Investor Representation Suitable Investment Securities Law by stt16066


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                                        By Michael K. Wolensky


With the growth of Internet-distributed public company information and the advent of Internet-based
securities trading, securities regulators have been required to undertake new approaches and programs to
augment their traditional enforcement programs attacking sales practice abuses by securities professionals
in the sale of securities. In 1998 and 1999 the SEC and NASD Regulation, Inc. ("NASDR") have issued a
number of pronouncements addressing Internet fraud. They have undertaken a number of studies of
electronic investing and have been very active in bringing enforcement actions where fraudulent conduct
has occurred.

The actions have included cases against issuers promoting their stock with false and misleading
announcements on the Internet; cases against the plethora of illegal stock "touts" that have materialized;
and cases against brokers that have used the Internet to pressure the growing number of Cyber-investors
who seek to take advantage of the lower costs and ready access to information via the Internet to buy
unsuitable securities.

The past few years have seen a dramatic increase in the number of small investors who have become "on-
line traders" eager to test their investment ability with ready market access. While there were no broker-
dealer firms providing Internet access to small investors in 1994, there are approximately 100 firms doing
so today with an estimated five million accounts. Moreover, while the tales of woe, demonstrating the folly
of many of this new breed of on-line traders, have been fodder for the evening news, the regulators have
been hesitant to rush to fashion new rules to protect these so-called investors—really speculators. The
regulators have examined methods to apply the traditional sales practice obligations to the broker-dealers
providing company information and market analysis along with the facilities for this trading activity. But
that approach can go only so far; as SEC Chairman Arthur Levitt recently stated in commenting upon the
need for new rules to protect investors from the risks of on-line trading: "You can't protect people against
their own foolishness."

One of the primary obligations of broker-dealers operating in the traditional investment arena is that of
suitability. Based upon the well-established doctrine that a broker recommending a particular security to a
particular customer must be satisfied that the security is suitable to the investor's financial ability and
investment objectives, enforcement of this obligation has long been a focus of NASDR and the SEC, the
latter largely through application of the anti-fraud provisions of the federal securities laws.

This outline explores the application of the broker-dealer's suitability obligation to the provision of
investment information and electronic investing through the Internet.


The suitability doctrine is set forth in NASD Rule 2310 (formerly Article III, Section 2 of the NASD Rules
of Fair Practice). The Rule states, in pertinent part: "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."

The suitability doctrine originated in the "shingle theory." That theory, first announced in the 1930s by the
SEC, states that by hanging out its shingle, a broker-dealer impliedly represents that it will deal fairly with
its customers and when it recommends a security to a customer, it has determined that the security is
suitable for that customer, in the light of that customer's particular financial situation and investment
objectives. See, generally, Mundheim, "Professional Responsibilities of Broker-Dealers: The Suitability
Doctrine," 1965 Duke L.J. 445, 450 (1965). Where the other elements of a violation are present, the courts
have viewed a broker's breach of its suitability obligations as a violation of SEC Rule 10b-5. See Clark v.
John Lamula Investors, Inc., 583 F.2d 594 (2d Cir. 1978) (a broker making unsuitable recommendations
breaches the implied representation that it will deal with its customers fairly and in accordance with the
standards of the securities industry).

The doctrine arose as a result of the nature of the broker-customer relationship, which was personal in
nature and involved payment by the customer for individualized services by his trained professional
broker. In this traditional relationship, the customer was entitled to expect that the broker would not
recommend securities to him without having determined that the recommended transaction was suitable
based upon the particular circumstances relevant to the customer. The customer's reliance on that
understanding was entirely reasonable, and the rule grew up to protect customers from misplaced reliance.
By requiring recommendations to be suitable, a wide range of potential sales abuses, such as high-pressure
sales tactics, "one-size-fits-all" recommendations, and inventory unloading, have been prohibited.

Traditionally, the broker-dealer's suitability obligation has applied only where the broker-dealer has made a
specific recommendation to a particular customer. See, e.g., Parsons v. Hornblower & Weeks-Hemphill
Noyes, 447 F. Supp. 482, 495 (M.D.N.C. 1977), aff'd, 571 F.2d 203 (4th Cir. 1978) ("the NASD suitability
rule requires that a broker act in accordance with his knowledge of the customer's financial capabilities
only when he recommends the purchase, sale or exchange of any securities"). On the other hand, where the
customer enters into a transaction that the broker has not recommended, the broker has a much more
limited duty to the customer. See, e.g., Hill v. Bache Halsey Stuart Shields, Inc., 790 F.2d 817, 824 (10th
Cir. 1986) (where broker's duties were limited to executing orders, only obligation to customer is confined
to making authorized trades); Canizro v. Kohlmeyer, 370 F. Supp. 282, 288 (E.D. Louisiana. 1974) (same).

