|II.||Results in Brief|
|A.||Day Trading in Context|
|B.||Characteristics of Day-Trading Firms|
|C.||Characteristics of a Day Trader|
|IV.||Examination Findings and Recommendations|
|B.||Fees and Costs|
|C.||Common Characteristics of Day Traders|
|D.||Complaints from the Public|
|E.||Disclosure and Investor Education|
|1.||General Risk Warnings|
|2.||Web Site Information Concerning Risks of Day Trading|
|3.||Written Information Concerning the Risks of Day Trading|
|G.||Financial Responsibility and Record Keeping Rules|
|1.||Net Capital Compliance|
|2.||Books and Records|
|3.||Annual Audited Financial Statements|
|4.||Net Capital Restrictions on the Withdrawal of Partnership Capital|
|H.||Broker-Dealer Lending Practices|
|1.||Proposed Margin Rules for Day Trading|
|2.||Lending in Excess of Margin Requirements|
|3.||Arranging for Loans by Others|
|a. Customer-to-Customer Lending|
|b. Loans by Others|
|5.||Joint Back Office Arrangements|
|2.||Synthetic Short Sales|
|J.||Suitability and Appropriateness|
|L.||Supervision and Registration|
|Appendix A.||Summary of SEC and SRO Regulatory Action Concerning Day Trading|
|Appendix B.||Summary of SEC Day Trading Enforcement Efforts|
The Staff from the Securities and Exchange Commission's ("SEC") Office of Compliance Inspections and Examinations ("Staff") conducted an examination sweep of 47 registered broker-dealers providing day-trading facilities to the general public ("day-trading firms"). Examinations were conducted from October 1, 1998 through September 30, 1999.1 This is a Report by the Commission's Staff summarizing the results of these examinations. The purpose of the examinations was to review each firm's compliance with federal securities laws and self-regulatory organization ("SRO") rules. In addition, examiners reviewed how day-trading activities fit within the current securities regulatory structure and identified regulatory issues that may require further consideration.
The examinations generally focused on the following issues:
During the on-site examinations, the Staff conducted extensive interviews with the registrants to better understand the business of day trading and characteristics unique to each firm. The Staff also analyzed trade data, exception reports, account documentation, and required books and records.
This Report also describes recent regulatory actions relating to day trading, including proposed and new SRO rules relating to risk disclosure and margin (Appendix A). Finally, this Report summarizes recent and ongoing Commission enforcement efforts (Appendix B).
The Staff, in coordination with the NASDR, is conducting additional examinations of day-trading firms. Specifically, the Staff is examining all day-trading firms that have not yet been examined to ensure that they are complying with the law. The staff is also conducting additional targeted examinations to follow up on previous examination findings. In addition, the Staff has initiated a review of the internal controls and risk management procedures utilized by firms that clear trades for day-trading firms.
While the Staff's examinations did not reveal widespread fraud, examiners found indications of serious securities law violations warranting referrals to the SEC's Enforcement staff at several firms. These violations related to net capital, margin and lending disclosure. At most firms, however, the examinations revealed less serious violations, but indicated that many firms need to take steps to improve their compliance with net capital, short selling, and supervision rules. Firms at which examiners found violations or deficiencies generally were issued deficiency letters, and corrective action was required.
While the deficiencies found are not unique to day-trading firms, the Staff believes that the nature of day trading itself -- frequent, fast and risky trading -- makes compliance with securities laws difficult to achieve without an automated compliance infrastructure. In addition, while disclosure of the risks of day trading is not explicitly required by current SEC or SRO rule, the examinations revealed that, as of the time of the examinations, many firms did not provide their customers with information concerning the risks of day trading. Recent reviews of day-trading firms' advertising and disclosure indicate improved practices -- many firms are using more balanced advertising and providing potential customers with better information concerning the risks of day trading.
Specific findings from the examinations are detailed below, and italics indicate the Staff's conclusions.
While professional traders have long engaged in day trading, day trading as a strategy employed by retail investors is a fairly recent phenomenon. The number of day traders in the new industry is estimated to be less than 7, 000.2 While this is an estimate of full-time day traders, there may be significantly more on-line investors who occasionally engage in day trading. By comparison, according to some estimates, there are close to an estimated 80 million individuals who own stock and more than 5 million investors using the Internet for brokerage services.3 Even though the number of day traders may be relatively small, some commentators suggest that their influence may be great -- by some estimates the industry accounts for approximately 15% of the Nasdaq's daily trading volume.4
Day-trading firms, like all broker-dealers registered with the SEC under the Securities Exchange Act of 1934 ("Exchange Act"), are required to comply with applicable federal securities laws and SRO rules. They also have some unique characteristics. For example, day-trading firms often advertise day trading and day-trading training, and generally offer their services at on-site trading facilities, rather than through a registered representative or an Internet web site. A day-trading firm generally provides its traders with direct access to market centers using high-speed computer linkages. The high-speed computer connections supply, among other things, access to Nasdaq Level II and ECNs -- services that are generally not available to most on-line customers.5
While day-trading firms are not required to identify themselves as such, in February 2000 the Staff identified 133 firms that appeared to meet the above characteristics of a day-trading firm.
In May 1999, Chairman Levitt defined a day trader as "an individual, not registered as a broker-dealer or as a registered representative, who trades stock at a firm that allow[s] the individual real time' access to the major stock exchanges and the Nasdaq market."6 The NASD also recently defined a day trader as "an individual who conducts intra-day trading in a focused and consistent manner, with the primary goal of earning a living through the profits derived from this trading strategy."7 Day traders generally attempt to derive a profit by executing many intra-day trades to take advantage of small price movements in stocks (e.g., 1/8 or 1/16 of a point per trade).
The principal characteristic that distinguishes day traders from other market participants is their mind-set. Day traders generally acknowledge that they are not investors, due to the short time they hold positions. Many day traders hold stocks for seconds or hours, seldom overnight, closing out positions for small profits.
Day-trading firms are typically organized in one of two ways: as traditional corporate entities or limited liability companies or partnerships ("LLC"). These organizational differences separate day-trading firms into two specific operating models with fundamentally different characteristics.
Most day-trading firms are organized as traditional customer-based corporate entities and are members of the NASD. Customer-based firms are required to comply with federal securities laws and regulations that are designed to further customer protection. Firms that conduct a retail customer business must comply with NASD membership requirements; customer reserve requirements;8 the Federal Reserve Board's initial margin9 and SRO maintenance margin requirements;10 and SRO suitability rules.11 The Staff estimates that there are more than 100 day-trading firms organized as retail brokerage firms.
The second model is the LLC partnership structure in which a firm operates a proprietary business. These firms represent that they do not have customers, but "members" who become part owners of the firm. Day traders at these firms, as part owners, contribute capital to the firm and in turn, trade the firm's capital. Most of these firms are members of the PHLX. There are approximately 13 day-trading firms that are members of the PHLX. To become a member of a day-trading firm structured as an LLC, individuals are required to sign operating agreements that designate the member's ownership rights including: profit sharing arrangements, restrictions on withdrawals, provisions limiting losses, and other provisions common to partnership agreements. Because these firms are exempt from registering with the NASD, they are not subject to the NASD Conduct Rules.12
Prior to a change in its rules, the PHLX allowed members of proprietary firms to trade proprietary accounts without being licensed representatives. Thus, proprietary day-trading firms were able to advertise day trading to the general public and accept members that were not licensed. The PHLX recently amended PHLX Rule 604 to require individuals trading off the floor of the exchange to pass the Series 7 licensing examination.13
Day traders incur significant trading costs. Day-trading firms generally charge commissions of between $15-$25 per trade and charge a substantial amount for additional services such as RealTick III data feeds, news, and exchange fees, which range between $50-$675 per month.14 Day traders must factor in these fees and costs in determining the point at which they are able to make a profit. The following graph highlights the fees and costs of day trading:
For example, a day trader who makes 50 trades per day at a firm with moderate fees ($16.70 per trade, $150 per month), must generate $16,850 each month in trading profits to recoup the costs of the trades.
In addition to the costs and fees described above, many firms stated that they require prospective customers to have a minimum amount of money to open an account. A February 2000 review of seven large day-trading firms revealed that five firms required initial deposits ranging from $20,000 to $75,000. A few firms noted, however, that their initial deposit requirements may be relaxed in certain circumstances, depending on the experience of the prospective day trader. Two of the seven firms did not indicate any minimum capital requirement.
The Staff analyzed the limited customer information obtained by day-trading firms to generate a profile of day traders based on their self-reported age, income, and net worth.15 The Staff compiled age information on 224 day traders and found that over half (57%) were between 20 and 39 years of age.16 As shown in graph 2 below, there are fewer day traders between the ages of 40 and 79.
