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Une étude de la NASAA sur le day-trading et le trading actif qui
met en évidence que la majorité des intervenants perdent de l'argent, l'étude
porte sur des comptes réels d'intervenants en bourse.
REPORT OF THE DAY
TRADING PROJECT GROUP
NORTH AMERICAN SECURITIES ADMINISTRATORS
ASSOCIATION
FINDINGS AND RECOMMENDATIONS
AUGUST 9, 1999
Any reprint or public dissemination of this
publication or any part thereof should reference the source and state that
information regarding the entire report on this subject may be obtained from
the North American Securities Administrators Association, Inc., 10 G Street,
NE, Suite 710, Washington, D.C., 20002, (202) 737-0900, (202) 783-3571 (fax),
general@nasaa.org.
NASAA PROJECT GROUP ON DAY TRADING
Members of Project Group
Chairman of Project Group
David E. Shellenberger, Esq.
Chief of Licensing Massachusetts
Securities Division
Jay Cassidy
Senior Examiner Colorado Division of
Securities
Jerel A. Hopkins, Esq.
Counsel Pennsylvania Securities Commission
Division of Enforcement & Litigation
Joel Sauer
Examination Coordinator Dealer
Registration Division Texas Securities Board
Chairman of NASAA
Broker-Dealer Section
Franklin L. Widmann, Esq.
Chief New Jersey Bureau of Securities
The North American Securities Administrators Association Project Group
on Day Trading Report (“Report”) is the product of the collective
experience of the Project Group members in work related to day trading
firms. This has included reviewing numerous applications for registration,
conducting numerous examinations, and participating in investigations and
enforcement proceedings.
The Project Group gratefully acknowledges the contributions of the
following in the preparation of this Report:
- Officials of the U.S. Securities and Exchange Commission, Federal
Reserve Bank,
U.S. Internal Revenue Service, and National Association of
Securities Dealers for their unofficial consultations regarding
technical issues.
- The respective state officials and Securities Directors of the
Project Group members’ states, for their support of the Project
Group’s work: William Francis Galvin, Secretary of the Commonwealth of
Massachusetts, Matthew J. Nestor, Director,
Massachusetts Division of Securities; M. Michael Cooke, Executive
Director, Colorado Department of Regulatory Agencies, Fred J. Joseph,
Commissioner, Colorado Division of Securities; Robert M. Lam,
Chairman, Pennsylvania Securities Commission, A. Richard Gerber, Esq.
Commissioner, Pennsylvania Securities Commission, John A. Maher,
Commissioner, Pennsylvania Securities Commission Eliott Klein, Chief
Counsel, Pennsylvania Securities Commission; Denise Voigt Crawford,
Securities Commissioner, Texas State Securities Board.
The Board of Directors and corporate staff of NASAA,
especially Marc Beauchamp, Communications Director, for their support of
the Project Group’s work and cooperation with the Group.
Consultant Ronald L. Johnson, for his analysis of
the trading activity in a sampling of day trading accounts; Consultant
Eric Sikowitz, for his compilation of the trading data for the accounts.
Kimiko K. Butcher and Peter Cassidy, attorneys with
the Massachusetts Securities Division, and Kelli O’Donnell, a legal
intern with the Division, for their extensive work in researching and
drafting sections of the Report and their editing the overall
Report; Joseph Sheehan and David Briden, attorneys with the
Division, for their review of drafts and recommendations concerning
content.
The Project Group is solely responsible for the
Report.
PREFACE
This Report is primarily intended to
assist state securities regulators in understanding, and responding to, the
issues posed by the day trading industry. It may also serve as a word of
caution for those who believe that day trading offers a viable career
opportunity, or that frenetic trading is an alternative to prudent,
diversified, long-term investing.
The Report is only one of the undertakings by the
Project Group. The Group has also provided information in response to
frequent media inquiries, commented on rule proposals by the National
Association of Securities Dealers, Inc. (“NASD”), shared information and
ideas with the U.S. Securities and Exchange Commission (“SEC”) and NASD
Regulation, Inc., and provided consultation to many state securities
divisions. In addition, the chairman of the Group moderated a panel
presentation on day trading before the NASAA/Florida broker-dealer training
program in June 1999.
NASAA PROJECT GROUP ON DAY TRADING
REPORT
TABLE OF CONTENTS
Summary………………………………………………………………………….1
I. The Day Trading Industry………………………………………………………....2
A. Definition………………………………………………………………….2
B. Size of Industry and of Customer Base of Firms………………………….2
C. Comparison of NASD versus Philadelphia Stock Exchange Firms……....3
II. Issues Presented by the Day Trading Industry……………………………….……4
A. Introduction……….……………………………………………….………4
B. Misleading and Deceptive marketing…………………..…………………5
- The Reality: Day Trading is Speculative, and Unprofitable for Most
People……………………………………..5
The Problem: Misleading and Deceptive Marketing……………10
Legal Framework…………………………....……………...……14
C. Violation of Suitability Requirements…………………………………...15
- The Suitability Doctrine………………………………………….15
Application to the Day Trading Industry………………………...15
Violations……………...…………………………………………16
Legal Framework………………………………………………...18
D. Encouragement of Activity by Unregistered Investment
Advisers……...22
- The Phenomenon………………………………………………...22
Legal Framework………………………………………………...24
E. Promotion of Lending Arrangements………..……………………….….25
- The Phenomenon………………………………………………...25
Legal Framework Concerning Promotion and Arrangement of Lending Among
Customers………………….…26
Legal Framework Concerning Brokers Lending to Customers….30
F. Abuse of Discretionary Accounts………………………………………..31
- The Phenomenon………………………………………………...31
Legal Framework………………………………………………...31
G. Failure to Maintain Proper Books and Records………………………….33
- Introduction………………………………………………………33
Transactional Records……………………………………………33
Client Account Documentation………………………………..…37
Compliance Records…………………………………………..…38
Financial Records………………………………………………...40
H. Failure to Supervise……………………………………………………...40
- The Phenomenon…………………………………….………..…40
Legal Framework………………………………………………...40
III. Summary of Cases Brought to Date……………………………………………...41
A. Case Brought by Indiana…………………………………………………41
B. Cases Brought by Massachusetts………………………………………...41
C. Cases Brought by Texas..…..…………………………….…………....…43
D. Case Brought by Wisconsin…….…………………………………….….44
E. Case Brought by the SEC………………….……..……………………...44
F. Cases Brought by the NASD…..………………………………………...44
- IV.
- Analysis of Customers’ Day Trading Accounts…………………………………44
- V.
- Recommendations……………………………………………………………..…45
A. New Rules………………………………………………………………..45
- Promotion of Suitability and Disclosure of Risks………….…….45
Explicit Prohibition of the Lending
Arrangements………………46
B. Enhanced Regulatory Focus……………………………………………..46
Appendix
Summary
Technological advances, particularly in the
past few years, have made it possible for the average person to effect
transactions in their own brokerage accounts. Day traders are retail
customers of brokerage firms who attempt to make profits intra-day on small
changes in the prices of stocks. Day trading firms market this type of
trading and derive their revenue from the commissions generated.
Day trading firms have high overhead and other costs. In
addition, their customers have a high failure rate, leading to a high
dropout rate. These factors have led firms to need a continuous inflow of
new customers with trading capital.
The need for customers to provide infusions of capital
has pressured some firms to skirt existing rules and regulations in order to
attract and maintain customer accounts. Some of the abuses and problems that
the Project Group has observed include:
- Deceptive marketing, including inadequate risk
disclosure
Violation of suitability requirements
Questionable loan arrangements, including promotion of
loans among firms’ customers and loans to customers by brokers
Abuse of discretionary accounts where brokers have day
traded customers’ accounts
Encouragement of unregistered investment adviser
activity through the customers trading the funds of third parties.
Failure to maintain proper books and records
Failure to supervise
Recent enforcement actions brought by state securities
regulators against day trading firms have alleged violations related to
these abuses and problems. In addition, the NASD has responded by approving
proposed special rules for suitability and risk disclosure.
The Report describes and analyses the major
problems and abuses observed with respect to the day trading industry and
summarizes the enforcement actions brought to date.
The NASAA Project Group retained two consultants to,
respectively, 1) tabulate data, and 2) analyze activity in a sampling of
customer day trading accounts. The conclusions are consistent with
regulators’ warnings that most customers will lose money day trading.
