[Senate Report 106-364]
[From the U.S. Government Publishing Office]
106th Congress Report
SENATE
2d Session 106-364
_______________________________________________________________________
DAY TRADING:
CASE STUDIES AND CONCLUSIONS
__________
R E P O R T
prepared by the
PERMANENT SUBCOMMITTEE ON
INVESTIGATIONS
of the
COMMITTEE ON GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
July 27, 2000.--Ordered to be printed
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, Chief 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
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Page
I. Executive Summary................................................1
II. Background.......................................................5
A. Day Trading Defined................................. 5
B. Regulatory Structure and Enforcement Activities..... 6
C. Background on the Day Trading Industry.............. 13
D. Day Trading Closely Resembles Gambling for Novice,
Undercapitalized Traders........................... 22
E. Only a Small Percentage of Novice Day Traders Will
Be Profitable and Even a Majority of Experienced
and Well Capitalized Day Traders Lose Money........ 27
F. Day Trading Has Resulted In Positive And Negative
Market Developments................................ 32
G. Summary of Findings................................. 35
III. Case Study: All-Tech Direct, Inc................................37
A. Background of All-Tech Direct, Inc.................. 37
B. All-Tech Allowed Unsuitable Customers to Day Trade.. 41
C. All-Tech Enabled Customers to Trade Beyond Their
Means.............................................. 50
D. All-Tech's Risk Disclosure Was Often Ineffective and
the Firm's Advertising Was Occasionally Misleading. 58
E. All-Tech's Failure to Supervise its Employees....... 65
IV. Case Study: Providential Securities, Inc........................75
A. Providential's Founding and Corporate Structure..... 75
B. Providential's Risk Disclosure Policies............. 81
C. Providential's Misleading Advertising............... 81
D. Providential's Suitability Standards for New Day
Trading Accounts................................... 85
E. A Providential Day Trader Mislead the Firm's Clients
for Whom He Traded, and Generated Significant
Losses............................................. 90
F. A Providential Official ``Recommends'' That Day
Traders Purchase Particular Stocks................. 103
G. Providential Failed to Supervise Mr. Nguyen, Mr.
Moon and Mr. Cao................................... 108
V. Case Study: Momentum Securities, Inc...........................109
A. Founding and Structure.............................. 109
B. Jim Lee Was The Catalyst for the Creation of the
Electronic Traders Association..................... 112
C. Suitability: A Case Study--Scott Webb, David Dial,
Justin Hoehn and the Atlanta Office................ 113
D. Momentum Operates A Lending Program That Allows Day
Traders To Evade The Purpose of the Margin Rules... 122
E. Momentum Has Not Engaged in a Deceptive or
Misleading Advertisement Campaign.................. 125
F. Increased Regulatory Scrutiny of Day Trading
Prompted Momentum To Improve Its Standards and
Compliance Program................................. 126
G. Momentum's Profitability Survey..................... 138
H. The Role of Suitability in Day Trading.............. 141
VI. Suggested Reforms and Remedies.................................142
A. The New Rules Proposed by The NASD And NYSE Are
Helpful Remedies to Many of The Problems And Abuses
That Were Identified in the Subcommittee's
Investigation...................................... 142
B. While These Proposals Are Useful Starting Points for
a Discussion of Reform, the Subcommittee Recommends
Several Modifications to the Proposed Rules........ 146
VII. Conclusion.....................................................152
106th Congress Report
SENATE
2d Session 106-364
======================================================================
DAY TRADING: CASE STUDIES AND CONCLUSIONS
_______
July 27, 2000.--Ordered to be printed
_______
Mr. Thompson, from the Committee on Governmental Affairs, submitted the
following
R E P O R T
I. EXECUTIVE SUMMARY
On September 16, 1999, the Permanent Subcommittee on
Investigations (``Subcommittee'') held the first congressional
hearing on day trading (``Overview Hearing'').\1\ The hearing
provided an overview of day trading and included testimony from
securities regulators and the Electronic Traders Association
(``ETA''),\2\ a trade group that represents some day trading
firms. Subcommittee Chairman Susan M. Collins raised three
questions during that hearing: (1) is day trading similar to
gambling for many investors; (2) are some day trading firms
engaged in deceptive and fraudulent practices and, if so, how
pervasive is this misconduct; and (3) what is the impact of day
trading on individual companies and the markets? In her opening
statement, Chairman Collins indicated that the Subcommittee
would examine these questions through an in-depth investigation
of the day trading industry and announced that subsequent
hearings would highlight case studies developed by the
Subcommittee.\3\
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\1\ Day Trading: An Overview: Hearing Before the Permanent
Subcommittee on Investigations of the Committee on Governmental
Affairs, 106th Cong., 1st Sess. 106-285 (1999) (``Overview Hearing'').
\2\ The participants were: Arthur Levitt, Jr., Chairman of the U.S.
Securities and Exchange Commission; Mary L. Schapiro, President of NASD
Regulation, Inc.; Peter C. Hildreth, President of the North American
Securities Administrators Association; David E. Schellenberger, Chief
of Licensing for the Commonwealth of Massachusetts Securities Division;
and Saul S. Cohen, Consulting Counsel for the ETA.
\3\ Opening Statement of Senator Susan M. Collins, Chairman of the
Subcommittee, Overview Hearing, at 3-4 (``Collins Statement'').
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Over an eight month period, the Subcommittee conducted an
investigation by casting a wide net and examining the largest
day trading firms. The Subcommittee formally requested
documents from nineteen day trading firms through the use of a
comprehensive document request. Eighteen of those firms
responded to the Subcommittee's request. Those firms produced
approximately 50,000 pages of documents to the Subcommittee and
at least ten videotapes containing television advertisements.
The staff reviewed all of these materials. During the course of
its investigation, Subcommittee staff interviewed approximately
107 people and deposed seven individuals who are or were
employed by the day trading industry. Those witnesses included
chief executive officers and other employees of day trading
firms, former and current day traders, gambling experts,
academics and authors. The staff also met with state and
federal regulators and representatives of self-regulatory
organizations (``SROs'').
In furtherance of the investigation, the Subcommittee
requested that eighteen day trading firms or companies that
support the day trading industry respond to written
interrogatories concerning customer lending, third party
trading, trading policies, customer financial qualifications
and advertising. The Subcommittee then submitted a second set
of interrogatories to fifteen of those firms, primarily
requesting financial information such as gross revenues, net
income, and commission charges.
In addition, the Subcommittee looked extensively at the
support industries that have evolved as day trading has become
more popular. Promoted heavily over the Internet, this vast and
largely unregulated industry often contributes to the hype and
unrealistic expectations regarding day trading. The support
industry includes books, training programs and seminars, stock
picking systems and software, as well as periodic newsletters
that firms distribute by e-mail and facsimile. In this regard,
the Subcommittee reviewed a variety of websites that the day
trading support industry uses to advertise its products and
services and found many questionable claims. The Subcommittee
then requested that nine support industry firms provide
documentation to support these assertions.
Based on all of the information provided, the Subcommittee
narrowed its focus to three day trading firms, which were
examined in detail: All-Tech Direct, Inc. (``All-Tech''),
Providential Securities, Inc. (``Providential''), and Momentum
Securities, Inc. (``Momentum''). The case studies of those
three firms are located in sections III, IV and V of this
report and were the subject of public hearings on February 24
and 25, 2000. As Ranking Member, Senator Carl Levin, stated at
the Subcommittee's February hearings, ``The Subcommittee
investigation looked behind the claims of day trading companies
and found how some day trading firms skirt the rules, and take
advantage of their customers in the pursuit of profits.'' \4\
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\4\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
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Day trading is a highly speculative activity that can be
fairly compared to certain types of gambling. A growing number
of people are giving up their existing careers or withdrawing
their savings to become full-time professional day traders. The
Subcommittee's investigation suggests that day trading closely
resembles gambling for novice, undercapitalized traders. The
Subcommittee based this conclusion on statements by regulators,
members of the day trading industry, gambling experts,
documents produced by day trading firms, and profitability
data.
The best evidence, based on studies conducted by state
securities regulators suggests that only a tiny fraction of
novice day traders are ever profitable and that, even among
well capitalized and experienced day traders, a majority will
lose money. In fact, the Subcommittee's February hearings found
that more than 75% of day traders lose some or all of their
investment. Furthermore, the average day trader must realize
gains of more than $200,000 annually just to pay commissions
and fees. The Subcommittee's findings contrast with some of the
deceptive advertising the Subcommittee found that has created
unrealistic expectations of easy profits. Moreover, some day
trading firms have failed to adequately disclose the risks
attendant to day trading in their advertisements and during
their interactions with prospective customers. Even when firms
have given prospective customers good written risk disclaimers,
some firms have undermined that risk disclosure through
contradictory verbal statements about the profitability of day
trading or the ease with which risk can be avoided.
Contrary to their own internal policies, some day trading
firms have frequently failed to gather the information about
their prospective customers that is necessary to determine
whether those customers are suitable for day trading.\5\ In
addition, many day trading firms have gathered the pertinent
information, but then accepted customers whose stated financial
condition and/or investment objectives were inconsistent with
their firms' internal policies regarding the opening of high
risk, day trading accounts. For example, firms have opened day
trading accounts based on new account forms indicating that the
customers' investment objectives were ``income'' or ``long term
growth with safety,'' two objectives commonly understood to be
at odds with a day trading strategy. Some day trading firms who
maintained sound minimum financial requirements for opening new
accounts have now lowered their standards to compete with other
day trading firms who have weak minimum requirements or no
standards at all. These firms are now accepting customers that
they previously considered unsuitable for day trading, and they
are doing so largely because they do not wish to lose the
commission revenue generated by those unsuitable customers.
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\5\ There is some disagreement between the industry and the
regulators as to whether existing suitability rules apply to day
trading. NASD Rule 2310 (the ``suitability'' rule) requires NASD
members to have ``reasonable grounds'' for believing that a
recommendation to a customer for the ``purchase, sale or exchange of
any security'' is suitable for that customer. See infra Section VI(A) &
(B). Regardless of whether the rule applies to day trading, most day
trading firms have internal standards for determining whether day
trading is a suitable strategy for their prospective customers. The
NASD has recently proposed a rule that would require day trading firms
to perform an ``appropriateness'' (i.e. suitability) analysis for each
potential customer prior to opening a day trading account. Id.
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Some day trading firms have failed to hire qualified
personnel to manage their branch offices and have failed to
adequately train and supervise those branch managers after they
were hired. Many day trading firms have provided their
customers with poor training--training that does little or
nothing to prepare a novice for a profitable career as a day
trader. Also, many day trading firms arrange for customers who
cannot satisfy margin calls to obtain from other customers
short term loans at high interest rates. The firms then manage
all of the administrative and clerical functions attendant to
servicing those loans. Finally, many day trading firms allow
individuals to day trade the accounts of third parties without
the day traders verifying that they are registered as an
investment adviser or that they are not required by law to be
registered.
The Subcommittee's findings are similar to those of the
Securities and Exchange Commission (``SEC''), state securities
regulators, and the securities industry's own self-regulatory
organization. The regulators have recognized that the day
trading industry needs to establish and then comply with
responsible industry standards, as have the more respectable
day trading firms. In line with this sentiment, the National
Association of Securities Dealers (``NASD'') and the New York
Stock Exchange (``NYSE'') have recently proposed rule changes
for the day trading industry. The proposed rules would require
day trading firms to give new customers risk disclosure before
opening their accounts. The firms would also be required to
evaluate the appropriateness or suitability of day trading
strategies for their customers before opening their accounts.
The last proposal would tighten the rules governing margin
trading by day traders.
The Subcommittee believes that these rule changes will help
combat some of the abuses and problems uncovered by the
Subcommittee's investigation but that they require
modification. At the conclusion of this report, the
Subcommittee includes recommended modifications to the existing
proposals from the NASD and the NYSE.
The Subcommittee has also proposed two new rules to more
fully address the problems in the day trading industry. These
reform proposals were submitted to the SEC in March, 2000.
Regulators must also be more aggressive in their enforcement
activities relating to errant day trading firms, particularly
with respect to the supervision that day trading firms are
providing their branch offices.
The Subcommittee does not recommend a ban on day trading.
If an investor with adequate capital is fully informed of the
risks of day trading, he or she should be allowed to do so. As
the Subcommittee found however, far too often, the consumer has
no idea of the true risks involved. Too many firms entice
inexperienced and undercapitalized individuals to day trade,
sometimes with borrowed money that they can ill-afford to lose.
In addition, the Subcommittee closely evaluated the evident
impact of the day trading phenomenon on the markets as a whole.
The Subcommittee's investigation determined that day trading
has had both positive and negative effects on the securities
markets, and that the negative developments warrant close
scrutiny by regulators and policymakers. As the Subcommittee
found, the three developments that have made day trading
possible are arguably very positive for investors. First, day
traders have added liquidity to the markets. Second, the almost
exponential growth in low-cost trading execution platforms has
dramatically lowered commissions for investors as more broker-
dealers lower commission costs to compete with online trading
systems. Third, the new technologies of day trading have
greatly expanded access to financial information. All of these
changes are positive for investors.
The Subcommittee also found evidence, however that day
trading may be contributing to an increase in volatility for
individual stocks and the markets as a whole, such as Nasdaq.
Some day trading critics contend that the strategies of day
traders, such as buying in ``up-trending'' markets and selling
in ``down-trending'' markets, increases price volatility.
Market volatility is generally considered detrimental to
investors because stock prices fluctuate for reasons unrelated
to the business prospects of the company or the fair value of
its shares. With an estimated ten to fifteen percent of Nasdaq
trading volume attributable to day traders, their impact on the
markets continues to grow. Though the volatility may be only
partially a result of increased day trading, it seems clear
that the psychology of day traders has infected the broader
markets. Securities regulators and policymakers will need to
diligently monitor these trends in order to react prudently to
the swift changes underway in our stock markets.
In conclusion, the Subcommittee applauds the
democratization of the markets and heralds the many positive
developments that have derived from the technology that makes
day trading possible. However, simply because an industry
utilizes a new technology does not mean that it should be
allowed to circumvent the basic tenets of our securities laws.
Reasonable and measured government regulation fosters investor
confidence and is an important reason the United States has the
strongest and most successful capital markets in the world.
II. BACKGROUND
A. Day Trading Defined
Day trading typically is defined as placing multiple buy
and sell orders for securities and holding positions for a very
short period of time, usually minutes or a few hours, but
rarely longer than a day.\6\ Day traders seek profits in small
increments from momentary fluctuations in stock prices after
paying commissions, which can range from $15 to $25 per
trade.\7\ The NASD has recently defined a ``day trading
strategy'' as an ``overall trading strategy characterized by
the regular transmission by a customer of intra-day orders to
effect both purchase and sale transactions in the same security
or securities.'' \8\ In its proposal to amend NASD Rule 2520,
which would change margin lending requirements for day traders,
NASD seeks to:
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\6\ Jane Bryant Quinn, ``Trade by Day, Lose Sleep by Night,''
Newsweek, Apr. 18, 1999, at H2. There is no standard definition of the
number of trades that characterize a day trading account. Some day
traders execute as few as seven buy and sell orders per day, while
others may make 100 or more trades per day. See Jeffrey H. Harris and
Paul H. Schultz, ``The Trading Profits of SOES [``Small Order Execution
System''] Bandits,'' 50 J. Fin. Econ. 39, 51 (1998).
\7\ NASAA, Report of the Day Trading Project Group, at 7 (Aug. 9,
1999) (``NASAA Report'').
\8\ NASD Proposed Rule 2360(e).
Revise the definition of ``pattern day trader'' to
include any customer who (a) the firm knows or has a
reasonable basis to believe will engage in pattern day
trading, or (b) day trades four or more times in five
business days, unless his or her day trading activities
do not exceed 6% of his or her total trading activity
for that time period. A day trader would be able to
shed the day trader classification if he or she did not
day trade for a ninety (90) day period.\9\
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\9\ ``Proposed Rules Change by National Association of Securities
Dealers, Inc.,'' File No. SR-NASD-0-03, Jan. 13, 2000.
The estimated number of ``professional'' day traders, those
who devote nearly all of their time to the activity, represents
only a small fraction of the millions of investors who
participate in the securities markets. James Lee, President of
the ETA, told the Subcommittee that about 4,000 to 5,000
individuals trade from 100 or more specialized day trading
firms.\10\ In response to Subcommittee interrogatories,
however, fifteen day trading firms reported opening 12,666 new
accounts between January 1, 1998 and October 1, 1999. Although
the number of day traders is relatively small, ETA estimates
that day traders engage in a disproportionately high number of
securities transactions which account for ten to fifteen
percent of the daily dollar volume traded on the Nasdaq
exchange.\11\
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\10\ According to the Congressional Research Service (``CRS''), it
is difficult to estimate the total number of day traders since many
quit, due to losses, within three months of starting. See Congressional
Research Service, Day Trading, at 2 (1999).
\11\ Interview of William Lauderback, Aug. 11, 1999 (``Lauderback
Int.'').
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A close relative to the day trader is the ``swing'' trader.
This type of trading differs from day trading in that swing
traders hold positions open for longer intervals of time. Henry
Fahman, President of Providential, described a swing trader as
one who finds positions and then holds them for a number of
days or sometimes weeks, depending on the projected frequency
of price movement.\12\
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\12\ Deposition of Henry D. Fahman, Dec. 15, 1999, at 119 (``Fahman
Dep.'').
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Day traders do not invest in a particular security based on
the fundamental strengths or weaknesses of the company. Indeed,
the trading decision may have nothing whatsoever to do with the
merits of a particular stock. One day trader was quoted as
follows: ``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 2000?'' \13\ In essence, each trade is little more than a
bet on the short-term price fluctuation of a particular stock.
The training manual for Cornerstone Securities Corporation
(``Cornerstone'') describes the differences between day trading
and traditional investing as follows:
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\13\ Ianthe Jeanne Dugan, ``For These Day Traders, Stock Market Is
One Big Casino,'' Washington Post, Feb. 25, 1999, at A1.
Unlike in traditional investing where the investor's
returns are pegged to market indexes or prices of
issues increasing in value, a day trader is not
concerned with whether or not the market goes up.
Rather, he cares only that there is movement--up or
down, the direction is not as important as the presence
of volatility.\14\
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\14\ Training Manual, ``The Fundamentals of Successful Day
Trading,'' Cornerstone Securities Corporation, 1999, at 2
(``Cornerstone Training Manual'') (Day Trading: Everyone Gambles But
the House: Hearing Before the Permanent Subcommittee on Investigations
of the Committee on Government Affairs, 106th Cong, 2nd Sess. (February
24-25, 2000) (``Feb. Hr'gs'') Ex. 135.
Mr. Lee explained that day trading is more active than
traditional investing and focuses on the short term.\15\ He
elaborated that the two differ greatly in terms of time
commitment, trading volume, the systems used, and the
indicators on which those engaged in the activity rely.\16\
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\15\ Deposition of James H. Lee, Dec. 22, 1999, at 70 (``Lee
Dep.'').
\16\ Id.
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B. Regulatory Structure and Enforcement Activities
(1) Securities & Exchange Commission (``SEC'')
(a) Jurisdiction. The SEC is the federal agency that
regulates the United States securities markets. The SEC
supervises SROs which are charged with the initial
responsibility to regulate the conduct of their member
firms.\17\ The most prominent SROs include the NYSE, the
American Stock Exchange (``AMEX''), the Philadelphia Stock
Exchange (``Phlx''), and the NASD.\18\ In order to change their
rules and procedures, SROs must file written proposals with the
SEC that are then subject to public comment prior to approval
or rejection by the SEC.\19\
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\17\ SROs are ``member organizations that create and enforce rules
for its members based on the federal securities laws.'' ``The
Investor's Advocate: How the SEC Protects Investors and Maintains
Market Integrity,'' www:sec.gov/asec/wwwsec.htm, Dec. 1999, at 6
(``Investor's Advocate'').
\18\ John R. Hewitt et al., Securities Practice and Electronic
Technology at para.6.02 (1998).
\19\ Id.
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The SEC's Division of Enforcement (``Enforcement'')
investigates potential violations of the federal securities
laws.\20\ If the Enforcement staff finds sufficient evidence
that the federal securities laws have been violated, it may
seek approval from the Commissioners of the SEC to file a
complaint in federal court or to initiate an administrative
proceeding.\21\ The SEC only has authority to pursue civil
remedies for violations of federal securities laws, but it
routinely supports criminal law enforcement efforts:
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\20\ ``About the Division of Enforcement,'' www.sec.gov/enforce/
abenf.htm, Jan. 30, 2000, at 1.
\21\ The SEC has five presidentially-appointed commissioners, each
serving a five-year term. Investor's Advocate at 3.
While the SEC has civil enforcement authority only,
it works closely with various criminal law enforcement
agencies throughout the country to develop and bring
criminal cases when the misconduct warrants more severe
action. The Division obtains evidence of possible
violations of the securities laws from many sources,
including its own surveillance activities, other
Divisions of the SEC, the self-regulatory organizations
and other securities industry sources, press reports,
and investor complaints.\22\
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\22\ Id. at 7-8.
The SEC files about 400 to 500 civil enforcement actions each
year.\23\
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\23\ Id. at 2.
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(b) Examinations of Day Trading Firms in 1999. In March
1999, due to rising reports of fraudulent practices in the day
trading industry, the SEC and NASDR launched a joint
examination of more than 60 of the 100 day trading firms.
During the Subcommittee's overview hearing, SEC Chairman Arthur
Levitt testified that the SEC was examining more than forty day
trading firms.\24\ Chairman Levitt testified that the SEC's
examinations indicated that some of the firms were not in
compliance with applicable rules and regulations but that the
SEC ``had not found marked and widespread fraud by these
firms.'' \25\ The SEC is particularly concerned with day
trading firms not maintaining adequate books and records, and
their failure to comply with net capital rules, the short-sale
rule and margin requirements.\26\ Chairman Levitt stated that
the examinations were also focusing on advertisements and
promotions that were inconsistent with NASD rules.\27\
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\24\ Prepared Statement of Hon. Arthur Levitt, Jr., Chairman, U.S.
Securities and Exchange Commission, Overview Hearing, at 61 (``Levitt
Statement'').
\25\ Id.
\26\ Id.
\27\ Id. at 62.
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(c) Enforcement Actions Against Day Trading Firms. During
his testimony, Chairman Levitt noted that the Division of
Enforcement was pursuing ``several active investigations
concerning day trading operations,'' most of which derived from
the examinations being conducted by the SEC.\28\ Some of the
enforcement actions arose from customer complaints as well. The
investigations cover potential violations including margin,
short-sale and net capital violations, and misleading
advertising.\29\ As the result of these investigations, the SEC
brought enforcement actions against two day trading firms in
February, 2000. The Commission said that the firms violated
regulations put in place to protect investors. Specifically,
All-Tech Direct Inc., was charged with making 103 loans
exceeding $3.6 million to customers throughout 1998 in
violation of federal rules.\30\ Regulators also contend that
All-Tech management failed to advise its customers of the loan
terms. A second, smaller day-trading company based in Miami,
the Investment Street Company, was accused of similar loan
violations. The SEC contends that the firm improperly extended
$250,000 in credit to customers, and allowed people to conduct
business as registered stockbrokers even though they were not
registered.\31\
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\28\ Id. at 77.
\29\ Id.
\30\ Morgenson, Gretchen, ``U.S. Accuses 3 Companies Of
Violations,'' New York Times, Feb. 23, 2000, at C1.
\31\ Id.
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(2) Self-Regulatory Organizations (``SRO'')
(a) Jurisdiction. The SEC's website describes SROs as ``the
front line in regulating broker-dealers.'' \32\ Each SRO is
responsible for its member firms. When a firm is a member of
more than one SRO, the SEC will appoint one of the SROs to
serve as that firm's ``Designated Examining Authority,'' which
is then responsible for regulating the member firm.\33\ For
purposes of the Subcommittee's investigation of the day trading
industry, the relevant SROs are the NASD, the NYSE, and the
Phlx.
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\32\ Investor's Advocate at 6.
\33\ Pursuant to Section 17(d)(1)(B) of the Securities Exchange Act
of 1934, the SEC may ``allocate among self-regulatory organizations the
authority to adopt rules with respect to matters as to which, in the
absence of such allocation, such self-regulatory organizations share
authority under this title.'' 15 U.S.C. Sec. 78q(d)(1)(B).
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The NASD is the world's largest SRO for the securities
industry.\34\ The regulatory arm of the NASD is NASD
Regulation, Inc. (``NASDR''), which is an independent
subsidiary of the NASD.\35\ ``Virtually every broker-dealer in
the U.S. that conducts a securities business with the public is
required by law to be a member of the NASD.'' \36\ There are
5,600 NASD member firms, operating over 75,000 branch offices
with more than 600,000 registered securities professionals.\37\
NASDR performs its regulatory function through ``registration,
education, testing and examination of member firms and their
employees, and through the creation and enforcement of rules
designed for the ultimate benefit and protection of
investors.'' \38\ NASDR's regulatory jurisdiction is limited to
its members and their associated persons:
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\34\ Prepared Statement of Mary Schapiro, President of NASDR,
Overview Hearing, at 81 (``Schapiro Statement'').
\35\ ``NASD Regulation--Who We Are,'' www.nasdr.com/2200.htm.
\36\ Schapiro Statement at 81.
\37\ Id.
\38\ ``NASD Regulation--Who We Are,'' www.nasdr.com/2200.html.
NASDR Enforcement brings cases against members and
their associated persons based on information developed
internally by periodic examination of member firms,
broker terminations for cause, market surveillance, and
referrals from [its] arbitration, corporate financing
and advertising departments. It also uses external
sources, including federal and state agencies, customer
complaints, news media and anonymous tips.\39\
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\39\ Schapiro Statement at 81a (errata sheet).
In 1998, NASDR initiated more than 1,000 disciplinary cases and
suspended or barred more than 650 individuals from the
securities industry. NASDR is also responsible for adopting
rules to govern the brokerage industry, which do not become
final until approved by the SEC.\40\
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\40\ Id. at 81a (errata sheet)-82.
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Like the NASD, the NYSE has numerous member firms that it
regulates and whose conduct is subject to NYSE rules.\41\ NYSE
is the Designated Examining Authority for most of its member
firms.\42\ It is responsible for regulating firms that ``carry
63 million customer accounts and operate over 10,800 branch
offices throughout the world, employing 128,000 registered
personnel.'' \43\ The NYSE
---------------------------------------------------------------------------
\41\ ``NYSE, Member Firm Regulation,'' www.nyse.com/regulation/
memberfirmreg.html.
\42\ Id.
\43\ Id.
uses a broad range of techniques that includes:
sophisticated and comprehensive computer-assisted
analysis; field visits by Exchange Examination staff;
constant monitoring of the status of, and information
relating to, its membership; and finally, the
investigation and prosecution of violators of Exchange
rules and the Securities and Exchange Act of 1934 and
rules thereunder.\44\
---------------------------------------------------------------------------
\44\ Id.
As with new rules proposed by the NASD, NYSE also must obtain
the SEC's approval of new rules before they become final.
The Phlx is a regional exchange that functions as an SRO.
About twelve to fifteen day trading firms are members of the
Phlx and not the NASD.\45\ As such, these Phlx firms need not
comply with NASD rules.\46\ These firms avoid NASD membership
by operating as limited liability companies (``LLCs''), rather
than as traditional broker-dealers.\47\ The LLCs sell interests
to day traders so that those persons are part-owners of the
firm rather than customers of the firm.\48\ Not only does this
arrangement allow firms to avoid compliance with NASD rules,
but it also allows day traders to use more leverage than would
otherwise be permitted if they were customers of an NASD member
firm.\49\ The SEC recently approved a new Phlx rule that
requires persons associated with member firms who trade off the
floor of the Exchange to successfully complete the General
Securities Representative Examination Series 7.\50\ Thus, day
traders at Phlx firms are now required to take and pass the
Series 7 examination.
---------------------------------------------------------------------------
\45\ Levitt Statement at 60.
\46\ Id.
\47\ Under Rule 15b9-1 of the Securities Exchange Act of 1934, a
broker-dealer that does not have customer accounts and is a member of a
national securities exchange is not required to be a member of the
NASD. 17 CFR Sec. 240.15b9-1.
\48\ Levitt Statement at 59.
\49\ Id. at 60.
\50\ ``Order Granting Approval to Proposed Rule Change and
Amendment Nos. 1 and 2 and Notice of Filing and Order Granting
Accelerated Approval of Amendment No. 3 to the Proposed Rule Change
Requiring Off-Floor Traders for which the Phlx is the Designated
Examining Authority to Successfully Complete the General Securities
Representative Examination Series 7,'' SEC Release No. 34-41776, File
No. SR-Phlx-99-07 (Aug. 20, 1997).
---------------------------------------------------------------------------
(b) Examinations of Day Trading Firms in 1999. As part of
its coordinated examination effort with the SEC, NASDR examined
twenty-two day trading firms through the use of fifty-five
specially trained examiners.\51\ The firms varied in size and
composition.\52\ For example, two of the day trading firms
NASDR examined had 1,500 or more day trading accounts, while
six of the firms had fewer than twenty customers that were day
trading.\53\ During the overview hearing, NASDR President Mary
Schapiro testified that NASDR discovered several potential
problem areas during the examinations, ``including advertising,
Regulation T and margin lending, registration of individuals,
short sales and supervision.'' \54\ Furthermore, she stated
that formal enforcement actions would be instituted to the
extent that investigations growing out of the examinations
revealed violations of NASD rules or federal securities
laws.\55\
---------------------------------------------------------------------------
\51\ Schapiro Statement at 92.
\52\ Id.
\53\ Id.
\54\ Id.
\55\ Id.
---------------------------------------------------------------------------
(c) Enforcement Actions Against Day Trading Firms. The
NASDR has yet to bring any enforcement actions against day
trading firms. The NYSE recently initiated and settled
disciplinary proceedings against a broker-dealer, its
president, vice president, and branch office manager alleging
numerous violations of the NYSE Rules and federal securities
laws and regulations, many of which involved day trading
activities.\56\ The allegations included violations of ``day
trading margin requirements, sales practice and compliance
procedures, financial responsibility standards, books and
records requirements, and supervision of its business
operations and of persons under its supervision and
control.''\57\ In addition, the NYSE charged the firm's
president with extending approximately $23 million of credit to
about sixty-eight customers to open day trading accounts at the
firm or at a non-member organization owned by the president and
affiliated with the firm.\58\ The NYSE Hearing Panel censured
the firm and fined it $1,350,000 and required the firm to,
among other things, hire an independent consultant to review
the firms ``policies, procedures, practices and supervisory
systems,'' a general counsel, an internal auditor and a full-
time Director of Compliance.\59\ The Hearing Panel also
penalized the individual respondents through censures and
suspensions.\60\
---------------------------------------------------------------------------
\56\ NYSE Exchange Hearing Panel Decisions 99-158, 99-159, 99-160,
and 99-161, Nov. 18, 1999. The firm, Schonfeld Securities, LLC, is a
proprietary trading firm with two categories of traders--day traders
and overnight traders. Although the majority of the firm's traders were
proprietary traders, the firm also had over 100 customer accounts. Id.
at 11-12. The respondents consented to the findings by the Hearing
Panel, although they neither admitted nor denied guilt. Id.
\57\ Id. at 10.
\58\ Id.
\59\ Id. at 28-29.
\60\ Id. at 30.
---------------------------------------------------------------------------
(3) State Securities Commissions
(a) Jurisdiction. Each of the fifty states is also directly
involved in the regulation and oversight of the securities
industry. Each state has a securities agency which is a member
of the North American Securities Administrators Association,
Inc. (``NASAA''). NASAA is a voluntary association which acts
as the voice of the fifty state securities agencies.\61\ The
shared system of federal and state securities regulation
developed in 1934, when Congress created the SEC.\62\ ``The
complementary approach to the regulation of the securities
markets in the U.S. has resulted in a logical division of
labor, under which the states focus, for the most part, on
individual investor protection issues, while the SEC deals with
matters of broad-based market concerns.''\63\ The state
securities agencies conduct licensing and registration
activities.\64\ Each state agency also has an enforcement
division that investigates fraud and abusive sales
practices.\65\
---------------------------------------------------------------------------
\61\ ``NASAA: Who We Are,'' www.nasaa.org/whoweare, at 1-2.
\62\ Id. at 1.
\63\ Id. at 2.
\64\ Id.
\65\ Id.
---------------------------------------------------------------------------
In most states, persons acting as investment advisers must
be registered with the state unless they are exempt.\66\ An
``investment adviser'' is a person who advises others for
compensation concerning the value of securities or the
advisability of investing in, purchasing or selling
securities.\67\ Under the National Securities Markets
Improvement Act of 1996 (``NSMIA''), Title III of which is the
Investment Advisers Supervision Coordination Act,
responsibility for investment adviser oversight is divided
between the states and the federal government.\68\ In very
general terms, an investment adviser with less than $25 million
under management is required to register with the state unless
he or she is exempt from registration.\69\ An investment
adviser with more than $25 million under management is required
to register with the SEC.\70\ Many states, such as
Massachusetts and California, have followed NSMIA which allows
a person with no place of business in the state to trade up to
five accounts for compensation without registration.\71\
---------------------------------------------------------------------------
\66\ The states that do not register investment advisers are
Georgia, Louisiana, Michigan, Minnesota, New Jersey, New York,
Tennessee, and Wyoming. ``NASAA: New Investment Advisers must take
`competency exam' starting Jan. 1,'' www.nasaa.org/whoweare/media/
IAexam.html, at 2.
\67\ Investment Advisers Act of 1940, Section 202(a)(11), 15 U.S.C.
Sec. 806-2(a)(11)(A).
\68\ ``Memorandum of Understanding Concerning Investment Advisers
and Investment Adviser Representatives,'' Apr. 27, 1997, www.nasaa.org/
iaoversight/iamou.html, at 1.
\69\ Id.
\70\ Id.
\71\ National Securities Markets Improvement Act of 1996, National
Pub. L. No. 104-290 (Oct. 11, 1996); Mass. Regs. Code tit. 950,
Sec. 12.205; Cal. Corp. Code Sec. 25202.
---------------------------------------------------------------------------
(b) Examinations of Day Trading Firms. Like the SEC and the
SROs, states conduct examinations of firms within their
jurisdictions. For example, the Securities Division of the
Washington Department of Financial Institutions (``Washington
Division'') recently conducted examinations of the seven day
trading firms located in the State of Washington.\72\ The
Washington Division found that profitability among day traders
was very low and that there was a significant volume of inter-
customer lending to meet margin calls.\73\ The Washington
Division did not find significant evidence of misleading
advertising or inadequate risk disclosures.\74\ The Washington
Division referred some of its findings to the state's
enforcement division, but the enforcement division has not yet
determined whether to initiate enforcement actions.\75\
---------------------------------------------------------------------------
\72\ Telephone Interview of Deborah Bortner, Director of Securities
for the Washington Securities Division, and Christina Knipe, Counsel
for the Washington Securities Division, Nov. 18, 1999, at 1 (``First
Bortner Int.''); Telephone Interview of Deborah Bortner, Director of
Securities for the Washington Securities Division, and Christina Knipe,
Counsel for the Washington Securities Division, Dec. 20, 1999, at 1
(``Second Bortner Int.'').
\73\ First Bortner Int. at 1. For example, at one firm, the
examiners found that the president of the firm was lending money to
customers. Second Bortner Int. at 2. While at another firm, a person in
a different city loaned an aggregate of more than $1 million to several
Washington State customers. Id.
\74\ Second Bortner Int. at 2.
\75\ First Bortner Int. at 1; Second Bortner Int. at 2.
---------------------------------------------------------------------------
(c) Enforcement Actions Against Day Trading Firms. Several
states have brought enforcement actions against day trading
firms. For example, within the last two years,
Massachusetts,\76\ Tennessee,\77\ Indiana,\78\ Texas \79\ and
Wisconsin \80\ filed cases against day trading firms. The
securities violations alleged in those actions included, among
other things, failure to supervise, deceptive marketing,
unregistered investment advisory activities, arrangement and
promotion of unlawful loans, falsification of information on
new account forms, unauthorized transactions, and unauthorized
transfers of funds among customer accounts.\81\ The
Massachusetts Securities Division has been the most aggressive
state regulator thus far, filing six actions against day
trading firms doing business in the state.
---------------------------------------------------------------------------
\76\ In re Landmark Securities, Inc., Mass. Sec. Div. 99-29 (July
8, 1999); In re TCI Corp., Inc., Mass. Sec. Div. 99-9 (Mar. 2, 1999);
In re On-Line Investment Services, Inc., Mass. Sec. Div. 99-1 (Jan. 14,
1999); In re All-Tech Investment Group, Inc., Mass. Sec. Div. 98-77
(Dec. 10, 1998); In re Bright Trading, Inc., Mass. Sec. Div. 98-70
(Nov. 9, 1998); In re Block Trading, Inc., Mass. Sec. Div. 98-58 (Oct.
19, 1998).
\77\ Tennessee Securities Div. v. Carlin Equities Corp., Docket No.
12.06-004482J, File No. 98-011 (Dec. 11, 1998), Complaint Amended, Apr.
23, 1999.
\78\ In re Self Trading Securities, Inc., In. Sec. Div., Cause No.
99-0047 (Feb. 16, 1999).
\79\ In re Infinitum Capital Management, Inc., Tex. SSB, Docket No.
97-011 (Jan. 6, 1999); In re Day Trade, Inc., Tex. SSB, Ref. 98-020
(Apr. 6, 1998).
\80\ In re Block Trading, Inc., Wis. Sec. Div., File S-981 (Dec.
17, 1998).
\81\ NASAA Report at 41-44.
---------------------------------------------------------------------------
(d) 1999 Day Trading Report of the North American
Securities Administrators Association. In August 1999, NASAA
released its Report of the Day Trading Project Group (``NASAA
Report''), the purpose of which was ``to assist state
securities regulators in understanding, and responding to, the
issues posed by the day trading industry.'' \82\ The Day
Trading Project Group, which comprised state securities
regulators from Massachusetts, Colorado, Pennsylvania, Texas,
and New Jersey, derived its conclusions from reviewing
registration applications, conducting examinations and
participating in enforcement proceedings.\83\ The NASAA Report
states that the problems in the day trading industry stem from
two underlying factors: (1) firms fail to follow basic
compliance requirements, with many of the firms' officers and
managers having little or no experience in the brokerage
industry; and (2) firms constantly require a steady flow of new
customers because most day traders lose money and the firms
need new commission revenue to cover high overhead costs.\84\
---------------------------------------------------------------------------
\82\ NASAA Report, ``Preface.''
\83\ Id. at ``Members of Project Group.''
\84\ Id. at 4.
---------------------------------------------------------------------------
Overall, the NASAA Report identified the following abuses
and problems in the day trading industry:
Deceptive marketing, including inadequate
risk disclosure;
Violation of suitability requirements;
Questionable loan arrangements, including
promotion of loans among customers and loans to
customers by brokers;
Abuse of discretionary accounts where
brokers have day traded customers' accounts;
Encouragement of unregistered investment
adviser activity through customers trading the funds of
third parties;
Failure to maintain proper books and
records; and,
Failure to supervise.\85\
---------------------------------------------------------------------------
\85\ Id. at ``Summary.''
---------------------------------------------------------------------------
The NASAA Report also contended that day trading is analogous
to gambling and is unprofitable for most customers.\86\
---------------------------------------------------------------------------
\86\ Id. at 5.
---------------------------------------------------------------------------
C. Background on the Day Trading Industry
(1) Origin of Day Trading. The origins of the modern day
trading industry can be traced to 1971, when the NASD
introduced ``a computerized, over-the-counter stock market
called Nasdaq.'' \87\ In 1985, Nasdaq created SOES, the Small-
Order Execution System, to enable individual traders to
directly and automatically trade within the market.\88\ ``As
its name implies, orders placed in the SOES system (1,000
shares or less) are executed automatically within a few
seconds, bypassing the traditional telephone method of
executing Nasdaq trades.'' \89\ Arguably, the greatest
attribute of the SOES system is the enhanced liquidity it
provides for traders and the requirement that SOES orders must
be honored with few exceptions.\90\ After the stock market
crash of 1987, the Nasdaq generally mandated that market makers
honor orders executed through SOES.\91\
---------------------------------------------------------------------------
\87\ Cornerstone Training Manual, Introduction, at 2.
\88\ Jennifer Basye Sander and Peter J. Sander, Day Trading Like a
Pro, at 69 (1999).
\89\ Cornerstone Training Manual, Introduction, at 2.
\90\ Sander and Sander, Day Trading Like a Pro, at 69.
\91\ Id. at 19.
---------------------------------------------------------------------------
There are several key characteristics of SOES that include:
SOES trades cannot exceed lots of greater
than 1,000 shares.
A SOES trader is prevented from either
buying or selling the same stock during a five minute
period.
A market maker must honor the SOES
transaction.\92\
---------------------------------------------------------------------------
\92\ Id. at 69.
---------------------------------------------------------------------------
It was through the use of the SOES system that a notorious
group of traders, known as ``SOES bandits,'' first took
advantage of direct access electronic trading to earn quick
profits on small price fluctuations in stocks.\93\ ``The SOES
system * * * enabled the creation of a whole new class of
trader, commonly referred to as the SOES Trader.'' \94\
---------------------------------------------------------------------------
\93\ Harvey I. Houtkin and David Waldman, Secrets of the SOES
Bandit 1-2 (1999).
\94\ Cornerstone Training Manual, Introduction, at 3.
---------------------------------------------------------------------------
The modern day trader is no longer limited to SOES. Indeed,
it has become increasingly evident that today's day
trader conducts his business via a much broader
mechanism than just SOES. With the advent of the
various electronic communication networks (ECNs) and
advances in the technology that delivers data and
executes our orders, SOES today is simply one method of
transacting an order.\95\
---------------------------------------------------------------------------
\95\ Id.
Originally established over 30 years ago to handle large blocks
of stock trades, electronic communication networks (``ECNs'')
now allow customers to trade directly with each other or place
orders directly to the market.\96\ Customers who use an ECN are
part of an internal network and may place their buy and sell
orders within that network of traders.\97\ Other traders on
that network can see the order and fill it, or contact the
trader to negotiate a different price.\98\ Day traders utilize
ECNs as their primary means to place limit orders.\99\ The most
prominent ECNs include Instinet, Island, Bloomberg's B-Trade,
and All-Tech's Attain.
---------------------------------------------------------------------------
\96\ Sander and Sander, Day Trading Like a Pro, at 70.
\97\ Id.
\98\ Id.
\99\ Id. at 71.
---------------------------------------------------------------------------
One of the most important tools for a day trader is the
Nasdaq Level II screen. As opposed to simply the ``inside'' or
best bid that is displayed on Level I screens, Level II shows
all the bid prices for all market makers in a selected
stock.\100\ This improved access provides critical information
to the day trader including the number of bids and offers; the
sizes and prices of bids and offers; who is bidding and
offering; how consistently they do so; and how they move.\101\
Using all of these indicators, a trader can estimate how a
particular stock will move and trade accordingly.
---------------------------------------------------------------------------
\100\ Id. at 157.
\101\ Id. at 159.
---------------------------------------------------------------------------
(2) Early Growth of Day Trading Firms. Day trading has
grown dramatically as a full-time profession since the early
1990s. Professional day traders generally trade on-site at
roughly 100 specialized firms. Some of these firms are large
and have branch offices nationwide, while others are smaller
organizations with one or two offices in a single state. Table
1 lists the ten largest day trading firms as measured by the
number of branch offices.\102\ According to NASAA and the SEC,
the specialized day trading firms are generally broker-dealers
registered with the NASD, although some are registered with the
Phlx.
---------------------------------------------------------------------------
\102\ Table 1: The Ten Largest Day Trading Firms as Measured by
Number of Branch Offices:
---------------------------------------------------------------------------
Firm; Home Office Location; and Number Of Branch Offices:
Carlin Financial Group--New York, New York: 36
All-Tech Direct, Inc.--Montvale, New Jersey: 23
Bright Trading, Inc.--Las Vegas, Nevada: 23
Cornerstone Securities--Austin, Texas: 19
Landmark Securities--Houston, Texas: 15
Andover Brokerage--Montebello, New York: 13
Tradescape, LLC--New York, New York: 12
Terra Nova Trading--Chicago, Illinois: 11
On-line Investment--Jersey City, New Jersey: 10
Stock USA--San Diego, California: 10
Source of Information: NASAA Report.
Firms registered with the Phlx typically are organized as
LLCs in which each day trader is an agent of the firm rather
than a ``customer.'' These ``agents'' trade the firms'' own
capital on a highly leveraged basis through the firms' margin
privileges. The day trading firms typically require the agents
to provide a substantial security deposit or, ``performance
deposit'' as it is called, to cover losses incurred by the
individual agents.\103\ Phlx firms also charge commissions to
their agents.\104\
---------------------------------------------------------------------------
\103\ NASAA Report at 3.
\104\ Dugan, ``For These Day Traders, Stock Market Is One Big
Casino,'' at 3. For example, Bright Trading--a Phlx firm--charges its
customers a penny a share per trade. Id.
---------------------------------------------------------------------------
Day trading firms that are broker-dealers generally do not
require a performance deposit and do not receive a percentage
of any profits earned by their day traders, since those traders
are customers of the firms rather than limited partners. The
broker-dealer firms make money primarily from the commissions
charged to their customers on a per trade basis and from any
fees that they might receive from trading customers.
The Subcommittee's investigation found that the day trading
industry has grown dramatically over the last three years. The
fifteen firms examined by the Subcommittee reported gross
revenues of $144,359,655 in 1997. Those firms also reported net
income of $22,202,459 in 1997. Last year, the firms had gross
revenues of $541,440,682, with a net income of $66,538,142.
Consequently, these day trading firms have experienced
explosive growth in the last three years, witnessing a 276
percent increase in revenues and a 200 percent increase in
profits.
The Subcommittee's investigation also determined that, in
the aggregate, day traders pay approximately $16 per trade at
the fifteen firms examined in this investigation. These firms
estimated--in the aggregate--that their customers execute
twenty-nine trades per day. Thus, the average day trader at
these firms must generate a daily trading profit of $464, each
and every day, simply to break even. On an annualized basis,
assuming twenty trading days per month, the average day trader
must generate a trading profit in excess of $111,360 to achieve
profitability for the year. The growth of day trading has also
made it more difficult to achieve that profitability. The
training manual for Cornerstone Securities notes that,
``[u]nlike a few years ago when there were fewer players and
the margins of inefficiency were large enough to get in and out
virtually unchallenged, today's environment is extremely
competitive. The advantage today is that those traders that
lack either the discipline or technology to compete will drop
out.'' \105\
---------------------------------------------------------------------------
\105\ Cornerstone Training Manual, Introduction, at 3.
---------------------------------------------------------------------------
(3) Distinction Between Day Trading Firms and On-Line
Discount Brokerage Firms. Day trading firms provide a
fundamentally different service than traditional brokerage
houses and even on-line discount brokerage firms, such as
E*Trade and Charles Schwab.\106\ Neither discount on-line
brokerage firms nor traditional full-service firms offer
customers direct electronic access to the stock market, as do
day trading firms. Online brokerage firms generally do not
offer immediate stock order execution to their customers.\107\
Rather, online brokerage firms generally refer customer orders
to other entities--such as market makers--for execution.\108\
The other basic difference between day trading firms and on-
line firms is that day trading firms generally promote active
trading by their customers and, in most instances, cater
primarily to persons seeking to trade for a living.
---------------------------------------------------------------------------
\106\ Id.
\107\ Id.
\108\ U.S. General Accounting Office, ``Securities Market
Operations; The Effects of Small Order Execution System (``SOES'') on
the NASDAQ Market,'' Aug. 31, 1998 (GAO/GGG-98-194), at 3 (``GAO SOES
Report''). Market makers are NASD-member securities firms that ``make
markets'' in particular securities by agreeing to buy and sell the
securities at quoted prices. Market makers provide liquidity to the
Nasdaq market.
---------------------------------------------------------------------------
There are about 1.7 million people in the United States who
are categorized as ``hyper-active traders.'' \109\ It is
estimated that ``hyper-active'' traders execute 80 to 100 stock
trades per year through their online brokerage accounts.\110\
In addition, ETA estimates that 250,000 people execute more
than 400 trades per year, largely through on-line brokerage
firms, such as Charles Schwab and E*Trade.\111\
---------------------------------------------------------------------------
\109\ Interview of Dan Burke, Gomez Advisers, July 29, 1999
(``Burke Int.''). Gomez Advisers is a consulting firm located in
Concord, Massachusetts that provides information about on-line broker-
dealers. Id.
\110\ Id.
\111\ Telephone Interview of James H. Lee, President of ETA, Aug.
11, 1999.
---------------------------------------------------------------------------
The immediate order execution capability offered by day
trading firms has become a marketing tool by which day trading
firms attract active investors from the established on-line,
discount brokerage firms. Mr. Lee told Subcommittee staff that
day trading firms market their services to the estimated
250,000 individuals who make 400 or more on-line securities
trades per year, since these investors would most benefit from
the ability to immediately execute their stock orders.\112\
Similarly, All-Tech's Chief Executive Officer, Harvey Houtkin,
stated that his firm markets its Attain trading system to
individuals who actively trade through on-line brokerage
accounts.\113\
---------------------------------------------------------------------------
\112\ Id.
\113\ Harvey I. Houtkin, Remarks at an All-Tech Informational
Seminar, July 21, 1999 (``Houtkin Remarks'').
---------------------------------------------------------------------------
The technology available to day trading firms also has
attracted the interest of several leading investment and
securities firms.\114\ Fidelity Investments, Lehman Brothers,
and Instinet, a division of Reuters Group, reportedly have
discussed adopting the software platforms of day trading firms,
forming alliances with them, or making outright acquisitions.
Despite concerns about the practices of day trading firms, the
electronic trading boom is forcing established securities firms
to consider more efficient and inexpensive trading formats.
---------------------------------------------------------------------------
\114\ David Barboza, ``Why Big Firms Are Courting Day Traders,''
N.Y. Times, Aug. 13, 1999, at C1.
---------------------------------------------------------------------------
For instance, in an advertisement directed to ``hyper-
active'' investors, On-Site Trading, Inc. (``On-Site''), a day
trading firm, markets its execution system as a tool for on-
line investors to avoid paying higher execution costs resulting
from ``order flow'' agreements between discount brokerage firms
and market makers.\115\ The advertisement depicts a large man
gorging himself at a buffet table and states that ``your online
broker may not live by commissions alone.'' \116\ The
advertisement then explains as follows: ``Online brokers have
made a big business out of low commissions. But they may be
receiving payment for your orders * * * When you trade with The
On-Site Trader, you get the best opportunity for price
improvement because we let you direct your own order flow.''
\117\ This advertisement illustrates how the once distinct line
between day trading firms and online brokerage firms has
blurred, as both compete for many of the same customers. This
change can likely be attributed to the fact that day trading
firms may now have critical experience developing and using
advanced trade routing systems that could someday give all
investors instant access to the financial markets.\118\
---------------------------------------------------------------------------
\115\ Advertisement of On-Site Trading, Inc. (Feb. Hr'g Ex. 1).
\116\ Id.
\117\ Id.
\118\ Barboza, ``Why Big Firms Are Courting Day Traders,'' at C1.
---------------------------------------------------------------------------
(4) Support Industries. As day trading has become more
popular, a support industry offering related goods and services
has evolved. It is promoted heavily over the Internet. This
vast and largely unregulated industry often contributes to the
hype and unrealistic expectations regarding day trading. The
support industry includes books,\119\ training programs and
seminars, stock picking systems and software, as well as
periodic newsletters that firms distribute by e-mail and
facsimile. At the overview hearing, Chairman Levitt noted the
SEC's concern about websites attempting to capitalize on the
day trading phenomenon by providing so-called ``expert
investment advice'' for a fee.\120\ Chairman Levitt added that
these websites often highlight the potential rewards of day
trading without providing adequate risk disclosure.\121\ The
Subcommittee's investigation found evidence to support Chairman
Levitt's concern.
---------------------------------------------------------------------------
\119\ Subcommittee staff counted nearly 50 day trading titles
currently for sale as of January 2000. Amy Lambo, ``bn.com'' business
editor, included The Day Trader: From the Pit to the PC by Lewis J.
Borsellino and Patricia Commins on her list of ``Best Business Books of
1999.'' bn.com Subjects--Business, at www.barnesandnoble.com/book. In
August 1999, Subcommittee staff contacted publisher John Wiley & Sons
and learned that at least 55,000 copies of Day Trade Online by
Christopher Farrell have been sold. In August 1999, two of the Barnes &
Noble Top 20 business books were the day trading titles: How to Get
Started in Electronic Day Trading by David S. Nassar and Electronic Day
Traders' Secrets by Marc Friedfertig and George West. bn.com Subjects--
Business, at www.barnesandnoble.com/subj. In addition, Mr. Houtkin has
published two books: Secrets of the SOES Bandit: The Original
Electronic Trader Reveals His Battle-Tested Trading Techniques in 1999,
and SOES Bandits' Guide: Day Trading in the 21st Century in 1995.
\120\ Levitt Statement at 64.
\121\ Id.
---------------------------------------------------------------------------
The Subcommittee reviewed a variety of websites that the
day trading support industry uses to advertise its products and
services and found many questionable claims. Some members of
the support industry market their products by promoting a
glamorous lifestyle that is work-free and risk-free, while
others make exaggerated claims of wealth and success and
provide minimal risk disclosure, if any at all. Others promise
simple solutions and guaranteed techniques for success that
belie the intensive and disciplined effort that profitable day
trading demands. The Subcommittee requested that nine support
industry firms provide documentation to support the claims
posted on their websites. The firms' responses ran the gamut:
several provided supporting materials, while others simply
restated their claims without support, and some simply removed
the questionable claims from their websites shortly after
receiving the Subcommittee's request.
(a) Lazy Day Trader. ``Lazy Day Trader'' is a website that
made statements promising a life of leisure and independence
with very little effort. Frank van der Lugt continually refers
to his product, which he sells for $300,\122\ as a ``system''
and describes it as ``a simple method to determine what to buy
and sell, how much, and when to buy and sell which everyone can
follow.'' \123\ On only one of the more than twelve pages of
his website does Mr. van der Lugt refer to his ``system'' as a
paper document. In his response to the Subcommittee's
interrogatories, however, Mr. van der Lugt claimed that his
website is designed to promote a book recounting his
experiences as a day trader.\124\ Mr. van der Lugt posted the
following glowing statements on his website, creating the
impression that day trading is a simple way to get rich: \125\
---------------------------------------------------------------------------
\122\ www.lazydaytrader.com, July 30, 1999. On the ``What will your
Day Trading System give me'' page of his website, Mr. van der Lugt
refers to his system as ``[a] complete 220 page structured Electronic
Day Trading System allowing you to start Trading and to Make Money
immediately.'' Id.
\123\ ``The Ideal Profession: Daytrading!'', www.lazydaytrader.com,
July 30, 1999, at 1.
\124\ Letter from Frank van der Lugt, Lazy Day Trader, to K. Lee
Blalack, II, Chief Counsel & Staff Director for the Subcommittee, Sept.
17, 1999, at 1 (Feb. Hr'g Ex. 2).
\125\ ``The Ideal Profession: Daytrading!'' www.lazydaytrader.com,
July 30, 1999, at 3. Mr. van der Lugt posted the following at the
bottom of his website home page under the heading ``Important: Please
Read'':
This System was designed and is being sold with the understanding
that my personal trading experiences past and future may and will not
be the same as yours.
You should also understand that Day Trading is a very high risk
business in which you may lose considerable amounts of money.
The System is also being sold with the understanding that the
author is not engaged in rendering legal, accounting or other
professional services.
The Trading System is not meant to be an endorsement or offering
of any stock for purchase.
We do not represent ourselves as investment advisors [sic] and
you should consult a professional stockbroker or competent financial
advisor before utilizing the techniques outlined in our Day Trading
System. Id.
---------------------------------------------------------------------------
I can work my own hours, take as much time
off as I want and when I am finished trading I am
finished and the money is in my account insured up to
$500,000.\126\
---------------------------------------------------------------------------
\126\ Id.
---------------------------------------------------------------------------
I will show you how you can make money even
when the market is down, up or sideways and how you can
protect against losses while letting the winners
ride.\127\
---------------------------------------------------------------------------
\127\ Id.
---------------------------------------------------------------------------
You don't have to be able to understand
Economics, the [sic] Stockmarket or International
Finance.\128\
---------------------------------------------------------------------------
\128\ Id.
---------------------------------------------------------------------------
I am not a rocket scientist, [sic]
brainsurgeon or computer whiz.\129\
---------------------------------------------------------------------------
\129\ Id.
---------------------------------------------------------------------------
(b) Taking Profits. The Subcommittee examined a website for
Taking Profits Publishing (``Taking Profits''), which contained
several statements that promise vast wealth. Louis Russo of
Taking Profits contributes to the hype surrounding day trading
by posting on his website statements such as the following:
``Trading Stocks can make you wealthier beyond your dreams.
There is an ocean of money waiting to be brought aboard from
trading stocks, and make sure you get yours. Imagine having the
extra cash to buy the things you want, and to live the
lifestyle you've dreamed about.'' \130\
---------------------------------------------------------------------------
\130\ ``Home page,'' www.takingprofits.com, July 29, 1999, at 1.
---------------------------------------------------------------------------
In an effort to capitalize on the day trading craze he
encourages, Mr. Russo sells a weekly ``Taking Profits''
newsletter at a yearly subscription rate of $349, and a ``Day
Trader Newsletter'' at a yearly rate of $990.\131\ Mr. Russo
also offers a six lesson online, ``How to Beat the Market,''
course that costs $99.95 and purports to teach students how to
use charts, price patterns, and indicators.\132\ In Mr. Russo's
own words, ``[a]fter taking my course, you'll know how to spot
the winners[.]'' \133\ Mr. Russo added that ``[y]ou can start
today and begin to profit tomorrow.'' \134\ Mr. Russo
positioned limited risk information on the ``Company
Information'' page of his website at the end of a paragraph
detailing the subscription costs of his newsletters.\135\
---------------------------------------------------------------------------
\131\ ``Taking Profits Publishing--Company Information Page,''
www.takingprofits.com, July 29, 1999, at 1.
\132\ ``How to Beat the Market--Online,'' www.takingprofits.com,
July 29, 1999, at 1.
\133\ Id.
\134\ Id.
\135\ The risk information, printed in small font on the sample
``Day Trader'' newsletter, stated the following:
Contents herein are believed to be reliable, however,
their accuracy and completeness cannot be guaranteed. Past
performance cannot be indicative of future results. Do not
assume that present or future recommendations will be
profitable. The securities portfolios of employees, or
affiliated companies may include securities included in
---------------------------------------------------------------------------
``Taking Profits'' and ``Day Trader'' newsletter.
``Company Information Page,'' www.takingprofits.com, July 29, 1999. In
addition, Taking Profits' risk disclosure statement also included the
following:
Sophisticated traders only, who are aware of the risks in
forecasting and trading, should use the Day Trader. There
is absolutely no guarantee that any indicators, theory
charts or indices will assure stock market success. Making
money in the stock market is a high-risk undertaking.
``June 23,'' www.takingprofits.com, July 29, 1999.
Despite the Subcommittee's written request, Mr. Russo
provided no documentation to support the statements about the
course posted on his website. Instead, Mr. Russo simply
directed the Subcommittee to the website, a copy of which he
enclosed, stating that ``[a]ll information is found on our
website.'' \136\ Interestingly, however, the copy of the
website Taking Profits mailed to the Subcommittee did not
contain the statements the Subcommittee questioned, because he
had subsequently removed them from his website.
---------------------------------------------------------------------------
\136\ Letter from Louis Russo, Taking Profits, to Subcommittee
staff, Sept. 20, 1999, at 1 (Feb. Hr'g Ex. 3).
---------------------------------------------------------------------------
(c) Coastal Day Traders. Richard Kane of Coastal
Technologies Group (``Coastal Technologies'') posted several
questionable claims on the website he uses to promote stock
picking software called the ``Wealth Wizard.'' \137\ Mr. Kane
claimed that he is awaiting a patent for the Wealth
Wizard,\138\ and that the methods it employs ``were developed
over three years of active trading, and take full advantage of
14 years of experience with pattern analysis, mathematical
modeling and artificial intelligence.'' \139\ Coastal
Technologies' website does make some risk disclosures,\140\ but
contains the following claims:
---------------------------------------------------------------------------
\137\ ``Home page'' www.coastaldaytrader.com, July 30, 1999.