The Staff also reviewed limited information on annual income for 166 traders.17 As shown below, more than half (53%) of the day traders purportedly earned more than $100,000 annually. The data does not indicate whether any of this income is derived from day trading.
Net worth information was compiled for 168 day traders.18 As shown below, most (78%) indicated that they had a net worth greater than $200,000. Six percent, however, reported net worth of less than $50,000.
Based on the information reviewed with regard to these day traders, most day traders in this limited sample appear to be under the age of 40, earn more than $100,000 per year, and have a net worth greater than $200,000.
The Staff did not determine whether day trading was generally profitable or unprofitable, but did seek to determine whether there were any factors common to traders who had profitable accounts and common to traders who had unprofitable accounts (at the time of the examinations).19 The Staff compiled year-end 1998 trading data for a sample of the profitable and unprofitable accounts at each of seven day-trading firms.20 The Staff reviewed a total of 123 trading accounts. The average of the profitable accounts was $177,732, while the average of the unprofitable accounts was $73,756. The Staff did not find a correlation between training and profitability or prior trading experience and profitability. It appears that many day traders with both profitable and unprofitable accounts had varying levels of prior professional trading experience, ranging from no experience to significant experience.
The SEC has received relatively few complaints from the public concerning day trading. In calendar year 1998, the SEC's Office of Investor Education and Assistance ("OIEA") received a total of 10,326 complaints, of which only 37 (or 0.36%) involved day-trading broker-dealers. For calendar year 1999, OIEA received 73 complaints related to day-trading firms (0.56% of total complaints received).21 Complaints from the public related to day-trading firms concerned topics not unique to day-trading firms: failure to follow customer's instructions; unauthorized transactions; and errors in account records. Each complaint was reviewed and appropriate action taken.22
The SEC is concerned about the potential for individuals to be seduced by promises of easy profits by day trading without fully understanding the risks.23 While no current law or rules explicitly mandate that firms disclose the risks of day trading, regulators have repeatedly urged day-trading firms to provide potential customers with information concerning the risks, and have urged day traders to be aware of the risks.24
The SEC has posted on its Web site a list of facts and warnings about which every prospective day-trader should consider prior to engaging in day trading. The full text "Day Trading: Your Dollars at Risk" is at http://www.sec.gov/consumer/daytips.htm:
In September 1999, the Staff conducted a survey to evaluate information that day-trading firms were making available on their web sites, and whether these firms provided information concerning the risks of day trading. The Staff also reviewed whether these firms made exaggerated, unwarranted, or misleading claims as to the profitability of day trading. The Staff's analysis of web sites from 22 day-trading firms revealed that:
Some of the common warnings found on firms' web sites included:
During each examination, the Staff reviewed documents provided to potential customers to determine if the firm provided written disclosure of the risks of day trading. Although there is no explicit law or rule requiring firms to provide such information, at the conclusion of the examinations the Staff recommended to firms that they provide information concerning the risks of day trading to all prospective customers. The firms examined fell into one of three disclosure categories: no disclosure, limited disclosure, and considerable disclosure, described below.
No Disclosure: A few firms did not provide any written disclosure to prospective customers concerning the risks of day trading.
Limited Disclosure: Most firms appeared to provide limited written disclosure to prospective customers, although this information was not as comprehensive as that required by the proposed NASD rule or suggested by the ETA. For example:
These findings demonstrate the importance of the SEC's examinations and public education initiative regarding the risks of day trading. As noted, some firms are providing the type of disclosures detailed in the NASD rule proposal.
The Staff also recommends that day-trading firms increase the information they provide concerning the costs of day trading. For example, the staff believes it is a good practice for firms to provide traders with an estimate of the costs to break even based on a variety of scenarios, such as 20 or 50 trades per day. Furthermore, if firms tout the profitability of day trading, they should be prepared to provide specific information to support their claims.
The NASD and PHLX advertising rules are designed to ensure that broker-dealers provide truthful advertising to the public and in some cases require that communications be pre-approved by the SRO prior to publication or broadcast.27 NASD rules prohibit exaggerated, unwarranted or misleading statements in advertisements to the public by NASD members.28 The Exchange Act does not contain provisions exclusively tailored to advertising, although the antifraud provisions of the Exchange Act make it unlawful to "make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made not misleading" in connection with the purchase or sale of a security.29
The day-trading firms reviewed utilized various methods to advertise to potential customers. Newspaper advertisements, magazine advertisements, web sites, and television commercials were among the most popular advertising methods. Advertisements typically offered individuals "maximum leveraged capital of 10 to 1," "state-of-the-art trading systems," "after-hours trade execution capability," "maximum profit potential," and "training by experienced professionals." The Staff was particularly concerned with claims or offers of services that firms did not actually provide. The Staff was also concerned with misleading advertising and puffery; in other words, advertisements that detailed the benefits of day trading, but did not adequately describe the risks and costs associated with day trading. While this advertising may not rise to the level of a violation of the antifraud provisions of the federal securities laws, it may violate SRO advertising rules. Several firms were sent deficiency letters for advertisements that appeared to include exaggerated claims or omitted required information. The Staff also found that firms improperly maintained advertising files and lacked proper supervisory approval over advertising. For example:
Day-trading firms should continue to focus on presenting truthful and balanced advertising. The SROs will continue to carefully scrutinize advertising of day-trading firms under SRO rules.
Day-trading firms, like all broker-dealers registered with the Commission, are subject to financial responsibility rules under the Exchange Act. Specifically, all broker-dealers must comply with the net capital rule (Section 15(c) of the Exchange Act and Rule 15c3-1 thereunder). The net capital rule requires registered broker-dealers to maintain a specified amount of liquid assets as a method of protection for customers and creditors. In addition, registered broker-dealers are required to make and keep current certain books and records, and to preserve these books and records.30 Accurate and current books and records are necessary to determine a broker-dealer's true financial condition and to support the firm's reported net capital position.
Ensuring compliance with the net capital rule and financial record-keeping requirements was an important component in the Staff's examinations. Day-trading firms generally encourage traders to end the trading day "flat," (i.e., without holding long or short securities positions in their accounts overnight), to limit the risk associated with these securities. The Staff found, however, that day-traders at several firms held sizeable leveraged long and short positions both intra-day and overnight. Day-trading firms must have an adequate capital base to support the dollar volume of intra-day and end-of-day positions. In accordance with the net capital rule, firms must be in net capital compliance at all times,31 even if the intention of the firms is to liquidate or cover the positions before the end of the day. During the examinations, however, the Staff found that most day-trading firms did not monitor for intra-day compliance with the net capital rule.
Day-trading firms must be able to demonstrate that they are in net capital compliance throughout the trading day. The NYSE reminded its members of their obligations to maintain moment-to-moment net capital in NYSE Interpretation Handbook Release, August 5, 1999. Other SROs will emphasize to their members their obligation to maintain net capital compliance at all times.
The Staff found net capital violations, including inaccurate computations and net capital deficiencies, at more than a quarter of the firms examined. These violations resulted in the maintenance of erroneous books and records. Many of the inaccurate net capital computations resulted from firms' failure to properly apply generally accepted accounting principles, as required by the net capital rule.32
While net capital violations and errors are not unique to day-trading firms, the net capital compliance will remain a focus of day-trading examinations by the SEC and the SROs.
Examinations also revealed numerous books and records violations. A sizable number of firms were cited for failing to maintain accurate financial records and/or for failing to maintain required documents. Several firms were cited for failing to maintain necessary customer account documentation (i.e., customer confirmations and account statements) or to preserve memoranda of each brokerage order.
Pursuant to Exchange Act Rule 17a-5(d), a broker-dealer is required to file an annual audited financial report with the SEC and its designated examining authority (SRO). The Staff found that almost half of the Philadelphia Stock Exchange firms, that we examined, failed to file annual audited reports. Most of the firms had concluded that they were exempt from the requirement pursuant to a provision of the rule designed for market makers and specialists on the floor of a stock exchange and subject to daily oversight by the exchange. The Staff found, however, that these firms were incorrectly relying on the exception, and were required to file annual audited reports.
The Philadelphia Stock Exchange recently issued a Notice to Members reminding members of their obligations under financial audit and books and records rules.33 The PHLX will conduct follow-up examinations to ensure compliance with books and records and financial responsibility rules.
A proprietary firm may include the capital contributed by its members as an allowable asset for net capital purposes. This practice may restrict the ability of the firm's members to withdraw their funds, if the withdrawal would place the firm in violation of the net capital rule.34 All of the proprietary firms examined by the Staff had operating agreements restricting partners' withdrawal of equity capital or capital contributions made by members of the firm. In general terms, the operating agreements stated that the general partner may restrict distributions of capital if such withdrawals would cause the firm to violate the requirements of the net capital rule.
