Corporation, Securities & Business Law Forum
March 2003 VOL. 48, NO. 3
Statements or expressions of opinion or comments appearing herein are those of the editors or contributors, and not necessarily those of the association or section.
Contents
* New technology raises a new question: What is the definition of a broker-dealer?
* Security futures: The "state of the union"
* The name game: Preventing trademark infringement against newly formed businesses
New technology raises a new question: What is the
definition of a broker-dealer?
By Ana M. Mencini
Introduction
One of the goals of the Securities and Exchange Commission (Commission) is to ensure that the Commission meets the challenge of keeping up with technology and its impact on the marketplace. (See remarks by Acting Chairman Laura S. Unger at "The SEC Speaks in 2001," sponsored by the Practicing Law Institute (Mar 2, 2001) (transcript available at <http://www.sec.gov/news/speech/spch465.htm> [hereinafter Unger Speech One]). To this end, the Commission established the Office of Internet Enforcement (OIE) in July 1998 to combat online fraud. (See The Securities and Exchange Commission, Internet Enforcement Program: About the Office of Internet Enforcement (Oct 26, 2002), available at <http://www.sec.gov/divisions/enforce/internetenforce.htm>). In addition to the OIE, the Commission established the "CyberForce," which is comprised of attorneys, accountants, and investigators who monitor the Internet for fraud. (See id). To date, the Commission has performed five "Internet Fraud Sweeps" to find and end trading-related fraud on the Internet. (See id). However, the Internet's impact on the marketplace is not limited to fraudulent trading and practices. Advances in the use of the Internet and the sheer volume of users and information on the Internet has changed some of the basic assumptions that are made about the marketplace. This article examines one of those assumptions: who is a broker-dealer in this age of financial portals and Web sites? The answer to this question is not yes or no; it depends on the what activities the portal is performing, how it interacts with clients, and what safeguards are already in place for the investing public. This article will examine which online financial portals are required to register as broker-dealers and it will explore those factors which are critical to the determination of whether registration is required. Questions such as this one take on a certain urgency because of the phenomenal growth of the Internet and its ability to affect so many people. As Acting Chairman Unger noted in March 2001, "[i]n the midst of such rapid and dynamic change, standing still [is] almost the same as walking backwards." (Id.)
Part I of this article will address what the Internet is, who uses the Internet, and why it is different from other technologies. Part II of this article will discuss which online financial portals are required to register as a broker-dealer. Finally, the article will conclude with some remarks concerning how attorneys should address this issue when advising clients.
The Internet
"The Internet is not a physical or tangible entity, but rather a giant network which interconnects innumerable smaller groups of linked computer networks." (ACLU v. Reno, 929 F Supp 824, 830 (ED Pa 1996), aff'd, 117 S Ct 2329 (1997)). The Internet is unique in that no single entity owns, administers, or maintains it. (Id at 832). Its existence is dependent on the "hundreds of thousands of separate operators of computers and computer networks [who] independently decided to use common data transfer protocols to exchange communications and information with other computers." (See id). As a result, "[t]here is no centralized storage location, control point, or communications channel for the Internet, and it would not be technically feasible for a single entity to control all of the information conveyed on the Internet."(Id).
The Internet began in 1969 as an experiment of the Advanced Research Project Agency. (See id at 831). At the time, it was called ARPANET and its purpose was to link computers owned by various military defense contractors and university laboratories that were performing defense-related research. (See id). Eventually, ARPANET began to be used by universities and businesses worldwide and its name changed to DARPA Internet. (See id). The name was then shortened to the Internet. (See id). The Internet continues to grow as technology advances. Today, the ability of the Internet to convey information doubles every 100 days. (See Jeffery I. Cole, The UCLA Internet Report: Surveying the Digital Future, 4 (Nov, 2000), <www.ccp.ucla.edu/pages/Internet-report.asp>.) In 2000, the number of online documents and the number of hits on U.S. Web sites each surpassed the one billion mark. (See Cole, supra note 12, at 4-5.) In each 24-hour period, 3.2 million new pages and 715,000 new images are added to the Internet. (See id).
