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U.S. Securities and Exchange Commission (SEC) History & Fraud Cases

By Mark Cussen

sec seal logoThe Securities and Exchange Commission (SEC) is a regulatory agency that oversees a major segment of the economy along with the IRS, the Consumer Protection Bureau, and the Federal Trade Commission.

Specifically, the SEC oversees “Wall Street” where market activity is measured in the trillions of dollars and intersects with virtually every other facet of the economy.

Thousands of transactions are routed and filled instantly by sophisticated computers that take orders from buyers and sellers all over the globe. All of them fall under the jurisdiction of the SEC.

Nature and Purpose

The SEC was created to protect investors, prevent securities fraud, and assist in the creation of new capital for businesses and investments. It also ensures that all securities transactions are placed in a fair and orderly manner.

A myriad of new financial products and services have become available to the public over the past few decades, including variable annuities and variable life insurance, exchange-traded funds, hedge funds, and other alternative investments, as well as investment advisory services that provide fee-based financial planning and asset management.

The SEC regulates all of these plus “traditional’ market investments like stocks and bonds and works to prevent investment fraud in several ways, including:

  • Full and Fair Disclosure Requirements. Investment companies are required to disclose the specific and general risks of their financial products plus other investment specific information as well as a clear statement of the company’s financial condition. The SEC believes that fair and equitable markets can only exist when there is full and fair disclosure to investors.
  • Recordkeeping Requirements. The SEC monitors and regulates all securities exchanges, broker-dealers, mutual funds, and other industry players by requiring adequate recordkeeping and proper licensing for all securities personnel.
  • Inspections and Audits. The SEC has the authority to conduct inspections and audits of all securities-related organizations, such as broker-dealers and personnel and ratings agencies in order to verify wrongdoing or insolvency.
  • Legislation. The SEC has the power to interpret existing securities laws and create additional legislation as needed in order to protect investors and regulate capital markets.
  • Coordination and Oversight. The SEC oversees all other regulatory agencies in the industry, such as FINRA, state securities regulators, and the auditing and accounting fields. It also coordinates overall securities regulation at all levels of government and with foreign governments through its membership with the International Organization of Securities Commissions (IOSCO). The SEC is able to help police securities fraud through the Multilateral Memorandum of Understanding that it has with other members as well as through direct bilateral regulatory treaties with other governments.
  • Enforcement. The SEC can levy fines and censures to those who are convicted of securities violations and can suspend or expel securities personnel if they determine that such action is warranted. Severe violations can also result in substantial prison terms (see examples below).

History of the SEC

The SEC has been an evolving force for many decades now and was inspired by one of history’s more infamous events:

1929 Market Crash

The SEC was borne from the aftermath of the 1929 stock market crash. In an effort to prevent such as occurrences from happening again, President Roosevelt commissioned a group of experts to analyze the underlying economic factors that caused the crash.

Up until this time, the securities markets were largely unregulated, fraught with fraud and deception, and caveat emptor (“let the buyer beware”) was the operating principle. In fact, the only laws then governing the securities industry were known as Blue Sky laws, which required the registration of investment firms and personnel in each state. However, these laws were largely ineffective due to the ease with which unscrupulous investment firms could get around them.

Securities Acts of 1933 and 1934

Roosevelt’s team of experts found that abusive and unregulated margin lending was largely responsible for the crash as such practices had become commonplace in the decade preceding it. Therefore, in order to restore the public’s confidence in the stock market and the financial industry, Congress passed several major acts of legislation designed to bring order to the markets and prevent a crash of this magnitude from ever happening again.

The Securities Act of 1933 was the first piece of legislation enacted, which provided regulations for all initial public offerings and primary issues of securities. Quickly on its heels, the Securities Exchange Act of 1934 was enacted to regulate the secondary securities markets and thereby create the SEC. The SEC was charged with the enforcement of all securities legislation and President Roosevelt designated Joseph P. Kennedy as the first chairman of the SEC.

sec building washington

Organizational Structure

The SEC currently consists of five separate divisions with 18 offices, all of which are headquartered in Washington D.C. In addition to headquarter offices, it maintains 11 satellite offices located across the country and is governed by a board of commissioners.