\138\ Letter from Richard Kane, Coastal Technologies Group, to K.
Lee Blalack, II, Chief Counsel & Staff Director for the Subcommittee,
Sept. 9, 1999, at 1 (``Kane Letter'') (Feb. Hr'g Ex. 4).
\139\ ``Home page,'' www.coastaldaytrader.com, July 30, 1999.
\140\ Id. Mr. Kane posted the following statement at the bottom of
his website's home page: ``There is no guarantee that past results will
be recreated in the future. Investing in the markets, actively or not,
carries significant risk. Invest only risk capital, that you are
prepared to lose. If you can not tolerate risk, do not invest with this
program.'' Id.
---------------------------------------------------------------------------
Wealth Wizard monitors your portfolio in
real time, executing trades automatically.\141\
---------------------------------------------------------------------------
\141\ Id.
---------------------------------------------------------------------------
Wealth Wizard performs the kind of careful,
tireless monitoring required, giving you a potential
daily return on your investments, while minimizing your
risks.\142\
---------------------------------------------------------------------------
\142\ Id.
---------------------------------------------------------------------------
You make money on the way up and more on the
way down.\143\
---------------------------------------------------------------------------
\143\ Id.
---------------------------------------------------------------------------
Coastal Technologies provided no documents to support the
claims cited above. The first claim remains on the website
unchanged, while the second claim remains on the website with
slight modification.\144\ Mr. Kane noted in his response to the
Subcommittee that no Wealth Wizard software systems have yet
been sold.\145\ Coastal Technologies subsequently removed,
without comment, the above cited claim that ``you make money on
the way up and more on the way down,'' and posted additional
information on the risks associated with day trading.
---------------------------------------------------------------------------
\144\ ``Home,'' www.coastaldaytrader.com, Nov. 4, 1999. The second
claim now reads: ``Wealth Wizard performs the kind of careful, tireless
monitoring required, giving you a potential daily return on your
investment, while attempting to minimize your risk.'' Id. (emphasis
added).
\145\ Kane Letter at 1. Mr. Kane also stated in his response that,
``prior to the sale of the software we will seek support to re-work the
informational and disclosure sections of the license agreement, web
site, and related materials to ensure compliance with both the spirit
and intent of regulations and in keeping with good business practice.''
Id.
---------------------------------------------------------------------------
(d) Precision Management Group. Precision Management Group,
Inc.'s (``Precision'') website promotes day trading as a
stepping stone to a prosperous life. A division of 1-
800RETIRENOW.COM, Inc., Precision offers a ``Precision Day
Trader Seminar'' and the ``Pro-Trader Boot Camp.'' \146\
Precision also offers several online services such as a
``Trader-Online Student Chat Room,'' a ``Trade-Tutor Strategic
Market Analysis'' and ``Online Mastermind Interactive
Seminars.'' \147\ Precision has a page link from its home page
to its risk disclosure page and is one of the few support
industry firms the Subcommittee examined that presented
balanced risk information with its claims.\148\ For example,
unlike other websites, Precision provided approximately four
pages of information on the risks associated with day trading,
some of which was in boldface font. The statement included, in
part: ``The risk of loss in day trading and/or option trading
can be substantial. You should, therefore carefully consider
whether such forms of trading are suitable for you in light of
your circumstances and financial resources.'' \149\
---------------------------------------------------------------------------
\146\ ``Weekly Calendar of Advanced Support Services,''
www.precisiondaytrader.com, July 29, 1999, at 1.
\147\ The Subcommittee was unable to determine course prices from
the website, although documents Precision provided to the Subcommittee
indicate that the Precision Day Trader Seminar costs approximately
$1,495 and the Pro-Trader Boot Camp costs approximately $3,500.
``Customer Data Base From Inception through the end,'' at 1.
\148\ ``Risk Disclosure,'' www.precisiondaytrader.com, July 29,
1999.
\149\ Id.
---------------------------------------------------------------------------
Precision did, however, make the following claims that the
Subcommittee found potentially questionable:
The founders of Precision realized long ago that
``trading'' (despite being a very efficient and
profitable way of making a living), is nothing more
than a ``vehicle'' which, when operated correctly,
allows you to spend the majority of your time and
energies focused on the truly important things in life.
Out of this philosophy eventually grew Precision's
simple, one-line mission statement: * * * trading your
way to a better life! \150\
---------------------------------------------------------------------------
\150\ ``Explanation of Events,'' www.precisiondaytrader.com, July
29, 1999, at 1.
---------------------------------------------------------------------------
Each day of our Boot Camps is jam-packed with live
trading sessions and focused, small group tutorials
that cannot help but propel your skills to an entirely
new level of profitability.\151\
---------------------------------------------------------------------------
\151\ Id.
In its response to the Subcommittee's interrogatories,
Precision had no support for its statement ``trading your way
to a better life,'' or its claim that trading is an efficient
and profitable means of making a living, other than to state
that those are opinions.\152\ Precision attempted to justify
its claim that its courses are highly effective by submitting a
record of trades made during Precision classes.\153\ The
Subcommittee reviewed the record, however, and discovered that
the account made only $500 in profits while generating
approximately $8,000 in commissions and fees during the six
months of trading.\154\ Moreover, shortly after receiving the
Subcommittee's interrogatories, Precision removed the above
cited claims from its website.
---------------------------------------------------------------------------
\152\ Letter from Kathy K. Cregan, CFO of 1800retirenow.com, Inc.,
to Eileen Fisher, Subcommittee Investigative Assistant, Nov. 10, 1999,
at 2 (Feb. Hr'g Ex. 5).
\153\ ``Copies of Trades Made During the Live Course,'' Precision
Management Group, Inc. (Feb. Hr'g Ex. 6).
\154\ Id.
---------------------------------------------------------------------------
(e) Winning Day Traders. The Winning Day Traders website
promotes a chat room featuring ``Exceptional `Real-Time' Stock
Recommendations'' and ``Minute by Minute Market Analysis and
News Alerts in Our Trading Auditorium.'' \155\ Membership in
the Trading Auditorium costs $795 quarterly. Winning Day
Traders also offers a newsletter published three times each
week for $59 per month, and the ``Secrets of Winning Day
Traders'' Handbook for $149. In addition, the owners of the
firm, Brian Zavodnik and Thomas Wolski, offer consultations for
$75 per hour to analyze trades and help customers develop a
trading style.\156\ Winning Day Traders provided the
Subcommittee with no support for the claims of ``Explosive
Winning Strategies and Secrets to Increased Profitability.''
\157\ Rather, Winning Day Traders simply referred to the claims
as ``slogans that we came up with,'' \158\ and later removed
them from the website without comment.
---------------------------------------------------------------------------
\155\ ``WinningDayTraders,'' www.winningdaytraders.com, Sept. 21,
1999, at 1.
\156\ ``Consulting Services,'' www.winningdaytraders.com, Aug. 2,
1999.
\157\ ``Welcome to WinningDayTraders,'' www.winningdaytraders.com,
Aug. 2, 1999. In addition, the website's risk disclosure is limited to
the following disclaimer: ``Please note: We are required by the SEC to
state that past performance is not indicative of future results and
that we also do not expect that members or guests achieve these exact
or similar results. Commissions have not been used to compute the
results as they vary.'' ``WinningDayTraders,''
www.winningdaytraders.com, Sept. 21, 1999, at 1.
\158\ Letter from Brian Zavodnik, WinningDayTraders, to K. Lee
Blalack, II, undated, at 2 (Feb. Hr'g Ex. 7).
---------------------------------------------------------------------------
(f) RML Trading. Another support industry firm is RML
Trading, which is run by Robert Luecke. RML Trading offers a
two-part online training course which, along with a text, costs
$995.\159\ RML Trading also offers direct market access to its
customers.\160\ RML Trading's website provides the following
optimistic view of a day trader's chances of success:
---------------------------------------------------------------------------
\159\ ``RML Trading,'' www.thestockcam.com/home, Sept. 21, 1999, at
1. RML Trading includes additional risk information on a form that
customers must sign before training to day trade.
\160\ Id.
---------------------------------------------------------------------------
Do I have to know anything about the stock
market? No! Because of our support system you will be
helped along the way to becoming a successful day
trader.\161\
---------------------------------------------------------------------------
\161\ ``Frequently Asked Questions,'' www.thestockcam.com, Aug. 3,
1999, at 1.
---------------------------------------------------------------------------
Can anyone electronically day trade
successfully? If you have an average intelligence,
discipline and desire you have a very good chance of
becoming a successful trader.\162\
---------------------------------------------------------------------------
\162\ Id.
---------------------------------------------------------------------------
RML Trading stated in its cover letter to the Subcommittee that
the above statement reflects ``the opinions of successful day
traders.'' \163\ It is unclear which successful day traders RML
Trading consulted, since in that same letter, RML Trading
stated that it ``does not have information, including internal
or external reports, on the financial performance of the
individuals who have completed the StockCam program.'' \164\
RML Trading also disclosed that it is undergoing NASD
review.\165\ RML Trading removed the above cited claims from
its website shortly after it received the Subcommittee's
letter. The website's risk disclosure is comprised of the
following three sentences: ``The risk of loss in Electronic Day
Trading can be substantial. You should carefully consider
whether such trading is suitable for you. See SEC's speech on
Online Trading, the website does have a link to Chairman
Levitt's May 4, 1999, Speech at the National Press Club.''
\166\
---------------------------------------------------------------------------
\163\ Letter from Ralph S. Jarvey, Counsel for RML Trading, Inc.,
to K. Lee Blalack, II, Chief Counsel & Staff Director for the
Subcommittee, Sept. 29, 1999, at 2 (See hearing record Ex. 8).
\164\ Id.
\165\ Id.
\166\ ``RML Trading,'' www.thestockcam.com/home, Sept. 21, 1999, at
1. RML Trading's training materials include an additional risk
disclosure form which the customer must sign before trading online.
Disclosure statement, Stockcam, Inc., at 1.
---------------------------------------------------------------------------
This burgeoning support industry for day traders is a
troubling development because, as these websites illustrate,
the support firms contribute heavily to the perception that day
trading is a vehicle to easy money. They do so with very
little, if any, risk disclosure and, thus, present
unsophisticated investors with an unbalanced picture of the
risks and rewards of being a professional day trader. As
Chairman Levitt noted at the Subcommittee's overview hearing,
these support industries also pose regulatory problems since
most of the companies involved are not broker-dealers or
exchange members that would be subject to regulatory scrutiny
and accountability.
D. Day Trading Closely Resembles Gambling for Novice, Undercapitalized
Traders
At the overview hearing, one of the questions the
Subcommittee considered was whether day trading is in fact
gambling. This is an important matter because, as Chairman
Collins noted in her opening statement, ``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.'' \167\ Yet, a growing
number of people are giving up their existing careers or
withdrawing their savings to become full-time professional day
traders. The Subcommittee's investigation suggests that day
trading closely resembles gambling for novice, undercapitalized
traders. The Subcommittee based this conclusion on statements
by regulators, members of the day trading industry, gambling
experts, documents produced by day trading firms, and
profitability data.
---------------------------------------------------------------------------
\167\ Collins Statement at 3.
---------------------------------------------------------------------------
Like gambling, which is defined as playing a game of chance
for money or other stakes,\168\ day trading offers the chance
for quick riches. The odds are somewhat longer for the day
trader than for the professional blackjack player, however: the
day trader pays a commission charge for every trade regardless
of whether it is profitable.
---------------------------------------------------------------------------
\168\ Webster's Third New International Dictionary at 932.
---------------------------------------------------------------------------
(1) Regulators Liken Day Trading to Gambling. Securities
regulators have been comparing day trading to gambling for some
time. In 1998, Philip A. Feigin, Executive Director of NASAA,
said that, ``for the typical retail investor, day trading isn't
investing, it's gambling. If you want to gamble, go to Las
Vegas; the food is better.'' \169\ Peter C. Hildreth, President
of NASAA, testified at the Subcommittee's Overview Hearing that
``the odds are 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.'' \170\ Because most day traders buy and sell
securities without the benefit of the research associated with
traditional investing and attempt to time the short term
movement of a stock, many analysts have analogized the day
trader to a card counter playing blackjack. Chairman Levitt
cited the limited market knowledge of most day traders when he
noted that ``some argue that day trading is nothing more than
speculation. And speculation is not new to our markets.
Personally, I don't think day traders are speculating, because
speculating requires some market knowledge, and they are
instead gambling, which really doesn't.'' \171\
---------------------------------------------------------------------------
\169\ NASAA Press Release, Nov. 25, 1998 (Feb. Hr'g Ex. 9).
\170\ Prepared Statement of Peter C. Hildreth, President of NASAA,
Overview Hearing, at 25 (``Hildreth Statement'').
\171\ Arthur Levitt, Jr., SEC Chairman, ``Speech to the National
Press Club,'' May 4, 1999 (Feb. Hr'g Ex. 10).
---------------------------------------------------------------------------
(2) Day Trading Industry Rejects Gambling Comparison. Most
day trading firms reject the comparisons between gambling and
day trading. Harvey Houtkin, Chief Executive Officer of All-
Tech, testified that Chairman Levitt was ``just wrong'' when he
called day trading gambling and that ``if he went back and
thought about it, he'd recant.'' \172\ Other industry
representatives have countered the regulators' statements with
a variety of arguments. For example, Jim Lee, Momentum's
President, pointed out in a press account that ``if day trading
was nothing more than a gamble, the turnover rate would be
high, and if you're running a revolving door, you're gone.''
\173\ Mr. Lee said that he preferred that people not draw
analogies between day trading and gambling, because society has
a negative perception of gambling, and because he felt that the
gambling analogy is not the most descriptive of the day trading
industry.\174\ Mr. Lee conceded, however, that he understood
why people may associate gambling with some day trading firms,
but felt that the comparison did not apply to Momentum.\175\
---------------------------------------------------------------------------
\172\ Houtkin Dep. at 227.
\173\ Brian Kunath ``Day Trading: The `Dealerization' of the
Markets,'' Global Investment Magazine, Dec. 1999, at 51.
\174\ Lee Dep. at 82-86.
\175\ Id.
---------------------------------------------------------------------------
In order to distinguish day trading from gambling, other
industry officials have drawn attention to the tools day
traders have at their disposal. In his written testimony at the
overview hearing, Saul S. Cohen, Consulting Counsel to the ETA,
quoted day trader Dan Ripoll who stated that ``day trading is
not gambling.'' \176\ Mr. Cohen added that ``it requires skill,
state of the art technology and hard work.'' \177\ In its
training manual, Cornerstone Securities also takes issue, at
least in part, with the gambling analogy:
---------------------------------------------------------------------------
\176\ Prepared Statement of Saul S. Cohen, Consulting Counsel for
ETA, Overview Hearing, at 179 (``Cohen Statement'').
\177\ Id.
You may have heard comments equating trading to
gambling. While this notion may apply to some traders
participating in the markets today, it certainly does
not apply to those that have earned consistent returns
over time. For them, only by mastering risk have they
been able to effectively stack the odds in their favor
time and time again.\178\
---------------------------------------------------------------------------
\178\ Cornerstone Training Manual, Introduction, at 4.
Instead, Cornerstone compares day trading to meteorology.\179\
Cornerstone notes that, like day traders, weathermen rely ``on
systems and historical data to predict short-term, future
movements in the weather.'' \180\ Though Cornerstone disputes
what it calls the ``gambling myth,'' the firm's training manual
concedes that
---------------------------------------------------------------------------
\179\ Id.
\180\ Id.
[t]here will always be recreational gamblers, and, I
suppose, there will always be traders that simply
gamble. Far too many existing traders throw caution to
the wind, and their hard-earned money along with it.
Because they lack the guidance, discipline, and a well
thought-out trading plan, they are left to the
uncertainties of guessing, wishing, hoping, and of
course gambling.\181\
---------------------------------------------------------------------------
\181\ Id. (emphasis added).
(3) Training Documents Frequently Refer to Gambling.
Despite the objections of many in the day trading industry to
the comparison between day trading and gambling, day trading
firms produced many documents to the Subcommittee which openly
embraced the comparison. A training syllabus produced to the
Subcommittee by the parents of Scott Webb, a young day trader
and trainer who was killed in Momentum's Atlanta branch office
by Mark Barton on July 29, 1999, refers expressly to gambling
as a trading technique. The syllabus lists three trading
techniques: ``1. Scalping; 2. Position trading; and 3.
Gambling.'' \182\ Similarly, a list of trading tips produced to
the Subcommittee by Insider Trading offers the following
advice:
---------------------------------------------------------------------------
\182\ Syllabus, ``Professional Traders Group, Training Seminar,''
Jan. 4, 1999--Jan. 29, 1999, at 2 (Feb. Hr'g Ex. 11).
Always take profits and cut losses. You must have a
goal every day of the amount of money you want to make
in the stock market. When you reach your goal, stop,
and quit trading. Try not to get greedy and still
trade. Remember, you are gambling and most likely you
will loss [sic] what you have made.\183\
---------------------------------------------------------------------------
\183\ Insider Trading Inc., Training Manual, ``Teachdaq School of
Stock Market Training: Day Trading 301,'' at Review Trading Rules
(emphasis added) (Feb. Hr'g Ex. 12).
Thus, Insider Trading blatantly states that day trading is
gambling, and that the odds are against trading profitably.
(4) Industry Representatives Identify Day Trading with
Gambling. Despite attempts by members of the day trading
industry to distance themselves from gambling, representatives
of several day trading firms have openly compared successful
day traders to professional gamblers. Richard McCall, described
as a behavioral therapist, martial-arts master, professional
trading coach and casino gambler, offered a course in the fall
of 1999 aboard a river-boat casino that taught students how to
day trade using strategies commonly applied to craps.\184\ Mr.
McCall was quoted in the press as follows: ``There are too many
people getting into trading the markets who let their emotions
rule the game. These are the folks you have to worry about.
Craps is the fastest way to learn how to trade the markets
right. It requires strategy, strict discipline, and impeccable
timing.'' \185\
---------------------------------------------------------------------------
\184\ Marcia Vickers, ``A School for Day Traders,'' Business Week,
Nov. 8, 1999, at 148.
\185\ Id.
---------------------------------------------------------------------------
Mr. Houtkin discussed the similarities between professional
gamblers and certain traders, noting that traders who have the
skills, technology and capital turn their trading into a
business and are no longer gambling.\186\ Mr. Houtkin also
likened himself to a card counter and the brokerage industry to
a casino that tried to throw him out of the house for
winning.\187\ He testified as follows:
---------------------------------------------------------------------------
\186\ Houtkin Dep. at 231, 236.
\187\ Id. at 237.
Q: So to kind of take the analogy you've extended
here, is it fair to say you believe that the house,
essentially NASDAQ, and
A: And the brokerage industry.
Q: And the brokerage industry viewed you essentially
as a card counter or a professional trader who was
beating them at their own game and they tried to throw
you out of the house?
A: I think that would be an analogy that would
certainly have certain validity to it.\188\
---------------------------------------------------------------------------
\188\ Id. at 237-38.
Don Bright, Chief Executive Officer of Bright Trading,
which is appropriately based in Las Vegas, considers himself,
like Mr. Houtkin, essentially a card-counter.\189\ Mr. Bright
is a professional gambler and day trader who said that his
``traders don't gamble, just like blackjack card counters don't
gamble. They only make a trade when they have an edge.'' \190\
Mr. Bright also said of day trading and gambling, ``the
discipline's the same, the focus is the same, the edge is the
same.'' \191\
---------------------------------------------------------------------------
\189\ Dugan, ``For These Day Traders, Stock Market Is One Big
Casino,'' at A1.
\190\ John G. Edwards, ``Minute by Minute Man,'' Las Vegas Review
Journal, Mar. 28, 1999, at 1K.
\191\ Dugan, ``For These Day Traders, Stock Market Is One Big
Casino,'' at A1.
---------------------------------------------------------------------------
(5) Gambling Experts Cite Dangers of Day Trading As An
Addiction. The analogy between day trading and gambling seems
to extend to the pathology of addiction that frequently
accompanies gambling. Psychotherapist and former stockbroker,
Chris Anderson, described day trading as ``lethal, toxic, and
addictive'' because so much money can be gained and lost so
quickly.\192\ Mr. Anderson noted that this can produce a rush
of excitement in the trader similar to that experienced by a
gambler.\193\ He added that, as losses mount, day traders often
retreat to a fantasy world and increasingly chase their losses
with more trades.\194\ Another gambling counselor, Dr.
Frederick Woolverton, Director of The Village Institute, told
Subcommittee staff that, like addicted gamblers, traders often
live in a fantasy world in which the next trade is the one that
will propel them into wealth.\195\ Dr. Woolverton found
striking similarities between a room full of day traders
clicking a mouse on a computer screen, complete with dancing
lights, and a casino full of gamblers pulling the levers of
slot machines.\196\
---------------------------------------------------------------------------
\192\ Interview of Chris Anderson, Aug. 25, 1999, at 1 (``Anderson
Int.'').
\193\ Id.
\194\ Id.
\195\ Interviews of Dr. Frederick Woolverton, Dec. 14, 1999 and
Dec. 17, 1999, at 1 (``Woolverton Int.'').
\196\ Id.
---------------------------------------------------------------------------
Members of the day trading industry acknowledge the
addictive thrills of trading. For example, in his book Secrets
of the SOES Bandit, Mr. Houtkin describes the attitude of
fellow day traders: ``Many of my associates curse the long
weekends that keep them away from trading. Day trading is so
exhilarating that it can become almost addictive.'' \197\
During his Subcommittee deposition, Mr. Houtkin elaborated on
that statement, noting that, when his customers ``start losing
money, I mean, they beg us, beg us. When they lose money, we
say, look, we're going to close you down. * * * They literally,
[say] please, let me trade some more.'' \198\ Mr. Bright's
daughter, Tammy Bright, herself a day trader and blackjack
dealer, described the feeling she gets from day trading as ``a
natural high; it's wonderful.'' \199\ Several firms acknowledge
the addictive nature of trading in their training materials.
For example, in its training manual, On-Site Trading describes
the rush of excitement trading provides: ``[T]rading is a heady
experience and can be very addictive. Losers who drop money in
the markets receive a tremendous entertainment value.'' \200\
---------------------------------------------------------------------------
\197\ Houtkin, Secrets of the SOES Bandit, at 3.
\198\ Houtkin Dep. at 242.
\199\ James Kim, ``A new breed of traders: pizza guys to lawyers
heed market's siren song,'' USA Today, May 22, 1998, at 1B.
\200\ On-Site Trading, Inc., Training Manual, at 6 (Feb. Hr'g Ex.
13).
---------------------------------------------------------------------------
These statements echo the thrill-seeking motivation
described by Ed Looney, Executive Director of the New Jersey
Council on Problem Gambling, who said, ``when you look at the
day traders you're talking about an activity that attracts
people who love action, who love excitement. You're going to
see a lot of them who are really in it for gambling.'' \201\
The Stockcam Institute, Inc. noted a similar phenomenon in its
training manual:
---------------------------------------------------------------------------
\201\ Raymond Fazzi, ``Day Trading: Boom or Bust?'' Asbury Park
Press, Sept. 26, 1999, at A11.
Many traders feel that they must trade all day, every
day, or at least every day. In other words, they are
addicted to trading. An hour or day without a trade is
like a day without a meal. The fact is that there are
some days which offer few if any trading opportunities.
Overtrading is also the trader who has a string of
losses and experience the overwhelming desire to keep
trading (pushing a trade) in order to ``get their money
back,'' without taking time to analyze what is really
going on. A great technique to help you control the
overtrading urge is to STOP trading when you feel this
urge. Take some time, walk away for awhile until you
regain your perspective.\202\
---------------------------------------------------------------------------
\202\ Training Manual, ``Trading Psychology,'' The Stockcam
Institute, Inc., at G-2 (emphasis added) (Feb. Hr'g Ex. 14).
According to Mr. Looney, the ranks of day traders addicted
to gambling are growing: ``Last year [1998], slightly under
three percent of the council's hot line calls were from day
traders. This year [1999], they're running at about four
percent.'' \203\ The hot line averages about five or six calls
per day from day traders and, when the markets are falling, day
traders represent approximately forty percent of the hot line
calls.\204\ Mr. Looney, Mr. Anderson and Dr. Woolverton agree
that increased awareness of the similarities between trading
and gambling is one way that compulsive behavior by day traders
can be minimized.
---------------------------------------------------------------------------
\203\ Fazzi, ``Day Trading: Boom or Bust?,'' at A11.
\204\ Vanessa Richardson, ``Addictions: Trading the Day Away,''
Money, Sept. 1999, at 34.
---------------------------------------------------------------------------
The Subcommittee's investigation found one firm that has
implemented precautionary measures to detect compulsive trading
and provide counseling. At its expense, Broadway Trading, LLC
(``Broadway'') has hired Dr. Woolverton's The Village Institute
to consult with its traders whenever they are in need of
help.\205\ On some occasions, Broadway employees have suggested
to day traders who appeared to be having problems that they
visit Dr. Woolverton.\206\ Dr. Woolverton said that he has met
with a significant number of day traders, both from Broadway
and other firms and that, in most cases, the traders he
counsels return to trade profitably and with discipline.\207\
Dr. Woolverton added that Broadway has discussed potential
group sessions for all its traders.\208\
---------------------------------------------------------------------------
\205\ Woolverton Int. at 2.
\206\ Id.
\207\ Id.
\208\ Id.
---------------------------------------------------------------------------
E. Only a Small Percentage of Novice Day Traders Will Be Profitable and
Even A Majority of Experienced and Well Capitalized Day Traders
Lose Money
The Subcommittee's investigation indicates that only a
small percentage of novice day traders will be profitable and
that, even among experienced and well capitalized traders, a
majority will lose money. The Subcommittee reached this
conclusion after reviewing internal documents that day trading
firms produced to the Subcommittee, interviewing day traders
and representatives of the day trading industry, and examining
profitability data collected by several day trading firms and
securities regulators.
(1) Anecdotal Evidence Suggests That Day Trading Is Highly
Unprofitable. The Subcommittee has compiled strong anecdotal
evidence suggesting that day trading is highly unprofitable.
Much of this evidence comes directly from day trading firms
themselves, although the firms continue to speak about day
trading careers in glowing terms when talking with potential
customers. Barry Parish, the former manager of All-Tech's San
Diego office, admitted during his Subcommittee deposition that
eighty to ninety percent of customers who traded at the San
Diego office lost enough money to quit within six months.\209\
Mr. Houtkin would not take issue with Mr. Parish's estimate but
did indicate that he believes only about one-third of all day
traders ever become full-time traders.\210\
---------------------------------------------------------------------------
\209\ Deposition of Barry Parish, Nov. 30, 1999, at 45 (``Parish
Dep.''). Mr. Parish defined ``enough to quit'' as a relative term,
based on each customer's capacity for loss, and noted that the customer
sets the figure. Id.
\210\ Houtkin Dep. at 199, 216-17.
---------------------------------------------------------------------------
In addition, All-Tech's Branch Office Surveys (``Surveys'')
from the Boca Raton and Seattle offices indicate that very few
customers were turning a profit. In response to the survey
question ``what percentage of your customers are making
money,'' the former manager of the Boca Raton Office wrote
``0%'' \211\ and the branch manager of the Seattle office wrote
``>10%.'' \212\ All-Tech's Chicago office had the most
successful traders, noting on the survey that ``30%'' of the
traders were profitable.\213\ In an interview with Subcommittee
staff, the Seattle branch manager estimated that about 90
percent of his Seattle customers lost money.\214\
---------------------------------------------------------------------------
\211\ All-Tech's Boca Raton ``Branch Office Survey,'' June 22-24,
1997, at 4 (Feb. Hr'g Ex. 15).
\212\ All-Tech's Seattle ``Branch Office Survey,'' June 5, 1997, at
4 (Feb. Hr'g Ex. 16).
\213\ All-Tech's Chicago ``Branch Office Survey,'' June 4, 1997, at
4 (Feb. Hr'g Ex. 17).
\214\ Interview of Michael Benson, Dec. 1, 1999, at 9 (``Benson
Int.'').
---------------------------------------------------------------------------
The chances for success were equally grim at Providential.
Mr. Fahman testified that only about 20 to 30 percent of
traders at Providential make money.\215\ Tae Goo Moon, the
branch manager of Providential's Los Angeles office, reported
in his response to Subcommittee interrogatories that none of
the day traders in the Los Angeles office were profitable.\216\
In fact, Mr. Moon estimated that the average day trading
customer traded for approximately one month before quitting,
and lost approximately $50,000.\217\ At his Subcommittee
deposition, Mr. Fahman did not dispute Mr. Moon's
estimates.\218\ He added that only a ``couple'' of day traders
at Providential's Oregon branch office were profitable and that
a substantial majority lost money.\219\
---------------------------------------------------------------------------
\215\ Fahman Dep. at 253.
\216\ Letter from Susan H. Tregub, Counsel for Hahna Global
Securities, to Wesley M. Phillips, Investigator for the Subcommittee,
Dec. 3, 1999, at 4 (Feb. Hr'g Ex. 18).
\217\ Interview of Tae Goo Moon, Dec. 9, 1999, at 5 (``Moon
Int.'').
\218\ Fahman Dep. at 256.
\219\ Id.
---------------------------------------------------------------------------
Similarly, Mr. Bright, of Bright Trading, stated in a press
account that fewer than 10% of day traders will turn a profit
if the trader universe includes those who trade out of their
homes.\220\ Mr. Bright added that about two-thirds of traders
quit day trading during their first year.\221\ In response to
Subcommittee interrogatories, Direct Net Trading indicated
that, as of June 30, 1999, ``[a]pproximately 30-40% of total
traders at any one time are making money. Typically, less
experienced traders lose for three months and by the fourth
month they have either become successful or given up.'' \222\
In its training manual, Cornerstone stated that, ``[i]t's a
well known fact that somewhere between 70% and 90% of new
traders go bust or quit trading within 6 to 12 months of their
first trade.'' \223\
---------------------------------------------------------------------------
\220\ Edwards, ``Minute by Minute Man,'' at K1.
\221\ Id.
\222\ Letter from Laurence Briggs, Chief Executive Officer of
InvestIn.com Securities Corp., to K. Lee Blalack, II, Chief Counsel &
Staff Director to the Subcommittee, Nov. 18, 1999, at 3 (Feb. Hr'g Ex.
19).
\223\ Cornerstone Training Manual, Psychology, at 5.
---------------------------------------------------------------------------
While not conclusive, this voluminous anecdotal evidence
strongly indicates that, on the whole, day traders lose money
and that an extremely high percentage of novice traders fail to
achieve profitability. This tentative finding is also generally
supported by what little empirical data exists on the success
rates of day traders.
(2) NASAA Report's Profitability Study. The NASAA Report
was one of the first large scale examinations of the day
trading industry. The NASAA Report concluded that ``70 percent
of public traders will not only lose, but will almost certainly
lose everything they invest.'' \224\ In order to evaluate the
profitability of day traders generally, NASAA commissioned a
financial consultant to perform a limited study of day trading
accounts at one day trading firm's branch office in
Massachusetts. The consultant reviewed 30 randomly selected
accounts at the branch office and found that 70% of them lost
money, and would likely lose all the capital they traded.\225\
Based on that review, the consultant estimated that 70 to 90
percent of all day traders at that branch office lost
money.\226\
---------------------------------------------------------------------------
\224\ NASAA Report at 7.
\225\ Id. at 4.
\226\ Id.
---------------------------------------------------------------------------
The day trading industry roundly criticized the NASAA
Report because it was based on a relatively small sample of day
trading accounts.\227\ At the Overview Hearing, ETA's Counsel,
Mr. Cohen, noted that NASAA's profitability analysis only
examined seventeen day trading accounts at a single branch
office of a single firm.\228\ He also stated that NASAA's
consultant examined only four months of account activity.\229\
Former NASAA official David Shellenberger indicated, however,
that the sample was actually taken during the two year period
of 1997-1998, and that the four month statistic represented the
average amount of time an account remained open. Mr. Cohen
alleged that the sample analyzed in the NASAA report was
insufficiently representative to draw broad conclusions about
the profitability of day trading generally.\230\
---------------------------------------------------------------------------
\227\ Cohen Statement at 186.
\228\ Id.
\229\ Id.
\230\ Id.
---------------------------------------------------------------------------
The Subcommittee find that despite its heavy criticism, the
study is somewhat instructive regarding profitability. The
findings of the NASAA Report are generally consistent with the
anecdotal evidence that the Subcommittee uncovered in this
investigation as well as that of the 1999 Washington State
Securities Division profitability analysis. Thus, the NASAA
Report clearly has some probative value on the question of
profitability. The Subcommittee agrees, however, that the
sample of accounts reviewed was too limited to draw broad
conclusions about the day trading industry as a whole.
(3) ETA Indicated at the Subcommittee's Overview Hearing
That It Was Preparing A Broader Profitability Study But ETA
Declined To Commission Such A Study. During the Subcommittee's
Overview Hearing, Mr. Cohen testified that ETA was ``in the
process of retaining KPMG to conduct a day trading
profitability study,'' which was ``expected to be completed''
within two months of the hearing.\231\ In January of this year,
the Subcommittee inquired of ETA about the progress of the
study. Through counsel, ETA advised the Subcommittee that it
declined to pursue this study because the cost was
prohibitive.\232\ Mr. Lee, in testimony before the Subcommittee
on February 25, 2000, reiterated this as the reason for not
going forward with the study and added, ``* * * there were also
some internal conflict issues that [ETA] pinpointed in their
ability to produce the study.'' \233\ Mr. Cohen's strong
condemnation of NASAA's profitability analysis at the
Subcommittee's overview hearing combined with and his
declaration that ETA intended to commission an independent
study ``[t]o put the matter [of day trading profitability] to
rest,'' \234\ and then ETA's failure to pursue the study,
undermine the level of confidence ETA really has in its survey.
---------------------------------------------------------------------------
\231\ Id. at 188.
\232\ Telephone call with Robert Bennett, Counsel for Momentum
Securities, Inc., Jan. 24, 1999.
\233\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
\234\ Cohen Statement at 188.
---------------------------------------------------------------------------
(4) Profitability Data From Day Trading Firms. In response
to Subcommittee document requests, several day trading firms
produced profitability data to the Subcommittee, including
Momentum, Tradescape, LLC (``Tradescape''), and Broadway. A
cursory review of the data produced by these firms indicates
that many of their traders are or were profitable. The
Subcommittee concluded that the profitability data from
Momentum,\235\ Tradescape \236\ and, to a lesser degree,
Broadway \237\ did not provide an adequate nor probative
picture of the industry as a whole for many of the same reasons
that we found the NASAA Report of limited value. In all three
cases, the profitability data derived from a limited sample of
day trading accounts and was derived from one firm or even a
subset of the firm's total universe of traders. As such, the
Subcommittee believes that, like the NASAA Report, the
profitability data from Momentum, Tradescape and Broadway has
limited predictive value for the industry as a whole.
---------------------------------------------------------------------------
\235\ Momentum provided the Subcommittee with data detailing the
success of its day traders over a five month period at the end of 1998.
Momentum has distanced itself from this data, declining to call it a
``study'' but instead labeling the analysis as an unscientific
``survey.''
This data is limited for several reasons. For example, the
Preliminary Results data covers trading activity for a five month
period only, and reflects Momentum's 107 Texas based traders, but not
those at Momentum's other branch offices including Atlanta, Chicago,
Milwaukee and Irvine.
The Preliminary Data does not indicate how many traders survived
the three to five month learning curve. In fact, Mr. Lee stated in his
deposition that Momentum does not track how many accounts remain open
and active for six months or longer. The Preliminary Data indicates
that 70 percent of Momentum's traders have been day trading for more
than six months. As Mr. Lee confirmed in his deposition, this is not
the same as saying that 70 percent of accounts that customers open at
Momentum remain open after six months. Lee Dep. at 346.
\236\ Tradescape's ``Trader Performance Analysis,'' Nov. 12, 1999
(``Tradescape Analysis'') Feb. Hr'g Ex. 20). Tradescape informed the
Subcommittee that 85 percent of the traders included in the study
traded at one Landmark Securities office located in New York City. The
other 15 percent traded in equal numbers at four other Landmark offices
located in Los Angeles, Denver, Miami and Boston. Tradescape's internal
study entitled the ``Trader Performance Analysis'' tracks gross and net
profit and loss data over six months. This study is valuable because it
provides six accurate snapshots of trader profitability. Monthly
snapshots, however, only tell a portion of the profitability story and
cannot be extrapolated to describe the industry as a whole. It is worth
noting that, of these monthly snapshots, unprofitable traders
outnumbered profitable traders during four of six months studied. The
study suffers from several limitations. For example, the Tradescape
study is largely limited to one Landmark branch office, which is a
subsidiary of Tradescape and Co.
Furthermore, the Tradescape data is averaged over six months.
Averaging the number of traders over the course of the six month
period, as well as averaging the percentage of profitable and
unprofitable accounts, conceals customer turnover. By averaging the
account data, Tradescape counted profitable, repeat customers every
month they traded. Thus, those accounts were given more weight. In
contrast, Tradescape weighted those customers who stopped trading after
one or two months less heavily. It should be noted, however, that even
with this skewed picture of traders' success, less than half the
accounts were profitable: 48 percent were profitable as opposed to 52
percent that were unprofitable.
The more accurate method for determining overall customer
profitability is to track each account separately and determine at the
end of the six month period how many were profitable and how many were
unprofitable. For example, given the data on Tradescape's Trader
Performance Analysis, it is impossible to know how many of the 163
traders trading in January, 1999 were among the 193 traders in
February, 1999 or among the 211 traders trading in March, 1999. Those
who quit day trading after January, 1999 were counted once in the
average Tradescape provided, and those who quit in February, 1999 were
counted twice, while those who continued to trade through June were
counted six times.
To illustrate this point, the Subcommittee tracked the fortunes of
twenty losing traders. Of this group of twenty, twelve had quit day
trading by the end of the six month period, and five of those had
stopped trading after three months. Of the eight who were still trading
at the end of the six month period, only two had net profits.
\237\ ``Trader Statistics,'' www.broadwaytrading.com (Feb. Hr'g Ex.
21).
---------------------------------------------------------------------------
The Momentum data, which the firm has not made public,
indicates that 64 percent of Momentum's experienced traders
were profitable from September 1998 through January 1999, and
that 44 percent of inexperienced traders were profitable.\238\
By comparison, Tradescape reported that 48 percent of its
traders were profitable over a six month average when
commissions were included.\239\
---------------------------------------------------------------------------
\238\ Momentum Survey at ``Preliminary Results,'' Feb. 1999.
\239\ Feb. Hr'g Ex. 20.
---------------------------------------------------------------------------
Broadway posted useful data on its website charting the
profitability of its traders in 1999, dividing them by branch
office and by experience.\240\ For example, Broadway's data
indicates that, when experienced and novice traders are grouped
together, a majority lost money in six months of the year.\241\
When the sample consisted solely of novice traders, however,
the data shows that they were profitable during only the last
two months of 1999, and those two months no longer reflected
truly novice traders since many of the customers included in
the sample at the end of the year had been trading for more
than six months by that time.\242\ Segregating the novice from
the experienced traders clearly demonstrates the significance
of the learning curve. Some traders who survived the learning
curve eventually began to profit.
---------------------------------------------------------------------------
\240\ Feb. Hr'g Ex. 21.
\241\ Broadway traders represent some of the most well-capitalized
traders in the day trading industry. Unlike the majority of firms that
require $25,000 to open a day trading account, Broadway requires
$75,000. This larger sum enables traders to survive the learning curve
and take full advantage of trading opportunities.
\242\ Feb. Hr'g Ex. 21.
---------------------------------------------------------------------------
A few aspects of Broadway's data, however, prevent it from
presenting an accurate and complete view of the day trading
industry overall. For example, Broadway does not keep
statistics on how long its traders keep their accounts open and
active,\243\ and it is impossible to assess from Broadway's
data how many traded for a short time and then gave up. Data
concerning this turnover rate would provide a more complete
study of overall trader success at Broadway. Moreover, while
Broadway's data is useful, it is still limited to one firm.
---------------------------------------------------------------------------
\243\ Telephone Interview of Mark Peckman and Andrew Actman,
Broadway Trading, Inc., Jan. 17, 2000.
---------------------------------------------------------------------------
Broadway's 1998 data, which is not posted on the website,
probably provides a more accurate picture of the industry
because it tracks each trader for the entire year, regardless
of how long he or she traded.\244\ The 1998 data shows that 53%
of Broadway day traders lost money for the year.\245\
---------------------------------------------------------------------------
\244\ Broadway Trading, Inc., Profitability Data for 1998 (Feb.
Hr'g Ex. 22).
\245\ Id.
---------------------------------------------------------------------------
(5) Though There Is No Definitive Study Regarding the
Profitability of Day Trading, the Best Evidence Suggests That
Only a Small Fraction of Novice Day Traders Are Ever Profitable
and That, Even among Well Capitalized and Experienced Day
Traders, a Majority Will Lose Money. In 1999, the Washington
Securities Division examined every day trading firm in the
State of Washington and, in the process, conducted the most
comprehensive profitability analysis that the Subcommittee has
seen to date.\246\ The Washington examiners analyzed the day
trading account records at the seven day trading firms doing
business in the State of Washington.\247\ The examiners
reviewed day trading account records at each firm for the life
of every account, commencing at the opening of each account and
ending on the day of the exam.\248\ At five of the firms, the
examiners reviewed the records for every account.\249\ For All-
Tech and Richmark Capital Corporation (``Richmark''), however,
the examiners reviewed a sampling of accounts because the firms
are so large.\250\
---------------------------------------------------------------------------
\246\ Securities Division, Washington State Department of Financial
Institutions, Report to the United States Senate Permanent Subcommittee
on Investigations: Day Trading Practices in Washington State, Feb. 10,
2000 (``Securities Division Report'') (Feb. Hr'g Ex. 23). The
Securities Division is part of the Washington Department of Financial
Institutions. ``Local Security Regulators for Washington,''
www.nasaa.org/regulatory/WA.html, Dec. 20, 1999.
\247\ Those firms are Daytrading, Bright Trading, Inc., Action II,
Inc., On-Line Investment Services, Inc., Cornerstone Securities
Corporation, Richmark Capital Corporation, and All-Tech Direct, Inc.
Second Bortner, Int. at 1.
\248\ Id.
\249\ Id.
\250\ Id. At All-Tech, the examiners reviewed records for 34 for
the 125 accounts and, for Richmark, they reviewed 23 of the 203
accounts. Id.
---------------------------------------------------------------------------
Based on this comprehensive analysis, the Washington
examiners concluded that, net of commissions, 77 percent of the
traders were unprofitable.\251\ Moreover, even for the
remaining 23 percent that incurred net gains, the profits were
small in comparison to the individual losses suffered by the
vast majority of day traders.\252\ The Subcommittee finds the
Washington State study to be the most accurate picture of
profitability in the day trading industry because it is based
on the most representative sample of day trading accounts. The
examiners did not limit their analysis to one firm as was the
case with the NASAA Report and the profitability data submitted
by Momentum, Tradescape and Broadway. In addition, the
examiners determined account profitability based on the life of
the account rather than a limited snapshot of a day trader's
success over several months. Lastly, the examiners reviewed all
accounts at five of the seven firms, which accurately measures
the high turnover that frequently attends day trading and that
is often disguised by profitability data that averages the
success rates of a changing universe of traders over time.
---------------------------------------------------------------------------
\251\ Id.
\252\ Id.
---------------------------------------------------------------------------
At the Subcommittee's hearing on February 25, 2000, Ms.
Lori A. Richards, Director of the Office of Compliance,
Inspections, and Examinations at the SEC further expounded on
the effect high commissions have on the likelihood of success
for day traders. Ms. Richards testified that given a medium fee
structure, where commissions are $16.70 per trade and
additional services (data feeds, news, research) average
$150.00 per month, a day trader would have to generate $16,850
each month just to break even.\253\ As Chairman Collins pointed
out at the hearing, this means that given these figures, a day
trader would have to earn in excess of $200,000 a year just to
pay commissions before incurring one cent of profit.\254\
---------------------------------------------------------------------------
\253\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
\254\ Id.
---------------------------------------------------------------------------
F. Day Trading Has Resulted In Positive And Negative Market
Developments
At the Subcommittee's Overview Hearing, Chairman Collins
commented that, ``[t]he 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.'' \255\ She noted that ``[n]ew technology now
allows investors to access the markets directly without the aid
or advice of a broker-dealer, something that was previously
limited to a relatively small number of professional traders.''
\256\ This dramatic change in access raises profound questions
for securities regulators, broker-dealers, and investors.\257\
The Subcommittee's investigation determined that day trading
has had both positive and negative effects on the securities
markets, and that the negative developments warrant close
scrutiny by regulators and policymakers. The Subcommittee
emphasizes, however, that the evidence suggesting a correlation
between day trading and market volatility is by no means
conclusive and merits further study.
---------------------------------------------------------------------------
\255\ Collins Statement at 2.
\256\ Id.
\257\ Id.
---------------------------------------------------------------------------
(1) The Positive Impact of Day Trading. The three
developments that have made day trading possible are arguably
very positive for investors. First, day traders have added
liquidity to the markets. Indeed, at the Subcommittee's
Overview Hearing, Chairman Levitt testified that an argument
could ``be made that [day trading] does represent some modest
increase in liquidity.'' \258\ Given the growing numbers of day
traders--and the increasing use of ECNs by day traders--there
are more ready and willing buyers in the market than ever
before. Thus, there is strong evidence that day trading has
expanded liquidity. Second, the almost exponential growth in
low-cost trading execution platforms has dramatically lowered
commissions for investors as more broker-dealers lower
commission costs to compete with online trading systems. Third,
the new technologies of day trading have greatly expanded
transparency, or access to financial information. All of these
changes are positive for investors.
---------------------------------------------------------------------------
\258\ Levitt Statement at 18.
---------------------------------------------------------------------------
(2) There Is Some Evidence That Day Trading May Be
Contributing to an Increase in Volatility for Individual Stocks
and the Market as a Whole, Particularly the Nasdaq. During the
Subcommittee's Overview Hearing, Chairman Levitt indicated his
opinion that day trading was not contributing to an increase in
market volatility.\259\ Some day trading critics, however,
contend that the strategies of day traders, such as buying in
``up-trending'' markets and selling in ``down-trending''
markets, increases price volatility.\260\ Market volatility is
generally considered detrimental to investors because stock
prices fluctuate for reasons unrelated to the business
prospects of the company or the fair value of its shares.
---------------------------------------------------------------------------
\259\ Id.
\260\ GAO SOES Report at 14.
---------------------------------------------------------------------------
As part of a 1998 analysis, the General Accounting Office
(``GAO'') reviewed available studies on potential links between
day trading and market volatility.\261\ Based upon the
available literature, GAO found that there was no conclusive
evidence to support the contention that day trading results in
market volatility. Although some studies found that there is a
correlation, these studies did not establish whether day
trading caused the volatility or whether other market factors
contributed as well.\262\ A study examined by GAO found mixed
evidence about the impacts of day trading on market
volatility.\263\ Consequently, GAO concluded that large volumes
of day trading increased market volatility in the short-run,
but contributed to lower volatility in the long-run.\264\
---------------------------------------------------------------------------
\261\ Id.
\262\ Id.
\263\ Robert H. Battalio, Brian Hatch, and Robert Jennings, SOES
Trading and Market Volatility Vol. 32, No. 2 (June 1997).
\264\ GAO SOES Report at 14.
---------------------------------------------------------------------------
New data suggests that day trading may indeed be
contributing to increased volatility. A recent New York Times
report cited evidence that day trading had caused a dramatic
decrease in the length of time investors are holding
stocks.\265\ The new data show that Nasdaq stocks are the most
popular with online investors who are trading heavily.\266\
Recent figures suggest that, among the 50 most traded Nasdaq
stocks, investors held their shares, on average, for just three
weeks.\267\ According to a study by the University of
California at Davis of 60,000 households that traded shares
through a discount broker from 1991 to 1997, those that traded
most frequently earned an annual net return of 11.4
percent.\268\ This return contrasted to the 18.5 percent earned
by those households that held their positions for a longer
time.\269\ The New York Times report noted as follows:
---------------------------------------------------------------------------
\265\ Gretchen Morgenson, ``Investing's Longtime Best Bet is Being
Trampled by the Bulls,'' N.Y. Times, Jan. 15, 2000, at A1.
\266\ Id.
\267\ Id.
\268\ Id at B14.
\269\ Id.
The figures confirm what some market analysts have
suspected for some time: the rapid-fire trading
mentality of a very small group of hyperactive
investors known as day traders has altered the behavior
of large numbers of investors and is seeping into the
overall market. The consequences are large, since
studies show that investors who trade frequently get
lower returns and heavy trading contributes to wide
swings in the market.\270\
---------------------------------------------------------------------------
\270\ Id.
The effect of all of this trading, some theorize, is
greater volatility in the markets. An investment firm in
Minneapolis, the Leuthold Group, recently noted that price
movements of two percent or more from the previous day's close
occurred on the Nasdaq market on average, one out of every four
days last year.\271\ This change represents an increase of 21
percent from the previous year.\272\ Moreover, the data shows
that the Nasdaq experienced such large price swings only 3
percent of the time between 1971 and 1998.\273\
---------------------------------------------------------------------------
\271\ Id at A1.
\272\ Id.
\273\ Id.
---------------------------------------------------------------------------
A recent Wall Street Journal article documented this
shifting trend. For instance, Qualcomm's stock price rose
during the week of January 4, 2000 from $9.94 to $150.\274\ The
Wall Street Journal explained that, during Qualcomm's meteoric
rise, many institutional investors that formerly led the
markets followed the lead of day traders.\275\ The report noted
as follows:
---------------------------------------------------------------------------
\274\ ``Qualcomm Back Draft: Day Traders Bet on Look-Alikes,'' Wall
Street Journal, Jan. 10, 2000, at C1.
\275\ Id.
Through it all has been a role reversal taking shape
at times between big investors and day traders. Not
long ago, institutional investors uniformly scoffed at
the stocks being chased by day traders. These days,
however, they increasingly are likely to jump on board
a stock being favored by these frenetic individual
investors rather than risk being left behind on another
Internet stock's rapid ascent. They aren't waiting for
stocks to become an Amazon.com or a Yahoo! before they
begin to nibble.\276\
---------------------------------------------------------------------------
\276\ Id.
With an estimated ten to fifteen percent of Nasdaq trading
volume attributable to day traders, their impact on the markets
continues to grow. This new evidence suggests that day trading
is beginning to affect the volatility of individual stocks and
the overall markets. Though the volatility may be only
partially a result of increased day trading, it seems clear
that the psychology of day traders has infected the broader
markets.\277\ Securities regulators and policymakers will need
to diligently monitor these trends in order to react prudently
to the swift changes underway in our stock markets.
---------------------------------------------------------------------------
\277\ Susan Pulliam, ``Day Traders Power Fuel--Cell Stock Rise,''
Wall Street Journal, Feb. 16, 2000, at C2.
---------------------------------------------------------------------------
G. Summary of Findings
During the course of this investigation, the Subcommittee
discovered troubling evidence regarding the business practices
of day trading firms. Some of these practices are illegal and
in violation of state and federal securities laws. For
instance, the Subcommittee found evidence that registered
representatives of day trading firms forged customer documents
and engaged in unauthorized trading. There is also evidence
that day trading firms altered customer account documents to
make customers appear more suitable for day trading than they
actually were. In addition, the Subcommittee found evidence
that day traders violated state laws requiring the registration
as an investment adviser of persons who trade the account of
another for compensation and that the day trading firms were
willfully blind to the illegal conduct of their day trading
customers. There is also some evidence that day trading firms
sponsored misleading advertisements that mischaracterized the
risks of day trading and/or failed to disclose the risks of
this speculative activity. The Subcommittee has set forth a
detailed exposition of this evidence in the three case studies
that follow.
While the above findings pertain to potentially illegal
conduct, the most disturbing evidence gathered by the
Subcommittee relates to business practices that are--under the
current regulatory framework--entirely legal. For instance,
there is evidence that some day trading firms did not give
their prospective customers any risk disclosure prior to
opening their day trading accounts. For instance, in a written
response to Subcommittee interrogatories, Andover Brokerage,
LLC stated that it did not begin providing its day trading
customers written risk disclosures until the end of 1998, even
though the firm has been in operation since 1996.\278\ Indeed,
the Subcommittee found that most day trading firms began giving
their customers written risk disclosures in late 1998 or early
1999, and that they improved their risk disclosures expressly
in response to increased regulatory scrutiny of day trading.
Despite the improved written risk disclosures, the Subcommittee
heard evidence from former customers of day trading firms who
complained that the risk disclosures were undermined or
contradicted by verbal promises of big profits or ``can't
lose'' systems.
---------------------------------------------------------------------------
\278\ Letter from David Laurent, Chief Operating Officer for
Andover Brokerage, LLC, to K. Lee Blalack, II, Chief Counsel & Staff
Director for the Subcommittee, Nov. 15, 1999, at 1999, at 3 (Feb. Hr'g
Ex. 24).
---------------------------------------------------------------------------
Another troubling finding of this investigation was that
many day trading firms have accepted customers whose stated
financial condition and/or investment objectives were
inconsistent with their firms' internal policies regarding the
opening of high risk, day trading accounts. Indeed, contrary to
their own policies, many day trading firms have often failed to
gather the information about their prospective customers that
is necessary to determine whether those customers are suitable
for day trading. Even more disturbing, some day trading firms
do not maintain minimum financial requirements to open a day
trading account. Thus, the Subcommittee discovered that some
day trading firms have recently lowered their minimum financial
requirements to compete with these firms that have no or very
low thresholds for account opening. In doing so, the firms are
now accepting customers that they formerly considered
unsuitable.
The Subcommittee also found significant evidence that day
trading firms allow and, sometimes even encourage, their
clients to trade beyond their means. For instance, the
Subcommittee uncovered circumstances where customers had their
accounts closed for failure to meet margin calls and were
assisted by registered personnel in establishing a second
account under a fictitious name to allow the customer to
continue trading. There was also disturbing evidence that day
trading firms systematically encourage customers to obtain
short-term loans from other customers for the purpose of
satisfying margin calls. In most instances, the evidence
indicates that the borrowing and lending customers did not know
one another and did not communicate during the lending process.
In fact, the day trading firms directed all ministerial and
clerical functions pertaining to the servicing of these margin
loans and apparently set their terms.
There was also evidence that day trading firms are poorly
managed and supervised. As an initial matter, the Subcommittee
found numerous examples where day trading firms hired personnel
to serve as branch managers of their satellite offices who had
little brokerage or managerial experience. The investigation
also indicated that the firms then provided those branch
managers little training followed by very poor supervision. As
a result, it should not be surprising that the Subcommittee
found that day trading customers often complained about the
poor training that they received and the all to frequent
malfunctions in the trading software offered by the firms. In
short, there was overwhelming evidence that these firms, and
especially their branch offices, were poorly managed and
supervised.
In the case studies that follow pertaining to All-Tech,
Providential and Momentum, the Subcommittee details the
testimonial and documentary evidence collected over the last
eight months of investigation to support the findings set forth
above. The Subcommittee believes that these case studies
provide a comprehensive factual record to justify the adoption
of the suggested reforms that are explained at the end of this
Subcommittee Report.
III. CASE STUDY: ALL-TECH DIRECT, INC.
A. Background of All-Tech Direct, Inc.
(1) Founding of All-Tech. All-Tech Direct, Inc. (``All-Tech
or the ``firm'') \279\ is a day trading firm that evolved on
the heels of the stock market crash of 1987.\280\ Because of
the market crash, Harvey Houtkin and his brother-in-law, Mark
Shefts, closed the doors of Domestic Arbitrage Group, Inc.
(``Domestic''), a broker-dealer they had been running since
approximately 1979.\281\ Messrs. Houtkin and Shefts voluntarily
closed the firm and withdrew from the NASD because they did not
possess sufficient capital and would have been operating in
violation of net capital rules if they had not closed.\282\
Although they had no trading capital after the liquidation of
Domestic, Messrs. Houtkin and Shefts did have office space and
equipment.\283\ Mr. Houtkin said that ``the only thing that
wasn't there were the people.'' \284\ In an effort to rebuild
their business, they took over a small broker-dealer that a
friend of Mr. Houtkin's was planning to close, because they
wanted a corporate entity without contingent liabilities.\285\
In approximately January 1988, Mr. Shefts purchased the
brokerage firm called C.L. Dichter & Company.\286\ He opened
the new firm under the name ``All-State Investment Group''
(``All-State''), and he was the only registered principal of
the firm.\287\
---------------------------------------------------------------------------
\279\ References to All-Tech (or the ``firm'') include each of All-
Tech's predecessor firms including Allstate Investment Group, All-Tech
Investment Group, Inc., Attain Direct, Inc. and All-Tech Director, Inc.
In addition, unless separately identified, All-Tech Training Group,
Inc. and its predecessor Rushmore Financial Services, Inc.
(``Rushmore'') will be collectively referred to as ``All-Tech.''Even
though All-Tech Training Group is not registered as a broker-dealer and
is a separate company from All-Tech, all of the All-Tech officers are
also officers of All-Tech Training Group, Inc. Interview with Mark
Shefts, Dec. 6, 1999, at 4 (``Shefts Inc.''). The common officers to
both companies are Harvey Houtkin, Mark Shefts and Linda Lerner. In
addition, Bob Varsalona, the Controller of All-Tech, is an officer of
All-Tech Training Group. Id.
\280\ Houtkin Dep. at 29-31.
\281\ Id. at 21-28.
\282\ Mark Shefts Int. at 1.
\283\ Houtkin Dep. at 29.
\284\ Id.
\285\ Id. at 29-30, 40-41.
\286\ Shefts Int. at 2.
\287\ Houtkin Dep. at 30, 42.
---------------------------------------------------------------------------
According to Mr. Houtkin, the birth of All-State, which
later evolved into All-Tech, represented the dawn of the
``electronic trading revolution.'' \288\ Initially, Mr. Houtkin
did not register with All-State, but simply used the firm to
day trade through SOES, Nasdaq's ``Small Order Execution
System.'' \289\ The firm grew as other traders started coming
to All-Tech to trade.\290\ Before accepting these new traders,
Messrs. Shefts and Houtkin required them to obtain
training.\291\ All-Tech first offered its training program
through its holding company, Rushmore, and then later through
an affiliate All-Tech Training Group, Inc.\292\
---------------------------------------------------------------------------
\288\ Id. at 30-31.
\289\ Id. at 31, 34. At the time Mr. Houtkin started trading
through SOES, the NASD Rules would not have permitted him to do so as a
principal of the firm (in a firm account). Id. at 45. Mr. Shefts told
Subcommittee staff that he and Mr. Houtkin were permitted to use the
SOES system once they were no longer a part of the securities industry.
Shefts Int. at 2. Mr. Houtkin denied acting as a customer rather than
an owner of the firm as a way to get around the rules. Houtkin Dep. at
45. Mr. Houtkin called it pure ``coincidence'' that he opted not to
register as a principal of the firm and, therefore, could freely trade
through SOES. Id. at 45-47.
\290\ Shefts Int. at 2.
\291\ Id.
\292\ Id.
---------------------------------------------------------------------------
Mr. Houtkin and his traders used SOES as an instrument to
compel market makers to honor quoted prices of stocks. He soon
became known as the ``SOES Bandit,'' a nickname that Mr.
Houtkin claims he never liked but also did not contest since it
gave him and the other ``bandits'' a ``Robin Hood-like image.''
\293\ So-called SOES bandits, including Mr. Houtkin, challenged
the established securities industry and the regulators to gain
what they perceived as fair access to the securities markets
for themselves and the average investor. All-Tech claims that
its initiative in March 1988 to use SOES to execute client
orders helped to create ``Electronic Day Trading'' on Wall
Street.\294\ Mr. Houtkin's crusade included filing suit against
the SEC to contest certain SOES rules \295\ and attempting to
narrow spreads (i.e., the difference between the inside bid and
inside offer) on Nasdaq securities.\296\
---------------------------------------------------------------------------
\293\ Houtkin, et al., Secrets of the SOES Bandit, at 177.
\294\ ``All-Tech Direct--Daytrading through the Attain ECN,''
www.attain.com/about/history.cfm, Jan. 5, 2000.
\295\ Houtkin, Secrets of the SOES Bandit, at 174-75.
\296\ ``All-Tech Direct--Daytrading through the Attain ECN,''
www.attain.com/about/history.cfm, Jan. 5, 2000.
