SEC Speech: Compliance + the New Internet Economy (L. Richards)
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U.S. Securities and Exchange Commission

Speech by SEC Staff:
The New Internet Economy –
A Compliance Imperative

Remarks by

Lori Richards

Director, Office of Compliance Inspections and Examinations
U.S. Securities & Exchange Commission

Spring 2000 Compliance Conference
National Regulatory Services, Miami, Florida

April 17, 2000

The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Ms. Richards and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff.

Thank you. It's a pleasure to be here.

We've heard a lot of talk recently about the "New Economy." The Internet, we are told, has changed everything. We're all wired, information moves at the speed of thought, and the future is now. Our leaders tell us that the "digital divide" is the most critical distinction between American haves and have-nots and our economists tell us that businesses must adapt or die. How many television ads now tout the services of "" companies? The pace of this change is depicted humorously in the TV ad showing the CEO of a bricks and mortar company aging and becoming obsolete in the course of a board meeting. And, on a consumer level, how many of us in this room, just a year ago, would have thought to have booked a vacation, purchased a stereo or a case of wine on the Internet?

The Internet has brought extraordinary change. Even if we limit ourselves to financial services, its impact has been phenomenal. Sales of securities on the web have skyrocketed. You've all heard the numbers before. In the space of five years, on-line securities sales went from zero, to more than a third of all retail trades. Mutual funds have also taken a prominent position on the Internet – it's the rare mutual fund today that does not have an active website. And, funds use of the Internet will only expand as they use the Net to sell fund shares. Finally, we're even beginning to see web-based advisory services in which advice is provided wholly electronically. And the pace of change has been so fast that even the most outrageous predictions look conservative in hindsight.

For those who are ready to seize the moment, these changes have created an environment of extraordinary opportunity. Of course, for those who are not ready, all of this change is very disconcerting. Have you noticed that the world is now being divided into two groups? It is said that there are those who "get it," who see the opportunity and are working to realize the future. And, there are those who don't get it. Dinosaurs – stuck in their legacy world. Instead of seizing opportunity they fear extinction, like the advertisement depicting the dying bricks and mortar company and its CEO.

In this morality play between opportunity and fear, where are compliance professionals? Do we get it? I know some people think compliance is a legacy system. They say that transactions now happen so quickly, investors on the Net demand speed above all else. They say that compliance can't keep up with the pace of investor expectations or the pace of change. I disagree. Growth in the use of the Internet by advisers, funds and broker-dealers must accompany and work hand-in-hand with compliance. In fact, the imperatives of the new economy depend on it. As the pace of change accelerates, and investors' expectations grow, they will greet compliance problems with less and less patience. To keep their confidence, compliance performance will have to be as fast, and as effective, as the rest of the new economy.

Let's look at some of the areas where this trend will be most clear. I've picked six issues that many compliance professionals deal with every day:

  • operational capability;
  • best execution;
  • advertising;
  • suitability;
  • investor education; and
  • security.

These are all issues that we look at very carefully in our examinations. They are also issues that should figure prominently in any good compliance program.

I want to talk about each of these areas in the on-line context. I have three goals. First, I want to show the continuity between on-line compliance and our existing standards. Then, I want to give you some suggestions on what I think you should be doing to successfully implement your responsibilities on-line. Finally, I want to talk about the opportunity that I see for each area in the new medium.

Issue Number 1 – Operational Capability

Operational capability is not a new concept. In the 1960s, many broker-dealers choked on the vast streams of paper flooding their back offices. The problem became so widespread that it was called the "back office crisis." Several prominent broker-dealers failed. The Commission warned broker-dealers that it was a violation of the anti-fraud provisions to accept or execute any order for the purchase or sale of a security, if the broker-dealer did not have the personnel or facilities to enable it to promptly execute and consummate all of its securities transactions.

