On-Line Brokerage: Keeping Apace of Cyberspace

EXECUTIVE SUMMARY

I. INTRODUCTION

Recent advances in information technology -- particularly the Internet -- are

revolutionizing commerce. The securities industry, most significantly on-line brokerage, is

at the forefront of this revolution.

Research reports estimate that last year’s $415 billion in online brokerage assets

will grow by more than sevenfold to $3 trillion in 2003. The 3.7 million on-line accounts

open in 1997 have almost tripled to reach 9.7 million by the second quarter of this year.

On-line trading volumes have increased dramatically over the last several years.

According to one analyst, volume has increased from under 100,000 trades per day in the

second quarter of 1996 to over half a million in the second quarter of 1999. The

percentage of equity trades conducted on-line has grown to 15.9 percent of all equity

trades in the first quarter of 1999.

On-line brokerage has significantly changed the dynamics of the marketplace,

causing one of the biggest shifts in individual investors' relationships with their brokers

since the invention of the telephone. For the first time ever, investors can -- from the

comfort of their own homes -- access a wealth of financial information on the same terms

as market professionals, including breaking news developments and market data. In

addition, on-line brokerage provides investors with tools to analyze this information, such

as research reports, calculators, and portfolio analyzers. Finally, on-line brokerage enables

investors to act quickly on this information.

The pace of change and the strength of the securities markets generally has enabled

investors to more directly participate in the securities markets. This confluence of events -

- the development of technology affordable to investors and increased investor access --

has raised a number of questions for the industry and the regulators. The questions

addressed in this Report are:

1. What will the brokerage industry look like in the future? Where is it

headed?

The Report provides a number of statistics to put in context the growth and

activities of on-line investors and firms. It also describes the various products and services

currently offered on-line. Finally, the Report describes various trends in the industry,

including: (a) the continued growth of on-line investing and the pressure it has put on

traditional firms to offer on-line services; (b) how the growth of on-line brokerage will
2

impact the services firms offer going forward; and (c ) how firms are developing

technology to provide automated, but personalized, advice on-line. 

2. What challenges do regulators face in applying the suitability doctrine

on-line?

A well-established doctrine, suitability refers to a broker-dealer’s obligation to

recommend only those investments that are suitable for a customer. In order to trigger a

suitability obligation, a registered representative must make an investment

recommendation to his or her customer. In the on-line environment, pinpointing what

constitutes a recommendation can be difficult. As data mining technology enables on-line

firms to customize information and provide it to customers, this question becomes even

more pressing.

3. How has technology impacted on-line firms’ performance and

evaluation of their best execution obligations?

The duty of best execution requires a broker-dealer to seek the most advantageous

terms reasonably available under the circumstances for a customer's transaction. Although

this duty evolves with changes in technology and market structure, the Commission has

stated that broker-dealers must carry out regular and rigorous evaluations of execution

quality across markets and consider price improvement opportunities. The combined

events over the last three years of : (a) the growth of on-line brokerage, (b) the move to

quoting in sixteenths,

( c) implementation of the Order Handling Rules, and (d) advances in order routing

technologies have impacted how firms approach fulfilling their best execution obligations.

4. How have on-line investors’ demand for market information impacted

the pricing of real-time data? 

The federal securities laws grant the Commission broad authority over information

about securities quotations and transactions. The Commission must ensure that market

participants and the public can obtain this information on terms that are "fair and

reasonable" and "not unreasonably discriminatory." The Internet’s ability to broadly

disseminate real-time information to the public and the concomitant rise of on-line

brokerage have substantially increased demand for market data. This demand has raised a

number of questions, including: (a) whether individual investors pay too much for the

information and (b) how much of that data revenue should be devoted to the operations of

self-regulatory organizations.

5. How do firms ensure sufficient capacity to keep up with the systems

demands resulting from on-line trading?

Over the past year, many on-line firms have experienced some type of systems

delay or outage that affected the ability of their customers to place orders. Despite the
3

industry’s efforts to improve capacity, the Commission’s highest number of complaints

about on-line trading comes from customers who cannot access their firms' systems. Online firms vary in their approach to measuring systems capacity and in their disclosure to

customers about the risks of systems delays and outages.

6. What type of investor education does the typical on-line customer

need and want? 

Investor education is critical to investor protection. The decreased personal

interaction between an on-line firm and its customers presents interesting challenges to

providing investor education. Investors can now access an unprecedented amount of

financial information without the guidance of a broker. Educating on-line investors

requires an understanding of how these investors trade and the appropriate time and place

to provide them with educational information. At the same time, the Internet provides a

valuable resource for the Commission to more widely disseminate investor education

materials.

7. What are the regulatory challenges involving “cyber chats” or on-line

discussion forums?

While on-line discussion forums may educate and provide a sense of community to

investors, they also may provide a venue for fraudulent behavior. Many issuers monitor

on-line discussions about their companies but refrain from addressing rumors about them

in the marketplace for fear that they may create a continuing duty to correct or update.

Instead, issuers oftentimes go to court to unmask the "anonymous" posters of

information.

Broker-dealers have generally refrained from sponsoring on-line discussion forums

on their sites although anectdotal evidence indicates that some firms may consider doing

so.

8. How do firms protect the privacy of their on-line customers’ personal

information?

Customers increasingly are concerned about the privacy of their personal

information. As on-line firms’ data mining capabilities develop and the number of financial

conglomerates continues to grow, so do customers’ concerns about what these institutions

can and will do with their personal information. Control over customers’ personal

information was recently the subject of much discussion in the financial modernization

legislation debate. While the Gramm-Leach-Bliley Act requires the Commission and other

regulators to adopt specific privacy rules, it appears the discussion is far from over.

9. How should brokerage firms be able to compensate Internet financial

portals?
4

Websites known as portals are considered the "on ramp" to the Internet, attracting

millions of monthly viewers. Well-known portals include Yahoo! Finance, America

Online, Quicken.com, and Microsoft MoneyCentral. Portals have become broker-dealers'

rivals for the attention of on-line investors. In addition, portals have become important

intermediaries between broker-dealers and their customers. A number of broker-dealers

have entered into cobranding arrangements with portals, either paying a flat up-front fee

or a per order "connection" fee for every order transmitted by an investor who hyperlinks

from a portal to the broker-dealer.

II. FINDINGS AND RECOMMENDATIONS

Suitability Roundtable participants generally subscribed to the traditional notion

of suitability, but suggested that the obligation did not apply to some, if not all, on-line

activities. Although the participants were not unanimous on this point, the majority of

them wanted clarification or guidance from regulators. Resolving this issue will require

several considerations. First, how should the regulators interpret the concept of

“recommendation” online? Push and pull technologies make this a difficult question to

answer. Regulators need to consider how defining suitability on-line may impact

information flow and customer access. Although some would argue that the Internet

gives investors (and consumers generally) too much information, investors may not want

this information flow restricted, even at the expense of receiving unsuitable advice.

The Report recommends that the Commission:

1. obtain information from the industry on: (a) how data mining products

would work, (b) what information the products would provide to the firms,

and

(c ) whether customers would understand that the firm had provided them

with customized information;

2. alternatively, include as part of future Commission or SRO examinations a

review of what services firms provide to their customers based on

information derived from data mining; and

3. work with the SROs to consider the hypothetical scenarios and relevant

analysis, found in the Appendix to the Suitability Section of the Report, in

providing guidance to the industry regarding on-line suitability obligations.

Best Execution Technology is making best execution an especially critical

concept in today's market structure, and a significant competitive factor. Indeed,

technology provides firms with the opportunity to adopt a new approach to order routing

and to meeting their best execution obligations. In the roundtable discussions, many online brokerage participants contended that speed and certainty of execution are factors that

should receive greater emphasis in their best execution evaluations. Moreover, some
5

participants questioned whether on-line customers actually understood how their brokers'

order routing decisions affected their total execution cost.

The Report recommends that the Commission:

1. encourage the industry to demonstrate the relative importance of factors

such as speed and certainty of execution in today's market environment;

2. consider requiring market centers to make certain uniform information

available on various best execution factors;

3. consider requiring broker-dealers to regularly provide customers with plain

English information about: (a) the execution quality available on different

market centers; (b) the broker-dealer’s order handling practices; and (c)

inducements for receiving order flow received by the broker-dealer; and 

4. evaluate the potential impact of new order routing technologies on brokers'

best execution obligations, investors, and the markets.

Market Data The Report briefly outlines the pricing structure for retail users of

market data. Roundtable participants generally agreed that the Internet warrants a

reevaluation of the pricing model for delivering real-time market data to individual

investors. However, the participants recognized the industry's need to meet the costs of

creating and maintaining an infrastructure to collect and disseminate market data.

The Report concludes that the Commission should encourage the broadest possible

dissemination of real-time market data to investors, which requires evaluating whether the

current pricing scheme for market data is consistent with the federal securities laws.

Because the Commission currently is involved in such an evaluation, the Report

recommends that the Commission's upcoming market data concept release address the

issues raised in this section.

Systems Capacity In the roundtable discussions, the participants acknowledged

occasional systems failures are inevitable, but indicated that they have committed

significant resources to ensuring that their systems remain operational. The Report

concludes that the Commission should focus on methods to ensure more adequate systems

capacity at all broker-dealers.

The Report recommends that the Commission consider requiring broker-dealers

to:

1. maintain and periodically test contingency plans;

2. maintain records of significant systems outages;

3. conduct regular systems testing and evaluation; and
6

4. include plain English disclosure of the risks of systems delays or outages in

new account documentation.

The Report also encourages the Commission to repropose the broker-dealer

operational capability rule.

Investor Education The Report reviews the current status of investor education

and makes certain recommendations for improvements. The Report recognizes that the

roundtable firm participants taking into account the roundtable participants’ preference for

keeping customers on their websites and that it would be useful to educate investors on

their sites. The Report also notes that it would be helpful to understand the behavior of

on-line brokerage customers in determining the most effective means for disseminating

investor education material.

The Report recommends that:

1. firms partner with the Commission in helping to educate investors; and

2. the Commission study on-line investor behavior to determine the best place

and time to educate investors on the Internet.

On-line Discussion Forums The Report describes on-line discussion forums on

the Internet and the challenges these forums pose to issuers, market participants, and

regulators. The roundtable discussions focused on two separate areas: (1) addressing

rumors on on-line discussion forums; and (2) whether broker-dealers should offer this

feature on their websites.

The Report recommends that:

1. the Commission conduct or encourage researchers to conduct a study

analyzing the effect of chat room discussions on company’s stock prices;

and

2. broker-dealers operating on-line discussion forums consider adopting

certain best practices to prevent investor confusion.

Privacy The Report describes: (1) the rising concerns over on-line privacy; (2)

how the Gramm-Leach-Bliley Act addresses privacy concerns; and (3) surveys on-line

firms’ privacy policies. The roundtable discussions focused on how on-line firms address,

if at all, investor privacy.

The Report recommends that the Commission:

1. evaluate on-line firms’ information collection practices; and
7

2. consider certain factors in conducting its statutorily required study on

privacy.

Portals The roundtable discussion focused on how broker-dealers want to change

the way they compensate portals for routing investors to them. Specifically, firm

participants indicated that they want to compensate portals based on the number of

accounts opened by viewers who hyperlink to a broker-dealer from a portal. Such a

“success-based” fee is typically how other commercial partners pay portals, but the federal

securities laws prohibits broker-dealers from paying portals that are not registered brokerdealers in a way that gives them a salesman’s stake in the transaction.

Because the federal securities laws generally prohibit entities not registered as

broker-dealers from receiving securities transaction-based compensation, the Report

recommends that the Commission consider whether alternative compensation

arrangements are appropriate for entities not registered as broker-dealers.

III. CONCLUSION

Technology has made this an exciting and challenging time for the industry and the

Commission. As discussed in this Report, the Internet is rapidly making on-line trading

ubiquitous. This Report provides the Commission with a comprehensive examination of

the critical issues to be addressed in the area of technology. Although it may still be

premature for extensive rulemaking in this area, this Report highlights for the Commission

certain key issues facing investors and the industry and recommends how the Commission

can resolve some of these issues.

The Commission staff is already at work exploring ways to help firms fulfill their

duty to ensure effective customer service, best execution, high-quality disclosure, and

responsible advertising, whether on-line or off. Through inspections, surveillance,

enforcement, and investor education, the staff is responding swiftly and decisively to the

challenges posed by the constantly evolving technology.

This Report continues our progress in molding securities regulation to fit the age

of technology.
8

TABLE OF CONTENTS

I. TRENDS IN ON-LINE BROKERAGE ................................................................. 1

A. Current Status...................................................................................................... 1

1. Statistical Snapshot........................................................................................ 1

a. On-Line Investors..................................................................................... 1

b. On-Line Accounts.................................................................................... 2

c. On-Line Trading Volume ......................................................................... 2

d. On-Line Market Share.............................................................................. 4

e. On-Line Commission Rates...................................................................... 4

2. Products and Services Currently Offered On-Line .......................................... 5

B. Trends in On-Line Brokerage............................................................................... 6

1. Continued Growth of the On-Line Channel .................................................... 6

2. Convergence of On-Line and Full-Service Brokerage ..................................... 7

a. On-Line Firms.......................................................................................... 7

b. Full-Service Firms Go On-Line................................................................. 8

3. Brokers Providing Customized On-Line Content and

Financial Advice............................................................................................. 9

II. SUITABILITY....................................................................................................... 13

A. Background ....................................................................................................... 13

1. SRO Rules................................................................................................... 13

2. The Shingle Theory...................................................................................... 15

3. Options and Penny Stocks............................................................................ 15

4. SEC Antifraud Actions................................................................................. 15

B. Suitability Issues in the On-Line Context............................................................ 16

C. Roundtable Participants’ Views.......................................................................... 17

D. Conclusions and Recommendations.................................................................... 20

1. Conclusions ................................................................................................. 20

2. Recommendations........................................................................................ 20

Suitability Hypotheticals .................................................................................... 21

III. BEST EXECUTION............................................................................................. 24

A. Background ....................................................................................................... 24

B. Best Execution Issues Raised in the On-Line Context......................................... 26

C. Roundtable Participants’ Views.......................................................................... 29

D. Conclusions and Recommendations.................................................................... 32

1. Conclusions ................................................................................................. 32

2. Recommendations........................................................................................ 33

IV. MARKET DATA ................................................................................................. 35

A. Background ....................................................................................................... 35

1. Current Regulatory Framework.................................................................... 35

2. CTA Network A and NASD Pricing Schedules............................................ 36

B. Market Data Issues Raised in On-Line Brokerage .............................................. 37

C. Roundtable Participants’ Views and Other Findings ........................................... 38

1. Roundtable Participants’ Views.................................................................... 38

2. Other Recent Developments......................................................................... 40
9

3. SROs and Market Data Revenue .................................................................. 43

D. Conclusions and Recommendations.................................................................... 44

1. Conclusions ................................................................................................. 44

2. Recommendations........................................................................................ 45

V. SYSTEMS CAPACITY ........................................................................................ 47

A. Background ....................................................................................................... 47

1. Current Regulatory Framework.................................................................... 47

2. Measuring Capacity...................................................................................... 50

3. Disclosure to On-Line Customers................................................................. 51

B. Roundtable Participants’ Views.......................................................................... 51

C. Conclusions and Recommendations.................................................................... 53

1. Conclusions ................................................................................................. 53

2. Recommendations........................................................................................ 54

VI. INVESTOR EDUCATION .................................................................................. 56

A. Background ....................................................................................................... 56

B. Education through Websites............................................................................... 58

1. Commission’s Website ................................................................................. 58

2. Industry Association Website ....................................................................... 59

3. Firm Websites.............................................................................................. 60

C. Roundtable Participants’ Views.......................................................................... 60

D. Conclusions and Recommendations.................................................................... 61

1. Conclusions ................................................................................................. 61

2. Recommendations........................................................................................ 62

VII. ON-LINE DISCUSSION FORUMS ................................................................... 64

A. General Background .......................................................................................... 64

1. Broker-Dealer Sponsored On-Line Discussion Forums................................. 65

a. Background............................................................................................ 65

b. Roundtable Participants’ Views.............................................................. 68

2. Issuers ......................................................................................................... 69

a. Background............................................................................................ 69

b. Roundtable Participants’ Views.............................................................. 73

B. Conclusions and Recommendations.................................................................... 74

1. Conclusions ................................................................................................. 74

2. Recommendations........................................................................................ 75

VIII. PRIVACY ......................................................................................................... 76

A. Background ....................................................................................................... 76

B. Privacy Concerns Raised in an On-Line Environment ......................................... 77

C. Current Legislation Affecting Privacy................................................................. 81

D. On-Line Broker-Dealers’ Privacy Policies.......................................................... 82

E. Roundtable Participants’ Views.......................................................................... 83

F. Conclusions and Recommendations.................................................................... 85

1. Conclusions ................................................................................................. 85

2. Recommendations........................................................................................ 85

IX.PORTALS ......................................................................................................... 87
10

A. Background ....................................................................................................... 87

B. Current Regulatory Requirements...................................................................... 90

C. Roundtable Participants’ Views.......................................................................... 92

1. Portals’ Business Model............................................................................... 92

2. Portals’ Compensation Arrangements........................................................... 93

D. Conclusions and Recommendations.................................................................... 94

1. Conclusions ................................................................................................. 94

2. Recommendations........................................................................................ 95

APPENDICES

1. On-Line Broker-Dealers

2. Ten On-Line Brokers’ Policies for Delivering Market Data Via the Internet

3. Enforcement Actions Involving On-Line Discussion Forums

4. Privacy Survey Findings

5. On-Line Trading Complaints Received by the Commission
11

LIST OF EXHIBITS

I. CHARTS

A. TRENDS IN ON-LINE BROKERAGE

1. On-Line Average Daily Trades 2Q97-2Q99.................................................... 3

2. On-Line Share of Equity Trades 1Q97-2Q/99................................................. 3

3. Adjusted On-Line Trading Market Share 2Q99 .............................................. 4

4. On-Line Commission Rates 1Q96-1Q99......................................................... 5

B. PRIVACY

1. Reasons for not Filling Out On-Line Registration Forms............................... 78

2. Most Surfers Still Won’t Opt In ................................................................... 79

C. PORTALS

1. Percent of Surfers Bypassing Portals for E-Commerce Sites......................... 89

II. TABLES

A. MARKET DATA

1. CTA Network A and NASD Market Data Revenues.................................... 44

B. PORTALS

1. Portal Traffic Trends.................................................................................... 88

III. DIAGRAM

A. SYSTEMS CAPACITY

1. Internet Connection Points........................................................................... 52

I. TRENDS IN ON-LINE BROKERAGE

Electronic brokerage actually predates individual investors’ access to the Internet.

In the mid-1980s, a number of broker-dealers offered customers software and direct dialup access that permitted them to submit orders via their personal computers.1

 In the early

1990s, several broker-dealers gave customers the ability to enter orders through private

computer networks. In 1995, broker-dealers introduced the first systems that allowed

customers to submit orders through the Internet. Approximately 160 broker-dealers now

offer on-line trading.2 In less than five years, on-line brokerage has become an important

channel for conducting retail brokerage transactions.

 

1

In response to the development of such systems, the Commission issued a release that anticipated

many of the issues facing on-line firms and investors today, such as suitability and access to

market data. Exchange Act Release No. 21,383 (Oct. 9, 1984), 49 Fed. Reg. 40,159 (1984).

[hereinafter Computer Brokerage Release].

2

See Appendix 1 for a list of on-line broker-dealers.
12

 A. Current Status

1. Statistical Snapshot

a. On-Line Investors

According to a survey on U.S. equity ownership by the Investment Company

Institute (“ICI”) and the Securities Industry Association (“SIA”), investors who trade

equities on-line tend to be younger and more affluent than those who use traditional fullservice firms.3

 On-line investors have a median age of 41, median household income of

$73,800, and median household financial assets of $229,000. They are more often

college-educated than other investors. The typical on-line investor has $127,600 invested

in equities.4 The ICI and SIA estimated that only 11 percent of individuals trading equities in

1998 (or five percent of all equity owners) traded on-line.5 In the 1999 Annual SIA Investor

Survey, 18 percent of investors responded that they used the Internet to buy or sell securities in

1999, up from 10 percent in 1998.6

b. On-Line Accounts

U.S. Bancorp Piper Jaffray (“Piper Jaffray”) estimates that by the end of the second

quarter of 1999 there were 9.7 million on-line accounts, up from 3.7 million in 1997 and 7.3

million in 1998. Discounting for multiple accounts, Piper Jaffray estimates that there are now

approximately 5.8 million on-line traders.7Jupiter Communications estimates that $415 billion

in assets were in on-line accounts in 1998. 8

 

3

ICI and SIA, Equity Ownership in America, Fall 1999 at 29 [hereinafter ICI/SIA Survey].

4

These statistics generally concur with the on-line customer demographics offered by several

roundtable participants.

5

ICI/SIA Survey, supra note 3, at 31.

6 Yankelovich Partners, 1999 Annual SIA Investor Survey: Investors’ Attitudes Towards the

Securities Industry Nov. 1999 at 33 [hereinafter 1999 Annual SIA Investor Survey].

7 U.S. Bancorp Piper Jaffray, On-line Financial Services Update (Sept. 1999) at 11. See also Rebecca

Buckman, Firm Pegs Accounts in On-line Trading at 3.7 Million, WALL ST. J., Mar. 25, 1999, at B10

(discusses discrepancy between Forrester Research and Gomez Advisors, which reported 3.7 million

and 7.3 million on-line brokerage accounts, respectively).

8

Jupiter Communications: $3 Trillion in Assets by 2003 in Online Brokerage Accounts, But

Customer Service Still Lacking, Sept. 1, 1999 <http://www.com/jupiter/press/releases/

1999/0901.html> [hereinafter Jupiter Report].
13

c. On-Line Trading Volume

On-line equity trading volume has grown dramatically over the past several years.

Piper Jaffray reported that there was a daily average of 547,500 on-line trades in the second

quarter of 1999. However, as the following graph shows, the growth in on-line equity trading

volumes slowed significantly in the second quarter of 1999. Subsequently, there have been

indications that, while on-line trading volumes may have witnessed their first sequential decline

in the third quarter,9 growth has once again picked up in the fourth quarter.10

 

9

See Credit Suisse First Boston (“CS First Boston”), On-line Trading Update: Volumes Weak in

July (Aug. 3, 1999).

10 See Online Brokers Jump as Analyst Points to Higher Trading Volumes (Nov. 12, 1999)

<http://www.dowjones.wsj.com/archive/gx.cgi/AppLogic+retrieve?id=ON-CO-19991112-

000601.djml&d2>.
14

Chart I-1

On-Line Daily Average Trades 3/97-6/99

96.2 117.9 139.5 149.4

186.3

224

254.6

336.7

505.3 547.5

0

100

200

300

400

500

600

Mar-97

Jun-97

Sep-97Dec-97

Mar-98

Jun-98

Sep-98Dec-98

Mar-99

Jun-99

(in thousands)

Reprinted with permission from Piper Jaffray

Not only have on-line equity trading volumes risen, but on-line trading is accounting

for an increasing percentage of overall equity trading. CS First Boston reported that in the first

quarter of 1999, almost one in six equity trades (15.91 percent) took place on-line.11 As the

following chart indicates, on-line trading volume has almost tripled in the past two years.

Chart I-2

On-Line Share of Equity Trades

0.00%

5.00%

10.00%

15.00%

20.00%

1Q 1997 2Q 1997 3Q 1997 4Q 1997 1Q 1998 2Q 1998 3Q 1998 4Q 1998 1Q 1999 2Q 1999

(est.)

 Reprinted with permission from CS First Boston

 

11 CS FIRST BOSTON, ON-LINE TRADING QUARTERLY: 1ST QUARTER 1999, June 1999 at 4

[hereinafter CS First Boston On-Line Trading Quarterly].
15

On-line trading accounts for an even higher percentage of overall equity and options

trades by retail investors. Piper Jaffray estimates that on-line firms processed 37 percent of all

retail trades in equities and options in 1998. 12

d. On-Line Market Share

While over 160 firms offer on-line trading, a few players currently dominate the

market. Recent entrants, including Merrill Lynch, PaineWebber, and American Express

certainly will impact the current division of on-line trading market share.13

Chart I-3

ADJUSTED ONLINE TRADING MARKET SHARE - EXCLUDING 

ESTIMATED MUTUAL FUND TRADES (Second Quarter 1999)

Schw ab

23.8%

Suretrade

2.7%

Waterhouse

Discover 13.4%

2.6% Fidelity

11.5%

Ameritrade

11.1%

DLJdirect

4.5%

E*Trade

16.4%

Datek

12.7%

NDB

1.4%

Reprinted with permission from U.S. Bancorp Piper Jaffray

e. On-Line Commission Rates

In the first few years of on-line trading, competition among on-line firms dramatically

reduced commission rates. As the following chart shows, the average commission charged by

 

12 U.S. Bancorp Piper Jaffray, On-line Financial Services Update (Mar. 1999) at 1.

13 See, e.g., Rebecca Buckman, American Express Plans to Overhaul, Relaunch On-line Brokerage

Operations, WALL ST. J., Oct. 6, 1999, at C7; Joseph Kahn and Patrick McGeehan, Morgan

Stanley to Offer On-line Trading to All its Customers, N.Y. TIMES, Oct. 18, 1999, at C1; Ruth

Simon and Charles Gasparino, Full-Service Brokers Complicate On-line World, WALL ST. J.,

Oct. 19, 1999, at C1; Charles Gasparino and Rebecca Buckman, Horning In: Facing Internet

Threat, Merrill to Offer Trading On-line for Low Fees, WALL ST. J., June 1, 1999, at A1; Walter

Hamilton, Rivals’ Ranks Grow in On-line Trading Field, L.A. TIMES, Oct. 21, 1999.
16

the top ten on-line firms recently has stabilized at about $15.75 per trade. Some on-line firms

have lowered commission rates even further, particularly for their most active customers.

Chart I-4

Average Commission Charged by Top-10 Online Trading Firms: 1/96-12/98

$52.89

$32.19

$15.53 $15.75

$50.20

$31.66

$15.75

$46.69

$21.10

$15.75

$34.65

$15.95 $15.75

$0.00

$10.00

$20.00

$30.00

$40.00

$50.00

$60.00

1996 1997 1998 1999

1Q 2Q 3Q 4Q

Reprinted with permission from CS First Boston

2. Products and Services Currently Offered On-Line

On-line investors can click onto a firm’s website and, frequently at no charge, find

market data, historical charts, securities analyses (e.g., analyst reports, industry reports,

earnings estimates, comprehensive charts, news stories), stock and mutual fund screeners, asset

allocators, mutual fund supermarket offerings, interactive calculators, and customizable home

pages.

On-line firms offer trading in equities, mutual funds, listed options, and fixed-income

securities. Many on-line firms also offer access to IPOs, after-hours trading, and pre-opening

trading. Investors can opt to have these services delivered not only to their personal

computers, but via wireless communications as well (e.g., pagers or personal digital assistants).

Moreover, investors can access information on-line that was previously unavailable or

difficult to obtain, such as information about hedge funds,14 proxy voting records,15 a mutual

 

14 Site Offers Research on Hedge Funds, AM. BANKER, Sept. 22, 1999, at 9 (discussing

www.hedgeworld.com, which intends to be clearing house for data and discussion for hedge

funds).

15 See Patrick S. McGurn, CalPERS Unveils New Governance Web Page, ISSUE ALERT, Feb. 1999,

at 5.
17

fund’s investment record,16 daily price information about certain fixed-income securities,17 and

information about corporate issuers.18

B. Trends in On-Line Brokerage

1. Continued Growth of the On-Line Channel

Industry analysts foresee continued growth both in the number of on-line

brokerage accounts and account assets. Forrester Research predicts that by 2003, 9.7

million U.S. households will manage more than $3 trillion in 20.4 million on-line

accounts.19 Jupiter Communications estimates that by 2003, 20.3 million households will

trade on-line and also puts total on-line account assets at more than $3 trillion.20

According to the 1999 SIA Investor Survey, 28 percent of respondents stated that they

were either very or somewhat likely to begin using the Internet to trade securities in the

next 12 months.21

One securities analyst described what he perceives to be the five sources of on-line

market growth today: (1) traditional mutual fund investors investing incremental income in

stocks; (2) employees who previously let employers invest for them now investing for

themselves; (3) new investors in the market favoring on-line firms; (4) investors transferring

their accounts from full-service firms; and (5) investors who open on-line accounts while

maintaining their full-service accounts.

 

16 Jeffrey M. Laderman, A Mutual Fund that Lets it all Hang Out, BUS. WK., Sept. 27, 1999, at 126

(Open Fund posts on its website every trade that it makes).

17 See, e.g., The Bond Market Association <http://www.investinginbonds.com> (visited November

15, 1999); Toddi Gurtner, The E-Bond Revolution, BUS. WK., Nov. 15, 1999, at 270.

18 See National Investor Relations Institute (“NIRI”) Releases Follow-Up Survey on the Growing

Use of Communications Technology in the Practice of Investor Relations (visited Nov. 1, 1999)

<http://www.niri.org/publications/alerts/ea051898.cfm>.

19 Forrester Research, Net Investing Goes Mainstream (visited Nov. 1, 1999)

<http://www.forrester.com/ER/Research/Report/Analysis/0,1338,5876,FF.html>.

20 Jupiter Report, supra note 8. In this same report, Jupiter Communications predicts that 80 percent

of revenue will come from interest, fees, and non-transaction services by 2003, up from 36 percent in

1998. It expects the number of trades and resulting commission revenues generated per household to

drop by 2003. Id.

21 1999 Annual SIA Investor Survey, supra note 6, at 40.
18

2. Convergence of On-Line and Full-Service Brokerages

The big question is where does on-line brokerage go from here. Does it represent

an evolutionary step or a revolutionary event? Is it merely the natural evolution of

discount brokerage from a telephone-based technology platform to an Internet-based

one?22 Or does it represent a revolution in the way brokerage will be conducted in the

future? Will it be a necessary channel for every broker? Will technology drive the

convergence of the business models of full-service and the more upscale on-line firms?

a. On-Line Firms

Discount brokerage firms pioneered the industry’s move to on-line trading. Initially,

these firms did not need to rethink their business model or unbundle their services to provide

on-line executions. As shown in Chart I-4, the on-line industry recently underwent a “virtual

price war” over commission rates. Some firms avoided or eventually removed themselves

from the fray, preferring instead to differentiate themselves by offering more services.

One roundtable participant observed that important quality distinctions exist among online firms in areas such as ease of access, pricing of services, and information resources. An

on-line firm participant stated that the challenge ahead for on-line firms will be to teach

customers how to use the available research tools; otherwise, customers will be overwhelmed

with information.

A roundtable participant representing a market research firm believed that on-line firms

will continue to differentiate themselves by mimicking the process of investment assistance that

investors expect from traditional firms. This participant also believed that on-line firms will

give their customers more access to research, portfolio management tools, and financial

planning.

 

22 According to some industry participants, there already has been somewhat of a convergence offline between discount and full-service firms:

Traditionally, the term discount broker has been used to distinguish broker-dealers who allow customers to enter

unsolicited or non-recommended orders for their accounts from broker-dealers who provide investment

advice and, through, registered representatives assigned to specific customers, solicit the purchase of

specific securities (called full-service brokers). The term discount arises out of the original prototype, in

which the unsolicited broker charged a commission which was substantially discounted from the

typical commission charged by the full-service broker. Since 1980, the prototype has substantially

changed, while the moniker stayed the same. Discount brokers now provide added services, such as

access to research and other information and full service brokers allow substantial discounts in

commission to certain individuals. . . .

