CHAPTER 3

REGULATION
by James J. Angel, PhD, CFA
LEARNING OUTCOMES

After completing this chapter, you should be able to do the following:

a Define regulations;

b Describe objectives of regulation;

c Describe potential consequences of regulatory failure;

d Describe a regulatory process and the importance of each step in the

process;

e Identify specific types of regulation and describe the reasons for each;

f Describe elements of a company’s policies and procedures to ensure the

company complies with regulation;

g Describe potential consequences of compliance failure.

Introduction 67

INTRODUCTION 1
Rules are important to the investment industry. Without rules, customers could be
sold unsuitable products and lose some or all of their life savings. Customers can
also be harmed if a company in the investment industry misuses customer assets.
Furthermore, the failure of a large company in the financial services industry, which
includes the investment industry, can lead to a catastrophic chain reaction that results
in the failure of many other companies, causing serious damage to the economy.

Recall from the Investment Industry: A Top-­Down View chapter that regulation is
one of the key forces driving the investment industry. Regulation is important because
it attempts to prevent, identify, and punish investment industry behaviour that is
considered undesirable. Financial services and products are highly regulated because
a failure or disruption in the financial services industry, including the investment
industry, can have devastating consequences for individuals, companies, and the
economy as a whole.

Regulations are rules that set standards for conduct and that carry the force of law.
They are set and enforced by government bodies and by other entities authorised by
government bodies. This enforcement aspect is a critical difference of regulations
with ethical principles and professional standards. Violations of ethical principles
and professional standards have consequences, but those consequences may not be as
severe as those for violations of laws and regulations. Therefore, laws and regulations
can be used to reinforce ethical principles and professional standards.

It is important that all investment industry participants comply with relevant regula-
tion. Companies and employees that fail to comply face sanctions that can be severe.
More important, perhaps, than the effects on companies and employees, failure to
comply with regulations can harm other participants in the financial markets as well
as damage trust in the investment industry and financial markets.

Companies set and enforce rules for their employees to ensure compliance with reg-
ulation and to guide employees with matters outside the scope of regulation. These
company rules are often called corporate policies and procedures and are intended
to establish desired behaviours and to ensure good business practices.

© 2014 CFA Institute. All rights reserved.

68 Chapter 3 ■ Regulation

Laws and
Company Regulations
Rules

TRUST
IN THE
INDUSTRY

Professional
Ethical Standards
Principles

An understanding of the regulatory environment and company rules is essential for

success in the investment industry. In this chapter, many of the examples are drawn
from developed economies primarily because the regulatory systems in these econo-
mies have had longer to evolve. Many of these systems have been adjusted over many
years, so they not only protect investors and the financial system but also allow the
investment industry to innovate and prosper.

2 OBJECTIVES OF REGULATION

Regulators act in response to a perceived need for rules. Regulation is needed when
market solutions are insufficient for a variety of reasons. Understanding the objectives
of regulation makes it easier for industry participants to anticipate and comply with
regulation.

The broad objectives of regulation include the following:

1 Protect consumers. Consumers may be able to quickly determine the quality

of clothing or cars, but they may not have the skill or the information needed
to determine the quality of financial products or services. In the context of
the financial services industry, consumers include borrowers, depositors, and
investors. Regulators seek to protect consumers from abusive and manipulative
practices—including fraud—in financial markets. Regulators may, for instance,
prevent investment firms from selling complex or high-­risk investments to
individuals.

2 Foster capital formation and economic growth. Financial markets allocate funds
from the suppliers of capital—investors—to the users of capital, such as compa-
nies and governments. The allocation of capital to productive uses is essential
Consequences of Regulatory Failure 69

for economic growth. Regulators seek to ensure healthy financial markets in

order to foster economic development. Regulators also seek to reduce risk in
financial markets.

3 Support economic stability. The higher proportion of debt funding used in the
financial services industry, particularly by financial institutions, and the inter-
connections between financial service industry participants create the risk of a
systemic failure—that is, a failure of the entire financial system, including loss
of access to credit and collapse of financial markets. Regulators thus seek to
ensure that companies in the financial services industry, both individually and
as an industry, do not engage in practices that could disrupt the economy.

4 Ensure fairness. All market participants do not have the same information.
Sellers of financial products might choose not to communicate negative infor-
mation about the products they are selling. Insiders who know more than the
rest of the market might trade on their inside information. These information
asymmetries (differences in available information) can deter investors from
investing, thus harming economic growth. Regulators attempt to deal with
these asymmetries by requiring fair and full disclosure of relevant information
on a timely basis and by enforcing prohibitions on insider trading. Regulators
seek to maintain “fair and orderly” markets in which no participant has an
unfair advantage.

5 Enhance efficiency. Regulations that standardise documentation or how to trans-

mit information can enhance economic efficiency by reducing duplication and
confusion. An efficient dispute resolution system can reduce costs and increase
economic efficiency.

6 Improve society. Governments may use regulations to achieve social objectives.

These objectives can include increasing the availability of credit financing to
a specific group, encouraging home ownership, or increasing national savings
rates. Another social objective is to prevent criminals from using companies
in the financial services industry to transfer money from illegal operations to
other, legal activities—a process known as money laundering. As a consequence
of the transfer, the money becomes “clean”. Regulations help prevent money
laundering, detect criminal activity, and prosecute individuals engaged in illegal
activities.

