Testimony of Barry R. Goldsmith
Executive Vice President for Enforcement
Before the Permanent Subcommittee on Investigations
Committee on Governmental Affairs
Hearing on the Securities Day-Trading Industry
February 25, 2000
I am Barry R. Goldsmith, Executive Vice President for Enforcement of NASD Regulation, Inc. (NASDR). NASDR and its parent, the National Association of Securities Dealers, Inc. (NASD®), would like to thank the Subcommittee for this opportunity to testify at today’s hearing. Madam Chairman, my testimony will address the specific issues relating to day trading that you identified in your invitation letter. Those issues deal with our enforcement actions and investigations relating to day trading, as well as NASD’s recent rule proposals in this area. You also have asked us to address the issue of what additional enforcement tools, if any, are needed to deal with abuses in this area.
Let me first compliment Senator Collins and her colleagues on the Subcommittee, as well as its staff, for holding these hearings. Without question, they have provided the industry, the regulators, and the public with important new information in this area. Let me also reiterate what NASDR President Mary L. Schapiro said about day trading when she testified before this Subcommittee on September 16, 1999. NASDR recognizes that day trading is a legitimate trading strategy, and if it is conducted by individuals who understand and knowingly assume its risks, we do not intend to encourage or discourage such activities. However, that being said, NASDR continues to view day-trading as a highly risky form of trading that requires new regulatory initiatives and close attention by securities regulators.
As my testimony here today demonstrates, we are continuing to address those risks through dissemination of information to our members and investors, new rules, examinations, investigations and, where appropriate, the filing of formal enforcement actions. The eight day-trading enforcement cases that we have brought this week, are further examples of our strong commitment to compliance by member firms and their personnel with the securities laws and NASD Rules.
First, let me briefly outline the role of the NASD in the regulation and operation of our securities markets. Established under authority granted by the 1938 Maloney Act Amendments to the Securities Exchange Act of 1934, the NASD is the largest self-regulatory organization for the securities industry in the world. Virtually every broker-dealer in the U.S. that conducts a securities business with the public is required by law to be a member of the NASD. The NASD’s membership comprises 5,500 securities firms that operate in excess of 80,000 branch offices and employ more than 620,000 registered securities professionals.
The NASD is the parent company of NASD Regulation, Inc. (NASDR), The Nasdaq Stock Market, Inc. (Nasdaq) and the American Stock Exchange (AMEX). NASDR and Nasdaq operate under delegated authority from the parent, which retains overall responsibility for ensuring that the organization’s statutory and self-regulatory functions and obligations are fulfilled. The NASD is governed by a 27-member Board of Governors, a majority of whom are non-securities industry affiliated. The NASDR subsidiary is governed by a 10 member Board of Directors, balanced between securities industry and non-industry members. Board members are drawn from leaders of industry, academia, and the public. Among many other responsibilities, the boards, through a series of standing and select committees, monitor trends in the industry and promulgate rules, guidelines, and policies to protect investors and ensure market integrity.
NASDR is responsible for the registration, education, testing, and examination of member firms and their employees and the enforcement of federal securities laws and NASD rules. In addition, we oversee and regulate trading on Nasdaq and the over-the-counter markets.
The 1,650 member staff of NASDR is devoted exclusively to carrying out the NASD’s regulatory and enforcement responsibilities. NASDR carries out its mandate from its Washington headquarters and 14 district offices located in major cities throughout the country. NASDR closely cooperates with federal and state authorities and other self-regulators, minimizing overlap and duplication and freeing governmental resources to focus on other areas of securities regulation.
NASDR Enforcement brings cases against members and their associated persons based on information developed internally and received from external sources. NASDR develops information internally through periodic examination of member firms, review of firms’ reports of broker terminations for cause, market surveillance systems, and referrals from our arbitration, corporate finance and advertising programs. Enforcement receives and processes information from external sources that include federal and state agencies, customers who file complaints, news media, and anonymous tips. NASDR investigators gather information through on-site examinations, document requests, trading analyses, and customer and member interviews. If cases are not settled, they go to formal hearings for disposition, and may be appealed to the NASD’s National Adjudicatory Council, the Securities and Exchange Commission (SEC), and the U.S. Courts of Appeals. In 1999 alone, NASDR initiated more than 1,100 disciplinary cases and suspended or barred more than 740 individuals from the industry.
