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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Securities Law and the Internet

Remarks by

Commissioner Laura S. Unger

U.S. Securities & Exchange Commission

Practicing Law Institute
New York, New York

June 13, 2000

Good morning and thank you for inviting me to be your early morning keynote speaker – itís been some time since Iíve had the opportunity to see the sunrise!

Itís always hard to choose a topic for a conference about the Internet because there is so much to say. Rest assured. I have only a short time to speak and will confine my remarks to two main areas. First, I will report to you about what Iíve been working on to implement some of the recommendations to the Commission made in last Novemberís on-line brokerage report.

After that, I want to talk about some issues percolating on the international front. I just got back from the IOSCO conference in Australia where I spoke about the various types of Internet securities fraud and the Commissionís Internet enforcement program. The audience of international securities regulators was fascinated. But they expressed some non-enforcement concerns that I want to share with you.

Before I begin, let me state that the views I express here today are my own, and do not represent the official position of the Securities and Exchange Commission.

On-Line Suitability

As you know Ė probably ad nauseum by now – one of the issues discussed in my on-line brokerage report was how traditional suitability concepts apply in the on-line world. I set out a number of hypotheticals on how Ė if at all – the use of technology to provide on-line services to customers affects a broker-dealerís suitability obligation. To put it another way, we all know (and most of us can accept) that suitability only applies when a broker makes a recommendation. Some industry participants, regulators and commentators have expressed concern that technology may make it more difficult to tell when a recommendation is being made on-line. As the use of data-mining tools becomes more prevalent, this determination may become even more difficult.

The divergence of views on how suitability applies on-line became the basis for my reportís recommendation that regulators should become more knowledgeable about how broker-dealers are using technology. It also made sense to coordinate our efforts on this issue. Over the last few months, my office, the NASDR and NASAA have visited several broker-dealers that provide on-line services to customers. To get a cross-section of perspectives, weíve visited full-service and discount firms. More visits are scheduled for this month, including one later today. It has been gratifying to see how much the firms have appreciated having us come to learn from them. Itís a rare experience for them to have almost all of their regulators appear together!

Based on all of our discussions so far, I think itís safe to say that there is still no consensus in the industry about how to approach on-line suitability. Not surprisingly, there is a clear difference of opinion between "execution-only" on-line firms and full-service firms. There are also, however, differences among the firms in each category based on a firmís existing structure, business model and client base. Most firms agree that the delivery channel is not dispositive of whether a broker-dealer has a suitability obligation. Whether a broker has a suitability obligation shouldnít depend on whether his customer executes a trade on-line or through his broker.

One interesting notion that does not factor into a legal analysis of suitability but which has made its way into numerous conversations about suitability is "customer expectation." Most firms seem to agree that the disintermediation of many traditional brokerage functions Ė and the resulting absence of human contact – reduces, if not eliminates, customer expectations that their broker is monitoring their investment decisions for suitability.

Some firms (and I wonít say which ones) have procedures in place to supervise all of their customersí trades for suitability purposes whether the trades have been recommended by a registered representative in an off-line account or entered by the customer on-line. Other firms donít really confront suitability obligations as suitability per se, but limit customer risk exposure in the course of eliminating firm risk exposure. This includes increasing margin maintenance requirements for certain accounts and certain securities, limiting options trading and prohibiting the purchase of penny stocks and Bulletin Board stocks.

I would just observe that neither of these approaches has been adopted as a result of, or necessarily motivated by, the suitability doctrine. These firms Ė each with its own business model Ė are following what they believe to be good business practices. My question for you is what drives good business practices? My guess is that the answer would be customer expectation.

In that case, should the notion of customer expectation factor somehow into the discussion of suitability? Not in whether suitability attaches to a recommendation, of course, because that obligation is well settled. Perhaps though, in determining whether "information provided" is in fact a recommendation made, it may be useful to at least consider whether investors think they have received a recommendation or whether they expect that the level of information provided comes with some type of suitability obligation. As firms continue to develop "segment-of-one" customization products, this analysis of customer expectations may become more relevant.

At this point, the question is whether the industry wants guidance on "on-line" suitability from the Commission or the NASDR. I donít have the answer to this question yet. Data-mining technology doesnít appear to be in widespread use right now, but the industry trend is clearly toward providing advice, automated or otherwise.

My original goal in visiting the firms, and my offer to the industry to consider whether there is a need to clarify on-line suitability requirements, grew out of my interest in finding out whether regulatory or legal requirements such as suitability obligations were in any way impeding the development of technology to the detriment of investors. Based on the information weíve gotten so far, this doesnít seem to be the case. Iím impressed with the industryís creativity in using technology as a way to improve their services to customers, rather than limit obligations to customers, and Iím excited for what this means for customers who will soon have many different options for investing. Not to mention the impact that wireless technology will have on investors . . . .

Investor Education Survey

Another recommendation in my report was to conduct an investor education survey to find out how investors process the investor education material available to them on the Internet. Having this information will help the Commission determine how to make better use of our investor education resources.

