adopted by SROs will restrict the use of JBO arrangements. These rules are described in Appendix A. Short Sales The examination staff, in conjunction with the SEC's Office of Economic Analysis, conducted an analysis of day-trading firms' trading data to determine compliance with the short sale rules. The Staff found several violations of those rules, including executions of short sales in violation of Exchange Act Rule 10a-1. In addition, several firms either failed to mark or improperly marked order tickets and failed to make an affirmative determination that they could locate and borrow stock being sold short. Day-trading firms need to enhance compliance with short sale rules. In light of violations in this area, SEC and SRO examiners will continue to focus on short sale compliance. SROs also will continue to remind members of their obligations under SEC and SRO short sale rules. 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. If broker-dealers recommend that their customers buy or sell specific securities, they must ensure that the security is suitable for the customer. The NASD has proposed a rule requiring broker-dealers that promote day-trading strategies to their non-institutional customers to determine whether day trading is an "appropriate" strategy, based on the customer's financial situation, tax status, employment status, prior investment and trading experience and investment objectives. This proposal is described in more detail in Appendix A. • The Staff found that many day-trading firms refer potential customers to firms that offer day-trading training. The Staff identified significant links (e.g., common personnel or managers, or monetary or other forms of compensation) between the day-trading firms reviewed and these training entities. Because these entities are not registered broker-dealers, the Staff was unable to review the content of training programs conducted by these entities. The SEC's Division of Enforcement is also investigating certain Internet web sites that provide daily stock recommendations to day traders for a subscription fee. These sites generally hype possible returns from day trading using their recommendations, while making little or no risk disclosure. Supervision III. The Staff found that many day-trading firms maintained inadequate written supervisory procedures relating to: the review of exception reports, the process for opening new day-trading accounts, and compliance with short sale and margin rules. Some firms also were not adequately supervising branch offices. The Staff found that many day-trading firms relied heavily on automated systems to perform certain supervisory functions, such as to ensure compliance with margin and short sale rules. Examinations disclosed that many of these automated systems were easily bypassed or disabled by traders. Day-trading firms must ensure that they have an adequate compliance and supervisory infrastructure. The SEC and the SROs will rigorously enforce existing supervisory obligations. The Staff found instances where unregistered entities and persons were engaged in activity that may require registration under the federal securities laws or SRO rules. Day-trading firms should ensure that all associated persons and branch offices are properly registered with the SEC, SROs and state securities regulators. Firms also need to be careful not to facilitate the violation of registration requirements by their customers. BACKGROUND A. Day Trading in Context While professional traders have long engaged in day trading, day trading as a strategy employed by retail investors is a fairly recent phenomenon. The number of day traders in the new industry is estimated to be less than 7,000. While this is an estimate of full-time day traders, there may be significantly more on-line investors who occasionally engage in day trading. By comparison, according to some estimates, there are close to an estimated 80 million individuals who own stock and more than 5 million investors using the Internet for brokerage services. Even though the number of day traders may be relatively small, some commentators suggest that their influence may be great - by some estimates the industry accounts for approximately 15% of the Nasdaq's daily trading volume.* 2 See Day Traders Working Hard to Influence How the Profession is to be Defined, Securities Week (McGraw-Hill Companies, Inc.), May 24, 1999, at 3. 3 ICI and SIA, Equity Ownership in America, Fall 1999, at 14. 4 Day Traders Working Hard to Influence How the Profession is to be Defined, supra note 2. B. Characteristics of Day-Trading Firms Day-trading firms, like all broker-dealers registered with the SEC under the Securities Exchange Act of 1934 (“Exchange Act”), are required to comply with applicable federal securities laws and SRO rules. They also have some unique characteristics. For example, day-trading firms often advertise day trading and daytrading training, and generally offer their services at on-site trading facilities, rather than through a registered representative or an Internet web site. A day-trading firm generally provides its traders with direct access to market centers using high-speed computer linkages. The high-speed computer connections supply, among other things, access to Nasdaq Level II and ECNs - services that are generally not available to most on-line customers." While day-trading firms are not required to identify themselves as such, in February 2000 the Staff identified 133 firms that appeared to meet the above characteristics of a day-trading firm. In May 1999, Chairman Levitt defined a day trader as “an individual, not registered as a broker-dealer or as a registered representative, who trades stock at a firm that allow[s] the individual 'real