Letter from Michael J. Anderson, President, Ameritrade, et al. to Jonathan G. Katz, Secretary,

SEC (dated Dec. 9, 1998).
19

While the most significant recent trend seems to be full-service firms seeking to

establish an on-line presence, some on-line firms are trying to establish an off-line presence.23

To borrow a phrase, these on-line firms are seeking to build a “clicks and mortars” business.24

b. Full-Service Firms Go On-Line

The availability of on-line trading at reduced commission rates has forced full-service

firms to reconsider the viability of their commission-based pricing models. These models

traditionally bundle execution services and investment advice into one transaction fee. Several

full-service are already moving from a commission-based pricing model to an asset

management fee model for broker-assisted and on-line trading and/or competitively-priced online per trade commissions.25

As full-service firms go on-line, however, the most significant challenge they face is a

potential “channel conflict” between their traditional method of distributing financial services --

the registered representative -- and their new distribution method -- the Internet.26 Some fullservice broker-dealers are seeing customers shift from trading through a registered

representative to trading independently on-line.27 In the traditional full-service model, the

customer typically develops a stronger relationship with the registered representative than with

the firm itself. When a registered representative leaves the firm, he usually takes his “book” of

clients with him. In the on-line model, however, the customer develops the stronger

relationship with the firm itself, rather than with any registered representative. While some fullservice firms have moved slowly in establishing an on-line presence because of potential

 

23 Gaston F.Ceron, E*Trade Could Be Looking for Alliance, DOW JONES NEWSWIRES (Sept. 9,

1999); Blaise Zenega, On-line Shopping Gets Real, RED HERRING, Sept. 1999, at 112 (on-line

and off-line retailers are integrating their sales channels); Christine Stubbs, Getting Physical,

RED HERRING, Sept. 1999, at 116 (reasons that on-line businesses may purchase off-line

businesses); Catherine Yang, No Website is an Island, BUS. WK., E.BIZ, Mar. 22, 1999, at EB38

(discussing how on-line and off-line firms are marketing both in the real world and in

cyberspace).

24 Jonathan Webber, Clicks and Mortar, THE INDUSTRY STANDARD (July 26, 1999)

<http://www.thestandard.com/articles/display/0,1449,5636,00.html>.

25 Joseph Kahn, Full-Service Brokerage Seek Foothold On-Line, N.Y. TIMES, Oct. 21, 1999, at 2.

26 See Jerry Useem, Internet Defense Strategy: Cannibalize Yourself, FORTUNE, Sept. 6, 1999, at

121 (gives examples of companies that have shifted to new business strategies that destroy the

value of past investments).

27 See, e.g., National Discount Brokers Group, Inc. Management’s Discussion and Analysis of

Financial Condition and Results of Operation, May 1999 (company’s commission income

increased principally due to a 31 percent increase in customer average daily tickets but was offset

by more customers trading with National Discount Broker’s lower-priced automated systems

instead of higher cost registered representatives).
20

channel conflicts, others have established an on-line presence to avoid having their customers

transfer a portion of their assets elsewhere.28

Roundtable participants generally believed that registered representatives would not

disappear as full-service firms go on-line, but acknowledged that their role would evolve. One

full-service brokerage participant remarked that customers will gravitate toward firms that give

them the choice of investing on-line and off-line.

Another full-service brokerage participant contended that information transparency will

create more intelligent customers, changing the registered representatives’ advisory role and

consequently the culture of larger broker-dealers. This participant observed that registered

representatives previously had to spend much of their time with ministerial duties, such as

providing stock quotes, faxing account statements, or telephoning the customer about an

earnings report. The participant posited that because the customer can help himself to this

information on-line, registered representatives can devote more time to adding value in the

form of customer advice.

An on-line brokerage participant asserted that while most investors will use the Internet

to retrieve investment information, not everyone will trade on-line. Instead, this participant

believed that full-service firms will have fewer representatives to serve their customers and will

leverage their resources to provide customers with more and better technology-related

services.

Finally, a full-service brokerage participant said that it is risky to continue to view the

world in terms of on-line versus off-line clients. This participant believed that regulators need

to think about regulating customers’on-line and off-line activity as if it was a seamless

relationship.

3. Brokers Providing Customized On-Line Content and Financial 

Advice

A number of broker-dealers have begun to personalize website content to create

dynamically generated website content relevant to each user.29 By personalizing website

 

28 Charles Gasparino and Rebecca Buckman, Facing Internet Threat, Merrill to Offer On-line for

Low Fees, WALL ST. J., June 1, 1999, at A1 (Merrill Lynch announces plans to offer low cost

trading after registered representatives complained that they were losing customers to on-line

trading); Charles Gasparino and Rebecca Buckman, Some Top Brokers at Merrill are Jumping

Ship as Company Prepares to Enter On-line Waters, WALL ST. J. Sept. 15, 1999, at C2; Rebecca

Buckman, Morgan Stanley’s On-Line Experiment is Test for Traditional Brokerage Firms, WALL

ST. J., Sept. 8, 1998, at C1; Randall Smith, Full-Service Brokers Are Put in a Bind, WALL ST. J.,

June 1, 1999, at C1; and John Williamson, Full-Service Brokers Must Use Net or Keep on

Losing Ground, AM. BANKER, Aug. 21, 1998, at 8 (to differentiate themselves on-line, fullservice firms must leverage their on-line capabilities, “including greater mobility and

accessibility of data, providing real-time data or improving efficiency, and channeling and

filtering information for their customer”).
21

content, broker-dealers can create customer loyalty, lower administrative costs, increase

revenues,30 and cross-sell products and services.31

There are two general types of personalization: push and pull technology. With

pull technology, the website user sets his preferences and the on-line merchant sends

information tailored to these preferences.32 With push technology, an on-line merchant

develops a user profile based on observations about the users’ behavior on-line (“tracking the

clickstream”) or transaction history. The merchant can either classify users and target different

information to different categories of users or recommend products based on user profiles that

it has developed.33

 

29 Personalization has been described as “customer relationship management” or “mass

customization.” A number of books have been written on this subject: DON PEPPERS AND

MARTHA ROGERS, PHD, ENTERPRISE ONE TO ONE: TOOLS FOR COMPETING IN THE INTERACTIVE

AGE (1999); SETH GODIN AND DON PEPPERS, PERMISSION MARKETING, (1999); FREDERICK

NEWELL, THE NEW RULES OF MARKETING: HOW TO USE ONE-TO-ONE RELATIONSHIP MARKETING

TO BE THE LEADER IN YOUR INDUSTRY (1997).

30 According to CS First Boston, on-line firms that personalize and push information such as

breaking news to customers may be “generating higher activity levels in their existing customer

bases, which can lead to huge incremental gains in overall trading levels.” CS FIRST BOSTON:

ON-LINE TRADING QUARTERLY, supra note 11, at 3.

31 Alex Frew McMillan, Data Mining Goes On-line, CNNFN (Sept. 24, 1999)

<http://www.cnnfn.com/1999/09/24/investing/q_datamine/> (discussing how broker-dealers

intend to use data mining techniques to sell to investors); Chuck Epstein, Financial Securities

Firms Take Aim At Customers, WALL ST. & TECHNOLOGY, Sept. 1999, at 32 (financial

institutions are beginning to cross-sell financial products to customers who interact with the firm

through the Internet, a call center, or a branch office). Producers of personalization software

include: Andromedia <http://www.andromedia.com>, Applix, Inc. <http://www.applix.com>,

Broadvision, Inc.<http://www.broadvision.com>, eShare Technologies, Inc.

<http://www.eshare.com>, IBM Corp. <http://www.ibm.com>, MessageMedia, Inc.

<http://www.messagemedia.com>, Naviant Technology Solutions <http://www.naviant.com>,

Nestor, Inc. <http://www. nestorinteractive.com>, Net Perceptions, Inc.

<http://www.netperceptions.com>, Personify, Inc. <http://www.personify.com>, Pivotal Corp.

<http://www.pivotal.com>, Sterling Software, Inc. <http://www.infoadvan.com>, SAS Institute,

Inc. <http://www.sas.com> ServiceWare, Inc. <http://www.molloy.com>, Sybase, Inc.

<http://www.sybase.com>, and Vignette Corp. <http://www.vignette.com> (all visited Oct. 27,

1999).

32 For example, Charles Schwab & Co., Inc. allows viewers to create a personalized web page

incorporating Schwab and Excite content into the Schwab site. Schwab, Excite to Launch

Personalized Web Pages, INSTITUTIONAL INVESTOR, May 10, 1999, at 2.

33 See, e.g., Phil Patton, Buy Here, and We’ll Tell You What You Like, N.Y. TIMES, Sept. 22, 1999,

at 22; William J. Holstein et al, Click ‘til You Drop ..., U.S. NEWS & WORLD REP., Dec. 7, 1998,

at 37; Chris Taylor, Once Upon a Time, TIME, Nov. 2, 1998, at 37.
22

On-line firms have already begun to segment their customers by account size and

trading patterns to reward preferred customers.34 For example, active traders may get trading

screens.35 High net worth clients may get a “concierge service” to act as a facilitator or

handholder.36

One analyst stated that firms are segmenting products by customer to take care of their

best customers by account assets and trade rates. At the roundtables, one on-line firm said that

it currently puts all its customers into the one-size-fits-all category but that future plans include

segmenting customers and delivering information to them accordingly. Another on-line firm

stated that firms should customize the on-line experience of each investor.

Many other firms are also thinking about data mining, although they are early in their

data mining capabilities.37 It seems inevitable that firms will use information customization to

compete. Doing so will provide customers with a means to sift through the enormous

amount of “noise” on the Internet. It also will provide firms with another means to deliver

personally relevant content to their customers and to market themselves through the

services they provide.38

 

34 See Joseph Kahn, Web Brokerage Firms Roll Out the Red Carpet to Lure Bigger Investors,

INT’L. HERALD TRIB., Sept. 14, 1999, at 16 (discusses firms giving red carpet treatment to highend investors).

35 See, e.g., Schwab Desktop System for Frequent Traders, AM. BANKER, Aug. 26, 1999, at 7

(Charles Schwab introduces Velocity for active traders); Lynnley Browning, Fidelity Uses

Merger to Boost On-line Investing Service, BOSTON GLOBE, Sept. 28, 1999 (LEXIS, News

Library, 90 Day File) (Fidelity introduced Powerstreet for active traders).

36 D.F., NDB Tests Services for Wealthy Customers, FIN. NETNEWS, Sept. 20, 1999, at 38 (National

Discount Brokers is testing its new “Concierge Group” service targeted at high net worth clients);

see also, Geri Coleman Tucker, Schwab Exec Heads Personal Finance Start-Up, USATODAY,

Oct. 19, 1999, at 3B (discusses MyCFO, a “financial butler” for the superrich, offering

investment advice, portfolio management, tax preparation, and bill payment).

37 Kerry Massaro, Ernst & Young Study Shows Increase in CRM Spending by 31%, WALL ST. &

TECHNOLOGY, at 14 (Ernst & Young study of customer relationship management applications

found that 63 percent of respondents did not know if customer relationship management

spending was increasing or decreasing profitability; 60 percent did not know if such spending

was helpful in cross-selling; 25 percent segmented their customers by profitability. Still, 77

percent of respondents had between one and ten CRM projects and 54 percent considered them to

be mission critical).

38 A 1998 Jupiter Communications study found that customizing increased 25 electronic commerce sites’

new customers by 47 percent and revenue by 52 percent. Robert D. Hof, Now it’s Your Web, BUS. WK.,

Oct. 5, 1998, at 164. Amazon.com was the first on-line business to use technology to analyze its

customers’ purchase patterns and suggest other books that customers with similar purchase patterns

had bought in the past. Robert D. Hof, Amazon.com, The Wild World of E-Commerce, BUS. WK., Dec.

14, 1998, at 106. The securities industry is expected to increase its spending on customer

relationship management software by 14 percent annually through 2003, from $120 to $170

billion today to $250 to $300 billion in 2003. Chuck Epstein, Financial Services Firms Take Aim
23

Roundtable participants largely agreed that the next battleground will be fought over

providing automated financial advice on-line. Data mining and personalization technologies

will permit broker-dealers to engage in what Forrester Research calls “the industrialization

of financial advice.”

39 The ability to customize advice will become increasingly important

as more investors trade on-line.40

Some of the ways on-line firms might use these technologies include:

• An on-line broker sees that an investor tends to purchase shares of blue-chip

companies after their stock prices have fallen. The broker can send an e-mail to the

investor when the stock price of a similar blue-chip company has fallen.41

• An investor has what he believes to be a well-diversified portfolio of stocks. His online broker-dealer e-mails a report to him demonstrating that he is actually not as well

diversified as he believes and suggests alternative investments to reach his

diversification goals.42

• A broker-dealer preparing an IPO for a PC manufacturer could use its data warehouse

to find a 60-year old Iowa investor who likes PC manufacturers and has never sold any

of her holdings in such companies.43

• An investment adviser could use an investor’s profile and its library of records on

financial funds to create a personalized investment portfolio on-line.44

 

at Customers, WALL ST. & TECHNOLOGY, Sept. 1999, at 32 (describing 1998 Jupiter

Communications study on customization).

39 Geoffrey Smith, A Richer Future for On-line Investors, BUS. WK. E.BIZ, Mar. 29, 1999

<http://www.businessweek.com/ebiz/9903/ep0329.htm>.

40 See Pamela Savage Forbat, Are You Done For? REGISTERED REPRESENTATIVE, June 1998, at 64

(wealth of information on-line creates more demand for advice). LAWRENCE E. LIFSON AND

RICHARD A. GEIST, THE PSYCHOLOGY OF INVESTING (1999) at 33 (information overload makes it

difficult for investors to sell stocks); Michael Menduno, Retirement Plans Go On-line, THE

INDUSTRY STANDARD, July 23, 1999, <http://www.thestandard.com/article/display/

0,1151,5601.html>.

41 Smith, supra note 39.

42 Id.

43 Timothy J. Mullaney, Building the Perfect Shareholder, BUS. WK. E.BIZ, Sept. 27, 1999, at 1999

WL 27295102 (discusses how investment banks could use data mining techniques to target the

“perfect” shareholder).

44 Heather Green, The Information Gold Mine, BUS. WK. E.BIZ, July 26, 1999, at EB17 (PIMCO

Funds creating investment portfolios using data mining techniques).
24

II. SUITABILITY

A. Background

As discussed in the preceding section, providing financial advice on-line will be the

next area of focus for the brokerage industry. This likely trend raises the issue of how

suitability rules apply on-line.

Generally, suitability refers to a broker-dealer’s obligation to recommend only

those specific investments that are suitable for its customers. The concept of suitability

comes from self-regulatory organization (“SRO”) rules and the shingle theory, which

developed under the antifraud provisions of the federal securities laws.45

1. SRO Rules

The National Association of Securities Dealers (“NASD”) first adopted a

suitability rule in 1939 as part of its Rules of Fair Practice.46 This rule requires NASD

member firms to have reasonable grounds for believing that any recommendation47 they

make to a customer is suitable, based on what the customer has disclosed, if anything,

 

45 For a discussion of suitability generally, see Lewis D. Lowenfels and Alan R. Bromberg,

Suitability in Securities Transactions, BUS. LAWYER, Aug. 1999 at 1557.

46 This rule is currently designated Rule 2310, “Recommendations to Customers (Suitability).” Rule

2310(a) provides:

In recommending to a customer the purchase, sale or exchange of any security, a member shall

have reasonable grounds for believing that the recommendation is suitable for such customer

upon the basis of the facts, if any, disclosed by such customer as to his other security holdings

and as to his financial situation and needs. NASD MANUAL (CCH) (1999).

47

 The NASD has made several pronouncements regarding when a broker-dealer makes a

“recommendation.” In 1996, the NASD stated that:

a broad range of circumstances may cause a transaction to be recommended,” and this

determination does not depend [on whether the transaction is] ‘solicited’ or ‘unsolicited.’ In

particular, a transaction will be considered recommended when the member. . . brings a specific

security to the attention of the customer through any means . . . including, but not limited to,

direct telephone communication, the delivery of promotional material through the mail, or the

transmission of electronic messages. NASD Notice To Members 96-60, “Clarification of

Members’ Suitability Responsibilities under NASD Rules . . .” (Sept. 1996)(emphasis added).

The Commission has not defined what constitutes a recommendation, although it has stated that

a “recommendation may be found to have been implied even where one has not been made

expressly.” National Committee of Discount Brokers, SEC No-Action Letter (May 27, 1980).

The Commission has also suggested that a broker-dealer has not made a recommendation when it

acts solely as an order taker or when it makes general advertisements. Exchange Act Rel. No.

30,608 (April 20, 1992), 57 Fed. Reg. 18,004 (1992).
25

about other security holdings, financial situation and needs. This requirement is referred

to as customer-specific suitability. This rule does not merely prohibit a registered

representative from making an unsuitable recommendation. It imposes an affirmative

obligation on registered representatives to make certain determinations before making a

recommendation. The registered representative must, prior to executing a recommended

transaction to a non-institutional customer, make reasonable efforts to obtain information

concerning: (1) the customer’s financial status; (2) the customer’s tax status; (3) the

customer’s investment objectives; and (4) any other information the registered

representative considers reasonable in making a recommendation to its customer. This

requirement imposes a duty of inquiry on registered representatives to obtain certain

financial information from customers and keep such information current.48

In addition to customer-specific suitability, the rule requires registered

representatives to have an “adequate and reasonable basis” for any recommendation made.

This requirement is referred to as reasonable basis suitability.49 Reasonable basis

suitability relates to the particular investment, rather than to any particular customer.50 In

other words, a registered representative could violate the NASD’s suitability rule if he fails

so fundamentally to comprehend the consequences of his own investment recommendation

that such investment is unsuitable for any investor, regardless of his wealth, willingness to

bear risk, age, or other individual characteristics.51

 Other SROs have similar rules which are grounded in concepts of

professionalism, fair dealing, and just and equitable principles of trade. Although originally

intended to protect the exchanges and their members from uncreditworthy customers,

these rules have been interpreted as customer protection and suitability rules. For

example, New York Stock Exchange (“NYSE”) Rule 405,52 or the “Know Your

Customer Rule,” requires members to use due diligence to learn the essential facts relative

to every customer, every order, every cash or margin account accepted or carried by the

member, and every person holding a power of attorney over any account.

 

48

 NASD Conduct Rule 2310(b), NASD Manual (CCH) (1999). See also, Gerald M. Greenberg, 40

S.E.C. 133 (1960) (holding in an NASD suitability case that a broker cannot avoid the duty to

make suitable recommendations simply by entirely avoiding knowledge of the customer’s

financial situation); Exchange Act Release No. 33,869 (April 7, 1994) 59 Fed. Reg. 17,632

(1994) (approving amendments to MSRB rule G-19 relating to suitability of municipal securities

recommendations and stating that the rule includes a duty of inquiry).

49

 F.J. Kaufman and Co., 50 S.E.C. 164 (1989).

50 Id.

51 Id.

52 NYSE Rule 405(1), 2 NYSE GUIDE (CCH) 2405, at 3696 (Aug. 1994).
26

2. The Shingle Theory

In the 1963 Special Study of the Securities Markets,53 the Commission specifically

identified suitability as a distinct doctrine giving rise to a “legal obligation” under the

federal antifraud provisions, and an “ethical duty” under SRO rules.54 The shingle theory

arises from common law and provides that by virtue of “hanging out its shingle” as a

securities professional, a broker-dealer makes an implied representation to its customers

that it will deal with them fairly and according to the standards of the profession.55 As

part of this obligation of fair dealing, broker-dealers must make a customer-specific

suitability determination. In addition, the shingle theory requires that broker-dealers have

a reasonable basis for believing that the particular security being recommended is

appropriate for any investor.56 To have such a reasonable basis, a broker-dealer must have

performed due diligence on the security to be in a position to recommend the security to a

customer.57

3. Options and Penny Stocks

Broker-dealers also must comply with specialized suitability rules when

recommending certain kinds of securities, such as penny stocks and options.58

4. SEC Antifraud Actions

The Commission’s statutory authority to bring suitability claims comes under the

general antifraud provisions -- Exchange Act Sections 10(b)59 and 15(c)60 and Rules

10b-561 and 15c1-262 thereunder. To prove a violation, the Commission must establish

 

53 H.R. Doc. 95, 88th Cong., 1st Sess. (1963).

54 Id. at 238.

55

 In the Matter of Duker v. Duker, 6 S.E.C. 386 (1939); Charles Hughes & Co. v. SEC, 139 F.2d

434 (2d Cir. 1943), cert. denied, 321 U.S. 786 (1944).

56 See Hanly v. SEC, 415 F.2d 589, 596 (2d Cir. 1969).

57 Id.

58 See Exchange Act Rule 15g-9, 17 C.F.R. 240.15g-9, (penny stocks); Rule 9.9, 2 Chicago Bd.

Options Ex. (CCH) 2309 (1998) (options rule); NASD Conduct Rule 2860(b)(19)(A); NASD

Rules of Fair Practice, Art. III, section II, Policy of the Board of Governors, NASD MANUAL

(CCH) P2152 (statement of policy concerning recommendations of speculative low-priced

securities and recommendations of or accepting orders for options).

59 15 U.S.C. § 78j(b) (1999).

60 15 U.S.C. § 78o(c)(1) (1999).

61 17 C.F.R. 240.10b-5.
27

that the conduct satisfies the required elements of fraud under the federal securities laws,63

including scienter. As a result, the Commission must meet the burden of proving a fraud

case while the SROs may bring suitability claims for violations of their own conduct rules.

B. Suitability Issues in the On-Line Context

Some industry participants question where the suitability obligation starts and ends

in the on-line context. On-line firms provide a wide range of services and information to

their customers. At one end of the continuum, firms provide pure order entry services. At

the other end of the continuum, firms provide order entry plus all types of specialized

services, including particularized recommendations. Because the Internet permits a firm to

disseminate securities-related information to its customers, the question becomes at what

point does a firm merely “provide” information to its customer and at what point does it

make a recommendation to its customer? As discussed in the Trends section of this

Report, the advent of data mining capabilities makes it more difficult to draw a bright line

between informing and recommending.64

In a white paper prepared for the NASD and provided to the SEC,65 Charles

Schwab & Co. argues that impersonal information provided generally to customers does

not constitute a recommendation and does not trigger a suitability obligation. The Schwab

paper advocates treating general impersonal research or generalized sales and marketing

materials as a solicitation -- subject only to NASD Rule 2210.66 The paper does not,

however, answer the question when that information becomes a “personalized”

recommendation.

These developments raise a number of questions about what suitability obligations

an on-line firm has to its customers. For example:

• Under what circumstances does it make sense for a firm to have suitability obligations

for its customers trading on-line?

 

62 17 C.F.R. 240.15c1-2.

63 For a more complete discussion of Section 10(b) and the requisite elements needed to establish a

case under this section, see infra note 220, and accompanying text.

64 For a more complete discussion of data mining, see Trends section, at page 1.

65 Charles Schwab & Co., Inc., Suitability Obligations in Online Investing, January 29, 1999,

updated and revised, October 27, 1999.

66 This rule provides that “[a]ll member communications with the public shall be based on

principles of fair dealing and good faith and should provide a sound basis for evaluating the facts

in regard to any particular security or securities or type of security, industry discussed, or service

offered.” NASD Conduct Rule 2210(a)-(d), NASD Manual (CCH) (1999) (rule entitled

“Communications with the Public”).
28

• When does a firm make a recommendation on-line? When does a firm using

technology, particularly push and pull technology, cross the line from providing

information to making a recommendation? When does a firm’s actions directing

information on-line -- through an e-mail or by forwarding a press release -- essentially

saying “look at this” or “consider this,” constitute a recommendation saying “buy

this”?

• Does focusing on the degree of personalization assist in determining whether there is a

recommendation? Can firms segment their customers and send them information

without that information being considered a recommendation?

• Fundamentally, do investor expectations play a role in determining what is a

recommendation?

The roundtable discussions provided insight into the industry’s perspectives on

these and other issues involving suitability obligations on-line.

C. Roundtable Participants’ Views

 Participants generally agreed that at least some existing suitability obligations

applied in the on-line context. For example, all but one participant who contributed to the

suitability discussion agreed that the reasonable basis suitability obligation -- that a

security must be suitable for someone -- applies on-line and off-line. Participants also

agreed when suitability obligations did not attach: when firms provide pure order entry

and execution services.

Roundtable participants did not dispute that on-line brokers could make the same

customer suitability determination as off-line firms. In fact, two on-line firms participants

said that technology actually enables a broker to do a better job of assessing customer

suitability.67 Actually making the suitability determination on-line is not a problem,

according to these participants.68 They questioned whether triggering a suitability

obligation on a recommendation still made sense in today’s markets.

Several general observations about on-line investors that broker-dealer roundtable

participants made may explain why some of them believed that traditional notions of

suitability do not apply on-line. First, participants believed that on-line customers do not

 

67 One participant spoke about going beyond existing suitability requirements qualifying an investor

for participation in a certain type of IPO offering and the other about an investor’s participation

in a private placement.

68

 According to a recent press report, E*Trade Securities is currently looking for a vendor to supply

technology to review suitability of on-line trades. As the article noted, “E*Trade believes on-line

brokerages will have to offer advice to remain competitive and to meet customer demand, which

could bring suitability responsibilities....” Margaret McKegney, “E*Trade Seeks Technology to

Review Trade Suitability,”FIN. NETNEWS, Nov. 9, 1999.
29

want registered representatives interfering with their trading. Second, they believed that

customers like to trade on-line partly because they can avoid the traditional registered

representative - client relationship in which the representative is compensated on the size

and frequency of transactions. Third, participants observed that investors think it is

cheaper to trade on-line without a registered representative. Finally, participants asserted

that customers who trade without a registered representative’s intervention should not

expect “protection” from inappropriate investment decisions.

There would appear to be no customer specific suitability obligation when a

customer pulls information from a firm’s website, makes his or her own investment

decision and places an order through an on-line account. That may be today’s customer,

but what about tomorrow’s customer?

According to some of the industry participants, and industry representatives

generally, in the future, on-line brokerage will move away from pure execution at a cheap

price to the rebundling of advice with execution.69 As part of this move, many firms are

developing or planning to develop products that provide personalized information on-line.

Some of these products exist today.70 For example, on-line asset allocation systems ask a

customer about his financial objectives and then provide a number of potential investments

that the customer may want to consider adding to the portfolio.71

Investors can customize information they want directed to them. Some observers

call this feature “automated pull.” Even more subtle from the customer’s perspective, the

Amazon.com type of push technology allows firms to collect information about its

customers and direct personally relevant investment information to that customer.72 In

 

69

 Id.

70

 See e.g., Ivy Schmerken, J.C. Bradford Invests in Internet Technology, WALL ST. &

TECHNOLOGY, at 64 (Sept. 1999) (firm creating technology tools for its investment advisers to

provide investment advice); Ivy Schmerken & Kerry Massaro, Financial Planning Tools, Web

Sightings, , (identifies sites with “do-it-yourself” financial planning, investment tools and

calculators); Julio Bucatinsky, Black Box Developer Generates Buy/Sell Signals on the Internet,

WALL ST. & TECHNOLOGY, at 48 (Feb. 1999)(describes Indigo Online service that provides

access to trading algorithms traders may use to update portfolios: “Indigo tells you exactly which

stock or funds to buy or sell.”); Menduno, Retirement Plans Go Online, supra note 40 (describes

on-line 401(k) custom advice systems, including Financial Engines); Discover Brokerage

<http://www.discoverbrokerage.com/cgi.bin/Help/investorRsrc> (describes LIMresearch.com

Ideas historic analysis modeling product) (visited Oct. 1, 1999).

71

 See id.

72

 Amazon.com, an on-line bookseller, uses collaborative filtering to compare customer’ purchase

history or clickstream with other buyers to suggest items that may be of interest to a particular

customer.
30

that scenario, the information pushed could be issuer-specific research reports, e-mails

about investment opportunities or press releases about a particular company.73

Most participants opined that making available proprietary research on a firm’s

website would not be a recommendation. Some participants also questioned when

bringing a security to the attention of a customer should be considered a recommendation.

Other participants contended that it all depended on how the information was

disseminated. Research that an investor can pull from a firm’s website likely requires a

different analysis than e-mails or other communications targeted to certain customers

about developments in a particular company in which customers may want to invest.

Part of the roundtable discussions focused on identifying and managing customer

expectations. While the firms represented agreed that a firm could not use disclosure to

disclaim liability under the federal securities laws, they discussed how they could use it to

inform customers. Another participant suggested that the benchmark for suitability should

be whether a customer reasonably believed that information sent to him took into account

his “personal circumstances.”

Participants also discussed what information firms do not disseminate to investors

due to their uncertainty about the firms’ suitability obligations. Attorney participants

indicated concerns about their clients sending e-mails or group e-mails and posting

research on websites. One firm participant was interested in knowing whether the firm

could send its “tech stock” customers information about other tech stocks and whether the

firm could include research reports or summaries in its newsletter. One participant, whose

firm featured an asset allocation system, indicated that it did not retain customer data input

into the calculator because the firm was not sure what its suitability obligation would be if

a customer placed an unsolicited trade that was inconsistent with his or her stated

objective. Finally, another firm participant stated that his firm had used data mining to

collect information but had not yet put the information to use because the firm had

questions about what it could do with the data.

Many of the participants sought reassurances that the Commission and SROs were

approaching suitability in a way that provided sufficient flexibility to accommodate the

rapid changes in the technology used in on-line trading. Some participants indicated that

they preferred no changes in the area of suitability regulation at this time. Most of the

participants did, however, indicate that some guidance would provide a useful framework

for determining what activities associated with on-line trading did or did not trigger

suitability obligations -- particularly given the new product development underway.

D. Conclusions and Recommendations

 

73

 See e.g., McMillan, Data Mining Goes On-Line, supra note 31 (firms using customer profiling to

give customers what they want -- “on-line brokerages hope they can learn what you want and

give it to you, perhaps before you even ask for it.”)
31

1. Conclusions

Most of the participants believed that the general policy goals behind suitability

continued to make sense on-line. They also noted the Commission’s and the SROs’

challenge moving forward will be how to apply this obligation to the on-line trading

environment.

Resolving this issue will require several considerations. First, how should the

regulators interpret “recommendation” on-line? Push and pull technology make this a

difficult question to answer. Regulators need to consider how defining suitability on-line

may impact information flow and access. Although some would argue the Internet gives

investors (and consumers generally) too much information, investors may not want this

information restricted. Second, it would be helpful to better understand: (1) what types of

products are on-line firms developing or considering, and (2) what do on-line investors

really need and want in terms of information delivery or recommendations? Third, when is

the appropriate time for regulators to provide additional guidance on what on-line

activities trigger suitability obligations?

2. Recommendations

• The Commission should consider a candid dialogue with the industry about customer

relationship management product development and data mining. The Commission

should encourage the industry to provide information on: (1) how the products would

work, (2) what types of information would be pushed or pulled, and (3) whether

customers would recognize that the firm had specifically provided them with

customized information. This discussion should yield more insight on what is

information or what is a recommendation.

• Alternatively, the Commission should consider incorporating into any future on-line

firm examination program a review of what services firms provide to their customers

based on information derived from data mining.