While our regulatory jurisdiction is limited to our broker-dealer member firms and their associated persons, our examinations, surveillance, and regulatory intelligence alert us to illegal conduct outside of our jurisdiction. We routinely refer such findings to the SEC, the states and criminal prosecutors for their action. We formed a Criminal Prosecution Assistance Group in April 1998 to help coordinate the substantial resources we devote to assisting prosecutors in bringing securities cases. Since the beginning of this program, we have provided assistance in more than 150 criminal investigations and prosecutions around the country.
NASDR is responsible for developing rules that govern the conduct of the brokerage industry in areas as diverse as sales practices, advertising, trading and underwriting. Rulemaking is a widely participatory process with broad input from industry members, trade associations, other regulators, and the public. Pursuant to the requirements of the Securities Exchange Act of 1934, NASDR rules do not become final until they are approved by the SEC.
NASDR has examination responsibilities for all of its 5,500 members. In addition to special cause investigations that address customer complaints and terminations of brokers for regulatory reasons or other cause, NASDR has established a comprehensive periodic cycle examination program. This program is carried out through a regulatory plan that prioritizes examination efforts based on the firms, individuals, issues and practices that present the greatest regulatory challenges and concerns.
During 1999, 2,750 periodic examinations of main offices were completed and 6,671 customer complaints and 2,803 terminations for cause were investigated.
NASDR shares responsibility for developing and administering qualifications testing for securities professionals. All sales and supervisory persons associated with NASD member firms must demonstrate a requisite understanding of the products offered by their firms, as well as regulatory requirements. Individuals acting in a management capacity must pass the appropriate principal's examination, while sales personnel must demonstrate specific understanding of the products they intend to sell and the regulations that govern those products. In 1999, NASDR administered more than 300,000 examinations for 29 different qualification areas. In addition, NASDR administers proctored continuing education sessions for registered persons who deal with public investors.
The Nasdaq Stock Market
Nasdaq develops, operates, and regulates a variety of marketplace systems and services. Nasdaq is the largest electronic, screen-based stock market in the world, capable of handling trading volume well in excess of one billion shares a day. Today, more than one-half of all equity shares traded in the United States each day are traded on Nasdaq.
The American Stock Exchange
The AMEX is the nation’s second largest floor-based securities exchange and is the only U.S. securities exchange that is both a primary market for listed equity securities as well as a market for equity options, index options, and equity derivatives.
Day-Trading Examinations And Enforcement Actions
On September 16, 1999, NASDR President, Mary L. Schapiro, testified before this Subcommittee and described our cooperative day-trading examination initiative with the SEC. In 1999, the staffs of NASDR and the SEC launched a coordinated focused examination program of day-trading firms. As part of that effort, NASDR examined 22 day-trading firms that varied significantly in size and makeup. Fifty-five NASDR examiners received special training in the intricacies of day-trading. We developed and used customized examination modules to implement this special program.
During her testimony, Ms. Schapiro reported on several potential problem areas that surfaced during these examinations, including:
Advertising – Many of the day-trading firms examined used potentially problematic advertisements that may violate NASD Rule 2210, which governs "Communications with the Public." The problem areas noted included exaggerated statements of the profitability of day-trading without corresponding risk disclosure or qualifying language. Some day-trading firms appear to have failed to provide investors with a sound basis for evaluating the services being offered and may have made misleading statements.1
Regulation T and Margin Lending – Our examiners found that at some day-trading firms, principals and employees arrange for credit to be extended by customers who have excess equity in their accounts to those customers who require funds to cover margin calls. Absent these infusions of capital, many of the recipients of the loans would be unable to continue to trade. We are investigating the role of the member firm in arranging these loans and what, if any, representations are made to the lending customers concerning the risks associated with making the loans. In addition, we are investigating the nature and amount of the fees and interest rates being changed to the borrowing customers.
