On October 29, 1929, the stock market lost $14 billion in a single day. By the time the dust settled, investors had lost $30 billion—more than all of World War I cost the United States. The cause? A market with no rules, where manipulation was sport and insider trading was just good business.
Congress responded with back-to-back legislation: the Securities Act of 1933 for new issues, and the Securities Exchange Act of 1934 for everything after. The '34 Act created the SEC and established the rules that still govern secondary market trading today. One key difference: while the '33 Act has exemptions, the '34 Act's anti-fraud provisions apply to everyone—exempt or not.
Section 1: The SEC and Market Manipulation
The Birth of the SEC
The Securities and Exchange Commission (SEC) was created by the Securities Exchange Act of 1934 as the principal federal regulatory agency for the securities industry. The SEC writes the rules, enforces compliance, and can pursue both civil and criminal penalties against violators.
The SEC regulates nonexempt securities. It does NOT regulate:
- General account insurance products
- Commodities and futures contracts
- Exempt securities (U.S. Treasury bonds, municipal bonds)
No parties are exempt from the anti-fraud provisions of the '34 Act. Whether you're trading exempt or nonexempt securities, fraud is fraud.
Prohibited Activities: Market Manipulation
A major focus of the '34 Act was to outlaw market manipulation. Before 1934, these practices were common—and profitable for those doing the manipulating. Today, they're all illegal:
| Practice | What It Means |
|---|---|
| Front Running | Placing your order ahead of a pending customer order, especially large block orders |
| Trading Ahead | Trading ahead of customer limit orders OR ahead of your firm's not-yet-released research report |
| Painting the Tape | Trading a security to create the false impression of rising or falling prices |
| Pump and Dump | "Pumping" up prices through hype and rumors, then "dumping" shares at the inflated price |
| Pegging | Artificially preventing price movement (except under strict SEC rules for new issue stabilization) |
Civil Lawsuits for Manipulation
In addition to criminal penalties, guilty parties may face civil lawsuits from investors. The statute of limitations requires suits to be filed:
- Within 2 years of discovering the violation
- But no later than 5 years after the violation occurred
Section 2: Insider Trading Rules
Who Is an Insider?
Under the '34 Act, an insider is specifically defined as:
- An officer of the company
- A director of the company
- A 10% shareholder of the company's equity securities
What Insiders Cannot Do
- No trading on MNPI: Cannot trade based on material nonpublic information
- No short swing profits: Profits from buying and selling (or vice versa) within 6 months must be returned to the issuer
- No short selling: Cannot sell their company's stock short (but buying protective puts IS allowed)
- Must report trades: File with SEC within 2 business days
Material Nonpublic Information (MNPI)
The definition of insider trading extends beyond officers and directors. Anyone who trades on Material Nonpublic Information (MNPI)—information not released to the public that could influence a security's price—can be liable.
It's not just the person with inside information who's liable. If you pass MNPI to someone who trades on it, both parties face prosecution:
- Tipper: The person who shared the information
- Tippee: The person who received it and traded
However: If the tippee doesn't trade, neither party is guilty of insider trading.
Penalties for Insider Trading
Violators face serious consequences:
| Penalty Type | Amount |
|---|---|
| Civil penalties | Up to 3x the profit realized or loss avoided ("treble damages") |
| Criminal fines (individuals) | Up to $5 million per violation |
| Criminal fines (firms) | Up to $25 million |
| Prison time | Up to 20 years per violation |
| Informant rewards | 10%-30% of amounts recovered above $1 million |
Private parties have the right to sue under a 6-year statute of limitations.
Information Barriers
Firms are required to create information barriers (sometimes called "Chinese walls") to prevent MNPI from flowing between departments. For example, investment bankers working on a takeover might use code names, and the company's identity may only be known to a handful of senior people.
Test Tip: Creating information barriers is a REQUIREMENT of the '34 Act, not a violation. Stock analysts cannot share information with brokers until it's made public.
Rule 10b5-1: The Safe Harbor
Insiders can protect themselves from liability by establishing a prearranged trading plan under Rule 10b5-1. This "safe harbor" rule lets officers, directors, and 10% shareholders create a written plan specifying future trades. Once the plan is in force, the insider has no further influence on the trades—they happen automatically.
