Chapter 1

• Jurisdiction: United States

Chapter 1 Overview of the Securities Markets and Securities Regulation¹

The History of Federal Securities Regulation

The history of and the need for federal regulation of the securities market begins in the nineteenth century, long before the stock market crash of 1929 and the Great Depression. In the early nineteenth century, for example, caveat emptor was the watchword, and the equivalent of today's securities regulators were the journalists, who wrote about business fraud.² P.T. Barnum's "A sucker born every minute" was more than a tale. The out-of-control market characterized by the railroads and the oil barons gave birth to the Sherman Antitrust Act of 1890. But the securities markets, marked by periodic crashes as they were in the nineteenth century, were hotbeds of fraud. For example, in 1880, after his presidency, Ulysses S. Grant invested in a securities firm created by one of his sons, Buck, and a friend of his, Ferdinand Ward. The firm of Grant & Ward turned out to be a giant Ponzi scheme in which the same securities were used over and over again as collateral for loans. Before the firm crashed into bankruptcy, Grant told his wife: "Ward is making us all rich—them as well as ourselves."³ The cartoonist in Harper's Weekly referred to the firm as "Smash, Bang & Co." There was, of course, no regulation to speak of.

Shortly after Herbert Hoover took office as President in 1929, the stock market crashed, followed by the Great Depression. This crash and Depression were no doubt caused in large part by the financial problems caused by World War I. The unemployment that followed was soon corrected and by the end of the year more than a million people had been put back to work.⁴ But the underlying problems of "rags to riches" and easy credit, plus the widespread use of margin to buy securities, led not only to a plethora of fraud and discontent, they soon led to the market crash of 1929. Although by 1932 the stock market, still below its pre-crash high, had crept its way into positive territory, the economy remained in tatters. It has been estimated that of the $50 billion in new securities that were marketed during the period immediately before the crash, more than half became worthless.

The 1932 Senate Banking Committee hearings revealed the shambles left by the rampant speculation and market manipulation practiced by greedy securities dealers. Presidential candidate Franklin Roosevelt campaigned against the fraud in the markets, claiming that Hoover was exploiting the American people on behalf of the "not more than five human individuals" who controlled America's wealth, and he promised reform.⁵

Congress considered introducing bills to impose federal regulation on the securities markets, but President Hoover and congressional Republicans resisted. FDR campaigned on securities regulation—"letting in of the light of day" (FDR speech at the 1932 Democratic Convention accepting the presidential nomination).⁶

Ferdinand Pecora (a former prosecutor), chief counsel to the Senate Banking Committee, led hearings in which the committee investigated a wide variety of efforts to manipulate the markets; how companies used public relations to manipulate news reports; insider trading (e.g., Harry Warner and Mrs. David Sarnoff); how companies put politicians and executives on "preferred lists" for stocks at low prices before public offerings; and high salaries (e.g., $1.2 million to the chairman of National City Bank) and interest free loans.

The committee's 400-page report formed the basis for the securities laws. As a result, within months after the election, FDR's advisors drafted legislation to regulate both new issues and stock exchanges On the eve of the introduction of the bill that became the Securities Act of 1933, President Roosevelt sent a message to Congress that was annexed to a bill that dealt only with new issues: "[P]ut the burden of telling the whole truth on the seller."⁷ Congress agreed and passed the bill that separated new issues from a bill regulating stock exchanges, which later became the Securities Exchange Act of 1934.

The first draft of the new-issue legislation allowed the government to judge the merits of new issues. There was much opposition and Professor (later Justice) Felix Frankfurter, Jim Landis, Ben Cohen, and Tommy ("the Cork") Corcoran were brought in to fix the draft. They proposed a British model: full disclosure by the issuer, not a review by the government/regulators of the merits of a proposed offering. The Securities Act of 1933 passed in two months. The 1933 Act was not popular. Some said it was too weak, others said it was too strong and would hold back the economy.

