Any person who willfully violates the 1933 Act or the SEC's rules and regulations is subject to five years in prison or a $10,000 fine (or both). The Act of 1933 also holds directors, attorneys, accountants, underwriting syndicates, and any others who sign a security's registration statement civilly liable for any false or misleading statements contained in the registration statement or prospectus. Any of these individuals are likely to be sued by the investor in the event this occurs.

The SECURITIES EXCHANGE ACT OF 1934

The Securities Exchange Act of 1934 administers the rules for securities that trade on the secondary markets, as well as the rules for agents and broker-dealers. This ensures a fair and orderly market for investors.

The Act of 1934 defines a broker as any person who effects securities transactions for investors. A dealer is a person or entity who buys and sells securities for its own account. A security is a financial instrument that signifies some kind of financial value. It can represent an ownership position in a publicly-traded corporation (stock), or a creditor relationship with a corporation (bond) or governmental body. A security does not include any note, draft, bill of exchange, or banker's acceptance with a maturity of nine months or less.

An investment contract refers to a transaction whereby a person invests his money in a common enterprise, and the profits only come from the efforts of a promoter or third party. This definition was clarified by the Supreme Court in the 1948 case "Howie versus the SEC."

One of the most significant outcomes of the Act of 1934 was the creation of the Securities and Exchange Commission (SEC). The SEC is responsible for enforcing securities laws in the United States. It administers oaths, subpoenas witnesses, takes evidence, and requests documentation from any issuers that have possibly violated any federal securities law. Its five commissioners are chosen by the president of the United States with guidance from the Senate. Only three of the five members can have the same political party affiliation. Members serve five-year terms. During this time, they are considered full-time employees of the SEC and are not able to participate in securities transactions.

The SEC can suspend trading on a security for up to 10 days. It can also suspend trading on an exchange for up to 90 days. Prior notification and approval from the president of the United States is needed for this to occur. When a new exchange is formed, it must fill out an application and register its constitution, bylaws, and articles of incorporation with the SEC. The application contains the rules of the exchange and any other information the SEC requires. An exchange cannot grant membership to broker-dealers who are not registered with the SEC. Membership must be denied to anyone not associated with a broker-dealer. It must also be denied to anyone who has received a statutory disqualification. A statutory disqualification prevents a person from being associated with a self-regulatory organization (SRO). If an exchange discovers that a member has been expelled or suspended by a different SRO, it might also suspend that member. Additionally, it has the authority to suspend or limit the activities of any member experiencing financial or operational difficulties that could harm investors, other members, creditors, or the exchange itself.

Rule 17f-2 of the SEC requires those involved in selling securities or handling cash to be fingerprinted. This is done to protect the public. An exemption applies to broker-dealers and related employees who only transact mutual fund shares, variable contracts, or unit investment trusts.

THE INVESTMENT ADVISORS ACT OF 1940

The Investment Advisors Act of 1940 protects the public from investment advisers by requiring them to register as advisers with the SEC. It lists the required and prohibited behaviors of advisers.

An investment advisor (IA) is an individual (or entity) who engages in the business of advising others for compensation. An IA advises clients regarding the investment in and purchasing or selling of securities. Advice is given either directly to clients or through publications and writings.

In 1987, a document called the IA 1092 was issued as a result of the increased activity in financial planning and investment advice. It redefined the definition of an "investment advisor" to include pension consultants. Advisors to athletes and entertainers are also now considered to be providers of investment advice ever since the issuing of this act. Firms that recommend IAs might also be required to register. This act also reaffirmed that if an IA gives any advice at all, he must be registered (even if advising is not his primary business). Finally, if a registered representative of a broker-dealer sets up a separate business to provide investment advice, he may not rely on the "broker-dealer exemption from registration." Compensation is not always monetary because services and discounts are considered as compensation.

Employees of investment advisors must register as investment advisor representatives (IARs) if they do any of the following:

•make investment recommendations or give securities advice
•manage client accounts or portfolios
•solicit or offer investment advisory services
•supervise employees who perform any of the aforementioned tasks

Investment advisor employees who only perform clerical duties do not have to register as IARs.

THE INVESTMENT COMPANY ACT OF 1940

The Investment Company Act of 1940 was passed to register and regulate investment companies. It ensures adequate and truthful information for investors to reduce the abuses in selling investment company securities. The most important provision is the requirement of all investment companies to register with the SEC. This process includes the submission of a registration statement and a prospectus clearly stating the fundamental investment objectives of the fund.

A registered company must abide by this act's rules and regulations. The company is not permitted to offer its shares without continually offering an up-to-date prospectus. Revising and resubmitted the prospectus every 13 months satisfies this requirement. The investment company must have a minimum net worth of $100,000.

An affiliated person is someone who can exercise control over an investment company. This includes an active officer, director, investment adviser, or partner of the company. It also includes a person or entity who owns of at least 5% of the company's voting stock.

An interested person includes all active broker-dealers, the principal underwriter, an investment company with same underwriter, employees of the active investment advisor, and any immediate family members of an affiliated person. Anyone who has been an attorney, IA, or principal underwriter for the investment company within the past two years is also considered an interested person.

Affiliated and interested parties are prohibited from borrowing money or any other property from an investment company. They are also prohibited from buying and selling securities or other property from the company (unless that company is the one issuing the securities).

