the end of the day. During the examinations, however, the Staff found that most daytrading firms did not monitor for intra-day compliance with the net capital rule. Day-trading firms must be able to demonstrate that they are in net capital compliance throughout the trading day. The NYSE reminded its members of their obligations to maintain moment-to-moment net capital in NYSE Interpretation Handbook Release, August 5, 1999. Other SROs will emphasize to their members their obligation to maintain net capital compliance at all times. The Staff found net capital violations, including inaccurate computations and net capital deficiencies, at more than a quarter of the firms examined. These violations resulted in the maintenance of erroneous books and records. Many of the inaccurate net capital computations resulted from firms' failure to properly apply generally accepted accounting principles, as required by the net capital rule. 32 While net capital violations and errors are not unique to day-trading firms, the net capital compliance will remain a focus of day-trading examinations by the SEC and the SROS. 2. Books and Records Examinations also revealed numerous books and records violations. A sizable number of firms were cited for failing to maintain accurate financial records and/or for failing to maintain required documents. Several firms were cited for failing to maintain necessary customer account documentation (i.e., customer confirmations and account statements) or to preserve memoranda of each brokerage order. Pursuant to Exchange Act Rule 17a-5(d), a broker-dealer is required to file an annual audited financial report with the SEC and its designated examining authority (SRO). The Staff found that almost half of the Philadelphia Stock Exchange firms, that we examined, failed to file annual audited reports. Most of the firms had concluded that they were exempt from the requirement pursuant to a provision of the rule designed for market makers and specialists on the floor of a stock exchange and subject to daily oversight by the exchange. The Staff found, however, that these firms were incorrectly relying on the exception, and were required to file annual audited reports. 32 The firms examined generally fell into two categories, those with a $5,000 minimum net capital requirement and those with a $100,000 minimum net capital requirement. Introducing daytrading firms that effect more than ten transactions in their proprietary accounts are subject to a minimum net capital requirement of $100,000. 17 C.F.R. § 240.15c3-1(a)(2)(iii) (1998). 33 The Philadelphia Stock Exchange recently issued a Notice to Members reminding members of their obligations under financial audit and books and records rules. The PHLX will conduct follow-up examinations to ensure compliance with books and records and financial responsibility rules. 4. Net Capital Restrictions on the Withdrawal of Partnership Capital A proprietary firm may include the capital contributed by its members as an allowable asset for net capital purposes. This practice may restrict the ability of the firm's members to withdraw their funds, if the withdrawal would place the firm in violation of the net capital rule. All of the proprietary firms examined by the Staff had operating agreements restricting partners' withdrawal of equity capital or capital contributions made by members of the firm. In general terms, the operating agreements stated that the general partner may restrict distributions of capital if such withdrawals would cause the firm to violate the requirements of the net capital rule. The SEC's staff has issued an interpretive letter relating to the net capital treatment of temporary capital contributions." Under the interpretive letter, if an individual contributes capital to a broker-dealer with an understanding that the contribution can be withdrawn at the option of the individual, the contribution may not be included in the firm's net capital computation and must be re-characterized as a liability. In addition, the letter states that any withdrawal of capital by that individual within a year (other than a withdrawal to make required tax payments and reasonable compensation to partners as described in Exchange Act Rule 15c3-1), shall be presumed to have been contemplated by the individual at the time of the contribution. The Staff believes that this interpretation is consistent with the position it has emphasized for some time and should clarify a day-trading firm's obligation to maintain permanent capital under the net capital rule. Section 7 of the Exchange Act prohibits broker-dealers and other persons from extending crcdit in contravention of the rules and regulations promulgated by the Board 34 35 SEC Net Capital Rule, 17 C.F.R. § 240.15c3-1 (1998). The Net Capital Rule imposes restrictions and limitations on the withdrawal of equity capital from a broker-dealer by a stockholder or partner. The rule also obligates a broker-dealer to provide written notification to the SEC and its SRO of a withdrawal or expected withdrawal, if the withdrawal or expected withdrawal exceeds a certain percentage of the firm's net capital. Letter to Mr. Raymond J. Hennessy, Vice President, New York Stock Exchange, Inc. and Ms. of Governors of the Federal Reserve ("Federal Reserve Board")." The Federal Reserve Board has adopted Regulation T, which imposes initial margin requirements for brokerdealers. 37 39 Under Regulation T, a broker-dealer must ensure that a customer deposit, or have on deposit in a margin account, 50% of the cost of a transaction; the broker-dealer may lend the customer the other 50% using the securities as collateral." This calculation is performed at the end of the day and includes transactions that occur that day." If the customer's funds are insufficient to meet the 50% requirement, the broker-dealer issues a Regulation T margin call and the customer must deposit the additional capital within five business days.40 In addition to Regulation T initial margin requirements, broker-dealers must comply with SRO requirements commonly referred to as "maintenance margin."" Under these rules, broker-dealers must ensure that customers maintain a specified minimum amount of equity in their accounts at all times. Currently, a customer is required to maintain capital in his/her account equal to 25% of all long positions. Similar to Regulation T, this calculation is performed by brokerage firms at the end of the day and, in the event of a deficiency, the firm issues a margin call which must be met as promptly as possible and in any event within 15 business days," or seven business days for day 42 37 38 39 41 Regulation T, supra note 9. Any "broker or dealer, or any person associated with a broker or dealer" is a "creditor" for purposes of Regulation T. 12 C.F.R. § 220.2 (1998). Persons associated with a broker-dealer generally include partners, officers, directors, branch managers, and employees. 