On-Line Broker-Dealers: Conducting Compliance Reviews in Cyberspace

Business Lawyer

Volumn 56, Issue 4, 2001, Pages 1461-1499

  Furey, Joseph M ^a   Kiesewetter, Beth D ^a  

^a NONE

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EID: 0347769445     PISSN: 00076899     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Review

References (177)

1. Full service broker-dealers, such as Merrill Lynch and Morgan Stanley, are developing and marketing an on-line capability. Joseph Kahn & Patrick McGeehan, Morgan Stanley to Offer On-Line Trading to All Customers, N.Y. TIMES, Oct. 18, 1999, at C1. Merrill Lynch clients with a central asset account or retirement account that work with a Merrill Lynch financial consultant are invited to enroll in Merrill Lynch OnLine, which is an Internet-based service that provides 24 hour access to account balances, statements, stock quotes, news and research. For individuals who prefer to self-direct their investments, however, Merrill Lynch offers Merrill Lynch Direct, which permits investors to open accounts and effect transactions without having a financial consultant assigned to the account. See Merrill Lynch, Merrill Lynch Direct, available at . At the same time, traditional discount broker-dealers that developed a significant on-line presence are looking to expand their services, including some services traditionally offered by full service broker-dealers, to meet client demands. See, e.g., Joseph Kahn, Brokerage Firms Seek Foothold On Line, N.Y. TIMES, Oct. 21, 1999, at C2; Gretchen Morgenson, Call off the Death Watch for Brokers, N.Y. TIMES, June 6, 1999, at 3.1; see also, COMMISSIONER LAURA S. UNGER, SEC, ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE 19 (1999) available at .
2. Full service broker-dealers, such as Merrill Lynch and Morgan Stanley, are developing and marketing an on-line capability. Joseph Kahn & Patrick McGeehan, Morgan Stanley to Offer On-Line Trading to All Customers, N.Y. TIMES, Oct. 18, 1999, at C1. Merrill Lynch clients with a central asset account or retirement account that work with a Merrill Lynch financial consultant are invited to enroll in Merrill Lynch OnLine, which is an Internet-based service that provides 24 hour access to account balances, statements, stock quotes, news and research. For individuals who prefer to self-direct their investments, however, Merrill Lynch offers Merrill Lynch Direct, which permits investors to open accounts and effect transactions without having a financial consultant assigned to the account. See Merrill Lynch, Merrill Lynch Direct, available at . At the same time, traditional discount broker-dealers that developed a significant on-line presence are looking to expand their services, including some services traditionally offered by full service broker-dealers, to meet client demands. See, e.g., Joseph Kahn, Brokerage Firms Seek Foothold On Line, N.Y. TIMES, Oct. 21, 1999, at C2; Gretchen Morgenson, Call off the Death Watch for Brokers, N.Y. TIMES, June 6, 1999, at 3.1; see also, COMMISSIONER LAURA S. UNGER, SEC, ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE 19 (1999) available at .
3. Full service broker-dealers, such as Merrill Lynch and Morgan Stanley, are developing and marketing an on-line capability. Joseph Kahn & Patrick McGeehan, Morgan Stanley to Offer On-Line Trading to All Customers, N.Y. TIMES, Oct. 18, 1999, at C1. Merrill Lynch clients with a central asset account or retirement account that work with a Merrill Lynch financial consultant are invited to enroll in Merrill Lynch OnLine, which is an Internet-based service that provides 24 hour access to account balances, statements, stock quotes, news and research. For individuals who prefer to self-direct their investments, however, Merrill Lynch offers Merrill Lynch Direct, which permits investors to open accounts and effect transactions without having a financial consultant assigned to the account. See Merrill Lynch, Merrill Lynch Direct, available at . At the same time, traditional discount broker-dealers that developed a significant on-line presence are looking to expand their services, including some services traditionally offered by full service broker-dealers, to meet client demands. See, e.g., Joseph Kahn, Brokerage Firms Seek Foothold On Line, N.Y. TIMES, Oct. 21, 1999, at C2; Gretchen Morgenson, Call off the Death Watch for Brokers, N.Y. TIMES, June 6, 1999, at 3.1; see also, COMMISSIONER LAURA S. UNGER, SEC, ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE 19 (1999) available at .
4. Full service broker-dealers, such as Merrill Lynch and Morgan Stanley, are developing and marketing an on-line capability. Joseph Kahn & Patrick McGeehan, Morgan Stanley to Offer On-Line Trading to All Customers, N.Y. TIMES, Oct. 18, 1999, at C1. Merrill Lynch clients with a central asset account or retirement account that work with a Merrill Lynch financial consultant are invited to enroll in Merrill Lynch OnLine, which is an Internet-based service that provides 24 hour access to account balances, statements, stock quotes, news and research. For individuals who prefer to self-direct their investments, however, Merrill Lynch offers Merrill Lynch Direct, which permits investors to open accounts and effect transactions without having a financial consultant assigned to the account. See Merrill Lynch, Merrill Lynch Direct, available at . At the same time, traditional discount broker-dealers that developed a significant on-line presence are looking to expand their services, including some services traditionally offered by full service broker-dealers, to meet client demands. See, e.g., Joseph Kahn, Brokerage Firms Seek Foothold On Line, N.Y. TIMES, Oct. 21, 1999, at C2; Gretchen Morgenson, Call off the Death Watch for Brokers, N.Y. TIMES, June 6, 1999, at 3.1; see also, COMMISSIONER LAURA S. UNGER, SEC, ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE 19 (1999) available at .