---------------------------------------------------------------------------
In what appears to be an All-Tech marketing document
touting All-Tech's Attain computer system, Mr. Houtkin
explained his crusade as follows:
After eight years of fighting with market makers,
regulators and the established financial community and
spending millions of dollars on legal fees, I am proud
to say we have finally been instrumental in creating an
environment where the average person can now compete on
a level playing field with the market professionals.
\297\
---------------------------------------------------------------------------
\297\ Generic letter from Harvey Houtkin, undated, bates number
4071 (Feb. Hr'g Ex. 25).
Mr. Houtkin and All-Tech were some of the first challengers to
the traditional market maker structure of the Nasdaq. Indeed,
the evidence suggests that, in the early 1990s, Mr. Houtkin and
All-Tech contributed positively to the Department of Justice's
(``DOJ'') efforts to break up the price-fixing schemes of
certain Nasdaq market makers. Mr. Houtkin and All-Tech were
also instrumental in helping ordinary investors gain access to
the same technology and information available to sophisticated
traders on Wall Street.
(2) All-Tech Today. According to All-Tech's website, the
firm currently has twenty-three offices across the country,
including its main office in Montvale, New Jersey (the ``main
office''). \298\ All-Tech has expanded rapidly in the 1990s
through the opening of branch offices across the nation. Each
branch office is managed by one or more All-Tech employees who
have paid an initial fee to open the office. \299\ A ``Branch
Office Management Agreement'' between All-Tech and the branch
manager sets for the duties and responsibilities of the branch
and home offices. \300\ In general, the branch offices pay the
main office a fee for every trade executed by their customers,
which ranges from $12.50 to $15.00 per trade. \301\ The
remaining commission paid by the customer covers overhead
expenses with the balance used as revenue for the branch
managers' gross payroll. \302\
---------------------------------------------------------------------------
\298\ All-Tech Direct--Daytrading through the Attain ECN,''
www.attain.com/about/branches.cfm, Jan. 5, 2000.
\299\ All-Tech's fees have varied between $50,000 and $100,000 per
office. Branch Office Management Agreement between All-Tech, Frederick
M. Benson and David Niederkrome, May 8, 1998, at ``Rider'' (``Portland
Branch Agreement''); Branch Office Management Agreement between All-
Tech and David Niederkrome, Feb. 1, 1997, at ``Rider'' (``Seattle
Branch Agreement''); Branch Office Management between All-Tech and Fred
Zayas, Dec. 6, 1996, at 5 (``Watertown Branch Agreement''); Branch
Office Management Agreement between All-Tech, Barry Parish and Rogert
Luecke, Nov. 11, 1996, at 5 (``San Diego Branch Agreement'').
\300\ See. e.g., Portland Branch Agreement; Seattle Branch
Agreement; Watertown Branch Agreement; and, San Diego Branch Agreement.
\301\ Portland Branch Agreement, at 4; Seattle Branch Agreement, at
4; Watertown Branch Agreement, at 4; San Diego Branch Agreement, at 4.
Mr. Shefts and former San Diego Branch Manager, Barry Parish, stated
that the fee is $12.50. Shefts Int. at 5; Parish Dep. at 35.
\302\ Shefts Int. at 5.
---------------------------------------------------------------------------
Between January 1, 1998 and November 12, 1999, the firm
opened 1,421 customer accounts. \303\ For the first quarter of
Fiscal Year 1999, All-Tech had gross revenues of $9,176,000 and
net income of $1,009,800. \304\ For Fiscal Year 1998, the firm
had $18,295,849 in gross revenues and $492,863 in net income.
\305\ For Fiscal Year 1997, the firm had $16,063,816 in gross
revenues and $937,436 in net income. \306\ In 1998 alone, Mr.
Houtkin's total compensation from All-Tech was approximately
$919,231, and Mr. Shefts' compensation for that year was
$943,363. \307\
---------------------------------------------------------------------------
\303\ Letter from Stephanie Rosenblatt, Counsel for All-Tech, to K.
Lee Blalack, II, Chief Counsel & Staff Director for the Subcommittee
and Linda J. Gustitus, Minority Chief Counsel and Staff Director for
the Subcommittee, Nov. 12, 1999, at 1 (``All-Tech Letter, Nov. 12,
1999'') (Feb. Hr'g Ex. 26).
\304\ Letter from Stephanie Rosenblatt, Counsel for All-Tech, to K.
Lee Blalack, II, Chief Counsel & Staff Director for the Subcommittee,
and Linda J. Gustitus, Minority Chief Counsel and Staff Director for
the Subcommittee, Jan. 20, 2000, at 1 (``All-Tech Letter, Jan. 20,
2000'') (Feb. Hr'g Ex. 27).
\305\ Id.
\306\ Id.
\307\ Houtkin Dep. at 81-82.
---------------------------------------------------------------------------
All-Tech is headed by Mr. Houtkin, who serves as Chairman
and Chief Executive Officer, and Mr. Shefts, who is the
President, Chief Operating Officer and Chief Financial Officer.
\308\ From the time he became a principal of All-Tech until
March 1999, Mr. Houtkin served as the Chief Compliance Officer
for the firm. \309\ In March 1999, All-Tech replaced Mr.
Houtkin with Franklin Ogele who currently serves as the firm's
Chief Compliance Officer and Associate General Counsel. \310\
---------------------------------------------------------------------------
\308\ All Tech Investment Group Corporate Organization Chart, Aug.
16, 1999 (Feb. Hr'g Ex. 28).
\309\ Houtkin Dep. at 79.
\310\ Shefts Int. at 6; Houtkin Dep. at 79; Ex. 28.
---------------------------------------------------------------------------
Both Messrs. Houtkin and Shefts have several disclosable
incidents on their CRDs, including actions by regulators. \311\
For example, most recently, the Securities Division of the
Commonwealth of Massachusetts filed an administrative action
alleging, among other things, that All-Tech, Messrs. Houtkin,
Shefts and Harry Lefkowitz \312\ failed to supervise the
operation of their Watertown, Massachusetts Branch Office, then
managed by Fred Zayas. \313\ All-Tech settled the matter in May
1999.
---------------------------------------------------------------------------
\311\ Harvey I. Houtkin CRD #251066 (``Houtkin CRD'') (Feb. Hr'g.
Ex. 29); Mark David Shefts CRD #709147 (``Shefts CRD'') (Feb. Hr'g Ex.
30).
\312\ Mr. Lefkowitz is the firm's Senior Vice President of
Operations. Feb. Hr'g Ex. 28.
\313\ Feb. Hr'g Ex. 29; Feb. Hr'g Ex. 30. This enforcement action
will be discussed in detail in section E, 2.
---------------------------------------------------------------------------
In 1990, the New Jersey Bureau of Securities (``New Jersey
Bureau'') settled an action it had initiated against All-Tech
and Mr. Shefts, alleging that Mr. Shefts failed to supervise
Mr. Houtkin on behalf of All-Tech and permitted Mr. Houtkin to
act as an unregistered agent and undisclosed principal of the
firm. \314\ In 1990, the New Jersey Bureau also settled a
related action it had initiated against Domestic and Mr.
Houtkin, alleging that Domestic had filed a false and
misleading application for registration as a broker-
dealer.\315\ In his Subcommittee deposition, Mr. Houtkin
claimed that the New Jersey action ``was a smear campaign
against Harvey Houtkin to prevent me from putting forward
direct access. * * *'' \316\
---------------------------------------------------------------------------
\314\ In re: All-Tech Investment Group, Inc. and Mark Sheets [sic],
1990 N.J. Sec. LEXIS 171, No Number (June 25, 1990), at *1 (Feb. Hr'g
Ex. 31). Mr. Shefts and All-Tech neither admitted nor denied the
allegations. Id. The terms of the settlement included, among other
things, that All-Tech would withdraw its registration as a broker-
dealer in New Jersey and would not reapply for registration for three
years. Id. at *2. In addition, Mr. Shefts agreed that he would not
apply for registration or act as an agent, broker-dealer, investment
adviser, or issuer in New Jersey or act as a principal of a broker-
dealer registered in New Jersey for three years. Id.
\315\ In re: Domestic Securities, Incorporated, 1989 N.J. Sec.
LEXIS 404, No Number, at *4 (Apr. 25, 1989) (Feb. Hr'g Ex. 32). Mr.
Houtkin was apparently added as a respondent in order to resolve the
matter In re: Domestic Securities, Incorporate and Harvey I. Houtkin,
1990 N.J. Sec. LEXIS 170, OAL Docket No. BOS 03957-89, at *1 (June 26,
1990) (Feb. Hr'g Ex. 33). Domestic and Mr. Houtkin neither admitted nor
denied the allegations but agreed, among other things, that Domestic
would pay $50,000 to the New Jersey Bureau as reimbursement for the
costs and expenses of the investigation; that Domestic would withdraw
its broker-dealer registration application and not reapply for three
years; and that, Mr. Houtkin would not apply for registration or act as
an agent, broker-dealer, investment adviser or issuer in New Jersey or
as a principal in a broker-dealer registered in New Jersey for three
years. Id. at *2-*3.
\316\ Houtkin Dep. at 131-32.
---------------------------------------------------------------------------
In July 1989, the NASD District Business Conduct Committee
alleged that Mr. Houtkin violated the NASD's Rules of Fair
Practice. According to Mr. Houtkin's CRD, most of the charges
were dismissed on appeal, but Mr. Houtkin and his firm had to
pay $1,000 plus costs for violating certain record keeping
requirements. \317\ In January 1989, Mr. Shefts was censured
and fined $10,000 for violation of the NASD Rules of Fair
Practice. \318\ In 1985, the NASD District Business Conduct
Committee alleged that Mr. Houtkin had violated the NASD's
Rules of Practice regarding his participation in SOES. \319\
The NASD found Mr. Houtkin guilty and fined him $2,000, and
assessed costs against him of $400. \320\
---------------------------------------------------------------------------
\317\ Feb. Hr'g Ex. 29.
\318\ Feb. Hr'g Ex. 30.
\319\ Feb. Hr'g Ex. 29.
\320\ Id.
---------------------------------------------------------------------------
When All-Tech sought to open a branch office in Florida in
1993, the Division of Securities of the Florida Department of
Banking and Finance (``Division'') agreed to approve the
application for registration only under certain conditions.
\321\ Among other things, the Division required All-Tech and
Mr. Shefts to agree that Mr. Shefts would be All-Tech's
registered principal and that Mr. Houtkin would not have any
involvement ``in the trading, purchase, or sale of securities
prior to the registration of Mr. Houtkin as an associated
person in Florida.'' \322\
---------------------------------------------------------------------------
\321\ Re: Approval of the pending application for registration of
All-Tech, 1993 Fla. Sec. LEXIS 49. Admin. No. 93.471.DOS (Dec. 7, 1993)
(Feb. Hr'g Ex. 34).
\322\ Id. at 4.
---------------------------------------------------------------------------
Mr. Houtkin testified that all of these regulatory actions
against him and All-Tech were based on either unfounded or
exaggerated charges. \323\ Mr. Houtkin cited no credible
evidence of collusion by state regulators and the NASD, nor did
the Subcommittee's investigation uncover any such evidence.
When asked at his deposition whether he believed that the state
securities regulators in New Jersey, Florida and Massachusetts
were part of an outright conspiracy with the NASD and its
member firms to undermine All-Tech and day trading, Mr. Houtkin
stated that he did not ``believe they got in a room, but [he
did] believe they have all too much contact. It's very
incestuous. All regulation is incestuous.'' \324\ He added to
this sentiment at the Subcommittee's hearing on February 25,
2000, when he stated, ``* * * if you are looking to regulate
and close down this type of activity, let me tell you there
will not be a business left in this country.'' \325\
---------------------------------------------------------------------------
\323\ Houtkin Dep. at 127-45.
\324\ Id. at 150.
\325\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
---------------------------------------------------------------------------
B. All-Tech Allowed Unsuitable Customers to Day Trade
All-Tech has failed to consistently and vigilantly apply
its own guidelines concerning the opening of day trading
accounts, and All-Tech management has failed to communicate
those guidelines to the branch offices where many of the
accounts were held. In addition, All-Tech recently lowered the
minimum amount of capital required to open a day trading
account to $25,000, even though Mr. Houtkin admits that
``$50,000 is a limiting minimum.'' \326\ Thus, All-Tech is now
opening accounts for new day traders that Mr. Houtkin
considered unsuitable just one year ago. Mr. Houtkin was asked
by Senator Levin about this discrepancy at the Subcommittee's
hearing on February 25, 2000.
---------------------------------------------------------------------------
\326\ Houtkin, Secrets of the SOES Bandit, at 42.
Q: But is it not fair to say that even though you
believed that $50,000 was the minimum for successful
day trading, you lowered yours to $25,000 in order to
meet the competition? Is that a fair statement?
A: My personal opinion in the book, it was written by
myself, I believe $50,000 would be an appropriate
minimum. There are other people in the firm and we have
other contributing opinions into what we had to do to
maintain a competitive business. It was not just my
decision to drop it. It was a decision of----
Q: Your firm.
A: Of the firm.
Q: Are you not CEO of this firm?
A: Yes, but I am not a dictator.
Q: You may or not be that, but you are the CEO of a
firm.
A: Yes, I am.
Q: And that firm has now got a minimum lower than
what its CEO said was a minimum needed for successful
day trading. That is, I believe, a fact. And you can
say you have done that in order to meet what your
competitors are doing. That is well and good, but you
are also then taking people and their money and you're
doing it, although you believe the $25,000 is less than
what is a minimum necessary for them to be successful.
* * * \327\
---------------------------------------------------------------------------
\327\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
(1) All-Tech Employees Did Not Know or Did Not Apply the
Minimum Standards for Opening New Accounts. In response to
Subcommittee interrogatories, All-Tech stated that, in order to
open a day trading account, a potential customer must have a
minimum net worth of $100,000 and $25,000 in risk capital.\328\
In addition, the $25,000 initial deposit may not exceed ``75%
of net worth for individuals, 50% of net worth for married
persons, and 25% of net worth for persons with dependents.''
\329\ All-Tech implemented the net worth standard in
approximately 1997,\330\ prior to which there were no written
minimum standards for opening new accounts.\331\
---------------------------------------------------------------------------
\328\ Feb. Hr'g Ex. 26.
\329\ Id.
\330\ Id.
\331\ Interview of Harry Lefkowitz, Dec. 6, 1999, at 2 (``Lefkowitz
Int.'').
---------------------------------------------------------------------------
Even now there seems to be uncertainty among All-Tech
employees concerning what the minimum standards are for opening
new accounts. Mr. Lefkowitz told Subcommittee staff that, in
addition to a minimum net worth of $100,000, a customer must
have an income of $50,000 to open a day trading account.\332\
All-Tech's written response to the Subcommittee's
interrogatories made no reference to a minimum income standard.
To add to the confusion, Lisa Esposito, who works for Mr.
Lefkowitz, stated that, at one point, the minimum net worth
required to open a new day trading account was $150,000.\333\
---------------------------------------------------------------------------
\332\ Id. Until Mr. Ogele joined the firm in March 1999, Mr.
Lefkowitz was responsible for opening new accounts at All-Tech. Id.
\333\ Deposition of Lisa Esposito, Nov. 29, 1999, at 49 (``Esposito
Dep.''). Ms. Esposito was Mr. Lefkowitz's assistant in 1996 or 1997,
and was responsible for ensuring that new account forms were filled out
properly before passing them along to Mr. Lefkowitz for final approval.
Id. at 46-47. Ms. Esposito is currently a supervisor in the Margins
Department, and although she only recently obtained that title, Ms.
Esposito has been the director of the Margins Department for the past
two years. Lefkowitz Int. at 2. According to Ms. Esposito, her
supervisors are Messrs. Shefts, Lefkowitz and Houtkin. Esposito Dep. at
33.
---------------------------------------------------------------------------
This lack of uniformity concerning both the existence of
standards and the nature of the standards appears to have been
pervasive at All-Tech's branch offices as well. The ``Branch
Procedures'' section of the All-Tech Branch Office Manual
states that, in opening a new account, the branch office must
ensure that ``[n]ew account information is complete'' and
determine the ``[s]uitability of [the] client.'' \334\ However,
the former Branch Manager of All-Tech's San Diego office, Barry
Parish, testified that the main office did not discuss minimum
net worth or minimum income requirements with him.\335\ As far
as Mr. Parish was concerned, a customer was suitable to day
trade so long as he or she had $50,000 to open a day trading
account.\336\ Mr. Parish testified in his deposition, however,
that in September 1998, All-Tech only required a minimum
deposit of $25,000 to open a day trading account.\337\ Then on
February 24, 2000, Mr. Parish provided testimony before the
Subcommittee further illustrating the minimum standard
confusion. He stated, ``So there was a time it was as little as
$10[,000]. It started at $50[,000]. It went to $25[,000]. It
came down to $10[,000]. And then it went back to $25[,000].''
\338\
---------------------------------------------------------------------------
\334\ All-Tech Branch Office Manual (``Branch Office Manual'')
``Branch Procedures'' at 2 (Feb. Hr'g Ex. 35).
\335\ Parish Dep. at 43.
\336\ Id. at 44. Mr. Parish added the caveat that he would have
considered individual circumstances when determining whether a person
was suitable, but he provided no concrete standards. Id.
\337\ Id. at 70.
\338\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
Frederick Michael Benson, another branch manager for All-
Tech, informed the Subcommittee that there are certain minimum
income and net worth standards for day trading accounts, but
that he did not know what they were.\339\ Sean Strawbridge, who
was a branch manager for the Beaverton, Oregon office between
July 1998 and November 1998, said that he did not pay much
attention to a customer's disclosed income or net worth--
customers simply needed to have $50,000 to open a day trading
account.\340\ Fred Zayas, formerly the branch manager of the
Watertown, Massachusetts office, said that account applications
had to show that a customer possessed between $25,000 and
$50,000 in cash.\341\ Yet, when Mr. Zayas was a branch manager,
All-Tech purportedly required a minimum opening deposit of
$50,000.\342\
---------------------------------------------------------------------------
\339\ Benson Int. at 7 (``Benson Int.''). Mr. Benson is the co-
owner of All-Tech's Beaverton, Oregon and Seattle, Washington offices.
Id. at 2-3. Mr. Benson claims to have no title, id. at 3, although the
branch office management agreement governing the Portland office
designates Mr. Benson and David Niederkrome as the branch managers.
Portland Branch Agreement, at ``Rider'' incorporated by reference. In
addition, Mr. Houkin testified that Mr. Benson is the branch manager of
the Beaverton office and has been since it opened. Houtkin Dep. at 226.
\340\ Telephone Interview of Sean Strawbridge, Dec. 14, 1999, at 3,
5 (``Strawbridge Int.''). Mr. Strawbridge told Subcommittee staff that
he had a verbal partnership agreement with Messrs. Benson and
Niederkrome but that he later realized that they considered him an
employee. Id. at 2.
\341\ Deposition of Fred A. Zayas, Dec. 16, 1999, at 98 (``Zayas
Dep.'').
\342\ Mr. Zayas was employed by All-Tech from April 30, 1996 to
November 20, 1998. Zayas CRD #2816153 at ``Previous Employment'' (Feb.
Hr'g Ex. 36).
---------------------------------------------------------------------------
In some instances, the Subcommittee found that potential
customers filled out new account forms indicating that they had
$50,000 of risk capital even though they opened their accounts
with far less.\343\ Subcommittee staff interviewed a
significant number of former All-Tech customers who also
indicated that they opened accounts with less than the required
$50,000 minimum deposit and, in most instances, those funds
could not be characterized as risk capital.\344\ In fact, Mr.
Shefts stated that he does not care about the source of a
potential customer's capital, so long as the person could
sustain the loss of the funds without it affecting their
lives.\345\
---------------------------------------------------------------------------
\343\ Experienced Customer Letter of Understanding for Carmen
Margala, Sept. 10, 1998 (``Margala Experienced Letter'') (Feb. Hr'g Ex.
37); Customer Letter of Understanding for Yusef Liberzon, Oct. 12, 1998
(``Liberzon Customer Letter'') (Feb. Hr'g Ex. 38).
\344\ Telephone Interview of Georgia Bovee, Nov. 2, 1999, at 1
(``Bovee Int.''): Interview of Fred Cook, Oct. 5, 1998, at 3 (``Cook
Int.''); Interview of Golina Gogenko, Nov. 10, 1999, at 1 (``Gogenko
Int.''); Interview of Carmen Margala, Oct. 6, 1999, at 3 (``Margala
Int.'').
\345\ Shefts Int. at 9.
---------------------------------------------------------------------------
All-Tech employees also told Subcommittee staff that it
would be inappropriate for a person whose account objective was
anything other than, ``short term growth with high risk,'' to
open a day trading account.\346\ All-Tech, however, has opened
accounts for customers who indicated on their new account forms
that their objectives were other than high risk. For example,
former San Diego customer Carmen Margala initially indicated on
her new account form that her investment objectives were
``income'' as well as ``short term growth with high risk.''
\347\ Within the securities industry, these two objectives are
commonly understood to be at odds with each other. Ms.
Margala's new account form also indicates that the check mark
next to ``income'' was crossed out at some point.\348\ At his
Subcommittee deposition, Mr. Parish testified that it is very
possible that Ms. Margala checked the box and then crossed it
out after he told her that income could not be her objective if
she wanted to be a day trader.\349\ The Subcommittee reviewed
over 300 new account forms for All-Tech day trading accounts
that contained objectives other than, or in addition to,
``short term growth, with high risk.''
---------------------------------------------------------------------------
\346\ Interview of Franklin Ogele, Dec. 1, 1999, at 2 (``Ogele
Int.''); Esposito Dep. at 49; Parish Dep. at 43-44.
\347\ New Account Approval-B for Carmen Margala, Sept. 11, 1998
(``Margala New Account Form'') (Feb. Hr'g Ex. 39).
\348\ Id.
\349\ Parish Dep. at 79-80.
---------------------------------------------------------------------------
All-Tech willingly accepts customers who are totally
unsophisticated concerning the markets and have no previous
experience investing, other than perhaps through a full-service
brokerage firm. In fact, All-Tech actively markets itself to
unsophisticated investors. For example, the following All-Tech
document called ``Frequently Asked Questions'' makes clear that
the firm considers prior investment experience to be a
hindrance to successful day trading:
5. Do I have to know anything about the stock market?
NO! As a matter of fact, in many instances, the less
you know means the less baggage you have to discard
when learning the new trading techniques that we
teach.\350\
---------------------------------------------------------------------------
\350\ ``Frequently Asked Questions,'' at 2 (Feb. Hr'g Ex. 40). Mr.
Houtkin testified that he believed this document was previously on All-
Tech's website and was prepared by an All-Tech employee who handles
advertising. Houtkin Dep. at 252-53. Mr. Houtkin was uncertain whether
the document was still on the website. Id.
Mr. Parish testified that prior trading experience was not
a prerequisite to opening a day trading account.\351\ Rather,
the firm will teach the customer how to day trade.\352\ All-
Tech does not require new customers to take its training
course, however, so long as they complete a form stating that
they have prior experience.\353\ For example, Mr. Parish did
not insist that Carmen Margala take All-Tech's training course,
even though Ms. Margala told Mr. Parish that she had never
heard of day trading before.\354\ According to Ms. Margala, Mr.
Parish recommended that she take the course, but when she opted
not to do so, Mr. Parish simply provided her with a packet of
forms to complete.\355\ Mr. Parish did so even though Ms.
Margala, as she testified to the Subcommittee on February 24,
2000, was not employed and had no income.\356\ The forms
included an ``Experienced Customer Letter of Understanding,''
which represents that the customer has ``more than one year of
experience in active short-term trading of OTC securities.''
\357\ Ms. Margala signed the All-Tech form even though her past
experience in the securities markets consisted of equity
investments in a Quick & Reilly account and owning some shares
of a mutual fund.\358\ Additionally, Ms. Margala told
Subcommittee staff that Mr. Parish asked her to complete an
additional form that asked for her understanding of certain
terms, such as ``market makers,'' ``crossed markets,'' and
``hedges.'' \359\ Ms. Margala said she had no idea what the
terms meant, and that Mr. Parish never commented on her lack of
knowledge; nor did he ever explain to her the meanings of the
terms.\360\ At the Subcommittee's hearing in February, Ms.
Margala testified, ``Mr. Parish nor anyone else ever discussed
risk or my tolerance for risk, my background, goals, or
objectives, past experiences, my financial position, or
anything else other than how much money I could deposit in the
All-Tech account.'' \361\
---------------------------------------------------------------------------
\351\ Parish Dep. at 44.
\352\ Id.
\353\ Shefts Int. at 5.
\354\ Margala Int. at 2. Ms. Margala lost approximately $45,000 day
trading as an All-Tech customer between September 1998 and January
1999. Id. at 1. At the time Ms. Margala opened her account at All-Tech,
she had no income that year, and her income from the previous year was
approximately $20,000. Id. She had heard about All-Tech through a
television advertisement that Mr. Parish wrote and produced, Parish
Dep. at 161, and her impression was that All-Tech might be a good
opportunity to start a new career and make a lot of money. Margala Int.
at 2.
\355\ Margala Int. at 2.
\356\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
\357\ Feb. Hr'g Ex. 37.
\358\ Margala Int. at 1.
\359\ Id. at 2; All-Tech ``Experience Trader Qualification,''
undated (Feb. Hr'g Ex. 41).
\360\ Margala Int. at 2.
\361\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
---------------------------------------------------------------------------
Subcommittee staff interviewed various All-Tech customers
who were clearly unsuitable for day trading based on All-Tech's
own internal standards. These customers lost significant
amounts of money day trading at All-Tech. For example, All-Tech
allowed Ms. Margala to open a day trading account with an
initial deposit of only $20,000,\362\ $10,000 of which she
obtained through the sale of stock given to her by her
parents.\363\ At the time Ms. Margala opened her account, the
All-Tech minimum requirement was $50,000. As noted above,
however, the branch manager of the San Diego office, Mr.
Parish, testified that he was not aware of that $50,000 minimum
but understood the required minimum deposit to be only
$25,000.\364\
---------------------------------------------------------------------------
\362\ Feb. Hr'g Ex. 39; Margala Int. at 3.
\363\ Margala Int. at 3.
\364\ Parish Dep. at 70.
---------------------------------------------------------------------------
In addition, Georgia Bovee lost about $22,000 day trading
in the Beaverton, Oregon All-Tech office.\365\ Even though the
minimum capital for account opening at the time was $50,000,
Ms. Bovee told Subcommittee staff that All-Tech personnel
advised her that she could open the account with $40,000.\366\
Ms. Bovee eventually opened her account with between $38,000
and $40,000 and was permitted to day trade just like any
customer who had the requisite minimum.\367\ Mr. Benson, the
branch manager, told Subcommittee staff that he knew Ms. Bovee
had less than the $50,000 minimum deposit.\368\ Mr. Benson
explained that Ms. Bovee was determined to open an account at
All-Tech so he allowed her to do so.\369\ However, Ms. Bovee's
new account form makes clear that Mr. Benson knew that Ms.
Bovee was not funding her day trading account with risk
capital. Ms. Bovee wrote a notation on the bottom of the new
account form that said, ``Please draw $1,500.00 from my Visa
account # [number provided on form] Expiration date 10/00, and
put into my day trading account.'' \370\
---------------------------------------------------------------------------
\365\ Bovee Int. at 1.
\366\ Id.
\367\ Id.
\368\ Benson Int. at 4-5. He estimated that Ms. Bovee funded her
account with $42,000. Id. at 5.
\369\ Id. at 5.
\370\ New Account Approval-B for Georgia Sweet Bovee, July 13, 1998
(``Bovee New Account Form'') (Feb. Hr'g Ex. 42).
---------------------------------------------------------------------------
Ms. Bovee claims that she attempted to use her Visa credit
card on two separate occasions to fund her day trading
activities.\371\ Ms. Bovee said that, on one occasion, All-Tech
processed the request and, on the second occasion, Ms. Esposito
informed Ms. Bovee that All-Tech would not permit her to use
funds from a credit card for day trading.\372\ Mr. Benson
stated that there was no way for him to know whether she used a
credit card to fund the account.\373\ Ms. Esposito testified
that she could not remember ever taking $1,500 from a credit
card to fund a new account.\374\ Ms. Esposito admitted,
however, that she had customers who opened accounts with less
than $50,000.\375\ She said that Mr. Lefkowitz, Mr. Shefts or
Linda Lerner retained final authority to open new accounts
below the minimum requirements.\376\
---------------------------------------------------------------------------
\371\ Bovee Int. at 1-2.
\372\ Id. at 2.
\373\ Benson Int. at 5.
\374\ Esposito Dep. at 97-98.
\375\ Id. at 99.
\376\ Id. Ms. Lerner is All-Tech's General Counsel. Feb. Hr'g Ex.
28.
---------------------------------------------------------------------------
Subcommittee staff interviewed the spouses of three victims
of Mark Barton's shooting rampage at All-Tech's Atlanta office,
all of whom lost money day trading at All-Tech. Yusef Liberzon,
who was shot in the head by Mark Barton, opened his day trading
account with the family's ``life savings'' of about $25,000,
according to his wife, Golina Gogenko.\377\ Mr. Liberzon's new
account form indicates that he opened his day trading account
in October 1998, when All-Tech's policy required a minimum
deposit of $50,000 of risk capital.\378\ Ms. Gogenko stated
that she is a cosmetologist with an income of $25,000 per year
and that her husband, an immigrant from the Ukraine, previously
drove a taxi cab and earned about $30,000 per year.\379\ Mr.
Liberzon lost about $9,000 at All-Tech before he was shot by
Mark Barton.\380\
---------------------------------------------------------------------------
\377\ Interview of Golina Gogenko, Nov. 10, 1999, at 2 (``Gogenko
Int.''). According to Ms. Gogenko, Mr. Liberzon can no longer speak due
to his severe injuries. Id.
\378\ New Account Approval-B Form for Yusef Liberzon, Oct. 12, 1998
(``Liberzon New Account Form'') (Feb. Hr'g Ex. 43). The earliest
account statement that Ms. Gogenko provided to the Subcommittee is for
the period February 26, 1999 to March 26, 1999. The Subcommittee is
unclear as to when Mr. Liberzon actually commenced day trading with
All-Tech.
\379\ Gogenko Int. at 2.
\380\ Id.
---------------------------------------------------------------------------
Subcommittee staff also interviewed Gulshan Harjee, whose
husband, Dean Delawalla, was killed by Mark Barton. Ms. Harjee
has learned since her husband's death that the funds he used
for day trading derived from his retirement fund, their
children's trust funds, and a construction loan that he
obtained to build their new home.\381\ Similarly, Jamshid
Havash, who was killed by Barton, lost about $10,000 day
trading at All-Tech's Atlanta Office.\382\ Mr. Havash
apparently funded his day trading account of $75,000 with a
$130,000 loan that he allegedly obtained at the ``urging of
All-Tech'' employees in Atlanta.\383\
---------------------------------------------------------------------------
\381\ Interview of Gulshan Harjee, Nov. 10, 1999, at 2 (``Harjee
Int.'').
\382\ Interview of Roira Masta, Nov. 10, 1999, at 1 (``Masta
Int.'').
\383\ Id.
---------------------------------------------------------------------------
As this evidence indicates, the Subcommittee's
investigation found that All-Tech personnel, even senior
management, did not have a clear and consistent understanding
of All-Tech's account opening standards for new traders. The
evidence shows that this confusion was particularly acute among
branch office personnel. Consequently, it should not be
surprising that All-Tech frequently opened accounts for new
customers who did not provide the financial information
necessary to evaluate their suitability for day trading or,
even worse, disclosed financial information that did not
satisfy All-Tech's minimum standards.
(2) All-Tech Employees Altered New Account Forms. All-Tech
employees sometimes changed information on new account forms
that were incomplete or disclosed financial information that
was below All-Tech's minimum standards for opening new day
trading accounts. Mr. Zayas, the former branch manager for All-
Tech's Watertown, Massachusetts office, testified under oath at
a Subcommittee deposition that Ms. Esposito instructed him to
change numbers on the new account forms to make customers
appear more suitable for day trading.\384\ When asked whether
he changed the numbers as instructed by Ms. Esposito, Mr. Zayas
refused to answer the question, asserting his Fifth Amendment
right against self-incrimination.\385\ But when posed the same
question at the Subcommittee's hearing on February 24, 2000,
Mr. Zayas conceded, ``Yes.'' \386\
---------------------------------------------------------------------------
\384\ Zayas Dep. at 103.
\385\ Id.
\386\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
Ms. Esposito testified that, during the time period when
she was helping to open new accounts, her job was to review new
account forms for completeness and to ensure that the figures
listed on the forms satisfied All-Tech's internal
standards.\387\ She would then pass the forms along to Mr.
Lefkowitz for final review and approval.\388\ According to Ms.
Esposito, there were occasions when she received new account
forms that were missing necessary information or the
information supplied did not meet All-Tech's minimum
criteria.\389\ Ms. Esposito said that, on such occasions, she
would speak with the branch manager or the customer concerning
the missing or insufficient information.\390\ Ms. Esposito
testified that, in some cases, she would change the information
on the form or insert the missing information.\391\ Ms.
Esposito testified that, in other cases, the branch manager
would change the information on the form.\392\
---------------------------------------------------------------------------
\387\ Esposito Dep. at 47.
\388\ Id.
\389\ Id. at 50. Ms. Esposito stated that the standards she applied
were $150,000 in net worth, $50,000 of income, and a stated investment
objective of ``short-term growth with high risk.'' Id. at 49.
\390\ Id. at 53.
\391\ Id. at 51-53.
\392\ Id. at 51-52.
---------------------------------------------------------------------------
Ms. Esposito claimed that she never changed or inserted any
information on new account forms without first speaking with
either the customer or the branch manager, whom she told to
speak with the customer.\393\ The reason for speaking with the
customer was purportedly to determine whether the information,
which was missing or did not meet the standards, was
accurate.\394\ Ms. Esposito testified that she would tell the
branch managers, ``that if the customer didn't meet these
criteria, [she] couldn't open [the account].'' \395\ At her
Subcommittee deposition, Ms. Esposito explained the procedure
as follows:
---------------------------------------------------------------------------
\393\ Id. at 53-55, 68-69.
\394\ Id. at 51-52.
\395\ Id. at 51.
Q: Was there ever a time when you saw a new account
form that didn't meet the standards and you told the
branch manager that the numbers needed to be changed?
A: I told them that the numbers are too low and I
can't open accounts according to the numbers. They knew
what my criteria was, that it had to be 50,000 or 150.
So they in turn would--I mean, I would gather they went
to the customer, and then if they called me back and
said the numbers are wrong, he makes 100,000 a year and
his net worth is 300,000, then I would change it or fax
it to him. He'd change it, initial it. Either way, he'd
have to initial that he knew the change was going or
the customer would have to sign a new form, a change
form, and sign off on the new information.\396\
---------------------------------------------------------------------------
\396\ Id. at 51-52.
Yet, Ms. Esposito stated that there were two instances
when, after speaking with the customers, she inserted numbers
into the net worth column of the new account forms that she
believed were false.\397\ Ms. Esposito claimed that, in both
instances, she informed either Mr. Lefkowitz or Ms. Lerner that
she did not believe the customers were suitable for day
trading. In those cases, Ms. Esposito said Mr. Lefkowitz or Ms.
Lerner opened each of the accounts anyway.\398\ Ms. Esposito
said the following regarding one of those cases: ``[I] handed
[the account form] over to Harry [Lefkowitz], and, I believe,
Linda [Lerner], and they discussed it and they said they
approved the account.* * *'' \399\
---------------------------------------------------------------------------
\397\ Id. at 58.
\398\ Id. at 58-60.
\399\ Id.
---------------------------------------------------------------------------
The testimony of Mr. Zayas and Ms. Esposito is very
disturbing because it suggests that All-Tech deliberately
altered the financial information provided by prospective day
trading customers in order to justify the opening of an account
that was otherwise unsuitable under the firm's minimum
standards. If true, Mr. Zayas' charge would be a profound
indictment of All-Tech. While Ms. Esposito denies the substance
of Mr. Zayas' charge that she instructed him to change new
account forms to comport with firm policies, Ms. Esposito
willingly acknowledges that she instructed branch managers to
advise potential customers that, if they wanted to open a day
trading account, the information disclosed by the customer on
the new account form would have to be changed to satisfy All-
Tech's minimum standards. Ms. Esposito's testimony suggests
that All-Tech may have performed its suitability analysis with
a ``wink and a nod'' that encouraged unsuitable customers to
inflate their financial condition to satisfy All-Tech's
standards.
(3) All-Tech Lowered Its Minimum Capital Requirement to
$25,000. In response to competitive pressures from other day
trading firms with lower minimum standards, All-Tech lowered
the minimum capital required to open a day trading account from
$50,000 to $25,000--a 50% decrease.\400\ All-Tech made this
policy change in early 1999.\401\ Mr. Lefkowitz said that the
decision was a concession to branch managers who wanted to
remain competitive with other day trading firms.\402\ All-Tech
lowered its minimum requirements despite Mr. Houtkin's public
statements that a minimum of $50,000 is required to have a
reasonable chance of success at day trading. In fact, just
about the time All-Tech lowered its minimum standard to
$25,000, Mr. Houtkin published his second book on day trading
which stated as follows:
---------------------------------------------------------------------------
\400\ Houtkin Dep. at 187-88; Shefts Int. at 8; Lefkowitz Int. at
2.
\401\ Feb. Hr'g Ex. 26.
\402\ Lefkowitz Int. at 2.
Before the market was booming to new, record-setting
highs every other day and stock prices were uniformly
lower, you could have had success trading with $50,000
on margin. Today, probably $150,000 is the most
advantageous amount of capital for trading, $100,000 is
adequate, and $50,000 is a limiting minimum. These sums
are based on the availability of margin under
Regulation T of the Federal Reserve Board.\403\
---------------------------------------------------------------------------
\403\ Houtkin, Secrets of the SOES Bandit, at 42 (emphasis added).
At his Subcommittee deposition, Mr. Houtkin was asked
whether the recommended deposit for opening a day trading
account at All-Tech was still $100,000. He responded, ``I still
think a day trader, an active day trader, should have $100,000
on deposit, but once again, I discussed with you before, there
are competitive aspects of the business that we have to be
cognizant of.'' \404\ Thus, All-Tech now allows customers to
commence day trading with one-half the amount of risk capital
that Mr. Houtkin considers to be a ``limiting minimum'' for
success, a point he conceded at the Subcommittee's hearing on
February 25, 2000.\405\ Messrs. Shefts and Lefkowitz also
acknowledged that the amount of risk capital available to a day
trader is directly related to the trader's likelihood of
success.\406\ Mr. Lefkowitz said that the more risk capital day
traders have at their disposal the greater their chances of
success.\407\ Mr. Shefts told Subcommittee staff that, if
someone trades with less than $100,000, their chance of success
decreases because they cannot make as much with less
capital.\408\
---------------------------------------------------------------------------
\404\ Houtkin Dep. at 182.
\405\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
\406\ Lefkowitz Int. at 2; Shefts Int. at 8.
\407\ Lefkowitz Int. at 2 .
\408\ Shefts Int. at 8.
---------------------------------------------------------------------------
Given the significance that All-Tech officials assign to
possessing adequate risk capital and Mr. Houtkin's view that
``$50,000 is a limiting minimum,'' it is disturbing that All-
Tech has elected to accept new day trading customers who have
amounts of risk capital that All-Tech considers inadequate. In
fact, under the old $50,000 standard, All-Tech's policy
restricted a customer's ability to trade in his or her account,
aside from liquidating positions, if the customer's account
equity dropped below $30,000.\409\ Before the customer could
begin trading again, the equity in the customer's account had
to be raised to $40,000.\410\ Thus, All-Tech now accepts new
day trading customers whose beginning risk capital is below the
amount at which it formerly restricted a customer's ability to
trade. By doing so, All-Tech is now aggressively competing for
the commission revenue generated by day traders who All-Tech
knows will probably fail. Whether or not the customers make
money, however, All-Tech earns a commission on every trade.
---------------------------------------------------------------------------
\409\ Feb. Hr'g Ex. 35, Section 4, ``Re: Day Trading Account
Guidelines,'' May 13, 1997.
\410\ Id.
---------------------------------------------------------------------------
C. All-Tech Enabled Customers to Trade Beyond Their Means
All-Tech uses several devices that allow customers to
continue day trading, even when that might be inappropriate for
their financial circumstances. Because All-Tech's business
model depends upon high volume trading, the firm employs these
devices to allow customers to pursue trading strategies that
require more capital than customers actually possess and to
avoid regulatory limits that might curtail continued trading.
(1) All-Tech May Have Allowed Customers Whose Day Trading
Accounts Were Closed for Failure to Meet Margin Calls to Open
New Accounts to Allow Continued Trading. The first of these
techniques involved the use of multiple accounts by a single
customer to evade the constraints of margin rules. In his most
recent book, Mr. Houtkin discusses at length the ``learning
curve'' associated with day trading, noting that ``one should
almost expect to have losses on the outset of trading.'' \411\
Mr. Houtkin's book explains, however, that ``[o]ne of the self-
cleansing effects of [day] trading is that if, for some reason,
you do not do well and your capital is reduced, you must
replenish it or you cannot continue to trade. Margin
requirements are a fail-safe mechanism.'' \412\ The
Subcommittee's investigation found evidence, however, that All-
Tech employees undermined the ``fail-safe mechanism'' of the
margin rules by allowing customers whose accounts were closed
for failure to meet margin calls to open new accounts and
continue day trading.
---------------------------------------------------------------------------
\411\ Houtkin, Secrets of the SOES Bandit, at 44.
\412\ Id. at 45 (emphasis in original).
---------------------------------------------------------------------------
Mr. Zayas, the former branch manager of All-Tech's
Watertown office, and Mr. Parish, the former branch manager of
the San Diego office, both testified that All-Tech employees
allowed customers to open new accounts to continue day trading
after their initial accounts had been closed for failure to
meet margin calls. Mr. Zayas testified as follows:
A: Well, what generally would happen is the account
would be closed up and that account would be liquidated
and shut off, so they could no longer trade in that
account, so they wanted to trade, so they needed to
open up another account.
* * * * *
Q: [d]id you assist people in opening new accounts
when you knew that other accounts, one or more, that
they had been closed or liquidated because they
couldn't meet margin calls in those accounts?
A: Well, if an account would get closed up and the
customer would say to me, ``What do I do? What do I
do,'' I would talk to the Montvale office and say,
``Can this account get reopened,'' and sometimes they
would say yes and sometimes they would say no, and I
don't know what determined that; but if the answer was
no, they would then tell me, ``Just have them open up
another account under a relative's name or----
Q: Who told you that?
A: Lisa.
Q: Isposito? [sic]
A: Yes.
Q: And did you do that for customers?
A: Sure. Yes.\413\
---------------------------------------------------------------------------
\413\ Zayas Dep. at 144-46.
When asked whether he ``encourage[d] customers to open new
accounts under fictitious names when they had their old
accounts closed or liquidated because of failure to meet margin
calls,'' Mr. Zayas asserted his Fifth Amendment right and
declined to answer.\414\ At the Subcommittee's hearing on
February 24, 2000, Mr. Zayas, when asked the same question,
once again asserted his Fifth Amendment right and did not
answer.\415\
---------------------------------------------------------------------------
\414\ Id. at 146.
\415\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
Mr. Parish testified that customers whose accounts were
closed for failure to meet maintenance calls were allowed to
open other accounts with All-Tech so that they could continue
to day trade.\416\ When asked whether he encouraged customers
to open additional accounts, Mr. Parish answered, ``[i]f they
wanted to keep trading sometimes, yes.'' \417\ Mr. Parish
confirmed that the home office in Montvale had to approve the
opening of the second account for the customers.\418\
---------------------------------------------------------------------------
\416\ Parish Dep. at 156-57.
\417\ Id. at 157.
\418\ Id. at 158.
---------------------------------------------------------------------------
This testimony is disturbing because it indicates that All-
Tech management, acting through Ms. Esposito who was the
Margins Department Supervisor, willfully disregarded the margin
rules that are designed to protect both All-Tech and its
customers from becoming over-extended. The testimony of Messrs.
Parish and Zayas suggests that the ``fail-safe mechanism'' that
Mr. Houtkin described in his book may be broken at All-Tech.
(2) All-Tech Employees Arranged Loans Between Customers.
All-Tech has allowed, and even encouraged, customers to trade
beyond their means by arranging loans for customers to satisfy
margin and maintenance calls.\419\ In the typical scenario, the
loan remained in the borrowing customer's account overnight and
was then transferred back to the lending customer the next day.
In many instances, the borrowing customer paid an exorbitant
fee to the lending customer for the use of the funds.
---------------------------------------------------------------------------
\419\ There are three types of margin calls that may have applied
to customers at All-Tech: Regulation T initial margin calls;
maintenance margin calls; and special maintenance margin calls for day
trading (``day trading calls''). The Subcommittee does not know for
certain, and neither does All-Tech, whether the lending practices
implicated each of these kinds of calls. All-Tech provided to the
Subcommittee no written firm policy or documentation to support the
assertion that these inter-customer loans were limited to day trading
calls.
---------------------------------------------------------------------------
All-Tech claims that its written policy prohibits the
firm's employees from arranging customer loans, but All-Tech
acknowledges that this practice occurred in the past.\420\ The
Subcommittee requested that All-Tech produce all documents
pertaining to such policies. In its review of All-Tech's
documents, the Subcommittee found no policy prohibiting All-
Tech employees from ``arranging'' loans between customers for
the purpose of satisfying margin calls. The Subcommittee did
find an All-Tech policy stating that ``[n]o employee, relative
of an employee or entity owned by either is permitted to lend
money to any customer.'' \421\ As is evident, this policy does
not address employees arranging loans between customers.
Indeed, the Subcommittee discovered that the practice of All-
Tech employees arranging loans for customers to meet margin
calls was common-place until very recently.\422\ Several former
customers told Subcommittee staff that All-Tech branch managers
either assisted them in obtaining a customer loan or solicited
them to provide loans to customers they did not know.
---------------------------------------------------------------------------
\420\ Feb. Hr'g Ex. 26.
\421\ Feb. Hr'g Ex. 35, ``Operations Memorandum,'' Memorandum from
Mark Shefts, to All Employees, re ``Loans to Customers.'' Feb. 11,
1999.
\422\ According to Mr. Shefts, All-Tech now requires the customer's
signature authorizing loan transfers to be notarized and the original
journal authorization must be sent to the main office. Shefts Int. at
7. Ms. Esposito said that, as of January 1999, All-Tech no longer
permits lending between customers from different branch offices.
Esposito Dep. at 111-12.
---------------------------------------------------------------------------
For example, according to former customers in the San Diego
office, Mr. Parish arranged and attempted to arrange numerous
loans for customers. Former San Diego customer Fred Cook said
that Mr. Parish would act as a ``middleman'' to arrange
loans.\423\ Mr. Cook also said that Mr. Parish sometimes called
out to the trading room to see if anyone could loan another
customer money.\424\ Mr. Cook borrowed money once from another
customer and loaned money twice.\425\ He stated that $100 was
the normal fee for the margin loans.\426\
---------------------------------------------------------------------------
\423\ Cook Int. at 5.
\424\ Id.
\425\ Id.
\426\ Id.
---------------------------------------------------------------------------
Ms. Margala informed Subcommittee staff that some of the
loans Mr. Parish solicited were for customers in other branch
offices.\427\ According to Ms. Margala, Mr. Parish occasionally
approached individual customers and told them how much they had
in their accounts, and asked them to make specific loans to
others.\428\ Ms. Margala recalled an incident in which Mr.
Parish solicited customers to lend $100,000 to another day
trader.\429\ In addition to borrowing funds from customers in
the San Diego office, Ms. Margala received loans from customers
in other branch offices whom she did not know.\430\ Ms. Margala
informed Subcommittee staff that lending customers sometimes
charged a fee of $50.00 for the overnight use of the
funds.\431\ Former San Diego customer Sandra Harlacher told
Subcommittee staff that an All-Tech employee approached her and
asked her to loan another customer $100,000.\432\ Ms. Harlacher
said that she was uncomfortable with the solicitation but
agreed to make the loan.\433\ She apparently knew the borrowing
customer and felt that she could not refuse.\434\ Ms. Harlacher
said that she did not charge a fee for the loan.\435\
---------------------------------------------------------------------------
\427\ Margala Int. at 4.
\428\ Id.
\429\ Id.
\430\ Id.
\431\ Id.
\432\ Interview of Sandra Harlacher, Oct. 6, 1999, at 4
(``Harlacher Int.'').
\433\ Id.
\434\ Id.
\435\ Id.
---------------------------------------------------------------------------
Another former San Diego customer, Marilyn Sherman, allowed
Mr. Parish to use her account to make loans on a routine
basis.\436\ Ms. Sherman decided to take a respite from day
trading, but left funds in her inactive account.\437\ Mr.
Parish asked Ms. Sherman if she would make her account
available to loan money to customers--on an as needed basis--to
meet margin calls.\438\ Ms. Sherman agreed.\439\
---------------------------------------------------------------------------
\436\ Interview of Marilyn Sherman, Oct. 6, 1999, at 4 (``Sherman
Int.'').
\437\ Id.
\438\ Id.
\439\ Id.
---------------------------------------------------------------------------
Mr. Parish admitted that he had customer accounts available
to him, as in the case of Ms. Sherman, for the purposes of
lending funds to customers to meet margin calls.\440\ According
to Mr. Parish, his secretary, Sue Paine, would telephone Ms.
Sherman to inform her of the need for a loan, and Ms. Paine
would then send an authorization to Ms. Sherman for her
signature.\441\ Ms. Sherman provided Subcommittee staff with
twelve authorizations to journal a total of $168,640 from her
account to the accounts of other customers between June and
August 1998.\442\ On at least one occasion, however, Ms.
Sherman stated that All-Tech transferred funds out of her
account without her authorization.\443\ Mr. Parish testified
that Ms. Paine forged Ms. Sherman's signature on the journal
authorization form because she could not reach Ms. Sherman and
the deadline to cover the margin call was approaching.\444\
Though he approved the transfer, Mr. Parish claims that he did
not know that the signature was forged until after the transfer
occurred and Ms. Sherman's husband called to complain.\445\
However, Mr. Parish never reported the forgery to the All-Tech
main office, nor did he fire or discipline Ms. Paine.\446\
---------------------------------------------------------------------------
\440\ Parish Dep. at 95-96.
\441\ Id.
\442\ Sherman Journal Authorizations, June 1999 to Aug. 1999 (Feb.
Hr'g Ex. 44).
\443\ Sherman Int. at 4-A.
\444\ Parish Dep. at 97.
\445\ Id. at 97-100.
\446\ Id. at 99-101.
---------------------------------------------------------------------------
Ms. Bovee told Subcommittee staff that Mr. Benson,
Beaverton's Branch Manager, frequently arranged loans for her
when she had margin calls.\447\ She said that Mr. Benson would
bring her blank journal authorization forms to sign,
authorizing the receipt and repayment of the loan through
journal transfers.\448\ Ms. Bovee stated that, when funds were
journaled out of her account to repay the loans, All-Tech
deducted a fee of $25 to $100 for the lender.\449\ Ms. Bovee
said she never knew which particular customer loaned her
money.\450\ Mr. Benson, on the other hand, characterized his
role in the lending process differently. He told Subcommittee
staff that he facilitated loans merely by informing day traders
in need of funds that he knew of customers who had accounts
available for lending.\451\ Mr. Benson claimed that he did not
call other All-Tech offices to locate lenders.\452\ Mr. Benson
acknowledged, however, that Ms. Esposito called him on two
separate occasions on behalf of traders in need of loans.\453\
---------------------------------------------------------------------------
\447\ Bovee Int. at 3.
\448\ Id.
\449\ Id.
\450\ Id.
\451\ Benson Int. at 7.
\452\ Id.
\453\ Id.
---------------------------------------------------------------------------
In fact, at her Subcommittee deposition, Ms. Esposito
admitted that there were two accounts at her disposal from
which she could make loans to customers in need of funds to
meet margin calls.\454\ The first account was held by former
All-Tech employee and co-author of ``Secrets of the SOES
Bandit'', David Waldman.\455\ According to Ms. Esposito, Mr.
Waldman signed a blank journal authorization form which Ms.
Esposito photocopied and repeatedly used to make loans at her
discretion.\456\ Ms. Esposito said she had access to Mr.
Waldman's account from May 1998 until September 1998, and used
it to make loans as large as $100,000.\457\ Through Ms.
Esposito, Mr. Waldman charged customers $40 for obtaining the
loan and, for every $10,000 of principal, he received a fee of
$10.\458\ Ms. Esposito also had discretionary access to an
account belonging to the sister of the branch manager of All-
Tech's Edison, New Jersey office, which was held in the name of
``Z-Tech.'' \459\ The Edison branch manager, Ralph Zulferino,
initiated the use of the Z-Tech account to cover customer
margin calls.\460\
---------------------------------------------------------------------------
\454\ Esposito Dep. at 113-14, 116.
\455\ Mr. Waldman is a lawyer who worked for All-Tech for several
months. Houtkin Dep. at 176. He helped Mr. Houtkin write his book and
he then worked for All-Tech as Mr. Houtkin's ``right-hand man.'' Id. at
177. Several branch managers told Subcommittee staff that Mr. Waldman
had been actively involved in hiring them as branch managers. Benson
Int. at 2; Parish Dep. at 25-28. In addition, Mr. Shefts stated that
Mr. Waldman negotiated most of the branch agreements. Shefts Int. at 6.
\456\ Esposito Dep. at 113-14.
\457\ Id. at 115.
\458\ Id. at 116.
\459\ Id.
\460\ Id. at 116-17.
---------------------------------------------------------------------------
Ms. Esposito said that, prior to the action by the
Commonwealth of Massachusetts against All-Tech's Watertown
office, Messrs. Lefkowitz and Shefts knew that Ms. Esposito had
been using these two accounts to loan money to customers to
meet margin calls.\461\ She did not believe, however, that Mr.
Shefts knew the extent to which she used the accounts to make
loans.\462\ Ms. Esposito testified that Mr. Lefkowitz was
completely aware of this lending activity because ``[h]e signed
all the journals. He knew David had the account and that we
were using it to cover margin calls.'' \463\ Mr. Lefkowitz
claimed, however, that he did not learn about Ms. Esposito's
involvement in arranging the loans until 1999.\464\ Mr.
Lefkowitz said that, when he learned of her actions, it
bothered him because it was wrong for All-Tech to be
facilitating these loans.\465\ Given Ms. Esposito's testimony
and the extent of this lending practice at the various branch
offices, Mr. Lefkowitz's claimed ignorance strains credibility.
---------------------------------------------------------------------------
\461\ Id. at 118-19.
\462\ Id. at 119.
\463\ Id. at 118-19.
\464\ Lefkowitz Int. at 3.
\465\ Id.
---------------------------------------------------------------------------
The evidence shows that All-Tech systematically--and quite
affirmatively--promoted the extension of short term credit from
its better capitalized day trading customers to those customers
who needed additional funds to satisfy margin and maintenance
calls. While there is nothing inappropriate about customers
lending money to one another, All-Tech's role as a middleman in
the process is problematic. The Subcommittee's investigation
shows that customers loaned money to other customers without
even knowing the borrowing customer's name much less the
borrower's credit worthiness. In some instances, the lending
customer had no role whatsoever in the process since, as Ms.
Esposito testified, she exercised discretionary access over two
accounts in which the lender was not even consulted on a
transaction-by-transaction basis. These loan programs are also
highly susceptible to unauthorized journaling of funds, as
occurred in the case of Ms. Sherman. Thus, it is encouraging
that All-Tech appears to be discontinuing the practice of
facilitating customer-to-customer loans, though the
Subcommittee has seen no written statement of firm policy to
support that contention.
(3) All-Tech Employees Recommended Stocks to Customers. The
day trading industry contends that existing NASD suitability
rules do not apply to day trading because a trader executes his
or her own trades directly rather than submitting those orders
to a broker. In addition, because day traders theoretically buy
and sell securities without the guidance or recommendation of a
broker, the industry argues that day trading firms have no
legal obligation to evaluate the suitability of day trading for
their customers or the suitability of particular stocks that
their customers might trade. The Subcommittee's investigation
found evidence, however, that All-Tech brokers recommended to
their customers the purchase and sale of specific stocks, at
specific prices, and at specific times. This evidence may
support the application of existing suitability rules.\466\
---------------------------------------------------------------------------
\466\ As explained in Section VI, the NASD has proposed a new rule
for day trading firms that would resolve this ambiguity by requiring
member firms to evaluate the ``appropriateness'' or ``suitability'' of
a day trading strategy for their prospective customers before opening a
day trading account.
---------------------------------------------------------------------------
Several former customers of All-Tech's San Diego office
indicated that Mr. Parish, the former branch manager,
recommended that they purchase and sell specific stocks.\467\
Most of the customers asserted, and Mr. Parish admitted, that
he frequently used the term ``load to buy'' to advise customers
to prepare to buy a certain stock.\468\ The following exchange
occurred during Mr. Parish's Subcommittee deposition:
---------------------------------------------------------------------------
\467\ Cook Int. at 4; Harlicher Int. at 5; Margala Int. at 3;
Sherman Int. at 5; Interview of Rodney Haseltine, Oct. 5, 1999, at 2-3
(``Haseltine Int.'').
\468\ Cook at 4; Haseltine at 2-3; Margala Int. at 3; Sherman Int.
at 5; Parish Dep. at 115.
Q: You said load to buy to your customers, didn't
you?
A: Yes. I said, get ready.
Q: And you gave them specific stocks at specific
prices that they should load to buy, didn't you?
A: Yes.
Q: You did this on a frequent basis?
A: Oh, yes.\469\
---------------------------------------------------------------------------
\469\ Parish Dep. at 115.
Mr. Parish claimed that this practice does not violate All-
Tech policy prohibiting its licensed personnel from
recommending securities to customers.\470\ During his
deposition, Mr. Parish was asked whether All-Tech's management
discouraged these recommendations:
---------------------------------------------------------------------------
\470\ Id. at 120-21.
Q: Did [Mr. Ogele] specifically say you should not be
recommending stocks to customers?
A: We don't believe that's a recommendation. It's a
trade. You see, there's a difference between me telling
you to buy Dell at 47 and hold on to it. I recommend
that you buy the stock. All we do as traders is try to
teach people that have no experience how to recognize
an entry point to get in and get out. It's not a
recommendation. If I recommend a stock to you, you
assume I know something about the company, right? I
know nothing about almost any of these companies.\471\
---------------------------------------------------------------------------
\471\ Id.
Mr. Parish said that his recommendations were based simply on
``very short-term technical analysis.'' \472\ As for the stocks
he recommended, Mr. Parish testified that he knew,
``[a]bsolutely nothing. Most of the time, I don't even know
what they do. Half the time, I don't even know the name of
them. I just know the four-letter symbol. So I don't look at
them as recommendations. They're strictly trades.'' \473\
---------------------------------------------------------------------------
\472\ Id. at 121.
\473\ Id.
---------------------------------------------------------------------------
Ms. Bovee told Subcommittee staff that Mr. Benson made
verbal recommendations to buy specific stocks and another
employee, Angus Beal, issued written stock pick
recommendations.\474\ According to Ms. Bovee, Mr. Benson would
sit at the branch manager's computer and yell out
recommendations to the trading room.\475\ Mr. Beal frequently
sent e-mail messages that listed his stock picks to several
customers who traded remotely.\476\ When asked about making
stock recommendations, Mr. Benson indicated that, in a roomful
of traders, it is only natural to have conversations about
stocks and that he would discuss various securities and what
the market was doing.\477\ He claimed to have no idea if
customers made trades based upon those ``conversations.'' \478\
Mr. Benson was aware that Mr. Beal sent stock picks to
customers.\479\ Mr. Strawbridge admitted that he posted in the
office the ``plays of the day'' from Mr. Beal.\480\
---------------------------------------------------------------------------
\474\ Bovee Int. at 2. Mr. Beal was a registered representative who
was ultimately fired by All-Tech for making unauthorized trades in a
customer's account. Ogele Int. at 3.
\475\ Bovee Int. at 2.
\476\ Id.; E-mail messages from Beal to Bovee, et al. (Feb. Hr'g
Ex. 45). In addition to trading on-site, Ms. Bovee also day traded
remotely from her home. Bovee Int. at 3.
\477\ Benson Int. at 6.
\478\ Id.
\479\ Id. at 3-4.
\480\ Strawbridge Int. at 6.
