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Overview
The Regulatory Framework section of the SIE Exam tests your knowledge of the agencies, laws, and rules that govern the U.S. securities industry. You must understand who regulates what, the landmark legislation that created the modern framework, and the specific rules that govern broker-dealer conduct, customer accounts, and market integrity. This is one of the most heavily tested areas on the SIE, requiring both conceptual understanding and precise factual recall.
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Key Regulators & Their Roles
Summary
The U.S. securities industry operates under a layered regulatory structure involving federal agencies, self-regulatory organizations (SROs), and state regulators. Understanding each regulator's scope and authority — and how they relate to one another — is essential.
Primary Regulators
| Regulator | Type | Primary Function |
|---|---|---|
| SEC | Federal Agency | Enforces federal securities laws; primary investor protection authority |
| FINRA | SRO (under SEC) | Regulates broker-dealers and registered representatives |
| CFTC | Federal Agency | Regulates futures contracts and commodity derivatives |
| MSRB | SRO | Creates rules for municipal securities; no enforcement power |
| Federal Reserve Board (FRB) | Federal Agency | Sets monetary policy; regulates margin under Regulation T |
| DTCC/NSCC/DTC | Clearing/Settlement | Clears and settles most U.S. securities transactions |
Key Concepts
• The SEC is the apex regulator — all SROs operate under its oversight
• FINRA is not a government agency; it is a private SRO funded by member firms
• The MSRB writes the rules but relies on FINRA and bank regulators for enforcement
• The FRB's Regulation T sets the initial margin requirement at 50% for equity purchases
• Investment Adviser Registration Threshold:
- ≥ $110 million AUM → Register with the SEC
- < $110 million AUM → Register with state securities regulator
Key Terms
• Self-Regulatory Organization (SRO): A non-governmental organization that has the power to create and enforce industry regulations, subject to SEC oversight
• Regulation T: Federal Reserve rule governing the extension of credit by broker-dealers; sets initial margin at 50%
• Assets Under Management (AUM): Total market value of investments managed on behalf of clients
Watch Out For
> ⚠️ Common Pitfall: The MSRB creates rules but does NOT enforce them — this is a favorite trick question. FINRA enforces MSRB rules for broker-dealers; bank regulators enforce them for banks.
> ⚠️ Common Pitfall: Do not confuse the CFTC (futures/commodities) with the SEC (securities). Futures are regulated separately, though the jurisdictions can overlap with security-based swaps.
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Landmark Securities Legislation
Summary
Congress has passed a series of landmark laws that form the backbone of U.S. securities regulation. Each law was generally enacted in response to a specific market failure or crisis. Understanding the purpose, key provisions, and historical context of each law is critical.
The Core Legislative Framework
#### Securities Act of 1933 — "The Truth in Securities Law"
• Context: Enacted after the 1929 stock market crash
• Primary purpose: Regulates the primary market (new issuances)
• Key requirement: Issuers must register offerings with the SEC and provide a prospectus with full and fair disclosure
• Core principle: "Let the buyer have full information"
#### Securities Exchange Act of 1934 — "The Exchange Act"
• Context: Created to regulate ongoing market activity after 1933 Act addressed new issues
• Primary purpose: Regulates the secondary market (trading of existing securities)
• Key provisions:
- Created the SEC
- Required periodic reporting by public companies (10-K, 10-Q, 8-K)
- Regulated broker-dealers and exchanges
- Established Rule 10b-5 (anti-fraud)
- Prohibited insider trading
#### Investment Company Act of 1940
• Regulates the organization and activities of investment companies
• Covers mutual funds, closed-end funds, and ETFs
• Requires registration with the SEC and ongoing disclosure
#### Investment Advisers Act of 1940
• Requires investment advisers to register with the SEC or state regulators
• Imposes a fiduciary standard — advisers must act in the best interest of clients
• Applies to persons or firms compensated for advising others about securities
#### Securities Investor Protection Act of 1970 (SIPA)
• Created the Securities Investor Protection Corporation (SIPC)
• Protects customers if a broker-dealer becomes insolvent
• Coverage limits:
- Up to $500,000 per customer total
- Up to $250,000 for cash claims
• ⚠️ SIPC does NOT protect against investment losses — only broker-dealer insolvency
#### Bank Secrecy Act (BSA)
• Requires financial institutions (including broker-dealers) to detect and prevent money laundering
• Key requirements:
- File Currency Transaction Reports (CTRs) for cash transactions over $10,000
- File Suspicious Activity Reports (SARs)
#### Gramm-Leach-Bliley Act of 1999
• Repealed Glass-Steagall Act provisions separating commercial and investment banking
• Allowed banks, securities firms, and insurance companies to affiliate and cross-sell
#### Dodd-Frank Wall Street Reform Act of 2010
• Context: Response to the 2008 financial crisis
• Created the Consumer Financial Protection Bureau (CFPB)
• Increased systemic risk oversight
• Regulated OTC derivatives markets
• Established the Volcker Rule (restricts proprietary trading by banks)
Key Terms
• Primary Market: Market where new securities are first issued to the public
• Secondary Market: Market where previously issued securities are traded between investors
• Prospectus: A formal legal document providing details about a securities offering
• Fiduciary Standard: Legal obligation to act in the client's best interest
• SIPC: Non-profit membership corporation that protects customers of failed broker-dealers
• Glass-Steagall Act: 1933 law that separated commercial and investment banking (repealed in 1999)
• Volcker Rule: Provision of Dodd-Frank that restricts banks from proprietary trading
Watch Out For
> ⚠️ Common Pitfall: SIPC ≠ insurance against market losses. SIPC only protects against the failure of a broker-dealer firm, not against a bad investment declining in value.
