    [Senate Hearing 106-285]
    [From the U.S. Government Publishing Office]

                                                            S. Hrg. 106-285

                            DAY TRADING: AN OVERVIEW

    =======================================================================

                                    HEARING

                                   before the

                                   PERMANENT
                         SUBCOMMITTEE ON INVESTIGATIONS

                                     of the

                                  COMMITTEE ON
                              GOVERNMENTAL AFFAIRS
                              UNITED STATES SENATE

                           ONE HUNDRED SIXTH CONGRESS

                                 FIRST SESSION

                                   __________

                               SEPTEMBER 16, 1999

                                   __________

          Printed for the use of the Committee on Governmental Affairs

                         U.S. GOVERNMENT PRINTING OFFICE
    61-159 CC                    WASHINGTON : 1999

    _______________________________________________________________________
    For sale by the Superintendent of Documents, Congressional Sales Office
             U.S. Government Printing Office, Washington, DC 20402

                       COMMITTEE ON GOVERNMENTAL AFFAIRS

                       FRED THOMPSON, Tennessee, Chairman
    WILLIAM V. ROTH, Jr., Delaware       JOSEPH I. LIEBERMAN, Connecticut
    TED STEVENS, Alaska                  CARL LEVIN, Michigan
    SUSAN M. COLLINS, Maine              DANIEL K. AKAKA, Hawaii
    GEORGE V. VOINOVICH, Ohio            RICHARD J. DURBIN, Illinois
    PETE V. DOMENICI, New Mexico         ROBERT G. TORRICELLI, New Jersey
    THAD COCHRAN, Mississippi            MAX CLELAND, Georgia
    ARLEN SPECTER, Pennsylvania          JOHN EDWARDS, North Carolina
    JUDD GREGG, New Hampshire
                 Hannah S. Sistare, Staff Director and Counsel
          Joyce A. Rechtschaffen, Minority Staff Director and Counsel
                     Darla D. Cassell, Administrative Clerk

                                     ------

                    PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                       SUSAN M. COLLINS, Maine, Chairman
    WILLIAM V. ROTH, Jr., Delaware       CARL LEVIN, Michigan
    TED STEVENS, Alaska                  DANIEL K. AKAKA, Hawaii
    GEORGE V. VOINOVICH, Ohio            RICHARD J. DURBIN, Illinois
    PETE V. DOMENICI, New Mexico         MAX CLELAND, Georgia
    THAD COCHRAN, Mississippi            JOHN EDWARDS, North Carolina
    ARLEN SPECTER, Pennsylvania
              K. Lee Blalack, II, Chief Counsel and Staff Director
          Linda J. Gustitus, Minority Chief Counsel and Staff Director
                         Mary D. Robertson, Chief Clerk

                                C O N T E N T S

                                     ------
    Opening statements:
                                                                       Page
        Senator Collins..............................................     1
        Senator Levin................................................     4
        Senator Cleland..............................................     5

                                   WITNESSES
                          Thursday, September 16, 1999

    Hon. Arthur Levitt, Jr., Chairman, U.S. Securities and Exchange
      Commission, accompanied by Robert L.D. Colby, Deputy Director,
      Market Regulation, Securities and Exchange Commission..........     7
    Mary L. Schapiro, President, NASD Regulation, Inc., Washington,
      DC.............................................................    19
    Peter C. Hildreth, President, North American Securities
      Administrators Association, Washington, DC, accompanied by
      David Shellenberger, Chief of Licensing, Commonwealth of
      Massachusetts Securities Division, Boston, Massachusetts.......    22
    Saul S. Cohen, Consulting Counsel, Electronic Traders
      Association, New York, New York................................    35

                         Alphabetical List of Witnesses

    Cohen, Saul S.:
        Testimony....................................................    35
        Prepared statement, with attachments.........................   178
    Hildreth, Peter C.:
        Testimony....................................................    22
        Prepared statement, with attachments.........................   167
    Levitt, Hon. Arthur, Jr.:
        Testimony....................................................     7
        Prepared statement...........................................    55
    Schapiro, Mary L.:
        Testimony....................................................    19
        Prepared statement with attachments..........................    79
    Shellenberger, David:
        Testimony....................................................    22

                                    Exhibits

    * May Be Found In The Files of the Subcommittee

     1. GFall 1999 Adult Education Program, Gardiner, Maine,
      highlighting the course ``Day Trading For Beginners''..........   213

     2. GPicture of road sign seen by Senator Carl Levin on freeway
      exit in Detroit, Michigan, ``Day Traders--Learn To Trade
      Futures & Options On-Line--1-800-704-7071''....................   215

     3. GTwo print outs from TCI Corporation's Web site..............   216

     4. GPrint out from All-Tech Investment Group, Inc.'s Web site...   218

     5. GTwo print outs from On-Line Investment Services, Inc.'s Web
      site...........................................................   219

     6. GSupplemental answer provided for the record by Robert L.D.
      Colby, Deputy Director, Division of Market Regulation,
      Securities and Exchange Commission, regarding Day Trading
      Margin Requirements............................................   221

     7. GSecurities and Exchange News Release, dated September 16,
      1999, SEC Investor Alert--Day Trading: Your Dollars At Risk....   225

     8. GNorth American Securities Administrators Association, Inc.
      (``NASAA''), Day Trading Program Report, dated August 9, 1999
      (Three parts: (1) Findings and Recommendations, (2) Appendix,
      and (3) Analysis prepared by Ronald L. Johnson, Investment
      Consultant, entitled ``Day Trading--An Analysis of Public Day
      Trading at a Retail Day Trading Firm'')........................     *

     9. GSupplemental questions and answers for the record of Saul
      Cohen, Consulting Counsel, Electronic Traders Association......   228

     10. GMemoranda prepared by K. Lee Blalack, Chief Counsel and
      Staff Director, Brian C. Jones, Investigator, and Wesley M.
      Phillips, Investigator, Permanent Subcommittee on
      Investigations, dated September 14, 1999, to Permanent
      Subcommittee on Investigations' Membership Liaisons, regarding
      September 16 Hearing: Day Trading: An Overview.................   246

                            DAY TRADING: AN OVERVIEW

                                  ----------

                          THURSDAY, SEPTEMBER 16, 1999

                                         U.S. Senate,
                    Permanent Subcommittee on Investigations,
                      of the Committee on Governmental Affairs,
                                                        Washington, DC.
        The Subcommittee met, pursuant to notice, at 9:37 a.m., in
    room SD-628, Senate Dirksen Office Building, Hon. Susan M.
    Collins, Chairman of the Subcommittee, presiding.
        Present: Senators Collins, Levin, and Cleland.
        Staff Present: K. Lee Blalack, Chief Counsel and Staff
    Director; Mary D. Robertson, Chief Clerk; Glynna Christian
    Parde, Chief Investigator and Senior Counsel; Kirk E. Walder,
    Investigator; Brian C. Jones, Investigator; Wesley Phillips,
    Detailee/GAO; Eileen M. Fisher, Investigative Assistant;
    Elizabeth Hays, Staff Assistant; Linda Gustitus, Minority Chief
    Counsel; Leslie Bell, Congressional Fellow; Anne Bradford
    (Senator Thompson); Brian Benczkowski (Senator Domenici);
    Michael Loesch (Senator Cochran); Felicia Knight and Steve
    Abbott (Senator Collins); Seema Singh and Gregory Thomas
    (Senator Specter); Nanci Langley (Senator Akaka); Lynn
    Kimmerly, John Brownlee, Michael Andel, and Andrew
    Vanlandingham (Senator Cleland); Darla Silva (Senator Durbin);
    and Peter Ludgin and Diedre Foley (Senator Lieberman).

                  OPENING STATEMENT OF SENATOR COLLINS

        Senator Collins. The Subcommittee will come to order.
        I would like to thank our witnesses for braving the
    hurricane to be with us here this morning. I know that for some
    of you, who are coming some distance, that was indeed a
    challenge, and I appreciate the efforts that you have made to
    be with us today.
        We convene the first congressional hearing on day trading.
    This hearing is the first in a series that the Permanent
    Subcommittee on Investigations will hold on this subject.
        Today's hearing will provide an overview of the day-trading
    industry, while subsequent hearings will highlight case studies
    developed during our on-going investigation. These hearings
    continue the tradition of the Subcommittee of investigating
    issues affecting small investors.
        Unlike traditional investing, day trading involves taking
    positions in stocks for very short periods of time, usually
    minutes or hours, but rarely longer than a day. One day trader
    was recently quoted as saying, ``Wall Street's not about
    investing anymore, it's about numbers. Who cares whether [the
    stock] is a car company or a chemical company? Who cares what
    they're going to be doing in [the year] 2000?''
        Day traders seek to profit in small increments from moment-
    to-moment fluctuations in the stock's price. The firms that
    cater to day traders provide high-speed computer access and
    real-time market quotes, which are necessary to rapidly take
    advantage of small changes in stock prices.
        The technology revolution that is affecting so many aspects
    of American life is also changing, in a very fundamental way,
    the relationship between the ordinary investor and the markets.
    New technology now allows investors to access the markets
    directly without the aid, or the advice, of a broker-dealer,
    something that was previously limited to a relatively small
    number of professional traders. This dramatic change in access
    raises a host of questions for Federal and State regulators,
    for the security industry, and for investors.
        Ironically, the three developments that have made day
    trading possible are otherwise very positive for investors. The
    first is the ability to execute transactions at the investor's
    convenience using the Internet. The second is dramatically
    lower commissions, and the third is greatly expanded access to
    financial information, including documents such as a company's
    Form 10-K contained in the SEC's EDGAR system.
        I should emphasize that day-trading firms differ
    significantly from traditional brokerage houses, and even from
    the discount brokerage industry. Online discount brokerage
    firms, such as Charles Schwab, do not provide their customers
    with direct access to the trading floor.
        Moreover, the Subcommittee recognizes that the use of the
    Internet to obtain information about investing or to place,
    buy, and sell orders has given consumers substantially greater
    access to financial information and investment opportunities
    previously available only to industry professionals. Day
    trading, however, raises serious concerns unrelated to the use
    of the Internet for trading or as a source of financial
    information.
        I would like to show something that illustrates why it is
    so imperative for the investing public to better understand day
    trading and its risks.\1\ This course, and you can see the
    cover of the Adult Education leaflet that was circulated, is
    from an adult education program in Gardiner, Maine. It was
    recently sent to me by one of my constituents. As you can see
    from the course offerings, folks in Gardiner, Maine, can learn
    from their adult education course dried floral arranging,
    perennial gardening, and Christmas wreath design, and for a fee
    of only $5, they can go to the local high school and attend Day
    Trading for Beginners.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 1 on page 213 in the Appendix.
    ---------------------------------------------------------------------------
        The very fact that adult education programs in small
    communities like Gardiner, Maine, might be teaching day-trading
    strategies reflects the increasing pervasiveness and popularity
    of the day-trading phenomenon and the degree to which it is
    being presented to ordinary investors as just another bona fide
    investing strategy. As an interesting side note, this
    particular course was canceled after the tragic shooting by the
    Atlanta day trader.
        Our hearing today will attempt to answer three questions.
    First, is day trading really nothing more than gambling? To
    answer this question, the Subcommittee is examining the
    profitability of day trading, the risks involved, and the
    responses to this development from the industry and the
    regulators.
        Policymakers need to know whether day-trading firms teach
    investing or simply another form of card counting. Many day-
    trading firms provide seminars for customers who wish to learn
    day-trading strategies. These seminars generally run for only
    several days and cost anywhere from $1,500 to $5,000. One such
    course is called ``1-800 RetireNow!'' Enticed by such
    exaggerated promises, some individuals who complete these
    courses actually give up their careers to day trade full time.
        Now, very few Americans would think it prudent to quit
    their jobs or to cash in their retirement savings to become
    professional gamblers who support their families at a Las Vegas
    casino. Yet, the day-trading industry estimates that nearly
    5,000 citizens are full-time day traders. The SEC's estimate is
    even higher.
        For example, a 28-year-old bank employee in California left
    his job and borrowed $40,000 from credit cards to become a day
    trader, only to lose all of his money day trading within 2
    months. This young man is now deeply in debt and living with
    his parents.
        In Chicago, a waiter with no investment experience became a
    day trader and lost an inheritance of more than $200,000. The
    waiter told the Subcommittee staff that many of the people with
    whom he day-traded knew as little about investing as he did.
        In Boston, an elderly man with severe health problems lost
    about $250,000 of his wife's savings in just a few hours at a
    day-trading firm.
        The second important question is whether some day-trading
    industry firms are engaged in deceptive and fraudulent
    practices, and if so, how pervasive is this misconduct? State
    regulators have charged the day-trading industry has engaged in
    widespread abuses, including deceptive advertising, trading by
    unregistered broker-dealers, and violations of rules relating
    to suitability and margin requirements. Although several day-
    trading firms settled cases brought by State regulators, the
    industry as a whole strongly contests these findings. We will
    hear testimony on these general issues today, while the
    Subcommittee continues to investigate the practices of specific
    day-trading firms.
        The third question that is central to our inquiry is what
    is the impact of day trading on individual companies and the
    markets? The industry's own estimates indicate that between 10
    and 15 percent of the daily volume on the NASDAQ exchange is
    attributable to day trading. Now, some critics argue that day
    trading increases and creates excessive market volatility.
    Other observers, however, contend that day trading increases
    market efficiency and liquidity, while still others believe
    that day trading simply has had very little impact on the
    markets. By the conclusion of our investigation, the
    Subcommittee hopes to have a much better understanding of the
    economic impact of day trading on the markets and capital
    formation.
        Finally, let me add that I convene this hearing highly
    skeptical of day trading, but not as an advocate for banning
    the practice altogether. State securities regulators have
    estimated that more than 70 percent of day traders lose money
    and only about 12 percent demonstrate the capacity to be
    successful. I find those statistics to be very troubling.
        These figures also raise critical questions about whether
    investors are truly informed of the risks involved or whether
    they are simply being fleeced by some unscrupulous day-trading
    company.
        If an investor is fully aware of the risks and decides to
    engage in day trading anyway, that is his choice. If, however,
    a day-trading company fails to disclose the risks and entices
    the unsophisticated investor with deceptive advertisements and
    exaggerated claims, that is quite another matter.
        While we are confronted with many complex issues today, we
    are very fortunate to have an outstanding group of witnesses to
    assist us as we attempt to sort through the conflicting claims
    about day trading. I particularly look forward to hearing
    testimony from the Securities and Exchange Commission Chairman
    and the National Association of Securities Dealers Regulation
    President about their recent examination of more than 60 day-
    trading firms. The preliminary results of these examinations
    will be released for the first time at our hearing today.
        It is now my pleasure to recognize my distinguished
    colleague and the Ranking Minority Member of this Subcommittee,
    Senator Levin, for his opening statement.
        Thank you.

                   OPENING STATEMENT OF SENATOR LEVIN

        Senator Levin. Thank you, Madam Chairman, and thank you for
    your leadership in trying to protect American consumers.
        Earlier this year, this Subcommittee held hearings on
    sweepstakes, and today, we are talking about day trading. To
    me, they fall under the same category of business practice,
    which involves enticing consumers with the promise of quick
    money.
        Many of us would love to get rich quickly and retire young,
    and when you are told that there is a ready-made investment
    system that holds out quick and large returns, the instinct to
    jump aboard and try it out is there for many people. What can
    be overlooked, however, is the fact that the system being
    promoted does not involve investment in the sense that we know
    it and understand it, and that it does involve significant
    risk.
        Once in the system, when you realize that you are starting
    to lose money and think perhaps that this is not the right
    business to be in, you can be enticed to recover your losses by
    borrowing money and making more trades. That is a sketch of day
    trading, and its visibility and allure to the public is
    growing.
        Just the other day, I was exiting a freeway near my home in
    Detroit, and I came across a sign on a fence at the exit
    ramp.\1\ In big bold letters, it announces ``Day Trading'' and
    gives an 800 number to call.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 2 on page 215 in the Appendix.
    ---------------------------------------------------------------------------
        Now, that particular notice does not use any promotional
    language other than getting people to notice the name and the
    number, but it shows just how pervasive this allure to day
    trading is that they put signs on fences for people to see if
    they can get them to call 800 numbers to get into the system.
        Too many firms, once people make that original contact,
    entice consumers with deceptive and misleading advertisements,
    such as ``earn 12 percent per day before a commission'' and ``6
    to 7 figure income per year.'' One company claims to have a
    ``trading system with a profit-to-loss ratio of 12 to 1 and an
    average return better than 18 percent per trade before
    slippages.'' \1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3 on page 216 in the Appendix.
    ---------------------------------------------------------------------------
        Moreover, it claims that no experience is needed, and when
    asked by State regulators to prove those claims, the company,
    TCI, could not do it. Apparently, most day traders lose money.
        Regulators have said that day traders must make a 56-
    percent profit just to cover commissions and fees. A recent
    report by the North American Securities Administrators
    Association revealed that at one branch office, over 70 percent
    of the traders lost money.
        In analyzing the trading strategy used through the types of
    trades made, the report concluded that the majority of traders
    appeared to use strategies which engendered 100-percent risk of
    loss.
        Day trading is not investing, and most people, even in the
    day-trading industry, acknowledge that. The SEC says it is
    gambling.
        Given the estimate referred to in the testimony of the
    North American Securities Administrators Association that 70
    percent of day traders lose money, you would have a better
    chance of playing the slot machine.
        Now, if day trading is gambling, and it sure looks like it
    to this outsider, and more importantly, if it is gambling as is
    stated by the SEC, a key insider, then on-site firms are
    gambling casinos and should be regulated as such.
        We have rules in the securities industry with respect to
    suitability and margin requirements in order to protect
    consumers. If these rules are not sufficiently protective of
    persons solicited for and engaged in day trading, I hope that
    we can develop legislation and enact legislation which will
    protect those consumers.
        Again, I want to thank you and commend you, Madam Chairman,
    for your leadership in another area where there is just too
    much consumer abuse going on in this country.
        Senator Collins. Thank you very much, Senator Levin.
        I am now pleased to call on Senator Cleland. Senator
    Cleland and I both in previous life were involved in securities
    regulations of State officials, and he has been an active
    participant in all of our investigations on securities issues.