Because of political considerations, Congress agreed on concurrent federal and state jurisdiction.⁸ This will become important later in this Handbook. The second step in the federal regulatory scheme was the Securities Exchange Act of 1934, and it was far more politically ambitious than the 1933 Act.

Predecessors of the Federal Securities Laws: State "Blue Sky" Laws

State securities laws existed prior to the federal securities laws of the 1930s. "Blue sky laws" are state laws that were originally designed to prevent "speculative schemes that have no more basis than so many feet of 'blue sky' over Kansas." The first blue sky law was enacted in Kansas in 1911. It regulated the offering of securities, required the licensing of brokers and dealers, and prohibited misinformation. There are many different accounts as to where the term "blue sky" came from; one was that rainmakers promised farmers rain, but after taking their money, delivered only "blue skies." Blue sky laws have largely been replaced by the Uniform Securities Act of 1956 (amended in 1985 and 2002) that has been adopted in one form or another by forty-one jurisdictions, one of which is not New York.⁹

Nature of the Securities Markets

Most securities markets are places in which securities are bought and sold and provide issuers with access to capital and liquidity and investors with a ready market for selling their securities or buying additional securities.

1. Primary Markets. In these markets, issuers can raise capital by selling registered securities in public markets or through unregistered private placements. They provide fora in which buyers and sellers can easily find sellers and purchasers, and learn about other transactions that might inform their buying and selling decisions. From a company's early seeding, to investing by an "angel," to venture capital, investing is usually carried out directly between the issuer and the investor. However, once an issuer has equity securities trading on a public market, it is rare for issuers to sell equity securities directly to end purchasers. Rather, investment banks facilitate the process by working with the issuer to provide information and by purchasing equity securities for resale to their customers and others.

a. Initial Public Offerings (IPOs). These are used by firms distributing equity capital via a registered offering for the first time. However, many IPOs involve sales of securities by selling shareholders so the issuer does not actually "raise capital." This is sometimes referred to as a "traditional" or underwritten IPO.¹⁰ Once the SEC has declared the relevant registration statement effective, the equity securities are typically purchased by underwriters who take the risk of being able to resell them to customers. However, the risk is largely theoretical, given the way IPOs are priced and distributed.
b. Private Placements. These are direct sales of unregistered equity securities to sophisticated purchasers. They do not take place on or through exchanges but instead are privately negotiated and may or may not include a financial intermediary.

2. Secondary Markets. (Trading Transactions) These transactions are not between the issuer and the investor but are between traders who buy or sell to other investors either in the public market or in private transactions. The transactions typically take place on exchanges, which are becoming increasingly reliant on technology to execute trades.¹¹ The exchange floor is where floor brokers negotiate certain trades, although exchange floors and brokers are becoming increasingly rare. For example, there are far more electronic stock exchanges in New Jersey than there are in New York City. The NASDAQ market, a combination of three markets, is a good example of an exchange that is entirely an electronic network in which most transactions are consummated using desktop computers.¹² Today, Alternate Trading Systems have replaced the market-making intermediary and use computers to link sellers and purchasers by matching bids and asks.
3. Functions of Securities Markets.

a. Capital Formation. This occurs when issuers sell securities to raise capital.
b. Liquidity. This exists when investors are able readily to sell securities in a public market.
c. Risk Management. The essence of an investment decision by an investor is to compare the value of money today with its expected value sometime in the future in order to decide whether a particular investment (or sale) is worthwhile. One of the goals and benefits of the securities registration system is to make sure that investors have at least some of the information they need to make a wise investment decision. That is why our securities laws mandate certain disclosures and prohibit deception and fraud through omission or commission.

4. Participants in the Securities Markets.

a. Individual investors;
b. Institutional investors;
c. Issuers (businesses, governments, agencies, not-for-profit organizations, mutual funds, others), including those who securitize pooled obligations that are packaged and sold; and
d. Broker-dealers, investment companies, commercial banks, accounting firms that prepare and vouch for the accuracy of issuer financial statements, lawyers, and others.

5. Operation of the Markets.

a. Infor

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