Regulations and Compliance

Securities Act of 1933

The regulatory framework governing the U.S. securities industry is built upon a series of landmark federal laws, self-regulatory organization rules, and industry practices. As a Series 7 candidate, you must understand these regulations in depth — not just the rules themselves, but how they apply in real-world scenarios. This chapter covers the major securities laws, FINRA rules, anti-money laundering requirements, communication rules, and compliance obligations that every registered representative must know.

The Securities Act of 1933 — often called the "Paper Act" or the "Truth in Securities Act" — was the first major federal securities law. Enacted in response to the stock market crash of 1929 and the Great Depression, its two primary objectives are:

1. Require issuers to provide investors with material information about securities being offered for public sale through a registration statement and prospectus
2. Prohibit fraud and misrepresentation in the sale of securities

Registration Requirements

Under the 1933 Act, all securities offered to the public must be registered with the SEC unless they qualify for an exemption. The registration process requires filing a registration statement (typically Form S-1 for IPOs) containing detailed financial and business information. The registration statement has two parts: Part I is the prospectus (which must be delivered to investors), and Part II contains additional information filed with the SEC but not required to be given to investors.

The Prospectus

The prospectus is the primary disclosure document for new securities offerings. It must include:

• Description of the company's business and properties
• Description of the security being offered
• Information about company management
• Audited financial statements
• Risk factors
• Use of proceeds
• Underwriting arrangements and fees

The SEC does NOT approve or disapprove of any securities. It only ensures that proper disclosure has been made. Any statement suggesting SEC approval is a violation of the law.

Exempt Securities

Certain securities are exempt from registration under the 1933 Act (but NOT from anti-fraud provisions):

• U.S. government securities (Treasuries, agency securities)
• Municipal securities
• Commercial paper with maturities of 270 days or less
• Bank securities (issued by national or state-chartered banks)
• Insurance policies and annuity contracts (regulated by state insurance commissioners, except variable products)
• Non-profit and religious organization securities

Exempt Transactions

Certain transactions are exempt from registration (the security itself is not exempt — only the specific transaction):

• Regulation D (Private Placements): Sales to accredited investors (institutions, high-net-worth individuals) and a limited number of non-accredited investors. No general solicitation permitted under Rule 506(b); general solicitation allowed under Rule 506(c) if all purchasers are verified accredited investors.
• Regulation A/A+ (Small Offerings): Tier 1 allows raises up to $20 million; Tier 2 allows up to $75 million in a 12-month period with ongoing reporting requirements.
• Rule 147 (Intrastate Offerings): Securities offered and sold only to residents of a single state, by an issuer incorporated and doing business in that state.
• Rule 144: Governs the resale of restricted and control securities. Restricted securities must be held for at least 6 months (if the issuer is a reporting company) before resale. Affiliates must also comply with volume limitations, manner of sale requirements, and filing Form 144.

Securities Exchange Act of 1934

The Securities Exchange Act of 1934 — often called the "People Act" — created the SEC and governs the secondary market (trading of already-issued securities). While the 1933 Act focuses on new issues, the 1934 Act focuses on ongoing trading, reporting, and market conduct.

Key Provisions

• Created the SEC as the primary federal securities regulator
• Registration: Requires registration of exchanges, broker-dealers, and transfer agents
• Periodic reporting: Public companies must file annual reports (Form 10-K), quarterly reports (Form 10-Q), and current event reports (Form 8-K)
• Proxy rules: Regulates the solicitation of proxies from shareholders for corporate votes
• Insider trading: Section 10(b) and Rule 10b-5 prohibit any person from using material, nonpublic information (MNPI) to trade securities or to tip others who trade
• Section 16 reporting: Officers, directors, and 10% shareholders must report their transactions in company stock and are subject to the short-swing profit rule (profits from buy-sell or sell-buy within 6 months must be disgorged to the company)
• Regulation FD (Fair Disclosure): Prohibits selective disclosure of material nonpublic information. If an issuer discloses MNPI to certain market professionals or shareholders, it must simultaneously (for intentional disclosures) or promptly (for unintentional disclosures) make the information public
• Regulation T: Grants the Federal Reserve authority to set margin requirements

Key FINRA Rules

FINRA rules govern the conduct of broker-dealers and their registered representatives. The Series 7 exam tests several specific FINRA rules in detail. You must know the rule numbers, their requirements, and how they apply in practice.

