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Regulation of the Securities Markets and Securities Professionals
Most disclosure is “filtered” before it reaches the typical investor. The immediate audience for information is investor analysts and professional investors. They in turn analyze, interpret, summarize the information which is transmitted to typical investors, either directly or through a broker.
many possible conflicts of interests (for the intermediary actors)
Blue sky laws: state (federal) securities laws.
NASDAQ: National Association of Securities Dealers Automated Quotation. It’s an OTC exchange: it is the marketmakers’ quotation (their bid and buy prices, on a computer screen) of the 6 000 most active OTC securities.
Efficient Capital Market Hypothesis (ECMH): it’s a descriptive theory of the relationship between the disclosure of financially significant information, and changes in securities market prices. There are 3 types of markets:
1) weak market efficiency: if the market’s efficiency is weak, then stock prices will fully reflect all information contained in the historical pattern of market prices.
2) semi-strong market efficiency: if the market’ efficiency is semi-strong, then prices will reflect all public information, including that in financial statements.
3) strong market efficiency: if the market’s efficiency is strong, then prices will reflect all information, including nonpublic or inside information.
A.The Structure of Regulation and the Evolution of the Securities Markets
The Exchanges
The most important markets are the NYSE and the AMEX. The are privately owned not-for-profit corporations. They are owned by members who have exclusive access to their trading facilities.
All national securities exchanges are placed under the direct federal supervision since 1934. It is unlawful for any broker-dealer to effect any transaction on any facility that operates as an exchange unless that exchange is registered with the SEC. The SEC will only accept registration if certain conditions are met (fraud prevention, allow free trade..).
What is an exchange? S/3(a)(1) ’34 Act: “any facility intended for bringing together purchasers and sellers of securities, or performing the functions commonly performed by a stock exchange as generally understood”
Proprietary Trading Systems (PTS): they are communication linkages that permit the interaction of buyers and sellers away from traditional exchanges.
The SEC considers that PTS’s lack many of the elements of an exchange as commonly understood. Therefore, it doesn’t require registration by PTS’s, but asks them for regular information. Thus, PTS’s are regulated via the reporting obligations imposed on broker-dealers generally.
Once registered, an exchange is, by statute, given the responsibility for its own regulation. To this end, it is designated by law as a Self-Regulatory Organization (SRO).
The Over-the-Counter Markets
Marketmakers maintain inventories of securities, and publish quotes of their bid and asked price. NASDAQ links marketmakers with brokers (who buy for investors).
Broker-dealer associations must be registered as SRO’s (just like exchanges) => NASD is registered. A broker may not transact unless he is member of a registered association.
Self-Regulation Revisited
There is a political compromise between the expertise of SRO’s and their tendency to place their own interests first. There is a risk that the establishment quash competition,…
This has led to constant SEC supervision. The SEC’s role was extended in 1975: it must approve any proposed by SRO’s, and may, on its own motion, abrogate, add to, and delete from SRO rules.
Best Execution and the National Market System
Which system leads to the best execution price (=lowest transaction costs)?
Centralization: all orders are routed to a single site. But strong anticompetitive risks as there is a monopoly. This system prevailed until the early ‘70’s.
Competition: each exchange would show its prices on the same screen. This was the idea of the National Market System. This now exists for the NYSE, AMEX, and the major stocks on NASDAQ: the informational phase is more or less complete (more thanks to technology than regulation) + there are Intermarket Trading Systems that route orders from one market to another.
However, exchange rules still limit their members from trading on other exchanges. Instead of repealing this, the SEC tried an experiment: these rules were repealed for stocks introduced on markets after 1979. The fear of a total repeal was one of fragmentation: no market would be liquid enough, there wouldn’t be experts on every exchange,… = chaos. However, technology and competition have acted: NASDAQ, PTS’s, international markets,… have eroded the exchanges’ dominance.
The SEC has still not devised a clear policy or philosophy on “regulation, or free market forces?”, because it is not clear which is best for investors (OTC markets have their own anticompetitive problems).
SEC regulation has become outdated by technology. Technology has enabled:
1)the exponential growth of PTS’s (represent 20% orders on OTC stocks + 4% orders on NYSE stocks)
2)the development of automated mechanisms that facilitate access to international markets.
Many alternative trading systems have characteristics of a traditional exchange (centralization of orders) and of a traditional broker-dealer (use of trading desks to facilitate trading). Should they register as exchanges, broker-dealers, or both? The SEC decides on a case-by-case basis, but generally has said that they should register as broker-dealers (if they registered as exchanges, this would be burdensome, and innovation would be limited).
However, this means that these systems are subject to a regime which is not adapted to them (this has led to gaps and overlaps in old/general and new/specific regulation: this 26has limited integration and surveillance of these markets: cf. Supplement p.82-88)
+ broker-dealers must be members of an SRO (i.e.: an exchange or the NASD = their competition: big anticompetitive concerns)
Derivative Markets
Derivatives : They are financial instruments whose value depends upon the price of some underlying instrument.