Commissioners

The Securities and Exchange Commission is headed by a board of five commissioners who are appointed by the President for terms of five years that run on a staggered basis. Only three of the commissioners are permitted to belong to the same political party in an effort to avoid political bias in the administration of the agency. The five divisions of the SEC are Corporate Finance, Enforcement, Investment Management, Risk, Strategy and Innovation, and Trading Markets.

Division of Corporate Finance

This branch of the SEC is charged primarily with overseeing the financial disclosures of corporations that issue any type of publicly traded security. It periodically reviews the required filings of these companies, such as K-10 forms, registration statements for new issues, proxy voting materials, and annual shareholder reports plus all paperwork related to tender offers, mergers, and acquisitions. These disclosures must contain any and all financial information that would assist an investor in deciding whether or not to purchase company-issued securities.

Division of Trading and Markets

This branch is in charge of maintaining fair and equitable trading in the securities markets. It oversees the daily operations of the exchanges, plus self-regulatory organizations (SROs), such as FINRA and the MSRB (Municipal Securities Rulemaking Board), as well as transfer agents, clearing custodians, informational administrators, ratings agencies, and all of their respective personnel.

This division also oversees the SIPC (Securities Investor Protection Corporation), which is to the securities industry what the FDIC is to the banking industry. It guarantees investor deposits for up to $250,000 per account against broker-dealer insolvency – not market loss. It also assists the Board of Commissioners in the rulemaking and interpretive process for all rules pertaining to secondary market trading.

Division of Investment Management

This division is devoted to overseeing all parties in the securities industry that manage assets for investors, including mutual funds, Registered Investment Advisers, portfolio managers, and analysts who provide research and commentary on any type of security. It also reviews the filings submitted by all investment advisers and companies to ensure that adequate disclosures are provided to investors for all professionally managed products and services.

Division of Enforcement

When a violation of SEC regulations has been committed, the Division of Enforcement steps in. This division makes recommendations to the agency regarding courses of action, such as commencing investigations, bringing civil actions, and prosecution. It also works in conjunction with other law enforcement agencies and governmental agencies, such as the IRS, when necessary.

Any investigation made by this division is private in nature and closely resembles the legal process followed by other law enforcement agencies. The Division of Enforcement will first collect evidence and other data from historical research, SROs, and other relevant entities. It then has the authority to hand out subpoenas and indictments to witnesses and suspects. Some cases are also referred to federal courts, depending upon the issues involved, while others are handled internally as administrative actions.

This branch commonly investigates several different types of violations, including the sale of unregistered securities, insider trading activities, manipulation of market prices, omissions or distortions of material facts about a security or company, theft or embezzlement of funds, and failure to treat customers fairly.

Division of Risk, Strategy, and Financial Innovation

The rapid changes and innovations in the securities markets coupled with the explosion of new financial products and services has impacted our economy and society in ways that we do not yet understand. This division of the SEC was therefore created to study and monitor the impact of these changes in the economy and on investors in particular. Such observation can help the agency recognize new trends and risks that did not exist before. It may also coordinate with other branches to effectively monitor certain conditions and factors that have arisen as a result of new technology and other forces.

Rulemaking and Counsel

Each division of the SEC also advises the entities they govern on legal and procedural issues in an effort to educate them on how to best comply with regulations. They may also issue more formal guidance via “No-Action” letters that spell out the division’s opinion on whether the SEC would approve of a proposed course of action taken by the party in question.

Rulemaking

Whenever the SEC intends to create a new rule, it will first submit a proposal for public opinion. This proposal will outline the nature and purpose of the rule as well as its implementation. The proposal will typically be open to public comment for 30 to 60 days. After this point, the SEC seriously considers the input and attempts to incorporate it into the specific tenets of the final rule.

Offices of the SEC

The offices of the SEC address each of the specific functions within the agency on a day-to-day basis. These offices include the Office of the General Counsel, which serves as the chief legal counsel to the SEC, the Office of the Chief Accountant, which serves as the advisor to the SEC Chairman, and the Office of Compliance Inspections and Examinations, which examines all securities-related exam and inspection programs administered by SROs.

