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Chapter 1
Regulation
Securities and the Public Interest
A law-making body such as Congress or a state legislature has the constitutional authority to regulate commerce in the public interest. That includes the regulation of securities, securities markets, and securities transactions. The law-making body:
- Formulates regulatory objectives and approves securities laws;
- Creates a securities-regulation agency;
- Assigns responsibility and delegates authority to that agency as the primary administrator of securities laws;
- Provides financial and legal support for the agency's continuing operations; and
- Monitors the agency's administration of securities laws.
Securities laws are codified as amended in the government's general and permanent laws, which are available to the public in printed form and from government and private-sector Web sites.
In addition to delegating institutional authority to the securities-regulation agency, the law provides a structure by which that entity is governed by natural persons appointed for fixed terms of office. Appointees and persons employed by the securities regulator are prohibited from engaging in any business and prohibited from participating in some securities-related activities regulated by the agency.
The securities-regulation agency establishes regulations for the purpose of administering the securities law. These regulations are codified as amended in the government's regulations, which are available to the public in printed form and from government and private-sector Web sites.
The agency enforces regulations:
- Directly;
- Through one or more self-regulatory organizations;
- Through the courts; and
- By cooperation with other government agencies and departments, domestic and foreign, which administer securities laws and nonsecurities laws.
The structure of laws, regulations established by the securities-regulation agency, and rules established by self-regulatory organizations is shown in Exhibit 1.1.
Securities, markets, and transactions are part of a private-sector process called capital formation. Capital formation results in investments that are essential for economic growth. The current income and accumulated wealth produced by a growing economy increase the standard of living for a country's population. Income and wealth are taxed to pay the expense of government. There is a public interest in the cost efficiency and effectiveness of capital formation.
There also is a public interest in government-securities markets: public primary markets in which governments sell debt securities and public secondary markets in which these securities are bought and sold prior to maturity. The ability of governments to borrow money and the cost of borrowing are affected by the efficiency and effectiveness of these markets.
Government regulation is a political response to the real or perceived failures of markets to serve the public interest. Regulation also may be used to promote or protect special interests by means that are not compatible with efficient capital formation. All politics are local, but capital formation is national and international.
Effective regulation in the public interest requires:
- Law-making and regulation-making processes that are efficient and open to public participation;
- Efficient administration of the securities-regulation agency;
- Access to the courts for entities and natural persons affected adversely by questionable laws and regulations; and
- A competent and independent judiciary.
There is a cost for the regulation of securities, markets, and transactions. Most of that cost is for information-processing systems and the salaries and related expenses for people. Some people are employed by government to formulate and administer laws and regulations. Others are employed by private-sector entities, such as broker-dealers and the issuers of securities, to ensure compliance with laws and regulations. In addition, significant costs are incurred by the private sector for the services of attorneys and public accountants because these services are required, directly or indirectly, by the law. Ultimately, these costs are paid by the owners of securities. High costs are a barrier to effective capital formation.
[Notes 1–4]
Meaning of “Security”
The authority of a law is based on definitions and descriptions of what is or is not within the purpose or scope of that law. The scope of a securities law is established in part by the law's definition of the word “security.” The law regulates financial assets, which are defined as securities, but the law does not apply to financial and other assets not defined as securities. The law also defines or describes securities transactions that may or may not be regulated.
A security is what the law defines a security to be. Definitions of “security” are established and amended by the law-making bodies. These definitions are interpreted by the securities-regulation agency and by the courts. Definitions are added and amended from time to time, and interpretations evolve as new forms of securities, markets, and transactions are created by competition and innovation.
Securities laws usually define a security descriptively as a bond, note, stock, or an option. Descriptive definitions use all-purpose words, such as “evidence of indebtedness,” to describe the general form of a security. Descriptive definitions have two weaknesses:
1. They do not identify the essential qualities of a security.
2. They require ever more specific definitions of “bond,” “note,” “stock,” and “option” as new forms of securities are created.