• The Commission should consider clarifying how suitability principles apply to certain

on-line circumstances and situations. As a starting point, the Commission should work

in consultation with the SROs to consider issues raised by the following scenarios and

relevant analysis:
32

SUITABILITY HYPOTHETICALS

Whether a broker-dealer has made a recommendation depends on the facts and

circumstances. For example, if fraud were involved in the following hypotheticals, the

analysis would be different. The Commission and SROs should consider using the

following hypotheticals as a basis for providing further clarification or guidance.

1. AN ON-LINE BROKER-DEALER PROVIDES ONLY ORDER EXECUTION

SERVICES TO ITS CUSTOMERS.

This activity should not require a customer-specific suitability review, assuming

that the firm acts purely as an order taker. This scenario is substantially similar to when

the investor contacts a discount firm by telephone to execute a particular trade. The only

difference is the medium by which the order is communicated to the firm. A firm’s

suitability obligation does not depend on whether a trade is executed on-line or

otherwise.74

2. AN ON-LINE BROKER-DEALER PROVIDES ORDER EXECUTION

SERVICES AND ALLOWS ITS CUSTOMERS TO PULL INFORMATION

FROM ITS “VIRTUAL LIBRARY” (WHICH CONTAINS RESEARCH

REPORTS, MARKET COMMENTARY, AND NEWS). THIS VIRTUAL

LIBRARY APPEARS THE SAME TO EVERY CUSTOMER.

This type of activity should not trigger customer-specific suitability requirements.

However, the broader reasonable basis suitability standard would apply in this context. In

other words, the firm must have a reasonable basis for believing the research reports and

market commentary are plausible and that the investments or strategies discussed therein

may be appropriate for at least some of its customers.75

3. IN ADDITION TO THE SERVICES PROVIDED IN SCENARIO 2, THE

CUSTOMER HAS THE ABILITY TO PERSONALIZE WHAT SHE SEES

EACH TIME SHE GOES TO THE ON-LINE FIRM’S WEBSITE. THE

CUSTOMER’S PERSONALIZED WEBPAGE TRACKS QUOTES IN

SPECIFIED STOCKS, AND PROVIDES ALERTS ABOUT RESEARCH IN

SUCH STOCKS OR THE SECTOR THEY ARE IN. THE CUSTOMER ALSO

IDENTIFIES HERSELF AS A PARTICULAR TYPE OF INVESTOR (E.G.,

CONSERVATIVE, GROWTH, SPECULATIVE).

Resolving this scenario requires a more difficult determination. On the one hand,

the customer has personalized the website, with no intervention from the firm. If the

 

74

 See NASD Notice to Members 99-11, n.3 (Jan. 26, 1999).

75

 See Kaufman, supra note 49.
33

investor had not identified herself as a particular type of investor, no customer-specific

suitability requirement should be triggered by this scenario. If, however, the customer

does identify herself as a particular type of investor, the firm is on notice that the customer

is following stocks that may be inappropriate for her if she has indicated a very low risk

tolerance. This difference between how the investor identifies herself and how she

customizes her web page may trigger a firm’s suitability obligation. As a good business

practice, the firm would probably want to advise the customer (in writing and prior to

executing any transactions) that risky stocks are not consistent with a conservative

investment strategy.

4. THE ON-LINE BROKER-DEALER CLASSIFIES ITS CUSTOMERS INTO

DIFFERENT CATEGORIES BASED ON FACTORS SUCH AS ACCOUNT

BALANCE, SECURITIES HOLDINGS, AND FREQUENCY OF TRADING

ACTIVITY. THE FIRM DIRECTS DIFFERENT INFORMATION TO

CUSTOMERS IN EACH CATEGORY.

This scenario may require more facts to determine whether the firm has a suitability

obligation. One relevant factor is how finely the firm segments investors and personalizes

the information that they see. If a firm makes individualized recommendations to the

customer based on information it has collected about that customer, the firm would have a

customer-specific suitability obligation. Firms would most likely not have suitability

obligations if customers select certain investment categories and request to receive

information appropriate for that category.

5. IN ADDITION TO THE SERVICES PROVIDED IN SCENARIO 2, THE ONLINE BROKER-DEALER PUSHES SELECTED INFORMATION TO THE

CUSTOMER BASED ON OBSERVATIONS THAT THE FIRM HAS MADE

OF THE USER WHILE SHE WAS ON-LINE. FOR EXAMPLE, AN ON-LINE

BROKER-DEALER SEES THAT SHE TENDS TO PURCHASE SHARES OF

BLUE-CHIP COMPANIES AFTER THEIR STOCK PRICES HAVE FALLEN

AND SENDS AN E-MAIL TO HER WHEN THE STOCK PRICE OF A

SIMILAR BLUE-CHIP COMPANY HAS FALLEN.

At this point on the continuum, the firm now has a customer-specific suitability

obligation. While the process may be somewhat mechanized, the firm is now tailoring

particular securities to her.

6. IN ADDITION TO THE SERVICES PROVIDED IN SCENARIO 2, THE ONLINE BROKER-DEALER HELPS THE CUSTOMER MANAGE HER

PORTFOLIO ON-LINE, EITHER BY PROVIDING BENCHMARKS THAT

HER PORTFOLIO SHOULD MEET OR BY ADVISING ON THE

CUSTOMERS’ ASSET ALLOCATION FOR HER PORTFOLIO.

An “asset allocation calculator,” where an investor enters basic information and the

calculator provides a suggested asset mix (68% in stocks, 20% in bonds, and 12% in cash,
34

for example), is usually akin to a generalized recommendation and in those situations the

firm should not have to make a customer-specific suitability determination. As always, the

reasonable basis suitability standard would apply.

Now let us assume that after entering all of her investment assets into the “asset

allocation calculator,” she is alerted that she has too much common stock in her portfolio

and should consider selling her blue-chip company shares and buying a municipality’s

industrial development bonds. This would be viewed as a personalized recommendation

regarding specific securities, triggering a customer-specific suitability obligation.

7. A FULL-SERVICE BROKER-DEALER ALLOWS CUSTOMERS TO ENTER

ORDERS ON-LINE OR THROUGH A REGISTERED REPRESENTATIVE.

THE REGISTERED REPRESENTATIVE RECOMMENDS A PURCHASE IN

A SPECIFIC STOCK TO A CUSTOMER OVER THE TELEPHONE. THE

CUSTOMER THEN ENTERS THE ORDER ON-LINE IN THE EVENING.

In this scenario, the firm has a customer-specific suitability obligation. The

registered representative made a personalized recommendation to a customer. The more

difficult issue for a firm will be how to monitor a broker’s off-line recommendations to its

customers for suitability when the customer enters the order on-line.
35

III. BEST EXECUTION

A. Background

The duty of best execution requires a broker-dealer to seek the most advantageous

terms reasonably available under the circumstances for a customer’s transaction. The duty

originally derived from agency law principles and fiduciary obligations.76 Subsequently, it

was incorporated into SRO rules.77 In addition, judicial and Commission decisions have

established that a broker-dealer’s failure to perform its best execution obligation may form

the basis for an action under the antifraud provisions of the federal securities laws.78

The Commission has not promulgated a separate best execution rule or explicitly

defined best execution. Rather, how the broker-dealer satisfies its duty continues to

evolve with changes in technology and market structure. Traditionally, price has been the

predominant factor in determining whether a broker-dealer has satisfied its best execution

obligations.79 The Commission has stated that broker-dealers also should consider at least

six additional factors: (1) the size of the order; (2) the speed of execution available on

competing markets; (3) the trading characteristics of the security; (4) the availability of

 

76 The duty of best execution derives from the common law agency duty of loyalty, which obligates

an agent to act exclusively in the principal’s best interest. Restatement 2d Agency Sec. 387

(1958). When a broker-dealer acts as agent on behalf of a customer in a transaction, the agent is

under a duty to exercise reasonable care to obtain the most advantageous terms for a customer.

Restatement 2d Agency Sec. 424 (1958). The duty applies whether a broker-dealer is acting as

agent or principal. See E.F. Hutton & Co., Exchange Act Release No. 25,887, 49 S.E.C. 829,

832 (1988); Opper v. Hancock, 250 F. Supp. 688, 673-74 (S.D.N.Y.), aff’d 367 F.2d 157 (2d Cir.

1966); Rule 2320(f), NASD MANUAL (CCH) (1999).

For a detailed discussion on the development of the duty of best execution, see Exchange Act

Release No. 37,619A (Sept. 6, 1996), 61 Fed. Reg. 48,290 (1996) [hereinafter Order Handling

Rules Adopting Release] at 162-3; SEC, Division of Market Regulation, MARKET 2000: AN

EXAMINATION OF CURRENT EQUITY MARKET DEVELOPMENTS [hereinafter Market 2000] (Jan.

1994) at Study V, V-1, V-2 and sources cited therein.

77 See, e.g., NASD MANUAL (CCH), Rule 2320; NYSE CONSTITUTION AND RULES, Rule 123.41.

78 See Market 2000, supra note 76 and cases cited at Study V, V-17, nn. 8-10. See also Newton v.

Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998) (en banc)

(liability may exist under Section 10(b) for firms’ violations of duty of best execution).

79 The Commission has stated that “[i]n its purest form, best execution can be thought of as

executing a customer’s order so that the customer’s total cost or proceeds are the most favorable

under the circumstances.” Exchange Act Release No. 34,902 (Oct. 27, 1994), 59 Fed. Reg.

55,006 (1994) [hereinafter Payment for Order Flow Adopting Release]. The Third Circuit went

even further in Newton by stating “the broker-dealer is expected to use reasonable efforts to

maximize the economic benefit to the client in each transaction.” Newton, supra note 78, at 270.

However, the Commission never has stated that a broker-dealer is bound exclusively by price

considerations in satisfying its best execution obligations. See Order Handling Rules Adopting

Release, supra note 76.
36

accurate information comparing markets and the technology to process such data; (5)

the availability of access to competing markets; and (6) the cost of such access.80

One of the Commission’s main concerns regarding best execution has been that

internalization and inducements for order flow could cause automated routing decisions to

be made for reasons other than a customer’s best interest. The Commission also has

struggled over the years with how to reconcile its policy goal of having broker-dealers

achieve best execution on an individualized basis with the practical reality of firms

automatically routing aggregated retail order flow to a particular market center.

Attempting to alleviate this concern, in 1978 the Commission called for the

development of a neutral message switch to facilitate order-by-order routing by brokerdealers to the market with the best price.81 Commenters opposed the proposal, believing

that the order routing decision should be made by the broker-dealer responsible for

executing an order.82 A year later, the Commission suspended its consideration of this

mechanism indefinitely, citing both the practical limitations in the trading environment at

the time and progress in enhancing intermarket linkages.83 At that time, the Commission

reasserted that a broker-dealer routing retail order flow on an aggregate basis to a single

market must make at least periodic assessments of the quality of competing markets to

assure that it was taking reasonable steps to seek best execution of customer orders.84

Subsequently, the Commission has found that internalization and inducements for

order flow could be reconciled with the broker-dealer’s duty of best execution as long as

the broker-dealer conducts a “regular and rigorous” evaluation of the execution quality of

the different markets trading a security.85

 

80 See, e.g., SEC, Second Report on Bank Securities Activities, at 97-98, n.233, as reprinted in H.R.

Rep. No. 145, 95 Cong., 1st Sess. 233 (Comm. Print 1977).

81 See Exchange Act Release No. 14,416 (Jan. 26, 1978), 43 Fed. Reg. 4,354 (1978).

82 Commenters believed that a neutral message switch would eliminate broker discretion,

differences in execution services, and competitive opportunities created by such differences. See

Exchange Act Release No. 15,671 (Mar. 22, 1979), 44 Fed. Reg. 20,360 (1979).

83 Id.

84 Id.

85 See, e.g., Exchange Act Release No. 15,926 (June 6, 1979), 44 Fed. Reg. 36,912 (1979);

Exchange Act Release No. 16,590 (Feb. 19, 1980), 45 Fed. Reg. 12,391 (1980); Exchange Act

Release No. 17,583 (Feb. 27, 1981), 46 Fed. Reg. 15,713 (1981); Exchange Act Release No.

26,870 (May 26, 1989), 54 Fed. Reg. 23,963 (1989); and Payment for Order Flow Adopting

Release, supra note 79.
37

The Commission’s most detailed pronouncement regarding a broker-dealer’s best

execution obligations came in the 1996 Order Handling Rules Adopting Release.86 In this

release, the Commission emphasized the importance of price improvement opportunities in

determining best execution. Specifically, the Commission stated that broker-dealers must

modify their best execution evaluations to consider price improvement opportunities that

become “reasonably available.” Perhaps most significantly, the Commission stated that

internalizing or routing order flow for execution at the national best bid or offer

(“NBBO”) would not necessarily satisfy a broker-dealer’s duty of best execution for retailsized orders in listed and over-the-counter (“OTC”) securities.

Accordingly, the Commission stated that a broker-dealer’s regular and rigorous

evaluation should include the extent to which directed order flow would be afforded better

terms if executed in a market offering price improvement opportunities.87 As part of that

evaluation, a broker-dealer must take into account material differences that exist among

the price improvement opportunities offered in different markets.88 In addition, the

broker-dealer must consider whether different markets are more suitable for certain types

of orders or particular securities.89

The Commission reiterated this point in its 1997 Report on the Practice of

Preferencing.90 In concluding that preferencing arrangements were not necessarily

inconsistent with a broker-dealer’s best execution obligations, the Commission again

stressed that firms automatically routing orders to a particular exchange must regularly

and rigorously evaluate execution quality in the various markets trading the security.

B. Best Execution Issues Raised in the On-Line Context

The markets have changed significantly since 1997, due in large part to technology

and the Order Handling Rules. Technology has made on-line brokerage increasingly

popular, expanding the rate of individual investors’ participation in the markets. The

Customer Limit Order Display Rule (“Display Rule”), adopted as part of the Order

 

86 See Order Handling Rules Adopting Release, supra note 76.

87 Id.

88 Id.

89 Id.

90 The Commission recognized that preferencing arrangements existed because of the need for

broker-dealers to automate the routing of their retail order flow, given the lack of a practical

means for firms to route on an order-by-order basis. SEC, REPORT ON THE PRACTICE OF

PREFERENCING PURSUANT TO SECTION 510(C) OF THE NATIONAL SECURITIES MARKETS

IMPROVEMENT ACT OF 1996 [hereinafter Preferencing Study] (Apr. 11, 1997).
38

Handling Rules, also has led to more direct individual investor participation.91 Generally,

under the Display Rule a customer order that improves the NBBO must be reflected in the

quote. The Display Rule and the adoption of sixteenths have dramatically narrowed

spreads and affected the quoted depth at the NBBO.92 The Order Handling Rules and

technological advancements also have increased significantly the percentage of trading

volume handled by alternative trading systems (“ATSs”), particularly in the Nasdaq

market.93 Taken together, these developments have greatly affected trading patterns and

market participants’ behavior.

These developments raise a number of questions, including:

• Do recent market developments affect how a broker-dealer carries out its regular and

rigorous evaluation of execution quality?

• Looking forward, what impact will decimalization have on broker-dealers attempting

to achieve best execution for their customers?

• Do most on-line investors have particular expectations as to what constitutes best

execution?

Another more current development affecting the best execution analysis involves

technological advances on-line brokerages can now offer their customers -- services

previously available only to market professionals. Already, several smaller on-line firms94

offer active traders the ability to direct orders in Nasdaq stocks to the market center of

 

91 For a discussion of the synergy between on-line brokerage and the Display Rule, see Laura S.

Unger, Speech by SEC Commissioner: Regulating on Internet Time, (Sept. 22, 1999)

<http://www.sec.gov/news/speeches/spch298.htm>.

92 See, e.g., Michael J. Barclay et al., The Effects of Market Reform on the Trading Costs and

Depths of Nasdaq Stocks, 54 J. OF FIN. 1 (Feb. 1999); MICHAEL A. GOLDSTEIN & KENNETH A.

KAVAJECZ, EIGHTHS, SIXTEENTHS AND MARKET DEPTH: CHANGES IN TICK SIZE AND LIQUIDITY

PROVISION ON THE NYSE (NYSE Working Paper No. 98-01, 1998).

93 One recent report states that electronic communications systems (“ECNs”), a subcategory of

ATSs, now execute approximately 30 percent of share volume in Nasdaq stocks and projects that

this number may increase to 50 percent by 2001. OCTAVIO MARENZI, MERIDIEN RESEARCH,

ECNS -- WHO WILL THE WINNERS BE? (Aug. 31, 1999) (summary available at

<http://www.meridien-research.com/search/SearchList.html>).

94 These firms are ‘smaller’ on-line firms measured in terms of on-line customer accounts.
39

their choice.95 The customer can direct orders through a connection to the on-line

broker’s order routing system.96

Broker-dealers also have developed sophisticated software that attempts to reduce

best execution to an algorithm. These algorithms dictate customer order routing on an

order-by-order basis.97 Several on-line firms are marketing order-by-order routing to

active traders.98 The active trading segment is a very lucrative one for on-line

brokerages.99 While the largest on-line firms do not yet provide direct access or order-byorder routing capabilities,100 several do compete for the active trader segment by offering

features such as Nasdaq Level II quotes101 and faster connections through dedicated

trading websites.102

 

95 Among the on-line firms currently offering this service are A.B. Watley, onlinetradinginc.com,

and TradeCast. See <http://www.abwatley.com>; <http://www.onlinetrading.com>; and

<http://www.tradecast.com> (all visited Oct. 18, 1999).

96 Generally, these customers have direct access to one or more ECNs, to other ECNs and market

makers through Nasdaq’s SelectNet service, and access to Nasdaq’s Small Order Execution

System (“SOES”). For listed stocks, these firms may offer customers direct access to the

NYSE’s and Amex’s order entry systems (DOT and PERS), but do not offer access, direct or

otherwise, to the regional exchanges or third market makers trading these stocks.

97 An order-by-order routing algorithm may take into account factors such as currently displayed

prices and sizes, as well as markets’ past performance in filling orders and market makers’

automatic execution guarantees. The broker’s order management system may monitor the results

of the algorithm, and reapply it if any part of the order remains unexecuted after a certain time

period.

98 Among the on-line firms offering this service are CyberBroker, Timber Hill, and Tradescape.

See <http://www.cyberbroker.com>; <http://www.timberhill.com>; and

<http://www.tradescape.com> (all visited Oct. 18, 1999). These firms do not offer order-by-order

routing capabilities in listed stocks.

99 See, e.g., Rebecca Buckman, On-line Brokers, Day-Trade Firms Start to Encroach on Each

Other’s Cyberturf, WALL ST. J. , Oct. 6, 1999, at C1; David Barboza, Why Big Firms Are

Courting Day Traders, N.Y. TIMES, Aug. 13, 1999, at C1.

100 However, one on-line broker currently routes its customers’ limit orders in Nasdaq stocks to an

ECN. Datek Online routes its customers’ non-marketable limit orders to the Island ECN for

display and possible execution, and its customers’ marketable limit orders are routed through the

Island book for a possible match before being routed out to a market maker. In addition,

E*Trade intends to allow customers to route orders to the Archipelago ECN. See Walter

Hamilton, Individuals May Soon Get a Say in Order Handling, L.A. TIMES, May 16, 1999, at

C14. 

101 Access to Nasdaq Level II quotes allows the user to view bid and ask prices from various market

makers and ECNs but does not allow the user to place quotes or enter orders.

102 See,e.g.,<http://www.gomez.com/features/article.cfm?topcat_id=0&col=11&id= 3300>

(discussing DLJdirect MarketSpeed 3.0 software); <https://trading.etrade.com/cgibin/gx.cgi/appogic+ActiveTrader> (describing Power E*Trade services);

<http://personal400.fidelity.com/accounts/activetrader> (describing Powerstreet Pro workstation);
40

If the trend of commoditizing order routing technologies continues, on-line

brokerages will almost certainly adopt these new technologies for use by the average

customer. How will these technologies impact the duty of best execution? For example:

• If an on-line firm facilitates its customers’ ability to route orders to the market of their

choice, does this alter the on-line firm’s best execution obligation? If so, what, if any,

residual best execution obligation would the on-line firm retain? Would the answer

depend upon whether (1) the firm provides access to all the markets trading a

particular security, or (2) the quality of disclosure provided regarding execution

quality on different market centers? In such instances, what information should on-line

firms disclose to customers? How would the widespread application of such services

impact the markets?

• If on-line firms adopt technology that permits them to perform order-by-order routing

of customer orders, how will this technology affect, if at all, the way they fulfill their

best execution obligations? Will the Commission have to evaluate such firms’ order

routing algorithms? How will the traditional best execution factors apply in such an

environment? What is the potential impact of order-by-order routing on the markets?

• For on-line investors, what are the potential advantages and disadvantages of orderby-order routing compared to the current practice of aggregate routing of retail order

flow?

C. Roundtable Participants’ Views

On-line and full-service broker-dealer participants said they set up procedures to

conduct their regular and rigorous evaluations of execution quality across market centers.

Generally, each has an internal committee that meets at least quarterly to review the firm’s

order routing practices. The committee evaluates information generated internally,

information supplied by various market centers, and, in some cases, reports from

independent transaction evaluation services. Most firms indicated that they conducted

more frequent execution quality reviews, beyond the committee’s quarterly review.

Many participants expressed frustration with the process of obtaining and

evaluating execution data from market centers. They stated that not all market centers

made information available, particularly those markets to whom participants did not

currently route order flow. Some participants believed, however, that competitive

pressures were forcing market centers to provide data. Even where market centers did

make data available, participants complained that not all of it was useful, or in a form that

 

Jack Reerink, Schwab Offers Software that Speeds the Trade Process, USA TODAY, Aug. 25,

1999, at 2B (discussing Schwab’s Velocity software).
41

allowed for cross-market comparison. Again, some participants believed that competitive

pressures were beginning to force markets to provide better quality data.

Partly because of the difficulties encountered in obtaining comparable data, a

number of participants subscribed to execution quality reports issued by independent

transaction evaluation services. They claimed that such reports had inherent flaws and, at

best, painted an incomplete picture of market quality.

On-line brokerage participants expressed views on the factors entering into their

regular and rigorous evaluations of execution quality. On-line brokerages uniformly

believed that best execution needed to remain an evolving standard. In this regard, a

number of on-line brokerages believed that the adoption of the Order Handling Rules and

the move to sixteenths had reduced the amount of price improvement opportunities

available, both in the markets as a whole and among market centers. Consequently, they

contended that price improvement should have reduced importance in their best execution

evaluations.103

Many of the on-line brokerages believed that speed and certainty of execution

should be given greater emphasis in their best execution evaluations.104 In support of this

view, on-line broker-dealers cited the increased volatility characteristic of today’s markets

and the difference in on-line customer expectations. Whether realistic or not -- on-line

customers supposedly expect ‘immediate’ execution at the NBBO. On-line broker-dealers

also suggested that a number of other factors should be considered by broker-dealers in

routing order flow, including a market center’s automatic execution policies, error rates,

speed in posting customers’ limit orders, and help desk responsiveness.

There were a variety of views on the potential conflict between a broker-dealer’s

best execution obligation and its receipt of payment for order flow. Some participants

questioned whether a broker-dealer receiving payment for order flow could adequately

carry out its fiduciary duties. Another participant expressed the view that payment for

 

103 Two participants asserted that price improvement opportunities would continue to diminish as a

result of decimal pricing. In addition, these participants raised questions as to how

decimalization would impact firms’ obligation to provide best execution.

104 It is important to note that in executing a customer’s order there is not always a tradeoff between

ensuring speed of execution and acquiring price improvement. For example, some market

centers use an algorithm to provide automatic price improvement to eligible orders (e.g., when

the spread between its bid and offer is wider than the minimum variation). In addition, under the

“stopping stock” rules of various exchanges, a specialist may stop an incoming customer order

against order(s) on the limit order book, guaranteeing the stopped order an execution at the

prevailing market price while attempting to achieve price improvement. The Commission,

however, has had mixed reactions about the practice of stopping stock, because any customer

limit order with time priority that the incoming order is stopped against, is deprived of an

immediate execution if the stopped order receives price improvement or perhaps any execution at

all if the market subsequently moves away from the limit price. See Preferencing Study, supra

note 90, at Section II.B.4. 
42

order flow returned benefits to the customer in reduced commission rates and in other

forms.105 Still another participant believed that payment for order flow eventually will end

because of the reduction in spreads that will result from next year’s scheduled move to

decimal pricing.

Participants had differing perspectives on how regulators conducted their oversight

of firms’ best execution evaluations. Some believed that regulators placed too much

emphasis on particular factors. These participants believed that such an approach may

unduly constrain their ability either to carry out their fiduciary duties or exercise

appropriate business judgment. A few other participants complimented the Commission in

particular for its renewed focus on best execution. They believed that by prompting online firms to seek modifications in market makers’ practices (such as the handling of

customer orders at the Nasdaq opening), the Commission’s examination of on-line brokerdealers’ best execution practices had demonstrated the tremendous influence on-line firms

had over market makers’ order handling practices.

The question whether on-line customers actually understood all of the costs

involved in executing their orders provoked a lively discussion among the participants.

Participants acknowledged that customers were keenly aware of differences in commission

rates among on-line brokerages. However, many participants believed that on-line

customers remained largely unaware of how differences in execution prices available

among different market centers could affect customers’ total transaction costs. In this

regard, several participants cited examples where a customer might pay a low commission

rate, but then receive an execution price inferior to that available on another market,

yielding a higher overall total transaction cost.106 These participants and others believed

that customers needed to be better educated as to how orders are executed at different

trading venues (e.g., dealer vs. agency) and how this affects the customer’s total

transaction costs.107

Some participants believed that customers gradually were becoming more aware of

how on-line firms’ order routing decisions affected the customers’ total transaction costs.

Several thought that competitive initiatives by the industry would increase customer

 

105 For a concurring view, see R. BATTALIO, R. JENNINGS, & J. SELWAY III, PAYMENT FOR ORDER

FLOW, TRADING COSTS, AND DEALER REVENUE FOR MARKET ORDERS AT KNIGHT SECURITIES, L.P.

(NASD Working Paper No. 98-03, 1998).

106 One participant cited internally-produced statistics finding that the volatility in Internet stocks

meant that a one minute delay in execution could cost a retail investor in excess of $1.00 per

share. Moreover, this participant asserted that the average spread for Internet stocks is $0.28,

resulting in an annual “hidden cost” of approximately $200 million for retail investors in this

sector alone.

107 At the same time, these participants generally stressed the importance to the markets of investor

access to both agency services and proprietary capital.
43

awareness and understanding of these issues,108 while others called upon the Commission

to conduct its own educational efforts.

Other participants were less sanguine about the potential success of the industry or

the Commission in educating investors about transaction costs. These participants

believed that the typical customer would not understand distinctions among the markets or

the intricacies of total execution costs. This customer, they hypothesized, only cared

about receiving the NBBO, or, as one put it, “the price he saw on his computer screen.”

109

Participants expressed views on issues relating to customer choice and best

execution. They raised this issue initially in the context of whether on-line customers

should be able to choose speed of execution over opportunities for price improvement

and, if so, what disclosures would enable customers to make an informed choice. One

participant believed that, at a minimum, firms needed to inform customers about

differences in market structure and provide information on opportunities for price

improvement available in different market centers. This participant thought that the

Commission should dictate the specifics of the disclosure. Another participant thought

that customers needed to know the likelihood of trading between the spread.

Finally, participants expressed opinions on the advisability of allowing investors to

route orders directly to the market of their choice. Several favored providing direct

access. These participants pointed to the benefits on-line customers and the markets as a

whole receive when broker-dealers have available a variety of order routing options.110 In

addition, these participants believed that the industry will act responsibly in educating

customers about best execution. Two other participants took the view that providing

customers with direct access may be problematic, because customers might not appreciate

the subtleties of achieving best execution on their own.

D. Conclusions and Recommendations

1. Conclusions

The seemingly ever-increasing number of execution venues and types of

inducements for routing order flow makes the duty of best execution particularly

important in today’s market structure. Requiring broker-dealers to carry out a regular and

 

108 In this regard, one participant thought that the increased use of real-time market data might

cause more customers to compare real-time quotes with the executions they receive, heightening

customers’ interest in the issue. Still another participant thought that the shrinkage of margins

in other areas will require firms to compete based on execution price.

109 One on-line brokerage participant stated that the perception of most on-line customers is that

speed of execution is equivalent to quality of execution.

110 One participant asserted that the Commission should ensure that firms are given the opportunity

to provide a variety of order routing options.
44

rigorous evaluation of execution quality is vital to ensuring that firms meet their best

execution obligations.

As the Commission has stated consistently over the years, best execution is not a

static concept. It is a standard that continues to evolve with changes in technology and

market structure. On-line firms may legitimately take into account speed of execution and

certainty of execution in making their order routing decisions. As with any of the other

factors, however, their relative importance in a broker-dealer’s best execution analysis

requires the broker-dealer to consider whether material differences exist among the

markets trading the security.

The roundtable discussions and recent developments lead to the following

observations and conclusions on best execution. First, in carrying out their regular and

rigorous evaluations of execution quality, on-line and full-service brokerages are having

some difficulties obtaining comparable information from the market centers trading a

security. Second, execution quality appears to be an emerging competitive factor among

broker-dealers and this competition depends on investors gaining an understanding of

execution quality and transaction costs.

Third, order-by-order routing technologies that are developing may provide firms

with new ways to meet their best execution obligations. Currently, most firms do not

route retail orders on an individualized basis. Instead, decisions about order routing are

made on an aggregate basis. Order-by-order routing technologies may provide firms with

a way to route smaller, retail orders on a more individualized basis, but would not

eliminate a broker’s obligation to conduct a regular and rigorous evaluation of execution

quality available at other markets. Unless done in a neutral fashion, these new order-byorder routing technologies would not by themselves eliminate the potential conflicts of

interest (such as payment for order flow, internalization, and preferencing) inherent in the

current practice of routing retail orders to a particular market center.

Finally, technology has developed that would allow an on-line customer to direct

its order to the market of the customer’s choice. These technologies appear to be

particularly attractive to active traders. This technology is not currently in widespread use

among on-line firms, but if it does become widespread, raises new issues about what type

of information a customer would need to make his own order routing decisions.

2. Recommendations

• There have been significant changes in the markets over the last few years including

the Display Rule, quoting in sixteeths, and increased individual participation. In this

new environment, the industry has questioned whether factors such as speed and

certainty of execution should receive greater emphasis in the best execution analysis.

The Commission should encourage the industry to demonstrate the relative importance

of these factors: specifically, they should identify what material distinctions in these
45

factors among markets would merit their consideration as determinative factors in

making order routing decisions.

• The Commission should consider requiring market centers to make publicly available

certain uniform information on various factors relating to best execution (such as price

improvement rates and order turn-around times).

• The Commission should consider requiring that broker-dealers regularly provide their

customers with plain English information about: (1) the execution quality available on

different market centers; (2) the broker-dealer’s order handling practices; and (3) the

broker-dealer’s receipt of inducements for routing order flow.111

• As on-line brokerages offer their customers a choice of order routing options, the

Commission should consider how this phenomenon might affect the duty of best

execution. The Commission also should ensure that on-line firms sufficiently disclose

to customers the consequences of directing their own order flow.

• The Commission should monitor and evaluate the potential consequences of

technological advancements that are making order-by-order routing a practical

alternative to the aggregate routing of retail order flow. The Commission’s evaluation

of these technologies should include an opportunity for industry and public input.