Other offices deal with international affairs, investor education and advocacy, legislation and intergovernmental regulations, public affairs, internal affairs, and employment. The COO, the inspector general, and the secretary have their own offices within the agency as well. The Office of Administrative Law Judges presides over the criminal and administrative legal proceedings levied against potential securities regulation offenders. The law judges that staff this office consist of independent judicial administrators.

Key Legislation

Several major pieces of legislation have been passed since the act that created the SEC. A partial list includes:

The Trust Indenture Act of 1939

This act requires that all issuers of any type of debt or fixed-income security such as a note, debenture, or bond use an acceptably independent and properly qualified trustee to act on behalf of the purchasers of the security. The agreement between the issuer and the trustee must adhere to the standards that are set forth in this act.

The Investment Company Act of 1940

This act regulates the activities of the three types of investment companies: Face Amount Certificate Companies, managed investment companies (mutual funds), and Unit Investment Trusts (UITs). Chief among its provisions is the requirement of informational disclosures by investment companies, such as what securities they hold and their investment policies.

The Investment Advisers Act of 1940

This act is similar to the Investment Company Act, but regulates investment advisers and requires anyone who provides investment or financial advice for compensation to register directly with the SEC. The Act does not delineate specific qualifications or accreditations that advisers must possess in order to function as such.

However, the following persons are not considered advisors and are therefore not required to register:

  1. Banks that are not also investment companies
  2. Broker/dealers or their registered representatives who receive no special compensation for providing advice
  3. Publishers of financial media that has a general and regular circulation
  4. Those who deal in U.S. government securities
  5. Teachers, lawyers, accountants, and others whose advice is incidental to their primary profession

The Act further lists three subcategories of advisers who are considered exempt and are also not required to register with the SEC.

  1. Advisers who do not recommend publicly traded securities and whose clients all reside in the same state as the adviser’s home office
  2. Advisers who only advise insurance companies
  3. Advisers who advised less than 15 clients in any prior one-year period.

However, these three exemptions were essentially eliminated in 1997 with the Investment Advisers Supervision Coordination Act. This amendment to the previous act requires any adviser who manages more than $25 million in assets to register with the SEC. Those with assets below this level can register with their home state, provided that their state has a registration requirement. If not, then those advisers must also register with the SEC.

Those who are required to register under either act must file Form ADV with the SEC and pay a $150 filing fee. The ADV form must be updated annually and lists the adviser’s nature and scope of business, personal and professional history, background, and other relevant data.

The Insider Trading and Securities Fraud Enforcement Act of 1988

This act was enacted to combat insider tradingThe 1980s saw a wave of leveraged mergers and buyouts that made trading on inside information very lucrative. This act authorizes the SEC to levy three times the amount of gain from these activities against offenders, and it also substantially raised maximum monetary fines and prison terms for insiders. It also mandated liability for the supervisors of employees who engage in insider trading.

The Sarbanes-Oxeley Act of 2002

This act was created in the wake of the Enron and Worldcom meltdowns. This act fortified the informational disclosures required of corporations and contains several major statutes aimed at preventing corporate and accounting fraud. It also created the Public Company Accounting Oversight Board (PCAOB), which now functions as an oversight committee for the accounting profession.

The Dodd-Frank Wall Street Reform and Consumer Protection Act

This act is a complex and wide-ranging piece of legislation enacted in 2010 that seeks to prevent future credit crises like the one that began in 2008. It does this, in part, by monitoring the financial stability of institutions, further regulating financial derivatives and credit-swaps, and in general providing more authority and funding to regulatory agencies.

wall street michael douglas

Famous SEC Cases

The SEC has ruled on thousands of civil and criminal securities-related issues pertaining to both individuals and institutions since its inception. Some of these cases have received substantial attention from the media, particularly when a non-securities-related celebrity is involved, such as a movie star or professional athlete.

A list of some of the more famous SEC cases involving securities fraud includes:

Fran Tarkenton

Although this wily former NFL hall of fame quarterback was known for his ability to escape defenders on the field, he was not agile enough to evade the SEC when it blitzed him and his computer software firm with charges of accounting fraud.

The SEC accused him of reporting millions of dollars of false income for his software firm over a two-year period by unloading company products on customers and resellers at no charge (unless the products actually led to further sales.) The company then recorded these gifts as sales in what the SEC charged was an effort to camouflage the company’s dwindling income. Tarkenton was forced to pay over $150,000 in fines and sold his company for only a few dollars a share in 1994.