                  OPENING STATEMENT OF SENATOR CLELAND

        Senator Cleland. Thank you, Madam Chairman.
        Ladies and gentlemen, welcome to this hearing.
        I am intrigued by the comments by the distinguished Senator
    from Michigan, Senator Levin, and marvel at the insight of our
    wonderful Chairman here who has decided to focus on a very
    fascinating issue of the world of securities and investments in
    America. I am delighted to be here at this hearing.
        Let me just say that tragically enough, I have a personal
    interest in the whole issue of day trading. Maybe the good news
    first. The good news is I was securities administrator in
    Georgia for 12 years, and my Administrative Assistant today in
    the Senate is Wayne Howell who was the Assistant Commissioner
    of Securities in Georgia for 12 years--but we had a tragic
    incident in Atlanta.
        We had a situation in which an individual killed his family
    members and then came in with guns ablazing into two different
    office complexes killing and maiming a number of other people
    that he day-traded with, and then after being apprehended off
    of an interstate north of Atlanta, killed himself after losing
    almost half-a-million dollars as a day trader.
        That is an incredible situation. It has been discovered
    that in one 3-day binge, this day trader lost $153,000,
    according to a trading report from Momentum Securities in
    Atlanta. Ultimately, his losses totalled a half-a-million
    dollars.
        In the wake of the shootings, the news reports and other
    studies have led me to the conclusion, the risks associated
    with day trading are extremely serious. While many day traders
    are aware of the possibilities of large losses, some are not.
        The interesting thing about going to Las Vegas is it is
    sometimes called ``Lost Wages,'' and that people understand
    they can go in, in a $20,000 car and come out in a $200,000
    bus, but people who day-trade are not necessarily aware of
    those kind of risks.
        The recent tragedy in Atlanta showed us just how stressful
    day trading can really become. Traders without the proper
    experience or training are at the greatest risk of losing their
    entire portfolios. I do not think most people who day-trade are
    aware of that.
        I believe I do echo the sentiments of my colleagues on this
    Subcommittee when I state that there is an obvious need, as
    stated by our Chairman and our Ranking Minority Member, and I
    state that there is a great need to take a closer look at this
    issue.
        Specifically, I am concerned with an apparent abuse of
    existing regulations by many day-trading firms, as highlighted
    in the North American Securities Administrators Association Day
    Trading Report.
        My Administrative Assistant now, who was the assistant
    administrator for securities in Georgia, is a former head of
    the North American Securities Administrators Association.
        So I am optimistic that in addition to shedding light on
    the problems associated with this segment of the securities
    industry, this hearing will act as a catalyst for increased
    cooperation between representatives of the trading firms,
    regulators, and investors. Such cooperation, I think, is
    essential to ensuring the continued viability of this practice,
    while also protecting the interest of the American people.
        We used to say in our office in Atlanta, and in Georgia, to
    our investing public, if it sounds too good to be true, it
    probably is too good to be true, and that caution should
    certainly be applied to day trading.
        Madam Chairman, I am glad to be with you today and look
    forward to our panelists.
        Senator Collins. Thank you very much, Senator.
        I am pleased to welcome our first witness this morning, the
    Hon. Arthur Levitt, the Chairman of the Securities and Exchange
    Commission. Chairman Levitt is now in his second term at the
    SEC, and he is the longest-serving SEC Chairman in history.
        I also want to add as a comment that I think of all the SEC
    Chairmen in history that there is no one who has been more
    dedicated to educating the small investor than Chairman Levitt,
    and I commend him for the emphasis that he has placed on that
    important duty.
        We were here previously in this Subcommittee and heard
    testimony from Chairman Levitt on the persistent problem of
    fraud in the micro-cap markets. We benefited tremendously from
    his testimony then, and we look forward to hearing his views on
    day trading as well.
        I would note that the SEC has just announced today that
    they will be posting an investor alert on day trading on their
    Web page. I think that is an excellent example of the
    Chairman's commitment to investor protection, and I look
    forward to hearing his testimony.
        Pursuant to Rule 6 of the Subcommittee, all witnesses who
    testify are required to be sworn in. So, at this time, I would
    ask Chairman Levitt to stand and raise his right hand.
        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?
        Mr. Levitt. I do.
        Senator Collins. Thank you.
        Please proceed. We would ask that you attempt to limit your
    formal testimony to 10 minutes to allow time for questions.

        TESTIMONY OF HON. ARTHUR LEVITT, JR.,\1\ CHAIRMAN, U.S.
    SECURITIES AND EXCHANGE COMMISSION; ACCOMPANIED BY ROBERT L.D.
    COLBY, DEPUTY DIRECTOR, MARKET REGULATION, U.S. SECURITIES AND
                          EXCHANGE COMMISSION

