13.3 Regulatory Bodies and Investment Legislation

Regulatory bodies and investment legislation form the backbone of the financial industry, ensuring fair practices and investor protection. From the SEC to FINRA, these entities create and enforce rules that shape how investments are made and managed. Their oversight impacts everything from securities offerings to trading strategies.

Key laws like the Securities Act and Dodd-Frank have transformed the investment landscape. They've increased transparency, tightened regulations, and influenced how firms operate. Understanding these rules is crucial for investors and professionals alike, as they dictate compliance requirements and create new opportunities in the market.

Investment industry regulation

Primary federal regulatory agencies

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• The Securities and Exchange Commission (SEC) enforces federal securities laws, proposes securities rules, and regulates the securities industry, stock and options exchanges, and other electronic securities markets in the US
• The Commodity Futures Trading Commission (CFTC) is an independent agency that regulates the US derivatives markets, including futures, swaps, and certain kinds of options
• These agencies work to protect investors, maintain fair and orderly functioning of securities markets, and facilitate capital formation

Other key regulatory bodies

• The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the US, overseeing more than 624,000 brokers and analyzing billions of daily market events
• State securities regulators protect retail investors within their state by regulating securities offerings and investment professionals, complementing the SEC's role
• Self-Regulatory Organizations (SROs) like the New York Stock Exchange (NYSE) and the National Association of Securities Dealers (NASD) create and enforce industry regulations and standards as non-governmental organizations

Investment legislation and impact

Key laws regulating securities offerings and disclosures

• The Securities Act of 1933 requires investors to receive financial and other significant information about securities offered for public sale and prohibits fraud in the sale of securities
• The Securities Exchange Act of 1934 created the SEC, giving it broad authority over the securities industry, and requires periodic reporting by companies with publicly traded securities
• The Sarbanes-Oxley Act of 2002 mandated strict reforms to improve financial disclosures from corporations and prevent accounting fraud, aiming to protect investors by enhancing the accuracy and reliability of corporate disclosures

Laws governing investment companies and advisers

• The Investment Company Act of 1940 regulates companies that primarily invest, reinvest, and trade in securities, and whose own securities are offered to the public, including mutual funds
• The Investment Advisers Act of 1940 requires investment advisers to register with the SEC and follow regulations designed to protect investors, including a fiduciary duty to act in clients' best interests
• The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 increased oversight of systemically important financial institutions, created the Consumer Financial Protection Bureau, and restricted certain risky trading activities in response to the Great Recession

Regulatory compliance in investment management

Role of compliance departments and Chief Compliance Officers (CCOs)

• Compliance departments ensure that investment management firms and their employees follow all applicable laws, regulations, and internal policies and procedures
• CCOs develop and implement comprehensive compliance programs, including policies, procedures, training, monitoring, and reporting
• Investment advisers must adopt and implement written policies and procedures reasonably designed to prevent violations of the Investment Advisers Act

Tailoring compliance programs to firm-specific risks

• Compliance programs should be customized to the specific risks and business practices of each investment management firm
• Factors to consider include the firm's size, investment strategies (long-only, hedge funds, private equity), client base (institutional, retail), and geographic reach (domestic, international)
• Regular compliance training ensures all employees understand their regulatory obligations and the firm's policies, fostering a culture of compliance

Monitoring and testing compliance

• Periodic reviews and audits identify potential violations, assess the effectiveness of the compliance program, and guide improvements
• Compliance monitoring and testing are essential for detecting and preventing regulatory breaches
• Examples of monitoring activities include reviewing employee trading activity, testing the accuracy of disclosures, and conducting mock regulatory examinations

Regulatory changes vs investment strategies

New opportunities and challenges

• Regulatory changes can create opportunities or challenges for certain investment strategies
  • The JOBS Act of 2012 facilitated the growth of alternative investments by easing restrictions on private placements and hedge fund advertising
  • Increased scrutiny of insider trading may discourage investment managers from pursuing strategies that rely on material non-public information
• New disclosure requirements, such as those related to ESG factors (carbon emissions, board diversity), may shift investment decisions towards responsible investing

Impact on market structure and trading strategies

• Regulations affecting market structure (tick sizes, order handling rules) can impact the efficiency and profitability of trading strategies, especially high-frequency or algorithmic trading
  • Tick size refers to the minimum price increment at which a security can be traded
  • Order handling rules govern how brokers must execute client orders, such as the "Order Protection Rule" that requires trades to be executed at the best available price
• Compliance costs related to new regulations may disproportionately affect smaller investment management firms, potentially leading to industry consolidation

Global considerations for cross-border strategies

• Investment managers must consider the implications of regulatory changes in multiple jurisdictions when pursuing cross-border transactions or investing in foreign securities
• Divergent regulations across countries can create compliance challenges and limit the feasibility of certain global investment strategies
• Examples of global regulatory considerations include the European Union's Markets in Financial Instruments Directive (MiFID) and the Foreign Account Tax Compliance Act (FATCA) in the US