Accordingly, the Commission’s upcoming concept release on market fragmentation

issues should raise questions on the potential consequences of these emerging

technologies, including how they would affect marketplace centrality.

• As part of the Commission’s focus on firms’ compliance with their best execution

obligations, the Commission should examine how broker-dealer’s fulfill this obligation

in light of new technologies available including: (1) algorithm-based order-by-order

routing; and (2) customer direct access routing.

 

111 The Commission already requires some disclosure on broker-dealers’ order handling practices

and receipt of payment for order flow. See Payment for Order Flow Adopting Release, supra

note 79. When it adopted these requirements, the Commission proposed, but never acted on,

additional disclosure requirements relating to broker-dealers’ order handling practices and

inducements for routing order flow. Exchange Act Release No. 34,903 (Oct. 27, 1994), 59 Fed.

Reg. 55,014 (1994).
46

IV. MARKET DATA

A. Background

1. Current Regulatory Framework

Section 11A of the Exchange Act grants the Commission broad authority over

information about securities quotations and transactions.112 In particular, Section 11A

requires the Commission to ensure that market participants and the public can obtain such

information on terms that are “fair and reasonable” and “not unreasonably

discriminatory.”

113

In the 1970s, the Commission approved the Consolidated Tape Association and

Consolidated Quote plans.114 Under these plans, the exchanges and the NASD formed the

Consolidated Tape Association (“CTA”), which is the administrative and policy-making

body for the consolidation and reporting of quotation and last sale information in

exchange-listed stocks. The CTA participants provide their quotation and last sale

information to the Securities Industry Automation Corporation (“SIAC”),115 which

processes and consolidates this information on behalf of the CTA for distribution to

vendors and others.

The administrators of Network A and Network B enter into contracts with both

direct users of market data and with vendors (including broker-dealers) that provide

consolidated market data to third-party subscribers. The CTA has adopted pricing

schedules for market data, which are subject to review and approval by the Commission.

The CTA participants divide market data revenues among themselves based upon each

participant’s pro rata share of transactions in eligible stocks.

The NASD is the entity responsible for the consolidation of quotation and last sale

information for securities quoted on Nasdaq. Like the CTA, the NASD enters into

contracts with both direct users and vendors for the delivery of market data to third

parties according to Commission-approved pricing schedules.

 

112 15 U.S.C. § 78k-1(c)(1) (1999).

113 15 U.S.C. § 78k-1(c)(1)(C) and (D) (1999).

114 Exchange Act Release No. 10,787 (May 10, 1974), 39 Fed. Reg. 17,799 (1974)(order approving

CTA plan); Exchange Act Release No. 15,009 (July 28, 1978), 43 Fed. Reg. 34,851 (1978)(order

temporarily approving CQ plan); and Exchange Act Release No. 16,518 (Jan. 22, 1980), 45 Fed.

Reg. 6,521 (1980)(order permanently approving CQ plan). For a more detailed account of the

development of the consolidated tape and quotation systems, see MARKET 2000, supra note 76, at

Appendix III.

115 The Commission regulates SIAC pursuant to its authority over exclusive securities information

processors. See 15 U.S.C. § 78k-1(b) (1999). SIAC is jointly owned by the NYSE (two-thirds)

and the American Stock Exchange, LLC (one-third).
47

2. CTA Network A and NASD Pricing Schedules116

Generally, the CTA and NASD vendor pricing schedules vary depending on three

factors: (1) the mode of delivering market data; (2) whether the third party is a

professional or non-professional user; and (3) whether the market data delivered is realtime or delayed. Currently, neither the CTA nor the NASD charge vendors for delivering

delayed market data.117 Because this Report focuses on on-line brokerage and individual

investors, the following discussion mainly describes the pricing scheme for firms’ delivery

of real-time market data to their customers.

In a traditional full-service brokerage relationship, a customer interested in a

security visits or calls his or her registered representative, who looks up the security on a

terminal (or interrogation device) and provides the customer with the current quoted

price. Both the CTA and NASD impose a monthly per terminal charge on the registered

representative’s brokerage firm for an unlimited number of inquiries.118 Neither entity

imposes any additional charge on the brokerage firm for using these devices to verbally

provide real-time market data -- such as stock price quotes -- to its customers.

Contrary to their practice off-line, the CTA and NASD do impose fees for on-line

firms’ delivery of real-time market data to customers via the Internet. Currently, on-line

firms have available two pricing options: (1) a flat monthly fee per customer for unlimited

real-time market data queries; and (2) a fee for each customer real-time market data query.

The Commission recently approved changes to the CTA Network A and NASD pricing

schedules in October and June of this year, respectively.119

 

116 Consolidated data in listed stocks is transmitted over two networks: Network A for NYSE-listed

stocks and Network B for Amex and regional exchange-listed stocks. The NYSE and Amex

administrate Networks A and B, respectively. Each Network has its own pricing schedule.

Because of its relative importance, this discussion is limited to a description of the Network A

pricing schedule.

117 In this context, market data is considered “delayed” if it is at least 20 minutes old for exchangelisted stocks and 15 minutes old for Nasdaq NMS and SmallCap securities.

118 The CTA imposes a sliding scale charge depending on the number of terminals used by the

brokerage firm (ranging from $127.25 for one terminal to $18.75 for 10,000 or more terminals).

The NASD imposes a flat rate charge of $20.00 per each terminal. It also charges an annual

administrative fee to vendors and distributors (ranging from $500.00 for one to 999 terminals to

$3,750 for 10,000 or more terminals).

119 Exchange Act Release No. 41,977 (Oct. 5, 1999), 64 Fed. Reg. 55,503 (1999) (order approving

amendment to CTA Network A market data fee schedule); Exchange Act Release No. 41,499

(June 9, 1999), 64 Fed. Reg. 32,910 (1999) (order approving NASD market data fee schedule

pilot program until Apr. 1, 2000). Previously, the CTA charged vendors a flat monthly fee of

$5.25 per customer or $0.01 per customer inquiry. The $0.01 fee pilot was a CTA pilot, not

formally approved by the Commission. See Exchange Act Release No. 39,370 (Nov. 26, 1997),

62 Fed. Reg. 64,414 (1997). Under the CTA Network A’s new schedule, monthly fees are set at

$1.00 for each of a vendor’s first 250,000 customers, and $0.50 for each additional customer. As
48

The general public also can access delayed and real-time market data over the

Internet through non-broker-dealer financial websites. Individuals can receive free realtime market data from a number of Internet vendors by supplying certain personal

information and entering into a click-through subscriber agreement with the vendor.120

Apparently, these vendors intend to recoup the costs of assuming their subscribers’ CTA

and NASD fees by building sufficient site traffic to generate advertising revenues.121

B. Market Data Issues Raised in On-Line Brokerage

In pre-Internet days, the typical individual investor could access real-time market

data only by calling or visiting his or her broker-dealer or chancing upon a ticker tape

display. Newspaper stock tables displayed very delayed data in the form of the previous

day’s high, low and closing prices. The Internet’s development as a communication

channel enabling the broad public dissemination of real-time information, and the

concomitant rise of on-line brokerage, has altered significantly individual investors’

relationship and demand for market data.

On-line brokerages and non-broker financial websites place a wealth of delayed

and real-time market data into the hands of investors. 122 Even without opening an on-line

brokerage account or paying a service fee to a non-broker financial website, an Internet

user can access delayed market data. They can use this delayed data to track single stocks

and sectors, price a real or hypothetical portfolio, and produce historical charts. As noted

above, several financial websites also make real-time market data available at no charge to

their subscribers.123

 

for the per query options, a vendor is charged $0.0075 for its customers’ first 20 million queries,

$0.0050 for the next 20 million queries, and $0.0025 for each additional query. The CTA

Network A schedule includes an enterprise arrangement, under which a broker-dealer would pay

no more than $500,000 per month for delivering market data to their account holding customers.

The NASD’s new pilot schedule reduces on-line firms’ monthly fees for customers’ unlimited

usage of market data from $4.00 to $2.00 per customer and per query fees from $0.01 to $0.0050.

120 See, e.g., Freerealtime <http://www.freerealtime.com>; Market Guide <http://www.

marketguide.com>; FinancialWeb <http://www.financialweb.com>; SmartMoney

<http://www.smartmoney.com>; Thomson Investors Network <http://thomsoninvest.com>; and

Wall Street City <http://www.tscn.com/wsc./Free_RT_Quotes.html> (all visited Nov. 1, 1999).

See also CNBC <http://www.cnbc.com> (registered users receive 25 free real-time quotes per

day) (visited Oct. 18, 1999).

121 See also Portals section beginning at page 1 for a more complete discussion about non-brokerdealer financial websites and advertising revenues.

122 See Appendix 2 for a table of ten on-line broker-dealers’ policies for delivering market data via

the Internet.

123 In addition, an Internet user can view the limit order books of several ATSs in real-time at no

charge. See Island <http://www.isld.com>; MarketXT <http://www.marketxt.com> (both visited

Oct. 1, 1999).
49

Depending on the services their on-line firms offer, account holders have access to

real-time market data to track stocks and sectors, price their portfolios, and produce

charts. For the more sophisticated investor, on-line firms and financial websites offer

streaming quotation and last sale information, Nasdaq Level II quotes, and technical

tracking. These products may be offered at an extra charge or, in the case of an on-line

broker-dealer, in return for maintaining a minimum account balance or executing a certain

number of trades in a specific time period.

These developments raise a number of questions about the current real-time

market data pricing scheme, including:

• How do the market data pricing schedules take into account the difference between

the access fees charged for retail (non-professional) and professional users so that

these fees are “fair and reasonable” and not “unreasonably discriminatory” for both

groups of users?

• Do the market data pricing schedules strike the right balance in terms of raising

sufficient revenues while encouraging the wide availability of real-time market data in

light of today’s market exigencies, technological advances, and investor demand?

• How do the new pricing schedules take into account retail (non-professional)

investors’ demand for real-time market data given the rapid growth of the Internet and

on-line brokerage?

C. Roundtable Participants’ Views and Other Findings

1. Roundtable Participants’ Views

Generally, the on-line brokerage participants stated that their customers expected

them to make available as much real-time market data as possible. As one put it, on-line

investors have an “insatiable” demand for real-time data.

Among the participants expressing views, there was general agreement that the

Internet represented changed circumstances, warranting a reevaluation of the pricing

model for delivering real-time market data to individual investors. The on-line brokerage

participants were especially critical of the current market data pricing model. Several

stated that the cost associated with real-time data required them either to “ration” it out to

customers, absorb the cost, or to pass the cost on to their customers. These firms did not

believe that passing the cost on to customers was a practical alternative. The majority of

on-line firms stated that they rationed out real-time market data. While they expressed a

 
50

desire to make real-time data more widely available, they claimed that it was very difficult

to justify the expense, particularly for their inactive customers.124

Two participants questioned why firms should pay to furnish market data to

customers at all, if it was generally agreed that the Commission and the industry should

encourage transparency and the free flow of information. In addition, one participant

expressed the view that charging fees for investors’ use of real-time data is inconsistent

with the e-commerce model of making information free and charging customers only for

transactions.

As a group, the participants recognized the industry’s need to meet the costs of

creating and maintaining an infrastructure to collect and disseminate market data. A

difference of opinion emerged among the participants, however, as to whether Section

11A contains a cost recovery standard. Several participants believed that Section 11A

clearly had a cost recovery standard.125 Others thought that the statute was silent on the

cost recovery issue, allowing the Commission to set policy on the appropriate uses of

market data revenues.

In connection with this discussion, various participants observed that market data

revenues had become a significant source of funding for SRO oversight functions,

coinciding with a period when the Commission had stepped up its demands for more

oversight. The participants cautioned that eliminating market data revenue as a source of

funding for SRO oversight functions may impede the Commission’s goal of enhancing

SRO regulation. Two participants emphasized that the SROs needed some way to secure

sources of funding to meet the costs of self-regulation. These participants added that, if

market data revenues were not an appropriate means to meet these costs, another means

surely needed to be found to prevent the SROs from facing revenue shortfalls. In

response, a participant suggested that the Commission test the assumption that the SROs

actually direct revenues from market data fees to meet regulatory costs. On this point,

several participants questioned whether SRO programs to rebate or share market data

revenues with their members were an appropriate use of such revenues.126 Another

 

124 One on-line broker-dealer remarked that its policy of providing a real-time quote along with the

entry of an order had the unintended consequence of leading some customers to enter limit orders

well away from the current market just to receive a quote. The on-line brokerage added that this

created unnecessary message traffic for both itself and the market centers handling its customers’

orders.

125 Two of these participants cited as support a 1984 decision by the Commission later affirmed by

the D.C. Circuit Court of Appeals. See In re Institutional Networks Corp., Exchange Act Release

No. 20,874 (Apr. 17, 1984), aff’d, NASD v. Securities and Exchange Commission, 801 F.2d

1415 (D.C. Cir. 1986). Another participant believed this decision was silent on the cost recovery

question.

126 Several exchanges and the NASD have adopted programs to rebate or share market data revenues

with their members. See, e.g., Exchange Act Release No. 41,174 (Mar. 16, 1999), 64 Fed. Reg.

14,034 (1999) (NASD); Exchange Act Release No. 41,286 (Apr. 14, 1999), 64 Fed. Reg. 19,843

(1999) (Cincinnati Stock Exchange); Exchange Act Release No. 40,591 (Oct. 22, 1998), 63 Fed.
51

participant believed that the SROs should find a funding source other than market data

fees to meet their regulatory costs.127

Another related issue arose during the discussion. How would eliminating market

data revenues affect certain exchanges that are now highly dependent on these fees as a

source of income? While some participants expressed sympathy on this point, two

participants stated the view that market data revenues should not be used to subsidize the

operation of markets.

Finally, the conversation briefly touched upon whether any entity had proprietary

rights in market data. The three on-line brokerage participants who raised the issue

contended that market data belonged to the public and should not be considered the

property of the SROs.

2. Other Recent Developments

Since the roundtables concluded, a number of significant developments involving

the market data issue have arisen. In June 1999, the SIA and Arthur Andersen issued a

White Paper on Market Data Pricing (“White Paper”).128 The White Paper noted that

over the last several years, there has been exponential growth in on-line trading and

individual investors’ use of market data.129 The White Paper also noted that full-service

firms often pay a professional terminal-based fee which allows them to provide quotes

over the telephone to their customers at no additional cost.130 On the other hand, when an

on-line broker-dealer customer requests a quote through the Internet, a fee-per-quote

charge is imposed.131 This difference in quote fees leads to the disparate use of market

data between the full-service and on-line discount firms. In addition, the White Paper

stated that, given today’s volatile and high-volume markets, delayed market data “cannot

seriously be used as part of an investor’s trading decisions,” and noted that the markets

“uniformly encourage the use of real-time data for investors.”

132

 

Reg. 58,078 (1998) (Boston Stock Exchange); and Exchange Act Release No. 38,237 (Feb. 4,

1997), 62 Fed. Reg. 6,592 (Feb. 12, 1997) (Chicago Stock Exchange).

127 The participant suggested that a possible solution might be for each SRO to incorporate its

regulatory costs into its quotation after decimal pricing was implemented, with the cost being

passed through to the customer.

128 SIA and Arthur Andersen, White Paper on Market Data Pricing (June 1999).

129 Id. at 16.

130 Id.

131 Id.

132 Id.
52

Several broker-dealers interviewed for the White Paper expressed views similar to

those voiced by the roundtable participants on the cost of providing real-time data to

customers and the relationship of market data revenues to SRO operating costs.133 The

White Paper concluded that it was time to take a “fresh look” at market data pricing to

build a framework flexible enough to meet the SROs’ needs and yet responsive enough to

adapt to changes within the industry.134

Members of Congress have introduced three different bills relating to market data

this session.135 In June, the House held hearings on one of these bills, H.R. 1858, the

“Consumer and Investor Access to Information Act of 1999.”

136 H.R. 1858 would

prohibit the misappropriation of real-time market data and provide new federal remedies

against misappropriators of such data. Representatives from the Commission, NYSE,

NASD, Bloomberg Financial Markets, and three on-line brokerages (Ameritrade,

DLJdirect Inc., and Charles Schwab & Co., Inc.) testified in support of this legislation.137

The testimony also touched upon a variety of other issues relating to real-time

market data. DLJdirect, Schwab, and the NYSE each made the point that real-time

market data helps level the playing field between individual investors and market

 

133 Id. at 20.

134 Id. at 29. Specifically, the White Paper’s goals for such a framework are to: reduce

administrative burdens, explore enterprise licensing models, balance professional and nonprofessional usage for equitable allocation of costs, and explore the Internet as a delivery

mechanism for market data. The SIA set out some specific means to accomplish these goals. Id.

at 29-30.

135 S. 95, 106th Cong. (1999) (the “Trading Information Act”); H.R. 354, 106th Cong. (1999) (the

“Collections of Information Antipiracy Act”); and H.R. 1858, 106th Cong. (1999) (the

“Consumer and Investor Access to Information Act”).

136 The Consumer and Investor Access to Information Act of 1999: Hearings on H.R. 1858 Before

the Subcomm. on Finance and Hazardous Materials of the House Comm. on Commerce, 106th

Cong. (1999) [hereinafter Information Act Subcommittee Hearings].

137 Except for Bloomberg, each organization also was a roundtable participant. In addition, Charles

Schwab & Co., Inc. recently submitted a rulemaking petition to the Commission to review the

market data fee structures imposed by the CTA, NASD, and OPRA. Petition for Rulemaking

under Section 11A of the Exchange Act, Letter from Sam Scott Miller, Orrick, Harrington, &

Sutcliffe, to Jonathan G. Katz, Secretary, SEC (June 29, 1999). The petition charges that the

current fee structures are inconsistent with the requirements of Section 11A. Among other

things, the petition asserts that the new CTA pilot schedule places a disproportionate share of

CTA fees on on-line investors compared to customers of traditional brokerages, Section 11A

requires the CTA to justify its fee schedule on a cost basis, and the Commission should both

exercise greater regulatory oversight of the CTA and require industry and public representation

in the CTA’s management.
53

professionals.138 The on-line brokerages noted that: (1) technology, (2) the immediacy of

the Internet, (3) customer demand, and (4) competition among firms were driving the

increased demand for real-time market data.139 In addition, the NYSE noted the

importance of the Internet as a distribution channel for the delivery of market data to

individual investors.140 DLJdirect and Schwab offered indicia of how frequently

customers used real-time market data: DLJdirect claimed that its 600,000 customers had

accessed 53.5 million real-time quotes in a recent one month period, while Schwab posited

that it registered approximately 75 quote looks per trade.141 In the second quarter of

1999, DLJdirect and Schwab executed approximately 18,000 and 137,000 on-line trades

daily, respectively.142 They contended that the current structure disadvantaged on-line

firms vis-a-vis traditional firms.143 Moreover, they asserted that the cost of real-time

market data affected on-line firms’ ability to provide it to their customers in existing and

proposed applications.144

The NYSE and NASD referenced their efforts to make market data as widely

available as possible for the benefit of investors.145 At the same time, the NYSE stated

 

138 Information Act Subcommittee Hearings, supra note 136, at 18 (self-directed on-line investor

desires access to information broker-dealers formerly provided only to professionals; real-time

market data allows investors to make decisions on same basis as professionals “in the know”); id.

at 40 (widespread distribution levels the playing field for all investors); and id. at 50 (helps

individuals play on level field with professionals).

139 Id. at 18 (the power of the Internet is in providing immediate access to current information, less

than real-time information is in many cases unacceptable); id. at 23, 25 (ease and speed with

which customers can transact has increased demand for and value of real-time data because

investors can put it to use; competitive process is increasing use of real-time data as technology

makes it more readily available); and id. at 51 (technology has transformed the way Schwab can

deliver products and services to investors).

140 Id. at 46.

141 Id. at 18 (period was mid-April to mid-May 1999); id. at 60.

142 CREDIT SUISSE FIRST BOSTON, ON-LINE TRADING QUARTERLY, supra note 11, at 1.

143 Information Act Subcommittee Hearings, supra note 136, at 24 (asserting that on-line customers

pay twice for market data: once in commissions and once in on-line firm’s fee to access data); id.

at 53.

144 Id. at 25 (costs of accessing market data affect customer usage of market data and consequently

the efficiency of customer’s transactions); id. at 49, 52-3 (the higher the cost, whether Schwab

absorbs or passes it along, the more a barrier to providing it to customers in as many ways and

forms as they want it; unnecessary restrictions on real-time market data could chill innovative

uses such as streaming quotes or technical tracking; cost is the single greatest hurdle in providing

access to market data).

145 Id. at 34, 40, and 46 (intent is to make market data ubiquitous; 70 million investors have access

to real-time market data via cable television; 100 million investors have access to delayed and

real-time market data via the Internet; real-time market data is available free to investors who

enter into click-through agreements offered on a number of websites).
54

that ensuring widespread distribution of market data is good business for the Exchange, as

it “primes the pump” and helps generate additional trading volume.146 Finally, the NASD

detailed the role that market data revenues play in funding the NASD’s regulatory

operations.147

3. SROs and Market Data Revenue

 A comparison of NYSE and NASD market data revenues as a percentage of total

revenues indicates the relative importance of market data revenues as a component of

these SROs’ total revenues both before and after the debut of on-line brokerage. In 1994,

the NYSE’s share of CTA Network A revenue amounted to $68.1 million, or 15.1 percent

of total NYSE revenues,148 while the NASD’s received $62.1 million, or 16.7 percent of

its total revenues, from Nasdaq market data in 1994.149 In 1998, NYSE’s share of CTA

revenue was $111.5 million (15.3 percent of total revenues).150 The NASD’s market data

revenues from Nasdaq were $128.5 million (17.4 percent of total revenues).151

These figures show that market data revenues make up a significant portion of the

NYSE’s and NASD’s total revenues. They also reveal that, while in absolute dollars

terms NYSE and NASD market data revenues have increased substantially since 1994,

market data revenues have remained a relatively constant percentage of both SROs’

overall revenues.

Although professional user revenues continued to make up the largest component

of overall market data revenues in 1998, on-line investor demand for this data has

undoubtedly contributed to the increased revenue for both the CTA Network A and

Nasdaq. As Table IV-1 illustrates from 1994 to 1998, non-professional user fees, as a

percentage of the total fees collected, have increased. For CTA Network A, they have

increased from 1.6 percent to 9.9 percent of total fees collected and for the Nasdaq they

have increased from 2.1 percent to 14.0 percent.

Table IV-1: CTA Network A and Nasdaq Market Data Revenues

 

146 Id. at 40.

147 Id. at 34.

148 1994 NYSE ANNUAL REPORT 31.

149 1994 NASD ANNUAL REPORT 44. The NASD’s annual reports combine Nasdaq market data

revenues with the NASD’s share of CTA revenue and transaction service charges. Accordingly,

the figures used in this Report are lower than those found in the NASD’s 1994 and 1998 annual

reports.

150 1998 NYSE ANNUAL REPORT 43.

151 1998 NASD ANNUAL REPORT 35.
55

From Professional and Non-Professional User Sources -

1994 and 1998 (in thousands of dollars)

1994 (% total) 1998 (% total)

CTA Network A

 Professional 79,519 (89.4%) 112,444 (78.2%)

 Non-Professional 1,470 (1.6%) 14,276 (9.9%)

 Other 7,972 (9.0%) 17,009 (11.8%)

Nasdaq

 Professional 59,564 (96.0%) 107,867 (84.3%)

 Non-Professional 1,287 (2.1%) 17,918 (14.0%)

 Other 1,195 (1.9%) 2,135 (1.7%)

According to some firms, the old fee schedule caused on-line investors to pay a

disproportionate share of the fees. The recent changes to the CTA and NASD fee

schedules have reduced on-line firms’ costs for providing real-time market data to their

customers. This decrease undoubtedly will have a significant impact on the growth rates

in non-professional market data revenues in 1999 and beyond. Though only recently

implemented, the new fee schedules may result in less ‘rationing’ of market data to on-line

customers. In addition, the new cost schedules may enhance the ability of on-line firms to

make greater use of real-time data in existing account features, as well as encourage the

development of innovative products.

D. Conclusions and Recommendations

1. Conclusions

Although the views diverge on many of the market data issues, it is still possible to

draw a number of general conclusions. First, individual investors must be able to access

real-time market data to make informed investment decisions -- particularly in today’s

market environment.152 The industry’s recognition of the relative importance of real-time

data, may be evidenced by the fact that it levies fees on the use of real-time market data,

but gives away delayed data. Second, real-time market data currently is widely available.

On-line brokerages offer real-time data to account-holding customers and, in some cases,

to registered users. A number of non-broker financial websites make real-time data

 

152 In adding Section 11A of the Exchange Act almost twenty-five years ago, Congress recognized

that “it is critical for those who trade to have access to accurate, up-to-the-second information as

to [last sale reports and quotation information].” S. Rep. No. 75, 94th Cong., 1st Sess. at 8

(1975).
56

available for free to individuals who enter into a click-through agreement. Individual

investors also have access to a real-time ticker via cable news networks.

Third, the Internet is emerging as the preeminent channel for disseminating market

data to individual investors. Fourth, many of the services on-line brokerages offer depend

upon access to real-time market data. Fifth, on-line brokerages’ (and non-broker financial

websites’) consumption of real-time market data only will increase. Competitive

initiatives and technological advances will drive on-line brokerages to widen their use of

real-time market data-dependent applications.153 Sixth, the SROs’ market data revenues

historically add up to a significant percentage of their overall revenues. Consequently, any

decrease in these revenues could have implications for the SROs’ regulatory expenditures.

Seventh, since the debut of on-line brokerage, SRO market data revenues have grown, but

remain a consistent percentage of overall SRO revenues. SRO revenues from individual

investors’ use of market data, however, have grown significantly over the same period.

Consistent with the Commission’s posture as a full disclosure agency, it should

encourage the broadest possible dissemination of real-time market data to individual

investors. Integral to carrying out this policy, the Commission must determine whether

real-time market data in today’s market environment is available on terms that are “fair

and reasonable” and “not unreasonably discriminatory.” Resolving this issue will require

the Commission to consider: (1) the appropriate factors that should enter into the pricing

of market data, and (2) the appropriate uses of market data revenues by the SROs.

2. Recommendations

These issues will be considered in a broad review of the current scheme for the

generation, distribution, and pricing of market data. This review should receive input

from all of the affected constituencies. The Commission’s upcoming market data concept

release provides the perfect vehicle to conduct this evaluation. The concept release will

allow the Commission to lay out the complex issues involved in this review and solicit

views and analyses from all interested parties.

In conclusion, the Commission’s concept release should pay particular attention to

the issues raised in this section, namely:

• Should the CTA and NASD justify their pricing schedules on a cost recovery basis?

• What elements should be considered as part of the cost of producing market data? For

example, should the regulator’s costs of ensuring the integrity of the information be

included in determining the appropriate pricing schedule?

 

153 Examples of such applications (most of which are already offered) include: real-time account

balances; streaming quotes; technical charting; portfolio evaluators and portfolio optimizers.
57

• Should SROs be entitled to rebate or share revenues with their membership?

• How do the market data pricing schedules take into account the difference between

the access fees charged for retail (non-professional) and professional users so that

these fees are “fair and reasonable” and not “unreasonably discriminatory” for both

groups of users?

• Do the market data pricing schedules strike the right balance in terms of raising

sufficient revenue while encouraging the wide availability of real-time market data in

light of today’s market exigencies, technological advances, and investor demand?

• How do the new pricing schedules take into account retail (non-professional)

investors’ demand for real time market data given the rapid growth of the Internet and

on-line brokerage?
58

V. SYSTEMS CAPACITY154

A. Background

1. Current Regulatory Framework

As noted in the Trends section of this report, on-line firms have experienced

tremendous growth in the last three years.155 To keep pace with this unprecedented

growth, firms have had to upgrade systems capacity on a regular basis. During their

attempts to add excess capacity, several of the leading on-line firms experienced wellpublicized delays and outages.156 These delays and outages have renewed regulatory

concern as to whether firms are maintaining sufficient operational capability.157

Consistent with Sections 2 and 11A of the Exchange Act of 1934, the Commission

has authority to regulate systems capacity for exchanges and the NASD. Section 2

indicates the need to perfect the national market system for securities.158 Sections

11A(a)(1)(B) and (C) note the opportunity to make the securities markets more efficient

and effective using data processing and communications techniques.159 These sections

also establish the Commission’s responsibility to maintain fair and orderly markets to

assure the execution of securities transactions.160 The staff has defined sufficient

 

154

 The roundtables focused on systems capacity. These discussions did not focus on reliability and

performance issues which are very important as well.

155

 See supra Trends section at pages 1-1 discussing the growth in on-line investors and accounts.

156

 See Megan Barnett, Walking a Tightrope, THE INDUSTRY STANDARD, May 17-24, 1999, at 46-48

(discussing in greater detail systems outages in the on-line brokerage industry); Blake A. Bell,

On-line Brokerages Under Siege for Trading Outages and Delays, WALLSTREETLAWYER.COM,

Apr. 1999; Too Much too Soon? THE WALL ST. J. INTERACTIVE EDITION, June 14, 1999

(chronicling the significant delays and outages).

157

 Due to the intense competition for order flow in on-line brokerage, at least one state regulator

considered taking action against firms that solicit new on-line accounts without devoting

sufficient resources to update systems capacity. N.Y. Eyes First Enforcement Action Over Online Capacity, COMPLIANCE REPORTER, Aug. 16, 1999, Vol. VI, No. 17 (indicating that claims of

fraudulent advertising may be brought by the New York Attorney General’s office against firms

if they solicit new clients without ensuring that they have adequate capacity).

158 15 U.S.C. § 78(b) (1999). Section 2 of the Exchange Act recognizes that “ . . . transactions in

securities . . . are affected with a national public interest which makes it necessary to provide for

regulation and control of such transactions . . . to require appropriate reports, to remove

impediments to and perfect the mechanisms of a national market system for securities . . . and to

ensure the fair and honest markets in such transactions . . .” Id.

159 15 U.S.C. § 78k-1 (1999). Section 11A provides that “the securities markets are an important

national asset which must be preserved and strengthened . . .” (emphasis added). Id.

160 Id.
59

operational capability in two Automation Review Policy (“ARP”) statements, ARP I and

ARP II.161

Section 15(b)(7) gives the Commission the authority to adopt standards of

operational capability for broker-dealers.162 The staff has provided guidance to brokerdealers in Staff Legal Bulletin No. 8 (“SLB No. 8”).163 Finally, the Commission has

proposed Rule 15b7-2,164 the Operational Capability Rule, to further clarify the obligation

of broker-dealers to have sufficient capacity as required by Section 15(b)(7).

The Commission adopted ARP I in 1989 in response to the 1987 Market Break

and ensuing concerns about the capacity of exchanges in periods of natural disasters.165

ARP I expresses the Commission’s and SROs’ policy on capacity requirements. It states

that SROs should, on a voluntary basis, establish comprehensive assessment and planning

programs to determine the extent of the systems capacity of their markets and the

vulnerability of their automated trading systems.166 Although ARP I and II do not

specifically mention broker-dealer requirements, the Commission has encouraged all

broker-dealers to comply voluntarily with these policy statements.167

 

161 Exchange Act Release No. 27,445 (Nov. 16, 1989), 54 Fed. Reg. 48,703 (1989); Exchange Act

Release No. 29,185 (May 9, 1991), 56 Fed. Reg. 22,490 (1991).