The number of Internet users has grown phenomenally. In 1981, less than 300 computers accessed the Internet. (See ACLU, 929 F Supp at 831). By 1989, that number had grown to 90,000 computers and by 1993, more than one million people were using the Internet. (See id). In 1996, 40 million people worldwide were accessing the Internet. (See id). That figure has grown and today, 580.78 million people worldwide are online. (See NUA Internet Surveys (visited Oct 26, 2002) <http://www.nua.ie/surveys/index.cgi>). In the United States alone, 167 million people use the Internet and 59.1 percent of households have access to the Internet. (See id). There are approximately 55,000 new users each day in the United States alone. (See Cole, supra note 12, at 5). That breaks down to "2,289 new users each hour, or 38 new users each minute." (Id). The growth in the use of the Internet is unique because the Internet has existed for 32 years, yet most of the growth in its use has occurred in the last seven years alone. (See id).
That growth makes the Internet the fastest growing technology we have ever seen. (See Robert D. Hof, The "Click Here" Economy, Bus Wk, June 22, 1998, at 122). As a comparison, radio did not reach 60 million listeners until 30 years after its introduction and television did not reach 60 million viewers until 15 years after its introduction. (See id). Likewise, in the United States, it took 46 years for electricity to reach 30 percent of American homes; 38 years for telephone to reach 30 percent of American homes; and 17 years for television to reach 30 percent of American homes. (See Cole, supra note 12, at 5). However, it took only seven years for the Internet to reach 30 percent of American homes. (See id).
The Internet differs from previously introduced technologies because it contains so much information, has so many users, and there is no single control point for the Internet. The combination of these characteristics make issues regarding the Internet and protecting the investing public a high priority for the Commission.
Online financial portals: Should they register as broker-dealers?
Online financial portals: a definition and a dilemma. Basically, "financial portals provide a central location where investors can find all types of financial information and portfolio analysis tools." (Unger Speech Two, supra note 32, at 5). Functions investors can perform on financial portals include viewing all their financial account data in one place and using hyperlinks to go to broker-dealer Web sites to open accounts or enter trades in existing accounts. (See id). An example of a financial portal is Yahoo! Finance. (See <http://finance.yahoo.com/?u>).
The question the Commission is asking about financial portals is: "Do portals act and look enough like broker-dealers so that they should be regulated like broker-dealers?" (Unger Speech One, supra note 1, at 4). To answer this question, the Commission needs answers to questions like: "what are the portals doing? What are their relationships with the broker-dealers they hyperlink to? What are their business arrangements and compensation arrangements? How do the hyperlinks work, and what do they look like?" (Unger Speech Two, supra note 32, at 5). Some answers to these questions are found in the securities laws which indicate who is required to register as a broker-dealer and the Commission's no-action letters which indicate which financial portals have been required to register in the past and why they have been required to register.
