Simpson Thacher & Bartlett
A version of this article appeared in
wallstreetlawyer.com, April 1999
©1999 wallstreetlawyer.com. All rights reserved. Reproduced with permission of Glasser LegalWorks, 150 Clove Road, Little Falls, NJ 07424 (800) 308-1700.
The growth in online trading has been colossal. Now online brokerage firms are experiencing colossal growing pains. These growing pains have attracted the unwanted attentions of federal securities regulators, class action plaintiffs' lawyers and investigators from the New York State Attorney General's office.
Last January, leading online broker Charles Schwab & Co. reportedly had fifty-five million hits at its Web site in one day.(2) It also registered more than one billion hits at its Web site during the entire month as record numbers of investors accessed online trading accounts and research.(3)
Nearly all online brokerage firms are experiencing increasing demands on their system resources. Indeed, so far this year there reportedly has been a thirty percent industry wide surge in online trades to 440,000 transactions each day.(4)
Additional assaults on system resources are likely. One recent industry analysis forecasts that the number of online trading accounts will nearly quadruple from approximately 6.4 million online accounts in 1998 to 24 million online accounts by 2002.(5)
Recent Online Trading Outages And Slowdowns
With such growth has come increasing strain on the online brokerage firms' computer systems. It seems, as one media account put it, that "[h]ardly a week goes by without a computer glitch disabling a major online brokerage."(6)
While the online brokerage industry's record is not even remotely as bad as such a statement might suggest, a review of recent news reports indicates that there recently has been a spate of widely-reported outages or service slowdowns that have affected several of the industry's principal players.
As the following chart suggests, such outages and trading difficulties appear to be occurring with increasing frequency:
Widely-Reported Outages or Service Difficulties(7)
- Brokerage Firm
- October 27-28, 1997
- Trading delays; volatile markets
- October 27-28, 1997
- Trading delays; volatile markets
- Late November 1998
- Online trading crash
- January 8, 1999
- Outage with subsequent delays
- Second January 1999 Outage
- Brief outage; second of month
- February 3, 4 & 5, 1999
- Sporadic outages (upgrade)
- February 8, 1999
- 30-minute outage
- Week of February 15, 1999
- 10-minute Web site crash
- February 24, 1999
- 1-hour outage due to upgrade
- March 1, 1999
- 25-minute outage
- March 9, 1999
- Web site down for 15 minutes
- March 9, 1999
- Order-placing difficulties
- March 17, 1999
- 20-minute trading problems
- March 17, 1999
- Trading difficulties
- March 19, 1999
- Heavy order backlog delays
SEC Proposed Rulemaking To Require Adequate Operational Capacity
This recent spate of problems has attracted the attention of the U.S. Securities and Exchange Commission. On March 8, the SEC published for comment a set of proposed rules dealing with the operational capability requirements of registered broker-dealers.(8)
The SEC's proposed rules provide fascinating insight into a regulatory agency that is struggling mightily to keep up with the swift pace of technological changes in the broker-dealer industry. The SEC's Introduction and Executive Summary contained in its Notice of Proposed Rulemaking states:
Because of the tremendous growth in the volume and complexity of securities trading in recent years, broker-dealers and transfer agents are becoming increasingly reliant on computer systems to perform their functions. Securities firms rely on computers to handle every aspect of trading, from routing orders to various markets to maintaining customer accounts. As with broker-dealers, the majority of transfer agents also now rely on computers instead of manual processing to record changes of ownership of securities, maintain issuer security holder records, cancel and issue certificates, and distribute dividends. Accordingly, it has become more essential than ever that broker-dealers have sufficient operational capability to process transactions for customers as well as to maintain control of customer funds and securities, and for transfer agents to assure the prompt transfer and processing of securities and maintenance of security holder files.
Online brokerage firms should take heed. The SEC already has issued statements indicating that it means business.
