HD56 - Statutory and Regulatory Requirements Concerning Broker-Dealers Who Provide Discount Brokerage Services

  • Published: 2001
  • Author: State Corporation Commission, Division of Securities and Retail Franchising
  • Enabling Authority: Letter Request from House Committee on Rules

Executive Summary:
By letter dated March 10, 2000, Speaker of the House of Delegates, S. Vance Wilkins, Jr., asked the Virginia State Corporation Commission ("Commission") to conduct an in depth study of on-line and off-line discount brokerage firms to determine the feasibility and necessity of requiring disclosure and suitability interviews for high-risk securities accounts. Accordingly, the Commission agreed to conduct the study by providing staff and conducting the study by utilizing the Commission's numerous information resources.

Pursuant to a request from the Speaker of the House of Delegates, the Commission prepared this report to include discussion of:

(1) federal, Self Regulatory Organization ("SRO"), and state suitability requirements;

(2) recent developments in the brokerage industry and market place;

(3) recent regulatory agency actions;

(4) Virginia's current suitability requirements;

(5) a survey of a small sample of Virginia investors and an extensive survey of recent customer complaints against discount brokerage firms to examine customer concerns, interests; and

(6) the study's findings and recommendations for addressing the issue of on-line and offline discount brokerage suitability and disclosure requirements.

As a part of the continuing development of the highly successful off-line or "brick and mortar" discount brokerage industry, the on-line brokerage industry has enjoyed tremendous growth since 1998. For the most part there are three distinct types of firms that provide on-line brokerage services. The first type of firm is the "hybrid firm." Hybrid on-line brokerage firms are full-service brokerage firms that also offer their customer's investment advice along with the ability to place trades on-line.

The second type of firm is the on-line discount brokerage firm. Much like traditional "brick and mortar" discount brokerage firms, on-line discount brokerage firms are firms that offer their customers order placement services. Unlike hybrid firms or full-service brokerage firms, on-line and off-line discount brokerage firms provide their customers the ability to place trades to market without offering any investment advice. In general, trades placed with on-line and off-line discount brokerage firms are unsolicited trades placed at the sole discretion of the customer. Thus, the commission fees customers pay to on-line or off-line discount brokerage firms are usually less than the fees paid by customers of hybrid firms or full-service brokerage firms.

The third and final type of on-line brokerage firm is the day trading firm. Day trading firms offer their customers access to both software and information technology systems that allow the customer to view market-makers' bid and ask prices for stocks. Day trading firms' information technologies also provide customers with direct access to financial markets. Therefore, the trades placed with a day trading firm are immediately executed once the customer enters the trade on the day trading firm's system. Day trading firms are a separate class of on-line brokerage service provider that is not related to either on-line discount brokerage firms or hybrid firms. Promotion of numerous intraday trades and momentum trading characterizes the practices of day trading firms.

During the course of the study the Commission made three significant findings that form the impetus for the Commission's recommendations. The findings are as follows:

(1) Virginia's current statutory requirements generally provide sufficient enforcement authority for the Commission to prevent and prosecute violations of widely accepted suitability rules.

(2) There is still a need for extensive disclosure and educational programs for on-line investors.

(3) There does not seem to be an overwhelming epidemic of problems with on-line brokerage accounts in the state of Virginia.

Virginia's current statutory requirements provide sufficient enforcement authority for the Commission to prevent and prosecute violations of widely accepted suitability rules.

The Virginia Securities Act ("Act"), under section 13.1-523, grants the Commission the authority to adopt such disclosure and suitability rules as are necessary to carry out the provisions under the Act. Any rules changes contemplated by this report can be accomplished through the Commission's rule making authority.

Presently, Virginia follows the majority of jurisdictions that have suitability rules. Virginia's suitability rules are substantially similar to the suitability language used by the North American Securities Administrators Association ("NASAA"). (*1) 21 V.A.C. 5-20-280 A2 to 3 provides the Commission with the authority to investigate suitability complaints brought by investors. Furthermore, 21 V.A.C. 5-20-280 A2 to 3 in conjunction with 21 V.A.C. 5-20-270 A2 creates an affirmative duty for broker-dealers (*2) to solicit financial suitability information from investors. Therefore, broker-dealers must learn of the financial capacity of an investor and must also use that information when considering the suitability or appropriateness of a securities recommendation, whether the broker-dealer operates on-line or off-line.

