Chapter 13

BROKER-DEALER REGULATION

A. REGISTRATION

Persons who are in the business of buying and selling securities must register with the Securities and Exchange Commission and meet the requirements of the SEC rules for the continuing operation of a broker-dealer firm.[1] The broker-dealer must also become a member of a stock exchange registered with the SEC or a self-regulatory organization (SRO) registered with the SEC, such as the National Association of Securities Dealers.[2]

SECTION 15(a) OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. § 78o(a) (1988)

Problems have existed for many years because a number of broker-dealer firms have elected to specialize in the penny stock market.[3] This penny stock market consists of stocks that trade for pennies a share and do not have a listing on any stock exchange or on the NASDAQ electronic market for over-the-counter trading.[4] An investor might find price quotations for the stocks, if at all, in the pink sheets.[5] The pink sheets comprise a daily publication distributed to broker-dealers.[6] As a result, the investor has difficulty determining the current bid and asked price of the stock in the over-the-counter market.[7] Also, because of the lack of information about volume and which market makers are active, large spreads can be present between the bid and asked price.[8]

Problems with broker-dealer firms operating as boiler rooms or bucket shops have also existed for a long time.[9] A boiler room is a room containing many telephones where sales agents spend most of their time calling potential investors.[10] These sales agents use high-pressure sales techniques to induce investors to purchase securities.[11] A bucket shop is a firm that will make purported sales of stocks to investors, but will keep the funds and not actually purchase the stock for the investors.[12]

Firms have set up to offer day trading accounts and equipment to individuals for the purpose of rapidly trading in and out of the stock market, with the goal of making a small profit on each trade.[13] In a similar vein, many investors with online accounts are involved in day trading activities by rapidly purchasing and selling stocks during a single day.[14]

SECURITIES OPERATIONS: DAY TRADING REQUIRES CONTINUED OVERSIGHT, Government Accounting Office Letter Report (February 24, 2000)

B. BROKER-DEALER LIABILITY

Broker-dealers can be liable to customers for violations of the securities laws.[15]

Broker-dealers can be liable to customers for churning accounts.[16]

Broker-dealers can be liable to customers by charging excessive mark-ups on the price of securities and not disclosing such.[17]

Broker-dealers can be liable to customers by not performing a due diligence investigation of the securities being sold.[18]

Broker-dealers can violate the rules of SROs by not determining the suitability of the customers for buying particular securities.[19]

Section 1416 of the Federal Securities Code[20] proposes to provide that a member of a self-regulatory organization who violates a rule of the organization is liable to a customer for any loss caused by the violation.

Broker-dealers can be liable to customers for violations of the securities laws by persons under their control.[21]

SECTION 15(c)(1) OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. § 78o(c)(1) (1988)

SECTION 15(c)(2) OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. § 78o(c)(2) (1988)

SECTION 9 OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. § 78i (1988)

SECTION 20(a) OF THE SECURITIES EXCHANGE ACT OF 1934, 15 U.S.C. § 78t(a) (1988)

DONALD A. ROCHE, Securities Exchange Act Release No. 34-38742 (June 17, 1997)

MARTIN R. KAIDEN, Securities Exchange Act Release No. 34-41629 (July 20, 1999)

SEC v. FIRST JERSEY SECURITIES, INC., 101 F.3d 1450 (2d Cir. 1996)

ON-LINE BROKERAGE: KEEPING APACE OF CYBERSPACE, Securities and Exchange Commission Special Study (1999)

INTERPRETATION OF NASD SUITABILITY RULE, Securities Exchange Act Release No. 34-37588 (August 20, 1996)

C. ARBITRATION

Broker-dealers today require customers to sign agreements to submit claims for securities law violations to arbitration.[22]

