Corporation, Securities
& Business Law Forum
June 2001 Vol. 46, No. 5
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
* NASD outlines new online suitability obligations for brokerage firms
* Computer disposal regulations for businesses
* Recent corporation, securities and business law section's Law Ed Seriesprogram
* Do charitable organizations have a safe haven from general real estate taxes?
This is the last edition of the newsletter for the current year, and it has several articles that should be of interest to the readers. We include an article by Andrew Stoltmann that addresses the suitability obligations faced by brokerage firms offering online investment services. In addition, we present an article by Ethel Spyratos that outlines issues environmental issues raised by computer equipment disposal practices. We also present an article by Brent Gwillim that discusses whether charitable organizations have a safe haven from general real estate taxes.
This edition also contains our regular column--BusinessLaw Flashpoints (also available at IICLE's Web site: www.IICLE.com), which is provided to us by Donna Cunningham, secretary of our section council. Several recent developments of note are discussed in this column.
Finally, we look forward to your comments and suggestions. We also welcome your submissions to the newsletter.
David E. Doyle
10 S. La Salle Street
Suite 3500
Chicago, Illinois 60603
312/606-0529
NASD outlines new online suitability obligations for
brokerage firms
By Andrew J. Stoltmann and Thomas A. Hargett, Maddox Koeller Hargett & Caruso, Chicago
I. Introduction
On March 19, 2001, the National Association of Securities Dealers ("NASD") released Notice to Members 01-23 ("NTM 01-23"). It was the NASD's first attempt to formally address the suitability obligations faced by brokerage firms offering online investment services.
II. NASD suitability rule
The suitability rule is considered a bedrock principal underlying the regulation of the relationship between a stockbroker and investor. The suitability rule for the NASD is Conduct Rule 2310, which dates to the formation of the NASD in 1938. Rule 2310 imposes an obligation on broker and brokerage firms to ensure investment recommendations are suitable based on the individual information disclosed by the client. The obligation imposed by the Rule is as follows:
a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs; and
b) Prior to the execution of a transaction recommended to a non-institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning:
1) the customer's financial status;
2) the customer's tax status;
3) the customer's investment objectives; and
4) such other information used or considered to be reasonable by such members or registered representative in making recommendations to the customer.
Suitability disputes between investors and brokerage firms are extremely common. In 2000, 900 suitability claims were filed at the NASD, making it the fifth most common complaint filed against brokers and brokerage firms. Through March of 2001, suitability claims at the NASD are up 15 percent from the previous year. That trend will likely continue through the rest of 2001 as investors begin to comprehend the magnitude of their investment losses caused by stockbrokers' misconduct during the market crash of 2000.
III. Need for guidance
Mary Schapiro, President of NASD Regulation, stated in March of 2001 "[T]here has been much debate within the industry about whether, or to what extent, the suitability rule applies at all to online brokerage activities. It should be clear that the suitability rule applies to all recommendations made by members to customers, including those made by electronic means. We recognize that some forms of electronic communications defy easy characterization." NTM 01-23 was designed to provide guidance for brokerage firms in reviewing their communications with the public in order to ascertain whether the suitability protections of Rule 2310 are triggered.
The guidance of NTM 01-23 was desperately needed. By the end of 1999, there were approximately 7.5 million online trading accounts nationwide. By the end of 2000, that number was expected to swell to 10.5 million according to Concord, Massachusetts-based Gomez Advisors. By 2002, the number is expected to reach 18 million. Unfortunately, the number of investor complaints against online firms have also grown. According to the NASD, in 2000, 214 claims were filed against online firms, up from none in 1998. 4,258 complaints were lodged against online firms with the SEC from September 30, 1999 through September 30, 2000. While not all of these were alleged suitability violations, the increasing number of online investors coupled with a dramatic rise in complaints against online brokerage firms necessitated guidance by the NASD.
IV. NASD NTM 01-23
NTM 01-23 states that the "facts and circumstances of whether a communication is a 'recommendation' requires an analysis of the content, context, and presentation of the particular communication or set of communications." While NTM 01-23 discloses that no one bright line test is available for determining if a recommendation was made, thereby triggering the protections of Rule 2310, a key determinant is whether an analysis of the content, context, and manner of presentation of a particular communication from a brokerage firm to a customer reasonably would be viewed as a "call to action," or suggestion that the customer engage in a securities transaction.
Crucially important under NTM 01-23 in determining whether a recommendation has been made (and therefore whether the suitability obligations of Rule 2310 are triggered) is if the information provided is "individually tailored" to that particular customer. The more individually tailored the communication is to a specific customer, the greater the likelihood that the communication may be viewed as a "recommendation." NTM 01-23 does state, however, that no single factor, standing alone, necessarily determines whether a recommendation was made. If, for example, an online firm sends an investor a research report based upon parameters that the investor previously disclosed, that would likely be viewed as a recommendation under NTM 01-23 since it was "individually tailored" to that specific investor.
