SUITABLITY’ REGS NOT NEEDED YET, REGULATORS AGREE: E-BROKERS JUST TRADE, NOT ADVISE

Online brokerages may have to use their new technology to determine whether customers’ trades are appropriate for their financial situation, regulators suggested last week.

The four regulators participating in a 10-person roundtable in Washington sponsored by the North American Securities Administrators Association Inc. agreed that executing trades for online customers should not trigger “suitability” regulations — under which brokers are responsible for making appropriate recommendations based on a customer’s income, age, market experience and tolerance for risk. But they hinted that new technology enabling online brokers to tailor ads, research reports and the messages they send to their customers may result in new responsibilities.

One suggestion was a regulation requiring the brokerages to set up systems that check customers’ trades to ensure that they are making appropriate investments.

The roundtable comes just as the Securities and Exchange Commission is preparing a report on online brokerages.

Online firms are expected to spend $1.5 billion over the next year to market their services, according to the state administrators group.

“This type of spending fundamentally weakens the ability of the industry to argue that customer protection software for those investors who are untrained is too costly to develop and deploy,” said William Mohr, deputy bureau chief of New York’s Investor Protection and Securities Bureau.

sees paradigm software

He envisions software that brokers could provide to analyze investor holdings and compare them to a model portfolio, factoring in consensus earnings forecasts, volatility data and the investor’s tax status. “These tools will, in short, make purchase and sales recommendations,” Mr. Mohr said.

He also raised the issue of whether investors themselves should be “required to show proficiency” in their knowledge of the markets.

While online trading technology makes suitability requirements more difficult to apply, “Technology does not eliminate the need for suitability regulations,” argued Elisse Walter, chief operating officer of NASD Regulation Inc.

“Many people say that we should no longer be protecting people from their own folly. People are taking control of their own lives, and I agree with that,” she added. But, “If we interpret these obligations too narrowly we could deny online investors the kinds of protections that they should get. The medium shouldn’t alter the message.”

Regulatory lawyers representing Charles Schwab & Co., E*Trade Securities Inc. and Island ECN Inc. argued that as long as online brokers are not making recommendations to customers but are simply providing information, no suitability requirements should apply to them.

Online brokerages argue that customers do not want them to check their trades, and that such a system would eliminate the speed and cost advantages these services now offer.

Schwab “allows customers to customize their website,” and decide what stocks they want to receive research reports about, said Hardy Callcott, senior vice president and general counsel of the San Francisco discount brokerage.

Set up that way, Schwab’s technology “is not necessarily a recommendation,” he said.

But investor arbitration lawyer Stephen Caruso, a partner in the New York office of Indianapolis law firm Maddox Koeller Hargett & Caruso, said the online industry should be subjected to stricter suitability regulations.

“Somebody needs to stand up on behalf of the individual investor. We’re not talking about Goldman Sachs and some managing partner. We’re talking about somebody who runs a barber shop in upstate New York,” he said.

With $500 billion tied up in 9 million online accounts, Mr. Caruso added: “Mainstream America is being enticed into the belief that online trading is as easy as going to the supermarket… When they think they’re showing up at the party they’re instead getting slaughtered.”

He described clients who put in orders for initial public offerings without knowing what a limit order is. They thought they were buying the stock at $9 a share and instead found they had paid $90, he said.

Henry Carter, vice president and chief compliance officer of E*Trade, said his company now requires customers to fill out questionnaires to trade in IPOs, and no longer allows IPO market orders because markets are too volatile.

SEC Commissioner Laura Unger, who is preparing the report on online brokerages, suggests “The industry is in the best position to judge when they need (to apply) suitability” requirements.