Should Online Brokerages Play By Offline Rules?

Online brokers are the focal point of a 95-page report that was just issued by the U.S. Securities and Exchange Commission (SEC).

In the report, the SEC pointed out instances where online brokers may become subject to the same suitability rules that now govern their brick-and-mortar counterparts.

These strictly-enforced offline rules state that brokers who recommend specific stocks to customers — as full-service brokers do — must check whether those stocks are suitable for those particular investors. For example, under current suitability rules, it would be wrong for a broker to recommend that an elderly retiree plow their life savings into a volatile dot-com stock when their investment objective is steady, guaranteed income.

In fact, under existing rules, if such a hypothetical pensioner were coerced into an investment without their suitability being addressed, they would have legal grounds to get their money back if the investment crashed and burned.

Online Brokers Want It Both Ways

By claiming that they are not in the business of giving advice, online brokers have shimmied through a loophole in the suitability rules.

Nonetheless, many of these same online brokers have recently expanded their offerings to include stock analysis in an effort to compete with brick-and-mortar brokers that have launched their own online services.

For instance, E*Trade Group, Inc., the third largest online broker, offers its users online analysis of individual stocks by its own stable of stock experts.

This service has caused some full-service brokerage houses to cry foul and point out that online brokers have the advantage of giving advice without being subject to the suitability rules.

Free Ride Could Be Over

The SEC report cites several hypothetical scenarios where online brokers could become subject to suitability rules.

One example is when online brokers track different customers’ buying habits and then solicit similar purchases via e-mail.

“While the process may be somewhat mechanized, the firm is tailoring particular securities (to the investor), the SEC report says.

Even so, SEC officials still contend that it is premature for extensive rulemaking in this area, but I think it is only a matter of months before the regulatory agency will be forced to step in.

Why?

Since the time I began writing this column, I have watched online brokers ignore every legitimate criticism leveled at them. Sure, they have spent a few million (US$) on ads that show them as being more responsible and caring businesses.

However, when one really looks at the subliminal get-rich-quick message they keep pumping out, one soon realizes that they are not serious about mending their ways.

Meanwhile, as the market continues to skyrocket, most investors won’t give a damn about suitability.

That is, until the market takes a really big nose-dive. Then these same investors will be screaming at the top of their lungs for stronger SEC regulation.

What do you think? Let’s talk about it.