Martha Stewart

In one of the most widely publicized trading scandals in recent history, this media queen of cooking and home decoration became embroiled in a major insider trading scandal in the fall of 2001. She dumped almost a quarter million dollars’ worth of shares of ImClone, a pharmaceutical company, shortly before the FDA announced that it would not accept the firm’s latest cancer drug, Erbitux.

Shortly after she sold her holdings, the stock plummeted to $10 a share. The fortuitous timing of her sale aroused the suspicions of investigators, who discovered she was among a group of friends of Samual Waksal, the CEO of ImClone. She and her broker were both convicted of insider trading in 2004 and Martha was sentenced to a few months in a federal penitentiary plus a $30,000 fine. Of course, this was nothing compared to what Waksal received. He had to pay a whopping $4.3 million on top of a 7-year sentence. Stewart was, however, forced to resign from her own company due to the negative publicity stemming from her conviction.

Mark Cuban

The outspoken billionaire owner of the NBA champion Dallas Mavericks has been fighting insider trading accusations since 2004. The SEC stipulated that he sold his block of shares of Mamma.com upon discovering that the Internet search engine firm intended to release a public stock offering. The SEC charged that the timing of his sale allowed him to evade losses of over three-quarters of a million dollars. Cuban has been quick to fire back at the agency, denouncing its case as “merit-less.” He is currently seeking sanctions against the SEC as a result of this investigation. The final outcome is yet to be determined.

Ivan Boesky

This famous insider trading case from the 1980s helped to inspire the Oliver Stone film, Wall Street. Gordon Gekko’s character is drawn from several major Wall Street players of the time, including Boesky and Michael Milken. Boesky was a corporate arbitrageur with an incredible knack for finding stocks of companies that turned out to be targets for corporate takeover. When the takeover was announced, Boesky’s stock picks would jump in price and he and his investors would reap quick profits.

But securities investigators realized that no one could be this consistently smart or lucky and an investigation revealed that he was engaging in more than mere research or securities analysis. He was, in fact, consulting the mergers and acquisitions branches of major investment banks to discover who was buying whom. Boesky was compensating two other partners for specific details of takeovers, one of whom the SEC coerced into testifying against him. The agency then levied a $100 million fine against him on top of a jail sentence for his crimes. Boesky’s actions directly led Congress to pass the Insider Trading Act of 1988.

Michael Milken

A key executive of the investment bank Drexel Burnham Lambert, this famous racketeer earned the nickname “Junk Bond King” in the 1980s and is indeed credited with creating the subprime bond market. However, Milken used the revenue created from junk bond issues to refinance insolvent issuers in a pyramid-type scheme that generated enormous income for Drexel Burnham Lambert.

Milken also began trading on inside information, and the instability created by his schemes is considered a major factor behind the Savings and Loan collapse in the late 1980s. Ivan Boesky finally ratted Milken out to the SEC in an effort to lighten his own sentence. Milken was subsequently convicted and sentenced to 10 years in prison and assessed a fine in excess of a billion dollars. He and Boesky were also both banned for life from the securities industry. However, Milken promptly violated his probation after serving his sentence by becoming a consultant and was quickly fined another $42 million by the SEC.

Bernie Madoff

This former chairman of NASDAQ eventually started his own hedge fund that presumably generated its consistent monthly returns from an option collar strategy. However, the fund was actually posting losses that eventually totaled approximately $50 billion.

However, Madoff was able to cover these losses for a time with capital from new investors, but was finally caught when he admitted what he was doing to his own employees. By the time it was over, Madoff had bilked investors of a mind-numbing $65 billion and ultimately received an unprecedented 150 years in prison for what has come to be known today as the Bernie Madoff Ponzi Scheme.

Final Word

Since its inception in 1934, the SEC has strived to protect investors by promoting fair and orderly markets. It accomplishes this through several different avenues, including legislation, administrative requirements, and enforcement action. The nature and scope of this integral part of government will most likely continue to expand in order to keep up with the growing size and complexity of the securities markets.

Mark Cussen
Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.

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