15 U.S.C. § 78c(a)(18) (1999). 12 C.F.R. § 220.4(b) (1998) (describing the initial margin customers must deposit on securities transactions). The margin required for equity securities is generally 50% of the current market value of the security or the percentage set forth by the SROS, whichever is greater. 12 CFR § 220.12(a) (1998). The firm combines all transactions that occur on the same day to determine whether additional margin is necessary. Additional margin is required on any day when the day's transactions create or increase a margin deficiency. The additional margin required is the amount of the margin deficiency created or increased. 12 C.F.R. § 220.4(c) (1998). Under Regulation T, a margin call must be satisfied “within one payment period after the margin See NYSE Rule 431(c), 2 NYSE Guide (CCH) ¶ 2431, at 3751-3 (Oct. 1998); NASD Conduct 42 E.g., NYSE Rule 431(f)(6), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998). trading accounts." Thus, every day-trading firm must make two separate margin calculations for each customer every day, one for Regulation T and the other for SRO maintenance margin. Regulation T and SRO margin requirements are designed to work in tandem. For example, because Regulation T is calculated on the position in the account at the end of the day, which for most day traders' accounts would be flat, a Regulation T margin call would not be issued unless the account activity resulted in a loss. During the course of the day, however, the broker-dealer has extended credit to the customer for intra-day positions and was therefore at risk. Accordingly, the SROs amended the maintenance rules to capture these day-trading transactions. In effect, the rules require an individual to demonstrate that he/she could meet a margin call if he/she did not unwind the largest open positions by the end of each day." In addition to these amendments, the SROs have disseminated interpretive releases specifically addressing day trading margin issues. The NYSE and NASD have proposed rules that would require day-trading firms to restrict the use of margin by active day traders. Both the NYSE's and NASD's rule proposals are similar. On January 14, 2000, the SEC issued the NYSE's rule proposal for public comment." On February 11, 2000, the SEC issued the NASD rule proposal for public comment. The proposed amendments would adopt a new term, “pattern day trader,” which would include any customer that executes four or more day trades within five business days, provided the number of trades is more than six percent in the account for the five day period. Under the proposed amendments, a pattern day trader would be required to maintain a minimum equity of $25,000 at all times. If the account falls below the $25,000 requirement, the pattern day trader would not be permitted to day trade until the account is restored. The proposed amendments would require special maintenance margin for pattern day traders equal to 25% of the cost of all day trades made during the day. In effect, this would permit a pattern day trader to have buying power of four-times the equity in the 43 See e.g., NYSE Rule 431(f)(8)(C), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998). Neither Regulation T nor the SRO maintenance margin rules prevent a broker-dealer from imposing more stringent margin requirements, such as imposing margin calls on an account during the day or requiring more margin for volatile securities. In fact, some firms provide only one or two days to meet a margin call. 44 E.g., NYSE Rule 431(f)(8)(B), 2 NYSE Guide (CCH) ¶ 2431, at 3771 (Oct. 1998). 45 Exchange Act Release No. 42343 (Jan. 14, 2000), 65 Fed. Reg. 4005 (2000). Exchange Act Release No. 42418 (Feb. 11, 2000), 65 Fed. Reg. 8461 (2000). pattern day trader's account. In addition, the pattern day trader would be permitted to maintain margin based on the largest aggregate open position during that day. Under the proposed amendments, if the pattern day trader exceeds his/her buying power during the day, the pattern day trader would receive a margin call, which is required to be met within five business days. If the margin call is not met, the pattern day trader's buying power would be reduced to two-times the equity in the account and the pattern day trader's margin requirement would be based on the pattern day trader's cumulative positions during the day, not the largest aggregate open position during the day. This would have the effect of substantially limiting the day-trading activity. In addition, if the margin call is not met within the required five business days, no trades on margin would be allowed for 90 days or until the margin call is met. In addition to these new margin requirements for pattern day traders, the proposed rules would also require a pattern day trader that makes a deposit to satisfy a margin deficiency, to keep the deposit in the account for at least two business days. Further, a pattern day trader would be prohibited from using cross guarantees to satisfy a margin requirement. Together, these requirements are designed to provide greater financial stability to pattern day trader accounts and effectively require pattern day traders to utilize funds actually on deposit in their accounts. A broker-dealer violates Regulation T and SRO maintenance rules when the broker-dealer, directly or indirectly, extends credit in excess of the requirements set forth in the rules. Broker-dealers that extend credit beyond the 50% Regulation T or 25% SRO margin obligations are, in effect, meeting the margin obligations of the customer. For example, in a typical transaction, a customer who purchases securities in his/her margin account at a cost of $10,000 would be required to deposit 50%, or $5,000, of the transaction cost. The broker-dealer lends the customer the remaining 50%, or $5,000, using the securities as collateral. If the customer is unable to meet his/her 50% obligation, the broker-dealer is required to issue a Regulation T margin call. Contrary to the rule, examinations revealed that several day-trading broker-dealers loaned funds to customers to meet their margin obligations -- in addition to and separate from credit extended for initial margin. As a result, the customer was left with a highly leveraged security transaction in excess of the amount contemplated by the rules. 3. Arranging for Loans by Others Until recently, broker-dealers were prohibited from facilitating the arrangement of credit for their customers to purchase securities. In 1996, the Federal Reserve Board adopted amendments to Regulation T that allowed broker-dealers to arrange loans that |