Originally prepared by Deepa Sarkar of the Cornell Law School Securities Law Clinic.
Securities Exchange Act of 1934 (Exchange Act)
In contrast to the Securities Act of 1933, the Exchange Act primarily regulates transactions of securities in the secondary market - that is, sales that take place after a security is initially offered by a company (the issuer). These transactions often take place between parties other than the issuer, such as trades that retail investors execute through brokerage firms. The Exchange Act operates somewhat differently from the Securities Act. To protect investors, Congress crafted a mandatory disclosure process that is designed to force companies to make public information that investors would find pertinent to making investment decision. In addition, the Exchange Act provides for direct regulation of the markets on which securities are sold (the securities (stock) exchanges) and the participants in those markets (industry associations, brokers, and issuers).
In a major step by Congress, Section 4 of the Exchange Act (codified in 15 U.S.C. § 78d) established the Securities and Exchange Commission (SEC), a federal agency responsible for regulating the securities markets. Congress initially granted the SEC power to enforce the Exchange Act, but the SEC's enforcement powers have grown to include the Securities Act, the Sarbanes-Oxley Act of 2002, and other legislation. One important function of the SEC is to ensure that companies meet the Exchange Act's disclosure requirements. Companies must file their periodic filings with the SEC, and the regulatory agency makes this information available to all investors through EDGAR, its online filing system. The SEC's power to compel the statutory disclosure requirements is backed by the SEC's power to bring enforcement actions against companies that disseminate fraudulent or incomplete information in violation of the federal securities laws. The agency also is responsible for registering and establishing rules for the conduct of market participants and for exchanges and self-regulatory organizations (SROs). Under the Exchange Act, the SEC can sanction, fine, and otherwise discipline market participants - both organizations and associated individuals - who violate federal securities laws. The SEC, in enforcing the various statutes, can also issue rules pursuant to specific provisions, to help effectuate those provisions.
The mandatory disclosure system operates at several stages, and the required disclosures and forms of disclosure vary depending on the situation and the registrant. In general, under Section 13(a) of the Exchange Act (codified in 15 U.S.C. § 78m), companies with registered publicly held securities and companies of a certain size are called "reporting companies," meaning that they must disclose continuously by filing annual reports (10Ks), quarterly reports (10Qs), and reports when certain events occur (8Ks), per SEC rules. These periodic reports include or incorporate by reference types of information that would help investors decide whether a company's security is a good investment. Information in these reports includes information about the company's officers and directors, the company's line of business, audited financial statements, and the management discussion and analysis section (in which the company's management discusses the prior year's performance and plans for the next year). Aside from periodic reporting, the Exchange Act also mandates disclosure at certain crucial points so that investors can make an informed decision before exercising ownership rights in stock. Sections 14(a)-(c) (codified in 15 U.S.C. § 78n(a)-(c)) govern disclosure during proxy contests, when various parties might solicit an investor's vote on a corporate action or to vote for certain board members. All of these disclosure materials must be filed with the SEC. If a party makes a tender offer, by attempting to buy up 5% or more of the company's stock on the open market, the Williams Act governs (Sections 13(d)-(e) codified in 15 U.S.C. § 78m(d)-(e), 14(d)-(e) codified in 15 U.S.C. § 78n(d)-(e)). A tender offeror must also file disclosure documents with the SEC that disclose its future plans relating to its holdings in the company, among other information; this allows investors to decide whether to sell or not.
Under the Exchange Act, various market participants are subject to direct SEC regulation. Securities exchanges, such as the New York Stock Exchange where individuals trade stocks and bonds, must register with the SEC under Section 5 (codified in 15 U.S.C. § 78e) and Section 6 (codified in 15 U.S.C. § 78f). Similarly, NASDAQ, an electronic market on which brokers can trade stock, must also register. Registration entails a disclosure, since the registered markets must file detailed disclosure documents with the SEC; such documents help the SEC monitor the markets for trading activity that might indicate that market participants are violating securities laws. To further this goal, all securities traded on the securities exchanges must be registered under Sections 12(a) and 12(b) (codified in 15 U.S.C. § 78l(a)-(b)) of the Exchange Act, with the issuers of the securities disclosing comprehensive information about themselves and the stock in the registration process.
In addition to directly regulating the markets, the SEC oversees SROs, which in turn have independent oversight over the markets. Nearly all broker-dealers must register with the main SRO, FINRA, meaning that the SEC directly regulates another set of market participants: broker-dealer firms and the brokers who are employed by them. SROs must develop conduct rules and standards of good practice for their members, pursuant to SEC directives. This joint supervision of broker-dealers and their employees is extremely important to investors, because it ensures that broker-dealers and their employees are sufficiently qualified and meet minimal levels of training, and that firms keep accurate, truthful records. Broker-dealer firms and employees who violate the SRO standards of conduct are subject to disciplinary action by the SRO, pursuant to a SRO hearing.
