United States: Day Trading - What Regulators Think About It

Day trading recently has drawn the attention of the Securities and Exchange Commission ("SEC" or "the Commission"), several self-regulatory organizations ("SROs"), including the National Association of Securities Dealers, Inc. ("NASD"), the New York Stock Exchange ("NYSE"), and the Philadelphia Stock Exchange ("PHLX"), as well as the United States Congress. A consensus has developed among regulators and lawmakers that day trading is an unusually risky form of trading whose popularity among amateur investors has necessitated intensified scrutiny of broker-dealers that provide day-trading services and the adoption of new regulatory measures to govern them.

On February 25, 2000, the SEC released a staff report entitled "Report of Examinations of Day-Trading Broker-Dealers" ("the Report") (please see endnote 1). The Report describes findings by the SEC’s Office of Compliance Inspections and Examinations, which recently conducted an "examination sweep" of several day-trading firms. The examinations did not uncover widespread fraud, but, according to the staff, they did reveal widespread securities laws violations, including deficiencies in firms’ net capital, margin violations, inadequate lending disclosure, misleading advertising, and improper short sales. In addition, the staff found lax supervision at many firms. The Report notes that "a number" of violations warranted referral to the SEC’s Division of Enforcement. Three enforcement matters are described in detail, two involving alleged margin violations and one involving alleged fraud by an internet-based stock recommendation service.

Like the SEC, SROs have increased their enforcement efforts. For example, on February 24, 2000, NASD Regulation announced the filing of eight enforcement actions against day-trading firms (please see endnote 2). The charges included misuse of customer funds and securities, improper lending and margin practices, exaggerated and misleading advertising, violation of short sale rules, failure properly to register employees, improper use of the Small Order Execution System ("SOES"), and inadequate supervision.

Some of the day-trading practices that troubled regulators the most are permissible under current law. Accordingly, SROs are seeking to adopt (or have adopted) new rules that specifically address the activities of day-trading firms. For example, the NASD and the NYSE have proposed new rules that would impose special margin restrictions for day traders, require day-trading firms to disclose the risks of day trading to potential customers, and require day-trading firms to determine the appropriateness of day trading for potential customers before opening accounts. The margin restrictions would come in the form of amendments to NASD Rule 2520 (please see endnote 3) and NYSE Rule 431 (please see endnote 4). The disclosure and customer assessment requirements would be included in two new NASD rules governing the opening of accounts, proposed NASD Rules 2360 and 2361 (please see endnote 5).

Day trading also has attracted attention on Capitol Hill. In September 1999 and February 2000, the Senate Committee on Governmental Affairs Permanent Subcommittee on Investigations held several days of hearings about day trading. Witnesses included SEC Chairman Arthur Levitt, NASD Regulation President Mary Schapiro, several professionals from the day-trading industry, and several day traders or family members of day traders who testified that they were harmed either by day trading or misconduct by day-trading firms (please see endnote 6). The hearings are not likely to result in new legislation, but the anecdotal and statistical evidence presented did highlight the risks entailed in day trading -- Senator Susan Collins concluded that day trading was akin to gambling -- as well as the perception among lawmakers that day trading firms should be subject to additional regulation and oversight (please see endnote 7).

Quoting Chairman Levitt, the SEC staff Report describes a typical 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." In her Congressional testimony, Mary Schapiro described 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." (please see endnote 8) The SEC staff Report states that the "principal characteristic that distinguishes day traders from other market participants is their mind-set," in that day traders "generally acknowledge that they are not investors, due to the short time they hold positions." According to the Report, there are less than 7,000 full-time day traders, but many more people may occasionally engage in day trading. The number of day traders is relatively small compared to the estimated 5 million individuals who use the Internet for brokerage services or the estimated 80 million who own stock, but the Report states that day trading may account for as much as fifteen percent of the Nasdaq’s daily trading volume.

