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A.4 Function, purpose, and regulation of financial institutions

The sale of corporate securities is regulated by the Securities and Exchange Commission (SEC), a federal agency that administers the Securities Act of 1933, the Securities Exchange Act of 1934, and other federal statutes. The main objective of the SEC is to protect the public when investing by requiring full and fair disclosure of relevant information. Federal and state require regulation, however, most regulation is from the federal government because the majority of trading is done across state borders

Federal Securities Regulation

Securities Act of 1933

This act is primarily concerned with new issues of securities or the primary market. The first objective of the act is to require investors to receive financial and other significant information regarding the security being sold. The second objective for the securities act is to prohibit deceit, misinterpretation, and er fraud in the sale of securities. The act requires securities that are sold in the US to be registered with the SEC. A registration statement is a thorough description of the securities. It includes the financial structure, condition, and management personnel of the issuing corporation, and could also contain pending litigation against the issuing corporation. The act requires that a prospectus based information be given to any potential investor. Prospectus and registration statements become public shortly after filing with the SEC. There are however some securities that are exempt from registration requirements:

  1. Intrastate offerings
  2. Securities of municipal, state, and federal governments
  3. Offerings of limited size
  4. Private offerings to a limited number of persons or institutions

Glass-Steagall Act(1933)

The act prohibited commercial banks from acting as an investment banker established the Federal Deposit Insurance Corporation and prohibited commercial banks from paying interest on demand deposits.

Securities Exchange Act of 1934

The securities act of 1933 was only limited to new issues, but the securities exchange act of 1934 extended the regulation to securities that are sold in the secondary market. The act made several different provisions. The act established the primary function of the SEC, which is to regulate the securities market. It made disclosure requirements for the secondary market, things such as annual reports and other financial reports are required to be filed with the SEC prior to any listing on exchanges. The act also made provisions for the registration of organized exchanges. Special rules governing solicitation of proxies were also established. Securities of federal, state, and local governments that are not traded across state lines and any other securities specified by the SEC are exempt from registering with the SEC. Insider trading provisions were made, a public report called the insider report must be filed with the SEC every month in which a change in the holding of a firm’s securities occurs for an officer, director, or 10% or more shareholder. The 1934 Act forbids insiders profiting from securities held less than six months and requires these profits be returned to the organization. Short sales are also not permitted by individuals considered to be insiders.

Investment Company Act of 1940

This act required registration with the SEC and restricted the activities of investment companies including mutual funds

Maloney Act of 1938

This act brought over the counter markets under the regulation of the SEC and called for the self-regulation the securities dealers

Federal Bankruptcy Act of 1938

It was amended in 1978 and requires a trustee that was appointed by the court to oversee the affairs of a firm for which bankruptcy charges have been filed. The act provided liquidation for troubled firms. It also provides for the reorganization of troubled firms that may be able to survive

Investment Advisers Act of 1940

The act made it so that investment advisers were regulated. It required firms or sole practitioners to be compensated for advising others about securities. They must also register with the SEC and follow regulations aimed at protecting investors. Generally, only advisers who have at least $100 million of assets under management or advise a registered investment company has to register with the SEC.

McCarran Ferguson Act of 1945

This act clarified that insurance has to be regulated at the state level

Securities Investor Protection Act of 1970

This act established the Securities Investor Protection Corporation (SIPC) to ensure investors against losses that might arise from the failure of any brokerage firm

Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act)

This act repealed sections of the Glass-Steagall Act that prohibited a bank holding company and a securities firm that underwrites and deals in ineligible securities from owning and controlling each other. The act also amended the Bank Holding Company Act of 1956 to permit cross-ownership and control among bank holding companies, securities firms, and insurance companies.

Sarbanes-Oxley Act of 2002

The act reformed corporate responsibility, it increased financial disclosure requirements and reduced corporate and accounting fraud. The act also created the Public Company Accounting Oversight Board to watch over the auditing.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

The act reformed the U.S. regulatory system in a number of areas including consumer protection, trading restrictions, credit ratings, regulation of financial products, corporate governance, disclosure, and transparency. It modified the Investment Advisers Act of 1940 thresholds for registration with the SEC. Small advisers which are those with less than $25 million of assets under management are regulated by one or more states unless the state in which the adviser has its principal office and place of business has not enacted a statute regulating advisers. Mid-sized advisers which are those with between $25 million and $100 million of asset under management are regulated by one or more state if (i) the adviser is registered with the state where it has its principal office and place of business, and (ii) the adviser is “subject to examination” by that state authority. Large advisers which are those with more than $100 million of the asset under management must register with the SEC unless there is an exemption, and state adviser laws are preempted for these advisers.

State regulation of securities or blue-sky laws

State security law regulates the offering and sale of securities in intrastate commerce. The antifraud provisions that they have is that of similar to federal laws. In the securities, they regulate the broker and dealers. They also regulate the registration and disclosure that are required before a security can be offered for sale. Some state statutes impose some standards of fairness. State statutes can sometimes be more restrictive than the federal statutes and SEC rules.

