Four federal securities laws have become quite relevant to the life insurance industry: (1) the Securities Act of 1933, (2) the Securities Exchange Act of 1934, (3) the Investment Company Act of 1940 and (4) the Investment Advisers Act of 1940.

to a group of securities firms represented by one or more principal underwriters, thereby assuring the issuer of a specified amount of money (for example, $23.00/share) at a specified time. In turn, the principal underwriter(s) may either retail their shares of the issue directly to the investing public or sell to a larger selling group of dealers who in turn sell to the public. There is an agreement lasting for a specified period of time, such as 30 days, after the initial public offering during which the public offering will be made at an agreed upon price (for example, $25.00/share). The principal underwriters are compensated for their concerted selling effort and the assumption of the investment risk (that is, the risk of being able to sell the entire issue at the contemplated price) by the price differential between what they pay the issuer and what they receive from either the public or the dealers to whom they sell the shares. If dealers are involved, their compensation comes from the spread between what they pay the principal underwriters (for example, $24.00/share) and the price they receive from the public investors (for example, $25.00/share).

It is the distribution process which is the primary subject of SEC regulation under the Securities Act of 1933. (In the context of insurance, the distribution process is the sale and issuance of insurance products such as variable life policies and variable annuity contracts.) The 1933 Act is designed to afford potential investors an adequate basis upon which to judge whether the new security offering represents a good investment and to prevent misrepresentation and other fraudulent practices in the sale of securities. The fundamental philosophy underlying the Act is accurate disclosure of information needed by a prudent investor to make an intelligent decision as to whether or not to buy the security. The SEC does not pass upon the merits, or lack thereof, of a security.

The objectives of the Securities Act were to be achieved by a general antifraud provision and a registration provision. The registration provision was designed to place facts before the public by (1) adequate and accurate disclosure of detailed information concerning the issuer and the securities being offered in the form of a registration statement filed as a matter of public record for 20 days before the sale of the securities and (2) requiring the underwriters and dealers to furnish prospective investors with a prospectus based upon information contained in the registration statement. This basic statutory pattern continues today, although it has been amended to permit certain types of offers, but not sales, during the waiting period.

To achieve full disclosure at the appropriate times, the registration process contemplates three stages: the prefiling stage, the waiting period, and the post-effective date stage.

During the prefiling stage, the Act prohibits offers to sell and sales of securities through interstate facilities or the mails prior to the filing of a registration statement. Although preliminary agreements between the issuer and the underwriters may be made, neither the issuer nor the underwriters may offer securities to investors or dealers at this time.

During the waiting period stage (that is, after the filing of the registration statement but before the statement’s effective date), offers to sell securities but not actual sales are permitted. However, any written offer must be made by a statutorily prescribed prospectus which must contain much of the information included in the registration statement. During this period, a preliminary prospectus, which omits information related to the offering price, may be used to enable discussing the security with prospective purchasers. However, before the actual sale, a full prospectus must be provided. The purpose of the waiting period is to provide dealers and investors the opportunity to become familiar with the information contained in the registration statement so as to be able to make an unhurried decision.

In theory, the registration statement becomes effective 20 days after filed (that is, a 20-day waiting period) unless the SEC declares it effective sooner or institutes administrative action to suspend its effectiveness. In actual practice, it may take considerable time due to changes necessitated by SEC comments on the initial filing. The Commission has no authority to approve or disapprove the security on its merits. Rather, the Commission’s sole function is to ensure that the registration statement is accurate and complete.

Once the registration is effective, securities may be sold. However, even during the post-effective date period, it still remains unlawful to deliver through the mails or in interstate commerce any security for the purpose of sale or delivery after sale unless such is accompanied or preceded by a full prospectus in which the omission of information related to the offering price must now be disclosed.

Civil and criminal liabilities are imposed for material misstatements or omissions in the registration statement and/or prospectus. In addition, there is a general antifraud provision enforceable by an injunction and/or criminal sanctions which apply to securities sold by use of the mails or facilities of interstate commerce.