How does this apply in the new economy? Operational capability has migrated to a new platform. Instead of clerks sorting paper, in the on-line world we need capacity in servers, in Internet Service Providers, in order routing systems, and in the communication links between them. But the basic idea remains true. If you hold yourself out to the public and accept business that you cannot consummate, it doesn't matter that you're choking on message traffic instead of paper traffic.

What do I think you should do? I think you should evaluate the capacity of your systems on a periodic basis. In these reviews, you should use a model that includes all uses of a system, and both historical and anticipated. You should consider periods of market volatility. Finally, consider having a third party take a look at your capacity and your future capacity estimates. That kind of independent review always helps.

Internet providers like to talk about "five nines reliability." That means you're up and running 99.999% of the time. In times of high volume and low volume. That's a goal to aspire to. If we can achieve five nines operational reliability – industry wide – investors are going to be much more confident doing business in the Internet economy.

Issue Number 2 – Best Execution

Like operational capability, best execution isn't a new issue. Broker-dealers' duty of best execution emerged under the common law duty of agency, and it was well established before the SEC was ever created. The duty requires broker-dealers and advisers to seek the most favorable terms reasonably available in executing their clients' securities transactions.

How does this duty apply in the new economy? On a regulatory level, the answer is easy. It applies the same way it always has. Broker-dealers and advisers must seek out for their customers the most favorable terms that are reasonably available. What makes our current situation different is how that standard is met. Not that long ago, seeking the most favorable terms meant placing three phone calls. Now, a wealth of information is available in real-time electronic format. That gives you extraordinary new tools for searching out the best deal. Similarly, with new trading technologies, like ECNs and automatic order routers, the meaning of what is 'reasonably available' has been expanded, along with the alternatives for execution.

The factors that drive the best execution analysis have also changed. In this age of impatient investors and market volatility, speed is more important than ever before. Competition in our markets has also brought more and more opportunities for price improvement and for lower commission costs. In the unlikely possibility that you haven't heard, the NBBO at six cents a share is not presumptively best execution any more.

How can advisers and broker-dealers best comply with the duty of best execution in this new environment?

First, you should carefully monitor the quality of your executions, and periodically assess the quality of competing markets. Because the markets are so dynamic, you should be assessing execution quality often. You should then route orders to the markets and providers that provide the most beneficial terms. Remember, it's not enough to monitor the market centers where you do business. You need to periodically consider other alternatives as well, and reroute orders accordingly.

Second, make sure that payments for order flow, client referrals or other inducements are not interfering with your duty of best execution. If you route orders to the market centers that are best for you, instead of best for your clients, you are breaching your duty. We're paying careful attention to these issues in the examination program.

Third, have a process that ensures that more than just your trader is involved in deciding where to route your orders. Many firms have created execution quality committees (that may include compliance/legal staff) that review execution quality regularly, and may report to the Board or to Senior Management. This process has been effective for many firms.

Fourth, make the steps you take to comply with your duty of best execution transparent. You could have the finest program in the world, but if you can't demonstrate it to the internal review process you have established, to SEC examiners, or to a disappointed investor, you may still have problems.

As with operational capability, technology is improving the way you fulfill your duty of best execution. Computers are powerful tools for searching out the best prices, and electronic trading platforms are demonstrating their ability to aggregate buyers and sellers. As technology continues to develop to automatically route individual orders to the best market center, more of the benefits of better executions will be available to retail investors.

Issue Number 3 – Advertising

Whether you're a broker-dealer, a mutual fund or an investment adviser, advertising is an important way you communicate with potential clients. Over the years the Commission and the SROs have worked to make sure that advertising is truthful, not misleading and qualified with appropriate warnings and legends. While this regulatory regime was developed for paper-based advertising, it continues to be relevant in the new economy.

Today, many – if not most – funds and advisers have established web sites. On these sites, potential clients can learn about the firm's investment philosophy, its personnel, its investment processes, its investment objectives and its performance. These sites serve a very important role. They provide a lot of information in an easy-to-access format. To get all of the information on a good web site into a single brochure would be difficult. To get it all into a single paper advertisement would be impossible.