For example, following the wild market swings on October 27 and 28, 1997, the SEC's Division of Market Regulation Staff issued a Legal Bulletin warning that broker-dealers need to have enough systems capacity to ensure a "high degree" of operational capability. According to the bulletin, "broker-dealers should not merely have sufficient systems capacity to handle average-to-heavy loads. Rather, broker-dealers should have the systems capacity to handle exceptional loads of several times the average trading volume." Additionally, the bulletin warned that "adequate capacity should be a top priority for broker-dealers."(9)
Of course, the Division of Market Regulation Staff Bulletin was not the first time that the SEC has dealt with systems capacity issues. During difficulties experienced with certain broker-dealers' so-called "back office" operations in the 1960s, the SEC warned that if the firms did not have the personnel and facilities to enable them to execute and to consummate all securities transactions promptly, they could be in violation of the antifraud provisions of the federal securities laws if they accepted or executed any additional customer orders.(10)
Additionally, the SEC has published two Automation Review Policy statements in which it addressed operational capacity issues.(11) Together the Policy Statements make clear that market participants including broker-dealers and the Self Regulatory Organizations that oversee them should "establish comprehensive planning and assessment programs to determine systems capacity and vulnerability."(12) Indeed, the SEC's Staff has described the Policy Statements as "guidelines" to be followed by Broker-Dealers and has noted that the statements emphasize "the importance of: (i) formally establishing capacity estimates; (ii) conducting periodic capacity stress tests; and (iii) contracting with independent reviewers to assess performance at current and future capacity levels and to assess vulnerability to physical threats."(13)
SEC Investigation of the Online Trading Industry
The SEC's proposed rulemaking is not the only battlefront opened by securities regulators. The SEC's Office of Compliance, Inspections and Examinations also has begun what has been described as a "top-to-bottom review" of the online trading industry.(14)
This "top-to-bottom" review reportedly includes formal examinations of some of the industry's largest online brokers. The SEC Staff reportedly is interested in the following question:
Do online brokerage firms make good on promises involving the reliability of their services as millions of investors, many of them newcomers to the stock market, start trading on the Internet? . . . In recent months, several online firms have suffered high-profile outages in their trading system, meaning that some investors couldn't place trades or access accounts.(15)
In addition, SEC Commissioner Laura Unger is overseeing the preparation of a study of the online trading industry. The report, which reportedly will be ready by early this fall, is expected to contain an assessment of whether the current regulatory scheme applicable to online trading is adequate or needs to be revisited by the Commission.(16)
Some in the online brokerage industry reportedly suspect that large, traditional broker-dealers have prompted the regulatory scrutiny to which the online brokers are being subjected. More likely, however, the widespread media attention that the high profile outages have attracted is the culprit, combined with the regulators' well-founded concerns with maintaining the continued integrity of the U.S. financial markets.
Lawsuits Against Online Brokerage Firms
Plaintiffs' lawyers have not lost sight of perceived opportunities presented by the growing pains being faced by online brokerage firms.
On October 27 and 28, 1997, the Dow Jones Industrials posted their then-largest one-day drop and one-day gain respectively. Most online brokerage systems held up, but trading delays reportedly were common due to extraordinarily heavy trading volume.
Only days later, on November 21, 1997, a class action was commenced against E*Trade in Santa Clara County Superior Court in California. The complaint alleged that E*Trade aggressively marketed its services despite a computer system that could not handle the additional volume. The complaint further alleged that E*Trade's alternative of permitting telephone trades was inadequate because callers allegedly experienced long delays due to busy signals and unanswered phones. The suit accuses E*Trade of making "reckless marketing representations" and seeks to "restore to the members of the class all monies and property wrongfully acquired by means of E*Trade's deceptive practices." E*Trade denies the allegations.(17)
More recently, E*Trade was hit with a second lawsuit filed shortly after the difficulties its online trading customers reportedly suffered on February 3, 4 and 5, 1999. The suit, filed on February 9 by attorneys for Coleen Divito in Santa Clara County Superior Court in California, is brought on behalf of a class of E*Trade customers affected by four separate service outages during the first week of February 1999. The complaint in the action alleges that "[a]s a result of [a] virtual lockout, class members lost potentially millions of dollars."(18)
E*Trade is not the only online brokerage defending such suits. In October 1997, suit reportedly was filed against Ameritrade alleging that late stock prices and transactions occurred with trades placed through Ceres Securities, an online firm acquired by Ameritrade.(19) Additionally, other firms including Charles Schwab and Datek apparently have, at various times, sought to settle claims to avoid lawsuits by irate investors who reportedly have experienced online trading difficulties.(20)
On February 4, four Democratic members of the United States House of Representatives issued a letter to Arthur Levitt, Jr., Chairman of the Securities and Exchange Commission. The letter was signed by Representatives John Dingle of Michigan, Ron Klink of Pennsylvania, Ed Markey of Massachusetts and Edolphus Towns of New York.