        Mr. Levitt. Chairman Collins, Senator Levin, Senator
    Cleland, and Members of the Subcommittee, thank you for the
    opportunity to be here this morning to discuss day trading and
    its impact on our Nation's securities markets.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Levitt appears in the Appendix on
    page 55.
    ---------------------------------------------------------------------------
        This hearing could not be more timely. It seems almost
    every day we hear one story or another about day trading. As we
    speak, the Commission is conducting examinations of day-trading
    firms. I will have more to say about this in a moment, but let
    me begin by stating the obvious.
        Technological developments are revolutionizing our capital
    markets from how people invest to how brokers do business to
    how our markets function. Today's individual investor, for
    example, has ready, instant access to market data, and in some
    cases markets, that up until a few years ago was available only
    to securities professionals.
        One of the byproducts of this revolution has been the
    emergence of the day trader. Through the use of sophisticated
    computer software, day traders sit in front of computer screens
    and look for nothing more than real-time price movements.
        What it is that they are buying or selling is of absolutely
    no concern to them. The coin of the realm for the day trader
    does not extend beyond volatility. If you sense a stock will
    rise, buy. And if you sense that it might fall, sell. That is
    the strategy of day trading. It is not illegal, it probably is
    not unethical, but it is highly risky.
        In recent months, I have been asked more than once why the
    SEC cares whether a day trader loses his or her money. It is
    their life, and it is their choice, but I do not think that is
    the issue.
        I am concerned that many day traders do not fully
    understand the level of risk that they are assuming. I am
    concerned that many people may be lured into the false belief
    that day trading is a sure-fire strategy to make them rich,
    and, when individuals are swayed by misleading advertising, the
    Commission has a duty to act.
        That is why I believe we should be focusing on the
    advertising and marketing practices of a number of day-trading
    firms. It is in this area that I believe that the Commission's
    partnership with the States and State regulators is absolutely
    crucial. A number of States have been leaders in addressing
    this issue not just as a matter of securities law, but more
    importantly, as a matter of consumer protection.
        The NASD also has proposed rules that are designed to
    address the sales practices of day-trading firms. This proposal
    will require these firms to disclose up-front risks associated
    with this activity and to screen potential day traders to
    determine suitability. Eliminating deceptive marketing and
    advertising practices is a large part of the solution. Another
    is how day-trading firms comply with the law.
        The Commission is in the process of completing an
    examination sweep of day-trading firms. Our preliminary
    findings indicate that many of these firms have extremely lax
    compliance practices. The inability of some firms to monitor
    their adherence to the capital, margin, and short-sale rules or
    to maintain adequate books and records, raises very serious
    concerns. These rules, in many ways, go right to the heart of
    the integrity of our markets and market participants.
        The Commission intends to vigorously pursue any violations
    of law and has a number of enforcement investigations underway.
    The use of margin in particular raises a number of issues.
        We found that many day traders do not fully appreciate
    that, by borrowing to buy securities, they can actually lose
    substantially more than their initial investments. So when day-
    trading firms aggressively promote the lending of equity
    between day traders to cover margin deficiencies, I find it
    very troubling. We are reviewing the practice to ensure that
    firms are following the law and are fully disclosing to
    customers the risks of day trading on margin.
        The SEC can regulate, and the Congress can probably
    legislate if they wish, but if an individual does not take the
    personal responsibility to be informed of the risks involved in
    day trading, I believe that no rule or law will ever fully
    protect him or her.
        I do not minimize, in any way, the responsibility of the
    firm to fully disclose the risks involved, but day traders
    really need to take the time to consider what they are getting
    themselves into.
        I commit to you that the SEC will do everything it can to
    ensure that day-trading firms are operating within the
    boundaries of the law, but I sincerely hope that individuals
    considering this type of strategy do their homework before
    risking their hard-earned money. Thank you.
        Senator Collins. Thank you very much, Chairman Levitt.
        Day trading has really arisen out of a booming stock market
    and an unprecedented access to technology. On some days, it is
    the dark side of the booming stock market.
        However, the boom is not going to go on forever. What is
    going to happen if stock prices plunge to people who have given
    up their careers and are day-trading full time when we know
    already, on the basis of some preliminary studies, that the
    profitability is very questionable in a booming stock market?
        Mr. Levitt. Just from my own experience and in our markets,
    having lived through more cycles than most present investors
    have ever experienced, I would say that my expectation would be
    that many day traders will be completely wiped out, and most,
    the vast majority of day traders, will endure punishing losses.
    But the discipline of the marketplace will do more to dis-abuse
    investors of the notion of easy profits by day trading than
    almost anything else we can do.
        Senator Collins. The day-trading industry has been very
    critical of a report that was issued by the State regulators
    association, NASAA, and has criticized it as focusing on one
    branch office that was badly run of one day-trading firm.
    However, we now have considerably more data to look at as a
    result of the examinations that NASDR and the SEC have
    conducted, which I understand you have some preliminary results
    from.
        It is my understanding that together you have examined
    around 67 day-trading firms. Could you share with us what the
    preliminary results of your examinations have been and whether
    the findings from those examinations have supported the
    conclusions of the NASAA report or not?
        Mr. Levitt. I think that the NASAA effort is absolutely
    critical to anything that we hope to accomplish in terms of
    eliminating some of the really bad practices of day trading.
        Our joint investigation and examination done with the NASDR
    resulted in approximately 10 referrals to the Enforcement
    Division for scrutiny. I find that worrisome. That is a very
    high percentage of referrals, and clearly, there is a problem.
        Senator Collins. Can you give us some further idea of the
    types of problems that your investigators found?
        Mr. Levitt. Some of the problems involved the use of
    margin. Some involve lending deficiencies, short sale
    violations. There were some net capital violations, including
    both incorrect computations and net capital deficiencies. We
    observed a number of advertising violations, including failures
    to obtain NASD approval of advertising and potentially the kind
    of misleading advertising that you have cited before.
        We noted supervision deficiencies, including instances
    where there were no written procedures and deficient
    supervision with respect to lending, review of branch offices
    and short sale activity. We also found books and records
    violations where firms were simply sloppy in basic procedures.
    These were the areas that came to light during these recent
    examinations.
        Senator Collins. Would it be fair to say, then, that many
    of the problems uncovered by your examiners were similar to
    those that were found by the State regulators?
        Mr. Levitt. I think there clearly was some overlap, yes.
        Senator Collins. I would like to turn to the issue of
    appropriateness or suitability. When a broker in a traditional
    brokerage house recommends a stock, the broker has to determine
    its suitability for the investor and does a review of the
    investor's investment objectives, financial status. Those kinds
    of issues are carefully reviewed.
        By contrast, it is my understanding that day-trading firms
    currently do not do any sort of suitability review. Is that
    correct?
        Mr. Levitt. I am not aware of any suitability reviews that
    are being engaged in by day-trading firms. I can recall, again,
    in my days as a stockbroker, when a client came in who was
    overly aggressive, we were very concerned about the
    appropriateness of their embarking on that kind of activity.
        We have asked the NASD to take a look at this issue because
    I think--I certainly feel that there is a responsibility on the
    part of any firm to see to it that individuals who clearly are
    not in a position to engage in that kind of activity, to take
    that kind of risk--an individual, for instance, a retired
    person, who depended for his or her very survival on a return
    from their investments--are not allowed to day trade. That, I
    would regard as absolutely irresponsible. The NASD is examining
    this, and I believe they will have some very specific
    recommendations in that regard.
        Senator Collins. I would like to follow up on that point by
    showing you an exhibit that suggests to me that some day-
    trading firms may actually be targeting people who are not
    suitable for day trading, who are unsophisticated investors, or
    who simply would be taking risks that they cannot afford to
    take.
        This particular exhibit is a marketing pitch by All-Tech,
    and I think it illustrates my concern. This was on All-Tech's
    Web site as of July 26 of this year, and in case it is
    difficult to read, I am just going to read through it. It says,
    ``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.'' \1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 4 on page 218 in the Appendix.
    ---------------------------------------------------------------------------
        This is the part that concerns me: ``Electronic day trading
    appeals to executives, victims of downsizing or layoffs,
    retirees, graduating students, and anyone who recognizes the
    unlimited earning potential and quality of life which day
    trading may achieve.''
        Is day trading generally appropriate for someone who has
    been laid off from his job or has just graduated from college?
        Mr. Levitt. Absolutely not.
        Senator Collins. So would this be the kind of advertising
    pitch that would concern the SEC or--I realize the NASDR has
    been delegated the authority to review such matters.
        Mr. Levitt. Without regard to the Nation's securities laws,
    just as a private citizen, I find that kind of advertising
    absolutely appalling. It is a plea to the worst instincts of
    people who might otherwise be spending their time in casinos
    rather than in engaging in that practice. I think it is very,
    very bad.
        What the NASD is considering is requiring day-trading firms
    to determine whether day trading is appropriate for particular
    customers.
        Senator Collins. And it is my understanding those proposed
    rules are now before the SEC or have just been submitted to the
    SEC for review. Is that correct?
        Mr. Levitt. We have published them for comment.
        Senator Collins. So they are now in the public comment
    phase?
        Mr. Levitt. Yes.
        Senator Collins. Unfortunately, we have a vote that has
    just begun. I am going to yield to Senator Levin for questions
    and go vote, and we will hope to keep the hearing going between
    us. Thank you.
        Senator Levin [presiding]. Thank you.
        While Senator Collins' chart is up there, the unlimited
    earnings potential, do you have any comment about unlimited
    earnings potential?
        Mr. Levitt. Unlimited loss potential would be more
    appropriate. [Laughter.]
        Senator Levin. I would like to put up another picture from
    a Web site of a company called TCI.\1\ You have a provision in
    the Securities Act and a rule which prohibits deceptive
    practices, including material misstatements and omissions.
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3 on page 216 in the Appendix.
    ---------------------------------------------------------------------------
        This firm, I do not think actually is a broker. This firm
    is a trainer of day traders. It allures people with these
    promises here of what day trading can do for them.
        It says their potential earnings, 6 to 7 figure income per
    year, and then later down on the screen, it says no experience,
    no selling, no boss, no employees, no inventory, no traveling,
    no invoice collection. All you need is a computer and a small
    amount of start-up capital. That is all that you need.
        Now, would you agree that is a misleading advertisement?
        Mr. Levitt. Yes.
        Senator Levin. The Massachusetts Attorney General got a
    cease-and-desist order against TCI for that statement. We then
    went to the TCI's Web site in preparation for this hearing to
    see what they are saying now, and here is what we found. This
    is as of yesterday. This is after a cease-and-desist order
    against them. ``The absolute best and most mechanical trading
    system that we know of in the financial market with a profit-
    to-loss ratio of 12 to 1 and an average return better than 18
    percent per trade before slippages.''
        Do you believe that day trading will produce a profit-to-
    loss ratio of 12 to 1?
        Mr. Levitt. I think that claim is ridiculous.
        Senator Levin. Now, this firm trains people, allegedly. I
    do not know if that is the word I would pick, but, nonetheless,
    shows people how to day-trade, and, yet, I do not know that it
    is subject to SEC enforcement. It is, I think, to State
    enforcement, but because they do not do the actual trading for
    the person, but train the person, I think we have to find a way
    in our law nationally, federally, to get at that kind of
    misrepresentation.
        I am wondering whether or not there is anything you are
    considering which would get to this situation where TCI is not
    engaged in the actual brokerage operation, but is misleading
    and using deceptive advertising in order to try to lure people
    into buying their course. Is there anything you are considering
    which would get at this?
        Mr. Levitt. As you have noted, because TCI is not a broker,
    not registered with the SEC, we would have to prove that the ad
    is fraudulent in connection with a securities transaction. We
    would certainly examine that connection with this or any other
    advertising that really goes beyond the pale as this one does.
        Senator Levin. You have to show that there is fraud in
    relation to a specific transaction.
        Mr. Levitt. Yes.
        Senator Levin. But if there is fraud in relation to a
    process of trading, then the current law at least would not
    seem to cover that. Is that correct?
        Mr. Levitt. I believe so.
        Senator Levin. And that is one of the issues that we need
    to face because these are not specific transactions that are
    being promoted.
        Mr. Levitt. It is a process.
        Senator Levin. It is a process which is being promoted, and
    that, it seems to me, is one of the big issues we should
    address, to get at that problem that we are now dealing with a
    process which is being held out too often as a process of big
    returns, and where there are deceptive representations about
    that process. We have got to find a way to get at the
    representation, even though it does not relate to a specific
    stock transaction. Would you agree that would be a----
        Mr. Levitt. Yes.
        Senator Levin. OK. Now, on the issue of margin--well, no.
    Let me go back to the suitability requirement because this
    relates to this same process question that we were just talking
    about.
        Is the current suitability requirement that a broker
    determine whether an investment is suitable for a customer--is
    that what the suitability requirement is in general?
        Mr. Levitt. Yes.
        Senator Levin. All right. Would that requirement then apply
    to whether a process is suitable for a customer or only whether
    a specific transaction is suitable for a customer?
        Mr. Levitt. I believe that the process would be covered by
    suitability requirements. In other words, again, a broker or a
    firm that took an elderly widow with limited resources and
    allowed that person to engage in a strategy such as this would
    run afoul of----
        Senator Levin. Of the current suitability rule.
        Mr. Levitt. Yes.
        Senator Levin. All right. Now, who makes the determination
    on suitability? Is it the broker, or is it the customer?
        Mr. Levitt. I think it is the broker that has the
    responsibility.
        Senator Levin. That responsibility falls on the broker to
    make.
        Mr. Levitt. Yes.
        Senator Levin. OK. Now, on the margin issue, I do not know
    that there has been a survey of this, but do you believe that
    the average new day trader understands that he or she would be
    subject to a margin call if that day trader buys too much stock
    on margin during a day even if at the end of the day the day
    trader no longer holds that stock and even if the day trader
    did not lose money on that stock transaction, indeed maybe made
    a profit? Would the average new day trader realize that the
    margin rules apply to a position at a moment in time during the
    day?
        Mr. Levitt. My guess, again, based on my own experience
    handling retail customers, is that the typical customer does
    not understand and is often surprised by that.
        I have also been corrected, Senator, in response to an
    earlier question which I would like to call to your attention.
    That is, that today's rule requires a broker to make sure the
    recommendation of a security is suitable for the investor, but
    the NASD is expanding that requirement now to include the
    recommendations of a strategy. So the rule today deals with the
    security. The rule, as will be expanded if this proposal is
    approved by the Commission, would include strategies.
        Senator Levin. All right. I think that is a very important
    change. I was not sure, but that was my understanding, too. So
    I am glad that you have clarified that point because that is a
    critical issue. That is now under consideration?
        Mr. Levitt. Yes. That has been put out for public comment.
        Senator Levin. Now, going back to margin, assume a
    situation where someone who has a $50,000 equity capital
    investment is allowed to buy $100,000 with that $50,000, so
    there is a margin of $50,000 using somebody else's money. They
    are in and out in a day. Assume that there is no loss on the
    transaction, but at some moment in time during that day, the
    person had a purchase of $120,000, more than was allowed, even
    for an hour. What does the margin rule provide in that
    situation? $50,000 in the account in cash. At a moment in time,
    they were--$120,000 purchase, more than is allowed by the
    rules, no loss at the end of the day because it was sold, let's
    say, for as much as it was purchased for, plus commissions or
    whatever. What, then, is supposed to be the result?
        Mr. Levitt. That is a violation of the margin rules.
        This is Bob Colby who is the head of our division of Market
    Regulation. I would like him to respond to that, if I may.
        Mr. Colby. The New York Stock Exchange margin rules, which
    apply to this trading for day traders, require them to take
    margin on the largest position, short or long, outstanding at
    any point during the day, even if the trading is flat at the
    end of the day.
        Senator Levin. What is the effect of that violation that I
    just outlined, if it was clear? Was I talking your language?
        Mr. Colby. Yes, but I did not get the numbers perfectly.
        Senator Levin. Well, they had $120,000 position, I think
    you call it.
        Mr. Colby. Yes.
        Senator Levin. So they only had $50,000, let's say, in the
    bank. They are only allowed $100,000 under my hypothetical, but
    they were $120,000.
        Mr. Levitt. They are in violation.
        Senator Levin. Right, there is a violation, but what is the
    practical effect? Are they then required to increase their
    account to $60,000? What happens?
        Mr. Colby. They are required to put into the account enough
    margin to cover their largest position.
        Senator Levin. But it is done.
        Mr. Levitt. During the day, they should be asked for
    additional funds.
        Senator Levin. As a practical matter, does that happen
    where broker firms dealing with day traders will ask people for
    funds for an hour or 20 minutes?
        Mr. Levitt. It happens in our markets. It happens in the
    commodity markets all the time.
        Senator Levin. Where people are actually asked right then,
    write out a check, give me cash?
        Mr. Colby. They are asked at the end of the day.
        Senator Levin. Not at the end of the day. The end of the
    day, there----
        Mr. Colby. They are asked at the end of the day, which
    means that they have to have the capability to come up with the
    funds at the end of the day to cover that large position.
        Senator Levin. And if they do not?
        Mr. Colby. If they do not, then the firm is in violation,
    and they have to close the customer account down.
        Senator Levin. So the customer must at the end of the day
    come up with the $60,000, the extra $10,000?
        Mr. Colby. Margin to cover its largest position open during
    the day.
        Senator Levin. And if that customer does not have that
    $10,000, under my hypothetical, at the end of the day, put in
    that account, the account must be closed?
        Mr. Colby. That is right.
        Senator Levin. OK. I am going to have to put us in recess
    just for a few minutes to go vote.
        I note that Senator Cleland wanted to ask you some
    questions, and I know that the Chairman is going to be back for
    some additional questions. So if we could just ask you to stay
    there.
        Mr. Colby. Senator, I spoke too concisely on that. They are
    required to come up with it at the end of the day. They are
    required to have that amount, but they do not have to get it in
    for 7 days.
        Senator Levin. And if they do not get it in for 7 days----
        Mr. Colby. If they do not get it in 7 days, that is when
    the account is closed.
        Senator Levin. The account must be closed. The word
    ``closed'' is the word I am emphasizing.
        Mr. Colby. I believe it actually has to be frozen.
        Senator Levin. At what level? Frozen so you cannot act on
    it?
        Mr. Colby. Yes, but I--could we supplement this?
        Senator Levin. I have got to run. Can you figure out what
    the right answer is? \1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 6 on page 221 in the Appendix.
    ---------------------------------------------------------------------------
        Mr. Colby. Yes. [Laughter.]
        Senator Levin. Because I think there may not be any
    effective penalty, and if there is no effective penalty,
    because there was no loss, then it seems to me we have got a
    problem we also ought to address as well, but let me run and
    come back.
        We will stand in recess.
        [Recess.]
        Senator Cleland [presiding]. The Subcommittee will come to
    order.
        May I just say that this is a scary moment in American
    history with me in charge. [Laughter.]
        I am on the Armed Services Committee also, and at one
    moment of distress, everyone was gone and I was the last person
    sitting. I had decided that instead of declaring war, we would
    just adjourn for lunch. So that might be our best course today.
        Chairman Levitt, you have decided to have a wonderful staff
    person join you at the table. I do not know whether I should
    swear in the gentleman there. We will assume--I will make a
    command decision. I will assume that you both will be truthful,
    as a good staff person always is.
        Chairman Levitt, would you just give us a little bit of
    insight here on day trading? I thought I knew a little bit
    about securities, again having been a securities regulator at
    the State level for a dozen years, up until about 1996. I
    thought I knew the business fairly well, though not the
    technicalities of it. As I mentioned to Wayne Howell, my
    current administrative assistant, who was my assistant
    administrator, Assistant Secretary of State for Securities
    Regulation in Georgia, day trading seems to me a relatively new
    phenomenon.
        Is it a part of this whole world of e-commerce that we have
    learned is revolutionizing our society, and that enables, shall
    we say, a consumer, in this case an investor, to directly
    access a commodity, cars, books, in this case, stocks, and,
    therefore, bring to the table in effect their own needs or
    whatever without going through a whole series of professional
    standards, laws, regulatory environments that have been set up
    since 1934, say since the SEC was created? Do you see this day
    trading as risky business, in effect part of e-commerce,
    bypassing the normal regulatory environment that was set up for
    people accessing the securities industry?
        Mr. Levitt. I think we have always had day traders in the
    securities industry. We have always had people who were
    prepared to take extraordinary and, in some cases, foolish
    risks to make a quick dollar. Clearly, a market such as we have
    experienced tends to bring the more aggressive, less careful
    practices on the part of individuals. We see more bad thinking
    and bad decisions than you do during other kinds of markets.
        We have also seen the technology changes that you have
    referred to making it possible for traders to do what they
    never could have done in the past because, with a few strokes
    of a key, they can buy or sell hundreds of thousands of dollars
    worth of securities.
        I think what that implies is kind of an emotional linkage
    there. Our literature and our television and movies have
    stressed the machismo of the trader, and individuals sitting
    behind their computer terminal begin to think that, well, they
    are as strong and smart and willing to take risks as that
    revered professional trader. What they do not know is that they
    lack the resources; they lack the experience, and, perhaps most
    importantly, they lack the emotions of a professional.
        I think I mentioned before, that of the 30 examinations we
    have completed of day-trading firms, a third of them have
    resulted in enforcement recommendations. That is a significant
    number, and that, I think, substantiates your observations.
        Senator Cleland. I do not want to beat that point too much
    to death, but I guess I am hypersensitive to the question of,
    shall we say, the psychological mood of those who are attracted
    to get-rich-quick schemes just in general.
        Senator Collins [presiding]. I am glad you did.
        Senator Cleland. I am in the middle of a question. Would
    you like for me to continue my question?
        Senator Collins. I would like you to continue. Thank you.
        Senator Cleland. It has to do with one of your charts.
        Senator Collins. OK.
        Senator Cleland. If we could put that first chart back
    up.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 4 on page 218 in the Appendix.
    ---------------------------------------------------------------------------
        Chairman Levitt, again, I do not want to beat this to
    death, but having lived through the Atlanta tragedy where a guy
    named Mark Barton took a number of lives and went down with his
    ship and ultimately took his own life, all in the space of a
    few days, I guess I came onto several words here. It just
    jumped out at me. It attracts people who are dead end, unhappy
    in their current field, victim, layoffs, then, on the other
    side, the flip side, the real get-rich-quick part of it, the
    unlimited earnings potential. In other words, on the one side,
    you have that kind of psychological profile--but on the other
    side is gold.
        Now, quickly--and that, as it has come to be discovered,
    was basically Mark Barton's psychological profile, dead end,
    unhappy in the current field, a victim, and all of a sudden day
    trading became his way out, but it was his way down, and he
    took his family and his associates--he went right back to the
    scene of his day trading and started pulling the trigger. And
    as I recall--maybe I am incorrect, but as I recall, before he
    pulled the trigger with one of his fellow associates, he said,
    ``I hope this does not spoil your day.''
        I mean, it seems to me that in this world of securities,
    there always has been that side of the securities industry that
    attracted those who wanted to get rich quick and those things
    at the margin, the boiler rooms that prey on the elderly with
    the nonexistent gas stocks and oil stocks and so forth and gold
    mines, on the phone, the penny stock ripoffs, that maybe this
    is in that genre.
        I wonder, from your point of view, do you think it is the
    role of Congress to require day-trading firms to live under the
    same auspices and under the same laws and regulations as, say,
    Merrill Lynch?
        Mr. Levitt. I do not think so, Senator.
        I think that the proposal now out there from the NASD to
    address the issue of suitability really goes a long way toward
    doing that job.
        I think hearings of this kind are terribly important in
    terms of alerting the public to the fact that day trading is
    not the kind of business that this ad would suggest.
        The tragedy in Atlanta was one involving an aberrational
    personality that could have occurred with someone who had been
    to the racetrack or casinos too often and taken out his
    frustrations in a similar way in a different venue.
        So I think that the important job that all of us have is to
    call public attention to the fact that investors simply have to
    be careful; that as far as I am concerned, it is a casino
    mentality that brings people to day trading, and that the
    overwhelming numbers of people practicing day trading will lose
    their money, and it is not easy money. It has always led
    investors to a very sorry ending. I do not think legislation
    could be sufficiently pointed to go to the emotional depths of
    individuals who have a predilection toward making the easy
    dollar.
        Senator Cleland. I agree that Congress cannot be everyone's
    personal psychologist, but the attitude that it is their life
    and their choice--I guess in my State the total laissez-faire
    attitude resulted in a loss of life and a loss of choices for a
    number of people, and somewhere in between, I think we have to
    find a reasonable solution.
        Mr. Levitt. I agree, Senator. I do not have a laissez-faire
    attitude about this, and I think the process that is being
    played out today is critically important.
        Senator Cleland. You are so kind to comment and state with
    such a strong and firm conviction your warning to American
    investors as you have done so beautifully.
        Madam Chairman, I turn the hearing back to you.
        Senator Collins. Thank you very much, Senator Cleland.
        Chairman Levitt, I just have two final questions for you
    before we move on to our next panel of witnesses.
        First, I want to give you the opportunity to respond to
    criticisms of the SEC's efforts to crack down on some troubling
    marketing and other practices of day-trading firms by giving
    you an opportunity to respond to Saul Cohen's previous comments
    about the SEC's efforts. We will be hearing from Mr. Cohen
    later today.
        In his written testimony today, he was very critical of the
    NASAA study, but in previous writings, Mr. Cohen wrote an
    article called ``The Empires Strike Back, Part Two,'' in which
    he also sharply attacks the SEC for its efforts to oversee the
    day-trading industry and to correct abuses.
        Specifically, he labels the SEC's policy regarding day
    trading as ``a war'' and accuses the SEC of resorting to
    intimidating examination tactics and of ``coming down with
    hobnailed boots on day-trading firms.''
        I want to give you the opportunity to address those very
    pointed criticisms.
        Mr. Levitt. The SEC historically has dealt with a number of
    constituencies that make up our great American capital markets,
    and it has been the position of this Commission and I expect
    our predecessor Commissions, that no constituency is more
    important than the individual investor.
        At this point in time in the history of our country's
    markets, with more investors involved in equities today than
    ever before, it is essential that the SEC serve to protect
    investors and place their interests above those of firms,
    brokers, or anyone else in the system.
        Part of the process is the collaboration of the commission
    with the NASD and other self-regulatory organizations and State
    regulators. I believe that the combined efforts of the SRO's,
    the States, and the SEC with a commitment to protecting
    investors in the midst of a rapidly proliferating interest in
    gambling practices such as day trading, has been a balanced
    effort and an important effort. This effort, as part of our
    process, is exposed to public comment, protects the interests
    of investors, is fair, and, I believe, is reasonable and
    balanced.
        Senator Collins. Well, I want to go on record as commending
    the SEC for its examination and consumer protecting efforts, as
    well as the other regulatory bodies involved.
        The comments of a prominent representative of the
    Electronic Traders Association being so harsh towards the
    regulators raises real questions in my mind about their
    willingness to correct the problems that you have identified,
    and it is something that we are going to continue to watch
    closely.
        I have just one final question for you, and that is the
    question that I raised at the very beginning of this hearing,
    and that is, based on your observations to date, do you believe
    that day trading is having an impact on the market in terms of
    increasing volatility or perhaps in a positive sense increasing
    liquidity, or do you think the volume is too small to have an
    impact?
        Mr. Levitt. As best I can tell, the volume of day trading
    probably amounts to not more than 5 percent of total volume in
    our markets. I think an argument can be made that it does
    represent some modest increase in liquidity. I do not think it
    has had a significant impact on volatility in our markets, and
    I do not intend to sound a note of doom with respect to
    electronics. I think electronics and technological changes in
    our markets have been exciting and important, critically
    important developments as our markets move ahead. I am very
    supportive of technology as being the best, and perhaps only,
    way that this Nation's markets can compete in increasingly
    globalized markets. It is where we target individuals who are
    inappropriate for certain techniques such as day trading that I
    take exception. The appropriate response to that, I believe, is
    hearings such as this, as well as the kinds of alerts and
    warnings that all of us can convey to see to it that we
    eliminate bad practices and clamp down hard on fraud.
        Senator Collins. Thank you very much, Chairman Levitt. I
    want to thank the SEC for its efforts and----
        Senator Cleland. Madam Chairman.
        Senator Collins. Yes.
        Senator Cleland. I would just like to associate myself with
    your remarks particularly commending the Chairman with his
    strong consumer protection and investor protection role that he
    plays in our government.
        Thank you very much, Chairman Levitt.
        Mr. Levitt. Thank you.
        Madam Chairman, Senator Levin, before he left, asked a
    number of questions about margins which I would like to
    supplement our testimony with. Within the next several days, we
    will send follow-up responses to those questions.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 6 on page 221 in the Appendix.
    ---------------------------------------------------------------------------
        Senator Collins. That would be very helpful. I, too, am
    very interested in the whole issue of the margin issues and the
    borrowing and the increased lending among customers. So I look
    forward to getting your replies.
        In addition, your full testimony and any additional
    information will be included in the hearing record.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 7 on page 225 in the Appendix.
    ---------------------------------------------------------------------------
        Again, thank you very much for your assistance.
        Mr. Levitt. Thank you.
        Senator Collins. I would now like to welcome our next panel
    of witnesses this morning.
        Mary L. Schapiro is the President of NASD Regulation, and
    Peter Hildreth is the President of the North American
    Securities Administrators Association, known as NASAA.
        As the President of the NASDR, Ms. Schapiro is responsible
    for regulating member brokerage firms, individual registered
    representatives, and overseeing the NASDAQ Stock Market.
        We look forward to hearing about her organization's recent
    examinations of day-trading firms, as well as NASDR's recent
    proposed rules to strengthen disclosure and suitability or
    appropriateness determinations for day trading.
        Mr. Hildreth testified before the Subcommittee earlier this
    year on securities fraud on the Internet and was extremely
    helpful to us in that investigation as well.
        In addition to serving as President of NASAA, he is Chief
    of the New Hampshire State Securities Commission. He is
    accompanied by David E. Shellenberger, who is the Chief of
    Licensing of the Massachusetts Securities Division. Mr.
    Shellenberger took a lead role in preparing NASAA's report on
    day trading.
        As I have explained earlier, all witnesses are required to
    be sworn. So I would ask that you stand and raise your right
    hand.
        Do you swear 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?
        Senator Collins. Ms. Schapiro, I am going to ask you to
    begin, please.

     TESTIMONY OF MARY L. SCHAPIRO,\2\ PRESIDENT, NASD REGULATION,
                         INC., WASHINGTON, DC.

