The current market structure is dispersed and complex: (1) trading volume is dispersed among highly automated trading centers that compete for order flow in the same stocks; and (2) trading centers offer a wide range of services that are designed to attract different types of market participants with varying trading needs
Can we say we have one stock market? No; there are lots of markets
In one market, there would be more competition between buyers and sellers everyone would be in the same room
Central Order Book (COB)
So if you have IBM, all the shares have to go into one computer network
Proposed system allows for greater transparency
And reduces the spread more competition between buyers/sellers
But maybe buyers/sellers don’t just want the best price maybe they want other things, like service, anonymity
Dark pool: allows for discrete/anonymous trading
So that large investors’ trading activity will not impact the share price
Trade-through rule
If you have a sell order or buyer order, you have to expose the order
The rule prohibits an incoming market order from ignoring (trading through) a better quote in market A to trade with a poorer quote in market B
There is one computer linkup for all these markets
Before the broker moves to market A, it has to expose the order for a very short period of time to see if another market picks it up
Electronic trading benefits investors in increasing the speed and lowering the cost of trading while at the same time creating a complete audit trail that facilitates monitoring brokers
Consolidated audit trail
Electronic trail of the trades
So SEC can come in after the fact to assess whether the trade-through rule was complied with
Payment order flow
If the broker sends the order to market x, market x will send the broker a kickback
Unlisted securities trade in a number of markets today, all of which are electronic. The OTC Bulletin Board, operated by FINRA, emerged as a trading site for smaller issuers, but since 1999 the OTCBB has been limited to reporting companies under the ’34 Act, which made it less attractive to issuers unwilling to take on those responsibilities
The major platforms for electronic “pink sheet” trading today are operated by OTC Market Groups
Difference between a broker and a dealer
Broker acts only as an agent
Dealer actually buys
So dealers want disjointed markets/lack of transparency keep the spread large, and allow for bigger profits
Because the more transparency/competition, the smaller the spread less profit
Much of the day-to-day work of regulating the broker-dealer industry is done by FINRA, the industry’s “self-regulator”
EA §15(a): no person may act as a broker or a dealer in securities unless registered with the SEC or expressly exempted from the registration requirement must also join FINRA
3(a)(4): Broker is a person engaged in the business of effecting transactions in securities for the account of others
3(a)(5): Dealer is a person engaged in the business of buying and selling securities for his own account
“In the business” = generally, engage in the activity on a regular basis and typically in a fairly public fashion
Website & frequency of contracting market maker
Problem 18-1: dealer; public=website + contact market maker
Problem 18-2: broker: public
18-3: yes, broker-dealer
15(b)(1): the SEC may deny (or subsequently revoke) a registration based on evidence of misconduct or false statements to the Commission
The SEC has authority with respect to setting standard for both the conduct of broker-dealers and discipline
Issuer can create a bulletin board for its own shares (to enhance liquidity) without being a broker
But they can’t receive money for it
Duty to supervise
Broker-dealer duty: 15(b)(4)(E)
Duty to supervise subordinates to prevent them from engaging in securities violation
15(b)(6)(A)
“Once a person in Feuerstein’s position becomes involved in formulating management’s response to the problem, he is obligated to take affirmative steps to ensure that appropriate action is taken to address the misconduct”
Once lawyer is brought in, he needs to take affirmative steps to prevent a recurrence
Has to exercise ongoing obligations to ensure future compliance
Once such a person has supervisory obligation by virtue of the circumstances of a particular situation, he must either discharge those responsibilities or know that others are taking appropriate action
SRO “just and equitable” conduct rules
Best execution
The virtue of a “centralized” system is that an order will come together with all others, so that the resulting market price will reflect the full range of supply and demand
A broker has a fiduciary-like duty to seek “best execution” for the customer
Best execution refers to traders receiving the most favorable terms available for their trades
Best execution does not connote a single execution attribute, such as a price, but rather attaches to a vector of execution components
Moreover, when markets compete in different ways with respect to different components of trade executions, it is no longer clear what “best” execution is, let alone how or when it is attained
The broker-dealer, absent instructions to the contrary, is expected to use reasonable efforts to maximize the economic benefit to the client in the transaction. That means “the best reasonably available price.”
Broker has obligation to expose the order, and to constantly be thinking, “Can I get a better price somewhere else?”
202(a)(11) of Investment Advisers Act
Investment adviser definition
Is investment advice incidental to legal service?
If yes, not investment adviser
Must be compensated
Investment advice can’t be generic as to resource allocation
So your broker may be an investment adviser
The duties/obligations we impose on investment advisers may be greater or less than those imposed on brokers
A broker can sell to you shares they have in inventory
Can act as principal
An investment adviser can’t do that
Broker doesn’t have to disclose kickbacks
But investment adviser does
Broker has best execution rules investment adviser doesn’t
Know your security
Do we know what the law is?
In terms of private party rights, this is a black box
All of this legal uncertainty hardly gives customers much notice of precisely how their brokers are expected by law to behave
If the broker has a duty, what is the source of that duty?
Fiduciary relationship? Shingle theory? Fraud?
Absent a recommendation (absent the broker doing something), the customer is not likely to have a cause of action
Shingle theory
When you put our your shingle as a broker, you impliedly represent that you’ll treat people fairly
FINRA: “fair, just equitable”
So you’re representing that you’ll treat me fairly, justly, equitably
Fiduciary relationship
If client is depending on broker
Facts may determine fiduciary relationship
The more pathetic the client, the better
Misstatement/omission
Brokers and salesman are under a duty to investigate, and their violation of that duty brings them within the term “willful” in the Exchange Act. Thus, a salesman cannot deliberately ignore that which he has a duty to know and recklessly state facts about matters of which he is ignorant. He must analyze sales literature and must not blindly accept recommendations made therein. The fact that his customers may be sophisticated and knowledgeable does not warrant a less stringent standard
A securities dealer occupies a special relationship to a buyer of securities in that by his position he implicitly represents he has an adequate basis for the opinions he renders
He cannot recommend a security unless there is an adequate and reasonable basis for such recommendation. He must disclose facts which he knows and those which are reasonably ascertainable. By his recommendation he implies that a reasonable investigation has been made and that his recommendation rests on the conclusions based on such investigation. Where the salesman lacks essential information about a security, he should disclose this as well as the risks which arise from his lack of information
A salesman may not rely blindly upon the issuer for information concerning a company, although the degree of independent investigation which must be made by a securities dealer will vary in each case. Securities issued by smaller companies of recent origin obviously require more thorough investigation
The duty of investigation is a continuing one, with a special obligation to monitor management projections to see if they indeed pan out
If you’re making a recommendation, then your duty as a broker is to have a reasonable basis for that recommendation
The market for low-priced securities, so-called penny or microcap stocks, is fertile ground for misrepresentations and omissions by brokers using boiler room tactics
The problem with analysis
Implicit in the “know your security” rule is the idea that customers are entitled to trust their brokers to make carefully researched, objective recommendations
New set of rules:
Prohibit analysts from issuing “booster shot” research that supplements or reiterates a buy recommendation around the expiration of a lock-up on insider selling as part of a public offering
Bar analyst participation in “pitch meeting” designed to solicit...