So we heard testimony about a number of very disturbing aspects, including the lack of analysis by day-trading firms as to whether day trading is even an appropriate strategy for a new client. We learned that not only was such analysis a low priority, but we learned that it is often ignored, or worse, that documents are doctored to make a client appear to be appropriate for day trading who otherwise would not even meet the firm's own requirements. These practices have exploited an ambiguous area in securities. law to the detriment of unwitting consumers. The securities laws in general require that an individual who buys or sells stock on behalf of another individual for compensation must be licensed as a broker-dealer, yet we have apparently some nuances and loopholes in the law of which day-trading firms too often take advantage. These practices are open and widespread, and today we will be asking our first panel why this is happening.

Day trading is an expensive gamble. People who try it without adequate information and safeguards and forewarning are likely to lose tens of thousands of dollars. The stories can be sad, sometimes tragic. Victims get caught up in the hype of day-trading firms. They fail to ask questions about the risk. They fail to be informed about the risk.

Madam Chairman, I hope we can get some understanding today of just what the people at the top of these day-trading firms know or do not know about the lapses and irregularities that we heard about yesterday, and from our first panel, what actions the regulatory bodies are going to take to bring day trading within both the spirit and the letter of the requirements of securities laws and regulations.

Again, I commend you and thank you, Madam Chairman, for your leadership and determination to probe this area.

Senator COLLINS. Thank you very much, Senator Levin.

We are now very pleased to have with us as our first panel of witnesses this morning three members of the regulatory community. First, I would like to welcome Lori A. Richards, who is the Director of the Office of Compliance Inspections and Examinations for the Securities and Exchange Commission. Ms. Richards will make public for the first time today a report prepared by the SEC staff summarizing their findings from a comprehensive examination of 40 day-trading firms. Those of you who attended the Subcommittee hearing last fall may remember that the SEC Chairman, Arthur Levitt, told us that such an examination was underway and we are very pleased to hear the results of it today.

Next, we will hear from another witness who has appeared before us in the past, Barry Goldsmith, who is Executive Vice President, Enforcement of the National Association of Securities Dealers Regulation. The NASD Regulation, Inc. is a self-regulatory body that is charged with the initial duty of overseeing the day trading industry, and again, we look forward to hearing Mr. Goldsmith's testimony regarding enforcement efforts on the part of the self-regulatory organization.

And finally, we are also very pleased to have with us today Deborah Bortner, who is the Director of the Washington State Securities Division. In one of my previous jobs, I spent 5 years in Maine State

miration for securities administrators and I am delighted to welcome you here today. As the chief securities regulator for the State of Washington, Ms. Bortner directed a comprehensive examination of every day-trading firm doing business in her State. We are particularly interested in the profitability data which her office collected during this examination because it is the most comprehensive assessment of profitability that I believe has been conducted. I should also mention that Ms. Bortner is the President-Elect of the North American Securities Administrators Association, also known as NASAA, which represents State securities regulators from all 50 States and Canada.

So I am delighted to welcome our witnesses. I would ask you to stand so that I can swear you in. Do you swear that the testimony you are about to give to the Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God?

Ms. RICHARDS. I do.

Mr. GOLDSMITH. I do.

Ms. BORTNER. I do.

Senator COLLINS. I am going to ask that each of you limit your oral testimony to no more than 10 minutes. We will be using a timing system this morning. The green light will come on at the beginning. One minute before the 10-minute period has expired or is about to expire, the orange light will go on. And when you see the red light, if you will conclude your testimony, that will be helpful to us. We will, however, print your written testimony in its entirety in the hearing record, as well as any other documents you may wish to submit.

Ms. Richards, we will ask you to begin. Thank you.

TESTIMONY OF LORI A. RICHARDS,1 DIRECTOR, OFFICE OF COMPLIANCE, INSPECTIONS AND EXAMINATIONS, SECURITIES AND EXCHANGE COMMISSION, WASHINGTON, DC

Ms. RICHARDS. Chairman Collins, Ranking Member Levin, good morning. I am pleased to appear before the Subcommittee this morning on behalf of the Securities and Exchange Commission to outline our recent actions with respect to day trading. I am Lori Richards, Director of the Exam Program at the Commission.