---------------------------------------------------------------------------
Stock picks were not limited to the Beaverton and San Diego
offices of All-Tech. Dr. Leslie Levine, who was a customer at
All-Tech's Montvale office, told Subcommittee staff that there
was a board in the office that listed stock recommendations for
the day, usually containing ten stock picks.\481\ Dr. Levine
understood the stock pick instructions to mean that, if the
stock whose symbol was listed reached the stated price, then
customers should buy it.\482\
---------------------------------------------------------------------------
\481\ Telephone Interview of Dr. Leslie Levine, Nov. 1, 1999, at 1
(``Levine Int.'').
\482\ Id.
---------------------------------------------------------------------------
This evidence casts significant doubt on the claims of many
day traders, including Mr. Houtkin, that day trading firms do
not recommend the purchase and sale of specific securities.
Though Mr. Houtkin takes the extreme view that it is
``impossible'' for a day trading firm to give a solicited
recommendation that would implicate the existing NASD
suitability rules,\483\ a strong argument can be made that All-
Tech employees issued recommendations to their day trading
customers that would have required a basic suitability
analysis.
---------------------------------------------------------------------------
\483\ Houtkin Dep. at 325.
---------------------------------------------------------------------------
(4) All-Tech Encouraged Customers to Trade Heavily. A sign
hangs outside the door of All-Tech's trading room in Montvale,
New Jersey, which reads as follows:
It's better to be boldly decisive
And risk being wrong
Than to agonize at length
And to be right too late.\484\
---------------------------------------------------------------------------
\484\ E-mail message from Stephanie Rosenblatt, Counsel for All-
Tech, to Deborah Field, Counsel for the Subcommittee, Jan. 18, 2000
(Feb. Hr'g Ex. 46).
This sign captures All-Tech's trading philosophy, which
encourages ``clicking the mouse'' and thereby placing as many
orders as possible. Indeed, All-Tech instructs customers,
through its training programs, to trade heavily. At the
Subcommittee's hearing on February 24, 2000, Ms. Harlacher
testified, ``Mr. Parish was constantly harassing me and others,
often making suggestions regarding which stocks to buy and
sell, including when to buy and sell. When I was hesitant to
trade, he would egg me on, telling me that I would never get
experience or learn how to trade or make up my losses unless I
traded often.'' \485\ Another telling example is one of All-
Tech's training documents that cites ``REASONS TO INITIATE A
TRADE,'' and states:
---------------------------------------------------------------------------
\485\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
Knowing when to pull the trigger. * * * Do not
hesitate! When confident a stock is going to make a
move, do not be afraid to pull the trigger! If you wait
until it looks picture perfect, you will never get the
price you're looking for, and you will always pay up or
down. By paying up or down, this will cost any trader a
substantial amount of money. I REPEAT!! DO NOT
HESITATE!!! \486\
---------------------------------------------------------------------------
\486\ ``Reasons to Initiate a Trade'' (Feb. Hr'g Ex. 47).
Similarly, when questioned about ``paper trading,'' which
is simulated trading that All-Tech uses to train new customers,
Mr. Parish testified that it was ``just to teach you how to
click, click, click, click. It's an exercise like the solitaire
game in Microsoft Windows. It's to teach you how to use the
mouse. It's not to teach you how to trade.'' \487\ The
following colloquey illustrates Mr. Parish's view of the
connection between heavy trading and commission revenue:
---------------------------------------------------------------------------
\487\ Parish Dep. at 145.
Q: Is it really to encourage you to click the mouse?
A: Yes. How else are you going to learn? You've got
to do a trade to learn how to trade.
Q: And you also have to do a trade for All-Tech to
get a profit, isn't that true?
A: Yes.
Q: And for you to get a profit, for that matter.
A: That's right. I'm not in business to lose
money.\488\
---------------------------------------------------------------------------
\488\ Id. at 145-46.
Mr. Zayas, the former branch manager in Watertown,
Massachusetts, testified that All-Tech's training was
``horrible'' because it ``did not teach you how to trade,''
only how to generate commissions.\489\ Ms. Harlacher, a former
customer from the San Diego office, agreed with this
characterization, noting that the emphasis during All-Tech's
training program was to encourage customers to trade as much as
possible in order to ``rack up commissions.'' \490\ When asked
to evaluate All-Tech's training program at the Subcommittee's
hearing on February 24, 2000, Ms. Harlacher described it as,
``* * * totally inadequate. All it really taught you to do was
operate the software and to make as many trades as possible and
rack up as many commissions as possible for All-Tech * * *.''
\491\ Indeed, Dr. Levine, a customer in the Montvale office,
said that there was great pressure to trade heavily.\492\ Dr.
Levine said that one day an All-Tech employee told him that,
because he was not trading enough, he would have to leave the
Montvale office, but that he could trade at another office or
trade remotely from home.\493\
---------------------------------------------------------------------------
\489\ Zayas Dep. at 86.
\490\ Harlacher Int. at 3.
\491\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
\492\ Levine Int. at 1.
\493\ Id. The fee for remote trading is $250 per month, which can
be waived if the customer makes 200 trades per month. Feb. Hr'g Ex. 35,
Section 1, ``Operations Memorandums'' from Mark Shefts to All
Employees, re ``Remote Pricing,'' Feb. 25, 1999. Dr. Levine did not
identify the name of the All-Tech employee who allegedly made the
statement.
---------------------------------------------------------------------------
This testimony is troubling because it indicates that All-
Tech promoted heavy trading by its novice customers even when
high volume trading might have resulted in the customer
becoming overextended. All-Tech, of course, generates
commission revenue whether or not the customers who pursue high
volume trading are successful.
D. All-Tech's Risk Disclosure Was Often Ineffective and the Firm's
Advertising Was Occasionally Misleading
(1) Verbal Representations and Some Advertising Undermined
All-Tech's Written Risk Disclosure.
(a) Advertising. Although All-Tech provides its customers
with good written risk disclaimers,\494\ the firm may have
undermined those disclosures with advertising that failed to
disclose the risks of day trading and by verbal representations
from employees that contradicted those warnings. Mr. Cook and
Ms. Harlacher were both attracted to All-Tech by commercials on
CNBC that Ms. Harlacher said made it seem like day trading was
easy and simple.\495\ Mr. Cook was impressed by the
advertisements and told Subcommittee staff that they created a
``very positive presentation of a way to make a living starting
off with $25,000.'' \496\
---------------------------------------------------------------------------
\494\ Among the forms customers must complete when seeking to open
an account is a ``Customer Letter of Understanding'' requires day
trading customers to acknowledge that, among other things, their losses
could exceed their initial investment and that their capital is risk
capital. In addition, it appears that All-Tech provided customers who
took the training courses a risk disclosure document in connection with
the registration forms. ``Customer Letter of Understanding'' (Feb. Hr'g
Ex. 38). ``Rushmore Financial Service, Inc.--Disclosure Statement''
(Feb. Hr'g Ex. 49); ``All-Tech Training Group, Inc.--Disclosure
Statement'' (Feb. Hr'g Ex. 50). All-Tech also sends a very good risk
disclosure letter to customers whose accounts have experienced a
significant decline in equity. Account Decline Letter from Mark Shefts
to Sandra Harlacher [sic], Nov. 28, 1997, bate snumber 4049 (Feb. Hr'g
Ex. 51).
\495\ Harlacher Int. at 1.
\496\ Cook Int. at 2. At the time Mr. Cook joined All-Tech,
however, the new account minimum was $50,000.
---------------------------------------------------------------------------
Shortly before Mr. Cook began day trading at All-Tech's San
Diego office, Mr. Parish produced an advertisement that
featured Mr. Cook smiling in apparent triumph, receiving a
congratulatory hand shake from Mr. Parish, and then grinning
broadly. At that point, however, Mr. Cook had not yet started
live trading with All-Tech.\497\ Ironically, Mr. Cook
eventually lost $175,000 day trading at the firm and has filed
an NASD arbitration claim against All-Tech.\498\ At the
Subcommittee's hearing in February, all Mr. Parish could offer
in evaluating the impetus behind Mr. Cook's losses was that he,
``* * * made bad investments.'' \499\ In that particular
commercial, Mr. Parish touts All-Tech as a good place to
``start a whole new full or part-time career'' and he states
that, ``if you have $10,000 or more in working capital along
with the will and desire to take advantage of the incredible
opportunities offered by day trading, you need to call All-Tech
Investment Group today!'' \500\ The commercial, however, fails
to mention the risks of day trading. Ms. Margala told
Subcommittee staff that she saw the commercial featuring the
enthusiastic Mr. Cook and that it prompted her to contact All-
Tech.\501\ She said that the commercial left her with the
impression that she could learn how to day trade and make a lot
of money.\502\
---------------------------------------------------------------------------
\497\ Parish Dep. at 163.
\498\ Cook Int. at 1. In May 1999, Mr. Cook, Ms. Margala and Judith
Payne Cook filed a claim in arbitration against All-Tech, Mr. Parish,
Southwest Securities, Mr. Shefts and Mr. Houtkin. Cook v. All-Tech
Investment Group, Inc., NASD Arbitration Claim No. 99-02325, filed May,
1999. On December 28, 1999, the arbitration claim was amended to add
claimants Ms. Harlacher, Neil Harlacher, and Ms. Sherman and certian
additional allegations. Cook v. All-Tech Investment Group, Inc., Case
No. 90-00515, filed Dec. 28, 1999.
\499\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee on Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
\500\ Advertisement for San Diego office featuring Barry Parish.
\501\ Margala Int. at 2.
\502\ Id. Ms. Margala stated that, when she first went to All-Tech,
she wanted to open her account with $10,000, as specified in the
commercial, but Mr. Parish told her that she needed $20,000. Id. at 3.
Mr. Parish said that the $10,000 mentioned in the commercial was only
for an ``investment account,'' not a day trading account. Id. At least
three radio advertisements for All-Tech's Beaverton, Oregon office also
stated that the minimum account balance was $10,000. All of these radio
advertisements purport to be for day trading at All-Tech even though
the initial minimum deposit at the time was $50,000. Radio Copy, ``Open
House #28 Portland,'' 7/23/98; Radio Copy, ``Open House #30P,'' 8/14/
98; Radio Copy, ``New Class #31P,'' 8/17/98.
---------------------------------------------------------------------------
According to All-Tech's Branch Office Manual, and the
deposition testimony of Mr. Houtkin, all advertising must be
approved by the main office.\503\ Mr. Parish testified that, as
required by firm policy, Linda Lerner and Richard Raciti from
the main office approved the commercial containing the
ebullient Mr. Cook.\504\ Mr. Parish said that no one at the
main office ever informed him that the commercial should
contain a risk disclosure.\505\ Mr. Houtkin admitted in his
deposition that he was not aware of any risk disclaimers that
All-Tech makes on any of its television advertisements.\506\ He
claimed, however, that there is some kind of risk disclosure
for print advertisements.\507\ Mr. Houtkin also testified that
All-Tech's advertising, especially in the last few years, has
been limited to promoting the benefits of its Attain trading
system rather than the strategies of day trading.\508\ He said,
``[w]e do not advertise day trading * * * [s]o we really don't
have to show a disclaimer because we're not making any claims,
other than come see the Attain trading system and the power of
the Attain system.'' \509\
---------------------------------------------------------------------------
\503\ Ex. 35, ``Branch Procedures,'' Sections 3(A) at 3, and 3(B)
at 3; Houtkin Dep. at 288.
\504\ Parish Dep. at 162. According to Mr. Parish, Ms. Lerner and
Mr. Raciti were responsible for reviewing all advertisements. Id. at
161-62.
\505\ Id. at 162-63.
\506\ Houtkin Dep. at 289-90.
\507\ Id. at 290.
\508\ Id. at 288-89.
\509\ Id.
---------------------------------------------------------------------------
However, the following All-Tech radio commercial featuring
a monologue by Mr. Houtkin, is directly at odds with this
statement:
Never in history has the stock market presented such
tremendous opportunity, especially for traders. Trading
is now becoming the most sought after new career. But
how does one learn to be a day trader? Simple
observation and imitation doesn't cut it. I'm Harvey
Houtkin, and for the past four years I have been
teaching people to compete in today's volatile markets
using proven trading techniques and the state-of-the-
art Attain Trading System. Hundreds of students have
successfully completed my program and are actively
trading for themselves at home or any one of my many
offices nationwide. If you have always wanted to trade
for a livelihood, or are unhappy in your present
occupation, training to be a trader may be perfect for
you. How much did you spend sending your kids to
college? Isn't it time to do something for yourself?
Day trading is exciting, fun and potentially incredibly
profitable. [Tag line follows.] \510\
---------------------------------------------------------------------------
\510\ All-Tech radio commercial. Mr. Houtkin also implies in this
commercial that he has trained hundreds of students who have become
successful day traders. When the words are examined closely, it becomes
clear that Mr. Houtkin is merely boasting that hundreds of students
have completed his training program, hardly an exacting standard.
This commercial promotes not only the Attain trading system,
but also day trading itself. Mr. Houtkin stresses that day
trading could be incredibly profitable but says nothing about
its risks and perils. Ironically, Mr. Houtkin testified during
his deposition that, ``if I came out and said, become a day
trader because it's a great way to make a living and it's fun
and could be profitable, I think we would definitely put a
disclaimer on, especially in today's environment, absolutely.''
\511\
---------------------------------------------------------------------------
\511\ Houtkin Dep. at 293.
---------------------------------------------------------------------------
Much of All-Tech's advertising describes the Attain System
as the best software for day-trading and makes the following
claims about day trading through Attain:
``Real-Time Level II Quotes''
``Instantaneous Order Entry''
``Instantaneous Cancellation''
``Control How, When & Where Your Orders are Entered''
``No busy signals, No Delays, No Stories, No
Excuses''
``Direct Instant Order Processing''
However, several former All-Tech customers told Subcommittee
staff that the Attain System malfunctioned frequently and
contributed to their losses. For example, Mr. Cook said that
the system was slow and often did not provide current quotes--
sometimes for as long as thirty minutes.\512\ Ms. Margala
testified at the Subcommittee's hearings that such delays were
prevalent and that, ``the inaccurate quotes resulted in losses
in my All-Tech account.'' \513\ Though the customers' systems
were often down, Mr. Parish's computer continued to provide
accurate quotes during those time periods.\514\ Consequently,
Mr. Parish would yell out quotes to the trading room, thus
earning him the nickname ``Quote God.'' \515\ According to the
former San Diego customers, Mr. Parish acknowledged that there
were problems with the timeliness of quotes, and he and other
All-Tech officials said that the problem would be fixed.\516\
---------------------------------------------------------------------------
\512\ Cook Int. at 4. The problem apparently started in the fall of
1998. Margala Int. at 4; Sherman Int. at 3.
\513\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
\514\ Cook Int. at 4; Margala Int. at 4; Sherman at 3-4.
\515\ Cook Int. at 4; Margala Int. at 4.
\516\ Margala Int. at 4; Haseltine Int. at 2; Sherman Int. at 4.
---------------------------------------------------------------------------
(b) Verbal Representations. In some cases, alleged
statements by All-Tech employees may have contradicted the
written risk disclaimers that All-Tech provided its customers.
For example, Ms. Harlacher said that no one at All-Tech ever
discussed risk with her personally but that ``wealth and
riches'' were stressed.\517\ Ms. Margala told Subcommittee
staff that Mr. Parish did not directly discuss risk with her
and that he stated, ``day trading is easy; who would sit here
if it was hard?'' \518\ Ms. Margala said that she asked Mr.
Parish if people made money day trading and he responded by
pointing to Mr. Cook--the customer who eventually lost
$175,000--as someone who was making money.\519\
---------------------------------------------------------------------------
\517\ Harlacher Int. at 2.
\518\ Margala Int. at 2.
\519\ Id.
---------------------------------------------------------------------------
In addition, both Ms. Harlacher and Ms. Bovee attended
seminars given by Mr. Houtkin. Ms. Harlacher said that Mr.
Houtkin made day trading seem as ``easy as pie.'' \520\ Ms.
Bovee said Mr. Houtkin made it seem as though a person could
make a lot of money day trading.\521\ She said Mr. Houtkin did
mention a learning curve, but she does not recall Mr. Houtkin
discussing risk and, if he did, she claimed it was a very minor
part of the seminar.\522\
---------------------------------------------------------------------------
\520\ Harlacher Int. at 2.
\521\ Bovee Int. at 1.
\522\ Id.
---------------------------------------------------------------------------
(2) All-Tech Fails to Warn Customers of Low Profitability
Rates. Another important component of an effective risk
disclosure program relates to informing prospective customers
about their chances of success. The Subcommittee's
investigation shows that All-Tech employees generally do not
advise customers about the low profitability of its day
traders. At his Subcommittee deposition, Mr. Parish testified
that 80 to 90 percent of the people who start trading with the
San Diego office lose enough money within the first six months
to quit day trading all together.\523\ When asked what would
constitute ``enough to quit,'' Mr. Parish said ``[t]hat's a
relative number. You, if you're a waitress, maybe you would say
to yourself, if I lose $10,000, I'll keep $40,000 and quit. If
I lose $20,000, I'll keep $30,000 and quit. You set the number,
I don't. I just warn you.'' \524\ Indeed, Mr. Parish testified
that starting six to eight months after he became the branch
manager, he told every customer who came into the San Diego
office that 80 to 90 percent of the people who day trade lose
their money within six months.\525\ However, the former San
Diego customers who spoke with Subcommittee staff did not
mention Mr. Parish giving such a warning. At the Subcommittee's
hearing on February 25, 2000, Mr. Houtkin was asked by Senator
Levin whether All-Tech tells its customers that one in three
will be profitable. ``Absolutely,'' Mr. Houtkin responded. ``We
probably tell them worse than that. We definitely warn
people.'' \526\ But when asked to provide the Subcommittee with
written verification of such warnings, Mr. Houtkin failed to do
so.
---------------------------------------------------------------------------
\523\ Parish Dep. at 45.
\524\ Id.
\525\ Id. at 46.
\526\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
---------------------------------------------------------------------------
In 1997, All-Tech asked its branch offices to complete
surveys regarding their operations, and one question on those
surveys related to customer profitibility. The surveys returned
by the the Boca Raton, Seattle and Chicago offices indicated
that profitability was extremely low. For example, in response
to the question ``what percentage of your customers are making
money,'' Michael Zindman, former branch manager of the Boca
Raton office, wrote ``0%.'' \527\ Mr. Benson of the Seattle
office wrote ``>10%.'' \528\ In addition, when asked about the
progress of his customers, Mr. Benson wrote the following:
``Overall Good! We need to have a couple of people making
money.'' \529\ When interviewed by Subcommittee staff, Mr.
Benson said that about 10 percent of the day traders in the
Seattle office were profitable.\530\ Though no profitability
study has been conducted for the Beaverton office, Mr. Benson
also estimated that slightly more than 10% of the day traders
in that office were profitable.\531\ William Demas, the branch
manager of the Chicago office, wrote in his Branch Office
Survey that 30% of his customers were making money.\532\
Furthermore, Mr. Zayas testified that, out of his 40 to 50
customers in the Watertown office, only one customer was
profitable through day trading.\533\ Mr. Zayas said that Ms.
Esposito told him, ``[w]hy would you want to be in this
business? You know all of these people lose money.'' \534\
---------------------------------------------------------------------------
\527\ Feb. Hr'g Ex. 15, at 4.
\528\ Feb. Hr'g Ex. 16, at 4.
\529\ Id.
\530\ Benson Int. at 8.
\531\ Id.
\532\ Feb. Hr'g Ex. 17, at 4.
\533\ Zayas Dep. at 78. Mr. Zayas estimated that, in the day
trading industry overall, only about 5 percent of day traders are
profitable. Id. at 80.
\534\ Id. at 84.
---------------------------------------------------------------------------
Mr. Shefts told Subcommittee staff that only about three of
ten day traders will be successful.\535\ In his Subcommittee
deposition, Mr. Houtkin offered a similar estimate, commenting
that only about one-third of the customers who open day trading
accounts will become full-time traders.\536\ Given the
extremely low customer profitability reported by most of the
All-Tech branch offices, Mr. Houtkin's already low estimate may
be optimistic.
---------------------------------------------------------------------------
\535\ Shefts Int. at 8.
\536\ Houtkin Dep. at 199.
---------------------------------------------------------------------------
What is clear, however, is that All-Tech knows and
anticipates that a significant percentage of its new customers
who open day trading accounts will fail within six months. As a
result, it is incumbent on the firm, even if it does not advise
prospective customers about low profitability rates, to present
a fulsome risk disclosure that is balanced in its presentation
and that is not undermined by deceptive oral statements or
misleading advertising.
(3) Contrary to Its Claims, All-Tech's Training May Not
Equip Customers With The Skills And Knowledge to Successfully
Day Trade. There are currently two types of training courses
offered by All-Tech Training Group, Inc. There is a four-week
course offered in Montvale and Seattle which costs $5,000, and
a one week course at the branch offices for $3,000.\537\ The
program at the branch offices is often referred to as a ``boot
camp.'' \538\ After the formal training is completed, customers
may continue to paper trade for as long as they wish.\539\
---------------------------------------------------------------------------
\537\ Shefts Int. at 5. If a trainee subsequently becomes a client
of All-Tech, the customer receives a rebate of $2.50 per trade until he
or she recoups the entire tuition charge. Id.
\538\ Parish Dep. at 173. At one point, boot camps lasted one
weekend each. Ex. 35, 9A. ``All-Tech Training Camp, Inc. Training
Program and Weekend Boot Camp.''
\539\ Shefts Int. at 5. Paper trading is simulated trading without
the use of real money.
---------------------------------------------------------------------------
All-Tech claims that it can teach customers all they need
to know to trade effectively. For example, All-Tech's
``Frequently Asked Questions'' encourages inexperienced traders
to learn everything they need to know from the training course:
5. Do I have to know anything about the stock market?
NO! As a matter of fact, in many instances, the less
you know means the less baggage you have to discard
when learning the new trading techniques that we
teach.\540\
---------------------------------------------------------------------------
\540\ Ex. 40, at 2.
In one of the training manuals produced by All-Tech Training
Group, Inc., the introductory letter describes the training
---------------------------------------------------------------------------
program as comprehensive and effective:
The training program has been designed to cater to
the cross section of society. The prerequisites needed
for our training are discipline, confidence, and the
desire for success and independence.
* * * * *
All-Tech Investment Group, Inc. and All-Tech Training
Group, Inc. provides [sic] all of the resources to
become an effective day trader, you must possess the
discipline to become a successful day trader.\541\
---------------------------------------------------------------------------
\541\ All-Tech Training Group, Inc. Manual, ``Welcome to All-Tech
Training Group,'' at 5 (Feb. Hr'g Ex. 52).
Some of the former customers interviewed by Subcommittee
staff disputed All-Tech's claim that the training program
equipped them to trade successfully. For example, Ms. Harlacher
took the ``boot camp'' training course in San Diego, which was
taught by Jai Ramoutar from the Montvale office.\542\ Ms.
Harlacher said that Mr. Ramoutar promised to teach her all she
needed to know to trade effectively, and ``being naive and
gullible I believed.'' \543\ Ms. Harlacher told Subcommittee
staff that All-Tech showed her how to operate the computer and
the software, but she did not learn about the markets or how to
perform technical analysis.\544\ Ms. Harlacher said that much
of the training was over her head.\545\ Although Mr. Ramoutar
discussed certain technical terms involving the actions of
market makers, she said that the training did not equip her to
understand how those actions affected prices.\546\
---------------------------------------------------------------------------
\542\ Harlacher Int. at 2.
\543\ Id.
\544\ Id. Ms. Sherman, who also took a ``boot camp'' training
course, stated that the trainer from the Montvale office taught the
students the mechanics of executing trades but not why or when they
should trade. Sherman Int. at 2.
\545\ Harlacher Int. at 2.
\546\ Id.
---------------------------------------------------------------------------
After losing about $100,000 in four months of day trading,
Ms. Harlacher left All-Tech.\547\ She subsequently studied for,
and passed, the Series 6, 7, and 63 securities exams.\548\ Ms.
Harlacher told Subcommittee staff that she obtained these
licenses because she wanted to finally understand the markets
and ``conquer'' the material that she had not understood while
at All-Tech.\549\ Ms. Harlacher said that, after getting her
licenses in the securities industry, she believes that All-Tech
set her up for failure through a lack of education, experience,
and market knowledge.\550\ She affirmed that sentiment at the
Subcommittee's hearings in February, 2000, when she testified,
``My education after leaving All-Tech made me realize how
little All-Tech had taught me. I was trading at All-Tech, but
did not know enough to realize that I really did not know what
I was doing.'' \551\ Further, Ms. Harlacher commented that, in
retrospect, she is ``shocked'' that she day traded at All-Tech
because she did not know what she was doing 90 percent of the
time.\552\ Ms. Harlacher added that there is no system at All-
Tech to test a customer's knowledge.\553\
---------------------------------------------------------------------------
\547\ Id. at 1, 3.
\548\ Id. at 1.
\549\ Id. at 6.
\550\ Id.
\551\ Day Trading: Everyone Gambles but the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong. 49 (Feb. 24, 2000) (hearing transcript).
\552\ Harlacher Int. at 5.
\553\ Id. at 5-6.
---------------------------------------------------------------------------
In his Branch Office Survey, Mr. Parish also criticized
All-Tech's training program for failing to teach trading skills
and focusing excessively on the use of the computer and
software. In response to the question, ``[w]hat can Rushmore do
to improve their current teaching procedure,'' Mr. Parish
wrote, ``[t]each how to actually trade. Too many traders chase
the stock and get jiggled out after.'' \554\ Mr. Parish
acknowledged in his deposition that All-Tech taught primarily
computer mechanics, and that he wanted the course to teach more
specifics about when to buy and sell.\555\
---------------------------------------------------------------------------
\554\ San Diego ``Branch Office Survey,'' Aug. 4, 1997, at 6 (Feb.
Hr'g Ex. 53).
\555\ Parish Dep. at 176. Mr. Parish admitted, however, that a
trainer he hired for the San Diego office without All-Tech's approval,
also only taught computer mechanics. Id. at 130, 176. All-Tech
management forced him to shut down the program when it learned, through
a customer complaint, that Mr. Parish was offering unsanctioned
training. Shefts Int. at 5; Parish Dep. at 130-31.
---------------------------------------------------------------------------
The last part of the training program is called ``paper
trading.'' This allows the customers to make simulated trades
with an ``inputter'' from the main office on the other side of
the trades.\556\ Many former customers told Subcommittee staff
that paper trading did not portray a realistic picture of live
trading. For example, Ms. Sherman, Ms. Margala, and Mr.
Haseltine said that orders were filled during paper trading
that would not necessarily have been filled if an actual order
in the market had been placed.\557\ Mr. Parish confirmed that
orders are usually filled in paper trading, whereas in live
trading, ``[p]eople have orders that don't get filled all the
time.'' \558\ Mr. Parish called paper trading an ``imprecise''
simulation of live trading.\559\
---------------------------------------------------------------------------
\556\ Parish Dep. at 143.
\557\ Sherman Int. at 3; Margala Int. at 2-3; Haseltine Int. at 2.
\558\ Parish Dep. at 143.
\559\ Id. at 144.
---------------------------------------------------------------------------
Given the testimony of these former customers--and even
former branch managers--it appears that All-Tech may have
overstated the quality of its day trading instruction,
something that All-Tech CEO Harvey Houtkin described at the
Subcommittee's hearing on February 25, 2000 as, ``one of the
best training programs in the industry.''\560\ If so, All-Tech
should take steps to moderate its claims about the training
with appropriate disclaimers.
---------------------------------------------------------------------------
\560\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
---------------------------------------------------------------------------
E. All-Tech's Failure to Supervise its Employees
1. General Lack of Supervision. The Subcommittee's
investigation found that All-Tech's management has not
exercised sufficient supervision of its employees and branch
offices. Mr. Houtkin was the Chief Compliance Officer for All-
Tech from the time he became an All-Tech principal in June 1991
until March 1999, when the firm hired Franklin Ogele as its
Chief Compliance Officer and Associate General Counsel.\561\
---------------------------------------------------------------------------
\561\ Shefts Int. at 6; Houtkin Dep. at 79; Feb. Hr'g Ex. 28.
---------------------------------------------------------------------------
All-Tech provided a one page document to the Subcommittee
entitled ``Supervision,'' which states the following:
All registered employees listed below shall report to
Harvey Houtkin, except as otherwise noted. In his
absence all registered employees shall report to Harry
Lefkowitz or Mark Shefts. All non-registered [sic]
employees in the Montvale Office shall report to Mark
Shefts. In his absence all non-registered [sic] shall
report to Harvey Houtkin or Harry Lefkowitz. All
specific matters related to options and municipal
business shall report to Harvey Houtkin.\562\
---------------------------------------------------------------------------
\562\ Schedule 1B, ``Supervision,'' Aug. 23, 1999 at 1 (Feb. Hr'g
Ex. 54). Messrs. Parish, Benson, Niederkrome and Esposito appear on the
list of registered personnel that follows. Id. at 1, 3. Mr. Zayas
testified that Mr. Lefkowitz and Ms. Esposito seemed to have
responsibility for oversight of the Watertown office. Zayas Dep. at 51.
According to Mr. Shefts, Mr. Houtkin delegated many of his
compliance duties to various members of management.\563\ Mr.
Houtkin testified that, in performing the function of Chief
Compliance Officer, he frequently ``delegated almost all
aspects [of compliance] to people who were competent in that
area.''\564\ Mr. Houtkin explained that, even though he was
Chief Compliance Officer for All-Tech, his other
responsibilities required that he delegate compliance duties as
much as possible.\565\ He stated, ``I basically am what you'd
probably call the rainmaker. I go out and I handle the public
relations * * * and it worked out pretty well. So while I
didn't formally do it full-time, whatever had to be done was
done.''\566\
---------------------------------------------------------------------------
\563\ Shefts Int. at 6.
\564\ Houtkin Dep. at 313.
\565\ Id. at 313-15.
\566\ Id. at 315.
---------------------------------------------------------------------------
In practice, however, Mr. Houtkin's delegation of his
compliance duties worked poorly. For instance, Mr. Shefts said
that he visited branch offices regularly, but it does not
appear that there was a formal audit process in place until Mr.
Ogele joined the firm in March 1999.\567\ Mr. Shefts stated
that, during his visits, he reviewed documents at the branch
offices and completed a one-page questionnaire concerning his
visit.\568\ There is no documentary evidence, however, of
actual audits until Mr. Ogele was hired last year.\569\
---------------------------------------------------------------------------
\567\ Shefts Int. at 7.
\568\ Id. Mr. Shefts stated, however, that the questionnaires did
not actually represent what he did during his visit to the branch
offices. Id.
\569\ The Subcommittee requested ``[a]ll internal and external
audit reports, including, without limitation, those audit reports that
apply to All-Tech's branch offices nationwide.'' Letter from K. Lee
Blalack, II, Chief Counsel & Staff Director for the Subcommittee and
Linda J. Gustitus, Minority Chief Counsel & Staff Director for the
Subcommittee, to Mark D. Shefts, President of All-Tech, Aug. 5, 1999,
at Sched. A, #15. All-Tech did not provide any audit documents prepared
by Mr. Shefts or Mr. Houtkin. Rather, All-Tech provided a handful of
``Branch Office Surveys'' that were completed by the branch managers
themselves and typed reports of several branch audits conducted by Mr.
Ogele in mid-1999.
---------------------------------------------------------------------------
Mr. Zayas testified that no one from All-Tech ever audited
the Watertown office while he was the branch manager.\570\ When
asked whether his office had ever been audited, Mr. Parish
testified that he thought so because Messrs. Houtkin and Shefts
had visited his office before.\571\ Mr. Parish acknowledged,
however, that he had never seen a formal audit document for any
of those visits.\572\ The testimony of Messrs. Zayas and Parish
seems consistent with that of Mr. Houtkin. When asked whether
he visited every All-Tech branch, Mr. Houtkin said, ``[n]o,
there were just too many. I'd be out of the office all the
time. We had about 25 offices. I'd never be there.''\573\
---------------------------------------------------------------------------
\570\ Zayas Dep. at 52. He said that an All-Tech sales person
visited his office to perform an evaluation at some point but that the
visit was geared more towards sales issues. Id.
\571\ Parish Dep. at 160.
\572\ Id. at 160-61.
\573\ Houtkin Dep. at 317.
---------------------------------------------------------------------------
(2) The Massachusetts Action. On December 10, 1998, the
Securities Division for the Commonwealth of Massachusetts
(``Securities Division'') filed an administrative complaint
against All-Tech, Mr. Shefts, Mr. Houtkin, Mr. Zayas and two of
Mr. Zayas' customers, Isaac Belbel and John L. Powell.\574\ On
May 3, 1999, the Securities Division amended its complaint to
add Mr. Lefkowitz as a respondent.\575\ The Securities Division
alleged that All-Tech and Messrs. Houtkin, Shefts and Lefkowitz
failed to reasonably supervise Mr. Zayas in his operation of
the Watertown office.\576\ The underlying allegations against
Mr. Zayas included that he
---------------------------------------------------------------------------
\574\ Commonwealth of Massachusetts, Securities Division,
``Administrative Complaint,'' Docket No. R-98-77, Dec. 10, 1998, at 1
(``Complaint'') (Feb. Hr'g Ex. 55a).
\575\ Commonwealth of Massachusetts, Securities Division,
``Amendment to Administrative Complaint,'' Docket No. R-98-77, May 3,
1999, at 2 (``Amended Complaint'') (Feb. Hr'g Ex. 55b).
\576\ Feb. Hr'g Ex. 55a at para. 162; Feb. Hr'g Ex. 55b at para. 3.
exercised discretion in day trading customers' accounts
without written authorization; commingled funds of
customers and failed to comply with customers'
instructions; forged customers' signatures to
authorization forms, and used these forms to have funds
transferred among customers [sic] accounts, without
their authorization or knowledge; made
misrepresentations to the Division during the
examination; cooperated in the creation of fraudulent
accounts; and encouraged and cooperated in the unlawful
activities of unregistered investment advisers,
including preying upon customers of All-Tech.\577\
---------------------------------------------------------------------------
\577\ Feb. Hr'g Ex. 55a at 2.
The Securities Division settled the matter with each of the
respondents on May 3, 1999.\578\ During his Subcommittee
deposition, Mr. Houtkin denied that All-Tech acted improperly
with respect to the office in Watertown, claiming that Mr.
Zayas was simply a rogue broker.\579\ Moreover, Mr. Houtkin
believes that the action was initiated because, ``the State of
Massachusetts had an agenda to close down day trading, active
trading operations, we had a few bureaucrats there who decided
they wanted to get their name in the paper and who started
coming out.'' \580\
---------------------------------------------------------------------------
\578\ Commonwealth of Massachusetts, Securities Division,
``Stipulated Order,'' Docket No. R-98-77, May 3, 1999 (for Respondents
All-Tech, Messrs. Shefts, Houtkin and Lefkowitz) (``Stipulated Order
1'') (Feb. Hr'g Ex. 56); Commonwealth of Massachusetts, Securities
Division, ``Stipulated Order,'' Docket No. R-98-77, May 19, 1999 (for
Respondents Messrs. Zayas, Belbel and Powell) (``Stipulated Order 2'')
(Feb. Hr'g Ex. 57).
\579\ Houtkin Dep. at 145.
\580\ Id. at 145-46.
---------------------------------------------------------------------------
When Subcommittee staff questioned Mr. Zayas concerning the
substance of these allegations, he declined to answer on the
basis of his Fifth Amendment right against self-incrimination.
For example, when Subcommittee staff asked whether he exercised
discretion in a customer's account over which he did not have
written authorization, Mr. Zayas took the Fifth Amendment.\581\
Mr. Zayas also took the Fifth Amendment with regard to whether
he forged a customer's name on a form purportedly authorizing
the transfer of funds out of her account into the account of
another customer.\582\ When asked whether he made or effected
transfers of funds through the use of forged documents and
whether he forged documents to make account transfers for the
purpose of meeting margin calls, Mr. Zayas again took the Fifth
Amendment.\583\ Finally, Mr. Zayas took the Fifth Amendment
when asked whether he ever encouraged customers to open new
accounts under fictitious names after their old accounts were
closed or liquidated because of a failure to meet margin
calls.\584\
---------------------------------------------------------------------------
\581\ Zayas Dep. at 55.
\582\ Id. at 73.
\583\ Id. at 74.
\584\ Id. at 146.
---------------------------------------------------------------------------
The Securities Division made a specific finding in the
``Stipulated Order'' that Harry ``Lefkowitz failed reasonably
to supervise the operation of the Watertown office.'' \585\
All-Tech and Messrs. Shefts, Houtkin, and Lefkowitz agreed to
the following conditions for settlement:
---------------------------------------------------------------------------
\585\ Feb. Hr'g Ex. 57, at 1. Like Mr. Houtkin, Mr. Lefkowitz
described Mr. Zayas as a ``rogue broker.'' Lefkowitz Int. at 3
---------------------------------------------------------------------------
All-Tech will not open or operate a branch
office in Massachusetts for two years;
All-Tech will not open any new accounts for
Massachusetts customers for two years;
All-Tech will send a copy of the Offer of
Settlement and the Stipulated Order to the owners of
all the Massachusetts accounts;
All-Tech will not allow impermissible
journaling and/or lending of funds to, from, between or
among accounts of Massachusetts customers beyond that
permitted under Regulations T and U;
All-Tech will not permit any Massachusetts
customer to effect transactions for third parties nor
will it permit third parties to have trading
authorizations for any Massachusetts customer for two
years;
All-Tech will hire, within three months of
the Order, a compliance officer who meets the following
criteria;
All-Tech will pay $50,000 to the
Massachusetts Investors Protection Trust Fund;
Lefkowitz will withdraw from Massachusetts
as an agent, and will not reapply to the Division for
registration in any capacity for two years; and
Lefkowitz consents to the finding concerning
him and the sanction against him set forth in the
Order.\586\
---------------------------------------------------------------------------
\586\ In re All Tech, Docket No. R-98-77, ``Offer of Settlement,''
May 3, 1999, at 1-3; In re All-Tech, Docket No. R-98-77, ``Stipulated
Order,'' May 3, 1999. Mr. Zayas also settled with the Securities
Division by agreeing that ``he will not apply for registration with the
Division in any capacity until after January 1, 2002.'' In re All-Tech,
Docket No. R-98-77, ``Offer of Settlement,'' May 10, 1999, at 1 (Feb.
Hr'g Ex. 58b); Ex. 57.
---------------------------------------------------------------------------
Thus, as part of the settlement, All-Tech agreed to ``hire
* * * a compliance officer who meets [certain enumerated]
criteria.'' \587\ In March 1999, Mr. Ogele joined All-Tech as
its Chief Compliance Officer, Vice President and Associate
General Counsel.\588\ Mr. Ogele confirmed to Subcommittee staff
that he was hired as a result of the problems that were
uncovered at the Watertown office.\589\ Mr. Houtkin stated
that, by the time of the settlement with the Massachusetts
Securities Division, All-Tech had already been searching for a
new Chief Compliance Officer because the events in the
Watertown office prompted All-Tech to pursue a ``much tighter
compliance environment than [it] had previously.'' \590\
---------------------------------------------------------------------------
\587\ In re All-Tech Investment Group, Inc., Offer of Settlement,
Docket No. R-98-77, May 3, 1999, at 2.
\588\ Ogele Int. at 1.
\589\ Id.
\590\ Houtkin Dep. at 329-30.
---------------------------------------------------------------------------
Upon his arrival at All-Tech, Mr. Ogele identified
compliance areas that required improvement, including revision
and expansion of the firm's supervisory procedures manual.\591\
In his audits of various branch offices, which appear to be the
first formal audits conducted by All-Tech, Mr. Ogele documented
a host of problems.\592\ For example, in his review of the
Detroit, Michigan and Falls Church, Virginia offices, Mr. Ogele
noted that records were ``maintained [in] a haphazard manner,''
and that there was ``no evidence that whatever few records
maintained were being reviewed and signed off on by the [Branch
Manager].'' \593\ In addition, in his write-up of the Seattle
Branch Audit, Mr. Ogele listed forty customers whose files
needed to be reviewed because the majority of them were missing
either ``check logs'' or ``account opening documents that
[we]re not properly signed.'' \594\
---------------------------------------------------------------------------
\591\ Ogele Int. at 1.
\592\ In response to a Subcommittee request, All-Tech produced
certain reports of audits conducted by Mr. Ogele as Chief Compliance
Officer. All-Tech declined, however, to produce eight of those reports
based on a claim of ``attorney/client'' privilege, and for five of
them, All-Tech also claimed that there is a ``self-evaluative''
privilege that applies to the documents. Letter from Stephanie
Rosenblatt, Counsel for All-Tech, to Deborah Field [sic], Counsel to
the Subcommittee, Jan. 4, 2000, at 1-2 (Feb. Hr'g Ex. 59); Letter from
Stephanie Rosenblatt, Counsel to All-Tech, to Deborah Field, Counsel to
the Subcommittee, Jan. 18, 2000 (Feb. Hr'g Ex. 60). The attorney-client
privilege, however, has never been formally recognized by Congress, and
the Subcommittee is unaware of a bona fide privilege known as the
``self-evaluative privilege.'' The Subcommittee intends to pursue these
withheld documents in due course where appropriate.
\593\ Internal Memorandum from Franklin I. Ogele, Chief Compliance
Officer for All-Tech, to Steven Plotnick, Branch Office Manager, re:
Detroit Branch Audit, May 6, 1999, at 3 (``Detroit Office Audit'')
(Feb. Hr'g Ex. 61); Internal Memorandum from Franklin I. Ogele, Chief
Compliance Officer for All-Tech, to Fabian Norwood and Frederick
Vetter, re: Falls Church, VA Branch Audit, June 28, 1999, at 3 (``Falls
Church Office Audit'') (Feb. Hr'g Ex. 62).
\594\ Internal Memorandum from Franklin I. Ogele, Chief Compliance
Officer for All-Tech, to David Niederkrome (BOM) and Michael Benson,
Branch Office Manager, re: Seattle Branch Audit, July 27, 1999, at 6-7
(``Seattle Office Audit'') (Feb. Hr'g Ex. 63).
---------------------------------------------------------------------------
Though Mr. Ogele has made tremendous progress in improving
All-Tech's compliance program and internal controls, it is
troubling that his hiring was precipitated by the apparent
misconduct of All-Tech employees in the Watertown office.
Though Mr. Lefkowitz attributed All-Tech's difficulties to a
``rogue'' broker, the Securities Division found that Mr.
Lefkowitz failed in his duty to supervise Mr. Zayas. Thus, the
Subcommittee concludes that, until Mr. Ogele's hiring, All-Tech
was often deficient in its legal duty to supervise its
registered personnel, particularly those operating branch
offices. It is particularly unfortunate that state securities
regulators felt compelled to demand, as a condition of settling
their action against All-Tech, that the firm retain an
experienced chief compliance officer. The evidence suggests
that Mr. Houtkin was too focused on marketing and paid
insufficient attention to the internal controls that are
necessary to ensure that registered personnel heed not only
securities laws and regulations but also firm policies.
(3) All Tech Lacked Appropriate Qualifications For Hiring
Branch Managers and Trainers. All-Tech has no apparent minimum
qualifications for hiring branch managers and course trainers.
In fact, candidates for both positions do not need a securities
background, and need not need to demonstrate past success in
day trading. Mr. Houtkin testified that there was no
prerequisite for branch managers or trainers to have been
successful day traders.\595\ Mr. Zayas, in fact, had almost no
experience day trading before he became an All-Tech branch
manager and certainly was never a profitable day trader.
Overall, Mr. Zayas lost between $40,000 and $60,000 from his
trading experience at All-Tech before Mr. Houtkin offered him
the position as the branch manager of the Watertown
office.\596\ Moreover, Mr. Zayas said that he personally only
made one trade in his account before becoming a branch manager,
and he lost $1,000 to $1,500 as a result.\597\ Similarly,
neither Mr. Benson nor Mr. Niederkrome had ever day traded when
they first opened the Seattle office of All-Tech.\598\ Mr.
Zayas did not possess a single securities license when Mr.
Houtkin agreed to let him open the Watertown branch
office,\599\ and Mr. Benson worked for All-Tech for an entire
year before obtaining his license.\600\ Mr. Zindman, the former
branch manager of the Boca Raton office, told Subcommittee
staff that he was an unsuccessful proprietary trader at All-
Tech for about six to ten months prior to becoming a branch
manager.\601\
---------------------------------------------------------------------------
\595\ Houtkin Dep. at 302.
\596\ Zayas Dep. at 40. Mr. Zayas' losses stemmed largely from the
trading losses and fees generated by a third-party who was trading his
account. Id. at 39. Mr. Zayas was introduced to the trader by All-Tech.
Id. at 34.
\597\ Id. at 32-33.
\598\ Benson Int. at 2.
\599\ Zayas Dep. at 46.
\600\ Benson Int. at 2.
\601\ Interview of Michael Zindman, Oct. 27, 1999, at 1 (``Zindman
Int.''). Proprietary traders are employed by the firm to trade on
behalf of the firm.
---------------------------------------------------------------------------
Even more troubling than the poor qualifications and
experience of several All-Tech branch managers is evidence that
Mr. Houtkin offered his customers branch offices as consolation
for the money they lost day trading. For example, a secretly
taped conversation between former Montvale customer, Jon
Olson,\602\ and Mr. Houtkin recorded Mr. Houtkin trying to
appease Mr. Olson by offering him the chance to open an All-
Tech branch office.\603\ Earlier in that tape recorded
conversation, Mr. Olson can be heard informing Mr. Houtkin that
he had lost $227,000 day trading at All-Tech.\604\ Mr. Olson
told Subcommittee staff that the running joke at All-Tech was
that, if you lost money, Mr. Houtkin would offer you a
job.\605\
---------------------------------------------------------------------------
\602\ Mr. Olson was an All-Tech customer from about May 1997 until
about August 1998. Telephone Interview of Jon Olson, Nov. 2, 1999, at 1
(``Olson Int.'').
\603\ Computer Disc of conversation between Jon Olson and Harvey
Houtkin taped on Dec. 9, 1998 and produced to the Subcommittee under
subpoena, at approx. 51:35.
\604\ Id. at approximately 3:45.
\605\ Olson Int. at 1.
---------------------------------------------------------------------------
Mr. Zayas testified that Mr. Houtkin made similar appeals
to him. He stated as follows:
Q: Did [Mr. Houtkin] offer for you to open the branch
office as a consolation for your significant losses?
A: Yes. Basically, he said, ``I'm sorry that Jody
lost the money for you, and what I'll do is I will
charge you--I will discount the initial fee that we
charge to open up a branch office.\606\
---------------------------------------------------------------------------
\606\ Zayas Dep. at 45. Jody Krajack is the trader who Mr. Houtkin
allegedly found to trade Mr. Zayas' account. Id. at 34-35.
During his Subcommittee deposition, Mr. Houtkin denied that he
would have offered a branch manager position to a customer as a
consolation for losses, but he acknowledged the possibility
that he offered branch manager positions to people who had lost
money day trading at All-Tech.\607\
---------------------------------------------------------------------------
\607\ Houtkin Dep. at 307-309.
---------------------------------------------------------------------------
All-Tech also occasionally hired trainers who were
unsuccessful day traders. According to Mr. Zayas, for example,
Don Traponese was first a customer of All-Tech and then an
instructor.\608\ Mr. Zayas said that Mr. Traponese was not a
profitable trader and that he blamed his losses on inadequate
trading capital.\609\ In addition, Ms. Sherman told
Subcommittee staff that, when she asked her training instructor
Mr. D'Adamo why he did not trade for himself, he told her that
he was not good at it.\610\
---------------------------------------------------------------------------
\608\ Zayas Dep. at 36, 51.
\609\ Id. at 37.
\610\ Sherman Int. at 2-3.
---------------------------------------------------------------------------
(4) All-Tech Failed to Adequately Train Branch Managers.
Given the very limited experience and qualifications of many of
All-Tech's branch managers, it was particularly imperative that
All-Tech give its branch managers high quality training. The
Subcommittee's investigation indicates, however, that the
training for branch managers may have been limited and
ineffective.
Although Mr. Benson said that All-Tech trained him to be a
branch manager,\611\ the Subcommittee learned that some branch
managers apparently received little or no training prior to
opening their branch offices. For example, Mr. Zayas, who had
no previous experience as a professional in the securities
industry, summed up his branch manager training as follows:
---------------------------------------------------------------------------
\611\ Benson Int. at 2. His training apparently consisted of a
four-week day trading course and meeting with management at All-Tech to
discuss aspects of the business. Id.
Q: Were you supposed to get any training?
A: Well, it was supposed to be included. The $50,000
I paid, I was supposed to receive a week of training in
my office. I was told to come down to New Jersey, to
the New Jersey office for the training. I went down for
three days. It was three-day training period. I was
there for probably four hours, and basically, I was
introduced to various people within the office that I
would be dealing with in the margin, and I was given a
couple of manuals and told to read them; and if I had
any questions, to ask them.
Q: And that was the sum total of your training?
A: That was it.\612\
---------------------------------------------------------------------------
\612\ Zayas Dep. at 50.
Mr. Parish testified that All-Tech trained him to be a
branch manager but, when questioned about the details, it
became apparent that All-Tech trained Mr. Parish primarily on
how to use the computer system, not how to manage a branch
office.\613\ Mr. Parish claimed that he already knew ``[a]ll of
the administrative things that it takes to run a branch.''
\614\ Mr. Strawbridge conceded that the training he received to
be a branch manager was limited.\615\ He said that he traveled
to the All-Tech main office for several days where he spent
some time with Ms. Lerner, Mr. Lefkowitz and Ms. Esposito.\616\
Other than that, Mr. Strawbridge said he ``mirrored'' Mr.
Niederkrome in the Seattle office for one week \617\
---------------------------------------------------------------------------
\613\ Parish Dep. at 40-41.
\614\ Id. at 42.
\615\ Strawbridge Int. at 8.
\616\ Id.
\617\ Id.
---------------------------------------------------------------------------
(5) All-Tech Allowed Persons To Act As Branch Managers
Prior to Being Registered. All branch managers, for both
Offices of Supervisory Jurisdiction (``OSJ'') and non-OSJ
offices, must register with the NASD.\618\ Branch managers for
non-OSJ offices may register as representatives or principals,
while branch managers for OSJ offices must register as General
Sales Supervisors or principals qualified for the activities
they will be supervising.\619\ Thus, for a non-OSJ branch, the
manager must have passed either the Series 62 or Series 7
licensing exams,\620\ and for OSJ branches, the Series 8 or
Series 24 exams.\621\
---------------------------------------------------------------------------
\618\ ``An Explanation of the NASD Registration and Qualification
Requirements,'' Oct. 1999, at 14 (``NASD Registration and
Qualification''). An OSJ branch office is one where one or more certain
enumerated functions occur, including, for example, final approval of
new accounts or supervision of branch office employees. NASD Rule
3010(g).
\619\ NASD Registration and Qualification at 14.
\620\ The Series 7 is the ``General Securities Representative''
exam, Id. at 3, and the Series 62 is the ``Corporate Securities Limited
Representative'' exam. Id. at 4.
\621\ Id. at 14. The Series 8 is the ``General Securities Sales
Supervisor'' exam, and the Series 24 is the ``General Securities
Principal'' exam. Id. at 2, 14.
---------------------------------------------------------------------------
Mr. Benson told Subcommittee staff that he joined All-Tech
in or about mid 1997, and his CRD indicates that he started
working for All-Tech on March 10, 1997.\622\ In the Branch
Office Management Agreement governing the office, dated May 8,
1998, he is designated as a branch manager.\623\ Mr. Houtkin
testified that Mr. Benson has been the branch manager of the
Beaverton office since it opened.\624\ Mr. Benson, however, did
not pass his Series 62 exam until November 9, 1998,\625\ which
means that he was not a registered representative until at
least that date. Thus, Mr. Benson worked for All-Tech from
March 1997 until November 1998, over 1\1/2\ years, without
being licensed, and acted as a branch manager for six months
without a license.
---------------------------------------------------------------------------
\622\ Frederick M. Benson, CRD # 2876856, at ``Employment History''
(``Benson CRD'') (Feb. Hr'g Ex. 64).
\623\ Portland Branch Agreement, at Rider.
\624\ Houtkin Dep. at 226.
\625\ Feb. Hr'g Ex. 64, at ``Exam History.'' Mr. Benson failed the
Series 62 exam the first time he took it on May 24, 1997. Id.
---------------------------------------------------------------------------
Mr. Benson stated that he worked at All-Tech for an entire
year without receiving any salary due to the fact that he did
not yet have his Series 62 license.\626\ When asked how many
hours per week he worked for no pay, he said ``eighty.'' \627\
Even if his claim is true, it does not relieve Mr. Benson and
All-Tech from the NASD registration requirement. The NASD
requires ``[e]very securities professional associated with a
member firm that will engage in securities transactions [to]
register with the NASD as a registered representative or
principal.'' \628\ Mr. Benson claimed that he only worked on
the ``business'' half of the office rather than the broker-
dealer side of the business and that his primary function was
to market the business and attract new clients.\629\ He
acknowledged that he frequently answered questions for day
traders but claimed that he never executed trades for
them.\630\
---------------------------------------------------------------------------
\626\ Benson Int. at 2.
\627\ Id. Mr. Benson claimed he did this to protect his investment
in All-Tech. Id.
\628\ NASD Registration and Qualification at 1.
\629\ Benson Int. at 3, 5.
\630\ Id. at 3.
---------------------------------------------------------------------------
The Subcommittee, however, obtained Georgia Bovee's typed
notes from September 22, 1998, indicating that Mr. Benson
executed trades for her because her computer was not
functioning correctly.\631\ Ms. Bovee wrote:
---------------------------------------------------------------------------
\631\ Typed notes, Sept. 22, 1998, produced by Georgia Bovee (Feb.
Hr'g Ex. 65).
CALLED MIKE BENSON AND HAD HIM BUY ANOTHER STOCK GENZ
FOR ME. HE BOUGHT IT FOR ME * * * I IMMEDIATELY HAD
MIKE SELL IT FOR ME AT MARKET. HE DID THE BEST HE COULD
AND SOLD IT FOR 12\7/16\. THAT CAUSED ME TO LOSE
$143.00 WITH COMMISSION.\632\
---------------------------------------------------------------------------
\632\ Id.
Mr. Strawbridge claimed that Mr. Benson ran the trading floor
and acted ``as a guide for traders.'' \633\ Mr. Strawbridge
also alleged that Mr. Benson told him and his customers that he
was licensed when, in fact, he was not.\634\ Mr. Benson said
that customers may have viewed him as a branch manager because
he was a part owner of the office.\635\
---------------------------------------------------------------------------
\633\ Strawbridge Int. at 3.
\634\ Id.
\635\ Benson Int. at 5.
---------------------------------------------------------------------------
In addition, Mr. Benson inserted in his name as ``Branch
Manager'' on the Branch Office Survey for the Seattle
Office.\636\ During a Subcommittee interview, however, he
claimed that it was a mistake.\637\ Mr. Benson admitted that he
may have also signed new account forms and journal forms prior
to obtaining his Series 62 license.\638\ Ms. Bovee told
Subcommittee staff that she first learned from Mr. Strawbridge
that Mr. Benson was not licensed.\639\ Ms. Bovee claimed that
she confronted Mr. Benson with that information, both in
writing and personally, and that Mr. Benson tried to explain
how he was doing his job without possessing a license.\640\
---------------------------------------------------------------------------
\636\ Feb. Hr'g Ex. 16, at 1.
\637\ Benson Int. at 5.
\638\ Id.
\639\ Bovee Int. at 4.
\640\ Id.
---------------------------------------------------------------------------
It appears that Mr. Zayas also worked as a branch manager
prior to being fully licensed. Although Mr. Zayas obtained his
Series 7 license prior to opening the Watertown office,\641\ he
did not obtain his Series 63 license,\642\ required by the
Commonwealth of Massachusetts, until August 6, 1997, well after
he opened the office.\643\ The Branch Office Agreement that
governed the Watertown office refers to Mr. Zayas as ``the
Manager,'' and is dated December 6, 1996.\644\ Mr. Zayas
claimed that he was not the branch manager between March and
September 1997, because he did not have his Series 63 license
during that time period.\645\ In fact, Mr. Zayas stated that no
one at All-Tech ever told him that he would need to obtain a
Series 63 license until about three weeks before he was
scheduled to open the office.\646\ Mr. Zayas testified that a
broker named Allen Sloane was the branch manager in the
Watertown office until Mr. Zayas passed the Series 63
exam.\647\ Yet, in a document called Boston Branch Office
Survey Results, dated June 18, 1997, Mr. Zayas is listed as the
``Branch Manager'' and Mr. Sloane is listed as the ``Assistant
Manager.'' \648\
---------------------------------------------------------------------------
\641\ Zayas Dep. at 46.
\642\ Zayas CRD #2816153 at ``Exam History.'' The Series 63 exam is
the ``Uniform Securities Agent State Law Examination'' which is
required by some states in addition to the NASD's requirements. NASD
Registration and Qualification Requirements at 9.
\643\ Zayas Dep. at 46-47, 130.
\644\ Watertown Agreement at 1.
\645\ Zayas Dep. at 130-31.
\646\ Id. at 130.
\647\ Id. at 130-31.
\648\ Boston ``Branch Office Survey Results,'' June 18, 1997, at 2
(``Boston Branch Survey'') (Feb. Hr'g Ex. 66). Mr. Zayas testified that
this document was filled out by Richard Raciti, a sales manager at All-
Tech. Zayas Dep. at 172.
---------------------------------------------------------------------------
Mr. Zayas' explanation of whether or not he was the branch
manager at this time was inconsistent. First, he testified that
he does not know why his name appeared as Branch Manager.\649\
Yet, he said ``yes'' in response to the question, ``[w]ere you
told at the time, even though you hadn't taken the Series 63,
that you were going to be the branch manager during that time
frame?'' \650\ Then, Mr. Zayas testified that he was the branch
manager, and in the same answer stated that Allen Sloane was
the branch manager.\651\ Finally, in response to the question,
``[a]t the time this was prepared, which is June 1997,
regardless of whatever licenses you had, were you acting as the
branch manager of this office,'' Mr. Zayas took the Fifth
Amendment.\652\
---------------------------------------------------------------------------
\649\ Zayas Dep. at 172.
\650\ Id. at 173.
\651\ Id.
\652\ Id. at 174.
---------------------------------------------------------------------------
The evidence strongly suggests that, for some period of
time, both Messrs. Benson and Zayas acted as the branch
managers for their respective offices and did so without
obtaining the necessary securities licenses. Even more
problematic, however, is the evidence that All-Tech allowed
Messrs. Benson and Zayas to operate branch offices without the
requisite securities licenses. Indeed, All-Tech's failure to
perform this most rudimentary oversight and supervisory
function is probative of the large weaknesses in its compliance
structure before the arrival of Mr. Ogele.
(6) All-Tech May Have Allowed Certain Persons to Act as
Unregistered Investment Advisers in Violation of State Laws. In
general terms, and with certain exceptions, an ``investment
adviser'' is a person who advises others for compensation,
concerning the value of securities or the advisability of
investing in, purchasing or selling securities.\653\ Under the
National Securities Markets Improvement Act of 1996
(``NSMIA''), Title III of which is the Investment Advisers
Supervision Coordination Act, responsibility of investment
adviser oversight is divided between the states and the federal
government.\654\ In very general terms, an investment adviser
with less than $25 million of assets under management is
required to register with the state unless he or she is exempt
from registration and investment advisers with more than $25
million of assets under management are required to register
with the SEC.\655\ Many states, such as Massachusetts and
California, have followed NSMIA which allows a person with no
place of business in the state to trade up to five accounts for
compensation without registration.\656\
---------------------------------------------------------------------------
\653\ Investment Advisers Act of 1940, Section 202(a)(11), Codified
at 15 U.S.C. Sec. 80b-2(a)(11).
\654\ ``Memorandum of Understanding Concerning Investment Advisers
and Investment Adviser Representatives,'' adopted Apr. 27, 1997,
www.nasaa.org/iaoversight/iamou.html, at 1.
\655\ Id.
\656\ National Securities Markets Improvement Act of 1996, National
Pub. L. No. 104-290 (Oct. 11, 1996); Mass. Regs. Code tit. 950,
Sec. 12.205; Cal. Corp. Code Sec. 25202.
