Understanding the SEC

The U.S. Securities and Exchange Commission (SEC) is often referred to as the Watchdog of Wall Street, but it wouldn’t be too much of a stretch to think of it as the “Capital Markets Cop.” Two of the SEC’s main objectives are to protect investors and maintain fair, orderly and efficient markets, similar to a regular police force’s primary goals of protecting the public and maintaining law and order. The SEC also has a third key objective in its three-pronged mission – facilitating the capital formation that is necessary to sustain economic growth. These diverse goals necessitate the involvement of the SEC in many areas of the capital markets, as discussed below.

Why the SEC was created

The SEC was formed in 1934, when the U.S. economy was in the iron grip of the Great Depression that had been partly precipitated by the market crash of 1929. Federal regulation of the securities markets was not a burning topic in the free-wheeling days of the 1920s. While securities activity soared in the post-World War I period, proposed regulations aimed at financial disclosure and the prevention of stock fraud were neither actively pursued nor implemented. As an estimated 20 million U.S. investors flocked to the stock market during the “Roaring 20s,” the combination of an intensely speculative environment and little regulation resulted in rampant stock fraud.

The speculative frenzy ended with the stock market crash of October 1929, which took a tremendous toll on public confidence in the markets. Half of the $50-billion in new securities issued in the 1920s became worthless, and by 1932, U.S. stocks were worth only one-fifth of their values in the summer of 1929. With investors and banks losing colossal sums of money, as many as 5,000 U.S. banks had failed by 1933, while the unemployment rate approached 30%.  

In this dismal period, there was a growing consensus among U.S. lawmakers that an economic recovery could only take hold if the public’s faith and confidence in capital markets were restored. The U.S. Congress held hearings to identify the root cause of the economic problems and search for solutions, and based on its findings, passed the Securities Act of 1933. The following year, the SEC was created by the Securities Exchange Act of 1934. The Act aimed at restoring public confidence in the capital markets by providing investors and markets with more reliable information, and transparent, clear rules to foster honest dealing. President Franklin D. Roosevelt subsequently appointed Joseph P. Kennedy – President John F. Kennedy’s father – as the first Chairman of the SEC.

Founding Principles

The SEC interprets and enforces the federal laws that govern the U.S. securities industry, which are based on two basic principles –

• Investors should have access to all pertinent information about a security prior to making an investment decision. Companies offering securities to the public must therefore disclose comprehensive and accurate information about their businesses, the securities offered for sale, and the risks involved in investing in them.

• People engaged in securities sales and trading must put investors’ interests first and treat them fairly and honestly. The SEC ensures this by overseeing the key players in the securities industry, including exchanges, broker/dealers, advisers, funds and rating agencies.

As the SEC notes on its website, it is first and a foremost a law enforcement agency. Arguably the SEC’s most feared unit, the Division of Enforcement has brought civil enforcement actions against innumerable individuals and companies for securities law violations such as insider trading, accounting fraud and providing misleading information about securities offered to the public.

Organization of the SEC

The SEC has five Commissioners appointed by the President of the United States, with the advice and consent of the Senate. The President designates one of the five Commissioners as Chair of the Commission; the current Chair, Mary Jo White, was sworn in on April 10, 2013, and will be in office until 2019.

The Commissioners serve staggered five-year terms, with one Commissioner’s term ending on June 5 of each year. In order to ensure that the SEC remains non-partisan, a maximum of three Commissioners may belong to the same political party.

The SEC has its headquarters in Washington, DC. It is organized into five Divisions and 23 Offices, with about 3,500 staff located in Washington and 11 regional offices across the U.S.

The SEC’s five Divisions have the following responsibilities:

• Division of Corporation Finance – oversees corporate disclosure of important information to the investing public. It reviews documents that public companies are required to file with the SEC, such as registration statements, annual and quarterly filings, proxy materials and annual reports. The Division also provides interpretation of securities acts, monitors activities of the accounting profession that result in formulation of generally accepted accounting principles (GAAP), and provides guidance and counseling to registrants and the public to help them comply with securities law.
• Division of Trading and Markets – assists the SEC is executing its responsibility to maintain fair, orderly and efficient markets. It provides day-to-day oversight of major securities market participants and also oversees the Securities Investor Protection Corporation. Additional responsibilities include reviewing proposed new rules and proposed changes to existing rules, and market surveillance.
• Division of Investment Management – is responsible for investor protection, and for promoting capital formation through oversight and regulation of the U.S. investment management industry, which includes mutual funds and professional fund managers, research analysts, and investment advisers to retail customers. A focus of this Division is ensuring that disclosures about popular retail investments like mutual funds and exchange-traded funds are useful to retail investors, and that the regulatory costs such consumers have to bear are not excessive. Additional responsibilities include assisting the SEC in interpreting laws and regulations for the public, and providing assistance in enforcement matters involving investment companies and advisers.

Recent Developments

The SEC’s stellar reputation has been a bit tarnished in recent years by its failure to detect the massive Bernie Madoff and Allen Stanford Ponzi schemes, as well as its lack of success in booking one of the really big players who contributed to the 2008-09 financial crisis. However, it has scored a couple of major wins in its ongoing crusade against white-collar crime.

• Raj Rajaratnam – In 2011, billionaire hedge fund manager Rajaratnam was sentenced to 11 years in prison for insider trading, the longest jail term imposed in such a case. Founder and manager of the Galleon hedge fund, Rajaratnam was convicted for orchestrating a wide-ranging insider trading ring that included Rajat Gupta, former McKinsey CEO and Goldman Sachs board member.
• SAC Capital – In November 2013, SAC Capital – founded by Steve Cohen, one of the 150 wealthiest people in the world – agreed to a record $1.8 billion fine for insider trading. The SEC alleged that insider trading was widespread at SAC Capital, and involved stocks of more than 20 public companies from 1999 to 2010. As many as eight traders or analysts who worked for SAC have either been convicted or have pleaded guilty to charges of insider trading.

The Bottom Line

The SEC’s triple mandate of investor protection, maintenance of orderly markets and facilitation of capital formation makes it one of the most important entities in capital and financial markets. The increasing complexity of these markets will continue to give the SEC a prominent role in ensuring that they function smoothly and offer all investors a level playing field.