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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks at the National Regulatory Services Fall 1999 Compliance Conference

by Commissioner Laura S. Unger

U.S. Securities & Exchange Commission

Santa Fe, New Mexico

September 14, 1999

Thank you for inviting me to give the keynote speech this morning at your conference in Santa Fe. Also, thank you for having the conference in Santa Fe. I had been looking forward to attending this conference – at least until I boarded the ten person plane in Denver – at which point I was somewhat unsure that you wouldn't be looking for another keynote speaker.

Before I begin my remarks today, I must provide the standard SEC disclaimer that I am speaking for myself and not for my fellow Commissioners or the Commission as a whole.

I want to start by mentioning how important compliance officers are to the Commission. Rather than just hearing from the Commission's Enforcement's Division, I believe that it is important to emphasize just how critical the Commission believes that you are to our success in regulating the industry. Compliance officers are the front line soldiers for maintaining the integrity of the securities industry and protecting investors. You should never underestimate the importance of this role and how critical it is that you do it well, lest the Enforcement Division might let you know.

It has become almost trite to say that technology has created a brave new world. The Internet lets people trade online, shop online, communicate online, educate themselves online and even date online.

The Internet has particularly impacted the securities industry; it has changed the way people trade and the way they raise capital. New electronic trading systems pose competitive challenges to the traditional marketplaces – driving changes in market structure and possibly the regulatory structure.

As for online trading, in the first quarter of 1999, almost one in six trades took place over the Internet. U.S. Bancorp Piper Jaffray estimates that online brokers processed over one-third of equities and options trades in 1998. The number of online accounts is estimated to exceed 8 million, over double what is was just two years ago.

Issuers can now raise capital online and investors have increasing access to IPOs over the Internet. The Commission facilitated this trend – which we will likely be seeing more of – by issuing the Wit Capital no-action letter. Competition from the electronic communications networks or ECNs has made the Big Board consider listing itself as a public company. Even if you are not online today, you may be affected by Internet trading in ways that you did not consider even six months ago. Your customers may have an account with you but shift some of their assets to trade at a virtual broker. That makes it hard to meet your suitability obligations if you cannot see your customers' entire financial picture.

You may be "featured" on Internet discussion forums or somebody may even have created a gripe site to complain about you. In fact, one of those posters may be one of your employees, writing disparaging remarks or unwittingly giving away sensitive information. Or you may have an employee e-mailing clients from home, which is great from an efficiency perspective but not so great from a compliance perspective.

You may make a market in a security that has been targeted by momentum traders – a phenomenon that we are seeing more and more – making it very difficult to fulfill your obligations as a market maker.

I first started thinking about the issues that arise in connection with online trading almost two years ago, when I first became a Commissioner. Back then, I wasn't sure if this would be just a blip on the radar screen or if it was really a seismic shift towards self-directed investing. I believe that eventually there will be no "online" before "broker" and that we will all have the option of trading over the Internet through all of our brokers.

One question that I am asked and that I have asked myself is how the Commission will regulate this new industry. Does our regulatory scheme continue to make sense in the online environment?

I think and hope that the industry will share this regulatory challenge. The SEC and the compliance industry must reinterpret our existing regulation of the bricks and mortar securities industry and make sense of it in the clicks and mortar context.

I spent the first half of this year convening roundtables to discuss online trading related issues. The roundtables focused on observations about trends in the industry, suitability obligations, capacity, best execution, market data, chat rooms and bulletin boards, investor education and the Commission's challenges. We also briefly touched on: financial portals, privacy, margin, decimals, and after hours trading.

The roundtable participants included compliance officials, securities lawyers, former and present regulators, academics and brokers' representatives.

Each of the issues we discussed at the roundtable were worthy of a separate roundtable. It was an opportunity, however, to hear from industry participants about their concerns and experiences. I am in the process of preparing a report to the Commission on the roundtable findings, including recommendations.

Today, I will touch on three of the most interesting and challenging of the roundtable topics: suitability, best execution and capacity.


The biggest issue by far seems to be determining what suitability obligations online brokers have with respect to their customers. Online brokers have consistently told me that they do not believe that they have any suitability obligations because their customers direct their own investment decisions. In other words, brokers do not make recommendations to their customers and therefore, do not need to "know" their customers like traditional brokers know their customers.

While that may be true when a broker merely provides execution services to a customer, when a broker personalizes the information that a customer sees online, the answer is not so clear cut. In fact, under some scenarios, the online broker most definitely would have a suitability obligation.

This issue becomes particularly nettlesome when you look towards future product development, which may be more imminent than we expect. I have heard from a number of firms that they collect information about their customers. According to the participants in a Deloitte & Touche sponsored survey conducted almost a year ago, 100 percent of full-service firms, 62 percent of full-service discount firms, and 43 percent of deep-discount firms responding to the survey "segmented" their customers, profiling them as a particular type of investor.

Firms have indicated that they collect information about their customers because they want to send customized information. As recently as last Friday, at least one major firm said that, although they have this information, the firm is unwilling to develop a product without knowing what suitability obligations would attach to that product.

Of course, this presents the chicken and egg problem since it would be difficult to make a pronouncement on what suitability obligations would attach without knowing what the product would be.

