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#13103 - Regulation Of Markets And Brokers - Securities Regulations (Duke Cox)

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  1. The current market structure is dispersed and complex: (1) trading volume is dispersed among highly automated trading centers that compete for order flow in the same stocks; and (2) trading centers offer a wide range of services that are designed to attract different types of market participants with varying trading needs

  2. Can we say we have one stock market? No; there are lots of markets

    1. In one market, there would be more competition between buyers and sellers everyone would be in the same room

  3. Central Order Book (COB)

    1. So if you have IBM, all the shares have to go into one computer network

    2. Proposed system allows for greater transparency

      1. And reduces the spread more competition between buyers/sellers

    3. But maybe buyers/sellers don’t just want the best price maybe they want other things, like service, anonymity

  4. Dark pool: allows for discrete/anonymous trading

    1. So that large investors’ trading activity will not impact the share price

  5. Trade-through rule

    1. If you have a sell order or buyer order, you have to expose the order

      1. The rule prohibits an incoming market order from ignoring (trading through) a better quote in market A to trade with a poorer quote in market B

      2. There is one computer linkup for all these markets

      3. Before the broker moves to market A, it has to expose the order for a very short period of time to see if another market picks it up

  6. Electronic trading benefits investors in increasing the speed and lowering the cost of trading while at the same time creating a complete audit trail that facilitates monitoring brokers

  7. Consolidated audit trail

    1. Electronic trail of the trades

      1. So SEC can come in after the fact to assess whether the trade-through rule was complied with

  8. Payment order flow

    1. If the broker sends the order to market x, market x will send the broker a kickback

  9. Unlisted securities trade in a number of markets today, all of which are electronic. The OTC Bulletin Board, operated by FINRA, emerged as a trading site for smaller issuers, but since 1999 the OTCBB has been limited to reporting companies under the ’34 Act, which made it less attractive to issuers unwilling to take on those responsibilities

    1. The major platforms for electronic “pink sheet” trading today are operated by OTC Market Groups

  10. Difference between a broker and a dealer

    1. Broker acts only as an agent

    2. Dealer actually buys

      1. So dealers want disjointed markets/lack of transparency keep the spread large, and allow for bigger profits

        1. Because the more transparency/competition, the smaller the spread less profit

  1. Much of the day-to-day work of regulating the broker-dealer industry is done by FINRA, the industry’s “self-regulator”

  2. EA §15(a): no person may act as a broker or a dealer in securities unless registered with the SEC or expressly exempted from the registration requirement must also join FINRA

    1. 3(a)(4): Broker is a person engaged in the business of effecting transactions in securities for the account of others

    2. 3(a)(5): Dealer is a person engaged in the business of buying and selling securities for his own account

    3. “In the business” = generally, engage in the activity on a regular basis and typically in a fairly public fashion

      1. Website & frequency of contracting market maker

    4. Problem 18-1: dealer; public=website + contact market maker

    5. Problem 18-2: broker: public

    6. 18-3: yes, broker-dealer

  3. 15(b)(1): the SEC may deny (or subsequently revoke) a registration based on evidence of misconduct or false statements to the Commission

  4. The SEC has authority with respect to setting standard for both the conduct of broker-dealers and discipline

  5. Issuer can create a bulletin board for its own shares (to enhance liquidity) without being a broker

    1. But they can’t receive money for it

  6. Duty to supervise

    1. Broker-dealer duty: 15(b)(4)(E)

      1. Duty to supervise subordinates to prevent them from engaging in securities violation

    2. 15(b)(6)(A)

  7. “Once a person in Feuerstein’s position becomes involved in formulating management’s response to the problem, he is obligated to take affirmative steps to ensure that appropriate action is taken to address the misconduct”

    1. Once lawyer is brought in, he needs to take affirmative steps to prevent a recurrence

      1. Has to exercise ongoing obligations to ensure future compliance

    2. Once such a person has supervisory obligation by virtue of the circumstances of a particular situation, he must either discharge those responsibilities or know that others are taking appropriate action

