Currently, online brokers are operating in a gray space. They seem to want to replace traditional brokers, as evidenced by their marketing and the services they offer. Yet they do not want to take on the responsibility of making suitable recommendations for investors.
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After the stock market crash in 1929, Congress acted to put more effective protections in place for investors. Congress passed the Securities Exchange Act of 1934, which required a broker’s investment recommendations be suitable for each investor. Shortly thereafter, Congress passed the Investment Advisers Act of 1940, which required investment advisors to act as fiduciaries when advising and investing their client’s money. These laws ratcheted up the legal responsibilities of brokers and investment advisors by making them potentially liable for failures.
A crucial source for this article was a note in the Columbia Law Review by Alec Smith. You can read his note, “Advisors, Brokers, and Online Platforms: How a Uniform Fiduciary Duty Will Better Serve Investors” here.
Brokers are held to a suitability standard and courts have repeatedly found that a recommendation is suitable if it is consistent with the customer’s best interests.
According to FINRA’s guidance, for a broker to provide suitable recommendations they must first take reasonable steps to understand the customer. FINRA’s rule states that brokers should pull together an investment profile that includes factors like the customer’s age, financial situation, tax status, investment objectives, and risk tolerance.
Then the broker must make reasonable recommendations that are in line with customer’s objectives. According to FINRA, a broker is not permitted to “disclaim any responsibilities under the suitability rule.”
In 1940 most people interacted with their brokers in person, or on the phone, but today many people use online brokers like Fidelity or TD Ameritrade. Like traditional brokers, these online platforms ask you questions and construct an investment profile. Many of these platforms also have online tools that will suggest investment strategies that correspond with the information you imputed into your profile.
The online platforms will also attempt to teach you about investing through materials available on their website and through regular emails. This education should help you to recognize if the suggestions made by the programming is a good fit for your investing needs.
Online Brokers Argue That They Are Not in a Position of Trust
However, unlike traditional brokers, these online platforms argue that they are not liable if they suggest an unsuitable investment. In essence, they argue that they should not be considered “brokers” as contemplated in the 1934 Securities Exchange Act. They argue that since they do not exercise “discretionary authority” over the client’s account, the client has not entrusted the money to the online broker and therefore no fiduciary responsibilities arise.
Additionally, online brokers require new users to sign an agreement before opening an online brokerage account. The agreement will typically state that the user does not rely on the platform for any recommendations or advice concerning their investments. This language is designed to reinforce the notion that the online broker and the investor are operating at arm’s length.
Here a modified example from a top online broker:
I have not and will not rely on [Online Broker] or any [Online Broker] representative for advice, information or recommendations regarding Designated Investments, their nature or features, their risk profiles, or their suitability for me.
Although rarely tested, these agreements have held up so far in court. In Williams v. Scottrade, Inc., No. 06-10677, 2006 WL 2077588, at *9-10 (E.D. Mich. July24, 2006) a judge found that the online platform did not owe a fiduciary duty to its customer, and that even if it did, the contractual agreement would have modified any duty owed. This case is hardly binding precedent for the whole legal system, but it stands for now.
Could the Courts Change Their Minds?
The Williams v. Scottrade case was decided in 2006. Plenty of things have changed since then. The internet is no longer a sandbox where people keep some of their toys. It is rapidly becoming fully integrated into every aspect of our lives. Our dependence on the internet grows daily as online businesses slowly but surely replace traditional businesses.
In his Note, Alec Smith argues that the suggestions online brokers offer based on a customer profile, along with the frequent educational material offered, could give a court grounds to find that online brokers exercise some de facto control over their customer’s accounts.
In essence, he argues that online brokers are … brokers. And that investors should have the same protections in their dealings with online brokers as they would have with traditional brokers.
A Hybrid Solution?
There is a practical problem with requiring online brokers to make suitable recommendations to investors. It would dramatically increase costs as the online brokers would need to communicate with every customer and assess their accounts to ensure that the algorithms had correctly identified suitable investments for the customers. Many of the competitive advantages that online brokers possess (cost savings, lower barrier to entry for investors), would be lost.
A potential hybrid solution would be for the online platforms to provide investors with lots of independent research, enabling investors to make truly independent judgements. Here at Watchdog Research, we have independent research on almost every public company listed on a U.S. exchange, as well as on hundreds of ETFs.
Currently, the online brokers are operating in a gray space. They seem to want to replace traditional brokers, as evidenced by their marketing and the services they offer. Yet they do not want to take on the responsibility of making suitable recommendations for investors.
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