Says when suitability rule must be observed

InvestmentNews (March 26, 2001 11:01 pm) — Online brokers could be accused of churning if their customers trade too much based on their recommendations.

The warning was one of the lesser noticed provisions laid out last week by the National Association of Securities Dealers Regulation Inc. in a policy statement extending suitability requirements to online brokers.

Most regulators and industry officials applauded the NASDR’s declaration. But some industry officials expressed concerns about potentially unforeseen side effects.

The NASDR notice said that some types of online communications are in fact recommendations, and members are responsible for ensuring that they are appropriate for the investors to whom they are made, based on such factors as an investor’s age, assets and risk tolerance.

But a footnote in the notice states, “In certain instances, a suitability violation also can be based on an inappropriate frequency of trades, often referred to as excessive trading or churning.”

The notice says that a broker-dealer could violate suitability rules by recommending “an excessive – and, based on the customer’s financial situation and needs, an inappropriate – number of securities transactions, and the customer routinely followed the broker-dealer’s recommendations.”

no impact on day trader

Linda Lerner, general counsel for All-Tech Direct Inc., a day trading company in Montvale, N.J., says that the practice could cause problems for online brokers that single out customers who may be interested in particular investments.

“You, by making recommendations, churn the guy’s account,” she says, interpreting the NASDR notice.

“You can’t just willy-nilly throw recommendations at him. That’s going to be very difficult for firms that are using push technology to police. Most of the online firms that offer research, a lot of them are using push technology.”

With push technology, brokers identify potential buyers of particular investments by information they have in their records, then “push” the product to the customer.

That is in contrast to “pull,” in which the customers originate the contact.

Indiana’s securities commissioner, Brad Skolnik, endorsed the guidelines, calling them “a common-sense approach to this issue.”

And Laura Unger, acting chairman of the Securities and Exchange Commission, said that the notice was “very thoughtful and measured,” according to Susan Wyderko, a spokeswoman.

Marta von Loewenfeldt, a spokeswoman in the New York office of San Francisco’s Charles Schwab & Co., the country’s largest online broker, says Schwab is “very pleased with the NASDR’s interpretation of online suitability.

“It endorses several of Schwab’s own principles regarding general information on the web, e-mail alerts and search tools that help people get more information about investments.”

But one lawyer who represents investors in arbitration cases was not so thrilled with the policy notice.

Tracy Pride Stoneman, a lawyer in Colorado Springs, Colo., and a member of the Public Investors Arbitration Bar Association in Norman, Okla., says the notice “didn’t go far enough. They’ve created a definition that is too narrow.”

Ms. Stoneman says that it could be possible for an online broker to recommend investments to all of its customers without falling under the so-called “suitability” rules as long as the recommendations were not tailored to clients with particular profiles.

lobbying seen

“I think that what has happened here is the bigger online firms lobbied and put so much pressure on the NASD that what we ended up with here is a prohibition of actions that the bigger online firms never do,” Ms. Stoneman says.

Indeed, according to most brokers contacted for this article, the notice will have little direct effect on their operations.

Multex.com Inc., a New York company that publishes the Market Guide stock information service on Yahoo!, says that under the NASDR’s guidelines, its service would not be characterized as recommending stocks.

“Market Guide gives fundamental data. It’s not specialized or tailored advice,” says Ed Fargis, vice president and associate general counsel. “We don’t give specified investment advice tailored for individuals. We distribute fundamental data, screening tools, research tools. None of those run afoul of these new guidelines.”

Likewise, Jim Lee, president of Momentum Securities LLC in Houston, the country’s largest day trading operation, says his company would not fall under the suitability guidelines because it does not make recommendations to its day traders, who may conduct as many as 1,000 trades daily.

“Someone has to be cleared at the outset for our style of trading,” he says. “No recommendations are taking place for trades placed every two minutes.”