5. Full service broker-dealers, such as Merrill Lynch and Morgan Stanley, are developing and marketing an on-line capability. Joseph Kahn & Patrick McGeehan, Morgan Stanley to Offer On-Line Trading to All Customers, N.Y. TIMES, Oct. 18, 1999, at C1. Merrill Lynch clients with a central asset account or retirement account that work with a Merrill Lynch financial consultant are invited to enroll in Merrill Lynch OnLine, which is an Internet-based service that provides 24 hour access to account balances, statements, stock quotes, news and research. For individuals who prefer to self-direct their investments, however, Merrill Lynch offers Merrill Lynch Direct, which permits investors to open accounts and effect transactions without having a financial consultant assigned to the account. See Merrill Lynch, Merrill Lynch Direct, available at . At the same time, traditional discount broker-dealers that developed a significant on-line presence are looking to expand their services, including some services traditionally offered by full service broker-dealers, to meet client demands. See, e.g., Joseph Kahn, Brokerage Firms Seek Foothold On Line, N.Y. TIMES, Oct. 21, 1999, at C2; Gretchen Morgenson, Call off the Death Watch for Brokers, N.Y. TIMES, June 6, 1999, at 3.1; see also, COMMISSIONER LAURA S. UNGER, SEC, ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE 19 (1999) available at .
6. Chairman Arthur Levitt, Jr., Plain Talk About On-Line Investing, Remarks at the National Press Club, Washington, D.C. (May 4, 1999), available at .
7. See generally Unger Report, supra note 1; see also INVESTOR PROTECTION & SECURITIES BUREAU & INTERNET BUREAU, OFFICE OF NEW YORK STATE ATTORNEY GENERAL ELIOT SPITZER, FROM WALL STREET TO WEB STREET: A REPORT ON THE PROBLEMS AND PROMISE OF THE ON-LINE BROKERAGE INDUSTRY (1999) available at [hereinafter Spitzer Report].
8. Securities Exchange Act of 1934 § 2, 15 U.S.C. § 78b (1994). Section 2 of the Exchange Act recognizes that "transactions in securities . . . are affected with a national public interest which makes it necessary to provide for regulation and control of such transactions . . . to require appropriate reports to remove impediments to and perfect the mechanisms of a national market system for securities . . . and to insure the maintenance of fair and honest markets in such transactions. . . ." Id. See Securities Exchange Act of 1934 § 11A, 15 U.S.C. § 78k-1(a)(1) (1994). Section 11A provides that "[t]he securities markets are an important national asset which must be preserved and strengthened." Id.
9. Automated Systems of Self-Regulatory Organizations (ARP I), Exchange Act Release No. 27,445, 54 Fed. Reg. 48,703, 48,705-06 (Nov. 16, 1989); Automated Systems of Self-Regulatory Organizations (ARP II), Exchange Act Release No. 29,185, 56 Fed. Reg. 22,490, 22,491 (May 15, 1991).
10. ARP I, 54 Fed. Reg. at 48,706.
11. ARP II, 56 Fed. Reg. at 22,491.
12. Id.
13. Id.
14. SEC Staff Legal Bulletin No. 8 (MR) (Sept. 9, 1998) available at .
15. Id.
16. Id.
17. See Securities Exchange Act § 15(b)(7), 15 U.S.C. § 78o(b)(7) (1994). Section 15(b)(7) provides that "No registered broker or dealer . . . shall effect any transaction in, or induce the purchase or sale of, any security unless such broker or dealer meets such standards of operational capability. . . ." Id. 14. See Operational Capability Requirements of Registered Broker-Dealers and Tansfer Agents and Year 2000 Compliance, Exchange Act Release No. 41,142, 64 Fed. Reg. 12,128, 12,137 (Mar. 11, 1999). Proposed Rule 15b7-2 would provide:
18. (a) This section applies to every broker or dealer registered pursuant to Section 15 of the Act (15 U.S.C. § 78o). If you do not have the operational capability, taking into consideration the nature of your business, to assure the prompt and accurate order entry, execution, comparison, allocation, clearance and settlement of securities transactions, the maintenance of customer accounts, and the delivery of funds and securities, you may not: (1) Effect any transaction in securities; (2) Induce the purchase or sale of securities; (3) Receive or hold customer funds or securities; or (4) Carry customer accounts. (b) For the purposes of this section, the term customer includes a broker or dealer. Id.
19. See Year 2000 Operational Capability Requirements for Registered Broker-Dealers and Transfer Agents, Exchange Act Release No. 41,661, 64 Fed. Reg. 42,012 (Aug. 3, 1999). The Commission noted: "On March 5, 1999, the Commission also proposed Rule 15b7-2 and 17Ad-20 under the Exchange Act. These rules would have codified a statutory requirement that broker-dealers and non-bank transfer agents have sufficient operational capability to conduct a securities business. The Commission is deferring action on the general operational capability rules at this time." Id. at 42,013 n.9.
20. Unger Report, supra note 1, at 65; Spitzer Report, supra note 3, at 183-86.
21. Unger Report, supra note 1, at 65; Spitzer Report, supra note 3, at 191.
22. Unger Report, supra note 1, at 65; Spitzer Report, supra note 3, at 183-86.
23. Unger Report, supra note 1, at 66; Spitzer Report, supra note 3, at 188.
24. OFFICE OF COMPLIANCE INSPECTIONS AND EXAMINATIONS, SEC, EXAMINATIONS OF BROKER-DEALERS OFFERING ON-LINE TRADING: SUMMARY OF FINDINGS AND RECOMMENDATIONS (2001), available at [hereinafter OCIE Report].
