By Lori A. Richards
Director, Office of Compliance Inspections and Examinations
U.S. Securities & Exchange Commission
Before the Senate Permanent Subcommittee on Investigations,
Committee on Governmental Affairs
February 25, 2000
Chairman Collins, Ranking Member Levin, and members of the Subcommittee:
I appreciate the opportunity to appear before the subcommittee today on behalf of the Securities and Exchange Commission ("Commission") to discuss day trading and our current initiatives to address concerns in this area. As you know, the Commission has been actively monitoring the day-trading industry, and the Commission's examination staff recently completed an examination sweep of broker-dealers providing day-trading opportunities to the public. The Commission's staff has released a report today entitled Report of Examinations of Day-Trading Broker-Dealers, which describes our findings in some detail. It is included with my testimony. I am pleased to have this opportunity to provide you with our findings from these examinations, and also to update you on recent regulatory initiatives and enforcement cases.
I. Examination Sweep: Findings
In the last year, the Commission's examiners in its headquarters and regional and district offices conducted targeted examinations of 47 day-trading firms. The purpose of the examinations was to review firms' compliance with federal securities laws and self- regulatory organization ("SRO") rules, to evaluate how day-trading activities fit within the current securities regulatory structure and to identify regulatory issues that may require further consideration.
While these examinations did not reveal widespread fraud, they did reveal a number of serious violations warranting referral to the Commission's Division of Enforcement. The examinations also revealed deficiencies in the areas of short selling, net capital, books and records, advertising, and supervision, and that many firms need to take steps to improve compliance with these rules. Firms at which examiners found violations or deficiencies were cited in deficiency letters and corrective action was required. The Commission has also recently initiated enforcement action against two firms for violations related to day-trading lending.
In addition, while not explicitly required by Commission or SRO rule at the time of the examinations, the examinations also revealed that many day-trading firms were not providing potential customers with information concerning the nature and risks of day trading. Recently, many day-trading firms have enhanced their risk disclosure to potential customers.
Specific Staff findings from the examinations are outlined below and are described in detail in the Staff's Report of Examinations of Day-Trading Broker-Dealers.
- A September 1999 review indicated that many day-trading firms provided little or no information to prospective customers concerning the risks of day trading. A follow-up review in February 2000 indicates that day-trading firms generally have enhanced their risk disclosure.
- Several firms' advertisements contained exaggerated or unwarranted claims. While these claims may not amount to violations of the antifraud provisions of the federal securities laws, they appear to violate SRO rules. For example, some firms advertised services they did not actually offer.
- Several day-trading firms prepared inaccurate net capital computations due to the misapplication of the net capital rule, and a small number of firms experienced net capital deficiencies.
- Several firms extended credit in excess of that allowed by margin rules, and at least two firms indirectly extended credit to customers in apparent violation of margin rules. The Commission recently initiated enforcement actions alleging the unlawful extension of credit to customers (In the Matter of All-Tech Investment Group, Inc., et al. and In the Matter of Investment Street Company, et al.).
- Day-trading firms generally complied with disclosure requirements when they extended credit. Several day-trading firms, however, failed to adequately disclose the essential terms of credit when the firm indirectly extended credit to meet a customer's margin obligation.
- Numerous firms permitted short sales on a minus or zero tick in violation of short sale rules. A significant number of firms also violated securities rules by failing to mark or improperly marking order tickets and failing to make an affirmative determination that they could locate and borrow stock being sold short.
- Many day-trading firms maintained inadequate written supervisory procedures relating to: the review of exception reports; the process for opening new day trading accounts; and compliance with short sale and margin rules. Some firms also were not adequately supervising branch offices.
- Many day-trading firms relied heavily on automated systems to perform certain supervisory functions, such as to ensure compliance with margin and short sale rules. Examinations disclosed, however, that some of these automated systems were easily bypassed or disabled by traders.
- The Staff found instances where unregistered entities and persons were apparently engaging in activity that may require registration as a broker-dealer or investment adviser under the federal securities laws or SRO rules.
Many day-trading firms need to take steps to improve compliance with rules. While the deficiencies found during the examinations are not unique to day-trading firms, the nature of day trading itself frequent, fast and risky trading makes compliance with securities laws difficult to achieve without an automated compliance infrastructure. As noted, 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 Commission has also taken steps to educate investors about the risks of day trading. Also, the SROs have proposed rules to address regulatory concerns including rules tightening margin, requiring disclosure of the risks of day trading, and requiring day-trading firms to make determinations concerning the "appropriateness" of day trading for customers before opening accounts. The Commission's staff is committed to working in cooperation with the SROs to address the concerns described in the Report of Examinations of Day-Trading Broker-Dealers and to continue efforts to ensure that all firms comply with the securities laws and with any additional new rules that may govern their operations.
Note: Please see the Special Studies section of the SEC Website for copies of the report to above.