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Denis T. Rice, July 1998

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III. Secondary Trading of Securities in Cyberspace. Continued

E. The Effect of Online Discount Trading on Suitability and Other Obligations of Broker-Dealers.

Because online discount trading is essentially impersonal and customer-driven, online firms have less of certain broker-dealer obligations, such as those of suitability and a reasonable basis for recommendations. The suitability doctrine holds that, when a broker-dealer recommends a security to a specific customer, it impliedly represents that it has determined that the security is suitable for that customer in the light of the latter’s financial situation and investment objectives. The requirement that a broker-dealer have a reasonable basis for recommending a given security is a separate but parallel duty. Both duties have their genesis in the so-called “shingle theory.” In other words, a broker-dealer, simply by “mounting his shingle,” impliedly represents that it will deal fairly with the public regardless of whether it is compensated as broker or as dealer.

Online discount trading involves minimal contact between broker-dealer and customer and an absence of recommendations, hence there are no obligations of suitability or reasonable basis. Both suitability and the duty to have a reasonable basis involve a situation where a trade is recommended by the broker-dealer. Accordingly, if a broker does not recommend the transaction, it has a much more limited duty. As a matter both of regulatory interpretation and case law, a broker-dealer has not been held to an obligation to determine whether a customer’s investment is suitable for that customer unless the broker-dealer has made a specific recommendation of that security to that customer.

An investor accessing the Web site of a discount broker normally will not find individually tailored recommendations of investments; instead, brokerage Web sites contain impersonal, general recommendations to the public at large, much like print periodicals that register as investment newsletters. At least to this point, Internet brokers have concentrated on distribution of impersonal information to viewers at large, making the medium more akin to generally distributed advertising. It is therefore notable that the SEC, in issuing special suitability rules, has generally held that distribution of general, impersonal advertising material does not, in itself, give rise to suitability obligations on the part of the broker. The same rule should probably apply to Web site information.

However, neither the SEC nor the NASD has yet provided a specific answer as to whether Web site information in itself may constitute a “recommendation to the customer” that gives rise to suitability obligations. While the NASD’s Rule 2210 contemplates that certain advertising and sales material, including generally available electronic communications, can constitute a recommendation, the NASD has refrained from providing a formal definition of the term “recommendation” as used in Rule 2310. The NASD has said prior a suitability notice was “intended only to stress that recommendations may be made in a variety of ways, and that the determination of whether a recommendation has been made in any given case does not depend on the mode of communications.” Analysis of the facts and circumstances surrounding paradigmatic electronic trading establishes that the information provided cannot be regarded as recommendations yielding suitability obligations.

Thus, when online trading goes beyond unsolicited orders, suitability may become a factor. In the event commission broker-dealers offer electronic trading as a supplement to traditional interactions and relationships with customers, who receive individually-tailored recommendations concerning particular securities places orders electronically, the traditional suitability analysis would be appropriate. The trend in the Internet is toward empowering the individual more than the professional. As discussed below, the Internet is able to provide small investors access to information and methods of trading previously available only to licensed brokers or investment advisors. In the words of SEC Chairman Arthur Levitt Jr.,

“One of the tools that is giving investors unprecedented opportunities is the Internet. Information and ideas are flowing constantly over an affordable, accessible system– giving individuals the same access to market information as large institutions. The Internet is a supremely powerful force for the democratization of our marketplace.”

F. Clearing, Back Office Operations and Market Data.

Internet services available to broker-dealers are not limited to institutional sales or retail activities. Many broker-dealers do not handle the execution or clearing of their customer’s transactions or other “back-office” functions, but instead have them handled by clearing firms. Over the past few years, clearing firms have sought to position themselves to offer clearing services via the Internet. PaineWebber’s Correspondent Services Corp. for example, provides execution and clearing services for about 125 correspondent firms. It has developed an Internet information delivery system which offers account access, market data and other services to retail customers of U.S. correspondent firms, which in turn receive account information, online forms and broker order entry over the Internet. Since late 1996, Pershing, National Financial Services Corp., BHC Securities and other clearing firms unveiled Internet services that will allow retail brokerage firms and their customers the ability to access account information, market data, research and news, as well as to execute trades.