The analyst concluded that, based on the study of
accounts, “70% of public traders will not only lose, but will almost
certainly lose everything they invest.” He also concluded that only 11.5% of
the accounts reviewed evidenced the ability to conduct profitable short-term
trading.
The Report supports the NASD’s new rules. It also
recommends the explicit prohibition of the questionable lending
arrangements. The Report also calls for enhanced regulatory
attention, including more enforcement actions.
I. The Day Trading Industry
A. Definition
Day
trading firms differ from traditional brokerage firms in that they provide
the means for customers to trade their own accounts, and promote and
facilitate a particular type of trading. They also furnish customers with
information on order flow and provide electronic execution of orders.
Customers may trade through equipment at firms’ offices or from their own
computers that are equipped with the firms’ special software.
The firms’ customers, the day traders, attempt to make
profits on small changes in the prices of stocks. They are known as day
traders because they make intra-day trades, i.e., they are taught to close
out positions by the end of each day.
Traditional brokerage firms, by contrast, have focused
on making recommendations to customers, processing orders from customers,
and handling accounts on a discretionary basis. Traditional firms have
some customers who trade; however, the level of activity in these
customers’ accounts is considerably less than the trading that takes place
at day trading firms.
Day trading firms differ not only from traditional
brokerage firms, but also from traditional discount brokerage firms.
Discount brokers tend to passively accept orders from customers, eschewing
the making of recommendations. In contrast, day trading firms promote day
trading as a strategy, or a program of investment. They also often market
courses in trading to their prospective brokerage customers; the courses
include recommendations of trading strategies. In addition, firms commonly
offer the services of trainers or coaches.
On-line brokerage firms are sometimes confused with day
trading firms. On-line brokerage firms simply offer a tool, i.e., services
for the placement of orders through the Internet
B. Size of
Industry and of Customer Base of Firms
The Appendix to this Report
includes a chart developed by the Project Group that lists firms that are
believed to offer, as at least one of their services, day trading
services. The chart includes those registered with the NASD and those
registered with the Philadelphia Stock Exchange. The chart identifies a
total of 62 firms that are currently active, with a total of 287 branch
offices. It is common in the day trading industry for offices to have only
one registered agent, so the number of agents employed with each firm is
fewer than might be expected.
The Project Group is not aware of any assessment by
regulators or other third parties of the number of customers of day
trading firms. Stories in the media have cited figures provided by an
industry trade group, the Electronic Traders Association, or ETA. The ETA
estimates “4,000
5,000 people trade full-time through day trading
brokerages, making 150,000-200,000 trades a day.” 1
The transactions of these day traders “represent nearly 15% of daily
Nasdaq volume.”2
C. Comparison of NASD versus Philadelphia
Stock Exchange Firms
As reflected by the chart in the Appendix,
the majority of day trading firms are registered with the NASD. These
firms have customers, whom they often refer to as traders. The firms are
subject to the rules of the NASD and the states where they do business.
Day trading firms registered with the Philadelphia
Stock Exchange (“PHLX”) typically disclaim having “customers.” Instead,
they register their traders with the PHLX as agents of the firm. These
“agents” trade the firm’s own capital on a highly leveraged basis through
the firm’s margin privileges. Some firms issue interests in their firms to
their traders; often these interests are in the form of company shares.
The firms typically require the traders to place a
substantial security deposit or to make other arrangements to cover losses
incurred by the individual traders. This means that the traders, even
though they trade with the firm’s capital, are themselves exposed to
losses.
The PHLX-member day trading firms, as noted above,
disclaim having customers, thereby avoiding NASD registration. This
arrangement purportedly negates investor suitability considerations. It
also permits these firms to provide their traders much higher leverage
than do the NASD member firms, since the firms’ capital is traded. This
means that the firms may not have experienced the problems associated with
customer-to-customer lending arrangements. The lending arrangements of
some NASD member firms are discussed below.
Some day trading firms registered with the NASD, we
believe, have allowed customers to trade beyond their means, and these
customers often have been unable to meet their margin calls. Many firms
have responded by promoting and arranging loans among customers. Since the
PHLX member firms provide greater leverage to their traders, the traders
are able to trade larger volumes with less capital, reducing any pressure
for the firms to arrange loans.
Nevertheless, PHLX-member firms may still engage in the
types of problematic conduct discussed in this Report, and they
require further scrutiny by regulators. Examinations of the firms suggest
that some may suffer from the same problems of casual supervision as do
the firms regulators have examined that are registered with the NASD.
Finally, the traders/agents should be aware that they might not get the
benefit of SIPC insurance.
Until states took action, some PHLX-member firms
claimed that they did not have to register with state regulators. Colorado
required Bright Trading, Inc. and Generic Trading Associates, LLC to
register with the Securities Commissioner. In re Bright Trading, Inc.
(Co. Sec. Div., Aug. 28, 1998); In re Generic Trading of
Philadelphia, LLC (Co. Sec. Div., May 27, 1998). Massachusetts has
brought a proceeding against one such firm for failing to register with
the
1
Randy Whitestone and Phil Serafino, Day Traders’ Invasion,
BLOOMBERG, May 1999, at 36, 39.
2
Britt Tunick, Day Traders Working Hard to Influence How the Profession
is to be Defined, SEC. WEEK, May 24,
1999.
state. In re Bright Trading, Inc., et al. (Ma. Sec. Div. 98-70,
Nov. 9, 1998) [hereinafter Bright Complaint].
Pennsylvania declined to issue a no action letter
concerning the proposed activities of one firm. Pennsylvania’s response
discusses the possibility that the firm’s traders could be treated as
customers for regulatory purposes, and also comments on the firm’s
proposed securities offering, i.e., the issuance of interests in a limited
liability company to traders. Lieber & Weissman Securities, LLC, (Pa.
Sec. Comm. No-Action Letter, Mar. 6, 1998). (Copies of the request for the
no action letter and Pennsylvania’s response are included in the Appendix.)
Most of the problems discussed in
this Report have been observed at firms registered with the NASD.
The Report generally focuses on NASD-member firms, except as noted,
but many of the issues are also applicable to PHLX-member firms.
II. Issues
Presented by the Day Trading Industry
A. Introduction
Problems in the day trading industry
appear to be widespread. Two factors underlie the problems discussed in
this Report.
The first factor is the failure to follow basic
compliance requirements. Firms have engaged in practices that would be
clearly unacceptable if conducted by traditional brokerage firms. The
officers and managers of many firms have little or no experience in the
brokerage industry. As a result, many day trading firms are operated by
people with little knowledge of or respect for the regulations or
standards of the securities industry.
The second factor is that firms require a continuous
inflow of customers and their trading capital. Most customers lose money,
leading to high customer turnover. In addition, firms’ apparently have
high overhead and high expenditures for each customer who trades. This has
led firms to take questionable measures to draw new capital, including
using misleading and deceptive marketing, pushing day trading without
regard for suitability considerations, and allegedly encouraging trading
by unregistered investment advisers.
Furthermore, this need for customers has caused firms
to attempt to cling to their existing customers, even those who cannot
meet margin calls. Firms have retained these customers by operating
questionable lending schemes and allegedly participating in the creation
of fictitious accounts.
Each of the following sections describes the problems
that have been observed, and includes a presentation of the applicable
law. The Report includes discussion of SEC and NASD rules because
violations of these rules may constitute a violation of state laws or
regulations.
B. Misleading and Deceptive Marketing
1. The Reality: Day Trading is Speculative, and
Unprofitable for Most People
Trading refers to purchasing and selling
securities on a short-term basis, with the intention of achieving quick
profits. Trading is, by definition, a form of speculating, as
distinguished from investing. Day trading is simply trading on an
extremely short-term basis, and is thus particularly speculative.
Analogy to Gambling
Common sense suggests that day traders will lose money.
As Philip Feigin, formerly Securities Commissioner of Colorado and now
Executive Director of NASAA, observed last fall, day trading is virtually
a form of gambling. This means that most traders at a firm will incur net
losses, while the brokerage firm, the “house,” reaps profits through
commission revenue.
Chairman Arthur Levitt of the SEC has stated that, in
his opinion, day trading is not just speculation, but amounts to gambling.