The current suitability scheme also affords investors the freedom to invest quickly and efficiently taking advantage of the efficiencies and savings delivered by discount brokerage services that only offer order execution services. Therefore, the Commission's current suitability rules allow self-directed investors to trade without the burden of having their trade placement and execution slowed by a manual suitability analysis. However, the suitability rule automatically becomes applicable in situations where self-directed investors receive some sort of recommendation or solicitation from their discount broker-dealer or broker-dealer agent. The need for further government intervention in the realm of self-directed trading is not pressing because investor problems in this area are not widespread throughout self-directed investors. In fact, the discovery that less than one percent of self-directed on-line trading account holders make complaints regarding problems shows that a large majority of self-directed investors do not need regulatory assistance to protect their financial interests. The enactment of more regulations requiring across the board suitability may significantly reduce the efficiencies of the order execution process to the detriment of competent self-directed investors who are more concerned with speed and efficiency than some form of government or institutional oversight.

On the other hand, there appears to be a need for the Commission to pursue adoption of rules addressing suitability, disclosure, and margin requirements regarding day traders. Possible rules are discussed in detail in this report.

There is still a need for extensive disclosure and education programs for on-line investors.

Most on-line broker-dealers provide the on-line investor with a wealth of market information. However, consumers do not receive a wealth of information that discloses all of the risks involved with on-line investing. Furthermore, if an on-line brokerage firm provides disclosure of the risks involved with on-line investing, then the information may not always be easily accessible nor conspicuously noticeable amid all the other information offered by the on-line firm. The level of complaints, as well as input from customers surveyed, indicates that novice investors feel that they want and need clearer investor education information and website operations disclosure.

There does not seem to be an overwhelming epidemic of problems with online brokerage accounts in the Commonwealth of Virginia. Although the study documented over four hundred complaints of Virginians with on-line brokerage accounts during the first four months of the year 2000, the number of account holders that made complaints represent less that one percent of the total number of on-line account holders associated with the firms examined during the course of the study. Furthermore, although there were more complaints in the four-month period examined in the year 2000 than the number of complaints examined during the six-month period in 1999, the increase in complaints does not necessarily mean that on-line brokerage firms' suffered a deterioration in their service capacities. Numerous articles and reports noted a large increase in the number of on-line investors. The increase in complaints for the smaller time period is logical given the large growth in on-line investment accounts and does not necessarily indicate degrading service quality in the online brokerage industry. In fact, year 2000 access complaints were considerably reduced when compared to the access complaints documented during the 1999 survey of Virginia on-line brokerage complaints.

In light of the study's findings, the Commission makes the following recommendations:

(1) All firms should increase and improve their risk disclosure and investor education schemes.

(2) On-line brokerage firms should strive to make websites and on-line trading systems more user-friendly.

(3) On-line brokerage firms should collect suitability information even if the firm does not make recommendations. Furthermore, if technically feasible, on-line firms should utilize the collected suitability information to provide an automated suitability warning service available at the option of the on-line investor.

(4) Virginia, NASAA, the Securities and Exchange Commission ("SEC"), and Self Regulatory Organizations ("SROs") should continue to monitor trends and practices within the on-line brokerage industry. The organizations should also aggressively prosecute irresponsible and misleading advertisers.

(5) Virginia, NASAA, the SEC, and SROs should consider other uniform measures of investor protection and education that may be applicable to both on-line firms and off-line firms. A good starting point would be the best practices noted in this report.

(6) In regards to day trading, the Commission should consider working through NASAA to adopt a uniform rule that recognizes and adopts rules similar to the National Association of Securities Dealers (*3) ("NASD") Rules 2360 and 2361. (*4)

(7) In regards to margin trading, the Commission should consider coordinating with NASAA to adopt a uniform rule that captures the day trading margin rules stated in NASD 2520.

(8) By letter from the Commission, Virginia should recommend to NASAA that it conduct a nationwide survey of on-line and off-line discount brokerage account holders.

All firms should increase and improve their risk disclosure and investor education schemes.