25. Id. at IV, Operational Capability.
26. In re TD Waterhouse Investor Servs., Inc., Exchange Hearing Panel Decision 01-0003 (N.Y. Stock. Exch. Jan. 10, 2001), available at .
27. Id. at ¶ 11.
28. Id. at ¶ 5.
29. Id.
30. Id. at ¶¶ 22, 29.
31. Id. at II.
32. Ameritrade Holding Corporation, E-Trade Group, Inc., Charles Schwab Corporation and TD Waterhouse Group, Inc. spent $44.6 million for advertising in October 2000, which was down from $52.8 million from October 1999. Sally Beatty, As Economy Sags, So Do Ratings for Some Once-Hot TV Business Shows, WALL ST. J., Jan. 30, 2001, at B1.
33. See, e.g., CHARLES SCHWAB & CO., FAST MARKET CONDITIONS - UNDERSTANDING THE RISKS OF VOLATILE MARKETS (1999); WATERHOUSE SECURITIES INC., TACTICS FOR TRADING IN A VOLATILE MARKET (1999).
34. See, e.g., CHARLES SCHWAB & CO., FAST MARKET CONDITIONS - UNDERSTANDING THE RISKS OF VOLATILE MARKETS (1999); WATERHOUSE SECURITIES INC., TACTICS FOR TRADING IN A VOLATILE MARKET (1999).
35. See NASD Conduct Rule 2210(d)(1)(A), NASD Manual (CCH) 4174 (Aug. 2000) (emphasis added).
36. NASD Conduct Rule 2210(d)(1)(B), NASD Manual (CCH) 4174 (Aug. 2000).
37. NASD Conduct Rule 2210(c)(6), (d)(1)(C), NASD Manual (CCH) 4173-74 (Aug. 2000).
38. Chairman Levitt, Jr., supra note 2.
39. NASD Regulation Censures and Fines E* Trade Securities $90,000 for Violations of Advertising and Supervision Rules, NASD Regulation Press Release (July 9, 2001) available at .
40. Id.
41. Id.
42. Id.
43. Id.
44. Id.
45. One advertisement specifically identified in New York Attorney General Spitzer's report was an Ameritrade advertisement in the October 4, 1999 issue of Barron's which used a testimonial from an investor. The advertisement said, "After trying several brokers, I finally found a stock market whiz. Me." Spitzer Report, supra note 3, at 39. The advertisement continues, "You can pick stocks with the best of them. All you need is a computer and Ameritrade. We give you the same research tools that many professionals use. So it's easy to gain the knowledge you need to make the right picks." Id. The report then states that on-line brokers' claims of "'easy access to information' may give the investor the illusion that he or she has an 'inside edge' to the markets which the investor does not have." Id.
46. Unger Report, supra note 1, at 71-72; Spitzer Report, supra note 3, at 187.
47. Unger Report, supra note 1, at 73-74; Spitzer Report, supra note 3, at 187.
48. Unger Report, supra note 1, at 73; Spitzer Report, supra note 3, at 187.
49. Spitzer Report, supra note 3, at 189.
50. Id. at 188.
51. Id. at 189. NASD Regulation has provided advice about maintenance margin requirements for certain volatile stocks. Special NASD Notice to Members No. 99-33 (Apr. 15, 1999), available at ; see also NASD Conduct Rules 2520, 2521, NASD Manual (CCH) ¶ 2520 at 4441, ¶ 2521 at 4462 (Aug. 2000).
52. Spitzer Report, supra note 3, at 189.
53. Id. at 190.
54. Id.
55. OCIE Report, supra note 20, at 6.
56. Id. at 2.
57. Id. at 3.
58. Id. at 3-4.
59. Id. at 4-5.
60. Id. The NASD currently has a rule proposal pending with the SEC that would require member firms to deliver to non-institutional customers a detailed disclosure statement that discusses the operation of margin accounts and the risks associated with trading on margin. See Self-Regulatory Organizations; Notice of Filing of Proposed Rule Change by the National Association of Securities Dealers, Inc. Relating to the Delivery Requirement of a Margin Disclosure Statement to Non-Institutional Customers, Exchange Act Release No. 43,441, 65 Fed. Reg. 63,275 (Oct. 12, 2000).
61. See generally NASD Conduct Rule 2310, NASD Manual (CCH) 4261 (Dec. 2000); see also New York Stock Exchange Rule 405, N.Y.S.E. Guide (CCH) ¶ 2405, at 3696-97 (Sept. 1999).
62. See generally NASD Conduct Rule 2310, NASD Manual (CCH) 4261 (Dec. 2000); see also New York Stock Exchange Rule 405, N.Y.S.E. Guide (CCH) ¶ 2405, at 3696-97 (Sept. 1999).
63. NASD Conduct Rule 3210(a), NASD Manual (CCH) 4921 (Dec. 2000) (emphasis added).
64. NYSE Rule 405 is more broad in its application than NASD Conduct Rule 2310. NYSE Rule 405 is often referred to as the "know your customer" rule and has been interpreted to apply to all transactions regardless of whether a registered representative has made a recommendation. New York Stock Exchange Rule 405, N.Y.S.E. Guide (CCH) ¶ 2405, at 3696-97 (Sept. 1999); see Lewis D. Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557, 1571-72 (1999).