He has noted that speculation requires market knowledge and that
short-term trading has historically been the domain of professional
traders. 3
Day trading is
analogous to guessing the outcome of a coin toss. Just as a coin may land
heads or tails, a stock may go up or down during the day. However, the
odds with day trading stocks are actually worse than this, akin to
guessing the results of tossing a coin that sometimes lands on its edge. A
stock’s price has three possible outcomes, since the stock may
remain static. In addition, the day trader has to pay commissions for the
privilege of making his guesses.
Analogy to Retail Futures Trading
Day trading is also analogous to futures trading. Both
types of speculation entail leverage, and both, by definition, are forms
of trading rather than investing.
The lessons from the world of retail futures trading
are instructive. Futures trading by retail customers is unsuccessful. Even
industry leaders have acknowledged that 80 to 90 percent of individual
customers lose money at their firms. 4
Speculators versus
Long-Term Investors
By contrast to traders, the investors and money
managers who have been hugely successful, and who have served as
legitimate inspiration for individual investors, are those who have
invested long-term. Kenneth L. Fisher, in a 1985 article in Forbes,
noted:
3
No Day Trading
Rules Planned, WORLD SEC. LAW REP. (BNA) May 1999, at 13.
4
Scott McMurray, Burned Alive, WORTH, Apr. 1994, at 68, 70.
If you could
make good money with short-term approaches, there
would be lots of visible folks who had done so. Where are those
who have made fortunes as short-term traders?
….
Take a look at John Train’s book The Money Masters.
One thing
you will see in common among the big successes – however their
style may vary – is that they bought stocks to hold for several years
or longer. Warren Buffet, John Templeton, Ben Graham [etc.] –
they bought long term. 5
Analogy to Market
Timing
Day trading is analogous, on a microscopic level, to market timing.
Market timing refers to when investors attempt to determine when the stock
market is at highs and lows. Market timers attempt to sell at the
perceived peak of the market, stay in cash, and then buy at the perceived
bottom of the market.
As noted by the Vanguard Group, Inc. (“Vanguard”), “The problem is that
few investors, if any, can accurately foresee the direction of the stock
or bond markets.” 6
A study cited by Vanguard, entitled “Stock Market Extremes and Portfolio
Performance,” was conducted by Professor H. Nejat Seyhun of the University
of Michigan in 1994. Seyhun concluded, “The financial results of perfect
timing are indeed attractive. Yet they are virtually unreachable.”
7
Similarly, few speculators can
correctly determine the short-term movements of individual stocks.
The Inherent Flaws of Day Trading
Day trading is more speculative than longer-term stock trading for two
reasons. First, price changes on a given day are usually small. This means
that any profits the trader takes will, on average, be small.
Professional traders succeed by quickly cutting their losses and
letting their profits run. If day traders close all positions intra-day,
they cut their losses but forego the running of profits. In reality,
retail customers, including day traders, tend to take profits too quickly
and let their losses
8
run.
Also costs, i.e., commissions and bid-ask spreads, will tend to devour
profits. Since day trading entails high turnover, the return necessary for
a trader just to break even is high.
5
Kenneth L. Fisher, Where are They Hiding? Winners at Short-Term Trading,
FORBES, Aug. 26, 1985, at 162.
6
The Danger of Market Timing, The
Vanguard Group, (visited July 16, 1999)
<http://www.vanguard.com/educ/module4/m4_8_0.html>.
7
H. Nejat Seyhun, Towneley Market Timing Study, (1994) (Study,
School of Business Administration, University of
Michigan) (available at <http://www.towneley.com/html/study.htm>).
8
Jeffrey Heisler, Loss Aversion Among Small Speculators in a Futures
Market, (1998) (Study, Boston University),
at 1.
The commissions
charged by day trading firms vary. All-Tech Investment Group, Inc. (“All-Tech”)
charges its customers a standard commission of $25 for every purchase or
sale transaction. 9
The average commission per trade charged by on-line brokerage firms is
about $15.10
The Paradox of the
Existence of the Day Trading Industry
The very existence of an industry devoted to offering day trading of
stocks is paradoxical. For those who wish to speculate, futures and
options provide much greater leverage than stocks purchased or sold short
on margin, allowing bets to be made on small movements. Futures and
options also provide the ability to speculate on the direction of the
market, rather than on the price of individual stocks. In short, futures
and options may be more effective speculative trading vehicles than
stocks.
Perhaps day traders are aware that retail customers usually lose money
trading futures and options, so they wish to trade a seemingly safer
vehicle. This usually results in the slower loss of capital, but in loss
nonetheless. It can also result in day traders compensating for the lack
of leverage by trading beyond their means, and trading with funds borrowed
from other customers and other sources.
Academic Studies of Trading in General
Academic research is consistent with the common sense expectation that
day traders generally will lose money. First, consider the findings of
Professors Brad M. Barber and Terrance Odean of the Graduate School of
Management, University of California, Davis, in what they describe as “the
first comprehensive study of the aggregate common stock performance of
individual investors who manage their own equity investments without the
advice of a full-service broker.” 11
Based on the records of activity of customers of a discount brokerage firm
over a six-year period ending January 1997, they determined that
“individual investors who hold common stocks directly pay a tremendous
performance penalty for active trading.”12
The authors found that “those investors
who trade most actively realize, on average, the lowest net returns.”13
They concluded, “Our central message is that trading is hazardous to your
wealth.”14
The authors believe the counterproductive level of trading they found “can
be at least partially explained by a simple behavioral bias: People are
overconfident; overconfidence leads to too much trading.”15
9 All-Tech Investment Group
Online, Costs of Quotes and Execution System (visited May 10, 1999)
<http://www.attain.com/costs.html>.
10
The Real Virtual Business,
ECONOMIST , May 8, 1999, at 71.
11
Brad M. Barber and Terrance Odean, Trading is Hazardous to Your Wealth:
The Common Stock Investment
Performance of Individual Investors (Apr., 1999) (Study, Graduate
School of Management, University of California
at Davis), (J. FIN. forthcoming).
12
Id. abstract.
13
Id. at 22.
14
Id. abstract.
15
Id at 28.
The Barber and Odean study, through its design, ignored intra-month trades,
thus excluding the very short term trading that characterizes day trading.
The most active traders in the study had a positive annual return on
average, but they substantially underperformed the market (11.4% vs.
17.9%).16
The study’s finding of the inverse correlation between trading and return
is consistent with the expectation that day traders will experience a
negative return.
Professor Odean’s prior study of a set of earlier data
from discount brokerage accounts also found that excessive trading leads
to losses. 17
He found that “on average, the securities [investors] purchase actually
underperform those they sell.”18
Professor Odean concluded:
[I]nvestors’ overconfidence in the precision of their
information may contribute to this finding, but it is not sufficient to
explain it. These investors must be systematically misinterpreting
information available to them.
19
In this study,
Professor Odean explains the model of overconfident traders, based on his
own prior work and that of other researchers:
An investor who receives a signal of low precision but
believes it to be of high precision will profit, on average, less than she
expects. If the precision of her signal is actually zero, that is, if she
has no information but believes she has some, she will on average have
zero profit. In a market with trading costs the profits overconfident
traders earn from speculative trading may not be enough to offset trading
costs. (emphasis added). 20
The model of
overconfident traders discussed above correlates well with what common
sense tells us about day trading. Day traders are taught to believe they
can interpret stock price changes and predict short term price changes.
The “precision of the signal” is likely to be zero, and trading costs are
likely to absorb any profits.
The facts developed to date are consistent with the
theoretical observations above. As alleged in Massachusetts’ Complaint
against Block Trading, Inc., (“Block”) the former branch manager of the
firm’s Boston office testified in an on-the-record interview that, of 68
accounts in the office, 67 lost money. In re Block Trading, Inc., et
al. (Ma. Sec. Div. 98-58, Oct. 19, 1998) [hereinafter Block
Complaint]. The allegations in the Block Complaint even raised a
question as to the legitimacy of the profits in the sole account that was
claimed to be profitable. The customer who held this account was allegedly
an unregistered investment adviser who was in a position to allocate
trades, and thus profits and losses, among his own account and the
accounts of other customers.
16
Id. at 2.