> ⚠️ Common Pitfall: The 1933 Act covers primary markets (new issues); the 1934 Act covers secondary markets (trading). Students frequently mix these up.
> ⚠️ Common Pitfall: Gramm-Leach-Bliley repealed Glass-Steagall — know the direction of this change and which law came first.
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SRO Rules & FINRA Regulations
Summary
FINRA is the primary SRO for broker-dealers. Its rules govern everything from how accounts are opened to how recommendations are made and how disputes are resolved. Understanding the standards of conduct — particularly suitability vs. Reg BI — is essential.
Standards of Conduct
#### Suitability Rule (FINRA Rule 2111)
• Applies to all customers
• Requires a reasonable basis to believe a recommendation is suitable based on the customer's:
- Financial situation and needs
- Investment objectives
- Risk tolerance
- Tax status
- Time horizon
• Three components:
1. Reasonable-basis suitability — suitable for at least some investors
2. Customer-specific suitability — suitable for this particular customer
3. Quantitative suitability — overall series of recommendations is not excessive
#### Regulation Best Interest (Reg BI)
• Applies specifically to retail customers
• Requires broker-dealers to act in the best interest of the customer
• Higher standard than suitability — must place customer interests above the firm's own
• Requires disclosure of conflicts of interest
• Key difference from suitability: Reg BI requires prioritizing customer interests, not just finding a reasonable match
#### Know Your Customer (KYC) Rule
• Requires reasonable diligence to learn essential facts about each customer
• Goes beyond account opening — ongoing obligation throughout the relationship
• Foundation for both suitability and Reg BI compliance
Prohibited Practices
| Practice | Definition |
|---|---|
| Churning | Excessive trading primarily to generate commissions, disregarding customer objectives |
| Free-Riding | Buying securities and selling before paying, using proceeds to fund the purchase |
| Front-Running | Trading in your own account ahead of a known pending customer order |
Additional FINRA Rules
• Elder Financial Exploitation: Broker-dealers may place a temporary hold on disbursements from senior/vulnerable adult accounts if exploitation is suspected; must notify trusted contact person
• Arbitration: FINRA operates the largest securities dispute resolution forum in the U.S.; provides arbitration and mediation between investors and broker-dealers or between industry parties
Key Terms
• Suitability: Standard requiring recommendations to be appropriate based on customer profile
• Regulation Best Interest (Reg BI): SEC rule requiring broker-dealers to act in retail customers' best interest
• Churning: Excessive, unsuitable trading to generate commissions — a fraudulent practice
• Free-Riding: Using sale proceeds to pay for the original purchase (prohibited under Reg T)
• Trusted Contact Person: Individual a broker-dealer may contact regarding concerns about a customer's welfare
Watch Out For
> ⚠️ Common Pitfall: Reg BI > Suitability. Reg BI is a higher standard. A recommendation can be "suitable" but still violate Reg BI if the broker chose it to earn a higher commission when a comparable, cheaper option existed.
> ⚠️ Common Pitfall: Free-riding is a violation even if the customer ultimately profits. The rule is about the mechanics of payment, not the outcome.
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Anti-Fraud & Market Integrity Rules
Summary
The securities laws contain broad anti-fraud provisions designed to maintain market integrity. These rules prohibit deception, manipulation, and trading on unfair informational advantages. Understanding the specific definitions and examples of prohibited conduct is critical.