65. NYSE Rule 405 is more broad in its application than NASD Conduct Rule 2310. NYSE Rule 405 is often referred to as the "know your customer" rule and has been interpreted to apply to all transactions regardless of whether a registered representative has made a recommendation. New York Stock Exchange Rule 405, N.Y.S.E. Guide (CCH) ¶ 2405, at 3696-97 (Sept. 1999); see Lewis D. Lowenfels & Alan R. Bromberg, Suitability in Securities Transactions, 54 BUS. LAW. 1557, 1571-72 (1999).
66. In Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977), the Supreme Court noted that a breach of a fiduciary duty without any deception, misrepresentation, or nondisclosure does not violate section 10(b) or Rule 10b-5 promulgated thereunder. Id. at 474. In light of Supreme Court decisions holding that there must be deceptive conduct for there to be a violation of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, id. at 473-74, the viability of the shingle theory is not free from doubt. A discussion or analysis of the viability of the shingle theory and Rule 10b-5 is beyond the scope of this article. See generally Roberta Karmel, Is the Shingle Theory Dead?, 52 WASH. & LEE LAW. REV. 1271 (1995);
67. Allen D. Madison, Derivatives Regulation in the Context of the Shingle Theory, 1999 COLUM. BUS. L. REV. 271, 278-90 (1999).
68. Cf. New York Stock Exchange Rule 405, N.Y.S.E. Guide (CCH) ¶ 2405, at 3696-97 (Sept. 1999).
69. Unger Report, supra note 1, at 28 (emphasis added).
70. Id. at 31.
71. Id.
72. OCIE Report, supra note 20, at 11 n.3.
73. See Suitability Rule and Online Communications, NASD Notice to Members 01-23 (April 2001) available at . NASD Regulation filed this Policy Statement with the SEC. Pursuant to section 19(b)(3)(A) of the Exchange Act and Rule 19b-4(f)(1), the Policy Statement became immediately effective upon filing. Securities Exchange Act § 19(b)(3)(A), 15 U.S.C. § 78s(b)(3)(A) (1994).
74. See Suitability Rule and Online Communications, NASD Notice to Members 01-23 at 2.
75. Id.
76. Id.
77. Id.
78. The Policy Statement asserts that, in addition to when a member acts merely as an order-taker, the following activities and communications generally fall outside the definition of "recommendation": (1) A member creates a Web Site that is available to customers or groups of customers [which has] research pages or "electronic libraries" that contain research reports; . . . news, quotes, and charts that customers can obtain or request. (2) A member has a search engine on its Web Site that enables customers to sort through the data available about the performance of a broad range of stocks and mutual funds, company fundamentals, and industry sectors. The data is not limited . . . and does not favor, securities in which the member makes a market or has made a "buy" recommendation. Customers use and direct this tool on their own. Search results from this tool may rank securities using any criteria selected by the customer, and may display current news, quotes, and links to related sites. (3) A member provides research tools on its Web Site that allow customers to screen through a wide universe of securities (e.g., all exchange-listed and N[ASDAQ] securities) or an externally recognized group of securities (e.g., certain indexes) and to request lists of securities that meet broad, objective criteria (e.g., all companies in a certain sector with 25 percent annual earnings growth). The member does not impose limits on the manner in which the research tool searches through a wide universe of securities, nor does it control the generation of the list in order to favor certain securities. . . . (4) A member allows customers to subscribe to e-mails or other electronic communications that alert customers to news affecting the securities in the customer's portfolio or on the customer's "watch list." Id. at 3.
79. The Policy Statement asserts that the following activities and communications generally fall within the definition of "recommendation:" (1) A member sends a customer-specific electronic communication (e.g., an e-mail or pop-up screen) to a targeted customer or targeted group of customers encouraging the particular customer(s) to purchase a security. (2) A member sends its customers an e-mail stating that customers should be invested in stocks from a particular sector . . . and urges customers to purchase one or more stocks from a list with "buy" recommendations. (3) A member provides a portfolio analysis tool that allows a customer to indicate an investment goal and input personalized information such as age, financial condition, and risk tolerance. The member in this instance then sends (or in this instance displays to) the customer a list of specific securities the customer could buy or sell to meet the [customer's investment objective]. (4) A member uses data-mining technology . . . to analyze a customer's financial or online activity . . . and then, based on those observations, sends (or "pushes") specific investment suggestions that the customer purchase or sell a security. Id. 73. Id. at 4.
80. President George W. Bush designated Laura S. Unger as Acting Chairman of the Securities and Exchange Commission on February 12, 2001. See Laura S. Unger Designated as Acting Chairman, Press Release 2001-20, available at .
81. SEC Has Eye on Internet Suitability and Advertising, BD WEEK, April 9, 2001 at 3.
82. Id.
83. See NASD Conduct Rule 2320, NASD Manual (CCH) ¶ 2320, at 4265 (Dec. 2000); New York Stock Exchange Rule 123A.41, N.Y.S.E. Guide (CCH) ¶ 2123A.41, at 2748 (Mar. 2001).
84. See NASD Conduct Rule 2320, NASD Manual (CCH) ¶ 2320, at 4265 (Dec. 2000); New York Stock Exchange Rule 123A.41, N.Y.S.E. Guide (CCH) ¶ 2123A.41, at 2748 (Mar. 2001).
85. For a detailed discussion of a broker-dealer's duty of best execution, see Order Execution Obligations, Exchange Act Release No. 37,619A, 61 Fed. Reg. 48,290 (Sept. 6, 1996). See also SEC, MARKET 2000: AN EXAMINATION OF CURRENT EQUITY MARKET DEVELOPMENTS (1994), available at 1994 SEC LEXIS 136, at *11-*12; In re E.F. Hutton & Co., Inc., Exchange Act Release No. 25,887, 41 SEC Docket (CCH) 413, 418 (July 6, 1988); Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998).
