Securities and Exchange Commission

What Is the Role of the Securities and Exchange Commission (SEC)

Legal AssistantAdministrative Law, Business Law, Regulatory Law, Resources

Have you ever wondered what a world without the stock market would look like? Let’s just say things would be very different from what they are now.

For one thing, getting business funding would be virtually impossible. Business growth would progress at an unbelievably slow pace, if at all, and the economy would stagnate.

Now, picture a world where the stock market exists, except, in this case, it’s a free-for-all affair. No checks and balances. Anything goes. What would that look like?

Think – Wolf of Wall Street on steroids. The gap between the haves and the have-nots would be the widest it’s ever been, with no sign of letting up. It would be complete and utter mayhem.

This is precisely why the Securities and Exchange Commission (SEC) exists – to ensure that no entity tips the balance in their favor.

What is the Securities and Exchange Commission, and what role does it play in the US stock market? Here’s everything you need to know.

Black Tuesday – Where It All Began

The period right after World War I was an interesting and exciting time in US history. The Roaring 20s, as they were affectionately called, saw an unprecedented economic boom during which overproduction, consumerism culture, and debt were at an all-time high. Everyone wanted to strike it rich, and they turned to the stock market to make this happen.

With no federal oversight, people invested in stocks, often buying shares on margin and taking on a huge amount of risk in the process – and then it happened. The now infamous Black Tuesday when everything came crumbling down. The stock market crashed on October 29, 1929.

In a single day, people lost billions of dollars’ worth of investment. More than 5,000 banks shut down.

Thousands of companies went bankrupt. Massive unemployment swept across the nation. People lost their homes and their livelihoods. They lost everything. This triggered the onset of the Great Depression.

To help identify the root cause of this devastating crash and develop measures to prevent the likelihood of a similar event occurring in the future, the US Senate Banking Committee convened a series of meetings in 1932, which were later named the Pecora hearings.

What emerged from the proceedings was that several financial institutions had not only misled investors with misinformation, but they had also engaged in unethical and irresponsible business practices, one of which included insider trading.

The Securities Act of 1933

Before the establishment of the SEC, Blue Sky Laws existed on paper at the state-level.

These so-called rules were supposed to regulate securities trading and curb fraud. Despite their existence, they were widely ineffective at streamlining the operations of the stock market.

After the Pecora hearings, however, Congress enacted the Securities Act of 1933. The Act’s goal was to avert securities fraud and ensure that investors receive accurate and truthful financial information about the securities on sale. Moreover, it now gave the Federal Trade Commission the authority to block the sale of securities if they deem it not to be in the public’s interest.

Additionally, the Pecora hearings also led to the enactment of the Glass-Steagall Act of 1933.

The legislation separated commercial banking from investment banking to build public trust and confidence in the financial sector and restore the economy to what it once was before the Black Tuesday crash.

The Act established the Federal Deposit Insurance Corporation (FDIC) to play an oversight role in the regulation of banks, safeguard customers’ bank deposits, and manage customer complaints.

The Securities and Exchange Act of 1934

In June 1934, the Securities and Exchange Act was signed into law. This legislation established the SEC, giving it extensive authority to regulate all aspects of the securities sector.

The SEC has five divisions, each of which is led by a commissioner who the President himself appoints. They consist of:

  • The Division of Corporation Finance – Regulates all publicly-traded corporations
  • The Division of Economic and Risk Analysis – Monitors the state of the economy to identify the effects any new SEC rules would have on the markets
  • The Division of Enforcement – Investigates the potential violation of securities laws
  • The Division of Investment Management – Oversees and regulates the investment management sector and associated entities
  • The Division of Trading and Markets – Ensures that trade markets remain fair and efficient

The new law also gave the SEC the power to bring civil charges against companies and individuals who break securities laws.

Common SEC violations include insider trading, manipulation of market prices, sale of unregistered stocks, violation of broker-customer integrity, disclosure of false financial information, and theft of customer funds.

The Trust Indenture Act of 1939

In 1939, Congress enacted the Trust Indenture Act in a bid to protect individuals and entities investing in bonds. The TIA prohibits the sale of debt securities valued above $5 million if they are not issued under a formal written agreement or “indenture.”

Both parties, i.e., the bondholder and the bond issuer, have to sign the indenture and disclose all the details surrounding the bond issue.

A trust indenture is designed to protect the interests of the bondholders and must receive approval from the SEC. All parties are bound by the terms of the contract for the entire lifetime of the bond.

The TIA was introduced as an amendment to the Securities Act of 1933 to give indenture trustees a more proactive role.

It achieved this by placing reporting requirements, as well as other regulatory obligations on them. The SEC is responsible for administering the TIA.

Bondholder Rights

The Act also gave investors more substantive power. Before its enactment, an individual bondholder couldn’t use legal channels to receive any payment due to them. The TIA changed all this.

If the bond issuer goes through an insolvency process, the law now gives the appointed trustee the authority to go after all assets belonging to the issuer and sell them to recover the bondholder’s investment.

The Investment Company Act of 1940

While the Securities Act of 1933 focused on enhancing transparency for investors, the Investment Company Act of 1940 was enacted to regulate how investment companies are organized and the activities they engage in.

