This white paper is intended to explore and discuss the potential corruption and abuse that may arise from regulatory uncertainties resulting from the drastic increase of online brokerage usage.
Although corruption generally entails several illegal acts, there are no specific legal provisions that addresses corruption in and of itself. Therefore, the absence of a specific law in turn raises the question as to what makes corruption wrong. One approach defines corruption as “an abuse of a public right for the sake of personal gain”. Although this definition was put forth from an excerpt pertaining to corruption in the political context, its universal applicability is nothing but apparent.
A right or power that the public is entitled to implicates a sense of trust. This trust is vital because it provides members of a community assurance with a set of foreseeable results after they engage with communities. Corruption devalues and even negates this predictability. As a result, it undermines sustainable goals, erodes stable infrastructures, causes personal loss, and many more.
18 U.S.C.A. § 1344. BANK FRAUD
Fraudulent intent is a core component of corruption because it is an abuse of trust. And although there are no statutory protections provided for corruption, there are several that are provided for fraud. Financial institutions specifically are protected by Title 18 U.S.C.A. § 1344. The statute is as follows:
Whoever knowingly executes, or attempts to execute, a scheme or artifice—
(1) to defraud a financial institution; or
(2) to obtain any of the moneys, funds, credits, assets, securities, or other property owned by, or under the custody or control of, a financial institution, by means of false or fraudulent pretenses, representations, or promises;
shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both.
ELEMENTS OF 18 U.S.C.A. § 1344. BANK FRAUD
The stated statute consists of five elements. Each of these elements must be satisfied for the prosecution to have a claim for fraud. The first element pertains to the whether the alleged fraudster acted knowingly. The second element requires an act or an attempt to act. The third element requires a scheme or an artifice which the courts have generally defined as a plan or pattern of conduct. The fourth element requires that plan is implemented to either defraud the financial institution or to obtain property held by the financial institution through false pretenses or promises. The final element requires that the victim or intended victim of the fraudulent act be a financial institution.
Some other important points worth mentioning is that the term “financial institution” is not limited to banks (despite the title of the statute). When using the term “financial institution”, the government refers to a list provided in §20 of Title 18. Also, the statute's reach is not limited to fraudulent parties targeting assets of the financial institution itself, but also those targeting assets of depositors or account holders. The statute boasts a very broad applicability and online brokerages are not an exception.
ONLINE BROKERAGES BACKGROUND
Before delving deeper into the issues pertaining to online brokerages, it is worthy to mention the context pertaining to the rise of online brokerages. Advancements in information technology resulted in drastic shifts in terms of the relationships between brokerages and customers.
Investors are now able to access information on similar capacities as market professionals. In response, brokerages provide more tools (research reports, calculators, portfolio analyzers) to help analyze information. In addition to an increase in exposure, investors can respond quicker to the accessed information. This significant increase in amount and speed enabled investors to more directly involve themselves with the securities market.
SUITABILITY OBLIGATION DOCTRINE
Since the widespread usage of online brokerages, one of the more representative legal obligations that has been raised as a matter of concern is the suitability obligation doctrine. The suitability obligation doctrine provides that brokers have an obligation to only make recommendations that are suitable for the customer. Suitability of recommendation is based on factors including the customer’s financial situation, knowledge of the risks, and investment objectives. It is crucial to note that brokerages are only held liable for communications that constitute as recommendations.
The next issue to consider is determining whether a communication constitutes a recommendation. This was a much simpler issue in a time before online brokerages. A distinct characteristic of non-electronic mediums is that it is not easily capable of being personalized. Therefore, there is little to no reason to expect that the message is directed to a specific person. The increase of engagement with online brokerages resulted in confusion because many methods of electronic communication defy easy characterization.
Unfortunately, the regulators (SEC and NASD) have not provided a definition for the term “recommendation”. However, they have provided some guidelines. Some factors to consider when determining whether a communication constitutes a recommendation are the content, context, and the presentation of the communication. Also, general solicitations and advertisements do not constitute as recommendations. However, despite these guidelines there are still some areas of confusion that remain.
DATA MINING VS. CUSTOMER PROFILING
One representative example is communications extended to customers based on information acquired from data mining. Data mining practices allow brokerages to gather information on customer’s habits and investment preferences based on their past activities. The practice of exposing customers to investment opportunities based on the data mined has been deemed to constitute as making a recommendation.
However, no clear guidance has been provided regarding conclusions made from data acquired from customer profiling practices. Many online brokerages acquire data regarding the customer’s background for reasons outside of better understanding the customer’s investment habits and preferences.
POTENTIAL FOR COLLUSION
The fact that customer profiling practices do not constitute recommendations can potentially give way to collusions. Collusions are a form of corruption where competing organizations cooperate in secret to defraud persons of their legal right. The most recognized example is when competing parties agree on setting a higher price for their product or services in order to increase profits.
A potential consequence from this regulatory uncertainty regarding customer profiling is an exchange of data amongst collusive parties. A brokerage might not be held liable under the suitability doctrine when communications are made based on the data provided by a third-party. Consequently, brokerages could provide recommendation-like communications that may push investors to make certain decisions that might not be in their best interest.
Although the drastic increase in usage of online brokerages resulted in the public’s efficient engagement with the market, these shifts have resulted in regulatory gaps that provide opportunities for fraud and corruption. The core purpose of the suitability obligation doctrine is to protect the rights of investors to suggestions from brokerages that serve their best interests. However, with new technological advancements, corrupt online brokerages can knowingly frame their communication methods in ways that could manipulate investors to make decisions that go against the best interest of the investor but with low risk of being held liable.
Although it seems that online brokerages are in a significantly more advantageous position, there are certain precautionary measures that investors can take in order to lower the risks of becoming victims of fraudulent brokerages. For example, investors could apply data mining technology to assess prior activities of brokerages to determine if they have any abusive history. Investors could also educate themselves regarding the specifics of when a communication constitutes a recommendation. They may also have to understand how to protect themselves from customer profiling practices in order to limit data extraction. There are various preventive options available, but until further regulations are provided, the investors will have to assume a substantial burden of protecting their assets from corrupt online brokerages.