86. For a detailed discussion of a broker-dealer's duty of best execution, see Order Execution Obligations, Exchange Act Release No. 37,619A, 61 Fed. Reg. 48,290 (Sept. 6, 1996). See also SEC, MARKET 2000: AN EXAMINATION OF CURRENT EQUITY MARKET DEVELOPMENTS (1994), available at 1994 SEC LEXIS 136, at *11-*12; In re E.F. Hutton & Co., Inc., Exchange Act Release No. 25,887, 41 SEC Docket (CCH) 413, 418 (July 6, 1988); Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998).
87. For a detailed discussion of a broker-dealer's duty of best execution, see Order Execution Obligations, Exchange Act Release No. 37,619A, 61 Fed. Reg. 48,290 (Sept. 6, 1996). See also SEC, MARKET 2000: AN EXAMINATION OF CURRENT EQUITY MARKET DEVELOPMENTS (1994), available at 1994 SEC LEXIS 136, at *11-*12; In re E.F. Hutton & Co., Inc., Exchange Act Release No. 25,887, 41 SEC Docket (CCH) 413, 418 (July 6, 1988); Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270-71 (3d Cir. 1998).
88. SEC, Second Report on Bank Securities Activities, at 97-98, n.233, reprinted in H.R. REP. No. 145, 95 Cong., 1st Sess. 233 (Comm. Print 1977).
89. Internalization generally refers to circumstances where a broker-dealer retains or internalizes customer orders and executes those transactions as principal rather than forwarding customer orders to other broker-dealers for execution.
90. Payment for order flow generally refers to arrangements broker-dealers have with other broker-dealers that make markets in hundreds of different securities. Pursuant to a payment for order flow arrangement, one broker-dealer agrees to send its customer order flow to another broker-dealer for execution in return for payment, typically $.01 or $.02 per share. The executing broker-dealer is willing to pay the routing broker-dealer a certain sum to ensure that the executing broker-dealer will have order flow against which it can effect transactions. See generally THOMAS P. LEMKE & GERALD T. LINS, SOFT DOLLARS AND OTHER BROKERAGE ARRANGEMENTS 273-78 (1999-2000 ed.).
91. Unger Report, supra note 1, at 44-45.
92. Id. at 45. The enactment of Rule 11Ac1-5, in effect, implements this recommendation. 17 C.F.R. § 240.11Ac1-5 (2001).
93. Id. The enactment of Rule 11Ac1-6, in effect, implements this recommendation. 17 C.F.R. § 240.11Ac1-5 (2001).
94. Id.
95. Id.
96. OCIE Report, supra note 20, at 7.
97. Id.
98. Id.
99. The Commission approved Rules 11Ac1-5 and 11Ac1-6 on November 15, 2000. Disclosure of Order Execution and Routing Practices, Exchange Act Release No. 43,590, 65 Fed. Reg. 75,414 (Nov. 17, 2000); SEC Chairman Arthur Levitt, Jr., Opening Statement at the Commission Open Meeting on Market Structure Initiatives in the Options and Equities Markets and Rules Governing Auditor Independence, Public Disclosure of Order Routing Practices and Execution Quality (Nov. 15, 2000), available at
100. ECNs, or electronic communications networks, are registered broker-dealers that, pursuant to Regulation ATS, compete for investor order flow with the NASDAQ and the various exchanges. ECNs make markets and provide quotations that are publicly displayed in the consolidated quotation system. ECNs are not subject to many of the regulatory burdens imposed on national securities exchanges and the NASD, but must comply with the requirements of Regulation ATS, depending on their activities and trading volume. See Regulation of Exchanges and Alternative Trading Systems, Exchange Act Release No. 40,760, 63 Fed. Reg. 70,921 (Dec. 22, 1998) (adopted by Regulation ATS, 17 C.F.R. § 242.300-303 (1999)).
101. Disclosure of Order Execution and Routing Practices, Exchange Act Release No. 43,590, 65 Fed. Reg. 75,414, 74,435 (Nov. 17, 2000).
102. Id.
103. The Commission extended the initial compliance date of Rule 11Ac1-5 from April 2, 2001, to May 1, 2001. The extension was intended to allow market centers a fuller opportunity to implement procedures for making reports available to the public and to incorporate the Commission staff's interpretive guidance on the Rule. The extension also provided market centers additional time to program their systems to comply with the Rule's reporting requirements and to produce accurate, reliable, and useable monthly reports. See Disclosure of Order Execution and Routing Practices, Exchange Act Release No. 44,060, 74 SEC Docket (CCH) 1193 (Mar. 9, 2001). The Division of Market Regulation also has issued Staff Legal Bulletin No. 12, which sets forth the views of the staff of Market Regulation in response to frequently asked questions concerning Rule 11Ac1-5,
104. see SEC Staff Legal Bulletin No. 12 (MR) (Mar. 12, 2001), available at , and the Commission on April 13, 2001 issued an order approving a national market system plan that establishes procedures for market centers to follow in making reports available under Rule 11Ac1-5. Joint Industry Plan; Order Approving Plan Establishing Procedures under Rule 11Ac1-5 by the American Stock Exchange, Boston Stock Exchange, Chicago Stock Exchange, Cincinnati Stock Exchange, National Association of Securities Dealers, New York Stock Exchange, Pacific Exchange and Philadelphia Stock Exchange, Exchange Act Release No. 44,177, 74 SEC Docket (CCH) 1598 (Apr. 13, 2001).
