Buyer Beware, Says the NASD

In one fell swoop, the NASD with its release of Notice to Members 01-23 today, undid much of the good done by Arthur Levitt, the former Chairman of the SEC. One wonders if the NASD waited to dispense such an anti-investor stance until Levitt left office so as not to incur his wrath.

The NASDs Notice to Members 01-23 Suitability Rule and Online Communications attempts to overturn much of the heart of the securities regulations starting from the issuance of the 1934 Securities Act.

The release reads as if it was crafted by the online brokerage firms and the NASD just issued its stamp of approval.

I question the timing of this release. Millions of investors have lost billions of dollars in the last few months with the recent drop in the U.S. stock market. Many of these investors were relatively new investors who were drawn into the markets by the deceptive and misleading advertising campaigns of many of the online brokerage firms. The SEC and NYSE have both been critical of some of this misleading advertising.

Many investors were misled by these advertising campaigns and opened brokerage accounts at firms such as E*Trade, Ameritrade, Waterhouse, SureTrade, and the like, when they had no investment experience and could not afford the risks attendant to a volatile stock market. These online firms introduced them to concepts such as margin, options, IPOs, and short-term trading.

I know that many of these individuals did not truly understand what was being offered. I am receiving an influx of contact from these inexperienced investors who lost money they could ill afford to lose.

The NASDs Notice to Members 01-23 has now conveniently protected the online brokerage firms from lawsuits and claims that otherwise might have been filed. For the first time in 66 years, the NASD has proclaimed with its notice that, at least as it pertains to online brokerage firms, the securities industry is A BUYER BEWARE industry, just like used cars.

The NASDs suitability rule, which states that an investment must be recommended before any suitability obligation is triggered, has been under the gun for years. The NYSE suitability rule does not have a similar restriction.

For years, online firms have argued that the suitability rule does not apply to them, because they merely offer or introduce investors to investments and investment concepts but do not recommend them. The NASDs release today has drawn an incredible line in the sand. The NASD is basically saying that it does not deny that these online firms solicit investments, but it does not believe that they recommend investments. Yet, the NASD release artfully avoids any mention of the word solicited. I suspect that it did this, because there are far too many interpretations out there, including NASD proclamations, that the offering or introduction of investments, even by electronic means, is in fact a solicitation.

Back in 1996, the NASD issued Notice to Members 96-32 entitled, Members Reminded To Use Best Practices When Dealing In Speculative Securities. There was a section entitled Suitability that stated:

Members are cautioned to take special care with respect to their suitability analysis where the securities involved are low-priced or speculative in nature. The NASDs suitability requirement under Article III, Section 1 of the Rules of Fair Practice is fundamental to fair dealings and is intended to promote ethical sales practices and high standards of professional conduct. Members responsibilities include having a reasonable basis for recommending a particular security or strategy. In addition, the know-your-customer requirement embedded in Article III, Section 1 of the rules of Fair Practice requires a careful review of the appropriateness of transactions in low-priced, speculative, particular security or strategy. In addition, the know-your-customer requirement embedded in Article III, Section 1 of the Rules of Fair Practice requires a careful review of the appropriateness of transactions in low-priced, speculative securities, whether solicited or unsolicited.

As is fairly typical, the NASD backed off of the above language in NASD Notice to Members 96-60. As will be shown below, the NASD has a habit of crafting rules, like the one above, that go a long way toward protecting investors, and then succumbing to the intense lobbying and pressure of brokerage firms and watering the rules down.

The second paragraph of footnote No. 7 also raises my hackles. The NASD showed its true colors when it implied that its members should abide by the know your customer rule but only in an attempt to protect the brokerage firms, not to protect the investing public. This is a most incredible interpretation, and one again clearly crafted by the NASDs members to further protect them from any obligations to investors. To my knowledge, the NYSE has not interpreted its own know your customer rule (NYSE Rule 405) in such a one-sided manner. Legal scholars, arbitrators, and judges would surely disagree with the NASD. The know your customer requirements exist not just so that members can protect themselves, but to protect the investing public.

In the NASDs attempt to placate its online members, it appears that the NASD has stumbled over itself. In releasing Notice to Members 01-23, the NASD must have forgotten that fairly recently the NASD released Notice to Members 99-32. There, the NASD proposed that brokerage firms, including online firms, be required to warn investors as to the risks of day trading and to make sure that day trading was appropriate for investors. There was no reading between the lines in Notice to Members 99-32. It proposed requiring all firms to make sure that risky day trading was suitable for investors. That Notice to Members defined recommendation much more broadly than the current Notice. It stated that, a member would be recommending a day-trading strategy for purposes of the proposed rules if it affirmatively promoted day trading through advertising. Advertising!!! Now again, the NASD backed off of its investor-oriented stance in Notice to Members 99-32 after firms like E*Trade submitted a 13-page opposition to it. And in the current Notice, the NASD goes even further.

The NASD has stood by its members, not the investing public. With the release of Notice to Members 01-23, the NASD has stated that both it and its broker members will smugly stand by and knowingly allow investors to blow themselves up and lose their life saving while investing in the U.S. markets.

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