17
Terrance Odean, Do Investors Trade Too Much? (Apr., 1993) (Study,
Graduate School of Management,
University of California at Davis), (AM. ECONOMIC REV. forthcoming).
18
Id. abstract.
19
Id. at 3.
20
Id. at 2.
The branch manager of the Watertown, Massachusetts office of All-Tech
testified in an on-therecord interview that an employee of the firm’s
margin department asked him rhetorically in or about August of 1998, “Why
would you even want to be in this business? You know all these people lose
money-” Finally, the manager testified that, in a meeting held by about
twelve All-Tech managers from around the country, the managers discussed,
among other things, that, “most people [lose] money.”
Harvey Houtkin, the principal of All-Tech, himself has
implied that the vast majority of day traders lose money. Houtkin was
quoted as follows in an article in the February issue of Securities
Regulation and Law Report :
Day Trading is a business like any other. It’s not wild
speculation.
And, like other businesses, 95 percent will fail in
the first two
years. (emphasis added). 21
Day Trading
Industry’s Failure to Meet its Burden of Proving its Claims
As discussed below, some day trading firms have
marketed to prospective customers through general and specific claims of
customer success. Indeed, the existence of the day trading industry is
apparently based on a belief that day trading can be an easy route to
profits. The day trading industry has the burden of proof to show that its
implicit and explicit claims are true.
The day trading industry has failed to meet this burden.
As discussed below in the section on deceptive marketing, the day trading
industry has demonstrated a pattern of making claims that it is unable to
support in response to regulators’ inquiries.
An example of this phenomenon occurred in connection
with the Project Group’s work on this Report. The Project Group
wrote the Electronic Traders Association (“ETA”), a trade organization of
the day trading industry, on February 26, 1999. The Project Group invited
the ETA “to provide copies of any reports by [the] organization or its
members regarding the profitability of day trading by customers.”
The ETA’s counsel responded by letter dated March 19,
1999 (See Appendix):
[I] am unaware of any ETA report of this nature,
although I understand that certain ETA members have informally surveyed
part of their operations to provide a rough estimate of such profitability.
While such information is probably sound, I doubt if the information
prepared to date is all that useful since it is so narrow.
By letter dated March 25, 1999, the Project Group wrote
the ETA’s counsel:
21
Much Ado About
Day Trading; Are Existing Regulations Adequate?, SEC. REG. AND LAW REP.,
(BNA), Feb.12, 1999, at 215.
As you know, Momentum Securities recently issued a press release
concerning its purported analysis of the profitability of its customers’
accounts. It would be helpful for the Project Group to have copies of all
documents related to the study, including design documents and work papers.
The ETA has yet to respond to the Project Group’s
request for copies of the documents that would have allowed a review of
the claims made by Momentum Securities Management Company (“Momentum
Securities”).
The subject press release was issued by Momentum
Securities on January 28, 1999. According to press coverage in the Los
Angeles Times, the “study” by Momentum Securities found that 58% of
its customers included in the review lost money in their first three
months of trading, and that, after three to five months, presumably of
those that remained, 65% were making money and 35% losing.
22
James H. Lee, the president of Momentum Securities, as well as the
president of the ETA, is cited as stating that “the success rate is strong
for those who stick with day trading.”23
In addition, the
article quotes the study’s assertion that “there is an extremely high
correlation between high profitability [for traders] and high trading
volume.”24
The latter claim, whether or not it is true, would certainly promote the
day trading industry’s interest, since higher trading volume correlates
with higher commission revenue for firms. However, the day trading
industry has either failed to conduct or to release the analyses
supporting this claim.
The analysis conducted by the Project Group was
resource-intensive, since the project required obtaining records, checking
them for completeness, copying statements for an independent consultant,
and having the consultant input thousands of entries from voluminous
statements.
By contrast, the day trading industry could simply
download the electronic records maintained by its member firms’ clearing
day trading brokers, and have them analyzed. Yet it chooses not to have
the analyses made, or not to release the findings.
2. The
Problem: Misleading and Deceptive Marketing
Marketing by elements of the day trading
industry has misleading and sometimes deceptive. The problems have
included:
- Implicit and explicit representations that customers
are likely to achieve profits;
Implicit and explicit representations that day
trading can be a career opportunity for many people; and
Claims of specific success rates.
22
Walter Hamilton, ‘Day-Trading’ Study Finds Split Results, LOS
ANGELES TIMES, Jan. 29, 1999, at C1.
23
Id.
24
Id.
Four of the six administrative proceedings concerning day trading brought
by the Massachusetts Securities Division (the “Division”) have alleged the
use of deceptive marketing. The Block Complaint alleged the following:
- The firm used a brochure for prospective investors
that described Block’s commitment to “educating others to the unlimited
earning potential of day trading.”
The brochure stated that the firm’s principals “help
their customers profit from fluctuations in the NASDAQ market.”
- The firm’s web site referred to Block’s “giving
individuals the ability to maximize their investment potential.”
25
The Massachusetts Complaint against,
In re All-Tech Investment Group, Inc., et al. (Ma. Sec. Div.
98-77, Dec. 10, 1998) [hereinafter All-Tech Complaint] alleged
the following:
The firm’s web site and marketing brochure quoted
the firm’s principal, Harvey I. Houtkin, stating, “You’ve probably read
about the many successes utilizing my trading techniques” and that “some
people claim I have found the key to financial independence.”26
All-Tech’s Branch Office Manual included
a section providing guidance to branch managers in overcoming the
objection of prospective customers. The manual stated that managers
should respond to the inquiry, “What is your success ratio?” with the
following: “Those who follow the program do exceptionally well.”
In an interview with CNBC broadcast on October 23,
1998, in a segment on day trading, Houtkin asked rhetorically, “But how
about the thousands of people who love what they’re doing, who are
making money, changing their lifestyles, and having the time of their
life?”
In response to Houtkin’s remark, the Division requested
documents from All-Tech relating to all accounts maintained by the firm
that had been profitable during the calendar year to date. The firm stated
that it did not keep records concerning the profits and losses incurred by
its customers, and that it did not know what percentage of its customers
have profitable accounts. The response also claimed that Houtkin’s remark
referred to “day trading as a whole, not just retail customer electronic
day trading” and included “market making … of firms.”
The Massachusetts Complaint against On-Line Investment
Services, Inc. (“On-Line”), In re On-Line Investment Services, Inc. et
al. (Ma. Sec. Div. 99-1, Jan. 14, 1999) [hereinafter On-line
Complaint] alleged the following:
• The firm’s web site included, under the heading
“Press Releases,” the assertion: “We have a success rate of around 85%
with customer traders, meaning people who come here and actually make
money doing this over time.” 27
25 The Block Trading web
site is no longer operational.
26
All-Tech Investment Group Online <http://www.attain.com>; cited
information no longer found on web site.
27
On-line Investment Services, Inc. <http://www.onli.com>; cited information
no longer found on web site.
The Licensing Section requested “copies of records substantiating the
claim [of] a success rate of 85% with customer traders.” The firm
responded that its “web site makes no such claim.”
The firm further stated that the document it had
labeled a press release was actually a news article. It also advised that
it had deleted the article from its web site to alleviate the
“Commonwealth’s apparent concern.”
• On-Line’s web site also included, again under the
heading “Press Releases,” a release with the title, “Major Day Trading
Firm Opens 6 New Offices.”
This release asserted, “On-Line’s Training and
Mentoring Programs boast an 85 percent success rate for new traders,
unusually high for an industry in which some analysts claim there is a 90
percent failure rate.”
On-Line deleted this page from its web site, too, at
the same time it deleted the other page.
The Massachusetts proceeding against TCI Corporation (“TCI”)
concerned an entity that offered a purported two-day course in day trading,
at a cost of $6,000. In re TCI Corporation, Inc., et al. (Ma. Sec.
Div. 99-9, Mar. 2, 1999) [hereinafter TCI Complaint]. This case is
thus different from the other Massachusetts cases, which involved
broker-dealers. The TCI Complaint cited the following regarding the firm’s
alleged deceptive marketing:
- Newspaper advertisements claimed “pinpoint accuracy”
and “6 to 7 figure income per year.”
The firm’s web site claimed that TCI offered the
“absolutely best trading system in the financial market.”28
The web site also claimed returns of
“12% per trading day minus slippage and commission,” and a “profit to
loss ratio [of] better than 12 to 1.”