The Commission has sought to address concerns about day trading by using a four-part strategy. First, by conducting an examination sweep of day-trading firms to evaluate their compliance with the law and to gather information about this new industry. Second, by fostering investor education about the risks of day trading. Third, by considering regulatory changes. And finally, by bringing enforcement actions, where appropriate.

I am pleased today to provide you with a report summarizing the findings of the first part of that initiative. The report summarizes our findings from our examination sweep of firms offering day trading to the public. From October 1998 through September 1999, in coordination with the NASD, we examined 67 firms offering day trading to the public. I would like to take a moment, if I could, to briefly summarize what we found in those examinations.

The prepared statement of Ms. Richards with an attachment appears in the Appendix on

While the examinations did not reveal widespread fraud, they did reveal a number of serious violations warranting referral to our Division of Enforcement. These violations included net capital, short sale, and margin violations. The examinations also revealed deficiencies in advertising, in supervision, and in registration rules. As a result of these examinations, we have concluded that many day-trading firms need to enhance their compliance with securities regulations. The inability of some firms to monitor their compliance with capital, margin, and the short-sale rule, or to maintain adequate books and records, raises serious concerns. All of the firms at which deficiencies were found have been cited in deficiency letters, or in the most serious cases, referred to our Division of Enforcement.

In September, Chairman Levitt told this Subcommittee that he was concerned about the potential for individuals to be seduced by promises of easy profits from day trading without fully understanding the risks. During our examinations, we reviewed the information that firms were providing to customers concerning the risks of day trading. We found that as of the time of the examinations, most firms provided little or no information to their customers concerning the risks of day trading. A recent review indicates, however, that many firms have vastly improved their risk disclosure. Clearly, the industry is responding to regulators' concerns, and certainly the work of this Subcommittee and the media have highlighted the risks associated with day trading.

I would like to also address another area of concern, margin lending. During examinations, we focused on a number of lending practices by the firms, direct lending by the firm, lending through associated persons of the firm, and the arranging of loans by the firm between customers and between third parties and customers. By using leverage, day traders hope to increase their potential profit from small movements in the price of stocks. Unfortunately, that leverage can also substantially increase losses, often beyond what day traders can afford to lose. We are concerned that many day traders do not fully appreciate that by borrowing to buy securities, they can actually lose more than their initial investment.

This is why our collective efforts to educate investors are so important. Today, we are continuing to do that by posting another notice on the Commission's investor education Web site. Along with our investor alert concerning the risks of day trading, we have today posted investor tips concerning the risks of buying stock on margin.

We are also focusing on securities rules and how we can address concerns about day trading by tightening up regulations. The NASD, the New York Stock Exchange, and other SROS have taken a number of steps and have proposed rules that would restrict margin for day traders, require day-trading firms to disclose the risks of day trading to potential customers, and to determine whether day trading is appropriate for their customers.

Finally, our Division of Enforcement is continuing to investigate several referrals that stemmed from our examination sweep, and recently, the Commission brought two cases against day-trading

The SEC will continue to focus resources on day trading. We will be conducting additional targeted examinations, continuing to evaluate whether regulatory changes are appropriate in light of industry practices, continuing to work to educate investors about the risks of day trading, and we will bring additional enforcement actions, where appropriate.

As Chairman Levitt told this Subcommittee last September, we are committed to doing everything we can to ensure that day-trading firms are operating within the boundaries of the law and we hope that individuals considering this type of trading strategy do their homework on the risks of day trading before risking their money.

Thank you. I am happy to respond to any questions you may have.

Senator COLLINS. Thank you very much, Ms. Richards. Mr. Goldsmith.