Registration Issues – NASD rules prohibit a firm’s proprietary equity traders from trading in the Nasdaq and over-the-counter markets without first passing a qualification examination for trading (the Series 55 examination) and registering with NASDR . NASDR examiners found instances where persons engaging in day trading for a firm’s proprietary account were not Series 55 registered.2
Short Sales – We have found problematic short selling practices at some day-trading firms that appear to violate our rules and the federal securities laws. Specifically, our rules require that firms mark all sales as either "long" or "short" and that the firm determine if they can obtain shares of the security sold short to deliver to the buyer. We have seen practices at some day-trading firms that facilitate short sales by customers when the short sales are not marked as such and when no affirmative determination has been made that shares can be delivered to the buyer. We have also seen potential violations of our rules prohibiting customer short sales on what is commonly known as a "downtick."
Supervision – It is important for all broker/dealers, including day-trading firms, to have adequate supervisory procedures and good compliance with those procedures. Our examiners have found that at some day-trading firms, written supervisory procedures have not adequately addressed many aspects of their core day-trading business. In other instances, firms have failed to enforce the written supervisory procedures they do have. Areas that have received potentially deficient supervision include margin lending procedures, review of advertising, marketing and training materials, short-selling compliance, and cancellation of transactions and use of firm error accounts.
This week NASDR brought eight new enforcement actions against six different day-trading firms and a total of fourteen individuals.3 These formal disciplinary actions are the direct result of our focused examination efforts begun last year. These actions were investigated and filed by our New Orleans, Dallas and Chicago District Offices. While other day-trading investigations continue, the actions we announce here today represent an important step in NASDR’s efforts to address problems in this area and improve member firm compliance with the federal securities laws and NASD rules.4
These eight cases include allegations and, in some cases, findings of violations that reflect many of the concerns we originally reported to this Subcommittee last September:
Two of these cases involve allegations of misuse of funds, including one in which the owner of a day-trading franchise solicited funds from outside investors, falsely representing that these moneys would be used for "risk-free" loans to day-trading customers of the firm. Instead, the funds were loaned to customers with no controls or restrictions, were improperly used for firm operating expenses, and were eventually lost.
Two other cases involve violations of the rules governing margin lending, including one in which a firm’s principal allowed a customer to effect 120 transactions while the customer’s account was coded "no more business" by the clearing firm for failing to meet a margin call. In another case, a firm employee established a separate entity, which then loaned funds to firm customers to meet Regulation T margin calls.
Four of the day-trading actions announced today include allegations or findings of violations of the NASD’s advertising rules, including instances in which firms placed exaggerated and potentially misleading advertising on the Internet, as well as in local print and radio media. These firms typically exaggerated the ability of customers to immediately access markets, without disclosing the risks inherent in day-trading strategies, including market volatility.
Violations of the NASD’s short sale rules were found in three cases, including the failure to make affirmative determinations that securities could be delivered prior to the execution of each customer short sale transaction. In one case, a firm impermissibly allowed its day-trading customers to review daily postings of securities’ availability to be borrowed and make their own affirmative determinations of whether the securities could be borrowed prior to executing short sale transactions.
NASDR, in its formal complaints alleged, and in certain settled cases, made findings that firms failed to ensure that individuals actively engaged in their day-trading operations were properly registered, including one case in which the individual running the firm’s day-trading business was not registered as a principal. In other cases, employees of the firm were acting as equity traders without having completed the NASD’s Series 55 registration requirements. In one case, the firm allowed individuals to input trades for customers for periods of several weeks, without registering them in any capacity with the firm.
Finally, certain of the actions taken today involve serious supervisory deficiencies, including one case in which a firm engaged in day-trading activities without having any written procedures in place to address that area of the firm’s business.
The sanctions in the group of settled actions announced this week include censures, suspensions and individual fines, and fines against firms ranging from $13,000 to $37,500.
I would like to discuss two of these cases in more detail. These involve customer lending and violations of our margin rules.
Heath A. Butler 5
This complaint deals directly with firm-facilitated customer borrowing. In this case, we allege that a management company, Better Capital Management, L.L.C., Abstract Consulting, operated the branch office of a day-trading firm under a contract pursuant to which the management company was paid a percentage of commission revenue generated in the branch office.