Among other things, the letter asked for a briefing on "the capacity and other operational problems afflicting online trading systems." (21) The letter further indicates that Congressional representatives have asked the National Association of Securities Administrators Association for input on the same issues as well as the organization's views regarding the adequacy of state law protections for investors.
The letter also suggests that the four Congressmen have asked the United States General Accounting Office to provide them with a report on the issue and further indicates that Congressional hearings regarding online trading are forthcoming.(22)
Investigation by New York State Attorney General's Office
Also on February 4, 1999, New York State Attorney General Eliot Spitzer announced an investigation into service disruptions at online brokerages. According to Attorney General Spitzer, "Consumers have complained about frequent system crashes, server unavailability, and long delays in executing trades. Some customers have reported losing thousands of dollars due to slow trading."(23)
As part of the investigation, Attorney General Spitzer's office has asked online brokerage firms to provide documents, reports and other information regarding their services. Additionally, the Attorney General's Web site has published a "Survey: Online Brokerage Industry" as well as an Online Brokerage Service Complaint Form.(24)
The Online Brokerage Service Complaint Form requests substantial details regarding customer difficulties with online trading services. Among many other things, the form asks for information regarding such matters as:
- Inability to access OBS's [Online Brokerage Service's] Web site
- Inability to access real-time stock quotes
- Excessive delays in updating account information
- Inability to access customer service
- Unauthorized changes of account information
- Orders executed beyond purchasing power of account
- Inadequate research available online
- Excessive delays in order processing and execution
- Inability to access timely account status information
- Inadequate customer service
- Inaccurate postings to account
- Failure to provide best execution price
- Single order executed multiple times
According to a statement issued by Attorney General Spitzer's office, "[t]he public knows that there are always risks involved in investing in the stock market. But part of the risk should not include questions about whether trades will be executed promptly or whether online brokerage firms can deliver the services that they've promised."(25)
What are Online Brokerage Firms Doing To Address these Issues?
What are online trading firms doing to address these issues, besides cooperating with investigators and regulatory authorities? First, they are adding capacity, capacity and more capacity as well as increasing levels of redundancy. The difficulties and expenses involved with such systems upgrades are likely to change the makeup of the industry profoundly. Increasing regulatory scrutiny and expensive technology upgrades are likely to lead to consolidation in the industry as the smaller players find it more difficult to compete.(26)
Some online brokerage firms reportedly have begun to compensate customers for customer execution price adjustment during periods of trading system delays or outages.(27) Others have offered to waive up to $500 or more worth of trading commissions to customers who can document that they have experienced difficulties in making online trades. For example, Schwab recently offered customers unable to trade online who have waited five minutes or longer on hold for phone trading a waiver of up to $500 in trading commissions.(28)
Most firms are setting up special e-mail customer service addresses, although at particularly tough times, the worst thing that can happen is to set up such addresses and not have the capacity to respond to the e-mails for two days or even longer as recently happened at E*Trade.(29)
The larger firms are expanding their customer service staffs. For example, after recent difficulties at E*Trade, the company announced that it was adding 200 customer service representatives to bring its customer service staff up to 300 people.(30)
Some firms are expanding their broker phone banks to increase availability of telephone trading at times of outage.
Some firms are scaling back plans to bring new customers online. For example, Ameritrade recently announced that it is scaling back its advertising plans to slow membership increases while it focuses on increasing its capacity.(31)
Although some outsourcing of technology operations is taking place, such outsourcing is not necessarily the answer. As the SEC's Staff has clearly stated, "broker-dealers should recognize that they are not excused from taking the steps necessary to ensure that adequate systems are in place merely because they rely on outside vendors. They need to exercise oversight of vendors' operations, and ensure that vendors adequately address capacity problems."(32)
As anyone in the technology industry knows, computer glitches and gremlins are a fact of life. Most believe that such problems cannot be eliminated entirely, even in the most sophisticated technological environments. While the risks of such failures must be minimized to the extent that is technologically and economically rational, no trading systems will ever be rendered failsafe.
Reducing the risk of failure will be an extraordinarily expensive proposition for the industry. Indeed, it is ironic that at precisely the time that the SEC is pushing online brokerage firms to spend extraordinary sums to upgrade their systems and add trading capacity, the agency itself is begging Congress for money to upgrade its own computer systems to permit it to regulate the markets more effectively.
1. Blake A. Bell is Senior Knowledge Management Counsel with Simpson Thacher & Bartlett, New York City. He focuses on computer-related matters, Internet law, securities regulation and commercial litigation. He can be reached at email@example.com. This article reflects his views, not necessarily those of his firm.