Anyone who has been convicted of any felony or a securities-related misdemeanor (usually within the past ten years) is prohibited from serving on the board of directors of an investment company. The person is also prohibited from serving as an affiliated person. The SEC might allow exceptions if the terms of the appeal are reasonable and fair. The terms must also be consistent with the Investment Company Act of 1940, as well as with the investment company's policy listed in its registration statement.

TYPES OF INVESTMENT COMPANIES

An investment company is a privately or publicly-owned business entity that issues securities but is primarily engaged in the business of investing in securities. The company invests the money it receives from its investors, and each investor shares in these profits and losses (proportionate to how much he invested in the company). Congruent with managing, selling, and marketing funds, investment companies offer a variety of investment services (i.e. portfolio management, recordkeeping, tax management, custodial or legal services). The three classifications of investment companies are face-amount certificate companies, unit investment trusts, and management companies.

Face-amount certificates issue face-amount certificates in installments or a lump sum. Per its name, a face-amount certificate is just an investment that provides an investor with a set amount of money (face amount) on a set date (maturity date). These are usually issued at a discount, and are redeemable by the issuer at the face value upon maturity or at a lesser surrender value if redeemed early.

Unit investment trusts (UITs) only issue redeemable securities that are sold back to the trust. The securities that the UIT issues do not entitle holders to any voting rights, but investors do own an undivided interest in the securities held by the fund. In other words, the securities entitle the holder to a portion of a pool of investment securities. UITs do not actively manage portfolios, have no management fees, and do not have a board of directors. There are two types of UITs--fixed and non-fixed. A fixed UIT invests in bonds. They hold the bonds until maturity, and then the proceeds are distributed to the investors. A variable UIT invests in mutual fund shares.

Management companies are every other type of investment company. In other words, management companies fit the definition of an investment company, but do not fall into the category of a face-amount certificate company or a unit investment trust. Management companies are considered closed-end or open-end.

Open-end management companies issue redeemable securities that are redeemable within seven calendar days at net asset value (NAV). Open-end companies can only issue common stock. They can also borrow up to 33 1/3% of their total assets from a bank (“33 1/3%” is also described as a “coverage ratio of 3:1” or “300% coverage”).

Closed-end management companies issue securities that are traded on the secondary market with other investors. The secondary market price is set by supply and demand, so the CMV (current market value) can be at a premium or discount to the NAV per share. Although closed-end companies can only issue a fixed number of shares, they can issue preferred stock up to 50% of their total assets, as well as bonds up to 33 1/3% of their total assets.

RULES AND REPORTING REQUIREMENTS FOR MUTUAL FUNDS

Certain restrictions apply to mutual fund companies, such as the following:

•It may not purchase securities on margin
•It may not own a joint account that trades securities
•It may not effect a short sale of any security
•It may not purchase more than 3% of the outstanding voting stock of another investment company

A mutual fund company must abide by certain shareholder rights. Unless approved by a majority shareholder vote, a mutual fund company is prohibited from borrowing money, making loans, buying or selling real estate, and underwriting securities issued by another company. A mutual fund company may not change its investment objectives or the nature of its business, and it may not suddenly cease acting as an investment company. A mutual fund company may change from diversified to undiversified. Again, the aforementioned is all contingent upon a majority shareholder vote. Shareholders must also receive semiannual financial reports that include the following:

•a balance sheet
•a statement of the fund's total investment value
•an income statement for the covered period
•a list stating the amount and value of each security on the date that the balance sheet was issued
•a statement of the salaries paid to the directors and advisory board officers
•the total dollar amounts of securities purchased and sold.

Section 12b-1 of the Investment Company Act of 1940 allows a mutual fund company to pay the principal underwriter the costs of sales literature, promotional items, and other selling expenses by collecting 12b-1 fees. These fees are charged to fund's shares and are permissible if the following conditions are met: Payments to the principal underwriter are made per a written plan that outlines the proposed financing and distribution agreement. Shareholders and the majority of non-affiliated directors must annually review and approve the plan. The board of directors must quarterly review the payments under the plan. The plan may be terminated without penalty at any time, but with a written notice of 60 days.

INSIDER TRADING AND SECURITIES FRAUD ENFORCEMENT

While the Securities Act of 1934 was imposed to prohibit insider trading, the Insider Trading and Securities Fraud Enforcement Act of 1988 was passed to further prevent this. It placed new responsibilities on broker-dealers and investment advisers to prevent insider trading. It also listed penalties on all controlling persons for failure to detect it. Additionally, it made other changes concerning federal securities laws.

An insider is guilty of insider trading when he has access to material (non-public information) to trade securities, and he passes on the information to another person who then acts on the information. An insider is defined as an officer, director, or owner of more than 10% of the voting stock in a company. The immediate family of any of these people is also considered to be an insider. An insider is also referred to as an affiliate or control person.

The recipient of insider information is just as guilty as the one who passed along the information (the insider). Investors who have suffered monetary damage due to insider trading have legal recourse against the insider and any other person who misused the non-public information. Furthermore, the SEC may seek civil and criminal penalties against anyone it believes committed this violation. Liability for violating this Act is capped at the greater of $1 million or 300% of profits made or losses avoided. All broker-dealers must establish and actively enforce written supervisory procedures that prohibit the use of material non-public information by all persons affiliated with, interested in, or in any way engaged in securities-related activities.