Options : they are rights to buy (call) or sell (put) securities from or to another at some pre-determined price and date. (risk shifting devices). The buyer of an option has a choice as to using it or not. Of course he will only use it if he is in the money. Options trading can be a way of hedging or leveraging risk
Futures : futures are like options, except for the fact that there is no choice of use. A future is a CT which either party can enforce. Exclusive jurisdiction of futures is given to CFTC.
Ex: option: I buy an option to buy Xstock at $20 on June 1st. If on June 1st the price is $30, I will exercise the option: profit $10
If the price is $15, I will not exercise the option
Ex: futures: I buy a futures corn CT for $20for delivery on June 1st. If on June 1st the price is $30, or if it is $15, I must pay $20.
Futures and options are standardized contracts traded in exchanges. There are many other custom-made futures which are traded OTC.
B.Regulation of the Broker-Dealer Industry: Structure and Oversight
- Entry
S/15(a) 1934 Act: No person may act as a broker unless registered with the SEC or exempted thereby
Broker: s/3(a)(4): person engaged in the business of effecting transactions in securities for the account of others.
Dealer: s/3(a)(5): person engaged in the business of buying and selling securities for his own account.
“In the business” means on a regular basis and in a fairly public fashion.
The SEC has the authority to deny or revoke entry upon evidence of misconduct.
Firms that deal exclusively in exempt securities need not register. Same for people who do business on a purely intrastate basis and don’t use any national exchange facilities.
- Supervising the Conduct of Broker-Dealers and their Associated Persons
- Self-Regulation
There is a very visible disciplinary process. The rules are set by the exchanges, and are very open-ended.
S/6 and s/15A Exchange Act: SROs have the power and responsibility to discipline. Their disciplinary power extends to SEC and statutory violations as well as exchange rules’ violations.
The SEC has a right to review sanctions: it may change them, overturn them, but not increase them.
In re Robert Jautz (SEC, 1987)
Broker obtains a loan from a client, and fails to repay on time. He is prosecuted by the NASD.
Held: There’s nothing wrong with borrowing money from a client, and the default was a breach not committed in bad faith.
- Direct SEC Supervision of Brokers and Dealers
SROs do not have exclusive or primary authority in conduct regulation. The SEC plays an important role based on s/10(b) 1934 Act. The SEC also has rule making power in the financial responsibility of firms, and discipline. It can discipline broker-dealers and associated persons under s/15(b)(4) if:
-broker willfully violated securities laws or aided such a violation by others
-broker willfully made a false statement in registration to the SEC
-broker is subject to a “statutory disqualification”
Willfulness exists if the broker is aware of problems and ignores the obvious need for further inquiry.
The SEC has a unique power of fining money in administrative proceedings. For civil penalties against other violators, it must go to court.
Firms have a responsibility to actively supervise their staff and employees.
In the Matter of John Gutfreund (SEC, 1992)
Salomon’s chief legal officer saw a violation. He reported it in a meeting and recommended action. None was taken. He did nothing more. SEC prosecutes the legal officer.
Is a firm’s chief legal officer a supervisor?
Given his role and influence in the firm, he had a duty to act more than he did, and to disclose the violation to the SEC.
C.The Responsibilities of Brokers to their Customers
- The Shingle Theory and Fiduciary Obligations
There are many broker/client relationships. Broker may be offering:
-advice on the market (a particular stock)
-execution service
-advice on portfolio selection
There is general agreement on the use of s/10(b)(5) in clear cases of deceit by the broker. The problem is that most of the time there is no deceit, just a breach of trust.
The Shingle Theory: by the very step of going into business, a broker impliedly represents that he will deal fairly with clients (Charles Hughes & Co. v. SEC (U.S. SC, 1944)). The theory not only creates a duty of fair dealing, but also that any breach of that duty can easily be deemed fraudulent since it also constitutes a breach of the implied representation. A finding of fraud allows the SEC to impose administrative sanctions, as well as giving rise to damage liability under 10(b)(5).
This theory – and the duty it creates – pretty much comes from nowhere.
Generally, there must also be disclosure of risks and conflicts of interest.
2.“Know your Security”
Hanley v. SEC (2nd Circuit, 1969)
Brokers make fraudulent misrepresentations about a stock. Also they made negligent representations which they hadn’t checked up.
Held: they are punished for lying, but the Court also says that if you are a broker, you by definition imply that you have researched the stock. If you don’t reveal that you haven’t researched, that is fraud.
Easterbrook: Ridiculous ruling. There is no statutory obligation to do research (otherwise, all discount brokers would be illegal!), only obligation is for truthful statements.
