InvestmentNews (October 18, 1999 11:01 pm) -- Online brokerages exploiting new technology to inform customers of certain investment opportunities are doing so at their own risk.

The nation's top securities cops are preparing a report that looks into whether online brokerages should be held more accountable for monitoring their customers' trading activities and for warning them about risky practices.

At the heart of the matter is the unprecedented access that online brokers have to information about customer tastes, demographics and trading habits along with a capability to electronically send out stock research and perhaps specific recommendations to targeted audiences.

Suitability requirements usually apply to traditional brokerage firms, which are required to make investment recommendations that are appropriate based on clients' age, income and investment knowledge. But the Securities and Exchange Commission is concerned because online brokers are moving beyond simply executing trades for investors.

"I think the analysis becomes a little more difficult when you consider developing technology that will allow firms to collect information about their customers and provide what could be considered recommendations based on that information," says Laura Unger. The commission member is writing a report for the agency that she plans to turn over to chairman Arthur Levitt within the next few months.

She says, however, that "firms are probably correct in saying that providing pure execution does not trigger a suitability obligation because there is no recommendation involved."

Online brokers reject any suggestion that they should be held responsible for monitoring trades or making recommendations to customers. They say they're giving information at a client's request. Sometimes they actively market retirement services, for instance, but not specific securities.

Fidelity Investments uses the statistical modeling capabilities of its direct marketing business to "help predict what the next purchase of a client might be," says Tracey Curvey, executive vice president for online brokerage at the Boston-based mutual fund giant.

"Based on information about your life stage, we suggest products and services that might be of service to you. Customers don't mind marketing messages that are relevant."

At Omaha, Neb.-based Ameritrade, corporate vice president Michael Anderson says the online broker will focus on letting investors specify the type of information they want. "Targeting messages back to our customers about particular products or categories is a concept we talked about," he says. "We talked quite a bit about it, thinking 'push technology' would be better received than it was."

Still, a lot of folks are weighing in against the online brokers.

Edward Kwalwasser, group executive vice president of the regulatory administration and regulation group at the New York Stock Exchange, says that brokers who target research reports to specific groups of clients could fall under suitability regulations.

It used to be that such reports were commonly given by brokers only to those customers to whom they were recommending buying the researched stock. Now these reports are available to all customers who subscribe to online services. That raises the question of whether making the reports available constitutes a "recommendation."

Brokers also could target certain customers for the reports. "I could push out (online reports) to everyone with $100,000 in their account," Mr. Kwalwasser says. "I think you could make a good case that's a recommendation even if it went out to a thousand people. On the other hand, if you just put it up on your website, or you use third-party research, it may be too impersonal" to be considered a recommendation.

NASD Regulation spokeswoman Nancy Condon says the regulator is "taking a close look" at this issue. And state securities regulators are holding a roundtable in Washington Nov. 1, inviting participation by authorities and the industry representatives.

Arbitration lawyers are calling for increased requirements since as much as one-third of all trades are being executed over computers -a significant percentage by unsophisticated investors.

Mark Maddox, president of the Public Investors Arbitration Bar Association and a partner with Indianapolis law firm Maddox Koeller Hargett & Caruso, suggests requiring firms to program computers to contact investors if their trading practices are inappropriate.

His organization also wants limits set on who gets margin accounts. "The online accounts in general tend to be smaller sized accounts than what you see at the full-service firms," Mr. Maddox says. Yet, "They are having margin added to their accounts and they are losing money in a very short period of time."

Mr. Maddox points to an arbitration case his firm is handling in which a 50-year-old disabled woman from Hawaii lost most of her $100,000 IRA account after she attempted to profit from an initial public offering for an Internet stock through her online account with Charles Schwab Corp. Mr. Maddox maintains that when Schwab executed the trade, it violated the New York Stock Exchange's "know your customer" rule, which requires that brokers make suitable recommendations.

Hardy Callcott, general counsel for Schwab, replies, "We do have some basic know-your-customer obligations under both NYSE and NASD rules before we can open any account. But that's not the same thing as a sort of order-by-order monitoring requirement." He would not comment on the litigation.

A proposal by NASDR to require day trading firms to determine whether that risky practice is an appropriate trading strategy for their customers leads California securities enforcement director Bill McDonald to ask whether the requirement would be imposed on online brokers.

"That's a very slippery slope," he says. "Is there a different standard for a customer who only wants trade execution from (standards for) full service?" he asks. "How do you define the difference? Fiduciary duties are difficult enough to decide."

NASD Regulation needs to define standards determining someone's suitability to day trade, Mr. McDonald says, adding, "I think setting standards is going to be extremely difficult." He holds that regulators should not try to protect online traders from themselves. "People who are electing to go it alone are electing to do so without some of these fiduciary protections."

But the much-maligned day traders may be able to push the issue against their bigger online kin. "It would be wrong to ask the day trading firm to do that and not ask everybody to do it," Todd Hawley, president of day trading firm Net Trade Inc. in Arlington, Va.

"Where do you draw a line in the sand? A lot of people trade online, and are pretty active," he says. "A lot of people try to do this that are not suitable, but it's difficult to draw the line. Who is a suitable person to day trade? I wasn't suitable initially, but I have been successful."