2. Overwhelmed Schwab Site Sees Delays, Bloomberg News Special to CNET News.com, Jan. 8, 1999 .
3. A Billion Hits for Schwab Last Month, Bloomberg News Special to CNET News.com, Jan. 29, 1999 .
4. Another Outage for Schwab, Bloomberg News Special to CNET News.com, Mar. 17, 1999 .
5. Paul Johnson, Online Brokerage Forecast, 1997-2002: Redefining the Brokerage Landscape, Nov. 1998 (Int'l Data Corp. Rep. #W17465). See also Study Sees Strong Growth of Online Trading, CMP Net TechWeb, Nov. 10, 1998 .
6. Scott Thurm, Glitches Hinder Online Brokers: Growth Pushes Limits of Trading Technology, Wall St. J. (republished by MSNBC), Mar. 4, 1999 .
7. The table is based on a review of the following materials: Suzanne Galante, Delays Spur Suit Against E*Trade, CNET News.com, Dec. 1, 1997 ; Mo Krochmal, Online Investors Shout While Being Shut Out, CMP Net TechWeb, Nov. 3, 1997 ; Ameritrade Site, Trading Services Crash, Bloomberg News Special to CNET News.com, Feb. 8, 1999 ; Overwhelmed Schwab Site Sees Delays, Bloomberg News Special to CNET News.com, Jan. 8, 1999 ; Schwab Suffers Fourth Outage, Reuters Special to ZDNet ZDNN Tech News, Mar. 1, 1999 ; Mark Leibovich, E-Trade's Disabling Software Glitch Attests to the Fallibility of Online Services, Defines Crisis Situation in Computer Age, The Wash. Post Special to star-telegram.com, Feb. 25, 1999 ; Kora McNaughton, Problems Hit E*Trade for Third Day, CNET News.com, Feb. 5, 1999 ; Dan Goodin, Quest for Market Share Has Fallout, CNET News.com, Feb. 5, 1999 ; R. Scott Raynovich, Etrade Goes Down, Wired News, Feb. 3, 1999 ; Matt Hines, E*Trade Site Experiencing Problems, Newsbytes Special to CNNfn.com, Feb. 3, 1999 ; Matt Hines, E*Trade Suffering From Slowdowns Again, Newsbytes Special to CNNfn.com, Feb. 4, 1999 ; Kora McNaughton, Schwab Web Site Crashes During Trading, CNET News.com, Feb. 24, 1999 ; Jeffrey Schwartz, Software Upgrade Causes Another Schwab Outage, CMP Net TechWeb, Mar. 3, 1999 ; Schwab Web Site Goes Down After Markets Open, Reuters Special to InternetNews.com, Feb. 24, 1999 ; Another Outage for Schwab, Bloomberg News Special to CNET News.com, Mar. 17, 1999 (noting that Schwab has had five outages this year); Schwab Suffers Fourth Outage, Reuters Special to ZDNN Tech News, Mar. 1, 1999 ; Glitches at Schwab and E*Trade Sites, N.Y. Times, Mar. 10, 1999, at C22, col. 2; Steve Gelsi, E-Trade Bugs Strike Again: Trouble Dogs Online Broker a Second Time This Week, CBS MarketWatch, Mar. 19, 1999 (available via search at http://cbs.marketwatch.com/).
8. Operational Capability Requirements of Registered Broker-Dealers and Transfer Agents and Year 2000 Compliance, Exchange Act Release No. 34-41142 (Mar. 8, 1999).
9. SEC Division of Market Regulation Staff Legal Bulletin No. 8 (MR) (Sept. 9, 1998) .
10. Important Notice to Broker Dealers, Exchange Act Release No. 8363, 33 Fed. Reg. 11150 (July 29, 1968); see also Operational Capability Requirements of Registered Broker-Dealers and Transfer Agents and Year 2000 Compliance, Exchange Act Release No. 34-41142 n.1 (Mar. 8, 1999) .
11. See Automated Systems of Self-Regulatory Organizations, Securities Exchange Act Release No. 27445, 54 Fed. Reg. 48703 (Nov. 16, 1989) ; Automated Systems of Self-Regulatory Organizations (II), Securities Exchange Act Release No. 34-29185, 56 Fed. Reg. 22490 (May 15, 1991) .