One of the stated purposes of NTM 01-23 is to provide clear examples and guidance to the securities industry as to what would be considered a recommendation and therefore trigger the suitability protections of Rule 2310. NTM 01-23 lists the following examples of what would fall outside of a "recommendation" and therefore be excluded from the umbrella of NASD Conduct Rule 2310:
a) A firm creates a web site that is available to customers or groups of customers that has research pages or "electronic libraries" that contain research reports (which may include buy/sell recommendations from the author of the report), news, quotes, and charts that customers can obtain or request;
b) A brokerage firm 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;
c) A brokerage firm provides research tools on its web site that allow customers to screen through a wide universe of securities (e.g., all exchange-listed and NASDAQ securities); and
d) A brokerage firm allows subscriptions 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." Such news might include price changes, notice of pre-scheduled events (such as an imminent bond maturation) or other generalized information.
The following examples under NTM 01-23 would be considered a "recommendation," thereby triggering the suitability obligations under Rule 2310:
a) A brokerage firm sends a customer-specific electronic communication (e.g., an e-mail or pop-up screen) to clients encouraging the particular customer to purchase a security;
b) A brokerage firm sends its clients an e-mail stating that customers should be invested in stocks from a particular sector (such as technology) and urges customers to purchase one or more stocks from a list with "buy" recommendations;
c) A brokerage firm 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 brokerage firm in this instance then sends the customer a list of specific securities the customer could buy or sell to meet the investment goal the customer has indicated; and
d) A brokerage firm uses data-mining technology (the electronic collection of information on web site users) to analyze a customer's financial or online activity--whether or not known by the customer--and then, based on those observations, sends (or "pushes") specific investment suggestions that the customer purchase or sell a security.
V. Analysis of NTM 01-23
While NTM 01-23 is a good first attempt by the NASD to provide some guidance to the securities industry, it does not go far enough. Online brokers have long resisted the notion they have suitability obligations like those imposed on traditional stockbrokers, arguing they generally only fill trading orders generated by their clients. The NASD, through NTM 01-23, refutes that argument but unfortunately does not extend protections far enough to the online investors who need the suitability protections the most.
Online firms are "morphing" into and becoming very similar to traditional full service broker firms. Many online firms offer what looks like the same detailed research provided by full service firms. E*Trade clients have access to work provided by BancBoston Robertson Stephens. Investors who use Fidelity.com can get research from Salomon Smith Barney. Discover Brokerage Direct investors have access to Morgan Stanley Dean Witter stock picks. Investors who use Charles Schwab's Schwab.com can choose research from Credit Suisse First Boston.
Almost all of the major online firms also provide financial planning tools on their web site that permit customers to specify certain criteria and then, based on that criteria, present customers with investment alternatives. Most online firms provide research dealing with particular companies and their securities. Many e-brokers have links from their Web sites to external sites that reference and address particular pre-chosen securities. When online brokerage firms provide research reports, alert clients to news regarding securities in the client's account, generate investment ideas for their clients, provide chat rooms that allow investors to discuss investment ideas and send out price and news alerts on individual companies these activities are an implicit sales solicitation and an encouragement to trade for their investors. Therefore, the same suitability obligations faced by full service firms should also apply to online firms.
Many online firms actively promote themselves through their advertising and marketing as a substitute for full service brokerage firms while at the same time denying the corresponding responsibilities inherent to full service firms. Charles Schwab's advertising campaign last year positioned the firm as a "full-service electronic investing" firm even though Schwab made its name as a discount broker. Unfortunately, most online firms target less experienced investors who are typically the most likely to be swayed by the frequent barrage of encouragement from online firms to actively trade. Former SEC Chairman Arthur Levitt stated on May 5, 1999 that "[I]n a market environment where many investors are susceptible to quixotic euphoria, I'm worried these commercials step over the line and border on irresponsibility."
Unfortunately, NTM 01-23 does not go far enough and should have, at a minimum, imposed obligations on a brokerage firm to make a threshold determination that an investor's strategy is suitable for the individual investor. NTM 01-23 should have required online brokerage firms to first determine if an active trading strategy is suitable or too risky for an individual investor. A state does not allow a person to have a driver's license without a showing of competence in driving. Online brokerage firms are not applying for casino licenses from the states where they seek to engage in business. Online brokerage firms should not be allowed to bury their head in the sand when an inexperienced investor with limited investment assets is looking to commit, in effect, financial suicide by engaging in a high-risk day/short term trading strategy encouraged, in part, by the marketing message from the online firm.
NTM 01-23 should have mandated that during the account opening stage the e-brokerage firm should inform the investor that his or her account would be monitored for unusual activity and to present the customer with a list of activities that will be monitored, such as frequency of trading or purchases and sales that exceed a certain amount of money. If the investor's trading activity runs counter to the initially stated customer investment goals and financial situation, then the online firm should be compelled to intervene and investigate to ensure the trading is suitable for that client given his or her income, prior trading experience and investment objectives.