---------------------------------------------------------------------------
All-Tech customers are permitted to give another day trader
the authority to trade for them through the use of an
authorization form completed by the customer.\657\ In fact,
former branch manager Fred Zayas said that Mr. Houtkin helped
to organize arrangements where a third party would trade a
customer's account.\658\ Mr. Zayas said that Mr. Houtkin
located a trader for Mr. Zayas' personal account when he first
became a customer of All-Tech, because at the time there was no
office geographically convenient to Mr. Zayas.\659\ According
to Mr. Zayas, Mr. Houtkin found a few potential traders for Mr.
Zayas to interview before making his selection. Mr. Zayas
testified that the ``rules'' of these third-party trading
arrangements included that Mr. Zayas would pay the trader a
draw of $1,000 per week and that Mr. Zayas and the trader would
split profits and losses 50/50 against which the $1,000 draw
would be applied.\660\ Mr. Zayas said that, to his knowledge,
the day trader who traded his account was not registered as an
investment adviser.\661\ When asked whether he was aware that
one of his customers was trading for others and whether that
person was registered as an investment adviser, Mr. Zayas
asserted his Fifth Amendment right and refused to answer the
questions.\662\
---------------------------------------------------------------------------
\657\ Feb. Hr'g Ex. 35, Section 4(B), Sample Forms (1) ``Trading
Authorization Limited to Purchases and Sales of Securities and
Commodities;'' (2) ``Full Trading Authorization with Privilege to
withdraw Money and/or Securities.''
\658\ Zayas Dep. at 171.
\659\ Id. at 34.
\660\ Id. at 35.
\661\ Id. at 36.
\662\ Id. at 77-78.
---------------------------------------------------------------------------
Allowing--and especially constructing--third party trading
arrangements means that All-Tech might be permitting persons to
trade illegally as unregistered investment advisers. Thus, All-
Tech requires day traders who seek to trade the accounts of
other customers to complete a form on which they represent that
they are registered as investment advisers.\663\ In his audit
of the Dallas Branch Office, Mr. Ogele stated as follows:
---------------------------------------------------------------------------
\663\ Feb. Hr'g Ex. 35, Section 4(B), Sample Forms: Instructions
for Investment Advisor Representation Letter and Letter.
As with the other branches, the Dallas branch has
customers who have designated other traders to trade
their account pursuant to a limited trading authority.
The State of Texas does not have a de minimis [sic]
exemption for investment advisers; consequently,
anybody that trades another person's account must
register as an investment adviser. As a matter of
policy, All-Tech does not gather detailed information
from such traders as to whether they are registered but
obtains only a representation from the traders that
they are currently registered as investment
advisers.\664\
---------------------------------------------------------------------------
\664\ Internal Memorandum from Franklin I. Ogele, Chief Compliance
Officer for All-Tech, to David Thompson, Branch Manager for Dallas
Branch, re: Dallas Branch Audit, June 25, 1999, at 2 (``Dallas Office
Audit'') (Feb. Hr'g Ex. 67).
Because All-Tech does not independently verify that a day
trader is registered as an investment adviser, it is impossible
for the firm or the customers whose accounts are being traded
to be certain that third-party traders are not in violation of
state laws governing the registration of investment advisers.
At a minimum, All-Tech should take affirmative steps to ensure
that, when it facilitates a third-party trading arrangement for
one of its customers, as it did for Mr. Zayas, the selected
trader is either registered as an investment adviser or is
exempt from the registration requirement.
IV. CASE STUDY: PROVIDENTIAL SECURITIES, INC.
Providential Securities, Inc. (``Providential'') offers
retail brokerage and day trading services to its approximately
5,000 clients at offices in California, Oregon, and New
York.\665\ The firm focuses its marketing and customer
recruitment efforts on the Vietnamese community, particularly
in the ``Little Saigon'' area of Southern California.\666\
---------------------------------------------------------------------------
\665\ Fahman Dep. at 72, 188-89.
\666\ Id. at 32, 34.
---------------------------------------------------------------------------
A. Providential's Founding and Corporate Structure
Providential President Henry D. Fahman is a 46 year-old
Vietnamese immigrant who told Subcommittee staff that he worked
for several brokerage firms prior to opening Providential in
March 1993.\667\ Mr. Fahman said that he decided to open
Providential because he saw a tremendous opportunity to provide
brokerage services to the Vietnamese community in Southern
California.\668\ These traditional services include providing
investment advice and stock recommendations, executing trades,
and offering investment options, such as mutual funds, to
clients. Mr. Fahman said that the original incorporators of
Providential were himself, his wife, and two close friends and
that his total initial investment was about $20,000.\669\ Mr.
Fahman noted that he served as the sole officer of Providential
during its first years of operations.\670\ Mr. Fahman holds the
following securities licenses: Series 3, 4, 7, 24, 53, and
63.\671\
---------------------------------------------------------------------------
\667\ Id. at 6, 18, 21-24, 32.
\668\ Id. at 34.
\669\ Id. at 35, 37.
\670\ Id. at 36.
\671\ Id. at 27-28.
---------------------------------------------------------------------------
Providential's headquarters is located in Fountain Valley,
California, and Mr. Fahman is the President and Chief Executive
Officer of the firm.\672\ He told Subcommittee staff that
Providential currently has offices located in the following
California municipalities: Alhambra, Encino, Glendale, Lake
Forest, and Laguna Hills.\673\ Providential had a branch office
in Los Angeles until November 1999.\674\ Further, Mr. Fahman
said that Providential has a branch office in Beaverton, Oregon
and a branch office in New York City.\675\ According to Mr.
Fahman, Providential also has an office in Phoenix, Arizona
which it is in the process of closing.\676\
---------------------------------------------------------------------------
\672\ Id. at 70, 106.
\673\ Id. at 67.
\674\ Moon Int. at 2.
\675\ Fahman Dep. at 68.
\676\ Id.
---------------------------------------------------------------------------
Mr. Fahman said that about 5,000 customers currently
maintain accounts with Providential.\677\ In 1998,
Providential's gross revenues were $3,702,357 and the firm made
a profit of $154,940,\678\ most of which Mr. Fahman said he
reinvested in the firm's operations.\679\ In 1999, Providential
had gross revenues of $5,315,205 but incurred a loss for the
year of $379,334.\680\ Mr. Fahman estimated that his salary
ranged from $45,000 in 1998 to $55,000 in 1999.\681\
---------------------------------------------------------------------------
\677\ Id. at 189.
\678\ Letter from Providential Securities, Inc. to Wesley Phillips,
Investigator for the Subcommittee, undated (Feb. Hr'g Ex. 68 ).
\679\ Fahman Dep. at 189-190.
\680\ Feb. Hr'g Ex. 68.
\681\ Fahman Dep. at 189, 191.
---------------------------------------------------------------------------
(1) Providential's Senior Officers and Compensation System
for Registered Representatives. In addition to serving as
Providential's President and Chief Executive Officer, Mr.
Fahman said that he was the firm's Chief Compliance Officer
from its founding until late 1999.\682\ Mr. Fahman said that he
hired Richard J. Ponce as Providential's new Chief Compliance
Officer in late 1999, and he hired Stephen M. Rubenstein to
serve as the Vice President of Clearing Services.\683\
According to Mr. Fahman, Mr. Ponce has more than ten years
experience as an SEC and NASD examiner and Mr. Rubenstein is a
former Chief Executive Officer of J.B. Oxford, which is a self-
clearing firm.\684\ Mr. Fahman testified that these two
individuals will report directly to him and will manage other
officers and employees within the firm.\685\ Mr. Fahman said
that one of the reasons he hired Mr. Ponce was to ``provide
stricter supervision over [the] day trading operation'' and to
bring on board compliance personnel ``with more experience and
knowledge to oversee and supervise the growing day trading
business.'' \686\
---------------------------------------------------------------------------
\682\ Id. at 138-39. Mr. Fahman testified that he relinquished his
role as Chief Compliance Officer shortly before his deposition by
Subcommittee staff on December 15, 1999. Id. at 138.
\683\ Id. at 106-107.
\684\ Id. at 106.
\685\ Id. at 108.
\686\ Id. at 22, 139, 140.
---------------------------------------------------------------------------
Among Providential's senior officers, Mr. Fahman said that
his brothers, Timothy D. Fahman and Theodore Fahman, are key
figures in the firm and that they serve as the Operations
Manager and Financial and Operations Principal,
respectively.\687\ According to Mr. Fahman, Timothy Fahman is
not a registered representative and is responsible for managing
Providential's back office support systems.\688\ Mr. Fahman
said that his brother Theodore essentially serves as
Providential's chief financial officer in his role as the
Financial Operations Principal.\689\ In addition, Mr. Fahman
testified that Theodore serves other key roles at the firm,
such as reviewing and approving new customer account
forms.\690\
---------------------------------------------------------------------------
\687\ Id. at 108, 110
\688\ Id. at 40.
\689\ Id. at 110.
\690\ Id. at 143-44. According to Mr. Fahman, Theodore Fahman is a
registered representative. Id. at 40.
---------------------------------------------------------------------------
Mr. Fahman said that about 20 individuals work at
Providential's Fountain Valley headquarters and those persons
are actually employees of the firm and provide support services
to the various Providential offices.\691\ In his Subcommittee
deposition, however, Mr. Fahman explained that the registered
representatives who work in Providential's branch offices are
independent contractors rather than employees of the firm.\692\
Under the contracts that Providential signs with its registered
personnel, the brokers retain about 85 to 90 percent of their
gross commissions to cover virtually all of their operating
expenses, including compensation for branch office employees,
rent, and telephones.\693\ Mr. Fahman testified that
Providential retains the remaining ten to fifteen percent of
the commissions.\694\ In return for paying these funds to
Providential, Mr. Fahman said that Providential provides
various services to the branch offices, such as compliance
procedures, stock order execution systems, and stock quotation
services.\695\ According to Mr. Fahman, Providential's
compensation plan is superior to that of larger brokerage firms
because it encourages the brokers to generate additional
business, thereby benefitting both the brokers and
Providential.\696\
---------------------------------------------------------------------------
\691\ Id. at 93.
\692\ Id. at 50.
\693\ Id. at 51-52, 94.
\694\ Id. at 55.
\695\ Id.
\696\ Id. at 50-51.
---------------------------------------------------------------------------
(2) History of Providential's Day Trading Business.
According to Mr. Fahman, Providential first began to offer day
trading services to its customers through its Los Angeles
branch office.\697\ The branch manager of Providential's Los
Angeles office was Tae Goo Moon.\698\ Mr. Fahman said that he
first met Mr. Moon in late 1996, after Mr. Moon had read an
article about Providential in a brokerage industry trade
magazine.\699\ Mr. Fahman testified that, in late 1996 or early
1997, he hired Mr. Moon to work as a full-service broker in
Providential's former headquarters in Huntington Beach,
California.\700\ Mr. Fahman said that about 50 of Mr. Moon's
customers, who were mainly of Korean descent, transferred their
accounts to Providential when Mr. Moon joined the firm.\701\
---------------------------------------------------------------------------
\697\ Id. at 78-80.
\698\ Id. at 42-43.
\699\ Id. at 45. At the time of their meeting, Mr. Moon was the
President of Hanmi Securities (``Hanmi'') in Los Angeles.
\700\ Id. at 43, 45.
\701\ Id. at 49.
---------------------------------------------------------------------------
According to Mr. Fahman, Mr. Moon opened the Los Angeles
branch office under the name ``Hahna Global Securities'' as a
dba of Providential.\702\ Mr. Fahman said that he entered into
a verbal agreement with Mr. Moon in which Mr. Moon and the
other personnel at the Los Angeles office would be independent
contractors of Providential.\703\
---------------------------------------------------------------------------
\702\ Id. at 54. Mr. Moon told Subcommittee staff that the name
``Hahna'' means ``first'' or ``unique'' in the Korean language. Moon
Int. at 3.
\703\ Fahman Dep. at 55. Mr. Fahman explained that this arrangement
was similar to the independent contractor agreements he uses for
Providential's other branch offices. Id.
---------------------------------------------------------------------------
According to Mr. Fahman, in June or July 1997, Mr. Moon
suggested that the Los Angeles office begin offering day
trading services to its clients in addition to traditional
retail brokerage services.\704\ Mr. Fahman said, however, that
Providential's clearing firm, Bear Stearns, was not equipped to
provide day trading services at that time.\705\ Mr. Fahman
testified that Mr. Moon was eager to enter the day trading
business, so Mr. Moon entered into an agreement with another
broker-dealer, Go Trading, which was prepared to immediately
provide day trading services through its clearing firm, Penson
Financial.\706\ According to Mr. Fahman, the Los Angeles branch
office provided day trading services to its clients under the
supervision of Go Trading from June or July 1997 until July
1998, when Providential changed clearing firms and acquired the
capacity to offer day trading services.\707\ Providential
purportedly supervised Mr. Moon's day trading operation from
that date until the Los Angeles branch office closed in
November 1999.\708\
---------------------------------------------------------------------------
\704\ Id. at 80.
\705\ Id.
\706\ Id. at 80, 82.
\707\ Id. at 83, 92.
\708\ Id. at 92; Moon Int. at 2.
---------------------------------------------------------------------------
Mr. Fahman testified that, between July 1997 and July 1998,
Providential continued to supervise all of the Los Angeles
office's retail brokerage operations but he insisted that
Providential had no responsibility to supervise Mr. Moon's
handling of the day trading business, since Mr. Moon had a
separate arrangement with Go Trading.\709\ Mr. Fahman claimed
that California law allows a registered representative to be
licensed with more than one broker-dealer.\710\ Based on this
understanding of California law, Mr. Fahman testified that he
had no obligation to supervise Mr. Moon's day trading operation
before July 1998, when Mr. Moon ceased doing business with Go
Trading.\711\ Mr. Fahman conceded that, even during Mr. Moon's
relationship with Go Trading, Providential was still obligated
to supervise Mr. Moon's retail brokerage operations.\712\
---------------------------------------------------------------------------
\709\ Fahman Dep. at 84.
\710\ Id. at 82-83.
\711\ Id.
\712\ Id. at 84.
---------------------------------------------------------------------------
While dual licensing of registered representatives is
permitted by applicable securities laws, it does not--contrary
to Mr. Fahman's claim--relieve broker-dealers of the obligation
to supervise all registered representatives who are licensed
with their firms. SEC officials interviewed by Subcommittee
staff indicated that, while a branch office could be affiliated
with more than one broker-dealer, neither firm could avoid the
legal responsibility to supervise the operations of the branch
office.\713\ In other words, Mr. Fahman and Mr. Moon could not
agree to relieve Providential of the legal responsibility to
supervise the Los Angeles office's day trading operation as
long as the registered personnel in that office were licensed
with Providential.
---------------------------------------------------------------------------
\713\ Subcommittee Interview with SEC senior officials, Dec. 17,
1999.
---------------------------------------------------------------------------
Mr. Fahman said that Providential's next foray into the day
trading business started in October or November 1997, when his
childhood friend, Tony Nguyen, expressed an interest in
offering day trading services to clients of Providential's
branch office in Oregon.\714\ Mr. Nguyen told Subcommittee
staff that, in 1997, he became interested in day trading as a
result of reading an article about a day trading firm called
Block Trading.\715\ Mr. Fahman testified that Providential
opened the Oregon office primarily to offer day trading
services rather than retail brokerage services.\716\ Mr. Fahman
said that, much like Mr. Moon's relationship with Go Trading,
the Oregon office initially cleared its day trading
transactions through a firm called Choice Investments.\717\ Mr.
Fahman testified that the Oregon office cleared its day trading
business through Choice Investments from October or November
1997 until July or August 1998, when Providential began
offering day trading services of its own.\718\
---------------------------------------------------------------------------
\714\ Fahman Dep. at 19, 84.
\715\ Interview of Tony Nguyen, Dec. 9, 1999, at 2 (``Nguyen
Int.'').
\716\ Fahman Dep. at 64.
\717\ Id. at 84-85.
\718\ Id. at 86-87.
---------------------------------------------------------------------------
Mr. Nguyen said that he does not have a Series 24 license,
which is necessary to manage a branch office designated as an
OSJ branch.\719\ However, several former customers identified
Mr. Nguyen as the branch manager of the Oregon office. Mr.
Nguyen said that Mr. Fahman's brother, Theodore, is technically
responsible for overseeing the Oregon office because he has a
Series 24 license.\720\ Mr. Nguyen said that Theodore Fahman
travels periodically from Fountain Valley to Oregon for one to
two weeks at a time to oversee its operations.\721\ Mr. Nguyen
said, however, that he is generally responsible for directing
the activities of the Oregon office, including all dealings
with prospective customers and ensuring that the computer
system is operating correctly.\722\
---------------------------------------------------------------------------
\719\ Nguyen Int. at 2.
\720\ Id.
\721\ Id.
\722\ Id.
---------------------------------------------------------------------------
Henry Fahman testified that Providential offers day trading
services to customers at its California offices in Fountain
Valley, Alhambra, Glendale, Encino, and Lake Forest as well as
the Oregon branch office.\723\ Mr. Fahman said that, on any
given trading day, about seven to ten customers day trade at
Providential's offices.\724\ In response to Subcommittee
Interrogatories, Providential indicated that approximately 200
customers opened day trading accounts at the firm between July
1997 and October 1, 1999.\725\
---------------------------------------------------------------------------
\723\ Fahman Dep. at 79.
\724\ Id. at 95.
\725\ Letter from Henry D. Fahman, President of Providential
Securities, Inc. to Wesley M. Phillips, Investigator for Subcommittee,
Dec. 3, 1999, at 2 (Feb. Hr'g Ex. 69). Providential provided day
trading customer account forms to the Subcommittee. The Subcommittee
identified 234 day trading customer accounts among these Providential
records.
---------------------------------------------------------------------------
(3) Key Providential Officials Have Committed Securities
Violations or Settled Securities Litigation. Several key
Providential officials have been cited for securities
violations or have settled litigation asserting such
allegations. The following summarizes the alleged securities
violations and the settlements of these allegations against
Henry D. Fahman, Tae Goo Moon, and Keith Kim:
Henry D. Fahman--On September 25, 1998, NASDR
approved a letter of acceptance by Henry D. Fahman and
Providential to resolve outstanding allegations of
securities violations. Specifically, these allegations
were that Providential, acting under the supervision of
Mr. Fahman, effected transactions in securities or
attempted to do so without sufficient net capital.
Further, NASDR alleged that Providential, acting
through Mr. Fahman, failed to disclose to public
customers by written notice or confirmation the price
securities were purchased from and sold to customers
and the firm's contemporaneous offsetting purchase or
sales price to or from a market maker. NASDR censured
Mr. Fahman and Providential and issued a fine of
$28,500. In addition, NASDR ordered Mr. Fahman to
requalify by examination as a financial operations
principal.\726\ On August 11, 1999, a panel of NASD
arbitrators also found Providential's Los Angeles
office liable in connection with an NASD complaint
filed by Amy Le. Providential paid an award of $12,500
to Ms. Le on behalf of Mr. Moon and the Los Angeles
branch office. In that case, which is discussed in
detail later in this report, the arbitration panel
sanctioned Providential for failing to comply with
discovery orders and ordered the firm to pay $450.\727\
Mr. Fahman and Providential also recently settled an
NASD complaint filed by a former day trading customer
named Brenda Richardson.\728\ In the NASD complaint,
Ms. Richardson alleged that the respondents, among
other things, engaged in deceptive practices and made
false and misleading statements.\729\ While denying the
allegations, Providential and its clearing firm
recently agreed to settle the matter, paying Ms.
Richardson a significant sum of money for her
losses.\730\
---------------------------------------------------------------------------
\726\ NASD.CRD for Henry D. Fahman at 4-5 (Feb. Hr'g Ex. 70).
\727\ NASD Regulation, Inc. Arbitration Judgment, Case #98-03309,
Aug. 11, 1999, at 3 (``Le Judgment'') (Feb. Hr'g Ex. 71).
\728\ Telephone Interview of William Shepherd, Jan. 14, 2000, at 1
(``Shepherd Int.'').
\729\ Second Amended Statement of Claim, Case No: 98-02900, at 4-5
(``Richardson Complaint'').
\730\ Shepherd Int. at 1.
---------------------------------------------------------------------------
Tae Goo Moon--A former client named Hee Young Kim
filed an NASD complaint against Mr. Moon when he was
the President of Hanmi, before he joined Providential.
Mr. Moon said that Mr. Kim sued him and Hanmi for
making unsuitable stock recommendations that cost Mr.
Kim money. Mr. Moon said that Hanmi settled the NASD
complaint for $60,000 in 1995.\731\ As explained above,
an NASD arbitration panel found Mr. Moon liable in the
Amy Le case on August 11, 1999.\732\ The arbitration
panel ordered Mr. Moon to pay $12,500 in connection
with his role as branch manager of Providential's Los
Angeles office.\733\ As with Mr. Fahman and
Providential, Mr. Moon also recently settled the NASD
complaint brought by Ms. Richardson.\734\
---------------------------------------------------------------------------
\731\ Moon Int. at 2.
\732\ Ex. 71, at 3.
\733\ Id.
\734\ Shepherd Int. at 1.
---------------------------------------------------------------------------
Keith Kim--In August 1997, Mr. Moon hired Keith Kim
as a Senior Vice President at Providential's Los
Angeles branch office. In January 1998, Mr. Kim faced
allegations of failure to supervise, breach of
fiduciary duty, and negligence. On September 29, 1998,
the NASD held Mr. Kim liable and ordered him to pay the
claimant $32,541.\735\
---------------------------------------------------------------------------
\735\ NASDR CRD for Kwang Ho Kim (Feb. Hr'g Ex. 72). Kwang Ho Kim
is also known as Keith Kim.
---------------------------------------------------------------------------
B. Providential's Risk Disclosure Policies
Today, Providential maintains new customer account
documentation that gives very strong warnings about the
potential risks associated with day trading.\736\
Providential's ``Customer Acknowledgment of Risk'' warns
potential customers that the risk of loss in day trading can be
substantial and encourages the customer to determine whether he
or she is suitable for day trading.\737\ The document also
warns potential day trading customers that they could lose more
than their initial investment, that customers will be charged
interest for margin loans, and that commission charges can be
significant because of the high volume of trading.\738\
---------------------------------------------------------------------------
\736\ ``Customer Acknowledgment of Risk,'' Providential Securities,
Inc. (Feb. Hr'g Ex. 73).
\737\ Id. at 1.
\738\ Id. at 1-2.
---------------------------------------------------------------------------
The Subcommittee's investigation found evidence, however,
that this risk disclosure form has not always been used by
Providential and that the form has not been consistently
utilized by the firm's various branch offices. For instance,
when Amy Le opened a day trading account at Providential's Los
Angeles office, neither Mr. Moon nor Mr. Cao gave her this risk
disclosure form. Instead, Mr. Cao asked Ms. Le to sign a form
entitled ``Acknowledgment of Liability,'' which did not mention
day trading, much less its risks.\739\ The form also made no
reference to excessive commission charges or the risks of
margin trading.\740\
---------------------------------------------------------------------------
\739\ ``Acknowledgment of Liability,'' Hahna Global Securities,
June 6, 1998 (Feb. Hr'g Ex. 74).
\740\ Id.
---------------------------------------------------------------------------
The Subcommittee reviewed new account forms provided by
Providential and determined that Providential has generally
required new customers to review and sign the risk disclosure
forms. For example, virtually all of the 43 new day trading
customers who opened accounts at the Oregon branch office
signed the risk disclosure statements. In addition, the
Subcommittee reviewed the new account forms provided for
Providential's California offices, which also show a
substantial number of customers signed the risk disclosure
forms. The Subcommittee could not verify, however, that all of
Providential's day trading customers reviewed written risk
disclosure forms.
C. Providential's Misleading Advertising
Even though the evidence suggests that Providential
provided most of its customers written risk disclaimers, the
evidence shows that Providential officials may have undermined
these good risk disclosure documents with misleading
advertising and oral statements that contradicted the
disclaimers. The Subcommittee's investigation uncovered several
questionable statements by Providential in newspaper
advertisements and on its website. Former Providential
customers also claimed to Subcommittee staff that Providential
officials made statements regarding the high profitability of
day trading without adequate disclosure of the attendant risks.
Such deceptive and misleading practices can often encourage
individuals with limited investment experience and financial
resources to enter the high-risk, day trading lifestyle.
(1) Deceptive Newspaper Advertisement. In his Subcommittee
deposition, Mr. Fahman testified that he was responsible for
reviewing and approving all firm advertising.\741\ He said that
Providential has never advertised on television for day trading
customers.\742\ Mr. Fahman explained that Providential had
occasionally advertised on the radio but that the bulk of its
day trading advertising was in newspapers.\743\
---------------------------------------------------------------------------
\741\ Fahman Dep. at 243.
\742\ Id. at 242.
\743\ Id.
---------------------------------------------------------------------------
In 1998, Providential ran an advertisement in the Orange
County Register and in Oregon newspapers that significantly
distorted the risks and difficulties of profitable day
trading.\744\ The Providential advertisement states that day
trading is ``a very simple'' and ``is not complex.'' \745\ It
then adds the unremarkable proposition that day trading
requires traders to ``Buy Low, * * * Sell High!!!'' \746\ In
addition, the Providential advertisement encourages prospective
day traders in the following manner: ``Take the appropriate
gain Put the advantage in your column with the best of the best
in the stock market today!!!!'' \747\ The advertisement omits
any mention of, or disclosure about, the risks of day
trading.\748\
---------------------------------------------------------------------------
\744\ Two former Providential day trading customers have filed a
complaint with the NASD seeking $425,000 in damages from Providential,
resulting from trading losses and commissions. Claimants First Amended
Statement of claim, Case No.: 99-01874, at 1. Among other allegations,
the plaintiffs allege that they saw this newspaper advertisement and
opened day trading accounts at Providential on the basis of the
misleading representations made about the profit potential of day
trading. Id. at 3-4. The claimants also allege that the ``Premier Day
Trading Course'' cited in the advertisement lasted less than two hours
and consisted of a few ``simplistic charts.'' Providential and the
other respondents have denied the allegations in the lawsuit and claim
that the plaintiffs were sophisticated investors. Id. at 2.
\745\ Providential advertisement (Feb. Hr'g Ex. 75).
\746\ Id.
\747\ Id.
\748\ Id.
---------------------------------------------------------------------------
Under questioning at his deposition, Mr. Fahman conceded
that day trading is not a ``simple game.'' \749\ In fact, Mr.
Fahman testified that day trading is ``rather complex'' and
``[i]t's not that simple.'' \750\ Further, at the
Subcommittee's hearing on February 25, 2000, he described day
trading as, ``very complex.'' \751\ He indicated that
Providential later discontinued the advertisement because it
did not accurately reflect the difficulties and risks
associated with day trading.\752\ Mr. Fahman acknowledged under
questioning from Subcommittee staff that the advertisement
``only reflected the positive, exciting aspects of day
trading.'' \753\ In addition, he remarked at the Subcommittee's
hearing that the ad was, ``* * * not wholesome in all
context.'' \754\
---------------------------------------------------------------------------
\749\ Fahman Dep. at 247.
\750\ Id.
\751\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
\752\ Fahman Dep. at 246.
\753\ Id.
\754\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
(2) Deceptive Website Text. Prior to January 2000,
Providential's Internet website contained potentially
misleading information about Providential's day trading
operation. Specifically, Providential's website states that the
firm and its current clearing agent, Penson, have the technical
capacity to quickly execute clients' trades, which is essential
for day traders to profit from small changes in stock
prices.\755\ The website states that ``Providential Securities,
Inc. can process trades quickly and efficiently to secure
optimum prices for our clients.'' \756\
---------------------------------------------------------------------------
\755\ ``Welcome to Providential Securities,'' www.providential.net/
english/main.html, Dec. 14, 1999, at 1.
\756\ Id.
---------------------------------------------------------------------------
The Subcommittee's investigation has raised questions,
however, about whether Providential's software and other
technology actually provides efficient execution services to
day trading clients as the website proclaims. For example, Mr.
Moon told Subcommittee staff that one reason he decided to
close Providential's Los Angeles branch office was that his
customers were constantly experiencing computer-related
problems.\757\ Mr. Moon said that customers frequently
complained about the computer system and that computer
difficulties prompted some customers to take their business to
other firms.\758\ Mr. Moon further stated that neither Go
Trading nor Providential ever provided adequate computer
support.\759\ In addition, two former Providential clients, who
day traded from Providential's Oregon branch office, told
Subcommittee staff that the firm's order execution system
frequently malfunctioned and caused them to lose money.\760\
---------------------------------------------------------------------------
\757\ Moon Int. at 4.
\758\ Id.
\759\ Id.
\760\ Telephone Interview of Holly Clark, Nov. 22, 1999, at 3
(``First Clark Int.''); Telephone Interview of Matt Lehr, Nov. 29,
1999, at 4 (``Lehr Int.'').
---------------------------------------------------------------------------
Providential's website also contains misleading information
about customer account protection provided by the Securities
Investor Protection Corporation (``SIPC''). SIPC is a non-
profit corporation chartered by Congress that provides limited
customer account compensation to the clients of registered
brokerage firms that fail or are liquidated.\761\
Providential's website includes the following statement
regarding the firm's SIPC coverage:
---------------------------------------------------------------------------
\761\ ``Who We Are,'' www.sipc.org, Feb. 10. 2000.
PROTECTION FOR ALL INVESTOR ACCOUNTS
Providential Securities, Inc. is a Member of the
Securities Investor Protection Corporation (SIPC). Each
client account is insured for $25,000,000; the first
$500,000 of protection is provided by SIPC and the
balance by an excess SIPC coverage insurance policy
through a major domestic insurer.\762\
---------------------------------------------------------------------------
\762\ ``Welcome to Providential Securities, ``www.providential.net/
english/main.html, Dec. 14, 1999, at 1.
To unsophisticated investors, Providential's statement
regarding SIPC coverage could easily leave the misimpression
that SIPC would cover their day trading losses when, in fact,
SIPC protection only applies when the entire brokerage firm
fails. The Subcommittee referred Providential's website to SIPC
officials for review and comment. SIPC's General Counsel later
informed the Subcommittee that SIPC objected to Providential's
use of the word ``insured'' in its disclosure about SIPC
protection.\763\ He explained that the word ``insured'' is
``inappropriate in this context. A reference to `insurance' can
lead investors to believe that they can never lose money which
they invested with a brokerage firm that is a member of SIPC.''
\764\ He also informed Subcommittee staff that he would refer
the Providential advertisement to the NASDR and ask
Providential to conform with SIPC's advertising
regulations.\765\
---------------------------------------------------------------------------
\763\ Letter from Stephen P. Harbeck, SIPC General Counsel, to
Wesley M. Phillips, Investigator for the Subcommittee, Nov. 30, 1999,
at 1 (Feb. Hr'g Ex. 76).
\764\ Id.
\765\ Id.
---------------------------------------------------------------------------
(3) Deceptive Statements by Providential Officials. The
investigation uncovered several former day trading customers of
Providential who alleged that the firm's employees or agents
made misleading and deceptive statements about the risks of day
trading. For instance, Amy Le, a former customer of
Providential's Los Angeles office, told Subcommittee staff that
Huan Van Cao, a day trader at the office, persuaded her to open
an account with deceptive statements about the risks of day
trading.\766\ She said Mr. Cao told her that he ``could
guarantee a twenty percent annual return.'' \767\ Mr. Cao,
according to Ms. Le, chided her for being overly cautious with
her funds when she declined initially to open a day trading
account at Providential's Los Angeles office.\768\ Ms. Le added
that on the day she decided to open the account with Ms. Cao he
asked her to sign a form called a ``Sophisticated Investor
Acknowledgment'' but did not explain the purpose of the
form.\769\ In addition, Ms. Le said Mr. Cao told her nothing
about the risks of day trading, even after she told him that
her investment objective was ``income,'' an objective at odds
with a speculative day trading strategy.\770\ Mr. Cao denied
most of Ms. Le's allegations under oath at his Subcommittee
deposition, though he conceded that he never gave Ms. Le any
risk disclosure pertaining to day trading.\771\
---------------------------------------------------------------------------
\766\ Interview with Amy Le, Oct. 21, 1999, at 4 (``Le Int.'').
\767\ Id. at 2.
\768\ Id. at 3.
\769\ Id. at 4.
\770\ Id.
\771\ Deposition of Huan Van Cao, Dec. 28, 1999, at 158, 161-68
(``Cao Dep.'').
---------------------------------------------------------------------------
Subcommittee staff also interviewed a former day trader at
Providential's Oregon office named Holly Clark, who stated that
Providential officials Tony and Alex Nguyen frequently made
misleading statements about the profit potential of day trading
without adequately disclosing the risks involved. For example,
Ms. Clark stated that Tony Nguyen would frequently walk the day
trading floor and state that the clients would become
``millionaires'' if they day traded for one year.\772\ Ms.
Clark also said that Alex Nguyen, who taught Providential's
training course, stated that day traders should follow certain
technical strategies that would virtually guarantee that they
would ``make a lot of money.'' \773\ Ms. Clark alleged,
however, that Alex Nguyen told her that she should not tell
anyone about this technical strategy to get rich day
trading.\774\ Subcommittee staff interviewed Tony Nguyen and he
adamantly denied making any statements that would mislead
Providential customers about the profit potential of day
trading and the risks involved.\775\
---------------------------------------------------------------------------
\772\ Holly Clark Written Complaint to Oregon's Division of Finance
and Corporate Securities, Nov. 12, 1999 at 4 (``Clark Complaint'')
(Feb. Hr'g Ex. 77).
\773\ Id.
\774\ Id.
\775\ Nguyen Int. at 3.
---------------------------------------------------------------------------
D. Providential's Suitability Standards for New Day Trading Accounts
In addition to requiring risk disclaimers, Providential has
established suitability standards to ensure that the financial
resources and investment objectives of its customers are
appropriate for a high-risk, day trading strategy. Mr. Fahman
told Subcommittee staff that he was responsible for reviewing
and approving Providential's General Securities Supervisory
Procedures and Compliance Manual (``Compliance Manual'') as
part of his previous responsibilities as Chief Compliance
Officer.\776\ Mr. Fahman said that the Compliance Manual has
been in effect in several versions since the firm's
founding.\777\ The Compliance Manual sets forth Providential's
procedures for complying with securities laws and regulations
as well as the firm's day trading account opening and
documentation procedures.\778\
---------------------------------------------------------------------------
\776\ Fahman Dep. at 136-37.
\777\ Id. at 137.
\778\ Providential Securities, Inc., General Supervisory Procedures
and Compliance Manual, (Oct. 1998) (Feb. Hr'g Ex. 78).
---------------------------------------------------------------------------
The most recent version of Providential's Compliance
Manual, dated October 1998, contains a section entitled ``Know
Your Client.'' \779\ This section states in pertinent part:
---------------------------------------------------------------------------
\779\ Ex. 78, ``Branch Office Supervisory Procedures,'' at 7.
Living in such a litigious society, [brokers] need to
take special care in gathering complete and accurate
financial information about [your] customers. You must
take the time with your clients to assess their
situation on a regular basis, and make [sic]
recommendations based on your fact finding mission.
Suitability is the key to client recommendation.\780\
---------------------------------------------------------------------------
\780\ Id. (emphasis in original).
According to Mr. Fahman, the Know Your Customer procedures
require Providential's brokers to collect significant financial
information about a prospective client before opening a new day
trading account, including the client's occupation, income, net
worth, investment objectives, and tax status.\781\ Mr. Fahman
testified that Providential requires the firm's representatives
to collect this information from prospective customers so the
firm can determine whether the customer is suitable for day
trading.\782\
---------------------------------------------------------------------------
\781\ Fahman Dep. at 161. Mr. Fahman confirmed that Providential
representatives must collect this information for both retail and day
trading accounts. Id. at 162.
\782\ Id. at 161, 169.
---------------------------------------------------------------------------
Providential's Compliance Manual also makes clear that firm
representatives should consider rejecting customers that do not
provide the necessary information. Specifically, the Compliance
Manual states the following: ``Suggestion--If a client refuses
to disclose certain information, you need to document it and
have the client initial the appropriate section. One last
thought, perhaps the client who will not disclose adequate
information is not the client you want to be spending your
valuable time with.'' \783\ The Compliance Manual advises its
brokers that ``the more you know about the customer and the
more of that information that is recorded on account cards and
associated documents * * * the more you are qualified to serve
as his agent.'' \784\ In addition, Mr. Fahman stated that all
Providential representatives are required to know their
customers and are required to ``strongly encourage the
potential day trader to provide complete financial information.
If they don't do that, it gives us reason to doubt their
ability or suitability of becoming a day trader.'' \785\
---------------------------------------------------------------------------
\783\ Feb Hr'g Ex. 78, ``Branch Office Supervisory Procedures,'' at
7.
\784\ Id. at 8.
\785\ Fahman Dep. at 161, 163.
---------------------------------------------------------------------------
Despite the Compliance Manual's requirement to obtain
financial information from prospective customers before opening
new day trading accounts, Subcommittee staff found that--in
practice--Providential often ignored its Compliance Manual and
failed to obtain the financial information from prospective
clients that would allow the firm to determine whether the
customer was suitable for day trading. The Subcommittee
reviewed 234 day trading account forms and found that 61, or 26
percent, of the new account forms lacked the basic financial
information, such as income and net worth, that Providential
stipulated was necessary to open new day trading accounts.
At Providential's Los Angeles office, the failure to obtain
basic financial information about new day traders was striking.
The Subcommittee analyzed 31 day trading account forms from the
Los Angeles branch office and found that 23, or 74 percent,
lacked either income or net worth data, or both. Providential's
Oregon branch office demonstrated the best performance where
only 14 percent of the new account forms failed to include the
required financial information. During his Subcommittee
deposition, Mr. Fahman was shown several of these new account
forms that lacked the necessary customer financial information.
Mr. Fahman conceded that it was an ``oversight'' for
Providential to have approved the opening of these day trading
accounts without the requisite financial information about the
customers.\786\
---------------------------------------------------------------------------
\786\ Id. at 216.
PROVIDENTIAL DAY TRADING CUSTOMER ACCOUNT FORMS THAT FAILED TO INCLUDE
REQUIRED FINANCIAL INFORMATION ON INCOME AND/OR NET WORTH
------------------------------------------------------------------------
Number of Percentage
Number of forms of forms
Branch forms without without
reviewed required required
information information
------------------------------------------------------------------------
California branches\1\........... 160 32 20
Los Angeles branch............... 31 23 74
Oregon branch.................... 43 6 14
--------------------------------------
Total...................... 234 61 26
------------------------------------------------------------------------
\1\ Providential's Fountain Valley, Alhambra, Encino, Glendale, and Lake
Forest offices.
Source: Providential day trading customer account forms.
(1) Providential's Minimum Financial Requirements for New
Day Trading Accounts. At the outset of this investigation, the
Subcommittee asked Providential to disclose any established
minimum financial standards for accepting new day trading
accounts. In a written response dated December 3, 1999,
Providential indicated that it required new day trading
customers to have a minimum income of $50,000 and a minimum net
worth of $200,000.\787\ Providential also stated that it
formerly required a minimum deposit of $50,000 to open a day
trading account.\788\ Providential indicated, however, that it
subsequently lowered this initial deposit requirement to
$10,000 in response to competitive pressure from other day
trading firms.\789\ In a letter to the Subcommittee, Mr. Moon
contradicted Mr. Fahman by stating that Providential's Los
Angeles branch office had no minimum financial requirements for
day trading accounts.\790\
---------------------------------------------------------------------------
\787\ Feb. Hr'g Ex. 69, at 2. In Mr. Fahman's deposition, he
retreated from the letter by referring to the standards as ``targets''
rather than fixed requirements. Fahman Dep. at 193-94.
\788\ Feb. Hr'g Ex. 69, at 2.
\789\ Id.
\790\ Feb. Hr'g Ex. 18, at 13.
---------------------------------------------------------------------------
During his deposition, Mr. Fahman was asked about the
competitive pressures that prompted the decision to lower the
minimum capital requirement for new day trading accounts:
Q: Are you saying that while that [$50,000] was your
minimum requirement when you started for risk capital,
you ended up having to lower it to $10,000 because the
day trading firms with which Providential was competing
were accepting people with much less risk capital than
$50,000, is that fair?
A: Right. Right.
Q: And in order to compete for those customers and
that business, Providential felt it was necessary to
lower their standards to $10,000, is that accurate?
A: Yes.\791\
---------------------------------------------------------------------------
\791\ Fahman Dep. at 195.
Mr. Fahman conceded that the amount of risk capital available
to a day trader is directly related to the day trader's chances
of profitability.\792\ At his Subcommittee deposition, Mr.
Fahman agreed that a trader ``starting with $150,000 has a
better chance of success than one with $50,000.'' \793\ He was
then asked as follows:
---------------------------------------------------------------------------
\792\ Id. at 134.
\793\ Id.
Q: And that would be the same--the same equation
would exist between $50,000 and $30,000, and $30,000
and $10,000?
A: Right.
Q: It's a sliding scale?
A: Right.\794\
---------------------------------------------------------------------------
\794\ Id.
Thus, by lowering its risk capital standards, Providential is
now routinely accepting prospective day trading customers that
it previously considered unsuitable for this speculative
strategy. As Mr. Fahman's testimony shows, Providential is now
accepting day trading customers whose chances of success are
less than what Providential formerly considered appropriate for
opening a new account. Moreover, Providential is now pursuing
the day trading business of these unsuitable customers because
of competitive pressures from firms whose standards were once
lower than those of Providential.
(2) Henry and Theodore Fahman Reviewed and Approved All New
Day Trading Accounts. Mr. Fahman testified that he and his
brother, Theodore, are ultimately responsible for reviewing and
approving all of Providential's new day trading account forms
to ensure compliance with the firm's minimum financial
requirements.\795\ For example, if a prospective customer
sought to open a day trading account at Providential's Oregon
office, the applicant would complete the required
documentation, including the new account form, and Tony Nguyen
would sign the paperwork. Mr. Nguyen would then send the
documentation to Providential's Fountain Valley
headquarters.\796\ According to Mr. Fahman, officials in
Providential's Operations Department would then review the
documentation prior to forwarding it on to either Mr. Fahman or
his brother.\797\ Once the Fahmans had approved the account
paperwork, Providential's home office would assign an account
number to the customer so that he or she could begin day
trading.\798\
---------------------------------------------------------------------------
\795\ Id. at 142-44.
\796\ Id. at 143.
\797\ Id.
\798\ Id. at 143-44.
---------------------------------------------------------------------------
(3) Providential Frequently Fails to Comply With Its Stated
Day Trading Suitability Standards. Despite Providential's
stated minimum financial requirements for new day trading
accounts, the Subcommittee found that the firm frequently
failed to comply with its own suitability standards. The
Subcommittee's analysis of the 234 new account forms produced
by Providential showed that the firm often frequently opened
day trading accounts in which the customers' stated financial
condition was below the firm's then-existing minimum financial
requirements of $50,000 in income and $200,000 of net worth.
Overall, the Subcommittee found that 123, or 52.5 percent, of
the 234 new account forms failed to satisfy the income or net
worth targets or both.\799\ For example, one new customer
account form from a Providential branch office in California
listed the client as having an income of $25,000 and a net
worth of $50,000.\800\
---------------------------------------------------------------------------
\799\ This figure includes the 61 new account forms that did not
contain the basic financial information needed to perform the
rudimentary suitability analysis required by Providential's Compliance
Manual. The Subcommittee included these poorly documented forms in the
overall total of 123 because, without the required financial
information, Providential officials had no way of determining whether
the new account forms were in compliance with the firm's financial
targets. If the 61 new account forms without the required financial
information are not included in the calculation, then 62, or 26
percent, of the 234 new account forms failed to meet Providential's
minimum financial requirements in place at the time.
\800\ New Account Approval-B for Kiem Van Dao, July 26, 1999 (Feb.
Hr'g Ex. 79).
---------------------------------------------------------------------------
The Subcommittee's analysis also found that Providential
representatives frequently failed to report the day trading
customer's initial deposit amount, which Mr. Fahman testified
was needed to open a new account.\801\ The Subcommittee found
that the vast majority of the 234 customer account forms do not
provide any information relating to the ``Initial Deposit.''
Moreover, based upon the information disclosed by many of its
customers, Providential permitted day traders to open new
accounts with less money than its already lenient standard of
$10,000. For example, Providential allowed one customer to open
an account with just $3,000.\802\ Another Providential customer
opened a day trading account with only $2,359.42.\803\ This
customer also listed a net income of $20,000 and net worth of
$20,000.\804\
---------------------------------------------------------------------------
\801\ Fahman Dep. at 194-95.
\802\ New Account Approval-B for Hon V. Bui and Huong H. Ly, Apr.
6, 1999 (Feb. Hr'g Ex. 80).
\803\ New Account Approval-B for Bedar Samee, Feb. 1, 1999 (Feb.
Hr'g Ex. 81).
\804\ Id.
---------------------------------------------------------------------------
During his Subcommittee deposition, Subcommittee staff
asked Mr. Fahman about the opening of a day trading account for
a bus driver who disclosed an annual income of $50,000 and a
net worth of $95,000.\805\ The applicant's new account form
does not indicate, however, how much risk capital the bus
driver had available to open her day trading account.\806\ When
asked whether the customer was suitable for day trading, Mr.
Fahman testified that: ``By purely looking at this [new account
document], it would be hard to tell whether or not [the
customer] would be suitable, and most likely they would not.''
\807\ Mr. Fahman's concession that it was impossible to
evaluate the suitability of customers whose forms were
incomplete evidences that Providential failed routinely to
obtain the basic information about its customers that its
Compliance Manual identified as critical to evaluating their
suitability for day trading.
---------------------------------------------------------------------------
\805\ New Account Approval-B for Clara B. and Daryl Larry
Grabowski, Apr. 13, 1999 (Feb. Hr'g Ex. 82).
\806\ Id.
\807\ Fahman Dep. at 224.
---------------------------------------------------------------------------
Subcommittee staff showed Mr. Fahman several other new
account forms that clearly did not meet Providential's
requirements for opening new day trading accounts. For example,
in one case, the new account form did not provide any
information about the client's income or net worth and the
client listed their investment objectives as ``short-term
growth with high risk'' and ``long-term growth with greater
risk.'' \808\ In this case, Mr. Fahman acknowledged that
Providential lacked the required information to determine and
that checking ``long term growth with greater risk'' is
inconsistent with opening a day trading account.\809\ These
examples illustrate that Providential representatives not only
failed to gather the information necessary to perform the
suitability analysis required in the firm's Compliance Manual,
but also frequently opened day trading accounts even when the
customer provided financial information below the minimum
requirements of the firm.
---------------------------------------------------------------------------
\808\ New Account Approval-B for Shao-Shin Liu, undated (Feb. Hr'g
Ex. 83).
\809\ Fahman Dep. at 215-16.
---------------------------------------------------------------------------
(4) Providential Officials Estimate That a Significant
Number of Day Traders Lose Money. Providential was unable to
provide empirical data to the Subcommittee regarding the
profitability of its day traders.\810\ Mr. Fahman estimated,
however, that only about 20 to 30 percent of Providential's day
traders actually make money.\811\ Although there is no concrete
data to support or contradict this estimate, other Providential
representatives gave evidence indicating that Mr. Fahman's
estimate of profitability is, if anything, high. For instance,
Mr. Moon indicated that none of the individuals who opened day
trading accounts at the Los Angeles branch office ever made
money.\812\ In fact, Mr. Moon estimated that the average day
trading customer remained at the Los Angeles branch for only
about one month and that the average customer lost
approximately $50,000.\813\ Mr. Fahman testified that he had no
reason to disagree with Mr. Moon's profitability estimates at
Providential's Los Angeles branch office.\814\ In addition, Mr.
Fahman said that only ``a couple'' of clients at the firm's
Oregon office were profitable.\815\ At his deposition, Mr.
Fahman was asked as follows:
---------------------------------------------------------------------------
\810\ Id. at 253.
\811\ Id.
\812\ Feb. Hr'g Ex. 18, at 4.
\813\ Moon Int. at 5.
\814\ Fahman Dep. at 256.
\815\ Id.
Q: * * * do you think, throughout the entire day
trading operation at Providential, that the substantial
majority of your day trading accounts are not
profitable but that there may be a handful of accounts
that are profitable? Would that be a fair, probably,
estimate?
A: Overall, I would say it's a fair estimate.\816\
---------------------------------------------------------------------------
\816\ Id. at 256-57.
---------------------------------------------------------------------------
E. A Providential Day Trader Mislead the Firm's Clients for Whom He
Traded, and Generated Significant Losses
The Subcommittee's investigation determined that Mr. Cao,
who traded for customers of Providential's Los Angeles office,
made misleading and deceptive statements to those customers
regarding the profitability and risks of day trading. Moreover,
the evidence shows that Mr. Cao was a de facto representative
of Providential's Los Angeles branch office when he enticed
several unsophisticated investors into opening day trading
accounts at Providential over which he possessed discretionary
trading authority. While in possession of the customers'
trading authorizations, Mr. Cao pursued a highly risky day
trading strategy that resulted in enormous trading losses and
excessive commission charges. The evidence gathered by the
Subcommittee indicates that, when he day traded the accounts of
these Providential customers, Mr. Cao may have been in
violation of Texas and California securities laws, requiring
the registration as an investment adviser of anyone who trades
the account of another for compensation.
On August 11, 1999, an NASD arbitration panel awarded one
of Mr. Cao's clients, Amy Le, a judgment of nearly $38,000
against Mr. Cao, Mr. Moon, and Providential's Los Angeles
office. Mr. Cao defaulted on the judgment and has sought
bankruptcy protection.
(1) Huan Van Cao's Initial Association With Providential's
Los Angeles Branch Office. In his deposition, Mr. Cao told
Subcommittee staff that he was born on April 7, 1953 in the
former South Vietnam and that he emigrated to the United States
in 1975.\817\ Mr. Cao said that he currently lives in an
apartment in Fountain Valley, California and that he maintains
a home in Houston, Texas where his family resides.\818\ Mr. Cao
told Subcommittee staff that, upon arriving in the United
States, he took pre-law and finance courses at the University
of Houston but never obtained his undergraduate degree.\819\
Mr. Cao said that, since 1993, he has been a full-time day
trader who trades for himself and clients for
compensation.\820\ Mr. Cao confirmed that he does not hold any
licenses in the securities industry.\821\ By the spring of
1998, Mr. Cao was day trading his own account and the accounts
of other customers at a day trading firm in Houston called
Gro.\822\
---------------------------------------------------------------------------
\817\ Cao Dep. at 15.
\818\ Id. at 6-7.
\819\ Id. at 27, 29-30, 48.
\820\ Id. at 5, 51-52.
\821\ Id. at 50-51.
\822\ Id. at 87.
---------------------------------------------------------------------------
Mr. Moon, the branch manager of Providential's Los Angeles
office, told Subcommittee staff that he first heard about Mr.
Cao from a friend who lived in Houston.\823\ Mr. Moon said
that, in March 1998, he offered Mr. Cao the position of Senior
Vice President for a consulting firm that Mr. Moon was starting
called Hahna Global Capital Management (``HGCM'').\824\ Mr.
Moon told Subcommittee staff that HGCM was a distinct corporate
entity from Hahna Global Securities, which was the trade name
for Providential's Los Angeles branch office.\825\ Mr. Moon
indicated that he established HGCM as a consulting firm to
cultivate investments by Korean businesses in Vietnam.\826\ Mr.
Moon told Subcommittee staff that he hired Mr. Cao to assist
HGCM's consulting business, since he believed that Mr. Cao had
many contacts in Vietnam.\827\
---------------------------------------------------------------------------
\823\ Moon Int. at 5.
\824\ Id.
\825\ Id. at 3.
\826\ Id.
\827\ Id. at 5.
---------------------------------------------------------------------------
Mr. Cao testified that, in the spring of 1998, Mr. Moon
called him from California and asked him to become a day trader
at Providential's Los Angeles office.\828\ Mr. Cao said that
Mr. Moon initially offered him compensation of $5,000 per
month.\829\ Mr. Cao said that Mr. Moon subsequently offered him
the position with HGCM and discussed potential consulting work
in Vietnam.\830\ In March 1998, Mr. Cao left Houston for
California to begin day trading at Providential's Los Angeles
office.\831\ When Mr. Cao left for Los Angeles, he took a few
of his Houston accounts with him, but Mr. Cao testified that
most of the 21 or 22 Providential customers for whom he day
traded were prospects that he developed from the Vietnamese
community in California.\832\
---------------------------------------------------------------------------
\828\ Cao Dep. at 89-90.
\829\ Id. at 90.
\830\ Id. at 57, 90-91, 93.
\831\ Id.
\832\ Id. at 126, 134-37.
---------------------------------------------------------------------------
(2) Mr. Cao Was a De Facto Representative of Providential.
Although Mr. Moon claims that he hired Mr. Cao to work for HGCM
and not Providential's Los Angeles office, the evidence
demonstrates that Mr. Cao was a de facto representative of the
branch office and that Mr. Moon brought him to Los Angeles
expressly to increase the day trading business. Mr. Moon told
Subcommittee staff that he understood that Mr. Cao was a
successful day trader in Houston and that Mr. Cao's trading
would benefit Providential's Los Angeles office by generating
as many as 300 ``tickets'' per day and attracting other high
volume day traders.\833\ Moreover, the Subcommittee obtained a
copy of an ``Independent Contractor Agreement,'' between Mr.
Moon and Mr. Cao that required Mr. Cao to generate ``around 300
tickets per day'' at a charge of $25.00 per ticket.\834\ The
contract, which was unsigned, was prepared on HGCM letterhead
and stated that it was based on a ``conversation'' between Mr.
Moon and Mr. Cao.\835\ In consideration for the 300 daily
tickets generated by Mr. Cao at the Los Angeles office, the
contract stated that Mr. Cao's expenses would be paid from the
net commissions.\836\ For example, the contract stated that Mr.
Cao's expenses would include his apartment, car, and personal
secretary.\837\ In addition, under the contract, Mr. Cao would
be entitled to 50 percent of the net profit from his day
trading activity.\838\
---------------------------------------------------------------------------
\833\ Moon Int. at 5.
\834\ Independent Contractor Agreement Between Hahna Global Capital
Management and Huan Van Cao, May 1998 (Feb. Hr'g Ex. 84).
\835\ Id. Mr. Moon and Mr. Cao gave conflicting stories to
Subcommittee staff about the unsigned contract. Mr. Moon told
Subcommittee staff that Mr. Cao proposed the contract and that he
promised to generate 300 trades per day and that his friends would
generate another 1,000. According to Mr. Moon, this was one of several
proposals Mr. Cao advanced to obtain compensation for his day trading
activities. Mr. Moon said that he never signed the contract and that he
became disillusioned by Mr. Cao and his clients because they never
generated close to 300 day trading tickets per day. Moon Int. at 5-6.
By contrast, Mr. Cao told Subcommittee staff that Mr. Moon proposed the
contract but that Mr. Cao rejected the proposal. Cao Dep. at 99-100.
Mr. Cao said that it was unreasonable for Mr. Moon to expect him to
generate 300 trades per day. Id. at 93-94.
\836\ Feb. Hr'g Ex. 84.
\837\ Id.
\838\ Id.
---------------------------------------------------------------------------
Despite Mr. Moon's contention that Mr. Cao was never an
employee of the Los Angeles office, the contract on HGCM
letterhead strongly suggests that Mr. Moon was responsible for,
and/or complicit in, the contract's preparation. Furthermore,
the terms of the contract are similar to other contracts that
Mr. Fahman testified are routinely used by Providential to
establish independent contractor relationships with branch
office personnel.\839\ For example, the independent contractor
agreements between Providential and its branch office
representatives allow the branch officers to retain a
significant percentage of the commissions charged to customers
to pay operating expenses.\840\ Indeed, Mr. Fahman testified
that he had a verbal independent contractor agreement with Mr.
Moon to operate Providential's Los Angeles branch office
whereby Mr. Moon retained 90 percent of his commissions to
cover the office's expenses.\841\ Similarly, the proposed
contract between Mr. Moon and Mr. Cao would have permitted Mr.
Cao to pay his expenses from the gross commissions that he
generated. The fact that Mr. Moon was familiar with such
Providential contracts as a branch manager strongly suggests
that he was responsible for drafting the contract between
himself and Mr. Cao and that it reflected Mr. Moon's
understanding of their mutual agreement.\842\
---------------------------------------------------------------------------
\839\ Fahman Dep. at 50-56.
\840\ Id. at 50-52.
\841\ Id. at 55-56.
\842\ Mr. Fahman testified that he was originally the President and
Chief Executive Officer of HGCM but that he resigned shortly after its
incorporation. Id. at 104.
---------------------------------------------------------------------------
The Subcommittee discovered other evidence suggesting that
Mr. Cao was a de facto representative of Providential's Los
Angeles branch office and that his mission was to increase its
day trading commission revenue. For example, Mr. Moon told
Subcommittee staff that HGCM and the Providential branch office
shared the same office space in Los Angeles and that Mr. Cao
had his own office and shared a secretary with Mr. Moon.\843\
Also, according to a document Mr. Moon provided to Subcommittee
staff, Mr. Moon paid Mr. Cao nine separate payments totaling
$13,500 between April 1, 1998 and September 25, 1998.\844\ Mr.
Cao testified that Mr. Moon paid him this money to cover his
expenses as a day trader at Providential's Los Angeles branch
office.\845\ Mr. Moon told Subcommittee staff that Mr. Cao
later repaid about $12,000 of these expense payments.\846\
---------------------------------------------------------------------------
\843\ Moon Int. at 6.
\844\ Letter from Susan H. Tregub, Attorney for Tae Goo Moon, to
Eugene Horwitz, Special Investigator for NASDR, Sept. 29, 1999, at 5
(Feb. Hr'g Ex. 85).
\845\ Cao Dep. at 221.
\846\ Feb. Hr'g Ex. 85, at 5. Mr. Cao testified that he borrowed
only $10,000, which he repaid in full. Cao Dep. at 220-21.
---------------------------------------------------------------------------
As documented in more detail below in the Brenda Richardson
and Amy Le case summaries, Mr. Cao held himself out as an
officer of Hahna by using the ``Hahna Global'' name to recruit
and maintain day trading clients. For example, HGCM's
letterhead listed Mr. Cao as an officer of the firm, and Mr.
Cao sent that letterhead to prospective clients, including Ms.
Richardson.\847\ Mr. Cao even used his office at Providential's
Los Angeles branch to meet with prospective day trading
clients, such as Ms. Le.\848\ Further, Mr. Moon said that he
authorized Mr. Cao to perform basic administrative functions,
suggesting that Mr. Cao acted as a Providential employee whose
role was to recruit prospective day traders and generate
commission revenue for the firm. For example, Mr. Moon said
that Mr. Cao had the authority to fill out information on new
account forms for prospective day trading clients, which he did
in the Amy Le case. Mr. Moon also told Subcommittee staff that
Mr. Cao was authorized to arrange loans from other Providential
customers to his clients so that the clients could satisfy
margin calls.\849\ Mr. Cao was even listed as the ``account
executive'' on Ms. Richardson's trading records.\850\
---------------------------------------------------------------------------
\847\ Letter from Huan Van Cao, Senior Vice President of Hahna
Global Capital Management, to Brenda Richardson, Mar. 20, 1998 (Feb.
H'g Ex. 86).
\848\ Le Int. at 3.
\849\ Moon Int. at 7. In fact, Mr. Moon told Subcommittee staff
that most of these loans were made by his partner, Chung Lee, rather
than other Providential customers. Id.
\850\ Trading records provided to the Subcommittee by Brenda
Richardson.
---------------------------------------------------------------------------
Based on this evidence, the Subcommittee determined that
Mr. Cao acted as an agent of Mr. Moon and Providential's Los
Angeles branch office from the spring of 1998 until Mr. Moon
asked him to leave later that fall. The evidence shows that, in
his capacity as an agent for the Los Angeles office, Mr. Cao
solicited new day trading accounts for the firm and the firm
obtained the benefit of commission revenue that was generated
from those new accounts.
(3) Summary of Brenda Richardson and Amy Le Cases. The
Subcommittee found that, in his role as an agent of
Providential's Los Angeles office, Mr. Cao made false and
misleading statements about the risks and profitability of day
trading to at least two clients, Ms. Richardson and Ms. Le. Ms.
Richardson recently compromised her NASD complaint against
Providential, Penson Securities, and others and received a
substantial sum of money in settlement. Ms. Le won a judgment
of nearly $38,000 against Mr. Cao, Mr. Moon and Providential's
Los Angeles office in August 1999. Neither Ms. Richardson nor
Ms. Le have received any compensation from Mr. Cao because he
has defaulted on the judgment and filed for bankruptcy
protection.\851\
---------------------------------------------------------------------------
\851\ Cao Dep. at 216, 220.
