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U.S. Securities and Exchange Commission

Speech by SEC Staff:
"On-Line Brokerage: Staying on the Right Side of the Line"

by Richard H. Walker

Director, Division of Enforcement,
U.S. Securities & Exchange Commission

Before the SIA Legal and Compliance Division

New York, N.Y.

November 17, 1999

Thank you and good afternoon.

I am honored to have been asked to be your luncheon speaker here today. It’s no secret that I’m a huge fan of the legal and compliance community and the SIA’s Compliance and Legal Division. I have enormous respect for the difficult work that you do. Day in and day out, you’re asked to make some pretty tough calls under enormous pressure. The great majority of you do so with courage and integrity. I’ve always viewed you as the Commission’s partners in helping to protect the reputations, not just of your firms, but of our securities markets which are the envy of the world.

As I join you today, I can’t help but marvel at how the current technological revolution is transforming our markets. The rapid pace of change during the last few years is unprecedented. Concepts such as on-line trading, after-hours trading, and day trading were barely part of our collective consciousness as recently as three years ago when I last spoke at this conference. Today, they are common parlance. These developments have taken the "wall" out of Wall Street, which is now virtually boundless.

In the past year alone, we’ve experienced momentous changes on all fronts -- the legislative, regulatory and, yes, even the enforcement front.

In the legislative arena, Congress has officially eliminated the artificial barriers separating banking and securities activities, and enacted major securities litigation reform.

On the regulatory front, we’ve seen the rapid rise of new electronic trading systems which have challenged more conventional markets, and we’ve heard talk about plans to de-mutualize exchanges. These innovations raise a host of questions about what the markets of tomorrow will look like and how they will be regulated.

And on the enforcement side, we’re dealing with the phenomenal growth of the Internet which often resembles the Wild West insofar as its borders are vast and largely unregulated. We’ve also had to contend with a certain perception of lawlessness that seems to prevail. To give you an example, we recently discovered a web site titled, "Arthur Levitt’s top stock picks." Needless to say, we were not amused. And neither was the Chairman when we told him it was probably not a good idea for the Chairman of the SEC to act as an investment adviser, particularly without filing a Form ADV. Our fears were allayed when the Chairman confirmed that he had not ventured into dangerous ethical territory and that the site was an impostor. I had a harder time explaining why we hadn’t taken quick and decisive action to shut the site down. The problem, you see, was that there wasn’t any traffic to the site and thus, happily, no one was being deceived.

The crush of investors and brokerage firms racing to the Internet to do business is reminiscent of the California gold rush. Scores of investors are arriving on-line with their checkbooks and a new sense of empowerment. And firms are scrambling to capture this business. The statistics are staggering. By the end of this year, Internet users will number close to 1 billion, and as much as 40 % of all retail trades will be done on-line. There are currently 160 broker-dealers that offer on-line trading services -- both start-ups operating exclusively on the Net as well as traditional full service securities firms.

What the Internet has done for investing is nothing short of revolutionary. Today, the average investor has more power and information available at his or her fingertips than ever before -- power and information that, until a few years ago, was only available to securities professionals. Access to such information is easy, quick and cheap. It’s no wonder, therefore, that investing has become so popular among so many.

In addition to revolutionizing the process of investing, the Internet is also transforming the face of Wall Street. Trades are now executed at a host of new cyber-market centers and into the evening hours. The Internet is also bridging the differences between discount and full service firms. Discount firms are beginning to offer research and services other than simply trade execution. And full service firms are offering low cost Internet trade executions, without the aid of a registered rep. There is also a movement afoot among larger firms to eliminate commissions in favor of an annual asset-based fee.

Advances in technology have fueled a surge in the popularity of individual investing. The extent of this new found popularity is perhaps best illustrated by the advertisements that ran during the recently completed World Series. Rather than the usual commercials for Budweiser, Coke and Doritos, we were bombarded by ads for a leading on-line brokerage firm. It would not be surprising if the nation’s favorite pastime -- baseball -- were soon replaced by a new favorite pastime -- investing. Regardless of whether this will happen, it is clear that investing is becoming a mainstay of our popular culture.