The use of descriptive and all-purpose words to define a security and to establish the scope of a securities law is a practical approach to regulation. In some situations, however, these words are not adequate and the meaning of the law must be interpreted by the courts. For more than 60 years, the courts have used the concept of an investment contract as the test of whether a specific bond, or note, or stock is regulated by the law.
Generally, an investment contract exists when:
An entity or a natural person commits money or other value
To provide capital for a common enterprise
With an expectation of receiving profits
From the efforts of others.
The profits from an investment contract include but are not limited to:
- Money paid by an issuer as interest to the owners of its debt securities;
- Money paid by an issuer as dividends to the owners of its equity securities;
- Money representing an increase in the value of a security realized when the owner sells the security to the issuer or a third party; and
- Money representing an increase in the value of a debt security realized by the owner when the security's maturity amount is paid by the issuer.
An investment contract that is a bond, note, or stock is usually a security regulated by the securities law.
[Notes 5–9]
Debt, Equity, and Option Securities
Most securities can be categorized as debt, equity, or option; however, some debt securities are convertible into equity securities, some equity securities have debtlike characteristics, and options may grant the right to buy or to sell a debt security or an equity security.
The property rights of debt, equity, and option securities may be transferred from one owner to another owner by the sale of these securities in private-market or public-market transactions.
Debt Securities
A debt security called a bond or a note is an obligation to pay money. The terms and conditions of a debt security are authorized by the constitutional documents of the entity that issues the security and described by an indenture document prepared by the issuer. The money received by the issuer from the sale of a debt security is time-limited capital for the issuer. The owners of a debt security are creditors of the entity that issued the security. The market value of a debt security, which may fluctuate, is determined by the issuer's obligations to make money payments in the future.
The issuer of a debt security:
- Is obligated to pay the maturity-value amount of the security to the current owners no later than the security's maturity date, and
- May be obligated to pay fixed or variable amounts of interest periodically to the current owners.
The payments required by a debt security are usually general obligations of the issuer; however, the payment obligations of some bonds and notes may be secured by specific property of the issuer or may be guaranteed by an entity other than the issuer.
The rights of debt-security owners are created by the issuer. The rights of one debt security may be subordinated to the rights of other debt securities issued by the same entity.
Equity Securities
An equity security called a stock or the shares of a stock is a right to participate in the income from property and the distribution of property. The terms and conditions of an equity security are authorized by the constitutional documents of the entity that issues the security and described by an offering document prepared by the issuer. The money received by the issuer from the sale of an equity security is permanent capital for the issuer. The owners of an equity security are owners of the entity that issued the security. The market value of an equity security, which may fluctuate, is determined by expectations of the issuer's profitability in the future.
The issuer of an equity security:
- If common stock, is not obligated to pay money dividends to the current owners of the stock. Common stock has no maturity date or maturity value, and the issuer has no obligation to buy the security from the owners.
- If preferred stock, usually is obligated to pay money dividends periodically to the current owners of the stock. Some preferred-stock issues are convertible into common stock. Preferred stock has no maturity date or maturity value, and the issuer may or may not have an obligation to buy the security from the owners. A preferred stock is a claim to the assets of the issuer that ranks higher than the claim of common stock but lower than the claim of any class of debt security.
The voting rights of equity-security owners are created by the issuer. The voting rights of one class of equity security may be different from the voting rights of other classes issued by the same entity.
Option Securities
An option is a “call” or a “put.” Every option has one issuer and one owner. The owner of a call option has the right (but no obligation), after paying the option price, to buy an amount of a given security from the call issuer at a fixed price before or on the option's expiration date. If and when the owner exercises the option, the issuer of that option has an obligation to sell the agreed amount of the security to the option owner at the agreed fixed price.
The owner of a put option has the right (but no obligation), after paying the option price, to sell an amount of a given security to the put issuer at a fixed price before or on the option's expiration date. If and when the owner exercises the option, the issuer of that option has an obligation to buy the agreed amount of the security from the option owner at the agreed fixed price.
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