FINRA (Financial Industry Regulatory Authority)

Any individual that wants to sell securities needs to be licensed by FINRA. FINRA is considered as a self-regulated organization because the responsibility that they have is delegated by the SEC.

Series 6

Series 6 is also known as the Investment company products or variable contracts limited representative. The individual is able to deal with mutual funds, the initial offering of closed-end funds, variable annuities, variable life insurance, unit investment trust but initial offering only.

Series 7

A series 7 which is also called a general securities representative can do a lot more than a series 6. It is able to deal in corporate securities, rights, warrants, mutual funds, money market funds, unit investment trusts, REITs, asset-backed securities, mortgage-backed securities, options, options on mortgage-backed securities, municipal securities; government securities, repos and certificates of accrual on government securities, direct participation programs, securities traders, mergers and acquisitions, venture capital, and corporate financing

Series 65/66

The series 65 and 66 are exams that were developed by the North American Securities Administrators Association (NASAA) and administered by FINRA Regulation. Unlike FINRA exams, such as the Series 6 and 7, an individual does not need to be sponsored by a broker/dealer.


The Securities and Exchange Commission regulates investment advisers under the Investment Advisers Act of 1940. Unless the advisers were exempt under specific conditions, the person must register with the SEC as an investment adviser. The SEC is the one that is responsible for monitoring Registered Investment Advisors. An investment adviser is defined to be a person that does any of the following:

  1. Provides advice or issues reports or analyses regarding securities
  2. In the business for providing such services
  3. Provides the service for compensation, including commissions on the sale of products

The following organizations and individuals are excluded:

  1. Banks and bank holding companies (except as amended by the Gramm Leach Bliley Act of 1999)
  2. Lawyers, accountants, engineers, or teachers, if advisory service is not the major service that they do
  3. Brokers or dealers, if their advisory service is not their major service, and if they do not receive any special compensation for their advisory services
  4. Publishers of bona fide newspapers, newsmagazines, or business or financial publications
  5. Individuals whose advice is only related to securities that are direct obligations guaranteed by the United States
  6. Individuals that hold themselves out to the public as providing financial planning, pension consulting, or other financial advisory services is no exemption

These kinds of advisers are exempted:

  1. An intrastate adviser for unlisted securities
  2. An adviser whose only clients are insurance companies
  3. Foreign private advisers
  4. Charitable organizations and plans
  5. Commodity trading advisors
  6. Private fund advisers
  7. Venture capital advisers
  8. Advisers to small business investment companies


Generally,  it is required for advisers that are entering into a contract with clients to deliver a written disclosure statement on their background and business practices. The key document that is often used for this purpose is Part 2A of the form ADV. The document should spell out the detail of the relationships and interest of the adviser. The form ADV is a reference tool that the client or potential client can compare to other firms for compatibility needs. The regulation requires that Part 2A of the Form ADV be given to the client no later than the time of entering the contract. An investment adviser shall deliver the statement required by this section to an advisory client or prospective advisory client not less than 48 hours prior to entering into any written or oral investment advisory contract with such client or prospective client, or at the time of entering into any such contract, if the advisory client has a right to terminate the contract without penalty within five business days after entering into the contract

Other regulations

The 1940 Advisers Act and the SEC require that advisers maintain and preserve specific books that are required to make them available for inspection. The term investment counsel is a term that a registered investment adviser may not use unless its principal business is acting as an investment adviser or providing investment supervisory service. Misstatement, misleading omission of facts, fraudulent acts, and practices are prohibited. An investment adviser owes to his client his undivided loyalty, and should not engage in activities that may be in a conflict of interest with the client. Lastly, the ADV form is to be kept up to date by filing periodic amendments. If an investment adviser wants to withdraw, they would be able to use the form ADV-W.

Professional Liability for Financial Planners

The scope of responsibility

Financial planners are expected to comply with standards of ethics and perform their services in abiding by the accepted principles and standards. Financial planners who fail to perform these duties can be held liable to their clients. In addition, civil and criminal liability may be given to financial planners because of statutes, such as the federal securities laws.

Common law liability to clients:

  1. Liability based on breach of contract: When the planer has failed to honestly, properly, and completely perform his duties as written in the contract. In most cases, a breach of contract by the planner will have certain damages to the client.
  2. Liability based on negligence: The planner has a duty to exercise the same standard of care that a reasonably prudent and skillful financial planner in the community would exercise under similar circumstances
  3. Liability based on fraud. In this case, the financial planner must have done one of the following:
    1. Made a false representation of a material fact;
    2. Made the representation with the knowledge that it was false or with reckless disregard for its truth or falsity
    3. Intentionally made the misrepresentation to induce the client to act or not act
    4. Made the misrepresentation and the client was injured as a result of the client’s reasonable reliance on the misrepresentation