        Ms. Schapiro. Thank you very much, Madam Chairman. Good
    morning, Senator Cleland.
    ---------------------------------------------------------------------------
        \2\ The prepared statement of Ms. Schapiro appears in the Appendix
    on page 79.
    ---------------------------------------------------------------------------
        I appreciate very much the opportunity to testify on behalf
    of NASD Regulation, Inc., and I also want to commend the
    Subcommittee for conducting these hearings which can only serve
    to further the education of investors about these important
    issues.
        NASD Regulation is the world's largest securities self-
    regulatory organization. It has responsibility for the
    oversight and surveillance of the NASDAQ Stock Market but, more
    importantly for these hearings today, we are also responsible
    for regulation, licensing, testing and examination for and
    enforcing compliance with our rules and the securities laws for
    our 5,600 broker-dealer members.
        I would like to preface my comments today by emphasizing
    that day trading is a legal trading strategy and to the extent
    it is conducted in accord with regulatory requirements, by
    individuals who are capable of understanding and assuming the
    risks involved, we neither encourage nor discourage it.
    However, with that said, we see day trading as a highly risky
    form of trading that deserves the closest scrutiny of
    regulators.
        Thus far, NASDR has taken a three-pronged approach to
    addressing the investor protection concerns that arise from day
    trading. First, we have been disseminating information and
    advisories to our members, reminding them of their many
    obligations under existing rules, and these advisories are
    fully outlined in my written statement. We have also been
    emphasizing to investors the risks involved with day trading.
        Second, we have enhanced our examination and enforcement
    programs and, third, we have proposed new rules in this area
    and are exploring additional rulemaking initiatives.
        With respect to examination and enforcement activities, we
    have been engaged in a cooperative day trading examination
    initiative with the SEC, as you have heard from Chairman
    Levitt. As part of that effort, NASDR 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 specialized exams several potential problem
    areas surfaced. In the area of advertising, for example, we
    found sales materials and advertisements that range from
    assertions of immediate execution to statements of profits that
    can be generated from day trading.
        One practice under review is the dissemination through
    public statements or Web sites, training materials and public
    statements of what may be materially misleading information
    regarding the success rate of customers. Our staff is
    investigating whether the firms' claims of customer success
    rates can be substantiated as our rules require.
        In addition to our ongoing investigations, we have already
    filed one formal disciplinary action against Lakeside Trading.
    That complaint alleges, in the advertising area, misleading
    statements that imply direct access to the markets by their
    day-trading customers and the failure to disclose material
    risks associated with the trading.
        Our examinations also surfaced Regulation T and margin
    lending and disclosure practices that are of great concern to
    us, particularly when we find firms facilitating and even
    encouraging loans from one customer to another customer, loans
    from a principal of a firm to a customer, and loans arranged by
    the firm from third parties to customers. Absent these
    infusions of capital, many of the recipients of the loans would
    be unable to continue to trade.
        Another area of concern relates to registration issues. Our
    exams identified individuals engaged in day trading for firms'
    proprietary account who are not qualified and registered. One
    disciplinary action has been filed and concluded in that area
    in which we fined a day-trading firm $25,000 for failure to
    properly qualify and register 14 people.
        Problematic short-selling practices at some day-trading
    firms have also been identified, including short-sales that are
    not properly marked, and where no affirmative determination has
    been made that the shares can, in fact, be delivered to the
    buyer. We have seen potential violations of our rules
    prohibiting customer short-sales on what is commonly known as a
    ``down-tick.''
        Supervision deficiencies were also identified during our
    examinations. Our rules require that a firm establish and
    maintain a supervisory system that allows them to carefully
    supervise the activities of each associated person. We found
    that at some day-trading firms, written supervisory procedures
    did not adequately address many aspects of their core business
    including lending practices, advertising and marketing, and
    short-selling.
        We are currently reviewing the results of our examinations
    and completing investigations growing out of them. To the
    extent that these investigations indicate that violations of
    our rules or the Federal securities laws have taken place,
    further enforcement actions will be instituted.
        In addition to our examination and enforcement activities,
    we have been working on several rulemaking initiatives to
    address the investor protection concerns associated with day
    trading that we believe are not adequately addressed under
    existing rules.
        As you heard earlier, in April of this year we solicited
    comment on and in August filed with the SEC, proposed rules
    that would require firms that promote day-trading strategies to
    first determine the appropriateness of day trading for each
    customer. And, second, to disclose to customers the risk that
    are associated with day trading.
        In order for a firm to approve an account for day trading,
    the firm would be required to have reasonable grounds for
    believing that a day-trading strategy is appropriate. To do so,
    they must obtain and keep information about the customer such
    as their financial situation, their tax status, their prior
    investment and trading experience and their investment
    objectives.
        The proposed rules also require that a firm that promotes
    day trading deliver a specialized risk disclosure statement to
    a customer prior to opening an account, informing investors
    that day trading can be extremely risky, that investors should
    be prepared to lose all of their funds used for day trading and
    that they may lose funds beyond their initial investment.
        In addition to this proposed rule, we are looking very
    closely at whether changes to existing rules regarding margin
    and lending practices are necessary. We have solicited comment
    on some of these issues.
        Concerns that we have identified include what levels of
    margin are appropriate for these types of activities, whether
    the timing of the margin deposit requirements should be
    changed, and whether minimum initial and maintenance cash
    deposits should be required.
        We are also addressing the role of firms that arrange loans
    between customers. We are particularly concerned about what, if
    any, risk disclosures are being made both to the customer
    obtaining the loan and the customer who is providing the loan.
    We believe facilitation of these lending activities by firms
    may pose a fundamental conflict of interest between the firm
    and the customer, given that these are the loans that often
    allow customers to continue to trade when they would not
    otherwise be in a financial position to do so and, thereby,
    continue generating commission income to the firm.
        We pledge to continue to be very vigilant with respect to
    day trading through examinations, regulatory initiatives, and
    the prompt completion of ongoing enforcement actions. We intend
    to continue to work together with the SEC and the States to
    address the many issues raised by day trading.
        At this time, we do not see a need for any new legislative
    initiatives, but believe that by continuing our current
    approach of dissemination of information to our members and
    investors, examination and enforcement efforts, and the
    development of new NASD rules and other policy initiatives, we
    can effectively address investor protection concerns associated
    with day trading.
        Thank you.
        Senator Collins. Thank you, Ms. Schapiro.
        Mr. Hildreth, welcome.

     TESTIMONY OF PETER C. HILDRETH,\1\ PRESIDENT, NORTH AMERICAN
      SECURITIES ADMINISTRATORS ASSOCIATION, WASHINGTON, DC; AND
       DAVID SHELLENBERGER, CHIEF OF LICENSING, COMMONWEALTH OF
        MASSACHUSETTS SECURITIES DIVISION, BOSTON, MASSACHUSETTS