Specific regulations are developed in response to the broad objectives of regulation.

A regulation can help to achieve multiple objectives. For example, rules about insider
trading protect consumers (investors) and promote fairness in financial markets.
Specific types of regulation are discussed in Section 4 of this chapter.

CONSEQUENCES OF REGULATORY FAILURE 3

Inadequate regulation and failure to enforce regulation can have a variety of conse-
quences, including failing to meet the objectives above. The results of a regulatory
breakdown can harm customers and counterparties as well as damage trust in the
70 Chapter 3 ■ Regulation

financial services industry, which includes the investment industry. Customers may
lose their life savings when sold unsuitable products or customers could be harmed
if an investment firm misuses customer assets. Furthermore, the failure of one large
company in the financial services industry can lead to a catastrophic chain reaction
(contagion) that results in the failure of many other companies, causing serious dam-
age to the economy.

4 A TYPICAL REGULATORY PROCESS

The processes by which regulations are developed vary widely from jurisdiction to
jurisdiction and even within jurisdictions. This section describes steps involved in a
typical regulatory process and compares different types of regulatory regimes.

Exhibit 1 shows steps in a typical regulatory process, from the need for regulation to
its implementation and enforcement.

Exhibit 1  The Regulatory Process

n
d y t a tio n tion
e t l i o lu
d Ne hori n su n tat ng
t
en Res
o
e u t is C o n e r i m
rc eiv al A alys blic optio plem nito force pute view
g
Pe Le An Pu Ad Im Mo En Dis Re

1 Identification of perceived need. Regulations develop in response to a perceived

need. The perception of need can come from many sources. There may, for
instance, be political pressure on a government to react to a perceived flaw in
the financial markets, such as inadequate consumer protection. Forces within
the investment industry, such as lobbying groups, may also attempt to influence
regulators to enact rules beneficial to their or their clients’ interests. Regulation
may be developed proactively in anticipation of a future need; or regulation may
be developed reactively in response to a scandal or other problem.

2 Identification of legal authority. Regulatory bodies need to have the authority to

regulate. Sometimes more than one regulator has authority and can respond to
the same perceived need.

3 Analysis. Once a need is identified, regulators conduct a careful analysis. The

regulators should consider all the different regulatory approaches that can be
used to achieve the desired outcome. Possible approaches include mandating
and/or restricting certain behaviours, establishing certain parties’ rights and
responsibilities, and imposing taxes and subsidies to affect behaviours. The
A Typical Regulatory Process 71

analysis also needs to carefully weigh the costs and benefits of the proposed
regulation, even though the benefits are often difficult to quantify. In other
words, does the cure cost more than the disease? Regulations impose costs,
including the direct costs incurred to hire people and construct systems to
achieve compliance, monitor compliance, and enforce the regulations. These
costs increase ongoing operating costs of regulators and companies, among
others. A regulation may be effective in leading to desired behaviours but very
inefficient given the costs associated with it.

In some countries, regulators explicitly consider the competitive position of

their country’s financial services industry, which includes the investment indus-
try, when they are developing regulation.1 Regulators are aware of the need for
innovation and try not to arbitrarily stifle new ideas.

4 Public consultation. Regulators often ask for public comment on proposed

regulations. This public consultation gives those likely to be affected by the reg-
ulations an opportunity to make suggestions and comments, on such issues as
costs, benefits, and alternatives, to improve the quality of the final regulations.
A regulation may go through several rounds of proposal, consultation, and
amendment before it is adopted.

5 Adoption. The regulation is formally adopted by the regulator. Regulators may

clarify formal rules by publishing guidelines, frequently asked questions (FAQs),
staff interpretations, and other documents. Companies or individuals that do
not comply with these published pronouncements put themselves at risk of
violating regulations.

6 Implementation. Regulations need to be implemented by the regulator and

complied with by those who are affected by them. Some regulations go into
effect immediately and some are phased in over time. Because companies have
a duty to comply with relevant new regulations, they need to monitor informa-
tion from regulators and act on any changes. Sometimes regulators will contact
companies directly about a new regulation, but not always.

7 Monitoring. Regulators monitor companies and individuals to assess whether

they are complying with regulation. Monitoring activities include routine
examinations of companies, investigation of complaints, and routine or special
monitoring of specific activities. Routine examinations may check for compli-
ance with such items as net capital requirements and safeguarding of customer
assets. Regulators may check whether a company has compliance procedures
in place and whether the company is actually following these procedures.
Regulators may also have systems in place for receiving and investigating
complaints about violations. They may also monitor for certain prohibited or
required activities. For example, regulators may routinely investigate all pur-
chases just before a takeover announcement to determine whether there has
been any insider trading.