In short, the Securities Act of 1933 adopts the philosophy of disclosure as the fundamental means to govern the distribution process. The three-stage registration and prospectus process seeks to ensure that dealers and investors have access to and timely opportunity to consider the material facts concerning the issuer, the terms of the offering, and the distribution arrangements. Also, the antifraud and the liability provisions demand that such disclosure be full and accurate.

In addition to enabling the raising of capital through the issuance of securities, a second basic function of the securities markets is to afford a means of trading outstanding securities. Whereas the Securities Act of 1933 focuses upon new offerings of securities, the Securities Exchange Act of 1934 governs dealings in securities after they have been issued, sometimes referred to as secondary trading. This is achieved through (1) disclosure to people who buy and sell securities, (2) prevention of fraud and manipulation, (3) regulation of the securities exchange markets, (4) regulation of the over-the-counter markets, and (5) control of credit in securities markets.

The 1934 Act contains general prohibitions outlawing fraud and manipulation in both the exchange and the over-the-counter markets and affords the SEC considerable antifraud rule-making authority. Pursuant to such authority, the SEC has promulgated a series of rules against the use of manipulative and deceptive techniques in the purchase or sale of any security whether or not listed on a national exchange.

A securities exchange market, such as the New York Stock Exchange, is a continuous auction system involving competition between both buyers and sellers. Historically, the hallmark of an exchange has been the centralization of trading on the exchange floor.

The facilities of a securities exchange may not be used by any broker or dealer unless the exchange is either registered with or exempted by the SEC. To register, an exchange must agree to enforce compliance by its members with statutory and regulatory requirements and must file information as to its organization, procedures and membership. Periodic follow-up reporting is required. The rules of the exchange must include provision for discipline of a member for misconduct. If the SEC determines that the exchange meets these requirements and that the exchange’s rules are adequate to protect investors, registration will be granted. The SEC possesses certain supervisory functions as to the exchanges, including authority with respect to exchange activities concerning the suspension or expulsion of exchange members who violate the Act.

No security may be traded on an exchange unless it is listed by the exchange. A security may not be listed unless the issuer files an application for registration of the security with both the exchange and the SEC containing much the same information required for new issues under the 1933 Act. This information must be kept current by filing annual and other reports with the exchange and the SEC.

Although the regulation of securities exchanges is not particularly relevant to the sale of life insurance products, which occur in the over-the-counter rather than in the exchange markets, the brief description here of the regulation of the exchange markets is included because (a) it is an important part of the overall framework of securities regulation and (b) such regulation may apply to the trading of insurance company securities (for example, the stock of a life insurer).

The over the counter (OTC) market refers to the trading of securities other than on an exchange. Unlike the exchange markets, there are no centralized places of trading and no listing requirements. Securities traded in OTC markets are quite diverse and include stocks, municipal securities, mutual funds, United States Treasury notes, bonds, and variable annuities. A person dealing in securities in the OTC market need not purchase a seat on an exchange. Instead, OTC dealers become market makers in a security primarily by signifying an intent to deal in that security. For a long period of time OTC dealers were quite literally tied together by only a nationwide web of telephone lines and telegraph wires.

The SEC exercises control in the OTC markets through the broker-dealer. Sec. 15(a)(1) of the 1934 Act requires registration with the SEC of any broker-dealer effecting any transaction in or inducing or attempting to induce the purchase or sale of a security.

Registration of a broker-dealer requires disclosing specified information and filing financial statements. The SEC shall deny, suspend or revoke registration of a broker-dealer for specified misconduct as well as take disciplinary action against any person associated with a broker-dealer engaged in inappropriate conduct. Since the regulation of broker-dealers greatly impacts life insurers and their agents, further consideration of the 1934 Act regulation of broker-dealers is discussed later in this chapter.

Since the control of credit in the securities market is less relevant to insurance regulation, it is mentioned here only to round out the basic framework of the 1934 Act. To prevent excessive use of credit in securities transactions, the Board of Governors of the Federal Reserve System can promulgate margin requirements on the amount of credit which may be extended for the purchase of securities. The responsibility for enforcing such requirements is vested in the SEC.

