Speech by SEC Commissioner:
Securities Law and the Internet
Commissioner Laura S. Unger
U.S. Securities & Exchange Commission
Practicing Law Institute
San Franciso, California
July 28, 2000
Thank you for inviting me to speak. It is a pleasure to be here in cool and sunny California to give a second round of my presentation for this conference. To avoid being repetitive, I would like to touch on different topics than I did for the New York version of the conference. I’d like to raise a number of theoretical, yet very real, questions about how technology and the Internet affect the way the Commission regulates. Of course, the requisite disclaimer states that I can’t actually speak for the Commission, but it does not prevent me from making observations about the regulatory and interpretive challenges the Commission is now facing as a result of the Internet.
I won’t go into my usual observations about how technology is changing our lives or the usual litany of statistics about Internet use or online trading. We know and can simply accept that it is. (Otherwise, I suspect this group would not be here this morning.) For me, the impact of technology is fascinating, not really in terms of how it affects my personal life, but in how it affects the way I view regulation. The Internet provides all of us with a unique opportunity to view the federal securities laws and its various rules, regulations and interpretations with a fresh eye and a new perspective. The challenge, simply put, is understanding how technology changes the way the Commission regulates public companies, market participants and the self-regulatory organizations.
This morning I thought I would talk about four of the fundamental tenets of the securities laws that must be re-examined as a result of the Internet.
First, although it has become a cliché to talk about the amount of financial information now available to investors, we need to ask the question: "How can information be made meaningful to investors?"
Second, with many new participants providing financial information and effecting securities transactions: "What is a broker-dealer?" (Or, more pointedly, what makes financial portals different from broker-dealers and should portals be included in tomorrow’s regulatory scheme?)
Third, in this day of Internet publications, newsletters and stock-picking sites: "What is an investment adviser?"
Fourth, with technology, and Regulation ATS providing additional trading venues and competition: "What is tomorrow’s market and how do we promote competition and innovation in that market?"
And finally, now that technology has made a global marketplace truly feasible: "What can regulators do to facilitate this? In the short term, what should we do to provide foreign access to U.S. markets and investors?"
1. How does the Internet impact information flow to investors and the marketplace?
From the big picture policy perspective, the Internet enables us to achieve an unlimited amount of disclosure. The Internet has made information a relatively cheap and accessible commodity. Information that could never previously have been provided -- never mind broadly disseminated -- is now available real-time to those individuals with Internet access, which is now at least half of U.S. households. Some of this information was previously available through a market intermediary, if the customer requested it, but can now be found on most brokerage firm and financial portal websites. There is a whole new category of information, however, that was not previously available to retail investors, but that can now be accessed through electronic media.
This is a welcome development for the SEC – a disclosure-based agency. The first question we need to ask, however, is what information most benefits investors? Right now, this question is being asked in two significant ways.
The Internet has made it feasible for issuers to open up their analyst conference calls, and many companies have begun doing this. A recent NIRI study indicated that approximately 80% of all companies either had or were about to open up their analyst calls to investors. This access would clearly benefit investors.
The Commission has a proposal before it, however, that would go beyond analyst conference calls. Proposed Regulation FD, intended to cure selective disclosure of material, non-public information (usually earnings-sensitive information), would require issuers intentionally disclosing material, non-public information to disclose it to everyone simultaneously. If an issuer inadvertently disclosed such information, it would have to tell the rest of the world promptly.
For some, the proposal presents a danger that the information flow may be reduced if issuers decide not to talk at all rather than get it wrong. But ironically, a major concern voiced by other commenters is the opposite scenario - that Regulation FD, if adopted, will result in significantly greater amounts of information being disclosed in the form of press releases.
Can the information be disseminated and digested in a meaningful way? Do we need to be concerned about potential "information overload?" Admittedly, this is a lesser concern than the one about the information flow being chilled. But if Regulation FD is adopted and makes significantly more information available to individual investors, will it be the sort of information the average investor wants to know?