8 Enforcement. For a regulatory system to be effective, it must have the means

to identify and punish lawbreakers. Punishments include cease-­and-­desist
orders and monetary fines, fees, and settlements. In the case of individuals,

1  For example, the United Kingdom’s Financial Services Authority took into account “the desirability of
maintaining the competitive position of the UK” (www.fsa.gov.uk/pages/About/Aims/Principles/index.shtml).
72 Chapter 3 ■ Regulation

punishments also may involve the loss of licences, a ban from working in the
investment industry, and even prison terms. The loss of reputation resulting
from regulatory action, even when the individual is not convicted or punished,
can have significant effects on individuals and companies.

9 Dispute resolution. When disputes arise in a market, a fair, fast, and efficient
dispute resolution system can improve the market’s reputation for integrity and
promote economic efficiency. Mechanisms that provide an alternative to going
to court to resolve a dispute—often known as alternative dispute resolutions—
have been developed globally. These typically use a third party, such as a tribu-
nal, arbitrator, mediator, or ombudsman, to help parties resolve a dispute. Using
alternative dispute resolutions may be faster and less expensive than going to
court.

10 Review. Regulations can become obsolete as technology and the investment

industry change. For this reason, a good regulatory system has procedures in
place for regularly reviewing regulations to determine their effectiveness and
whether any changes are necessary.

Although the creation of regulation often involves the processes just outlined, regula-
tions can be created less formally. Sometimes, regulators will issue informal guidance
that may not have the formal legal status of written regulations but will affect the
interpretation and enforcement of regulations. Enforcement officials may decide, for
instance, that a previously acceptable practice has become abusive and start sanctioning
individuals and companies for it. This potential is one of the reasons why individuals
and companies should maintain ethical standards higher than the legal minimums.

4.1  Classification of Regulatory Regimes

The type of regulation that an individual or company encounters will affect how
they respond to and comply with it. The way that regulations are classified can differ
between countries, so it is important to understand the types of regulatory regimes,
particularly if your company operates at a global level.

Regulatory regimes are often described as “principles-­based” or “rules-­based”. In a

principles-­based regime, regulators set up broad principles within which the invest-
ment industry is expected to operate. This avoids legal complexity and allows regula-
tors to interpret the principles on a case-­by-­case basis. Rules-­based regimes provide
explicit regulations that, in theory, offer clarity and legal certainty to investment
industry participants. However, real-­world regulatory regimes are usually hybrids of
these two types. For example, US regulation is often described as rules-­based. One
such rule is that insider trading is banned. Yet, the rule includes no statutory defini-
tion of insider trading—prosecutions are made under the broad anti-­fraud provisions
Types of Financial Market Regulation 73

of US law that outlaw any type of fraud or manipulation.2 Equally, UK regulation is

often described as principles-­based, yet some regulations—such as those for credit
unions—are very detailed.

Regulatory systems can also be designed as “merit-­based” or “disclosure-­based”. In

merit-­based regulation, regulators attempt to protect investors by limiting the products
sold to them. For example, a regulator may decide that a hedge fund product is highly
risky and should only be available to investors that meet certain criteria. Investing
in hedge funds is usually restricted to investors that have a certain level of resources
and/or investment expertise. Disclosure-­based regulation seeks to ensure not whether
the investment is appropriate for investors, but only whether all material information
is disclosed to investors. The philosophy behind disclosure-­based regulation is that
properly informed investors can make their own determinations regarding whether
the potential return of an investment is worth the risk.

Again, the real world regulatory environment is often a hybrid of these two types of
regulation. For example, although US regulation is mostly disclosure-­based, US reg-
ulators sometimes impose extra burdens of disclosure and restrict access to products
that they think lack merit, are highly risky, or are poorly understood.

TYPES OF FINANCIAL MARKET REGULATION 5

The broad objectives of regulation discussed in Section 2 are used by regulators to
create sets of rules. Each set of rules focuses on a type of investment industry activity.
These rules include the following:

■■ Gatekeeping rules

■■ Operations rules

■■ Disclosure rules

■■ Sales practice rules

■■ Trading rules

■■ Proxy voting rules

2  To be precise, US prosecutions for insider trading are typically made under US SEC Rule 10b-­5, which
does not mention insider trading directly. It states, “It shall be unlawful for any person, directly or indirectly,
by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any
national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in
order to make the statements made, in the light of the circumstances under which they were made, not
misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or
deceit upon any person, in connection with the purchase or sale of any security.”
74 Chapter 3 ■ Regulation

■■ Anti-­money-­laundering rules

■■ Business continuity rules

5.1  Gatekeeping Rules

Gatekeeping rules govern who is allowed to operate as an investment professional as
well as if and how products can be marketed.

Personnel.  One of the primary activities of regulators is screening investment indus-

try personnel to ensure that they meet standards for integrity and competency. Even
honest people can do tremendous damage if they are untrained or incompetent. For
this reason, regulators in most financial markets require individuals to pass licensing
exams to make sure that industry personnel have an understanding of the financial
laws and of financial products in general.

Financial products.  Financial products must generally comply with numerous regula-
tions before they can be sold to the public. In disclosure-­based regimes, the regulators
monitor the accuracy of the disclosures; in merit-­based regimes, the regulators pass
judgement on the merits of the investments.