Broker-dealer registration requirements. The Securities Exchange Act of 1934 (the 1934 Act) defines a broker as "any person engaged in the business of effecting transactions in securities for the account of others, but does not include a bank." (15 USC § 78c(a)(4)). A dealer is defined as "any person engaged in the business of buying and selling securities for his own account, through a broker or otherwise, but does not include a bank...." (15 USC § 78c(a)(5)). The Act stipulates that those people or entities who meet the definition of broker or dealer cannot "make use of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security... unless such broker or dealer is registered in accordance with subsection (b) of this section." (15 USC § 78o(a)(1)). In other words, those entities falling under the definition of a broker-dealer must be registered under the 1934 Act. The courts have clarified the definition of a broker by indicating that "[t]o qualify as a 'broker,' the activities of the alleged broker must be 'characterized by a certain regularity of participation in securities transactions at key points in the chain of distribution.'" (SEC v. Zubkis, No 97 Civ 8086, 2000 WL 218393 (SD NY Feb 23, 2000); accord S.E.C. v. Hansen, 1984 US D LEXIS 17835, No. 83 Civ 3692, 1984 WL 2413, at 10 (SD NY Apr 6, 1984) (quoting Massachusetts Financial Services, Inc. v. Securities Investor Protection Corp., 411 F Supp 411, 415 (D Mass), aff'd, 545 F.2d 754 (1st Cir 1976)). Some factors the courts have used to determine whether an entity is a broker are if the entity: "(1) receives transaction-based compensation, such as commissions or referral fees; (2) is involved in negotiations between the issuer and the investor; (3) makes valuations as to the merits of the investment or gives advice; and (4) is an active rather than passive finder of investors." (Zubkis, 2000 WL 218393, at 9; Hansen, 1984 WL 2413, at 10; MuniAuction, Inc., SEC No-Action Letter, 2000 WL 291007 (Mar. 13, 2000) [hereinafter MuniAuction]; Charles Schwab & Co., Inc., SEC No-Action Letter, 1996 WL 762999 (Nov 27, 1996) [hereinafter Schwab Two]; Angel Capital Electronic Network, SEC No-Action Letter, 1996 WL 636094 (Oct 25, 1995) [hereinafter Angel]). This is the test the Commission has applied in its no-action letters regarding whether portals must register as broker-dealers.
No-action letters. In June of 1993, Quick America Corporation (Quick) requested a no-action letter from the Commission to ensure that it would not be required to register as a broker-dealer if it introduced a new product they refer to as the Order Management System. (See Quick America Corporation, 1993 SEC No-Act. LEXIS 821 (Jun 28, 1993) at 8 [hereinafter Quick]). This new system would be a companion product to Quick's Market Data System, which provides subscribers with "U.S. securities and futures market information, such as current prices, last trade date, montages of quotes in different market centers, news wire stories, and the ability to display, analyze and format this information in a variety of ways." (Id at 9). The Order Management System would "enable users to route orders to participating brokers, monitor the status of orders, receive electronic order execution reports from brokers, and perform transaction analysis." (Id at 10). The purpose of this system is to facilitate the flow and management of order information between institutional traders and their broker-dealers. (See id at 11). The Order Management System was not designed to select a market or broker, automatically enter preset orders, provide order execution, or facilitate in the settlement of trades. (See id at 11).
Quick contends that they, through their Order Management System, will not be acting as a broker-dealer because they will only be providing a means for the monitoring of futures and securities markets and the flow of information between market participants. (See id at 17). Furthermore, Quick will be compensated by a flat fee per server and workstation and not based upon the number of trades or the size of the orders executed. (See id at 13).
The Commission granted the no-action letter primarily because the Order Management System would act only as a conduit between institutional traders and their brokers so Quick will not handle or hold customer funds. (See id at 4). Quick customers will retain control over which broker and market is used for a particular trade. (See id). Furthermore, Quick will not allow any automatic trade generation. (See id). Finally, the Commission noted Quick's assurance that compensation for their services would be based on a flat fee per month for the servers and workstations provided rather than as a percent of the trades executed. (See id at 5).
In October of 1996, the U.S. Small Business Administration (SBA) requested a no-action letter from the Commission to ensure that they would not be required to register as a broker-dealer if they developed the Angel Capital Electronic Network (the "Network"). (See U.S. Small Business Administration, 1996 SEC No-Act. LEXIS 812 (Oct 25, 1996) at 6 [hereinafter SBA]). The Network would be an Internet site on which Network Operators (primarily universities and non-profit entities which specialize in entrepreneurism) would post small corporate offerings for the purpose of making it easier for small businesses to raise capital through equity offerings. (See SBA, supra note 114, at 9). Only accredited investors (Accredited investors are defined in Regulation D, Rule 501 of the Securities Act of 1933. Individual Accredited investors are defined as "(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, at the time of his purchase exceeds $1,000,000; (6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year") who have been issued passwords will be able to access the following information listed on the Web site: "a small corporation's 'tombstone' advertisement, and an offering circular in the form of the Small Corporate Offering Registration Form.... In addition, 'solicitation of interest documents'... may be listed on the Network." (SBA, supra note 114, at 11). The small businesses and accredited investors using the Network will pay a nominal, flat fee to cover the administrative costs of operating the Network; the fees are not contingent on any sales made on the Network. (See id at 19).
