I.  Why regulate?

• Economists often justify regulation when there is a market failure
• equilibrium market outcome would not be optimal
• why? asymmetric information
• some investors have more/better information than others
• level playing field encourages more investment, and larger, more liquid financial markets
• Financial markets important for stability of entire economy

• Disclosure regulation
• Companies issuing securities must make financial information available to the public
• Is this necessary? Some argue that competition would force companies to disclose information without laws, but we see fraud today even with the laws (e.g. Enron, Adelphia, Tyco).
• difference between fraud and creative (but legal) accounting
• Financial activity regulation
• rules about trading securities
• buy/sell order priorities
• conflicts-of-interest
• brokerage houses placing investment banking clients ahead of small investors?
• insider trading
• Financial institution regulation
• depository institutions and nondepository institutions
• acceptable activities and investments
• protection/insurance for liabilities
• Regulation of foreign participants

• Major pieces of regulation resulted from financial crises: Panic of 1907, Great Depression 1930s, S&L crisis 1980s
• Federal Reserve System
• created after Panic of 1907
• regulates depository institutions and financial markets
• influences money supply and interest rates
• Great Depression
• creation of SEC and disclosure, insider trading rules
• creation of FDIC to insure bank deposits
• creation of other bank regulations that were later repealed
• S&L crisis
• changes in S&L regulators
• changes in permissible activities of S&Ls
• Will the latest scandals result in new legislation?
• issue with new legislation or enforcement of existing legislation?
• or will financial sector beef up self-regulation?
• Case 1:  Mutual fund scandal
• Elliot Spitzer, NYS Attorney General
• Late trading
• some mutual funds were allowing certain clients to trade their shares at 4:00 p.m. price AFTER 4:00 p.m. but before the next trading day
• this is illegal
• market timing
• some mutual funds were allowing a select group of clients to frequently buy and sell their shares to profit from daily price movements in U.S. and overseas markets
• this is not illegal per se, but it is illegal if this opportunity is not given to all shareholders
• fees
• Spitzer is charging that many mutual fund fees are excessive (beyond the cost of operating the fund)
• while this might be true, the fees are within legal limits, which are under the jurisdiction of the SEC, not NYS
• Case 2:  Martha Stewart
• currently on trial, accused of
• obstruction of justice (lying to prosecutors investigating insider trading allegations)
• stock fraud
• NOT insider trading
• allegations
• Martha Stewart sold ImClone stock before an announcement that one of its drugs would not get FDA approval
• Did she get tipped off by broker or company president Sam Waskal?
• Stewart then lied to prosecutors about why she sold her stock and tampered with evidence
• Stewart lied about why she sold the stock to prevent the stock in her own company from falling (stock fraud)
• Stewart has consistently held that she had a prior agreement with her broker to sell ImClone once it dipped below $60/share