Laws and Regulations in Global Financial Markets

R. Girasa

• Publisher: Palgrave Macmillan
• Year: 2013
• Print ISBN:
  9781137346520
• eBook ISBN:
  9781137345462
• Topic: Business
• Subtopic: Contabilità
• Index: Business

The major financial scandals of the past decade, which have been discussed exhaustively in corporate offices by corporate attorneys, and in accounting firms, have led to the passage of massive Congressional enactments in the United States that impact the world of finance. The enactment of the Sarbanes-Oxley Act in 2002, with its significant provisions of 20-year imprisonment for certain offenses, and the conviction of Enron's CEO and other senior executives, finally caught the attention of corporate executives. Laws and Regulations in Global Financial Markets presents students, researchers, and practitioners with an in-depth global analysis of the legal and regulative aspects of corporate financial markets. Readers are introduced to international developments concerning rules and regulations impacting investment advisers and broker-dealers, bankruptcy law, important legal changes influencing banks and credit ratings organizations, real estate regulations, and insurance law. The book concludes with a discussion of personal finance, financial literacy, and federal statutes centered around the subject matter.

CHAPTER 1

Investment Adviser Regulation

Introduction

In an article in the April/May 2012 issue of AARP: The Magazine—a magazine for retired and older adults—the author, an investment adviser, reviewed the investment portfolio of a 90-year-old woman. She had been sold two expensive annuities, and the rest of her portfolio consisted of high-risk stock funds and junk bond funds. Her previous financial planner had received significant commissions by advising her to invest in totally inappropriate securities. The author noted that commissions can range from 1 percent (for the sale of some kinds of mutual funds) to up to 10 percent (for the sale of an annuity).¹ Clearly, the client, who relied on the integrity of the financial adviser, was misled by his negligent and possibly fraudulent advice concerning financial products that few clients understand.

With the increasing complexity of financial instruments available for investors, most people, including those with above-average intelligence, lack either the time to investigate or an understanding about which investment vehicles are best suited for their particular needs and circumstances. Thus, they often retain the services of investment advisers to assist them. Although most persons holding themselves in such capacity are forthright and honest in their dealings with clients and potential investors, abuses uncovered during the Great Depression of the 1930s led to the passage of the Investment Company Act of 1940 and the Investment Advisers Act of 1940. These acts, as amended, have served well for decades since their passage through the promulgation and enforcement of rules and regulations of the Securities and Exchange Commission (SEC), self-regulatory organizations (SROs), and state regulators. Nevertheless, the significant market disruptions of 2007–2009 and the events preceding them resulted in the perceived need for regulatory reform. Extensive congressional hearings led to the passage of the Dodd–Frank Act of 2010, which, when combined with the Sarbanes–Oxley Act, has significantly altered the landscape wherein investment decisions are determined. Title IX of Dodd–Frank and SEC rules promulgated pursuant to the act of 1940 as amended will be discussed hereafter in connection with investment advisers.

As of early July, 2012, there were approximately 10,500 advisers registered with the SEC managing over US$38 trillion for some 14 million individual and institutional clients. There were over 275,000 investment adviser representatives in the 50 states and over 15,000 state-registered investment advisers. Seventy-five percent of SEC-registered financial advisers manage portfolios of small businesses and individuals; 91.2 percent of the assets under management are in discretionary accounts.²

Statutory Authority

There are two major statutes that affect investment advisers: the Investment Company Act of 1940 (“Company Act”)³ and the Investment Advisers Act of 1940 (“Advisers Act”).⁴ The Company Act regulates investment companies such as mutual funds in order to protect the public and, specifically, investors in the said companies. The Advisers Act regulates the roles of investment advisers with respect to both funds and investors. Both statutes provide for detailed registration requirements and disclosures of data and for SEC supervision as well as exemptions. Our major concern in this chapter is with investment advisers and their regulation.

Definition of “Investment Adviser”

§202(11) of the Advisers Act gives a lengthy definition of “investment adviser.” She, he, or it is defined as “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”

Generally, a person is deemed to be an “investment adviser” if such person:

• Provides advice, or issues reports or analyses, regarding securities;

• Is in the business of providing such services; and

• Provides such services for compensation.⁵

An investment adviser, in essence, is an individual or a firm involved in the business of giving advice concerning securities to clients regarding stocks, bonds, mutual funds, pension planning, insurance, exchange-traded funds, and other investment vehicles. The advice may be given directly, through publications or writings, as part of the person’s business, and/or as issues analyses or reports concerning securities. The advisers may also manage portfolios of pooled investment vehicles such as hedge funds, pension funds, and registered investment companies.