It is alleged that the individuals operating the branch issued and sold investment contracts, styled "Loan Agreements" ("Investment Contracts") in an amount exceeding $150,000 through an entity known as Abstract Consulting, which was controlled by Heath Butler. Under the express terms of the Investment Contracts, funds put up by the investors would be loaned to customers of the day-trading firm, who would in turn use the funds for day trading. The Investment Contracts further provided that controls would be in place to limit losses in the day-traders’ accounts to the amounts that the day traders themselves had contributed, so that the funds put up by the investors would not be at risk. In addition, the Investment Contracts stated that the return to the investors would be the greater of 15 percent per year or 20 percent of the profits earned by the day traders to whom the funds were lent.
Notwithstanding the terms of the Investment Contracts, we allege that the corresponding contracts with the day traders expressly provided that the funds lent were at risk and that any loss exceeding the day traders’ contribution would be borne by the lender, Abstract Consulting. Moreover, no controls to restrict losses in the day traders’ accounts were ever implemented. Also, the complaint alleges that a portion of the funds advanced by the investors was used for payment of branch operating expenses and for trading in accounts controlled by Heath Butler.
Ultimately, the funds advanced by the investors were lost in securities trading by the day traders or were consumed in the payment of branch office expenses. The complaint alleges that to date, less than 10 percent of the investors’ money has been repaid to them.6
Choice Investments, Inc.7
Choice Investments, Inc., a day-trading firm located in Austin, Texas, consented to findings that it allowed a public customer to effect approximately 120 transactions while the customer’s account was coded "no more business" by the clearing firm for failing to meet an NASD Rule 2520 margin call. The firm caused the customer transactions to be placed in an account in the name of an entity in which a principal of the firm was a control person, without indicating on account documents that the public customer was the beneficial owner of the account. The firm subsequently moved these transactions into the customer’s account after the margin call had been met.8
In addition, Choice Investments failed, in nine instances, prior to the execution of customer short sales, to make an affirmative determination that stock could be delivered and failed to establish and maintain supervisory procedures reasonably designed to achieve compliance with the NASD’s short sale/affirmative determination rule. Instead, the firm allowed its day-trading customers to review daily postings of securities available to be borrowed and to make their own affirmative determinations that securities could be delivered prior to execution of each short sale transaction.9
Enhanced Review Of Day-Trading Firms’ Web Sites
During its day-trading hearings last September, this Subcommittee highlighted the issues surrounding the content of day-trading Web sites. NASDR has instituted new, heightened procedures in our review of day-trading firms’ Web sites. Last fall, senior staff from our Advertising Regulation, Enforcement, and Member Regulation Departments developed a process to identify and review all member firm day-trading Web sites on a regular basis. The protocol that emerged called for the regular review and capture of each day-trading member firm’s Web site. NASDR staff have looked at over 120 Web sites, reviewing each of those sites at least four times since the program’s inception through the end of 1999.
To date, more than 30 sites have needed revisions to achieve full compliance with our rules. The subject firms have been notified of the deficiencies identified in their sites. In the more serious situations, NASDR staff has contacted the firms immediately with a recommendation that materials or representations on the sites be removed. In each case where this was done, the problematic portion of the site has been taken down by the firm. This review process is ongoing, focusing both on new firms and those firms whose Web sites have posed problems in the past.
One such site involved a day-trading firm’s Web site that contained some very bold and misleading statements about the profitability customers could expect from day trading. This was all done in the absence of any meaningful disclosure of day-trading risks. Under the headline "You Do the Math" on one of the site's pages, the firm suggested that a typical day-trading customer could easily make almost a quarter million dollars per year. Their only support for this contention was a simplistic formula: one point on a thousand shares per day; 240 trading days per year; equals $240,000 per year. After NASDR staff contacted the firm and expressed our concern, the firm took down that portion of its site immediately.
To address the risks presented by day-trading firms both to individuals and to firms, NASDR has engaged in several rulemaking initiatives. We have already taken action in three main areas – risk disclosure, appropriateness determinations, and margin requirements. In particular, we have proposed new rules to further ensure that firms that promote day trading to individuals fully disclose the risks involved in day-trading as well as assess whether such a strategy is appropriate for the individual. We also are working closely with the New York Stock Exchange (NYSE) to amend margin requirements applicable to day traders to further promote the safety and soundness of member firms that extend credit to finance day-trading activities.