In their proposed new rules, the NASD and NYSE have attempted to clarify the concept of "day trading." Under proposed NASD Rule 2360(e), the term "day-trading strategy" would mean "an overall trading strategy characterized by the regular transmission by a customer of intra-day orders to effect both purchase and sale transactions in the same security or securities." Similarly, under proposed NASD Rule 2520(f)(8)(B)(i), "day trading" would mean "the purchasing and selling or the selling and purchasing of the same security on the same day in a margin account." (The proposed rule lists a few exceptional circumstances in which such paired purchases and sales would not be considered "day trading.") Under proposed NASD Rule 2520(f)(8)(B)(ii), a "pattern day trader" would be a "customer who executes four or more day trades within five business days," unless the number of day trades is 6% or less of the total trades for the five days. The NYSE has included identical definitions of "day trading" and "pattern day trader" as part of its proposed amendments to the margin rules contained in NYSE Rule 431.

Like all broker-dealers, day-trading firms are required to register with the Commission and are subject to the federal securities laws, SEC regulations, and rules imposed by SROs. Day-trading firms differ from other broker-dealers in that they generally offer their services at on-site trading facilities rather than through registered representatives or Internet sites; they provide the public with direct access to markets using high speed computer linkages, supplying, among other things, access to Nasdaq Level II and ECNs, which most broker-dealer customers do not receive; and they promote day-trading strategies, even offering to train customers in how to day trade. In February 2000, the staff identified 133 broker-dealers that appeared to meet the preceding loose definition of a day-trading firm.

While most day-trading firms are organized as corporations that provide services to customers, some are organized as partnerships in which the firm operates as a proprietary business. Such partnerships state that they have "members," not customers. They are not subject to the NASD’s conduct rules. Most of the partnerships are members of the PHLX, which recently amended PHLX Rule 604 to require that individuals trading off the floor of the exchange pass a Series 7 licensing examination (please see endnote 9).

According to the Report, the SEC has received "relatively few" complaints concerning day trading. In 1998, only 0.36% of all complaints received by the Commission’s Office of Investor Education and Assistance involved day-trading broker-dealers, and in 1999 only 0.56% of the complaints involved day-trading broker-dealers. The complaints about day-trading firms concerned allegations "not unique" to such firms, including failures to follow customer instructions, unauthorized transactions, and errors in account records.

Between October 1, 1998 and September 30, 1999, the staff examined forty-seven registered brokers that provide day-trading facilities. The examinations revealed numerous securities law violations. Although the violations were not unique to day-trading firms, the staff believes that the fast, frequent, and risky nature of day trading makes day-trading firms’ compliance with the securities laws especially challenging, and requires the implementation of automated compliance systems that many day-trading firms currently lack. The Report focused on the following areas of concern:

Disclosure and Investor Education. According to the Report, "[t]he SEC is concerned about the potential for individuals to be seduced by promises of easy profits by day trading without fully understanding the risks." The Report acknowledges that "no current law or rules explicitly mandate that firms disclose the risks of day trading," but states that "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." The Report observes that several firms improved their disclosures during the time period covered by the Report. The SEC has posted on its own web site a list of risks and facts that, in its view, all potential day traders should consider.

The NASD’s proposed Rule 2361 would require firms "promoting" day-trading strategies to provide a risk disclosure statement to every new potential account holder. The disclosure statement would include the following warnings: "Day trading can be extremely risky," "Be cautious of claims of large profits from day trading," "Day trading requires knowledge of securities markets," "Day trading requires knowledge of a firm’s operations," "Day trading may result in your paying large commissions," and "Day trading on margin or short selling may result in losses beyond your initial investment."

Advertising. The Report states that several firms’ advertisements contained exaggerated or unwarranted claims. According to the staff, most of the claims did not violate the anti-fraud provisions of the federal securities laws, but they may have violated SRO rules. Among the objectionable advertisements were one in which a firm employee made "exaggerated" statements to the effect that the number of trades at a branch office of the firm had doubled on two particular days and that a trader had netted more than $50,000 on one of those days, even though the Dow Industrial Average had fallen by hundreds of points; one in which a day-trading program claimed to be "the top trading school in the country" without having a basis for that claim; and one in which a firm solicited inexperienced traders by emphasizing its training program when, in fact, the firm accepted only experienced traders and referred inexperienced traders to an affiliated firm.