105. See Commission Issues Three-Month Exemption for NASDAQ Securities From Order Execution Quality Disclosure Rule, Press Release 2001-36, available at . The Division of Market Regulation, pursuant to delegated authority, on March 12, 2001 granted a temporary exemption until July 31, 2001 from the reporting requirements of the rule for smaller NASDAQ market centers. See Letter from Annette L. Nazareth, Director, Division of Market Regulation, SEC, to Stuart J. Kaswell, Senior Vice President and General Counsel, Securities Industry Association (Apr. 12, 2001) available at (citing Letter from Annette L. Nazareth to Richard G. Ketchum, President, NASDAQ (March 12, 2001)). The Securities Industry Association, Inc. (SIA) on April 11, 2001 requested a temporary exemption for all market centers that do not fall within the exemption previously granted smaller NASDAQ market centers. The Commission, through the Division of Market Regulation acting pursuant to delegated authority, granted the SIA's exemption request primarily to help assure the integrity and accuracy of information made available to the public during the initial months of reporting under Rule 11Ac1-5. The Division noted that it was essential for all significant market centers trading NASDAQ securities to begin reporting on their order executions at the same time and that the information available to the public be reliable and not materially misleading. See Letter from Annette L. Nazareth, Director, Division of Market Regulation, SEC to Stuart J. Kaswell, Senior Vice President and General Counsel, Securities Industry Association (April 12, 2001), available at .
106. NASD Reiterates Member Firm Best Execution Obligations and Provides Guidance to Members Concerning Compliance, NASD Notice to Members 01-22, at 201-09 (April 2001) available at .
107. Id. at 207.
108. Id. at 204.
109. Id.
110. The NTM specifically notes that NASD Regulation has brought disciplinary actions resulting from findings that customer orders were executed: (i) at prices inferior to the national best bid and offer without justification; (ii) in an untimely fashion; and (iii) in a manner designed to allow the member to profit at the expense of the customer. Id. at 201.
111. Id. at 207.
112. Id. at 205. The reviews should be conducted at least quarterly, though member firms should consider, based on their business activities, whether more frequent reviews are warranted.
113. NASD Regulation in July 2001 issued Notice to Members 01-44 to inform its members about interpretive guidance SEC Staff have provided with respect to Rules 11Ac1-5 and 11Ac1-6, available at . This NTM specifically noted that on June 22, 2001 SEC staff issued Staff Legal Bulletin 12R (Revised), which addresses frequently asked questions regarding Rule 11Ac1-5, and Staff Legal Bulletin 13, which addresses frequently asked questions about Rule 11 Ac1-6. The Staff Legal Bulletins also address interpretive questions SEC staff have answered with respect to Rules 11Ac1-5 and 11Ac1-6. Broker-dealers should periodically check the SEC's website to determine whether the SEC staff has updated Staff Legal Bulletin 12R and Staff Legal Bulletin 13. SEC staff review these legal bulletins and supplement them as necessary. Because Rules 11Ac1-5 and 11Ac1-6 are just now being implemented, it is likely that additional guidance from SEC staff can be expected in light of actual experience.
114. Securities Exchange Act § 11A, 15 U.S.C. § 78k-1(c)(1) (1994).
115. Resolution of Market Information Fees and Revenues, Exchange Act Release No. 42,208, 64 Fed. Reg. 70,613, 70,614 (Dec. 9, 1999).
116. Id. at 70,615. This twenty-one percent figure, despite the rapid growth in market information revenues, is a percentage that has remained remarkably steady during the 1994-98 period. Id.
117. Unger Report, supra note 1, at 47. Currently neither the Consolidated Tape Association (CTA), which disseminates last sale information for exchange listed and traded securities, nor the NASD, which disseminates last sale information for NASDAQ securities, charges vendors for delivering delayed market data. Market data is considered delayed if it is at least 20 minutes old for exchange listed stocks and at least 15 minutes old for NASDAQ securities.
118. Id. at 49.
119. Regulation of Market Information Fees and Revenues, Securities Exchange Act Release No. 42,208, 64 Fed. Reg. 70,613 (Dec. 9, 1999). In this concept release, the SEC noted that one of the most important functions that the Commission can perform for retail investors is to ensure that they have access to the information they need to protect and further their own interests. In this regard, the SEC added that communications technology now has progressed to the point that broad access to real-time market information should be an affordable option for most retail investors, as it long has been for professional investors.
120. SEC To Establish Advisory Committee On Market Information, SEC Press Release 2000-102 (July 25, 2000) available at .
121. Id. The Advisory Committee on Market Information is expected to address the following issues: "(1) the value of transparency to the markets; (2) the ramifications of electronic quote generation and decimalization for market transparency; (3) the merits of providing consolidated market information to intermediaries and customers; (4) alternative models for disseminating and consolidating information from multiple markets; (5) how market information fees should be determined, including the role of public disclosure of market information costs, fees, revenues, and other matters, and how the fairness and reasonableness of fees should be evaluated; and (6) appropriate governance structures for joint market information plans, as well as issues relating to plan administration and oversight." Id. 113. Id.
