional Knowledge (STOCK) Act, passed in 2012, attempted to address and combat insider trading by members of Congress and other government officials. The law prohibits members of Congress and their employees from using information derived from their position in the government for their own personal benefit.
In 2015, President Obama requested that the Department of Labor raise the investment-advice standards for brokers handling retirement accounts. Soon thereafter, the White House Council of Economic Advisers released a report indicating that conflicted investment advice for retirement accounts cost retirees approximately $17 billion per year.
The Department of Labor proposed the new regulations in April 2014. The final version, referred to as the fiduciary standard, was delayed for two years because of a bill introduced by Rep. Joe Wilson (R., S.C.).
The new fiduciary rule expanded the definition of “investment advice fiduciary” to include all financial professionals working with retirement plans or providing retirement planning advice.
The fiduciary rule faced significant pushback from the securities industry. Brokers previously held to the standard of suitability would now be required to uphold a fiduciary standard.
Things not considered investment advice under the new standard include:
- A customer requesting a specific product or investment;
- Providing education to clients, such as general investment advice based on a person’s age or income level; and
- Advice regarding taxable transactional accounts or accounts funded with after-tax dollars.
The fiduciary rule provides retirees with peace of mind that their brokers and investment advisers are recommending investments that are in their best interest.
State-Level Securities Regulation
Prior to the enactment of the Securities Act, American securities laws existed in each state in an attempt to regulate the sale of securities and prevent fraud. Known as blue sky laws, the regulations proved mostly unsuccessful.
Arizona led the charge on state securities legislation in the wake of the Securities Act, passing the Arizona Securities Act in 1951 that explicitly coordinated with the SEC on enforcement and exemptions.
The Uniform Securities Act
The Uniform Securities Act, first proposed in 1930, was enacted by only five jurisdictions.
The legislation was altered significantly, and by 1957, 37 states had adopted some version of the Uniform Securities Act, which attempted to balance the need to protect individual investors from fraud with the need of states and companies to raise capital efficiently. One way to strike the balance included allowing securities that were already federally registered to be exempt from further regulation at the state level.
The Uniform Securities Act underwent additional revisions in 1985; however, a majority of states continued to operate under the 1956 Uniform Securities Act. The most recent version of the Act, the Uniform Securities Act of 2002, has been adopted in:
- South Carolina,
- South Dakota,
- Wisconsin, and
- The U.S. Virgin Islands.
The 2002 version of the Act was revised most recently in 2005.
State Blue Sky Laws
State-level securities legislation, referred to as blue sky laws, differ from state to state. Blue sky laws generally impose anti-fraud regulations, including:
- Licensing requirements for brokerage firms, brokers, and investment advisers;
- Requirements that private investment funds register in every state they do business;
- Disclosure requirements with respect to material information; and
- Notice and filing requirements for the registration of securities.
While states are authorized to pursue some securities law violations, federal law preempts state law in many areas where securities are concerned.
Although many states adopted securities provisions closely aligned with the Uniform Securities Act, some states chose to enact dramatically different securities laws. Thus, it is vital to know which state law applies to determine what is or is not permitted in a certain state.
The Financial Industry Regulatory Authority (FINRA) replaced the National Association of Securities Dealers (NASD), which was originally created as an outcome of the Securities Exchange Act of 1934.
FINRA holds significant authority in regulating and overseeing the conduct by individuals in the business of selling securities to the public. All securities firms that are not regulated by another self-regulatory organization must be member firms of FINRA.
FINRA operates the largest arbitration forum for resolving disputes between investors and their member firms. Currently, almost all agreements between investors and their brokers contain a provision requiring arbitration in lieu of court proceedings. Federal courts have ruled that the arbitration provisions are lawful and upheld the enforceability and results of the arbitrations.
When an investor suffers losses caused by the negligence or misconduct of a financial advisor, arbitration provisions within their contract may require that the case be tried in front of a FINRA arbitration panel. To initiate an arbitration claim, the injured party must file a statement of claim outlining the relevant facts to inform the arbitrators of the circumstances of the case. Following the statement of claim, the brokerage firm and/or stockbroker accused of misconduct has 45 days to file an answer responding to your allegations.
After selecting arbitrators and outlining important dates for the arbitration, the discovery process begins. Adversarial parties are expected to engage in mediation discussions and negotiate the possibility of a settlement during the process of the arbitration. If unsuccessful, the arbitration proceeds to a final hearing where both sides will present their case to the arbitrators.
Within 30 days, FINRA requires arbitrators to render a verdict in the form of a written arbitration decision. Compensatory damages, pre- and post-judgement interest, attorney fees, arbitration fees and expenses, and punitive damages are available to be awarded in FINRA arbitration actions.
Securities Law Violations
Investors entrust their investment advisers and stock brokers to manage their portfolios in an honest and fair manner. Unfortunately, securities fraud violations occur at an alarming rate. The most common forms of securities fraud are listed below.
Breach of Fiduciary Duty
As stated above, registered investment advisers and some brokers must uphold a fiduciary standard when discharging their duties. That means they must act in the best interest of their clients, disclosing all possible conflicts of interests. A failure to do so amounts to a breach of their fiduciary duty.
Failure to Supervise
Investment firms are responsible for establishing and maintaining rules regarding the supervision of their employees. The supervision must include regular reviews of client portfolios to ensure the investments meet the objectives and risk tolerance of the investor. An investment firm that fails to implement an adequate supervisory system can be held liable for investor losses if its lack of supervision played a role in the losses.
Misrepresentations or Omissions
State and federal securities laws mandate full and complete disclosure of all material information about a security. That includes any conflict of interest that exists. A failure to provide clients with the full disclosure of information amounts to a breach of fiduciary duty and is a form of investment fraud.
Unauthorized trading occurs when a broker trades in a customer’s account without their authorization. If the customer has a discretionary account, the financial advisor can buy and sell securities that are suitable for the customer in light of their risk tolerance and investment objectives. However, if the customer has a non-discretionary account, the financial advisor must obtain authorization before each transaction. A failure to do so amounts to unauthorized trading and is a form of investment fraud.
Excessive trading occurs when a financial advisor makes multiple transactions in the investment account of a customer for the purpose of driving up commissions. Excessive trading costs investors significantly in the long run and is a common form of investment fraud.
Robert Wayne Pearce: Your Securities Law Attorney
Securities law is one of the most complex and confusing areas of the law. Thus, if you have questions about securities law and what rights you may have, it is always best to contact an attorney with extensive experience handling these types of legal issues.
Attorney Robert Wayne Pearce is one of the most experienced securities arbitration, securities fraud, and commodities fraud attorneys available. With over 40 years of experience navigating investment and securities law disputes in Florida, nationwide, and internationally, the Law Offices of Robert Wayne Pearce, P.A., is one of the most experienced securities law firms in the country.
Our attorneys have recovered more than $160 million on behalf of our clients, so contact us today to see how we can help you.