U.S. Clearing Corp. (“USCC”), a large clearing and execution firm, in April, 1997 announced a jointly-operated Internet service with Ernst & Co. for discount brokers that, among other things, would provide access to a database of 6,000 mutual funds. USCC also introduced an Internet securities tracking system in 1996 through an affiliated discount broker, Quick & Reilly, Inc. In late 1997, E*Trade began to offer its clients online access to mutual fund prospectus covering more than 4,000 funds. The system, developed by InUnity Corp., eliminates delays traditionally experienced in obtaining hard copies of fund prospectuses. The kinds of services that can be made available are endless, and could enable smaller broker-dealers to offer a much greater array of financial services and products than they have been able to previously.

G. Bulletin Boards and Message Groups as Secondary Trading Tools on the Web.

Assuming a small issuer successfully completes an online DPO, its securities may not become eligible for trading on Nasdaq or even in the over-the-counter (“OTC”) market maintained by broker-dealers. As a practical matter, broker-dealers will not actively make a market in a security if the issuer is not registered with the SEC under Section 12(g) of the 1934 Act and filing periodic reports required by that statute. Registration under the 1934 Act is only required when an issuer has at least 500 recordholders of a class of its securities and at least $10 million in assets. Because of the small size of DPOs and the issuers that use them, 1934 Act registration of the issuers is therefore generally not mandated. Newly-issued securities will not qualify for listing on Nasdaq unless the issuer meets Nasdaq requirements, such as minimum per share bid price, minimum public “float” (i.e., proportion of shares owned by the public) minimum market value, total assets, total equity and number of shareholders.

For a DPO issuer, the World Wide Web offers bulletin board trading as an alternative (or, in some cases, a supplement) to trading on Nasdaq or in the OTC market. On a Web bulletin board, potential buyers and sellers can post bids and offers and contact each other to facilitate transactions. Bulletin boards started with issuers who had made DPOs and sought to facilitate secondary trading. Spring Street Brewing was perhaps the first to attempt a bulletin board for its issued securities, but its early encounter with SEC problems ultimately led its promoter, Wit Capital, to move away from the bulletin board and become a licensed broker-dealer, undertaking to help other issuers establish online markets.

One of the early boards was that of “Real Goods `Off-the Grind’ Trading System,” operated by Real Goods at Real Goods, which issued the stock traded on the board, markets environmentally-oriented consumer goods such as energy-saving appliances. It obtained the SEC’s first no-action letter authorizing a Web site bulletin board in 1996, allowing it to operate a Web page for trading in its own shares. The SEC stated that Real Goods could operate the site without registering as a broker-dealer or investment adviser, on the condition that Real Goods would play no role in effecting any transaction, receive no compensation for creating and maintaining the system, not receive, transfer or hold funds or securities in connection with operating the system, put disclaimers on the site regarding any registered status, keep records of all quotes entered, and inform users of the applicability of securities laws to offers and sale.

Other issuers who proposed their own passive bulletin boards for prospective buyers and sellers of their common stock obtained similar no-action letters from the SEC. Thus, “PerfectData Corporation” (, like Real Goods, is a DPO issuer that provides a bulletin board for secondary trades only in its own stock. This is accomplished in a subsite called “PerfecTrade,” where potential buyers and sellers can post offers to buy or sell and then contact each other to facilitate transactions in PerfectData common stock. PerfecTrade’s business is operating an Internet service provider. Like Real Goods, it does not charge any commissions or transaction fees, and its site contains recent trading activity and stock quotations on PerfectData common. The Flamemaster Corporation received an SEC no-action letter for a parallel operation.