        Mr. Hildreth. Thank you.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Hildreth appears in the Appendix
    on page 167.
    ---------------------------------------------------------------------------
        Chairman Collins, Senator Levin and Senator Cleland, I am
    Peter Hildreth, Director of Securities Regulation for the State
    of New Hampshire and President of the North American Securities
    Administrators Association.
        Thank you for the opportunity to appear before you once
    again and to present the views of NASAA as you look into issues
    and problems surrounding day trading. We recognize and
    appreciate your leadership in focusing attention on the
    problems in this area.
        Last December, in part because of the enforcement actions
    taken by Texas and Massachusetts, the NASAA board of directors
    formed a project group to research the industry, prepare a
    report of its findings and make recommendations. The project
    group, chaired by David Shellenberger, gathered information,
    analyzed issues and studied trading records. The NASAA day-
    trading project group report, released in August, was the
    result of that effort.\2\
    ---------------------------------------------------------------------------
        \2\ Exhibit No. 8 is retained in the files of the Subcommittee.
    ---------------------------------------------------------------------------
        We believe there are problems associated with the day-
    trading industry, not the least of which is the hype about how
    average people can get rich quickly with no experience
    necessary. We hope our report, the first of its kind, will help
    Congress and the public as well as our fellow regulators better
    understand the issues and problems. We believe it will also
    help in framing appropriate responses from Congress and
    regulators.
        Electronic day trading has become part of our culture. It
    has captured the national imagination, in part, because it
    combines two major developments that characterize America in
    the late 1990's: The bull market on Wall Street and the
    technology revolution brought about by the personal computer
    and the Internet.
        Unfortunately, much of the early media coverage tended to
    glamorize day trading. The fact is day trading is anything but
    glamorous. As our report makes clear, day trading is very risky
    and most people who day trade will lose all of the funds they
    put into it.
        We have not examined all day-trading firms and their
    hundreds of offices we believe exist. However, at the firms and
    branch offices we have examined, we found problems with
    marketing, suitability, loan arrangements, supervision, and
    customers trading other people's money without regard to
    licensing requirements.
        There were several issues you asked us to address in our
    testimony. The first was a general discussion of day trading. I
    think that Chairman Levitt has already discussed how day
    trading is distinguished from other investment strategies. My
    written testimony provides NASAA's perspective on this issue.
    So, in the interest of time, I will move on to other issues you
    asked us to address, such as the risk of day trading.
        Trading is, by definition, a form of speculating as
    distinguished from investing. Day trading is trading on an
    extremely short-term basis and is highly speculative. When
    firms promote their services with claims as to the potential
    for success and profitability, they have an obligation to tell
    their customers the truth about the risks.
        We also believe they have an obligation to determine
    whether day trading is suitable or appropriate for that
    particular customer. That means not accepting just anyone who
    comes through the door with a check and wants to sit down at
    the computer and trade.
        We commissioned an outside expert, Ronald L. Johnson, to
    analyze customer account records from a day-trading firm in
    Massachusetts that was the subject of an enforcement action.
    His analysis suggests the majority of day traders, more than 70
    percent, lose money. Only about 12 percent showed the potential
    to be profitable.\1\
    ---------------------------------------------------------------------------
        \1\ Exhibit No. 8 is retained in the files of the Subcommittee.
    ---------------------------------------------------------------------------
        Mr. Johnson also found that day traders would have to
    generate annual returns of 56 percent just to cover commissions
    and margin interest, never mind taxes. These are long odds,
    indeed, just to break even.
        This was the first such analysis of retail day-trading
    account data. It was a limited sample but the results are
    consistent with what we found in other investigations, such as
    evidence from a Block Trading branch office where 67 of 68
    accounts lost money.
        We urge others, especially academics, to conduct further
    research on the profitability of day trading by retail
    customers. However, the burden of proof remains on the day-
    trading firms. They must justify their claims of customer
    profitability in their marketing that suggests that average
    people can make a career of day trading.
        As to the findings of State regulators' exams, some of the
    abuses and problems that the project group has observed
    include: Deceptive marketing, including inadequate risk
    disclosure. As you noted in your presentation, Chairman
    Collins, one firm On-Line Investment Services, Inc., maintained
    a Web site claiming that 85 percent of its customers were
    profitable. They deleted that claim when Massachusetts asked
    for proof.
        We also found violation of suitability requirements. In a
    case against Landmark Securities, Inc., the complaint alleged
    that the manager falsified information on new account forms to
    create the impression day trading might be appropriate for that
    customer. The customer, a recent college graduate, was a part-
    time bartender with an annual income of $15,000, a net worth of
    less than $15,000, and no prior investing experience.
        Other abuses we noted are questionable loan arrangements,
    including promotion of loans from one firm's customers and
    loans to customers by brokers, and also failure to supervise.
        The next issue is our position on the NASD proposed rule.
    In a comment letter to the NASD, the NASAA project group
    endorsed the draft rules on appropriateness and risk disclosure
    and made suggestions for enhancing the rules. We recommend that
    the SEC approve the rules.
        As to other legislative or regulatory initiatives, we
    believe the NASD should also adopt a rule prohibiting the abuse
    of loans I have discussed. We also recommend enhanced
    regulatory attention to day-trading firms.
        First, the proposed NASD rules on appropriateness and
    disclosure. The project group believes that the existing rules
    on suitability apply to day trading. The failure by some day-
    trading firms to adhere to the existing suitability rules,
    however, suggest that specific day-trading rules are warranted.
        Day trading is a particularly risky program of trading that
    warrants heightened suitability and disclosure requirements.
    The NASD already has special suitability requirements for
    opening option accounts and the like.
        Second, the matter of a ban on loan programs. Day-trading
    firms' promotion and arrangement of lending among customers to
    meet margin calls is problematic. Firms have promoted the loans
    in order to keep accounts open that would otherwise be closed
    or restricted for failure to meet margin calls. These loans
    serve to undermine margin requirements and encourage customers
    to trade beyond their means. Some of these loans come with
    interest rates that in some States may exceed legal limits. A
    typical rate is a tenth of a percent for an overnight loan or
    36.5 percent on an annualized basis. In addition, the loan
    programs have invited severe compliance problems including
    forgeries and the unauthorized transfer of customers' funds.
        We believe the loan programs are highly questionable under
    existing law. Nonetheless, we believe the NASD should adopt and
    explicit rule prohibiting the programs.
        Finally, enhanced focus on day-trading firms. Too many day-
    trading firms continue to engage in highly questionable conduct
    as you heard from Chairman Levitt's report. More enforcement
    actions should be brought.
        But let me be clear. State regulators do not have a problem
    with day trading per se. It has been around a long time, long
    before the personal computer. We believe investors should have
    available to them all the latest technologies. Technology and
    information have revolutionized investing. They have leveled
    the playing field between Wall Street and Main Street.
        Our concerns are with day-trading firms that aren't being
    honest with their customers about the risks. Firms that
    essentially say, ``hey, come on down, we will sell you a
    training course, you can sit in front of the computers and you
    will get rich.'' This is hucksterism. The odds are that you
    will not get rich. The odds are you will lose all the money
    with which you trade.
        The fact is day trading is not investing, it is gambling.
    There are no other words for it. Day traders can lose a lot of
    money in a hurry. People should not be gambling with money they
    cannot afford to lose.
        As Chairman Collins mentioned, All-Tech's recent Web site
    illustrates that some firms have held out day trading as an
    option for retirees, people laid off from their jobs, even
    college graduates just starting out. This sort of marketing is
    irresponsible, reckless and predatory.
        Day-trading firms need to play by the same rules that the
    rest of the brokerage industry has to follow. Frankly, in the
    examinations we have conducted of day-trading firms, we have
    found a cavalier attitude toward regulatory compliance. Too
    many firms either don't know the rules or are flouting them
    because they think the rules don't apply to them.
        Well, the rules do apply. We expect that more enforcement
    actions will be brought and that these will send a message to
    the firms that appear to believe they are above the law.
        Chairman Collins, I greatly appreciate the opportunity to
    chair the NASAA project group's findings with the Subcommittee
    today. NASAA and its members stand ready to assist you as you
    continue your investigation into the practices and operations
    of the day-trading industry.
        Senator Collins. Thank you very much, Mr. Hildreth.
        Mr. Shellenberger, do you have any formal comments you
    would like to make?
        Mr. Shellenberger. No, Chairman Collins. I am prepared to
    answer any questions that may be asked, though.
        Senator Collins. Thank you very much.
        Ms. Schapiro, you stated in your written testimony that
    NASDR examiners had identified questionable practices,
    questionable marketing and advertising practices at nearly 80
    percent of the day-trading firms that you have reviewed to
    date. Is that correct?
        Ms. Schapiro. Yes.
        Senator Collins. That is of great concern to me because
    that suggests that we are not dealing with isolated examples of
    misleading advertisements or exaggerated claims but rather an
    industry pattern of deceiving unsophisticated investors.
        Could you give us some examples of the kinds of deceptive
    marketing practices that your examiners uncovered?
        Ms. Schapiro. Sure.
        I think as a general matter we have seen extremely
    aggressive marketing and promotional campaigns engaged in by a
    number of day-trading firms. Some of the advertisements and
    sales literature which have been of particular concern to us
    includes promises of enormous profit potential, very high
    levels of customer success rates without there being any
    counter balancing information about either the risks or the
    fact that you can lose all of your money and more than your
    initial investment.
        We have seen ads that suggest that you are guaranteed
    immediate execution in the market place. When we all know that
    as good as the technology is, you are not guaranteed an
    immediate execution.
        And, we have seen advertisements that suggest that anybody
    can do this with just a little bit of a training or studying a
    manual when, in fact, sophisticated understanding of market
    operations and how stocks react in different markets and areas
    is very important to be successful.
        So, generally, I would say exaggeration, potentially
    misleading information and wild claims would characterize many
    of the ads that we have looked at and are investigating.
        Senator Collins. And I would note that the SEC examiners
    and the State regulators have also found a similar pattern of
    widespread abuse with advertising in this area.
        Ms. Schapiro. I think that is right. It is interesting to
    me that the examinations done by all three of us are very
    similar and largely parallel in their findings.
        Senator Collins. That does seem to be a consistent and very
    troubling theme or finding of all three regulatory
    organizations.
        Your examinations also indicated, Ms. Schapiro, that nearly
    half of the day-trading firms had established lending programs
    whereby day-trading customers who cannot meet the margin calls
    can borrow from other day-trading customers. This raises real
    concerns in my mind about suitability and appropriateness.
        If a day trader can't meet the margin call and is
    encouraged by the firm to borrow from a fellow day trader, what
    does that say about whether the individual should be day
    trading in the first place?
        Ms. Schapiro. That is a wonderful question and I think that
    my greatest concern in this area is that it is fundamentally a
    very severe conflict of interest for a firm to suggest to a
    customer who has run out of capital that that customer borrow
    money from other customers or from principals of the firm in
    order to continue to generate commissions for the firm. We are
    looking very closely at this issue and I would hope that in the
    next several months we will have taken some action with respect
    to the facilitation of lending arrangements by the broker-
    dealer.
        Senator Collins. Mr. Hildreth, I know this has been of
    particular concern to the State regulators. Would you like to
    comment on this and should NASDR simply ban this practice?
        Mr. Hildreth. Well, I think that certainly the NASD should
    look--what they are seeing in these exams is what we talked
    about in the report. And I know that Dave Shellenberger has
    some things to say about those also. But it would seem to me
    that with that widespread, as it appears in the industry,
    practice, is something that we have some real grave concerns
    about for the same reasons that Ms. Schapiro stated. Keeping
    people trading when there are some real concerns if they don't
    have the money, perhaps just to generate commissions.
        So, I think certainly it should be looked at.
        Senator Collins. Mr. Shellenberger.
        Mr. Shellenberger. Yes, thank you, Chairman Collins.
        One of the problems with the loan programs, and by the loan
    programs, of course, what we are referring to is day-trading
    firms promoting and arranging loans between customers so that
    customers can meet margin calls that they otherwise could not
    meet.
        The purpose of these loan programs is simply to keep
    accounts alive that would otherwise be closed and allow the
    brokerage firms to obtain a continuing stream of commissions.
        These programs encourage people to lose even more money.
    They certainly, as Madam Chairman has recognized, raise
    suitability concerns. If people are trading beyond their own
    means, don't have enough funds to meet margin calls, should
    they be day trading in the first place? To indicate the
    magnitude of this issue, we alleged in Massachusetts in the
    case against Landmark Securities that with respect to the tiny
    retail account held by the part-time bartender and recent
    college graduate in that office, $2.7 million in loans flowed
    through this person's account in only 9 months.
        Senator Collins. I think this is an area where we really do
    need to see regulatory action. It just raises all sorts of
    concerns.
        We also need to do a better job upfront screening out
    people for whom day trading is not appropriate. And I think
    that is why the NASD's appropriateness regulations are very
    important in that regard because we would have fewer people who
    would be tempted to borrow from fellow day traders if we were
    screening, if the industry was screening potential clients
    upfront.
        Would you agree with that, Ms. Schapiro?
        Ms. Schapiro. Yes, absolutely.
        Senator Collins. Mr. Shellenberger, as you are very well
    aware the day-trading industry has been extremely critical of
    NASAA's report on profitability of day trading in which it was
    found that more than, I believe it is, 70 percent of day
    traders are going to lose their money, perhaps even more, and
    only 12 percent were found to have the capacity to perhaps make
    a profit.
        The industry has countered with a study on day-trading
    profitability that was conducted by Momentum Securities. Have
    you reviewed that study and could you give us your thoughts on
    it?
        It is my understanding that the Momentum study acknowledges
    that 56 percent of day traders lose money in the first 3 months
    but it claims that after that point 64 percent of day traders
    actually make money.
        What are your views on the Momentum profitability study?
        Mr. Shellenberger. Chairman Collins, on behalf of the NASAA
    project group I requested copies from the Electronic Traders
    Association of any studies, including Momentum's purported
    study. I have yet to receive any documentation, anything
    related to that study. So, I am only familiar with the press
    clippings concerning it.
        Senator Collins. Well, that is problematic in and of
    itself, I would say. If you, as a regulator, are making a
    request for information that is that vital and are not
    receiving the cooperation of the day-trading industry that is
    of great concern to me.
        Mr. Shellenberger. Yes. I should clarify, Chairman Collins,
    that Momentum Securities is not registered in Massachusetts so
    we cannot legally force them to produce these records.
    Nonetheless, we did request them through the ETA. Claims of
    profitability or losses are meaningless unless the data are
    subject to scrutiny.
        So, I have been unable to scrutinize these claims. However,
    on the face of the claims there is a problem. And that is
    Momentum has acknowledged that the majority of its customers
    did lose money at least for a period of months. They claim that
    after that apparently the surviving customers were profitable.
    I don't know whether that is true or not.
        The question would be, how many people are going to burn
    through their capital and still have some money left once they
    supposedly learn how to day trade? I suggest that it may be too
    late.
        For instance, Ron Johnson, in reviewing our sample, found
    that the average account was only open 4 months.
        Senator Collins. So, in other words, given the high
    turnover of day traders, many of them aren't going to still be
    able to day trade because they will be broke by the time they
    may finally have figured out how to do this profitably?
        Mr. Shellenberger. Absolutely. Assuming that it is even
    possible for them to learn.
        Senator Collins. Have you seen anything, based on your
    further examinations, that leads you to question your initial
    findings that more than 70 percent of day traders will lose
    their money?
        Mr. Shellenberger. No, Chairman Collins.
        In fact, I believe that the 70 percent figure probably
    understates the problem. Ron Johnson concluded that if many of
    these people beyond the 70 percent continued to trade, those
    that had shown profits would end up losing money because, for
    instance, in many instances the profits had been gleaned from
    only one trade. Well, if you can make 50 percent of your
    profits in one trade, you can lose 100 percent of your capital
    in the next trade.
        Senator Collins. Ms. Schapiro, has the NASD done any work
    on the profitability of day trading?
        Ms. Schapiro. We haven't done a broad look at the
    profitability. In the context of the specific investigations of
    day-trading firms that are ongoing where they have made claims
    of customer success rates, we are requiring them to
    substantiate that those success rates are, in fact, true.
        Through that mechanism we will have a better sense, at
    least anecdotally, of what the success rates are and what the
    profitability is of day trading at particular firms.
        Senator Collins. I hope you will share that information
    with the Subcommittee.
        Ms. Schapiro. We will be happy to do that.
        Senator Collins. The appropriateness regulations that the
    NASD has proposed, and which are now pending before the SEC,
    apply, it is my understanding, to only new accounts. Is that
    correct?
        Ms. Schapiro. As the rule was proposed, yes, we applied it
    on a ``going forward'' basis to new accounts.
        Senator Collins. Would it not be useful to apply it also to
    current accounts, so that there at least is a disclosure of the
    risks?
        Ms. Schapiro. We will certainly revisit that issue.
        We targeted it to an account opening because that's a very
    definitive event that can trigger the need to do the
    appropriateness determination.
        To the extent that there are accounts already out there at
    firms that aren't even traditional day-trading firms but where
    people are, in fact, day trading, we thought it would be very
    difficult, as an operational matter, to go back and try to
    apply the rules to all of those accounts. But it is something
    we will look at very carefully.
        In submitting these rules to the SEC, we have said that
    this is a first step. And, if we determine there are additional
    regulatory initiatives that are needed in this area, we won't
    hesitate to recommend those.
        Senator Collins. Thank you very much. My time has clearly
    expired, and I will now turn to Senator Levin for his
    questions.
        Senator Levin. Mr. Shellenberger first, I believe you were
    the folks who got the restraining order against TCI; is that
    correct?
        Mr. Shellenberger. Yes, Senator Levin. Specifically, the
    cease and desist order applied to what we had alleged in the
    licensing section as a Ponzi scheme, beyond what we allege were
    false claims as reflected by the advertisement. Then the
    hearing officer referred the matter of the deceptive
    advertising to the Attorney General's office because he had
    concerns regarding our jurisdiction.
        Senator Levin. That is the original one, I believe, and I
    want to show you the new one that is currently on their Web
    site and ask you whether or not those concerns are still real,
    when they say that this system is the absolute best that they
    know of, and it says a profit to loss ratio of 12 to 1 and an
    average return of better than 18 percent per trade before
    slippages.\1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 3 on page 216 in the Appendix.
    ---------------------------------------------------------------------------
        It seems to me it's worse than their first site.
        Mr. Shellenberger. Yes. Senator Levin, I would share your
    concerns. The response, once regulators have raised questions
    regarding specifically Web sites, has been that these Web sites
    change. I believe this site has been modified. But I share your
    concerns that this remains unacceptable.
        You had asked a prior witness, Chairman Levitt, regarding
    the SEC's jurisdiction in this matter, and this is a very
    technical area. But I would note, if I may, that there are
    State consumer protection acts that prohibit deceptive
    advertising and, in addition, such matters may be under the
    purview of the Federal Trade Commission.
        Senator Levin. This is a current Web site, by the way. This
    is after the change. So at least as of yesterday, it was their
    Web site.
        Is this under Massachusetts' jurisdiction if that is false
    advertising? Is that what your Attorney General is looking into
    now?
        Mr. Shellenberger. Senator Levin, the referral was made to
    the Attorney General's office from the Massachusetts Division
    of Securities, because Massachusetts, I believe, like most
    States, has a Consumer Protection Act Chapter 93(a) which,
    among other things, prohibits unfair or deceptive acts or
    practices, including advertising. So this, in my view, would be
    subject to scrutiny under that law.
        Senator Levin. If the Attorney General concluded that was
    false and deceptive advertising, and if TCI is located--and I
    don't know where they're located----
        Mr. Shellenberger. In California, Senator.
        Senator Levin [continuing]. In California, would you be
    able to get at them because the advertising is on a Web site
    which obviously comes into Massachusetts? Would you be able to
    get a subpoena, for instance, under existing legal theory?
        Mr. Shellenberger. Senator Levin, I know that this area of
    States being able to obtain jurisdiction in response to Web
    site advertisements has been the subject of some brilliant Law
    Review articles that I have only skimmed.
        I can tell you that TCI has at least closed down its branch
    office in Massachusetts, and I don't expect them in my back
    yard again. Whether we would be able to enforce a subpoena on a
    California corporation that, to our knowledge, did not do
    business with any of our citizens, would be questionable.
        Senator Levin. Madam Chairman, I think this is an area that
    we also want to add to our list of things that we're looking
    into, because, given the amount of electronic trading, given
    the fact that this kind of a course and strategy is available
    electronically, or the touting of it is done electronically, it
    would be good to have not just the watchdogs in Washington, the
    Federal Trade Commission or others looking into these kind of
    phony representations, it would be good to have 50 States being
    able to go after them as well. That may require some kind of
    change in Federal law to authorize subpoenas. I'm not sure
    exactly what the legal complexity is, but I think we ought to
    add this, given the amount of electronic trading and the way in
    which these courses are advertised, to our list of things that
    we're looking into for possible legislation.
        I think this question will go to you, Mr. Hildreth. You
    indicated in your testimony that the odds are you won't get
    rich, and the odds are you'll lose all the money with which you
    trade. We will hear testimony later on this morning from Mr.
    Cohen that day trading is not gambling. But then he says the
    majority of those who do day trade after training do not lose
    money.
        You're telling us that the odds are you will lose all the
    money with which you trade?
        Mr. Hildreth. That's right.
        Senator Levin. That's about as sharp a conflict as we can
    possibly have. I'm just wondering what your reaction is to his
    comment?
        Mr. Hildreth. My statement is based on the report \1\ that
    was produced by Dave Shellenberger's project group, and hiring
    an outside consultant. It is based on the data that we have.
    ---------------------------------------------------------------------------
        \1\ Exhibit No. 8 is retained in the files of the Subcommittee.
    ---------------------------------------------------------------------------
        We also had the testimony of the manager of one of these
    sites, who said 67 out of 68 lost money.
        Senator Levin. They also will be testifying later on this
    afternoon that much of NASAA's report, that this mumble jumble
    would be unnecessary if NASAA had accepted ETA's March, 1999
    offer to provide current trading information.
        Now, we're going to be getting testimony under oath later
    on this morning that ETA offered NASAA, in March of this year,
    to provide current trading information. I'm wondering, did
    they, and if so, what was it?
        Mr. Hildreth. Dave Shellenberger is the appropriate person
    to respond, since he's the Chairman who would have dealt with
    them on that issue.
        Mr. Shellenberger. Thank you, Senator Levin.
        The answer is that that's a false assertion. What had
    happened is that the ETA, through its counsel, asked me to
    comment on a possible study that might be done by the ETA. The
    project group determined not to make any suggestions or comment
    but, rather, to reserve comment. The reason is that we did not
    want to endorse a study or survey of which we did not know the
    particulars.
        I would stress, Senator, if I may, that the burden of proof
    is on the industry. Before they make these claims of 85 percent
    success rates, before they make the claims that retirees should
    make careers of day trading, they should have the facts. It
    disturbs me that apparently studies have not been done to date,
    other than the alleged Momentum study.
        Senator Levin. Can any of you comment on the adequacy of
    current laws and regulations to address the problems which we
    have identified, and if you would prioritize the new
    regulations or laws that are needed in terms of their
    importance? Maybe we can start with you, Ms. Schapiro.
        Ms. Schapiro. OK. Well, we have identified a lot of
    problems, as you've heard. I think, with respect to
    advertising, for example, there are adequate regulations in
    place, assuming sufficient enforcement resources, to pursue all
    of those advertisements and marketing materials in an
    aggressive way.
        I think we have said, with respect to margin, and
    particularly margin lending practices, that we need to do some
    more work, as SRO's and the SEC, to look at whether there ought
    to be a prohibition and, at a minimum, enhanced disclosure of
    the risks of margin lending or some other modification to
    address the practices that we have seen with respect to margin
    lending.
        I think we also ought to look at whether, under the margin
    rules--and you asked these questions earlier, Senator Levin--we
    should be shortening the time frames by which Regulation T
    margin deposits must be made. It's currently 7 days and perhaps
    it ought to be shorter, given the kind of mismatch we have of
    these trading strategies that are intraday, with margin
    payments being required only within 7 days.
        I think with respect to short sales or short selling, the
    current regulatory and legal structure is adequate.
        With respect to supervision, there is a very detailed and
    comprehensive supervisory structure in place in the largest
    broker-dealers, and the best run small- and medium-size firms.
    Day-trading firms need to adopt those kinds of supervisory
    structures and hire compliance people who can ensure that they
    are following the rules and regulations that apply equally
    across the board to all broker-dealers.
        Senator Levin. Just very quickly, if I may, does your
    organization support the proposed rule on suitability, that it
    apply to strategy as well as----
        Ms. Schapiro. We wrote it. It is our rule and we are 100
    percent behind it.
        Senator Levin. Mr. Hildreth.
        Mr. Hildreth. We support it, as I said, and filed a comment
    letter in support of that.
        We wouldn't be here today if the current rules were met by
    the industry. What we found is the rules are being broken. I
    think that there is a need to look at the loan issues, and
    perhaps just ban them outright.
        If the current rules were being complied with, I don't
    think we would be here. I think the day-trading industry just
    has to comply with those.
        Senator Levin. But in terms of new regulations and rules,
    the first thing would have to be with the loan, and second,
    would be suitability or not?
        Mr. Hildreth. Well, we have supported the suitability
    proposal, and we hope that that's going to be approved quickly.
    We would like the NASD and the SEC to look at a ban on the
    lending programs.
        Senator Levin. Is there anything else from our third
    witness?
        Mr. Shellenberger. Senator, I concur with Mr. Hildreth's
    comments, and I emphasize that the industry seems to be doing a
    good job of violating existing law.
        Senator Levin. Thank you. Thank you, Madam Chairman.
        Senator Collins. Senator Cleland.
        Senator Cleland. Thank you very much, Madam Chairman.
        Ms. Schapiro, we're glad to have you with us today. I have
    spoken to your organization, mostly as Secretary of State in
    Georgia, and as a State regulator. Mr. Hildreth, it's nice to
    see you. I have great respect for your organization as well.
        I mentioned earlier today that Wayne Howell, my AA, has
    been very instrumental in my understanding of the regulatory
    process, in terms of the world of securities, and he was the
    former head of your organization. Mr. Shellenberger, as a
    former State regulator, we respect your role immensely.
        I think it is fascinating, Madam Chairman, a couple of
    things I have gotten out of this today. First, Mr. Hildreth,
    you're the second person to sit in that chair today to refer to
    day trading as gambling, the first being Arthur Levitt, head of
    the SEC, and then you, heading the North American Securities
    Administrators Association, referring to it as gambling.
        That is certainly far beyond any understanding of
    investment or even just speculative investment. It seems to me
    that our testimony today has reflected that it is, indeed,
    gambling.
        As a matter of fact, I started off somewhat quizzically
    about the relationship with Las Vegas, that it is now clear you
    have better odds in Vegas than in day trading, and that it's
    not roulette but it's Russian roulette, where there's a bullet
    in the chamber. If you keep playing this roulette game long
    enough, you're going to be dead.
        To hear the fact that, as a minimum, some 82 percent that
    go into day trading don't make anything, and 70 percent lose
    money, 12 percent have a potential of maybe making some money,
    that's astounding odds against you. So I think something is
    broken here. I'm not sure what's broken, but I think some
    things need fixing.
        What I would like to suggest here, before I leave the
    panel, is to ask Ms. Schapiro, Mr. Hildreth, and Mr.
    Shellenberger, what is your best shot here and what can this
    Subcommittee or Congress do to help get this thing back on
    track, to help main street get back in line with Wall Street,
    not abandoning the technology and certainly not wiping out the
    opportunity for the individual investor to get involved in the
    process, but how do we make this work?
        Ms. Schapiro.
        Ms. Schapiro. I believe, from the perspective of the U.S.
    Congress, the most important thing--because we don't have any
    recommendations at this point for specific legislative
    initiatives--would be to continue to support the regulators
    through hearings like this, that help us have an audience to
    air some of these issues and concerns, and continue to support
    the regulators in their initiatives to enact some new rules
    governing this kind of trading, have adequate resources,
    particularly for the Securities and Exchange Commission, to do
    the kinds of examinations and enforcement cases that will help
    protect investors.
        Senator Cleland. Mr. Hildreth.
        Mr. Hildreth. I would also say that this type of hearing
    goes a long way, toward publicizing this issue. When we
    released the report, there was a great deal of coverage, and
    that's good, because people need to know the real risks. They
    are not being told that when they see an ad that says you can
    come in here, be trained for a few days, and you can retire--or
    you've already retired and you can make extra money.
        It is important to get the message out, that day trading is
    risky. This kind of hearing, what you're doing here today, I
    think goes a long way in that regard. Again, I do think that
    the SEC and the NASD need the support of Congress, the SEC more
    directly, certainly, with the funds to do it.
        I would note once again, as I think Chairman Levitt
    mentioned earlier, that the three groups--the SRO's, the SEC
    and the States--really do work well together on these kinds of
    issues, and we look forward to doing that. We hope you give the
    SEC the resources to do it.
        Senator Cleland. Mr. Shellenberger.
        Mr. Shellenberger. Senator, I concur with the statements of
    Ms. Schapiro and Mr. Hildreth. I'm not sure additional
    legislation is needed. However, we find hearings of this nature
    very helpful in alerting the public, not only to the risks and
    problems, but reminding them that, as one of the Senators noted
    earlier today, if something sounds too good to be true, it
    probably is.
        Senator Cleland. That was me. [Laughter.]
        Mr. Shellenberger. It was a brilliant remark, with which I
    concur. [Laughter.]
        Thank you.
        Senator Cleland. Help me understand day trading just a
    little bit. First of all, I'm an individual citizen. Can I buy
    stocks through the Internet?
        Ms. Schapiro. Absolutely.
        Mr. Hildreth. Yes.
        Ms. Schapiro. Without day trading, you may open an on-line
    account at any one of hundreds of brokerage firms----
        Senator Cleland. But you've got to go through a brokerage
    firm to do that?
        Ms. Schapiro. Yes. Well, you do, if you're not going to
    engage in day trading. If you're going to engage in day
    trading, you have a couple of options. You can go on site, at a
    brokerage firm that is an NASD member and sit at what is the
    equivalent of a work station that one might see on a trading
    desk in a NASDAQ trading room at a big firm, and you may access
    the market through that terminal at the brokerage firm.
        You may also go into a limited liability company that might
    not be a member of the NASD and, therefore, not subject to all
    the rules and regulations of the NASD, but perhaps a member,
    for example, of the Philadelphia Stock Exchange, and trade as a
    limited partner of that LLC. You would deposit your own
    capital, which becomes part of the firm's capital, and trade as
    a partner, not as a customer and, therefore, not benefit from
    suitability and a number of other rules that protect customers.
        You would also have the benefit of even greater leverage,
    because you wouldn't be subject to the Regulation T margin
    requirement of 50 percent initial margin and 25 percent
    maintenance margin but, rather, whatever margin level is
    arranged between that limited liability company and their
    clearing firm. It could be as low as 15 percent margin. So you
    have several alternatives on how you want to approach day
    trading.
        Senator Cleland. Thank you. The panel has been most
    gracious with their time.
        Madam Chairman, thank you for holding this hearing. It is
    obviously a very fascinating part of the world in which we
    live, and certainly day trading is very risky business and
    these people are trying to help. Thank you very much.
        Senator Collins. Thank you very much, Senator.
        I want to thank our panel for their very helpful testimony.
    We look forward to continuing to work with you as we continue
    our investigation as well.
        Our final witness this morning is Saul Cohen, the
    consulting counsel to the Electronic Traders Association, which
    is known as ETA. Mr. Cohen has extensive experience in
    securities regulation and is currently a partner in the law
    firm of Proskauer, Rose in New York City.
        ETA is a nationwide association of firms and individuals
    which promote the interests of the day-trading industry.
        Mr. Cohen, before you get too comfortable, I do need to
    swear you in.
        Do you swear the testimony you are about to give will be
    the truth, the whole truth, and nothing but the truth, so help
    you, God?
        Mr. Cohen. I do.
        Senator Collins. Thank you very much. You may proceed.

