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Regulators’ Comments Suggest More Flux at Online Brokers

11/22/1999

TheStreet.com

One note to online brokers marching toward world domination: Be careful — regulators are watching.

Online brokerages have long been immune to the legal actions dogging full-service firms that make investment recommendations. But now the electronic upstarts such as E*Trade (EGRP:Nasdaq – news), Schwab (SCH:NYSE – news) and Ameritrade (AMTD:Nasdaq – news) face the prospect that their legal responsibilities will be expanded to include so-called suitability, over advice on whether to buy or sell an investment was appropriate.

As a result, online brokers moving toward personalization of their sites and a more full-service operation will have to better manage their client interactions to maintain appropriate ideas for specific clients.

And from the looks of separate reports from the Securities and Exchange Commission’s Laura Unger and New York Attorney General Eliot Spitzer, those aren’t the only changes that may be in the wind for the online brokers. Indeed, almost all of their functions appear to be under scrutiny.

The report by commissioner Unger is a key move for the SEC, and is a likely precursor to some degree of rulemaking, although an SEC press release dubbed “extensive rulemaking” still “premature.” The report, issued Monday morning, set out a framework for the agency to:

  • Gather information on suitability;
  • Push online firms toward best-execution practices regardless of payment for order flow and order handling;
  • Develop better real-time market information;
  • Expand systems’ capacity;
  • Increase investor education;
  • Analyze chat rooms’ effect on certain stock prices; and
  • Evaluate client privacy concerns.

The industry was busy evaluating the report Monday. “We’re just beginning to digest the report, so it’s too early to make a prediction,” says a Schwab spokesman. “But our view is that the online channel is one of many and that it would be a mistake to somehow single it out for specific regulation.”

An Ameritrade spokesman, however, said he didn’t see his firm venturing into the advice arena and thought the SEC report was trying to better regulate the evolution of Internet brokers.

If rulemaking does follow, says New York securities attorney Jonathan Kord Lagemann, it could dramatically change the way online brokers operate. “You’ve got to have a larger compliance and legal department, and that can make it difficult to keep giving cheap execution,” he says. “It’s going to force them to be more like Merrill Lynch (MER:NYSE – news).”

And like everything else they’ve touched on Wall Street, online brokers will be blazing some trails, especially in terms of suitability. In the days of flesh-and-blood brokers, an unsuitable investment would be an oil-and-gas limited partnership sold to a 98-year-old widow who had never before invested. That definition has changed to put the focus on bringing an idea to buy, sell or hold a security to the attention of a client.

“The world has changed,” says Los Angeles securities attorney Philip Aidikoff of Aidikoff & Uhl. “If Merrill Lynch advertises research available and someone read it and then buys the stock online, doesn’t suitability come into play?”

Spitzer managed to squeeze $500,000 from the Securities Industry Association for educational advertising and materials for investors. While half a mill is dogtrack money compared to the hundreds of millions online brokers will spend on advertising in 1999, the effort is getting some attention.

Spitzer’s push has all the right buzzwords. His report endorses “good old fashioned research and education” and says that “cheap, easy and frequent trading does not equal successful trading.”

But attorney Aidikoff says regulators won’t be the primary influence on how online brokerages develop. “The reality is they can put in collars on suitability the same way they have with equity,” Aidikoff says, referring to the kinds of margin controls and trading limits e-brokers have put on customers. “And I suspect in the next eight to 12 months, you’ll see that — no matter what the SEC does.”

At a legal conference in New York two weeks ago, the SEC’s Carmen Lawrence said the agency was keeping a close eye on suitability and whether links to other sites, bulletin boards or third parties could fall into the category of recommendations.

Aidikoff, for one, is expecting change: “The firms will adapt because it doesn’t make sense for them to get sued on something they can prevent.”


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