162 15 U.S.C. § 78(o) (1999). Section 15(b)(7) provides that “No registered broker or dealer . . .

shall effect any transaction in, or induce the purchase or sale of, any security unless such broker

or dealer meets such standards of operational capability . . . “

163

 SEC Staff Legal Bulletin No. 8 (Division of Market Regulation) (Sept. 9, 1998).

164 See Exchange Act Release No. 41,142 (Mar. 11, 1999), 64 Fed. Reg. 12,128 (1999). Proposed

Rule 15b7-2 would provide:

(a) This section applies to every broker or dealer registered pursuant to Section 15 of the Act (15

U.S.C. § 78o). If you do not have the operational capability, taking into consideration the nature

of your business, to assure the prompt and accurate order entry, execution, comparison,

allocation, clearance and settlement of securities transactions, the maintenance of customer

accounts, and the delivery of funds and securities, you may not:

(1) Effect any transactions in securities;

(2) Induce the purchase or sale of securities;

(3) Receive or hold customer funds or securities; or

(4) Carry customer accounts.

(b) For the purposes of this section, the term customer includes a broker or a dealer. Id.

165

 Contributing to the need to issue ARP I was the effect of the earthquake in northern California on

the Pacific Stock Exchange during the week of October 16-20, 1989 and an electrical fire in the

building that houses the Securities Industry Automation Corporation (“SIAC”) on November 10,

1989. Exchange Act Release No. 27,445, supra note 161, nn. 14-15.

166

 Id., nn. 17.

167 Id.
60

In ARP I, the Commission also noted the impact that systems failures and

problems could have on the investing public, the risk exposure of broker-dealers, and the

efficiency of market centers. As a result, ARP I states that SRO programs should:

(1) establish current and future capacity estimates; (2) conduct capacity stress tests

periodically; and (3) obtain an annual independent assessment of whether the affected

systems can perform adequately in relation to estimated capacity levels and possible

threats to the systems.

The Commission adopted ARP II in 1991 after recognizing the need for further

guidance in this area.168 ARP II encourages the exchanges and the NASD to obtain

independent reviews of whether the risks and controls in place in the SROs’ automated

trading and information dissemination systems need further reviews or enhancements.

ARP II also suggests that the SROs provide notice of significant additions, deletions, or

other changes to their automated systems on an annual and as needed basis. Finally, ARP

II notes that SROs should provide Commission staff with real-time notifications of

unusual events such as significant outages involving automated systems. ARPs I and II

have ensured that the markets function with adequate capacity.

Commission staff recently provided additional guidance on systems capacity for

broker-dealers in SLB No. 8.169 The Division of Market Regulation staff issued SLB No.

8

170 in response to the market break in October 1997. At that time, the staff had received

reports of broker-dealer operational problems and complaints from investors unable to

access their brokerage accounts. The large trading volume concentrated in a short time

period apparently overwhelmed the capacity of some broker-dealer systems. As a result,

many broker-dealers could not deliver or execute orders in a timely fashion. In addition,

broker-dealers were unsure of their responsibilities during circuit breaker trading halts,

which were triggered for the first time.171

 

168

 See also Michael J. Metzger, Capacity, Volatility and Other Developments: What All BrokerDealer Should Consider in Response to Increased Electronic Commerce, SIA COMPLIANCE AND

LEGAL DIVISION, NEWS & NOTES, Apr. 1999 (providing further guidance on broker-dealer

considerations).

169 A staff legal bulletin provides industry guidance, but does not have the binding effect of a

Commission rule.

170 The staff’s guidance appears to have been well-received by the industry. See Industry Welcomes

SEC Guidance on Trading Halts, WALL ST. LETTER, Sept. 21, 1998; Lawyers Advise Heeding

New SEC Capacity Guidelines, FIN. NETNEWS, Sept. 21, 1998; SEC Directs Firms to Boost

Capacity for Volume Spikes, SECURITIES INDUSTRY NEWS, Sept. 21, 1998.

171 The next significant test for broker-dealer systems capacity occurred on the high volume days of

August 31 and September 1, 1998. Having improved their capacity following the 1997 market

break, broker-dealers were better equipped to process customer orders during these peak periods

of market activity.
61

In SLB No. 8, the staff clarifies the obligations of broker-dealers during circuit

breaker trading halts. SLB No. 8 also reminds firms to maintain sufficient internal systems

capacity to operate properly during periods of excessive trading and encourages firms to

have procedures for handling systems capacity problems.

Because of the expected growth in on-line accounts, the staff indicated that a

firm’s capacity should be several times the firm’s average trading volume. In SLB No. 8,

the staff included additional steps a firm could take to improve access and decrease

capacity constraints, including: (1) employing multiple Internet service providers (“ISPs”);

(2) implementing class “B” Internet addresses to improve access quality; (3)

improving server capacity; and (4) at times of peak usage, giving priority to customers

who wish to enter orders over customers merely seeking account or quote information.172

The NASD provided additional guidance on systems capacity to member firms in

Notices to Members (“NTM”) 99-11 and 99-12. These NTMs generally reiterate the

guidance provided by SLB No. 8.173 Recognizing the need for rulemaking in this area, the

Commission had proposed an operational capability rule for broker-dealers, Rule 15b7-

2.174 This proposed rule would require registered broker-dealers to have and maintain

sufficient operational capability to perform the range of services normally rendered to their

clients. The Commission has not acted to adopt these rules due to commenters’ concerns.

2. Measuring Capacity

Presently, no single standard exists for measuring capacity. As a result, brokerage

firms measure capacity in many different ways. Some firms measure capacity based on the

number of shares and the number of trades their system can process. Other firms

determine capacity through the average number of total website users for a defined period

of time. Still other firms measure capacity in terms of the number of simultaneous

transactions during peak periods of activity, taking into account all possible uses of the

system, including trading and non-trading activities.

In addition to calculating capacity in different ways, firms differ in how frequently

they assess systems capacity. Some firms have adopted a continuous monitoring system

alerting firm personnel if there is a systems overload on any one component. Other firms

 

172 SLB No. 8 also advocated educating investors regarding on-line access and discussed the

necessity of providing alternative means to place orders when Internet access is slow or

unavailable.

173

 The NASD also advises firms to disclose to customers that delays at the market opening and at

closing may cause market orders to be executed at prices away from the price that was quoted at

the time the order was entered. See NASD Notices to Members 99-11 (Feb. 1999) and 99-12

(Feb. 1999).

174

 See supra note 164 (detailing the provisions of proposed Rule 15b7-2).
62

regularly test systems capacity on a weekly or monthly basis. Still other firms never test

systems capacity at all.175

3. Disclosure to On-Line Customers

Another integral issue is what systems capacity-related types of disclosure do

investors receive. Do investors understand that there may be delays in processing trades

and what they should do if they encounter delays or outages? A review of the ten largest

on-line firms’ websites176 for disclosure regarding systems capacity limitations and outages

demonstrates the need for better disclosure.

Most firms address delays and systems capacity issues in the new account

documentation. The documents contain a rather obtuse discussion using legalistic terms,

clearly not written -- and not clearly written -- in plain English. The disclosure also is

usually near the end of the customer agreement, not in a location intended to alert

customers about potential problems that could be caused by systems delays or failures. In

addition, very few firms have disclosures on their websites to educate customers about

delays and outages. Possibly setting the ideal standard for the industry to emulate, one

site actually advises customers to have alternative methods of trading, including a back-up

account at another brokerage firm.

B. Roundtable Participants’ Views

One roundtable participant noted that the proper focus in measuring systems

capacity is not the number of shares traded. Retail investors using the Internet trade more

frequently and in smaller increments. Although the volume of shares traded over the

Internet may be the same or slightly higher, message traffic has increased

disproportionately -- significantly straining capacity.

The roundtable participants also noted that the backup of orders at market opening

and to a lesser extent at market closing strains firms’ systems capacity. As the

conversation moved to systems outages, on-line firm participants reminded others that

system outages occur at off-line firms as well as at on-line firms, but that outages at offline firms received less, if any, publicity.

Several roundtable participants indicated that certain systems outages could be

difficult to detect because systems delays and outages can occur at many different points

along the path of communication between a broker-dealer firm and its customer.177 For

 

175

 Although there is no requirement, firms should at the very least test their systems periodically.

Exchange Act Release No. 27,445, supra note 161, nn.17.

176

 These firms were chosen on the basis of market share as provided by a Piper Jaffray chart located

on page 1.

177

 A user requesting information from an on-line broker-dealer may encounter delays in accessing

or an inability to access a website for the following reasons: (1) a user’s modem or computer is
63

example, a firm may not have a problem with its website but customers may have

problems with their ISPs. The diagram below displays the various connection points

susceptible to failure:

Diagram VI-1: Internet Connection Points

 

Customer’s Customer’s Internet Broker-Dealer’s Broker-Dealer’s Broker-Dealer’s Exchange or

Computer/Modem ISP ISP(s) Web Server(s) Order Routing Market Maker

System (ORS)

According to one roundtable participant, firms with a nationally dispersed

customer base have even more problems identifying systems outages. For example,

communication lines may be working in San Francisco but not in New York. Some firms

indicated that they do not always know when part of their systems is down if they

continue to receive orders from other regions of the country.

Many roundtable participants acknowledged an occasional systems failure. They

also said that they attempted to minimize these failures to the greatest extent possible.

One participant called for on-line firms to commit to running systems as close to

perfection as possible. That participant reasoned that, because on-line firms market

themselves primarily as receivers of orders through electronic means, they should ensure

that their electronic order entry systems receive the highest allocation of resources. Most

of the participants agreed that the threat of customers migrating to firms with the most

reliable systems has forced firms to have more than sufficient capacity.

Once a firm identifies a systems failure, two questions immediately arise: (1) how

should the firm handle the impact of the failure, and (2) how can the firm prevent such a

failure from recurring in the future? Several participants described their firms’ practices of

reimbursing customers for orders already in the system at the time of an outage. These

same participants conceded that their firms did not reimburse customers who claimed to

have tried to enter orders while the system was down. The firms justified this approach

based on their inability to determine which customers actually attempted to enter orders

and which customers were gaming the system and had never attempted to place an order.

Most roundtable participants believed that systems stress was not unique to the

bull market and that the volume message traffic would be equal, if not greater, in periods

 

slow or not working correctly; (2) a user’s ISP is down, slow or delayed; (3) traffic on the

Internet is heavy creating delays in overall usage; (4) an on-line broker-dealer’s ISP is down,

slow or delayed; and (5) the on-line broker-dealers website contains insufficient computer

hardware to process the user’s request.
64

of market decline. Many participants indicated that they had adopted contingency plans to

address systems failures prospectively. Some of the contingency plans included: (1)

allowing trading to continue to occur on-line, (2) temporarily suspending confirmation

delivery, and (3) delaying updates to account positions. Most firms also maintain a

network of telephone service representatives to process orders when electronic order

entry is not functioning. To handle order execution problems resulting from a systems

failure, most participants have access to multiple methods of execution. If any one

executing broker-dealer had systems problems, the firm can route the orders to a different

broker-dealer for execution. For example, an introducing broker-dealer178 normally routes

all of its order flow to executing broker-dealer X but maintains routing relationships with

broker-dealers Y and Z. If the introducing broker cannot route a customer order to

executing broker-dealer X because of systems problems at broker-dealer X, it would route

the order to broker-dealer Y or Z rather than wait for the systems at broker-dealer X to

accept the customer’s order. When asked whether they would like more guidance in the

area of systems capacity, most of the roundtable participants said that they indicated a

preference for Commission “jawboning” (i.e., informal guidance) over new rulemaking.

C. Conclusions and Recommendations

1. Conclusions

On-line firms have approached the issue of systems capacity in different ways.

Some firms assess systems capacity and increase capacity on a regular basis whereas

others firms are less proactive -- adding capacity only when required to prevent systems

outages. The disclosure of systems-related problems also differs among firms, with some

firms adequately educating their customers about systems delays and outages and other

firms opting to make only a passing reference about the possibility of systems failures.

The roundtable discussions and observations lead to the following conclusions

regarding systems capacity. First, based on the number of customer complaints involving

systems issues,179 customer expectations regarding systems capacity are not always in-line

with the disclosures that firms make in new account forms, customer agreements, and

other documents. Plain English disclosure of periodic systems failures (e.g., in customer

agreements) and prominent display of existing disclosures, would help alleviate inflated

expectations. Second, in the event of a computer systems failure, alternative methods of

order entry at some on-line firms may be insufficient to satisfy customer demand. As a

matter of good business practice, firms should: (1) provide sufficient back-up methods for

 

178 An introducing broker-dealer receives orders from customers but does not hold custody of client

funds, engage in clearance of trades, or generate confirmations. An introducing broker-dealer

receives orders and routes them to an executing broker-dealer.

179

 See Appendix 5 for a breakdown of complaints by category, including a customer’s inability to

access a broker-dealer’s system.
65

order entry and execution, and (2) make customers aware of the alternative methods for

order entry.

Third, in the event of systems failures, customers should be fully informed of the

extent of the problem and its expected duration. To that end, some firms notify customers

of delays and outages through the use of splash screens or pop-up messages that include a

transmission date and time and indicate the expected duration of the systems problem, if

known. Fourth, firms should consider as a matter of best practice maintaining the ability

to route orders to multiple market centers for execution to provide alternatives for the

execution of a customer’s order in the event that the preferred market center for execution

is not functioning. Fifth, firms should undertake contingency planning to detect and solve

systems-related problems before they become bigger problems.

2. Recommendations

• The Commission should consider requiring all firms to maintain contingency/backup

plans that are periodically tested and reevaluated to ensure that they continue to be

adequate. The Commission should consider requiring all firms to keep records

regarding significant outages pursuant to Section 17(a) of the Exchange Act.

• The Commission should consider advising all firms on how often they should test their

systems and whether they should be required to document their evaluation efforts.180

At a minimum, the Commission should consider requiring all firms to regularly subject

their systems to a rigorous stress test to evaluate systems at maximum capacity.

• The Commission should consider reproposing the operational capability rule. As part

of the reproposal, the Commission should consider the following issues:

• Should broker-dealers, including introducing firms, be required to evaluate

their systems capacity on a periodic basis?

• Should broker-dealers be required to produce and maintain records

demonstrating that they have performed such periodic capacity evaluations?

• Should capacity evaluations be based on a specific model? If so, should that

model review key uses of a system, both historical and anticipated, and the

system’s ability to process such uses?

• Should broker-dealers be required to maintain sufficient systems capacity to

process key anticipated uses of their systems during periods of market

volatility?

 

180 The Commission may want to encourage a periodic capacity assessment that includes: an

analysis of the bandwidth of the system’s ISP(s), capacity of its firewall, capacity of its Web

servers, capacity of its order routing system (“ORS”), and the capacity of all supporting

components.
66

• The Commission should require all firms to clearly inform new customers of potential

systems delays and outages in new account documentation. This disclosure should be

written in plain English and included in, among other documents, new account forms

and customer agreements.181

 

181 See Investor Education section at 1 (reiterating the need to put new account documentation in

plain English).
67

VI. INVESTOR EDUCATION

A. Background

As discussed in detail in the Trends section of this Report,182 the Internet provides

investors with access to financial information, cheap commissions, and self-directed

trading. Investors now have unfettered access to a multitude of information sources,

including: real-time quotes, research reports and historical stock price data.183 Prior to the

Internet, investors had to receive most of this information from a registered representative.

Currently, the combination of financial information and direct order entry has empowered

-- or at least emboldened -- investors to trade without the assistance of a registered

representative.

The current environment makes it more challenging for a registered representative

to get to know his or her customer. Customers often retrieve financial information from

many different sources without developing a personal relationship with their registered

representative. Although one can argue that this disconnect has occurred since the advent

of the discount brokerage firm, customers did not previously have access to this much

information without the guidance of a registered representative. This shift in control over

information from registered representatives to individual investors has altered investment

dynamics. It has resulted in many well-informed investors, but also in many “overinformed” investors who are unsure of how to digest the mass amounts of information

available. In addition, more full-service firms are providing on-line trading to their

customers, further increasing the trend towards disintermediation.

Investors may view this disintermediation as a benefit in terms of cost savings. But

does the average investor know and understand the intricacies of investing on-line?

Digesting the mass amounts of free financial information available in making investment

decisions poses one set of challenges. Getting the trade executed poses another.

Everyone has heard the horror stories about investors trading on-line: attempting to cancel

orders without success, receiving margin calls in their accounts that they cannot afford,

and entering market orders during fast markets only to receive executions at prices vastly

inferior to those quoted at the time the investors entered their orders.184

These stories demonstrate that learning to trade on-line can prove hazardous to

your pocketbook. These experiences also have resulted in an increasing number of

 

182

 See supra Trends section at pages 1-1.

183

 See supra notes 95, 98, 120 (listing some examples of websites where an individual can acquire

financial information); Arthur Levitt, Speech by SEC Chairman Common Sense Investing in the

21st Century Marketplace (May 23, 1999) <http://www.sec.gov/news/speeches/spch280.htm>

(discussing the amount of information available through the Internet, especially on EDGAR’s

electronic database).

184

 Id.
68

investor complaints. In fiscal year (“FY”) 1998, the number of complaints185 the

Commission received from investors regarding their on-line firms increased from 259 to

1,207, or 366 percent over FY 1997’s numbers.186 At the end of FY 1999, preliminary

numbers indicate the receipt of 3,290 complaints, which represents a 273 percent increase

over FY 1998’s complaints.187 The most common categories of complaints ranked by

frequency include: (1) difficulty accessing an account; (2) delays and failures in executing

orders; (3) errors in processing orders; and (4) best execution problems.188

Led by Chairman Levitt, the Commission has worked to educate investors about

the marketplace. In January 1999, the Chairman issued a statement to investors discussing

the benefits of on-line investing but warning investors to: (1) know what they are buying;

(2) know the ground rules under which they buy and sell a stock or bond; and (3) know

the level of risk they are undertaking.189 With regard to the last item, the Chairman

advocated the use of limit orders to protect customers from the risk of receiving an

inferior execution price.190 In a speech given in May 1999, Chairman Levitt indicated that,

“an informed and knowledgeable investor is good for the industry and good for individual

businesses.”

191 In that speech, he urged firms to: communicate clearly with their

 

185 There are two places to send complaints or inquires on the Commission’s website. The first

place is the Commission’s Office of Investor Education and Assistance (“OIEA”) by using the

OIEA complaint form located at <http://www.sec.gov/consumer/jtopq1.htm> or by directly emailing their mailbox at help@sec.gov. The second place is the Commission’s Division of

Enforcement (“Enforcement”) complaint center. An individual can e-mail their complaint to the

Enforcement mailbox at enforcement@sec.gov or could enter all relevant information into the

Enforcement Complaint form located at <http://www.sec.gov/enforce/con-form.htm> and submit

that form to the Commission electronically.

186

 OIEA statistics. Two possible factors contributing to this large number of complaints are: (1) the

ease of making a complaint using the Internet as opposed to making it by mail, and (2) greater

participation in the market by individual retail investors.

187

 OIEA statistics. In addition to these complaints tabulated by OIEA, Enforcement’s complaint

center receives between 200 and 300 complaints daily, for a total of between 52,000 and 78,000

per year. The complaints received by the Enforcement complaint center cover a wide-range of

activities and are not limited to complaints concerning on-line brokerage. In addition, there is

some double counting, the extent of which we were not able to calculate, based on a number of

complaints that arrive in the Enforcement complaint center that are then sent to an OIEA

investor assistant. These complaints would be part of both Enforcement’s and OIEA’s numbers.

188

 See Appendix 5 for a complete list of complaint categories and the number of complaints in each

category.

189

 See Arthur Levitt, Statement by SEC Chairman: Concerning On-Line Trading (Jan. 27, 1999)

<http://www.sec.gov/news/press/99-9.txt>.

190

 Id.

191

 See Arthur Levitt, Speech by SEC Chairman: Plain Talk About On-line Investing, (May 4, 1999)

<http://www.sec.gov/news/speeches/spch274.htm>.
69

customers, adopt plain English in their customer agreements, and advertise responsibly.192

As he did in January, the Chairman again challenged investors to educate themselves

because “investor protection -- at its most basic and effective level -- starts with the

investor.”

193

B. Education through Websites

1. Commission’s Website

The Commission has established a location for investors to visit and learn about

on-line investing. It developed an investor education section on its website194 in

September 1995. At that time, the Commission recognized the value of the Internet in its

investor education efforts. In a recent five month period, the investor education section195

received 677,728 hits.196 This section offers a “how to” invest section, cyberfraud alerts, a

roadmap that recreates the Commission’s “Get the Facts on Savings” brochure, media

outreach material, and Internet/On-Line trading tips. The site also offers interactive tools

such as a Test Your Money Smarts quiz,197 a link to a ballpark estimate sheet, and a

mutual fund calculator.198 The ballpark estimate sheet enables site visitors to quickly

calculate how much they need to save for retirement based on how much income they

expect they will need in the future. The Commission’s website was the first to include a

mutual fund calculator.199 This calculator allows individuals to compare the costs of

owning different mutual funds.200

 

192

 Id.

193

 Id.

194

 The address for the Commission’s website is <http://www.sec.gov>. In 1999, the Commission’s

homepage received an average of 137,369 hits per week.

195

 The investor education section of the Commission website is located at

<http://www.sec.gov/invkhome.htm>.

196

 OIEA statistics.

197

 The site also links to an Alliance for Investor Education quiz.

198

 From May 9, 1999 to August 29, 1999, individuals accessed the mutual fund fee calculator

52,511 times; the “how to” invest section 43,602 times; the cyberfraud alerts 38,429 times; the

Internet and on-line tips 37,879 times; and the Test Your Smarts on-line quiz 9,866 times.

199 See Aaron Lucchetti, Internet ‘Calculators’ Help Investors Untangle Web of Fees, Loads,

Expenses, WALL ST. J. INTERACTIVE EDITION, Nov. 1, 1999 <http://interactive.wsj.com/archive>.

200

 The OIEA staff plans to continue adding to the Commission’s investor education materials on an

ongoing basis by expanding the number of topics about which investors can get information. In

addition, OIEA plans to offer more interactive tools and intends to link to other sites with

interactive tools.
70

2. Industry Association Websites

Several industry associations offer a vast array of non-commercial, educational

materials on their websites. For example:

• The Bond Market Association’s website201 features an on-line checklist to help

investors assess how bonds might fit into their portfolios, brochures and articles

describing the features of various types of bonds, and links to current price

information on investment-grade corporate bonds, actively traded municipal bonds,

and Treasury securities.

• The “publications section” of the ICI’s website202 offers investors an interactive

quiz, a glossary of mutual fund terms, brochures in both English and Spanish, and

a list of -- and links to -- additional on-line investor resources, including calculators

and materials aimed at target audiences, such as women and young investors.

• The SIA’s website203 features interactive quizzes, brochures on investing basics

(including market risks and on-line trading), and a link to the Stock Market

Game— a low-cost, ten-week curriculum that helps students and adults learn more

about the stock market by investing an imaginary $100,000 portfolio.

Rather than reinvent the wheel, a firm that currently lacks on-line educational

resources for its customers could link with industry association websites or import key

brochures and tools. By purchasing or borrowing materials from industry associations,

firms can readily increase the breadth and depth of their educational offerings without

sending customers to other commercial websites.

3. Firm Websites

Websites of the ten largest on-line firms reveal that firms provide basic investment

information -- similar to the SEC’s site -- on their websites. Firm websites generally

offered information on: (1) the principles of investing, (2) asset allocation tools, (3) letters

and speeches by regulators, and (4) links to guides on personal investing. Of the ten firms

surveyed, only five had designed extensive education programs for their customers. For

the most part, firms provide passive information and tend not to have enough tools to

enable individuals to learn in a more interactive environment.

 

201 The Bond Market Association website, supra note 17.

202 The “publications section” of the Investment Company Institute’s website is located at

<http://www.ici.org/ici_info/publications.html>.

203 The SIA’s website is located at <http://www.sia.com>.
71

At least some firms, however, are looking at ways to better educate their

customers by offering innovative approaches to learning. One firm allowed investors to

practice investing with a $100,000 model portfolio. A second site afforded individuals the

opportunity to use financial calculators to determine their investment returns. A third

website offered a free on-line curriculum and strived to be an “institution of higher

learning.”

204 This firm’s program presented investors with education materials on a

variety of topics, including the basics of investing in stocks, bonds, mutual funds, and

IPOs.205

C. Roundtable Participants’ Views

The roundtable participants generally agreed that regulators and the industry

should coordinate better to provide investors with whatever information they need to

become informed investors. Although participants did not specify the content they would

provide, they were universally eager to partner with the Commission in providing that

information.

A consensus evolved that the most effective place to educate investors would be at

the firms’ websites. Most firms stated a preference for incorporating into their respective

websites whatever information the Commission chooses to provide on its website rather

than linking to the Commission’s site and sending customers off the firms’ sites. Because

firms want to create “stickiness,”

206 they are reluctant to send customers or visitors to

another site. The firms hope that the longer they keep investors on their sites the more

likely it is that they will engage in a transaction. They also feel strongly that they can build

a community of repeat users around their websites.207

D. Conclusions and Recommendations

1. Conclusions

Based on the less frequent or nonexistent contact between investors and registered

representatives, the need for developing useful, thoughtful and effective investor education

materials is now more important than ever before. Although there is widespread

agreement on the need to educate investors, there is a significant disparity among firms on

the depth and scope of the materials provided and the location of those materials on their

 

204

 Ivy Schmerken, Discount Broker Creates Investment University, WALL ST. & TECHNOLOGY, Feb.

1999, at 46.

205

 Id.

206 Stickiness refers to the amount of time a viewer spends on a website.

207 In our view, providing interesting educational materials would help build that community and

may attract other potential customers to their sites.
72

websites. In addition, firm practices differ on the timing of providing those materials and

on the amount of resources they devote to developing investor education.

One of the more difficult challenges involved in providing investor education

materials is deciding when and where to educate. Investors would not want firms to

provide voluminous educational material as required reading right at the point where

investors are attempting to place an order. After all, on-line trading is supposed to be

quick. Being interrupted during the process of placing an order may dissuade investors

from using certain on-line brokerage sites. To determine the best methods for educating,

it would be helpful to develop more background information regarding investors’ profiles,

expectations, and behavior on-line. In addition, it would benefit the Commission to

understand how firms and businesses involved in electronic commerce market their

products and services on-line.

A separate issue is where to locate educational information on the firm’s website

to maximize investor benefits. Many firms currently make investor education materials

generally available in discrete investor education sections on their websites. A strong

argument can be made, however, for incrementally educating investors at key

decisionmaking points of action. For example, firms could provide certain information at

investors’ discretion during the account opening process, or during order entry. Arguably,

investors would benefit from educational materials tailored to the task at hand because it

would give context to the information. Providing education during periods of on-line

activity therefore presents certain challenges which can only be met by delivering the

appropriate amount of information at the appropriate time.

In sum, the following conclusions can be drawn from the roundtables and other

recent developments:

• Most firms seem to prefer educating customers through the firms’ websites

rather than sending the customer elsewhere for that education via a hyperlink.

This education should result in informed investors and lower-risk clients for the

brokerage firm.

• Chairman Levitt has urged208 firms to link to the Commission homepage and

make that hyperlink readily accessible on their websites, but to date many firms

have not yet done this.

By periodically copying useful materials from the Commission site and other

industry association sites and devoting resources to developing their own on-line investor

education materials, firms will help to produce knowledgeable investors. The timing of

providing this information is critical in the on-line world. Educating the investor at key

decisionmaking points of action may provide the most effective results. By utilizing

 

208

 See Chairman Levitt, Plain Talk About On-Line Investing, supra note 191. In the Press Club

speech, Chairman Levitt urged firms to link to the Commission website.
73

splash screens and pop-up messages or sidebar messages, firms can funnel information

targeted to the specific action being taken. To avoid customer dissatisfaction, the

technology exists to allow investors to opt not to receive educational messages in the

future by equipping these dialogue boxes with a “click here if you do not wish to view

these educational messages again” option.

Due to the attraction of portals as search engines and information providers,

investors frequently obtain their financial information from these entities,209 which,

because of their popularity, are useful venues for communicating investor education

materials. Finally, some of the educational information, such as customer agreements and

new account forms, should be made continuously available and written in plain English.

Providing ongoing access to these documents and writing or rewriting them in plain

English would significantly help educate investors and reduce confusion.

2. Recommendations

• The Commission should devote sufficient resources, including technology and

personnel, to ensure that it can include more interesting and interactive educational

tools on its website. On-line quizzes and various financial calculators are two

examples of educational and entertaining learning tools. The Commission should

continue to develop quizzes and identify and link to other sites with informative

quizzes. The Commission should consider developing or contracting with an

appropriate entity to expand the scope of materials covered by the existing on-line quiz

and increase the visibility of the quiz and its accessibility to website visitors.

• The Commission should undertake a study of how investors process the information

available to them through on-line brokerage firms. This study would form the basis

for how and where the Commission devotes its investor education resources for online investors. This study should examine and provide conclusions on:

(1) the sources of financial information that investors rely on in making investment

decisions;

(2) methods to develop effective investor education materials;

(3) ways to promote informed decisions regarding broker-dealer and company

disclosure requirements;

(4) customer expectations at on-line versus off-line firms;

(5) the level of knowledge and experience of the average on-line investor;

(6) the trading frequencies of investors at on-line versus off-line firms;

(7) the success of currently existing disclosures and disclaimers; and

(8) how investors analyze risk and the segments of investors most at risk of poor

investment decisionmaking.

• Once the study on investor behavior is completed, the Commission should initiate

roundtables or focus groups on educating investors. A broad range of individual

 

209 See Portals section at pages 1-1.
74

investors and investor representatives should participate in these discussions which

should: (1) develop examples of how firms, regulators, and other agencies could help

investors learn more about on-line trading; (2) advise specific areas where investors

should receive better education; (3) determine where the educational information

should be provided; and (4) determine the appropriate timing for providing the

investor with educational information.

• The Commission should continue to regularly notify the media and portals of major

changes in its investor education materials. Notification has increased publicity

thereby alerting more individuals to the existence of this information.210

 

210

 See Jeff Brown, On-line Investing is not a Lottery, so be Cautious in your Approach,

PHILADELPHIA INQUIRER, Oct. 10, 1999, at Q26; Reid Kanaley, Investors should take Time to

Learn how to use the Web, PHILADELPHIA INQUIRER, Oct. 10, 1999, at Q14. Both articles endorse

and recommend visiting the Commission’s website to learn about investing.
75

VII. ON-LINE DISCUSSION FORUMS

A. General Background

On-line discussion forums are a popular feature of the Internet.211 At least three

types of Internet “discussions” have evolved. First, numerous websites host discussion

groups, or “chat rooms,” with real-time postings and viewing by participants on a wide

variety of topics. Other websites contain “bulletin boards,” cyberspace message centers

where comments concerning issuers, securities, industries, or any other facet of the

markets can be posted and saved for viewing over an extended period of time. Finally,

many websites offer moderated discussion forums, typically led by a real-time moderator

and featuring a guest “expert.”