122. Charles Schwab & Co., Inc., SEC No-Action Letter, 1996 SEC No-Act. LEXIS 976 (Nov. 27, 1996).
123. Id.
124. Unger Report, supra note 1, at 102.
125. Id. at 104.
126. Whether a person is acting as a broker-dealer, which would require registration with the SEC, depends on the specific facts and circumstances. Although there is no single fact that is determinative of whether a person is engaged in the business of effecting transactions in securities for the account of others, the receipt of transaction based compensation related to securities transactions typically would require a person to be registered as a broker-dealer or be a registered representative associated with a registered broker-dealer. See generally John Polanin, Jr., The Finder's Exception From Broker-Dealer Registration, 40 CATH. U. L. REV. 787 (1991).
127. Many of the participants noted that the Commission seemed to be placing too much emphasis on the receipt of transaction-based compensation as the determining factor with respect to whether broker-dealer registration is required. Although this is certainly an important consideration in determining whether a person is acting as a broker-dealer and the SEC staff have placed great importance on receipt of transaction-based compensation when addressing requests for no-action relief over the years, it is not the only consideration. In this regard, the focus, in many participants' view, should be on whether the Internet service provider is engaged in the business of effecting transactions is securities for the account of others. Those participants noted that if this is the primary focus of the analysis then it is unlikely the typical Internet service provider would be considered a broker-dealer. In this regard, Internet service providers generally provide access to many different types of businesses, not just financial intermediaries, and a registered broker-dealer is always involved in any transaction as the customer must already have an account with the broker-dealer or open a new account before effecting a transaction.
128. Unger Report, supra note 1, at 77-78.
129. Id. at 76.
130. Id. at 86.
131. Id.
132. OCIE Report, supra note 20, at 6.
133. Id.
134. Privacy of Consumer Financial Information (Regulation S-P), Exchange Act Release No. 42,974, 65 Fed. Reg. 40,334, 40,373 (2000).
135. Gramm-Leach-Bliley Financial Modernization Bill Act, Pub. L. No. 106-102, § 501, 113 Stat. 1338, 1436, (to be codified at 15 U.S.C. § 6801). Gramm-Leach-Bliley was signed into law by President Clinton on November 12, 1999.
136. Regulation S-P, 65 Fed. Reg. at 40,362 (codified at 17 C.F.R. § 248 (2001)).
137. Unger Report, supra note 1, at 97.
138. Id.
139. The SEC published proposed Regulation S-P on March 2, 2000, see Privacy of Consumer Financial Information (Regulation S-P), Exchange Act Release No. 42,484, 65 Fed. Reg. 12,354 (Mar. 2, 2000), and received a total of 115 comment letters in response to the proposal. See Privacy of Consumer Financial Information (Regulation S-P), Exchange Act Release No. 42,974, 65 Fed. Reg. 40,333 (June 22, 2000).
140. OCIE Report, supra note 20, at 8-10.
141. Id. at 8.
142. Id. at 9.
143. Id.
144. Electronic Signatures in Global and National Commerce Act, Pub. L. No. 106-229, 114 Stat. 464 (2000) (to be codified at 15 U.S.C. §§ 7001-7031).
145. Id. at § 106(5).
146. Id. at § 106(a).
147. Id. at § 101(b).
148. Id. at § 101(c).
149. Market centers include exchanges, NASDAQ, and electronic communication networks (ECNs).
150. NORTH AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION, REPORT OF THE DAY TRADING PROJECT GROUP (Aug. 9, 1999), available at .
151. Id.
152. See Self-Regulatory Organizations; National Association of Securities Dealers, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 and Notice of Filing and Order Granting Accelerated Approval of Amendment No. 2 Relating to the Opening of Day-Trading Accounts, Exchange Act Release No. 43,021, 72 SEC Docket (CCH) 2047 (July 10, 2000).
153. Interestingly, although the rule defines day-trading to mean an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transactions in the same security or securities, the rule does not define what constitutes "promoting a day trading strategy." See NASD Conduct Rule 2360(g), NASD Manual (CCH) 4297 (Mar. 2001). According to NASD Notice to Members 00-62, a member will be subject to the day trading rules if it affirmatively promotes day trading activities or strategies through advertising, training seminars, or direct outreach programs. SEC Approves Day-Trading Rules, NASD Notice to Members 00-62, 465 (Sept. 2000), available at .
154. See NASD Conduct Rule 2361, NASD Manual (CCH) 4297 (Mar. 2001). Firms are required to deliver the disclosure statement to each customer individually, by mail or other electronic means, prior to the opening of the account. The customer, however, is not required to sign the disclosure statement. See NASD Notice to Members 00-62, at 466 (Sept. 2000), available at .
155. See NASD Conduct Rule 2361, NASD Manual (CCH) 4297 (Mar. 2001). Firms are required to deliver the disclosure statement to each customer individually, by mail or other electronic means, prior to the opening of the account. The customer, however, is not required to sign the disclosure statement. See NASD Notice to Members 00-62, at 466 (Sept. 2000), available at .
156. See NASD Conduct Rule 2360, NASD Manual (CCH) 4296 (Mar. 2001). This rule, in essence, is a day trading suitability rule, as it requires the firm to make a threshold determination that day trading is appropriate for the customer. This determination is made by ascertaining essential facts relative to the customer, including investment objectives, financial condition, investment and trading knowledge and experience, age, number of dependents. The firm must also prepare and maintain records that record the rationale for approving a customer's account for day trading. See NASD Notice to Members 00-62, at 466 (Sept. 2000), available at .
157. See NASD Conduct Rule 2360, NASD Manual (CCH) 4296 (Mar. 2001). This rule, in essence, is a day trading suitability rule, as it requires the firm to make a threshold determination that day trading is appropriate for the customer. This determination is made by ascertaining essential facts relative to the customer, including investment objectives, financial condition, investment and trading knowledge and experience, age, number of dependents. The firm must also prepare and maintain records that record the rationale for approving a customer's account for day trading. See NASD Notice to Members 00-62, at 466 (Sept. 2000), available at .