I think the Commission would be amenable to clarifying some of these issues if we knew what the products were. Perhaps the best way to start is for us to provide guidance on what online activities do not trigger a suitability obligation.

Best Execution

One of investor's top five complaints to the Commission about online brokers involves best execution problems. Online firms have raised the question of whether best execution obligations are the same for online orders. According to the firms, online investors favor speed and certainty of execution over opportunities for price improvement. Consequently, they believe that speed of execution should be a more significant part of best execution in the online context.

While price is the predominant factor in determining whether a broker has satisfied its best execution obligations, the Commission has never stated that a broker is bound exclusively by price considerations in satisfying its best execution obligations. The Commission has said that a broker-dealer should consider other factors, such as: the size of the order; the speed of execution available on competing markets; the trading characteristics of the security; the availability of accurate information comparing markets and the technology to process such data; the availability of access to competing markets; and the cost of such access.

A number of developments, including online investing, have impacted trading patterns and market participants' behavior. Since the duty of best execution is constantly evolving, it may be time for the Commission to reevaluate the appropriate factors broker-dealers should consider in carrying out their regular and rigorous evaluation of execution quality.

Although I am not entirely sure how well investors understand the concept of best execution, as part of that reevaluation, the Commission should consider whether online investors have different expectations as to what constitutes best execution.

Operational Capability

Another one of our top five complaints involves failures or delays in processing investors' orders. Considering the rapid growth rate of the online industry in the last few years, it is not surprising that firms have experienced outages and delays. Regulators want to make sure that these outages and delays are growing pains and not stretched ligaments, particularly as the industry continues to grow.

The New York Attorney General's office has even considered bringing actions against firms that solicit new clients without making sure they have sufficient capacity to service those accounts.

Section 15 of the Exchange Act provides that the Commission will prohibit SROs, brokers, and transfer agents from trading if they do not have sufficient operational capability. SEC Staff Legal Bulletin Number 8 reminds firms that they must maintain sufficient capacity to operate properly when trading volume is high and sets out ways to accomplish this.

But what is sufficient capacity and how do firms measure capacity? The devil is in the details. Right now, online firms measure capacity in several different ways. Some firms measure capacity based on the number of shares and the number of trades their system can process. Other firms measure capacity based on the average number of website users for a defined period of time. Still other firms measure capacity the way we would probably like to see capacity measured, as the number of simultaneous users at peak periods of activity which considers all users of the system.

The Commission proposed but recently suspended plans to provide permanent rules governing general operational capability. The rule would require brokers to have and maintain sufficient operational capability to perform the range of services normally rendered. Although we temporarily suspended our efforts to pass these rules, it is likely that we will return to them in the near future.

Year 2000

Speaking of operational capability and Y2K, as the Y2K Commissioner I would be remiss if I did not mention the recently adopted Y2K operational capability Rule 15b7-3T. The Commission adopted Rule 15b7-3T this July to require broker-dealers to cease doing business if their mission critical systems are not Y2K compliant by August 31.

Any firm that is not ready by August 31 must notify us and cease operations unless they certify and demonstrate that they will be ready by November 15. As of September 7, we have received notices and certifications from nine firms. So far, it appears that these firms will complete testing and implementation by October at the latest.

As we look towards January 3, 2000, the Commission is now focusing on scenario planning. A major component of scenario planning involves assessing the contingency plans of the markets and market participants with a view to preparing our own response if problems should occur.

All of the SROs have filed their contingency plans with us, and we are now in the process of evaluating them. Our goal is to achieve consensus on how the Commission and each market participant will respond in the event of various scenarios, and to "practice" these responses in tabletop exercises conducted by senior management.

Examples of scenarios that we are considering include a disruption at a clearing agency or major broker-dealer, a major dive in the Dow Jones Industrial Average and disparities in the reporting of market data. Let me emphasize that we don't expect any of these to actually occur, but prudence and the public's trust require us to consider even the most remote possibilities.


I said at the beginning that I was not speaking for the rest of the Commission, but I feel safe in saying that there is one issue that is foremost on our minds. It is an issue that I alluded to earlier when I said the NYSE is considering listing itself – the demutualization of the exchanges. Exchanges are feeling competitive pressure from ECNs which are poised to take away market share from the established markets. With low overhead and no significant infrastructure to support, ECNs already execute about 30 percent of the trading volume in Nasdaq stocks and four percent of the trading volume in NYSE stocks.

While this issue will not necessarily affect compliance professionals in the near term, it certainly may affect you in the long term. The issues for the SEC are not so much to public company structure but how this change will impact the regulatory structure and investor protection. There are at least three possible regulatory structures. The NYSE could keep its current regulatory structure, it could adopt a structure that is closer to the NASD – NASDR structure where the regulator operates separately from the market, or there could be a single super regulator for all of the markets.

One of my principal concerns is how we address the conflicts that arise between the demutualized exchange being an independent and well-funded regulator and a public company accountable to shareholders for maximizing profits? It is possible that the inherent conflict that exists even today between being a regulator and a market competitor will be heightened once the exchanges go public. Those questions and others are questions of first impression for the Commission that will have to be answered as technology pushes market restructuring.

Thank you again for the opportunity to speak here today. I look forward to an ongoing dialogue about the future of regulation.