Rule 2010 — Standards of Commercial Honor

FINRA Rule 2010 is a broad ethical standard requiring that members, in the conduct of their business, "observe high standards of commercial honor and just and equitable principles of trade." This catch-all rule can be used to discipline conduct that violates the spirit of fair dealing, even if no specific rule is broken. Examples include lying on compliance questionnaires, personal financial misconduct (writing bad checks, tax evasion), and failure to cooperate with FINRA investigations.

Rule 2111 — Suitability

As discussed in Chapter 10, Rule 2111 requires that recommended transactions be suitable based on reasonable-basis, customer-specific, and quantitative suitability obligations. This rule is complemented by Regulation Best Interest for retail customer recommendations.

Rule 2210 — Communications with the Public

Rule 2210 governs all communications between broker-dealers and the public. It classifies communications into three categories with different approval requirements:

1. Retail communication: Any written or electronic communication distributed or made available to more than 25 retail investors within a 30-day period. Examples: advertisements, websites, social media posts, form letters. Must be approved by a registered principal before first use (or within 10 business days of first use for certain firms with a strong supervisory track record).
2. Institutional communication: Written or electronic communication distributed or made available only to institutional investors (broker-dealers, banks, insurance companies, registered investment companies, entities with $50M+ in assets, government entities). Does NOT require pre-approval by a principal, but the firm must have supervisory procedures to review these communications.
3. Correspondence: Written or electronic communication distributed to 25 or fewer retail investors within a 30-day period. Does NOT require pre-approval, but the firm must have procedures to review and supervise correspondence (review may be on a spot-check basis).

All communications must be fair, balanced, and not misleading. They must provide a sound basis for evaluating the investment. Performance claims must include appropriate risk disclosures, and past performance disclaimers must be included when showing historical returns.

Rule 3110 — Supervision

Rule 3110 requires each FINRA member firm to establish and maintain a system to supervise the activities of each associated person that is reasonably designed to achieve compliance with applicable securities laws and regulations. Key requirements:

• The firm must designate qualified supervisory personnel for each business unit
• Written supervisory procedures (WSPs) must be established and maintained
• Each Office of Supervisory Jurisdiction (OSJ) must have an on-site supervisor
• The firm must conduct annual compliance reviews of its supervisory system
• Branch office inspections must be conducted at least annually for OSJs and on a regular schedule for non-OSJ branches
• The firm must review and approve customer transactions, correspondence, and advertising

Rule 4512 — Customer Account Information

As discussed in Chapter 10, Rule 4512 requires member firms to obtain and maintain specific information for each customer account, including name, address, age, occupation, SSN/TIN, and information about association with other member firms.

Anti-Money Laundering (AML) Compliance

Anti-money laundering compliance is one of the most critical regulatory obligations for broker-dealers. Money laundering — the process of making illegally obtained money appear legitimate — poses serious risks to the financial system. The Series 7 exam tests your understanding of AML laws, reporting requirements, and compliance programs.

Bank Secrecy Act (BSA)

The Bank Secrecy Act of 1970 is the foundation of U.S. AML law. It requires financial institutions to assist government agencies in detecting and preventing money laundering. The BSA is enforced by the Financial Crimes Enforcement Network (FinCEN), a bureau of the U.S. Department of the Treasury.

Customer Identification Program (CIP)

As required by the USA PATRIOT Act, every broker-dealer must implement a CIP to verify the identity of each customer who opens an account. The CIP requires obtaining the customer's name, date of birth, address, and government-issued identification number. The firm must verify this information within a reasonable time using documentary or non-documentary methods.