The SEC's staff has issued an interpretive letter relating to the net capital treatment of temporary capital contributions.35 Under the interpretive letter, if an individual contributes capital to a broker-dealer with an understanding that the contribution can be withdrawn at the option of the individual, the contribution may not be included in the firm's net capital computation and must be re-characterized as a liability. In addition, the letter states that any withdrawal of capital by that individual within a year (other than a withdrawal to make required tax payments and reasonable compensation to partners as described in Exchange Act Rule 15c3-1), shall be presumed to have been contemplated by the individual at the time of the contribution. The Staff believes that this interpretation is consistent with the position it has emphasized for some time and should clarify a day-trading firm's obligation to maintain permanent capital under the net capital rule.
Section 7 of the Exchange Act prohibits broker-dealers and other persons from extending credit in contravention of the rules and regulations promulgated by the Board of Governors of the Federal Reserve ("Federal Reserve Board").36 The Federal Reserve Board has adopted Regulation T, which imposes initial margin requirements for broker-dealers.37
Under Regulation T, a broker-dealer must ensure that a customer deposit, or have on deposit in a margin account, 50% of the cost of a transaction; the broker-dealer may lend the customer the other 50% using the securities as collateral.38 This calculation is performed at the end of the day and includes transactions that occur that day.39 If the customer's funds are insufficient to meet the 50% requirement, the broker-dealer issues a Regulation T margin call and the customer must deposit the additional capital within five business days.40
In addition to Regulation T initial margin requirements, broker-dealers must comply with SRO requirements commonly referred to as "maintenance margin."41 Under these rules, broker-dealers must ensure that customers maintain a specified minimum amount of equity in their accounts at all times. Currently, a customer is required to maintain capital in his/her account equal to 25% of all long positions. Similar to Regulation T, this calculation is performed by brokerage firms at the end of the day and, in the event of a deficiency, the firm issues a margin call which must be met as promptly as possible and in any event within 15 business days,42 or seven business days for day trading accounts.43 Thus, every day-trading firm must make two separate margin calculations for each customer every day, one for Regulation T and the other for SRO maintenance margin.
Regulation T and SRO margin requirements are designed to work in tandem. For example, because Regulation T is calculated on the position in the account at the end of the day, which for most day traders' accounts would be flat, a Regulation T margin call would not be issued unless the account activity resulted in a loss. During the course of the day, however, the broker-dealer has extended credit to the customer for intra-day positions and was therefore at risk. Accordingly, the SROs amended the maintenance rules to capture these day-trading transactions. In effect, the rules require an individual to demonstrate that he/she could meet a margin call if he/she did not unwind the largest open positions by the end of each day.44 In addition to these amendments, the SROs have disseminated interpretive releases specifically addressing day trading margin issues.
The NYSE and NASD have proposed rules that would require day-trading firms to restrict the use of margin by active day traders. Both the NYSE's and NASD's rule proposals are similar. On January 14, 2000, the SEC issued the NYSE's rule proposal for public comment.45 On February 11, 2000, the SEC issued the NASD rule proposal for public comment.46
The proposed amendments would adopt a new term, "pattern day trader," which would include any customer that executes four or more day trades within five business days, provided the number of trades is more than six percent in the account for the five day period. Under the proposed amendments, a pattern day trader would be required to maintain a minimum equity of $25,000 at all times. If the account falls below the $25,000 requirement, the pattern day trader would not be permitted to day trade until the account is restored.
The proposed amendments would require special maintenance margin for pattern day traders equal to 25% of the cost of all day trades made during the day. In effect, this would permit a pattern day trader to have buying power of four-times the equity in the pattern day trader's account. In addition, the pattern day trader would be permitted to maintain margin based on the largest aggregate open position during that day.
Under the proposed amendments, if the pattern day trader exceeds his/her buying power during the day, the pattern day trader would receive a margin call, which is required to be met within five business days. If the margin call is not met, the pattern day trader's buying power would be reduced to two-times the equity in the account and the pattern day trader's margin requirement would be based on the pattern day trader's cumulative positions during the day, not the largest aggregate open position during the day. This would have the effect of substantially limiting the day-trading activity. In addition, if the margin call is not met within the required five business days, no trades on margin would be allowed for 90 days or until the margin call is met.
In addition to these new margin requirements for pattern day traders, the proposed rules would also require a pattern day trader that makes a deposit to satisfy a margin deficiency, to keep the deposit in the account for at least two business days. Further, a pattern day trader would be prohibited from using cross guarantees to satisfy a margin requirement. Together, these requirements are designed to provide greater financial stability to pattern day trader accounts and effectively require pattern day traders to utilize funds actually on deposit in their accounts.
A broker-dealer violates Regulation T and SRO maintenance rules when the broker-dealer, directly or indirectly, extends credit in excess of the requirements set forth in the rules. Broker-dealers that extend credit beyond the 50% Regulation T or 25% SRO margin obligations are, in effect, meeting the margin obligations of the customer. For example, in a typical transaction, a customer who purchases securities in his/her margin account at a cost of $10,000 would be required to deposit 50%, or $5,000, of the transaction cost. The broker-dealer lends the customer the remaining 50%, or $5,000, using the securities as collateral. If the customer is unable to meet his/her 50% obligation, the broker-dealer is required to issue a Regulation T margin call. Contrary to the rule, examinations revealed that several day-trading broker-dealers loaned funds to customers to meet their margin obligations -- in addition to and separate from credit extended for initial margin. As a result, the customer was left with a highly leveraged security transaction in excess of the amount contemplated by the rules.
Until recently, broker-dealers were prohibited from facilitating the arrangement of credit for their customers to purchase securities. In 1996, the Federal Reserve Board adopted amendments to Regulation T that allowed broker-dealers to arrange loans that they could not otherwise extend.47 The law allows a broker-dealer to arrange for the extension or maintenance of credit for customers provided the loan does not otherwise violate federal credit regulations.48 The Staff found that many day-trading firms arrange credit either between customers or from other persons or entities unrelated to the broker-dealer, in order to allow customers to meet margin calls and to continue to trade. These practices are described below.
Day-trading firms often arrange for customers to lend funds from their accounts to other customers. These loans are authorized by customers using a "letter of authorization." Day-trading firms typically provide these letters of authorization to customers. In the letter of authorization, the lender agrees that he/she will make funds available to the borrower primarily for the purpose of meeting margin calls. When needed, the funds are transferred or "journaled" from one customer's account to another to meet margin requirements at the end of the day. The funds are generally returned the next business day with interest and, if necessary, the process is repeated the following day. The interest paid on the loans reviewed by the Staff generally ranged from .05-.1% overnight (18-37% annualized). These loans as described are lawful under the federal securities laws. Nevertheless, the Staff is concerned that the parties to the lending may be unaware of terms and risks of such lending.49
The NYSE and NASD have proposed rules addressing day-trading margin. The proposed rules would require funds deposited to meet maintenance margin calls on pattern day-trading accounts to remain in the account at least two business days. The proposals also would prohibit pattern day traders from utilizing "cross guarantees," which consolidate accounts and permit maintenance margin based on the net positions of both accounts.
In addition to arranging credit between customers, the Staff found that some day- trading firms arrange loans for customers from outside entities such as private partnerships. The day-trading firm may inform its customers of the availability of credit from an outside lender to meet margin calls. These transactions are generally structured as simple loan agreements with the lender receiving interest for the credit extended. The rate of interest paid on the loans reviewed by the Staff generally ranged from .03 - .04% overnight (10-15% annualized). These arrangements as described are lawful under the federal securities laws.
The Staff believes however, that these arrangements may violate Regulation T when the lender is so closely related to the broker-dealer that the broker-dealer may be indirectly loaning funds to customers. For example, the lending entity may be affiliated with the broker-dealer if principals of the broker-dealer are also partners of the lending entity. In another example, a broker-dealer's employees appear to be lending funds to customers. If a strong connection is established, the broker-dealer arguably may be lending funds to customers beyond margin requirements. In at least two examinations, examiners found a connection or affiliation between the broker-dealer and the lender, indicating possible violations of Regulation T.
The SEC adopted Exchange Act Rule 10b-1650 to parallel the intent of the Truth in Lending Act, which focuses on full and meaningful disclosure of credit terms by financial institutions and other firms engaged in the extension of credit, enabling consumers to compare credit and to understand its costs.51 Rule 10b-16 makes it unlawful for any broker or dealer to extend credit, directly or indirectly, to any customer in connection with any securities transaction unless the broker or dealer has established procedures assuring that each customer receives a written statement disclosing certain characteristics of the credit extended, and the status of his/her account.52 The broker-dealer must notify the customer at the time of opening an account of certain items including:
The day-trading examinations generally revealed that firms complied with Rule 10b-16 when they extended credit within the guidelines of Regulation T. However, several day-trading firms were cited for violations of Rule 10b-16 when they either directly or indirectly through an associated person extended credit to meet a customer's Regulation T margin obligation.