Risk Disclosure and Appropriateness Determinations
Last fall, NASDR proposed two new rules in the day-trading area. If approved by the SEC, these rules will require new account opening procedures for day-trading accounts, including risk disclosure and appropriateness determinations. After putting these proposed rules out for comment and reviewing the comments received, we filed with the Commission, on February 18, 2000, amendments to the proposed rules, which the Commission will publish for further comment.
As amended, the proposed rules will require a member firm that is promoting a day-trading strategy to furnish a risk disclosure statement to a non-institutional customer prior to opening an account for the customer and either to (1) approve the customer’s account for a day-trading strategy or (2) obtain from the customer a written agreement that the customer does not intend to use the account for day-trading purposes. To approve the customer’s account for a day-trading strategy, the firm will be required to make a threshold determination that day-trading is "appropriate" for the customer.
In making this determination, the firm will be required to exercise reasonable diligence to ascertain the essential facts relative to the customer, including such items as his or her investment objectives, investment and trading experience and knowledge, financial situation, tax status, and employment status. The firm also will be required to document the basis on which the firm has approved the customer’s account for day trading. A firm need not make this determination if it obtains from the customer a written representation that he or she does not intend to use the account for day trading purposes. If a firm later discovers that a customer who provided this written representation is using the account for day-trading, the firm will be required to approve the account for day-trading within ten days of the date of discovery.10
These new rules will also require a firm that is promoting a day-trading strategy to deliver a risk disclosure statement to a customer prior to opening an account for the customer. The disclosure statement would provide the following:
Under the proposed rules, members will be permitted to develop an alternative disclosure statement as long as it is substantially similar to the mandated statement and is approved by NASDR’s Advertising Department prior to use. A firm also will be able to file any of its advertisements with the Advertising Department to determine whether the firm would be deemed to be promoting a day trading strategy as a result of the advertisement and thus subject itself to the proposed rules.
NASDR has considered the views of a wide array of parties in formulating the proposed rules. Our members and the public at large were afforded the opportunity to comment on these rules on two prior occasions. In April 1999, NASDR issued Special Notice to Members 99-32 ("NTM 99-32") to solicit comment on the proposed rules. In response to NTM 99-32, NASDR received thirty-nine comment letters.11 The majority of the letters generally supported our efforts to address the investor protection concerns raised by individuals engaging in day trading activities. Commenters, however, made different suggestions on how best to regulate day-trading activities and presented disparate views on the scope of the activities that should be covered by the rules. The NASD concluded that its original proposal would benefit from adopting a number of these suggestions, and accordingly, made appropriate modifications.12
In September 1999, the Commission published NASDR’s modified proposal and solicited comments in the Federal Register. The Commission received three comment letters in response to the Federal Register publication.13 Many of the issues raised by the commenters in response to the Federal Register publication also were raised in the comments in response to NTM 99-32. After considering this most recent set of comments, the NASD made additional changes to the proposed rules.
For instance, in the Federal Register publication, the Commission specifically requested comment on whether the proposed disclosure statement was adequate. While the ETA supported the concept of a risk disclosure statement, it proposed alternative language in several sections of the document. Based on the ETA’s comments, we made certain modifications to the disclosure statement, including advising potential customers that under certain market conditions, they may find it difficult or impossible to liquidate a position quickly at a reasonable price. We also revised the prescribed method for delivering the disclosure statement by specifying that it must be delivered to each customer individually, by mail or electronic means, prior to opening the account.
In addition, at the suggestion of the SIA, we revised the rule language to describe certain activities that we do not consider to be "promoting a day-trading strategy" and therefore would not trigger application of the proposed rules. These activities previously were set forth in the text of the rule filing – rather than the rule itself – and include (1) the promotion by a member of efficient execution services or lower execution costs; (2) providing general investment research or advertising the high quality or prompt availability of such general research; and (3) having a web site that provides general financial information or news or that allows the multiple entry of intra-day purchases and sales of the same securities. We also further delineated the types of information that a firm should consider in determining whether day trading is appropriate for an individual, modeling the requirements on the current account opening procedures for options trading.