The Division issued a cease and desist order against
TCI on an ex parte basis. At the hearing on whether the order
should be made permanent, the Respondents claimed that the advertised
returns were based on the buy and sell signals they posted on the
Internet. The Respondents admitted, however, that TCI posts its purported
buy and sell signals the week following market activity. The Licensing
Section argued that this post facto recording of market signals is
analogous to predicting the prior week’s weather.
Additional Examples of Problematic Marketing
All-Tech’s web site also includes material, in addition
to that cited in the All-Tech Complaint that encourages prospects to make
a career of day trading. Under the heading, “Who becomes an Electronic Day
Trader?”, All-Tech states that it hopes day trading will “become a
mainstream career choice” and goes on as follows:
28
TCI Corporation <http://www.tcicorp.net>; cited information no longer
found on web site.
Electronic Day
Trading attracts people dead-ended or unhappy in their current field of
endeavor and people with a desire to make trading their life’s work.
Electronic Day Trading appeals to executives, victims of downsizing or
lay-off, retirees, graduating college students and
anyone who recognizes the
unlimited earnings potential and quality of life which an Electronic Day
Trader may achieve.
Trading allows people to work a 61/2-hour
trading day, to take vacations on demand and to leave for the day on a
whim.29
(emphasis added).
This solicitation of unhappy employees, laid-off workers, retirees, and
recent college graduates clashes with the fact that day trading is risky
and most day traders fail to make money.
All-Tech has also claimed, through an interview of Houtkin on CNBC,
that the firm’s customers have a “success rate” of “four out of ten.” This
clashes with Houtkin’s implication, cited in the section above, that 95%
of customers will fail.
As discussed in the prior section, Momentum Securities advised the
media on January 28, 1999 of the alleged results of its study of customer
profitability. Shortly thereafter, in an article published January 31,
1999, a spokesman for the firm was reported as stating that “over the
course of a year, between 66 percent and 70 percent of the firm’s
customers are profitable – some in the high six-figures.” 30
This statement is at best misleading,
since it fails to disclose that, even according to the firm’s own
purported findings discussed above, the majority of customers lost money
during the first three months of trading. Further, the claim that some
customers are making profits in the “high six-figures” is meaningless
unless there is disclosure of the amount of capital traded and the period
of time during which the profits allegedly were achieved.
As noted above, James Lee, the president of Momentum Securities and
president of the Electronic Traders Association, continues to claim that
most day traders are profitable. A comment by Lee was cited in an article
in the Wall Street Letter concerning the Project Group’s work on
this Report: “[E]TA statistics show most transactions placed by day
traders are profitable.” 31
However, as noted above, the ETA failed to provide the Project Group with
any documents or information concerning any statistics to support those
claims.
29
All-Tech Investment Group Online, Frequently Asked Questions (visited
July 26, 1999)
<http://www.attain.com/faq.html>.
30
Earl Golz, Daring Day Traders Try to Make a Fortune in the Fast-Moving
World of Stocks, AUSTIN AM.-
STATESMAN, Jan. 31, 1999, at H1.
31
ETA Pooh-Poohs NASAA’s Day Trading
Study, WALL ST. LETTER, May 10, 1999, at 2.
3. Legal Framework
Deceptive marketing by a brokerage firm
may violate state and federal securities law and NASD rules. Generally,
the violation of a federal securities law, an SEC antifraud rule, or an
NASD conduct rule also constitutes a violation of state securities law.
Securities Act of 1933
Section 17(a) of the Securities Act of 1933 is a
general antifraud provision. It prohibits securities brokers from making
material misstatements or omissions or engaging in any “transaction,
practice, or course of business which operates or would operate as a fraud
or deceit upon the purchaser” in the purchase or sale of securities.
Securities Exchange Act of 1934
Section 10(b) of the Securities Exchange Act of 1934
prohibits the use of “any manipulative or deceptive device or contrivance”
in connection with the purchase or sale of securities.
SEC Rule 10b-5 is a broad antifraud rule applicable to
the purchase or sale of any security. It prohibits schemes to defraud,
material misstatements and omissions, and engaging in “any act, practice,
or course of business which operates … as a fraud or deceit.”
State Uniform Securities Act of 1956
Section 101 of the Uniform Securities Act is virtually
identical to SEC Rule 10b-5. It constitutes a broad antifraud prohibition.
The Act also includes a general prohibition of
misconduct. Under Section 204(a)(2)(G), the administrator may “by order
deny, suspend, or revoke” the registration of a broker-dealer, principal,
or other registrant if he finds that “the order is in the public interest”
and the registrant (or, in the case of a broker-dealer, an officer or
controlling person) “has engaged in dishonest or unethical practices in
the securities business.”
NASD Conduct Rules
Rule 2110 mandates that members “observe high standards
of commercial honor and just and equitable principles of trade.”
Rule 2120 states, “No member shall effect any
transaction in, or induce the purchase or sale of, any security by means
of any manipulative, deceptive or other fraudulent device or contrivance.”
NASD IM-2310-2 (Interpretive Material) sets forth the
NASD’s “requirement to deal fairly with the public.” The NASD prohibits
fraudulent activity, including violations of SEC antifraud rules.
Rule 2210(d) provides standards for “Communications with the Public.”
The standards require that communications be “based on principles of fair
dealing and good faith.” The rule also prohibits “exaggerated, unwarranted
or misleading statements or claims.” It is applicable not only to
advertisements, sales literature, and correspondence, but also to public
appearances, including radio and television interviews.
Application to the Day Trading Industry
Deceptive marketing by day trading firms falls within the antifraud
provisions of the securities laws. As discussed in the introductory
material, 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. Firms’ deceptive
marketing may constitute securities fraud under federal and state law and
NASD rules. It may also constitute a “dishonest or unethical practice”
under the State Uniform Securities Act or a violation of the NASD’S
general requirements of fair dealing.
Deceptive marketing of trading programs constitutes securities fraud.
For instance, in the case of In re Thomas J. Furnari, the SEC found
that a broker knew that a type of collateralized options writing program
was problematic and that he “had been specifically warned … not to set it
up for his customers.” In re Thomas J. Furnari, Release No.
34-21046, Fed. Sec. L. Rep. (CCH) ¶83,644 (June 14, 1984). Nevertheless,
he set up a similar options program and induced customers to enlist in the
program by “misrepresent[ing] to [them] … the anticipated rate of return,
his success with other accounts in the program, and the risks inherent in
the program’s trading strategy.” The SEC found that the broker’s
assertions that his customers were sophisticated investors and understood
the speculative nature of options trading did not diminish his
responsibility for making misrepresentations. The SEC held that the broker
violated section 17(a) of the Securities Act, Section 10(b) of the
Exchange Act, and Rule 10b-5.
C.
Violation of Suitability Requirements
1. The Suitability Doctrine
The suitability doctrine requires
brokerage firms to recommend only investments that are appropriate for a
customer. Failure to comply with this obligation violates NASD Rule 2310
and violates state and federal law.
2. Application to the Day
Trading Industry
The Project Group’s view on the
applicability of suitability rules to day trading is included in its May
28, 1999 comment letter in response to NASD’s proposed rules released in
Special NASD Notice to Members 99-32 (NASD Regulation Requests Comment on
Proposed Day-Trading Accounts, Apr. 1999), (see copy of comment letter and
NASD Notice in Appendix):
We believe that NASDR’s existing rules and policies concerning
suitability and risk disclosure already create obligations concerning the
day trading industry. Further, we believe that practices of some firms in
the day trading industry have violated these existing rules and policies.
Nonetheless, we support the issuance of the proposed rules, which
explicitly specify the industry’s obligations…
On July 29, 1999, the NASD Board of Governors approved
new suitability and disclosure rules concerning day trading. The new rules
will not become effective until approved by the SEC after public comment.
3. Violations
We believe that some day trading firms
have not adhered to suitability requirements. Day trading firms sometimes
do not follow their own stated policies concerning minimum account.
Misrepresentation of Information on Customers on New
Account Forms
In addition, regulators have found that branch managers
sometimes misrepresent information on new account forms, including such
crucial factors as customers’ income, net worth, and investment experience.
