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NASD Issues E-Brokerage Investor Protections Regulation

Los Angeles Times

The National Assn. of Securities Dealers unveiled guidelines Tuesday that could force online brokerages to determine whether certain investments their clients make are suitable for them.

But some critics said the guidelines don’t go far enough to protect do-it-yourself investors.

At issue is whether online brokers are doling out investment recommendations and, therefore, must screen their customers’ choices to ensure they aren’t too risky.

Full-service brokerages such as Merrill Lynch have long had to make sure that recommendations from their brokers are appropriate for customers. For example, a broker could be held legally liable for investing the life savings of an elderly woman in risky Internet stocks.

Online brokerages, by contrast, have argued that they are exempt from such know-your-customer rules because their clients make their own trading decisions. Critics, however, say the firms have a responsibility to make sure customers–many of whom are novice investors–make proper investing decisions. The goal, they say, should be to guard against the sort of devastating losses that many small investors suffered in the recent collapse of technology stocks.

On Tuesday, the NASD’s regulatory unit released broad guidelines outlining when online firms must determine the suitability of customers’ investments.

In general, the firms don’t have to assess suitability if customers are simply researching and buying stocks on their own via a brokerage’s Web site, without receiving investment advice from the firm, according to the guidelines.

But e-brokers must determine suitability if they recommend specific stocks or if they use “data-mining” techniques to make suggestions to targeted groups of customers, the guidelines say.

Tracy Pride Stoneman, a Colorado securities attorney, argued that the rules do “incredible harm” to average investors. Though e-brokers don’t recommend specific stocks, they encourage investors to make risky trades through advertising and other enticements, she said.

“The brokerage firms have an obligation, when an online investor is attempting to make trades far in excess of their net worth, to step in and prevent those trades from being executed,” she said.

But Jeffrey Holik, acting general counsel of the NASD unit, said the brokerage industry suitability rules that have been in force for decades apply only to recommendations involving individual stocks, not to general investment practices.

The new guidelines are intended to “strike a useful balance between customer protection . . . without stifling the benefits of the free flow of information” available on the Internet, Holik said.

Other consumer activists agreed with that view, saying small investors have the responsibility to invest wisely.

“I don’t think you can make rules to keep customers from hurting themselves,” said Barbara Roper, director of investor protection for the Consumer Federation of America.

Beverly Hills attorney Philip Aidikoff praised the inclusion of data-mining techniques in the new NASD guidelines.

In the next few years, online brokers will seek to drum up trading business by targeting recommendations to certain investors based on such factors as age and income, Aidikoff said. It’s important for firms to know that they must factor in suitability when doling out broad-based recommendations, he said.

Holik said the NASD has taken other steps to increase investor protection. Last year, the group proposed a rule that would require firms to disclose to investors the risks of trading on margin–meaning using borrowed money.

The proposed margin rule, which is awaiting approval by the Securities and Exchange Commission, would require firms to give investors disclosure statements when they open margin accounts and then again once a year.