Section 3: Issuer and Broker-Dealer Requirements
Corporate Disclosure Requirements
The '34 Act requires publicly traded companies to disclose information to the SEC—and through the SEC, to the public. Transparency isn't optional.
| Filing | What It Is | When Filed |
|---|---|---|
| 10-K | Annual report (audited financial statements) | Annually |
| 10-Q | Quarterly report (unaudited) | Three times per year |
| 8-K | Current report for major events (bankruptcy, merger, director changes) | Within 4 business days |
| Schedule 13D | Disclosure when acquiring 5%+ of voting stock | Within 10 days |
Self-Regulatory Organizations (SROs)
Stock exchanges trading nonexempt securities must register with the SEC and become Self-Regulatory Organizations (SROs). They set their own trading rules, but the SEC has ultimate authority.
FINRA (Financial Industry Regulatory Authority) is also an SRO—an organization of broker-dealers that regulates its members. Most broker-dealers must join FINRA, and all FINRA rules require SEC approval.
Broker-Dealer Registration Requirements
The '34 Act requires most broker-dealers to register with the SEC and join FINRA. Once registered, firms must comply with several key requirements:
- Net Capital Rule: Maintain minimum capital standards; clearing BDs have higher requirements than introducing BDs
- Financial Statements: Send semiannual statements to customers (balance sheet and net capital computation—but NOT income statements)
- Segregation: Fully paid customer securities must be segregated and cannot be commingled or pledged
- Buy-in Rule: If a customer fails to deliver sold securities, buy-in within 10 business days after settlement
- Free Credit Balances: Notify customers quarterly about uninvested cash and its availability
Test Tip: Broker-dealers are NOT required to provide income statements to customers—only balance sheets and net capital computations.
Section 4: Other Federal Regulations
Beyond the '33 and '34 Acts, Congress has passed additional legislation to address specific market concerns. Here are the ones you need to know:
Trust Indenture Act of 1939
Corporate bonds issued in amounts over $50 million across state lines must use an indenture (a contract) and have a trustee appointed to protect bondholders. This does NOT apply to U.S. Treasury or municipal bonds.
Investment Company Act of 1940
This landmark legislation governs mutual funds and other investment companies. Key provisions:
- Minimum $100,000 in net assets to register
- Must have at least 100 shareholders
- At least 40% of the board must be "disinterested" (independent)
- May borrow up to 1/3 of total assets but must maintain 300% asset coverage
- Shareholders vote on: investment adviser, major policy changes, custodian changes, mergers
- Securities on margin
- Commodity contracts (futures)
- Real estate and interests in real estate
- Securities of companies undergoing reorganization (if it would make fund >10% owner)
Investment Advisers Act of 1940
Anyone who advises others about securities for compensation must register as an investment adviser. Registered Investment Advisers (RIAs) must file Form ADV with the SEC and deliver a brochure to clients either:
- 48 hours before entering into a contract, OR
- At the time of signing with a 5-day cancellation right
Regulation FD (Fair Disclosure)
Reg FD prohibits issuers from selectively disclosing material nonpublic information. If you tell one analyst, you must tell the public. No favorites—everyone gets the same information at the same time.
Regulation SHO (Short Sales)
Reg SHO governs short selling with two key requirements:
- Locate Requirement: Before executing a short sale, the broker must have "reasonable grounds" to believe the security can be borrowed and delivered
- Easy-to-Borrow List: Updated daily; if a security is on this list, no further locate inquiry needed
- Threshold List: Securities that are hard to borrow (10,000+ share fails for 5+ consecutive days, equaling 0.5%+ of outstanding shares)
- Circuit Breaker: If a stock drops 10%+ from prior close, short sales can only execute above the national best bid for the rest of that day AND the entire next day
Test Tip: If someone owns convertible bonds and sells the underlying common stock (planning to convert and deliver), this is a LONG sale, not a short sale.
Penny Stock Rules
Penny stocks are priced at less than $5 per share and are usually unlisted (OTC). Due to their high risk, special rules apply:
- Must determine suitability for each customer
- Must provide written risk disclosure and get written customer approval
- Must provide monthly statements with financial information
- May need to wait 2 days before completing transaction
Regulation Best Interest (Reg BI)
Under Reg BI, broker-dealers must act in the best interest of customers when making recommendations. They cannot place their own financial interests ahead of the customer's. Form CRS (Customer Relationship Summary) is required.