---------------------------------------------------------------------------
(a) Brenda Richardson. Ms. Richardson was born in 1951 and
is a pharmacist living in Houston.\852\ In the summer of 1997,
Ms. Richardson began day trading on-site at a Houston firm
called Gro-Corporation.\853\ Ms. Richardson said that she had
no experience investing prior to her association with the day
trading industry.\854\ Ms. Richardson said that she was
completely unprepared to day trade successfully and lost about
$30,000 to $40,000 within a few weeks.\855\ While at Gro, Ms.
Richardson met Mr. Cao who she understood was a successful day
trader.\856\ Ms. Richardson said that Mr. Cao offered to help
her resolve several billing disputes that she had with
Gro.\857\ For example, Ms. Richardson said that Mr. Cao offered
to help her resolve disputed margin calls that Gro required her
to pay.\858\ Ms. Richardson alleges that, during this period,
Mr. Cao told her that he was an attorney and retired
policeman.\859\
---------------------------------------------------------------------------
\852\ Interviews of Brenda Richardson, No. 18, 1999 and Dec. 17,
1999, at 1 (``First Richardson Int.'').
\853\ Id. at 3.
\854\ Id. at 1.
\855\ Id. at 3. Ms. Richardson cited a lack of training by Gro as
one reason that she was ill-prepared to day trade. Id.
\856\ Id. at 4.
\857\ Id. at 5.
\858\ Id.
\859\ Id. at 4.
---------------------------------------------------------------------------
Ms. Richardson told the Subcommittee that she permitted Mr.
Cao to day trade her account at Gro and an account that she
shared with her daughter from about January 1998 until March
1998.\860\ Ms. Richardson said that she opened one account with
about $30,000 that she borrowed from her credit card.\861\
According to Ms. Richardson, she had a verbal arrangement with
Mr. Cao by which she received 60 percent of the net profits
that Mr. Cao generated day trading her account.\862\
---------------------------------------------------------------------------
\860\ If. at 6.
\861\ Id. at 5.
\862\ Id. at 6.
---------------------------------------------------------------------------
Mr. Cao acknowledged in a Subcommittee deposition that he
had an oral arrangement with Ms. Richardson whereby she paid
him ten to fifteen percent of the net trading profits he
generated in her Gro account.\863\ Mr. Cao testified that,
pursuant to this agreement, Ms. Richardson paid him about
$2,500 during the time he traded her account at Gro.\864\
---------------------------------------------------------------------------
\863\ Cao Dep. at 78-79.
\864\ Id. at 83.
---------------------------------------------------------------------------
When Mr. Cao arrived in California in March 1998, he sent
Ms. Richardson a letter advising her that he was in California
and that he would be in touch.\865\ Mr. Cao's letter was on
HGCM letterhead, but he sent the letter via the facsimile
machine in Providential's Los Angeles office.\866\ Ms.
Richardson alleges that Mr. Cao convinced her to transfer the
$56,000 which remained in her two accounts at Gro to
Providential's Los Angeles branch office.\867\ Ms. Richardson
told Subcommittee staff that, at that time, Mr. Cao told her
that ``Hahna'' offered many benefits over Gro. For instance,
she said that Mr. Cao told her that he had been given $500,000
from the firm to cover customer losses and that the firm did
not have margin calls.\868\ Ms. Richardson said that, to be
safe, she contacted the NASD to determine if a firm called
``Hahna'' actually existed.\869\ After the NASD confirmed to
her that Hahna was a branch office of Providential, Ms.
Richardson called the Los Angeles office to verify that Mr. Cao
was employed with the firm.\870\ After receiving assurances
that Mr. Cao was indeed affiliated with the Los Angeles office,
Ms. Richardson decided to transfer her accounts from Gro to
Providential.\871\
---------------------------------------------------------------------------
\865\ Ex. 86.
\866\ Cao Dep. at 85.
\867\ First Richardson Int. at 6-7.
\868\ Id. at 6.
\869\ Id. at 6.
\870\ Id.
\871\ Id.
---------------------------------------------------------------------------
In his deposition, Mr. Cao denied that he ever told Ms.
Richardson that she should transfer her accounts from Gro to
Providential's Los Angeles branch office.\872\ Mr. Cao claimed
that Ms. Richardson decided on her own to transfer the accounts
to Providential.\873\
---------------------------------------------------------------------------
\872\ Cao Dep. at 112.
\873\ Id. at 110, 112
---------------------------------------------------------------------------
Ms. Richardson told Subcommittee staff that it was her
understanding that Mr. Cao would embark on what she perceived
as a relatively conservative day trading strategy whereby he
would attempt to earn profits of $250 to $500 per day.\874\ The
evidence shows, however, that Mr. Cao pursued an aggressive day
trading strategy that resulted in substantial losses to Ms.
Richardson. Specifically, Mr. Cao made 1,397 trades in Ms.
Richardson's account in just ten weeks.\875\ Ms. Richardson
alleged that the trades generated commissions of about $38,000
and total trading losses of $30,000.\876\ Ms. Richardson also
alleged that Mr. Cao and the other respondents arranged for
about $550,000 to be loaned from other Providential customers
into Ms. Richardson's account to satisfy the margin calls
generated by Mr. Cao's trading.\877\ Ms. Richardson told
Subcommittee staff that she did not understand the purpose of
these loans. In fact, Ms. Richardson said that Mr. Cao told her
that the loans were necessary to utilize the $500,000 that the
firm had provided to him for the purpose of managing her
accounts.\878\ Ms. Richardson stated that Mr. Cao assured her
that the loans were not being used to meet margin calls.\879\
---------------------------------------------------------------------------
\874\ First Richardson Int. at 7.
\875\ Analysis of Richardson Account by William Sheperd &
Associates, at 1 (``Claimant's Exhibit 2A'').
\876\ Id. at 2.
\877\ Id. at 3.
\878\ First Richardson Int. at. 7.
\879\ Id.
---------------------------------------------------------------------------
Mr. Cao testified that, even though he day traded Ms.
Richardson's account, he never knew how much she earned for a
living and that he did not know her net worth.\880\ He also
denied ever knowing that Ms. Richardson borrowed money from her
credit cards to fund his day trading activities in her
account.\881\ Mr. Cao acknowledged that Ms. Richardson paid him
approximately $4,000 to $5,000 for trading her account at
Providential's Los Angeles office.\882\
---------------------------------------------------------------------------
\880\ Cao Dep. at 114.
\881\ Id. at 113.
\882\ Id. at 132.
---------------------------------------------------------------------------
On January 13, 2000, Ms. Richardson settled her NASD claim
arising from Mr. Cao's activities.\883\ As part of the
settlement, Ms. Richardson received a payment from
Providential's clearing firm, Penson Securities.\884\ Henry
Fahman, Providential's President, wrote Ms. Richardson a check
in satisfaction of her claims against Providential and Mr.
Moon, as the head of Providential's Los Angeles branch
office.\885\ As explained above, Mr. Cao has sought bankruptcy
protection and has refused to compensate Ms. Richardson for her
losses.\886\
---------------------------------------------------------------------------
\883\ Shepherd Int. at 1.
\884\ Id.
\885\ Id.
\886\ Cao Dep. at 216.
---------------------------------------------------------------------------
(b) Amy Le. Ms. Le is a homemaker who lives in Garden
Grove, California.\887\ In April of 1998, Mr. Cao approached
Ms. Le while she was working as a part-time sales clerk at a
music store that caters to the Vietnamese community located in
the ``Little Saigon'' area of Westminster, California.\888\ At
his Subcommittee deposition, Mr. Cao confirmed that he first
discussed day trading with Ms. Le in the music store in Little
Saigon.\889\ Mr. Cao testified that he frequently prospected
for clients among the members of the Vietnamese community in
Southern California.\890\ He explained his prospecting efforts
as follows:
---------------------------------------------------------------------------
\887\ ILe Int. at 1.
\888\ Id. at 2.
\889\ Cao Dep. at 145-46.
\890\ Id. at 136.
Q: Okay. And so you built a reputation in the
Vietnamese community working with these friends of
yours, and then they might pass your name on to other
people?
A: Well, I build my good reputation with my friend,
and it up to them to pass the word to somebody else.
* * * * *
Q: --on the West Coast? How many total do you think
you traded on their behalf?
A: In and out?
Q: Yeah.
A: Maybe 21, 22.
* * * * *
Q: So you might have a friend who wouldn't open an
account, but their brother might or their uncle----
A: No. They opened it----
Q: Oh, they would----
A: --and then after I make the good money, they--I
build up the trust, and then they refer to their
children or their in-laws.\891\
---------------------------------------------------------------------------
\891\ Id. at 136-37 (emphasis added).
Ms. Le said that, through a variety of misleading
statements, she came to trust Mr. Cao and he convinced her to
make her limited family savings available to him for day
trading at Providential's Los Angeles branch office. For
example, Ms. Le said that Mr. Cao told her that he could
guarantee a twenty percent investment return for his
clients.\892\ Ms. Le also said that Mr. Cao told her that he
was a registered broker and attorney.\893\ The Subcommittee has
determined that Mr. Cao was never an attorney or broker.\894\
According to Ms. Le, she believes that Mr. Cao made these
statements to impress her, explaining that such positions are
highly respected within the Vietnamese community.\895\ At the
Subcommittee's hearing in February though, Mr. Cao maintained
that Ms. Le was the one who inquired as to his occupation and
he responded, ``selling stock.'' \896\
---------------------------------------------------------------------------
\892\ Le Int. at 2.
\893\ Id.
\894\ The NASDR, Texas, and California securities regulators have
no listing of Mr. Cao as a registered broker or dealer. As stated
previously, Mr. Cao also told Subcommittee staff that he is not a
licensed broker or registered representative in the securities
industry. Cao Dep. at 51. Mr. Cao also confirmed that he was never an
attorney or auditor. Id. at 27.
\895\ Le Int. at 2.
\896\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
Ms. Le also said that Mr. Cao repeatedly contacted her by
telephone over a period of several weeks in an effort to
convince her to invest with him and Providential's Los Angeles
branch office.\897\ Ms. Le stated that she traveled to Los
Angeles from her home in Orange County to visit Mr. Cao in his
office.\898\ During this meeting, Ms. Le said that Mr. Cao took
several telephone calls from other customers and then claimed
that he had just made substantial profits for them.\899\
---------------------------------------------------------------------------
\897\ Le Int. at 3.
\898\ Id.
\899\ Id.
---------------------------------------------------------------------------
Mr. Cao also told her that he had a real-time quote machine
that ``blinked'' when it was time to buy and ``blinked'' again
when it was time to sell.\900\ Mr. Cao made similarly dubious
statements to the Subcommittee in his deposition. At his
Subcommittee deposition, Mr. Cao conceded that he told Ms. Le
that he had a ``money-making machine'' because the computer he
used for day trading was ``a machine to make money.'' \901\ He
explained that his computer monitor provided a blue signal when
it was time to buy a stock and a red signal when it was time to
sell a stock.\902\ Mr. Cao testified that the blinking lights
not only helped him ``avoid'' losses, but would actually
``prevent'' losses.\903\ Mr. Cao described his simplistic
approach to day trading in this colloquy:
---------------------------------------------------------------------------
\900\ Id.
\901\ Cao Dep. at 167.
\902\ Id. at 168-70.
\903\ Id. at 168.
Q: Is that kind of your strategy? You wait for the
light to start blinking?
A: Yes.
Q: And then when you see the light blinking that
tells you--if it's a blue light, that tells you that
you want to buy. And if you see a red light, that tells
you that you want to sell. Is that kind of the basics
of your strategy?
A: Yes, for day trading.\904\
---------------------------------------------------------------------------
\904\ Id. at 169-70.
In the course of her dealings with Mr. Cao, Ms. Le also
learned that Hahna was a branch office of Providential.\905\
Ms. Le said that Mr. Cao's association with Providential was
comforting to her because Providential was highly regarded
within the Vietnamese community.\906\ Ms. Le said that, in June
1998, she decided to invest with Mr. Cao because her car was
old and frequently broke down.\907\ She hoped Mr. Cao would
earn enough on her money from day trading so that she could buy
a new car.\908\
---------------------------------------------------------------------------
\905\ Le Int. at 4.
\906\ Id.
\907\ Id.
\908\ Id.
---------------------------------------------------------------------------
Mr. Cao drove from Los Angeles to Orange County, where Ms.
Le resides, and they sat in her old car to complete the
paperwork necessary to start Mr. Cao trading on her
behalf.\909\ Ms. Le said that, during their conversation, Mr.
Cao told her to look for a new car because he would earn a
substantial return on her investment.\910\ Ms. Le's new account
form stated that her investment objective was ``income'' rather
than ``short term growth with high risk.'' \911\ This new
account form strongly supports Ms. Le's contention that she did
not understand that Mr. Cao planned to use her funds for a high
risk trading strategy. The new account form also omitted Ms.
Le's net worth, which was required by Providential's Compliance
Manual, and indicated that the account was being opened with
only $10,000, well below the $50,000 minimum risk capital
requirement in effect at the time.\912\ Mr. Moon acknowledged
to Subcommittee staff that he was ``in error'' for approving
Ms. Le's new account form given her stated investment
objectives.\913\ Mr. Fahman agreed in his Subcommittee
deposition that, ``[b]ased on the information provided on the
new account form, it would not be appropriate'' to open Ms.
Le's account in 1998.\914\
---------------------------------------------------------------------------
\909\ Id.
\910\ Id.
\911\ New Account Approval-B for Amy Le, undated (Feb. Hr'g Ex.
87).
\912\ Id.
\913\ Moon Int. at 5.
\914\ Fahman Dep. at 239.
---------------------------------------------------------------------------
Ms. Le said that, while in Mr. Cao's car, she signed a
check for $10,000 and gave it to Mr. Cao.\915\ Ms. Le told
Subcommittee staff that ``her hands were shaking as she signed
the check'' and gave it to Mr. Cao.\916\ Ms. Le deposited
another $38,000 in her day trading account at Providential over
the next two months for a total deposit of $48,000.\917\ Ms. Le
said that the final deposit of $12,000 in July 1998, was money
that Ms. Le borrowed from her elderly mother.\918\ According to
Ms. Le, her mother planned to use this money to repair
ancestral graveyards in Vietnam.\919\ Ms. Le said that she
informed Mr. Cao of the source of these funds and the
importance of the money to her family.\920\ She told
Subcommittee staff that Mr. Cao promised to invest the funds
safely.\921\ Instead, Mr. Cao embarked on an aggressive day
trading campaign that, by September 1998, resulted in losses to
Ms. Le of about $35,000 out of her total deposit of
$48,000.\922\
---------------------------------------------------------------------------
\915\ Le Int. at 4.
\916\ Id.
\917\ Id. at 4-5.
\918\ Id. at 5.
\919\ Id.
\920\ Id.
\921\ Id.
\922\ Id. at 6.
---------------------------------------------------------------------------
Ms. Le also alleged that Mr. Cao provided misleading
information to her during this period about the performance of
her account.\923\ In addition, Ms. Le said that Mr. Cao and Mr.
Moon arranged for a $20,000 loan from Mr. Moon's partner into
Ms. Le's account to meet margin calls.\924\ Ms. Le said that
Mr. Cao telephoned her in July of 1998 and convinced her to
sign a loan authorization form.\925\ Even though the loan
authorization form states that the journalling of funds is ``to
cover the outstanding margin call in the account,'' Ms. Le
alleges that Mr. Cao told her that the purpose of the loan was
not to meet a margin call but, rather to increase her ``buying
power.'' \926\
---------------------------------------------------------------------------
\923\ Id. at 5.
\924\ Id.
\925\ Amy Le's Loan Authorization to Lori Assunto, Margin
Department of Penson Financial Services, July 6, 1998 (Feb. Hr'g Ex.
88). Le Int. at 5.
\926\ Le Int. at 5.
---------------------------------------------------------------------------
Mr. Cao testified that he ``never'' called Ms. Le on the
telephone to convince her to day trade her funds and he denied
that he ever told Ms. Le that he was an attorney or stock
broker.\927\ The Subcommittee did obtain some corroborative
evidence to support Ms. Le's claims from two other former day
trading clients of Mr. Cao, who substantiated her claim that
Mr. Cao presented himself as an attorney, registered
representative.\928\ One of these individuals, Dung Tran, has
since filed an NASD arbitration claim against Mr. Cao and
Providential, which is discussed in more detail below.\929\
---------------------------------------------------------------------------
\927\ Cao Dep. at 149, 167.
\928\ Telephone Interview of Dung Tran, Nov. 2, 1999, at 1-2
(``Dung Tran Int.''); Interview of Minn Tran, Nov. 2, 1999, at 1-2
(``Minn Tran Int.'').
\929\ NASD Regulation, Inc., Statement of Claim (No Case #), at 1
(``Tran Complaint'').
---------------------------------------------------------------------------
In his deposition, Mr. Cao made several key admissions that
corroborate much of Ms. Le's account. For instance, when asked
about any risk disclosure that might have been given to Ms. Le,
he claimed that Ms. Le was a sophisticated investor who said
she knew everything she needed to know to open a day trading
account.\930\ He was then asked directly about risk disclosure:
---------------------------------------------------------------------------
\930\ Cao Dep. at 162.
Q: Did you tell her it was high risk?
A: No, I did not tell her. I tell her that if you
want to know, Mr. Moon, he qualified to tell her.
Q: So you never sat down and told her this is a very
high risk, gambling type of strategy or anything like
that?
A: It not my job.\931\
---------------------------------------------------------------------------
\931\ Id. at 158.
Mr. Cao also admitted that Ms. Le told him she was ``very
poor'' in the course of his discussions with her about opening
an account at the Los Angeles office.\932\ Mr. Cao told
Subcommittee staff that, when he met Ms. Le in Orange County in
June 1998, Ms. Le showed him her old car and stated that she
would like to buy a new car from the proceeds of Mr. Cao's
trading activities.\933\ Thus, Mr. Cao essentially acknowledged
that he knew Ms. Le was not a suitable candidate for day
trading given her limited financial resources and unrealistic
investment objectives.
---------------------------------------------------------------------------
\932\ Id. at 151. Mr. Cao said that he understood Ms. Le to be a
housewife and part-time sales clerk at a music store. Id. at 155. He
also claimed, however, that Ms. Le's poverty was a ruse and that she
had access to a certificate of deposit in the amount of $280,000. Id.
at 171. Mr. Cao offered no evidence to support the allegation, however.
\933\ Id. at 151.
---------------------------------------------------------------------------
As explained above, Ms. Le filed an NASD arbitration claim
against Mr. Cao, Mr. Moon, Hahna, Providential and others. She
eventually received a judgment for $37,791.11 on August 11,
1999.\934\ The NASD arbitrators found Mr. Cao liable for
$22,600, Hahna liable for $12,500 and Providential and its
officers liable for $450.\935\ As stated previously, Mr. Fahman
testified that Providential paid the $12,500 judgment on behalf
of Mr. Moon as the branch manager of its Los Angeles
office.\936\ On October 22, 1999, Mr. Cao filed for bankruptcy
in the United States District Court in Houston.\937\ Ms. Le has
not been able to collect the $22,600 that Mr. Cao owes her as a
result of the judgment. Providential refused to pay Ms. Le the
portion of the judgment attributable to Mr. Cao because Mr.
Fahman claimed it was not his responsibility.\938\ Ms. Le told
Subcommittee staff that she has only collected about $8,000 of
the judgment after subtracting legal fees and court costs.\939\
---------------------------------------------------------------------------
\934\ Ex. 71.
\935\ Id.
\936\ Fahman Dep. at 182-83.
\937\ Huan Van Cao bankruptcy filing in the United States
Bankruptcy Court, Oct. 22, 1999, Case number: 99-40177 (Feb. Hr'g Ex.
89).
\938\ Fahman Dep. at 183.
\939\ Le Int. at 6.
---------------------------------------------------------------------------
(4) Huan Van Cao Continues to Day Trade for Clients at
Providential. Mr. Cao testified that Mr. Moon terminated his
day trading privileges at Providential's Los Angeles branch
office in September 1998.\940\ Mr. Moon told Subcommittee staff
that he terminated Mr. Cao in August 1998, after Ms. Le
complained about his trading activities.\941\
---------------------------------------------------------------------------
\940\ Cao Dep. at 189.
\941\ Moon Int. at 6.
---------------------------------------------------------------------------
The evidence shows that Mr. Cao obtained permission from
Mr. Fahman to begin day trading at Providential's Fountain
Valley office in September 1998, even though Mr. Fahman knew of
Ms. Le's complaints about Mr. Cao by the late summer of
1998.\942\ According to records provided to the Subcommittee by
Providential, Mr. Cao continued to day trade at Providential's
headquarters throughout 1999. The records indicate that Mr. Cao
day traded for himself, his wife, his daughter, and four other
clients.\943\ Mr. Cao testified that one of these clients had
paid him about $40,000 for his day trading services.\944\ Mr.
Cao said that this client's account subsequently lost
approximately $114,000, due largely to problems with
Providential's computer system.\945\
---------------------------------------------------------------------------
\942\ Cao Dep. at 181, 192.
\943\ Letter from Henry D. Fahman, President of Providential
Securities, to Wesley M. Phillips, Investigator for the Subcommittee,
undated (Feb. Hr'g Ex. 90).
\944\ Cao Dep. at 185.
\945\ Id. at 210.
---------------------------------------------------------------------------
That Mr. Cao continued to day trade for himself and other
clients at Providential throughout 1999 demonstrates the firm's
irresponsible business practices. By the time Mr. Cao began
trading at Providential's Fountain Valley office, Mr. Fahman
and Providential were fully aware that Ms. Le had alleged
serious misconduct against Mr. Cao and that he had been
expelled from the Los Angeles office by Mr. Moon. In addition,
other former customers of Mr. Cao, including Ms. Richardson,
had lodged similar allegations against him by this time.
Furthermore, in the fall of 1999, Mr. Cao filed for
bankruptcy. Indeed, Mr. Cao testified that he has no income and
insufficient assets to pay off his creditors, including Ms. Le.
Yet, Providential considers Mr. Cao suitable for day trading.
When asked at the Subcommittee's February hearing why Mr. Cao
was allowed to continue trading despite his bankruptcy status,
Mr. Fahman could only offer, ``I do not know if there is any
law that prohibits a person from trading if he has filed
bankruptcy.'' \946\ The Subcommittee believes that, based upon
his past performance and misconduct, Mr. Cao's continued day
trading activities on behalf of Providential's clients places
these clients at great risk of financial loss.
---------------------------------------------------------------------------
\946\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 25, 2000) (hearing transcript).
---------------------------------------------------------------------------
(5) Mr. Cao's Bankruptcy Claim. As explained above, Mr. Cao
filed a Chapter 7 bankruptcy petition in the United States
Bankruptcy Court in Houston on October 22, 1999.\947\ In that
petition, Mr. Cao sought to discharge the claims of his
unsecured creditors, including Ms. Le's judgment in the amount
of $37,791.11 and a fine of $5,000 by the NASDR for his
misconduct relating to Ms. Le.\948\ Mr. Cao's petition,
however, also claims approximately $100,000 of real and
personal property as exempt from the bankruptcy proceeding,
including $50,000 for his Houston home and $25,000 in the
retirement account held in his wife's name.\949\ Mr. Cao
testified at his Subcommittee deposition that he day trades at
Providential's Fountain Valley office in the account of his
daughter and several other customers.\950\ He claimed that,
even though he traded at the Fountain Valley office from the
fall of 1998 to the present, he has never been compensated by
those traders.\951\
---------------------------------------------------------------------------
\947\ Feb. Hr'g Ex. 89.
\948\ Id. at Schedule F.
\949\ Id. at Schedule C.
\950\ Cao Dep. at 209-10.
\951\ Id. at 209.
---------------------------------------------------------------------------
Despite Mr. Cao's bankruptcy petition and protestations of
poverty, there is some evidence that Mr. Cao may be concealing
income or assets from his creditors, including Ms. Le and the
NASDR. Based on the trading records produced to the
Subcommittee, Mr. Cao traded his own account and the accounts
of other Providential customers for almost a full year before
filing for bankruptcy. It seems highly implausible that he
would have done so without compensation or any other visible
means of financial support. In addition, Mr. Cao testified
that, when he opened his own day trading account with
Providential's Fountain Valley office in 1998, he deposited
about $400,000 of equity in the account.\952\ Mr. Cao said that
his equity increased to almost $1,000,000 in the spring of
1999, just six months before he filed for bankruptcy.\953\ Mr.
Cao then claimed that, because of malfunctions in
Providential's software, he lost all but $2,000 in August 1999,
the very same month that the NASD arbitration panel found Mr.
Cao liable to Ms. Le and just two months before he sought
bankruptcy protection.\954\
---------------------------------------------------------------------------
\952\ Cao Dep. at 189.
\953\ Id. at 190.
\954\ Id. at 190-91.
---------------------------------------------------------------------------
Mr. Cao's abrupt loss of his entire equity in the same
month that an NASD arbitration panel entered a judgment against
him and only two months before he sought bankruptcy protection
is an extremely suspicious sequence of events. At his
deposition, Mr. Cao testified under oath that he did not
transfer any funds out of his Providential day trading account
prior to his bankruptcy filing.\955\ However, when asked about
the nature of the property he is seeking to exempt from the
bankruptcy proceeding, Mr. Cao refused to answer the question,
asserting his Fifth Amendment right against self-
incrimination.\956\ Moreover, when Mr. Cao was asked about
paying Ms. Le's judgment, he refused to answer as follows:
---------------------------------------------------------------------------
\955\ Id. at 191-92.
\956\ Id. at 214.
Q: Okay. Now with respect to that matter, is it your
testimony that you do not have funds at your disposal
to satisfy the judgment and the fine from the NASD and
Amy Le?
A: I take the Fifth Amendment on that.\957\
---------------------------------------------------------------------------
\957\ Id. at 216.
The Subcommittee recommends that the bankruptcy court be
given copies of Mr. Cao's deposition and supporting documents
so that the court may inquire about any fraudulent transfer of
assets that Mr. Cao may have executed prior to filing for
bankruptcy protection. The court may deem such transfers
fraudulent and subject to recovery by the bankruptcy trustee
for distribution to creditors, like Ms. Le who received no
compensation from Mr. Cao.
(6) Mr. Cao May Have Violated State Investment Adviser
Registration Laws. The evidence gathered by the Subcommittee
indicates that Mr. Cao may have violated state laws in Texas
and California requiring investment advisers to register with
the state's securities commissions. Under these state laws,
persons who buy or sell securities on behalf of another for
compensation must register as investment advisers. Although
some states have de minimus exemptions that allow persons with
no place of business in the state to trade for a small number
of people for compensation without registration, Mr. Cao would
likely not qualify for such an exemption. Mr. Cao had places of
business in both California and Texas where he traded the
accounts of others for compensation. As discussed previously,
Mr. Cao had an arrangement with Ms. Richardson in Texas to
receive compensation for day trading on her behalf. In
addition, Mr. Cao had an arrangement with Ms. Richardson and,
at least one other client, to day trade for compensation in
their accounts at Providential's Los Angeles branch office.
The Subcommittee reviewed registration records in Texas and
California and found no evidence that Mr. Cao ever registered
as an investment adviser in either state. Moreover, Mr. Cao
admitted in his Subcommittee deposition that he never
registered with the State of Texas or the State of California
as an investment adviser.\958\ Mr. Cao claimed initially that
it was not necessary for him to register as an investment
adviser because he was told by the NASD that day traders were
exempt.\959\ Mr. Cao could offer no evidence to support this
dubious claim. He then argued the counterintuitive proposition
that he did not need to register as an investment adviser
because day traders are qualified to buy and sell stocks for
clients but not qualified to give financial advice.\960\ The
following exchange captures Mr. Cao's curious justification for
not registering as an investment adviser:
---------------------------------------------------------------------------
\958\ Cao Dep. at 114, 116.
\959\ Id. at 116.
\960\ Id. at 125.
Q: Let me just make sure we got that right. You're
qualified to buy and sell the stock on their behalf;
correct?
A: Correct.
Q: But you are not qualified to give them advice
about the buying and selling of stock on their behalf;
correct?
A: That right.
* * * * *
Q: Right, and in your mind, that's what distinguishes
you from an investment adviser?
A: That one of it.\961\
---------------------------------------------------------------------------
\961\ Id.
Mr. Cao's unusual logic aside, California and Texas law
requires day traders or anyone else who buys or sells
securities for another in return for compensation to register
as an investment adviser. Mr. Cao's own testimony suggests
that, by failing to register in Texas and California, he may
have violated the law.
(7) A Providential Official Who Had Been Accused of
Securities Violations Day Traded A Client's Account. While at
Providential's Los Angeles office, Mr. Cao briefly day traded
the account of another Vietnamese client by the name of Tom
Dzung Tran.\962\ Mr. Moon told Subcommittee staff that Mr. Cao
initially was responsible for the customer's account but that
Mr. Tran decided to transfer his trading authorization from Mr.
Cao to Keith Kim, a registered broker in the Los Angeles
office.\963\ Almost six months before he began trading Mr.
Trans' account, Mr. Kim became the subject of an NASD
arbitration claim in January 1998 and faced allegations of
failure to supervise, breach of fiduciary duty, and negligence.
On September 29, 1998, an NASD arbitration panel found Mr. Kim
liable and ordered him to pay the claimant $32,541.\964\
---------------------------------------------------------------------------
\962\ Id. at 217.
\963\ Moon Int. at 7.
\964\ Feb. Hr'g Ex. 72.
---------------------------------------------------------------------------
Mr. Tran and his wife also have filed an NASD arbitration
claim against Mr. Cao, Mr. Moon, Mr. Kim, Mr. Fahman,
Providential and others.\965\ In the complaint, Mr. Tran
alleges that he transferred his wife's accounts from a large
securities firm to Providential's Los Angeles office because
Mr. Cao told him that he was a registered broker and expert
trader.\966\ Mr. Tran also alleges that Mr. Moon recommended
that he transfer account authority to Mr. Kim who then
proceeded to grossly mismanage his account through excessive
day trading.\967\ For example, Mr. Tran alleges that Mr. Kim
purchased approximately $200 million in securities in his
account between September and November 1998, generating about
$90,000 in commissions over three months.\968\ He also claims
that Mr. Kim purchased and sold all of these securities with
only about $120,000 in equity in his account.\969\ He further
alleges that Providential arranged for $500,000 in loans from
other customers so that he could meet margin calls and Mr. Kim
could continue trading the account and generating
commissions.\970\ The customer is seeking damages of about
$275,000.\971\
---------------------------------------------------------------------------
\965\ Tran Complaint at 1.
\966\ Id. at 4. As discussed previously, Mr. Cao also allegedly
told Ms. Le that he was a registered broker. Another former client of
Mr. Cao, Minn Tran, told Subcommittee staff that Mr. Cao said he was a
registered broker, a lawyer, and a former auditor of securities firms.
Telephone Interview with Minn Tran, Nov. 3, 1999, at 3 (``Tran Int.'').
\967\ Tran Complaint at 5-6.
\968\ Id. at 5, 6, 8.
\969\ Id. at 13.
\970\ Id. at 6.
\971\ Id. at 9.
---------------------------------------------------------------------------
Messrs. Moon and Cao denied Mr. Tran's charges. Both Mr.
Kim and Mr. Moon claim that the customer was a risk-oriented
trader who was responsible for managing his own accounts.\972\
In addition, Mr. Cao testified that the customer frequently
traded his own account over the Internet.\973\ The Subcommittee
has uncovered no independent information to verify or discredit
Mr. Tran's claim against the respondents.
---------------------------------------------------------------------------
\972\ Moon Int. at 6.
\973\ Cao Dep. at 217, 219.
---------------------------------------------------------------------------
F. A Providential Official ``Recommends'' That Day Traders Purchase
Particular Stocks
The Subcommittee's investigation found persuasive evidence
that the senior official in Providential's Oregon branch
office, Tony Nguyen, made stock recommendations to day traders
in the office. These day traders told Subcommittee staff that
they lost significant sums of money following Mr. Nguyen's
recommendations. As discussed previously in this report, the
day trading industry has strongly contested the notion that it
is subject to existing NASD suitability rules, which require a
registered representative to recommend the purchase or sale of
a security that is suitable for the customer given the
customer's stated investment objective and financial
condition.\974\ Many in the day trading industry argue that
this rule is not applicable to day trading since the trader is
executing the orders rather than sending them through a broker-
dealer and because the trader is making the decision to buy and
sell the stock without the benefit of a broker's guidance. With
respect to Providential's Oregon office, however, several
former day traders told Subcommittee staff that Mr. Nguyen did
give instructions to customers as to what stocks to buy or
sell, when to purchase or sell, and at what price. Mr. Nguyen
denies making recommendations to clients but does acknowledge
suggesting that they ``follow'' certain stocks.
---------------------------------------------------------------------------
\974\ See NASD Rule 2310.
---------------------------------------------------------------------------
(1) Providential Client Holly Clark Was Unsuitable for Day
Trading. During its investigation, Subcommittee staff
interviewed a former Providential client by the name of Holly
Clark who day traded at the Oregon branch office. The
Subcommittee found that Providential opened a day trading
account for Ms. Clark even though she did not satisfy the
firm's minimum financial requirements. Ms. Clark told
Subcommittee staff that she was a single mother who moved from
California to Oregon in 1998.\975\ Ms. Clark said that, prior
to leaving California, she had worked at an entry level job
with a major computer manufacturer earning about $30,000 per
year.\976\ In addition, Ms. Clark said that, when she moved to
California, her entire net worth was $100,000, which included
$50,000 in net proceeds from the sale of her house, the value
of her automobile, and the value of personal property.\977\ Ms.
Clark said that she moved into a friend's apartment with her
youngest daughter upon arriving in Oregon.\978\
---------------------------------------------------------------------------
\975\ Telephone Interview with Holly Clark, Dec. 28, 1999, at 1
(``Second Clark Int.'').
\976\ Id.
\977\ Id.
\978\ Id.
---------------------------------------------------------------------------
Even though she had no prior investment experience, Ms.
Clark told Subcommittee staff that she decided to pursue day
trading in Oregon as a means to make a living since it offered
a potentially lucrative income as well as a flexible
schedule.\979\ Ms. Clark hoped to earn at least $3,000 per
month day trading on-site during the first year while she
learned the business and improved her skills.\980\ After the
first year, Ms. Clark expected to have progressed sufficiently
that she could become a remote day trader from her home.\981\
Ms. Clark said that she intended to fund her day trading
account with the proceeds from the sale of her California
home.\982\ She planned to use $25,000 to open her account and
keep the remaining $25,000 to pay living expenses.\983\
---------------------------------------------------------------------------
\979\ Id. at 2.
\980\ Id.
\981\ Id.
\982\ Id. at 1.
\983\ Id.
---------------------------------------------------------------------------
Ms. Clark told Subcommittee staff that, in January and
February 1999, she started day trading at a firm called Wein
Securities Corporation (``Wein'') in Beaverton, Oregon.\984\
However, Ms. Clark said she only spent about six weeks at Wein,
including three weeks of training and three weeks of
trading.\985\ Ms. Clark told Subcommittee staff that she did
not think Wein's training program was adequate and the firm's
computer system failed repeatedly.\986\ Ms. Clark indicated
that she lost about $700 of her $25,000 account equity during
her initial three weeks of day trading at Wein.\987\
---------------------------------------------------------------------------
\984\ Id. at 2.
\985\ Id.
\986\ Id. at 3.
\987\ Id. at 2-3.
---------------------------------------------------------------------------
In April 1999, Ms. Clark decided to leave Wein and open a
day trading account at Providential's Oregon branch
office.\988\ Ms. Clark said that she visited Providential on
the recommendation of an acquaintance and discussed opening a
day trading account with Tony Nguyen.\989\ Ms. Clark's new
account form indicates that she disclosed to Providential an
income of $30,000 and a net worth of $100,000, both of which
were below Providential's income and net worth financial
requirements in existence at the time.\990\ The form also
states the mutually contradictory investment objectives of
``income'' and ``short-term growth with high risk.'' \991\ In
Mr. Fahman's Subcommittee deposition, he conceded that
Providential did not follow appropriate procedures in approving
the Holly Clark day trading account.\992\
---------------------------------------------------------------------------
\988\ Id. at 3.
\989\ Id.
\990\ New Account Approval-B for Holly C. Clark, Apr. 26, 1999
(Feb. Hr'g Ex. 91).
\991\ Id.
\992\ Fahman Dep. at 232-34.
---------------------------------------------------------------------------
Ms. Clark did sign the risk disclosure form given to her by
Mr. Nguyen, which warns potential day traders about the high
risks of financial loss associated with day trading.\993\
During an interview with Subcommittee staff, Ms. Clark
acknowledged that she had been told of the risks of day trading
but she indicated that Mr. Nguyen put her at ease by discussing
day trading's profit potential.\994\ In fact, Ms. Clark said
that she told Mr. Nguyen that she was an ``inexperienced''
trader, and he replied that he would give her counsel and
advice to help her become successful.\995\ Ms. Clark told
Subcommittee staff that she felt like Mr. Nguyen had a day
trading system that she could follow that would limit risk and
increase profitability.\996\ Indeed, Ms. Clark said that she
felt that Tony Nguyen acted ``hypocritically'' after she signed
the risk disclaimer because he made frequent pronouncements
about the high profit potential of day trading.\997\ As
discussed previously, Ms. Clark said that Mr. Nguyen told her
and others that they could become ``millionaires'' by day
trading.\998\
---------------------------------------------------------------------------
\993\ Providential Securities, Inc.'s Customer Acknowledgment of
Risk for Holly C. Clark, Apr. 13, 1999, at 4 (attached hereto at Ex.
92).
\994\ Second Clark Int. at 4.
\995\ Id. at 3.
\996\ Id.
\997\ Id. at 4. Another day trader in Providential's Oregon office
confirmed that Mr. Nguyen acted ``hypocritically'' by warning about the
risks when the trader opened his account but then recommended
particular stocks for their high profit potential. Lehr Int. at 3.
\998\ Clark Complaint at 4.
---------------------------------------------------------------------------
(2) Holly Clark Allegedly Lost Money Day Trading on the
Recommendation of Tony Nguyen. Ms. Clark told Subcommittee
staff that she took Providential's two week training course
taught by Tony Nguyen's brother Alex.\999\ Ms. Clark said that
the training course was inadequate and that, as a new day
trader, she expected Tony and Alex Nguyen to assist her.\1000\
Ms. Clark said that she felt Tony Nguyen could assist her
because he was known to be a successful day trader and told her
``we want you to make money'' and ``we will help you.'' \1001\
---------------------------------------------------------------------------
\999\ Second Clark Int. at 4.
\1000\ Id. at 4-5.
\1001\ Id. at 4.
---------------------------------------------------------------------------
Ms. Clark told Subcommittee staff that Tony Nguyen offered
assistance by frequently coming out of his back office onto the
trading floor and recommending that customers purchase
particular stocks.\1002\ Ms. Clark said that Mr. Nguyen traded
in the back room for his own accounts and would
enthusiastically recommend that Providential clients buy the
same stocks that he purchased.\1003\ For example, Ms. Clark
alleges that Mr. Nguyen often shouted that a particular stock
was about to ``pop.'' \1004\ In fact, Ms. Clark further alleges
that, on her second day of trading at Providential in late
April 1999, Tony Nguyen recommended that she purchase a
particular stock that he said would do well.\1005\ According to
Ms. Clark, Mr. Nguyen said that he had already purchased 10,000
shares of the stock for his own account.\1006\ Ms. Clark
further alleges that Mr. Nguyen even clicked her computer mouse
without her consent to purchase 5,000 shares of the
stock.\1007\
---------------------------------------------------------------------------
\1002\ First Clark Int. at 3.
\1003\ Id. at 4.
\1004\ Clark Complaint at 4.
\1005\ Id. at 4-5
\1006\ Id. at 5.
\1007\ Id. at 4.
---------------------------------------------------------------------------
Ms. Clark said, however, that the stock recommended by Mr.
Nguyen quickly declined in value and that she lost a
substantial amount of the $25,000 that she used to open her day
trading account.\1008\ Ms. Clark stated that the losses in her
account were so great that she could no longer day trade at
Providential other than to ``paper trade'' on a computer
simulator.\1009\ Because Ms. Clark still desperately wanted to
learn how to day trade successfully, she traded on the
simulator for several months in the hope that the stock in her
account would rebound and she would have sufficient capital to
resume live trading.\1010\ Ms. Clark eventually stopped paper
trading after the stock price did not recover.
---------------------------------------------------------------------------
\1008\ Id. A Subcommittee analysis of Providential account
statements provided by Ms. Clark show that her account balance declined
from $25,000 in April 1999 to about $4,770 on July 30, 1999, which was
several weeks before Ms. Clark quit day trading and left Providential.
Ms. Clark told Subcommittee staff that she repeatedly had to sell
shares of her stock to meet margin calls since she had no more funds to
deposit into the account. Second Clark Int. at 6.
\1009\ Second Clark Int. at 6.
\1010\ Id. at 3.
---------------------------------------------------------------------------
Subcommittee staff contacted three other day traders from
Providential's Oregon office and they all corroborated Ms.
Clark's contention that Tony Nguyen frequently recommended or
suggested that traders purchase particular stocks.\1011\ For
example, one of the former traders stated that Mr. Nguyen would
frequently walk the trading floor and shout at traders ``BUY
NOW!'' \1012\ The day trader said that other customers would go
into a stock buying ``frenzy'' on the basis of Mr. Nguyen's
recommendations.\1013\ The day trader said that, as recommended
by Tony Nguyen, he purchased 2,500 shares of the same stock
that Ms. Clark purchased on Mr. Nguyen's recommendation.\1014\
The trader said that he also lost substantial sums of money on
this particular stock.\1015\ Another Providential customer
confirmed to Subcommittee staff that he purchased the same
stock on Mr. Nguyen's recommendation and then lost substantial
sums of money.\1016\ This trader said that he stopped listening
to Mr. Nguyen's recommendations thereafter and jokingly said to
other traders that the best strategy was to do the opposite of
what Mr. Nguyen recommended.\1017\
---------------------------------------------------------------------------
\1011\ Bogardis Int. at 2; Lehr Int. at 2; Scherner Int. at 2.
\1012\ Lehr Int. at 2.
\1013\ Id.
\1014\ Id.
\1015\ Id.
\1016\ Scherner Int.at 2.
\1017\ Id.
---------------------------------------------------------------------------
Mr. Nguyen told Subcommittee staff that he trades for a
client and for his wife and that all of the day traders in the
Oregon office are aware of this trading.\1018\ Mr. Nguyen also
said that the value of his client's account was about $400,000
as of December 1999 and the value in his wife's account was
about $500,000.\1019\ Mr. Nguyen asserted that he does not
receive any compensation for the trading that he performs for
the client.\1020\ The Subcommittee reviewed Mr. Nguyen's
trading records and confirmed that he does trade stocks that
former Providential traders allege he recommends to customers.
For example, Mr. Nguyen made a purchase of 10,000 shares in his
wife's account of the same stock that Holly Clark alleged that
Mr. Nguyen recommended she purchase. In fact, Mr. Nguyen
purchased the 10,000 shares on the same day that Ms. Clark
alleges that he clicked her mouse to buy 5,000 shares of the
stock.
---------------------------------------------------------------------------
\1018\ Nguyen Int. at 2-3.
\1019\ Id.
\1020\ Id. at 3.
---------------------------------------------------------------------------
However, Mr. Nguyen denied to Subcommittee staff that he
``recommends'' that day traders purchase particular stocks and
he denied that he ever screams at traders to buy a particular
stock.\1021\ Further, Mr. Nguyen denied that he ever clicked
Holly Clark's computer mouse thereby causing the purchase of
the stock mentioned earlier.\1022\ Mr. Nguyen said, however,
that he does suggest that customers ``watch'' a particular
stock that may do well.\1023\ Mr. Nguyen said that he generally
gives these suggestions to new day traders or those who are not
succeeding.\1024\
---------------------------------------------------------------------------
\1021\ Id.
\1022\ Id.
\1023\ Id.
\1024\ Id.
---------------------------------------------------------------------------
Mr. Fahman told Subcommittee staff that, if a Providential
official advises a client to buy a particular stock at a
particular time, he would consider such a statement to be a
``recommendation'' as defined by NASD rules.\1025\ Despite Mr.
Nguyen's denials, the evidence given by Ms. Clark and several
other day traders who were formerly customers of Providential's
Oregon office suggests that Mr. Nguyen may have advised
Providential's customers to buy or sell a particular security
at a specified time and price. If so, as Mr. Fahman indicated,
Mr. Nguyen's activities may implicate existing NASD suitability
rules.
---------------------------------------------------------------------------
\1025\ Fahman Dep. at 267.
---------------------------------------------------------------------------
G. Providential Failed to Supervise Mr. Nguyen, Mr. Moon and Mr. Cao
The Subcommittee uncovered disturbing evidence about the
management and compliance structure at Providential. The
investigation shows that Mr. Fahman, while acting as the firm's
President and Chief Compliance Officer, failed to exercise
diligent oversight of his branch office personnel, particularly
those in the Oregon and Los Angeles branch offices.
Specifically, Mr. Fahman neglected to supervise Mr. Moon's
handling of the day trading business at the Los Angeles office
and Mr. Nguyen's management of the Oregon office. This lax
supervision contributed to many of the problems discovered by
the Subcommittee.
One of the most glaring deficiencies in Providential's
compliance program related to the setting of company policies
and the communication of those policies to branch office
personnel. For instance, even though Providential claimed that
it required new day trading customers to have a minimum of
$50,000 of risk capital to open an account, Providential
apparently did not communicate this standard to its Los Angeles
office. Mr. Moon, the branch manager, indicated in a written
response to Subcommittee interrogatories that new accounts were
considered ``on a case by case basis and did not have specific
minimum financial standards.'' \1026\ In addition, at his
Subcommittee deposition, Mr. Cao testified that Providential's
Los Angeles office required new day traders to have a minimum
of $10,000 in 1998, \1027\ even though Mr. Fahman testified
that the standard in place at that time was $50,000.\1028\ The
disparity in this testimony highlights how poorly Providential
communicated firm policies to the branch offices.\1029\
---------------------------------------------------------------------------
\1026\ Feb. Hr'g Ex. 18, at 12.
\1027\ Cao Dep. at 156-57.
\1028\ Fahman Dep. at 194-95.
\1029\ In fact, Mr. Cao testified that Mr. Moon never gave him a
branch manual or compliance manual during the entire six months that he
day traded for Providential customers at the Los Angeles office. Cao
Dep. at 137-38.
---------------------------------------------------------------------------
The failure to set and communicate firm policies was not
the only deficiency in Providential's compliance program.
Providential also neglected to implement the internal
supervisory controls necessary to ensure that branch office
personnel complied with not only firm standards but also state
and federal securities laws. For instance, Mr. Fahman testified
that, as the Chief Compliance Officer, he frequently audited
the branch offices, including the Los Angeles office.\1030\
Yet, when asked to produce copies of all documents reflecting
audits or examinations, neither Providential nor Mr. Moon
produced any responsive documents.\1031\ In fact, Mr. Moon
contradicted Mr. Fahman's testimony when he told Subcommittee
staff that Providential never audited the Los Angeles branch
office.\1032\ As with the failure to set and communicate firm
policies, Providential made no serious effort to monitor the
compliance of its branch office personnel. Given that Mr.
Fahman was not only the President of Providential but also its
Chief Compliance Officer, he must bear the primary
responsibility for the firm's failure to detect and prevent
misconduct by registered personnel.
---------------------------------------------------------------------------
\1030\ Fahman Dep. at 172.
\1031\ Feb. Hr'g Ex. 69, at 1-2; Feb. Hr'g Ex. 18, at 6-7.
\1032\ Moon Int. at 3.
---------------------------------------------------------------------------
During Mr. Fahman's deposition, he tried to disassociate
himself from Mr. Moon's day trading operations prior to July
1998, when the Los Angeles office cleared day trading
transactions through Go Trading.\1033\ Mr. Fahman testified
that he did not approve day trading accounts from the Los
Angeles office prior to July 1998.\1034\ Even accepting Mr.
Fahman's questionable argument that he was not responsible for
supervising the Los Angeles day trading operation prior to July
1998, \1035\ his argument is moot with respect to the
Subcommittee's analysis of Providential's compliance with its
own suitability standards. The Subcommittee found that 26, or
84 percent, of the 31 new account forms provided for the Los
Angeles branch office were completed after July 1998, when
Providential assumed responsibility for overseeing the office's
day trading operations.\1036\ Moreover, Mr. Fahman conceded
that, when Providential began offering day trading services to
its Los Angeles customers all of Mr. Moon's existing day
trading customers had to be approved by Providential before
they were assigned an account number.\1037\
---------------------------------------------------------------------------
\1033\ Fahman Dep. at 144.
\1034\ Id.
\1035\ As noted above, senior SEC officials told Subcommittee staff
that, while a branch office may be registered with two different
broker-dealers, a registered representative with supervisory authority
cannot contract away legal responsibility for a particular line of
business. Thus, the SEC officials said that Mr. Fahman could not
disassociate himself from supervising the Los Angeles office's day
trading operations prior to July 1998. Subcommittee interview with
senior SEC officials, Dec. 17, 1999.
\1036\ One form was completed in July 1998 and Subcommittee staff
could not determine the dates for four other forms.
\1037\ Fahman Dep. at 146-47.
---------------------------------------------------------------------------
Finally, the Subcommittee notes that Messrs. Fahman and
Moon had an opportunity to present their defense to the charges
filed by Amy Le with the NASD. The NASD arbitrators heard and
rejected that defense, and held Messrs. Moon and Cao and the
Los Angeles office liable for a total judgement of $37,
791.11.\1038\ Mr. Fahman conceded at his Subcommittee
deposition that he was responsible for supervising Mr. Moon and
the Los Angeles office.\1039\ Mr. Fahman testified that
Providential actually paid Mr. Moon's $12,500 judgement.\1040\
As noted above, Mr. Fahman said that Providential has recently
retained two experienced compliance officers to improve the
firm's compliance program, particularly relating to its day
trading business. While this is a positive development, it is
disconcerting that Providential waited to hire those
individuals until approximately two weeks before Mr. Fahman's
Subcommittee deposition.\1041\
---------------------------------------------------------------------------
\1038\ Feb. Hr'g Ex. 71, at 3.
\1039\ Fahman Dep. at 57.
\1040\ Id. at 181.
\1041\ Id. at 107.
---------------------------------------------------------------------------
V. CASE STUDY: MOMENTUM SECURITIES, INC.
A. Founding and Structure
The genesis of Momentum Securities, Inc. (``Momentum'')
dates to1995, when James H. Lee and Jack ``Jay'' Earnest, Jr.
coupled Lee's investment banking experience and Earnest's
knowledge of systems design to form a securities firm dedicated
to servicing professional day traders.\1042\ Mr. Lee currently
maintains securities licenses with the registered broker-dealer
Momentum, including a Series 7, Series 24, Series 55, and
Series 63.\1043\ Mr. Earnest originally became involved with
Momentum after starting a software development and technology
company called Computer Stop, Inc. (``CSI.net'') in early
1990.\1044\ CSI.net provided software development, network
design, and maintenance.\1045\ Mr. Earnest was working with
CSI.net when he and Mr. Lee began Momentum in 1995.\1046\
---------------------------------------------------------------------------
\1042\ ``Momentum Securities, Inc.,'' www.soes.com, Jan. 14, 2000
(``www.soes.com'').
\1043\ Lee Dep. at 18-20. Mr. Lee also holds these securities
licenses with a registered broker-dealer called Sunbelt Securities, and
a third broker-dealer that he created, James H. Lee & Associates. Id.
\1044\ Id. at 19.
\1045\ Id. at 27-28.
\1046\ Id. at 19. Sometime prior to the summer of 1997, Mr. Lee
bought fifty percent of CSI.net for $250,000, which was secured by a
promissory note to Mr. Earnest that he ultimately paid off. Id. at 30.
In July, 1999, Messrs. Lee and Earnest sold CSI.net for cash to
Tradescape.com as a part of a stock swap between Momentum and
Tradescape.com. Id. at 26.
---------------------------------------------------------------------------
Currently, Momentum is a licensed broker dealer with the
SEC and the NASD.\1047\ In addition to its home office in
Houston, Texas, Momentum has branch offices located in several
other Texas cities, including North Houston, Austin, Dallas,
Tyler, and Plano.\1048\ Momentum has also opened several branch
offices outside of Texas, including Irvine, California;
Chicago, Illinois; Atlanta, Georgia and Milwaukee,
Wisconsin.\1049\
---------------------------------------------------------------------------
\1047\ www.soes.com. The firm holds licenses in the following
states: Arizona, California, Colorado, Connecticut, Delaware, Florida,
Georgia, Idaho, Illinois, Indiana, Kentucky, Louisiana, Maryland,
Nebraska, Nevada, New Jersey, New York, North Carolina, Oklahoma,
Oregon, Tennessee, Texas, Utah, Virginia, Washington, Wisconsin, and
Wyoming. Id.
\1048\ Id.
\1049\ Id.
---------------------------------------------------------------------------
Between January 1, 1998 and October 1, 1999, Momentum
opened 1,757 day trading accounts, including branch offices and
remote locations.\1050\ The firm claims that, since its
inception, Momentum customers have executed more than 6 million
securities transactions, totaling 5 billion shares and having a
market value in excess of $150 billion.\1051\
---------------------------------------------------------------------------
\1050\ Letter from Robert Bennett, Counsel for Momentum Securities,
Inc., to K. Lee Blalack, Chief Counsel & Staff Director for the
Subcommittee, Jan. 20, 2000, at 2 (Feb. Hr'g Ex. 93).
\1051\ www.soes.com
---------------------------------------------------------------------------
At the outset, Momentum's original shareholders were Mr.
Earnest, who held 50 percent of the stock, Mr. Lee, who held 30
percent, and Mr. Lee's brother, who held the remaining 20
percent ownership interest.\1052\ On June 30, 1999, Momentum
and Tradescape.com agreed to a stock swap by which Momentum's
shareholders, principally Messrs. Lee and Earnest, received
shares of Tradescape.com and became officers of the new
company.\1053\ Just before the stock swap with Tradscape.com,
Messrs. Lee and Earnest effectively owned 50% of the equity
interests in (i) Momentum Securities, Inc., a Texas
corporation, (ii) Momentum Securities Partners, L.P., a Texas
limited partnership, (iii) Momentum Securities Management
Company, a Texas corporation, and (iv) CSI.net, Inc., a Texas
corporation.\1054\ Following the agreement with Tradescape.com,
there were no changes in Momentum's essential business
structure and operations.\1055\ Mr. Lee testified that one
employee from Tradescape.com did join Momentum's Houston office
but the firm continued to operate under the Momentum
name.\1056\ In fact, in a letter to NASD Regulation, Mr. Lee
confirmed that
---------------------------------------------------------------------------
\1052\ Lee Dep. at 23.
\1053\ Id.at 58-59.
\1054\ Momentum's Organization Chart and Structure, undated (Feb.
Hr'g Ex. 94).
\1055\ Letter from James H. Lee, Principal for Momentum Securities,
Inc., to Robert Garza, NASD Regulations, Inc., Dist. 6, June 21, 1999,
at 1 (Feb. Hr'g Ex. 95).
\1056\ Lee Dep. at 104.
[Momentum] will not need to obtain additional licenses
or registrations as a result of the proposed
transaction [with Tradescape]. [Momentum] will maintain
its existing business relationships with banks,
auditors, and clearing entities. The financial
controls, compliance policies, supervisory procedures,
operational controls, training needs and record keeping
systems presently in place will be maintained by
[Momentum] following the ownership change.\1057\
---------------------------------------------------------------------------
\1057\ Feb. Hr'g Ex. 95, at 1.
One of the central features of Momentum's organization and
management structure is its reliance on management companies to
direct the day-to-day operations of its branch offices. The
Subcommittee's investigation found that Momentum contracts with
numerous management companies to provide general management
services for the branch offices.\1058\ These services range
from locating and leasing office space, setting up and
maintaining trader work stations, paying the salaries of branch
office employees and, in some cases, providing training for new
Momentum customers.\1059\ All of Momentum's branch offices
currently rely on a management company to direct its non-
broker-related functions.\1060\
---------------------------------------------------------------------------
\1058\ Lee Dep. at 37.
\1059\ Id. at 34-48.
\1060\ Id. at 40-48.
---------------------------------------------------------------------------
For example, in an interview with Subcommittee staff, David
Dial, the branch manager for Momentum's office in Tyler, Texas,
explained that L&D Trading (``L&D''), a management company run
by Harry Leatherwood and Kevin Dickinson, directs all
management functions for the Tyler office.\1061\ In
consideration for these services, L&D receives a management fee
from Momentum, which Mr. Dial characterized as an income based
commission.\1062\ Mr. Dial told Subcommittee staff that he
receives a salary from both L&D and Momentum.\1063\ He
indicated that all Tyler branch personnel are L&D
employees.\1064\ Mr. Dial's function as a branch manager is to
oversee the on-sight offices in Tyler and his direct
supervisors for compliance matters are Momentum's Elizabeth
Cummins and Chief Compliance Officer Bill Cathriner.\1065\
---------------------------------------------------------------------------
\1061\ Interview of David Dial, Dec. 21, 1999, at 1 (``Dial
Int.'').
\1062\ Id.
\1063\ Id.
\1064\ Id.
\1065\ Id.
---------------------------------------------------------------------------
This management structure is also present at the other
Momentum branch offices. Momentum Securities Partners, a
management company owned by Messrs. Lee and Earnest, directs
the Houston, Dallas, and Austin offices.\1066\ Mr. Dial and
several associates from the Tyler office manage Momentum's
branch office in Atlanta through a management company that they
started called Professional Traders Group.\1067\ In his
Subcommittee deposition, Mr. Lee confirmed that Momentum's
other offices were also run by management companies, but he
could not identify them all by name.\1068\ Mr. Lee stated as
follows:
---------------------------------------------------------------------------
\1066\ Lee Dep. at 36. Mr. Lee testified that neither he nor Mr.
Earnest possess an ownership interest in any of the other management
companies that direct Momentum's branch offices. Id. at 36-48.
\1067\ Dial Int. at 1.
\1068\ Lee Dep. at 40-42.
Q: Do you know what the name of the management
company is for the office located in Irvine,
California?
A: I believe it's Newport. I don't know the full
structure.
* * * * *
Q: With respect to Plano, is there a management
company for Plano?
A: I believe there is, but I couldn't tell you the
name.
* * * * *
Q: Okay. What about the office in north Houston?
A: I believe there is a management company there,
sir. I believe there is a management company.
Q: Do you know what the name of that management
company is?
A: No, sir.
Q: And the office in south Houston, do you know if
they use a management company?
A: I believe they do, yes, sir.
Q: And do you know the name of that management
company?
A: No, I do not offhand.\1069\
---------------------------------------------------------------------------
\1069\ Id.
Two other Momentum branch offices, those located in
Milwaukee and Chicago, have a ``piggy-back'' relationship with
La Salle Street Trading (``La Salle''), a broker-dealer located
in Chicago.\1070\ According to Mr. Lee, in such arrangements,
the functions of the brokerage firm are divided among three
entities--two order entry firms and a clearing firm.\1071\ La
Salle is responsible for controlling the trading activity of
the customers, and Momentum is responsible for account opening
procedures, trade processing and execution.\1072\ Mr. Lee said
that Southwest Securities, a clearing firm, acts as the
custodian.\1073\
---------------------------------------------------------------------------
\1070\ Id. at 48.
\1071\ Id. at 54.
\1072\ Id. at 50.
\1073\ Id.
---------------------------------------------------------------------------
B. Jim Lee Was the Catalyst for the Creation of the Electronic Traders
Association
In addition to starting Momentum, Mr. Lee took a lead role
in the creation of the Electronic Traders Association
(``ETA''), a Washington-based trade group that purports to
represent day trading firms.\1074\ In fact, Mr. Lee was the
driving force behind ETA, which he organized in 1996 to improve
the day trading industry's influence with respect to regulatory
changes that were being considered by the SEC.\1075\ At his
Subcommittee deposition, Mr. Lee said that, when the SEC
proposed new order-handling rules in 1996, it prompted him to
contact the heads of several competing day trading firms to
discuss the impact of the proposed rules on their
businesses.\1076\ Mr. Lee said that he successfully organized
an industry group to make its case to the SEC and that ETA
evolved from there.\1077\ Mr. Lee also stated that he believes
that through responsible leadership, ETA may be used to
encourage other day trading firms to strive for best policies
and practices to improve the industry as a whole.