The release calls for the disclosure of only material information, but many issuers will err on the side of caution and disclose both material and non-material information. The question is, will investors be able to distinguish one from the other? Another important issue to consider is how investors will process information that isn't first filtered through industry analysts and the financial press.
This is a new type of concern for the Commission – the question of whether there can be too much information. Should we instead opt for a carrot rather than a stick to bring about desired results? Should we look for ways to encourage companies to open up their analyst calls – a proposition the Internet certainly makes viable?
Another source of previously unavailable corporate information is the roadshow. The Commission will soon ask – and answer – whether all retail investors should have access to roadshow information and whether it should be the same information that institutional investors get.
Prior to the Schwab no-action letter issued last November, issuers were restricted from transmitting roadshows to anyone but sophisticated investors and industry participants. The traditional invitees – brokers, institutional investors and investment advisers – supposedly had the investment savvy to separate fact from fluff. The Schwab letter permitted electronic roadshows to be transmitted to retail investors meeting certain net worth and frequency of trading standards.
For now, roadshow content must be the same for all investors who may access them. A second Schwab no-action letter clarified that underwriters cannot develop two different versions of the roadshow. Issuers can’t have one version for traditional institutional audiences, complete with earnings projections and other material information often presented at roadshows, but not included in the prospectus, and a watered-down "roadshow lite" version for retail investors consisting primarily of management interviews.
The existing no-action relief is based on public policy grounds that making roadshow content more widely available is generally a good thing. The Commission will eventually have to consider whether all investors should have access to roadshow information and if so, whether issuers may offer different types of roadshows to meet different investors’ demands.
2. How does the Internet change our interpretation of what activity comes within the definition of, and regulatory scheme for, a broker-dealer?
I have heard much about this topic recently. A significant part of the brokerage industry is up in arms about financial portals. They view financial portals as doing the same things that broker-dealers do -- without the burden and constraints of regulation. Do portals act and look enough like broker-dealers so that they should be regulated like broker-dealers? It’s a good question and a fair question.
The answer is likely already in the Securities Exchange Act of 1934. As you all know, the Exchange Act defines a broker as any person "engaged in the business" of "effecting securities transactions" for the account of others. What does this mean in today’s information age?
Financial portals don’t execute trades, but they do almost everything else. No longer is financial and market information exclusively the domain of broker-dealers. Portals provide company and fund research. They provide earnings estimates, price and news alerts, charts and research reports. They provide lists of stocks that portfolio managers are currently buying, and they offer news on industry sectors and trends. They have on-line discussion forums dedicated to particular stocks and industries, and provide model portfolios with specific stock recommendations. They also "push" information to portal users either at the customer’s request or based on the user’s conduct on the portal’s site.
To date, the analysis of whether a portal is acting as a broker-dealer has generally focused on the first part of the definition – the "engaged in the business" requirement. Whether the portal receives transaction-based compensation from a broker-dealer – reflecting the portal’s economic interest or "salesman’s stake" in the transactions -- has traditionally determined whether the portal was "engaged in the business" of effecting securities transactions.
So far, staff no-action letters have permitted portals performing certain limited activities to receive nominal flat fees based on the number of orders transmitted or the number of households trading as opposed to the number of transactions executed. As a result, portals have been able to avoid triggering broker-dealer registration requirements as a result of their compensation arrangements.
A potential regulatory hook for portals, however, is the second part of the Exchange Act definition that refers to "effecting" securities transactions. As to this requirement, the no-action letters indicate that the actual execution of a securities transaction is but one small pinpoint on the continuum of activity that constitutes effecting a securities transaction. For example, the no-action letter to MuniAuction, Inc. (March 2000) states: "A person is effecting a securities transaction if he or she participates in such transactions at ‘key points in the chain of distribution.’"
As more and more of the customer’s investment decision-making occurs on portal websites, portals may be getting closer to "effecting" securities transactions. The fact that portals do not execute transactions or receive transaction-based compensation may not be enough to keep them from becoming subject to broker-dealer registration and regulation.
The Division of Market Regulation is working on a Commission interpretive release on broker-dealer registration issues right now, and I hope we will have guidance on these questions soon.