In arguing that neither the Network nor the Network Operators should be required to register as a broker-dealer, the SBA cites six specific activities that neither the Network nor the Network Operators will participate in. (See id at 22). They will not:
(i) provide advice about the merits of particular opportunities or ventures, (ii) receive compensation from Network users other than the nominal, flat fees to cover administrative costs, (iii) participate in any negotiations between investors and listing companies, (iv) directly assist investors or listing companies with the completion of any transaction, for example, through the provision of closing documentation or paid referrals to attorneys or other professionals, (v) handle funds or securities involved in completing a transaction, or (vi) hold themselves out as providing any securities-related services other than a listing or matching service. (See id).
These six factors are important to the Commission since it granted the SBA's request and granted the no-action letter. (See id at 1). In its reply, the Commission specifically noted these six factors as determinative in its decision to grant the no-action letter. (See id).
In November of 1996, Schwab requested a no-action letter from the Commission to ensure that the online services it planned to contract with would not be required to register as broker-dealers if the online service prominently displayed a Schwab hyperlink in the financial section of their Internet sites. (See Schwab Two, supra note 102, at 8). Schwab planned to contract with four types of online services: commercial networks (e.g., AOL, CompuServe), Internet access providers (e.g., AT&T, BellSouth), sponsors of World Wide Web electronic communities or search directories (e.g., InfoSeek and Yahoo), and software companies (e.g., Microsoft, Intuit) so that the online service would receive a nominal, flat fee whenever a user accessed the Schwab site through the online service's portal and executed a trade. (See id at 9). To ensure that the online services are not acting as a broker, Schwab limits their participation in a number of ways. First, Schwab takes all responsibility for the marketing materials that describe Schwab's services and are published by their online service partners. (See id at 18). The online service will act as a conduit for this material and nothing more. Second, the online services will not be able to perform the following functions: recommending or endorsing specific securities, opening or maintaining accounts, answering questions about the accounts or transaction in those accounts, accepting or routing of customer orders, handling customer funds or securities, or extending credit to any customer. (See id at 19). Third, all activities conducted by the online service will be specified in a written agreement between Schwab and the online service. (See id at 19-20). Fourth, Schwab notes that it will compensate its partner online services by paying them a nominal, flat fee per transaction and the fee will "not vary depending on the number of shares or the value of the underlying order securities comprising a customer order transmitted to Schwab or whether the order results in an executed trade." (Id at 17). Finally, Schwab emphasizes that it is registered as a broker-dealer and therefore customers will have all the regulatory protection afforded by the securities laws. (See id at 25-26). In addition to representing how the online services' activities will not be "characterized by a certain regularity of participation in securities transactions at key points in the chain of distribution," Schwab also cites policy reasons for its request. Schwab argues that by allowing arrangements such as the one Schwab is proposing, the Commission will be helping broker-dealers to service their clients more efficiently and more cost effectively. (See id at 21). Investors would not only realize cost savings, they would also have greater and more convenient access to the securities markets. (See id).
The Commission granted the no-action letter and specifically noted that Schwab would be responsible for the marketing materials, that the online services would not service, open, or maintain accounts, that the online services would not answer questions or recommend securities, and that there would be a flat-fee structure in its reasons for granting the no-action letter.