Exclusions

Exclusions from the definition of “investment adviser” are the following:

• A bank or bank-holding company, unless it serves or acts as an investment adviser to a registered investment company and provided it is performed in a separate department or division of the bank.

• An attorney, accountant, broker, engineer, or teacher dealer whose advice is incidental to their services in such capacity.

• A broker or dealer whose performance of such services is solely incidental to services performed and who receives no special compensation for advisory services.

• The publisher of a newspaper or news magazine, or of a business or financial publication of general or regular circulation.

• A person whose advice, analyses, or reports refer solely to obligations guaranteed by the United States or by certain US government–sponsored corporations designated by the Secretary of the Treasury, for example, FNMA (Federal National Mortgage Association or “Fannie Mae”) and GNMA (Government National Mortgage Association or “Ginnie Mae”).

• Any nationally recognized statistical rating organization unless such organization engages in making recommendations concerning the sale, purchase, or holding of securities on behalf of other persons.

• A family office.

• Such person designated by the SEC.

In the following case, the US Supreme Court discusses the exclusion of “The publisher of a newspaper or news magazine, or business or financial publication of general or regular circulation.”

Lowe v. SEC 472 U.S. 181 (1985)

FACTS: Christopher Lowe was the president and principal shareholder of Lowe Management Corporation. From 1974 until 1981, the corporation was registered as an investment adviser under the Advisers Act. During that period, Lowe was convicted of misappropriating funds of an investment client, engaging in business as an investment adviser without filing a registration application with New York’s Department of Law, tampering with evidence to cover up fraud of an investment client, and stealing from a bank. Consequently, on May 11, 1981, the SEC, after a full hearing before an Administrative Law Judge, entered an order that revoked the registration of the Lowe Management Corporation, and ordered Lowe not to associate thereafter with any investment adviser.

Lowe also published “Lowe Investment and Financial Letter,” a semi-monthly newsletter, which contained a general commentary about the securities and bullion markets, reviews of market indicators and investment strategies, and specific recommendations for buying, selling, or holding stocks and bullion. It had subscribers varying from 3,000 to 19,000. It also advertised a “telephone hotline” with current information. There was no evidence of false or materially misleading information, unlawful trading activity, or that the prior criminal conviction had any relation to the publication.

The SEC sought to enjoin [stop or prevent] Lowe from publishing the newsletter. The U.S. District Court denied injunctive relief sought by the SEC concerning the publication but did enjoin Lowe from giving advice to subscribers by telephone, personalized letter, or in person. The court determined that the First Amendment protected the issuance of the publication. The Court of Appeals reversed the District Court’s decision holding that Lowe and others were in the business of investment advisers within the meaning of the Advisers Act, rejecting the First Amendment’s application to the facts at hand.

ISSUE: The question is whether petitioners may be permanently enjoined from publishing nonpersonalized investment advice and commentary in securities newsletters because they are not registered as “investment advisers” under §203(c) of the Investment Advisers Act of 1940 or whether the injunction is prohibited by the First Amendment of the U.S. Constitution?

DECISION (Stevens, J.): [The court did not address the First Amendment issue but instead concluded that the said publication fell within the statutory exclusion for bona fide publications and that Lowe and the other petitioners were not “investment advisers” as defined by the Advisers Act and, thus, could not be barred from future publications of their newsletters.]

REASONING: [The court recited the definition of “investment adviser” as stated in the act.] One of the statutory exclusions is for “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation.” Although neither the text of the Act nor its legislative history defines the precise scope of this exclusion, two points seem tolerably clear. Congress did not intend to exclude publications that are distributed by investment advisers as a normal part of the business of servicing their clients. The legislative history plainly demonstrates that Congress was primarily interested in regulating the business of rendering personalized investment advice, including publishing activities that are a normal incident thereto. On the other hand, Congress, plainly sensitive to First Amendment concerns, wanted to make clear that it did not seek to regulate the press through the licensing of nonpersonalized publishing activities.

Congress was undoubtedly aware of two major First Amendment cases that this Court decided before the enactment of the Act. The first, Near v. Minnesota ex rel. Olson, 283 U.S. 697 (1931), established that “liberty of the press, and of speech, is within the liberty safeguarded by the due process clause of the Fourteenth Amendment from invasion by state action ….” Almost seven years later, the Court decided Lovell v. City of Griffin, 303 U.S. 444 (1938), a case that was expressly noted by the Commission [SEC] during the Senate Subcommittee hearings. [The US Supreme Court struck down an ordinance prohibiting the distribution of literature within the city without a permit.]

