One of the best things about studying securities regulation is that the topic is in the news everyday. Every day a new company chooses to go public, another executive at a public company ischarged with violating anti-fraud provisions, or another public company is investigated forattempting to bribe foreign government officials. The current event research paper assignmentasks that you choose one current event relevant to any of the topics we will study this semester,and write a research paper describing what happened, the relevant law, and the significance of thestory for the industry, the company, the law, and/or you.How to choose your current event:The current event must have been in the news within the last six months. To find a topic ofinterest, start reading the financial and business news now. You might also visit the SEC’swebsite for press releases, or some of the many blogs on securities regulation, white-collar crime,or corruption. You can also follow the SEC on Twitter. Once you find a news story, you willresearch it more deeply, including the relevant law. Your story does not have to be a case that hasgone to court already. It can be an investigation, a proposed new rule or regulation, or any otherstory that implicates the legal issues we discuss in class.What to include in your paper:[Revised 09.02.2019] PAGE 5a detailed description of the current eventa detailed discussion of the relevant law – explain the law from the very beginning, as if your readerknows nothing about the topic; this is how you demonstrate your understanding of the lawan analysis of the current event – Why is it important to the industry? What companies will care aboutthis news story? What will its impact be? Who will win? Why? You can choose to answer any or all ofthese questions (or any other question). The goal is to demonstrate meaningful application of law to facts,and deep thinking about the issues presented by the news storyLogistics:7-8 pages, single spacedCitation required anytime what you just wrote down did not originate in your brainThe paper should be prepared using the APA writing style and guideline for references’ format. You mustprovide a bibliography, and all direct quotations and data sources must be properly cited.The Department uses the APA style to facilitate reading the paper and understanding references withoutbeing as cumbersome as some other citation styles (such as Chicago or MLA).Students can download the student style guide from the American Psychological Association(http://www.apastyle.org/elecref.html) web site or you can purchase the APA style guide from the bookstore. There is even a help disk that can be purchased for about $ 40 (http://www.apa.org/software/) thatwill walk you through the process as you write the paper if you desire a more “personal assistance”.Papers are to be RESEARCH PAPERS. Remember that work that you use from other authors MUST bereferenced. Since it is assumed that you are not an authority on the topic that you are writing, it isexpected that this paper is an overview of many different sources of information. Each of these must beattributed to the author using the APA format.This is your paper and not the cut and paste of someone else’s work. The internet has led to a false senseof what research is all about. Those new to research tend to think that it means spending an afternoonsurfing the internet and then an afternoon cutting from material available.Keep in mind that the Internet: (1) is not quality oriented as it has good materials and not so goodmaterials, and does not know the difference; (2) is NOT a sole source location. In particular, sources suchas Wikipedia are the works of individual submitters which are not reviewed. Thus while many entriesprovide excellent information, some are fundamentally flawed or just plain wrong.Keep in mind that the Boston University Library as well as your local, state and the national US Libraryof Congress have extensive online services. USE THEM.
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AD678 Financial Regulation and Ethics
Lecture Notes
Broker-dealer Regulation
(continued from last session)
Irena Vodenska, Ph.D., Jim Stodder, Ph.D.
Vodenska@bu.edu, Jstodder@bu.edu
1
Investment Adviser
Regulation
2
Regulation of Investment Advisers
• Broker – any person engaged in the business of effecting transactions in securities for the
account of others. (1934 Act Section 3(a) (4))
• Dealer – any person engaged in the business of buying and selling securities for such
person’s own account. (1934 Act Section 3(a)(5))
• Many firms engage in both types of business and so are “broker-dealers.”
• Investment adviser – any person who, for compensation, engages in the business of
advising others as to the value of securities or as to the advisability of investing in,
purchasing, or selling securities…
but does not include …any broker or dealer whose performance of such services is solely incidental to the
conduct of his business as a broker or dealer and who receives no special compensation therefor;
• Intermediaries between Wall Street and “innocents”
3
Regulation of Investment Advisers
• The Investment Advisers Act of 1940 (“IAA”)
• Although the investment advisory industry is a large one, the IAA is a
relatively short securities law, with provisions and rules far less detailed than
those governing broker-dealers.