As noted above, many firms engaged in arranging loans between customers and third parties. There are no rules directly governing disclosures that must be provided when broker-dealers arrange credit. While the Staff generally found that firms provided written letters of authorization when arranging loans for the firm's customers, these agreements did not uniformly contain the same types of information about the lending arrangement and did not necessarily include the information required by Rule 10b-16.
When broker-dealers themselves extend credit they must ensure that lending agreements include the information required by Rule 10b-16 (i.e., when interest charges can be imposed, the annual rate of interest, and the method of computing interest charges). The Staff believes that it is a sound practice for broker-dealers that facilitate lending arrangements to ensure that essential terms of the lending arrangement are provided to both parties.
Proprietary day-trading firms often enter into joint back office ("JBO") arrangements with their clearing firms.53 These arrangements allow day-trading firms to receive preferential margin treatment from their clearing firms. Specifically, a day-trading firm that participates in a JBO arrangement can receive credit from its JBO clearing firm on "good faith" terms. As a result, the customer margin requirements found in Regulation T and SRO rules do not limit the extension of credit to a JBO participant. Rather, credit can be extended for up to 100 percent of the purchase price of securities. Because of the borrowing power permitted by JBO arrangements, the leverage of day-trading firms using a JBO is limited only by the net capital rule. A day-trading firm participating in a JBO must maintain equity in its account equal to the haircut percentages under the net capital rule.
JBO arrangements are lawful. Under Regulation T, a clearing firm may finance the transactions of any of its owners if the clearing firm is owned jointly or individually by other creditors.54 Typically, introducing firms establish the required ownership interest by purchasing limited partnership shares in the clearing firm.
While individual clearing firms allow proprietary firms to have different amounts of leverage, all day-trading firms examined by the Staff received leverage in amounts that greatly exceeded the amounts permitted under Regulation T and SRO maintenance rules.55 The examinations revealed that several firms allowed member day traders up to ten times the equity in their accounts intra-day, while limiting overnight positions to approximately four times their equity. At several other firms, there appeared to be no stated trading limits either for intra-day or for overnight trading positions. Finally, a few firms maintained more conservative limits, lending a maximum of four times the equity in the account both intra-day and overnight.
Recently, the Commission approved SRO rule changes relating to JBO arrangements.56 These new SRO rules adopt additional requirements for the creation and maintenance of JBO arrangements. Specifically, the rule changes establish capital and equity requirements for JBO brokers and JBO participants and are designed to protect the safety and soundness of JBO arrangements. The rule changes require a JBO broker to: (1) maintain a minimum of $25 million in tentative net capital or $7 million in net capital if the JBO broker's primary business is clearing options market-maker; (2) provide prompt written notification to the SROs if its tentative net capital or net capital (whichever applies) would fall below the prescribed requirements; (3) resolve any net capital deficiency within three business days or not be permitted to accept additional transactions through the JBO arrangement;57 (4) maintain a written risk analysis methodology for assessing the amount of credit extended to each JBO participant; and (5) deduct from its net capital each JBO participant's haircut requirement in excess of the equity maintained in the JBO participant's account.
In addition, the rule changes generally require a JBO participant to: (1) be a registered broker-dealer subject to SEC Rule 15c3-1; (2) maintain an ownership interest in the JBO broker in accordance with Regulation T; and (3) maintain a minimum liquidating equity of $1 million in an account with the JBO broker. Under the rule changes, if a JBO participant's liquidating equity would fall below the required $1 million, the JBO participant must deposit the deficiency within five business days or lose its JBO participant status and become subject to the margin account requirements under Regulation T and the other SRO maintenance margin requirements. The SEC's staff believes that these rule changes will address the risks associated with JBO arrangements and fulfill the Federal Reserve Board's mandate for the SROs to provide rules that "ensure the reasonableness of JBO arrangements."58
A short sale occurs when a market participant sells a stock that he does not own. If the price declines, he can buy the stock later at the lower price and deliver it to the purchaser. If the price rises, however, he will have to buy the stock at the higher price, incurring a loss. Day-traders frequently sell stock short, hoping that they can capture small incremental profits when stock prices decline. Short selling is lawful and not unique to the day-trading industry. The Exchange Act specifically authorizes the SEC to address short selling with rules.59
The SEC adopted Exchange Act Rule 10a-1 to prevent the added downward momentum to the price of a stock that short selling may cause.60 Rule 10a-1(a)(1) provides that, subject to certain exceptions, an exchange-listed security may be sold short: (i) at a price above the price at which the immediately preceding sale was effected (plus tick), or (ii) at the last sale price if it is higher than the last different price (zero-plus tick).61 Conversely, short sales are not permitted on minus ticks or zero-minus ticks, subject to narrow exceptions.62 This is often referred to as the "tick test."
The NASD's rules prohibit short selling National Market System ("NMS") stocks at or below the current best (inside) bid when the current (inside) bid as displayed on NASDAQ is below the preceding best (inside) bid in the security.63 This is commonly referred to as the "bid test." Basically, the tick test and bid test prohibit selling stock short at a price lower than the last different trade price (or last best inside bid).
In addition to these provisions, there are other SEC and NASD requirements that apply to short selling. In order to comply with the tick test and other short sale rules, broker-dealers must first determine whether a potential sale is long or short.64 Broker-dealers cannot accept or effect long sales unless they determine that the seller has the security and it will be available for delivery.65 Further, NASD member firms that sell a stock short or allow their customers to sell short must first make sure that the shares can be borrowed or that they can make delivery of the stock to the purchaser by the settlement date.66
Once it is determined whether a sale is long or short, Rule 10a-1 requires broker-dealers to mark all orders in exchange-listed securities as "long" or "short," and prohibits the execution of orders that are not marked.67 Similarly, an NASD rule68 requires that firms mark customer order tickets as "long" or "short."69 These marking requirements are essential to ensuring that short sales are executed in accordance with the short sale rules. In a recent notice to its members, the NASD reiterated its longstanding position that members must comply with all short sale rules when receiving orders by telephone, electronically through a proprietary electronic order routing system, via the Internet, or otherwise.70
An analysis conducted by the Staff of the trading activity at eight day-trading firms revealed that numerous firms permitted short sales on a minus or zero minus tick in violation of Rule 10a-1.71 In fact, a significant percentage of each of these firms' total short trades were executed unlawfully -- in one instance, as many as 40% of the firm's short sales were violative. A significant number of the firms also failed to mark order tickets or improperly marked order tickets. Non-compliance rates at these firms ranged from 10% to 59% of all short sales not being marked as short sales. Several of the firms also violated the NASD's affirmative determination rule. The firms with significant short sale violations appeared to lack any automated compliance systems to identify and mark short sales.
Below is a short sale analysis of five proprietary day-trading firms.
Day-trading firms need to enhance compliance with the short sale rules. Given the number of violations, SEC and SRO examiners will continue to focus on compliance with the short sale rules during examinations.
The Staff found instances of "synthetic short sales" by day-traders who took simultaneous positions in equity options and shares of stock underlying the options. The individual components of the synthetic transaction do not violate any law, but, when aggregated, the positions may effectively be short sales. The examinations revealed three types of synthetic short sales: Married Puts,72 Cougars,73 and Jaguars.74 For example:
The Staff is reviewing these findings and analyzing whether these strategies constitute a violation of the short sale rules.
The suitability doctrine stems from the antifraud provisions of the federal securities laws and various SRO rules. Generally, if a broker-dealer makes a recommendation to a customer, it must have a reasonable basis for believing that the recommendation is suitable for the customer based on the customer's security holdings, financial situation and investment objectives.75 The Staff focused on whether customer-based day-trading broker-dealers were recommending the purchase, sale, or exchange of specific securities to their customers.
Most of the firms examined represented to the Staff that they were discount brokerage firms, did not make "recommendations", and accepted and executed only unsolicited orders from their customers. Therefore, the firms reviewed generally did not believe they had any duty to determine the suitability of any customer transactions with the firm.76 The Staff did not find indications that firms were recommending specific securities. If broker-dealers recommend that their customers buy or sell specific securities, they must ensure that the security is suitable for the customer.