---------------------------------------------------------------------------
\1074\ Id. at 86-89.
\1075\ Id. at 87-88.
\1076\ Id.
\1077\ Id. at 88-89.
---------------------------------------------------------------------------
Mr. Lee stated that, at times, ETA has represented as many
as 30 or 40 different firms.\1078\ Today, according to Mr. Lee,
ETA only consists of the day trading firms that have a
representative sitting on ETA's Board of Directors ``and maybe
a handful of others.'' \1079\ In 1999, ETA's board members
included representatives of Momentum, Andover Brokerage, LLC,
Mount Pleasant Brokerage Services, LP, On-Line Investment
Services, Inc., and Tradescape.com, Inc.\1080\ Mr. Lee
indicated that, while ETA represents a small number of day
trading firms, ETA members are responsible for about 60% of the
trading volume attributable to the industry.\1081\
---------------------------------------------------------------------------
\1078\ Id. at 88.
\1079\ Id. at 90.
\1080\ Cohen statement at 204.
\1081\ Lee Dep. at 91.
---------------------------------------------------------------------------
C. Suitability: a Case Study--Scott Webb, David Dial, Justin Hoehn, and
the Atlanta Office
On July 29, 1999, a deranged day trader named Mark Barton
walked into the Atlanta offices of Momentum and All-Tech,
mumbled a few ominous words about the falling market and then
began firing gunshots at random.\1082\ After killing four
people at Momentum, Barton proceeded across the street to All-
Tech where he opened fire on the trading floor, killing five
people there.\1083\ In all, Barton shot and killed nine people
at the two day trading firms. One of his victims was Scott
Webb, a young man of 30 who was attempting to day trade for a
living at Momentum's Atlanta office. Mr. Webb opened his day
trading account with the Atlanta office of Momentum in July,
1998, approximately one year prior to his tragic and senseless
death. While the Subcommittee questions Mr. Webb's suitability
for day trading, no inference should be drawn that the
Subcommittee believes Momentum is responsible for his death.
Rather, how Scott Webb became a day trader at Momentum is a
telling case study about the importance of determining the
suitability of customers for this highly risky practice.
---------------------------------------------------------------------------
\1082\ Adam Cohen, ``A Portrait of a Killer,'' Time, Aug. 9, 1999,
at 22.
\1083\ Id.
---------------------------------------------------------------------------
(1) The Opening of Momentum's Atlanta Office. Justin Hoehn,
the branch manager of Momentum's Atlanta office, first became
interested in day trading in early 1998, after reading an
article on the subject while he was studying to become a retail
stock broker at Dean Witter in St. Louis.\1084\ At the time,
Mr. Hoehn was 22 years old and was preparing for his Series 7
and Series 63 exams.\1085\ Mr. Hoehn had joined Dean Witter in
September 1997, after working at A.G. Edwards for two years in
its computer department.\1086\ Though Mr. Hoehn passed his
Series 3, 7, 63 and 65 exams, he never became a producing
broker.\1087\
---------------------------------------------------------------------------
\1084\ Interview of Justin Hoehn, Dec. 21, 1999, at 1-2 (``Hoehn
Int.'').
\1085\ Id. at 2.
\1086\ Id. at 1.
\1087\ Id. at 2.
---------------------------------------------------------------------------
Mr. Hoehn left Dean Witter early in 1998 and began day
trading at Block Trading's office in St. Louis, which later
changed its name to Insight Trading.\1088\ As part of his
compensation agreement with Insight Trading, Mr. Hoehn received
a percentage of all commissions generated by day traders that
he brought to the firm.\1089\ Mr. Hoehn told Subcommittee staff
that he recruited three to six new customers to Insight Trading
and that one of those customers was Scott Webb, a colleague of
his from Dean Witter.\1090\ At the time, Mr. Webb was 29 years
old and a graduate of Loyola Marymount University.\1091\ Mr.
Webb's sister and mother told Subcommittee staff that Scott
Webb decided to join Mr. Hoehn at Insight Trading after he
failed to meet production quotas at Dean Witter.\1092\
---------------------------------------------------------------------------
\1088\ Id.
\1089\ Id.
\1090\ Id.
\1091\ Resume of Scott A. Webb, undated (Feb. Hr'g Ex. 96).
\1092\ Interview of Elizabeth Cheetham-Webb, Dec. 9, 1999, at 1
(``Cheetham-Webb Int.''); Interview of Alyce Wenzel, Dec. 7, 1999, at 1
(``Wenzel Int.'').
---------------------------------------------------------------------------
In order to begin their day trading careers, Messrs. Webb
and Hoehn needed capital and neither had it. Mr. Hoehn told
Subcommittee staff that he borrowed between $10,000 and $15,000
from a friend to finance his jump into day trading.\1093\ Mr.
Hoehn also said that Mr. Webb borrowed about $10,000 to fund
his day trading.\1094\ According to Mr. Hoehn, he and Mr. Webb
lost virtually all of those funds day trading at Insight over
the course of a few months.\1095\ Mr. Hoehn said that none of
the traders at Insight were profitable.\1096\ He told
Subcommittee staff that Insight Trading dissolved in March or
April of 1998.\1097\
---------------------------------------------------------------------------
\1093\ Hoehn Int. at 2.
\1094\ Id.
\1095\ Id.
\1096\ Id.
\1097\ Id.
---------------------------------------------------------------------------
Shortly after Insight Trading closed its doors, Mr. Hoehn
met David Dial, the branch manager of Momentum's Tyler, Texas
office.\1098\ The meeting occurred while Mr. Dial was visiting
Insight Trading to determine whether to purchase the firm's
computer systems for use by Momentum at a new branch office in
either St. Louis or Atlanta.\1099\ Mr. Dial told Subcommittee
staff that Mr. Hoehn was his point of contact.\1100\ Mr. Dial
said that he was impressed with Mr. Hoehn, describing him as
``eager and demonstrating confidence.'' \1101\ During the
meeting, Mr. Dial mentioned that he was considering opening a
Momentum branch office in Atlanta.\1102\ Mr. Hoehn told
Subcommittee staff that he expressed an interest in becoming
involved with this new Atlanta office.\1103\ During the spring
of 1998, Messrs. Hoehn and Dial continued their discussions
about Mr. Hoehn associating with Momentum and, in the summer of
that year, Mr. Hoehn traveled to Tyler for two weeks of
training at Momentum's branch office.\1104\
---------------------------------------------------------------------------
\1098\ Id. Mr. Dial is a 30-year-old resident of Tyler, Texas. Mr.
Dial attended Austin Community College and the University of Houston in
1990 and 1991 but did not earn his degree. Dial Int. at 1. He then
joined Texas Mortgage Investors for nine months in the loan servicing
department. Id. In 1993, Mr. Dial passed his Series 7 exam and later
went to work for Chris Block of Block Trading. Id. In October of 1995,
Mr. Dial moved to Tyler to help set up the first Block Trading branch
office. Id. On September 19, 1997, Momentum acquired Block Trading's
Tyler office, and Mr. Dial became its branch manager. Id.
\1099\ Dial Int. at 1.
\1100\ Id.
\1101\ Id.
\1102\ Hoehn Int. at 2.
\1103\ Id.
\1104\ Dial Int. at 1.
---------------------------------------------------------------------------
Mr. Hoehn told Subcommittee staff that he informed Mr. Dial
of his losses at Insight Trading and he assumed that Mr. Dial
was aware of Mr. Webb's losses as well.\1105\ Mr. Dial,
however, denied knowing of Mr. Hoehn's losses at Insight
Trading.\1106\ He nonetheless indicated that it ``would not
have affected his decision to make him a branch manager.''
\1107\ Indeed, Mr. Dial told Subcommittee staff that he did not
believe it was necessary for someone to demonstrate the ability
to day trade profitably before hiring them as a branch
manager.\1108\ He analogized the hiring of an unprofitable day
trader as a branch manager to hiring a coach who was never a
successful player.\1109\ Mr. Dial even told Subcommittee staff
that it was not necessary for a trainer of new customers to
show that they had day traded successfully in the past.\1110\
Mr. Dial stated that what was important to him was that Mr.
Hoehn had three months of day trading experience, which was ``a
lot in this business.'' \1111\
---------------------------------------------------------------------------
\1105\ Hoehn Int. at 2.
\1106\ Dial Int. at 1.
\1107\ Id.
\1108\ Id.
\1109\ Id.
\1110\ Id.
\1111\ Id.
---------------------------------------------------------------------------
Elizabeth Cheetham-Webb, Scott Webb's sister, told
Subcommittee staff that her brother traveled to Tyler for
training during the summer of 1998 in anticipation of moving to
Atlanta after Momentum's new branch office opened.\1112\ She
claimed that Momentum put the two young men in apartments and
that Momentum ``wined and dined'' them.\1113\ Mr. Webb trained
in Tyler for two weeks.\1114\ During this training period, Mr.
Webb told his sister that he was excited about his new day
trading career, stating, ``I think I have finally found my
niche.'' \1115\ In correspondence with his mother, Alyce
Wenzel, Mr. Webb expressed great optimism about his new career,
writing, ``It is so exciting being your own boss and I love
what I am doing, I finally feel like I have control of my
future.'' \1116\
---------------------------------------------------------------------------
\1112\ Cheetham-Webb Int. at 1.
\1113\ Id.
\1114\ Id.
\1115\ Id.
\1116\ Letter from Scott Webb to Alyce Wenzel, Apr. 1998, at 1
(Feb. Hr'g Ex. 97).
---------------------------------------------------------------------------
After completing their training in Tyler, Messrs. Hoehn and
Webb moved to Atlanta along with David Dial's older brother,
Kevin, to open the Atlanta office.\1117\ The elder Dial
directed the ``recruiting'' of new day traders while Mr. Hoehn
was responsible for the daily operations of the office.\1118\
Mr. Webb was only a day trader when he first arrived in Atlanta
but he was later retained by Momentum and Professional Traders
Group, the management company that runs the Atlanta office, to
train new customers.\1119\
---------------------------------------------------------------------------
\1117\ Dial Int. at 1-2. Kevin Dial was tragically killed by
Momentum day trader Mark Barton on July 29, 1999. Id.
\1118\ Id. at 2.
\1119\ Id. at 1-2.
---------------------------------------------------------------------------
(2) Scott Webb's Unsuitability for Day Trading and His
Resulting Losses. Upon arriving in Atlanta, Messrs. Hoehn and
Webb moved into an apartment together.\1120\ In addition to
having very little cash, Ms. Wenzel said that her son had a
very poor credit record and that his father even had to co-sign
his car loan.\1121\ Nevertheless, on July 29, 1998, Momentum
opened two day trading accounts for Mr. Webb. The first account
was in the name of Mr. Webb, and the second account was for
Spyderstorm Capital, LLC, a corporation created by Mr. Webb to
cross-guarantee trading in his personal account.\1122\ Prior to
opening his account, it appears that Mr. Webb reviewed and
signed a document entitled ``House Systems and Trading Rules
Acknowledgment.'' \1123\ The document advises the customer of
the execution risks associated with day trading using
Momentum's software system.\1124\ Specifically, the document
informed Mr. Webb of the possibility that the software system
might crash and that execution might be difficult on the highly
volatile NASDAQ market.\1125\ The disclosure made no attempt to
advise Mr. Webb about the risks of day trading. In fact, the
disclosure document does not even mention the term ``day
trading.'' Rather, the entire focus is on ``systems risks.'' It
does not address margin trading, excessive commission charges
from high volume trading or any of the other important subjects
that Momentum routinely discloses in its current risk
disclaimers.
---------------------------------------------------------------------------
\1120\ Hoehn Int. at 3.
\1121\ Wenzel Int. at 1.
\1122\ New Account Approval-B for Scott Allyn Webb, July 28, 1998
(Feb. Hr'g Ex. 98); New Account Approval-B for Spyderstorm Capital,
LLC, July 29, 1998 (Feb. Hr'g Ex. 99); Cross-Guarantee Agreement
between Scott Allyn Webb and Spyderstorm Capital, LLC, July 29, 1998
(Feb. Hr'g Ex. 100) (``Webb New Account Forms'').
\1123\ Momentum Securities, Inc., ``House Systems and Trading Rules
Acknowledgment,'' July 27, 1998 (Feb. Hr'g Ex. 136). The Subcommittee
requested that Momentum produce any risk disclosure documents that Mr.
Webb had reviewed and signed. Momentum produced this document as part
of Mr. Webb's new account materials early in the investigation. In
addition, Momentum produced three additional documents that were
purportedly risk disclosure statements signed by Mr. Webb in December
1998 and January 1999, almost six months after Mr. Webb opened his
account. These additional documents provide very good risk disclosure
regarding the key issues pertaining to day trading. However, the
Subcommittee has been unable to verify that these documents were signed
by Mr. Webb.
\1124\ Feb. Hr'g Ex. 136.
\1125\ Id.
---------------------------------------------------------------------------
Even though Mr. Webb had not been gainfully employed for
almost six months and had lost about $10,000 day trading with
Mr. Hoehn at Insight Trading, he disclosed an annual income of
$50,000.\1126\ In the space requesting his net worth, Mr. Webb
wrote ``N/A.'' \1127\ Mr. Webb also left blank the space on the
new account form denoting the customer's initial deposit.\1128\
---------------------------------------------------------------------------
\1126\ Feb. Hr'g Ex. 98; Feb. Hr'g Ex. 99.
\1127\ Id.
\1128\ Id.
---------------------------------------------------------------------------
The Subcommittee's investigation discovered that Mr. Webb
opened his day trading accounts entirely with borrowed
funds.\1129\ Mr. Hoehn told Subcommittee staff that Mr. Webb
borrowed $30,000 from his father and another $30,000 from
Gerald Simpson, a Momentum customer at the Tyler office and a
friend of Mr. Dial.\1130\ Roy Webb, Scott Webb's father,
confirmed to Subcommittee staff that he loaned $30,000 to his
son in order to fund his day trading career.\1131\ He said that
Scott assured him that the funds would be used for a
conservative trading strategy.\1132\ In order to obtain the
additional $30,000 of trading capital from Mr. Simpson, Mr.
Webb provided Mr. Simpson a promissory note in which Mr. Webb
agreed to pay 18 percent interest during the term of the
loan.\1133\ According to Mr. Hoehn, David Dial arranged the
loan between Mr. Webb and Mr. Simpson.\1134\
---------------------------------------------------------------------------
\1129\ Hoehn Int. at 2. There is currently no law that requires any
brokerage firm to determine the source of a customer's funds.
\1130\ Id.; Dial Int. at 2.
\1131\ Telephone Interview of Roy A. Webb, Dec. 9, 1999, at 1
(``Webb Int.'').
\1132\ Id.
\1133\ Promissory Note between Gerald Simpson and Scott Webb, July
29, 1998 (Feb. Hr'g Ex. 101).
\1134\ Hoehn Int. at 2.
---------------------------------------------------------------------------
Ms. Wenzel told Subcommittee staff that, ``from the moment
he started trading,'' her son lost money.\1135\ At the
Subcommittee's hearing on February 24, 2000, Ms. Wenzel
testified, ``* * * he thought he was going to be rich, he was
going to have this lavish lifestyle, and two weeks after he was
in Atlanta, when I talked to him, he was a different person.''
\1136\ Ronda McPherson, Mr. Webb's girlfriend, indicated that,
with the exception of a brief period at the outset, Mr. Webb
lost money day trading and was often depressed about his lack
of success.\1137\ In fact, Mr. Webb told Ms. McPherson that he
was glad ``he had lasted as long as he had.'' \1138\ An audit
of Mr. Webb's account shows that, of the $60,000 he borrowed to
begin day trading at Momentum, only about $19,000 remained at
the time of his death in July 1999.
---------------------------------------------------------------------------
\1135\ Wenzel Int. at 1.
\1136\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
\1137\ Telephone Interview of Ronda McPherson, Dec. 12, 1999, at 1
(``McPherson Int.'').
\1138\ Id.
---------------------------------------------------------------------------
Mr. Hoehn described Mr. Webb as a high volume trader,
usually averaging over 60,000 shares and 100 tickets per
day.\1139\ Mr. Hoehn told Subcommittee staff that Mr. Webb was
a ``sophisticated trader,'' a person ``attracted by the
opportunities [of day trading],'' and one who ``loved day
trading.'' \1140\ Ms. Cheetham-Webb said that her brother often
told her about his losses.\1141\ She said that Mr. Webb
frequently indicated that he received margin calls, which he
could not cover, and was prohibited from trading.\1142\ As Mr.
Webb's financial condition worsened, Ms. Wenzel described her
son as ``absolutely broke,'' ``scared'' about his looming
debts, and under ``so much stress.'' \1143\ She described her
son further at the Subcommittee's hearing, ``* * * he was in so
deep, he felt he probably could not get out. He had to keep
going and he was stressed. The first time I saw him after he
came home from Atlanta, I could see in his eyes, Scott had lost
some weight and was very, very stressed.'' \1144\
---------------------------------------------------------------------------
\1139\ Hoehn Int. at 2.
\1140\ Id. at 3.
\1141\ Cheetham-Webb Int. at 1.
\1142\ Id.
\1143\ Wenzel Int. at 1.
\1144\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
(3) Despite Heavy Trading Losses, Mr. Webb Was Hired to
Train New Momentum Customers. Even though Mr. Webb accumulated
mounting losses from day trading, he did develop a source of
income at Momentum in 1999, when Professional Traders Group
hired him to train new customers at the Atlanta branch office.
In fact, David Dial told Subcommittee staff that Mr. Webb was
in charge of creating the training curriculum and teaching the
courses at the Momentum office.\1145\ Professional Traders
Group paid Mr. Webb approximately 75 percent of the tuition fee
of $1,500 to $2,000 per customer.\1146\
---------------------------------------------------------------------------
\1145\ Dial Int. at 2.
\1146\ Id.; Hoehn Int. at 3. Mr. Hoehn said that, on occasion, Mr.
Webb was paid directly by the customer he was training. Hoehn Int. at
3.
---------------------------------------------------------------------------
According to Mr. Dial, Mr. Webb's training program focused
on Momentum's execution software rather than trading
strategies.\1147\ Mr. Dial said that it would have been
inappropriate for Mr. Webb to teach new customers trading
strategies.\1148\ The Subcommittee obtained a copy of Mr.
Webb's training syllabus which indicates that, contrary to Mr.
Dial's belief, Mr. Webb did teach prospective Momentum
customers trading strategies.\1149\ For instance, Mr. Webb
instructed potential customers about key trading indicators,
such as crossed and locked markets as well as trading
philosophies.\1150\ Mr. Webb's syllabus lists several different
trading techniques, such as ``scalping'' and ``position
trading'' and ``gambling.'' \1151\ Mr. Hoehn told Subcommittee
staff that he referred all new customers to Mr. Webb for
training.\1152\ He estimated that Mr. Webb trained
approximately 15 to 20 customers over a three or four month
period, ending with his death in July 1999.\1153\ Although he
was training Momentum's customers, Mr. Webb was not an actual
employee of Momentum and was never licensed with the state or
the SEC.\1154\
---------------------------------------------------------------------------
\1147\ Dial Int. at 2.
\1148\ Id.
\1149\ Syllabus for Professional Traders Group Training Seminar,
Jan. 4, 1999 to Jan. 29, 1999, at 1-2 (Feb. Hr'g Ex. 102).
\1150\ Id.
\1151\ Id. at 2. Mr. Hoehn told Subcommittee staff that he believed
Mr. Webb's inclusion of ``gambling'' as a trading ``technique'' was
probably Mr. Webb's effort to distinguish day trading from gambling.
Hoehn Int. at 3. Mr. Hoehn cited no documentary evidence to support
this conclusion but simply indicated that he knew Mr. Webb did not
consider trading equivalent to gambling. Id.
\1152\ Hoehn Int. at 3.
\1153\ Id.
\1154\ Id.
---------------------------------------------------------------------------
Mr. Webb was working at Momentum in his capacity as a
trainer on the day Mark Barton walked into Momentum's Atlanta
office and began his homicidal rampage. Mr. Webb was training a
new customer when Barton emerged and began shooting. His
mother, Ms. Wenzel, has filed a wrongful death action against
the estate of Mark Barton, Momentum and others as a result of
the shooting.\1155\ When Roy Webb attempted to collect the
remaining equity in his son's account, he was notified by Mr.
Hoehn that Gerald Simpson held a $30,000 promissory note from
his son and, therefore, Mr. Simpson had a superceding claim on
the funds.\1156\
---------------------------------------------------------------------------
\1155\ Wenzel Int. at 1.
\1156\ Webb Int. at 1.
---------------------------------------------------------------------------
(4) Momentum Failed to Properly Supervise the Atlanta
Office. The tragic story of Scott Webb raises serious questions
about Momentum's internal policies pertaining to risk
disclosure and the suitability of new day trading customers. It
also reveals several glaring deficiencies in Momentum's
management and supervision of its branch offices.
First and foremost, it is very troubling that Momentum
failed to provide Mr. Webb a comprehensive written risk
disclosure. The risk disclosure that Mr. Webb signed made no
mention of the risks of day trading strategies, the importance
of risk capital, the high commissions attendant to heavy
trading, or the risk of loss associated with margin trading. It
addressed only the systems and execution risks of day trading.
While important, these risks are only a few of the perils of
day trading. As discussed in detail below, Momentum's current
risk disclosure forms are quite comprehensive and thorough and
advise customers of risks that extend beyond those disclosed to
Mr. Webb. Given Mr. Webb's enthusiasm for his new career, it is
impossible to know whether better risk disclosures would have
been effective in informing Mr. Webb of the significant risks
of day trading. Because this simple precaution was never taken,
however, it is very possible that, at the outset, Mr. Webb did
not fully appreciate the financial risks of his new career.
The evidence is also overwhelming that Mr. Webb was not
suitable for day trading and that Mr. Hoehn and Mr. Dial knew
it at the time Mr. Webb opened his Momentum account. Mr. Hoehn
admitted to Subcommittee staff that he knew that Mr. Webb had
not been successful as a producing broker for Dean Witter and
had not been gainfully employed for almost six months when he
opened his day trading account in July 1998.\1157\ Mr. Hoehn
also knew that Mr. Webb had borrowed $10,000 to day trade at
Insight Trading in St. Louis and, within several months, had
lost most if not all of it.\1158\ Further, Mr. Hoehn knew that,
when Mr. Webb sought to open his Momentum account, he funded
the account entirely with borrowed funds.\1159\ In fact,
Messrs. Hoehn and Dial facilitated this borrowing by putting
Mr. Webb in touch with Gerald Simpson, a day trader at
Momentum's Tyler office, who loaned Mr. Webb $30,000 to day
trade.\1160\
---------------------------------------------------------------------------
\1157\ Hoehn Int. at 2.
\1158\ Id.
\1159\ Id. at 3.
\1160\ Dial Int. at 2.
---------------------------------------------------------------------------
Given what Messrs. Hoehn and Dial knew about Mr. Webb's
past trading performance and poor financial condition, it was
irresponsible for them to help him open an account at Momentum.
When interviewed by Subcommittee staff, Mr. Hoehn was asked why
he signed and accepted Mr. Webb's new account form when it
indicated that Mr. Webb had an annual income of $50,000 and no
available net worth. Mr. Hoehn said that he thought Mr. Webb
had a ``trust fund'' and some ``income from real estate''
investments.\1161\ Mr. Webb's mother and father told
Subcommittee staff, however, that their son had no trust fund
or investments that generated income.\1162\ At the
Subcommittee's hearing on February 24, 2000, Mr. Hoehn
attempted to justify the opening of Mr. Webb's account when he
stated, ``At the time of Scott Webb's initial account opening,
we did not have guidelines as we have today. So [the opening of
the account] was on the circumstantial situation.'' \1163\
---------------------------------------------------------------------------
\1161\ Hoehn Int. at 3.
\1162\ Wenzel Int. at 1; Webb Int. at 1.
\1163\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
Subcommittee staff also confronted Mr. Dial about why Mr.
Webb had been allowed to open his day trading account with
$60,000 of borrowed funds. Mr. Dial initially said that it did
not bother him that Mr. Webb opened his day trading account
with borrowed funds.\1164\ Mr. Dial then agreed with
Subcommittee staff that Momentum's internal policies require
day traders to use only ``risk capital,'' which he said were
``funds one can afford to lose.'' \1165\ Under questioning, Mr.
Dial conceded that borrowed funds do not qualify as risk
capital.\1166\
---------------------------------------------------------------------------
\1164\ Dial Int. at 2.
\1165\ Id.
\1166\ Id.
---------------------------------------------------------------------------
While it is disturbing that Messrs. Hoehn and Dial
knowingly encouraged Mr. Webb to open a day trading account
when he clearly did not possess adequate risk capital, the most
troubling finding of the investigation is that Momentum's
compliance personnel in Houston apparently knew for a full ten
months before Mr. Webb's death that he was unsuitable for day
trading. In mid-September 1998, Valynda Ewton, a former NASD
examiner who did consulting work for Momentum, conducted an
examination of the Atlanta office.\1167\ In her examination,
Ms. Ewton specifically flagged Mr. Webb's account, along with
several others, as only ``marginally suitable.'' \1168\ Ms.
Ewton stated her concern about these accounts in no uncertain
terms:
---------------------------------------------------------------------------
\1167\ Momentum Securities, Inc. Branch Examination, Atlanta,
Georgia, Sept. 14, 1998 to Sept. 17, 1998 (Feb. Hr'g Ex. 103).
\1168\ Id. at 3.
[S]ome written memorandum may be needed to document
why these persons were allowed to day trade. Perhaps
limits on dollar amounts of losses, additional credit
checks or written attestations from the customer. Or,
special attention needs to be provided by Kirk or
another trainer. I believe that NASD will start taking
a hard look at the knowledge and suitability of
customers.\1169\
---------------------------------------------------------------------------
\1169\ Id.
Ms. Ewton's warning about Mr. Webb's unsuitability for day
trading apparently went unheeded. Mr. Webb continued to incur
losses day trading for almost a full year before he was killed
by Mark Barton. When asked if any action was taken in regard to
limiting Mr. Webb's trading as the result of Ms. Ewton's audit,
Mr. Hoehn responded, ``As a result of this audit, no, but Scott
and I would frequently, on a daily basis, discuss his trading.
So we were monitoring the trading closely.'' \1170\
---------------------------------------------------------------------------
\1170\ Day Trading: Everyone Gambles But the House, Hearings Before
the Permanent Subcommittee On Investigations, Committee on Governmental
Affairs, 106th Cong., 2nd Sess. (Feb. 24, 2000) (hearing transcript).
---------------------------------------------------------------------------
That Momentum opened a day trading account for Mr. Webb is
itself troubling, given what the firm knew about his financial
condition and poor trading performance. Perhaps most startling,
however, is that Mr. Webb was then hired to train Momentum's
new customers at the Atlanta office. In light of Mr. Webb's
mounting trading losses at Insight and later Momentum, it is
shocking that Momentum relied on a young man who had never
traded successfully to teach new customers how to become
profitable day traders. Mr. Dial's analogy of Mr. Webb's role
as a trainer to a good coach who was never a great player is
flawed. Mr. Webb was a very poor day trader, and it is
unthinkable that an athlete of comparable skill could ever rise
to be a successful coach. Scott Webb clearly did not possess
the skills or temperament to be a successful day trader, and
the decision to have him instruct new customers reflects poorly
on Momentum's supervision of the Atlanta office.
The opening and handling of Mr. Webb's account typifies the
poor management and supervision that existed at Momentum's
Atlanta office from the summer of 1998 until the spring of
1999, when Momentum began to improve its compliance effort. It
is unclear why it took six months to clean up the Atlanta
office since Momentum's management in Houston had notice of a
serious problem as early as mid-September 1998. In Ms. Ewton's
examination findings on Momentum's Atlanta office, she noted
that Mr. Hoehn ``basically did not know what to do as far as
what records to review for what.'' \1171\ Ms. Ewton found that,
of 26 day trading customers at the time, there were 8 accounts
with incomplete or inaccurate information on the new account
forms and 5 accounts with no paperwork at all.\1172\
---------------------------------------------------------------------------
\1171\ Momentum Securities, Inc. Branch Examination, Atlanta,
Georgia, Sept. 14, 1998 to Sept. 17, 1998 at 4 (Feb. Hr'g Ex. 103).
\1172\ Id. at 2, 3, 5.
---------------------------------------------------------------------------
In her conclusion, Ms. Ewton was harshly critical of the
management and supervision of the Atlanta office.
Neither Justin [Hoehn] nor Kevin [Dial] have a clue
as to how to supervise. Despite supplying copies of the
Written Supervisory Procedure's to each of them,
neither one has read them. They received little if any
guidance from the Tyler office. Reports were printed in
Tyler for a period of time, but were not forwarded to
Atlanta until the SEC walked in. It only takes one
hiccup from a branch office to undermine an entire
broker/dealer organization. Tyler and Atlanta are
branch offices of Momentum--Houston. If there is a
regulatory problem, then it can and likely will go
against [Momentum]--Houston and its principals. David
[Dial] said he was reviewing all the reports in Tyler.
However, he needs to spend more time with Justin
[Hoehn] advising him how to read them and what to look
for. He must provide guidance to Atlanta.\1173\
---------------------------------------------------------------------------
\1173\ Id. at 6.
Ms. Ewton suggested that, ``[t]o help head off any future
problems,'' Momentum should ``draft a branch office manual''
which should be ``reviewed and circulated amongst all branch
managers in the near future.'' \1174\ She also suggested that
Momentum adopt ``a branch managers monthly compliance report''
that would be submitted to the home office in Houston at the
close of each month.\1175\ Ms. Ewton concluded with a stern
warning to Momentum management about the Atlanta office and
urged immediate action to avoid future problems:
---------------------------------------------------------------------------
\1174\ Id.
\1175\ Id. at 7.
Before another branch office is opened, [Momentum]
must make sure there are controls in place to monitor
the newly hired S24 and provide supervisory training if
required. I am hopeful that the SEC exam in Atlanta was
only a training exercise for a new examiner. This could
be a disastrous experience if a well seasoned
regulatory team would come in considering the shape of
the Atlanta office.\1176\
---------------------------------------------------------------------------
\1176\ Id.
To its credit, the Atlanta office did eventually improve.
Momentum conducted a second audit six months after Ms. Ewton
made her evaluations. Although the report did not address any
specific improvements by Messrs. Hoehn and Dial, it did note
that files were maintained with greater accuracy, customer
financial status was more thoroughly transmitted, and the
environment was much more conducive to customer service.\1177\
Nevertheless, the examination still reported that many new
account forms were not filled out completely.\1178\
---------------------------------------------------------------------------
\1177\ Momentum Securities, Inc. Branch Examination, Atlanta,
Georgia, Mar. 5, 1999, at 1 (Feb. Hr'g Ex. 104).
\1178\ Id. at 2.
---------------------------------------------------------------------------
Ms. Ewton's examination findings probably should not be
surprising given that Mr. Hoehn had virtually no experience or
qualifications to serve as a branch manager of a securities
firm. Mr. Hoehn was only 22 years old when he became the branch
manager of the Atlanta office. His only experience to serve as
a branch manager was that he had been a broker-trainee for
several months at Dean Witter before losing $10,000 to $15,000
of borrowed funds in several months at Insight Trading.\1179\
Mr. Hoehn had never before acted as a registered representative
for a brokerage firm when he became the branch manager of the
Atlanta office much less supervised other licensed personnel.
Mr. Dial justified hiring Mr. Hoehn as the branch manager
because he was ``eager and demonstrat[ed] confidence,'' and
also had three months of trading experience, which was ``a lot
in this business.'' \1180\ Mr. Dial's justification for hiring
Mr. Hoehn as the branch manager is hardly persuasive since, Mr.
Hoehn's confidence aside, he had virtually no management
experience as a young man of only 22. Moreover, three months of
unsuccessful day trading experience should not inspire
confidence.
---------------------------------------------------------------------------
\1179\ Hoehn Int. at 2.
\1180\ Dial Int. at 1-2.
---------------------------------------------------------------------------
Ms. Ewton's stinging critique of the management and
supervision of Momentum's Atlanta office was also directed at
Mr. Dial's failure to provide guidance to Mr. Hoehn.
Subcommittee staff found Momentum's reliance on Professional
Traders Group troubling since it appears that the Houston
compliance operation relied on Mr. Dial and his associates in
the Tyler branch office to provide direct supervision and
management. Indeed, it appears that Mr. Dial and the Tyler
office provided the entire impetus for the opening of the
branch office in Atlanta, suggesting that Momentum's reliance
on management companies has diluted the internal controls
necessary to ensure that branch office personnel comply with
not only securities laws, but also firm policies. The case of
Scott Webb and the Atlanta office suggests that Momentum failed
to adequately supervise its branch offices.
D. Momentum Operates a Lending Program That Allows Day Traders to Evade
the Purpose of the Margin Rules
One of the most troubling discoveries of the Subcommittee's
investigation of Momentum related to inter-customer lending to
satisfy margin calls. In response to Subcommittee
interrogatories, Momentum stated that as, of October 1, 1999,
103 of the firm's 2,128 customers had loaned money to another
customer to meet margin calls.\1181\ Momentum indicated that
these loans occur between customers in the same office and
those who are located in different branch offices.\1182\
Momentum also stated that the firm plays an essentially passive
role in the lending process.\1183\ Specifically, the firm
stated that ``Momentum may incidentally inform customers as to
the availability of private party loans from persons who may
themselves be existing customers, and identify such existing
customers. Terms of the loans are agreed upon between the
customers.'' \1184\
---------------------------------------------------------------------------
\1181\ Letter from Saul S. Cohen, Counsel for Momentum, to Glynna
C. Parde, Senior Counsel for the Subcommittee, Nov. 17, 1999, at 1, 2
(Feb. Hr'g Ex. 105). There are three types of margin calls that may
have applied to customers at Momentum: Regulation T initial margin
calls; maintenance margin calls; and special maintenance margin calls
for day trading (``day trading calls''). Subcommittee staff does not
know for certain, and neither does Momentum, whether the lending
practices implicated each of these kinds of calls. Momentum produced no
written firm policy or documentation to support the assertion that
these inter-customer loans were limited to day trading calls.
\1182\ Id. at 2.
\1183\ Id.
\1184\ Id. (emphasis added).
---------------------------------------------------------------------------
The Subcommittee discovered, however, that Momentum
performs more than an ``incidental'' role in the lending
process. In fact, the evidence shows that Momentum actively
promotes and encourages loans between its customers to satisfy
intra-day margin calls. For example, the branch manager for
Momentum's Atlanta office, Mr. Hoehn, told Subcommittee staff
that Momentum's clearing firm initiates the lending process by
notifying the margin department in Houston of those customers
that have margin calls.\1185\ Houston then notifies the branch
managers, who are responsible for informing the customers of
the margin calls and their options for satisfying the
calls.\1186\ Mr. Hoehn indicated that he informs customers that
they can cover the margin calls with their own funds or obtain
a short-term loan from other Momentum customers.\1187\ If the
customer wishes to take advantage of the loans, Mr. Hoehn
informs the home office in Houston, which apparently maintains
a list of customers who have agreed to make their accounts
available for short-term margin loans.\1188\ After the initial
authorization process is completed, Momentum will automatically
cover future margin calls with funds from the lending customer
unless the borrowing customer indicates that he or she wishes
to cover the calls themselves.\1189\
---------------------------------------------------------------------------
\1185\ Hoehn Int. at 3.
\1186\ Id.
\1187\ Id.
\1188\ Id.
\1189\ Dial Int. at 2.
---------------------------------------------------------------------------
Not only does Momentum affirmatively connect the borrowing
and lending customers, it also appears to set the terms of the
loans in direct contradiction of Momentum's written response to
the Subcommittee's interrogatories. Mr. Dial, the branch
manager of the Tyler office, confirmed that the borrowing
customers usually do not know or communicate with the lending
customers.\1190\ In addition, Mr. Hoehn did not believe that
his borrowing customers in Atlanta ever communicated directly
with the lending customers, who were usually located in other
branch offices and particularly Tyler.\1191\
---------------------------------------------------------------------------
\1190\ Id.
\1191\ Hoehn Int. at 3.
---------------------------------------------------------------------------
During their Subcommittee interviews, both Messrs. Hoehn
and Dial authenticated journal authorization forms between
Scott Webb and Gerald Simpson, a day trader in the Tyler
office, in which the names of the borrowing and lending
customers were simply written into blank spaces on pre-printed
forms.\1192\ Mr. Dial told Subcommittee staff that Mr. Simpson
is a long-time client of the Tyler branch office who ``makes
his account available'' to customers and provides them loans to
meet margin calls.\1193\ Mr. Dial said that, while Mr. Simpson
gives an initial authorization to make his account available to
other customers who need loans to cover margin calls, he
normally does not know or speak with the borrower and is not
necessarily aware of all the loans that are made from his
account.\1194\ In fact, Mr. Dial confirmed that Mr. Simpson's
signature on the Webb journal authorization forms was merely a
signature stamp applied by Momentum personnel.\1195\
---------------------------------------------------------------------------
\1192\ Dial Int. at 2; Hoehn Int. at 3. Mr. Simpson was also the
customer that loaned Mr. Webb $30,000 in July of 1998 to help fund his
day trading activities at Momentum. Id.
\1193\ Dial Int. at 2.
\1194\ Id.
\1195\ Id.
---------------------------------------------------------------------------
These blank journal authorization forms were apparently
maintained by the various branch offices so that funds could be
routinely moved between the accounts of borrowing and lending
customers. For instance, Subcommittee's analysis of several of
Mr. Webb's margin loans shows that Mr. Webb borrowed money from
Mr. Simpson frequently and in large amounts.
Webb margin loans from Simpson
Date Amount
October 5, 1998......................................... $27,000.00
October 14, 1998........................................ 61,000.00
November 20, 1998....................................... 800.00
November 24, 1998....................................... 82,000.00
December 17, 1998....................................... 51,000.00
January 27, 1999........................................ 136,000.00
February 4, 1999........................................ 120,000.00
February 23, 1999....................................... 134,000.00
March 3, 1999........................................... 32,000.00
May 12, 1999............................................ 54,000.00
June 1, 1999............................................ 76,000.00
June 9, 1999............................................ 77,000.00
June 17, 1999........................................... 117,000.00
June 28, 1999........................................... 86,000.00
July 7, 1999............................................ 90,000.00
July 21, 1999........................................... 89,000.00
Source: Journal Authorizations Between Accounts of Gerald Simpson and
Spyderstorm Capital, LLC.
The Simpson account was not the only account that Momentum
used to provide short-term margin loans to its day traders. The
Subcommittee reviewed the lending activity in one account held
by a customer named Claypool. According to an analysis by the
Subcommittee, between June 30, 1999 and July 30, 1999, Momentum
used the Claypool account to loan almost $10,000,000 to 52
other Momentum customers.\1196\ The Claypool account provided
loans in excess of $100,000 on 21 occasions during the month of
July.\1197\ Several of the borrowers were repeat customers. For
instance, a day trader named Baylor borrowed money to cover
margin calls on eight separate occasions during the month of
July for a total of $582,637.\1198\ Another customer named
Thofner borrowed money from the Claypool account in seven
different instances in July, totaling $335,394.\1199\
---------------------------------------------------------------------------
\1196\ Momentum Journal Authorizations into the Claypool Account
(Feb. Hr'g Ex. 106).
\1197\ Id.
\1198\ Id.
\1199\ Id.
---------------------------------------------------------------------------
During his interview with Subcommittee staff, Mr. Dial said
that he did not know of a circumstance when these loans were
not repaid by the borrowing day trader.\1200\ While the
Subcommittee has no indication that borrowing customers
defaulted on these margin loans, there is evidence that
Momentum's day traders did not always repay their loans in a
timely fashion and, thus, continued to incur substantial
interest charges. A review of the Claypool journal
authorizations indicates that Momentum customers often failed
to repay the margin loans on the anticipated date, prompting
Momentum officials to cross out the amount due on the journal
form and write in a new amount to reflect added interest.\1201\
For example, a customer named Schwinger failed to repay a loan
of $35,016 that was originally due on June 30, 1999.\1202\ The
form contains marginalia stating, ``6 days, went over''.\1203\
When the loan was repaid, the added interest resulted in
Schwinger paying Claypool an additional $114.\1204\ There are
several other journal authorizations in the Claypool records
which suggest that the loans may not have been repaid. For
instance, while most of the forms bear the notation ``done'' or
``completed''--presumably indicating that the loan was repaid--
some of the forms note ``went over'' or ``not done yet''.\1205\
---------------------------------------------------------------------------
\1200\ Dial Int. at 2.
\1201\ Feb. Hr'g Ex. 106.
\1202\ Id.
\1203\ Id.
\1204\ Id.
\1205\ Id.
---------------------------------------------------------------------------
In summary, the evidence indicates that customers
frequently borrowed funds from other customers to meet margin
calls and that, as a matter of course, Momentum managed the
entire lending process. Momentum connected the borrower and the
lender who normally did not know each other or communicate with
one another during the lending process. As such, it is simply
wrong to suggest, as Momentum does, that the terms of these
loans were in any way the process of a bargained exchange.
While there is nothing inherently improper with customers
lending money to one another to satisfy margin calls, it is
problematic for day trading firms to encourage such lending
when their revenue stream depends heavily on sustained customer
trading. The obvious conflict of interest should be sufficient
to dissuade Momentum from continuing this troubling practice in
the future.
E. Momentum Has Not Engaged in a Deceptive or Misleading Advertising
Campaign
In the area of advertising, the Subcommittee found that, in
general, Momentum did not sponsor deceptive or misleading
advertisements concerning the firm or the day trading industry
overall. Indeed, Momentum should be commended for including
risk disclosures on television commercials that it sponsors on
behalf of its branch offices. A review of these commercials by
Subcommittee staff found no misleading statements or unbalanced
presentations about the risks and profitability of day trading.
However, in August 1999, NASDR wrote a letter to Momentum
citing several potential violations of NASD advertising rules
that required corrective action.\1206\ NASDR examiners reviewed
a sample of Momentum's Internet website and print
advertisements and found exaggerated claims or failure to
disclose risks. For example, Momentum's website made the
claims, ``Cutting-Edge Technology and Thorough Customer
Training = Superior Performance Results,'' \1207\ which NASDR
said ``appear[ed] to exaggerate the potential performance that
a day trader can expect.'' \1208\ NASDR also criticized the
website's risk disclosure section because it did not warn
potential day traders that market volatility and volume can
delay system access and trade execution.\1209\ NASDR examiners
also criticized Momentum for a news release that they
characterized as ``exaggerated and unwarranted and in apparent
violation of NASD Conduct Rules.'' \1210\ Further, NASDR stated
that ``the material appears to be incomplete and unbalanced in
that if fails to reflect the risks inherent in day trading.''
\1211\
---------------------------------------------------------------------------
\1206\ Letter from Scott H. Maestri, NASD Examiner, to William
Cathriner, Vice President of Momentum, Aug. 10, 1999, at 1 (Feb. Hr'g
Ex. 107).
\1207\ Id. at 2.
\1208\ Id.
\1209\ Id.
\1210\ Id. at 3-4.
\1211\ Id. at 4.
---------------------------------------------------------------------------
In response to the NASDR, Momentum agreed to remedy these
complaints by removing the statement from its news release,
providing a more comprehensive risk disclosure on its website,
and giving more accurate risk disclosure in seminar
advertisements.\1212\ With the exception of the advertising
problems raised by the NASDR, the Subcommittee found no
evidence that Momentum has engaged in deceptive and misleading
advertising.
---------------------------------------------------------------------------
\1212\ Letter from William Cathriner, Momentum Chief Compliance
Officer, to Scott H. Maestri, NASDR Compliance Examiner, Aug. 23, 1999,
at 1 (Feb. Hr'g Ex. 108).
---------------------------------------------------------------------------
F. Increased Regulatory Scrutiny of Day Trading Prompted Momentum to
Improve its Standards and Compliance Program
The Subcommittee's investigation determined that, after
regulatory scrutiny of the day trading industry increased in
early 1999, Momentum made a concerted effort to improve its
standards and compliance program. Ms. Ewton's examination
findings concerning the Atlanta office in September, 1998,
suggest that Momentum's internal policies and compliance
structure were lacking during the firm's early years,
particularly as it related to branch office supervision. In
fact, the Subcommittee's investigation found that, until April
of 1999, Momentum either did not adopt minimum financial
requirements for new day trading accounts or neglected to
communicate those standards to branch office personnel. As the
Scott Webb case illustrates, Momentum also failed to implement
sound internal controls that would have allowed the firm's
management to supervise more effectively its branch office
personnel.
(1) Momentum Has No Branch Office Manual. From its founding
to as late as September, 1998, Momentum did not have a branch
office manual. Indeed, in her examination findings on the
Atlanta office, Ms. Ewton specifically indicated that Momentum
intended to prepare a branch office manual within two
weeks.\1213\ She noted that the manual would be circulated to
the branch offices as part of an effort to improve supervision
by Momentum's Houston office.\1214\ Ms. Ewton also indicated
that Momentum would create a new document known as a ``Monthly
Compliance Report'' that each branch manager would have to
complete and return to the compliance department in Houston by
the tenth day of each month.\1215\ The evidence indicates,
however, that Momentum did not circulate either of these
documents as Ms. Ewton anticipated.
---------------------------------------------------------------------------
\1213\ Feb. Hr'g Ex. 103, at 6-7.
\1214\ Id.
\1215\ Id. at 7.
---------------------------------------------------------------------------
In response to Subcommittee interrogatories, Momentum
produced two copies of a document entitled ``Brokerage
Operations Manual'', which appears to be a branch office
manual. One copy of the manual was marked ``draft'' and the
second copy bore no such designation. Both copies are dated
July 1999 and discuss new account opening procedures, including
risk disclaimers and minimum financial standards for new
accounts.\1216\ Because the new account standards and new
account documents listed in the Brokerage Operations Manual are
very similar to Momentum's currently stated policies, it
appears that Momentum might have introduced the Brokerage
Operations Manual by at least July 1999.\1217\ Mr. Lee
testified, however, that the manual was never completed or
circulated to Momentum personnel or the branch offices.\1218\
Mr. Lee stated that, while many of the directives set forth in
the manual reflect Momentum's current policy, several items do
not.\1219\ For instance, when asked about a document in the
manual entitled ``Branch Manager's Monthly Compliance Report,''
Mr. Lee testified that he did not believe that the form had
ever been utilized by Momentum's branch offices.\1220\
---------------------------------------------------------------------------
\1216\ Momentum Securities, Inc. ``Brokerage Operations Manual''
(July 1999) (Feb. Hr'g Ex. 109).
\1217\ Lee Dep. at 182.
\1218\ Id. at 112. Mr. Lee stated that the manual was in ``a draft
form'' and that Momentum was ``still working on it.'' Id.
\1219\ Id. at 170. Mr. Lee testified that, even though the
Brokerage Operations Manual describes a detailed risk management
program that requires Momentum personnel to monitor customer accounts
and note percentage losses, no such program has been implemented. Id.
at 170-77.
\1220\ Id. at 148.
---------------------------------------------------------------------------
Thus, it does not appear that Momentum ever heeded Ms.
Ewton's guidance. Almost fifteen months after Ms. Ewton
indicated the importance of preparing both a branch office
manual and a monthly compliance report, Momentum has still not
circulated those documents to its branch office personnel. In
April of 1999, however, Momentum introduced a series of new
account opening documents and accompanying standards that were
designed to respond to increased regulatory scrutiny of the day
trading industry.\1221\ The evidence shows that, before the
firm adopted these new standards, Momentum's internal policies
pertaining to opening new accounts were poorly understood by
branch office personnel and were frequently disregarded.
---------------------------------------------------------------------------
\1221\ Id. at 122.
---------------------------------------------------------------------------
(2) Momentum's Registered Personnel Failed to Gather
Financial Information About Customers In Order to Determine
Their Suitability for Day Trading. Without a branch manual to
communicate firm policies and standards to a growing number of
satellite offices, Momentum has relied on written supervisory
procedures to communicate the firm's expectations to its
personnel.\1222\ The ``Written Supervisory Procedures for
Momentum Securities, Inc.,'' dated March 31, 1998, set forth
the only written statement of Momentum's internal policies
concerning the opening of new accounts that the Subcommittee
has located for the period preceding April 1999.\1223\ The
Supervisory Procedures makes clear that Momentum expected its
registered personnel to collect financial information about its
prospective customers in order to evaluate their suitability
for day trading.\1224\ The Supervisory Procedures state as
follows:
---------------------------------------------------------------------------
\1222\ Ms. Ewton commented in her examination of the Atlanta office
that, even though she had given copies of Momentum's Written
Supervisory Procedures to Mr. Hoehn and Kevin Dial, neither gentleman
had read them. Feb. Hr'g Ex. 103, at 6.
\1223\ ``Written Supervisory Procedures for Momentum Securities,
Inc.,'' (Mar. 31, 1998) (Feb. Hr'g Ex. 110).
\1224\ Id. at III-5.
The Registered Representative must take steps to
gather all of the new account information required
including, but not limited to occupation, net worth,
annual income, and tax status. This information must be
taken into account when determining whether an
investment is suitable for a customer.
* * * * *
The representative must take care to insure that not
only he (she) is satisfied that suitability has been
met, but also that the investor fully understands the
significance of the suitability requirement. * * *
The representative has the responsibility of insuring
that written material to be completed by the customer
establishing suitability has been completed by the
customer and that the firm's records contain such
material.\1225\
---------------------------------------------------------------------------
\1225\ Id. (emphasis added).
Although the Supervisory Procedures did not specify minimum
financial requirements, they do require Momentum personnel to
obtain a complete picture of a customer's financial condition.
At a bare minimum, the registered representative was to obtain
the customer's occupation, net worth, annual income, and tax
status.\1226\ Despite the clear language of the Supervisory
Procedures, the Subcommittee found that many of Momentum's new
account forms did not contain this basic information about
prospective day traders.
---------------------------------------------------------------------------
\1226\ Id.
---------------------------------------------------------------------------
For example, the new account form for Benchmark Trading
Fund, Ltd., which was opened on April 14, 1998, is virtually
blank.\1227\ Momentum opened this account without the account
holder stating an investment objective, estimated annual
income, or net worth.\1228\ The new account form also omits any
information about the initial deposit and tax status.\1229\ In
fact, the only information on the new account form is the name
and address of the account holder.\1230\ At his Subcommittee
deposition, Mr. Lee was asked about the manner in which this
new account documentation was completed:
---------------------------------------------------------------------------
\1227\ New Account Approval-B for Benchmark Trading Fund, Ltd.,
Apr. 14, 1998 (Feb. Hr'g Ex. 111).
\1228\ Id.
\1229\ Id.
\1230\ Id.
---------------------------------------------------------------------------
Q: In your view, is this form filled out adequately
for the purposes of making a determination about
whether to open this account?
A: I would like to have seen it completed.\1231\
---------------------------------------------------------------------------
\1231\ Lee Dep. at 244.
The Subcommittee found numerous other examples where
Momentum opened a new day trading account for a customer
without collecting the financial information that the firm's
Supervisory Procedures identify as essential for determining
the suitability of the client. For instance, on September 29,
1998, Momentum opened a day trading account for Henry Castro
and an account for Amit Berstein.\1232\ Both new account forms
failed to provide figures for estimated annual income,
estimated net worth, or initial deposit amounts.\1233\ Once
again, Mr. Lee addressed these new account documents during his
deposition:
---------------------------------------------------------------------------
\1232\ New Account Approval-B for Henry Castro, Sept. 29, 1998
(Feb. Hr'g Ex. 112); New Account Approval-B for Amit Berstein, Sept.
29, 1998 (Feb. Hr'g Ex. 113).
\1233\ Id.
Q: * * * Do you believe that this form was filled out
appropriately for making--in terms of your business
judgment, business practices as the president of the
company for making the determination about whether or
not the account should be opened?
A: All of this paperwork could have been done better.
If the customer is a full-time day trader, I'd like to
see a higher standard. And I think safeguards are in
place today to improve upon this, what you're looking
at.
Q: That wouldn't have been in place back at that time
necessarily [in 1998]?
A: May not have been.\1234\
---------------------------------------------------------------------------
\1234\ Lee Dep. at 245-46.
The new account form for another day trading account,
Lunker Investment Corporation, indicates that the customer
declined to state their estimated annual income, net worth or
tax status.\1235\ Momentum's Supervisory Procedures make clear
that, ``[i]f the customer refuses to supply this information,
then the Registered Representative should keep complete notes''
of why the account was opened.\1236\ The Subcommittee found no
such notes in the new account materials produced by Momentum in
connection with this account. The new account form simply bears
marginalia stating, ``refuse to disclose.'' \1237\ In his
deposition, Mr. Lee explained his understanding of how Momentum
personnel are expected to respond to a customer's unwillingness
to disclose financial information essential to the firm's
suitability determination:
---------------------------------------------------------------------------
\1235\ New Account Approval-B for Lunker Investments Corporation,
Dec. 2, 1998 (Feb. Hr'g Ex. 114).
\1236\ Feb. Hr'g Ex. 110, at III-5.
\1237\ Feb.
Q: Is that a common problem that Momentum registered
representatives encounter when opening new accounts,
that customers don't want to disclose this information?
A: It's been my experience that it's very common.
Q: Okay. How are your registered representatives
instructed to respond when a customer tells them, I'm
not going to tell you what my annual income or net
worth is?
A: Today, we won't approve the account, once we
adopted that policy that we spoke about earlier, March
or May--March or April of this year.
Q: Okay. Back prior to the adoption of these new
procedures you were talking about, how was this sort of
thing handled, do you know?
A: I think we generally respect the interest of the
customer--desire of the customer.
Q: Okay. Would that likely lead to the opening of the
account if they wanted the account to be opened even
though they wouldn't provide the information requested?
A: It could happen, yes, sir.\1238\
---------------------------------------------------------------------------
\1238\ Lee Dep. at 248.
Momentum allowed another day trader, Flora Siman, to open
an account on July 7, 1998, and her new account form omitted
all information about her financial status.\1239\ In fact,
after noting her name and address, the abbreviation ``N/A'' is
written in all of the remaining spaces on the new account
form.\1240\ Mr. Lee conceded at his deposition that he
``expect[ed] the person on site to complete this information. I
would have expected Houston [compliance] not to approve this
until it was more complete at that time. That's certainly the
policy today.''\1241\
---------------------------------------------------------------------------
\1239\ New Account Aprpoval-B for Flora Siman, July 7, 1998 (Feb.
Hr'g. Ex. 115).
\1240\ Id.
\1241\ Lee Dep. at 254.
---------------------------------------------------------------------------
These poorly documented new account forms indicate that
Momentum's compliance personnel were not adequately enforcing
the Supervisory Procedures, which state clearly that the firm's
registered personnel were responsible for ``insuring that
written material to be completed by the customer establishing
suitability has been completed by the customer and that the
firm's records contain such material.''\1242\ These new account
forms suggest that new day trading customers were often allowed
to open an account without disclosing the financial information
that Momentum identified as critical to the firm's ability to
evaluate their suitability.
---------------------------------------------------------------------------
\1242\ Feb. Hr'g Ex.110, at III-5.
---------------------------------------------------------------------------
(3) Prior to April 1999, Momentum Had No Minimum Financial
Requirements for Opening Day Trading Accounts. According to the
Supervisory Procedures, Momentum personnel were to consider
factors such as annual income and net worth to determine a
prospective customer's suitability, but no minimum financial
thresholds were identified.\1243\ In response to written
interrogatories from the Subcommittee, Momentum indicated that
it now requires new day trading customers to possess a minimum
deposit of $50,000 and a net worth of $100,000.\1244\ Momentum
explained that these figures are ``guidelines'' and that
``other factors are used with this guideline to evaluate a
prospective customer's capabilities to day trade.''\1245\
---------------------------------------------------------------------------
\1243\ Id.
\1244\ Letter from Lily Camet, Counsel for Momentum Securities,
Inc., to Brian C. Jones, Investigator for the Subcommittee, Dec. 20,
1999, at 1 (Feb. Hr'g Ex. 116)
\1245\ Id.
---------------------------------------------------------------------------
Momentum also stated that, ``[p]rior to April of 1999,
Momentum used a benchmark or guideline criteria of a deposit of
approximately $25,000 on the opening of an account. This is a
guideline, however, and other factors were used with this
benchmark to evaluate a prospective customer's capabilities to
day trade.''\1246\ During his Subcommittee deposition, however,
Mr. Lee gave a confusing description of Momentum's minimum
financial standards. Mr. Lee initially stated that there were
no minimum financial requirements in place before April 1999
but that customers were advised that they needed $125,000 of
risk capital to have the best opportunity for success.\1247\
Mr. Lee was then shown Momentum's response to the
Subcommittee's interrogatories indicating that, prior to April
1999, the firm utilized a standard of $25,000. Mr. Lee stated
that he was unfamiliar with that standard:
---------------------------------------------------------------------------
\1246\ Id. at 2.
\1247\ Lee Dep. at 121-25.
Q: So, do I understand you to be saying that this
$25,000 benchmark or guideline was not something you
were familiar with?
A: I just don't recall that.
Q: Okay. Is it possible that there was such a
guideline or benchmark being implemented by the branch
managers' without your participation or knowledge?
A: That could have happened during the period that I
wasn't functioning in that supervisory role. I just--I
couldn't--I don't know.\1248\
---------------------------------------------------------------------------
\1248\ Id. at 136.
When asked to explain the discrepancy between his testimony
and Momentum's written response to the Subcommittee's
interrogatories, Mr. Lee again denied that the firm ever
maintained a uniform minimum financial standard for opening new
day trading accounts prior to April 1999, and expressed
---------------------------------------------------------------------------
confusion about his attorneys' response to the Subcommittee:
Q: So, in your view, setting of something like a
guideline for the opening of a new account would not
have been a policy decision rising to the level that it
was necessary to bring that to your attention as a
principal?
A: I don't believe that there was a uniform level.
And if there was, I wasn't aware of it in the system
prior to April. So, it's hypothetical what we're
talking about. It is here in this letter [from
Momentum's attorneys]. And I can't explain to you why
our counsel dealing with Bill Cathriner and Elizabeth
[Cummins] and whoever produced this happened to use
$25,000 because it's prefaced--it's prefaced with the
term ``benchmarking guidelines.''\1249\
---------------------------------------------------------------------------
\1249\ Id. at 139-40 (emphasis added).
Mr. Lee was not the only Momentum employee unfamiliar with the
firm's minimum financial standards prior to April 1999. For
instance, David Dial, the branch manager for Momentum's office
in Tyler could not recall any minimum financial standards
employed by the firm prior to the adoption of the new
standards.\1250\
---------------------------------------------------------------------------
\1250\ Dial Int. at 2. When asked what amount of risk capital he
considered necessary for a potential day trading customer, Mr. Dial
stated that an amount less than $10,000 would significantly limit the
trader's chances of success. Id. At the same time, however, Mr. Dial
believed that a trader could be profitable with amounts between $20,000
and $40,000. Id. He further stated that the current $50,000 standard is
a good benchmark because it is enough capital for a day trader to
survive the ``learning curve'', the first three to six months when a
new trader is the most susceptible to financial losses. Id.
---------------------------------------------------------------------------
The Subcommittee will assume that the testimony of Mr. Lee
and Mr. Dial accurately describes the firm's policy prior to
April 1999. However, the confusion about the firm's standards
prior to April of 1999 is unsettling. In light of the
uncertainty about what the firm's minimum standards were before
April 1999, it is not surprising that the Subcommittee found
many examples of new accounts that were opened with capital
well below the $125,000 figure that Mr. Lee cited originally in
his testimony.
For example, Momentum opened a day trading account for Hung
C. Chan on January 21, 1999, in which Mr. Chan made an initial
deposit of $30,000.\1251\ Also, Minder Singh opened a day
trading account with Momentum on November 6, 1998, with an
initial deposit of only $25,000.\1252\ Similarly, Larry Hartman
initially deposited only $30,000 in his day trading account,
which Momentum opened on October 19, 1998.\1253\ As a final
example, Michael St. John Dinsmore opened his day trading
account at Momentum on March 13, 1997 with a deposit of
$30,000.\1254\ During his deposition, Mr. Lee was shown each of
these new account forms and asked whether, based upon the
information disclosed by the customers, it was appropriate for
Momentum to have opened these accounts. Despite his earlier
testimony indicating that Momentum advised customers that they
should have a minimum of $125,000 of risk capital to day trade,
Mr. Lee testified that it was proper for the firm to have
opened these accounts based on the information disclosed by the
customers.\1255\
---------------------------------------------------------------------------
\1251\ New Account Approval-B for Hung C. Chan, Jan. 21, 1999 (Feb.
