Securities Markets Regulation: Part 2

Happy #FinanceFriday  and welcome back for part 2 of our discussion on securities markets regulations! Last week we went over some of the first regulations put in place by the government to protect investors. Now, let’s cover the rest of the regulations that have been established and talk briefly about the sale and pricing of new securities.

Regulations can be very specific regarding what securities they protect and who can benefit from their protection. The following lists seven regulations and their purpose:

  1. Public Holding Company Act of 1935– governs utility companies
  2. Investment Company Act of 1940– governs all pooled funds, mutual funds, ETFs (exchange traded funds), etc.
  3. Federal Deposit Insurance Corporation (FDIC)– protects depositors in banks up to $250,000. In other words, if you deposit money in a bank and that bank has too many defaulted loans and becomes bankrupt, you are guaranteed to get up to $250,000 of your money back.
  4. Securities Investor Protection Act of 1970– protects against fraud (if someone at the brokerage firm takes your money), NOT losses. This act is like the FDIC for brokerage accounts and protects up to $500,000 per accountholder. All brokerage firms that allow you to trade on the exchange market are required to be members of SIPC (Securities Investor Protection Corporation).
  5. National Association of Securities Dealers (NASD)– This association is over the testing and licensing of brokers/agents. Brokers have to take series exams (6,7) to be certified to handle portfolios for clients. This association also deals with customer complaints.
  6. Sarbanes-Oxley Act of 2002– As always, regulations normally come after a crisis. The Sarbanes-Oxley Act was established after the WorldCom and Enron accounting scandals in 2001. This act requires CEOs and CFOs to certify all corporate financial statements, companies to have independent accounting auditors who don’t work for the company, and does not allow a company to give loans to its officers. Anyone violating these laws can face penalties up to 20 years in prison.
  7. Dodd Frank Financial Reform of 2010– This regulation was established after the financial crisis of 2008 (discussed briefly last week). If you remember news coverage of the crisis, every headline talked about bailing banks out, banks merging, and/or banks going bankrupt. This reform protects against banks being too big to fail so tax payers don’t have to bail banks out to protect our entire financial system (because if we allow them to fail, our whole economy would decline). It requires income verification on mortgages, established the Volker Rule, which limits trading at banks, and created the Consumer Financial Protection Bureau (CFPB).

Companies can either sale investments through Private Placement or to the general public.

The sale of new securities through private placement is a direct sale of securities from the company to the investor (NOT through a marketplace).  This type of investing selling eliminates selling costs, features can be tailor-made for both parties, and is NOT regulated by the SEC (therefore, you as an investor are not protected by the SEC if you buy these types of investments).

The sale of new securities to the general public include Initial Public Offerings (IPOs), which is the first time shares are offered to the public. This type of investment selling must have an investment banker or underwriter to handle all processing and market the shares. There are several mechanics of security underwriting:

  • Beauty Pageants: No, Kenya Moore is not an investment underwriter. Beauty Pageant refers to when an underwriter visits investors with executives of the company that will sell investments in an effort to talk up their stock.
  • Prospectus/Red Herring: Every IPO must have this; it includes all financial statements, tells what the company is, and what their plans are with the money you will invest.
  • Shelf Registration: when a company goes through all the processes to go public, but because of issues with the market place, the company decides to wait.
  • Green Shoe: Issuing another share behind the IPO
  • Lock-Up: The time insiders (people who know inside information regarding investments) are limited to selling shares. This is usually between 3 to 6 months and is to avoid Insider Trading (see last week’s article).
  • Flotation Costs– This is how underwriters make money; normally 7% of the profits.

Pricing an IPO is critical to the success of the offering. This is the real role of the underwriter; knowing how to set the price of the stock. Underpricing leads to large gains to initial buyers who sell later on when the stock is valued at a higher rate. Of course, companies want their stock to be set at a high price, but overpricing causes losses to initial buyers and the investment bankers who backed the IPO. Underwriters tend to underprice an IPO to assure a successful sale of the shares. However, the price of IPOs is very volatile. Prices have a chance to rise dramatically, but many firms eventually fail. A year later, most IPOs are trading at less than the offering price, which means a loss to your portfolio.

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