The NASD has proposed a rule that would require broker-dealers that promote day trading to their non-institutional customers to determine, prior to opening an account for the customer, whether day trading is an "appropriate" strategy based on the customer's financial background and investment goals. In making this determination, the broker-dealer would be required to exercise reasonable diligence to ascertain the essential facts relative to the customer, including his/her financial situation, tax status, employment status, prior investment and trading experience and investment objectives.77 The proposed day-trading rule, which builds upon established NASD account approval guidelines, would require firms that recommend a day-trading strategy to an individual to approve the account for day trading. Prior to opening an account, firms also would be required to provide a disclosure statement to the customer describing the risks of day trading (discussed infra).
In general, a firm would be "promoting" a day-trading strategy if it affirmatively promoted day trading through advertising, training seminars, or direct outreach programs. If a firm's customers were generally engaged in day trading, it would reinforce a determination that the firm had affirmatively promoted day trading. However, merely providing access to research or to trading mechanisms that allow for intra-day trading would not necessarily constitute "promotion" of a day-trading strategy under the proposed rule.
The SEC is considering the NASD's rule proposal and public comments on the proposed rule.
The Staff found that about half of the firms reviewed offered formal training programs to their day traders.78 Some of these programs were offered "in-house" and some were conducted by independent, unregistered entities.
Of the firms that offered training programs, more than half were offered through an affiliate of the broker-dealer or through an outside vendor. Graph 6 below depicts the types of training delivery methods:
The Staff found that the firms that did not offer formal, organized training programs generally offered some sort of informal instruction or allowed traders to gain "hands-on" experience with strategies recommended by fellow traders who were often associated with the firm. Some of these firms also maintained very structured trading environments and traders had to execute mock transactions according to specific trading systems or strategies.
Because many of the training programs are conducted by unregistered entities, over which the SEC has no examination authority, it was difficult for the Staff to obtain training materials to ascertain what type of instruction was given to the day-traders in these training sessions. The Staff is particularly concerned that these training entities may be touting the benefits of day trading without discussing the risks and costs associated with day trading.
Broker-dealers and their supervisory personnel must comply with the federal securities laws to which they are subject and make reasonable efforts to ensure that persons subject to their supervision also comply with such laws. Specifically, the SEC can impose administrative sanctions upon a broker or dealer, or an associated person who, in connection with a violation of the federal securities laws, has "failed reasonably to supervise" persons subject to their supervision with a view to preventing such a violation.79
Broker-dealers will not be liable for a securities law violation for failing to supervise if the broker or dealer has: (i) established both procedures and a system for applying the procedures that should reasonably be expected to detect and prevent a securities law violation by a person subject to the broker's or dealer's supervision; and (ii) reasonably discharged the duties and obligations imposed by the procedures and system without having reasonable cause to believe that the procedures and system were not being followed.80
Under NASD rules, firms are required to adopt and implement a supervisory system that is tailored specifically to the member's business and that addresses the activities of all its registered representatives and associated persons.81 Firms are also required to designate appropriate supervisory personnel to assume authority and responsibility for internal supervision, control, and maintenance over their supervisory system.82
The Staff found numerous supervisory deficiencies in the firms examined. Several firms examined lacked adequate supervision and control of branch offices and remote sites. For example:
Day-trading firms must ensure that they have adequate compliance and supervisory infrastructure to ensure compliance with rules. The SEC and the SROs will rigorously enforce existing supervisory rules.
Examinations revealed instances where unregistered entities or persons were engaged in activity that may require registration under the federal securities laws or SRO rules. However, these situations were not widespread.
Examinations revealed that some day-trading firms may not be registering all of their branches as required by SRO rules.84 Most day-trading firms allow traders to be physically located in remote trading sites (i.e. , away from the headquarters or registered branch offices of the firm). Day-trading firms use terms such as "remote locations," "satellite offices," and "clusters" to describe these non-branch locations. The Staff found that a number of these remote locations were branch offices that were required to be registered under SRO rules.
Finally, the Staff found numerous situations where customers had been granted discretionary authority to trade the accounts of others. Trading with discretionary authority is not unique to day trading. In fact, it is relatively common among family members and between registered representatives and their customers. The Staff is concerned, however, that some of these customers may be acting as investment advisers or broker-dealers requiring registration under the law.85
Day-trading firms should ensure that all associated persons and branch offices are properly registered with the SEC, SROs and state securities regulators. Firms also need to be careful not to facilitate the violation of registration requirements by their customers.
In summary, while the Staff's examinations did not reveal widespread fraud, examiners found indications of serious securities law violations warranting referrals to the SEC's Enforcement staff at several firms. These violations related to net capital, margin, and lending disclosure. At most firms, however, the examinations revealed less serious violations, but indicated that many firms need to take steps to increase compliance with net capital, short selling, and supervision rules. Firms at which examiners found violations or deficiencies were issued deficiency letters, and corrective action was required.
While the deficiencies found are not unique to day-trading firms, the Staff believes that the nature of day trading itself -- frequent, fast and risky trading -- makes compliance with securities laws difficult to achieve without an automated compliance infrastructure. In addition, while disclosure of the risks of day trading is not explicitly required by current SEC or SRO rule, the examinations revealed that, as of the time of the examinations, many firms did not provide their customers with information concerning the risks of day trading. Recent reviews of day-trading firms' advertising and disclosure indicate improved practices -- many firms are using more balanced advertising and providing potential customers with better information concerning the risks of day trading.
The Staff intends to continue to focus examination resources on day-trading broker-dealers, in coordination with the SROs, to ensure that firms comply with securities laws and with any additional new rules that may govern their operations.
On August 20, 1999, the NASD proposed rules that focus on disclosing the basic risks of engaging in a day trading strategy and assessing the appropriateness of day trading strategies for individuals. The proposed rules were published for comment on September 21, 1999.86 The Commission is considering the comments received.
One of the proposed rules would require that a risk disclosure document be provided to "non-institutional customers." A "non-institutional customer" is one with an account that does not qualify as the account of: 1) a bank, savings and loan association, insurance company, or registered investment company; 2) an investment adviser; or 3) any other entity with total assets of at least $50 million. The firm may provide the customer with the risk disclosure statement proposed by the NASD, or another statement substantially similar to the one proposed that has been approved by the NASD's Advertising Department.
The other proposed rule would require members who promote a day-trading strategy to: 1) determine that a new account for a non-institutional customer is appropriate for day trading; or 2) obtain a written agreement that the non-institutional customer does not intend to use the account for day trading activities. A firm would not be permitted to rely on the written agreement from the customer if the firm knows that the customer intends to use the account for day trading, or the firm later determines that the account is being used for day trading.
In order to approve the customer's account for day trading, the member firm must have reasonable grounds for believing that the day trading strategy is appropriate. In making that determination, the member must exercise reasonable diligence to ascertain essential facts about the customer, including the customer's financial situation, tax status, employment status, prior investment and trading experience, and investment objectives. The firm would be required to prepare a record setting forth the basis on which the firm has approved the customer's account.
On February 23, 2000, the SEC staff issued an interpretive letter relating to the net capital treatment of temporary capital contributions.87 This letter makes it clear that if an individual contributes capital to a broker-dealer with an understanding that the contribution can be withdrawn at the option of the individual, the contribution may not be included in the firm's net capital computation and must be characterized as a liability. In addition, the interpretative letter states that any withdrawal of capital by an individual within a period of one year, other than a withdrawal to make required tax payments and reasonable compensation to partners described in Rule 15c3-1, shall be presumed to have been contemplated by the individual at the time of the contribution. This interpretation is consistent with the position the staff has emphasized in the past, and should clarify a day trading firm's obligation to maintain permanent capital under the net capital rule.
The NYSE and NASD have proposed rules that would require day trading firms to restrict the use of margin by active day traders. The NYSE and NASD rule proposals are substantially similar. On January 14, 2000, the SEC issued the NYSE's rule proposal for public comment, and the comment period closed on February 15.88 On February 11, 2000, the SEC issued the NASD's rule proposal for public comment, and the comment period will close 30 days after it is published in the Federal Register.89
The proposed amendments would adopt a new term "pattern day trader," which would include any customer that executes four or more day trades within five business days, provided the number of trades is more than six percent in the account for the five day period. Under the proposed amendments, a pattern day trader would be required to maintain a minimum equity of $25,000 at all times. If the account falls below the $25,000 requirement, the pattern day trader would not be permitted to day trade until the account is restored to a $25,000 equity level.
The proposed amendments would also require special maintenance margin for pattern day traders equal to 25% of the cost of all day trades made during the day. This, in effect, would permit a pattern day trader to have buying power of four-times the equity in the pattern day trader's account. In addition, if the day trading firm keeps a record showing the "time and tick" of each trade as evidence of the sequence of the day trades, the pattern day trader would be permitted to maintain margin based on the largest aggregate open position during that day.
