Brokers and Brokerage Firms Really Do Have Ethics and Professionalism Rules

t's hard not to read a daily newspaper without noticing a news story about a broker or brokerage firm doing something wrong. Consider some of the recent news:

Frank Gruttadauria of Lehman Brothers purportedly created phony account statements to dupe customers and his firm failed to supervise him in allowing him to use fictitious mailbox addresses to send the real account statements;

Salomon Smith Barney is under investigation purportedly for not conducting adequate due diligence in its underwriting shares of Adelphia Communications Corp. for sale to the investing public, and failing to disclose material information, including certain borrowing arrangements that its parent Citigroup, Inc. had extended to the company as one of the primary creditor banks;

Merrill Lynch is paying a $100 million fine because its analysts purportedly told the public that Internet stocks were Buys at the same time they privately panned those stocks;

Salomon Smith Barney's stock analyst, Jack Grubman, purportedly was instrumental in making key management and business decisions for Global Crossing, despite the fact that his "day job" was to act as an independent stock analyst covering the company; and

PaineWebber decided to fire stockbroker Chung Wu for telling his customers that they should sell Enron, albeit through an impermissible email message, purportedly because PaineWebber had a buy recommendation on the stock, had an investment banking relationship with the company, managed the company's stock option program and handled brokerage account for many company executives.

These news stories undermine the confidence that Americans, and the world, have in our securities markets.

Undoubtedly, there will be scores of securities class actions (in which most individual investors should not participate, opting instead to pursue their own securities arbitration claims). But that "justice" will come slowly and in piecemeal fashion.

Meanwhile, investors should find some (though not much) comfort in knowing that, in addition to rules prohibiting recommendations of unsuitable investments, manipulation, excessive trading, and so forth, there are ethics and professionalism rules that apply to brokers and brokerage firms.

The cornerstone of the ethics rules is Rule 2110, formerly Article III, Section 1 of the Rules of Fair Practice of the National Association of Securities Dealers, Inc. (the NASD). That rule commands that, "A [brokerage firm], in the conduct of [its] business, shall observe high standards of commercial honor and just and equitable principles of trade". The basis of this rule is nothing less than Section 15A of the Securities Exchange Act of 1934, which requires the NASD, as a registered securities association, to have and enforce rules that "promote just and equitable principles of trade".

One court has suggested that Rule 2110 is to ensure "professionalism". Another court has suggested that the rule "states a broad ethical principle". The SEC has commented that the rule gives the NASD authority to impose sanctions for "moral standards" even if there is no "unlawful" conduct. The NASD itself has stated that the rule applies when there is "bad faith".

But what does all that really mean? Undeniably, the scope of such a rule could be far-reaching, perhaps even a regulatory "blank check". To answer that question, we examined years of decisions by courts, state regulators and the NASD. We found, first, that Rule 2110 is applied not only to securities related conduct but also to any unethical business conduct. For example, Rule 2110 was violated when the broker:

Passed bad checks to his firm;

Cheated his firm to increase commissions;

Improperly obtained reimbursement for country club initiation fees from his firm; and

Improperly obtained a donation for his daughter's private school tuition from his firm's matching gift program by misrepresenting that he had contributed personal funds.

Second, we found that Rule 2110 is applied to numerous types of securities related activities, whether or not there is a violation of a more specific, companion provision of the NASD rules.

For example, in one decision, Alaska securities regulators found that the broker had violated the rule by 1) having a customer sign and date a blank new account form; 2) delaying (for three weeks) the execution of the investment program to which the customers had agreed; 3) altering the date on the new account form to mask the delay in program execution; 4) failing to return telephone calls of the customer promptly to discuss concerns of the customer; and 5) failing to promptly notify the firm's compliance department and keep it informed.

Brokers also have violated Rule 2110 when they have:

Sold securities that were neither registered nor exempt from registration;

Sold securities pursuant to private placement memoranda that contained material misrepresentations and omissions;

Improperly withheld customer funds and "deliberately" took advantage of an unsophisticated customer;

Induced an elderly customer to make a large, unsecured loan;

Delayed refunding customer funds to customers;

Forged signatures on documents;

Used customer funds for personal benefit rather than the customer's benefit;

Shared commissions from securities sales with an unlicensed individual;

Made unauthorized transactions in customer's account;

Recommended purchase of speculative warrants;

Failed to cooperate with NASD staff by not providing requested information;

Failed to disclose solicitation of outside business; and

Failed to honor arbitration award (as well as failed to produce documents in arbitration and failed to submit a dispute to arbitration as required by the NASD Code of Arbitration Procedure).

As one can see, while not a regulatory "blank check", Rule 2110 does have a significant reach. Brokers and brokerage firms, therefore, need to be mindful of their obligation to act ethically and professionally. Let's hope to see fewer news stories!