In contrast to the foregoing bulletin boards, which involve trading solely in the operator’s own outstanding stock, a company named Internet Capital Corporation (“ICC 2,” unrelated to ICC 1 discussed earlier in Section II) proposed in late 1997 to operate a bulletin board to cover trading in other issuers’ stock. It sought a no-action letter from the SEC authorizing it to operate a “passive” bulletin board without being required to register as a broker-dealer, investment adviser or national securities exchange. ICC 2 proposed that its bulletin board would only be available to companies whose common stock is either already registered under Section 12 of the 1934 Act or who file supplemental periodic information and reports in accordance with Section 15(d) of that Act.

ICC 2’s Web site would, in addition to the bulletin board, provide access to each company’s public SEC filings by hyperlinks to the SEC’s EDGAR database, a brief summary of information from the company’s SEC Form 10-K, a directory of all of the companies that are listed on an organized exchange such as the New York Stock Exchange or NASDAQ, and a periodic ICC 2 newsletter. ICC 2 would charge each company on its site a one-time fee for setting up its information and a monthly fee for maintaining its information. Importantly, neither ICC 2 nor any affiliate was to receive any compensation in connection with the purchase and sale of any common stock listed on its bulletin board. Its monthly fees to the listed issuers would not be related to the number or size of the quotes, expressions of interest or “hits” on a company’s information page. However, ICC 2 would reserve the right to require viewers in the future to pay a one-time fee upon their initial registration as a site participant. No transaction would be effected on the bulletin board itself. Instead, the board would give participants (1) the names, addresses and telephone numbers (or other contacts, such as e-mail) of all interested buyers and sellers, (2) the number of shares to be involved in a trade, (3) whether the participant is a prospective buyer or seller, (4) the proposed price, and (5) the date on which the information will be deleted from the bulletin board. The trades would all be effected only by direct contract between participants, and ICC 2 would not maintain transaction records. Neither ICC 2 nor any affiliate would (1) be involved in any purchase or sale negotiations, (2) give any advice on the merit of any trade, (3) use the bulletin board to offer to buy or sell securities, (4) receive, transfer or hold funds or securities as an incident of operating the bulletin board, or (5) directly or indirectly facilitate the clearance or settlement of any securities transactions except to refer participants to a bank.

Among various notifications and disclaimers that ICC proposed to include on the site were these:

(a) a disclaimer that ICC 2 is a registered broker-dealer or securities exchange;

(b) a prohibition against “two-sided quotes,” in which a person indicates both a bid at one price and an offer at a higher price;

(c) a disclaimer that the bulletin board postings are firm offers or quotes or that ICC 2 warrants any of the posted information;

(d) a warning that the registration requirements of the federal securities laws apply to all offers and sales through the bulletin board, hence each participants must ascertain the availability of an applicable exemption from registration.

In issuing its no-action letter allowing the foregoing method of operation to go forward, the SEC advised that it would not require ICC 2 to register under the 1934 Act as a national securities exchange or as a broker-dealer. In a second letter in January 1998, the SEC also advised that it would not require ICC to register as an investment adviser under Section 203(a) of the Investment Advisers Act of 1940.

H. “Membership”-Type Trading for the Public.

Wit Capital, which launched the first DPO on the Internet in 1995 and then abandoned a bulletin-board trading operation in 1996, brought out an Instinet look-alike in the summer of 1998. Called the Digital Stock Market, the system offers trading in over-the-counter and listed securities. ( Like Instinet, the system allows members to view and enter orders based on the “national best bid-and-offer” (NBBO) prices. The NBBO quotes will be drawn from the National Market System. A Wit Capital subscriber can trade based upon the NBBO quote listed in Wit’s system or can contact other subscribers directly and attempt to negotiate a better price inside the NBBO spread.

I. Effects of Electronic Trading on Stock Exchanges.

As electronic trading of all kinds has proliferated, the prices of seats on major stock exchanges have plummeted. In the first half of 1998, prices of seats on major exchanges in New York, Chicago, Philadelphia and even London dropped between 10 and 40 percent.While other factors have played a role, the largest concern is the rise of electronic trading. The growing competition from the extranets such as Instinet and Island have raised concerns over the very existence of the auction markets conducted on exchange floors. The chairman of the London International Financial Futures and Options Exchange has questioned “whether you’ll even need exchanges in the next century.”

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