In 1968 Congress enacted the Williams Act amendments to the 1934 Act specifically aimed at regulating tender offers used in takeover bids. Also, the Securities Acts Amendments of 1975 directed the SEC to facilitate the establishment of a national market system, to become involved in the clearance and settlement process and to regulate municipal securities dealers.

In short, the basic purpose of the Securities Exchange Act of 1934 is to govern the post-distribution trading of securities through a combination of disclosure requirements, antifraud provisions, regulation of both the exchange and the OTC markets, and controls over the extension of credit. In the context of the regulation of life insurance investment oriented products, the regulation of broker-dealers is the most significant aspect of the Act.

An investment company’s accumulation of liquid and readily negotiable securities has offered a tempting target for exploiters. To counteract actual past and potential future abuses, which were concluded to require sterner corrective measures than primary reliance upon disclosure, Congress enacted the 1940 Act. The Act encompassed six main areas: (1) disclosure through registration, (2) honest and unbiased management, (3) greater securityholder participation in management, (4) adequate and feasible capital structure, (5) financial statements and accounting and (6) selling activities.

An investment company is prohibited from conducting certain activities essential to its business, that is, using the mails or facilities of interstate commerce, unless it is registered. Most of the information required is similar to that contained in the registration statements filed under the 1933 and the 1934 Acts. But, in addition, a 1940 Act registration statement must recite investment company policy as to diversification, issuance of senior securities, and engaging in underwriting, borrowing, lending, and investing in real estate and/or commodities. Such policies may not be changed without majority vote of the outstanding voting securities.

unless it possesses a net worth of a specified minimum amount. The different types of investment companies are subject to different capital structure restraints. For example, an open-end company cannot issue senior securities. Also a registered investment company cannot pay dividends from other than accumulated undistributed net income or current income unless the sources of such payments are adequately disclosed.

Securities issued by investment companies (such as mutual fund shares, variable annuity contracts, and variable life insurance policies) are subject to the registration and prospectus requirements of the Securities Act of 1933 in addition to those posed by the Investment Company Act of 1940. However, in contrast to the 1933 Act, under the 1940 Act the sellers of redeemable investment company securities must utilize statutory prospectuses so long as shares of the same class are being offered.

The principal restrictions surrounding the sale of open-end investment company securities relate to their price relative to the value of their underlying assets. The Act provides that a registered securities association may by rule prohibit its members from offering such shares at a price which includes an excessive sales load. (However, the price can provide for reasonable compensation for sales personnel, broker-dealers and underwriters so long as it does not constitute an unreasonable sales load to investors.) The SEC may alter or supplement the rules of the securities association. Maximum sales loads are prescribed in certain situations. With respect to investment advisory fees, the Act specifies that an investment adviser of a registered investment company is under a fiduciary duty as to the receipt of compensation for services.

The SEC also exercises control over sales literature. A registered investment company must file copies of its sales literature distributed to prospective investors in connection with a public offering of its securities. The SEC has issued guides as to the types of advertisements and sales literature which may violate statutory standards.

An investment adviser is any person who for compensation engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of acquiring or disposing of securities. The Investment Adviser Act of 1940 requires investment advisers to register with the SEC, submit to SEC oversight, comply with certain requirements relating to advisory contracts and comply with antifraud provisions. This Act seeks to protect the public against the harmful and fraudulent conduct of persons who are paid to advise others as to the buying and/or selling of securities. It was aimed at those publishing market reports or newsletters containing recommendations regarding securities for paying subscribers and at those providing advice on securities to individual clients. A prime purpose of the law is to reveal conflicts of interests which may cause the adviser to make recommendations more in his or her own interest than that of the client.

The SIPC operates under the supervision of the SEC. It is funded by annual assessments against its members and is backed by borrowing authority against the United States Treasury (up to one billion dollars). The SIPC is the securities counterpart to the Federal Deposit Insurance Corporation (FDIC) for banking and the state guaranty funds for insurance. The function of the SIPC is to protect securities holders, not to bail out failed brokerage firms.