All firms should endeavor to divulge more information that accurately and fully describes the risks of fast market trading because of difficulties associated with placing on-line orders and having them executed during such fast market conditions. Also, more information describing how firms route orders to market and how market makers execute orders is necessary to make on-line investors' expectations match on-line brokerage firms' current levels of performance. All disclosures and educational material should be readily available to the consumer and easy to access. Furthermore, the Commission should act swiftly to deter any attempts to revive the misleading advertising by on-line brokerage firms characteristic of 1998 and 1999.

On-line and off-line brokerage firms should also increase disclosure of the rights, obligations, and risks involved in margin trading. The margin information and risk disclosure should be in a conspicuous place and described in plain and simple language. Furthermore, on-line brokerage firms should improve teaching customers how to use and manipulate the on-line trading system to decrease user errors. Providing some sort of systems training manual in a conspicuous and easily understandable manner would greatly assist on-line brokerage firms' customers. If the firms fail to strengthen the disclosures in these areas, the Commission should consider working with NASAA to adopt uniform disclosure guidelines to compel on-line brokerage firms to provide plain English disclosures to Virginia citizens.

The website and on-line trading system should be more user-friendly.

Many of the websites offered by on-line brokerage firms have a wealth of market and investment information that the on-line investor may review. However, there is very little information on most websites that addresses technical issues in regards to manipulation of the many features offered on the website. Thus, on-line firms appear to assume that most on-line investors have a high level of computer proficiency and that the on-line brokerage firms' systems are simple to use. However, the study's research showed that a high level of computer proficiency is not always the case for on-line investors.

Unfortunately, this has led to many consumer errors because there is frequently no "owners manual" that an on-line investor can reference if he or she gets confused. Although almost all on-line brokerage firms offer technical assistance over the phone, such live help is neither always timely nor effective. It would be helpful if an operations manual of some kind augmented the live technical assistance.

On-line and off-line brokerage firms should collect suitability information even if the firm does not make recommendations.

On-line and off-line firms that do not make recommendations should gather suitability information to protect their financial interests and their customers' financial interests. On-line and off-line brokerage firms need the invested assets of investors to remain solvent. Suitability information can help on-line brokerage firms warn the investors of transactions that have a high risk of failure and are not consistent with their investment objectives. Furthermore, a pre-trade or post-trade transaction review, similar to systems in use at certain full-service firms and hybrid firms, may help on-line investment firms warn investors to preserve assets through long-term trading strategies. On-line and off-line brokerage firms may offer the pre-trade or post-trade review as a value-added service. On-line and off-line firms should be free to develop this technology without extraneous interference from regulatory agencies in situations where the firms clearly did not recommend particular securities transactions.

Virginia, NASAA, the SEC, and SROs should continue to monitor trends and practices within the on-line brokerage industry.

Since on-line brokerage services are becoming more and more of an integral part of the financial investments industry, Virginia, NASAA, the SEC, and SROs have an increasing responsibility to make sure that on-line brokerage firms do not abuse current rules. Regulatory agencies must also consistently evaluate on-line brokerage firms' business practices as well as current proposed rules to identify the best practices that maximize investor protection and the firms' financial solvency. The key issues here are that investor protection and firm solvency are necessary to maintain the overall efficiency and life of the market. Working through NASAA and other regulatory agencies allows the Commission to be consistent with other states.

Virginia, NASAA, the SEC, and SROs should consider uniform measures of investor protections that are applicable to both on-line firms and off-line firms.

The need for uniform rules is of paramount importance to both regulators and members of the on-line and off-line brokerage industries. Uniform rules allow firms to efficiently transact business in various jurisdictions, because they provide a consistent means of enforcement and a uniform set of standards applicable to both on-line and off-line firms. A uniform rule that is applicable to on-line and off-line firms ensures a level playing field between the two types of brokerage firms. Therefore, investors can expect similar services and should have similar treatment whether the investor uses an on-line or off-line firm. Working with NASAA and other regulatory agencies would allow the Commission to assist in the creation of uniform rules that would be consistent throughout the states and would also allow the Commission to make a significant contribution to the development of national investor protection policy. A good starting point to consider is the best practices noted in this report.

In regards to day trading, the Commission should consider adopting rules through NASAA that recognize and adopt rules similar to NASD Rules 2360 and 2361.