Core Anti-Fraud Provisions
#### Rule 10b-5 (SEC)
The broadest anti-fraud rule in securities law. Prohibits:
• Employing any device, scheme, or artifice to defraud
• Making material misstatements or omissions
• Engaging in any act that operates as a fraud or deceit
• Applies to the purchase or sale of any security
#### Insider Trading
• Buying or selling a security based on material, non-public information (MNPI) in breach of a duty
• Primarily prohibited under Section 10(b) and Rule 10b-5
• Material: Information that a reasonable investor would consider important to their decision
• Non-public: Not yet disseminated to the general investing public
• Liability extends to tippees who trade on MNPI received from an insider
Market Manipulation Prohibited Practices
| Practice | Description |
|---|---|
| Painting the Tape | Executing wash trades to create a false appearance of active trading volume |
| Spoofing | Placing large orders with no intention of executing them to create false supply/demand signals, then canceling |
| Wash Trading | Simultaneously buying and selling the same security to generate misleading activity |
| Pump and Dump | Artificially inflating a stock's price through false statements, then selling at the inflated price |
Ponzi Schemes
• Returns to early investors are paid using new investors' money, not legitimate profits
• SEC response typically includes:
- Emergency court orders
- Asset freezes
- Appointment of a receiver
- Disgorgement of ill-gotten gains
Key Terms
• Rule 10b-5: The SEC's primary anti-fraud rule under the Securities Exchange Act of 1934
• Material Non-Public Information (MNPI): Significant information about a company that has not been publicly disclosed
• Front-Running: Trading ahead of a known customer order
• Spoofing: Placing and canceling orders to manipulate prices
• Wash Trade: Simultaneously buying and selling the same security to create false volume
• Pump and Dump: Inflating a stock price artificially, then selling at the peak
Watch Out For
> ⚠️ Common Pitfall: Insider trading doesn't require being a company employee — a tippee (someone who receives a tip from an insider) can also be liable if they trade on MNPI.
> ⚠️ Common Pitfall: Spoofing involves orders that are never intended to execute — the intent to cancel is the key element that makes it manipulative.
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Customer Account & Compliance Rules
Summary
Broker-dealers have extensive obligations when opening and maintaining customer accounts, including identity verification, anti-money laundering (AML) compliance, and privacy protections. These rules create a compliance framework designed to prevent fraud, money laundering, and terrorist financing.
Account Opening Requirements
Required Information (FINRA Rules):
• Full legal name and address
• Date of birth
• Social Security Number or Tax ID
• Employment status and employer name
• Annual income and net worth
• Investment objectives
• Risk tolerance
USA PATRIOT Act — Customer Identification Program (CIP):
• Requires broker-dealers to verify the identity of all new customers
• Purpose: Prevent money laundering and terrorist financing
• Minimum verification: name, date of birth, address, and identification number
Anti-Money Laundering (AML) Requirements
#### Currency Transaction Reports (CTRs)
• Must be filed with FinCEN (Financial Crimes Enforcement Network)
• Required for any cash transaction exceeding $10,000 in a single business day
• No exceptions for "regular" or "known" customers — filing is mandatory
#### Suspicious Activity Reports (SARs)
• Filed when a transaction may involve money laundering, fraud, or other illegal activity
• CRITICAL RULE: The subject of the SAR must NOT be notified of the filing
• Filed with FinCEN; strictly confidential
#### Structuring (Smurfing)
• Illegal practice of breaking up cash transactions into smaller amounts to avoid CTR requirements
• Illegal even if the underlying funds are legitimate
• A SAR must be filed if structuring is suspected
Privacy & Settlement Rules
#### Regulation SP (Privacy Rule)
• Requires broker-dealers to provide customers with a privacy notice explaining:
- What personal financial information is collected
- How it is used
- Whether it is shared with third parties
• Customers may have the right to opt out of certain information sharing
#### Settlement Cycle (T+1)
• As of May 28, 2024, the standard settlement cycle is T+1 (trade date + 1 business day)
• Shortened from previous T+2 standard
• Applies to most equity and corporate bond transactions
Regulation D — Private Placements
• Provides safe harbor exemptions from SEC registration
• Allows capital raising through private placements
• Sales permitted to:
- Accredited investors (no limit on number)
- A limited number of sophisticated non-accredited investors
• No public advertising in most Reg D offerings
Key Terms
• Customer Identification Program (CIP): Mandatory program to verify the identity of new customers under the USA PATRIOT Act
• FinCEN: Financial Crimes Enforcement Network; the U.S. bureau that collects CTRs and SARs
• Currency Transaction Report (CTR): Required filing for cash transactions over $10,000
• Suspicious Activity Report (SAR): Confidential filing for suspected illegal activity; subject must not be notified
• Structuring: Illegally breaking up transactions to avoid CTR thresholds
• T+1: Current standard settlement cycle (trade date + 1 business day)
• Regulation D: SEC rule providing registration exemptions for private placements
• Accredited Investor: Investor meeting SEC wealth/income thresholds, eligible for certain private offerings
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