- Suitability
Clark v. John Lamula Investors (2nd Circuit, 1978)
A plaintiff must prove that
-the securities bought were unsuited to his needs
-the broker knew this
-the broker sold the securities anyway
-the broker misrepresented the suitability
-the plaintiff relied on the misrepresentations
Thus, if the buyer is in part buying portfolio advice (and not just execution service), the broker has a duty not to sell unsuitable stocks.
Brown v. E.F. Hutton Group (2nd Circuit, 1993)
Brokers sell risky stocks saying that they are not risky. But, brokers did send to buyers the offering materials of the stock, which did say that there was risk.
Held: broker is not liable because the buyers shouldn’t have relied only on the broker’s advice as they had the offering materials.
Easterbrook: the disclaimer in the offering materials should work for the issuer, not for the broker! It’s the broker’s job to analyze these materials and tell clients what the risk really is. Here again, the case turns on what the broker is selling: portfolio advice, or just execution service.
Banca Cremi v. Alex. Brown & Sons (4th Circuit, 1997)
Buyer is a sophisticated investor. It makes very bad investments that increased the risk of its portfolio.
Held: the buyer lost its right to rely on broker’s advice through its recklessness. Therefore, it can’t sue for fraud.
Easterbrook: bad decision. Question is just: what was the broker selling? It looks like just execution service. If so, then buyer cannot sue as trades were always executed. But if broker was selling portfolio advice, then broker would be in breach for not having warned the buyer that the investment increased the portfolio’s risk.
SRO Rules
There is a trend that SRO suitability rules do not create a private right of action (which would have allowed avoiding the use of the Shingle Theory).
What renders an Investment Unsuitable?
Client’s age? Ability to understand risk? It probably turns on just how extreme the facts are.
The Duty to Read
Is there a customer duty to read the prospectuses? SEC tends to say no, courts tend to say yes (cf. Brown v. E.F. Hutton)
The Limits of the Suitability Rule: the Aggressive Customer
There is no obligation to warn of risks when the broker is just selling execution service.
If a client insists on a stock, broker may of course sell it.
Suitability and the Institutional Investor
Are there investments which could be considered unsuitable for IIs? The courts are unclear, but SRO rules say yes: suitability obligations apply to brokers, whoever their clients may be.
Penny Stocks
There are huge disclosure and paperwork obligations on brokers to avoid fraud and boiler room tactics.
- Churning and other “Relational” Frauds
Churning: it occurs when a broker buys and sells securities for a client’s account, without regard to the client’s investment interests, for the purpose of generating commissions.
Merrill Lynch, Pierce, Fenner & Smith v. Arceneaux (11th Circuit, 1985)
Plaintiff traded options and lost. He claimed that while the average turnover for a stock was 1 time per 2 years (=0,5/year), his account had turnover of 8 times per year.
Held: turnover of 6/year is churning.
Easterbrook: ridiculous ruling. Where does the 6 come from? Arbitrary. More importantly, options expire every 60 days. Of course there is a high turnover (different from stocks where best strategy is to hold).
The real problem here was suitability: why did ML allow a small client to trade options?
Nowadays, almost only accredited investors may trade options.
For a discussion on optimal damages and damages options: cf. Easterbrook
- Price Protection: Markups and Other Matters
The idea underlying the Shingle Theory is that a broker has an implied obligation to obtain the best possible price for its customer. Marking up prices is a typical case where there is no deceit.
The 5% Rule: NASD and courts often refer to 5% as being the highest fee a broker may charge for a transaction on a security. This is not a hard and fast standard.
Why is there such a rule?
On regulated exchange, the price reflects what IIs think the stock is worth. I will get the same price as them.
On an OTC market, I am not buying or selling from an II, but from a market-maker. The market-maker is on both sides of the transaction. The 5% rule comes from this fact, and aims to force market-makers to offer fair prices.
How do I know if there is a fraud? If the market-maker sells at $6, but buys at $1 or won’t buy at $5. That means that he is not acting as a market-maker: basically, he is emptying his inventory of stock and not refilling it, because he knows that $6 is over-priced.
However, there should be flexibility in mark-ups for OTC traders as they often have less liquidity than the NYSE: they should be compensated for market-making in this riskier stock.
Lehl v. SEC (10th Circuit, 1996)
A broker is prosecuted for charging 100% markups in penny stocks sold OTC.
Held: broker violated NASD rules on fair-trading
Easterbrook: bad decision. There is clear fraud here.
Atlanta-One v. SEC (9th Circuit, 1996)
A broker is prosecuted for charging excessive markups.
Held: only 23% of the broker’s clients made money once the commissions were subtracted.
Easterbrook: ridiculous decision. The court is using an ex-post fact as evidence. Furthermore, maybe the 23% who made money each made millions. The court’s information is worthless. If its going to use ex-post information, it might as well use something a little relevant (i.e. the average rate of return for all clients).