After a series of on-line investing roundtables conducted earlier this year, Securities and Exchange Commissioner Laura S. Unger on November 22 released a report summarizing the findings of the roundtable participants and recommendations for ongoing dialogue between regulators and the industry and for regulatory strategies the Securities and Exchange Commission ("SEC") should consider. This report may be a precursor to some new rulemaking or development of guidelines by the SEC in this area, though Commissioner Unger said "extensive rulemaking" may be "premature."
The report comes as on-line trading is experiencing a dramatic increase in the U.S. It is estimated that $415 billion in assets were in on-line accounts last year, that some 10 million Americans were trading at least occasionally over the Internet and that on-line customers account for about a quarter of all retail stock trades.
Report Findings and Recommendations
The report highlights what the roundtable discussions have determined to be the most vital issues concerning on-line brokerage: suitability, best execution, market data, systems capacity, investor education, on-line discussion forums, privacy and portals. Among the findings and recommendations, the report lays out guidelines and suggested areas for further study:
- Trends in On-line Brokerage. The report provides a number of statistics putting in context the growth and activities of on-line investors and firms and describes the various products and services currently offered on-line. The report also describes various trends in the industry, including: the continued growth of on-line investing and the pressure it has put on traditional firms to offer on-line services; how the growth of on-line brokerage will impact the services firms offer going forward; and how firms are developing technology to provide automated, but personalized, advice on-line.
"Providing financial advice on-line will be the next area of focus for the brokerage industry," says the report. "This likely trend raises the issue of how suitability rules apply on-line."
- Suitability. To resolve the issue of what constitutes advice and how to inform investors when information is customized, regulators need to consider how to interpret the concept of suitability on-line. New technology is blurring the distinction between mere order-taking and recommendations about investments, and therefore, makes this a difficult question to answer. The report provides some guidance to the industry by outlining situations that may trigger obligations on the part of brokers to assess the suitability of a client's investments. A suitability obligation may kick in, for example, when an on-line broker provides software to a customer that narrows down the field of stocks, or if the broker uses electronically gathered information about a customer's past transactions to alert them to similar investment opportunities when they click on the firm's website. The report says the suitability rule might apply depending on how finely an individual was targeted.
The report also suggests that regulators consider how defining suitability on-line may impact information flow and customer access. Although some would argue that the Internet gives investors (and consumers generally) too much information, investors may not want this information flow restricted, even at the expense of receiving unsuitable advice.
The report recommended that the SEC consider:
- obtaining information from the industry on how data mining products would work, what information the products would provide to the firms, and whether customers would understand that the firm had provided them with customized information;
- alternatively, expanding examinations of on-line firms to include a review of the services firms provide to their customers based on data mining information; and
- clarifying how suitability principles apply to certain on-line situations, and work with the self regulatory organizations ("SROs") to consider specific scenarios and analysis, found in the Appendix to the Suitability Section of the Report, as guidance to the industry regarding on-line suitability obligations.
- Best Execution. Technology is making best execution an especially critical concept in today's market structure and a significant competitive factor. The duty of best execution requires a broker-dealer to seek the most advantageous terms reasonably available under the circumstances for a customer's transaction. Although this duty evolves with changes in technology and market structure, the SEC has stated that broker-dealers must carry out regular and rigorous evaluations of execution quality across markets and consider price improvement opportunities. Technology provides firms with the opportunity to adopt a new approach to order routing and to meeting their best execution obligations. How firms approach fulfilling their best execution obligations is impacted by: the growth of on-line brokerage; the move to quoting in sixteenths; implementation of the Order Handling Rules; and advances in order routing technologies.
The report recommended that the SEC consider:
- encouraging the industry to demonstrate the relative importance of speed and certainty of execution in today's market environment;
- requiring "market centers" such as stock exchanges to make sure uniform information is available on best execution factors;
- requiring broker-dealers to regularly provide customers with information, written in plain english, about how they execute their trades (the execution quality available on different market centers, the broker-dealer's order handling practices, and inducements for receiving order flow received by the broker-dealer); and
- evaluating the potential impact of new order routing technologies on brokers' best execution obligations, investors and the markets.
- Market Data. The report outlines the pricing structure for retail users of market data and the availability of such information. The federal securities laws grant the SEC broad authority over information about securities quotations and transactions. The SEC must ensure that market participants and the public can obtain this information on terms that are "fair and reasonable" and "not unreasonably discriminatory." The Internet's ability to broadly disseminate real-time information to the public and the concomitant rise of on-line brokerage have substantially increased demand for market data. This demand has raised a number of questions, including whether individual investors pay too much for the information and how much of that data revenue should be devoted to the operations of self-regulatory organizations.
Roundtable participants generally agreed that the Internet warrants a reevaluation of the pricing model for delivering real-time market data to individual investors. However, the participants recognized the industry's need to meet the costs of creating and maintaining an infrastructure to collect and disseminate market data.
The report recommended that the SEC encourage the broadest possible dissemination of real-time market data to investors, and that the SEC evaluate whether the current pricing scheme is consistent with the federal securities laws. Because the SEC currently is involved in such evaluation, the report recommended that the SEC's upcoming market data concept release address the issues raised in this section.