My office is working right now on a questionnaire that will be distributed to customers of on-line broker-dealers that are members of the Securities Industry Association. We are interested in knowing:

  • the sources of financial information that investors rely on in making investment decisions;
  • customer expectations at on-line firms;
  • the level of knowledge and experience of the average on-line investor;
  • the trading frequencies of investors at on-line versus off-line firms;
  • the success of existing disclosures and disclaimers; and
  • how investors analyze risk and the segments of investors most at risk of poor investment decision-making.

We hope to distribute the survey to 2,000 on-line investors this summer. We may publish the results of the survey on the Commissionís website.

Let me now turn 180 degrees to the international front.

International Issues

If you think reaching a consensus on suitability raises regulatory challenges, consider reconciling the laws and regulatory policies of all the jurisdictions involved in creating a global securities marketplace. Cross-border trading presents a host of issues including market structure, listing and disclosure standards and enforcement.

The Commission attempted to deal with the issue of foreign market access in Regulation ATS, which set forth three non-exclusive approaches. The first was a mutual recognition approach in which foreign market regulation was analyzed to determine whether its regulation was "comparable" to U.S. exchange regulation. The second was an exchange regulation approach, which would require foreign markets that provide direct access to U.S. investors to register as U.S. exchanges or seek an exemption from exchange registration from the SEC. The third was an access regulation approach, in which, instead of regulating the foreign market itself, the SEC would regulate the entities that actually provide U.S. investors with access to trade on the foreign exchange.

Spurred by competitive forces as well as the Commissionís deferral of action on the foreign market access issue, numerous alliances have been proposed among international securities exchanges. An example of this is the proposed merger of the London Stock Exchange PLC and the Deutsche Boerse AG, which operates the Frankfurt exchange. Subject to the approval of both merger partnersí shareholders, the new entity, International Exchanges or iX, will be based in London and use Deutsche Boerseís electronic trading system. Initially, iX will list only U.K. and German securities, although it plans to list other foreign securities in the future.

Rather than adopt a single regulatory structure for this new entity, regulatory responsibility will be split between the U.K. and Germany based on the category of securities involved. The 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 Frankfurtís regulation. It is not clear whether U.K. growth stocks will remain in the U.K. or migrate to Frankfurt.

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 to provide Japanese investors the opportunity to invest in high-growth Japanese IPOs and other Japanese companies. Eventually, Nasdaq Japan intends to offer Japanese investors trading in Nasdaq-listed stocks. European and Japanese issuers will be able to trade through these linkages in the United States only if they comply with U.S. financial reporting and disclosure requirements. In another pilot project, a limited number of Nasdaq stocks will soon begin trading on the Hong Kong Stock Exchange.

The New York Stock Exchangeís announcement last week of a proposed Global Equity Market linkage among ten international exchanges stressed that its arrangement will not be a merger, but a linkage that will allow each participant to retain its identity, while serving as a portal to a larger trading platform. Each exchange participating in the alliance must be able to regulate itself.

Given the regulatory and pragmatic problems involved, it may take some time before any of these arrangements bears fruit. The point to be made, though, is that technology provides the opportunity for globally-linked, round-the-clock trading capabilities to satisfy investorsí growing diversified needs. With regulation as the only remaining impediment, it becomes more imperative than ever to remove the obstacles to a global marketplace. These issues are complex and intertwined, not easily resolved one at a time. The key to progress will be the degree to which international securities regulators can develop a regulatory scheme that honors national standards while not unduly impeding cross-border dealings. This is a very tall order, and I think it explains why it is taking us time to grapple with these issues. Beyond the regulatory issues, such practical problems such as the use of different trading systems, different clearance and settlement systems and different currencies must be resolved.

One aspect of the global marketplace that is working well is international Internet enforcement. I went to the International Organization of Securities Commissions ("IOSCO") conference in Australia last month and talked about our Internet enforcement program. As you might expect, the subject generated a lot of interest. The timing and the location were also right to talk about the Rentech case, a recent case brought by the SEC and the Australian Securities and Investments Commission.

Two Australian residents allegedly violated U.S. securities laws by touting the stock of Rentech, Inc., a U.S. company, over the Internet. These individuals allegedly sent out several million unsolicited "spam" e-mail messages to individuals worldwide, including U.S. citizens, and posted numerous messages on various Internet message boards relating to Rentech. The touting caused a spike in the price of Rentech stock and enabled the two individuals to sell their stock into the spike. In addition to our action, the Australian regulators filed a criminal action against the two Australians.

The case exemplifies both the obvious need for international cooperation as well as the positive results that can be achieved from such cooperation. Although the foreign regulators applauded the Rentech case, they complained to the SEC about U.S. firms soliciting their residents without the benefit of registration. At the same time, U.S. firms have expressed frustration at having to comply with different registration requirements in each jurisdiction. There is not a lot I can do to help you with this, but regulators are continuing to work cooperatively on this issue, and your input is valued.

Thank you very much.