1. Fair Practice Regulations of Broker-Dealers in US Hatice Ozge Uysal UPENN – Wharton School The Capital Markets Board of Turkey Program

2. 4 / 21 / 2003Fair Practice Regulations2 Consultants Thanks to; Mr. Larry E. Bergmann (SEC) and Prof. William C. Tyson (UPENN) for their valuable comments

3. 4 / 21 / 2003Fair Practice Regulations3 Focus of the Study The origins of fair practice provisions Theories used to explain the duties of BDs to customers Their link to anti-fraud regulations

4. 4 / 21 / 2003Fair Practice Regulations4 also… Regulatory; Conduct Regulation; Market overview Application of fair practice regulation on specific conducts Comparison with Turkey

5. 4 / 21 / 2003Fair Practice Regulations5 Conduct Rules Aim; maintaining orderly markets & protecting investors One instrument; setting conduct rules for BDs The SEC and SROs prohibit all kinds of fraudulent, manipulative and deceptive activities Also set special conduct rules to maintain high industry standards for BDs

6. 4 / 21 / 2003Fair Practice Regulations6 One significant need for detailed conduct rules is … The dual rules of market-makers (OTC) and specialists (exchanges) They both act as a principal (trading for their own account) and as an agent (trading for the customers)

7. 4 / 21 / 2003Fair Practice Regulations7 When imposing sanctions against BDs … General anti-fraud provisions of; Sections 10(b) & 15(c) of the SEA Section 17(a) the SA are largely used Also SROs have rules designed “to prevent fraudulent and manipulative acts and practices and to promote just and equitable principles of trade”

8. 4 / 21 / 2003Fair Practice Regulations8 These obligations are largely based on … Shingle theory and common law principles and in most of the cases the duties that arise from these theories are linked with the anti-fraud provisions.

9. 4 / 21 / 2003Fair Practice Regulations9 Shingle – Misrepresentation – Implied Representation Theory The essence is that, in hanging up a shingle a broker implicitly represents that he will conduct business in an equitable and professional manner

10. 4 / 21 / 2003Fair Practice Regulations10 Shingle Theory Initiation; charging excessive mark- ups over the current market without disclosure This action was found to be; - fraudulent and - omission to state a material fact; constituting a misrepresentation and anti-fraud violation

11. 4 / 21 / 2003Fair Practice Regulations11 Shingle Theory Traditional agency principals are applicable only to agents But fiduciary obligations which arise out of the shingle theory are binding brokers both in principal and agency capacity. Because BD’s representation is inherent to the customer-broker relationship, and this representation arises from the broker’s professional status, not from common-law agency duties

12. 4 / 21 / 2003Fair Practice Regulations12 Shingle theory describes the duties of BD as … (1) a duty to deal fairly with the customer (2) a duty to deal in accordance with the standards of the profession with the customer

13. 4 / 21 / 2003Fair Practice Regulations13 Shingle theory expanded to cover these areas: prompt execution of customer orders BD’s financial solvency not to trade excessively suitable recommendations maintaining reasonably related to prices complying with net capital rule or the SEC’s bookkeeping requirements not to misrepresent information to customers

14. 4 / 21 / 2003Fair Practice Regulations14 Fiduciary Theory “Fiduciary theory” has been imposed where the broker-dealer develops a special type of relationship with the customer that involves trust and confidence (shingle theo. → based on BD’s professional status)

15. 4 / 21 / 2003Fair Practice Regulations15 Fiduciary Theory For a broker in a principal capacity, acting as a fiduciary (who puts himself in a position of trust and confidence), to obtain informed consent from customers regarding to his “dual and conflicting role”, full disclosure of any conflicting interests must be made Anti-fraud provisions prohibit not only the disclosure of purposeful falsity but also the telling of half-truths and the failure to tell the whole truth

16. 4 / 21 / 2003Fair Practice Regulations16 Comparison shingle theory → professional status of BD fiduciary theory → BD’s relationship with customer However, both ultimately express the same obligations and there is no clear boundary between them considering their conclusions Indeed, by its nature, generally every BD-customer relationship is based on trust and confidence and this confidentiality usually arises from the BD’s professional status For both of the theories disclosure of every material element is the key point

17. 4 / 21 / 2003Fair Practice Regulations17 Linking the theories to anti-fraud The fraud is based on the implicit representation There can be several antifraud violations: - BD’s nonobservance of his duty makes false the implicit representation that the broker will conduct business in an equitable and professional manner - BD omits to state a material fact in failing to observe his duties - BD constructively defrauds the customer by promoting the customer’s trust in the broker’s observance of his shingle theory standards and then by deceiving the customer in failing to live up to that trust

18. 4 / 21 / 2003Fair Practice Regulations18 Anti-fraud rules can apply against such breaches of duties that prohibit… (1) devices, schemes or artifices to defraud; (2) making an untrue statement of a material fact or omission of a material fact necessary to make statements made not misleading; (3) engaging in practices which operate as fraud or deceit

