Broker-Dealer Regulation: Navigating Conduct Rules and Standards

This is the second installment in our series of articles for aspiring and novice stock brokers who’d like to get a brief overview of the regulatory environment they’re operating in (or are about to operate).

While in part one, we covered broker-dealer regulations in a nutshell as well as the registration and licensing requirements, in part two, we’ll explore the key conduct rules and standards that stock brokers must follow to maintain compliance and foster a trustworthy environment in the market. To be precise, we’ll delve into the Securities Act of 1933, the Securities Exchange Act of 1934, anti-fraud provisions, suitability requirements, and best execution obligations.

Securities Act of 1933

Brief historical note: The introduction of the Securities Act of 1933 followed the stock market crash of 1929, also known as Black Tuesday. The crash was caused by a speculative boom and market bubble. Investors bought stocks on margin and engaged in short-term speculation, leading to an overvalued market. When the bubble burst, panic selling occurred, causing a catastrophic collapse of the stock market. This event marked the beginning of the Great Depression, with widespread economic devastation and high unemployment.

The Securities Act of 1933, also known as the “Truth in Securities Act” or the “Federal Securities Act,” was enacted to restore investor confidence and promote fair and transparent practices in the securities market. Its primary objective is to provide investors with accurate and reliable information about securities sold to the public.

The 1933 Act requires companies issuing securities to register with the Securities and Exchange Commission (SEC) and disclose essential financial and business information through a prospectus. This registration process ensures that investors have access to relevant information before making investment decisions, reducing the risk of fraudulent activities and misrepresentations.

Moreover, the Securities Act imposes strict liability for false or misleading statements in the offering documents. It holds companies accountable for the accuracy and completeness of the information provided to potential investors. By establishing liability for any misrepresentation, the Act serves as a deterrent against fraudulent practices and helps maintain investor confidence in the securities market. Overall, the Securities Act of 1933 plays a crucial role in promoting transparency, protecting investors, and ensuring the integrity of the securities market in the United States.

Learn more about the Securities Act of 1933 on the SEC’s website here.

Securities Exchange Act of 1934

Brief historical note: The Securities Act of 1934 expanded upon the initial regulatory framework established by the Securities Act of 1933. It was introduced as a response to the widespread abuses and market manipulations that occurred during the Great Depression, particularly in the aftermath of the stock market crash of 1929. The crash revealed numerous fraudulent practices, insider trading, and a lack of oversight within the securities markets, leading to a loss of public trust and confidence.

To address these issues and restore stability to the financial system, the U.S. Congress passed the Securities Exchange Act of 1934. The act aimed to establish comprehensive regulation and supervision of the securities industry, with the creation of the Securities and Exchange Commission (SEC) as its central regulatory body.

The act introduced various provisions to achieve its goals. It mandated the registration of securities exchanges, brokers, and dealers, ensuring they adhere to regulatory requirements and standards. The act also imposed reporting obligations on publicly traded companies, requiring them to disclose essential financial information periodically. Moreover, the Securities Act of 1934 addressed insider trading, prohibited manipulative and fraudulent activities, and established rules for tender offers and proxy solicitations.

The Exchange Act is actually massive, so if you’d like to get into details, please head to the SEC website for the full version. If you’d like to learn only the most important parts, further on, we’ll dive deeper into the Act’s most significant provisions, requirements, and obligations.

Anti-fraud provisions

Under the Securities Act of 1933 and the Securities Exchange Act of 1934, stock brokers are prohibited from engaging in fraudulent practices. This includes making false statements, omitting material information, or employing any scheme to defraud investors. Stock brokers must act in the best interests of their clients and maintain high ethical standards in all interactions.

There are six anti-fraud provisions:

1. Duty to disclose all material information obliges companies to provide not only the information required by the SEC but also any additional data that prevents the company’s statements from being misleading.
2. Liability for false and misleading statements establishes accountability for inaccurate and deceptive statements in documents submitted to the SEC.
3. Exchange Act section 10(b) and Rule 10b-5 broadly prohibit fraudulent and deceptive practices and untrue statements or omissions of material facts in connection with the purchase or sale of any security. Unlike Section 18, these provisions apply to any information released to the public by the issuer and its subsidiaries, including press releases and annual and quarterly reports to shareholders.
4. Executive officer certification of reports and financial statements has a wide scope, forbidding fraudulent and deceptive practices, as well as the withholding of crucial facts, concerning the buying or selling of any security. In contrast to Section 18, they extend to all information disclosed to the public by the issuer and its subsidiaries, encompassing press releases and regular reports to shareholders, such as annual and quarterly filings.
5. Control person liability means that a person who exercises control over an individual held accountable under the SEC’s laws may share joint and several liabilities and be held equally responsible for violations of the Exchange Act or the Securities Act, just like the controlled individual.
6. Liability for securities offerings pertains to any significant misrepresentations or omissions made in association with registered offerings. The Securities Act forbids the use of any prospectus that fails to meet the SEC’s stipulated requirements. Additionally, it prohibits any registered sale of a security unless the security is preceded or accompanied by a prospectus that fulfills the SEC’s requirements. 

If you want to learn more, you can familiarize yourself with the full version of existing regulatory protections that include anti-fraud provisions here.

Suitability requirements

When a broker advises clients to purchase or sell a specific security, they must have a reasonable basis to believe that the recommendation is suitable for a client’s circumstances. To make this assessment, a broker takes into account factors such as a client’s income, net worth, investment goals, risk tolerance, and existing holdings of securities.

The major self-regulatory organizations in the securities industry have established suitability rules. You can find FINRA’s suitability rule here.

Stock brokers must recommend investments that are suitable for their clients’ financial circumstances, investment objectives, and risk tolerance. This obligation ensures that brokers make recommendations aligned with their clients’ needs and objectives, preventing the sale of unsuitable or overly risky investments.

Best execution obligations

Best execution mandates that brokers execute client orders in a way that achieves the most favorable terms reasonably available under the prevailing market conditions. This means brokers should seek to obtain the best possible price, speed, and likelihood of execution for their clients’ trades. While brokers are not required to get the absolute best price for every trade, they must demonstrate a diligent effort to secure the most advantageous terms possible. Brokers are also expected to consider factors such as transaction costs, market liquidity, and the size of the order when seeking the best execution.

Conclusion

That’s a wrap for conduct rules and standards. That’s a lot to process but stay tuned for our third article for stock brokers willing to know it all about regulations.

In the next installment, we’ll dive into capital requirements and financial responsibility.