• However, investment advisers are fiduciaries to their clients. Accordingly, IAA
regulation is generally is principles-based.
• This contrasts with broker-dealer regulation, which is primarily rules-based.
• Fiduciary status is derived from IAA Section 206, which makes it unlawful for
an investment adviser “to employ any device, scheme, or artifice to defraud
any client or prospective client” or “to engage in any transaction, practice, or
course of business which operates as a fraud or deceit upon any client or
prospective client.”
• In SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963), the Supreme Court
said these sections establish a federal fiduciary standard governing the conduct of
investment advisers.
4
Regulation of Investment Advisers-continued
• Investment advisers still are subject to some specific requirements
• Advisers must register with the SEC on Form ADV.
• ADV Part 1 describes the adviser’s business and any problems with regulators or clients. Part 2
describes the adviser’s services, fees, and strategies.

The “brochure rule:” IAA Rule 204-3 requires advisers to give ADV Part 2 information to prospective
clients. Advisers often fulfill this requirement by putting the information into a plain English
“brochure.”
• The SEC has limited resources to examine investment advisers and has no SRO delegate.
However, regulation is shared between state regulators, who oversee advisers with less than
$100 million in client assets, and the SEC regulating larger advisors.
• Investment advisers must adopt, maintain and enforce a written Code of Ethics
governing their employees’ business conduct.
• In particular, personal trading activities must be reported and monitored to prevent unlawful
trading and promote ethical conduct. Additional policies must be reasonably designed to prevent
the misuse of material non-public information.
5
Regulation of Investment Advisers – continued
• Like broker-dealers, investment advisers are required to:
• institute and maintain compliance programs
• maintain enumerated books and records
• prepare, update and file specified reports
• comply with advertising rules
• obtain best execution for client securities transactions
• comply with client asset safekeeping and custody rules; and
• disclose financial and disciplinary information
although the requirements for advisers generally are far less detailed and complicated than those for brokerdealers.
• Advisers also are subject to rules:
• Requiring disclosure if the adviser is paying someone to solicit new clients; and
• Regarding any advisory contract between the client and the advisor (including a prohibition on assignment).
• Remedies:
• Advisory clients generally have no private right of action for damages under Advisers Act Section
206. However,
• IAA 215 provides a right to rescind the advisory contract and a return of the fee, and
• advisory clients may be able to exercise other rights: under the Securities Exchange Act for fraud
in connection with the purchase or sale of a security, for example; or under a variety of state laws.
6
Recommendations: Salesperson or Trusted Advisor?
• FINRA suitability rules for broker-dealers require only that an investment be
“suitable” not “the best.”
• For example, a broker-dealer can recommend a higher-priced investment instead of a
lower priced one if both are suitable, given the customer’s circumstances.
• Current controversy: two types of securities professionals (broker-dealers and investment
advisers) provide personalized investment recommendations to retail investors.
• Two different standards of conduct:
• Suitability for broker-dealers
• Fiduciary (“best interest of the customer”) for fee-based investment advisers, but
not commission-based!
• Do investors know the difference? NO. Rand Study on Investment Advisers and
Broker-Dealers: www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf
• What about dually-registered Broker-Dealers AND Investment Advisers? Conflicts of
Interest? www.investmentnews.com/article/20190808/FREE/190809947/duallyregistered-advisers-found-to-have-conflicts-and-higher-fees
7
Source: FINRA, https://www.finra.org/rules-guidance/guidance/reports-studies/2019-industry-snapshot/firm-data
Some Congressional Pressure for stronger SEC Regulation
Dodd Frank – Section 913 (2010)
SEC “may promulgate rules to provide that, with respect to a broker
or dealer, when providing personalized investment advice about
securities to a retail customer…the standard of conduct for such
broker or dealer with respect to such customer shall be the same as
the standard of conduct applicable to an investment adviser.”
No SEC action yet; still considering
2017: DOL imposed a fiduciary standard for advice regarding
investments for retirement investments, muddying the waters
further.