12. SEC Division of Market Regulation Staff Legal Bulletin No. 8 (MR) (Sept. 9, 1998) .
14. See generally SEC Steps Up Oversight of Net Trading, Reuters Special to CNET News.com, Mar. 11, 1999 ; SEC Eyes Online Brokers: Agency Steps Up Scrutiny of Schwab, E*Trade, Others Sources Say, CNNfn, Mar. 11, 1999 .
15. Charles Gasparino & Michael Schroeder, Heard on the Net: Online-Broker Titans Pledge Cooperation with SEC Scrutiny, Wall St. J. Interactive Ed., Mar. 11, 1999 (available via search at http://interactive.wsj.com/) (also available via ZDNet ZDNN Tech News at http://www.zdnet.com/zdnn/stories/news/0,4586,2224139,00.html).
17. Suzanne Galante, Delays Spur Suit Against E*Trade, CNET News.com, Dec. 1, 1997 ; Edward Iwata, Angry Traders Sue Etrade: Suit Says On-Line Trading Company Can't Handle Heavy Volume, San Francisco Examiner, Dec. 2, 1997 .
18. E*Trade Hit by Class-Action Suit, Bloomberg News Special to CNET News.com, Feb. 9, 1999 ; Matt Hines, E*Trade Lawsuits Arrive in Wake of System Problems, Newsbytes Special to CNNfn.com, Feb. 10, 1999 ; E*Trade Hit With Second Lawsuit, Reuters Special to ZDNet ZDNN Tech News, Feb. 10, 1999 ; ETrade Sued for Bad Service, Wired News, Feb. 11, 1999 .
19. Suzanne Galante, Delays Spur Suit Against E*Trade, CNET News.com, Dec. 1, 1997 .
20. See Schwab Settles IPO Claims, CNNfn.com, Mar. 11, 1999 (noting that while it denies the claims, Schwab is settling the complaints of 300 investors who claimed they paid too much for shares of theglobe.com on its first day of trading); Suzanne Galante, Delays Spur Suit Against E*Trade, CNET News.com, Dec. 1, 1997 (noting that Datek offered online investors compensation for delays incurred in executing trades long after they were placed).
21. A copy of the letter is available at http://www.house.gov/commerce_democrats/press/106ltr8.htm.
22. See generally US Congress Tries To Grasp Internet Stock Trades, Newsbytes Special to CNNfn.com, Feb. 5, 1999 ; Congressmen Ask SEC About Net Trading, Reuters Special to CNET News.com, Feb. 5, 1999 .
23. Press Release - Office of New York State Attorney General Eliot Spitzer, Online Trading Glitches Prompt State Investigation, Feb. 4, 1999 . For a brief transcript of remarks by Attorney General Spitzer regarding the investigation made on February 8, see See also NY To Probe Net Brokers: Attorney General Spitzer's Inquiry Comes as E-Trade Battles Second Day of Glitches, CNNfn.com, Feb. 4, 1999 .
24. The Survey, which seeks personal data from Respondents and asks whether they have ever experienced problems with their current online broker and to provide detailed comments, is available at . The Online Brokerage Service Complaint Form is available in a PDF file at .
25. Kora McNaughton, Problems Hit E*Trade for Third Day, CNET News.com, Feb. 5, 1999 .
26. Online Brokers Going Broke, Wired News, Mar. 16, 1999 .
27. Dan Goodin, Quest for Market Share Has Fallout, CNET News.com, Feb. 5, 1999 (noting that last quarter, online broker Ameritrade "took a $3.1 million charge for 'customer execution price adjustment during periods of trading system delays or outages.'").
28. Kora McNaughton, Schwab Web Site Crashes During Trading, CNET News.com, Feb. 24, 1999 .
29. Kora McNaughton, Problems Hit E*Trade for Third Day, CNET News.com, Feb. 5, 1999 (quoting one E*Trade customer who claimed his e-mails to a special customer service address had gone unanswered for two days).
30. Kora McNaughton, Problems Hit E*Trade for Third Day, CNET News.com, Feb. 5, 1999 .
31. Steve Gelsi, E-Trade Bugs Strike Again: Trouble Dogs Online Broker a Second Time This Week, CBS MarketWatch, Mar. 19, 1999 (available via search at http://cbs.marketwatch.com/).
32. SEC Division of Market Regulation Staff Legal Bulletin No.l 8 (MR) (Sept. 9, 1998) (citing 17 C.F.R. 240.17a-4(f)(2)(i)).