Net Capital and Financial Record Keeping. The net capital rule requires registered broker-dealers to maintain a specified amount of liquid assets. The Report states that several firms misapplied the net capital rule, thereby generating inaccurate net capital computations, and a small number of firms experienced net capital deficiencies. Several firms also committed books and records violations. The failure by most of the examined firms to compute intra-day net capital figures was particularly troublesome because, as the Report explains, "firms must be in net capital compliance at all times, even if the intention of the firms is to liquidate or cover the positions before the end of the day." The Report notes that the NYSE recently reminded its members of their obligations to maintain "moment-to-moment" net capital compliance, and states that other SROs will soon issue similar reminders. The Report also states that nearly half of the day-trading firms that were members of the PHLX did not file required annual audited financial statements due to their erroneous assumption that they were exempt from the PHLX filing requirement.

Lending Practices. Several firms extended credit in excess of that allowed by the margin requirements of Regulation T and/or SRO maintenance margin rules. Some firms that otherwise were in compliance with the margin rules violated the securities laws by failing to disclose essential terms when extending credit to meet customers’ margin obligations. Similarly, day-trading firms often arrange loans to customers from third parties or other customers, and while those practices generally are legal, the staff found that the documentation regarding such loans often omitted key terms, such as when interest charges could be imposed, the annual rate of interest, or how interest charges were to be computed. At least two day-trading firms indirectly extended credit to customers through lenders that were so closely related to the broker-dealer entities that the staff regarded the transactions as violations of Regulation T.

The proposed amendments to NASD Rule 2520 and NYSE Rule 431 would require day traders to maintain a minimum of $25,000 equity in accounts at all times (whereas minimum equity for other margin accounts is $2,000) and to meet margin calls in five days (rather than the seven day requirement imposed on other margin accounts). The rules also would require that funds deposited to meet maintenance margin calls on day-trading accounts remain deposited for at least two business days. They also would prohibit pattern day traders from utilizing "cross-guarantees" that allow two accounts to be considered together in computing maintenance margin. Under the proposed rules, day traders would be permitted to borrow up to four times the equity in their accounts.

Many of the proprietary day-trading firms have entered into "joint back office" ("JBO") arrangements with clearing firms. Under Regulation T, a clearing firm may be permitted to finance its owners’ transactions. Day-trading firms may establish the required ownership interest by purchasing limited partnership shares in the clearing firm. Such JBO arrangements lawfully allow participating firms to engage in day trading exempt from margin rules. The Report notes that recent rules adopted by SROs will restrict the use of joint back office arrangements (please see endnote 10).

Short Sales. The staff found several violations of rules governing short sales, including violations of Rule 10a-1 of the Securities Exchange Act of 1934. Rule 10a-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"), but such a security may not be sold short on "minus ticks" or "zero-minus ticks," subject to narrow exceptions. The staff also found that some firms failed to mark order tickets or make affirmative determinations that they could locate or borrow the stock sold short. The Report states that, in light of the frequency and volume of improper short sales, the SEC and SROs will continue to focus on short sale compliance.

Suitability and Appropriateness. The staff "found no evidence that NASD firms provided recommendations to customers as to specific securities (either directly or indirectly through training programs), that would trigger a legal obligation for firms to evaluate the suitability of the security for the customer." The Report does suggest, however, that day-trading firms were promoting day-trading strategies that may not have been suitable for some non-institutional customers.

The proposed NASD Rule 2360 would require broker-dealers that promote day-trading strategies to their non-institutional customers to determine whether day trading is an "appropriate" strategy based on several factors, including the customer’s financial condition, tax status, employment status, prior investment and trading experience, and investment objectives.

