The Securities Industry and the Internet: A Suitable Match?

Monday, January 1st, 2001 at 12:00 am by Nancy C. Libin & James S. Wrona
Nancy C. Libin & James S. Wrona, The Securities Industry and the Internet: A Suitable Match?, 2001 Colum. Bus. L. Rev. 601

Technological innovation has radically changed the securities industry. One significant development is the advent of online brokerage accounts. The number of online accounts in the United States grew from about 1.5 million in 1996 to over 23 million by the end of 2000, and one estimate suggests about 18 percent of investors used the Internet to buy or sell securities as of January 2000. Another important change is the increased use of the Internet by broker-dealers to communicate with customers. As the National Association of Securities Dealers, Inc. (‘NASD ‘) explained in a Notice to Members (‘NTM‘), ‘In addition to more traditional channels of communication such as the telephone and postal mail, broker/dealers and customers now transmit information to each other through broker/dealers’ web sites, e-mail, web phones, personal digital assistants, and hand-held pagers.‘

Undoubtedly, online brokerage services benefit both broker-dealers and their customers. Broker-dealers now use technology to offer lower-cost, unbundled services that empower investors by providing them with new tools to obtain ‘important analytical information, conduct their own research, and place their own orders.‘ Indeed, online brokerage services give ordinary retail investors access to the kind of financial research that once was available only to institutions and very wealthy individuals. Online brokerage services also present new challenges, however, such as determining how the suitability rule applies online.

The suitability rule governs the methods by which a broker-dealer can induce a customer to purchase, sell, or exchange a security. Generally, this rule requires a broker-dealer, in recommending a particular security to a specific customer, to have reasonable grounds for believing that the security is suitable for that customer. The suitability rule seeks to neutralize the inherent conflict of interest in the broker-customer relationship, in which the broker-dealer’s interest in generating commissions may be at odds with the customer’s interest. This rule also implicitly recognizes that customers may rely on broker-dealers’ special investment skills and knowledge, and it is thus appropriate to make broker-dealers responsible for the investment advice that they give to customers.

The growth and development of online brokerage services have created substantial debate about the applicability of the suitability rule to online activities. A number of broker-dealers have argued that, because the Internet has altered the broker-customer relationship, the suitability rule does not, or should not, apply to online trading activities. According to this theory, the potential conflict of interest inherent in the traditional broker-customer relationship is absent in the online environment because most online investors manage their own accounts. Also, some broker-dealers have contended that applying the suitability rule to online activities would require them to limit the flow of information to online investors (conceivably stifling innovation) because they would be forced to withhold information or services that could be considered a ‘recommendation‘ to purchase or sell a security.

Conversely, some commentators have argued that because online investing is a risky investment strategy for certain investors, a more stringent suitability rule is necessary. Others have posited that the current suitability rule is applicable in the online environment because broker-dealers make recommendations online and potential conflicts of interests still exist.

The sound resolution of the issues created by the intersection of online brokerage activities and the suitability rule is critical because an ill-conceived regulatory response could jeopardize technological innovation or investor protection, or both. Regulators therefore must find a way to protect individual investors without interfering unnecessarily with the use of new technologies by broker-dealers (to become more efficient) and markets (to become more transparent).

As regulators try to navigate this uncharted territory, they would do well to consider a line from the 19th century English poet Alfred Lord Tennyson. In L ocksley H all, Tennyson wrote that ‘[k]nowledge comes, but wisdom lingers. ‘ Knowledge, or technological know-how, has indeed come–with a vengeance–and with knowledge has come tremendous change. It is likely, however, that the securities industry does not yet understand all the implications of this new technology. The new technology that broker-dealers can use to offer innovative services to investors is being developed rapidly, but whether broker-dealers and investors are using–or will use–that technology wisely in all instances remains uncertain. In order to allow wisdom to develop over time, a cautious approach by both brokerage firms and regulators may be prudent.

Although the suitability rule has been the subject of much scholarly analysis, its application to online activities has yet to be fully addressed in the literature. This Article explains both why the suitability rule is still needed to protect online investors and how the suitability rule applies in the online environment. It also proposes new standards and a new rule to address unique problems that arise in the online context.

Part II of this Article provides an overview of the suitability rule. Part III analyzes the applicability of the suitability rule to certain online brokerage activities. Part IV discusses the suitability rule’s application to initial public offerings and proposes a potential new rule to protect customers who invest in them.

Author Information

Nancy Libin and James Wrona are both an Assistant General Counsel of NASD Regulation, Inc., in Washington, D.C.