Just as the Securities Act of 1933 governs new issues, the Securities Exchange Act of 1934 is the most important piece of legislation governing securities that have already been issued, as well as the markets through which they trade. The main goal of both acts is to prevent fraud. The distinction is that the 1933 act concerns itself with the scruples of the issuers, and the 1934 act is aimed at brokers who make their money through the exchanges or the mail.

The 1934 act identifies the following activities as being criminally fraudulent:

  • Abusing discretionary authority, which will be discussed in Chapter 9 "Accounts: Keeping score"

  • Exercising discretion without authority, also to be discussed in Chapter 9

  • Churning, or trading excessively for the sake of making commissions on the trades

  • Insider trading, or trading on "material inside information" - that is, information that is currently held confidential but will affect the value of the security once it is made public

Insider Trading
When it comes to insider trading, an insider is defined as anyone who is an officer, executive, director or 10%-or-more owner of the company, as well as his or her immediate family.

Beware, insider trading is contagious. If you or anyone at your broker-dealer should come into possession of this sort of privileged information, you would be considered an insider as well, and you would be in violation of the 1934 act if you used that information to your financial advantage.

For example, say an executive at EFG Corp. breaches her fiduciary duty to her employer and blabs to you privately about what a great fiscal quarter EFG had and how the market will be really surprised, in a positive way, when her chairman announces earnings the day after tomorrow. If you were to buy EFG shares tomorrow and then sell them at a profit after the earnings announcement makes that formerly privileged information public, you might end up the wealthiest registered representative in your entire cellblock. The best way to avoid wrongdoing is to take the information directly to your firm's legal or compliance department.

See the article Defining Illegal Insider Trading for adiscussion on what an illegal insider is, how it compromises the essential conditions of a capital market and what defines an insider.

Look Out!
Insider status only has to do with equity ownership, not debt holding. Although an investor can be considered an insider if she owns 10% of the stock, she could own 100% of the bonds and still not be an insider.

The Securities and Exchange Commission
The 1934 act chartered the Securities and Exchange Commission (SEC), empowering it to register, regulate and oversee brokerage firms, transfer agents and clearing agencies, as well as the SROs.

The act also empowers the SEC to require annual reports and other periodic informational filings by companies with publicly traded securities - a power the Commission exercises on companies with the following:

  • more than $10 million in assets and
  • securities held by more than 500 owners.

Proxy Material Regulation
The 1934 act also governs the disclosure of materials used to solicit shareholders' votes in annual meetings held to elect directors and approve other corporate action. This information, contained in proxy materials, must be filed with the SEC in advance of any solicitation of votes. The act also requires disclosure of important information by anyone seeking to acquire more than 5% of a company's securities. This acquisition could be either by direct purchase or by tender offer: an offer to all shareholders specifying a price per share and listing an expiration date, both of which are open to revision.

Regulating Representatives
The Securities Exchange Act of 1934 requires a variety of secondary market participants to register with the SEC, including exchanges, broker-dealers, transfer agents and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis.

Once a share is trading publicly on a secondary market, it may have an encounter with a specialist, a member of the exchange who maintains an orderly market for that stock. The specialist ensures that stop orders, limit orders and orders with other qualifications that require exercise away from the current bid-ask prices do not disrupt the smooth efficiency of the market. The specialist does this by playing one of two roles:

  • broker, or agent, as he executes orders submitted by other member firms, or
  • principal, as he trades on his own firm's account.

The specialist cannot play both roles on the same transaction. For example, if IJK is currently trading at $50 and the specialist holds an order to sell it at $55, he cannot buy it on behalf of his firm.

The distinction between broker and principal comes further into play when the specialist, acting as a principal, takes on certain restrictions. For example, market orders must be filled first, then limit orders, and only then can the specialist trade on the firm's account.

Over the Counter (OTC) Markets

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