Under the proposed amendments, if the pattern day trader exceeds his/her buying power during the day, the pattern day trader would receive a margin call, which must be met within five business days. If the margin call is not met, the pattern day trader's buying power would be reduced to two-times the equity in the account and the pattern day trader's margin requirement would be based on the pattern day trader's cumulative positions during the day, not the largest aggregate open position during the day. In addition, if the margin call is not met within the required five business days, no trades on margin would be allowed for 90 days or until the margin call is met.
In addition to these new margin requirements, the proposed rules would also require a pattern day trader that makes a deposit to satisfy a margin deficiency to keep the deposit in the account for at least two business days. Further, a pattern day trader would be prohibited from using cross guarantees to satisfy a margin requirement. Together, these requirements are designed to provide greater financial stability to pattern day trader accounts and effectively require pattern day traders to utilize funds actually on deposit in their accounts.
A Joint Back Office (JBO) arrangement is where a clearing firm effects and finances transactions for other broker-dealers, or JBO participants, that are also owners of the clearing broker ("JBO clearing firm"). Under Regulation T, a JBO clearing firm may extend credit to its JBO participants without requiring Regulation T margin. This exemption from Regulation T, in effect, treats a JBO participant as a self-clearing broker-dealer, whose proprietary securities transactions are not subject to margin rules.
Recently, the SEC approved SRO rule changes relating to JBO arrangements.90 These rule changes establish capital and equity requirements for JBO clearing firms and JBO participants and are designed to protect the safety and soundness of JBO arrangements. Generally, the rule changes require a JBO clearing firm to: (1) maintain a minimum of $25 million in tentative net capital or $7 million in net capital if its primary business is clearing for options marketmakers; (2) provide prompt written notification to its SRO if its tentative net capital or net capital, whichever applies, falls below the prescribed requirements; (3) resolve any net capital deficiency within three business days or not be permitted to accept additional transactions through the JBO arrangement;91 (4) maintain a written risk analysis methodology for assessing the amount of credit extended to each JBO participant; and (5) deduct from its net capital each JBO participant's haircut requirement in excess of the equity maintained in the JBO participant's account.
In addition, the rule changes generally require a JBO participant to: (1) be a registered broker-dealer subject to SEC Rule 15c3-1; (2) maintain an ownership interest in the JBO clearing firm in accordance with Regulation T; and (3) maintain a minimum liquidating equity of $1 million in an account with the JBO clearing firm. Under the rule changes, if a JBO participant's liquidating equity falls below the required $1 million, the JBO participant must deposit the deficiency within 5 business days or lose its JBO participant status and become subject to the margin account requirements under Regulation T and the other SRO maintenance margin requirements.
On August 20, 1999, the Commission approved a Phlx rule change that requires each day trader that is a limited partner in one of these firms to pass the Series 7 examination.92 The rule becomes effective on February 25, 2000, which means that all currently registered associated persons who trade off the floor of Phlx must successfully pass the Series 7 by that date. In addition, all new persons that become associated with member organizations or participant organizations must successfully complete the exam prior to conducting trading.
The SEC's Division of Enforcement currently has several active investigations involving day-trading entities and other firms that provide stock recommendations to day traders. The Enforcement staff is reviewing their activities for, among other things:
On February 22, 2000, the SEC instituted administrative proceedings against two day trading firms for margin violations. Specifically, the Division of Enforcement alleged that these firms failed to comply with the margin lending provisions of the Exchange Act and Regulation T:
The SEC instituted administrative and cease-and-desist proceedings against All-Tech Direct, Inc., a registered broker-dealer, and seven All-Tech associated persons. The SEC's Order Instituting Proceedings alleges that All-Tech repeatedly breached the limits imposed by Regulation T by extending short-term loans to customers to meet margin calls with funds drawn from the accounts of three All-Tech associated persons. It is alleged that these associated person accounts funded at least 103 loans totaling more than $3.6 million to All-Tech customers. The SEC's Order also alleges that All-Tech violated Exchange Act Rule 10b-16 by failing to provide customers with certain written disclosures concerning the fees and other essential terms of the loans.
In a settled matter, the SEC instituted cease-and-desist proceedings against two entities, Investment Street Company and Dynamic Trading of Miami, Inc., and Investment Street's president as well as one its directors. Investment Street is a registered broker-dealer in Miami, Florida which specializes in facilitating day trading by its customers. Dynamic Trading is a Florida corporation that provides administrative services to Investment Street.
The SEC's Order found that Investment Street repeatedly exceeded the Regulation T limits by extending short-term loans to customers to meet margin calls with funds from accounts controlled by Emilio Sardi, a director of the firm. According to the SEC's Order, there were at least 22 such loans, totaling $250,000. The Order also finds that Investment Street violated Exchange Act Rule 10b-16 by failing to provide customers with certain written disclosures concerning the fees and other essential terms of the loans.
Separate from the margin violations, the SEC's Order found that Investment Street and Dynamic Trading were liable for violations arising from the conduct of two Dynamic employees . These two employees regularly used Investment Street's facilities to trade for the Sardi's account without registering.
All of the respondents agreed to settle this matter. The settlement includes cease-and- desist orders against all respondents, civil money penalties ranging from $5,500 to $25,000, and six-month and 90-day broker-dealer suspensions for Investment Street's president and director, respectively.
The SEC has also brought other enforcement actions related to day trading:
On January 5, 2000, the SEC filed an action in federal district court charging Yun Soo Oh Park a/k/a Tokyo Joe ("Park") and Societe Anonyme, a corporation under Park's control, with engaging in a scheme to defraud members of his Internet stock recommendation service and the investing public. The SEC's complaint alleges that Park, who charged his clients $100 to $200 per month to receive stock recommendations over the Internet, (i) made material misrepresentations about the recommendations and engaged in scalping; (ii) illegally touted at least one issuer by failing to disclose the receipt of compensation from that issuer; and (iii) misrepresented his track record of success. The SEC's complaint charges violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 17(b) of the Securities Act, and Sections 206(1) and (2) of the Advisers Act. The action is currently pending.
1Examiners from the SEC headquarters, regional and district offices participated in the sweep. The staff of the NASD Regulation, Inc. ("NASDR") and the Philadelphia Stock Exchange, Inc. ("PHLX") conducted additional examinations. The examination findings described herein are those of the Staff, and are not findings of the Commission.
2See Day Traders Working Hard to Influence How the Profession is to be Defined, Securities Week (McGraw-Hill Companies, Inc.), May 24, 1999, at 3.
3ICI and SIA, Equity Ownership in America, Fall 1999, at 14.
4Day Traders Working Hard to Influence How the Profession is to be Defined, supra note 2.
5Several on-line broker-dealers provide direct access to market centers for actively-trading customers. See Rebecca Buckman, Online Brokers, Day-Trade Firms Start To Encroach On Each Others Cyber Turf, Wall St. J., Oct. 6, 1999, at C1; David Barboza, Why Big Firms Are Courting Day Traders, N.Y. Times, Aug. 13, 1999, at C1.
7Mary L. Schapiro, Testimony on the Securities Day-Trading Industry, Testimony Before the Permanent Subcommittee on Investigations, Senate Committee on Governmental Affairs (Sept. 16, 1999) http://www.nasdr.com/1420/schapiro_14.htm.
817 C.F.R. § 240.15c3-3 (1998).
9Regulation T, 12 CFR § 220 (1998).
10E.g., NASD Conduct Rule 2520, NASD Manual (CCH) (1999); NYSE Rule 431, 2 NYSE Guide (CCH) ¶ 2431, at 3751 (Oct. 1998).
11E.g ., NASD Conduct Rule 2310, NASD Manual (CCH) (1999); NYSE Rule 405, 2 NYSE Guide (CCH) ¶ 2405, at 3696 (Oct. 1998).
12 Exchange Act Section 15(b)(8) provides that if a broker-dealer executes or attempts to execute the purchase or sale of any security, the broker-dealer must be registered with the NASD. 15 U.S.C. § 78o(b)(8) (1999). However, Exchange Act Rule 15b9-1 provides that "any broker or dealer required by Section 15(b)(8) to become a member shall be exempt from such requirement if it (1) is a member of a national securities exchange, (2) carries no customer accounts, and (3) has annual gross income derived from purchases and sales of securities otherwise than on a national securities exchange of which it is a member in an amount no greater than $1,000." 17 C.F.R. § 240.15b9-1 (1998).
13Exchange Act Release No. 41776 (Aug. 20, 1999), 64 Fed. Reg. 47214 (1999). The licensing requirement becomes effective on February 25, 2000. Other regional exchanges have amended or proposed rules to impose a Series 7 licensing requirement on their off-floor proprietary traders.