3. What is an investment adviser?
The proliferation of publications, newsletters and stock picking sites on the Internet raises questions about which of these activities comes within the definition of investment adviser. The publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation is excluded from the definition of investment adviser under the Investment Advisers Act of 1940.
In the Lowe case, the Supreme Court interpreted the Investment Advisers Act of 1940 as applying to persons engaged in the investment advisory profession who provide personalized investment advice based on the needs of a particular client. The Court stated that business or financial publications that provided impersonal investment advice fell within the publisher’s exclusion from investment adviser registration, provided that the publications were "bona fide," containing "disinterested commentary and analysis as opposed to promotional material disseminated by a tout," and had a "regular and general circulation" that was "not timed to specific market activity, or to events affecting or having the ability to affect the securities industry."
The SEC recently filed a case that raises the question whether a person offering investment advice over the Internet that is alleged to be false and misleading may rely on the "publisher’s" exclusion from Advisers Act regulation. In the Tokyo Joe case, the Commission alleged that Tokyo Joe offered real-time investment advice over the Internet in the form of stock recommendations and charged subscribers $100-$200 per month to get the advice. Tokyo Joe provided stock picks via his own website, e-mails to subscribers and on a real-time chat room within his web site where he discussed stocks. The complaint alleged that Tokyo Joe engaged in a fraudulent "scalping" scheme by (1) trading ahead of his Internet recommendations without disclosure to subscribers, (2) posting false performance results and (3) recommending the stock of an issuer without disclosing that he had received compensation from the issuer.
Based on these allegations, the SEC charged Tokyo Joe with acting as an investment adviser and with violating the antifraud provisions of the Advisers Act and the Exchange Act. Under the Lowe analysis, the first question is whether Tokyo Joe provided personalized investment advice. Can chat room communications over the Internet be sufficiently personalized or individualized to create the basis for an advisory relationship with a subscriber? The second question is, even without personalized advice, can a publication be considered "bona fide" if the advice offered is not "disinterested" or is false and misleading? In other words, is someone who provides investment advice over the Internet – although it may be fraudulent – exempt from the antifraud provisions of the Advisers Act because his Internet postings constitute a "bona fide" news publication?
Given the need to balance Internet regulation with First Amendment concerns, it will probably take this case and others to flesh out how the Advisers Act applies to Internet communications.
4. How has technology affected market structure and how are we dealing with foreign access to U.S. markets?
Technology has revolutionized nearly every aspect of the securities business, and the Commission is attempting to deal with a number of distinct, yet related, market structure issues as a result. We must figure out how to minimize the fragmentation of the marketplace, re-evaluate the model for self-regulation and determine how market data can be collected and disseminated fairly.
Since the adoption of Regulation ATS in 1998, competition among the exchanges, Nasdaq and the ECNs has intensified, with beneficial results for investors. The Commission’s statutory obligation to remove impediments to the national market system requires us to level the playing field among market participants to the extent possible. These developments have created a number of trading platforms that are not all visible to investors.
Following the repeal of NYSE Rule 390, an anti-competitive rule, we have moved to address another very real threat posed by the repeal and other market forces – internalization and market fragmentation. To encourage competition among the markets and among quotes, just this week, the Commission proposed rules as an initial step towards reducing fragmentation and internalization. The proposal requires disclosure of information about order routing and execution practices by market centers and broker-dealers. Market centers would be required to make monthly electronic reports on uniform statistical measures of execution quality on a security-by-security basis. Broker-dealers would be required to make quarterly reports to their customers describing their order routing practices and disclosing the venues to which customer orders are routed. This proposal will encourage quote competition among market centers and will, at the very least, educate investors about the costs of trading.
Another possible means of reducing fragmentation is Nasdaq’s controversial SuperMontage proposal which, among other things, would collect all OTC orders for display in a central location. The ECNs have numerous objections to SuperMontage, but one of their chief objections is that SuperMontage would permit Nasdaq to compete with its own members’ trading systems, particularly the ECNs, subsidized by NASD-member-generated revenue.