NASDR believes that these rules will provide an effective means of ensuring that those firms that are promoting day trading to individuals fully disclose the risks of engaging in this activity, as well as examine and document whether day trading is appropriate for the individual. We also believe that the proposed rules, as amended, serve to maintain the standards necessary for the protection of investors without imposing overly burdensome regulatory requirements on firms that promote day-trading activities. We look forward, however, to receiving additional comments on the proposed rules and to further discussing the proposal with the Subcommittee.
The Use of Margin by Day Traders
Day traders often use margin to leverage their trading activity. Because Regulation T initial margin requirements and NASD/NYSE14 standard maintenance margin requirements are only calculated at the end of each day, a day trader who has no positions in his or her account at the end of the day would not incur a Regulation T initial margin nor a standard maintenance margin requirement, assuming no losses in the account.15 Current NASD/NYSE initial margin provisions require a customer to deposit margin of at least $2,000, unless that amount is in excess of the cost of the security.
Although the day trader may end the day with no position, the day trader and the firm, if credit is extended, are at risk during the day. To address this risk, the NASD and NYSE require day traders to demonstrate that they have the ability to meet the initial margin requirements for at least their largest open position during the day. Specifically, a customer who meets the definition of day trader under the rule16 must deposit in his or her account, the margin that would have been required under Regulation T (i.e., the 50 percent initial margin requirement) if the customer had not liquidated the position during the trading day. If the customer day trades, but is not considered a "day trader," the customer is still required to post 25% of the largest open position during the day.
Currently, if a customer’s day trading results in a day-trading margin call, the customer has 7 days to meet the call by depositing additional cash or securities. Because day traders typically end the day flat and this day-trading "margin" deposit is not securing a margin loan, the customer is not required to leave the margin deposit in the account and may withdraw the deposit the day after the deposit is made.
The 431 Committee17 has met frequently over the last year to consider different approaches to the margin rules that would better address the risks associated with day trading. Based on recommendations from the 431 Committee and NASDR’s Financial Responsibility Committee, in December 1999, the Board of Directors of NASDR (the "Board") authorized a rule proposal that would amend the margin requirements that apply to pattern day traders. The amendments would:
Prohibit Cross Guaranteeing of Accounts. Day traders would be prohibited from using cross-guarantees to meet the minimum equity requirements or to meet day-trading margin calls.
The proposed rule change would also revise the current interpretation that requires the sale and repurchase on the same day of a position held from the previous day to be treated as a day trade. Instead, the sale of the position should be treated as a liquidation of the existing position and the subsequent repurchase as the establishment of a new position not subject to the rules affecting day trades.
An important distinction between the current and proposed day-trading margin rules is the significant consequences to the day trader under the proposed rules if he or she exceeds the day-trading buying power limitations. As noted above, under current rules, the funds used to meet a call are deposited after the day-trading risk has already been incurred and need only remain in the account overnight. Under the NASD’s proposal, funds used to meet a day-trading margin call must remain in the account for two business days. In addition, once a day-trading margin call is issued, the day-trading account will be restricted to day-trading buying power of two times maintenance margin excess, based on the customer’s daily total trading commitment. This will significantly reduce the amount of leverage available to the customer until the call is met. If the day-trading margin call is not met by the fifth business day, the account will be further restricted to trading only on a cash available basis for 90 days or until the call is met.
In authorizing the filing of the proposed rule change with the SEC, the Board recommended the formation of a Day Trading Margin Advisory Task Force (Task Force) to continue to review and evaluate the proposal, and if appropriate, recommend changes to the Board. The Task Force is composed of representatives from 15 member firms, including representatives from the ETA. The Task Force held its first meeting in early February and anticipates presenting its preliminary recommendations to the Board in March.