Training. According to the Report, many training programs and websites affiliated or operated by day-trading firms recommend day-trading strategies without disclosing risks entailed in day trading. The staff was unable to review the content of some day-trading training programs, even though they have significant managerial or financial relationships with the broker-dealers that refer the trainees, because the training firms themselves were not registered as broker-dealers. The Report also states that the SEC’s Enforcement Division is currently investigating certain websites that provide daily stock recommendations to day traders for a subscription fee.

Supervision. According to the staff, "many day-trading firms maintained inadequate written supervisory procedures relating to: the review of exception reports, the process for opening of new day-trading accounts, and compliance with short sale and margin rules." In addition, many of the automated systems on which firms rely to perform supervisory functions can be bypassed or disabled by traders. The staff also found that some firms fail adequately to supervise branch offices. The Report warns that the SEC and SROs will "rigorously enforce existing supervisory obligations."

Registration. According to the staff, several unregistered entities and persons were engaged in activities that may require registration as broker-dealers or investment advisers under the federal securities laws or SRO rules. The Report urges day-trading firms to ensure that all associated persons and branch offices are properly registered.

If you would like a copy of the Report or have any questions, please contact Brandon Becker (202-663-6979 or bbecker@wilmer.com), Soo Yim (202-663-6958 or syim@wilmer.com) or Stephen Weisbrod (202-663-6538 or sweisbrod@wilmer.com).

ENDNOTES:

1. The Report is available at <http://www.sec.gov/news/studies/daytrep.htm>.
2. Press Release, "NASD Regulation Announces Eight Day-Trading Enforcement Actions," (Feb. 24, 2000) <http://www.nasdaq-amexnews.com/news/pr2000/ne_section00_039.html>.
3. Securities Exchange Act Release No. 42418 (Feb. 11, 2000), 65 Fed. Reg. 8461 (Feb. 18, 2000).
4. Exchange Act Release No. 42343 (Jan. 14, 2000), 65 Fed. Reg. 4005 (Jan. 25, 2000).
5. 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).
6. See Hearings on Day Trading: An Overview Before the Permanent Subcomm. on Investigations of the Senate Comm. on Governmental Affairs, 106 Cong. (Sept. 16, 1999) [hereinafter Sept. 16, 1999 Hearings] available at <http://gov_affairs.senate.gov/091699_witness.htm>; Hearings on Day Trading: Everyone Gambles But the House, Part I Before the Permanent Subcomm. on Investigations of the Senate Comm. on Governmental Affairs, 106 Cong. (Feb. 24, 2000) [hereinafter Feb. 24, 2000 Hearings] available at <http://www.senate.gov/~gov_affairs/022400_witness.htm>; Hearings on Day Trading: Everyone Gambles But the House, Part II Before the Permanent Subcomm. on Investigations of the Senate Comm. on Governmental Affairs, 106 Cong. (Feb. 25, 2000) [hereinafter Feb. 25, 2000 Hearings] available at <http://www.senate.gov/~gov_affairs/022500_witness.htm>.
7. Feb. 24, 2000 Hearings, supra note 6 (Opening Statement of Senator Susan M. Collins, Chairman) ("I believe that day trading can be fairly compared to certain types of gambling") available at <http://www.senate.gov/~gov_affairs/022400_collins.htm>; id. (Staff Memorandum) available at <http://www.senate.gov/~gov_affairs/022400_report.htm>.
8. Sept. 16, 1999 Hearings, supra note 6 (Testimony of Mary L. Schapiro, President, NASD Regulation, Inc.) available at <http://gov_affairs.senate.gov/091699_schapiro_testimony.pdf>.
9. Exchange Act Release No. 41776 (Aug. 20, 1999), 64 Fed. Reg. 47214 (Aug. 30, 1999).
10. Exchange Act Release No. 42453 (Feb. 24, 2000) (order approving the following Joint Back Office 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).