     TESTIMONY OF SAUL S. COHEN,\1\ CONSULTING COUNSEL, ELECTRONIC
                TRADERS ASSOCIATION, NEW YORK, NEW YORK

        Mr. Cohen. Thank you, Senator. I'm the notorious Mr. Cohen
    referred to before.
    ---------------------------------------------------------------------------
        \1\ The prepared statement of Mr. Cohen appears in the Appendix on
    page 178.
    ---------------------------------------------------------------------------
        For those who are interested, the quote is from a much
    larger and broader article on philosophical concepts of
    regulation. It appears in two parts, in the Wall Street
    Lawyer.com, and it really deals with the threats of the
    Internet.
        But, in any event, I thought I would start with two quick
    quotes from Chairman Levitt's written testimony, because they
    are so much at odds at what anything else anybody has said
    here.
        ``To date, however--'' page 7 ``--we have not found marked
    and widespread fraud by these firms.'' Page 13, ``The staff has
    found isolated instances where day-trading firms appear to have
    failed to comply with margin requirements or properly disclose
    terms and conditions of loans in contravention of SEC rules.''
    Mr. Levitt was also kind enough to say that day traders don't
    add to volatility.
        Senator Levin had asked a very perceptive question before,
    he never got an answer, and that had to do with margin. It was
    perceptive in two ways. One was what would happen if you didn't
    come up with money, and the answer is, if you didn't come up
    with money, then after 7 days your account would be frozen and
    you will not be able to do anything but liquidating
    transactions. That's a universal rule.
        The part that I thought was interesting was that it
    indicated that it was possible to make a profit on a margin
    trade. All we've heard today so far is people going to margin
    because otherwise they're going to go broke sooner. But the
    point is that you can go into margin, and lots of people go
    into margin transactions because they want to keep profitable
    trades.
        On-site traders will emphatically tell you that they're not
    gamblers and day trading is not gambling. ETA traders have an
    extremely high percentage of college and professionally
    educated people. The New York Times pointed out just in August
    that ``many former professional traders, brokers and financial
    service professionals are becoming full-time day traders.''
        Successful day trading requires skill, hard work, and
    access to state-of-the-art technology.
        And while I'm at it in regards to this, in terms of risk
    disclosure, ETA has supported risk disclosure much broader and
    deeper than the NASD risk disclosure. It has been in place for
    months. And it requires that the particular individual involved
    sign the risk disclosure statement.
        Senator Levin, because I know margin is of interest to you,
    there is language in here that says you may sustain a total
    loss of the initial margin funds and any additional funds you
    deposit with your broker, and you may incur losses beyond your
    initial investment. There is lots and lots of disclosure in
    that form.
        You may well be, to go back to the subject of gambling,
    aware of people who are called ``quant'' traders. These are
    people who invest millions of dollars in computers, special
    phone lines and software, so that they can day trade
    successfully. They're not gamblers. They are market
    professionals.
        Day trading is not a cult, although sitting here today, I
    wondered about that, from a regulatory view, and there is
    nothing new about day traders. They have always existed on
    exchange floors. They're still there today. At least since the
    advent of Thomas Edison's stock ticker, there have been day
    traders in what are called upstairs offices.
        Now, I have repeated on-site day traders several times to
    differentiate these 4,000 or so individuals who Mr. Levitt also
    mentioned in his written statement have a very limited reach,
    so it's important to understand what we're looking at. From the
    estimated 250,000 people encouraged to trade on line through
    such household names, including the one the Chairman mentioned,
    Charles Schwab and Discover. You may have seen the Discover ad
    which shows a pig farmer who trades on line. The copy for the
    ad runs, ``Gorden Gekko, Eat Your Heart Out. Wall Street used
    to be about greed. Now it's about brains, about taking control
    of your money. So go ahead. Yup.'' That's a New York advertiser
    trying to be a farmer. ``Just a mouse click away.''
        Now, contrast the pig farmer with the on-site trader. ETA
    members get almost instantaneous executions, very often
    instantaneous executions. The farmer doesn't. ETA traders get
    price improvement. And if we're talking about consumer issues--
    and that's the most important consumer issue this Subcommittee
    ought to be concerned with--the pig farmer does not get price
    improvement. His order goes to a market maker in a preferencing
    arrangement. ETA traders take advantage of the firm's
    intellectual capital. That is, the people around them, the
    experience of the other traders--well, I guess the pig farmer
    has his pigs.
        It's very important, when we talk about on-site trading and
    risk, to understand that you would have to be totally oblivious
    to the world to not understand the risk because you are sitting
    in that office, cheek by jowl, with other traders.
        Now, there are, of course, lots of complaints by day
    traders, but they're from the on-line day traders. ``Why is the
    system down? Why did it take so long for my order to get
    executed?'' There are virtually no complaints from on-site day
    traders, so we've got a mystery on our hands. If there are no
    complaints, why is NASAA, not the SEC or NASD, seeking to
    isolate on-site day-trading brokerages from every other part of
    the securities industry?
        According to NASAA, on-site firms are a public danger in
    three respects. On-site firms routinely violate securities
    regulations. To quote Mr. Hildreth, ``day-trading firms need to
    play by the same rules the rest of Wall Street follows. If they
    don't get their act together, they'll be under increasing
    regulatory pressure.''
        The NASAA report charges on-site firms with order entry
    failings, short sale, margin and books and record violations,
    even omissions to disclose the risk of loss, and false
    marketing. But NASAA, in its survey of regulatory cases,
    apparently hasn't noticed that just over the past 18 months,
    and just looking at the top 100 well-capitalized firms by the
    SIA, not the hundreds of others--that Merrill Lynch and half a
    dozen other firms were disciplined for order entry matters.
    Piper Jaffray fined for short sale violations. Schroder, Cowen,
    and Fahnestock cited for margin. Salomon Smith Barney and three
    other firms, books and records. Merrill Lynch fined $2 million
    for sales materials which ``omitted material facts in the risks
    of investment losses.'' And Prudential Securities was fined
    $500,000 for false marketing information regarding CMO's.
        The Subcommittee also, I think, is aware that institutional
    investors have been buying interests in on-site firms. I think
    you're aware then that these investments are made after
    considerable due diligence and simply would not be made if day-
    trading firms were securities industry rogues. That's one of
    the reasons why I think Mr. Levitt felt comfortable in writing
    that there's no widespread fraud.
        The second charge against day-trading firms by the NASAA
    was that on-site firms engage in deceptive advertising. But it
    should be noted that no advertising, even as compelling as the
    Discover ad about the pig farmer that I just went through, can
    withstand reality. And, by the way, ETA has a statement of
    principles that decries in any sense deceptive advertising. It
    talks about giving a full picture to people and so forth.
        Day traders, as I have said before, are intelligent and
    well educated. They are on site. They can quickly observe from
    the traders around them what the range of risks and rewards
    are. To go back to Senator Levin for a minute, his comment
    about ``well, isn't this a surprise when you get the margin
    notice?'' Well, if it's a surprise, it's a surprise once. It's
    not going to be a surprise the second time.
        It is important to understand, by the way, with regard to
    risk and the risk of loss, that if this market collapses,
    you're much better off being a day trader holding securities
    for 4 minutes than people who are holding securities for months
    and years, as I am in some of my accounts.
        ETA members need not advertise for customers. Most
    prospects are references from customers.
        A third charge, on-site day traders lose money in wholesale
    lots. We have heard over the last year all kinds of numbers. We
    have heard 7 out of 10, 8 out of 10, 9 out of 10 lost money.
    Massachusetts--and they were here before, Mr. Shellenberger--67
    out of 68 lost money at one firm. Well, if that happened, you
    would think the Boston press would pick it up and they would
    notice 67 people running out of the office yelling ``plague.''
    No one is that dumb.
        Now the report is out, and I've got to tell you, as
    somebody who is a professional in this business, this is an
    amateurish report. NASAA's expert, Mr. Johnson, turns out to be
    a former commodity trader who earns his living as a plaintiff's
    witness, and whose resume, which we have put in our materials,
    lists with pride that, for 2 years, he ``published daily hot
    line trading recommendations,'' a fancy way, Senator, of saying
    that he gave option tips, and that he ``developed a low-price
    stock strategy that returned over 30 percent.'' You would think
    NASAA would be going after him for that kind of advertising.
        This expert, who operates out of his apartment, studied a
    grand total of 17 day-trading accounts. These, on average,
    traded for 4 months, 2 years ago, one office, on non-ETA firms.
    His conclusion? Sixty-five percent of the accounts had a risk
    of ruin; that is, if they kept going, never learned anything
    but just kept making the same mistake they made before, they
    were going to lose money. They would never stop and would never
    quit before they lost all their money. They would lose all
    their money.
        We tried to avoid the numbers game. We tried, no matter
    what Mr. Shellenberger is telling you--and there is
    correspondence on this and I will supply it to this
    Subcommittee afterwards, supply the Blue Sky people with
    current information for use in an independent survey. We
    provided them with a methodology of four pages. NASAA demurred.
    He told you why they demurred. They didn't want to endorse an
    independent study.
        We estimate, without any claim of scientific accuracy--but
    I can tell you that I spoke to a half-a-dozen on-site firms--
    that most customers will lose money or break even in the first
    3 to 5 months. They're not going to wipe themselves out in the
    first 3 to 5 months. They'll lose some money. And that
    thereafter nearly two out of three are going to net $28,000 a
    month, with the odd man out losing $6,000 to $8,000.
        But, hopefully, to put this particular matter to rest,
    because it is so important, ETA is in the process of retaining
    KPMG to conduct a day-trading profitability study.
        Let me go back to another point that was made before,
    Senator--and you've really made a number of perceptive points.
    One of them had to do with--I think this was asked of Mary
    Schapiro--would you allow somebody right out of college to day
    trade? A good question. How about right out of Wharton? I
    interviewed somebody right out of Wharton in January, who was
    out day trading for a year, and he made $750,000 in January. I
    felt very foolish being a lawyer.
        Given these facts, why has NASAA sought to demonize on-site
    day traders? The reason, quite frankly--and they said it here--
    is that they want the publicity. This is what Mr. Hildreth said
    last January. ``We need to reposition ourselves to cultivate
    media contacts. The news media is hungry for good crime
    stories, and with a little imagination, we can find them
    stories to write about.''
        Now let me move finally to something that is more positive.
    ETA members seek to meet all regulatory requirements and to
    foster high standards of ethics. We have statements of
    principles and we have risk disclosure that goes well beyond
    the NASD. ETA members tell prospects that day trading is not
    for everyone. In fact, ETA's own risk disclosure statement is
    broader and deeper than NASD requires, and acknowledging
    signature by the customer. We frankly urge that in the NASD's
    risk disclosure that they get it signed by customers. ETA's
    statement of principles reads, ``We will not make misleading or
    exaggerated claims, and will provide a balanced perspective in
    our presentation.'' We think you ought to consider asking the
    entire securities industry to adopt the statement of principles
    along these lines.
        The hardest issue to deal with is the appropriateness
    issue. It is very, very difficult. It's difficult because it
    undercuts what has been years and years of suitability theory.
    The security industries association has taken the position
    opposed to the NASD proposal because, in the past, all
    suitability decisions--and this was spoken to before by Mr.
    Colby--dealt with particular trading recommendations, not
    overall strategy. So this is a strategy.
        We have been working very hard to get to the point where we
    can agree with the kind of appropriateness standard. We think
    that, in doing that, one of the ways to do it is there are
    existing--and you might ask Ms. Schapiro about this--the NASD
    has existing rules on option trading. Option trading is a lot
    like day trading. It's a collection of different strategies.
    It's an approach to the market, not a particular recommendation
    thing. It starts off with somebody being approved, getting a
    risk disclosure statement and then being approved to trade
    options, or in this case, to day trade. We think that's a much
    better approach to appropriateness. It's much more focused than
    the generalized language they've been using.
        Senator Collins. Mr. Cohen, I'm going to ask you to wrap up
    your comments.
        Mr. Cohen. I will wrap up. OK.
        Let me wrap up with what I know is a particular concern of
    this Subcommittee, and that is consumers. Day traders help
    consumers. Day-traders' activities drive electronic
    communication networks, the ECN's. These ECN's provide market
    transparency. They are real competitors to market makers. The
    market makers are the group disciplined by the SEC and the
    Justice Department for collusive pricing, so the result for the
    small investor, the consumer, is better quote information and
    better handling of retail size orders.
        Day traders add importantly to liquidity and depth in the
    market without adding to volatility, so the small investor will
    find another side when he's ready to buy or sell.
        Last, day traders limit orders--and day traders put in a
    large amount of limit orders--compete directly with market
    makers. The result of that is that dealer spreads are narrowed
    and the small investor, the proverbial ``Aunt Janet in
    Portland,'' who is selling stock to pay for her daughter's or
    her niece's first year in college, is going to get a better
    price on her trade because there's a day trader in between the
    market maker's spread.
        This is the way the SEC intended it, and this is how it's
    working.
        Thank you very much.
        Senator Collins. Thank you, Mr. Cohen.
        We are going to take a 10-minute recess because,
    unfortunately, we have another vote on.
        [Recess.]
        Senator Collins. The Subcommittee will come back to order.
        Mr. Cohen, I think it's important for the record that I
    clarify that the SEC has confirmed to us that the reference in
    Chairman Levitt's testimony to the absence of widespread fraud
    in the industry was referring to such things as forgeries and
    other kinds of outright fraud, as opposed to the widespread
    pattern of deceptive advertising.
        Mr. Cohen. Did you also ask him about the isolated
    instances of margin problems?
        Senator Collins. I think, Mr. Cohen, that I'm the Chairman
    and you're not.
        Mr. Cohen. OK. I'm sorry. I had the belief we were going to
    have a discussion of these issues.
        Senator Collins. I did want to set the record straight in
    that regard.
        Mr. Cohen, in your testimony this morning you cited ETA's
    statement of ethical principles to support your contention that
    day-trading firms do not make exaggerated or misleading
    statements regarding trading results. Indeed, the statement of
    ethical principles indicates that ETA members ``will not make
    misleading or exaggerated claims about our services or the
    benefits of day trading, and will provide a balanced
    perspective in our advertisements and presentations.'' It goes
    on to say, ``We will not obscure the reality that most people
    lose money in their initial training period and that many will
    not ultimately become successful day traders.''
        I would like to show you two statements that were taken off
    the Web site of On-Line Investment Services, Inc. It is my
    understanding that this company is a member of your board of
    governors. Is my information correct on that?
        Mr. Cohen. They're an ETA member. I don't know whether
    they're a member of the board.
        Senator Collins. On-Line Investment Services was one of the
    five members of ETA, it is my understanding, who adopted the
    statement about the principles from which you quoted in your
    testimony. Is that correct, to your knowledge?
        Mr. Cohen. Yes.
        Senator Collins. I want to show you this first statement,
    which says, ``We have a successful rate of about 85 percent
    with customer traders, meaning people who come here and
    actually make money at this over time.'' \1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5 on page 219 in the Appendix.
    ---------------------------------------------------------------------------
        Is that consistent with the ethical principles?
        Mr. Cohen. It would be consistent if it's accurate. I don't
    know whether it's accurate. But the point I would make, because
    I have no information on it, is that the language on the
    bottom--and I can just about read it without my glasses--
    ``Cited information is no longer found on Web site.''
        The statement of principles is a learning curve for all
    industries. The statement of principles was adopted a couple of
    months ago. I don't know when this statement was made or when
    it came off, but it's conceivable that it's as long ago as a
    year or more.
        But the two parts to it, that somebody ought to ask again,
    is whether or not this is accurate as a statement, and second,
    when it was on and when it came off and what the circumstances
    were. But I don't know.
        It's important to understand----
        Senator Collins. Let me understand. Are you saying that
    this statement is OK if it was before the statement of
    principles?
        Mr. Cohen. I'm saying it's OK if it's correct. I'm saying
    it shouldn't have been there if it's incorrect, but in any
    case, it's before the statement of principles.
        What I would say is--and this is important to understand--
    ETA represents something like 54 percent of all day traders who
    enter a majority of orders. It does not represent all day-
    trading firms, nor does it have the power of government to say
    do this or do that. The fact that someone may or may not
    subscribe to ethical principles doesn't mean they're going to
    do it. On the other hand, the ethical principles were
    formulated and the discussion was formulated over the past few
    months, as this industry continues to learn and to grow,
    because it's very important to this industry--and I will now go
    back to what the Blue Sky people said, that this industry gain
    community acceptance. So the purpose of us being here is to
    dispel a number of misconceptions with the hope that we will
    get a fair hearing, so that a number of these misconceptions,
    in fact, can be dispelled.