14In comparison, over the past year, the average commission paid by U.S. investors was generally between $19 and $21. See Kathy Bergen, On-Line Investing Price Cuts Heating Up; Brokerages Going for Broke on Commissions, Chi. Trib., Sept. 5, 1999, at C1.
15 The Staff gathered age data, annual income information, and net worth data on a total of 294 day traders from ten NASD member firms, three PHLX member firms, and one NYSE member firm. This was not a scientific sample and the information was self-reported. The information was obtained from customer account forms, U-4 forms, and/or company questionnaires. Not all of the firms maintained information on traders in all three categories, so each area was analyzed independently. The Staff also attempted to compile information regarding prior trading and investing experience of day-traders, but source documents provided limited information in these areas.
16Age information was compiled from 11 firms.
17Annual income information was compiled from 11 firms.
18Net worth data was compiled from 11 firms.
19 The North American Securities Administrators Association, Inc. ("NASAA") Project Group Report on Day Trading states that, based on a sample of 26 accounts, "70% of public traders will not only lose, but will almost certainly lose everything they invest." See North American Securities Administrators Association, Inc., Day Trading Project Group Report: Findings and Recommendations (Aug. 9, 1999) nasaa.org/nasaa/scripts/fu_display_list.asp?ptid=16 The Electronic Traders Association ("ETA") states, "after an initial period of three to five months of losses, 60-65% netted in the range of $28,000 per month, with the balance of customers losing $6,000-$8,000 per month." The ETA concluded that "the majority of those who day-trade after training do not lose money." Statement of Electronic Traders Association, Hearing Before the Permanent Subcommittee on Investigations (Sept. 16, 1999) http://electronic-traders.org/state030.html
20Profits and losses were net of any fees charged to the trader for the trades.
21 The ETA pointed to the relative dearth of complaints as evidence that day-traders are not getting "wiped out" in the high numbers many regulators claim they are. Statement of Electronic Traders Association, supra note 19. Some commentators believe that the dearth of complaints is due solely to the current bull market.
22 OIEA typically contacts firms to request a response to the complaint and then notifies the complainant of the firm's response. OIEA makes referrals to the SROs or the Division of Enforcement where appropriate.
23Chairman Arthur Levitt, Testimony Before the Senate Permanent Subcommittee on Investigations Committee on Governmental Affairs Concerning Day Trading (Sept. 16, 1999) www.sec.gov/news/testmony/tsty2199.htm.
24NASDR has stated that investors should be made aware that day trading is "a risky, speculative activity, and even the most experienced day traders may suffer severe and unexpected financial losses, even beyond their initial investment." Mary Schapiro, supra note 7. NASAA has expressed concerns that day-trading firms provide inadequate risk disclosures to potential customers. NASAA, supra note 19. The ETA has also expressed concern that because of the recent attention day trading has received, many individuals may be encouraged to undertake the activity without the benefit of a clear understanding of the potential risks involved. ETA, supra note 19.
25 Exchange Act Release No. 41875 (Sept. 14, 1999), 64 Fed. Reg. 51165 (Sept. 21, 1999) (as amended by Exchange Act Release No. 42452 (Feb. 23, 2000).
26 The ETA also adopted a Model Risk Disclosure Statement to help inform potential customers of the risks associated with day trading. The statement includes the following:
27NASD Conduct Rule 2210, NASD Manual (CCH) (1999); PHLX Rule 605, 1 PHLX Guide (CCH) 2605, at 2203 (1998).
28NASD Conduct Rule 2210(d)(1)(B), NASD Manual (CCH) (1999).
2917 C.F.R. § 240.10b-5 (1998).
30SEC Books and Records Rules, 17 C.F.R. § 240.17a-3 and 17a-4 (1998).
31Moment to Moment Net Capital, NYSE Interpretation Memorandum No. 99-8, (Aug. 5, 1999).
32The firms examined generally fell into two categories, those with a $5,000 minimum net capital requirement and those with a $100,000 minimum net capital requirement. Introducing day-trading firms that effect more than ten transactions in their proprietary accounts are subject to a minimum net capital requirement of $100,000. 17 C.F.R. § 240.15c3-1(a)(2)(iii) (1998).
33 PHLX Circular 2000-01, (Jan. 3, 2000).
34SEC Net Capital Rule, 17 C.F.R. § 240.15c3-1 (1998). The Net Capital Rule imposes restrictions and limitations on the withdrawal of equity capital from a broker-dealer by a stockholder or partner. The rule also obligates a broker-dealer to provide written notification to the SEC and its SRO of a withdrawal or expected withdrawal, if the withdrawal or expected withdrawal exceeds a certain percentage of the firm's net capital.
35Letter to Mr. Raymond J. Hennessy, Vice President, New York Stock Exchange, Inc. and Ms. Susan DeMando, Vice President, NASD Regulation from Michael A. Macchiaroli, Associate Director, Securities and Exchange Commission, dated February 23, 2000.
3615 U.S.C. § 78g (1999).
37Regulation T, supra note 9. Any "broker or dealer, or any person associated with a broker or dealer" is a "creditor" for purposes of Regulation T. 12 C.F.R. § 220.2 (1998). Persons associated with a broker-dealer generally include partners, officers, directors, branch managers, and employees. 15 U.S.C. § 78c(a)(18) (1999).
3812 C.F.R. § 220.4(b) (1998) (describing the initial margin customers must deposit on securities transactions). The margin required for equity securities is generally 50% of the current market value of the security or the percentage set forth by the SROs, whichever is greater. 12 CFR § 220.12(a) (1998).
39The firm combines all transactions that occur on the same day to determine whether additional margin is necessary. Additional margin is required on any day when the day's transactions create or increase a margin deficiency. The additional margin required is the amount of the margin deficiency created or increased. 12 C.F.R. § 220.4(c) (1998).
40Under Regulation T, a margin call must be satisfied "within one payment period after the margin deficiency was created or increased." 12 C.F.R. § 220.4(c)(3)(i). A payment period is defined as the "number of business days in the standard securities-settlement cycle plus two business days." 12 C.F.R. § 220.2 (1998). The standard securities settlement cycle is currently three business days. 17 C.F.R. § 240.15c6-1(a) (1998).
41See NYSE Rule 431(c), 2 NYSE Guide (CCH) ¶ 2431, at 3751-3 (Oct. 1998); NASD Conduct Rule 2520(c), NASD Manual (CCH) (1999).
42E.g., NYSE Rule 431(f)(6), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998).
43See e.g., NYSE Rule 431(f)(8)(C), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998). Neither Regulation T nor the SRO maintenance margin rules prevent a broker-dealer from imposing more stringent margin requirements, such as imposing margin calls on an account during the day or requiring more margin for volatile securities. In fact, some firms provide only one or two days to meet a margin call.
44E.g., NYSE Rule 431(f)(8)(B), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998).
45Exchange Act Release No. 42343 (Jan. 14, 2000), 65 Fed. Reg. 4005 (2000).
46Exchange Act Release No. 42418 (Feb. 11, 2000), 65 Fed. Reg. 8461 (2000).
47Board of Governors of the Federal Reserve System Docket No. R-0772 (Apr. 24, 1996), 61 Fed. Reg. 20386 (1996).
4812 CFR § 220.3(g) (1998).
49 A large broker-dealer responsible for clearing trades for several day-trading firms recently prohibited the practice of customer-to-customer lending to meet margin calls. See Ruth Simon, Day-Trading Firms Face Pressure on Practices, Wall St. J., Aug. 17, 1999, at C1, C5.
5017 C.F.R. § 240.10b-16 (1998).
51Exchange Act Release No.8773 (Dec. 8, 1969) (adopting Rule 10b-16), 34 Fed. Reg. 19717 (1969). The Truth in Lending Act specifically exempted from its disclosure requirements brokers' margin loans to customers because the Committee (Senate Committee on Banking and Currency) preferred to allow the Commission to require substantially similar disclosure by regulation.
52The Rule [10b-16] requires an initial disclosure and periodic disclosures. The initial disclosure is designed to insure that the investor, before his account is opened, understands the terms and conditions under which credit charges will be made. This will enable him to compare the various credit terms available to him and to understand the methods used in computing the actual credit charges. The periodic statement will inform the investor of the actual cost of credit and, with the aid of the initial disclosure, enable him to accurately assess that cost. Id. at 2.
53JBOs are not limited to proprietary day-trading firms. They are utilized by other broker-dealers as well. However, proprietary day-trading firms pass the proprietary benefits of the JBO arrangement to their members.
5412 C.F.R. § 220.7(c) (1998).
55JBO arrangements appear to increase the overall risk to the clearing firm. This was not a focus of the initial series of exams, but will be reviewed in our examinations of the risk management procedures of clearing firms.
