Vol 14. No. 2

The Rules are Not Discounted for the Discounter 

By Mark A. Tepper 

Florida Securities Fraud Attorney

Discount firms frequently argue that they are merely “order takers”
and have no supervisory responsibilities to their customer accounts.  Interestingly, there is a long history of legal authorities that consistently say the opposite.  The NYSE Director of Rules and Interpretations discredited the discounter’s argument when he wrote that “. . . [e]xchange rules do not make a distinction between ‘discount’ firms and firms that conduct business on other than a discount basis.” 

That NYSE interpretive letter was published in the Wall Street Journal under the headline: Discounters Must Watch out for Customers, Big Board Says.  Eight months later, the NYSE elaborated on its position: “[a]ccordingly, the Exchange rules have always applied with equal force and effect to all Exchange member organizations, regardless of whether they choose to discount commissions.”

Charging less commission does not entitle a discount broker to disregard its supervisory obligations under the law – “the rules are not discounted for the discounter.” 

All Brokers Must Supervise their Customer Accounts

Arbitration claims against discount brokers are often prejudiced by a misunderstanding of the law.  SRO rules require on-line and discount brokers to supervise their customer accounts as well as monitor their transactions with respect to suitability even though they make no recommendation.  This concept is difficult for some arbitrators to understand. It shouldn’t be. 

Supervision is the watchword of the brokerage industry.  The supervisory duty is bound up in such basic concepts as “know your customer.”  Discount brokers are obligated to supervise customer accounts, regardless of how the account orders are received and transmitted, even if the broker makes no recommendation.

Discount brokers frequently argue that since they made no recommendation, they have no supervisory obligation.  However, this defense is inconsistent with NYSE Rule 405 and the applicable NYSE Information Memo regarding the electronic transmission of orders without a broker recommendation.  Referring to Rule 405, the NYSE plainly stated that “[t]he Rule’s [405] requirements are imposed on every customer order, regardless of the method or system used for their receipt and transmission, including those routed via electronic trading systems.”  

It makes no difference whether the broker made a recommendation or not, since how the order was received does not affect supervisory obligations.  As electronic brokers must supervise their customer accounts, discount brokers must do the same. 

Certain types of accounts and orders raise red flags which discount brokers cannot ignore by erroneously calling themselves “order takers.”  Every broker-dealer must follow the law and industry rules which includes supervisory responsibilities for every order carried by the organization.  NYSE Rule 405.

Discount Brokers Cannot Contract Out of their Duty to Supervise

Some brokers attempt to have clients execute disclaimers or indemnity agreements that would limit the discount broker’s liability for failure to supervise.  Disclaimers or indemnity agreements are not an obstacle to recovery from a discount broker because Federal and most State laws prohibit brokers from contracting out of their obligations under the securities laws.  Any such provision is null and void.
For example:

● Federal law – 15 USC §78cc(a) (“Any condition, stipulation, or provision binding any person to waive compliance with any provision of this chapter or of any rule or regulation thereunder, or of any rule of an exchange required thereby shall be void.”); and

● Florida Law – Fl. Adm. Code § 69W-600.012 (2) (“A dealer shall not enter into any contract with a customer if the contract contains any condition, stipulation or provision binding the customer to waive any rights under Chapter 517, F.S. [the Florida Investor Protection Act], or any rule or order thereunder.  Any such condition, stipulation or provision is void.”).
  
NYSE Rule 405 requires a discount broker to diligently supervise the establishment and trading of a customer’s account.  The discount broker must  “[u]se due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by such organization and every person holding power of attorney over any account accepted or carried by such organization.”  NYSE Rule 405 (1).

A discount broker must “[s]upervise diligently all accounts handled by registered representatives of the organization.”  NYSE Rule 405 (2). “The member, general partner, officer or designated person approving the opening of the account shall, prior to giving his approval, be personally informed as to the essential facts relative to the customer and to the nature of the proposed account and shall indicate his approval in writing on a document which is a part of the permanent records of his office or organization.”  NYSE Rule 405 (3).

Similarly, NASD Rule 3010 requires all member organizations to “establish, maintain and enforce written procedures . . . that are reasonably designed to achieve compliance with applicable securities laws and regulations, and with applicable NASD Rules.”  NASD Rule 3010.
 
What Does the Duty to Supervise Mean to a Discount Broker?