Regulation S-P (Privacy)
Reg S-P governs how firms handle nonpublic personal information (NPI). Firms must have written privacy policies and give customers the right to "opt out" of having their information shared with nonaffiliated third parties.
Statutory Disqualification
Certain convictions disqualify individuals from the securities industry:
- Felony: 10-year bar for convictions involving theft, fraud, bribery, perjury, embezzlement
- Misdemeanor: Can result in indefinite disqualification if involving fraud, bribery, or perjury
The Bank Secrecy Act requires fingerprinting of all employees, directors, officers, and partners.
Section 5: Investor Protection: SIPC and FDIC
Securities Investor Protection Corporation (SIPC)
SIPC was created in 1970 to protect customers when broker-dealers fail. Most broker-dealers are members. Here's what you need to know:
- Total coverage: Up to $500,000 per customer
- Cash sublimit: Up to $250,000
- Securities in customer's name: Returned without limits
- Investment losses from market decline
- Losses from fraud by the broker-dealer or its agents
- Commodity futures contracts
Many broker-dealers purchase "excess SIPC" coverage—often up to $25 million or more—to provide additional protection beyond the standard limits. (Whether those additional policies are worth the marketing materials they generate is a question best left to the actuaries.)
Federal Deposit Insurance Corporation (FDIC)
FDIC insures bank deposits—not securities. Don't confuse the two.
| FDIC Does Insure | FDIC Does NOT Insure |
|---|---|
| Checking and savings accounts | Stocks and bonds |
| Certificates of deposit (CDs) | Mutual funds |
| Money market deposit accounts | Annuity contracts |
| Life insurance policies | |
| U.S. Treasury securities | |
| Safe deposit box contents | |
| Losses from theft or fraud |
Test Tip: Uninvested cash in a brokerage account (in money market or sweep accounts) MAY be eligible for pass-through FDIC insurance if the deposit is held at an FDIC member bank. Know this distinction.
Chapter 15 Key Terms Glossary
| Term | Definition |
|---|---|
| SEC | Securities and Exchange Commission; principal federal securities regulator |
| Insider | Officer, director, or 10% shareholder |
| MNPI | Material Nonpublic Information; trading on it is illegal |
| Front Running | Trading ahead of customer orders |
| Painting the Tape | Trading to create false price impressions |
| Pump and Dump | Artificially inflating price, then selling |
| Information Barriers | Policies preventing MNPI flow between departments |
| Rule 10b5-1 | Safe harbor for prearranged insider trading plans |
| 10-K / 10-Q | Annual (audited) and quarterly (unaudited) SEC reports |
| 8-K | Current report for major corporate events; filed within 4 business days |
| Schedule 13D | Filed when acquiring 5%+ of voting stock; due within 10 days |
| SRO | Self-Regulatory Organization; exchanges and FINRA |
| FINRA | Financial Industry Regulatory Authority; broker-dealer SRO |
| Reg FD | Fair Disclosure; prohibits selective disclosure of MNPI |
| Reg SHO | Short sale rules including locate requirement and circuit breaker |
| Penny Stock | Stock under $5/share, usually OTC; special suitability rules apply |
| Reg BI | Regulation Best Interest; BD must act in customer's best interest |
| Reg S-P | Privacy regulation; customers can opt out of info sharing |
| SIPC | Securities Investor Protection Corporation; protects customers when BDs fail |
| FDIC | Federal Deposit Insurance Corporation; insures bank deposits only |
| Statutory Disqualification | Bar from industry for certain criminal convictions |
| Topic | Key Points |
|---|---|
| Securities Exchange Act of 1934 | Created SEC; governs secondary markets; anti-fraud applies to ALL |
| Insider Trading | Insiders = officers, directors, 10% holders; MNPI rules apply to everyone |
| Corporate Filings | 10-K annual, 10-Q quarterly, 8-K events (4 days), 13D (5%+ ownership, 10 days) |
| Short Sales (Reg SHO) | Locate required; 10% drop triggers circuit breaker for rest of day + next day |
| SIPC Protection | $500,000 total / $250,000 cash; does NOT cover market losses |
Chapter 15 covers the regulatory framework that makes modern securities markets possible. These rules exist because of what happened when there were no rules.