Similarly, a broker-dealer's use of general, impersonal advertising material has not been found to give rise
to suitability obligations. Since the days when the SEC regulated non-member firms, it has viewed
materials for general distribution, such as market letters, research reports, and other similar material as not
constituting a recommendation within the meaning of its then-existing suitability rule. See Securities
Exchange Act Release No. 8135 (July 27, 1967). This view carried over to the SEC's Penny Stock Rules
(Securities Exchange Act Rule 15g-9), where the SEC did not apply its suitability rule to general
advertisements not involving a direct recommendation to an individual customer. Instead, the SEC rule
applied suitability obligations to recommendations made after a customer contacted the broker-dealer in
response to the firm's general advertisements. See Securities Exchange Act Release No. 34-29093
(April 17, 1991) n.103 and accompanying text.

The SEC's concern with direct contact with individual customers via electronic access was apparently first
voiced in its "Computer Brokerage Systems" release on October 9, 1984. Securities Exchange Act Release
No. 34-21383. That release addressed the increasing use of electronic systems allowing direct
communication between broker-dealers and customers through personal computers and computer
networks. At that time, the Internet was not an issue because it was not generally available to the public.
Even in this early pronouncement, the SEC noted that the publication of information for general access
normally should not present a problem. The SEC did voice its concern that future electronic systems would
permit broker-dealers to use electronic systems to make recommendations to specific clients or to issue
"urgent recommendations" to clients trying to spur immediate action through computer brokerage systems.
Id. at n.12.

Thus, the traditional notions underpinning the suitability doctrine have focused on reasonable customer
expectations while dealing on a personal basis with a broker who has not only had informational advantage
but has also controlled market access.

The most difficult issue, both in the past and the present, relating to application of the suitability doctrine
involves determining what is meant by the term "recommendation" as used in Rule 2310 and in the case
law. The NASD has refused to define the term, claiming that a definition is unnecessary and would raise
many complex issues in the absence of the specific facts of a particular case. See Securities Exchange Act
Release No. 34-37588 (August 27, 1996).

Nevertheless, the NASD has managed to eliminate whatever clarity there may have been based upon
industry practice through a number of Notices to Members promulgated in recent years. Most, if not all, of
the confusion has arisen in the context of penny stocks and other low-priced, speculative securities. Thus,
for example, the NASD has directed brokers to provide "a careful review of the appropriateness of
transactions in low-priced, speculative securities, whether solicited or unsolicited." (NASD Notice to
Members 96-32) (May 1996). In September 1996, four months later, this Notice to Members was
withdrawn and the NASD issued another statement designed to "clarify members' suitability obligations to
customers under NASD Rules." See NASD Notice to Members 96-60 (September 1996). There, the
NASD confirmed that suitability obligations arise only when a member makes a recommendation to a
customer, but continued the confusion by claiming that "a transaction will be considered to be
recommended when the member . . . brings a specific security to the attention of the customer through any
means . . . (emphasis in original).

In March 1997, the NASD attempted again to clarify its position and disclaimed any intention in Notice to
Members 96-60 to define "recommendation." In Clarification of Notice to Members 96-60 (March 1997),
the NASD stated that the above-quoted language "was not meant to describe the content of
communications that may result in a recommendation, or to suggest that every statement that includes
mention of the security would be considered a recommendation" and 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 communication."
Continuing its refusal to define the term "recommendation," the NASD stated in this release that whether a
particular transaction "is in fact recommended depends on an analysis of all the relevant facts and

Also relevant to this discussion is NASD Rule 2210, governing "Communications With the Public." In
1995, the NASD amended that rule to include within the definition of "advertisements" material published
or designed for use in electronic media. The rule also designates as "sales literature" any written or
electronic communication distributed or made generally available to customers or the public, including
research reports, market letters and performance reports. These materials can, of course, constitute a
recommendation when directed to a particular security, but the suitability obligations do not arise in this
context. In making such a recommendation, the firm need have only "a reasonable basis for the
recommendation" and provide certain information with respect thereto.


Generally, broker-dealer customers engaging in electronic investing use their personal computers to access
the broker-dealer's Website to obtain information about investments in which they have an interest, to
obtain information about their accounts at the broker-dealer, and to place trades electronically by entering
an order in the trading system format provided by the broker-dealer. Once the trade has been entered by
the customer, the broker-dealer routes the trade to the appropriate market for execution, usually
immediately. The information available on broker-dealer Websites ranges from issuer-specific information
to broad market analysis. Many broker-dealer Websites include analytical tools for use by customers and
techniques for investing relating to specific investment objectives. Many firms post their own research
reports or research prepared by others and may provide specific recommendations of securities followed by
the firm.

In the overwhelming number of cases, the information provided is impersonal in nature, posted by the
broker-dealer for access by those with accounts or other rights to access its Website. Occasionally, a
broker-dealer may have electronic communication with a customer and provide specifically tailored
information based upon that customer's investment objectives and financial wherewithal. If that
information takes the form of a recommendation, then the relationship between the broker-dealer and
customer is of the traditional kind, rather than what is generally thought of as electronic investing, where
the customer determines what, if any, information will be obtained before making a trading decision. In
Notice to Members 99-11 (January 26, 1999), the NASD recently confirmed that a firm's suitability
obligation in connection with recommended transactions does not depend upon whether a trade is one in
the traditional context of personal communication between a broker and customer or is executed on-line.