19. 4 / 21 / 2003Fair Practice Regulations19 Suitability & Recommendations BD’s obligation to recommend only those specific investments that are suitable for its customers Originated in the common law, being a part of shingle theory and fair dealing obligation Where the other elements of a violation are present, the courts have viewed a BD’s breach of its suitability obligations as a violation of SEC Rule 10b-5

20. 4 / 21 / 2003Fair Practice Regulations20 Suitability – NASD Rule The main source for suitability obligations is the rules of SROs. The NASD’s suitability rule requires; BD’s have reasonable grounds for believing that any recommendation they make to a customer is suitable, based on what the customer has disclosed, if any, about other security holdings, financial situation and needs

21. 4 / 21 / 2003Fair Practice Regulations21 Suitability – 3 components “customer-specific suitability” –BD must tailor his recommendations to the customer’s financial profile and investment objectives –Reasonable efforts must be made to obtain information about his financial status and investment objectives and keep such information current “duty to investigate”, “know your security”, or “reasonable basis suitability” –BD must comprehend the potential risks and rewards of his own investment recommendation –Independent investigation “know your transaction/strategy” –BD must be aware of the consequences and implications of his strategy

22. 4 / 21 / 2003Fair Practice Regulations22 Suitability – what is a recommendation? The NASD refuses to define the term A transaction will be considered to be recommended when the firm brings a specific security to the attention of the customer through any means (direct phone communication, promotional material delivered via the mail, or electronic messages) The only time the broker-dealer is clearly relieved of a suitability duty is when he acts solely as an order-taker

23. 4 / 21 / 2003Fair Practice Regulations23 NYSE Suitability Rule NYSE’s “Know Your Customer Rule” requires members to use due diligence to learn the essential facts relative to every customer, every order, every cash or margin account accepted or carried by the member, and every person holding a power of attorney over any account NYSE’s rule is broader than the NASD rule and is not directly related to recommendations

24. 4 / 21 / 2003Fair Practice Regulations24 Special Conduct Rules Churning (excessive trading) prohibition and Best execution obligations are 2 of the extensions of shingle theory duties

25. 4 / 21 / 2003Fair Practice Regulations25 Churning BD does transactions that are excessive in light of the objectives and resources of the customer’s account in order to increase his compensation It is different from unsuitability, but sometimes unsuitability claims accompany churning claims (existence of excessive trades will represent an unsuitable frequency of trading)

26. 4 / 21 / 2003Fair Practice Regulations26 Churning Generally described as a practice and course of business which operates as a fraud or deception Where BD breaches his duty to deal fairly (implied representation) and acts against the customer’s interests The fraud of churning is typically considered to be a violation of Rule 10b-5 Churning also violates Section 17(a) of the SA and Section 15(c)(1) of the SEA and Rule 15c1-2

27. 4 / 21 / 2003Fair Practice Regulations27 Duty of Best Execution – Mark-ups Charging excessive mark-ups usually involves disguising all or a portion of the true mark-up that is being charged, This constitutes a deceptive and manipulative practice, thus will result committing fraud

28. 4 / 21 / 2003Fair Practice Regulations28 Duty of Best Execution – Mark-ups The most important issue related with the mark-ups is the obligation to disclose the compensation received fully, in order to maintain the customers know all the materially important facts But disclosure will not always prevent a violation of rules of ethics and degree of disclosure must be considered along with all other relevant circumstances in judging the reasonableness of a mark-up

29. 4 / 21 / 2003Fair Practice Regulations29 Duty of Best Execution – Order Execution Under the shingle theory, the representation of performance fulfilling the standards of the industry is applicable to every transaction Also common law agency principles (fiduciary theory) is another source for this duty

30. 4 / 21 / 2003Fair Practice Regulations30 Duty of Best Execution – Order Execution BD who fails to execute or deliver promptly, misappropriates, or acts inconsistently with the customer’s interests after receiving an order, securities, or cash, is considered to have violated to the standards of the industry He thereby breaches his implied representation and fiduciary duties, and commits a fraud in violation of Rule 10b-5

31. 4 / 21 / 2003Fair Practice Regulations31 Comparison with Turkey & Conclusion In Turkey: No market makers or specialists, BDs are agents: no need for detailed mark-up & order execution rules There are certain conduct rules, mainly based on the fair dealing, making full disclosure to the customers, avoiding conflicts of interests, and making suitable recommendations. By that means shingle and fiduciary theories’ principles can also be found in the securities regulation in Turkey

32. 4 / 21 / 2003Fair Practice Regulations32 Comparison with Turkey & Conclusion The main difference: the link between the fiduciary duties and the anti-fraud regulations are not as strong as it is in the US (difference between the law systems) Apart from the differences between the market and law systems, conduct and anti-fraud regulations are quite parallel in two countries and duties that arise from the professional status of the broker is always the basis of these regulations