Investment Company
Regulation
10
Regulation of Investment Companies
• An investment company issues its own shares, pooling the money of the many investors who buy those
shares, to fund a business of investing in other securities.
• One of the best known types of investment companies is an “open-end investment company,”
commonly referred to as a “mutual fund.”
• The mutual fund itself owns the investment securities in its portfolio, and investors holding mutual
fund shares own a pro rata interest in that portfolio. Portfolios can comprise almost any security,
including stocks, bonds or short-term money market instruments.
• Mutual funds typically are started and managed by a mutual fund company (the “sponsor”) which
provides most services the mutual fund needs, including:
• Management of the portfolio by an investment adviser
• Pricing and bookkeeping the portfolio securities by a pricing and bookkeeping agent
• Distribution of shares of the mutual fund by a broker-dealer
• Maintaining shareholder records of who owns mutual fund shares by a transfer agent
• Mutual funds are called “open-end” companies because they are always offering their shares for
sale, and always stand ready to redeem their shares. (Think of ‘always open’ like 24/7.)
• Shares are sold and redeemed at a price based on the net asset vale (NAV) of the mutual fund
portfolio.
11
Investment Company Act of 1940 (the “ICA”)
• The ICA responds to abuses by sponsors who often used investment companies for their own
benefit. Among other practices, unscrupulous sponsors might:
• charge the fund excessive fees
• use fund money to invest in, or lend to, their personal businesses
• “churn” investment company shares to generate commissions
• issue less valuable shares to the public and greater value shares to themselves
• intentionally understate the value of shares when buying and overstate when selling; and
• engage in excessive leverage.
• A conflict of interest exists between fund company sponsors who service a fund, and fund shareholders who pay
them. To address this, the ICA requires a Board of Directors to oversee the mutual fund and contract with service
providers, who are typically affiliates of the sponsor.
• The Board is legally required to act as a “watchdog” over the fund
• The Board must include a minimum percentage of directors who are independent of the fund sponsor.
• To address other conflicts, the ICA imposes a detailed regulatory scheme on investment companies.
• Although the securities laws generally only regulate issuers in their securities activities, the ICA regulates not
only the securities activities of an investment company, but the governance, structure and business activities
of the investment company itself.
• The ICA is not the exclusive law covering investment company activities.
• Other securities laws apply as well. For example, the 1933 Act requires an investment company to provide a
prospectus when offering its shares, just like other issuers.
12
Investment Company regulation – fees
• Most fees paid by a mutual fund are deducted from fund assets and expressed as an
“expense ratio.”
• A fund’s expense ratio is the annual percentage of expenses deducted from fund assets. The expense ratio is
required to be disclosed in a fund’s prospectus, as well as a table showing shareholders how fund expenses
translate into a dollar figure, using a hypothetical investment of $10,000 over 1,3,5 and 10 years.
• Fund advisory fees are often the biggest component of the expense ratio.
• In addition to Board approval, and approval of a majority of the independent directors, the ICA
imposes a fiduciary duty on the investment adviser regarding fees paid to it or its affiliates. ICA
Section 36(b)
• In Gartenberg v. Merrill Lynch Asset Management, the court noted fund boards should think
about all pertinent factors when considering whether to approve an advisory fee. These factors
included the nature and quality of the services provided, the adviser’s profitability, collateral
benefits to the adviser, fees paid by comparable funds, economies of scale, comparable fund fees,
and the independence, expertise, and conscientiousness of the board.
• If due consideration is given to these factors, then in order to find a 36(b) violation the advisory
fee must be “so disproportionately large that it bears no reasonable relationship to the services
rendered and could not have been the product of arm’s-length bargaining.”
• This rationale was approved by the US Supreme Court in Jones v. Harris Associates.
13
Investment Company Regulation – continued
• Mutual funds can be actively or passively managed.
• Active management: the investment adviser constantly makes decisions as to what securities the fund should hold, and
buys and sells accordingly.
• Passive management: the portfolio composition is determined in advance and rarely if ever changes. For example, a
passive mutual fund might track the S&P 500 index by either investing in index instruments or replicating the index in
its portfolio. Expense ratios for passive funds are generally lower than for active funds.