Most firms would contend that the information they post on their Websites falls within the rubric of
"advertisements" under NASD Rule 2210.

Recent technological advances and their acceptance by the mainstream have dramatically changed the
investment landscape for many individual investors by allowing immediate access to both information and
markets through the Internet. Most of the considerations that led to development of the suitability doctrine
in the traditional broker-dealer customer relationship are absent in the on-line trading systems available to
most customers. These customers have far different expectations arising from the rather mechanical
relationship of broker-dealer and on-line customer as distinct from the traditional relationship. No on-line
customer accessing impersonal information and entering his or her own trades could reasonably expect
individualized advice and scrutiny with respect to a particular transaction.

The SEC has recognized these developments in its Report to the Congress: The Impact of Recent
Technological Advances on the Securities Markets (September 1997) ("Electronics Market Report"). The
Electronics Market Report lauded the "unprecedented access to information" available to individual
investors, finding that it allowed them to make more informed investment decisions:

         by giving investors information faster; by giving investors information in electronic format, so
         databases can be searched and financial information can be analyzed more readily; by reducing
         disparities between large and small investors' ability to access information; and by helping
         investors communicate with each other and with companies.

(Id. at 6). The Electronics Market Report further noted:

         information is at the heart of the federal regulatory framework for protecting investors. It rests on
         the premise that an investor can make a reasoned decision on whether to buy, sell or hold
         securities . . . if the investor has full and accurate information.

(Id.) The SEC found great benefits being brought about by the Internet, which allows small investors for
the first time to have access to information that historically had been available only to securities market
professionals. Moreover, armed with such information, investors, according to the SEC, should be wiser
and more able to fend for themselves in the tumult of the securities markets.

The SEC also found significant the ability of investors, through electronic investing, to visit a broker-
dealer's Website, enter a few keystrokes and obtain almost immediate order routing and execution. Thus, a
small investor with only a modest capital outlay can operate at a level of sophistication achieved by only
the most well-heeled market professional just a few years ago.

Following the NASD's postulate that suitability determinations must be based upon the particular facts and
circumstances of the matter being reviewed, when looking at electronic investing one is struck by the
notion that the type of information available for access on a broker-dealer Website normally could not be
construed or regarded by any reasonable person as the type of personalized recommendation which would
lead to the broker-dealer having a suitability obligation under the NASD rule. There is simply nothing
individualized about the relationship. The customer cannot expect normally to deal with the same
representative of the broker-dealer, if any, each time he or she engages in on-line trading. Moreover, most
firms have strong disclaimers that any information provided on their Website can be construed as
individualized advice and there is no implied representation that any information about securities provided
on the Website is appropriate for any identifiable customer.
Generally, firms providing electronic investing specify in their customer agreements that the relationship is
not one providing individualized advice upon which a particular customer may rely. What the customer is
bargaining for is inexpensive and prompt execution and ready access to information. The customer makes
his or her own investment decisions without relying upon any "recommendation" of the broker-dealer. The
only reliance is that the broker-dealer has a good-faith belief in the accuracy of the information supplied on
its Website.

The suitability concept is not one which is itself suitable for application to electronic investing. Efforts to
impose suitability obligations on those broker-dealer firms providing information and access would serve to
severely impede development of this beneficial marketplace. The speed of the marketplace would be
sharply degraded and the cost would increase significantly. Only individual registered representatives can
make suitability determinations; no computer could be programmed to address every potential fact and
circumstance that could arise. Current electronic investing operations avoid human interfaces and
interference with the smooth functioning and efficiency in the marketplace. In short, the modicum of
protection that would be afforded by forcing a suitability review for on-line traders would destroy the very
things they seek to accomplish by on-line trading.

Similarly, if the regulatory view of a "recommendation" is expanded to encompass information made
available at a broker-dealer's Website, then useful information will rapidly disappear from those Websites.
The NASD's advertising rules and the SEC's enforcement of its anti-fraud rules have proved adequate in
dealing with false information being injected into these sites. Much of the information available on broker-
dealer Websites is precisely the type of information small investors have sought for years. To now deny
that to them in the guise of protecting them would not advance development of the marketplace or serve the
ends of investor protection.


In its Electronics Market Report the SEC has recognized that it will need to modify rules and
interpretations inhibiting use of current technological innovations in the securities marketplace. The
NASD, too, has acknowledged its responsibility in this area to avoid regulatory impediments to
development of this dynamic market. Small investors have never before been better served by the
marketplace. Imposing suitability obligations on electronic investing, while it may serve to protect the
foolish, will disserve the vast array of those seeking to take advantage of the opportunities provided.

                                                                                                October 1999

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