Finance Government Regulations PDF

15.1A Brief History of U.S. Government Financial Regulation This video can be viewed online. LEARNING OBJECTIVES 1 2 3 4 5 Describe the U.S. Securities and Exchange Commission (SEC) and its role in monitoring capital markets, including Rule 144A/Regulation S security types. Determine whether company...

15.1A Brief History of U.S. Government Financial Regulation This video can be viewed online. LEARNING OBJECTIVES 1 2 3 4 5 Describe the U.S. Securities and Exchange Commission (SEC) and its role in monitoring capital markets, including Rule 144A/Regulation S security types. Determine whether company controls meet the requirements of the SarbanesOxley Act. Explain the relationship between the prospectus and the Securities Act of 1933. Determine whether a company is in compliance with SEC and the Financial Industry Regulatory Authority (FINRA). Describe the Dodd Frank Act and its role in monitoring capital markets. Government regulation has historically played a critical role in the development and operation of financial markets and institutions. A brief history will help set the context for the learning objectives of this topic. During the mid-1800s, the government had a somewhat laissez-faire attitude towards regulating financial institutions. As a result, "wildcat banking" led the federal government to institute the National Banking Act of 1863, which was one of the first cases of government regulation within the U.S. banking industry. With the National Banking Act, regulation in America was born. This act was followed by the Federal Reserve Act of 1913, which was designed to curb a series of bank runs and recessions. Next, the McFadden Act of 1927 was designed to provide greater accessibility for bank customers. For example, it prohibited banks from establishing branches across state lines to deter customers from redeeming banknotes. Next, as a result of the Great Depression, the GlassSteagall Banking Act of 1933 was designed to decrease the number of banks that were failing. The Glass-Steagall Act was significant because it limited banks in a fairly dramatic way. For example, banks were not allowed to underwrite risky securities, pay interest on checking accounts, or hold corporate debt or equity. The Glass-Steagall Act essentially set up a wall between commercial/consumer banking and investment banking. The next law passed was the Bank Holding Company Act of 1956 designed to further protect the banking industry from competition. In the late 1970s, inflation and a sluggish economy were the catalyst for the Depository Institutions Deregulation and Monetary Control Act of 1980. This Act was the beginning of a deregulation trend, which was hoped to help spur financial institutions and the economy. The next phase of deregulation was a response to the savings and loan (S&L) crisis of the early 1980s. The Garn-St. Germain Act of 1982 loosened restrictions on what financial institutions could do in the United States with regard to products they could offer. For example, it allowed banks to offer adjustable rate mortgages, money market deposit accounts, and investment in government bonds, and permitted healthy institutions to acquire failing institutions. The next major regulation was a result of a major deterioration in the banking industry and reversed the deregulation trend a bit. Called the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (or FIRREA for short), it dealt mostly with capital requirements. This assessment can be taken online. 15.2Dodd Frank Act You will notice that government regulation of the banking industry is like a pendulum, first with little regulation in the wildcat days of the mid 1850s, to stiff regulation as a result of the Great Depression, back to a trend of deregulation as a result of the S&L crisis of the early 1980s, to the re-regulation of the SL fallout of the late 1980s, which continued into the late 1980s with the Federal Institutions Reform, Recovery, and Enforcement Act of 1989. This Act established risk-based insurance premiums for banks known as a CAMELS score (Capital adequacy, Asset quality, Management quality, Earnings, Liquidity, Sensitivity to market risk). After the 1989 Act, a wave of deregulation of institutions began again with the Reigle-Neal Interstate Branching and Banking Efficiency Act of 1994. Reigle-Neal allowed banks to transact business across state lines. Along with Reigle-Neal, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 continued to deregulate the banking industry. The deregulation wave was then blamed for the financial crises of 2008 and was the catalyst for the Dodd-Frank Act of 2010. Dodd-Frank was an aggressive step for re-regulation of the banking industry. For example, the repeal of the Glass-Steagall Act through mainly the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 