The NASD needed to require online firms to monitor all accounts at their firm to ensure the trading is consistent with the investment objectives listed on the new account application. For example, if a 65 year-old online investor discloses when opening an account that her objectives are conservative income and immediately engages in a high risk strategy of short selling stocks, online firms should have the obligation, at a minimum, to contact that investor to inquire why there is such a dramatic discrepancy between the investor's listed investment objectives and actual investment purchases. While online firms would likely argue this is too paternalistic an obligation, when dealing with investors' life savings and retirement funds, online firms should have the threshold responsibility to ensure the investments are suitable since the result of an unsuitable investment strategy is often financial devastation. Unfortunately, NTM 01-23 does not mandate this obligation.
Taken to an extreme, a 20 year-old, mentally impaired investor who received an inheritance today that represented 100 percent of his net worth could open an account at a online firm and actively trade the account into a complete loss through a high risk strategy of day trading even if the investor clearly and accurately disclosed the impairment and the need for income on the new account application. The online firm's position would likely be the losses were strictly the result of the investor's decisions and they have no responsibility to intervene, investigate or to discover if these transactions were suitable. Under NTM 01-23, so long as the online firm didn't "individually tailor" any information to the investor, they likely would not be held liable for these losses. Clearly, online firms should have the obligation to intervene in this type of a situation. The technology is available, and utilized by full service brokerage firms, to monitor all accounts to ensure the trading is consistent with the investment objectives listed on the new account application. Full service brokerage firms monitor accounts for turnover (the number of times the average net equity in the account is used to purchase securities) and cost to equity (the percentage of return the clients' average net equity needs in order to pay the broker's commissions and margin interest) to ensure the trading is consistent with the listed investment objectives. If there is inconsistent trading, typically the brokerage firm will (or at least should) intervene to discover why this discrepancy exists. Unfortunately, NTM 01-23 does not mandate this type of obligation for e-brokers.
VI. Conclusion
With suitability complaints against brokers and brokerage firms up 15 percent at the NASD in the first three months of 2001 and millions of novice investors joining the ranks of clients at e-brokers in recent years, the NASD needed to provide guidance concerning when the suitability protections of Rule 2310 were triggered. NTM 01-23 is the first attempt by the NASD to provide such guidance. While it is a good first step by the NASD, it does not go far enough in protecting online investors.
Computer disposal regulations for businesses
By Ethel Spyratos, Chicago
Computer-based technology is advancing at an increasing rate, as a result, faster, more efficient computers are produced continually. To be in the forefront of this technology, businesses are forced to upgrade their computers. Consequently, there is an abundance of outdated computer equipment that businesses want to discard. In considering computer equipment disposal practices, businesses must evaluate the impact of state as well as federal laws concerning hazardous material. Computer equipment may contain the following hazardous materials, polychlorinated biphenyls ("PCB's"), lead, mercury, cadmium and arsenic. In accordance with both Illinois and federal law, each of these materials is listed as being hazardous and must be properly discarded.
The disposal of certain parts of standard computer equipment for businesses is regulated under federal law. Specifically, computer casings have been identified by the United States Environmental Protection Agency ("EPA") as having plastic containing PBC's. The EPA requires commercial establishments to dispose of such casings in a regulated manner. It differentiates between business computers from commercial establishments and individual computers from households. The latter may be disposed of in solid waste landfills. Disposal options available for businesses to discard computer casings include:
* Dispose in an authorized hazardous waste landfill, an incinerator, or a chemical waste landfill
* Dispose in an approved solid waste landfill
* Develop and have approved by the EPA a disposal process following a risk assessment
* Deliver to a recycler
The EPA regulation is federal law, hence it applies to businesses in all states, including Illinois. Consequently, it would be in the interest of commercial establishments to review their computer disposal procedures for computer casings to ensure that such procedures comply with the EPA's rules.
No law or regulation in the State of Illinois directly addresses the disposal of any computer equipment. Note that the nature of the materials contained in a computer monitor's cathode ray tubes and batteries may qualify as hazardous waste in accordance with the Illinois Environmental Protection Agency (IEPA") regulations. These computer parts may contain small amounts of toxic compounds including, lead, mercury, cadmium and arsenic. Although certain computer parts may contain hazardous waste, there are presently no special disposal procedures that have been mandated under the IEPA regulations.
A suggested company disposal practice for Illinois is to recycle unwanted computer equipment. Recycling facilities such as System Service International ("SSI") in Lombard, have services for disposal of computer equipment for businesses. SSI's service includes transporting the computers from the business to its facilities and recycling the materials.
The recent trend in other states such as New Jersey is to incorporate certain computer equipment in the state's list of hazardous materials. In New Jersey, the hazardous material must be handled and disposed of in a regulated manner. This law is specifically applicable to computer equipment used in businesses and not to household computer equipment. Based upon information in recent publications addressing the issue of computer disposal, it seems reasonable to anticipate the adoption of similar regulations in Illinois.