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Does Your Brokerage Firm Follow The Law?

Aug 17, 2007
The brokerage industry is said to be the most highly regulated business field in the United States.

Brokerage firms must register with various governmental and private regulators, comply with arduous paperwork and record keeping requirements, and wade through multiple layers of red tape to gain the regulatory approval necessary just to make some of the most basic business decisions.

But despite all of this, brokerage firms occasionally run afoul of the law. As an individual investor, it is important to have a basic understanding of what is required of brokerage firms.

Brokerages that take short cuts and cut corners in terms of regulatory compliance are much more likely to be guilty of other transgressions - the type of transgressions that can cost you money.

The National Association of Securities Dealers

The National Association of Securities Dealers (NASD) is a brokerage regulatory agency second only to the governmental Securities and Exchange Commission (SEC) in terms of importance.

The NASD is known as a self-regulatory organization (SRO) in that it is not affiliated with the government in any way, but it operates under SEC oversight.

The NASD regulates all investment banking and securities underwriting activity. It also regulates trading in the OTC (over the counter) market of mostly small cap stocks, and the NASDAQ, which is named for the NASD.

It is this authority of the NASDAQ that makes it virtually impossible to conduct business as a brokerage firm without membership to the NASD.

Brokerage Firms' Use of the NASD Name

In order for the employees of brokerage firms to sell financial products or give financial advice, they must be approved by the NASD. Brokerage firms must also be registered members of the NASD, and while this affiliation does carry with it some promise of honesty and professionalism, it is illegal for a brokerage firm use the NASD's name in any manner that would suggest that the NASD has endorsed it.

Brokerages may use the phrase, "member of the NASD," but they may not put undue emphasis on it. If your brokerage firm or any of its brokers try to imply that they are endorsed by the NASD, it is a near surefire sign that they lack other, legitimate credentials and references.

Brokerage Firms' Sales Literature

Probably the most common manner in which brokerage firms violate NASD rules is through their noncompliance with sales literature requirements.

It is important to note that there is a distinction made between advertising and sales literature. Anything in which the brokerage firm has no control over the material's audience - i.e. publication in periodicals, radio or television broadcast, prerecorded telemarketing messages, billboards, phonebook ads, etc. - is considered advertising. The audience for advertising is the general public.

By contrast, sales literature is targeted to specific individuals or subsets of the general populace.

This distinction is important because there are different rules for each. All advertising materials must be filed with and approved by the NASD.

The only exception to this rule is for prospectuses and other such materials approved by the SEC (preliminary prospectuses, offering circulars, tombstones, etc.) Since advertising is, by definition, made available to broad audiences, it is difficult for brokerages to skirt the NASD's filing requirements.

After all, regulators are just as likely to see the unregistered ads as anyone, so any unapproved broadcasts or publications are dealt with behind the scenes by the NASD.

Sales literature is targeted marketing, and individual investors need to be much more wary of all such correspondence than commercials they may see on TV.

Firstly, all sales literature must identify its source - the brokerage firm's name, the person who prepared the materials, and the date it was created.

Secondly, if the sales literature recommends the purchase of a stock, it must identify the stock's most current price, and the price range at which the stock is a recommended buy. The brokerage must also disclose the market's general direction, any buy/sell/hold recommendations made for similar securities in the past 12 months, and data revealing all recommendations (winners and losers) made in the past year.

Additional Sales Literature Requirements

Mutual funds are a favorite financial product for brokerage firms to market. When recommending mutual funds in sales literature, brokerages should use 10-year charts to show the fund's performance in varying market conditions. If charts are used, the source of the data must be identified.

The fund's highest sales charge possible must be revealed, and the brokerage firm may not compare the fund being marketed to any other investment product in terms of safety or performance.

Finally, the most obvious violation of all is for a brokerage firm to guarantee performance of an investment product in any way. Any brokerage firm that attempts to masquerade opinions as facts is in willful violation of NASD regulations, not to mention standard professional ethics.

Any company that would be so careless in its regulatory compliance is likely to be careless with your investment capital, and should be avoided without exceptions.
About the Author
William Smith the author provides additional financial information on many subjects as well as the secret to his success in the market along with 5 Free power stock picks emailed daily so grab your Free subscription on his website at Brokerage (All is Free)
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