The exclusion itself uses extremely broad language that encompasses any newspaper, business publication, or financial publication provided that two conditions are met. The publication must be “bona fide,” and it must be “of regular and general circulation.” Neither of these conditions is defined, but the two qualifications precisely differentiate “hit and run tipsters” and “touts” from genuine publishers. Presumably a “bona fide” publication would be genuine in the sense that it would contain disinterested commentary and analysis, as opposed to promotional material disseminated by a “tout.” Moreover, publications with a “general and regular” circulation would not include “people who send out bulletins from time to time on the advisability of buying and selling stocks,” or “hit and run tipsters.” Because the content of petitioners’ newsletters was completely disinterested, and because they were offered to the general public on a regular schedule, they are described by the plain language of the exclusion.

The language of the exclusion, read literally, seems to describe petitioners’ newsletters. Petitioners are “publishers of any bona fide newspaper, news magazine or business or financial publication.” The only modifier that might arguably disqualify the newsletters are the words “bona fide.” Notably, however, those words describe the publication, rather than the character of the publisher; hence Lowe’s unsavory history does not prevent his newsletters from being “bona fide.” In light of the legislative history, this phrase translates best to “genuine”; petitioners’ publications meet this definition: they are published by those engaged solely in the publishing business, and are not personal communications masquerading in the clothing of newspapers, news magazines, or financial publications. Moreover, there is no suggestion that they contained any false or misleading information, or that they were designed to tout any security in which petitioners had an interest. Further, petitioners’ publications are “of general and regular circulation.” Although the publications have not been “regular” in the sense of consistent circulation, the publications have been “regular” in the sense important to the securities market: there is no indication that they have been timed to specific market activity, or to events affecting or having the ability to affect the securities industry.

The dangers of fraud, deception, or overreaching that motivated the enactment of the statute are present in personalized communications, but are not replicated in publications that are advertised and sold in an open market. To the extent that the chart service contains factual information about past transactions and market trends, and the newsletters contain commentary on general market conditions, there can be no doubt about the protected character of the communications, a matter that concerned Congress when the exclusion was drafted. The content of the publications and the audience to which they are directed in this case reveal the specific limits of the exclusion. As long as the communications between petitioners and their subscribers remain entirely impersonal and do not develop into the kind of fiduciary, person-to-person relationships that were discussed at length in the legislative history of the Act and that are characteristic of investment adviser-client relationships, we believe the publications are, at least presumptively, within the exclusion, and thus not subject to registration under the Act.

Questions

(1) Does the First Amendment protect all publications under the Advisory Act?

(2) At what juncture, if any, does the SEC have the right to seek an injunction of a publication that would not be offensive to the First Amendment?

(3) Compare Zweig v. Hearst Corp., 594 F.2d 1261 (9th Cir. 1979).

Title IV of the Dodd–Frank Act, “Regulation of Advisers to Hedge Funds and Others” and cited as the “Private Fund Investment Advisers Registration Act of 2010,” removed the private adviser exemption, which was previously included under the Advisers Act. It also provided new exemptions under §203(b)(3) of the Advisers Act.⁶ They are as follows.

• Venture capital funds.

• Advisers with less than US$150 million in private fund assets under management in the United States.

• Foreign private advisers if such adviser (1) has no place of business within the United States; (2) has in total fewer than 15 clients and investors in the United States in private funds advised by the investment adviser; (3) has aggregate assets under management attributable to US clients and investors in private funds advised of less than US$25 million; and (4) neither holds itself out in general to the public in the United States as an investment adviser nor acts in such capacity to any investment company registered under the Investment Company Act or any business development company.

Registration Requirement

§203 of the Advisers Act makes it unlawful for any person who acts as an investment adviser to use the mails or any means in interstate commerce unless such person is registered with the SEC. The required registration form filed online is Form ADV: “Uniform Application for Investment Adviser Regi...

Table of contents

• Cover
• Title Page
• Copyright
• Contents
• List of Figures
• Table of Cases
• Preface
• Deciphering Citations
• List of acronyms
• 1. Investment Adviser Regulation
• 2. Broker-Dealers Regulation
• 3. Mergers and Acquisitions
• 4. Bankruptcy of Business Enterprises
• 5. Bank Regulation and Credit Rating Organizations
• 6. Real Estate Financial Regulations
• 7. Selected Topics in Insurance Regulation
• 8. Consumer Protection and Personal Finance
• Notes
• Index