The Exchange Act protects investors by making sure information is available, but also protects investors by prohibiting fraud and establishing severe penalties for those who defraud investors, as well as those who engage in some trading practices that take advantage of information most investors do not have (e.g. insider trading). When federal securities laws are violated by market participants, the SEC can bring a civil enforcement action and can also bring criminal actions for some violations. The Exchange Act also allows investors to sue market participants who have defrauded them:
- Section 10b (codified in 15 U.S.C. § 78j) and 17 C.F.R. § 240.10b-5 (Rule 10b-5): These are the principal statutory weapons against fraud. Section 10b is the antifraud provision of the Exchange Act, while Rule 10b-5 is the rule the SEC promulgated under that section. Rule 10b-5 prohibits the use of any "device, scheme, or artifice to defraud," and creates liability for any misstatement or omission of a material fact, or one that investors would think was important to their decision to buy or sell the stock. Courts held early on that investors can sue, and the scope of liability is broad: a wide range of participants, from brokers to issuers to company employees may be liable, provided that the fraud was "in connection with" a securities purchase or sale. The fraud is considered to be "in connection with" a securities transaction, if it was material to the decision to buy or sell a security.
The Exchange Act antifraud provision has been used against all kinds of behavior, from misleading statements in company filings and documents used to sell the securities, to insider trading (where corporate insiders use information unavailable to investors to trade profitably) to market manipulation cases in which companies bought and sold their own stock so as to affect the market price of the company's stock. The breadth of Section 10(b) and Rule 10b-5, combined with the fact that individual investors have a cause of action, make 10b-5 suits very common. Plaintiffs can recover the excess of what they paid over the actual price of the security. The "actual price" is the average price of the security within a 90-day window of the disclosure of the fraud; this limitation on damages is the result of 21D(e) (codified in 15 U.S.C. § 78u-4(e)), which was added as part of legislation to reform securities litigation.
Section 10b and Rule 10b-5 may also provide a remedy for investors who have suffered from broker-dealer conduct that does not amount to fraud, but still harms clients who entrusted the broker-dealer with funds. Neither the Securities Act of 1933 nor the Exchange Act directly address behavior by brokers who breach their fiduciary duties, but courts have read in an implied promise of fair and honest dealing by brokers, by the fact of their transacting in securities for clients. Under the "shingle theory," a customer only needs to prove violations of professional duties of fair dealing, rather than intentional misstatements or intent to deceive. However, customers still must prove that they relied on a broker. The Supreme Court has also affirmed that 10b and 10b-5 contain a right of action for investors whose broker violates fiduciary duties to clients, even where individual transactions were legal. The Supreme Court's ruling in SEC v. Zandford, 535 U.S. 813 (2002), in which a broker was liable under 10b-5 for legitimate transactions made with funds stolen from the client's account, supports the applicability of 10b-5 in cases where brokers breach their fiduciary duties.
- Section 9 (codified in 15 U.S.C. § 78i): This provision addresses manipulation of the stock market by traders, the behavior that originally spurred the crash of 1929. However, modern market manipulation is accomplished through methods that are more subtle and harder to detect. Investors can sue under Section 9 for trading activities and patterns of trading conduct that cause investors to think that a stock is doing better or worse than it actually is, or is traded more frequently than it actually is, or that create the appearance of a stable price. Essentially, these activities create an artificial price that give the investor false information about the stock, and thus induces the investor to trade. Section 9(e) gives investors an explicit right of action to buyers or sellers who trade on a stock exchange, as long as the stock was registered on the exchange. However, the claim is somewhat difficult to prove, since investors must prove that the price was actually affected by the manipulation, and that the defendant acted willfully. Proving damages also involves proving the actual value, since successful claimants may recover the difference between the actual value and the price they paid.
- 17 C.F.R. 240.15c3-3 (Rule 15c3-3): This provision requires brokers to set aside a certain amount of cash and securities into specially protected accounts. The purpose of the provision is to limit risky use of client's funds, such that in the case the broker becomes insolvent, his or her customers would be able to recover a portion of their investment.
- Section 18 (codified in 15 U.S.C. § 78r): This is a narrower cause of action than the antifraud provision in 10b. Investors who actually purchased or sold a security may sue for fraudulent statement in a company's periodic filings with the SEC. Though the private right of action is advantageous to investors because it creates potential liability for a wide range of defendants, including those who actually made the fraudulent statement, "control persons," and aiders and abettors, the downside is the heavy burden of proof for the investor. A claimant must prove that he did not know the statement was false, that he relied on the statement when deciding to buy or sell, and that the fraudulent statement actually affected the price of the security.
- Section 20 (codified in 15 U.S.C. § 78t): Similarly to Section 15 in the Securities Act of 1933 (codified in 15 U.S.C. § 77o), this provision provides for joint and several liability for people who control or abet violators of the Exchange act, thus increasing the chance that an investor will be able to collect any damages that are awarded. Thus, if an employee violates a provision of the Exchange Act, the employer could be held liable. Similarly, if an individual encourages another to violate a provision of the Exchange Act, that individual could be held liable.
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Recent Supreme Court Decisions
- Merrill Lynch, Pierce, Fenner & Smith Inc. v. Manning, 136 S. Ct. 1562 (2016) (subject matter jurisdiction)
- Chadbourne & Parke LLP v. Troice, 134 S. Ct. 1058 (2014) (what does it mean for fraud to be "in connection with" a securities purchase?)
- Morrison v. Nat'l Australia Bank Ltd., 561 U.S. 247 (2010) (the Exchange Act does not cover transactions occurring abroad)
- SEC v. Zandford, 535 U.S. 813 (2002) (civil liability for broker under Rule 10b-5)
- Virginia Bankshares, Inc. v. Sandberg, 501 U.S. 1083 (1991) (liability for proxy solicitation)
- See Supreme Court Preview
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- 04/28/2015 - Wall Street Journal - What's the Big Deal About Rule 15c3-3?
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Last edited in June of 2016 by Eugene Temchenko