Brokers searching for door to exit costly portal race

After rushing into expensive deals to access Internet portals like AOL and Compuserve, online brokerages are crying for relief as they gear up to buy even more advertising.

Internet access sites are more than willing to rewrite their deals to keep the cash flowing their way. But there’s just one hitch: Federal rules prohibit the compensation arrangement brokerages prefer.

While a sympathetic Securities and Exchange Commission is working to solve the problem, there’s no such thing as an easily done deal in the highly competitive online brokerage business.

Firms like E*Trade Group Inc. are lining up against the SEC proposal because it would allow portals to be paid based on referrals or accounts opened without having to register as a broker-dealer.

“Portals want the cream off the top,” says Henry Carter, chief compliance officer for the Menlo Park, Calif., online discounter. “They want to get paid for acting like a broker-dealer, get the great revenue from account openings without having to assume the responsibility and liability for acting as a broker-dealer.

“This is an issue that’s not going to go away.”

He’s right on that score.

Kate McGuire, chief counsel for the SEC’s Division of Market Regulation, declined comment, but one source says the SEC could publish a proposal as early as this winter to address payments to portals.

SEC Commissioner Laura Unger also raised the possibility of relaxing the rules in a report issued last month.

Online brokerages have a lot riding on the debate.

Last year, Ameritrade Holding Corp., DLJdirect, E*Trade and TD Waterhouse Group Inc. each paid America Online Inc. $25 million for two-year advertising contracts, and Merrill Lynch & Co. Inc. paid an undisclosed amount to be the primary financial provider on Microsoft’s MoneyCentral site.

“These have become very expensive contracts, says John Muellin, president of Datek Online Brokerage Services in Iselin, N.J. “Brokerage firms would like (the costs) to be tied into the performance of how many new accounts were acquired from that portal.”

It remains to be seen if online brokers will continue to pay portals huge fees without the rule change. The AOL deals, the largest known so far, are due to expire shortly.

The portals have a huge stake in maintaining ties to online brokers with the industry about to go on a billion-dollar spending spree in a fierce battle for market share.

“It’s unbelievable the advertising dollars that are going to be spent,” says Dan Burke, an analyst with Gomez Advisors Inc., a Lincoln, Mass., online service research firm.

He estimates the top online brokerages will spend $1.2 billion next year for all advertising.

“I just don’t know how much brokers are going to continue to spend on portals,” he adds.

If there is any saving grace, supporters note that scrapping the current rule has some precedent.

In 1996, the SEC allowed America Online, Compuserve and Microsoft to escape broker registration for connecting their subscribers to Charles Schwab Corp.

The portals were paid flat fees based on orders transmitted, regardless of the value of the order, or even whether an order was executed.

Beyond that, the SEC forbids online services to receive payments based on most transaction measurements without registering, Ms. Unger says.

“The interpretation has been that if the portal has an interest in the account being opened, it could be perceived to be a salesman’s stake in the transaction,” Ms. Unger explains. “Once you have a salesman’s stake in the transaction, and you’re compensated based on the transaction in an account, then you’re acting like a broker-dealer.”

But Ms. Unger agrees that portal services are different.

The 1996 exceptions, she says, “beg the question as to why we won’t go further and allow the compensation to be changed, allow them to receive compensation this way.

“All they’re doing is providing a vehicle for advertising,” she says. But as far as affecting securities transactions, she adds: “Unless the portal did something in addition to providing the advertising, I don’t see how that would really be the case.”

Steven Stone, a partner in the Washington office of Philadelphia law firm Morgan Lewis & Bockius who represented Schwab in the 1996 SEC ruling and also represents Intuit and Yahoo!, argues that transaction-based fees should not be the overriding factor that the agency considers when deciding whether a company should register as a broker.

Mr. Carter already sees competition from online services such as Motley Fool and Microsoft MoneyCenter, which provide investment advice and information.

If the SEC allows portals to take transaction-based fees, he thinks the agency should regulate them “on a very limited basis.”

In practice, Mr. Carter says, online brokers are already basing their portal payments on accounts opened. They simply figure out how much it is worth to them to pay for online advertising by multiplying the number of orders transmitted by the probability that an order will be executed.

“I have a real problem with a portal acting as a broker-dealer,” he says, “because that could ultimately put our business at risk.”