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[1] 15 U.S.C. §§ 78g-78h, 78o (1988); Regulation G, 12 C.F.R. § 207 (1990); Regulation T, 12 C.F.R. § 220 (1990); Regulation U, 12 C.F.R. § 221 (1990); Regulation X, 12 C.F.R. § 224 (1990); 17 C.F.R. §§ 240.10b-6 to .10b-8, 240.10b-13 (1990); see DONNA S. CARPENTER & JOHN FELONI, THE FALL OF THE HOUSE OF HUTTON 99 (1989); WILLIAM GREIDER, SECRETS OF THE TEMPLE 311-12 (1987); 6 LOUIS LOSS & JOEL SELIGMAN, SECURITIES REGULATION 2965-76 (3d ed. 1990); CHRIS WELLES, THE LAST DAYS OF THE CLUB 242-245 (1975); T.G. Callery & Anne H. Wright, NASD Disciplinary Proceedings - Recent Developments, 48 Bus. Law. 791, 791-839 (1993); Jeffry L. Davis, William C. Dale & James A. Overdahl, Using Finance Theory to Measure Damages in Cases Involving Fraudulent Trade Allocation Schemes, 49 Bus. Law. 591, 597-610 (1994); Daniel R. Fischel & David J. Ross, Should the Law Prohibit "Manipulation" in Financial Markets?, 105 Harv. L. Rev. 503, 507-42 (1991); William W. Foshay, Market Activities of Participants in Securities Distributions, 45 Va. L. Rev. 907, 907-26 (1959); Fred N. Gerard & Michael L. Hirschfeld, The Scienter Requirement Under Rule 10b-6, 46 Bus. Law. 777, 777-780 (1991); Michael P. Jamroz, The Net Capital Rule, 47 Bus. Law. 863, 863-68 (1992); Robert L. Knauss, A Reappraisal of the Role of Disclosure, 62 Mich. L. Rev. 607, 635-40 & n.136 (1964); Donald C. Langevoort, Information Technology and the Structure of Securities Regulation, 98 Harv. L. Rev. 747, 751-54 (1985); William T. Lesh, Federal Regulation of Over-the-Counter Brokers and Dealers in Securities, 59 Harv. L. Rev. 1237, 1244-1274 & n.27 (1946); David A. Lipton, A Primer on Broker-Dealer Registration, 36 Cath. L. Rev. 899, 899-908 (1987); Henry F. Minnerop, The Role and Regulation of Clearing Brokers, 48 Bus. Law. 841, 841-852 (1993); Art Detman, Can Ross Perot Change Wall Street?, Dun's, Mar. 1973, at 46; Robert L. Frome, Registration of Employee Broker Dealer, N.Y. L.J., Oct. 27, 1988, at 3; Roberta S. Karmel, Net Capital, Customer Protection Rule Revisions, N.Y. L.J., Dec. 19, 1985, at 1; Carol J. Loomis, The Unbelievable Last Days of Hayden, Stone, Fortune, Jan. 1971, at 114; Rifka Rosenwein, In‑housers Gain From Rise In Securities Compliance Work, Manhattan Law., Mar. 1‑7, 1988, at 1; Michael Siconolfi, Lehman Brothers Plans Pretax Charge of $30 Million for Severance Payments, Wall St. J., Apr. 1, 1994, at A8; see, e.g., Miley v. Oppenheimer & Co., 637 F.2d 318 (5th Cir. 1981); Arthur James Huff, SEC Securities Exchange Act Release No. 29,017 (Mar. 28, 1991), reprinted in 48 SEC DOCKET 10 (1991).

[2] 15 U.S.C. § 78o(b)(8)‑(9) (1988); see LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION 602‑24 (2d ed. 1988); ROBERT C. POZEN, FINANCIAL INSTITUTIONS: INVESTMENT MANAGEMENT 50‑57 (1978).

[3] See The Penny Stock Scandal, Bus. Wk., Jan. 23, 1989, at 74.

[4] See John C. Boland, Penny Dreadfuls, Barron's, Aug. 16, 1982, at 10.

[5] JOEL SELIGMAN, THE TRANSFORMATION OF WALL STREET 490 (1982).

[6] JOEL SELIGMAN, THE SEC AND THE FUTURE OF FINANCE 18 (1985); CHRIS WELLES, THE LAST DAYS OF THE CLUB 284-86 (1975).

[7] See Rhonda Brammer, The Abracadabra Man, Barron's, Mar. 16, 1987, at 6.

[8] See Anthony De Toro, Market Manipulation of Penny Stocks, 17 Sec. Reg. L.J. 241, 245-46 (1989).