was blamed for allowing financial institutions to become “too big to fail.” After the repeal of Glass-Steagall, many large financial holding companies held huge subsidiaries in commercial banking, investment banking, and insurance. It was argued that these gigantic financial institutions would collapse the economy if they were permitted to fail, and as such, the government provided massive bailouts that were controversial to the American public. Dodd-Frank was an attempt to regain control of the financial institutions industry by the federal government. The major pieces of Dodd-Frank were the creation of the Financial Stability Oversight Council to monitor how systematic risk could impact the industry. Dodd-Frank also expanded governmental authority to force liquidation of financial institutions, increased regulation of hedge funds, created the Federal Insurance Office to monitor the insurance industry, and instituted the “Volcker Rule," which limits bank investments in hedge funds and proprietary trading. The overall purpose of Dodd-Frank is to monitor capital markets through market analysis of systematic risk, increased scrutiny of the hedge fund industry, monitoring of the insurance industry, and limitations of investible assets of banks. In the history of banking and market regulation, Dodd-Frank is another instance of the regulatory pendulum swinging back to the side of increased regulation. This assessment can be taken online. 15.3The Securities and Exchange Commission (SEC) The U.S. SEC was established by the Securities Exchange Act of 1934 as a response to the Wall Street crash of 1929 and the ensuing Great Depression. The SEC is the governmental oversight unit to enforce the statutes designed to regulate markets and protect investors. Some examples of these statutes are the Securities Act of 1933, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Sarbanes-Oxley Act of 2002 (to be covered later in this topic), and the Credit Rating Agency Reform Act of 2006. The SEC operationalizes its mission in two primary ways. First, it requires public disclosure of firm data for firms desiring to sell public equity or debt (or to non-accredited investors). There are several key filings that public companies make during their life cycles. When a firm desires to conduct an initial public offering (IPO), it files an original offering prospectus, known as SEC Form S-1 as well as the “red herring.” This form allows the firm to begin the process of going public, but the firm is not allowed to take any official offers to purchase shares until the actual IPO date. Once a firm is public, it must file quarterly (Form 10-Q) financial reports as well as the annual report (Form 10-K). There are a myriad of other forms dealing with insider sales of stock, procedural bankruptcy filings, and the like. Since 1994, firms have been required to file SEC documents online at the SEC EDGAR (Electronic Data Gathering, Analysis and Retrieval System). You can check out the site at edgar.sec.gov. One of the ways the Securities Act of 1933 allows firms to raise capital without going through the IPO process is Rule 144A. Rule 144A is known as a “safe harbor” from the registration requirement of the Securities Act of 1933. Rule 144A permits sale of private capital to accredited investors. Accredited investors, as defined by the SEC, are typically large financial institutions, or wealthy individuals. The cut-offs for individual investors to be considered accredited investors are (a) a net worth of $1 million (individual or joint with spouse) and (b) individual income of $200,000 per year or joint income of $300,000 income per year with spouse for the past two years and with the expectation of this year. (See http://www.sec.gov/answers/accred.htm for a full SEC definition.) Individuals only need to meet one of the requirements to be considered accredited. If a firm courts only accredited investors, then under Rule 144A, it may approach and sell securities (private placement) without full registration through the SEC. When a firm executes a private placement under Rule 144A, it typically prepares a private placement memorandum (PPM) to distribute to interested investors. The PPM provides enough information about the firm to satisfy private investor questions. Similar to Rule 144A, Regulation S is another safe harbor from the Securities Act of 1933. It allows raising capital without registering with the SEC; however, the securities must only be sold outside of the United States. Even U.S. entities and citizens physically located outside of the United States cannot invest under Regulation S. The rationale for the SEC reporting requirements is to protect U.S. investors; thus the prohibition of U.S. citizens investing inside or outside of the United States without full SEC registration. Because the SEC is primarily concerned with U.S. investors, it provides a safe harbor for U.S. firms to sell to foreign entities. This assessment can be taken online. 