Red flags are indications of irregularities.  Quest Capital Strategies, Release no. ID141, 69 SEC 1317 (1999).  In Quest, the SEC has made it clear that when there are red flags in a customer account, broker-dealers have specific duties to their customers:

Supervisors have an obligation to respond vigorously and with the utmost vigilance to indications of irregularity.  A supervisor cannot ignore or disregard ‘red flags’ and must ‘act decisively to detect and prevent’ improper activity.  Indications of wrongdoing demand inquiry as well as adequate follow-up and review.  (Citations omitted). 
           
Thus, a discount broker may not establish an unsuitable account or ignore unsuitable transactions in a customer’s account.  For example, an elderly person who relies on income, and has a conservative trading history is not suitable for a speculative margin account.  If a customer or her agent tried to establish such an account, it should not be opened. 

Similarly, a pattern of unsuitable transactions in a customer’s account may not be ignored.  Unsuitable accounts and unsuitable transactions are the most basic red flags. Discount brokers are not dime stores.  It is their legal duty to refuse unsuitable business.

The Duty to Supervise an Advised Account

The same supervisory concept that binds discount brokers to reject unsuitable accounts and transactions holds true for third party traders.
When a customer signs a power of attorney or trading authorization in favor of a third party, an advised account is created.  But an advised account does not suspend the broker’s supervisory obligations to that customer.

The law is well settled that the presence of an investment adviser does not relieve a broker of his fiduciary and regulatory obligations, even when the Adviser is deemed to be acting as the customer’s agent.  Rolf v. Blyth Eastman Dillon & Co., 570 F.2d 38, 45 (2nd Cir. 1978).  The Rolf Court specifically rejected the broker’s argument that an investor who signs a broad authorization giving an adviser full trading authority relieved a broker of its responsibilities to an advised account:   

We reject Stott’s argument that the trading authorization given to Yamada [investment advisor] relieves Stott of any duty to Rolf and thus of any liability.  Stott was still Rolf's broker, though not his investment advisor, and owed Rolf a duty of loyalty normally expected of brokers. Id.

Similarly, an American Stock Exchange Disciplinary Panel censured, barred and fined a branch office manager, when, among other things, he “failed to take meaningful and effective steps to prevent ... unsuitable options transactions from occurring [in an advised account] ....”  In the Matter of Richard DeCastro, 1998 WL 295513 (AMEX).  The AMEX Panel ruled:

The Panel believes that the existence of a third party power of attorney does not relieve a member organization or its supervisory personnel of their obligations under the Exchange’s rules to supervise the accounts of their customers.  DeCastro, supra. at *7.

The Exchange specifically rejected the broker’s argument that the branch office manager had no duty to supervise an advised account.  Id.

Finally, a broker may not turn a blind eye to unsuitable transactions.   In In Re Merrill Lynch, 1982 WL 522831 (S.E.C. Release No. 19070), the Commission found that “ . . . continued execution of the adviser's orders where a broker-dealer has knowledge of improprieties in an investment adviser's handling of accounts may subject the broker-dealer to liability for aiding and abetting a violation of the federal securities laws if the adviser is in fact a primary violator of some provision of those laws.. . . .” Id. Clearly, a discount broker’s duty to supervise its customer accounts applies even when the customer has an advisor.

Supervision is the Word

When faced with unsuitable accounts, discount brokers should refuse the business.  Just like a restaurant insists on shirts and shoes, a broker has legal standards it cannot ignore.  No suitability – No trade.  No suitability – No account.  Discount brokers are not free to take every account and every trade offered them.  They must evaluate each trade and account and, if appropriate, refuse the business.

In closing, supervision of an account and its trading is protection guaranteed to brokerage customers.  This is true whether the customer is dealing with a discount broker or a third party adviser.  The customer is entitled to the protection afforded by Federal and State securities laws, no matter how much commissions they pay or who is trading their account.  Brokers are bound by the law and cannot contract out of their responsibilities.

 1. December 22, 1989 letter from NYSE Director Rule and Interpretive Standards.  Exhibit 1.

  2. July 19, 1991 Wall Street Journal: Discounters Must Watch Out for Customers, Big Board Says, p. C-1 Exhibit 2.

  3. March 31, 1992 letter from NYSE Senior Special Counsel, Member Firm Regulation.  Exhibit 3.

  4. Comment by J. Boyd Page, July 19, 1991 Wall Street Journal: Discounters Must Watch Out for Customers, Big Board Says, p. C-14.  Exhibit 2.

  5. NYSE Information Memo 02-48, November 7, 2002, Electronic Transmission of Orders, p. 3, section “Due Diligence Obligations,”  Exhibit 4.

  6. Most states have a similar provision in their securities laws.