Users have participated in these on-line discussions forums to, among other things:

(1) educate themselves about investing by exchanging ideas with others or reading the

discussion “threads;” (2) act collectively;212 or (3) post information or opinions about an

issuer.213

The defining characteristic of these on-line discussion forums is that they enable

large numbers of geographically dispersed individuals to gather and communicate on-line

on a real-time and largely anonymous basis. Besides certain common ground rules, each

site imposes slightly different rules for participation. Some sites do not monitor users’

participation, while other sites use volunteers as a sort of “neighborhood watch” patrol to

maintain decorum and ensure topical discussions. Some sites charge a fee for posting but

not for viewing. On some sites, users may post anonymously or register themselves under

multiple aliases. Some financial sites do not permit discussion on certain securities

topics.214 On-line discussion forums can be found in America Online, Yahoo! Finance,

Silicon Investor, TheStreet.com, Raging Bull, and Motley Fool, among others.

 

211 For the purposes of this section, “on-line discussion forums” include investment-related bulletin

board systems, cyber message areas, newsgroups, Web discussion forums, and threads dedicated

to talking about investing.

212

 See, e.g., Diana B. Henriques, Disgruntled Shareholders Unite, N.Y. TIMES, Apr. 27, 1999 at C1

(bankrupt company’s shareholders discuss on-line representation in bankruptcy court); Alex

Lash, Disgruntled IBM Workers Organize On-line, THE INDUSTRY STANDARD, Aug. 16, 1999

<http://www.thestandard.com/articles/display/0,1449,5938,00.html>.

213

 See, e.g., Ianthe Jeanne Dugan, Amateur Stock Pickers Take on the Pros; Armchair Analysts

Bring Predictions from Chat Rooms to New Internet Sites, WASH. POST, Oct. 11, 1999, at A1

(new site, iExchange, ranks amateur stockpickers in chat rooms); Doughnut Chain Buys Up

Critical Web Site, THE ASSOCIATED PRESS, Aug. 27, 1999 (Dunkin’ Donuts purchases a gripe

site); Bank Rage Moves to the Web, BANK MARKETING INT’L., June 1999, at 13 (discussing

popularity of bank gripe sites).

214 See Paul Barr and Jennifer Tomshack, Can We Talk?, ON-LINE INVESTOR, Oct. 1999, at 33

(discusses features of on-line discussion forums).
76

A number of commentators have observed that these forums are an important

element in building communities of users in cyberspace.215 While these virtual

communities may be reminiscent of real-world communities, the ability of participants to

speak from “behind the screen” without fear of repercussion poses serious challenges for

regulators. Anecdotal evidence suggests that postings in on-line discussion forums have

caused volatility in some stocks.216 At the heart of the controversy over these on-line

discussion forums is the fact that readers may find it difficult to differentiate among

accurate information, “noise” (e.g., unsubstantiated opinions or rumors), or fraudulent

misstatements.217

1. Broker-Dealer Sponsored On-Line Discussion Forums

a. Background

While financial on-line discussion forums abound on the Internet, broker-dealer

sponsored on-line discussion forums where investors can exchange messages are rare.

E*Trade is a significant exception. A.B. Watley, Inc. also sponsors an on-line discussion

forum where investors can chat with “sales associates” and other investors. Some on-line

discussion forums also hyperlink to broker-dealers. For example, Raging Bull and Silicon

Investor both hyperlink to Datek Online

 

215 See generally JOHN HAGEL III AND JOHN ARMSTRONG, NET GAIN (1997) (discusses how

merchants can expand markets by creating virtual communities); Neil Gross, Building Global

Communities, BUS. WK. E.BIZ, Mar. 2, 1999, at EB 42.

216

 See, e.g., Kenneth R. Gosselin, CEO Fined in Web Case, Regulators Fault Way He Touted Firm,

THE HARTFORD COURANT, Sept. 4, 1999, at D1 (CEO of telecommunications company fined after

he posted messages anonymously on Yahoo! Finance); Gretchen Morgenson, Wild Rides on

Stock Market Begin in Internet Chat Rooms, N.Y. TIMES, Aug. 21, 1999, at A1 (chat room

discussions impact on share prices); Rebecca Buckman, SEC Studies “Momentum” Stock-Pick

Sites On the Internet, WALL ST. J., Nov. 2, 1999, at C1 (discusses web sites popular with day

traders and other investors); Short-Seller is Reinstated on Stock - Talk Web Site, WALL ST. J.,

Oct. 12, 1999, at C23.

Anecdotal evidence also suggests that short sellers may engage in “cybersmear” campaigns in online discussion forums to drive down the price of a security. The absence of restrictions on

selling certain securities short may magnify the impact of “cybersmear” campaigns in these

securities. To respond to this concern, the Commission sought comment in its recently issued

concept release on the short sale rule regarding whether the NASD should extend the short sale

restrictions to smaller capitalization securities. See Short Sales, Exchange Act Release 42,037

(Oct. 20, 1999), 64 Fed. Reg. 57,996 (1999).

217

 See, e.g., Company Blames Stock Drop on Net Rumors, ZDNET, June 3, 1998

<http://www.zdnet.com/zdnn/stories/zdnn_display/0,3440,2109614,00.html> (chat room rumor

about SEC investigation of issuer simultaneously with share price decline).
77

E*Trade’s on-line discussion forum allows members218 to discuss specific

securities, categories of securities (e.g., Internet High Flyers, Active Trader, Beer Budget

Investors, Long Term Investments) and industries, as well as general investment news

categories. E*Trade also sponsors live events where users can engage in interactive

conversations with event leaders.

A variety of federal securities law provisions may apply to on-line discussion

forums.219 Under the antifraud provision of Exchange Act Section 10(b) and Rule 10b-5

thereunder, the Commission has brought a number of enforcement cases that involved a

component of posting in on-line discussion forums.220 One of the most well-known

 

218 E*Trade requires only that an individual submit his or her name and address to become an

E*Trade “member,” (i.e., one need not open an account to become a member eligible to

participate in E*Trade’s on-line discussion forums). E*Trade’s on-line discussion forums are

subject to the following conditions, among others: (1) users must register; (2) users may only

maintain one active registration at any time although E*Trade does not verify the name and

address received from non-account holding members; (3) E*Trade’s “hosts,” who are

independent contractors, keep conversations on point and stimulate discussion; (4) E*Trade does

not consider itself to be a publisher or speaker of any information provided to users; (5) users

agree that postings are not attributable to E*Trade; (6) E*Trade does not prescreen or edit

messages although it may monitor them; (7) certain behavior is impermissible, including a)

impersonating someone or lying about a user’s affiliation, b) offering to buy or sell securities, or

c) posting false or misleading statements; (8) members may not discuss securities for which

E*Trade serves as an underwriter or selling group member and securities that are not listed on an

exchange or Nasdaq NMS.

219 For example, depending on the facts and circumstances, the Commission could bring an action

under the antifraud provisions of the federal securities laws. The Commission could also bring

an action against posters who violate the proxy solicitation rules. The Commission recently

relaxed restrictions on communications in mergers and acquisitions, as well as updated and

harmonized related disclosure rules. See Securities Act Release No. 7760 (Nov. 10, 1999), 64

Fed. Reg. 61,408 (1999). The Commission could also bring an action against a company that

violates the prohibitions of Section 5 of the Securities Act of 1933 by sponsoring or engaging in

conversation in an on-line discussion forum while in registration depending on what was said. A

person giving advice in an on-line discussion forum also could be acting as an unregistered

investment adviser. The Supreme Court held in Lowe v. SEC, however, that the publisher of a

regularly disseminated securities newsletter containing nonpersonalized investment and

commentary may fall within the exclusion from registration as an adviser found in Section

202(11)(D) of the Investment Advisers Act of 1940. 472 U.S. 181 (1985); see also, Taucher v.

Born, Civ. Act. No. 97-1711 (RMU), 1999 U.S. Dist. LEXIS 9304, June 21, 1999.

220

 15 U.S.C. § 78j (1999). Section 10(b) of the Exchange Act, and Rule 10b-5 thereunder, prohibits

any person from employing any device, scheme or artifice to defraud; making any untrue

statement of a material fact, or omitting to state a material fact necessary in order to make the

statements made, in light of the circumstances under which they were made, not misleading; or

engaging in any act, practice or course of business which operates or would operate as a fraud or

deceit upon any person in connection with the purchase or sale of any security. The elements of a

Commission action under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder are: (1)

a misstatement or omission; (2) of material fact; (3) made in connection with; (4) the purchase or

sale of securities. The defendant must also act with scienter. Ernst & Ernst v. Hochfelder, 425

U.S. 185 (1976).
78

actions involved a PairGain Technologies employee who posted a false message on a

Yahoo! Finance message board that PairGain was being acquired by an Israeli company.221

The posting was linked to a phony Bloomberg News Service page reporting the

“acquisition.” The price of PairGain stock rose 31 percent on heavy volume before the

hoax was exposed. The stock then fell 20 percent.

Broker-dealers and their registered representatives may be held responsible for

what they say regarding securities products and services when participating in on-line

discussion forums.222 These communications must comply with NASD Rules, including

NASD Conduct Rule 2210 (Communications with the Public), and the federal securities

laws. Rule 2210 generally requires broker-dealers to accurately describe any security or

service offered, including material information, such as risks and cost.223 With some

exceptions, NASD members must provide a copy of the communication to the NASD

upon request.224 In most cases, firms must review postings made by registered

representatives prior to use.225 Depending on its content, firms also may have to file

scripted material with the NASD in accordance with the requirements for sales literature

 

221 SEC v. Gary D. Hoke, Jr., Litigation Release No. 16117, 1999 LEXIS 781 (Apr. 21, 1999); see

also, SEC v. Comparator Systems Corp., Litigation Release No. 14927, 1996 LEXIS 1510 (C.D.

Ca. May 31, 1996) (defendants sold tens of millions of shares of Comparator stock while

inflating assets on its balance sheet and misrepresenting ownership of fingerprint identification

technology; shares increased 30-fold in three days and the market capitalization jumped to almost

$1 billion overnight while investors were posting messages in on-line discussion forums); SEC

v. Charles O. Huttoe, et al., Litigation Release No. 15571, 1997 SEC LEXIS 2421 (Nov. 25,

1997) (CEO of Systems of Excellence distributed approximately eleven million shares of

unregistered securities to nominees under his control and issued misleading press releases to

manipulate the share price; the shares were hyped in thousands of Internet postings); SEC v.

Uniprime Capital and Alfred J. Flores, Litigation Release No. 16252, 1999 SEC LEXIS 1613

(S.D.N.Y. Aug. 13, 1999) (the Commission charged Uniprime and a president of a subsidiary

with fraudulently touting a “major breakthrough” in treating HIV; the share price rose from

$0.625 to as high as $7.95; Uniprime became one of the most discussed securities on Raging

Bull, with 10,000 messages posted by Aug. 1999); see also, Timothy L. O’Brien, Stock Hucksters

Thrive on the Web, N.Y. TIMES, Aug. 23, 1999, at A1 (discussing alleged Uniprime fraud). For a

more complete list, including a brief description of the Commission’s cases involving postings in

on-line discussion forums, see Appendix 3.

222 See NASD, Internet Guide for Registered Representatives <http://www.nasdr.com/4040.htm>

[hereinafter Internet Guide].

223 NASD Rule 2210, NASD MANUAL (CCH) (1999). See also Member Firms Seek Guidance on

Public Appearances, NASD Regulatory & Compliance Alert (Sept. 1997)

<http://www.nasdr.com/pdf-text/rca0997.txt> [hereinafter Member Guidance].

224 For other applicable rules, see Internet Guide, supra note 222; see also NYSE Rule 472, NYSE

CONSTITUTION AND RULES (1999).

225 See Member Guidance, supra note 223.
79

and advertising.226 Broker-dealers must supervise their registered representatives’

participation in on-line discussion forums.227

The NASD also has issued guidance for broker-dealers that hyperlink to other

websites.228 Among other situations, the NASD generally will not hold the member

responsible for the content on a third-party website when a broker-dealer provides an

ongoing hyperlink to that site. However, a member may not establish a hyperlink “to a

site that the member knows or has reason to know contains false or misleading

information about the member’s products or services.”

229

b. Roundtable Participants’ Views

Roundtable participants generally disapproved of broker-dealer sponsored on-line

discussion forums. One roundtable participant acknowledged that broker-dealers may

have an incentive to create on-line discussion forums for three reasons: (1) broker-dealers

want to create a sense of “community” on their websites for marketing purposes; (2)

broker-dealers want to retain users on their websites because, once users go to another

website, they may lose business; and (3) if customers talk on-line just to other customers

rather than to the public at large they may have more confidence in the speakers and

believe that the site contains higher quality information.

Most of the broker-dealers who participated in the roundtables generally did not

believe they should be sponsoring on-line discussion forums on their websites because of

concerns about incurring legal or reputational risk. At one end of the spectrum, a

participant stated that a broker-dealer sponsoring or associating with on-line discussion

forums considers itself as nothing more than a conduit for information, similar to an

ISP.230 At the other end of the spectrum, a participant contended that a broker-dealer

 

226 NASD Rule 2210, NASD MANUAL (CCH) (1999).

227 See Internet Guide, supra note 222.

228 See Letter from Thomas Selman, NASD, to Craig S. Tyle, General Counsel, ICI (Nov. 11, 1997)

<http://www.nasdr.com/2910/2210_01.htm>; see also, Ask the Analyst about Electronic

Communications, NASD Regulatory & Compliance Alert (Apr. 1996) (broker-dealer should not

hyperlink to websites that it knows contain misleading information about the broker-dealer’s

products or services).

229 The Division of Corporation Finance is currently formulating an interpretive release for

consideration by the Commission which may include guidance for issuers that hyperlink to other

websites.

230 An ISP is generally shielded from liability for defamatory postings in on-line discussion forums

that it sponsors. After 1996, on-line discussion forums sponsors may be insulated for defamatory

statements posted in their forums by the Good Samaritan provision of the Communications

Decency Act of 1996.

Congress passed the Good Samaritan immunity in response to a court case that held Prodigy, an

ISP, liable as a publisher for defamation because it exercised a degree of editorial control over the
80

sponsoring a bulletin board may be accountable for suitability determinations if any

recommendations are made on that bulletin board. Another broker-dealer disagreed with

this position, although it conceded that a broker-dealer that establishes and runs a bulletin

board “owns it.”

One on-line broker-dealer participant indicated that his firm has been considering

where to locate an on-line discussion forum, assuming it decides to have one. He noted

his firm’s skepticism of on-line discussion forums is due to the lack of control over the

information posted. He believes that basically two alternatives exist for firms: (1) put the

on-line discussion forum within the firm’s website so that only firm customers who log in

can use it; or (2) place it outside of the firm’s website so that anyone can read it.

Currently, his firm favors placing it within its site to maintain some control and avoid

having its name associated with potentially misleading information from an unknown

origin.

The participants stated that they were unclear about the extent to which a brokerdealer would become liable for the content of information posted on an on-line discussion

forum that it sponsors. One participant asked whether a broker-dealer that monitors an

on-line discussion forum becomes liable for that information so that it assumes a duty to

correct misinformation posted there. The participant then questioned whether the brokerdealer incurred any liability for failing to correct the misinformation promptly. He

questioned what “prompt” would mean in cyberspace. For example, in the participant’s

hypothetical, would it be “prompt” if the broker-dealer took ten minutes to correct a

posting that an issuer’s projected earnings would be $10 a share when the broker-dealer’s

own research shows that they would be $5 a share?

2. Issuers

a. Background

Issuers have become increasingly concerned that on-line postings may influence

their stock price.231 Empirical research regarding the effect of postings in on-line

 

postings on its service. Stratton Oakmont v. Prodigy, 23 Media L. Rep. 1794 (N.Y. Sup. Ct.

1995). But see Cubby, Inc. v. Compuserve, Inc., 776 F. Supp. 135 (S.D.N.Y. 1991) (held that

ISP that did not exercise editorial control over the on-line newsletter where the allegedly

defamatory statements appeared should not be held liable as a “publisher”).

231

 Jerry Useem, !#&L% Day Traders: Feed 'Em or Freeze 'Em?' Which Tactic Hurts Investors

More?, FORTUNE, May 24, 1999, at 318; Martin Stone, Internet Libel Suits Bedevil Canadian,

U.S. Courts, NEWSBYTES PM, May 26, 1999 (Canadian court brings first case stemming from

criminal libel for postings made on an Internet website); Blake Bell, Dealing with False Internet

Rumors: A Corporate Primer, WALLSTREETLAWYER.COM, Dec. 1998, at 1 (discussing techniques

that corporations may follow for dealing with cybersmears); Broc Romanek, Employees as

Shareholders in the Cyber Age, INSIGHTS, May 1999, at 15 (discussing techniques for addressing

employees’ use of on-line discussion forums); Richard Rapaport, PR Finds a Cool New Tool,

FORBES, Oct. 6, 1997, at 100 (discussing public relations techniques in the age of the Internet).
81

discussion forums, however, is scarce. One study evaluating the effect of misleading

representations by sellers on buyer’s behavior found that misrepresentations, or “cheap

talk,” allowed sellers to profit at the expense of buyers.232 A draft study by a University of

Michigan Business School professor provides the most insight into the effects of postings

on on-line discussion forums.233 His study finds a strong positive correlation between

overnight message postings and next-day trading volume and stock price volatility.234 A

study that examined the information content of takeover rumors reported in the Wall

Street Journal columns “Heard on the Street” and “Abreast of the Markets” found that the

market tends to overreact to these rumors in moving the stock price.235

Not all rumors are inaccurate. A study that compared “whisper” forecasts to

earnings per share forecasts from First Call, a commercial source of earnings forecasts,

found that whisper forecasts were on average more accurate.236

So what should an issuer do? Correcting information creates potential liability but

ignoring false or incorrect information could adversely affect the issuer’s stock price.

Right now, issuers generally take several approaches to addressing misleading postings,

including: (1) ignore them; (2) monitor them or hire a firm to do so;237 (3) sue the

 

232

 University students were given assets of varying quality (low, medium, or high) and allowed to

engage in “cheap talk” before transaction prices were determined. Cheap talk in this setting

involved the seller disclosing the truth, lying, or being vague about asset quality. For example, a

seller with a low quality asset could state that it was either of a low, medium, or high quality, but

could not state that it was only medium or high quality. The gains in this situation accrued

wholly to the buyers. Efficiency improved when the sellers were prohibited from lying although

they were allowed to tell the truth or be vague. Robert Forsythe et al., Cheap Talk, Fraud and

Adverse Selection in Financial Markets: Some Experimental Evidence, 12 REV. OF FINANCIAL

STUD. 3, at 481-518 (Spring 1999).

233

 Peter D. Wysocki, Cheap Talk on the Web: The Determinants of Postings on Stock Message

Boards (1998) (Working Paper No. 98025. Univ. of Michigan School)

<http://papers.ssrn.com/paper.taf?ABSTRACT_ID=160170>.

234 Id.

235

 This study also suggests that a strategy of short selling after rumor publication may prove

profitable. Terry Zivney et al., Overreaction to Takeover Speculation , 36 Q. REV. OF ECON. AND

FIN. 1, Spring 1996, at 89-115.

236

 “Whisper” forecasts are unofficial earnings forecasts circulated before official company

announcements. Mark Bangoli, et al., Whisper Forecasts on Quarterly Earnings Per Share, 28

J. OF ACCT. & ECON. 1 (forthcoming 1999); Ed Leefeldt, Whispers, BLOOMBERG, Aug. 1999, at

28 (discusses accuracy of whisper numbers); Marcia Vickers, Psst! Want the CPI Number?, BUS.

WK., Oct. 18, 1999, at 182 (discusses web sites that post whisper earnings).

237

 Rebecka Buckman, Gumshoe Game on the Internet, WALL ST. J., July 27, 1999, at B1

(companies are hiring detectives to unmask on-line detractors); Matt Ritchel, Rumor Brigade

Scours Web, SAN DIEGO UNION-TRIB., Mar. 23, 1999, at 8.
82

anonymous “John and Jane Does,” to uncover their identities;238 (4) correct the misleading

statement where it originally appeared;239 or (5) contact the SEC or appropriate SRO.

An issuer generally has no obligation to comment on rumors in the marketplace

that affect its stock price unless the rumors are attributable to the issuer.240 The same is

true with respect to rumors on the Internet. Practitioners generally advise their clients to

refrain from commenting on rumors, electronic or otherwise, regardless of the nature and

extent of the rumor. Counsels’ primary concern is that the company’s response to a false

rumor may result in a duty to correct or update the information at a later time.241 In

addition, an issuer that corrects misinformation in the same on-line discussion forum

where it appeared may unintentionally selectively disclose material nonpublic information

or provide inaccurate information which would serve as a basis for liability for those who

acted on the incorrect information.242

 

238

 See, e.g., Michael Moss, CEO Exposes, Sues Anonymous On-line Critics, WALL ST. J., July 7,

1999, at B1 (CEO of HealthSouth Corp. sued a John Doe who claimed that he may be

committing billing fraud and engaged in wife swapping); Neil Roland, M.H. Meyerson Sues

Internet Users, Yahoo! Over Chat Messages, BLOOMBERG, May 20, 1999 (broker-dealer sued

anonymous posters who accused the CEO of stock manipulation, insider trading, and money

laundering); Kaiser, Lilly Industries Sues Anonymous Internet Critics, AP NEWSWIRES, July 20,

1999 (Kaiser Lilly); Banks Sue Over Internet Rumors, AP ON-LINE, July 28, 1999 (LEXIS, News

Library, Curnws File); see also Columbia Ins. Co. v. Seescandy.com, 185 F.R.D. (plaintiff must

meet a four part test in order to compel discovery of the true identity of an Internet tortfeasor).

A group of John Does who have been sued have even established their own message board on

Yahoo! to discuss their experiences. See <http://clubs.yahoo.com/clubs/johndoes?s> (visited

Nov. 14, 1999).

239

 See, e.g., Michelle Leder, Stemming the Tide of Touts on Those Stock Message Boards, N.Y.

TIMES., Feb. 21, 1999, at 9.

240 See State Teachers Retirement Board v. Fluor Corp., 654 F.2d 843 (2d Cir. 1981).

241 Some commentators have noted that there may be advantages to engaging in an ongoing dialogue

with individual investors, such as: (1) providing greater access to the issuer, (2) strengthening

ties with investors, (3) keeping investors informed, (4) countering any rumors or misinformation

in the marketplace, and (5) keeping the issuer informed of investors’ opinions. At least two

issuers presently participate in Internet discussion groups with what they view to be positive

results. See Kenneth Li, Zamba Exec Wants To Tell You What’s New, THE INDUSTRY STANDARD,

Sept. 27, 1999, at 54; Paul C. Judge, Internet Evangelist, BUS. WK., Oct. 25, 1999, at 140 (CEO

of Internet holding company CMGI, Inc., discussed his company on Yahoo! Finance over a sixday period).

242 At least one foreign stock exchange, the Toronto Stock Exchange, has issued guidance for issuers

regarding the appropriate forum to correct rumors.242 This guidance urges companies to refrain

from participating in on-line discussion forums to dispel rumors. Instead, it provides that the

company should issue a news release to ensure widespread dissemination of its corrective

statement.
83

Under the federal securities laws, to the extent that an issuer posts factual material

information on its website, the issuer may have a duty to correct or update.243 Generally,

however, there is no duty to correct statements issued by a third party unless the

statements are attributable to the issuer.244

Still, the NYSE admonishes issuers that if rumors occur at a time when the issuer

is considering significant corporate developments and the rumors are “false or inaccurate,

they should be denied promptly or clarified. A statement to the effect that the company

knows of no corporate developments to account for the unusual market activity can have

a salutary effect.”

245 SRO policies address how listed companies should disseminate

material information to the public. For example, NYSE-listed companies are “expected to

release quickly to the public any news or information which might reasonably be expected

to materially affect the market for its securities” and “act promptly to dispel unfounded

rumors which could result in unusual market activity or price variations.”

246 The NYSE

also requires its listed companies to disseminate press releases on material developments

by the “fastest available means.”

247 At a minimum, NYSE-listed companies must

distribute press releases to specified major news services.248 The NASD requires Nasdaq-

 

243 See, e.g., Ross v. A.H. Robins Co., Inc., 465 F. Supp. 904 (S.D.N.Y.), rev’d in part and

remanded on other grounds, 607 F.2d 545 (2d. Cir. 1979), cert. denied, 446 U.S. 946 (1980);

Naye v. Boyd (CCH) ¶92,980 (W.D. Wash. 1986); SEC v. Shattuck Denn Mining Corp., 297

F.Supp. 470 (S.D.N.Y. 1968); Fischer v. Kletz, 266 F. Supp. 180 (S.D.N.Y. 1967). See e.g.

Hilson Partners Ltd. Partnership v. Adage, Inc., 42 F.3d 204 (4th Cir. 1994); Evanowski v.

Bankworchester Corp., 788 F.Supp. 661 (D. Maine 1991).

244 “Related to the question of whether an issuer has a duty to correct or update its own statements is

the question of whether an issuer has a duty to correct or update misleading statements made

about it by third parties, such as by reporters or financial analysts. The nearly unanimous view of

courts that have considered this question is that issuers ordinarily have no such duty.”

Robert H. Rosenblum, An Issuer’s Duty Under Rule 10b-5 to Correct and Update Materially

Misleading Statements, 40 Cath. U.L. Rev. 289, 291 (1991); see also Electronic Specialty Co. v.

International Controls Corp., 409 F.2d 937 (2d Cir. 1969); Zucker v. Sable, 426 F. Supp. 658

(S.D.N.Y. 1976).

245 NYSE LISTED COMPANY MANUAL § 202.03 (1998). See also Rule 4310(a)(15-16), NASD

MANUAL (CCH) (1999); AMEX COMPANY GUIDE (401-405).

246 NYSE LISTED COMPANY MANUAL, supra note 245, § 202.05.

247 Id. § 202.06(C). The NYSE and NASD provide non-exclusive examples of what news items

should be considered to be material. See id. § 202.06(A); Nasdaq Marketplace Rules Update:

Nasdaq Clarifies Rule on Disclosure of Corporate Information Over the Internet (Rule IM-4120-

1), NASDAQ-AMEX BULLETIN Apr. 1999, at 1.

248 See NYSE LISTED COMPANY MANUAL, supra note 245, at § 202.06(C).
84

listed companies to promptly disclose any material developments through the news

media.249

Issuers are growing increasingly concerned about employees posting company

information in on-line discussion forums. One-third of companies represented by the

National Investor Relations Institute (“NIRI”) have adopted policies that prohibit

employee participation in such forums.250 Of those, two-thirds have enforcement

mechanisms to address employee violations. More than one-half of the companies that

have adopted such policies have done so within the past year.

b. Roundtable Participants’ Views

One participant noted that most issuers are starting to monitor postings concerning

their companies but that only three percent of issuers in his organization say that they will

respond to rumors arising in on-line discussion forums.251 His organization urges issuers

not to respond to on-line discussion forum rumors because it is concerned about creating

an ongoing duty to correct misinformation in on-line discussion forums. 252 However, he

recognizes the difficulties of a “no comment” policy -- particularly for smaller issuers. He

know of one recent situation in which an issuer learned that someone was posing as its

CEO and making earnings projections in a on-line discussion forum. The issuer’s counsel

advised the issuer to deny the posting in the same on-line discussion forum by stating that

the current poster was the real CEO and that the company, as a matter of practice, did not

project earnings.

Several participants suggested that one way to reduce the potential for on-line

hype about a company’s stock is to require any person who posts information about a

public issuer to register on the site under his or her true identity. At least one First

 

249 Qualification Requirements for Domestic and Canadian Securities, 1 NASD Manual (CCH), at

5273 (Feb. 1999). Pursuant to NASD Interpretation IM-4120-1, Nasdaq-listed companies should

disclose material information in the form of a press release to one of the traditional news

services. See NASDAQ-AMEX BULLETIN, supra note 247.

250 NIRI, Electronic and Telephone Communications Systems Policy, July 1, 1999

<http://www.niri.org/publications/alerts/ea070199.cfm>.

251 This is consistent with a 1998 survey of corporate disclosure practices which found that 52

percent of companies do not comment on market rumors under any circumstances and only two

percent respond to false rumors spread through on-line discussion forums. Proactive Corporate

Counsel Recommended by ABA Panelists, 31 SECURITIES REG. AND LAW REP. 1113 (Aug. 20,

1999).

252 This guidance appears to be premised on the Supreme Court decision in Basic v. Levinson that,

absent special circumstances, there is no duty to disclose preliminary merger negotiations. In

that decision, the Court observed that, “To be actionable, of course, a statement must be

misleading. Silence, absent a duty to disclose, is not misleading under Rule 10b-5. ‘No

comment’ statements are generally the functional equivalent of silence.” Basic v. Levinson, 485

U.S. 224, 239 nn. 17 (1988).
85

Amendment practitioner has recommended caution with this approach because the

Supreme Court has opined that the First Amendment right of free speech includes the right

to remain anonymous, at least with respect to political speech.253

B. Conclusions and Recommendations

1. Conclusions

On-line discussion forums have been variously described as the cyberspace

equivalent to writing on the bathroom wall, chatter at a cocktail party, and useful sources

for investor education. Anecdotal evidence suggests that on-line discussion forums affect

stock price volatility. In addition, the anonymous nature of postings may create a

significant impediment to developing quality communities. While Commission staff

generally unmasks fraudsters (who believe that they are acting anonymously) because they

leave footprints in cyberspace, it is very difficult for average investors to differentiate

among quality information, “noise,” and outright fraud. Sponsors exercise varying

degrees of control over on-line discussion forums, ranging from very little to hiring a

cyberspace “neighborhood watch” to patrol the forums. Issuers increasingly respond to

the content of false or misleading postings by filing “John and Jane Doe” suits to subpoena

information that discloses the posters’ identities.

To date, concerns over legal and reputational risk have made broker-dealers

generally reluctant to sponsor on-line discussion forums. An open question is whether

broker-dealers provide some benefit to investors by sponsoring such forums or whether

broker-dealers should not lend these forums the imprimatur of legitimacy.

Issuers also should look at the use of Internet discussion groups by their

employees. An employee participating in an on-line discussion may, intentionally or

inadvertently, disclose material non-public information with the attendant risk that the

disclosure may be attributed to the issuer. Because of the possibility that their employees’

postings may contain incomplete or misleading information, issuers should consider

adopting and actively enforcing policies monitoring the use of electronic forms of

communications by their employees. These policies should address: (1) whether Internet

postings about the issuer are permitted; (2) limitations on the types of postings allowed;

and (3) the penalties associated with violating the policies.

2. Recommendations

 

253

 Joseph McIntyre v. Ohio Elections Commission, 514 U.S. 334 (1995) (Ohio statute banning

distribution of anonymous political campaign literature held not justified on First Amendment

grounds, by state interest in preventing fraud and libel or informing the electorate); See also

ACLU v. Miller et al., Civ. Action No. 1:96-cv-2475-MHS (N.D. Ga. complaint filed Sept. 24,

1996) (court granted plaintiff's motion for a preliminary injunction and denied defendants'

motion to dismiss action against statute that criminalizes communicating under a false identity

through a computer network). For a discussion of the benefits of, and the methods for,

communicating anonymously, see ACLU v. Miller (complaint)

http://www.aclu.org/issues/cyber/censor/GACOMPLT.html>.
86

• Anecdotal evidence suggests that on-line discussion forums affect stock price

volatility. Because there is no study confirming these observations, the Commission

and other interested researchers are encouraged to study the effect of postings on online discussion forums on stock price volatility. Evidence of widespread volatility,

particularly among specific categories of securities, may be useful in considering these

issues and any potential Commission action.

