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Course 103
The SEC and Regulation of the Stock Market


The Roaring Twenties were a time of exuberance in America, and one of the most famous signs of this exuberance was the roaring stock market. But underneath all the giddiness was a dark undercurrent of questionable practices that ultimately worsened the effects of the stock market crash of 1929. Publicly traded companies were not required to report their financial results to the public, there was no prohibition against insider trading and other forms of market manipulation, and there was no central body to enforce the laws which did exist. Because of this lack of regulation, the extent of the crash and the subsequent depression took many people by surprise.

As a result, a series of laws was created in the 1930s to clean up the securities business. The Securities Act of 1933 required public companies to report financial and other significant information to investors on a regular basis. In addition, the act prohibited fraud in the sale of securities. The Securities and Exchange Act of 1934 strengthened and extended these regulations, most notably with the formation of the Securities and Exchange Commission (SEC). The SEC became the central body to make and enforce the rules for securities markets, a role it still has today. Other laws passed during the 1930s and early 1940s continue to regulate public utilities, bonds, mutual funds, and investment advisors; the SEC enforces all these regulations.

The SEC has five commissioners, appointed by the president for five-year terms, one of which expires each year. No more than three of the commissioners can be members of the same political party. For a good overview of what exactly the SEC does, we can look at its four main divisions: the Division of Corporate Finance, the Division of Market Regulation, the Division of Investment Management, and the Division of Enforcement.

The Division of Corporate Finance

The main function of this division is to make sure that all publicly traded companies disclose all the information they are supposed to, both financial and otherwise. The quarterly report that companies have to file with the SEC is called a 10-Q, and the annual report is called a 10-K. Both reports contain financial statements as well as information about the company’s operations, competitive environment, unusual expenses or charges, and more. The Division of Corporate Finance also reviews applications for initial public offerings (called prospectuses, or S-1 filings) and documents relating to mergers and acquisitions.

The Division of Market Regulation

This division oversees the participants in the secondary securities markets--primarily broker-dealers (represented by the National Association of Securities Dealers) and the stock markets themselves. These organizations make and enforce many of their own rules, and in fact they are officially known under the federal securities laws as self-regulatory organizations (SROs). The SEC has to approve these rules and make sure they conform to the various federal securities laws, and it also hears appeals from the regulatory divisions of the various SROs. The main purpose of this division is to make sure that the markets are operating fairly and smoothly, without practices such as insider trading.

The Division of Market Regulation also oversees the Securities Investor Protection Corporation (SIPC). The SIPC is a non-profit insurance company that is similar to the banking industry's FDIC. While the SIPC does not protect investors against losses due to trading or company fraud, it does ensure investors keep ownership of their shares should their brokers go under.

The Division of Investment Management

This division is responsible for regulating the practices of mutual funds and investment advisors. It makes sure that funds and advisors are properly registered and keeps an eye on their sales and advertising techniques, all of which are regulated by the Investment Company Act of 1940 and other laws. It ensures that funds and fund companies issue proxy statements and shareholder reports, among other documents. The Division of Investment Management also oversees public utilities such as power and gas companies, which were once cesspools of rampant abuse before being put under control of the SEC in 1935.

The Division of Enforcement

This division is the policing arm of the SEC, responsible for enforcing all the various securities laws and investigating violations. It became a separate division only in 1972 (before that, the other divisions enforced their own laws), but today it's probably the most active division of the SEC. The explosion in popularity of the Internet has resulted in a proliferation of Internet-based investment scams, which the Division of Enforcement has made a concerted effort to control. One of the scams involves illegal "touting" of small-cap stocks on the Internet. Touting a stock means promoting it, often with outlandish claims for its future potential, without revealing that you are being paid to do so by the company.

In addition to these four divisions, there are two offices of the SEC that serve important functions. The Office of the General Counsel is the legal arm of the SEC, representing it in court cases and providing general legal advice. The Office of Compliance Inspections and Examinations makes sure that stock exchanges, brokers, and investment advisers are complying with securities laws by conducting regular examinations and inspections. It's a sort of middleman between the first three divisions described above (which make the rules) and the Division of Enforcement (which enforces them). All the various parts of the SEC work together to try to make the U.S. securities markets operate as fairly and openly as possible.

Quiz 103
There is only one correct answer to each question.

1 Before the passage of the Securities Act in 1933:
a. There was no real stock market in the United States.
b. Insider trading was prohibited but widely practiced anyway.
c. Publicly traded companies were not required to report their financial results.
2 Which of the following is not regulated by laws passed in the 1930s and 1940s and enforced by the SEC?
a. The IRS.
b. Public utilities.
c. Mutual funds.
3 Self-regulatory organizations (SROs), such as the stock exchanges themselves…
a. Are all owned by the U.S. government as subsidiaries of the SEC.
b. Each have five commissioners appointed by the President for five-year terms.
c. Make their own rules, which have to be approved by the SEC's Division of Market Regulation.
4 The SEC's Division of Corporate Finance ensures public companies file a variety of documents. Which documents are the annual reports?
a. S-1
b. 10-Q
c. 10-K
5 Touting a stock means:
a. Promoting a stock, often deceptively, without revealing that you are being paid to do so.
b. Selling a stock just before it reaches its peak price.
c. Applying for a stock to be listed on one of the major exchanges.
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