Finally, NASDR is continuing to look at whether to impose any restrictions on day-trading firms’ facilitating or participating in arranging of loans among customers. We believe that there is an inherent conflict of interest when members facilitate or participate in lending activities with or between their customers. These lending activities often allow customers to continue to trade when they would not otherwise be in a financial position to do so, thereby generating more commission income to the member. These same conflicts of interest arise when principals, registered representatives and significant shareholders of members lend funds to customers. Such conflicts of interests can arise in a variety of situations, certainly not limited to day-trading activities.
We will continue our regulatory initiatives with respect to day trading. To the extent that our ongoing investigations find violations of the securities laws or our rules, additional enforcement actions will follow. We have received a broad array of constructive comments on our new rule proposals and will work with the SEC and all interested parties to finalize these rules and get them in place as soon as possible. Working with this Subcommittee, other regulators, our member firms and the investing public, we pledge to continue our vigilance with respect to day-trading and to continue to address the investor protection and market issues this type of trading presents. At this time, we remain of the view that new legislation on this subject is not necessary.
On behalf of NASDR, I wish to thank the Chair for the opportunity to appear before the Subcommittee and provide testimony on these important issues, and would be happy to answer any questions you may have.
1 In May 1999, NASD Regulation filed a complaint against Lakeside Trading, a Metairie, Louisiana day-trading firm, and its president and principal for violation of our advertising rules. The complaint alleged, in addition to margin violations and improper use of customer funds, that the firm’s Internet Web Site failed to provide a balanced and complete presentation by omitting disclosure concerning the risks associated with day trading. Department of Enforcement v. Lakeside Trading, et al. (No. C05990018, May 26, 1999).
2 On July 7, 1999, NASDR announced that it censured and fined On-Site Trading, Inc., a Great Neck, New York day-trading firm, $25,000 for failure to properly qualify and register 14 individuals. These individuals effected approximately 3,700 trades in 250 Nasdaq securities on behalf of the firm’s proprietary accounts. Without admitting or denying the allegations, On-Site consented to findings that it lacked adequate oversight to ensure proper registration of its traders, and agreed to implement new compliance procedures to prevent future violations. Letter of Acceptance, Waiver and Consent, On-Site Trading, Inc., CAF990009 (July 2, 1999).
3 See NASD Regulation Press Release (February 25, 2000).
4 Five of the disciplinary actions announced today were resolved through an NASDR process called Acceptance, Waiver, and Consent (AWC). In settling a formal action through an AWC, the firm consents to findings and sanctions without admitting or denying the allegations. The three other cases are formal complaints. The issuance of a disciplinary complaint represents the initiation of a formal proceeding by NASDR in which findings as to the allegations in the complaint have not been made and does not represent a decision as to any of the allegations contained in the complaint.
5 Department of Enforcement v. Heath A. Butler, et al. (No. C05000006, February 22, 2000).
6 The violations alleged in the complaint include: the use of manipulative, deceptive or other fraudulent devices, in violation of NASD Conduct Rule 2120; violations of NASD Conduct Rule 3040, dealing with private securities transactions; inadequate supervision, in violation of NASD Conduct Rule 3010; and failure to observe high standards of commercial honor and just and equitable principles of trade, in violation of NASD Conduct Rule 2110.
7 Letter of Acceptance, Waiver and Consent, Choice Investments, Inc. (No. C05000008, February 22, 2000).
8 These actions violated Rules 17a-3 and 17a-4 of the Securities Exchange Act of 1934 (Keeping and Preservation of Records), and NASD Rule Conduct 2110, failure to observe high standards of commercial honor and just and equitable principles of trade.
9 These actions violated NASD Conduct Rules 3370(b)(2)(A) and 3370(b)(4)(B), dealing with affirmative determinations in short sales and NASD Conduct Rule 3010(a), dealing with member firm supervision.
10 If the firm determines that a day-trading strategy is not appropriate for the person, the firm should prohibit the customer from using the account for day-trading purposes or close the account and return all funds to the customer.
