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 differently from the Securities Act. To protect investors, Congress crafted a mandatory disclosure process designed to force companies to make public information that investors would find pertinent to making investment decisions. In addition, the Exchange Act provides for direct regulation of the markets on which securities are sold (the securities (stock) exchanges) and participants in those markets (industry associations, brokers, and issuers).
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 make periodic filings with the SEC. The Commission makes this information available to all investors through EDGAR, its online filing system. The SEC enforces statutory disclosure requirements bringing enforcement actions against companies that disseminate fraudulent or incomplete information in violation of the federal securities laws.
The Commission is also responsible for registering and establishing rules regulating the conduct of market participants, stock exchanges, and self-regulatory organizations (SROs). Under the Exchange Act, the SEC can sanction, fine, or otherwise discipline market participants who violate federal securities laws. The SEC can also issue rules pursuant to specific statutory provisions, to help effectuate those provisions.
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 make periodic disclosures by filing annual reports (10KsForm 10-K) and quarterly reports (10QsForm 10-Q). Reporting companies must also promptly disclose certain important events (8KsForm 8-K). 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 (only required for annual reports using Form 10-K), and the management discussion and analysis section (in which the company's management discusses the prior year's performance and their plans for the next year).
The Exchange Act also mandates disclosure at certain crucial points so that investors can make an informed decision before purchasing 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 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 This information allows investors to decide whether to sell or not.
Under the Exchange Act, market participants are subject to direct SEC regulation. Securities exchanges, such as the New York Stock Exchange and NASDAQ, 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 Registered markets must file detailed disclosure documents with the SEC. These documents help the SEC monitor the markets for trading activity that might indicate that market participants are violating securities laws (such as insider trading). 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 exercise independent oversight over the markets. Nearly all broker-dealers must register with the FINRA, the most significant SRO (responsible for the regulation of broker-dealer firms and securities brokers). The SEC also directly regulates 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 and that firms keep accurate, truthful records. Broker-dealer firms and employees who violate the FINRA standards of conduct are subject to disciplinary action by FINRA.
The Exchange Act 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 market participants violate federal securities laws, the SEC can bring a civil enforcement action.the SEC or Department of Justice can also bring criminal actions for particularly serious violations. The Exchange Act also allows investors to sue market participants who have defrauded them:
- Section 10(b) (codified in 15 U.S.C. § 78j) and 17 C.F.R. § 240.10b-5 (Rule 10b-5): Section 10(b) is the primary statutory weapon against fraud. Section 10(b) 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." Rule 10b-5 also imposes 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 a stock.
- Courts held early on that investors could sue under Rule 10b-5. 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" the purchase or sale of any security. Only individuals who have actually bought or sold securities have standing to bring a 10b-5 claim.
The Exchange Act antifraud provision has been used against all kinds of deceptive practices, 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 to manipulate 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 10(b) also provides a remedy for investors who have suffered from broker-dealer conduct that does not amount to securities 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 10(b) 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 caused the crash of 1929. 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. These activities mislead investors about the true value of a security, and thus induce the investors to trade. Section 9(e) gives investors an explicit right of action to sue buyers or sellers who manipulate the price of any security traded on a stock exchange. Claims under Section 9 are difficult to prove, since investors must show 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 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 in 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 10(b). 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 imposes potential liability for a wide range of defendants, including those who actually made the fraudulent statement, "control persons," and aiders and abettors, the investor must meet a heavy burden of proof. 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.