158. See, e.g., Chairman Levitt, Jr., supra note 2.
159. OCIE's report of findings and recommendations relating to its 1999-2000 examination of broker-dealers providing their customers with on-line trading services provides a roadmap as to what SEC examiners will be focusing on in future examinations. OCIE Report, supra note 20, at 11.
160. NASD Conduct Rule 3010(c), NASD Manual (CCH) 4833 (1999).
161. Id.
162. NASD Conduct Rule 3010(a), NASD Manual (CCH) at 4831.
163. For a comprehensive discussion of the scope and applicability of the attorney client privilege and attorney work product doctrines, see EDNA SELAN EPSTEIN, THE ATTORNEY-CLIENT PRIVILEGE AND THE WORK PRODUCT DOCTRINE (3d ed. 1997).
164. See Georgia Pac. Corp. v. GAS Roofing Mfg. Corp., 93 C.V. 5125 (RPP), 1996 U.S. Dist. LEXIS 671 (S.D.N.Y. Jan. 24, 1996) (addressing in-house attorney's communications regarding negotiation of contract provisions not privileged).
165. Numerous possibilities exist. Attorneys from a broker-dealer's legal department may conduct the review under the direction of the firm's chief legal officer. In other circumstances, an attorney working within a broker-dealer's compliance department may conduct the review under the direction of the Compliance Department. And in many circumstances, reviews may be conducted with personnel, including attorneys, from a firm's compliance and internal review departments.
166. The question of the capacity in which counsel acts, particularly in-house counsel, arises with substantial frequency and is difficult to resolve. The giving of legal advice is often intertwined with the giving of business advice. For a good discussion of this issue, see EDNA SELAN EPSTEIN, THE ATTORNEY-CLIENT PRIVILEGE AND THE WORK PRODUCT DOCTRINE 93-106 (3d ed. 1997).
167. SEC and SRO examination staff generally do not begin broker-dealer examinations by requesting copies of internal audit or other similar reports. Rather the staff may request evidence that required internal reviews in fact were completed. Nevertheless, depending on what SEC and SRO examination staff find during the course of their examinations, they may request access to internal audit and other similar documents. See John F. X. Pelosso, The Privilege for Self-Critical Analysis: Protecting the Public by Protecting the Confidentiality of Internal Investigations in the Securities Industry, 18 SEC. REG. L.J. 229, 255 (1990).
168. See John Calvin Conway, Note, Self-Evaluative Privilege and Corporate Compliance Audits, 68 S. CAL. L. REV. 621, 650 (1995); John F. X. Peloso, The Privilege for Self-Critical Analysis: Protecting the Public by Protecting the Confidentiality of Internal Investigations in the Securities Industry, 18 SEC. REG. L.J. 229, 230-31 (1990); Note, The Privilege of Self-Critical Analysis, 96 HARV. L. REV. 1083 (1983).
169. See John Calvin Conway, Note, Self-Evaluative Privilege and Corporate Compliance Audits, 68 S. CAL. L. REV. 621, 650 (1995); John F. X. Peloso, The Privilege for Self-Critical Analysis: Protecting the Public by Protecting the Confidentiality of Internal Investigations in the Securities Industry, 18 SEC. REG. L.J. 229, 230-31 (1990); Note, The Privilege of Self-Critical Analysis, 96 HARV. L. REV. 1083 (1983).
170. See John Calvin Conway, Note, Self-Evaluative Privilege and Corporate Compliance Audits, 68 S. CAL. L. REV. 621, 650 (1995); John F. X. Peloso, The Privilege for Self-Critical Analysis: Protecting the Public by Protecting the Confidentiality of Internal Investigations in the Securities Industry, 18 SEC. REG. L.J. 229, 230-31 (1990); Note, The Privilege of Self-Critical Analysis, 96 HARV. L. REV. 1083 (1983).
171. Senior SEC and NASD Regulation staff have indicated that recent broker-dealer examinations have revealed that some firms are not conducting rigorous execution quality reviews. See Internal Controls Will Be High On Regulators' Scrutiny List, BD WEEK, Jan. 22, 2001, at 2.
172. See Gramm-Leach-Bliley Financial Modernization Bill Act, Pub. L. No. 106-102, § 502, 113 Stat. 1338, 1437 (1999) (to be codified at 15 U.S.C. § 6802).
173. Senior staff from the SEC's Office of Compliance Inspections and Examinations recently have noted that some on-line trading firms currently do not have the necessary encryption systems for customer communications and maintain inadequate firewalls to deter hackers. See Internal Controls Will Be High On Regulators' Scrutiny List, BD WEEK, January 22, 2001 at 8.
174. Pub. L. No. 106-229 § 101, 114 Stat. 464 (2000) (to be codified at 15 U.S.C. § 7001).
175. Barry Goldsmith, Executive Vice President and Director of NASD Regulation, Inc.'s Department of Enforcement, recently noted that regulators are currently scrutinizing a practice known as "journaling," whereby day-trading firms arrange customer-to-customer loans to cover some day traders' margin. See Some Day Trader Practices Still Concern NASDR, BD WEEK, January 22, 2001, at 7.
176. 17 C.F.R. § 240.15c2-5 (2000).
177. See In re Gutfreund, Exchange Act Release No. 31,554, 52 SEC Docket (CCH) 2849 (Dec. 3, 1992).