Proposed Change in Global Trading Rule Raises Risks

By Jane Bryant Quinn
Sunday, July 6, 2008

The Securities and Exchange Commission has proposed a new rule that might have passed you by. I'm alerting you here because it speaks volumes about where trading is going in the United States. For many, it offers new opportunities. We'll also be importing new risks, in the future, that we may regret.

The proposal allows overseas broker-dealers to solicit business directly from U.S. clients -- individuals as well as institutions -- with $25 million or more to invest. That's down from $100 million under the current rule.

Any broker-dealer will be able to join the fray as long as it's regulated by a securities administrator in its home country. The broker-dealers won't have to register with the SEC and won't be regulated for net capital and other requirements under U.S. rules. They will be able to pitch any debt, equity and derivative security listed on their home exchanges, even though those securities aren't registered with the SEC.

Before you say, "That has nothing to do with me" and scroll on, note the implications: The door is opening to more direct global trading. This first step simplifies cross-border selling and reduces costs for large investors who are already trading abroad. Smaller U.S. broker-dealers will be able to open electronic windows to world investing for larger clients.

All this is good.

In the background, however, something is happening that we need to think about. We're injecting other countries' accounting, disclosure and regulatory standards into our system, on the theory that they are good enough, although generally not as rigorous as our own. It's an unstated form of financial deregulation that Wall Street has been pushing for some time and has strong support in the SEC.

The proposed new rule affects high-dollar clients who are presumed to be able to look after themselves. They accept the risks of dealing with overseas brokers who operate under different standards than prevail in the United States.

The next question will be whether overseas brokers should be able to deal directly with retail customers -- you and me. "Whether for good or for bad, it's going to happen eventually, because the SEC is being overcome by a tsunami of globalization," said Jim Cox, a law professor at Duke University in Durham, N.C.

The problem is that, overseas, the culture of investor protection isn't as strong as in the United States. On paper, the rules may look the same, but enforcement isn't, said John Coffee, a professor at Columbia Law School in New York.

Take Britain, whose securities laws most closely resemble ours. The Financial Services Authority (the British equivalent of the SEC) spends only 8 percent of its budget on enforcement, compared with 40 percent in the United States, Coffee said. He called Europe "an enforcement-free zone" compared with the United States.

Coffee said it's unlikely that retail investors would be allowed to open foreign brokerage accounts. That's because there's no way they could sue for infractions, such as selling unsuitable investments or engaging in fraud. He especially fears "affinity fraud," with dishonest brokers from the home country soliciting their own nationals in the United States.

The SEC could require arbitration agreements from brokers soliciting in the United States, but where would they take place and under which country's laws? And which foreign regulator would take up a U.S. investor's cause?

Ethiopis Tafara, director of the SEC's Office of International Affairs, said the United States won't be giving up its jurisdiction over investment fraud. If overseas brokers were allowed to solicit retail investors, it would happen through a U.S.-registered broker.

The SEC might also limit what stocks could be sold -- for example, only those of larger companies. Those firms might have assets or offices in the United States, which would make enforcement easier.

Theoretically, a U.S. regulator could get a default judgment in the United States against a brokerage firm selling bad products from another country. But without a U.S. connection, the odds of it being enforced abroad are poor to zero.

Experience so far, with trillions of dollars in cross-border trading, shows few problems with deception and fraud. However, the investors have primarily been institutions, doing business through well-known brokerage firms. Sailing wouldn't be as smooth if smaller investors were involved.

The next step in globalization will be something called "mutual recognition." The SEC would make a deal with another country to let its brokers solicit customers in the United States. The brokers would operate under their home-country rules, not SEC rules, with similar privileges for U.S. brokers there.

Overseas exchanges would place their trading screens in the United States so their brokers could solicit customers. Participating countries will have laws similar to those in the United States, Tafara said. Australia will probably be the first.

For institutions, global blending is no problem. But individuals need full access to the protection of U.S. securities laws. If you want, you can already buy foreign stocks through many U.S. brokerage firms, including E-Trade Financial. And you don't have to suffer through cold calls from distant brokers insinuating that they have the inside track on their home markets.

Financial planner Harold Evensky, of Evensky & Katz in Coral Gables, Fla., said his wealthy clients aren't clamoring for direct foreign investments anyway. International mutual funds and exchange-traded funds do the job and with less risk.

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist. Alexis Leondis in New York contributed to this column.