time' access to the major stock exchanges and the Nasdaq market." The NASD also recently defined a day trader as "an individual who conducts intra-day trading in a focused and consistent manner, with the primary goal of earning a living through the profits derived from this trading strategy."" Day traders generally attempt to derive a profit by executing many intra-day trades to take advantage of small price movements in stocks (e.g., 1/8 or 1/16 of a point per trade). The principal characteristic that distinguishes day traders from other market participants is their mind-set. Day traders generally acknowledge that they are not investors, due to the short time they hold positions. Many day traders hold stocks for seconds or hours, seldom overnight, closing out positions for small profits. Several on-line broker-dealers provide direct access to market centers for actively-trading Chairman Arthur Levitt, Speech by SEC Chairman: Plain Talk About On-line Investing (May 4, 1999) <http://www.sec.gov/news/speeches/spch274.htm>. Mary L. Schapiro, Testimony on the Securities Day-Trading Industry, Testimony Before the IV. EXAMINATION FINDINGS AND RECOMMENDATIONS A. Organizational Structures Day-trading firms are typically organized in one of two ways: as traditional corporate entities or limited liability companies or partnerships (“LLC"). These organizational differences separate day-trading firms into two specific operating models with fundamentally different characteristics. Most day-trading firms are organized as traditional customer-based corporate entities and are members of the NASD. Customer-based firms are required to comply with federal securities laws and regulations that are designed to further customer protection. Firms that conduct a retail customer business must comply with NASD membership requirements; customer reserve requirements; the Federal Reserve Board's initial margin' and SRO maintenance margin requirements; and SRO suitability rules." The Staff estimates that there are more than 100 day-trading firms organized as retail brokerage firms. 8 10 The second model is the LLC partnership structure in which a firm operates a proprietary business. These firms represent that they do not have customers, but "members" who become part owners of the firm. Day traders at these firms, as part owners, contribute capital to the firm and in turn, trade the firm's capital. Most of these firms are members of the PHLX. There are approximately 13 day-trading firms that are members of the PHLX. To become a member of a day-trading firm structured as an LLC, individuals are required to sign operating agreements that designate the member's ownership rights including: profit sharing arrangements, restrictions on withdrawals, provisions limiting losses, and other provisions common to partnership agreements. Because these firms are exempt from registering with the NASD, they are not subject to the NASD Conduct Rules. 12 Regulation T, 12 CFR § 220 (1998). E.g., NASD Conduct Rule 2520, NASD Manual (CCH) (1999); NYSE Rule 431, 2 NYSE Guide (CCH) 2431, at 3751 (Oct. 1998). E.g., NASD Conduct Rule 2310, NASD Manual (CCH) (1999); NYSE Rule 405, 2 NYSE Guide (CCH) ¶ 2405, at 3696 (Oct. 1998). Exchange Act Section 15(b)(8) provides that if a broker-dealer executes or attempts to execute the purchase or sale of any security, the broker-dealer must be registered with the NASD. 15 U.S.C. § 780(b)(8) (1999). However, Exchange Act Rule 15b9-1 provides that “any broker or dealer required by Section 15(b)(8) ...to become a member... shall be exempt from such requirement if it (1) is a member of a national'securities exchange, (2) carries no customer accounts, and (3) has annual gross income derived from purchases and sales of securities otherwise than on a national securities exchange of which it is a member in an amount no greater than $1,000." 17 C.F.R. § 240.15b9-1 (1998). Prior to a change in its rules, the PHLX allowed members of proprietary firms to trade proprietary accounts without being licensed representatives. Thus, proprietary daytrading firms were able to advertise day trading to the general public and accept members that were not licensed. The PHLX recently amended PHLX Rule 604 to require individuals trading off the floor of the exchange to pass the Series 7 licensing examination.13 B. Fees and Costs Day traders incur significant trading costs. Day-trading firms generally charge commissions of between $15-$25 per trade and charge a substantial amount for additional services such as RealTick III data feeds, news, and exchange fees, which range between $50-$675 per month. Day traders must factor in these fees and costs in determining the point at which they are able to make a profit. The following graph highlights the fees and costs of day trading: 14 Comparative Analysis of Profit Required per Month to Break Even For example, a day trader who makes 50 trades per day at a firm with moderate fees ($16.70 per trade, $150 per month), must generate $16,850 each month in trading profits to recoup the costs of the trades. In addition to the costs and fees described above, many firms stated that they require prospective customers to have a minimum amount of money to open an account. 13 14 Exchange Act Release No. 41776 (Aug. 20, 1999), 64 Fed. Reg. 47214 (1999). The licensing requirement becomes effective on February 25, 2000. Other regional exchanges have amended or proposed rules to impose a Series 7 licensing requirement on their off-floor proprietary traders. In comparison, over the past year, the average commission paid by U.S. investors was generally between $19 and $21. See Kathy Bergen, On-Line Investing Price Cuts Heating Up; Brokerages Going for Broke on Commissions, Chi. Trib., Sept. 5, 1999, at Cl. |