Gatekeeping rules are necessary because some financial products are complicated to
understand, and sellers of these products may have incentives to offer and recommend
the wrong products to a client. For example, between 2002 and 2008, Hong Kong SAR
banks and brokerage firms sold a total of HK$14.7 billion of Lehman Brothers’ invest-
ment products—mainly unlisted notes linked to the credit of various companies—to
about 43,700 individual investors. After Lehman’s bankruptcy in 2008, investors lost
most, if not all, of the principal amount they had invested.

5.2  Operational Rules

Regulations may dictate some aspects of how a company operates.

Net capital.  It is important that companies in the financial services industry have
sufficient resources to honour their obligations. History shows that highly leveraged
companies (companies with a high amount of debt relative to equity) pose a risk not
only to their own shareholders, but also to their customers and the economy as a
whole. Bankruptcies of even small companies in the financial services industry can be
disruptive. The aggregate effects of a large number of small collapses can have a serious
impact on the overall economy.

The collapse of larger entities can result in global financial contagion, a situation in
which financial shocks spread from their place of origin to other locales or markets.
Contagion occurred in the 1997 Asian crisis—a crisis that began in some Asian
countries and spread across the globe. Contagion also took place during the financial
crisis of 2008. Regulators seek to prevent excessive risk taking by imposing capital
requirements that limit the amount of leverage that companies in the financial services
industry, particularly a financial institution, can use. More information about the effect
of leverage on a company’s performance is provided in the Financial Statements chapter.
Types of Financial Market Regulation 75

Handling of customer assets.  Most jurisdictions impose rules that require customer
assets to be strictly segregated from the assets of an investment firm. Even with regu-
lations, however, companies may be tempted to use these valuable assets in ways that
have not been approved by the customer. Even if there is no intentional diversion of
customer funds, mishandling or poor internal control of these assets exposes customers
to the risk of loss. Any reported problems in this area may damage the reputation of
the entire investment industry.

5.3  Disclosure Rules

In order for markets to function properly, market participants require information,
including information about companies and governments raising funds, information
about the specific financial instruments being sold and traded, and information about
the markets for those instruments. Rules specify what information is included and
how the information is disclosed.

Corporate issuers.  Regulators typically require corporate issuers of securities to

disclose detailed information to potential buyers before the offering of securities. This
requirement is to ensure that investors have enough information about what they are
buying to make informed decisions. The disclosures generally include audited financial
statements, information about the general business of the company, the intended use of
the proceeds, information about management, and a discussion of important risk factors.

Market transparency.  Information about what other investors are willing to pay for
a security, or the price they just paid, is valuable to investors because it helps them
assess how much a security is worth. But investors generally do not want to reveal
private information. Regulation requires the dissemination of at least some information
regarding the trading environment for securities.

Disclosure triggers.  A company may be exposed to various types of compulsory

regulatory disclosure requirements. Stock exchanges and market regulators typically
have a range of disclosures, which may be required as soon as a trigger event occurs
or a threshold is reached. For holdings in a particular stock, there can, for example, be
significant shareholder disclosures designed to inform the market of potential takeover
activity, directors’ dealings in shares of the company, or short positions.

5.4  Sales Practice Rules

Some consumers seeking financial advice find it difficult to assess the quality of the
advice they are receiving. These consumers may be vulnerable to abusive sales prac-
tices by sellers who are more concerned about their own profit than the customers’
best interests. For instance, some providers may be inclined to push products that
pay the highest commission. Regulators deal with potential sales practice abuses in
various ways.

Advertising.  Regulators may control the form and content of advertising to ensure
that advertising is not misleading. For example, regulators often disapprove of such
advertised promises as “guaranteed” returns and “sure win” situations. Providers of
76 Chapter 3 ■ Regulation

products and services to investors may be tempted to exaggerate past performance

by displaying only winning time periods or winning strategies. Regulators seek to
counteract this tendency by creating standards for the reporting of past performance.

Fees.  Regulators may impose price controls to limit the commissions that can be
charged on the sale of various financial products as well as to limit the mark-­ups and
mark-­downs that occur when investment firms trade securities with their customers
out of their own inventories.

Information barriers.  Many large firms in the investment industry offer investment
banking services to corporate issuers and, at the same time, publish investment research
and provide financial advice. This situation creates potential conflicts of interest. For
instance, firms may publish biased investment advice in order to win more lucrative
investment banking business. Similarly, research analysts may be under pressure to
publish favourable research reports on securities in which the firm has large positions in
its own inventory. Regulators attempt to resolve conflicts of interest by requiring firms
to create barriers—virtual and physical—between investment banking and research.

Suitability standards.  Regulation seeks to hold those in the investment industry

accountable for the advice that they give to their clients. Any advice or recommen-
dation should be suitable for the client (consistent with the client’s interests). Some
participants in the investment industry are held to an even higher standard, frequently
called a fiduciary standard. Under this standard, any advice or recommendation must
be both suitable for the client and in the client’s best interests. In order to advise or
make recommendations, it is critical to “know your customer”—gather information
about a client’s circumstances, needs, and attitudes to risk.