We look very carefully at these web sites in our examinations. And, we find issues. What makes this interesting, I think, is that we find the same issues on web sites that we find in paper advertisements. We find errors in performance calculations. We find that legends are missing. We find materials that have not been cleared by the NASD. We find improper uses of indexes – such as, for example, comparing an adviser's performance to an index that mixes up S&P total returns and S&P simple returns. We find backtested performance represented as actual performance, and so on.

Through the web, broker-dealers, advisers and funds have the opportunity to provide greatly enhanced advertising. But, don't let your marketing staff take over here. Compliance staff must have a role in ensuring that you are advertising responsibly on the web. But go further that that. Make sure that your ads don't just comply with the law, make sure that they don't overplay the potential for making money in this new economy. Don't imply or allude that you can replicate past performance. The industry cannot afford to let investors' expectations exceed that which is probable or possible.

Issue Number 4 – Suitability

When the NASD adopted its first rules, back in 1939, the duty of suitability was among them. As you know, when a broker-dealer recommends a security, it must have reasonable grounds for believing that the security is a suitable investment, based upon the customers' investment objectives and security holdings.

How does this apply in the new economy? There has been a lot of discussion about whether the duty of suitability applies on-line. Some say the duty does not apply to on-line broker-dealers. It does. It applies whenever a broker-dealer makes a recommendation. Most Internet broker-dealers believe that they are not making recommendations, and therefore, that they do not owe their customers a duty of suitability. Whether or not broker-dealers are in fact making recommendations is an issue we look at in our examinations. But even now, for those who believe they are not subject to the duty, there are things that can be done to enhance their compliance performance.

What do I think you should do? If you do not make recommendations about securities, you should take steps to prevent investors from being misled by prominently disclosing on your website that you do not offer opinions about specific securities, or endorse any opinions about specific securities on linked sites. To avoid investor confusion, it is particularly important that you prominently disclose that you have not independently verified information or opinions on linked sites. Moreover, if you sponsor chat rooms or bulletin boards, you should place a prominent and Plain English disclaimer at the point of entry and on the banner along with your name and logo.

I think this is simple common sense. I could sum this up by saying --don't let your customers guess what you're doing. Tell them. Give them explicit disclosure. Let them know precisely what services you are – and are not – performing.

Before I leave suitability, there is an area of special compliance danger that I want to mention. You should be very careful to identify and disclose any arrangements between your firm and participants in your chat room or bulletin board. If you are paying someone, who is offering opinions on securities in your chat room, you should make sure that is disclosed or better yet, to avoid confusion, don't do it at all! Similarly, if your employees are offering opinions on securities in your inventory, you should make sure that is disclosed.

The duty of suitability in the new economy is as important as it was when recommendations were made face-to-face. As data mining and push technology develop, we may actually get to a point where advice and the suitability determinations that accompany that advice, can be truly personalized and automated. I've heard conflicting opinions on how far away we are from a fully personalized Web environment, but I know that some of the biggest players in the business are working very hard to get there. Here again, we can see the promise of making an existing practice even better.

Issue Number 5 – Investor Education

Chairman Levitt has made investor education an important focus of the Commission's program. As he puts it, "protecting investors begins with investors themselves." The SEC and the NASD have important roles to play. We have investor education programs, websites, and an active outreach program, with town hall meetings and other events. But securities firms have always been, and remain, investors' primary point of contact and primary source of information.

How does this apply in the new economy? In the new economy, investor education is even more important. On-line, investors may be depending on your website for all the information they need. There may be no friendly salesperson waiting to explain that margin agreement or fill in the blanks in your advisory contract.

What should you do? I think there are several things you can do to meet this challenge. First, your investor education materials should speak plainly and clearly and should outline key investing terms and concepts. Make sure your customers are given adequate information on the risks and benefits of placing certain types of orders – like market orders and limit orders – on market volatility, on the difference between order entry and order execution, on margin, and, for funds and advisers, on the impact of expenses, fees and loads on performance. This information should be prominently provided, not buried in hyper links or written in legalese. Some websites do an excellent job in this regard. Unfortunately, many do not.