[9] See JOHN BROOKS, ONCE IN GOLCONDA 75 (1969); Ann Hagedorn, Boiler Room Brokers Just Keep Resurfacing, J.T. Moran Case Shows, Wall St. J., Apr. 26, 1990, at A1.

[10] See MURRAY T. BLOOM, ROGUES TO RICHES 25 (1971); LOUIS LOSS, FUNDAMENTALS OF SECURITIES REGULATION 829-31 (2d ed. 1988); see, e.g., Berko v. SEC, 316 F.2d 137 (2d Cir. 1963); Kahn v. SEC, 297 F.2d 112 (2d Cir. 1961).

[11] See PAUL HOFFMAN, THE DEALMAKERS 124-39 (1984); see also Constance Mitchell, Fast-Talking Brokers in Little Rock Target Small City Treasuries, Wall St. J., Apr. 12, 1989, at A1.

[12] See VINCENT P. CAROSSO, INVESTMENT BANKING IN AMERICA 127 & n.62 (1970); ROBERT SOBEL, AMEX 15-16 (1972).

[13] See GREGORY J. MILLMAN, THE DAY TRADERS 88-100 (1999).

[14] See generally EDWARD CHANCELLOR, DEVIL TAKE THE HINDMOST Ch. 10 (1999).

[15] See Donald C. Langevoort, Fraud and Deception by Securities Professionals, 61 Tex. L. Rev. 1247, 1271‑94 (1983); Charity Scott, Caveat Vendor: Broker-Dealer Liability Under the Securities Exchange Act, 17 Sec. Reg. L.J. 274, 275-77 (1989); Roberta S. Karmel, Revisiting the Shingle, Fiduciary-Duty Theories, N.Y. L.J., Oct. 16, 1986, at 1.

[16] See Note, Churning by Securities Dealers, 80 Harv. L. Rev. 869, 869-85 (1967); Richard A. Booth, New Churning Cases Add Twist To Claims for Portfolio Damages, Nat'l L.J. June 24, 1991, at 34.

[17] See Joseph I. Goldstein & L.D. Cox, Penny Stock Markups and Markdowns, 85 Nw. U.L. Rev. 676, 676-95 (1991); Note, Insider Trading in Junk Bonds, 105 Harv. L. Rev. 1720, 1722-25 (1992); Roberta S. Karmel, Pegging Dealer Profits, N.Y. L.J., Aug. 20, 1987, at 1.

[18] See, e.g., Victor Brudney, Origins and Limited Applicability of the "Reasonable Basis" or "Know Your Merchandise" Doctrine, in FOURTH ANNUAL INSTITUTE ON SECURITIES REGULATION 239, 247-49 (Robert H. Mundheim, Arthur Fleischer, Jr. & John D. Schupper eds., 1973).

[19] See, e.g., Martin Lipton, The Customer Suitability Doctrine, in FOURTH ANNUAL INSTITUTE ON SECURITIES REGULATION 273, 275-81 (Robert H. Mundheim, Arthur Fleischer, Jr. & John D. Schupper eds., 1973).

[20] FEDERAL SECURITIES CODE § 1416 (1980).

[21] See Ralph C. Ferrara & Diane Sanger, Derivitive Liability in Securities Law: Controlling Person Liability, Respondeat Superior, and Aiding and Abetting, 40 Wash. & Lee L. Rev. 1007, 1007-29 (1983).

[22] See Lewis D. Lowenfels & Alan R. Bromberg, Securities Industry Arbitrations: An Examination and Analysis, in 3 SELECTED ARTICLES ON FEDERAL SECURITIES LAW 137, 138-164 (Franklin E. Gill ed., 1991); Michael McGowan, See You in Arbitration, 79 A.B.A. J. 110 (May 1993); Brigid McMenamin, Friends of the Shafted, Forbes, Apr. 26, 1993, at 185; Rob Rossi, Brokers, Attorneys Try to Curb 'Claims Advisers', Legal Times, Nov. 22, 1993, at 4; Michael Siconolfi, Stock Investors Win More Punitive Awards In Arbitration Cases, Wall St. J., June 11, 1990, at A1.