Restrictions on self-­dealing.  Many firms in the investment industry sell financial

products such as securities directly to investors out of their own inventories. This
practice allows them to provide faster service and better liquidity to their customers
as well as to provide access to proprietary financial products that may not be available
elsewhere. However, self-­dealing potentially creates a conflict of interest because the
firm’s interests may differ from those of the consumer. The firm wants to charge the
highest price to the customer, who wants to pay the lowest price. There can also be
confusion among customers as to whether the firm is acting as a principal (the firm
is taking the other side of the trade) or an agent (the firm is working for the client,
but not trading with that client). Regulators may deal with the potential conflict in a
number of ways. They may impose “best execution” requirements, require disclosure
of the conflict, or ban self-­dealing with customers.

5.5  Trading Rules

Regulations are often designed to set investment industry standards as well as to
prevent abusive trading practices.

Market standards.  Government regulation can be used to set, for example, the stan-
dard length of time between a trade and the settlement of the trade (typically three
business days for equities in most global markets).
Types of Financial Market Regulation 77

Market manipulation.  Regulators attempt to prevent and prosecute market manip-

ulation. Market manipulation involves taking actions intended to move the price of a
stock to generate a short-­term profit.

Insider trading.  A market in which some participants have an unfair advantage over
other participants lacks legitimacy and thus deters investors. For this reason, most
jurisdictions have rules designed to prevent insider trading. Because material non-­
public information flows through companies in the financial services industry about the
financial condition of their clients and their trading, regulators often expect companies
to have policies and procedures in place to restrict access to such information and to
deter parties with access from trading on this information.

Front running.  As with insider trading, regulators may ensure that companies have
procedures in place to deter front running and to monitor employees’ personal trad-
ing. Front running is the act of placing an order ahead of a customer’s order to take
advantage of the price impact that the customer’s order will have. For example, if you
know a customer is ordering a large quantity that is likely to drive up the price, you
could take advantage of this information by buying in advance of that customer’s order.

Brokerage practices.  In some countries, investment managers may use arrangements

in which brokerage commissions are used to pay for external research. These are referred
to as soft money (soft dollar) arrangements. Rather than paying cash for the research,
the broker directs transactions to a provider. The payment of commissions on those
transactions, possibly made from client accounts, give the brokerage firm access to the
research produced by the provider. Regulators may have regulations regarding the use
of such arrangements because client transactions could be directed to gain access to
research rather than being used in clients’ interests.3

5.6  Proxy Voting Rules

In some countries, brokers are required to distribute voting materials to their cus-
tomers, gather voting instructions, and submit them for inclusion in the counting of
votes. In other countries, corporate issuers distribute materials directly to shareholders.
Regulation determines what procedures are used for conducting proxy votes.

5.7  Anti-­Money-­Laundering Rules

Companies in the financial services industry can be used by criminals to launder
money, to facilitate tax evasion, and to fund terrorism. Governments naturally want
to deter such activities and they may use their regulatory power over companies in
the financial services industry to do so. Regulations may require companies to confirm
and record the identity of their clients; to report payments, such as dividends, to tax
authorities; and to report various other activities, such as large cash transactions.

3  CFA Institute also has ethical standards for the use of soft dollars. See CFA Institute, CFA Institute Soft
Dollar Standards: Guidance for Ethical Practices Involving Client Brokerage (2011): www.cfapubs.org/doi/
pdf/10.2469/ccb.v2004.n1.4005.
78 Chapter 3 ■ Regulation

5.8  Business Continuity Planning Rules

Given the essential nature of financial services to the economy, regulators may be
concerned about business continuity in the event of disasters, such as fires, floods,
earthquakes, and epidemics. Regulators want to be assured that customer records are
adequately backed up and that companies have plans in place to recover from a disaster.

Regulations affect all aspects of the investment industry, from entry into it to exit
from it.

6 COMPANY POLICIES AND PROCEDURES

Companies within the investment industry, like all companies, are expected to have
policies and procedures (also referred to as corporate policies and procedures) in
place to ensure employees’ compliance with applicable laws and regulations. Policies
are principles of action adopted by a company. Procedures are what the company
must do to achieve a desired outcome. Although company policies and procedures
do not have the force of law, they are extremely important for the survival of com-
panies. Policies and procedures establish desired behaviours, including behaviours
with respect to regulatory compliance. Indeed, companies may be sanctioned or
even barred from the investment industry for not having policies and procedures in
place that ensure compliance with regulations. Policies and procedures also guide
employees with matters outside the scope of regulation. Recall from the Ethics and
Investment Professionalism chapter that policies and procedures are important in
helping to prevent undesirable behaviour.

Companies use a similar process as regulators when setting corporate policies and
procedures. Typically, corporate policies and procedures respond to a perceived need.
Companies establish systems to make employees aware of new policies and procedures,
to monitor compliance, and to act on failures to comply. It is important to document
policies and procedures so that the company can prove it is in compliance when
inspected by regulators. It is also important to document that the company follows
and enforces its policies and procedures.

Regulators also expect supervisors of subordinate employees to make sure that the
employees are in compliance with the company’s policies and procedures and with
relevant regulation. Regulators may discipline higher-­level executives for misdeeds
within a company because the executives did not supervise their employees properly,
even when the executives had no involvement whatsoever in the misdeeds.