In March of 2000, MuniAuction, Inc. (MuniAuction) was denied a no-action letter from the Commission because the Commission believed that MuniAuction was performing broker-dealer activity without being registered as a broker-dealer. (See MuniAuction, supra note 102, at 1). MuniAuction conducts auctions of municipal bonds, notes, guaranteed investment contracts, jumbo certificates of deposit, and agency discount notes through its Web site. (See id at 5). It was MuniAuction's belief that it did not fall under the definition of broker-dealer because it does not: "1) actively solicit investors, 2) advise investors as to the merit of an investment, 3) act with 'certain regularity of participation in securities transactions' and 4) receive commissions or transaction-based compensation." (Id at 5-6). However, the Commission's position is that MuniAuction is a broker because it "brings buyers and sellers of securities together for a fee." (Id at 3). Specifically, MuniAuction "solicits issuers and other securities holders to use its auction services through its site, transmits orders, and selects the broker-dealer who will cross the transaction." (Id). Other factors the Commission considered were the large number of participants in MuniAuction auctions (over 200 in an upcoming auction), and MuniAuction's extensive advertising of its service. (See id at 4).
In July of 2000, Stockback.com (Stockback) requested that the Commission issue a no-action letter to ensure that the merchants participating in their stock rebate plan need not register as broker-dealers. (See Stockback.com, LLC, 2000 SEC No-Act. LEXIS 762 (July 28, 2000) at 5 [hereinafter Stockback]). Stockback proposed to run a Web site wherein the public could enroll as members with Stockback by opening an investment account with Stockback Capital, LLC. (See id at 5). Members would then receive cash rebates when they made a purchase with a participating merchant. (See id). The cash rebate could either be used to purchase share of the Stockback Fund or could be left as cash in their Stockback accounts. (See id at 6). The participating merchants would not be compensated by Stockback; rather, their compensation would be in the increased revenue as a result of member purchases as well as increased customer loyalty. (See id at 7). Merchants would only be allowed to make the following three statements about their participation in the Stockback plan: that the merchant is a participating member of Stockback; that the merchant will rebate a certain amount of the purchase price to Stockback; that additional information about Stockback can be found on the Stockback site (a hyperlink will be provided). (See id). Stockback would be responsible for distribution of the Stockback Fund prospectus, opening and servicing customer accounts, holding customer monies, executing orders, answering questions, and providing members with statements. (See id at 7-8).
Stockback emphasizes a number of points in its request to the Commission. First, that Stockback will not compensate the merchants for their participation in this program. (See id at 10). Second, that the merchants will not be involved at all in members' investing decisions or in the relationship between Stockback and the members. (See id). Most importantly, Stockback emphasizes that members will have full regulatory protection since Stockback is a registered broker-dealer and requiring merchants to register would offer members no additional protection. (See id at 12).
The Commission granted the no-action letter. (See id at 1). In its reply, the Commission specifically notes that Stockback will perform all of the functions related to the securities ownership, that the merchants cannot enroll customers in the program, that members are not required to pay a fee to enroll, that members receive rebates in cash only; that all cash rebates are held by Stockback, and that Stockback will assist members in their investment decisions, and the merchants will have no role in this function.
In February of 2001, BondGlobe, Inc. (BondGlobe) requested a no-action letter from the Commission to ensure that it does not need to register as a broker-dealer to run its Web site which enables registered broker-dealers to trade with each other. (See BondGlobe, Inc., 2001 SEC No-Act. LEXIS 140 (Feb 6, 2001) at 6 [hereinafter BondGlobe]). BondGlobe's service would provide a venue for broker-dealers to post information about their inventory, match buyers to sellers, and begin the clearing and settlement process with the counterparty. (See id at 7). BondGlobe argues that it is not acting as a broker-dealer for a number of reasons. First, BondGlobe's fee will not be a commission; instead it will be a communication fee that is determined by a published schedule of fees. (See id at 9). Second, BondGlobe will not provide investment advice to its users, it will merely post information provided by the broker-dealers. (See id). Third, BondGlobe will not actively solicit investors; it is merely a medium through which investors can connect. (See id at 9-10).