- Systems Capacity. Over the past year, many on-line firms have experienced some type of systems delay or outage that affected the ability of their customers to place orders, according to the report. Despite the industry's efforts to improve capacity, the SEC's most common complaints about on-line trading have come from difficulty in accessing accounts and failures or delays in processing trading orders. On-line firms vary in their approach to measuring systems capacity and in their disclosure to customers about the risks of systems delays and outages. The roundtable participants acknowledged occasional systems failures are inevitable but indicated that they have committed significant resources to ensuring that their systems remain operational. The report concludes that the SEC should focus on methods to ensure more adequate systems capacity at all on-line brokers.
The report recommended that the SEC focus on ways to ensure more adequate systems capacity at all broker-dealers and that it repropose the broker-dealer operational capability rule. It was recommended that the SEC consider:
- requiring broker-dealers to maintain and periodically test contingency plans for dealing with systems outages and other problems with their systems; and
- requiring plain English disclosure of the risks of systems delays or outages in new account documentation.
- Investor Education. Investor education is critical to investor protection. The report reviews the current status of investor education and makes certain recommendations for improvements. The report recognizes the participants' preference for keeping customers on their web sites and that it would be useful to educate investors on their sites. It was also noted that it would be helpful to understand the behavior of on-line brokerage customers in determining the most effective means for disseminating investor education material. The decreased personal interaction between an on-line firm and its customers presents interesting challenges to providing investor education. Investors can now access an unprecedented amount of financial information without the guidance of a broker. Educating on-line investors requires an understanding of how these investors trade and the appropriate time and place to provide them with educational information. At the same time the Internet provides a valuable resource for the SEC to more widely disseminate investor education materials. It was recommended that the SEC partner with firms in increasing investor education and that the SEC study on-line investor behavior to determine the best place and time to educate investors on the Internet.
- On-line Discussion Forums. The report studied on-line discussion forums or "cyber chats" on the Internet and the challenges these forums pose to issuers, market participants and regulators, including the possibility that rumors disseminated on-line can manipulate stock prices. While on-line discussion forums may educate and provide a sense of community to investors, they also may provide a venue for fraudulent behavior. Many issuers monitor on-line discussions about their companies but refrain from addressing rumors about them in the marketplace for fear that they may create a continuing duty to correct or update. Instead, issuers oftentimes go to court to unmask the "anonymous" posters of information. Broker-dealers have generally refrained from sponsoring on-line discussion forums on their sites, although some firms may consider doing so.
It was recommended that the SEC conduct or encourage researchers to conduct a study analyzing the effect of chat room discussions on company's stock prices, and that broker-dealers operating on-line discussion forums consider adopting certain best practices to prevent investor confusion.
- Investor Privacy. Customers increasingly are concerned about the privacy of their personal information. The report describes rising concerns over on-line privacy and how the Gramm-Leach- Bliley Act addresses privacy concerns, and surveys on-line firms' privacy policies. As on-line firms' data mining capabilities develop and the number of financial conglomerates continues to grow, so do customers' concerns about what these institutions can and will do with their personal information. Control over customers' personal information was recently the subject of much discussion in the financial modernization legislation debate. While the Gramm-Leach-Bliley Act requires the SEC and other regulators to adopt specific privacy rules, it appears the discussion is far from over. The discussions focused on how on-line firms address investor privacy.
It was recommended that the SEC consider evaluating on-line firms' information collection practices and consider certain factors in conducting its statutorily required study on privacy.
- Portals. The report studied how brokerage firms should be able to compensate Internet financial portals for routing customers to them. Websites known as portals are considered the "on ramp" to the Internet, attracting millions of monthly viewers. Well known portals include Yahoo! Finance, America Online, Quicken.com, and Microsoft MoneyCentral. Portals have become broker-dealers' rivals as well as important intermediaries between broker-dealers and their customers. A number of broker-dealers have entered into co-branding arrangements with portals, either paying a flat up-front fee or a per order "connection" fee for every order transmitted by an investor who hyperlinks from a portal to the broker-dealer. The discussions focused on how on-line brokerages want to change the way they compensate portals for routing investors to them. Specifically, certain brokerages want to compensate portals based on the number of accounts opened by viewers who hyperlink to a broker-dealer from a portal. Such a "success-based" fee is typically how other commercial partners pay portals, but the federal securities laws prohibit broker-dealers from paying portals that are not registered broker-dealers in a way that gives them a salesman's stake in the transaction.
The report recommended that, because the federal securities laws generally prohibit entities not registered as broker-dealers from receiving securities transaction-based compensation, the SEC consider whether alternative compensation arrangements are appropriate for entities, particularly portals, not registered as broker-dealers.
Conclusion
The report discusses how the Internet is rapidly making on-line trading ubiquitous, and provides the SEC with a comprehensive examination of the critical issues to be addressed in the area of technology. Although it may still be premature for extensive rulemaking in this area, the report highlights for the SEC certain key issues facing investors and the industry and recommends how the SEC can resolve some of these issues.
The SEC staff is currently exploring ways to help firms fulfill their duty to ensure effective customer service, best execution, high-quality disclosure, and responsible advertising, whether on-line or off, according to the report. New rules could be considered by the SEC or the SEC could develop guidelines to help self-policing bodies such as the New York Stock Exchange and the National Association of Securities Dealers regulate brokers' dealings with investors.
The report, entitled "On-Line Brokerage: Keeping Apace of Cyberspace", dated November 1999, can be found at www.sec.gov/news/trendrpt.htm.