Suspicious Activity Reports (SARs)

Broker-dealers must file a Suspicious Activity Report (SAR) with FinCEN when they detect known or suspected violations of federal law, or suspicious transactions that may involve money laundering, terrorist financing, or other illegal activity involving $5,000 or more. SARs must be filed within 30 days of the initial detection of the suspicious activity (60 days if no suspect is identified). It is a federal crime to inform the subject of a SAR that a report has been filed (known as "tipping off").

Currency Transaction Reports (CTRs)

A Currency Transaction Report (CTR) must be filed with FinCEN for any cash transaction exceeding $10,000 in a single business day. This applies to deposits, withdrawals, or exchanges of currency. Multiple transactions by the same person that aggregate over $10,000 in a single day must also be reported (anti-structuring rules). Structuring — intentionally breaking up transactions to avoid the $10,000 threshold — is itself a federal crime.

OFAC (Office of Foreign Assets Control)

The OFAC, part of the U.S. Treasury Department, administers and enforces economic sanctions programs against targeted countries, individuals, and entities. Broker-dealers must screen customers and transactions against the Specially Designated Nationals (SDN) list. Transacting with persons or entities on the SDN list is prohibited and can result in severe civil and criminal penalties.

Customer Complaints, Arbitration, and Books and Records

Customer Complaints

FINRA rules require specific procedures for handling customer complaints. A complaint is defined as any written statement of a grievance involving a FINRA member or associated person's business activities. Key requirements:

• All written complaints must be reported to the firm's compliance department
• The firm must acknowledge receipt of the complaint promptly
• Complaints must be maintained in a complaint file and reported on the registered representative's Form U4/U5
• Certain complaints must be reported to FINRA through the firm's regular reporting process
• Representatives may never settle a customer complaint privately without the firm's knowledge and approval

FINRA Arbitration

Arbitration is the primary method for resolving disputes in the securities industry. FINRA operates the largest securities dispute resolution forum in the United States. Key features:

• Mandatory arbitration: Disputes between broker-dealers and between broker-dealers and registered representatives must go through FINRA arbitration (it is in the employment agreement). Customer disputes may go to arbitration if the customer signed a predispute arbitration agreement.
• Simplified arbitration: For claims of $50,000 or less, a single arbitrator decides the case based on documents only (no hearing unless requested).
• Standard arbitration: For claims over $50,000 and up to $100,000, a single arbitrator conducts a hearing. For claims over $100,000, a panel of three arbitrators conducts the hearing.
• Arbitration decisions are final and binding — there is very limited right of appeal to the courts.
• The statute of limitations for filing an arbitration claim is 6 years from the occurrence or event giving rise to the claim.

Mediation is a voluntary, non-binding alternative to arbitration where a neutral mediator helps the parties reach a settlement. Either party can withdraw from mediation at any time.

Books and Records Requirements

SEC Rules 17a-3 and 17a-4 specify the books and records that broker-dealers must create and maintain:

• Rule 17a-3: Specifies which records must be created, including trade blotters, ledgers, customer account records, order tickets, trade confirmations, and written communications.
• Rule 17a-4: Specifies retention periods for records:
  • 6 years: Trade blotters, general ledger, customer account records, customer statements
  • 3 years: Trade confirmations, customer complaints, written communications (including emails)
  • Lifetime of the firm: Articles of incorporation, partnership agreements, minute books

Business Continuity Plans (BCP)

FINRA Rule 4370 requires every member firm to create and maintain a Business Continuity Plan (BCP) that addresses how the firm will respond to significant business disruptions. The BCP must cover:

• Data backup and recovery procedures
• Alternate communications channels for customers and employees
• Critical business functions and how they will be maintained
• Financial and operational assessments
• Customer access to funds and securities
• Regulatory reporting during disruptions

The BCP must be reviewed and updated at least annually. A summary of the BCP must be provided to each customer at account opening and posted on the firm's website.