6.1  Supervision within Companies

Just as it is important for regulators to supervise companies in the investment indus-
try, it is also vital that companies supervise their employees. With large amounts of
money at stake, a single rogue employee can cause significant harm or even bring
down a company.
Consequences of Compliance Failure 79

Supervision starts even before a new employee joins a company. The company should
conduct background checks to make sure that the prospective employee is competent
and of good character. The employee’s initial orientation and training should empha-
sise the importance of compliance with corporate policies and procedures and with
relevant regulations.

It is not enough to train new employees. It is important to also provide continuing

education to reinforce the mission-­critical nature of compliance with corporate
policies and procedures and with relevant regulations. It is also important to have
documented systems in place to ensure that employees follow the company’s com-
pliance procedures. For example, a company may have rules in place to deter insider
trading and front running.

A company must also be able to prove to regulators that it has established good
corporate policies and procedures and that they are being followed. Good documen-
tation, such as keeping records of employees’ continuing education, is essential to
prove compliance and enforcement. The Investment Industry Documentation chapter
provides a discussion of documentation in the context of the investment industry.

6.2  Compensation Plans

Companies need to be aware of the potential effects of compensation plans on
employees’ behaviour. For example, bonuses for reaching target sales levels may moti-
vate employees to make more sales, but they may also motivate employees to break
rules and engage in deception to make those sales. Adherence to good compliance
practices should be a standard part of employees’ performance reviews and a factor
in determining bonuses.

6.3  Procedures for Handling Violations

No matter how honest and well-­meaning employees are, sooner or later, there will
be some rule violations. A culture of cover-­up is dangerous for a company because
once unethical employees discover that it is possible to hide problems, they will be
tempted to take advantage of that. Companies need to have procedures in place for
employees to report problems without fear of retribution, as well as procedures for
handling problems in an effective manner.

CONSEQUENCES OF COMPLIANCE FAILURE 7

Failure to comply with regulations and policies and procedures can have significant
consequences for employees, managers, customers, the company, the investment
industry, and the economy. Companies may fire employees and managers that fail
to comply with regulations and policies and procedures. When a regulatory action
occurs, even if no formal charges are brought, the legal costs to individuals and firms
involved in dealing with it can be high.
80 Chapter 3 ■ Regulation

Regulators have many ways of disciplining firms and individuals that violate informal
rules. Sanctions for individuals may include fines, imprisonment, loss of licence, and
a lifetime ban from the investment industry. When subordinates violate rules, man-
agers may also face consequences for failure to supervise. Even long after the issue
is resolved, the regulatory sanctions remain a matter of public record that can haunt
the individuals involved for the rest of their lives. The economic damage from loss of
reputation can be huge.

Companies also face sanctions including fines, loss of licences, and forced closure.
A company may be forced to spend significant resources in corrective actions, such
as hiring outside consultants, to demonstrate compliance. Companies interact with
regulators on an ongoing basis, so running afoul of a regulator’s opinion in one area
can lead to problems in other areas.

Compliance failures affect more than just the company and its employees. Customers
and counterparties can be harmed and trust in the investment industry and financial
markets damaged. Customers may lose their life savings and counterparties may suf-
fer losses. At the extreme, the failure of one large company in the financial services
industry can lead to a catastrophic chain reaction (contagion) that results in the failure
of many other companies, causing serious damage to the economy.

SUMMARY

If every individual and every company acted ethically, the need for regulation would
be greatly reduced. But the need would not disappear altogether because regulation
does not just seek to prevent undesirable behaviour but also to establish rules that
can guide standards that can be widely adopted within the investment industry. The
existence of recognised and accepted standards is important to market participants, so
trust in the investment industry depends, in no small measure, on effective regulation.

Some important points to remember include the following:

■■ Regulations are rules carrying the force of law that are set and enforced by
government bodies and other entities authorised by government bodies. It is
important that all investment industry participants comply with relevant regu-
lation. Those that fail to do so face sanctions that can be severe.

■■ Financial services and products are highly regulated because a failure or disrup-
tion in the financial services industry, which includes the investment industry,
can have catastrophic consequences for individuals, companies, and the econ-
omy as a whole.

■■ Regulation is necessary for many reasons, including to protect consumers; to

foster capital formation and economic growth; to support economic stability;
to promote fair, efficient, and transparent financial markets; and to improve
society.
Summary 81

■■ A typical regulatory process involves determination of need by a legal authority;

analysis, including costs and benefits; public consultation on proposals; adop-
tion and implementation of regulations; monitoring for compliance; enforce-
ment, including penalties for violations; dispute resolution; and review of the
effectiveness of regulation.

■■ Regulation may be principles-­based or rules-­based and merit-­based or

disclosure-­based.

■■ The types of regulations that have been developed in response to perceived

needs include rules on gatekeeping, operations, disclosure, sales practice, trad-
ing, proxy voting, anti-­money-­laundering, and business continuity planning.

■■ Corporate policies and procedures are rules established by companies to ensure

compliance with applicable laws and regulations, to establish processes and
desired behaviours, and to guide employees.

■■ Documentation is important for demonstrating regulatory compliance.

■■ Employees’ activities can have negative consequences for managers (supervi-

sors) and companies. It is vital to make sure that employees are competent and
of good character. They should receive training to ensure that they are familiar
with their regulatory responsibilities, corporate policies and procedures, and
ethical principles. Employees’ behaviour and actions should be adequately
supervised and monitored.