For instance, in Massachusetts’ proceeding against Landmark Securities (“Landmark”),
the Complaint alleged that the manager had opened accounts for customers
for whom day trading was unsuitable. In re Landmark Securities, Inc.,
et al. (Ma. Sec. Div. 99-29, July 8, 1999) [hereinafter Landmark
Complaint]. The manager allegedly misrepresented information on the
new account form for one such customer as follows:
Income: Misrepresented as $25,000 -- Actual figure of
$15,000;
Net worth: Misrepresented as $50,000+ -- Actual figure
of
$10,000-$15,000; and
Previous investment experience: Checked “yes” --Actual
experience: none.
Promotion of Excessive Activity
Because of the high cost of equipment, software, and
trading service subscriptions, day trading firms spend thousands of
dollars per customer. James H. Lee, president of Momentum Securities and
President of the ETA, cited above, estimates that an online brokerage firm
spends $250 per new customer, while an “on-site day-trading firm may spend
$30,000 on each new customer, counting the outlay on equipment, office
space and training.” 32
Based on their overhead
and monthly expenses, day trading firms need to have their customers
execute large numbers of trades per day. Project Group members have
received complaints from day trading customers alleging that day trading
firms explicitly and implicitly encourage their customers to pursue only
the highest volume trading strategies.
Effect of Unregistered Trading for Third Parties
As alleged in the All-Tech Complaint, the firm’s Branch
Office Manual, in the section cited above regarding overcoming prospective
customers’ objections, recommends responding to the objection, “not enough
capital,” with the following:
32
Diana B. Henriques, In Day Trading, Less Thrill and More Chill,
N.Y. TIMES, July 18, 1999.
Have you considered getting either an investor or partner? If client is
interested, answer questions, but do not volunteer to assist in finding
one for them, stay in contact and follow up periodically to offer
encouragement.
The All-Tech Complaint goes on to conclude,
“Notwithstanding the purported cautionary clause in the above, the purpose
of the sales technique described is to encourage investors who lack
sufficient capital to day trade to raise capital from third parties.”
Firms’ encouragement of customers’ raising capital from
third parties often promotes highly questionable activity by customers who
are not registered as investment advisers, as discussed below. The
practice also potentially violates firms’ obligations concerning
suitability. This is true with respect to not only the immediate customer,
since that customer lacks adequate capital to trade on his own, but also
any “partner” or “investor” whose funds are used in day trading. The
Project Group’s May 28, 1999 comment letter states:
We believe the current NASD suitability rule and
policies require firms to make inquiries as to the source of funds under
certain circumstances. For instance, if a customer reports a net worth of
$20,000, but deposits a check for $100,000, the firm should inquire as to
the source of the funds.
Nonetheless, we believe it is appropriate for the rules
to include an explicit requirement that day trading firms’ suitability
obligations include a determination of the source of funds to be used.
….
In addition, the rules, or commentary issued with the
rules, should make it clear that firms’ suitability obligations are
applicable to all investors whose accounts or funds are traded by a third
party.
Effect of Firms’ Lending Arrangements
As discussed below, day trading firms commonly engage
in lending arrangements. These arrangements generally are highly
questionable and they also raise significant issues of suitability. Day
trading is unsuitable for customers who have insufficient capital to open
an account without borrowing funds. Day trading, we believe, is also
unsuitable for customers who are unable to meet margin calls except by
borrowing funds from other customers. Customers with little or no account
equity, who would therefore not be able to afford to day trade, are
allowed to day trade through the use of firms’ lending arrangements.
The Landmark Complaint included allegations that
Landmark, through the branch manager, had promoted and routinely arranged
loans among its customers, so that trading customers could meet their
margin calls. The Landmark Complaint also included allegations that the
firm and manager had not only opened accounts for customers for whom day
trading was unsuitable, as noted above, but also had maintained
accounts for which the activity was unsuitable:
Landmark and [the manager] knew or should have known
that day trading was unsuitable for these customers in view of the fact
that these customers were unable to meet margin calls with their own funds.
The Project Group’s May 28, 1999 comment letter to the
NASD stated, in connection with the suggested expansion of the proposed
rule on disclosure:
We suggest that the disclosure under “Day trading is
extremely risky” should caution against the use of any borrowed funds, not
just the use of student loans and second mortgages.
…
The disclosure should also include a warning that
parties that trade the account of others … may be required to register
under state or federal law and subject to the laws and regulations
governing investment advisers.
4. Legal
Framework
General: Failure to Meet Obligation of
Suitability as Violation of the Securities Laws
A brokerage firm’s recommendation of unsuitable
securities may be a violation of SEC Rule 10b-5, i.e., federal securities
fraud. The basis for this concept is described as follows:
The deception in a 10b-5 suitability violation may be
supplied on the basis of either one of two theories: (1) that the broker
misrepresented to his customer that the recommended security was suitable
or failed to disclose to the customer that the recommendation was
unsuitable; or (2) that the broker engaged in fraud by his conduct,
because recommending an unsuitable security is inherently deceptive. 33
NASD Rule 2310,
“Recommendations to Customers (Suitability),” provides as follows:
- (a)
- In recommending to a customer the purchase, sale or exchange of any
security, a member shall have reasonable grounds for believing that the
recommendation is suitable for such customer upon the basis of the facts,
if any, disclosed by such customer as to his other security holdings and
as to his financial situation and needs.
- (b)
- Prior to the execution of a transaction recommended to a
noninstitutional customer, other than transactions with customers
33
NORMAN S. POSER,
BROKER-DEALER LAW & REGULATION, § 3.03, 3-82 (Aspen Law & Business, 2d.ed.
1999 Supp.).
where investments are limited to money market mutual funds, a member shall
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)
- such other information used or considered to be reasonable by such
member or registered representative in making recommendations to the
customer.
- (c)
- For purposes of this Rule, the term “non-institutional customer”
shall mean a customer that does not qualify as an institutional account
under Rule 3110(c)(4).
Some states have specific regulations concerning
suitability. In addition, some states have regulations that provide that
violation of NASD Conduct Rules constitutes a dishonest or unethical
practice. Violation of suitability requirements may constitute a dishonest
or unethical practice or securities fraud under state law.
34
Loan Arrangements and
Suitability Violations
As noted above, firms sometimes promote and arrange
loans among customers to meet margin calls and keep accounts open.
Customers’ inability to meet margin calls suggests that they are trading
beyond their means, and that day trading is unsuitable for them.
NASD IM-2310-2, “Fair Dealing with Customers,” includes
the following among types of conduct that violate the requirement of fair
dealing:
(a)(5) Recommending Purchases Beyond Customer
Capability
Recommending the purchase of securities or the
continuing purchase of securities in amounts which are inconsistent with
the reasonable expectation that the customer has the financial ability to
meet such a commitment.
Applicability of the Suitability Doctrine to Day
Trading
As noted above, the Project Group’s comment letter to
the NASD on the NASD’s proposed rules on suitability and disclosure took
the position that the existing rules on suitability apply to day trading.
A firm’s recommendation that a customer engage in day trading, or its
acceptance of a customer’s account, requires the firm to determine that
day trading is suitable for that customer.
34
See JOSEPH C. LONG, BLUE SKY LAW, § 7.07[1][d][ii] (West Group 1998);
JERRY W. MARKHAM AND THOMAS LEE HAZEN, BROKER-DEALER OPERATIONS UNDER
SECURITIES AND COMMODITIES LAW: FINANCIAL RESPONSIBILITIES, CREDIT
REGULATION AND CONSUMER PROTECTION, No. 5, (West Publishing 1999).
Firms market day trading as an investment program, often offering a
course that purports to train customers in successful trading. The
marketing of day trading as an investment program distinguishes day
trading firms from ordinary discount brokers, including on-line brokers.
The brokerage industry has attempted to dismiss the
concept that the day trading industry is subject to suitability
requirements. For instance, the Federal Regulation Committee, Discount
Brokerage Committee, and Ad-hoc Committee on Technology and Regulation of
the Securities Industry Association (the “SIA Committees”), in their June
4, 1999 comment letter to the NASD concerning the NASD’s proposed rules,
Special NASD Notice to Members 99-32, endorsed disclosure of the risks of
day trading but objected to the proposed rule on suitability:
The [SIA] Committees firmly believe that the historical
understanding that a recommendation is a specific
communication
from a broker to a customer at a specific time must be
maintained.