• Mutual funds are the most popular, but not the only type of investment company.
• Exchange Traded Funds have shares that trade on stock exchanges. The share price is set by the market, but generally
approximates the value of the ETF’s portfolio securities.
• Although certain institutions can redeem ETF shares, retail shareholders cannot. Liquidity
for shareholders is provided by buying and selling on the exchange.
• Most ETFs have unmanaged portfolios, often tied to a market index.
• Other types of investment companies include:
• Closed-End Funds: issue non-redeemable shares once. Shares then trade in secondary
market, sometimes at a premium or a discount. Portfolio usually actively managed.
• Unit Investment Trusts: issue redeemable shares (“units”) once; portfolio usually passive;
liquidates on a specified date.
• “Hedge” and other private funds for which an exemption from provisions of the ICA are
available.
14
Copyright, 1976
https://en.wikipedia.org/wiki/Peter_Drucker
https://www.etf.com/sections/features-and-news/goldmanetfs-own-record-share-us-stock-market
References:
• Palmiter, Alan, Securities Regulation: Examples and Explanations, 6th Ed., ISBN-13: 978-1454833925,
ISBN-10: 1454833920
• SEC Fast Answers Securities Investor Protection Corporation (SIPC) https://www.sec.gov/fastanswers/answerssipchtm.html)
• Study on Investment Advisers and Broker-Dealers As Required by Section 913 of the Dodd-Frank
Wall Street Reform and Consumer Protection Act, Staff of the U.S. Securities and Exchange
Commission January 2011 https://www.sec.gov/news/studies/2011/913studyfinal.pdf
• Special Study: Report of Examinations of Day-Trading Broker-Dealers February 25, 2000
https://www.sec.gov/news/studies/daytrading.htm#seci
• SEC Fast Answers Investment Advisers: What You Need to Know Before Choosing One
https://www.sec.gov/reportspubs/investor-publications/investorpubsinvadvisershtm.html
• SEC Information for Newly-Registered Investment Advisers (Nov. 23, 12010)
https://www.sec.gov/divisions/investment/advoverview.htm
16
AD678 Financial Regulation and Ethics
Lecture Notes
Irena Vodenska
Vodenska@bu.edu
Jim Stodder
Jstodder@bu.edu
Slides prepared by Irena Vodenska. Copyright © 2017. All rights reserved. No reproduction or distribution without the prior written consent of Irena Vodenska
Securities Exchange Act of 1934
• Main philosophy
• Truth in securities offerings flowing into:

Integrity in securities trading markets
• System of administrative supervision
• Includes supervision of self-regulation by

Securities exchanges, and

Financial industry
• Mandatory disclosure for publicly traded companies
• The Securities Exchange Act created the SEC
Exchange Act of 1934 amendments
• 1938 – Maloney Act
• Making the broker-dealers trading OTC subject to SEC supervision
• NASD (National Association of Securities Dealers) was required to register with SEC
• In 2007, FINRA (Financial Industry Regulatory Authority) – successor of NASD
• FINRA – in charge of the enforcement and arbitration functions of NYSE
• 1964 – OTC markets under the Exchange Act’s coverage
• 1968 – Williams Act
• Disclosure regulation on corporate control changes and tender offers
• 1975 – Congress gives SEC oversight authorities over SROs (self-regulatory organizations)
• Addition of two new SROs:
• Clearing agencies, and
• MSRB (Municipal Securities Rulemaking Board)
Exchange Act of 1934 amendments
(cont.)
• 1978 – Foreign Corrupt Practices Act
• Enhanced record keeping and ban on bribery of foreign officials
• 1986 – Government Securities Act
• To provide improved protection of investors in government securities, Congress eliminates the exemption for broker-dealers
in gov. securities
• Broker dealers need to comply with e.g. record keeping, large position requirements
• 1990 – Penny Stock Reform Act
• Regulates marketing of low cost/high risk penny stocks
• 1995 – Private Securities Litigation Reform Act (PSLRA)
• To address abuses in class action suits
• 1996 – National Securities Markets Improvement Act (NSMIA)
• Substantially limits STATE regulation of broker-dealers
• 1998 – Securities Litigation Uniform Standards Act
• Congress requires that class actions alleging securities fraud be files in federal courts
Exchange Act of 1934 amendments
(cont.)
