NASD REGULATION, INC.

OFFICE OF HEARING OFFICERS

SOURCE CITE

'34 Act

• Section 10(b) 

• Rule 10b-5 and

• Rule 10b-10(a)(2)(ii)(A)

• Section 17(a) 

• Rule 17a-3

NASD Conduct Rules 

• 2110

• 2120

• 2210(d)(1)(A) and (B), 

• 2230

• 3110

U.S. Rica (USR) was a small online brokerage firm founded in 1996 by Nguyen, who served as the firm’s sole registered principal.  At its peak, the member introduced some 2,500 accounts, which generated up to 300 daily orders (80-90% of which were received online; and 75% of which were limit orders).  

As part of a routine 1999 examination, NASD Staff reviewed USR’s website and found it had advertised online trades as low as $4.95.  There was also a free-trading-day promotion.  Order tickets and confirmations for the relevant timeframe indicated that some trades were effected on a riskless principal basis, but without disclosing to the customer that fact, nor the amount of mark-ups/-downs (some of which exceeded 5%).

What's the problem?
When executing riskless principal trades, a firm does not act as a market maker but rather as a principal.  Consequently, such trades should disclose the principal capacity. A principal trade is usually charged based upon a mark-up/-down, whereas an agent trade is usually charged as a commission.  Regulators tend to view a firm's failure to properly disclose its principal capacity as providing the broker-dealer with an opportunity to hide from the customer any profit it may make on the spread between what it paid/sold for the underlying shares.  This hidden profit is revenue to the firm, in addition to whatever commission it receives.

Nguyen apparently conceded the disclosure violations and agreed to revise USR's trade confirmations and online materials. Upon a follow-up review several months later, the Staff found that the promised corrections were not made and that another allegedly false and misleading advertisement was published that promised commission free Internet orders  --- again without the disclosure of riskless principal capacity and mark-ups/-downs. Respondents’ purported violations persisted even after the filing of the Complaint, only to be redressed just before the commencement of the hearing.  

Among the specific violations cited, were the failure to disclose riksless principal basis and undisclosed mark-ups/-downs for the following situations:

Commissions for customer trades of 500 shares or more: 
(a) $4.95 for Internet trades;
(b) $10 for touch-tone telephone trades; and
(c) $35 for broker assisted trades.

Commissions for customer trades of less than 500 shares
(a) $10 for Internet trades;
(b) $15 for touch-tone telephone trades; and
(c) $35 for broker assisted trades

What's Going on Here?
When Nguyen’s started USR, he charged $80 per trade. In time, competition (most notably E-Trade) undercut that figure and he was forced to lower USR's rate to $35, where the firm was barely profitable.  When  E-Trade further dropped its commission to $14.95, Nguyen concluded he could not survive without using the riskless principal trading strategy, which allowed him to lower commissions but retain the offsetting profits on the mark-ups/-downs. This gave the firm both a modest commission AND a mark-up/-down. 

The Staff sought severe sanctions for the conduct alleged, citing persistent misconduct and fraud.  Respondents defend their conduct as simple oversights and mistakes.  They cited competitive pressures and pointed to the fact that overwhelmingly their customer orders got filled at National Best Bid or Offer (NBBO). 

Respondents urged leniency based upon their position that the definition of riskless principal is unclear. The Panel discussed the Buys-MacGregor, MacNaughton-Greenwalt & Co., No Action Letter, 1980 SEC No-Act LEXIS 2851 (Jan. 2, 1980) [which NASD Staff sent to the firm for its consideration].  There the SEC stated that trades covered on the same trading day (where the transactions are designed to be offsetting), regardless of sequence, are considered riskless principal transactions--- requiring disclosure of remuneration under Rule 10b-10. Covering transactions effected the next trading date are not construed as contemporaneous with the initial trade.    

  The Panel concluded that the Respondent’s “excessively play[ed] down the egregious nature of their misconduct,” and further noted the intentional nature of the infractions and the extended period of their occurrence. Particular reference was made to the firm’s failure to take promised corrective action.  The Panel:

• expelled USR

• barred Vinh in any principal capacity, and

• imposed joint and several fines of $133,579.83 and costs