Consider providing links to the SEC's and the NASD's websites as some firms do today. Or, if you don't want your customers to leave your site – and, from a business perspective, I can understand that – then you could duplicate our information on your site.

I want to emphasize two areas of strong and growing regulatory interest where investor education is critically important – margin and IPO allocations.

In today's markets more than ever, you really need to make sure that you are adequately explaining margin. As Chairman Levitt has put it, investors need to understand that when they buy on margin they can double their money, but they can also double their losses. We frequently see investors complain that they did not understand their margin agreements. At the most fundamental level, you need to make sure that your customers fully understand the differences between cash and margin accounts. There are several ways you can do this, including by adopting completely separate agreements. How you do it is up to you – but it needs to be done.

You also need to make sure you are adequately explaining your methods for allocating IPOs. We all know that IPOs are hard to get in on. Shares are allocated according to business relationships and other subjective criteria. If you claim that your customers will get in on IPOs, then you need to fully and accurately describe your allocation and distribution methods, and the realistic probability of your clients receiving shares.

Finally, I can't leave investor education without reminding you that you need to have enough staff to respond promptly to customer complaints. Many firms are out there aggressively advertising, attracting new clients. You need to be just as aggressive in keeping those clients. When we see a firm that does not have adequate infrastructure to respond to questions and complaints, we'll cite them in deficiency letters. When you get back to your office, and your boss says, "why should I give you more staff?" – you can say, because our customers and the SEC's examiners say we need them!

A lot of this advice applies equally on-line and off. But the stakes are much higher when the human contact has been taken out of the loop. The Internet has proven itself to be a powerful tool for acquiring and communicating information. I think we are just starting to scratch the surface on how it can be used to enhance investor education. Particularly in this area, the new economy has tremendous compliance opportunity.

Issue Number 6 – Security

This is my final issue. In the legacy world, it is a very boring topic. Lock your doors. Protect your files. Don't leave sensitive client information on the subway. In the new economy, it's become much more exciting. We have passwords, firewalls, and encryption. We also have hack attacks, DOS attacks and FBI investigations. It's exciting, and challenging.

What should you do? I think you need to take security very, very seriously. For example, while all the Internet broker-dealers have password protection, very few have taken the extra step of protecting trade entry with a special password. There is no rule that says you must do so, but using double-layer password protection is an important security measure.

You should also have written policies prohibiting registered representatives or advisory personnel from using e-mail to send personal customer information unless adequate security measures are in place. This policy should cover sending the information to anyone, including the customer or another employee.

Finally, you should be sensitive to the possibility that your firm may be a victim. You should check the Internet regularly to make sure that imposters are not using your firm's good name and reputation to attract and defraud investors.

This is a formative time for the securities industry on the Internet. In my view, for the new economy to flourish and to meet its promise, investors – your customers and clients – must have confidence that they are being treated fairly. And that's where compliance comes in. By ensuring compliance with traditional fiduciary and legal obligations, we can ensure that the securities markets continue to meet customers' expectations and that they continue to have confidence in doing business in the new economy.

This conference is an important means to that end. Probably most or even all of you work for firms with a presence on the Net. I challenge each of you to ask, during this conference and afterwards, "what can I do to enhance my firm's compliance services?" Ask yourself:

"How can I up-grade the reliability of my firm's operational capability?"

"How can I improve our execution quality?"

"How can I make our advertising clearer and even more accurate?"

"How can I make sure our recommendations are suitable?"

"How can I help investors understand the basics and the complexities of the securities markets?"

"How can I protect my clients' privacy and security?"

Let's make sure that the new economy is defined as much by integrity as it is by its innovation. As we further explore the uses of the Internet for providing financial services, let's make sure that compliance with traditional and fundamental fiduciary principles keeps public investors' trust and confidence, on-line and off.

Thank you.