        Senator Collins. Well, one reason you're being asked to
    testify today, and were given the opportunity to make your
    opening statement, was to make sure that the industry's
    viewpoint was represented.
        Mr. Cohen. I'm sorry, Senator. I'm not making it clear, and
    it's my fault, not yours.
        We represent 54 percent of the day traders. I cannot tell
    you we represent the entire day-trading industry.
        Senator Collins. I understand that, Mr. Cohen, and that is
    why we selected examples of deceptive advertising to show you
    that are from members of your association. We're not asking you
    about nonmembers.
        Mr. Cohen. Well, I appreciate that. I have seen just one,
    and what I've said with regard to it first is that I don't know
    whether it's deceptive because I don't know what the number is,
    from an accuracy standpoint, and I don't know what the date is
    and whether it reflects the statement of principles that was
    adopted 2 to 3 months ago.
        Senator Collins. My point is that a company should not be
    making deceptive statements----
        Mr. Cohen. If it's deceptive. I agree with you. There is no
    dispute----
        Senator Collins [continuing]. Regardless of whether it's
    before or after the statement of principles.
        Mr. Cohen. If it is deceptive, it shouldn't be on there. If
    it's not----
        Senator Collins. Let me show you a similar statement, again
    by On-Line Investment Services, which is a member of your board
    of directors. I have confirmed that----
        Mr. Cohen. Again, can you tell me when these were? Are you
    talking about 1998?
        Senator Collins. I believe that these were within the last
    year. I am uncertain when they were removed.
        But that is not my point. My point is that it is troubling
    if it is misleading consumers at any point.
        Can I ask you about this statement: ``On-Line's trading and
    mentoring programs boast an 85 percent success rate for new
    traders.'' \1\ Do you think that is accurate? Could it possibly
    be accurate?
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 5 on page 219 in the Appendix.
    ---------------------------------------------------------------------------
        Mr. Cohen. Could it possibly be accurate? I don't know
    whether it is accurate or not accurate. I just wouldn't hazard
    a guess as to whether it's----
        If it is not accurate, it should not be used. I don't think
    there's any doubt. And I agree with you. Whether you have a
    statement of principles or not, you should not use statements
    that are inaccurate. I just can't tell you whether it's
    accurate or inaccurate.
        Senator Collins. You noted in your testimony--you said in a
    very straightforward way that disclosure of risk is simply not
    an issue. That's on page 6 of your testimony.
        Mr. Cohen. That's right.
        Senator Collins. The problem with that is the preliminary
    results of the joint examinations, the results announced by the
    SEC and NASD today, suggest otherwise. We have written
    testimony from Chairman Levitt saying that the SEC staff
    examined the Web sites of 40 day-trading firms and discovered
    that half of those Web sites today--I'm not talking about last
    year--had little or no risk disclosure, and many of them
    downplayed the risk associated with day trading.
        Do the SEC's preliminary findings that you've heard today
    change in any way your view that the disclosure of risk is not
    a problem with this industry?
        Mr. Cohen. I don't believe disclosure of risk is a problem,
    and I'll tell you why.
        First, ETA members, although we're 54 percent of the
    industry, six firms, I don't know what the other 34 firms are
    doing. But beyond that--and this is the important point, and I
    don't seem to be able to get it across--no matter what the risk
    disclosure was, you could put it in neon lights, when you show
    up at a day-trading firm, if you're there a day, 2 days, 3
    days, you will know every risk. You don't have to have it
    spelled out.
        I'm not suggesting there shouldn't be risk disclosure, or
    that people shouldn't sign off on it. What I'm saying is that
    common sense will tell you that if you spend 24 hours in day-
    trading firms, you're going to know what's going on. This is
    very different from where people are in the rest of the
    brokerage business. Because in the rest of the brokerage
    business, you're isolated. You are one customer with one
    broker, or one customer with an on-line firm, and you don't
    know what's going on. You don't know what the risks are.
        But here you're present and viscerally you know what the
    risks are. You cannot miss the risks if the guy next to you is
    losing a lot of money. You will know what's happening, or
    someone else will.
        Senator Collins. Do you support the NASD's appropriateness
    rule?
        Mr. Cohen. I have gone through that before. I think the
    difficulty with it is that the Securities Industry Association
    has pointed out--and it's important to understand, that day
    trading, as a group, is just a small part of the securities
    industry, that there has never been a test like that in
    general, that all tests have dealt with specific securities.
    That was the testimony, the recommendation as to specific
    securities.
        ETA would like to have some form of appropriateness test.
    It doesn't think the model that's been given is a good one. The
    model we're suggesting that people look at is the option rule,
    2860, the NASD option rule, which says that first you give
    people risk disclosure, they sign off on the risk disclosure,
    and then they sign up for particular strategies. Because what
    day trading is, just like option trading, it is a series of
    strategies. All risky, some riskier than others.
        Senator Collins. I don't see what you could object to in
    the appropriateness rule. All it is doing is requiring a day-
    trading firm to sit down with the customer, to get basic
    financial information, to look at whether or not day trading
    might be an appropriate strategy for this individual, to look
    at their investment goals.
        What's wrong with that? Wouldn't that screen out some of
    the people----
        Mr. Cohen. Senator, I----
        Senator Collins [continuing]. Who should not be engaging in
    this practice?
        Mr. Cohen. Senator, what I heard----
        Senator Collins. Mr. Cohen, I would appreciate you letting
    me finish my question.
        Mr. Cohen. I'm sorry. I thought you had. I apologize.
        Senator Collins. My point is, what is wrong with having an
    up-front screen that would screen out some people for whom day
    trading is clearly inappropriate because of their financial
    status?
        Mr. Cohen. May I answer now?
        Senator Collins. I would appreciate your answer.
        Mr. Cohen. I was one of those who watched Chairman
    Greenspan's testimony on the long-term capital management
    disaster. He made a number of points, one of which was
    regulation for the sake of regulation really doesn't do much
    good.
        An appropriateness test, in general, is not going to do
    much good if it's blurry and is completely generalized, which
    is why we have suggested focusing on an options test. What I
    will tell you is that these things can have an unfortunate
    effect, what is known as regulatory ``creep,'' which is that
    when you start off with regulations that are blurry to begin
    with--if you look at the NASDR's regulation, for example, they
    say we don't define the word ``promote.'' We're not saying who
    promotes day trading. That's very important. They don't define
    it. They say we're not going to define it. Leave it open.
        Well, I think it's a lot less of concern to on-site day-
    trading firms than it is to on-line firms, who I think are in
    an impossible position, because one of the tests the NASDR has
    in its suitability proposal is that you are promoting day
    trading, even if you do not advertise. I think I indicated
    before from the Discover ad, where the advertising is, that
    even if you don't advertise, if you have any day traders. Well,
    there are on-line firms with a million and a half customers. If
    one percent of them, one percent, are day trading, doing two or
    three trades a day, that's triple the amount of day traders in
    the day-trading industry.
        So this is a much broader and wider question, which is why
    the Securities Industry Association is opposed to this. What we
    have tried to do is look at it constructively and say let's get
    something that can work. We think the options model is the one
    that works.
        It's a little hard, frankly, to be criticized--I'm not
    suggesting you're criticizing--but to ask pointed questions
    when we're saying look at something more focused than more
    general with regard to this.
        Senator Collins. Let me turn to another practice that
    troubles me. Many day-trading firms have customer lending
    programs and they, in fact, promote and arrange loans from 1
    day trader and customer to another.
        Isn't the result of that practice to encourage people who
    are losing money to keep on trading?
        Mr. Cohen. Senator, you may have been out for a vote when I
    answered that before, with regard to Senator Levin. He had used
    a very good example of somebody who made money, and I pointed
    out to him that yes, in fact, there are perfectly good reasons
    why one would lend money to someone else.
        First of all, this loan was no risk. These are closed
    transactions. They're not open transactions. So the risks are
    known.
        The practice of lending money from account to account has
    gone on as long as the securities industry has gone on. It is
    noted. There's a New York Stock Exchange rule, 431(f)(4) that
    deals with it. There are letters of authorization forms that
    have existed since I've been in practice. So there is nothing
    special about it.
        One of the problems that this Subcommittee seems to be
    having is building on an edifice that I don't think is there,
    on a base that's there. You're focusing and trying to turn this
    part of the securities industry into something separate from
    the rest of the industry. But every regulation you write has an
    impact on the rest of the industry, and that's why you get
    opposition from the Securities Industry Association.
        Senator Collins. I think the problem the Subcommittee is
    having is that we're very concerned when we hear from State
    regulators, from the SRO, from the SEC, that day trading is a
    real problem and that we do need effective new regulations in
    order to ensure that small, unsophisticated investors realize
    what they're getting into, realize how highly risky this
    practice is, and realize, in fact, that they are likely to lose
    their money.
        Mr. Cohen. I'm sorry. If I may just finish----
        Senator Collins. You may respond.
        Mr. Cohen. I'm in agreement with you up to the last five
    words, and that is, yes, it's risky, they should have these
    disclosures made, there are disclosures. I don't think there's
    a certainty that people will lose money in on-site day trading.
        But hopefully, when the study, the real study is done and
    it's over, there will be a much better feel of statistics to
    argue about than we have now.
        Senator Collins. Senator Levin.
        Senator Levin. One of the day traders that we're familiar
    with says the following in their literature, the material that
    they hand out. ``Prior experience in trading is not essential
    to be successful in this business, although it is important to
    understand that all forms of investing involve risk in the loss
    of capital. An investors lack of familiarity with securities
    trading can even be a strong asset, not a liability.''
        Do you agree with that?
        Mr. Cohen. Yes.
        Do you want an explanation?
        Senator Levin. If you want, sure.
        Mr. Cohen. Mr. Levitt and I, I guess, share one thing,
    which is age. We were around in the Sixties when there were
    ``gunslingers,'' people who traded the market successfully
    because they hadn't learned any of the lessons of the past,
    because each market is different and each thing changes. So not
    having previous experience can be an advantage because you're
    starting fresh.
        I have gone to day-trading firms. I have sat down with the
    people. They are more or less uniform, the ones I have seen.
    They are young, they are computer types, people who have grown
    up with video games, and they sit there in half-darkened rooms,
    like a movie theater, looking at screens--it's not something I
    could do for 10 minutes, and they can do it endlessly, looking
    at it. And up until the end of the day, they count it as
    counting points.
        Now, whether or not that is a comfortable style of
    investing for people of my age, I can't tell you. But that's
    where the world is. It's taking advantage of the information
    edge that is provided by this technology in the same way that
    people took advantage of the information edge of Mr. Edison's
    stock ticker 110 years ago.
        Senator Collins. Senator Levin, would you allow me to
    intervene on just one point on that, because I think you've
    raised a very interesting point, and Mr. Cohen's response is
    interesting to me.
        The NASD has proposed as part of the risk disclosure
    statement that potential clients of day-trading firms receive a
    statement saying that day trading requires knowledge of
    securities markets. So would you oppose that statement being
    included?
        Mr. Cohen. By the time you start day trading, you will have
    knowledge of the securities markets. I don't think we're
    talking about----
        Let's see what we're talking about. I don't think Ms.
    Schapiro is going to say we expect you to have taken courses in
    finance or have an MBA, and no one is going to start day
    trading in an on-site firm, day one, without any knowledge of
    how the business works. So I don't think that's a problem for
    anyone in terms of how the markets work.
        Does it mean you could get a job at Goldman Sachs as an
    analyst or a technical analyst somewhere? No. But I don't think
    that's anybody's test.
        Senator Collins. Senator Levin.
        Senator Levin. Do you think these day traders are
    investors?
        Mr. Cohen. No.
        Senator Levin. Pardon?
        Mr. Cohen. No. It's an approach to the market to make
    money. Some are going to be successful and some won't.
        Senator Levin. Then you don't agree with the part of the
    statement I read, which says an ``investor's'' lack of
    familiarity----
        Mr. Cohen. Senator, the trouble is, when somebody writes
    articles, you can only use so many words for the same thing. An
    investor is one of these----
        Senator Levin. This isn't an article. This is the day
    trader's literature.
        Mr. Cohen. ``Investor'' is a word that is used commonly for
    anybody who trades in the market. It's an old----
        Senator Levin. You would agree they're not investors?
        Mr. Cohen. They're not investors. These are people who are
    traders.
        Senator Levin. Are you telling your members not to describe
    themselves as investors?
        Mr. Cohen. I'm sorry?
        Senator Levin. Are you telling your members not to describe
    these folks as investors?
        Mr. Cohen. If I'm asked, I'll tell them to try to find
    better phrasing. Traders would be better.
        Senator Levin. You're telling your members a number of
    things, though, aren't you?
        Mr. Cohen. When I'm asked. I should point out----
        Senator Levin. Aren't you asking them to get risk
    disclosure statements signed?
        Mr. Cohen. Let me answer it in two ways, OK?
        First, I have been counsel to ETA only since August,
    although my views and theirs are the same broad identification.
    Second, I don't see a reason why you wouldn't have them sign
    risk disclosure statements.
        Senator Levin. You are asking them to do that?
        Mr. Cohen. The ETA is asking them.
        Senator Levin. Your client.
        Mr. Cohen. ETA, as my client, is asking its members to have
    day traders sign risk disclosure forms.
        Senator Levin. So when I say ``you,'' I mean you or your
    client.
        Mr. Cohen. The client. I don't see anything wrong with it,
    so if you want me to identify with it, I will.
        Senator Levin. Good. Your client then is asking its members
    to sign this risk disclosure statement, which is Appendix C in
    your materials. Is that correct?
        Mr. Cohen. Yes.
        Senator Levin. But your client is not asking people to
    avoid the use of the word ``investor''?
        Mr. Cohen. Senator, what we will do is, when the NASDR
    approves its appropriateness rule, which I assume is going to
    happen, we will send this to NASDR advertising for review and
    ask them to sign off on it. I don't think they're going to have
    a problem with the word ``investor,'' but if that's a problem
    for anyone, it will be changed to ``trader.''
        Senator Levin. Relative to that disclosure statement,
    Appendix C, is this something which is required for signature
    by your members of their customers, or is this just something
    which is recommended to----
        Mr. Cohen. It's a trade association recommendation. We
    don't have the power to enforce it.
        Senator Levin. You have the power to do anything you want
    and say ``you're not going to be a member of this association
    unless you follow our rules.'' You can do that, can't you?
        Mr. Cohen. Pardon?
        Senator Levin. Any association can say its members have got
    to live up to the rules.
        Mr. Cohen. Trade associations--and I was at various times
    associated with membership of the Securities Industry
    Association--basically provide recommendations to their
    members, and beyond that, as long as the member is in good
    standing, the member stays in good standing. So that is a
    wonderful example, and perhaps you ought to apply it to a group
    that represents hundreds of brokers rather than six.
        Senator Levin. My question, though, is this, that you can
    make the adoption of this risk disclosure statement a condition
    of membership of the association.
        Mr. Cohen. I assume we could if somebody thought that was
    crucial to life, yes.
        Senator Levin. All right. Do you know how many of your
    members in fact require their customers to----
        Mr. Cohen. I don't.
        Senator Levin. Do you care?
        Mr. Cohen. Do I care? Yes. I would certainly like to know
    later on.
        Senator Levin. Could you find out for us?
        Mr. Cohen. Oh, absolutely.
        Senator Levin. How many members do you have again?
        Mr. Cohen. We have 6--we have 40-something members, but 6
    are----
        Senator Levin. I'm sorry. Forty?
        Mr. Cohen. Forty-something firms. Six are on-site trading
    firms. Those on-site trading firms represent 54 percent of all
    traders, day traders, so far as we know.
        Senator Levin. So----
        Mr. Cohen. It is, again, our estimates.
        Senator Levin. I understand. Your estimate is that you
    represent a majority of the day traders.
        Mr. Cohen. Right, and a majority of the day-trading orders
    being placed.
        Senator Levin. I would like to ask you about the informal
    survey that you referred to on page 11 of your testimony.
        Mr. Cohen. Right.
        Senator Levin. You have surveyed certain of its members to
    obtain a rough estimate of customer profitability.
        Mr. Cohen. Right.
        Senator Levin. Then you said these estimates were that
    after an initial period of 3 to 5 months of losses, 60 to 65
    percent netted in the range of $28,000 per month, but the
    balance of customers losing $6,000 to $8,000 per month.
        What was the capital investment that that represents?
        Mr. Cohen. I'm sorry. I don't understand the question.
        Senator Levin. Well, how much of $28,000 is what percentage
    of their investment that they have put down in the firm of
    their capital?
        Mr. Cohen. Anywhere between, I would say, 28 and 56
    percent.
        Senator Levin. Of their what?
        Mr. Cohen. Twenty-eight and 56 percent.
        Senator Levin. Of their capital?
        Mr. Cohen. Of their capital. I am talking $28,000 a month,
    300 percent a year, current, if you make that kind of money, on
    $100,000.
        Senator Levin. Let me say that the--let's talk about that
    initial period of 3 to 5 months of losses. Let's just focus on