  8. SRO “just and equitable” conduct rules

  1. Best execution

    1. The virtue of a “centralized” system is that an order will come together with all others, so that the resulting market price will reflect the full range of supply and demand

    2. A broker has a fiduciary-like duty to seek “best execution” for the customer

      1. Best execution refers to traders receiving the most favorable terms available for their trades

      2. Best execution does not connote a single execution attribute, such as a price, but rather attaches to a vector of execution components

        1. Moreover, when markets compete in different ways with respect to different components of trade executions, it is no longer clear what “best” execution is, let alone how or when it is attained

    3. The broker-dealer, absent instructions to the contrary, is expected to use reasonable efforts to maximize the economic benefit to the client in the transaction. That means “the best reasonably available price.”

    4. Broker has obligation to expose the order, and to constantly be thinking, “Can I get a better price somewhere else?”

    5. 202(a)(11) of Investment Advisers Act

      1. Investment adviser definition

        1. Is investment advice incidental to legal service?

          1. If yes, not investment adviser

      2. Must be compensated

      3. Investment advice can’t be generic as to resource allocation

      4. So your broker may be an investment adviser

        1. The duties/obligations we impose on investment advisers may be greater or less than those imposed on brokers

    6. A broker can sell to you shares they have in inventory

      1. Can act as principal

      2. An investment adviser can’t do that

    7. Broker doesn’t have to disclose kickbacks

      1. But investment adviser does

    8. Broker has best execution rules investment adviser doesn’t

  2. Know your security

    1. Do we know what the law is?

      1. In terms of private party rights, this is a black box

        1. All of this legal uncertainty hardly gives customers much notice of precisely how their brokers are expected by law to behave

    2. If the broker has a duty, what is the source of that duty?

      1. Fiduciary relationship? Shingle theory? Fraud?

      2. Absent a recommendation (absent the broker doing something), the customer is not likely to have a cause of action

      3. Shingle theory

        1. When you put our your shingle as a broker, you impliedly represent that you’ll treat people fairly

        2. FINRA: “fair, just equitable”

        3. So you’re representing that you’ll treat me fairly, justly, equitably

      4. Fiduciary relationship

        1. If client is depending on broker

        2. Facts may determine fiduciary relationship

          1. The more pathetic the client, the better

      5. Misstatement/omission

    3. Brokers and salesman are under a duty to investigate, and their violation of that duty brings them within the term “willful” in the Exchange Act. Thus, a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendations made therein. The fact that his customers may be sophisticated and knowledgeable does not warrant a less stringent standard

      1. A securities dealer occupies a special relationship to a buyer of securities in that by his position he implicitly represents he has an adequate basis for the opinions he renders

        1. He cannot recommend a security unless there is an adequate and reasonable basis for such recommendation. He must disclose facts which he knows and those which are reasonably ascertainable. By his recommendation he implies that a reasonable investigation has been made and that his recommendation rests on the conclusions based on such investigation. Where the salesman lacks essential information about a security, he should disclose this as well as the risks which arise from his lack of information

          1. A salesman may not rely blindly upon the issuer for information concerning a company, although the degree of independent investigation which must be made by a securities dealer will vary in each case. Securities issued by smaller companies of recent origin obviously require more thorough investigation

            1. The duty of investigation is a continuing one, with a special obligation to monitor management projections to see if they indeed pan out

          2. If you’re making a recommendation, then your duty as a broker is to have a reasonable basis for that recommendation

    4. The market for low-priced securities, so-called penny or microcap stocks, is fertile ground for misrepresentations and omissions by brokers using boiler room tactics

  3. The problem with analysis

    1. Implicit in the “know your security” rule is the idea that customers are entitled to trust their brokers to make carefully researched, objective recommendations

    2. New set of rules:

      1. Prohibit analysts from issuing “booster shot” research that supplements or reiterates a buy recommendation around the expiration of a lock-up on insider selling as part of a public offering

      2. Bar analyst participation in “pitch meeting” designed to solicit...

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Securities Regulations (Duke Cox)