Fair Practice Regulations of Fair Practice Regulations of Broker-Dealers in USBroker-Dealers in US

Hatice Ozge UysalHatice Ozge UysalUPENN – Wharton SchoolUPENN – Wharton School

The Capital Markets Board of Turkey The Capital Markets Board of Turkey ProgramProgram

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ConsultantsConsultants

Thanks to;

Mr. Larry E. Bergmann (SEC) and

Prof. William C. Tyson (UPENN)

for their valuable comments

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Focus of the StudyFocus 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

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also…also…

Regulatory; Conduct Regulation; Market overview

Application of fair practice regulation on specific conducts

Comparison with Turkey

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Conduct RulesConduct 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

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One significant need for detailed One significant need for detailed conduct rules is …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)

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When imposing sanctions against When imposing sanctions against BDs …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”

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These obligations are largely based These obligations are largely based on …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.

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Shingle – Misrepresentation – Shingle – Misrepresentation – Implied Representation TheoryImplied 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

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Shingle TheoryShingle 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

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Shingle TheoryShingle 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

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Shingle theory describes the duties Shingle theory describes the duties of BD as …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

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Shingle theory expanded to cover Shingle theory expanded to cover these areas: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

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Fiduciary TheoryFiduciary 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)

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Fiduciary TheoryFiduciary 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

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ComparisonComparison 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

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Linking the theories to anti-fraudLinking 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

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Anti-fraud rules can apply against Anti-fraud rules can apply against such breaches of duties that prohibit…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

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Suitability & RecommendationsSuitability & 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

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Suitability – NASD RuleSuitability – 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

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Suitability – 3 componentsSuitability – 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

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Suitability – what is a recommendation?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

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NYSE Suitability RuleNYSE 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

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Special Conduct RulesSpecial Conduct Rules

Churning (excessive trading) prohibition and

Best execution obligations

are 2 of the extensions of shingle theory duties

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ChurningChurning

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)

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ChurningChurning

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

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Duty of Best Execution – Mark-upsDuty 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

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Duty of Best Execution – Mark-upsDuty 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

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Duty of Best Execution – Order ExecutionDuty 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

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Duty of Best Execution – Order ExecutionDuty 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

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Comparison with Turkey & Comparison with Turkey & ConclusionConclusion

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

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Comparison with Turkey & Comparison with Turkey & ConclusionConclusion 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