As we move rapidly into the brave new world of on-line investing, it is critical that we not lose sight of the basics that have sustained our markets for decades. Our securities laws are premised on the philosophy of full and fair disclosure and the protection of investors. The securities laws have proven remarkably flexible and resilient in the face of technological advances never envisioned by the statutes’ draftsmen. I agree with Chairman Levitt who has stated that he is "not convinced it’s necessary for the SEC to promulgate a totally new and radical scheme of regulation specifically tailored to on-line investing."

What is important, however, is that we maintain our strong commitment to the bedrock principles of our existing regulatory system. Long established legal doctrines, such as best execution, suitability, and supervision apply equally in the new on-line environment. Hanging a shingle on the Internet is no different than hanging a shingle on Wall Street. As a result, the shingle theory requiring firms to deal fairly with their customers also applies with full vigor to the on-line broker.

Adherence to these principles is important because today’s new investors, empowered by technology, are not necessarily any better informed or educated to deal with the new choices available to them. Unfortunately, as we all know, there is still a tremendous gap between investment opportunity and investment responsibility. Accordingly, with the increase in individual freedom in the marketplace comes a greater need, on the part of all of us, to assure the highest standards of practice in order to preserve the enormous confidence in our markets and to protect individual investors. As investing moves from Wall Street to Madison Avenue, and from CNN to prime time, we must be vigilant in not permitting our time honored commitments to full disclosure and investor protection to give way to hype and hyperbole.

With this background in mind, I’d like to share with you my views, and they are my views, and not those of the Commission or its staff, about some of the challenges which we must confront in the fast evolving Internet marketplace. Perhaps no other topic is the subject of greater attention at the Commission at the present time. As you know, Chairman Levitt has spoken on several recent occasions about some of the more urgent questions and developments born of technology and change affecting our markets. And Commissioner Unger has conducted a series of roundtable discussions with industry participants on this subject and will soon be issuing a report. My objectives today are more modest. I’d like to talk about a few areas where I have concerns about whether we’re losing sight of the fundamentals in our scramble to adapt to the evolving marketplace.

The Quest for Market Share

My first concern arises out of some of the unhealthier aspects of competition among firms for customer accounts. Firms are expending great resources seeking ways to differentiate themselves and to attract market share. Current estimates are that on-line brokers will boost their ad budgets by more than 60% next year, to over one billion dollars. To put this in perspective, advertising expenditures by on-line brokers will exceed those of McDonalds and Burger King combined. And the ads are having a significant impact. Fifteen thousand new investors open on-line accounts each day. In a zeal to capture these investors, competition among on-line firms has been fierce. Without question, competition is vital to the marketplace and has produced many benefits for investors, in particular, greater transparency, more opportunity for price improvement and the lowering of transaction costs. I worry, however, that some investor concerns are being ignored in the relentless quest for market share.

There are three main aspects of the current competition that concern me. One, the offer of cash or similar awards to investors for opening an account. Two, the promise of participation in coveted initial public offerings. And three, the use of "aggressive" advertising.

The offering of cash awards is the latest variant of the bank toaster giveaway and seems to be a favorite promotion of on-line brokers. Customers are offered gifts ranging from $75 to frequent flier miles to a week of commission-free trades for opening an account. Maybe these giveaways are harmless, but I am concerned that they may induce some investors to engage in investment activity that does not best suit their needs. I’d hate to see an uneducated investor who needs hand holding drawn to an on-line account because of some one-time gift. Similarly, I’d be troubled if an investor best suited to purchasing mutual funds were lured into trading volatile Internet stocks or trading on margin because of a week’s worth of free commissions. One solution may be better disclosure of both the risks and the rewards of on-line investing by firms offering such inducements. On balance, though, I would much rather see firms distinguish themselves based on the quality of their executions and research, the competitiveness of their commissions, and a matching of services offered to particular types of targeted investors.

Another new fad is the enticement of investors through promises of opportunities to invest in coveted IPOs. Nothing whets an investor’s appetite as much as the possibility of getting in on a lucrative IPO. The IPO success stories are legion, including the recent offerings by UPS and Martha Stewart. I am concerned, however, that firms are making promises they cannot keep and are creating unrealistic expectations on two fronts.

First, there is no doubt that this is an area where supply does not equal demand, and only a small percentage of interested investors receive shares in each IPO. In fact, three on-line firms announced earlier this week that they are banding together to form an on-line investment bank because, as reported, they "are tired of picking up the crumbs of the IPO pie." Investors should not be misled into believing that their chances of participating in an IPO are better than they are.