The model for self-regulation is still in the discussion stage. As Nasdaq and the NYSE get closer to demutualizing, I suspect that this issue will move to the top of our list. Another issue raised during the open meeting on Tuesday was the important role of market data. Citing the critical role played by consolidated market data in the national market system, the release calls for the formation of an advisory panel to study market data and revenue issues. Given the complexity of this issue, the diversity of views and the impact of market data on competition, I am happy for further study.
The Emerging Global Marketplace
One area we have not focused on involves foreign access to U.S. markets. Cross-border trading presents a host of complex issues including market structure, listing and disclosure standards, and enforcement. We cannot avoid resolving these issues much longer, as interest in cross-border trading continues to expand rapidly.
Before the development of the Internet and on-line trading, institutional investors generally had direct access to foreign broker-dealers. U.S. retail investors wishing to purchase a foreign security, however, had to place an order with a U.S. broker, who would transmit the order to a foreign affiliate or other foreign broker-dealer for execution. The U.S. broker-dealer was required to book the trade and retain responsibility for all aspects of the trade. Today, however, investors are impatient with the slowness and expense of this approach. They do not understand why they cannot trade in markets they can access through their personal computers.
The Commission attempted to deal with the issue of foreign market access in Regulation ATS, which proposed three non-exclusive approaches aimed at protecting U.S. investors from less stringent foreign regulation without unduly impeding trading in foreign markets: (1) a mutual recognition approach for countries with regulation "comparable" to that of the United States, (2) an exchange regulation approach requiring U.S. registration as an exchange, and (3) an access regulation approach for entities providing U.S. investors with foreign market access.
As you know, the Commission decided Regulation ATS couldn’t wait for resolution of foreign market access. Aside from our granting a limited volume exemption from exchange regulation for the Tradepoint Stock Exchange in March 1999, there are no further regulatory developments to report on the foreign access issue.
The lack of regulatory action has not deterred industry action. Spurred by competition as well as the Commission’s apparent "deferral" of action, numerous alliances have been proposed among international securities exchanges. The London Stock Exchange PLC and the Deutsche Boerse AG are considering a merger that would result in a new London-based entity, International Exchanges or iX. Initially, iX will list only U.K. and German securities, although it plans to list other foreign securities in the future.
Of course, these alliances have not really advanced the ball on creating a global marketplace either. Rather than adopt a single shared regulatory structure for iX, regulatory responsibility will be split between the U.K. and Germany. iX blue chip securities will be traded on the London Stock Exchange subject to LSE regulation, and the growth or "tech" stocks listed on the Deutsche Boerse will trade subject to Frankfurt’s regulation. Other shares will trade on their existing national markets.
Not to miss a competitive opportunity, Nasdaq and the NYSE have also jumped into the foreign market fray. Nasdaq has announced a joint venture with iX to establish a pan-European market for growth stocks and the top 100 Nasdaq-listed companies. Nasdaq Japan has entered into a similar agreement with the Osaka Securities Exchange and seven Nasdaq stocks began trading recently in a pilot project on the Hong Kong Stock Exchange. The New York Stock Exchange recently announced a Global Equity Market linkage among eight international exchanges, including the NYSE, Euronext and the Tokyo Stock Exchange, that will work towards a round-the-clock trading platform for the world’s largest stocks.
Given the regulatory and practical problems involved, it may take some time before any of these arrangements bear fruit. Differences in trading systems, currencies and clearance and settlement systems must be resolved.
The important point for the Commission though, is that these alliances do not yet benefit U.S. retail investors. Technology provides the opportunity for globally-linked, round-the-clock trading capabilities to satisfy investors’ growing diversified needs. But without the SEC’s liberalizing foreign access, U.S. investors have direct access to trading only in those foreign securities that are listed in the United States. That doesn’t sound much like foreign access. With regulation as the only remaining impediment, the Commission must work hard to remove whatever obstacles it can to further the development of a global marketplace.
I thank you very much for the opportunity to speak today – and my mother thanks you very much for bringing me to visit. I am happy to take questions.