11 Comment letters were submitted from: A.G. Edwards & Sons, Inc.; Aldridge, Marlon R.; Arkansas Securities Department; Association for Investment Management and Research, Advocacy Advisory Committee; Astarita, Mark J., Gusrae, Kaplan & Bruno; Burkholder, Donn; Charles Schwab & Co., Inc.; Cornerstone Securities Corporation; DLJdirect Inc.; Eclipse Trading, Inc.; Edward Jones; Electronic Traders Association (ETA); E*TRADE Securities, Inc.; Fidelity Investments; Hall, Garry D.; Hoopes, Jonathan D.; Investment Company Institute; Jones, Kenneth; Kennedy, Cheryl; Kzfischer@aol.com; Lincoln Investment Planning; Lininger, Nancy; Lott, Chris; Merrill Lynch, Pierce, Fenner & Smith Incorporated; National Association of Investment Professionals, Legal Committee; National Discount Brokers; Nicastri, Tom; North American Securities Administrators Association, Project Group on Day-trading (NASAA); Orrick, Herrington & Sutcliffe LLP; Pettin, Tom; Prytulak, Lubomyr; Public Investors Arbitration Bar Association; Rollins, Eugene C.; Securities Industry Association, Federal Regulation Committee, Discount Brokerage Committee, and Ad-hoc Committee on Technology and Regulation (SIA); Security Traders Association; Seeley, E.C.; Singer, Bill, Singer Frumento LLP; Skiersch, John; and Traders Advantage.
12 Many of these changes were significant, and included: limiting the application of the rule to those firms that are "promoting a day-trading strategy," as compared to "recommending an intra-day trading strategy"; applying the rule to all non-institutional customers; requiring firms promoting a day trading strategy to have reasonable grounds for believing that the strategy is appropriate for the customers and to exercise reasonable diligence to ascertain the essential facts relative to the customers; revising the definition of "intra-day trading strategy"; requiring firms promoting a day trading strategy to deliver the risk disclosure statement to all non-institutional customers prior to opening an account for such customers; and revising the risk disclosure statement to include the additional key point that day trading generally is not appropriate for persons of limited resources and limited investment or trading experience and low risk tolerance.
13 Each of those who responded to the Federal Register publication also commented in response to NTM 99-32. These comment letters were from the North American Securities Administrators Association, Inc. (NASAA), the Federal Regulation Committee, the Discount Brokerage Committee and Ad-Hoc Committee on Technology & Regulation of the Securities Industry Association (SIA), and the Electronic Traders Association (ETA). Each of these commenters represents a group of interested parties. NASAA is an international organization of securities regulators devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Canada, Mexico and Puerto Rico. ETA is a trade association of on-site day trading firms. It has approximately 15 supporting organizations, including six of the ten largest on-site day trading firms. SIA brings together the shared interests of more than 740 securities firms. Its member-firms are active in all U.S. and foreign markets and in all phases of corporate and public finance.
14 NASD Rule 2520 and NYSE Rule 431 are the margin provisions for each self-regulatory organization and are substantially similar.
15 NYSE Interpretation Memo 96-5 states that losses resulting from day-trading are treated as withdrawals, requiring the creation of a margin call equal to 100% of the loss, which may be met by a deposit of cash or securities within seven business days from the trade date.
16 A "day-trader" is any customer whose trading shows a pattern of day-trading. The term "pattern of day-trading" has been interpreted as day-trading more than 3 times in a calendar year.
17 After the Board of Governors of the Federal Reserve System extensively amended Regulation T a few years ago, an informal ad hoc committee (the "431 Committee") was formed to consider changes to the NYSE’s and NASD’s margin rules (NYSE Rule 431 and NASD Rule 2520, respectively). The 431 Committee also was formed to ensure that the NYSE’s and NASD’s margin rules were consistent in order to prevent confusion and to avoid conferring advantages on members that are required to comply with one rule and not the other. The 431 Committee is composed of NYSE staff, attorneys from the NYSE’s outside counsel, Cleary, Gottlieb, Steen & Hamilton, NASD staff, Federal Reserve staff, and representatives from Bear Stearns, Pershing, Merrill Lynch, Prudential Securities, Morgan Stanley, and Sanford Bernstein & Co., as well as a small firm representative from Centennial Securities in Grand Rapids, MI. In addition, representatives from Charles Schwab, Goldman Sachs, Lombard Securities and A.G. Edwards participate on some subcommittees.
18 For a typical day trader who has no positions at the end of the day, this would be the equivalent of four times the cash in the account.