15.4Securities Act of 1933 Mentioned above, the Securities Act of 1933 was a direct result of the Wall Street crash and Great Depression. With the exception of a few safe harbors, like Rule 144A and Regulation S explained above, the 1933 Act requires firms to fully register with the SEC before selling securities to the public. The primary document a firm files to go public is the prospectus, SEC Form S-1. This form is designed to provide any public U.S. citizen interested in investing in a firm sufficient information to make an informed decision. It is designed to mitigate fraud in the securities industry. The prospectus includes audited financial statement information, the name of the lead underwriter(s), a discussion about the firm and its prospects by management, the price of the offer, the number of shares being offered, and even a section of risk factors, among many other requirements. Insiders in the IPO are very careful to be fully transparent in the prospectus disclosure. If they leave out any material information (for example, in the risk factor section), it opens the firm up to legal liability. Lawsuits may be brought by investors or by the SEC. Legal action by the SEC is the second primary way it enforces its duty of regulating security markets and protecting investors from corporate fraud. When the initial S-1 is filed, it is typically a boilerplate document with a lot of specific data missing. As the SEC combs through the S-1 and as the firm and its underwriter “build the book” through what is known as the roadshow, the firm files amendments to the S-1, known as S-1/As. It is not uncommon for a firm to have several amendments before it actually goes public. The last amendment is usually the pricing amendment, which lists the exact price per share at which the stock will be offered to the primary market and is often filed the night before or the morning of the actual offer. When the firm initially is sold to the public, in the United States it is almost always done as what is known as a firm commitment offering. The underwriter, typically a large investment bank like Goldman Sachs, purchases all of the shares the firm is offering the public and then immediately sells them to the primary market. The primary market buys the shares at the offer price, which is listed in the final prospectus. The primary market is typically composed mostly of large institutional investors, but usually includes a smaller proportion of individual investors as well. Some primary market participants sell their shares on the first day to the secondary market and begin a liquid market for the stock on an exchange such as the New York Stock Exchange or NASDAQ. This assessment can be taken online. 15.5Sarbanes-Oxley Act In the aftermath of Enron, perhaps the greatest firm failure based upon fraud to that point in history, Congress created the Sarbanes-Oxley Act of 2002. The idea of the Act, also known as SOX, was threefold. First, it was designed to ensure that public company boards of directors actually represented the shareholders in good faith. Second, it was designed to monitor company executives and ensure they were truthful in their SEC reporting. Third, SOX was designed to ensure that public accounting firms were being honest in their audits of public companies. The need for the threefold mission of SOX can be demonstrated with the Enron case. We will use this case, although other scandals and frauds such as Tyco, WorldCom, or HealthSouth could be used as well. Enron was a U.S. energy firm that eventually went bankrupt in 2001. Enron executives, primarily Chairman Kenneth Lay, CEO Jeffrey Skilling, and CFO Andrew Fastow, knowingly and strategically used accounting fraud to prop up the profits of Enron for almost a decade (1993–2001). The fraud was so elaborate, that it duped investment markets as well as the firm’s auditor, Arthur Andersen. Some argue that Arthur Andersen was actually complicit and point to the fact that Arthur Andersen was found guilty of obstruction of justice in 2002 for destroying documents related to the Enron audit. Though the Arthur Anderson conviction was dismissed by the Supreme Court in 2005, Arthur Andersen went out of business in a shock to the public accounting industry, and the “Big 5” accounting firms became the “Big 4” accounting firms with the demise of Arthur Anderson. As can be seen with Enron, 1) the board, under chairperson Lay, was guilty of fraud; 2) management, namely, CEO Skilling and CFO Fastow, were guilty of fraud; and 3) the auditor may have been guilty of fraud, but clearly destroyed evidence (at least a few Andersen employees did). SOX specifically targets these three areas by dictating significantly more severe punishment