Second, not all IPOs will be hot, and investors need to be sophisticated enough to withstand a loss in market value if the price of a new issue goes down instead of up. The SEC’s Office of Compliance Inspections and Examinations recently conducted a sweep of on-line broker-dealers and found that at least one firm did not appear to be evaluating customer eligibility to participate in the IPO.

My sensitivities were heightened after a recent visit to an on-line brokerage site promising IPO participation. From the home page, you are invited to click on a button entitled, "How to participate in our next offering." This, of course, suggests that you can and will be able to do so. You are immediately taken to a screen advising that you need to set up an on-line account with a certain on-line broker-dealer to qualify. A link is provided to open the account. The investor is next told, "Once you have established [this on-line] account, you may invest in one of our public offerings by clicking on the ‘Place a Conditional Offer’ link next to the public offering you are interested in." Wholly absent is any disclosure to the effect that actual participation in an IPO is anything but a guarantee. I think it would be advisable for firms to consider more balanced disclosure, including, for example: an explanation of their allocation method, any limitation or restriction on selling IPO shares or anti-flipping policies, and the probability of any one customer receiving IPO shares. Once again, an ounce of disclosure is worth a pound of cure.

A final technique used to capture market share is "aggressive" advertising. In a speech last Spring, Chairman Levitt expressed concern over "get rich quick" advertising. Images of tow truck drivers making enough profits in the stock market to purchase and name an island, and child investors being able to afford their own helicopters dominated the airwaves. After the Chairman’s speech, these ads largely disappeared.

Some of the new ads, however, raise similar concerns. A popular new theme is "broker bashing." For example, one notable ad shows a beautiful mansion accompanied by a statement that "your investments help pay for this dream house." The punchline adds, "unfortunately it belongs to your broker." Another new ad shows a pathetic broker bumping into people and knocking things over on his way into work. On arrival, he sits in his cluttered office, fumbles for his phone, and makes what can only be described as a feeble cold call. The ad ends with the words "who needs a broker?" splashed across the screen.

In truth, many people need brokers. A recent study by two University of California professors analyzed the trading of 1,600 on-line investors. They found that after going on-line, the investors traded more actively, more speculatively, and less profitably than before – lagging the market by three percent annually. They attributed this finding to overconfidence on the part of investors. This may be one of the by-products of the excessive hype and commercialization of on-line investing we are seeing today.

The NASD rules – in particular, Rule 2210 -- are the primary source of authority governing broker-dealer advertising. On September 21 of this year, the NASDR issued a report summarizing roundtables it held on this very issue. In the report, the NASDR noted it was troubled by ads that are "in such questionable taste as to potentially undermine investor trust and confidence in the industry as a whole." The report advises that going forward there will be "more aggressive oversight and investigation of possible violations." These are not idle words – in recent months, the NASDR has ordered several on-line brokers to cease using certain ads attacking full service firms. The message here is simple: Fair and balanced advertising is the prudent course.


The second issue I would like to address is the issue of capacity. We pride ourselves on the fact that our markets are the fairest in the world. Fairness is called into question, however, when a customer cannot execute a trade because his broker either has disappeared or is not returning phone calls. The same is true when an on-line broker’s web site crashes because of capacity overload. System crashes diminish investor expectations and confidence in our markets. In the past two years, we have seen system disruptions at nearly every major on-line broker. I worry that firms are spending too much time and money chasing business and too little ensuring they have sufficient capacity to handle the resulting influx.

We are experiencing a sharp rise in the number of complaints we receive at the SEC from customers having difficulty accessing their accounts. We received 135 complaints of this nature in 1998 as compared with just 11 in 1997. In addition, a quarter of the firms reviewed in the OCIE on-line broker-dealer sweep placed little emphasis on evaluating systems capacity or had difficulty answering the staff’s questions on the subject.

It is important for firms to ensure that they have adequate contingency planning. OCIE found that most firms had alternative means of processing orders, normally by telephone. Some firms, however, lacked adequate staff to process their normal volume of trades in the event of an outage.