The Commission should consider adopting rules similar to the new day trading rules adopted by the NASD and approved by the SEC. NASD Rules 2360 and 2361 make suitability determination mandatory for day trading firms. A similar requirement by the Commission would show that the Commission also expects day trading firms registered in Virginia to make such suitability determinations. Recognizing and adopting rules similar to NASD Rules 2360 and 2361 would also mandate risk disclosures and give the Commission the ability to bring actions against day trading firms that allegedly failed to comply with the guidelines prescribed by the Commission and uniform NASD requirements. Working through NASAA and other regulatory agencies would allow the Commission to assist in the creation of uniform rules that would be consistent throughout the states and would also allow the Commission to make a significant contribution to the development of national investor protection policy. Adoption of rules similar to NASD Rules 2360 and 2361 would allow the Commission to remedy consumer complaints against firms that violate these rules instead of leaving customers to seek a remedy from the NASD.

In regards to margin trading, the Commission should consider coordinating with NASAA to adopt a rule that captures the day trading margin rules stated in NASD Rule 2520.

To prevent day traders from overextending their financial capacity, the NASD proposed changes to its margin rules to protect individuals that pursue day trading strategies. Virginia may benefit from a similar policy because the NASD' s proposed margin amendments would make margin requirements more stringent for day traders. By adopting rules developed uniformly through NASAA, Virginia would enjoy having the authority to require day trading firms and on-line brokerages to meet the stringent margin requirements similar to the NASD's proposed amendments to Rule 2520. Working through NASAA would allow the Commission to assist in the creation of a uniform rule that would be consistent throughout the states and would also allow the Commission to make a significant contribution to the development of a national rule regarding day trading and margin. Again, these rules would allow the Commission to remedy consumer complaints against firms that violate these rules instead of leaving customers to seek a remedy from the NASD.

By letter from the Commission, Virginia should recommend to NASAA that it conduct a nationwide survey of on-line and off-line discount brokerage account holders.

The Commission should recommend by letter that NASAA conduct a nationwide survey of on-line and off-line discount brokerage account holders and their representatives to identify what information investors want disclosed. NASAA should try to identify investor's perceptions, preferences, concerns, and trends to help states determine how to effectively tailor uniform state regulations to meet investor needs in a consistent manner throughout the United States. If NASAA conducts such a study, and then proposes uniform policies or rules, the Commission should strongly consider adopting similar rules under its rule making authority.
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(*1) The North American Securities Administrators Association or "NASAA" is a voluntary association whose membership consists of 66 state, provincial, and territorial securities administrators in the 50 states, the District of Columbia, Puerto Rico, Canada, and Mexico. In the United States, NASAA is the voice of the 50 state securities agencies responsible for investor protection and efficient capital formation. (More information about NASAA can be found at www.NASAA.org.)
(*2) The term "broker-dealer" refers to "any person selling any type of security other than an interest in or unit in condominium ... for the account of others or for his own account otherwise than through a broker or agent." (defined in the Virginia Securities Act, § 13.1-501).
(*3) The National Association of Securities Dealers, Inc. or NASD is a securities industry self-regulatory organization that, through its subsidiaries, NASD Regulation, Inc. and the NASD Stock Market, Inc., develops rules and regulations, conducts regulatory reviews of members' business activities, disciplines violators, and designs, operates, and regulates securities markets and services all for the ultimate benefit and protection of the investor. (For more information about the NASD, visit their website at www.NASD.com.)
(*4) New Rules 2360 and 2361 focus on disclosing the basic risks of engaging in a day-trading strategy and assessing the appropriateness of day trading strategies for individuals pursuant to suitability analysis. In particular, these two proposed rules would require a firm that is "promoting a day-trading strategy," directly or indirectly, to deliver a specified risk disclosure statement to a non-institutional customer prior to opening an account for the customer. In addition to the risk disclosure statement, the Rules 2360 and 2361 would require a firm to either: (1) approve the customer's account for day trading; or (2) obtain a written agreement from the customer stating that the customer docs not intend to use the account for day-trading activities. See, Order Approving Proposed Rule Changes Relating to the Opening of Day Trading Accounts, 65 Fed. Reg. 44,082 (approved July 10, 2000). Once receiving approval, the NASD made Rules 2360 and 236 I effective on October 16, 2000.