■■ Failure to comply with regulation and policies and procedures can have signif-
icant consequences for employees, managers, customers, the firm, the invest-
ment industry, and the economy.
82 Chapter 3 ■ Regulation

CHAPTER REVIEW QUESTIONS

1 Consequences are most severe for market participants who violate which of the
following?

A Regulations

B Ethical principles

C Professional standards

2 Regulations that affect the financial services industry are most likely needed
because:

A power is equally distributed among industry participants.

B the same information is available to all industry participants.

C a high number of interconnections exists among industry participants.

3 Which of the following best describes a broad objective of regulation in the

context of the financial services industry?

A To protect consumers

B To eliminate financial risk

C To enforce corporate policies and procedures

4 Regulations to ensure that companies in the financial services industry do not

engage in practices that could cause failures in the financial markets most likely
have:

A a social objective.

B an efficiency objective.

C an economic stability objective.

5 Regulations intended to increase the national savings rate and encourage home
ownership most likely have:

A a social objective.

B a fairness objective.

C an economic stability objective.

© 2014 CFA Institute. All rights reserved.

Chapter Review Questions 83

6 In working toward ensuring fairness in the markets, regulators most likely

attempt to:

A increase information asymmetries.

B maintain fair and orderly markets.

C prevent public release of insider information.

7 Which of the following is most likely a regulatory failure?

A Only inadequate regulation

B Only failure to enforce regulation

C Both inadequate regulation and failure to enforce regulation

8 The step in the regulatory process at which regulators weigh the costs and ben-
efits of a proposed regulation is the:

A analysis.

B identification of perceived need.

C dispute resolution process.

9 In establishing a merit-­based rule, regulators are most likely to:

A restrict access to specific products deemed to be risky.

B mandate disclosure of information relevant to decision making.

C establish broad principles within which the industry is expected to operate.

10 Which of the following is most likely the first step in a typical regulatory
process?

A Public consultation

B Compliance monitoring

C Perceived need identification

11 In the regulatory process, regulators must assess whether firms and individu-
als are complying with regulations. This step in the regulatory process is best
described as:

A monitoring.

B enforcement.

C implementation.
84 Chapter 3 ■ Regulation

12 Insider trading is best defined as:

A trading for internal company accounts before placing a customer’s order.

B trading based on material, non-­public information that is likely to affect

prices.

C taking actions intended to move the price of a security to generate a short-­

term profit.

13 Regulations that require large financial firms to create virtual and physical bar-
riers between investment banking activities and research activities are examples
of:

A trading rules.

B gatekeeping rules.

C sales practice rules.

14 Regulations that attempt to prevent market manipulation are examples of:

A trading rules.

B operational rules.

C sales practice rules.

15 An objective of establishing corporate policies and procedures is to:

A promote economic growth and stability.

B ensure compliance with laws and regulations by employees.

C set standards for employee conduct that carry the force of law.

16 With respect to corporate policies and procedures, when should supervision of

employees begin?

A Before an employee is hired

B During an employee’s orientation

C During an employee’s job training

17 The consequences of failure to comply with regulations and corporate policies

and procedures:

A include costs to only the firm and employees.

B range from individual costs to damage to the global economy.

C are borne by the employee who failed to comply and not by the employee’s
supervisor or employer.
Chapter Review Questions 85

18 Regulatory sanctions against firms include:

A only financial penalties.

B only financial penalties and loss of licences.

C financial penalties, loss of licences, and forced closure.

86 Chapter 3 ■ Regulation

ANSWERS

1 A is correct. Consequences are most severe for violations of regulations. B and

C are incorrect because violations of ethical principles and professional stan-
dards have consequences, but those consequences may not be as severe as those
for violations of regulations, which carry the force of law.

2 C is correct. Regulations that affect the financial services industry are needed
because a high number of interconnections exist among industry participants.
The interconnections between industry participants create the risk of a systemic
failure. A and B are incorrect because there are differences in the relative power
and access to information among industry participants, which creates a need
for regulation.

3 A is correct. The protection of consumers is a broad objective of regulation in

the context of the financial services industry. B is incorrect because the reduc-
tion of risk may be an objective of regulation, but the elimination of risk in
the financial services industry is not possible. C is incorrect because corporate
policies and procedures are set by companies and are intended to ensure good
business practices and compliance with regulation; however, the enforcement of
internal company policies is not an objective of regulation.

4 C is correct. Regulations to ensure that companies in the financial services

industry do not engage in practices that could cause failures in the financial
market have an economic stability objective. A is incorrect because social
objectives of regulation include increasing the availability of credit to a spe-
cific group, encouraging home ownership, increasing national savings rates,
and preventing criminal activity. B is incorrect because efficiency objectives of
regulation are intended to reduce costs and increase economic efficiency. For
example, the adoption of rules to standardise documentation or how to trans-
port information.

5 A is correct. Regulations intended to increase the national savings rate and

encourage home ownership have a social objective. B is incorrect because the
fairness objective of regulation seeks to promote fair and orderly markets in
which no participant has an unfair advantage. C is incorrect because economic
stability objectives seek to ensure that companies in the financial services indus-
try do not engage in practices that could disrupt the economy.

