[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

                              ----------                              
                                                                   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\
---------------------------------------------------------------------------
    \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'').
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.'').
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \12\ Deposition of Henry D. Fahman, Dec. 15, 1999, at 119 (``Fahman 
Dep.'').
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \15\ Deposition of James H. Lee, Dec. 22, 1999, at 70 (``Lee 
Dep.'').
    \16\ Id.
---------------------------------------------------------------------------

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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \22\ Id. at 7-8.

The SEC files about 400 to 500 civil enforcement actions each 
year.\23\
---------------------------------------------------------------------------
    \23\ Id. at 2.
---------------------------------------------------------------------------
    (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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    (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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
            (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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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:
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \40\ Id. at 81a (errata sheet)-82.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------

                   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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \1344\ Deposition of Barry Parish, Nov. 30, 1999, at 94 (``Parish 
Dep.'').
    \1345\ Parish Dep. at 95-96.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.'').
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.

                                