It provides a list of requirements for publicly-traded retail investment products like unit investment trusts, closed-end mutual funds, and open-end mutual funds.

It requires investment companies to adhere to guidelines regarding their fiduciary duties, financial disclosures, service charges, and many more. All investment companies must register with the SEC before their securities can be traded in the public market.

The category they register under depends on the specific product or range of products they wish to issue to and manage on behalf of public investors.

Investment companies generally fall into one of three categories as per federal securities laws:

  • Closed-end management investment companies/closed-end funds
  • Open-end management investment companies/mutual funds
  • Unit investment trusts

The requirements for each one vary based on the class they fall under and the products they offer.

The Investment Advisers Act of 1940

The Investment Advisers Act

In 1935, the SEC prepared a report on investment companies and investment trusts which it later presented to Congress. The provisions of this report lay the groundwork for the enactment of the Investment Advisers Act of 1940.

It defines the roles and responsibilities of investment advisers. According to the legislation, any person or entity making a recommendation or advising on securities would be considered an adviser.

The Investment Advisers Act defines three criteria to address who is and isn’t an adviser. It looks at:

  1. What kind of advice is being offered
  2. The method of compensation for the advice in question
  3. Whether or not the bulk of the adviser’s revenue is derived from offering investment advice

The Act further states that any individual who presents themselves to a client as an investment adviser will be considered one. The law applies to entities and individuals who offer investment advice to institutions, individuals, and/or pension funds.

The Sarbanes Oxley Act of 2002

The Sarbanes-Oxley Act of 2002, also known as the SOX Act, was enacted to protect investors from corporations engaging in fraudulent financial reporting.

The legislation came about due to the rising number of financial scandals in the early 2000s involving large, publicly-traded corporations like Tyco International and Enron. These high-profile frauds eroded investor confidence in the legitimacy of corporate financial statements.

The SOX Act was established to complement and amend certain sections of the existing securities regulations, including the provisions of the Securities Exchange Act of 1934, in addition to other pieces of legislation enforced by the SEC. It also imposed stricter penalties on corporations and individuals flouting securities laws. SOX laws focus on four principal areas:

  1. Accounting regulations
  2. Corporate responsibility
  3. Stiffer criminal penalties
  4. New protections

The major provisions of the SOX Act are found in three sections. Here’s a brief overview of what each one entails.

Section 302

It requires senior corporate executives to certify in writing that the company’s financial statements are accurate, trustworthy, and in compliance with the disclosure requirements mandated by the SEC.

If a company’s executive officer signs off on financial statements they know to be falsified, they face criminal penalties, which may include a jail term of up to 20 years.

Section 404

This section of the SOX Act mandates auditors and management to establish adequate reporting methods and internal controls. These mechanisms should be designed to prevent fraud, promote accountability, and guarantee accounting and financial information integrity.

Section 802

This section has three rules that focus on corporations’ recordkeeping practices. These rules touch on three major areas.

  1. Record falsification and destruction
  2. The required record retention period
  3. The specific business records that corporations need to preserve

The SOX Act also has provisions related to how IT departments handle electronic records. Additionally, it offers protection to whistleblowers who report SEC violation practices and prohibits companies from altering their employment contract terms.

This means that employees can testify in court against their employer and still retain their job. The Act also offers similar protections to contractors.

White Collar Crime

Any non-violent crime committed for the sole purpose of monetary gain is classified as a white-collar crime.

It encompasses all activities characterized by deceit, the violation of trust, or intentional concealment, either gain or avoid the loss of money or property, or to secure a competitive advantage in personal or business-related dealings.

Common examples of white-collar crimes include money laundering, corporate fraud, embezzlement, and securities fraud. Aside from the FBI, the SEC also has a division charged with investigating white-collar crimes.

The Responsible Corporate Officer (RCO) doctrine fronts the presumption that any high-ranking corporate executive in an organization is aware of any illegal activity within the corporation.

This means that the officer in question can be found guilty of a white-collar crime, even if they did not know about the said criminal activity.

In the United States v. Park, the Supreme Court upheld the conviction of the president of a national chain of food store outlets, who was charged for failing to contain and eradicate a rodent infestation at one of the corporation’s warehouses.

In his appeal, the defendant asserted that he had delegated responsibility to a trusted member of his corporation. However, the Supreme Court upheld the ruling citing that he was entirely responsible given that he was the senior-most executive in the company.

As far as the penalties for white-collar crimes go, the government usually charges individual offenders. However, it does have the authority to sanction corporates for offenses of a similar nature. If convicted, penalties include:

  • Community confinement
  • Fines
  • Footing the cost of prosecution
  • Forfeitures
  • Home detention
  • Restitution
  • Supervised release
  • Imprisonment

According to federal sentencing guidelines, longer prison terms are usually instituted whenever a victim of the crime suffered grievous financial harm.

Leveling the Playing Field

The SEC makes it safe for investors to buy stocks and bonds and invest in mutual funds without the fear of being manipulated or defrauded. Keep in mind that the regulator does not play an oversight role when it comes to hedge funds and derivatives.

For more information on securities litigation, get in touch with an SEC lawyer today.