Expanding the scope of the suitability obligation to
cover non
specific recommendations would raise difficult
interpretative
questions about all forms of communication between firm
and
client.
….
Most strategies lack the requisite specificity for
purposes of determining appropriateness for individual customers.
The Project Group believes that the SIA’s position may
be incorrect. Day trading firms market their services in order to attract
prospective day trading customers. These firms should assume that accounts
are opened for the primary purpose of day trading. The firms, by marketing
the concept of day trading, and by approving accounts, implicitly have
recommended to customers that they engage in the highly speculative
strategy of day trading.
This situation is distinguished from that of
traditional discount brokerage firms. Such firms do not market trading,
day trading, or long-term investing, but instead only offer a ministerial
service to customers.
As discussed above, day trading is inherently
speculative, since the customer must speculate (or guess) on short-term
price changes of stocks. This means that firms that approve day trading
accounts determine that their customers have the sophistication to day
trade and the financial means allowing them to risk the loss of not only
the amount of their “investment,” but, as discussed below, even greater
amounts.
A day trading customer’s exposure to the risk of losing
more than his investment results from two factors. First, securities
purchased in a margin account may decline to the point where the amount
owed by the customer exceeds the equity in his account. Second, customers
who engage in short selling, which is necessary to day trade in a
declining market or with respect to a declining stock, face theoretically
unlimited loss, since stocks can rise to theoretically unlimited prices.
Day trading firms themselves tend at least nominally to recognize that
the suitability doctrine applies to their business. They virtually always
include provisions concerning suitability requirements in their compliance
manuals.
The Landmark Complaint included an allegation, in connection with the
firm’s alleged failure to supervise the Boston office, that the firm
should have terminated the branch manager in January 1999. The Landmark
Complaint cited a memorandum from Landmark to the manager. This document
reflects Landmark’s awareness of the firm’s obligations with respect to
suitability:
By memorandum dated January 20, 1999 … the firm’s Director of Office of
Supervisory Jurisdiction Operations advised [the branch manager] that his
misconduct had included, among other things:
Failure [to] comply with customer suitability and verbally
misstating material facts to our office about your customers. Failure to
establish family accounts in the Landmark system. Failure to follow the
Supervisory Procedures Manual. (emphasis added).
The SIA Committees, we believe, are incorrect in their assertion that
suitability “historically” includes only a specific recommendation.
Suitability also encompasses unsuitable programs or strategies. As
observed by Norman S. Poser (“Poser”):
The suitability doctrine is not limited to the choice of securities for
an account. For example, a broker who uses margin in an account may
violate the doctrine, even though the securities in the account are
suitable for the customer. Trading on margin falls under this doctrine
because it increases the risks to the customer. 35
In the In re Application of Rangen
case, cited above by Poser, the SEC sustained the New York Stock
Exchange’s findings of a violation and the sanctions it imposed. In re
Application of Rangen, 64 SEC Docket 628, Release No. 34-38486 (Apr.
8, 1997). The broker had, among other misconduct, unsuitably used margin
to trade the customers’ account. The case also includes the following
statement, which, like the SEC’s finding of unsuitability, is relevant to
day trading:
Even if we were to accept [the broker’s] view that these clients wanted
to speculate and were aware of the risks… the Commission has held on many
occasions that the test is not whether [the customers] considered the
transactions in their account suitable, but whether [the broker]
‘fulfilled the obligation he assumed when he undertook to counsel [them],
of making only such recommendations as would be consistent with [their]
financial situation and needs.’ (second and third use of brackets in
original; citation omitted).
35
POSER, at § 3.03, 3-69.
Further, the Project Group disagrees with the assertion of the SIA
Committees, in arguing that the concept of suitability should not apply to
day trading, that “[m]ost strategies lack the requisite specificity for
purposes of determining appropriateness for individual customers.” Day
trading is speculative; it is likely to result, over time, in the loss of
funds put at risk. It is therefore appropriate only for customers who can
bear the loss of any funds deployed, and the exposure to loss of their
other assets.
Brokerage firms routinely determine whether
strategies are appropriate for customers. This is seen most commonly in
connection with options strategies. Firms set minimum standards for
customer income and liquid net worth for various types of options activity,
depending on the level of risk. In addition, as discussed below in the
section on “Recommendations,” the NASD has special suitability
requirements for options accounts.
Furthermore, regulators routinely determine in
enforcement proceedings that certain strategies are unsuitable for
customers. See, e.g., In re David Allen, NYSE Hearing Panel
Decision 96-147 (Dec. 19, 1996) (explaining that the broker’s
“recommendations of the foregoing options strategies to the [customers]
was unsuitable in light of their investment objectives, which did not
include speculation, their financial resources and their limited
experience in options trading”). See also, In re Application of Clyde
J. Bruff, 52 SEC Docket 1266, Release No. 34-31141, Fed. Sec.
L. Rep. (CCH) ¶85,029 (Sept. 3, 1992) (affirming the NYSE’s finding of a
violation of its Rule 723, noted that the options activity “involved a
high degree of financial risk and complexity, and was unsuitable” for the
customers).
D. Encouragement of Activity by
Unregistered Investment Advisers
1. The Phenomenon
Day trading firms sometimes encourage
customers or prospective customers to trade the accounts or funds of third
parties. Firms present such trading as an opportunity for people who lack
funds of their own. Day trading firms’ incentive in encouraging the
trading of third parties’ funds is, of course, the same incentive that
drives them to attempt to draw the business of regular customers, i.e.,
the generation of commissions.
An example of a firm’s encouragement of the trading of
third parties’ funds appears on the web site for Landmark Securities:
HOW DO I PARTICIPATE IN DAY TRADING?
[A]n interested party can participate in a variety
[sic] different ways:
--A Trader is the customer of Landmark
Securities … A trader can work on his own behalf, or on the behalf of
others.
--An Investor may fund the account of a trader,
either as a loan to the trader, or as equity, with a percentage of the
trading profits. The terms of the partnership, such as profit split,
interest rate, risk parameters, etc. are agreed upon by the trader and the
investor at their own discretion.
36
Some firms have encouraged the trading
of third party accounts without regard to the registration requirements to
which investment advisers are subject. Generally, investment advisers that
have less than $25 million under management are required to be registered
with the states in which they do business, while advisers with more than
this amount under management must be registered with the SEC. In view of
this regulatory regime, the problems with registration have been in
connection with state requirements. Two of the proceedings brought by
Massachusetts have included allegations of encouragement of activity by
unregistered investment advisers.
The Block Complaint alleged that the branch manager had
recommended the trading services of a customer, a friend of the manager’s,
who was not registered as an investment adviser. The Block Complaint
further alleged that the trader had misrepresented his investment
experience on the trading authorization form, and that he had agreed to
manage the customer’s account on the basis of being paid a percentage of
profits. The trader was included as a respondent in the proceeding.
As noted in the preceding section, the All-Tech
Complaint alleged that the firm had “maintained a corporate policy of
encouraging customers and prospective customers to trade with the capital
of third parties.” The All-Tech Complaint concluded, “All-Tech knew or
should have known that its policy would lead to the unlawful trading of
accounts by unregistered investment advisers, and the abuse of parties
whose funds were handled by such investment advisers.”
The All-Tech Complaint included as respondents two
unregistered individuals who allegedly had engaged in investment advisory
activity. The All-Tech Complaint alleged, among other things, that one of
the respondents had made misrepresentations to a customer concerning the
value of the client’s account. It further alleged that he had entered into
unlawful fee arrangements with customers involving compensation based on a
percentage of profits.
The Landmark Complaint alleged that the branch manager
had, among other things, unlawfully entered into certain arrangements with
customers, through entities in which the branch manager was a part owner
and manager. These arrangements included the raising of funds from a
customer for the funding of customer accounts and the splitting of profits
with the customer who loaned these funds and with the customers who traded
the funds in their accounts. While to date, not specifically charged in
the Landmark Complaint, the activity of the trading customers may be
another example of unregistered investment advisory activity.
In a Notice of Hearing filed against The Exchange
House, Inc., the Texas Securities Board alleged that the day trading firm
unlawfully permitted 24 unregistered traders to manage customer accounts
at the firm. In re The Exchange House, Inc., et al. (Tex. SSB Ref.