    that. What was the average loss in that 3 to 5----
        Mr. Cohen. I didn't--and I apologize for this. I didn't
    take it down to a number, but the understanding I had when I
    was finished was that it was not a significant number. It was a
    loss number, but it wasn't a wipe-out loss number. It was a
    loss number.
        Senator Levin. Can you provide that to the Subcommittee?
        Mr. Cohen. From our six firms? Yes.
        Senator Levin. Well, whoever you did this informal survey
    of.
        Mr. Cohen. Yes, absolutely.
        Senator Levin. I mean, you have told us----
        Mr. Cohen. Senator, yes.
        Senator Levin. Were you asked for this information by
    Massachusetts or by the NASAA?
        Mr. Cohen. I don't--I really have nothing to do with
    Massachusetts. I'm not sure. You are talking about ETA being
    asked by Massachusetts?
        Senator Levin. Yes.
        Mr. Cohen. The Massachusetts thing is fascinating in
    itself.
        Senator Levin. Without getting into that, we had testimony
    this morning that you were specifically asked for the backup
    information here.
        Mr. Cohen. And we were willing--not with regard to--we are
    talking apples and oranges.
        Senator Levin. Relative to this survey of yours.
        Mr. Cohen. Let me see if we can define it, OK?
    Massachusetts is talking about some comments that the Los
    Angeles Times ran in an article in January in which--and then
    there was correspondence back and forth, and I was not the
    counsel involved in it, between Massachusetts acting, I guess,
    for ETA, acting for the Blue Sky people from NASAA and ETA.
        That correspondence is apparently subject to two
    interpretations. I think the Subcommittee ought to look at the
    correspondence. My understanding of it is that the--and that is
    what is reflected in the written submission--is that ETA
    offered to submit current information to NASAA with the
    methodology, which I have actually seen the methodology, we can
    supply it, and NASAA said no. And I think Mr. Shellenberger
    told you why he said no, because they did not want to endorse,
    as he put it, what the results would be.
        So the second survey that we are talking about is one that
    is at a later point, that I participated in, in this past
    summer--and I don't recall. I think it was in August--in which
    I spoke to a number of the firms and got those responses.
        Senator Levin. I am referring to the informal survey. Were
    you asked by them for any information relative to that informal
    survey that you refer to page 11?
        Mr. Cohen. ETA--I should look at the statement because I
    think we are talking about different things.
        Senator Levin. That is what I want to find out. Are you
    saying to us that that informal survey that you have taken,
    that you refer to on page 11, is not the subject of any request
    by the----
        Mr. Cohen. It says there are--it is actually clearly
    written as I look at it: Earlier this year ETA informally
    surveyed certain of its members to obtain a rough estimate of
    customer profitability. Its members considered these numbers
    still to be representative in August. My understanding was that
    earlier this year, membership--one or two of the members had
    been asked about it--these were their numbers. For the purpose
    of dealing with this as an issue, there was a--as part of a
    phone conference, the subject came up, what are the numbers,
    can I get a feel for the numbers. I raised the question. These
    are the responses I got from the particular people. So I am
    comfortable that is what I was told, and these are estimates.
    And the only way anybody is ever going to get comfortable with
    this is to do what ETA now proposes to do, and that is to get
    KPMG or someone else to do a study.
        Senator Levin. But I want to go back to my question.
        Mr. Cohen. OK. Senator, I am told the information has been
    supplied both to the Subcommittee and to the Texas regulator
    that asked the questions. That's what counsel for----
        Senator Levin. All right. That answers it. My time is up
    for this round.
        Mr. Cohen. All right. Sorry.
        Senator Levin. Thank you.
        Mr. Cohen. Is that what these lights mean?
        Senator Collins. I apologize for not giving you an
    explanation, and I assumed the staff had done so.
        Mr. Cohen. I thought I was almost boiled.
        Senator Collins. I have another commitment that I have to
    keep. I have asked Senator Levin to proceed with the hearing
    because there are a number of additional areas that we are both
    eager to pursue with you, Mr. Cohen. So I am going to turn over
    the Chairman's gavel to Senator Levin with my thanks.
        I do want to take this opportunity to thank our staffs for
    their very hard work on this hearing and to let people know
    that the Subcommittee's interest, if anything, has only been
    strengthened by the overview hearing today. We will be
    continuing in an ongoing investigation to look at the specific
    practices of selected day-trading firms to gain a better
    understanding of this day-trading phenomenon.
        So, with that, I would thank Senator Levin for his
    willingness to continue the hearing in my absence.
        Senator Levin [presiding]. Thank you, Madam Chairman.
        I want to go back to page 11 to understand what it is you
    are telling the Subcommittee. What is the average amount of
    capital that was put up at risk that this net of $26,000 is
    based on? Is that the capital investment of $100,000, 60 to 65
    percent, in the range of $28,000 a month? Give us an update.
        Mr. Cohen. The $28,000 is a P&L number. Capital is a
    balance sheet number. I mean, they are different things.
        Senator Levin. Right.
        Mr. Cohen. My understanding of capital is that--and this is
    based simply on my understanding, having worked with day
    traders over a period of months, is that capital runs from
    $50,000 to $100,000.
        Senator Levin. So you are saying that this informal survey
    demonstrated that after an initial period of 3 to 5 months of
    losses that 65 percent profited, in the range of $28,000 per
    month based on an average capital investment of perhaps $50,000
    or $100,000.
        Mr. Cohen. Yes.
        Senator Levin. You are going to supply us the data to
    support that estimate?
        Mr. Cohen. I understand data regarding those estimates have
    been supplied to the Subcommittee, but if they have not, I will
    find out from counsel who is doing it.
        Senator Levin. Now----
        Mr. Cohen. I would also think it would be useful to wait
    for the KPMG study.
        Senator Levin. That may or may not be useful, but the basis
    of this representation would be very useful to me.
        Mr. Cohen. The representation----
        Senator Levin. People who have $50,000 or $100,000 at risk
    and are making $300,000 a year profit, that is an absolutely
    incredible representation that you are making.
        Mr. Cohen. Here is what we wrote. In August, ETA's
    executive committee members considered these numbers still to
    be representative. Please note that these are only estimates.
    Unlike the NASAA report, they do not purport to be scientific.
    No one is purporting or representing these are scientific. This
    was the feel of the people who are running these firms that
    these were the numbers.
        Senator Levin. You are representing to this----
        Mr. Cohen. Absolutely. I am representing that I was
    informed by the----
        Senator Levin. Well, let me finish my statement now.
        You are representing to this Subcommittee that the
    estimates, the estimates of certain of your members to get an
    estimate of customer profitability demonstrates that after an
    initial period of 3 to 5 months of losses, 60 to 65 percent of
    those day traders netted in the range of 28,000 per month which
    is over $300,000 a year, based on a capital investment of
    $50,000 to $100,000. Now, that is what you are representing.
        Mr. Cohen. Absolutely. And let me say further that the
    capital issue really is not important because it----
        Senator Levin. It may not be to you.
        Mr. Cohen. If the average trade is 700 shares and the
    average NASDAQ stock is $27.15, according to the SIA
    statistics, you are talking about an average trade of $20,000
    that somebody holds for 4 minutes.
        Senator Levin. I understand.
        Mr. Cohen. OK.
        Senator Levin. I am only talking about a return on how much
    money you are putting at risk. That is what I am talking about.
        Mr. Cohen. Well, we have not done it as a return on
    capital, but we have put it as P&L numbers, the way it was
    written here.
        Senator Levin. I understand.
        I will tell you again, I find that estimate incredible, and
    I would like to see the data that supports it, and I think it
    is the kind of touting----
        Mr. Cohen. Well, it will either be or it will not be.
        Senator Levin. I think it is.
        Mr. Cohen. Well, let's wait for the numbers.
        Senator Levin. Yes. But I think it is the kind of touting--
    I am stating my opinion. I am giving you my estimate now. You
    are telling the world----
        Mr. Cohen. Well, as a lawyer, when I speak to clients----
        Senator Levin. Well, now, let me finish. Keep $50,000 here
    or $100,000 at risk. Play with it for a year. You will make
    $300,000--no. Two-thirds of you will make $300,000.
        Mr. Cohen. I don't----
        Senator Levin. That is what you are saying the estimate of
    your members are.
        Mr. Cohen. I think that is what you are saying it says.
        Senator Levin. No, that is what you said.
        Mr. Cohen. Can I use my own words?
        Senator Levin. Now it is your turn.
        Mr. Cohen. Thank you very much.
        What this says is that there is a period of time in which
    people will lose money. It is part of the normal learning
    curve, and that after that period, people will make money, and
    two out of three will average something like $28,000 net a
    month. That is based on discussions I have had with people
    running on-site firms, and I have no reason to believe that
    since they are there every day and more or less have a feel for
    it that those are not correct estimates, but we do not
    represent they are scientific and it says here they are not
    scientific, which is why we are going out to get KPMG to get
    these numbers.
        Senator Levin. You are also representing that they consider
    these numbers to be representative?
        Mr. Cohen. Yes.
        Senator Levin. That is a tout.
        Mr. Cohen. It is a tout--if it is inaccurate, I am saying
    what it says here.
        Senator Levin. OK.
        Mr. Cohen. We consider them to be representative. We spoke
    to our people. They believe they are representative.
        This is a document produced for this Subcommittee.
        Senator Levin. It still ought to be accurate.
        Mr. Cohen. It is accurate, so far as I know, and I would
    think you would want us to give you the broadest possible read
    we can, which is what we tried to do.
        Senator Levin. Yes.
        Mr. Cohen. Apparently, Senator, you have less problems with
    the NASAA report written by this guy out of his apartment.
        Senator Levin. Yes. I have a lot of problems with this
    report here because I do not believe you can put $50,000 to
    $100,000 at risk and then over a period of a year, two-thirds
    of the people who do that get back a return of over $300,000. I
    do not believe it.
        Mr. Cohen. Senator----
        Senator Levin. OK? I just do not believe it.
        Mr. Cohen. Well, that is fair. You----
        Senator Levin. You apparently do believe it.
        Mr. Cohen. You certainly----
        Senator Levin. Do you believe it?
        Mr. Cohen. I believe it. I certainly feel you are free not
    to believe it, but you also might ask yourself the question why
    haven't there been any complaints. Why if in fact something
    like 70 percent of people lose money in 6-month periods which
    mean 20,000 over 3 years, NASAA, this Subcommittee, the SEC,
    and the NASD have not been inundated with complaints by losing
    day traders?
        Senator Levin. I think maybe people want to gamble.
        Mr. Cohen. Well----
        Senator Levin. If people want to gamble, you say they ought
    to be free to do so.
        Mr. Cohen. The American--I haven't said that at all. What
    we have said is this is not gambling, that the people who trade
    in this market--Senator, I do not know what your previous
    profession was. You are good at it. I assume you were a lawyer.
    But this is not gambling.
        Senator Levin. See, you made another assumption here. That
    I was good at it. [Laughter.]
        Mr. Cohen. I have often been criticized for criticizing
    people, but to be criticized for praising somebody is a little
    different, but it is Washington and I am not used to it.
        I do not know if you were here when we talked about it, but
    the opening of my statement, I said that day traders do not
    regard this as gambling. That is a quote that is in the
    newspapers. That is something you can find. The people who do
    it do not think they are gambling. They think they are using
    informational edges in order to trade successfully.
        Senator Levin. I would like to go to another statement of
    yours on page 17 of your testimony, where you say day trading
    is not gambling.
        Mr. Cohen. Yes.
        Senator Levin. You say the majority of those who day-trade
    after training do not lose money.
        Mr. Cohen. Yes.
        Senator Levin. What is that based on?
        Mr. Cohen. That is based on the same survey.
        Senator Levin. This same unscientific survey?
        Mr. Cohen. This same unscientific survey.
        Senator Levin. I do not see all of those qualifiers next to
    your statement here.
        Mr. Cohen. Senator, I kind of feel that when people read
    the document, they read it as a whole, but that may well be a
    failing, and I will footnote things in the future.
        Senator Levin. No, I think----
        Mr. Cohen. When I write Law Review articles, I put
    footnotes after every sentence, so----
        Senator Levin. That is the kind of unqualified statement
    which people believe.
        Mr. Cohen. Well, if they don't read the whole thing.
        Senator Levin. Most people do not read 25 pages of
    testimony. They will look at one flat-out statement. The
    majority of those who day-trade after training do not lose
    money. That is what they hear.
        Mr. Cohen. I was here this morning sitting in the audience
    when somebody quoted something out of context that I said in an
    article that I wrote. So I know people on this Subcommittee
    certainly don't read entire articles.
        Senator Levin. Well, are you saying that that is out of
    context, what I just read?
        Mr. Cohen. What I am saying is that my article was out of
    context as it was quoted, and what this says, if you refer back
    to part of the summary--it is part of the summary, which I
    think fairly said means if it is part of a summary, you go back
    to the full text where it is referred to.
        Senator Levin. OK. You are going to let the Subcommittee
    know what percentage of your members require your Exhibit C to
    be signed by their members. Is that something you are going to
    give us?
        Mr. Cohen. Yes, sir.
        Senator Levin. If you have not already given us the
    material that supports this unscientific survey of yours, you
    are going to let us have the background material for your
    conclusion about netting $28,000, two-thirds of the people per
    month.
        You also indicated that you would supply to the
    Subcommittee what were the losses during the 3-to-5-month
    period.
        Mr. Cohen. I don't recall you asking that, but if it is
    part of the same stuff, it is all the same material. So it
    should be----
        Senator Levin. Would you do that----
        Mr. Cohen. Yes.
        Senator Levin [continuing]. If I did not ask for it? I will
    ask for it now.
        One other question. You said that after training, you
    indicate that the majority of those who day-trade based on that
    informal survey are now saying that they do not lose money.
    Does that training include the 3 to 5 months of losses?
        Mr. Cohen. Yes.
        Senator Levin. You consider that part of training?
        Mr. Cohen. Yes. That is part of the learning process. I
    could have used a different phrase. I apologize for the
    phrasing. It could have been after the learning process, but
    everybody is always learning.
        Senator Levin. You also have training before the 3 to 5
    months begins, don't you?
        Mr. Cohen. Senator, let me answer it this way. A lot of
    people who come into day trading have traded previously. There
    was a New York Times article that said professionals are coming
    to the business. So they presumably start trading day one with
    a vast amount of skill and experience. If we are talking about
    people who have not traded before, what we are talking about in
    their case is this 3-to-5-month period, which includes training
    and actual trading.
        Senator Levin. I guess my question is: You do training
    prior to the actual trading? Does some of the training that you
    are referring to take place before the actual----
        Mr. Cohen. I believe firms train people who have not been
    in the market before, that they have training programs. They
    certainly have training programs. I cannot tell you whether
    every on-site firm has got one.
        Senator Levin. If in fact your survey is accurate that most
    people lose money in the first 3 to 5 months, assuming you are
    accurate on that, would you be willing to have your risk
    disclosure statement notify people that most people lose money
    for 3 to 5 months?
        Mr. Cohen. I think it says it now, but I haven't gone back
    over it.
        Senator Levin. No. I do not think it says quite that. It
    says you can lose money. I am asking----
        Mr. Cohen. I thought it says--well, I apologize. I am not
    able to find it, but I do not have a problem if that is your
    question that people lose money in the first 3 to 5 months.
        Senator Levin. That most people.
        Mr. Cohen. That most people.
        Senator Levin. You do not have any problem in modifying
    your statement?
        Mr. Cohen. I don't see a reason not to.
        Senator Levin. Good.
        Mr. Cohen. By the way, that, of course, goes well beyond
    the risk disclosure of the NASDR, but we are well beyond where
    the NASDR is.
        Senator Levin. I think that would support that claim if you
    did that.
        We want to thank you and the other witnesses for appearing
    today. The hearing will be recessed. We will now adjourn this
    hearing because it is the first of a series of hearings.
        Again, I want to thank our Chairman for her leadership
    here. We are getting into an area which I think all of us would
    acknowledge as an extremely important area to consumers, and I
    think you also would acknowledge that, Mr. Cohen, even though
    there is obviously a difference here that this is a very
    important area to consumers. I think that on that, you would
    not disagree.
        Mr. Cohen. What I would say--thank you for the opportunity
    at least to comment on it. The consumers I would be concerned
    about are the online as opposed to the on-site people, and what
    I would say is it depends where you look in the telescope. What
    I am looking at the telescope is the on-site day traders are
    providing enormous benefits to consumers, the average guy
    throughout the market.
        Senator Levin. I thank all of our witnesses for coming
    forward.
        One other question, just for you and the other witnesses,
    if we still have them here. If we have additional questions for
    the record, whether you would be willing to answer those
    questions?
        Mr. Cohen. Of course. \1\
    ---------------------------------------------------------------------------
        \1\ See Exhibit No. 9 on page 228 in the Appendix.
    ---------------------------------------------------------------------------
        Senator Levin. I do not know if our other witnesses are all
    here.
        Mr. Hildreth. Yes.
        Senator Levin. Thank you all.
        Mr. Cohen. Thank you.
        Senator Levin. We will stand adjourned.
        [Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]

                                A P P E N D I X

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