• The Commission should encourage broker-dealers that host on-line discussion forums

to consider adopting best practices, including: (1) requiring posters to register;

(2) encouraging posters to disclose their stock positions; (3) monitoring the on-line

discussion forums; (4) using notices to advise investors not to rely on on-line

discussion forums as their sole or primary source of investment information; and (5)

disclosing the identity and professional experience of the event leaders.
87

VIII. PRIVACY

A. Background

The development of increasingly sophisticated data mining techniques and the rise of

financial conglomerates has recently pushed the issue of privacy of personal information254 onto

center stage. The issue arose as a flashpoint in the debate over financial modernization

legislation, the Gramm-Leach-Bliley Act,255 and in negotiations between the United States and

the European Union over protecting personal data.256 Financial institutions are developing

technology to observe customers’ behavior, combine it with their transaction history, and

create a detailed customer profile in order to manage customer relationships. According to

Meridien Research, financial firms spent over $1.6 billion in “customer relationship

management” software in 1998 and are expected to spend around $2.5 billion by 2003.257 The

financial services industry has argued that developing such synergies would be impossible if

individuals were allowed to control the use of their personal information. One of the mostoften cited reasons for creating financial conglomerates is the ability to develop “synergies” in

order to cross-market and sell products from different product lines to customers.

In addition to commercial intrusion, individuals also are concerned about governmental

intrusion into their privacy. Two recent debates demonstrate the difficulty of counterbalancing

privacy with other governmental interests, such as preventing money laundering. In 1998,

federal banking regulators proposed new "know your customer" regulations for banks and their

affiliates, including bank-affiliated broker-dealers, that would have required banks to give

heightened scrutiny to the financial transactions of their customers and report suspicious

 

254 The Federal Trade Commission (“FTC”) defines “personal information” to include two broad

information categories: (1) information that can be used to identify consumers, such as name,

postal or e-mail address (“personal identifying information”); and (2) demographic and

preference information, such as age, gender, income level, hobbies, or interests, that can be used

either in aggregate, non-identifying form for purposes such as market analysis, or in conjunction

with personal identifying information to create detailed profiles of consumers. FTC, PRIVACY

ON-LINE: A REPORT TO CONGRESS (1998) <http://www.ftc.gov/reports/privacy3/toc.htm>

[hereinafter Privacy Report]. See also Paula Duyer, Suddenly, Financial Privacy is a Hot-Button

Issue, BUS. WK., June 21, 1999, at 51. This section does not generally address privacy initiatives

by other financial regulators. See also, infra note 271.

255 Gramm-Leach-Bliley Act, Pub. L. No. 106-102, 113 Stat. 1338 (1999).

256 See European Union Directive 95/46/EC on the protection of individuals with regard to the

processing of personal data and on the free movement of such data, Off’l J. No. LL281, 1995

(Directive prohibits transfer of personal information from any source in the European Union to

any country without “adequate” privacy protections, as determined under the Directive); Draft

International Safe Harbor Principles (Apr. 19, 1999) <http:www.ita.doc.gov/ecom/sphrin/html>.

257 Chuck Epstein, Financial Services Firms Take Aim at Customers, WALL ST. & TECHNOLOGY,

Sept. 1999, at 36. See also Trends section at pages 1-1.
88

transactions.258 In response to over 300,000 negative comment letters, the federal banking

regulators withdrew the proposal.

Investors have not lodged a significant number of complaints with the Commission

against broker-dealers for violating their privacy expectations. Out of 19,250 complaints

against broker-dealers that the Commission received between February 8 and October 15,

1999, only 25 alleged violations of privacy or breaches of security involving personal

information.

B. Privacy Concerns Raised in an On-Line Environment

A 1999 poll found that more than 87 percent of Internet users were either somewhat or

very concerned about their personal privacy while on-line.259 As the following chart

demonstrates, web users are reluctant to give personal information to websites.260

 

258 See, e.g., “Know Your Customer” Requirements, 63 Fed. Reg. 67,524 (1998); “Know Your

Customer” Requirements, 64 Fed. Reg. 15,137 (1999) (withdrawal of proposed rulemaking).

259 AT&T Labs-Research Technical Report, Cranor, Reagle & Ackerman, Beyond Concern:

Understanding Net Users’ Attitudes About On-Line Privacy (1999)

<http://www.research.att.com/projects/privacy study>. See also, Mary Mosquera, Most Net

Users Worry About Privacy, TECHWEB NEWS, June 23, 1998 (LEXIS, News Library, Curnws

File); Bill Orr, NCR to Banks: Privacy is Good for Business, ABA BANKING JOURNAL, June,

1999, at 68 (citing various polls on privacy).

260 For further information regarding privacy practices of websites, see FTC, SELF-REGULATION AND

PRIVACY ON-LINE: A REPORT TO CONGRESS (1999)

<http://www.ftc.gov/os/1999/9907/privacy99.pdf; Mary J. Culnan, GEORGETOWN INTERNET

PRIVACY POLICY SURVEY: REPORT TO THE FEDERAL TRADE COMMISSION (1999)

<http://www.msb.edu/faculty/culnanm/gippshome.html>; FRB, FDIC, OCC, OTS, WEB SITE

PRIVACY REPORT (1999) <http://www.occ.ustreas.gov/ftp/release/99-103a.pdf>. See also, 1998

FTC Privacy Report, supra note 254.
89

Chart VIII-1

Reasons for Not Filling Out Online Registration Forms

4%

32%

36%

48%

51%

67%

73%

75%

0% 10% 20% 30% 40% 50% 60% 70% 80%

I Always Register

Requires My E-mail 

Address

Requires My Name

Takes Too Much time

Requires My 

Physical Address

Don't Trust Site

Not Worth the Risk

No Info. About How 

Data Will Be Used

From an on-line poll of 5,965 surfers. Source: “Tenth Annual

WWW User Survey,” October, 1998, Georgia Institute of Technology’s Graphic,

Visualization,and Usability Center.

Reprinted with permission from The Industry Standard

In addition to filling out on-line registration forms, website operators can get

information on their visitors by using “cookies.” “Cookies” are text files that collect

information about a web user’s visit to a website. They are placed on the user’s computer and

only that website’s server can read them. They also can be used to develop a visitor profile.261

As demonstrated by the following chart, web users also seem to be reluctant to give

information in exchange for targeted advertising:

 

261 Edward C. Baig, Marcia Stepanek, and Neil Gross, The Internet Wants Your Personal

Information. What’s in it for you? BUS. WK., Apr. 5, 1999, at 84; Saul Hansell, As Web Sites

Track Users’ Habits, Privacy Advocates Wince, INT’L. HERALD TRIB., Aug. 17, 1998, at 11;

Robert B. Libbon, Is Public Concern About Privacy Holding Up Commerce on the Internet?,

AM. DEMOGRAPHICS, Feb. 1999, at 35.
90

Chart VIII-2

Most Surfers Still Won't Opt In

86% 84% 84%

14% 16% 16% 0%

50%

100%

1997 1998 1999

Very/Somewhat Willing Not Very/Not at All Willing

From a telephone survey of 447 randomly selected U.S. on-line users

 Source: Harris Poll for Business Week

Reprinted with permission from The Industry Standard

The issue appears more complex than polls would suggest.262 Consumers appear

willing to disclose personally identifiable information when they believe that they are receiving

something of value in return, such as free long-distance service, personal computers, and

Internet access. Thus, while consumers do not want to give away their personal information,

they seem willing to exchange it for a benefit.263

 

262 For an opposing view on the issue of privacy, see Kenneth Neil Cukier, Is There a Privacy Time

Bomb, RED HERRING, Sept. 1999, at 91 (as consumers continue to give out their personal data, it

appears that the Internet’s threat to privacy may be exaggerated); Jonathan Franzen, Imperial

Bedroom, THE NEW YORKER, Oct. 12, 1999, at 48 (the real problem with privacy is that there is

too much of it).

263 Mark Leibovich, Ads’ Message: Talk Cheap; Callers Endure Pitches, Phone for Free, WASH.

POST, Jan. 20, 1999, at A1 (Broadpoint offers free long-distance services to customers who listen

to targeted ads). Matt Richel, Despite Privacy Concerns, Free PC’s Attract Many Consumers

and Schools, N.Y. TIMES, Feb. 25, 1999, at G7 (when Free-PC announced that it would give

away 10,000 computers, more than one million persons signed up); Elise Ackerman, Money For

Nothing and the Web for Free, U.S. NEWS & WORLD REP., Sept. 13, 1999, at 3 (discusses

Internet giveaways in exchange for personal information); NCR: Europeans Willing to Provide

Personal Data, May 28, 1999 <http://www.nua.ie/surveys/?f=VS&art=905354932&rel=true>.
91

Recent incidents in which consumers perceived violations of their privacy both on-line

and off-line have also raised awareness of the issue: 264

• The Minnesota Attorney General’s Office sued U.S. Bancorp alleging that the bank

illegally sold credit histories and other customer information to a telemarketer even though

it told customers that it did not do so.265

• Employees of NationsBank provided its affiliated broker-dealer with lists of maturing

certificates of deposit (CDs) and lists of likely prospective investors, financial statements,

and account balances, which the broker-dealer used to target bank customers to purchase

securities. During the course of the solicitation, the broker-dealer employees

mischaracterized the nature of the investments sold. As a result, many elderly customers

were moved from bank CDs to high-risk mutual funds or other unsuitable investments.

The defendants settled the Commission’s enforcement action for violations of the antifraud

provisions by paying a civil money penalty of $4 million.266

 

264 See, e.g., Robert O’Harrow, Jr., Drivers Angered Over Firms’ Purchase of Photos,WASH. POST,

Jan. 28, 1999, at E1 (as residents complained, state authorities sought to retrieve millions of

drivers’ photographs that they sold to a private company); James Frederick, Chain Pharmacy:

Patient Privacy Debate Raises Pharmacy Concerns Among State, Federal Legislatures, DRUG

STORE NEWS, Apr. 27, 1998, at C1 (drug chains stopped selling patient prescription records to

marketers after consumers complained); Ted Bridis, Microsoft Fixing Windows System to

Correct Privacy Problem, AP NEWSWIRES, Mar. 7, 1999; Ted Bridis, Watchdog Group Says it

Won’t Pursue Microsoft, AP NEWSWIRES, Mar. 23, 1999 (Microsoft, a member of an industry

seal program run by TRUSTe, will not face any sanctions); Charles Piller, Top PC Makers

Respond to Chip Privacy Concern with its Own Plan; Computers: Major Vendors Will Disable

ID in Basic Software to Prevent Intel’s Pentium III From Identifying Processor, L.A. TIMES, Feb.

26, 1999, at C1 (Intel agreed to provide a software utility that turns off the unique serial number

from the Pentium III chip that enabled individual users’ transactions to be traced on-line; top computer

makers are going further by disabling the ID); Saul Hannell, As Web Sites Track Users’ Habits,

Privacy Advocates Wince, INT’L. HERALD TRIB., Aug. 17, 1998, at 11 (AOL disclosed information

about one of its members to the Navy); Kathy Kristof, Wiping the Slate Clean; Privacy-Concerned

Consumers Want Their Records Deleted from Controversial Lexis-Nexis Database, CHI. TRIB.,

Nov. 19, 1996, at C7 (consumers overwhelmed Lexis-Nexis with requests to opt out of P-Trak, a

product which would allow users to obtain personal information about individuals, including

maiden names, current and previous addresses, birth dates, and some telephone numbers; Lexis

stopped providing social security numbers, which it was listing at one point); Sale of Data on

Credit Card Customers is Examined. Marketing Firms Are Buying Information From Banks;

Practice May be “Breaching Trust,”ST. LOUIS POST DISPATCH, Sept. 28, 1999, at A1 (states

attorney generals investigating whether banks that issue credit cards are selling data on

customers’ spending habits and creditworthiness to marketing firms); Hiawatha Bray, Real

Networks to Act on Data Concern, THE BOSTON GLOBE, Nov. 2, 1999, at C3 (Real Networks, Inc.

will change its product after it was discovered that it was transmitting information about its

users’ listening habits over the Internet).

265 Timothy L. O’Brien, Big Bank Says it Won’t Share Customer Data, N.Y.TIMES, June 12, 1999,

at C1.

266 In the Matter of NationsSecurities and NationsBank, N.A., Securities Act Release No. 7532 (May

4, 1998).
92

• GeoCities, a popular website that lets users create webpages for free, settled an action with

the FTC for disclosing information to third-parties, contrary to its stated policy.267

In a recent series of enforcement cases, the Commission echoed the view that personal

information is valuable because it allows companies to solicit potential customers. In deciding

whether giving free stock to website visitors who provided certain personal information

triggered a registration requirement under the Securities Act of 1933, the Commission

determined that personal information could fairly be viewed as “consideration” for the stock.268

C. Recently Enacted Legislation Affecting Privacy

Congress considered consumers’ privacy concerns in the Gramm-Leach-Bliley Act.269

The Gramm-Leach-Bliley Act repealed many of the restrictions imposed by Glass-Steagall on

broker-dealers, banks, and insurance companies while continuing to permit information sharing

between affiliates and agents of financial institutions.270 However, the Gramm-Leach-Bliley

Act contains restrictions aimed at restricting the disclosure of “nonpublic personal

information”

271 to unaffiliated third parties.

Briefly, the Gramm-Leach-Bliley Act has four main components. First, it requires all

financial institutions to disclose to customers their policies and practices to protect customers’

nonpublic personal information. Second, it limits sharing of nonpublic personal information

with an unaffiliated third party. One of these limitations would require an investor to be

notified in writing or electronically and have the opportunity to opt out of such disclosure,

before the disclosure occurs. This requirement would be subject to certain significant

exceptions, however, allowing financial institutions to continue much of the information

 

267 In the Matter of GeoCities, File No. 9823015 (FTC 1998).

268 SEC v. Joe Loofbourrow, No. 9934, 1999 SEC LEXIS 1419 (SEC July 21, 1999); SEC v.

Theodore Sotirakis, No. 9935, 1999 SEC LEXIS 1414 (SEC July 21, 1999); SEC v.

WowAuction.com and Steven Michael Gaddis, Sr., No. 9936, 1999 SEC LEXIS 1420 (SEC July

21, 1999); SEC v. Web Works Marketing.com and Trace D. Cornell, No. 9937, 1999 SEC

LEXIS 1424 (SEC July 21, 1999).

269 For a further discussion of regulators and market participants’ views on financial privacy

legislation, see Financial Institutions Subcommittee Hearing on Financial Privacy, Subcommittee

on Banking and Financial Services, 106th Cong. (1999) <http://www.house.gov/banking/

72099wit.htm> and <http://www.house.gov/banking/72199wit.htm> (visited Nov. 1, 1999).

270 Financial institutions are broadly defined and include broker-dealers, investment companies, banks,

thrifts, savings and loans, and insurance companies, among others.

271 “Nonpublic personal information” is defined as “personally identifiable information: (i) provided

by a consumer to a financial institution; (ii) resulting from any transaction with the consumer or

any service performed by the consumer; or (iii) otherwise obtained by the financial institution.”

The term does not included publicly available information. Section 509(4).
93

sharing that occurs today.272 Third, the Gramm-Leach-Bliley Act requires the federal financial

regulators, including the Commission and the banking agencies, to: (1) issue standards to

safeguard customer information; (2) issue regulations to implement the provisions; and (3)

study information sharing among financial institutions and their affiliates and the adequacy of

proposed regulations to prevent the unauthorized disclosure of customer financial information.

Fourth, the privacy provisions of the Gramm-Leach-Bliley Act do not supersede any state law

that provides any higher level of privacy protection than the Act provides.

The Gramm-Leach-Bliley Act requires the Commission, along with other regulators, to

adopt rules to implement the privacy provisions of that Act to prevent pretext calling and the

unauthorized disclosure of financial information, and to establish standards to address

administrative, technical, and physical safeguards involving customer confidentiality.

D. On-Line Broker-Dealers’ Privacy Policies

A survey of privacy policies and information practice statements posted by the ten

largest on-line firms was conducted on November 15, 1999.273 A privacy policy is

generally a comprehensive disclosure describing the broker-dealer’s policies and practices

regarding the collection and use of investor information. An information practice

statement is a statement focused on a more limited area, such as data security.274 The

following analysis of the content of privacy disclosures addressed the FTC principles of

fair information practice:275

1. Notice: included statements informing the investor of information collected, how

the information was collected, how the collected information would be used, and whether

the firm addressed the use of “cookies.”

2. Choice: included statements informing investors whether they could opt out of

being contacted by the firm for marketing or other purposes, or disclosure to third parties.

 

272 For example, the Gramm-Leach-Bliley Act would permit information sharing with an

unaffiliated third party that markets products or services in a joint agreement with the financial

institution. The Act does not affect information sharing under the Fair Credit Reporting Act of

1970. The Act generally prohibits disclosure of the most personal financial data, such as credit

card, deposit or other transaction account numbers, for third party marketing purposes. The

prohibition contains a number of exceptions, however, including an exception for disclosure to a

reporting agency.

273 See Appendix 4 for a more complete discussion of the findings.

274 For example, an information practice statement regarding security may state, “all on-line

transactions with the firm require a secure connection.”

275 No comparison should be drawn with surveys conducted by the FTC and federal bank regulators

because the scope differs materially. Each website was reviewed twice by two different reviewers

and any differences were reconciled. These principles have been articulated in various privacy

surveys of on-line sites. See supra notes 254 and 260.
94

Also included statements informing investors whether the information collected could be

used for purposes other than that for which it was originally collected.

3. Access: included statements informing investors how they might ask questions

about or review their own personal information. Access also included how investors

could correct inaccuracies in personal information maintained by the firm.

4. Security: included statements informing investors about security over their

personal information both during on-line transmission and while it was stored at the

broker-dealer. This category could include statements related to the use of a secure

server.

5. Contact: included statements informing investors how they could submit

questions or complaints about privacy.276

The review considered: 1) where the firm posted a privacy notice and the location

of the notice; and 2) the content of the privacy notice.

Overview:

• Eight of ten firms have a privacy policy. All ten firms have an information practice

statement.

• The principles most frequently addressed in privacy disclosures were security (nine

firms) and notice (eight firms).

• With respect to comprehensiveness of privacy disclosures: one firm addressed one of

the principles; one firm addressed two principles; two firms addressed three principles;

four firms addressed four principles; two firms addressed all five principles.

• Three of ten firms offered investors the ability to opt out of information sharing with

third parties; two of ten firms offered the opportunity to opt out of secondary uses of

information within the institution.

 

276 The survey substituted “contact” for the FTC information practice of “enforcement.”
95

E. Roundtable Participants’ Views

In an effort to boost customer confidence in using the Internet, one of the roundtable

participants created a privacy seal that participating merchants can use on their website if they

adhered to certain policies277 In order to receive a seal of approval, a company would need to

disclose: (1) the information being collected; (2) the use of the information; and (3) whether

the information is shared with anyone. Consumers also must be given the opportunity to: (1)

object to information sharing for unrelated purposes; (2) verify the accuracy of their

information; and (3) verify that the site has reasonable security measures to protect the

information. The privacy seal also provides third-party consumer recourse in case that firm

breaches its privacy obligation.278

The single participant present on that day who had the seal did not represent a brokerdealer.279 According to the participant whose company created the privacy seal, broker-dealers

had been reluctant to sign up because they view themselves as already highly regulated and

trusted. This participant also stated that, although brokerage firms have not expressly adopted

the privacy seal, they have told her that they generally subscribe to the privacy policies

underlying that seal.

A broker-dealer participant stated that because the Internet already has much potential

to collect personal information, there has to be some way for people to opt out of providing

information. There are legitimate circumstances under which a person would want to remain

anonymous, such as when researching information about a parent's medical condition. In the

near term, this participant believed that the FTC should be the agency that continues to take the

lead in formulating a uniform privacy policy.280 The participant believed that information

security used to be the primary concern with on-line customers. However, the participant

stated that information privacy is now the primary concern, which, in his view, means that the

industry has done a good job of addressing consumer's concerns about encryption and secure

service.

One broker-dealer participant contended that firms collect personal information already

and have a fiduciary obligation to keep the information private -- on-line or off-line. He

 

277 This participant advocates self-regulation and aims to avoid new privacy regulation.

278 The privacy seal sponsor requires consumers to contact the website first to resolve the dispute. If

the consumer is not satisfied, he may then complain to the privacy seal sponsor. The sponsor

will investigate the complaint. The privacy seal sponsor may require a compliance review by an

accounting firm, revoke the site’s seal, refer the complaint to regulators, or sue the website for

breach of contract or trademark infringement.

279

 Since the roundtable occurred, one of the broker-dealer participants has adopted a privacy seal.

280 The Gramm-Leach-Bliley Act, however, requires the functional financial regulators to set policy

for institutions under their jurisdiction.
96

believes that it is more important to have information security rather than information

privacy.

281

Another participant observed that a 1984 Commission release requires the industry to

take reasonable steps to protect customers' information.282 According to this participant,

broker-dealers do not let customers opt out of information sharing because they need to gather

a customer's personal information for suitability and for other purposes. 283 In fact, the

participant stated that a broker-dealer would violate SRO rules of suitability and fair practice by

not collecting certain customer information.

One participant objected to the application of a higher standard by regulators to

broker-dealers than to banks. According to this participant, banks engage in a lot of data

mining already, so a higher standard should not be imposed lest it constrain similar activities by

broker-dealers.284

F. Conclusion and Recommendations

1. Conclusions

To date, one SRO has brought an enforcement action against a registered

representative for, among other things, improperly disclosing customer account information

without the customer’s knowledge.285 Pursuant to the Gramm-Leach-Bliley Act, however, the

Commission is required to promulgate rules that would allow it to bring enforcement actions

against firms that fail to disclose their privacy policies. Although only a few investors have

complained to Commission staff about perceived invasions of privacy, the incidents noted in

Section B of this discussion suggest that consumers are concerned about the confidentiality of

their financial information.

 

281 The broker-dealer participant was frustrated by the ability of individuals to remain anonymous while in

on-line discussion forums because an anonymous poster had disseminated misinformation about his

employer.

282 See Computer Brokerage Release, supra note 1.

283 The participant did not consider, however, that a firm can meet its regulatory requirements

without sharing the gathered information.

284 In a 1998 survey of 300 commercial banks, Meridien Research found that 300 commercial banks

had spent approximately $1.1 billion on “customer relationship management” software and that

they expected to spend approximately $1.5 billion by 2003. See Chuck Espstein, Financial

Services Firms Take Aim at Customers, WALL ST. & TECHNOLOGY, at 36. See also Trends

section at 1-1.

285 In re Albert Anthony Dello Russo, NYSE Panel Decision 96-23 (March 5, 1996).
97

2. Recommendations

• The Commission should obtain and evaluate the information collection practices of on-line

firms.286

• The Gramm-Leach-Bliley Act requires the Commission and other functional regulators to

jointly issue a report on the state of privacy regulation in the United States. In preparing

the study, the Commission should consider the data gathering practices of on-line firms and

any burdens that firms would incur by letting customers opt out of information sharing.

The Commission also should review any complaints from customers that firms have

received about their information collection practices.

 

286 This Report does not take a position as to whether the Commission should evaluate off-line

firms’ information collection practices.
98

IX. PORTALS

A. Background

Portals, as gateways to the Internet, have been described as key to providing

financial services on-line. Portals also are significant competitors to on-line broker-dealers

and banks in the battle to catch viewers, also known as attracting “eyeballs.”

287 According

to a recent survey, the three most visited financial portals were AOL’s Personal Finance,

Quicken.com, and Yahoo! Finance.288 Portals charge broker-dealers, as well as other online merchants, to link from their sites. Their ability to generate revenue depends on

attracting an increasingly large numbers of viewers, as indicated in Table IX-1:

 

287 See Chris Costanzo, Banks on Web Rush into Deals for Pricey Portal Real Estate, AM. BANKER,

Aug. 10, 1999, at 1 (discussing the threat posed by portals to banks); Carol Power, Internet Giant

AOL Digs Deeper Into Virtual Financial World, AM. BANKER, Aug. 11, 1999, at 1 (AOL finance

channel, with ten million monthly users, is the most popular site for financial news; AOL would

consider delivering financial services like banking if it would help its customers); Adriana

Senior, Yahoo Sees Itself as Partner, Not Rival, of Banks, AM. BANKER, Aug. 12, 1999, at 1;

Nick Wingfield, Portal Sites Reap the Rewards of Strategies of Getting ‘Sticky,’WALL ST. J.

INTERACTIVE EDITION., Dec. 7, 1998 (portals attract repeat users by offering features such as free

e-mails, home pages, personalization features, on-line calendars, and even incentive programs,

thereby creating “high switching costs” or disincentives to going to a competitor); Bob Tedeschi,

As Web Portals Push to Sell More Goods Themselves, On-Line Merchants That Pay for the Sites

for Access Have Grown Uneasy, N.Y. TIMES, Apr. 21, 1999, at 4 (Internet merchants fear that

portals will compete with them by selling goods directly to their users, will try to keep consumers

on the portal sites rather than sending them to the merchant’s site).

288 In a July 1998 survey, more than two million on-line investors (out of 18.1 million) cited AOL’s

Personal Finance area as the most frequently visited site for managing their finances, more than

five times as large as the next financial portal. AOL had 32.5% of market share. The two other

most visited financial portals were: (1) Quicken.com (13.5% of market share), and (2) Yahoo!

Finance/My Yahoo! (10.8% of market share). See Portals Are Key to Financial Services

<http://www.cyberdialogue.com/press/releases/portals.html>. Microsoft’s Money currently has

about 7.8 million users while Intuit’s Quicken has 12.2 million users. See Carol Power,

Microsoft, Quicken Update Personal Finance Software, AM. BANKER, Sept. 3, 1999, at 11.
99

Table IX-1: Portal Traffic Trends

Portal Traffic Trends

Traffic December ‘98 to July ‘99 Change

Portal December ‘98

Visitors

July ‘99 Visitors Percent Change

Yahoo 32,266,000 +5,423,000 +20.2%

AOL.com 30,226,000 +1,971,000 +7.0%

MSN.com 28,868,000 +8,161,000 +43.6%

Netscape.com 19,284,000 +1,736,000 +9.9%

Go.com 19,176,000 -677,000 -3.4%

Lycos 15,057,000 +1,905,000 +14.5%

Excite 14,569,000 +183,000 +1.3%

AltaVista 9,091,000 -2,126,000 -19.0%

Snap.com 8,782,000 +3,396.000 +63.1%

LookSmart 8,302,000 +4,399,000 +112.7%

Go2Net 3,390,000 +988,000 +41.1%

Total Web Users 62,895,000 +6,114,000 +10.8%

Reprinted with permission from The Industry Standard

Top portals’ growing clout in attracting viewers to their sites is evidenced by their

increasing share of Internet advertising revenue. In the first quarter of 1999, the top 10

portals collected 75 percent of all Internet advertising revenue, as opposed to 64 percent a

year earlier.289 In 1998, Ameritrade, DLJdirect, E*Trade, and Waterhouse Securities

each signed $25 million advertising contracts with AOL.290 Citibank followed with a $30

million multiyear agreement with Netscape’s NetCenter.291 In the first of a series of deals

with finance portals, Merrill Lynch paid an undisclosed amount to be the “premier

financial provider” on Microsoft’s MoneyCentral site.292 While portals attract a steady

 

289 Heather Green and Linda Himelstein, To the Victors Belong The Ads, BUS. WK., Oct. 4, 1999, at

39.

290 See J. William Gurley, The Soaring Cost of E-Commerce, FORTUNE, Aug. 3, 1998, at 226; Chris

Costanzo, supra note 287 (the four broker-dealers would have to sign up 100,000 customers

through AOL at an average cost of $250 per investor to recoup their investment in the

partnership agreement with AOL).

291 Netscape and Citibank Announce Major Worldwide Agreement to Launch Personal Finance

Channel on Netscape Netcenter, PR NEWSWIRE, Aug. 11, 1998. Internet Giant AOL Digs

Deeper Into Virtual Financial World, AM. BANKER, Aug. 11, 1999, at 1 (agreement requires

Citigroup to pay as long as Netscape’s NetCenter channel meets certain goals, such as customer

account sign up); New Portal Strategy Formed with Netscape/Citibank Deal, NEWSBYTES, Aug.

11, 1998 (pay for performance strategy gives Netscape an incentive to help Citibank acquire

customers).

292 Margaret McKegney, Merrill to Pursue Portal-Based Marketing Strategy, FIN. NETNEWS, Jan. 1,

1999, at 1.
100

stream of users, the fees charged by portals may result in high account acquisition costs

for the broker-dealers and do not necessarily result in loyal visitors to the portals. As a

result, a number of broker-dealers have decided not to renew their contracts with

portals.293

Chart IX-1

Percent of Surfers Bypassing Portals for E-Commerce Sites

71.9%

41.3%

53.2%

58.5%

45.7%

60.9%

81.3%

35.5%

46.8%

47.6%

29.0%

34.8%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

Online Banking

Online Shopping

Financial Information

2-Plus Years Online Under 1 Year Online

Reprinted with permission from The Industry Standard

In addition to attracting “eyeballs,” portals try to create “stickiness” by

aggregating content to create customer loyalty.294 From a user’s perspective, little

substantively distinguishes the content of a portal from that of a broker-dealer. For

example, in addition to providing links to broker-dealers, portals may post stories on

investing prepared by broker-dealers; lists of stocks that portfolio managers are currently

buying; news on industry sectors and trends; and on-line discussion forums dedicated to

certain stock or industries. In addition, these sites often provide model portfolios (with

specific stock recommendations) plus fund and company research (including earnings

estimates, price and news alerts, charts, and research reports). Portals also may allow

users to discuss investments with each other in on-line discussion forums.295 Some portals

even allow investors to download portfolios from different brokerage accounts into a

consolidated on-line portfolio manager that remains on the portal rather than with the

 

293 See Power, supra note 284; see also, Heather Green and Linda Himelstein, Portals Are Mortal

After All, BUS. WK., June 21, 1999, at 144 (website merchants are rethinking their contracts with

portals as deals get pricier).

294 Nick Wingfield, supra note 287.

295 See On-Line Discussion Forums section, supra at pages 1-1.
101

ultimate financial services provider.296 An investor cannot, however, execute a securities

transaction through a portal unless the portal is registered as a broker-dealer.

B. Current Regulatory Requirements

Portals are not currently registered with the Commission as broker-dealers under

Section 15(a) of the Exchange Act. They operate pursuant to certain conditions that do

not trigger registration. 297 The Exchange Act broadly defines a “broker” to include any

person, other than a bank, engaged in the business of effecting transactions in securities

for the account of others.298 Although the Exchange Act does not explain what it means

to “effect transactions in securities,” courts and commentators have interpreted the term

broadly to mean participating in meaningful ways at key points in securities transactions.299

Making such a determination requires an analysis of the role the entity plays at each stage

of securities transactions.

In determining whether an entity is a broker, courts and commentators also have

considered whether an entity maintains custody of customer funds and securities and

whether it receives transaction-based compensation for its participation in securities

transactions.300

In addition, an entity that is compensated in a way that gives that entity a

salesperson’s stake in the transaction is generally considered to be acting as a brokerdealer. A person has a salesperson’s stake if he receives any number of fees, including a

referral fee or a fee based on the number of shares or dollar value of an executed order.301

A referral fee paid to a portal based on the number of new customer accounts that the

 

296 See Microsoft MoneyCentral <http://moneycentral.msn.com>; Yahoo! Finance

<http://finance.yahoo.com>; Quicken.com <http://quicken.com> (visited Oct. 1, 1999).