6 B is correct. Regulations seek to maintain fair and orderly markets by promot-

ing rules that eliminate unfair advantages to select participants. A is incor-
rect because information asymmetries refers to some market participants
having more information relevant to an investment than other participants.
Regulations seek to reduce information asymmetries, not to increase them. C
is incorrect because regulations seek to prevent participants from trading on
inside information to the detriment of other market participants. Public release,
or dissemination, reduces the unfair advantage of insider information.
Answers 87

7 C is correct. Both inadequate regulation and failure to properly enforce regula-

tions are examples of regulatory failure, potentially resulting in harm to market
participants and the industry as a whole.

8 A is correct. Analysis is the step in the regulatory process at which regulators

weigh the costs and benefits of a proposed regulation. B is incorrect because the
identification of perceived need is the step at which a future need or a previous
problem is perceived to exist and leads to regulation. C is incorrect because
the dispute resolution process is the step that identifies how disputes may be
handled.

9 A is correct. In a merit-­based regulatory system, regulators attempt to pro-

tect consumers by limiting the products sold to them. B is incorrect because
disclosure-­based, not merit-­based, regulatory systems mandate disclosure of
information relevant to decision making. In a disclosure-­based system, reg-
ulators do not decide whether a product is good or bad for consumers, but
merely ensure that consumers have sufficient information to make their own
decisions. C is incorrect because principles-­based, not merit-­based, regulatory
systems establish broad principles within which the industry is expected to
operate. In fact, most regulatory systems are hybrids that draw on each of the
four approaches: rules-­based, principles-­based, merit-­based, and disclosure-­
based. As a result, some regulations will be very detailed, some will establish
broad principles, some will attempt to protect consumers by limiting access
to products considered risky or harmful, and some will focus on ensuring that
appropriate information is provided.

10 C is correct. In a typical regulatory process, the first step is identification of a

perceived need. Perceived need for regulation may be proactive in anticipation
of need or in response to a current situation. A is incorrect because public
consultation is part of the regulatory step, but it comes after the identification
of a need, identification of legal authority, and analysis. B is incorrect because
compliance monitoring occurs after the regulation is in place.

11 A is correct. In a typical regulatory process, the step that involves monitoring

firms and individuals for compliance, including such things as examinations and
investigations, is the monitoring step. B is incorrect because the enforcement
step of the regulatory process involves regulators identifying and punishing
compliance violations. C is incorrect because the implementation step of the
regulatory process is when a new regulation goes into effect and may include
informing firms and individuals about the new regulations.

12 B is correct. Insider trading is trading based on material, non-­public informa-

tion. A is incorrect because trading for internal company accounts before plac-
ing a customer’s order is front running. C is incorrect because taking actions
intended to move the price of a stock to generate a short-­term profit is market
manipulation.

13 C is correct. Regulations that require large financial firms to create virtual and
physical barriers between investment banking activities and research activities
are examples of sales practice rules. Sales practice rules attempt to address
potential conflicts of interest when financial service providers have a financial
stake in the decisions that their clients make. Such regulation also includes con-
trols on advertising and pricing. A is incorrect because trading rules focus on
88 Chapter 3 ■ Regulation

trading practices in the market and trading activity of financial participants to

ensure fair, organised, and efficient markets. B is incorrect because gatekeeping
rules are intended to ensure that industry personnel meet standards for compe-
tency and integrity and that financial products offered meet certain standards.

14 A is correct. Regulations that attempt to prevent market manipulation are

examples of trading rules. Trading rules focus on trading practices in the
market and trading activity of financial participants to ensure fair, organised,
and efficient markets. Market manipulation involves investors taking actions
intended to move the price of a stock to generate a short-­term profit. B is incor-
rect because operational rules are related to how a company operates; oper-
ation rules include rules with respect to financial leverage and how customer
accounts are handled. C is incorrect because sales practice rules are intended to
ensure that industry professionals treat clients appropriately with regard to the
products recommended and fees charged. Furthermore, such rules are intended
to reduce potential conflicts of interest an industry professional might face in
the sale and recommendation of a financial product.

15 B is correct. An objective of establishing corporate policies and procedures is

to ensure compliance with laws and regulations by employees. A is incorrect
because promoting economic growth and stability are broad objectives of reg-
ulation. C is incorrect because corporate policies and procedures do not carry
the force of law.

16 A is correct. Supervision begins before employees are hired; the company

should conduct background checks to ascertain the competence and character
of prospective employees. B and C are incorrect because initial orientation and
training should emphasise the importance and role of corporate policies and
procures as well as regulatory compliance, but those occur after the employee
has been hired.

17 B is correct. The consequences of failure to comply with regulations and corpo-

rate policies and procedures can have far-­reaching consequences. A is incorrect
because these failures affect more than just the company and its employees. C is
incorrect because supervisors and the employer may be assigned some respon-
sibility for the failure.

18 C is correct. Failure to comply with regulations and internal policies may result
in regulatory sanctions, including fines, loss of licences, and forced closure. A
and B are incorrect because sanctions can include fines, loss of licences, and
forced closure.