Hr'g. Ex. 117). Mr. Chan also disclosed an estimated annual income of
$28,000 and an estimated net worth of $80,000. Id.
\1252\ New Account Approval-B for Minder Singh, Nov. 6, 1998 (Feb.
Hr'g Ex. 118). Mr. Singh also disclosed an estimated annual income of
$30,000 and a net worth of $100,000. Id.
\1253\ New Account Approval-B for Larry L. Hartman, Oct. 19, 1998
(Feb. Hr'g Ex. 119). Mr. Hartman disclosed an estimated annual income
of $30,000 and an estimated net worth of $60,000. Id.
\1254\ New Account Approval-B for Michael St. John Dinsmore, Mar.
13, 1997 (Feb. Hr'g Ex. 120).
\1255\ Lee Dep. at 269, 274, 281, 282.
---------------------------------------------------------------------------
As noted above, in April 1999, Momentum instituted a number
of changes in its internal policies and standards. For the
first time, the firm set minimum financial standards for
accepting new day trading customers.\1256\ Momentum's Brokerage
Operations Manual described the new standards as follows:
---------------------------------------------------------------------------
\1256\ Id. at 121.
EQUITY
The minimum equity a client can deposit into a new
day trading account is $50,000.00. If your customer
only deposits $50,000.00, it is recommended that he/she
trade in 100 share lots for at least the first month.
This will prohibit the client from losing the majority
of his equity during the learning curve.
NET WORTH
All customers must have a minimum net worth of
$100,000.00.
TRADING EXPERIENCE
If a customer has at least 5 years trading
experience, it is possible that an exception will be
made to the above parameters. A branch manager must
obtain permission from the CSO. He/she should complete
the Account Parameters Exception form and fax to
Houston for approval.\1257\
---------------------------------------------------------------------------
\1257\ Feb. Hr'g Ex. 109, Risk Management, at 2 (emphasis added).
Mr. Lee testified to the importance of the $50,000 minimum
within the context of the ``learning curve'' for day
trading.\1258\ He explained that, because new day traders
routinely experience losses during their first months of
trading, it is critical that they possess sufficient risk
capital to withstand that learning curve.\1259\
---------------------------------------------------------------------------
\1258\ Lee Dep. at 161.
\1259\ Id. at 161-62.
---------------------------------------------------------------------------
As stated in the Brokerage Operations Manual, Momentum
appears to have adopted a very stringent and exacting standard
for opening new day trading accounts. It suggests that, absent
the requisite risk capital and net worth, a prospective
customer cannot open a day trading account. The branch manager
can make an exception to this financial standard only if the
customer has five years of trading experience and the branch
manager obtains the approval of the home office in Houston.
During his Subcommittee deposition, however, Mr. Lee
distanced Momentum from the language of its Brokerage
Operations Manual. He indicated that the Brokerage Operations
Manual was never finalized and does not reflect an accurate
statement of firm policy regarding the opening of new day
trading accounts.\1260\ He explained that, under the policy
adopted by Momentum in April 1999, a new day trading account
can be opened if the prospective customer has a minimum
starting equity of $50,000 and a minimum net worth of $100,000,
or attests to five years of trading experience.\1261\ In
addition, Mr. Lee testified that these standards are very
flexible so that a customer who lacks the requisite capital or
trading experience can still open an account after appealing to
Houston's compliance office.\1262\ Mr. Lee explained the policy
as follows: ``Today, what we try to do as a matter of policy,
voluntarily, is to say, look, you need a $50,000 minimum
deposit and a minimum disclosed net worth of [$100,000]. We
have those two collective, or five years trading experience. If
you don't represent one of those two to us, then I believe the
process is that you're kicked out. It's rejected. And then you
have to go through an appeal. * * *'' \1263\
---------------------------------------------------------------------------
\1260\ Id. at 153.
\1261\ Id. at 128-29.
\1262\ Id. at 153.
\1263\ Id. at 128-29.
---------------------------------------------------------------------------
In a review of Momentum's new account documentation, the
Subcommittee found several examples of day trading accounts
that were opened for customers after April 1999 that did not
possess the $50,000 minimum deposit or $100,000 disclosed net
worth. In each case, as Mr. Lee testified, the prospective
customer attested on the new account paperwork that they
possessed five years or more of trading experience. For
instance, Momentum opened a new account for Manfred Pojar on
July 2, 1999 with only $18,000.\1264\ Mr. Pojar indicated on
the new account paperwork that he was ``unemployed'', had
annual income of approximately $15,000 and a liquid net worth
of $35,000.\1265\ Despite his very limited means, Momentum
opened the account for Mr. Pojar because he represented that he
had six years of trading experience.\1266\
---------------------------------------------------------------------------
\1264\ Momentum Securities, Inc., New Account Paperwork Check List
for Manfred Pojar, July 1, 1999 (Feb. Hr'g Ex. 121).
\1265\ Id. at 298.
\1266\ Id.
---------------------------------------------------------------------------
One new account form suggests that most customers that lack
the requisite capital can easily open the account by claiming
past trading experience, even when common sense might warrant
skepticism of the claim. A 23 year old named Charles Lande
opened a day trading account at Momentum with only $15,000, a
disclosed income of $31,500 and $50,000 in net worth--all well
below the firm's minimum standards.\1267\ Momentum approved his
account, however, because Mr. Lande listed trading experience
of six years.\1268\ If true, Mr. Lande was very precocious
indeed, since he would have begun his trading career at the age
of 17.
---------------------------------------------------------------------------
\1267\ Momentum Securities, Inc., New Account Paperwork Check List
for Charles R. Lande, Jr., July 19, 1999, at 3, 7 (Feb. Hr'g Ex. 122).
\1268\ Id. at 5.
---------------------------------------------------------------------------
Mr. Lee also disputed that Momentum policy requires new day
trading customers to indicate that their investment objective
is ``Short-Term Growth with High Risk.'' \1269\ Despite
language to that effect in the Brokerage Operations Manual, Mr.
Lee was unfamiliar with such a requirement:
---------------------------------------------------------------------------
\1269\ Feb. Hr'g Ex. 109, Risk Management, at 4.
Q: You would not open an account for the purposes of
day trading for any customer unless they indicate for
the opening of that account that their investment
objective is short-term growth and high risk?
A: I would--I wouldn't say never; but I would expect
it to be that way, yes.
Q: What are the circumstances in which you conceive
in which that would not be the case?
A: A person met the minimum thresholds, came in and
desired to day trade yet said their objective was
something different than that on, the paperwork.
Q: Such as?
A: Long-term growth with greater risk.
* * * * *
Q: If you'll look down under account information [of
the Brokerage Operations section of the manual], in big
bold print on the last sentence it says: In regard to
investment objectives, short-term growth with high risk
must be checked on all day trading accounts.
* * * * *
A: Okay.
Q: Is that not to be interpreted as an inflexible
rule but as a--just a guideline?
A: It's not a rule. Again, this document is used as
disclosure from a customer. If the customer is looking
at this a different way, I would tell you that I would
expect all day traders as we've defined them to
classify their intention and their goals this way, yes.
Q: But if they didn't, that wouldn't in any way cause
you to hold up the account approval process?
A: I would expect that it would probably get bumped,
but I don't know for sure, bump meaning sent
back.\1270\
---------------------------------------------------------------------------
\1270\ Lee Dep. at 265-66.
As stated in the Brokerage Operations Manual, the firm's
minimum financial standard for new day trading accounts is a
commendable policy that would be a best practice for the rest
of the day trading industry. It would discourage branch office
personnel from opening new accounts for prospective day traders
that have very little chance of success because they lack the
risk capital necessary to survive the learning curve or take
advantage of the full range of trading strategies. As the
policy is actually implemented, however, it provides much less
protection to the firm or the unwitting customer because the
prospective day trader can simply assert that he or she has
five years trading experience or simply appeal the decision to
Momentum's home office with no specified criteria to govern the
appeal. Moreover, many of the best internal policies in the
Brokerage Operations Manual have never been formally adopted or
communicated to the branch offices.
(4) Momentum Significantly Improved Its Written Risk
Disclosures to Prospective Day Traders in Early 1999. Prior to
1999, Momentum provided its new customers with a modest risk
disclaimer that was included within the account opening
paperwork.\1271\ As the Scott Webb case illustrates, however,
this risk disclosure was not comprehensive and was apparently
focused on the systems and execution risks of day trading. In
late 1998 and early 1999, as regulatory scrutiny of the day
trading industry increased, Momentum dramatically improved its
risk disclosure program for new customers. Today, Momentum's
written risk disclosure is one of the finest in the industry,
if not the best.
---------------------------------------------------------------------------
\1271\ Id. at 258-60.
---------------------------------------------------------------------------
Momentum's current risk disclosure documents are included
as part of a detailed package of materials exceeding thirty
pages that customers must review and acknowledge before the day
trading account will be opened. Specifically, Momentum's new
account paperwork contains several different disclosures of the
risks inherent to day trading.\1272\ The first disclosure
document advises customers of the risks associated with trading
Internet stocks and requires the customer to sign the
disclosure form acknowledging that they understand those
risks.\1273\ The form notes that some Internet stocks have
experienced price movements of as much as 100 points in a
single day and advises customers to consider their individual
trading strategies in light of such volatility.\1274\ The form
reminds customers that day trading is very risky and ``may not
be suitable for everyone.'' \1275\
---------------------------------------------------------------------------
\1272\ Feb. Hr'g Ex. 109, New Account Approval at 20, 29-30, 33-34.
\1273\ Id. at 20.
\1274\ Id.
\1275\ Id.
---------------------------------------------------------------------------
The second risk disclosure document is called the ``Risk
Disclosure Statement'' and states in bold face type that day
trading is extremely risky and, as such, ``this activity may
result in the loss of more than 100% of an investment,'' and
``leverage can lead to large losses as well as gains.'' \1276\
The form also advises new customers that day trading ``involves
a high volume of trading activity--the number of transactions
in an account may exceed 100 per day. Each trade generates a
commission and the total daily commissions on such a high
volume of trading can be in excess of any earnings.'' \1277\
Momentum requires new customers to review these disclaimers and
sign them.\1278\
---------------------------------------------------------------------------
\1276\ Id. at 29-30.
\1277\ Id. at 29.
\1278\ Id. at 30.
---------------------------------------------------------------------------
Momentum also gives new customers a disclosure form
reciting SEC Chairman Arthur Levitt's published statement
regarding the risks of Internet investing and day
trading.\1279\ This form states that, ``[f]or most individuals,
the stock market should be used for investment, not trading.
Strategies such as day trading can be highly risky, and retail
investors engaging in such activities should do so with funds
they can afford to lose.'' \1280\ The form must be reviewed and
signed by the new customer before Momentum will open the
account.\1281\
---------------------------------------------------------------------------
\1279\ Id. at 33-34.
\1280\ Id. at 33.
\1281\ Id. at 34.
---------------------------------------------------------------------------
Taken together, these new risk disclosure documents are an
impressive addition to the information customers review when
opening an account. The Subcommittee found that some day
trading firms provided their customers with written risk
disclosures that were undermined or contradicted by misleading
advertising or deceptive statements about the profitability of
day trading, but there was no such evidence relating to
Momentum. Though Momentum did not upgrade its written risk
disclosures until regulatory scrutiny increased in early 1999,
it nonetheless acted responsibly when it significantly improved
its risk management program.\1282\
---------------------------------------------------------------------------
\1282\ Mr. Lee testified that, after the new risk disclosure
documents were prepared, Momentum required that they be completed by
all new customers. Lee Dep. at 109. He also indicated that Momentum
required existing day traders to review the forms and sign them, though
he conceded that some existing customers may have been missed.
---------------------------------------------------------------------------
(5) The Evolution of Momentum's Compliance Operation. All
of Momentum's efforts to increase internal standards and
policies can be tied to the firm's effort to improve its
compliance operation. When Messrs. Lee and Earnest started
Momentum in 1995, Mr. Lee was responsible for all compliance
matters.\1283\ Mr. Lee said that, though he remained at the top
of Momentum's supervisory structure, he relinquished his day-
to-day responsibilities for compliance issues to Elizabeth
Cummins in mid-1996.\1284\ At that point in time, Ms. Cummins
acquired the primary responsibility for supervising compliance
matters at Momentum.\1285\ Mr. Lee testified that, in mid-1998,
he resumed an active role in compliance issues, particularly
with respect to setting firm policies and standards.\1286\ He
added the caveat, however, that Ms. Cummins continued to direct
the day-to-day compliance operation in Houston.\1287\ In fact,
Mr. Lee described his role as, ``if anything, more policy. I
have not since the first year had much day to day.'' \1288\
---------------------------------------------------------------------------
\1283\ Id. at 110.
\1284\ Id. at 111.
\1285\ Id. at 112-13. Mr. Lee also indicated that, at some point
after 1996, Scott Brooks assumed an active role in Momentum's
compliance effort. Id. at 114. Mr. Brooks joined Momentum after
Momentum acquired Access Trading in Dallas during 1996. Id. at 110,
114.
\1286\ Id. at 114-15.
\1287\ Id. at 115.
\1288\ Id.
---------------------------------------------------------------------------
Mr. Lee also said that, in addition to Ms. Cummins,
Momentum retained Ms. Ewton as an outside compliance
consultant.\1289\ As explained above, Ms. Ewton is a former
NASD examiner who conducted audits of Momentum's branch offices
to determine whether they were in compliance with applicable
securities laws and regulations as well as firm policies.\1290\
Mr. Lee described Ms. Ewton's primary function as an auditor
who ``goes through the branch office exams.'' \1291\ During his
deposition, however, Mr. Lee indicated that he had very little
knowledge about the audits performed by Ms. Ewton:
---------------------------------------------------------------------------
\1289\ Id. at 117-18.
\1290\ Id. at 118. Mr. Lee said that Ms. Ewton still works with
Momentum today. Id.
\1291\ Id.
Q: How long prior to Mr. Cathriner's joining Momentum
did [Ms. Ewton] perform that audit function?
A: We either did them internally or she assisted with
them since inception.
Q: Did it start out as annual and come to quarterly
or how did that --
A: I don't know.
Q: Okay. Do you know whether those audits that she
performed, if we can use that term, generated any kind
of written document for you or senior management's
internal review or did she report back in an oral
fashion?
A: I don't--she may have been oral.\1292\
---------------------------------------------------------------------------
\1292\ Id.
In response to Subcommittee document requests, Momentum
produced numerous written examination findings memorializing
Ms. Ewton's audits of the firm's branch offices. Indeed, her
branch examination of the Atlanta office in September 1998 was
included in this production. It is troubling that Mr. Lee did
not know whether Ms. Ewton documented her branch examinations
in writing. It would be a matter of great concern if Ms.
Ewton's warnings and suggestions for improvement pertaining to
the Atlanta office went unanswered because Momentum's
principals were unaware of her concerns. At a minimum, Mr.
Lee's vague understanding of Ms. Ewton's activities suggests
that he was not very involved in this critical oversight
function.
As explained above, early in 1999, Momentum moved to
improve its compliance operation and one critical aspect of the
firm's effort was its decision to hire Bill Cathriner as the
new Chief Compliance Officer.\1293\ Mr. Cathriner directs the
entire compliance effort at Momentum, and he reports directly
to Mr. Lee.\1294\ Mr. Lee testified that Momentum hired Mr.
Cathriner ``to raise the bar'' for the firm's supervision and
implementation of internal controls.\1295\ Despite the apparent
admission that Momentum's compliance operation was deficient
before Mr. Cathriner was retained, Mr. Lee denied that his
hiring of Mr. Cathriner was an acknowledgment of past problems.
Mr. Lee testified, ``I don't think that there was ever a
problem that we perceived and a need to heighten it.'' \1296\
---------------------------------------------------------------------------
\1293\ Id. at 107.
\1294\ Id. at 106-107.
\1295\ Id. at 116.
\1296\ Id. at 117. Mr. Lee testified that Momentum hired Mr.
Cathriner simply because, as the firm grew in size, it became more cost
effective to conduct branch examinations internally rather than
outsourcing those functions to Ms. Ewton. Id. Under questioning,
however, Mr. Lee agreed that Ms. Ewton still performs outside
consulting work for Momentum and that Mr. Cathriner, Ms. Ewton and Ms.
Cummins are collectively responsible for compliance matters at
Momentum. Id. at 103.
---------------------------------------------------------------------------
Mr. Lee conceded, however, that Momentum's drive to improve
its firm standards and internal policies in early 1999 was
expressly undertaken in response to increased regulatory
scrutiny:
Q: And how do you distinguish a guideline from a
threshold?
A: One is more of an advisory where a--how do I
distinguish between a guideline and a threshold? My
terms, I guess. One, it's worked its way into the
structure in the supervisory as a matter of policy of
the firm, how we may modify our business. I think it's
been more in a response to a great deal of scrutiny
whether--
Q: From who?
A: I think it was in response to the proposed NASD
rules.
Q: On risk disclosure and suitability or
appropriateness?
A: Yes. Voluntarily.
Q: You mean your voluntary response to that----
A: Yes sir.\1297\
---------------------------------------------------------------------------
\1297\ Id. at 122.
Despite Mr. Lee's assertion that Mr. Cathriner's hiring did not
reflect an acknowledgment of problems in the compliance
structure prior to 1999, the evidence strongly suggests that
Momentum recognized that regulatory scrutiny of day trading was
increasing.
There is also considerable evidence that the firm
determined that it must have the policies and standards in
place to govern its growing day trading business. Ms. Ewton's
examination of the Atlanta office shows that Momentum's
management should have known that the firm did not have in
place the kinds of internal controls that would allow for
appropriate supervision of branch office personnel. In
addition, Mr. Cathriner brought experience in branch office
supervision that neither Mr. Lee nor Ms. Cummins possessed.
During his deposition, Mr. Lee seemed to concede that, until
Mr. Cathriner came on board in early 1999, Momentum lacked both
adequate compliance policies and the managerial experience to
implement those policies. In explaining the firm's decision to
hire Mr. Cathriner, Mr. Lee stated as follows: ``Bill Cathriner
brought us some real experience * * *. So, he brought in some
experience of branch office supervision, compliance checklists.
And once we developed policies, he's pretty good at executing
those policies * * *. So, if that's--his job was to, you know,
raise the bar. * * *'' \1298\ While the Subcommittee believes
it would have been better if Momentum had improved its
compliance program earlier, the firm has nonetheless made great
strides in this area and should be commended. It seems highly
unlikely that Scott Webb would be allowed to day trade at
Momentum today.
---------------------------------------------------------------------------
\1298\ Id. at 116 (emphasis added).
---------------------------------------------------------------------------
G. Momentum's Profitability Survey
In response to Subcommittee interrogatories requesting
information about the profitability of Momentum's customers,
the firm produced documents purporting to catalog, among other
things, the success rates of its Texas day traders at the end
of 1998.\1299\ Mr. Lee and Momentum refer to the documents as
the ``Texas Facts.'' \1300\ Though the Texas Facts is
essentially a profitability study, Momentum has stressed
repeatedly that it is not a ``study'' but rather a ``survey''
that is unscientific and not intended for public
distribution.\1301\ Indeed, the Texas Facts bears a large bold
legend stating ``Not For Public Distribution'' and includes the
following disclaimer: ``The following data is based on an
unscientific survey of Momentum's Texas customers. The data is
un-audited and is not intended to be utilized for marketing or
advertising purposes.'' \1302\
---------------------------------------------------------------------------
\1299\ Feb. Hr'g Ex. 105.
\1300\ Lee Dep. at 319; Momentum Securities, Inc., ``Preliminary
Results,'' Feb. 1999 (``Texas Facts'') (Feb. Hr'g Ex. 123).
\1301\ Feb. Hr'g Ex. 123, at 2.
\1302\ Id.
---------------------------------------------------------------------------
In tabulating the Texas Facts, Momentum basically reviewed
the net profit and loss of 107 Momentum customers in Texas as
of February 1999.\1303\ The analysis purports to evaluate
trading activity between September 1998 and January 1999 for
both inexperienced traders--those in their first three months
of day trading--and experienced traders--those who have traded
at least five months.\1304\ Mr. Lee testified that, ``[w]e took
a snapshot and then divided it on what we consider to be a
reasonable learning curve.'' \1305\ The survey specifically
references this learning curve, noting that ``[t]hree to five
months of diligent effort are often required before a customer
can reasonably expect to become profitable, if at all.'' \1306\
---------------------------------------------------------------------------
\1303\ Lee Dep. at 340. In his deposition, Mr. Lee explained that
Momentum prepared the Texas Facts in response to anticipated public
criticism by Texas securities regulators. Id. at 341. For that reason,
Mr. Lee said that no other branch offices outside of Texas were
included. Id.
\1304\ Feb. Hr'g Ex. 123, at 2.
\1305\ Lee Dep. at 339.
\1306\ Feb. Hr'g Ex. 123, at 5 (emphasis in original).
---------------------------------------------------------------------------
The Texas Facts listed the following findings regarding the
profitability of Momentum's Texas customers during the relevant
five month period:
56 percent of Momentum's customers lost
money during their first three months of trading and 44
percent were profitable during their first three months
of trading;
36 percent of Momentum's customers who had
day traded longer than five months lost money from
September 1998 to January 1999, and 64 percent of those
same customers were profitable for that period;
70 percent of Momentum's customers, as of
February 1999, had been day trading at the firm for six
months or longer; and
there is a ``an extremely high correlation
between high profitability and high volume trading.''
\1307\
---------------------------------------------------------------------------
\1307\ Id. at 4-7 (emphasis omitted).
---------------------------------------------------------------------------
These conclusions are in some ways consistent with other
profitability data that the Subcommittee reviewed during this
investigation. For instance, the Subcommittee found that
inexperienced day traders are consistently less successful than
more experienced traders and that, without exception, a
significant majority of new traders lose money. The
similarities end there, however.
The profitability rates for both experienced and
inexperienced day traders reported in the Texas Facts are
considerably higher than the success rates generally reported
in other studies. Though the Subcommittee has not subjected the
Texas Facts to detailed scrutiny, there are several reasons to
be skeptical about whether these profitability rates are
representative of day traders as a whole. First, the Texas
Facts only analyze the profitability of one day trading firm.
Second, the Texas Facts only examines the profitability of
Momentum's Texas customers. It thereby excludes from the
analysis the customers who day trade at four of Momentum's ten
offices. Although Mr. Lee opined in his deposition that he
expected the results of the Texas Facts to be representative of
both the overall firm and the day trading industry, he offered
no data to support that estimation.\1308\ In order to draw any
meaningful picture of the success rates of Momentum's
customers, it is critical to factor in the performance of the
firm's customers in Atlanta, Irvine, Chicago and Milwaukee. Mr.
Lee testified that he was not aware of any similar data on the
profitability of Momentum's customers in those offices.\1309\
Fourth, Momentum's reluctance to rely on this profitability
data in public discussion and its advertising suggests that the
firm lacks confidence in either its methodology or the
representativeness of the sample.\1310\
---------------------------------------------------------------------------
\1308\ Lee Dep. at 339.
\1309\ Id. at 342.
\1310\ Momentum also acknowledged that the Texas Facts included
profitability data for three remote traders who lived in Texas.
Declaration of James William Lauderback, Vice President of Momentum
Securities, Inc., Jan. 12, 2000 (Feb. Hr'g Ex. 124). This is
potentially significant because Mr. Lee testified that he does not
consider Momentum's remote traders to be day traders but rather the
equivalent of an investor who invests on-line with an E*Trade or
Schwabb account. Lee Dep. at 298-99.
---------------------------------------------------------------------------
The best method of obtaining a true sense of day trading
profitability for any given sample is to evaluate the net
profit and loss of all traders over a sustained period of time.
In this respect, some of the best profitability data can be
found in an analysis of how many day traders continued to trade
actively in excess of six months after they commenced trading
in their accounts. The Texas Facts do not claim to perform such
an analysis. It does state that ``70 percent of Momentum's
Texas customers have been day trading for longer than six
months--many for multiple years.'' \1311\ Under examination,
however, Mr. Lee conceded that this statistic does not address
how many of Momentum's Texas customers lasted six months or
longer:
---------------------------------------------------------------------------
\1311\ Feb. Hr'g Ex. 123, at 4.
Q: So, just so that I understand conceptually what
you're talking about in this survey is if you--if the
universe of Texas customers was a--was 10, just take
that as an example, this statistic meant that 7 of
those 10 customers on that given day had been at
Momentum for the--for six months or longer at that day?
A. Yes, I believe so.
Q. It does not mean--that statistic does not mean
that out of every--those ten accounts that are open on
day one, seven of those accounts last six months?
A. No, sir.\1312\
---------------------------------------------------------------------------
\1312\ Lee Dep. at 346.
Mr. Lee also testified that Momentum did not possess such
data.\1313\ For all of these reasons, the Subcommittee believes
that the Texas Facts--while certainly an additional piece of
probative evidence on the profitability of day trading--is far
too limited in its sample and scope to provide a meaningful
evaluation of the general profitability of day trading.
---------------------------------------------------------------------------
\1313\ Id.
---------------------------------------------------------------------------
H. The Role of Suitability in Day Trading
During his Subcommittee deposition, Mr. Lee made clear that
Momentum philosophically opposes any regulatory requirement
which requires day trading firms to deny potential customers
the ability to day trade because the strategy is inappropriate
for the customer's financial condition or goals. For instance,
in the fall of 1999, Momentum began providing its new day
trading customers a disclosure document that summarizes the
testimony of SEC Chairman Arthur Levitt from the Subcommittee's
Overview Hearing on September 16, 1999.\1314\ Momentum asked
its day trading customers to review Chairman Levitt's remarks
and sign the form indicating that they had done so.\1315\
During his deposition, Mr. Lee was asked about several of
Chairman Levitt's statements regarding the risks of day
trading. While he agreed with those statements in general
terms, Mr. Lee took issue with Chairman Levitt's remarks in
several respects.\1316\
---------------------------------------------------------------------------
\1314\ Id. at 206-207.
\1315\ Momentum Securities, Inc., ``SEC Commentary `Day Trading:
Your Dollars at Risk' '', New Account Paperwork of Jeff Peterson, Sept.
24, 1999, at 2 (Feb. Hr'g Ex. 125).
\1316\ Lee Dep. at 207-21.
---------------------------------------------------------------------------
For instance, Mr. Lee agreed with Chairman Levitt's
testimony that ``[m]ost individual investors do not have the
wealth, the time, or the temperament to make money and to
sustain the devastating losses that day trading can bring.''
\1317\ Mr. Lee also initially agreed with Chairman Levitt's
comment that ``day traders should only risk money they can
afford to lose.'' \1318\ However, Mr. Lee disagreed with
Chairman Levitt's further statement that, ``[day traders]
should never use money they will need for daily living
expenses, retirement, take out a second mortgage, or use their
student loan money for day trading,'' \1319\ He disputed
Chairman Levitt's use of the word ``never'' since it suggested
that a person who chooses to trade such funds should be
prohibited from doing so.\1320\ When pressed on the issue
further, Mr. Lee conceded that, as a general business practice,
he would not encourage people to day trade these types of
funds.\1321\
---------------------------------------------------------------------------
\1317\ Id. at 207-208.
\1318\ Id. at 209.
\1319\ Id. at 212.
\1320\ Id. at 214-15, 216-17.
\1321\ Id. at 217-18.
---------------------------------------------------------------------------
Mr. Lee also took issue with Chairman Levitt's testimony
that ``[d]ay traders typically suffer severe financial losses
in their first months of trading, and many never graduate to
profit-making status.'' \1322\ He explained that, in his
opinion, day traders do not ``typically suffer severe
financial--severe is a word I wouldn't use.'' \1323\ Mr. Lee
also disputed Chairman Levitt's statement that, ``[d]ay trading
strategies demand using the leverage of borrowed money to make
profits. This is why many day traders lose all their money and
may end up in debt as well.'' \1324\ Though he agreed that
``some'' day traders lose money, Mr. Lee took issue with the
word ``many'', responding that ``[m]any day traders do not lose
all their money. That's, in my opinion, inaccurate.'' \1325\
Mr. Lee's discomfort with the word ``many'' seems particularly
odd since Momentum's own profitability survey--if accurate--
indicates that a majority of all new traders lose money during
their first three months.
---------------------------------------------------------------------------
\1322\ Id. at 208.
\1323\ Id.
\1324\ Id. at 220.
\1325\ Id. 220-21.
---------------------------------------------------------------------------
Mr. Lee's philosophical opposition to rules that limit
access to day trading may explain why, under his leadership,
ETA has publically opposed the new rule proposed by the NASD to
require day trading firms to open new accounts only for those
customers whose financial status suggests that they are
``appropriate'' or suitable for the practice.\1326\ Even though
ETA generally supports the newly proposed rule on risk
disclosure, Mr. Lee publicly stated ETA's opposition to the
``appropriateness'' or suitability rule in a letter to the
SEC.\1327\ He wrote that ``ETA believes that [the
appropriateness rule] is fatally flawed by assuming day trading
is a form of recommended strategy. In fact, day trading is an
approach to the market characterized by multiple trading
strategies, one or more of which are chosen by the customer.''
\1328\
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\1326\ Letter from James H. Lee, President of ETA, to Jonathan
Katz, Secretary of the SEC, Oct. 11, 1999, at 3-4 (Feb. Hr'g Ex. 126).
\1327\ Id.
\1328\ Id. at 4.
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VI. SUGGESTED REFORMS AND REMEDIES
The Subcommittee submitted to the SEC comments specific
rule changes, and recommendations to the National Association
of Securities Dealers, Inc. (``NASD'') that it initiate two
additional rule proposals regarding the day trading industry.
The Subcommittee's recommendations are based on the three day
trading hearings held by the Subcommittee and the
Subcommittee's eight month investigation of the day trading
industry. Set forth are (1) the Subcommittee's understanding of
the pending rule change proposals for day trading; (2) the
Subcommittee's suggested modifications to those rule change
proposals; and (3) the Subcommittee's recommendations to the
NASD for two new rule proposals.
A. The New Rules Proposed by the NASD and NYSE are Helpful Remedies to
Many of the Problems and Abuses That Were Identified in the
Subcommittee's Investigation
The NASD and the New York Stock Exchange (``NYSE'')
recently submitted to the SEC proposed rule changes for day
trading. Significantly, these rule changes address many of the
problems that the Subcommittee identified in its investigation.
The NASD proposed changes to the 2300 Series of the NASD Rules
to include two additional rules: Rule 2360 requires firms to
approve new accounts for day trading and disclose the risks of
day trading; Rule 2361 specifies the language of the required
risk disclosure that is to be given prior to account opening.
The NYSE then filed with the SEC a proposed rule change to
amend its margin requirements, as set forth in Rule 431, to
change the margin standards for customers who engage ``in a
pattern of day trading.'' Finally, the NASD filed a proposed
rule change to its margin requirements, Rule 2520,
substantially similar to the NYSE's proposed amendment.
(1) NASD Proposed Rules 2360 & 2361. NASD Rules 2360 and
2361 require firms to determine whether a day trading strategy
is appropriate for, and provide a detailed risk disclosure to,
day trading customers prior to account opening. The NASD
drafted Rules 2360 and 2361 to work in tandem in order to
address the ``unique investor protection concerns'' raised by
day trading. Those concerns include: day trading requires a
significant amount of capital; day trading requires investors
to possess a sophisticated understanding of markets and trading
strategies; and, investors must be able to withstand
significant risk.
(a) NASD Proposed Rule 2360: ``Approval Procedures for Day
Trading Accounts.''
NASD Proposed Rule 2360 requires firms that promote a day
trading strategy \1329\ to provide a detailed risk disclosure
statement to all customers and specifically approve each
customer's account for a day trading strategy or, prior to
account-opening, to obtain a written agreement from the
customer that the customer does not intend to use the account
for day trading. The rule prohibits the firm from approving a
customer's account for day trading if it does not have
``reasonable grounds'' to believe that a day trading strategy
is appropriate for that customer and it has not prepared and
maintained a record setting forth the basis for that
determination. The rule provides certain criteria for a firm to
consider in exercising ``reasonable diligence'' to determine
whether to approve the account, including the customer's
financial situation, tax status, prior investment and trading
experience, and investment objectives. In addition, if a
customer submits to the firm a written agreement stating that
the customer does not intend to engage in a day trading
strategy, the firm may not rely on the agreement if the firm
knows that the customer intends to pursue a day trading
strategy. If a firm opens a customer account while relying on a
written agreement that the customer will not engage in day
trading, and the firm later learns that the customer is
pursuing a day trading strategy in that account, the firm must
approve the account for a day trading strategy within ten days
of the date that the firm first learned that the customer was
using the account for day trading. The substance of the risk
disclosure required by Rule 2360 is set forth in Rule 2361.
---------------------------------------------------------------------------
\1329\ Under proposed Rule 2360(e), a ``day-trading strategy'' is
``an overall trading strategy characterized by the regular transmission
by a customer of intra-day orders to effect both purchase and sale
transactions in the same security or securities.''
---------------------------------------------------------------------------
(b) NASD Proposed Rule 2361: ``Day Trading Risk Disclosure
Statement.'' Rule 2361(a) includes the following detailed risk
disclosure for firms to provide verbatim to their customers
pertaining to the risks associated with day trading:
You should consider the following points
before engaging in a day trading strategy. For purposes
of this notice, a ``day trading strategy'' means a
strategy characterized by the regular transmission by a
customer of intra-day orders to effect both purchase
and sale transactions in the same security or
securities.
Day trading can be extremely risky. Day
trading generally is not appropriate for someone of
limited resources and limited investment or trading
experience and low risk tolerance. You should be
prepared to lose all of the funds that you use for day
trading. In particular, you should not fund day trading
activities with retirement savings, student loans,
second mortgages, emergency funds, funds set aside for
purposes such as education or home ownership, or funds
required to meet your living expenses.
Be cautious of claims of large profits from
day trading. You should be wary of advertisements or
other statements that emphasize the potential for large
profits in day trading. Day trading can also lead to
large and immediate financial losses.
Day trading requires knowledge of securities
markets. Day trading requires in-depth knowledge of the
securities markets and trading techniques and
strategies. In attempting to profit through day
trading, you must compete with professional, licensed
traders employed by securities firms. You should have
appropriate experience before engaging in day trading.
Day trading requires knowledge of a firm's
operations. Under certain market conditions, you may
find it difficult or impossible to liquidate a position
quickly at a reasonable price. This can occur, for
example, when the market for a stock suddenly drops, or
if trading is halted due to recent news events or
unusual trading activity. The more volatile a stock is,
the greater the likelihood that problems may be
encountered in executing a transaction. In addition to
normal market risks, you may experience losses due to
system failures.
Day trading may result in your paying large
commissions. Day trading may require you to trade your
account aggressively, and you may pay commissions on
each trade. The total daily commissions that you pay on
your trades may add to your losses or significantly
reduce your earnings.
Day trading on margin or short selling may
result in losses beyond your initial investment. When
you day trade with funds borrowed from a firm or
someone else, you can lose more than the funds you
originally placed at risk. A decline in the value of
the securities that are purchased may require you to
provide additional funds to the firm to avoid the
forced sale of those securities or other securities in
your account. Short selling as part of your day trading
strategy also may lead to extraordinary losses, because
you may have to purchase stock at a very high price in
order to cover a short position.
If a firm does not wish to use the above risk disclosure,
Rule 2361(b) provides an alternative. Under Section (b) of the
rule, a firm may create an alternative risk disclosure
statement that is ``substantially similar'' to the statement in
Section (a) and must file the alternative statement with the
NASD's advertising department for approval prior to use.
(2) Amendments to NYSE Rule 431 and NASD Rule 2520
Governing Margin Requirements for Day Trading Accounts. The
NYSE and the NASD recently filed substantially similar
amendments to their rules on margin requirements. The proposed
amendments would ``require that minimum levels of equity and
margin be deposited and maintained in day trading accounts
sufficient to support the risks associated with day trading
activities.'' Both the NYSE and the NASD based their proposed
amendments on recommendations made by a ``an ad-hoc committee
(the `431 Committee') [that] was formed to consider changes to
the NYSE's and NASD's margin rules (NYSE Rule 431 and NASD Rule
2520, respectively).'' Prior to making its recommendations, the
431 Committee formed a special subcommittee to study the
``risks associated with day trading in customer accounts.'' In
its rule amendment filing, the NASD stated that the amendments
``will more appropriately protect the safety and soundness of
member firms and ensure the overall financial well-being of the
securities markets.''
The amendments change several provisions of the margin
requirements for day trading. Under the amendments,
``[w]henever day trading occurs in a customer's account the
special maintenance margin required for the day trades in
equity securities shall be 25% of the cost of all the day
trades made during the day.'' In other words, under normal
circumstances, customers day trading in margin accounts will be
able to borrow funds intra-day at a 4:1 equity ratio. Under the
existing rules, the special maintenance margin required for day
trading is 50 percent of the cost of all trades made during the
day, which allows day traders to borrow intra-day on a 2:1
equity ratio.
The proposed rule changes include special requirements for
``Pattern Day Traders.'' \1330\ For example, a pattern day
trader who generates a margin call will be limited to margin of
two times the trader's equity. Furthermore, if the day trader
does not meet the special maintenance margin call within five
days (currently seven) as required, then that customer will be
limited to trading on a ``cash available basis'' for 90 days or
until the call is met.
---------------------------------------------------------------------------
\1330\ ``Pattern Day Traders'' are defined as ``any customer who
executes four (4) or more day trades within five (5) business days.
However, if the number of day trades is 6% or less of total trades for
the five (5) business day period, the customer will no longer be
considered a pattern day trader and the special requirements under
paragraph (f)(8)(B)(iv) of this Rule will not apply.'' Proposed NYSE
Rule 431(f)(8)(B)(ii). Proposed NASD Rule 2520(f)(8)(B)(ii)'s language,
although substantially the same, differs slightly and adds the
following to its definition:
In the event that the organization at which a customer
seeks to open an account knows or has a reasonable basis to
believe that the customer will engage in pattern day
trading, then the special requirements under paragraph
(f)(8)(B)(iv) of this Rule will apply. If a pattern day
trader does not day trade for a 90 day period, the customer
---------------------------------------------------------------------------
will no longer be considered a pattern day trader.
Proposed NASD Rule 2520(f)(8)(B)(ii).
Under the proposed rule changes, pattern day traders would
be subject to a minimum equity requirement of $25,000 in the
customer's account at all times. The amendments raise the
minimum equity requirements from $2,000 to $25,000 in order to
``more appropriately address the additional risks inherent in
leveraged day-trading [sic] activities and better ensure that
customers cover any loss incurred in the account from the
previous day prior to day trading.'' Regarding the $25,000
minimum, the proposed rules state that ``[t]his minimum equity
must be deposited in the account before such customer may
continue day trading and must be maintained in the customer's
account at all times.'' \1331\
---------------------------------------------------------------------------
\1331\ The NYSE rule change uses slightly different language but is
substantively the same.
---------------------------------------------------------------------------
Subcommittee staff spoke with officials from NASD
Regulation, Inc. (``NASDR'') and the SEC concerning the $25,000
minimum equity requirement. The staff sought to confirm that,
as the plain language of the rules suggest, a day trader whose
account drops below $25,000 would then lose access to margin
privileges altogether. During Subcommittee staff's first
discussion with NASDR officials regarding this proposal, the
NASDR officials were unclear whether in that scenario the
customer would forfeit the ability to trade on margin.\1332\
The SEC officials initially stated their belief that day
traders would be prohibited from day trading on margin if their
account equity dropped below $25,000.\1333\ NASDR subsequently
contacted Subcommittee staff, however, and after discussing the
scenario with NYSE officials, determined that a pattern day
trader whose account dropped below $25,000 in equity, would
still have access to margin trading pursuant to Regulation
T.\1334\ In other words, the day trader could still buy and
hold Securities on a 2:1 equity ratio. The NASDR officials
pointed out, however, that a firm could not prevent a customer
who buys stock from selling it. Thus, if persons choose to make
day trades on margin with less than $25,000 in their accounts,
there is no mechanism to stop them. The NASDR officials further
stated that a person who day trades on 2:1 margin with less
than $25,000 in his or her account would not violate the rule.
An SEC official later informed the Subcommittee staff, however,
that he understood that the rule was intended to prohibit day
trading by customers with less than $25,000 in their accounts.
The SEC official indicated that no determination has yet been
made as to how the rule could be changed to prevent a person
from day trading in an account with less than the minimum on
deposit.
---------------------------------------------------------------------------
\1332\ Meeting with NASDR officials, Dec. 28, 1999.
\1333\ Meeting with SEC officials, Dec. 17, 1999.
\1334\ Telephone Conversation with NASDR official, Feb. 4, 2000.
---------------------------------------------------------------------------
Additional proposed changes include that ``[f]unds
deposited into a day trader's account to meet the minimum
equity or maintenance margin requirements of this Rule * * *
cannot be withdrawn for a minimum of two business days
following the close of business on the day of deposit.'' The
purpose of this amendment is to discourage the inter-customer
lending to meet margin calls that has become so prevalent at
day trading firms. The rationale behind the amendment is to
increase the risk to the lending customer by requiring the
borrowing customer to retain the borrowed funds in his or her
account for two business days after the funds are deposited to
satisfy the margin call. In so doing, the NASD and NYSE expect
lending customers to be more cautious about the lending of
funds to other customers since the money will be tied up for
longer periods of time. Also, the amendments prohibit pattern
day traders from using the guaranteed account provisions \1335\
of the margin rule to meet the requirements of Section
(f)(8)(B), including for minimum equity and margin maintenance
purposes.
---------------------------------------------------------------------------
\1335\ The Guarantee Provisions permit traders to consolidate their
accounts with those of other traders for purposes of determining the
amount of margin that is due. NYSE Rule 431(f)(4). These are often
referred to as ``cross-guarantees.''
---------------------------------------------------------------------------
B. While These Proposals Are Useful Starting Points for a Discussion of
Reform, the Subcommittee Recommends Several Modifications to
the Proposed Rules
Although the proposed rules address many of the problems
discovered during the Subcommittee's investigation of the day
trading industry, we believe that they need further
modification to more fully address and resolve those problems.
Most of the modifications that we recommend are premised on two
factual findings, both of which are derived from a thorough
review of the evidence gathered by the Subcommittee. The first
finding is that possessing ``adequate risk capital'' is the
single most determinative factor in the success or failure of
the average day trader. Second, under current market
conditions, $50,000 of risk capital is a ``limiting minimum''
below which day traders significantly impair their chances of
success.
During the Subcommittee's investigation, industry leaders
agreed that a day trader's chance of success is directly and
proportionally related to the amount of capital with which a
person starts trading. For example, All-Tech Direct, Inc.'s
(``All-Tech'') President, Mark Shefts, and Senior Vice
President of Operations, Harry Lefkowitz, both said that the
amount of capital a person has to trade is directly related to
the trader's likelihood of success.\1336\ The more risk
capital, the greater one's chance of profitability.\1337\ Mr.
Shefts told Subcommittee staff that, if you trade with less
than $100,000, your chance of success decreases because you
cannot make as much with less.\1338\ All-Tech's Chief Executive
Officer, Harvey Houtkin, testified similarly: ``I think a day
trader, an active day trader, should have $100,000 on deposit.
* * *'' \1339\ Indeed, in his 1999 book, Secrets of the SOES
Bandit, Mr. Houtkin wrote as follows:
---------------------------------------------------------------------------
\1336\ Lefkowitz Int. at 2; Shefts Int. at 8.
\1337\ Lefkowitz Int. at 2 .
\1338\ Shefts Int. at 8.
\1339\ Houtkin Dep. at 182. Despite Mr. Houtkin's belief that
$50,000 ``is a limiting minimum'' for day trading success, All-Tech
recently lowered its minimum account opening standards from $50,000 to
$25,000 in response to competitive pressures from other day trading
firms with lower standards. Id. at 187-88; Shefts Int. at 8; Lefkowitz
Int. at 2.
Before the market was booming to new, record-setting
highs every other day and stock prices were uniformly
lower, you could have had success trading with $50,000
on margin. Today, probably $150,000 is the most
advantageous amount of capital for trading, $100,000 is
adequate, and $50,000 is a limiting minimum.\1340\
---------------------------------------------------------------------------
\1340\ Harvey I. Houtkin and David Waldman, Secrets of the SOES
Bandit at 42 (1999) (emphasis added). Mr. Houtkin stated that those
``sums are based on the availability of margin under Regulation T of
the Federal Reserve Board.'' Id. In reality, however, Subcommittee
staff found that day traders regularly trade using well beyond a 2:1
margin ratio, thereby generating margin calls that they often cannot
meet without obtaining loans from other customers.
Thus, according to Mr. Houtkin, a day trader should ideally
have at least $150,000 of risk capital, with $50,000 as an
absolute minimum.
Cornerstone Securities Corporation (``Cornerstone'')
requires $50,000 in minimum capital for day trading.\1341\ In
response to Subcommittee interrogatories, Cornerstone
acknowledged that ``[t]he establishment of an adequate minimum
beginning equity for an account is an appropriate component of
policies designed to ensure that day trading is an appropriate
strategy for specific customers.'' \1342\ Cornerstone stated
its considered view that the beginning equity of a day trader
is the most important factor in determining a trader's
likelihood of success or failure:
---------------------------------------------------------------------------
\1341\ Apparently, the minimum capital determination at Cornerstone
is made by the individual branch managers. Letter from Joan C. Waller,
Counsel for Cornerstone, to Joseph M. Gonzales III, Investigator for
the Texas State Securities Board, Oct. 26, 1999, at 1.
\1342\ Id. at 2.
Cornerstone's experience is that a person's beginning
equity capital corresponds more directly to success or
failure as a professional day trader than the person's
income or general net worth. A person who wants to
begin a career as a professional trader must have
significant equity capital, that the person can place
entirely at risk. A professional trader must be able to
withstand some losses and still have the financial
capacity to trade securities. Therefore, Cornerstone
places more emphasis in sufficient opening account
equity than on income or general net worth.\1343\
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\1343\ Letter from Joan Conway Waller, Counsel for Cornerstone
Securities, Inc., to K. Lee Blalack, II, Chief Counsel & Staff Director
to Subcommittee, Nov. 15, 1999, at 4 (emphasis added).
(1) Recommended Modification of Rule 2360. Although Rule
2360 makes significant strides to ensure that firms will
determine the suitability of day trading for their customers
before opening an account, we believe that the rule should be
strengthened. The proposed rule provides certain criteria for
firms to evaluate when determining whether day trading is
appropriate for a prospective customer, but it does not place a
priority on any particular factor. In other words, a day
trading firm is required to consider income, tax status, net
worth, and experience among several factors. As a result, firms
could justify opening a day trading account for a customer who
has insufficient risk capital to have any reasonable chance of
success by simply citing other factors like high income or
investment experience, factors which the Subcommittee's
investigation determined were relevant but not as predictive of
success or failure as available risk capital.
The Subcommittee recommends the addition of a ``rebuttable
presumption'' to Rule 2360, such that a firm must initially
presume that a day trading customer who does not have $50,000
with which to open the account is inappropriate for day
trading. This presumption could be overcome, however, by other
factors that the firm concludes outweigh the inadequate risk
capital. If the firm determines that day trading is an
appropriate strategy for the customer who does not possess
$50,000, the firm would be required to prepare and maintain a
record setting forth the reasons that it deemed that customer
to be appropriate for day trading. Thus, the proposed rule
would still vest day trading firms with the discretion to open
accounts for customers who have less than the $50,000 minimum,
but it would require the firm to examine more closely whether
the prospective customer is truly appropriate for a risky day
trading strategy.
(2) Recommended Modification of Rule 2361. The Subcommittee
believes that Rule 2361 is extremely helpful for informing
potential customers of the significant risks of day trading. It
is especially significant that the rule requires firms to
provide the risk disclosure to potential customers prior to
account opening. The Subcommittee recommends an added
disclosure, however, for potential customers who do not possess
$50,000 of risk capital to open the account. If a firm deemed a
potential customer with less than $50,000 appropriate for day
trading under Rule 2360, then Rule 2361 would require the firm
to provide that customer with a separate and additional risk
disclosure form. The form would state that day trading with
less than $50,000 of risk capital substantially diminishes a
person's chances of profitability. The firm would then be
required to obtain the customer's signature on that form to
acknowledge that the customer has read the added disclosure.
This would give notice to potential customers who lack adequate
trading capital that they will be trading at a significant
disadvantage. In doing so, Rule 2361 should encourage a more
informed decision by the day trader about whether to pursue the
opening of an account.
In addition, the Subcommittee believes that the risk
disclosure should include a stronger warning concerning the
significant commission fees that day traders pay before earning
one cent of profit. Through its investigation, the Subcommittee
found that, on an annualized basis, assuming twenty trading
days per month, the average day trader must generate a trading
profit in excess of $111,360 to achieve profitability for the
year. This figure is based on the fact that day traders paid
approximately $16 per trade at the fifteen firms examined in
this investigation. These firms estimated--in the aggregate--
that their customers execute twenty-nine trades per day. Thus,
the average day trader at these firms must generate a daily
trading profit of $464, each and every day, simply to break
even. Moreover, at our most recent day trading hearing, the SEC
released a report that included a study of average commission
costs and related fees under three scenarios called low, medium
and high fee structures. The SEC's report concluded that day
traders in a medium fee structure must generate $16,850 each
month to break even and recoup the costs of commissions and
fees. Under that scenario, a day trader would have to make
$202,200 per year day trading before making any profit.
In light of these astounding figures, the Subcommittee
believes that the risk disclosure in proposed Rule 2361 should
state that there is substantial evidence that most day traders
will need to generate at least $100,000 per year just to cover
commission costs and trading fees.
(3) Modification of NYSE Rule 431 and NASD Rule 2520
Amendments. The Subcommittee believes that the proposed
amendments to the margin rules were designed primarily to
protect the securities firms rather than investors. It is true,
however, that the proposed amendments could have an incidental
benefit for investor protection. In that regard, we find the
proposed amendments to be helpful reforms that will have the
ancillary result of stopping some of the more troubling
practices discovered during the Subcommittee's investigation.
The Subcommittee recommends, however, that the proposed $25,000
minimum equity requirement be raised to $50,000. Thus,
customers would be required to maintain at least $50,000 of
equity in their accounts at all times if they wish to day trade
on margin. If, at the end of the trading day, the equity in a
customer's account is less than $50,000, then, unlike the
currently proposed minimum, the customer would not be allowed
to day trade on margin the next day. In other words, a day
trader with less than $50,000 on deposit would not be permitted
to make new purchases on margin until that person's account
equity returned to $50,000. This standard is not meant to
interfere in any way with the operation and/or timing of margin
calls.
It is not at all clear to us how the NYSE selected the
$25,000 figure it proposed. Because the evidence is strong that
$50,000 is a limiting minimum for day trading success, margin
requirements should reflect that seminal standard. It is
important to note, however, that customers with less than
$50,000 in their account could still day trade in a margin
account on a cash available basis. The Subcommittee's proposal
would simply deny the continuation of leveraged trading until
the customer raised the equity in his or her account to the
$50,000 minimum standard.
Furthermore, the Subcommittee does not support the
amendments' recommended margin increase to a 4:1 equity ratio.
It is the Subcommittee's belief, based on the evidence that was
collected during the Subcommittee's investigation and hearings,
that providing day traders with even more leverage than under
the current rules will only increase the risk of day trading
for customers, as well as for the firms. Day trading customers
already stand to lose far more money than the funds they
deposited. The Subcommittee's hearings showed that a large
number of day traders do not even have sufficient capital to
meet their margin calls--rather, they borrow funds to meet
those calls. It is counterintuitive to provide those customers
with a significantly higher amount of leverage that could
substantially add to their losses. Thus, the Subcommittee
strongly opposes the increase of day trading margin to a 4:1
equity ratio.
(4) The NASD Should Propose a Rule Prohibiting Firms from
Arranging Loans Between Customers to Meet Margin Calls. The
Subcommittee recommends that the NASD propose a new rule to
prohibit firms from arranging loans between customers to meet
margin calls, which the Subcommittee's investigation found was
a common practice at day trading firms. The Subcommittee
learned that day trading firms affirmatively arrange loans
among customers so that day traders can meet margin calls and
continue to trade. For example, All-Tech's former San Diego
branch manager, Barry Parish, admitted to Subcommittee staff
that he helped customers to find others who would loan them
funds to meet margin calls.\1344\ One former San Diego customer
told the Subcommittee staff that Mr. Parish acted as a
``middleman'' to arrange loans. That customer also said that
Mr. Parish sometimes called out to the trading room to see if
anyone could loan another customer money. Former San Diego
customer, Carmen Margala, informed the Subcommittee staff that
some of the loans Mr. Parish solicited were for customers in
other branch offices. According to Ms. Margala, Mr. Parish
occasionally approached individual customers and told them how
much they had in their accounts, and asked them to make
specific loans to others. Ms. Margala recalled an incident in
which Mr. Parish solicited customers to lend $100,000 to
another day trader. Another former San Diego customer allowed
Mr. Parish to use her account to make loans on a routine basis.
Mr. Parish admitted that he had customer accounts available to
him for the purposes of lending funds to customers to meet
margin calls.\1345\ In addition, a customer of All-Tech's
Beaverton, Oregon office told Subcommittee staff that the
branch manager frequently arranged loans for her when she had
margin calls. That customer said that she never knew which
particular customer loaned her money.
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\1344\ Deposition of Barry Parish, Nov. 30, 1999, at 94 (``Parish
Dep.'').
\1345\ Parish Dep. at 95-96.
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Likewise, Momentum employees arranged loans between
customers despite the firm's claim that it remains passive in
the lending process. A Momentum branch manager specifically
told Subcommittee staff that he informs customers with margin
calls that they may obtain loans from customers at other branch
offices.\1346\ One of the accounts examined by Subcommittee
staff was used to loan almost $10,000,000 to 52 Momentum
customers in the span of a single month. At Providential, the
Los Angeles, California branch manager informed Subcommittee
staff that his partner opened a Providential account for the
sole purpose of lending funds to customers to meet margin
calls.\1347\
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\1346\ Interview of Justin Hoehn, Dec. 21, 1999, at 2 (``Hoehn
Int.'').
\1347\ Interview of Tae Goo Moon, Dec. 9, 1999, at 7 (``Moon
Int.'').
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Similarly, Subcommittee staff asked Cornerstone officials
to describe the firm's procedures relating to customer-to-
customer loans to meet margin calls. In a letter dated November
15, 1999, Cornerstone stated that it ``believed'' many
customers loaned money to one another to meet margin calls, but
that Cornerstone played an essentially passive role in the
lending process. For example, Cornerstone said that it
``suggested'' to customers who made such loans that they obtain
a signed promissory note from other customers who borrowed the
funds. Cornerstone officials told Subcommittee staff that
certain branch offices provided such notes as a ``courtesy'' to
their customers. Cornerstone discontinued the practice of
permitting customers to borrow funds from one another in August
1999.
Subcommittee staff also obtained information, however,
regarding customer lending activities at Cornerstone's Houston,
Texas office suggesting that the firm actively promoted these
loans rather than simply providing promissory notes to lenders
as a ``courtesy.'' Subcommittee staff obtained account records
for five former day trading clients of Cornerstone's Houston
office, and found that each of these clients signed multiple
promissory notes shortly after they opened their accounts. For
example, one customer signed fourteen different promissory
notes several weeks after he opened his account in early April
1999. Each of these promissory notes authorized the customer to
borrow $5 million to meet margin calls. The promissory notes
also identified fourteen separate lenders for these funds. In
addition, Subcommittee staff interviewed a former Cornerstone
client who said that the Houston office's former assistant
branch manager asked her to sign promissory notes when she
received her first day trading margin call.
These lending programs effectively undermine the margin
requirements and could likewise evade the purpose of the
proposed minimum equity requirements. The Subcommittee believes
it is a significant conflict of interest for firms to arrange
loans for their customers, because the firms are dependent on
commission revenue generated by the day traders who are allowed
to continue trading through use of these lending programs. Our
proposed rule would not impinge on a firm's ability to perform
the purely ministerial tasks associated with lending between
customers, such as making journal transfers at the customers'
behest. There is nothing inherently improper about customers
negotiating agreements between themselves to provide short-term
credit to cover a margin call or any other legal activity. It
would, however, prohibit firms from supplying lenders to those
in need of funds, asking customers to lend funds to other
customers, and other similar activities that could be
reasonably construed as ``arranging'' loans.
(5) The NASD Should Propose a New Rule Regarding Day
Traders Who Act As Investment Advisers. The Subcommittee
recommends that the NASD propose a rule requiring member firms
to do the following before allowing a day trader to exercise
discretionary trading authority over another customer's account
for compensation: (1) determine whether the trader's proposed
activities at that firm alone would require the trader to
register as an investment adviser, or whether the trader would
qualify for an exemption from registration; and (2) if
registration would be required, verify that the trader is
registered with the appropriate regulatory body.
The Subcommittee learned during this investigation that
most firms have no policies in place to determine whether day
traders who trade the accounts of others for compensation are
properly registered as investment advisers, where required by
law. The most egregious example Subcommittee staff found was at
Providential, where unregistered trader, Huan Van Cao, traded
the accounts of at least twenty customers in apparent violation
of Texas and California securities laws, and generated
significant losses and commission charges in their
accounts.\1348\ For example, Mr. Cao convinced a part-time
sales clerk, Amy Le, to permit him to day trade her life
savings and, in the process, generated about $35,000 of losses
and commission charges in her account over eight weeks.\1349\
Ms. Le said that Mr. Cao told her that he could guarantee a
twenty percent investment return for his clients, and that he
was a registered broker, attorney, and former government
auditor who examined broker-dealers.\1350\ Subcommittee staff
have determined that these were all false statements.\1351\
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\1348\ Mr. Cao claimed to have day traded for twenty-one or twenty-
two customers. Cao Dep. at 136.
\1349\ Le Int. at 2, 6.
\1350\ Id.
\1351\ For example, Texas and California Securities regulators and
NASDR have no listing of Mr. Cao as a registered broker-dealer. Mr. Cao
also told Subcommittee staff that he is not a licensed broker or
registered representative in the Securities industry. Cao Dep. at 51.
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Some firms, such as All-Tech, require day traders to sign a
form affirming that the trader is currently registered as an
investment adviser if he or she will have discretionary trading
authority over another customer's account. While that is a step
in the right direction, All-Tech does not require the trader to
prove that he is registered, and the firm takes no independent
steps to verify registration. Summit Trading, on the other
hand, has a commendable policy that requires each person
seeking to trade other people's money for compensation to
submit proof that he or she is registered as an investment
adviser unless exempt from registration. The Subcommittee
believes Summit Trading's policy is a best practice that should
be implemented for the day trading industry as a whole.
VII. CONCLUSION
The Subcommittee's eight month investigation found many
disturbing business practices by day trading firms, some of
which appear to be even criminal. Securities regulators will
need to devote more resources and scrutiny to policing this
growing industry. Until new reforms are adopted for the day
trading industry, however, regulators will not be able to stop
the most troubling abuses by day trading firms relating to risk
disclosure, suitability, and improper lending to encourage
trading beyond a customer's means.
Ultimately, however, the leading day trading firms must do
more to clean up their own industry. As explained above, the
technology of day trading has prompted several positive
developments for the markets and the average investor. Yet, the
marketing and promotion of a strategy predicated upon short-
term, high volume trading necessarily implicates speculation
and, for some customers, outright gambling. Given the poor
profitability rates for most day traders, it is therefore
imperative that day trading firms take all reasonable steps to
ensure that their prospective customers appreciate the risks of
this speculative strategy. Even more important, it is critical
that day trading firms discourage the opening of day trading
accounts for customers who do not possess the financial means
or goals to suitably pursue day trading as a career. It is a
promising development that some of the leading day trading
firms have recently taken steps in this direction. However,
prompt adoption of new regulations to set uniform rules for the
entire industry is clearly needed. This staff report sets forth
a comprehensive factual record in support of a new regulatory
framework for day trading.
The following Senators, who are members of the Permanent
Subcommittee on Investigations, have approved this report:
Susan M. Collins.
William V. Roth, Jr.
Ted Stevens.
George V. Voinovich.
Pete V. Domenici.
Thad Cochran.
Carl Levin.
Daniel Akaka.
Richard Durbin.
Max Cleland.
John Edwards.
Other Senators, who are Members of the Committee on
Governmental Affairs, approving this report are:
Judd Gregg.