How do you protect your firm from exposure for a series of system crashes? Simple, remember the basics. Once again, disclosure is your best friend. What impression does a broker-dealer give to its customers when it guarantees 60 second trade execution? Is this guarantee unconditional? Are sufficient risk disclosures made? I would not take for granted that investors know systems may crash and therefore deem risk disclosure unnecessary. As a competitive measure, a few on-line brokers are beginning to market themselves based on the reliability of their systems. Overly bold claims here could wind up getting a firm in hot soup should problems surface. Also, most firms charge more for telephone orders than for orders transmitted electronically. You should consider whether it is permissible, much less advisable, to charge more for telephone orders in periods when your web site is down.

I believe that as a matter of best practice, firms should make plain-English disclosure on their web sites and in account opening documents concerning their capacity. Chairman Levitt made a similar recommendation in a May 4, 1999 letter sent to all the CEOs of the major on-line brokers. Specifically, Chairman Levitt noted, "It would be useful to investors if firms’ web sites better explained to customers the possibility of system slow downs or shut downs." It appears that many firms have not embraced this approach. In fact, this Monday’s Wall Street Journal ran an article reporting that the ten largest on-line brokers refuse to make this information available, even when asked by investors. If problems persist, this may be an area ripe for further action.

A related issue is how to measure capacity. Some firms measure capacity in terms of simultaneous users, while others measure in terms of the maximum number of trades per day the firm can process. As we all know, there are certain points in the day when there is a surge in volume, particularly at the opening and right before the close of the market. For this reason alone, I believe that an assessment of systems capacity should evaluate the ability of the system to process orders during peak periods.

I suspect that market pressures will ultimately be the most powerful force driving conduct and disclosure here. The press has been quick to publicize system slowdowns and outages. No firm wants to end up in the funny papers. Nonetheless, we will keep a watchful eye on problems in this area. Our Division of Market Regulation has already proposed a rule mandating that firms maintain sufficient "operational capability." Most commenters opposed the proposal as being overly vague. We are considering how best to proceed.

Order Execution

Finally, I’d like to address briefly order execution issues. Chairman Levitt addressed the topic of best execution two weeks ago at the SIA’s annual conference in Florida. His speech is on our web site and I commend it to you. As the Internet is driving down commissions, firms no doubt are looking to recapture income from other areas. We must not allow low commissions, however, to translate into poor executions. In this regard, the Chairman expressed concern that best execution may be compromised by payment for order flow, internalization and certain other routing practices.

As more brokers either invest in or create ECNs, order execution practices will receive even greater focus. Directing order flow to ECNs in which you have a proprietary interest certainly raises questions and you need to make sure that you satisfy your best execution obligations when doing so.

I would advise all firms to evaluate, and re-evaluate, periodically, your order routing and execution policies in this new electronic trading environment. Our OCIE sweep found that, "contrary to their best execution obligations, many firms did not periodically assess the quality of competing markets to assure that order flow was directed to those markets providing the most beneficial terms for their customer’s orders." This, too, is an area we will watch closely.

I also understand that, at several firms, the trading department, rather than legal and compliance staff, conducts best execution analysis. I personally think this function is better placed in the hands of legal and compliance personnel where potential conflicts are less likely.

Legal and compliance officers of on-line firms can also serve their firms well by remaining alert to questions of suitability. This is a "hot button" issue that will soon be addressed in Commissioner Unger’s report. As you know, suitability generally refers to a broker-dealer’s obligation to recommend only those securities that are suitable for its customers. The issue therefore becomes: when is an on-line broker making a "recommendation?" In many situations, suitability is not implicated as investors simply enter unsolicited orders. But firms are beginning to expand the services they offer to customers by, for example, sending e-mail alerts or hosting chat rooms. Whether a broker is making a recommendation is a facts and circumstances determination. At a minimum, you should not assume that the directive simply does not apply in the impersonal, on-line world, unless, of course, you are doing no more than executing unsolicited orders. Commissioner Unger’s report will likely highlight certain scenarios where the doctrine may apply.


I leave you today secure in the belief that by working together, we will continue to safeguard the credibility and reputation of our markets, even as our markets change before our eyes. Effective regulation of the new world of cyber trading requires a team effort. We must all continue to play our part in attaining our shared goals. And we must be careful not to allow our attention to be diverted from the fundamental principles of full disclosure and investor protection. As you work to safeguard these principles, I urge you never to be scared to ask the tough questions, and never to shy away from unpopular decisions that you know are correct. While I understand the pressures that you face, your courage in standing up for the truth and fighting for what’s right provides the first line of defense for public investors. Thank you.