for financial fraud by the board or management, requiring top management to sign financial statements individually certifying their accuracy, and creating greater separation between outside accounting auditors and the firms they audit. Company controls must meet multiple key provisions of SOX. Firms must be concerned with information transparency, proper audits, disclosures of offbalance sheet items, internal assessment of corporate controls, non-retaliation against whistleblowers, and independence from U.S. enforcement agencies. The disclosure controls of Section 302, for example, require a set of internal control policies that can add significant expense to operating firms. Many firms find that the internal audits necessary to comply with SOX are too costly in terms of time and money. As a result of SOX, some analysts argue that many public firms have delisted to become private and others do not publicly list, or list internationally, to avoid the headaches of SOX. There were approximately 8,000 listed firms in the United States. After SOX, the number of public firms decreased nearly monotonically to fewer than 5,000 in 2011. Whether this decrease can actually be attributed to SOX is a matter for careful researchers to decide, but for our purposes, we just need to realize that complying with SOX can be costly to a firm. For additional information on SOX, see http://www.sec.gov/about/laws/soa2002.pdf. Figure 15-1: This assessment can be taken online. 15.6Financial Industry Regulatory Authority (FINRA) In this subsection, we discuss a regulatory organization that acts much like a governmental agency, but is actually a private corporation. An SRO (selfregulatory organization), FINRA is itself overseen by the SEC. Thus, firms that are regulated by FINRA are ultimately overseen by the SEC as well. The primary substituents of FINRA are brokerage firms and exchange markets. FINRA is the largest independent regulating service for all securities firms operating within the United States. The overall mission of FINRA is to protect investors by ensuring the securities industry acts fairly and honestly with all investors. Does this sound familiar? This is similar to the role the SEC plays as a governmental agency. Companies that trade in equities, corporate bonds, financial futures, and options that are not regulated by another SRO, must be members of FINRA to be compliant with the SEC. Among the functions of FINRA are to license individuals, admit firms to the industry, write rules to govern their behavior, examine firms for regulatory compliance, and to discipline members that do not comply with federal securities laws or FINRA’s own rules. Along with these oversight roles, FINRA offers education opportunities for industry professionals, qualification exams, and outsourced regulatory products to various markets and exchanges. To determine if a firm is compliant with FINRA, the site http://finra.complinet.com/ is very useful. The site includes tabs for regulation, compliance, education, and enforcement. Under the compliance tab, information can be found for registering, regulatory filings, reporting, and market transparency. Official compliance examinations of firms and traders occur on a regular basis. From the FINRA website: Compliance Exams FINRA regularly examines all firms to determine compliance with FINRA's rules and those of the SEC and the Municipal Securities Rulemaking Board (MSRB). During a routine examination, FINRA examines those aspects of a firm's business that present heightened regulatory risk, as well as certain core areas. Specifically, FINRA examines a firm's books and records to see if they are current and accurate. FINRA analyzes sales practices to determine whether the firm has dealt fairly with customers when making recommendations, executing orders, and charging commissions or markups and markdowns, and scrutinizes a firm's anti-money laundering program, business continuity plans, and financial integrity and internal control programs. Similarly, firms go through a rigorous review for financial and operational compliance. Routine examinations also seek to determine each firm's compliance with the anti-fraud provisions of the Securities Exchange Act of 1934, the Securities Act of 1933, FINRA's advertising rules and Regulation T of the Federal Reserve Board, which governs the extension of credit (margin) by brokers and dealers Author’s Note: The authors would like to thank Dr. Colby Wright for information that significantly contributed to the first two sections of this topic. Information taken from government pages was also very instructive. For more details on governmental regulation, we encourage the interested reader to peruse http://www.sec.gov/. This assessment can be taken online. 15.7Topic 15 Review Select the correct answer This assessment can be taken online.