56Exchange Act Release No. 42453 (Feb. 24, 2000) (order approving the following JBO rule changes: SR-NYSE-97-28; SR-CBOE-97-28; SR-Phlx-97-56; SR-PCX-97-49; SR-CHX-98-12; SR-Amex-99-26).
57See SEC Net Capital Rule, supra note 34. Under the Rule, a broker-dealer is required to maintain at all times a minimum level of net capital as prescribed under the Rule. If a broker-dealer's net capital falls below its prescribed minimum requirement under the Rule, it must cease conducting a securities business.
58See Board of Governors of the Federal Reserve, supra note 47.
59 15 U.S.C. § 78j(a) (1999). Section 10(a) of the Exchange Act states that
[i]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange [t]o effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
On October 20, 1999, the Commission issued a concept release seeking public comment on the regulation of short sales of securities. The purpose of the concept release is to gather public comments on possible amendments to Exchange Act Rule 10a-1 and other potential changes to the Commission's regulation of short selling. . Exchange Act Release No. 42037 (Oct. 20, 1999), 64 Fed. Reg. 57996 (1999).
6017 C.F.R . § 240.10a-1 (1998).
61Id. Exchange Act Rule 10a-1 applies to transactions in exchange-listed securities, therefore, short sales on the national securities exchanges must comply with the Rule. The exchanges have codified Rule 10a-1 as their short sale rule. E.g., NYSE Rule 440B, 2 NYSE Guide (CCH) ¶ 2440B, at 3784 (Oct. 1998).
6217 C.F.R. § 240.10a-1(e) (1998).
63NASD Conduct Rule 3350, NASD Manual (CCH) (1999).
64Exchange Act Rule 3b-3 defines short sales. 17 C.F.R. § 240.3b-3 (1998). The NASD uses this definition to define short sales in NASD Conduct Rule 3350. Firms must aggregate securities positions in accounts that are under common control to determine the net long or short position. For customer short sales, the firm must aggregate all the customer's positions in all accounts. For day traders that are trading for the firm's proprietary account, the firm must aggregate all the day traders' positions with the firm's other positions to determine the firm's net long or short position before any sales are executed.
6517 C.F.R. § 240.10a-1(c) and (d) (1998); NASD Conduct Rule 3370(b)(1), NASD Manual (CCH) (1999).
66NASD Conduct Rule 3370(b)(2) ("Affirmative Determination Rule"), NASD Manual (CCH) (1999). The Affirmative Determination Rule does not apply to a number of transactions, including "bona fide market making transactions." NASD Conduct Rule 3370(b)(2)(B). In other words, bona fide market makers may sell short without checking the availability of borrowable stock to be used for delivery.
6717 C.F.R. § 240.10a-1(c) (1998).
68NASD Conduct Rule 3110(b)(1), NASD Manual (CCH) (1999). Although this rule only applies to customer orders, short sales of NMS securities by members of LLCs still must be conducted in accordance with the bid test. For exchange-listed securities, firms must also mark customer and proprietary short sale orders in accordance with Rule 10a-1 and any other applicable exchange rules.
69NASD Conduct Rule 3350(e) states that: "No member shall knowingly, or with reason to know, effect sales for the account of a customer or for its own account to avoid the application of this Rule." See also, NYSE Rule 440B.13, 2 NYSE Guide (CCH) ¶ 2440B, at 3788 (Oct. 1998).
70NASD Notices to Members 99-98 (Dec. 1999).
71The SEC's Office of Economic Analysis conducted a more comprehensive analysis of the trading activity at eight firms over a one-week period. The analysis focused on compliance with Rule 10a-1, and identified short sales by comparing actual trades with specific equity inventory positions of the broker-dealer at the beginning and close of business. After short sales were identified, the transactions were tested for short sale rule compliance by matching the transactions against exchange data for time of trade.
72A Married Put is a strategy in which one owns an option to sell a security on a specific date at a predetermined price, while simultaneously purchasing the underlying security.
73Cougars mimic a married put, consisting of a short call position and a long position in the common stock of the same issuer.
74A Jaguar employs an option strategy known as a conversion. The Jaguar consists of a long position of 1,000 shares stock, a purchase of 10 deep-in-the-money puts and a sale of 10 calls that are out-of-the-money.
75NASDR Conduct Rule 2310(b), NASD Manual (CCH) (1999). The Rule requires that, in recommending the purchase, sale, or exchange of a security, a broker-dealer have reasonable grounds for believing that the recommendation is suitable for the customer based on the customer's security holdings, financial situation, and needs. In meeting this duty, broker-dealers must make reasonable efforts to obtain information concerning: (1) the customer's financial status, (2) the customer's tax status, (3) the customer's investment objectives, and (4) any other information the broker considers reasonable in making a recommendation to the customer.
76In its recent report on day trading, NASAA states that analogizing between discount brokerage firms and day-trading firms may be incorrect. NASAA believes that "while day-trading firms generally do not make specific recommendations to customers, they do promote day trading as an investment program, often in conjunction with training courses." NASAA, supra note 19.
77Exchange Act Release No. 41875, supra note 25. Proposed NASD Conduct Rule 2360 uses the term "intra-day trading strategy" as an overall trading strategy characterized by the regular transmission by a customer of multiple intra-day electronic orders to effect both purchase and sale transactions in the same security or securities.
78 Formal training included a day-trading course or seminar. Many firms advertised the features of the training programs on their web sites. Most of the firms charged fees for formal day trading instruction, ranging from $250 to $5,000, however, several firms provided instructional seminars at no cost. A couple of firms offered rebates of the training cost back to the trader in dollar increments if the trader opened an account and executed trades with the firm. Although the training cost is refunded, the trader still incurs and pays the fees associated with each trade.
7915 U.S.C. § 78o(b)(4)(E) (1999).
81NASD Conduct Rule 3010, NASD Manual (CCH) (1999). PHLX Rule 748 also requires a member's supervisory system to diligently supervise all accounts to ensure compliance with securities laws and regulations. 1 PHLX Guide (CCH) ¶ 2748, at 2282 (1998).
82See e.g., NASD Conduct Rule 3010(a)(2), NASD Manual (CCH) (1999).
83SRO rules also require that members adopt appropriate written procedures for supervision and control. See supra note 79.
84See e.g., NASD By-Laws Article IV Section 8, NASD Manual (CCH) (1999); PHLX Rule 601, 1 PHLX Guide (CCH) ¶ 2601, at 2201 (1998).
85Persons are required to be registered with the SEC if they are engaged in the business of effecting transactions in securities for others, or are engaged in the business of buying and selling securities for their own account. This definition does not include a bank, or any person who buys or sells securities individually or as a fiduciary not as part of a regular business. 15 U.S.C. § 78c(a)(4) and (5) (1999). Persons are required to be registered with the SEC or with a state securities regulator, as appropriate, as investment advisers if they are engaged in the business of advising others about securities for compensation. 15 U.S.C. § 80b-2(a)(11) (1999).
86Securities Exchange Act Release No. 41875 (September 14, 1999), 64 FR 51165 (September 21, 1999) (as amended by Exchange Act Release No. 42452 (Feb. 23, 2000).
87Letter to Mr. Raymond J. Hennessy, Vice President, New York Stock Exchange, Inc. and Ms. Susan DeMando, Vice President, NASD Regulation from Michael A. Macchiaroli, Associate Director, Securities and Exchange Commission, dated February 23, 2000.
88Securities Exchange Act Release No. 42343 (January 14, 2000), 65 FR 4005 (January 25, 2000).
89Securities Exchange Act Release No. 42418 (February 11, 2000), 65 FR 8461 (February 18, 2000).
90Exchange Act Release No. 42453 (Feb. 24, 2000) (order approving the following JBO rule changes: SR-NYSE-97-28; SR-CBOE-97-28; SR-Phlx-97-56; SR-PCX-97-49; SR-CHX-98-12; SR-Amex-99-26).
91SEC Rule 15c3-1 requires a broker-dealer to maintain at all times its minimum net capital requirement prescribed under the Rule. Under SEC Rule 15c3-1, if a broker-dealer's net capital falls below its prescribed minimum requirement under the Rule, it must cease conducting a securities business.
92Securities Exchange Act Release No. 41776 (August 20, 1999), 64 FR 47214 (August 30, 1999).
93Securities Exchange Act Release No. 41881 (September 17, 1999), 64 FR 51822 (September 24, 1999).
94Securities Exchange Act Release No. 39874 (April 14, 1998), 63 FR 19990 (April 22, 1998).
95SR-BSE-99-13 was filed on December 30, 1999.
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