97-011, May 7, 1997). This group of traders managed essentially all of the
accounts at the firm. The complaint also alleged that the firm used an
unregistered branch office, and employed several unregistered brokerage
agents to take customer orders. (The Exchange House eventually
36
Landmark Securities Corporation, Frequently Asked Questions, (visited
July 2, 1999) <http://www.landmarksecurities.com/faq/htm>.
withdrew its brokerage license, and consented to a censure and a $20,000
fine. After a hearing on the merits, the Texas Securities Commissioner
issued a cease and desist order and fines totaling $104,000 against the
various investment advisers involved in the case.)
In a Consent Order entered against Day Trade, Inc. the
Texas Securities Commissioner found, among other things, that a related
brokerage firm, Superior Financial Group, Inc., permitted unregistered
traders to manage customer accounts. The individuals acting as
unregistered investment advisers were employees of Superior Financial
Group. In re Day Trade, Inc., et al. (Tex. SSB Ref. 98-020, Apr. 6,
1998).
2. Legal
Framework
Section 201(c) of the Uniform Securities
Act requires the registration of investment advisers. Section 401(f) of
the Act defines investment advisers as follows:
‘Investment adviser’ means any person who, for
compensation, engages in the business of advising others, either directly
or through publications or writings, as to the value of securities or as
to the advisability of investing in, purchasing, or selling securities, or
who, for compensation and as a part of a regular business, issues or
promulgates analyses or reports concerning securities.
This definition, subject to the exceptions set forth,
generally covers people who trade others’ funds or accounts for
compensation. In the day trading industry, the typical compensation of
unregistered advisers is a percentage of profits.
Traders who violate the registration provisions, have
unlawful fee arrangements, or otherwise engage in misconduct (e.g.,
deceptive practices) are themselves subject to enforcement action by state
regulators. The brokerage firms that encourage unregistered investment
advisory activity may be engaging in dishonest or unethical practices
under state law, and violating NASD Rule 2110, “Standards of Commercial
Honor and Principles of Trade.”
E. Promotion of Lending Arrangements
1. The Phenomenon
Certain day trading firms engage in
lending arrangements. These arrangements are separate from margin lending
to customers by clearing brokers.
Promotion and Arrangement of Loans among Customers
The most common type of this activity is the promotion
and arrangement of loans among customers to meet margin calls. This
activity, we believe, appears to be so prevalent that it may be an
integral part of the day trading industry.
The arrangement results from the fact, as noted above,
that stocks are a poor vehicle for short-term trading by individual
customers. Most customers lack sufficient capital to take advantage of
small price changes. The margin structure for equity securities allows a
maximum of 50% to be borrowed for initial purchases. This limits the
leverage that may be used to magnify gains beyond commission charges.
Some day traders thus commonly trade beyond their means,
and are unable to meet margin calls. Day trading firms recognize that
clearing brokers generally will not tolerate flagrant or repeated
violations of margin requirements by customers. Therefore, to prevent
clearing brokers from closing or restricting customer accounts, some day
trading firms promote and arrange loans among customers.
The volume of these loans can be high. The Landmark
Complaint alleged that the total transfers of funds into one account alone,
between August 1998 and May 1999, was almost $2.7 million. Within a single
branch of a day trading firm, the transfers over the course of a year
could total tens of millions of dollars.
The Block Complaint alleged that the firm actively
arranged loans to and among its customers. One alleged major lender was
the father of the firm’s president.
The Landmark Complaint alleged that the branch manager
promoted and arranged loans among the firm’s customers. The Complaint
further alleged the following misconduct in connection with the loan
arrangement:
- The branch manager forged customers’ signatures on
funds transfer forms (letters of authorization, or LOAs);
The branch manager accepted LOAs that bore customer
signatures that were forged by parties other than the manager;
The firm permitted improper procedures whereby 1)
the manager transmitted LOAs directly to the clearing broker rather than
through the firm itself, and 2) the manager was allowed to use
photocopies of customers’ signatures on LOAs (subject to the customers
purportedly authorizing blanket use of such photocopies);
The manager used or accepted the use of photocopied
signatures even with respect to customers who had not purportedly
authorized the use of such photocopies; and
The manager effected or accepted the effecting of
unauthorized transfers of funds into and out of a customer’s account.
Lending by Principals and Agents of Firms
Some principals and agents of day trading firms have
loaned funds to customers. The Landmark Complaint alleged that the manager
had, respectively, direct and indirect ownership interests in two entities
that engaged in lending, borrowing, and profit splitting arrangements with
customers.
2. Legal Framework Concerning
Promotion and Arrangement of Lending Among Customers
Circumvention of Margin Regulatory
Structure
The day trading industry commonly defends its promotion of loans among
customers by asserting that the activity does not violate Regulation T of
the Federal Reserve Board. This is true, since Regulation T applies only
to secured loans, and is thus inapplicable to the unsecured loans
that are the norm in inter-customer lending. Therefore, the day trading
industry’s assertion is meaningless, and the matter of the legality of the
loan arrangements must be examined in the light of other regulatory
concerns.
It is sometimes stated that the Federal Reserve Board has moved towards
deregulation of margin lending and the arrangement of loans by brokerage
firms. This is inaccurate; the Board has moved towards reducing its
regulation of these areas and increased reliance on the existing rules of
other regulatory agencies. The SEC, NASD, and NYSE still have applicable
rules in place, and still have regulatory responsibilities in these areas.
The NASD requires that day trading be done in margin accounts.
Customers must have equity of at least 50% for any purchase, even if the
account is flat at the end of the day (i.e., all open positions have been
closed). The NASD also has a margin maintenance requirement of 25% equity.
The NASD additionally has special margin requirements for short sales, and
specific requirements for day trading accounts. NASD Notice to Members
98-102, Calculating Margin for Day Trading and Cross-Guaranteed
Accounts, Dec. 1998.
Firms’ promotion and arrangement of loans among customers to meet
margin calls has the effect of circumventing and undermining the
regulatory structure concerning margin. The margin rules limit the
leverage customers may utilize, or, to state it another way, the rules
require customers to commit a certain amount of their own funds in
order to effect transactions. When day trading firms have customers meet
margin calls for other customers receiving the calls, the firms are
defeating the purpose of the margin requirements. This practice was
recently discussed in a Wall Street Journal article. 37
As noted by Michael T. Reddy in
Securities Operations, “The thrust or intent of many of the rules … is
to avoid a situation in which securities firms or their customers become
overextended.”38
The lending arrangements create, in economic terms, a moral hazard, i.e.,
they encourage customers who lack the financial ability to day trade
nonetheless to undertake the risks of day trading. This puts the firms and
their clearing brokers (who are financially exposed if transactions are
not paid for or debits are not paid) at risk. As discussed above, it also
has the effect of maintaining accounts that have traded beyond their means,
in violation of suitability requirements.
37
Ruth Simon, Regulators are Investigating Effort by Firms to Circumvent
Margin Rules, WALL ST. J., June 23,
1999.
38
MICHAEL T. REDDY, SECURITIES OPERATIONS,
263 (New York Institute of Finance, 2d ed. 1995).
Violation of SEC Rule 15c2-5
SEC §240.15c2-5, Disclosure and Other Requirements when Extending
Credit in Certain Transactions, requires brokerage firms to make
special disclosures, and imposes special suitability requirements, in
connection with firms’ arrangement of loans outside of margin arrangements
that are subject to Regulation T. Rule 15c2-5 provides as follows:
- (a)
- It shall constitute a “fraudulent, deceptive, or manipulative act or
practice” as used in section 15(c)(2) of the [1934] Act for any broker
or dealer to offer or sell any security to, or to attempt to induce the
purchase of any security by, any person, in connection with which such
broker or dealer, directly or indirectly offers to extend any credit to
or to arrange any loan for such person, or extends to or participates in
arranging any loan for such person, unless such broker or dealer, before
any purchase, loan or other related element of the transaction is
entered into:
- (1)
- Delivers to such person a written statement setting forth the exact
nature and extent of (i) such person’s obligations under the particular
loan arrangement, including, among other things, the specific charges
which such person will incur under such loan in each period during which
the loan may continue or be extended,
- (ii)
- the risks and disadvantages which such person will incur in the
entire transaction, including the loan arrangement, (iii) all
commissions, discou
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