Microsoft’s MoneyCentral also features an Advisor Finder Service which matches investors with

prescreened investment advisors. See also Matthew Schifrin, Getting Started, FORBES, Sept. 13,

1999, at 32 (list of top financial portals).

297 15 U.S.C. § 78o (1999).

298 Section 3(a)(4) provides that, “the term ‘broker’ means any person engaged in the business of

effecting transactions in securities for the account of others, but does not include a bank. 15

U.S.C. § 78c (1999). Section 3(a)(5) provides that, “the term ‘dealer’ means any person engaged

in the business of buying and selling securities for his own account, through a broker or

otherwise, but does not include a bank, or any person insofar as he buys or sells securities for his

own account, either individually or in some fiduciary capacity, but not as a part of a regular

business.” 15 U.S.C 78c. The terms are oftentimes combined as “broker-dealer.”

299 Massachusetts Financial Services Inc. vs. SIPC, 411 F. Supp. 411, 415 (D. Mass.), aff’d, 545

F.2d 754 (1st Cir. 1976), cert. denied, 431 U.S. 904 (1977).

300 Id.

301 Id.
102

broker-dealer opens as a result of the placement of the broker-dealer’s hyperlink on a

portal could cause the portal to be a broker-dealer.

Portals that link to electronic commerce sites (other than on-line brokerages) often

enter into revenue sharing arrangements. Typically, the on-line merchant pays the portal a

fee for every completed transaction generated by the portal’s site. If a portal entered into

a similar revenue-sharing arrangement with a broker-dealer, it would be deemed to be

receiving transaction-based compensation and would have to register as a broker-dealer.

In 1996, Commission staff granted no-action relief from registration to AOL,

Compuserve, and the Microsoft website. The no-action letter permitted these companies

to connect their subscribers to Charles Schwab & Co., Inc. and receive order-based

compensation.302 The 1996 Schwab no-action letter set the standard for the types of

arrangements permissible between broker-dealers and ISPs, subject to certain conditions:

• The ISPs would receive a nominal flat fee per order transmitted. The fee would

not vary depending on the number of shares or value of the underlying securities

under a customer order transmitted to Schwab by the ISPs. The fee would not

vary depending on whether the order resulted in an executed trade.

• Schwab would be responsible for all advertising and sales material relating to its

financial services. The ISPs would provide these materials only with appropriate

disclosure.

• The ISPs would not recommend or endorse specific securities.

• None of the ISPs would participate in the financial services offered by Schwab

(other than by routing messages), including opening, maintaining, or closing

accounts, or handling customer funds or securities.303

Although not explicitly stated, it appears that the no-action relief was premised on

the theory that the ISP operated similarly to a phone line and a newspaper, simply carrying

the message between the broker-dealer and the investor.

 

302 Charles Schwab & Co., Inc., SEC No-Action Letter (Nov. 27, 1996).

303 Id.; see also, Charles Schwab & Co., Inc., SEC No-Action Letter (Sept. 18, 1997) (no-action

relief granted to two research services to receive compensation based on the greater of a base

monthly fee or a variable fee calculated by multiplying the number of active customer households

by a nominal fixed dollar amount); StockPower, Inc., SEC No-Action Letter (Mar. 26, 1998) (noaction relief granted to software developer to charge a licensing fee to investors and transfer

agents for program that would allow users to connect to transfer agents managing dividend

reinvestment and stock purchase plans); Evare L.L.C., SEC No-Action Letter (July 29, 1998)

(no-action relief granted to a provider of an on-line communication system linking market

professionals to obtain quotes, enter orders, and communicate with custodians for a flat annual

fee plus a usage fee per interaction with the system, regardless of whether a trade occurs).
103

C. Roundtable Participants’ Views

1. Portals’ Business Model

Roundtable participants representing a financial portal described their portal as a

publisher of third party financial information. Their portal also hyperlinks to other sites that

provide objective information. Their business model is an advertising business model, but they

separate advertising from editorial control. They currently do not segment viewers into

different classes, although they may try to do so in the future. In their view, customers trust

some portals because they do not sell securities and because they are well-known for related

financial management software. They noted that portals have broad market appeal because

they provide information on a wide spectrum of financial products, such as banking, credit card

monitors, mortgages, insurance, and retirement planners.

In response to a question from a broker-dealer participant, this portal representative

stated that she does not believe that Open Financial Exchange (OFX) technology has changed

the portal business model, although it has made it more attractive from a consumer’s point of

view. 304 Customers can download information from their various accounts instead of manually

inputting their account data monthly. OFX technology allows users to exchange transaction

information among different websites. For example, a user with multiple brokerage or bank

accounts could maintain a consolidated portfolio of personal account data with an Internet

portal. A broker-dealer participants expressed concern that OFX technology will affect their

relationship with investors because users will manage their finances on portals rather than on

websites run by on-line broker-dealers or banks.

Although financial institutions may view portals as competitors, this portal’s

representatives stated that they do not see themselves as competing with financial institutions.

The portal does not open accounts, allow customers to trade, or have a broker-dealer

subsidiary. The operator of the portal registered one subsidiary as a financial advisor solely

because the subsidiary provided asset allocation models for users.

One securities analyst had a different opinion. He described portals as a threat to

the broker-customer relationship. This analyst believes that portals may set up on-line

broker-dealers as affiliates in the future. According to him, this option might be more

attractive to second-tier portals that do not generate much revenue for hyperlinking

customers to different sites. He said that portals aggregate content on their own sites so

that, as on-line broker-dealers do the same, portals may lose market share. The analyst

noted that broker-dealers may partner with portals as an interim step, but in the long term

would most likely want more control over their relationships with their customers.

 

304 OFX technology is a unified specification for the electronic exchange of financial data between

financial institutions, businesses, and consumers on-line. See Open Financial Exchange

<http://www.ofx.net> (visited Nov. 14, 1999).
104

2. Portals’ Compensation Arrangements

The roundtable discussions focused on how broker-dealers currently compensate

portals for driving traffic to their sites and how broker-dealers would prefer to compensate

them. Currently, broker-dealers can compensate portals by paying a flat up-front fee or a

nominal fee per order transmitted through the portal. Broker-dealer participants indicated

that they wanted to compensate portals based on results for accounts actually opened.

They argued that broker-dealers tend to pay up front fees to be featured on a portal. This

means that firms compensate portals inefficiently because the Internet makes feasible payfor-performance compensation arrangements.305 Broker-dealer participants also argued

that technology is undermining the Commission’s position that portals only can be paid

based on orders transmitted (not based on account openings or orders executed), without

having to register as a broker-dealer.306

One broker-dealer participant argued that the Commission should extend to portals

the same regulatory relief that allows affinity groups to receive transaction-based

compensation.307 Finally, broker-dealer participants argued that paying on the basis of

account openings does not meet the broker-dealer activity test of effecting securities

transactions for the accounts of others. One broker-dealer participant contradicted this

argument by noting that visitors can view most of its site without opening an account,

consequently disabusing the notion that a viewer would not open and fund an account just

to access an incremental amount of information.

 

305 Broker-dealers believe that they can pay based on the portals’ performance today by multiplying

the number of orders transmitted by the probability that an order will be executed.

306 See e.g., Advertising that Clicks, THE ECONOMIST, Oct. 9, 1999, at 71 (Internet may instantly

reveal whether advertising is working); Randall Rothenberg, An Advertising Power, but Just

What Does Doubleclick Do? N.Y. TIMES, Sept. 22, 1999, at 14 (discussing technology to track

success of Internet advertising); PATRALI CHATTERJEE, MODELING THE CLICKSTREAM:

IMPLICATIONS FOR WEB-BASED ADVERTISING EFFORTS (May 1998)

<http://ecommerce.vanderbilt.edu/papers/pdf/ clickstream/pdf>.

307 Commission staff has granted no-action relief from broker-dealer registration to affinity groups

that enter into compensation arrangements with broker-dealers. No-action relief in those

instances is conditioned on the fact that these non-profit affinity groups do not perform financial

services. The line of affinity group “no-action” letters are not analogous situations to the brokerdealer-portal arrangements. Broker-dealers affiliate with portals to drive viewers to the brokerdealers’ sites so portals would be considered to be performing “financial services.” See, e.g.,

Atkisson, Cartney & Akers, SEC No-Action Letter (June 23, 1998).
105

D. Conclusions and Recommendations

1. Conclusions

The growing relationship between portals and broker-dealers is beginning to create

pressure for the Commission to relax its historical prohibition against receipt of

transaction-based compensation by non-broker-dealers. Commercial websites that are not

related to the securities business are generally shifting from basing their payment for

advertising on cost per thousand impressions (“CPM”) to actual transactions

consummated.308 This trend can be attributed to the fact that web users generally ignore

banner ads, clicking on fewer than one out of every 100 that they see.309

A recent report issued by Forrester Research found that on-line merchants

currently pay for about 15 percent of advertising based on performance. That number is

expected to rise to over 50 percent by 2003.310 According to the report, the quid pro quo

may be that content providers demand higher levels of revenue sharing from on-line

merchants for on-line purchases.311 A number of on-line merchants already pay a

percentage of the sale to websites from which visitors hyperlink.312 A new advertising

 

308 Tedeschi, As Web Portals Push to Sell More Goods Themselves, supra note 287 (“Revenue

sharing, wherein merchants pay portals for a small fee for each transaction generated, is an

increasingly common arrangement between portals and their partners, analysts say.”); J.

William Gurley, Above The Crowd, FORTUNE, May 11, 1998, at 170 (discusses reasons

performance-based advertising will succeed on the Internet).

309 Richard A. Shaffer, Listen Up! Pay Attention! New Web Startups want Ads That Grab You,

FORTUNE, Oct. 25, 1999, at 348 (notes that banner ads are adapting themselves to attract more

viewers).

310 See Yochi Dreazen, On-line Ad Spending is Expected to Surge, WALL ST. J. EUROPE, Aug. 13,

1999, at 4.

311 Id.

312 “Affiliates place your graphics and code somewhere on their Web site. When visitors click that

link and buy a product (or, in some cases, complete a questionnaire), the affiliate gets a

percentage of the sale, or, in the case of the questionnaire, a flat fee. Some software programs

track repeat customers and pay your affiliates accordingly.” Dennis Berman, A Point-and-Click

Sales Force. BUS. WK., June 28, 1999, at F14; Mylene Mangalindan, Web Sites Willing to Pay

for Referrals, THE SEATTLE TIMES, Sept. 10, 1999, at C3 (Amazon.com has more than 320,000

affiliates which earn from five to fifteen percent of a sale); E*Trade/Amazon.com -2: Accessible

Through E*Trade Site, DOW JONES NEWS SERVICE, Oct. 14, 1999 (E*Trade and Amazon.com

agree to create a co-branded bookstore on E*Trade’s website); Gary B. Smith, Monday Musings:

When We All Agree on Dell, It’s Time to Start Worrying, THESTREET.COM, Sept. 20, 1999,

(LEXIS, News Library, 90 Day File) (TheStreet.com has a revenue sharing arrangement with

Amazon.com).
106

model has also emerged in which merchants pay a combination of CPM and pay-forperformance.313

Broker-dealers want to compensate portals based on the success of their

advertising, which appears to be the trend in compensation arrangements between portals

and non-broker-dealers. As one commercial bank executive noted, this approach gives

portals an incentive to help its partner acquire customers.314 It is precisely this salesman’s

stake, however, that is a significant factor in determining what triggers broker-dealer

registration.

2. Recommendation

• The Commission should consider the types of permissible compensation arrangements

between broker-dealers and unregistered entities given that technology will let on-line

merchants measure the success of Internet advertising models with a high degree of

specificity.

APPENDIX 1

Table of On-Line Broker-Dealers*

On-Line Broker-Dealer Home Page URL

1st Discount Brokerage, Inc. www.1st-discount.com

Mutual Securities, Inc. (Cowles Sabol) www.mutualsec.com

A.B. Watley, Inc. www.abwatley.com

Accutrade, Inc. www.accutrade.com

Advisors Group, Inc. (The) www.advisorsgroup.com

Alex Moore & Company, Inc. www.livetrade.com

Amber Securities Corporation www.swiftrade.com

America First Associates www.aftrader.com

American Century Brokerage www.brokerage.americancentury.com

American Express Co. www.americanexpress.com/direct

Ameritrade, Inc. www.ameritrade.com,www.ebroker.com

AmeriVest, Inc. www.amerivestinc.com

Amerivet Securities Inc. www.amerivet.com

 

313 In that model, the web merchant pays a lower CPM rate but gives the publisher seven to eight

percent of any sales directly attributable to the banner advertising. Greg Farrell, Ad Rates on

Web May be Pay-per-view Performance-based Ad Prices Change Advertising Game, USA

TODAY, Sept. 1, 1999, at 1B.

314 Bob Woods, New Portal Strategy Formed With Netscape/Citibank Deal, NEWSBYTES, Aug. 11,

1998 (LEXIS, News Library, Curnws File) .
107

AmSouth Investment Services, Inc. www.amsouth.com

Andrew Peck Associates Inc. www.andrewpeck.com

Arvest Investments www.netvest.com/arv

Atlantic Financial of Mass. www.af.com

Bank One Securities Corporation www.oneinvest.com/home.html

BB&T Investment Services, Inc. www.bbandt.com

Benjamin & Jerold Brokerage, Inc. www.stockoptions.com

Benson York Group, Inc. www.mostactives.com, www.buystocks.com

Bidwell & Company www.bidwell.com

Brook Street www.brookst.com

Brown & Company Securities Corporation www.brownco.com

Bull & Bear Securities, Inc. www.ebullbear.com

Burke, Christensen and Lewis Securities, Inc. www.bclnet.com/fincenter.htm

Bush Burns Securities, Inc. www.bushburns.com

Capital West Investment Group, Inc. www.cwigroup.com/trading.htm

Charles Schwab & Co., Inc. www.eschwab.com; www.schwab.com

Chase Manhattan Corp. www.chase.com

CIGNA Financial Services, Inc. www.cigna.com/cfs/broker/index.html; www. bhcihc.com/cig

Citicorp Investment Services www.citibank.com/us/investments/ home.htm

Comerica Securities www.comerica.com/invest/dbol.html

Compass Bank www.compassweb.com

Crestar Securities Corporation www.crestar.com/crestatinvest

CyBerBroker, Inc. www.cybercorp.com

Datek Securities Corp. www.datek.com

Dain Rauscher (announced - not live) www.dainrauscher.com

Delta Equity Services Corporation www.deltaequity.com

Dime Securities, Inc. www.dimesec.com

DLJdirect, Inc. www.dljdirect.com

Downstate Discount Brokerage, Inc. www.trade4less.com

Dreyfus Brokerage Services, Inc. www.edreyfus.com

Dreyfus Investment Services Corp. www.disc.mellon.com

E*Trade Securities www.etrade.com

Emmet A. Larkin Company, Inc. www.internettrading.com

Empire Financial Group, Inc. www.lowfees.com

FarSight Financial Services, L.P. www.nfsn.com

Fidelity Brokerage Services, Inc. www.fidelity.com

Fifth Third Securities, Inc. www.53.com/advisors/brokerage; www.bhcihc.com

First Capital Brokerage Services, Inc. www.firstcapitalbrokerage.com

First Flushing Securities, Inc. www.firstflushing.com; www.firstrade.com

First Georgetown Securities, Inc. www.firstgeorgetown.com

First Security Investor Services www.bhcihc.com/fir

First Tennessee Brokerage, Inc. www.firsttennessee.com/

Freedom Investments, Inc. (Trade Flash) www.freedominvestments.com

Freeman Welwood & Co., Inc. www.freemanwelwood.com

G H Securities, Inc. www.ghsecurities.com.ky

G.W. & Wade Asset Management Company www.gwwade.com

Grace (R. K.) & Co. (Cardinal Capital) (in development) www.cardinalcapital.net

Heim & Young Securities, Inc. www.heimandyoung.com

Herzog, Heine, Geduld, Inc. www.maxule.com/htdocs/trade1.html

Howe Barnes Investments, Inc. www.netinvestor.com

Huntington Investment Company (The) www.huntington.com

Instinet (announced - not live) www.instinet.com

Investex Securities Group, Inc. www.investexpress.com
108

Investin.com Securities Corp. www.investin.com

Investrade Discount Securities www.netvest.com/rg2

J B Oxford & Company www.jboxford.com

Jack White & Company www.jackwhiteco.com

Keystone Brokerage, Inc. www.keyfin.com/kfb

Lintz, Glover, White & Co., Inc. www.lintztrade.com

Lynx Capital Corporation www.lynxcapital.com/trading.htm

M. One Securities, Inc. www.mone.com

Madison Securities, Inc. www.madisonsecurities.com

Marsco Investment Corporation www.marscoinvestments.com

Mercantile Investment Services, Inc. www.mercantile.com

Merrill Lynch www.merrilllynch.com, www.ml.com

McDonald & Company (annonced - not live) www.laurelkay.com

Morgan Stanley Dean Witter Online www.online.msdw.com

Mr. Stock, Inc. www.mrstock.com

Muriel Siebert & Co., Inc. www.msiebert.com

MyDiscountBroker.com/Southwest Securities www.mydiscountbroker.com

MyTrack www.mtrack.com

National Discount Brokers www.ndb.com

Nations Financial Group, Inc. www.ffutures.com

NationsBanc www.nationsbank.com/investments

NBC Captial Markets Group, Inc. www.nbcbank.com

New Times Securities Services, Inc. (in development) www.newtimessecurities.com

New York Life Securities, Inc. www.bhcihc.com/nyl

Newport Discount Brokerage, Inc. www.newport-discount.com

Norwest Investment Services, Inc. www.edart.com/nisi

Old Kent Brokerage Services www.bhcihc.com/oka

Online Trading Inc. www.onlinetradinginc.com

People's Securities Inc. www.peoples.com/invest/onlinetr.htm

Peregrine Financials & Securities, Inc. www.peregrinefinancial.com

Peremel & Co. www.peremel.com

Preferred Capital Markets, Inc. www.deltatrader.com; www.tradeoptions.com

ProTrade Securities www.protrade.com

Pyramid Financial Corporation www.wyse-sec.com

Quick & Reilly, Inc. www.quick-reilly.com

R.M. Stark & Co., Inc. www.rmstark.com

Recom Securities, Inc. www.trutrade.com

Regal Discount Securities www.eregal.com; www.investrade.com

Robert Van Securities, Inc. www.robertvan.com; www.robvanonline.com

Sagamore Trading Group, Inc. www.time2trade.com

Salomon Smith Barney (Citicorp) www.salomonsmithbarney.com

Scottsdale Securities, Inc. www.scottrade.com

Scout Brokerage Services, Inc. www.scoutbrokerage.com

Scudder Brokerage Services www.scudder.com

Seaport Securities Corp. www.sea-port.com

Searle & Co. www.esearle.com; www.searlco.com

Securities Research, Inc. www.securitiesresearch.com; esecuritiesresearch.com

Sloan Securities Corp. www.sloansecurities.com

Southtrust Securities, Inc. www.bhcihc.com/sou

State Discount Brokers www.state-online.com

State Street Brokerage Services, Inc. www.ssga.com

Stocks4Less www.stocks4less.com

Summit Financial Services Group, Inc. www.summitbank.com
109

Sun Trust www.suntrust.com

Sunlogic Securities, Inc. www.sunlogic.com

Suretrade, Inc. (Owned by Fleet Financial) www.suretrade.com

T. Rowe Price Investment Services, Inc. www.troweprice.com/brokerage/index.html

TF Partners (offered via Vanguard Capital) www.taxfreebond.com

The Advisors Group, Inc. (TAG) www.advisorsgroup.com

The R.J. Forbes Group, Inc. www.forbesnet.com

Thomas F. White & Co., Inc. www.computel.com; www.prodiscount.com

TradeCast www.tradecast.com

Tradescape.com www.tradescape.com

Tradestar Investments, Inc. www.tradestar-trade.com;www.bhcihc.com/tsr

Trade-Well Discount Investing, LLC www.trade-well.com

U.S. Clearing Corporation www.mainstmarket.com; www.bsdmtweb.com

U.S. Discount Brokerage, Inc. www.usdb.com

U.S. Rica Financial, Inc. www.usrica.com

U.S. Securities & Futures Corp., Chicago www.ussecurities.com

UBOC Investment Services, Inc. www.investathome.com/UBOCPages

Unified Management Corporation www.umctrade.com; www.umcstock.com

UNISE Investment Corp. www.unise.com

UVEST Investment Services www.netbank.com/investments.htm

Vanguard Brokerage Services, Inc. www.vanguard.com/vbs/online/

Vision Securities, Inc. www.visiontrade.com

Wachovia Investments, Inc. www.wachovia.com

Wall Street Access www.wsaccess.com

Wall Street Discount Corporation www.wsdc.com

Wall Street Equities, Inc. www.wsei.com

WallStreet Electronica Online Trading, Inc. www.wallstreete.com

Wang Investments Associates, Inc. www.wangvest.com

Waterhouse Securities, Inc. www.waterhouse.com

Web Street Securities www.webstreetsecurities.com

Wells Fargo Securities, Inc. www.wellsfargo.com/wellstrade

Westminster Securities Corporation www.livebroker.com

Wilshire Capital Management, LLC www.wilshirecm.com

Wit Capital Corporation www.witcapital.com

York Securities, Inc. www.yorktrade.com; www.tradingdirect.com

Your Discount Broker www.ydb.com

Ziegler Thrift Trading, Inc. www.ziegler-thrift.com

Zions Investment Securities, Inc. www.zionsdirect.com

*The Commission staff compiled this chart from a variety of sources.

 This chart may not represent every on-line firm. In addition, some of the information may have changed since its compilation.
110

APPENDIX 2

Policies of Ten On-Line Broker-Dealers for Delivering Market

Data Via the Internet to Retail Customers as of November 15, 1999*

On-Line Broker Website Visitors Account Holders Features Available to Active

Traders/High-Asset Accounts

Ameritrade delayed quotes only 100 real-time quotes when opening

an account; 100 additional quotes

upon each trade; unlimited real-time

quotes available for $20.00/month

same

Charles Schwab delayed quotes only 100 real-time quotes when opening

an account; 100 real-time quotes

upon each commissionable trade

Signature Service accounts with $100K

or more receive 200 real-time quotes

upon each trade (number of quotes

accumulates)

Datek Online delayed quotes;

streaming real-time

quotesa

unlimited real-time quotes;

streaming real-time quotes

same

DLJdirect delayed quotes only 100 real-time quotes upon opening

an account; 100 additional quotes

per on-line trade; 500 additional

quotes available for $9.95;

streaming real-time quotes available

for $24.95/month

Select Client accounts have access to

streaming real-time quotes

E*Trade delayed quotes onlybunlimited real-time quotes Power E*Trade customers executing 30

trades/quarter receive streaming realtime quotes; those executing 75

trades/quarter have access to Nasdaq

Level II quotes

Fidelity delayed quotes only unlimited real-time quotes same; Active Traders executing 36 trades

on a rolling 12 month basis have access

to Nasdaq Level II quotes; InstantBroker

wireless services users receive 100 realtime quotes/day in 30 securities

Morgan Stanley

Dean Witter

Onlinec

delayed quotes only unlimited real-time quotes same;

NDB delayed quotes only unlimited real-time quotes same

SureTrade delayed quotes only 100 real-time quotes/day same

TD Waterhouse delayed quotes only unlimited real-time quotes same

* Table based on materials available on-line, supplemented by a telephone survey.

a

 Datek Online visitors must register to receive access to streaming quotes.

b

 Non-account holding ‘registered users’ of E*Trade receive 100 real-time quotes/day.

c Formerly Discover Brokerage Direct
111

APPENDIX 3

Enforcement Actions Involving On-Line Discussion Forums

Other Commission cases involving postings in on-line discussion forums include:

COMPLETED CASES

Case Name Summary of Commission Charge Case No./Lit. Rel.

1 Scott A. Frye Frye posted misleading messages on an Internet news

group message board in an attempt to solicit investors

for two Costa Rican coconut companies.

LR-14702, 10/30/95

LR-14720, 11/15/95

LR-15139, 10/29/96

2 Global Info. Services

d/b/a Investment Hotlines

Respondents posted corporate profiles and press

releases on an Internet web site.

33-7605, 10/27/98

33-7632, 1/21/99

3 Green Oasis

Environmental et al.

Promoter inflated stock price by disseminating false

press releases on Internet. Conducted unregistered

partnership offering on company’s website.

LR-15864, 9/1/98

LR-15876, 9/9/98

4 David A. Wood, Jr. and

ICS Communications,

Inc.

Wood sent spam and posted messages on an Internet

bulletin board touting one issuer.

33-7601, 10/27/98

5 Intl. Heritage, Inc. Defendants used an Internet website and postings to

discussion forums to recruit approximately 155,000

members to a pyramid offering scheme.

LR-15672, 3/17/98

LR-16330, 10/7/99

6 Eugene B. Martineau Defendant posted messages on an Internet bulletin

board that touted one issuer in exchange for stock

options.

33-7599, 10/27/98

7 Pleasure Time d/b/a

Telephone Information

Defendants raised over $3 million by using telephone

calls, faxes, and Internet postings to recruit investors

to participate in an international telephone lottery

with projected receipts of $300 million.

LR-14440, 3/15/95

LR-15178, 12/6/96

8 Donald B. Spencer and

IVT Systems, Inc.

Offering fraud in which respondents used Internet

bulletin board postings, newspaper ads and live

presentations to promise 50% and greater returns

from building an ethanol plant in the Dominican

Republic.

LR-14856, 3/29/96

LR-15042, 9/12/96

9 Wye Resources, Inc. and

Rehan Malik

Defendants used Internet bulletin board postings and

ads in U.S. publications to solicit investors in an

unregistered offering. The messages and ads

misrepresented Wye’s ownership interests in Zairian

diamond mines.

LR-15073, 9/26/96
112

CASES IN LITIGATION

Case Name Summary of Commission Charge Litigation Rel. No.

1 Remington Hall Capital

Corp. and Douglas T.

Fonteno

Fonteno, a convicted felon, raised at least $1 million

in a fraudulent offering of his company stock by

promoting the sale of Remington Hall’s stock

through spams, bulletin board postings, and

informational releases.

LR-15943, 10/22/98

2 Wayne Gorsek et al Defendants touted 20 issuers through radio talk

shows, cold calls, conference calls, and the Internet,

where they posted newsletters, bulletin board

messages, and research reports.

LR-16018, 1/7/99

3 Interactive Products and

Services and Matthew P.

Bowin

Defendants used Internet to conduct a fraudulent

IPO.

LR-15700, 4/8/98

4 Intl. Automated Systems Defendants issued false press releases that it had

developed a new technology that would revolutionize

electronic communications, which generated activity

on Internet bulletin boards. During the period, the

stock price rose from $3.50 a share to $40 a share.

LR-15898, 9/24/98

5 Liberty Capital Group,

Inc. and Jason A. Greig

Greig published a newsletter, sent e-mails, and

posted messages to Internet bulletin boards.

Operated Internet web site that touted 9 issuers.

LR-15953, 10/27/98

6 Omnigene Diagnostics,

Inc.,* Dominic Scacci*

and Jerome Wenger

Defendants used the mail to disseminate false and

misleading information concerning Omigene’s

financial condition, patents, and number of

outstanding shares. The information was then

repeated on an Internet bulletin board.

LR-15899, 9/24/98

7 Arete Industries, Inc. False press releases regarding an impending

acquisition, sales projections, and relations with

retail sales outlets.

LR-16235, 8/2/99

* Parties who are no longer litigating and have settled proceeding.
113

APPENDIX 4

Privacy Survey Findings as of November 15, 1999

Privacy Notices:

We analyzed whether firms posted privacy disclosures. Privacy disclosures include privacy policies or

information practice statements.

• Eight of ten firms post a privacy policy.

• All ten firms post an information practice statement.

Location of Disclosures:

• Four of ten firms provide a link to their privacy disclosure from the bottom of their home page.

• No firm provides a link to its privacy disclosure form from the top of its home page.

• Three of ten firms provide a link to their privacy disclosure from a page on the account opening

statement.

• One firm links from both the home page and the account opening statement.

• Six firms link from either the home page or the account opening statement.

• Four firms do not link from either the home page or the account opening statement.

Content of Disclosures:

Notice:

• Six of ten firms say something about what information is collected from investors.

• Seven of ten firms say something about how information collected from investors will be used.

• Five of ten firms say something about the use or non-use of cookies.315

• Eight of ten firms address at least one of the statements above regarding notice.

• Four of ten firms address all three statements above regarding notice.

Choice -- Secondary use:

• Six of ten firms state that they may use information collected about investors to contact them for

marketing or for other purposes.

• Six of ten firms state that the information collected about investors may be disclosed to third parties,

other than as required by law.

• Three of ten firms provide information about the types or names of third parties to whom information

collected about investors will be disclosed, other than as required by law.

• Five of ten firms provide information regarding the limitations on, or the circumstances under which,

information about investors will be disclosed to third parties.

• Eight of ten firms address at least one statement concerning secondary use.

• Two of ten firms address all four statements.

Choice -- Opt Out:

• Two of ten firms inform investors about any opportunity to exercise choice regarding whether they

want to be contacted by the firm for marketing or for other purposes.

• No firm allows the investor to exercise this choice on-line.

 

315 We did not verify whether or not the firm used cookies.
114

• Three of ten firms state that investors may exercise choice about whether collected information will

be shared with third parties, other than as required as law.

• One firm explicitly allows the investor to exercise this choice on-line.

• Eight of ten firms address one of the elements of either secondary use or opt out.

• None of the firms address all of the elements of secondary use and opt out.

Access:

• Six of ten firms state that investors may ask questions regarding information collected about them.

• Two of ten firms state that investors may review information collected about them.

• Three of ten firms state how investors may proceed to correct any errors in the information collected

about them.

• Seven of ten firms provide one of the access statements mentioned above.

• Two of ten firms provide all three access statements mentioned above.

Security:

• Nine of ten firms state something about steps taken to provide security for information during on-line

transmissions between the investor and the firm.

• Eight of ten firms state something about steps taken to provide security for information while it is

stored with the firm.

• Nine of ten firms provide one security statement mentioned above.

• Eight of ten firms provide both security statements mentioned above.

Contact Information:

• Two of ten firms address how to submit a question about privacy.

• One of ten firms addresses how to complain about privacy.

• Two of ten firms address one statement mentioned above.

• One firm addresses both statements mentioned above.
115

APPENDIX 5

On-line Trading Complaints Received by the Commission

Leading Complaint Categories

January 1, 1999 through September 30, 1999

Complaint Type Code Number of Complaints

1. Difficulty accessing account D37 504

2. Failures/delays in processing orders D08 393

3. Errors in processing orders D09 247

4. “Best Execution” problems C03 155

5. Errors/omissions in account records/documents D15 / E06 116

6. Transfer of account problems D21 / E04 116

7. Margin position sellouts D25 105

8. Problems with IPO allocations C17* 103

9. Problems with executing cancellation orders D42* 94

10. Problems with opening an account D38* 89

11. Inaccurate quotes/pricing information D40 62

12. Problems with depositing/withdrawing funds D43* 57

13. Use of false/misleading advertising material C01 47

14. Inadequate disclosure/understanding of margin D23 40

15. Failure to honor limit order D36 38

*ACTs complaint codes D42 and D43 were established in March 1999. Complaint Codes D38 and C17 were added in the Fall of 1998.