• 2002 – Sarbanes-Oxley Act
• Congress creates a new accounting board to oversee public companies’ audits
• Increased responsibilities for officers who make corporate disclosures
• 2010 – Dodd-Frank Act
• Securities reforms include regulation of OTC derivatives to trade on exchanges
• Registration of hedge funds and private equity funds
• Corporate governance reforms including shareholder vote on executive pay
• 2012 – Jumpstart Our Business Startups Act (JOBS Act)
• Promotes start ups by easing registration requirements
• Possibility for online “crowdfunding” offerings to public investors
Securities Act of 1934 Act covers many
areas




Today: Regulation of markets and market practices
Next week: Deeper dive into regulation of broker-dealers
Session 9: Regulation of public companies
Later weeks:
• 10b-5
• insider trading,
• whistleblower, etc
Regulation of securities markets
• Regulation of stock exchanges
• What is an “Exchange”? – Bringing together buyers and sellers to trade (Section 3(a)(1))
• Exchanges have BID and ASK quotes, centralized trading, and continuous liquidity
• Registration and Self-regulation (Exchange Act – Section 6)
• Trading Rules (activities by specialists, listing requirements, proprietary trading by members, bids and offers on exchange floor, clearing and
settlement of trades)
• Member qualification (qualifications of salespersons, handling of customer accounts, member firm organization, financial condition of
members)
• Discipline: Exchanges are SROs; can discipline members
• SEC reviews exchange rule changes & disciplinary actions; and can act directly as well
• Exchanges and Competition
• Historically, substantial anti-competitive practices
• NYSE prohibitions on proprietary trading away for listed stocks
• Fixed commission schedules
• In 1975, the Supreme Court upheld the exchange rule mandating minimum commission by member firms (Gordon v. NYSE, 422 U.S.
659 (2975))
• But changes: SEC Rule 19c-3 prohibits restrictions on off-exchange trading after 4/26/1979
• May 1, 1975 “May Day”: SEC ends fixed commission schedules (per exchange Act, Section 6(e))
• Deregulation enables rise of discount brokers
Regulation of securities markets
• Over-the-Counter Market – decentralized trading by broker-dealers
• NASDAQ – NASD Automated Quotation (AQ) system
• Stand alone for-profit corporation
• Market Makers – maintaining liquidity of the market with bid-ask quotes
• Created by the National Association of Securities Dealers (“NASD”)
• Alternative trading systems – compete with NYSE and NASDAQ




Securities traders deal directly with each other through ECNs
ECNs (Electronic Communication Networks) such as Archipelago, Instinet
ECNs have significant trading volume (5% of NYSE, 30% of NASDAQ)
Archipelago is linked to NASDAQ and displays highest bids and lowest offers
Bad News: Bubbles are Endemic
Arlington Williams, “Price Bubbles”
www.indiana.edu/~arlwilli/pdf%20files/bigmkts.pdf
Good News: People Do Learn
V. Smith & A. Williams,
“Experimental Market
Economics,” Scientific
American, Dec. ‘92
1929
1933-34
Hatry Securities Acts
2000
Enron
2002
Sarbanes-Oxley
1960s
Kohlberg, Kravis
1968
Williams Act
1920
Ponzi
2008
2008
WorldCom,
Madoff 2010
Dodd-Frank
Bubbles
Popping
Frauds
Uncovering
Securities Laws
Passing
Regulation of market participants
• Finra – the Financial Industry Regulatory Authority
• Currently the premier self-regulatory organization for broker-dealers (members)
• Not only BD firms, but registered representatives and other firm employees
• Created in 2007 by combining the NASD SRO and NYSE Regulation
• Finra regulates both NYSE and NASDAQ member regulation, arbitration and enforcement
• Collateral Market Participants must register with/regulated by the SEC
• Securities information processors – Section1 …
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