TESTIMONY OF BARRY R. GOLDSMITH,1 EXECUTIVE VICE PRESIDENT, ENFORCEMENT, NASD REGULATION,

WASHINGTON, DC

INC.,

Mr. GOLDSMITH. Thank you. Good morning. Thank you for the opportunity to testify today on behalf of NASD Regulation, Inc. These hearings provide the industry, the regulators, and most importantly, the investing public with new and useful information about day trading. My testimony this morning will deal with NASD Regulation's enforcement actions and investigations relating to day trading, as well as the NASD's recent rule proposals in this area. NASDR recognizes that day trading is a legitimate trading strategy and, if it is conducted by individuals who both understand and knowingly assume its risks, we do not intend to encourage or discourage such activities. That being said, NASDR continues to view day trading as a highly risky form of trading that requires new regulatory initiatives and, where appropriate, the filing of formal enforcement actions. The eight day trading enforcement cases we filed this week are examples of our strong commitment to compliance by NASD member firms and their personnel in this area.

In 1999, the staffs of NASDR and the SEC launched a coordinated, focused examination program of day-trading firms. As part of that effort, we examined 22 day-trading firms that varied significantly in size and makeup. Fifty-five NASDR examiners received special training in the intricacies of day trading. During these examinations, we found several potential problem areas, including misleading and exaggerated advertising, improper margin lending practices, improprieties in customer-to-customer loans arranged by day-trading firms, registration violations, supervisory failures, and violations of the NASD short-sale rules.

As a direct result of our examination efforts begun last year, NASDR announced yesterday that it had filed eight new day trading enforcement actions. While other day trading investigations continue, the actions that we filed this week represent an important step in our efforts to address problems in this area and our goal overall of improving member firm compliance.

These eight cases allege allegations and findings against firms and individuals that reflect many of the concerns we originally reported to the Subcommittee last September. They include misuse of customer funds and securities, improper lending and margin practices, exaggerated and misleading advertising, improperly registered persons, violations of the NASD short-sale rule, improper use of the small order execution system, and supervisory inadequa

cies.

Two of the cases involve allegations of misuse of funds, including one in which we allege that the owner of a day-trading firm solicited more than $150,000 from outside investors, falsely representing that these monies would be used for risk-free loans to day-trading customers of the firm. In that case, the investors were promised returns of at least 15 percent per year, or 20 percent of the profits earned by the day traders to whom the money was lent. Instead, the funds were loaned to customers with no controls or restrictions and were improperly used for branch operating expenses and virtually all of the money was eventually lost.

In two other cases, NASDR found violations of the NASD rules in connection with margin calls, including one in which a firm's principal allowed a customer to effect 120 transactions while the customer's account was coded "no more business" by the clearing firm for failing to meet a margin call.

In another case, a firm employee established a separate entity which then loaned funds to firm customers to meet margin calls to enable them to continue to trade.

Four of the day trading actions announced yesterday include allegations or findings of violations of our advertising rules, including instances in which firms placed exaggerated and potentially misleading advertising on the Internet, as well as in local print and media advertisements. These firms typically exaggerated the ability of customers to access markets immediately without disclosing the risks inherent in day-trading strategies, including market volatility. One advertisement told prospective day traders that they could, "Control their own destiny through electronic day trading" without any corresponding disclosure of the risks.

NASDR alleged and made findings that firms failed to ensure that individuals actively engaged in their day trading operations were properly registered, including one case in which the individual running the firm's day trading business was not even registered as a principal. In other cases, employees of the firm were acting as equity traders without having completed the NASD's Series 55 registration requirements. In one case, the firm allowed individuals to input trades for customers for periods of several weeks without registering them in any capacity with the firm.

Finally, certain of the actions taken this week involve serious supervisory deficiencies, including one case in which a firm engaged in day trading activities without having any written supervisory procedures in place to address that area of the firm's business.

In addition to the enforcement actions we filed, we also have instituted new heightened procedures in our review of day-trading firms' Web sites. Since we instituted this program, NASDR staff have looked at over 120 Web sites, reviewing each of those sites at