[Federal Register Volume 65, Number 137 (Monday, July 17, 2000)]
[Notices]
[Pages 44082-44088]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-17968]


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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-43021; File No. SR-NASD-99-41]


Self-Regulatory Organizations; National Association of Securities 
Dealers, Inc.; Order Approving Proposed Rule Change and Amendment No. 1 
and Notice of Filing and Order Granting Accelerated Approval of 
Amendment No. 2 Relating to the Opening of Day-Trading Accounts

July 10, 2000.

I. Introduction

    On August 20, 1999, the National Association of Securities Dealers, 
Inc. (``NASD'' or ``Association''), through its wholly owned 
subsidiary, NASD Regulation, Inc. (``NASD Regulation''), filed with the 
Securities and Exchange Commission (``SEC'' or ``Commission''), 
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change 
relating to the opening of day-trading accounts.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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    The proposed rule change was published for comment in the Federal 
Register on September 21, 1999.\3\ The Commission received three 
comment letters on the proposed rule change.\4\ On

[[Page 44083]]

February 18, 2000, NASD Regulation submitted Amendment No. 1 to the 
proposed rule change.\5\ Amendment No. 1 was published for comment in 
the Federal Register on March 2, 2000.\6\ The Commission received four 
comment letters on the proposed rule change in Amemdment No. 1.\7\ On 
June 21, 2000, NASD Regulation submitted Amendment No. 2 to the 
proposed rule change.\8\ In this notice and order, the Commission is 
seeking comment from interested persons on Amendment No. 2 and 
approving the proposed rule change and Amendment No. 1, and is 
approving Amendment No. 2 on an accelerated basis.
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    \3\ Securities Exchange Act Release No. 41432 (September 14, 
1999), 64 FR 51165.
    \4\ See Letters from James H. Lee, President, Electronic Traders 
Association (``ETA''), to Jonathan G. Katz, Secretary, SEC, dated 
October 11, 1999; Bradley W. Skolnik, President, Indiana Securities 
Commissioner, North American Securities Administrators Association 
(``NASAA''), to Jonathan G. Katz, Secretary, SEC, dated October 12, 
1999; and Lee B. Spencer, Jr., Chairman, Federal Regulation 
Committee, Everett Lang, Co-Chairman, Discount Brokerage Committee, 
Michael L. Michael, Chairman, Ad-Hoc Committee on Technology and 
Regulation, and Michael Anderson, Co-Chairman, Discount Brokerage 
Committee, Securities Industry Association (``SiA''), to Margaret H. 
McFarland, Deputy Secretary, SEC, dated October 22, 1999.
    \5\ In Amendment No. 1, NASD Regulation responded to issues 
raised in the initial three comment letters by revising the proposed 
rule change and the proposed rule text with respect to: modifying 
the disclosure statement; revising the method for delivering the 
disclosure statement; describing certain activities that will not 
trigger application of the proposed day-trading rules; and 
clarifying information-gathering requirements. See Letter from Alden 
S. Adkins, Sr. Vice President and General Counsel, NASD Regulation, 
to Katherine A. England, Assistant Director, Division of Market 
Regulation (``Division''), SEC, dated February 10, 1999 (``Amendment 
No. 1'').
    \6\ Securities Exchange Act Release No. 42452 (February 23. 
2000), 65 FR 11353.
    \7\ See Letters from The Honorable Susan M. Collins, Chairman, 
Permanent Subcommittee on Investigations, The Honorable Carl Levin, 
Ranking Minority Member, Permanent Subcommittee on Investigations, 
and The Honorable Richard J. Durbin, Committee on Governmental 
Affairs, U.S. Senate, to Jonathan G. Katz, Secretary, SEC, dated 
March 17, 2000 (``Senators''); Linda Lerner, General Counsel, All-
Tech Direct, Inc., to Jonathan G. Katz, Secretary, SEC, dated March 
20, 2000 (``All-Tech''); Bradley W. Skolnik, President, Indiana 
Securities Commissioner, NASAA, to Jonathan G. Katz, Secretary, SEC, 
dated March 23, 2000; and Robert P. Mazzarella, Chairman, Discount 
Brokerage Committee, and Michael L. Michael, Chairman, Ad Hoc 
Committee on Technology and Regulation, SIA, to Jonathan G. Katz, 
Secretary, SEC, dated March 23, 2000.
    \8\ In Amendment No. 2, NASD Regulation responded to the comment 
letters submitted on Amendment No. 1 and incorporated several 
recommendations from the letters into the proposed disclosure 
statement. See Letter from Joan Conley, Senior Vice President and 
Corporate Secretary, NASD Regulations, to Nancy Sanow, Assistant 
Director, Division, SEC, dated June 21, 2000 (``Amendment No. 2'').
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II. Description of the Proposal

    The NASD, through NASD Regulation, proposes to add two new rules to 
its Rule 2300 series.\9\ New Rules 2360, approval Procedures for Day-
Trading Accounts, and 2361, Day-Trading Risk Disclosure Statement, only 
apply to firms that are ``promoting a day-trading strategy.''
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    \9\ NASD's 2300 series of rules covers Transactions With 
Customers.
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    The proposal focuses on disclosing the basis risks of engaging in a 
day-trading strategy and assessing the appropriateness of day-trading 
strategies for individuals. In particular, the proposal would require a 
firm that is ``promoting a day-trading strategy,'' directly or 
indirectly, to deliver a specified risk disclosure statement to a non-
institutional customer prior to opening an account for the customer. In 
addition to delivering the risk disclosure statement, the proposal 
would require a firm to either: (1) Approve the customer's account for 
day trading; or (2) obtain a written agreement from the customer 
stating that the customer does not intend to use the account for day-
trading activities. A firm would not be permitted to rely on the 
written agreement from the customer if the firm knows that the customer 
intends to use the account for day trading. In addition, if a firm 
knows that a customer who provided such an agreement is engaging in a 
day-trading strategy, the firm would be required to approve the account 
for day trading.
    As part of approving an account for day trading, a firm would be 
required to have reasonable grounds for believing that the day-trading 
strategy is appropriate for the customer. In making this determination, 
the firm would be required to exercise reasonable diligence to 
ascertain the essential facts about the customer, including his or her 
financial situation, tax status, prior investment and trading 
experience, and investment objectives. The firm also would be required 
to prepare a record setting forth the basis on which the firm has 
approved the customer's account for day trading. Any record or written 
statement prepared or obtained by the firm pursuant to the proposed 
rule change would have to be preserved in accordance with NASD Rule 
3110(a).

A. Scope of Proposal

1. Firms ``Promoting a Day-Trading Strategy''
    As discussed below, the proposed new rules only apply to firms that 
are ``promoting a day-trading strategy'' and to new accounts opened by 
all non-institutional customers at those firms.\10\ While the proposal 
does not expressly define ``promoting a day-trading strategy,'' it does 
state that none of the following actions alone would trigger the 
proposed rule's requirements: (1) The promotion by a member of 
efficient execution services or lower execution costs based on multiple 
trades; (2) providing general investment research or advertising the 
high quality or prompt availability of such general research; and (3) 
having a web site that provides general financial information or news 
or that allows the multiple entry of intra-day purchases and sales of 
the same securities.\11\
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    \10\ As proposed, ``day-trading strategy'' is defined 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.'' The proposed 
definition would include those instances where an individual 
regularly transmits one or more purchase and sale (i.e., ``round-
trip'') transactions in a single day. The proposed definition of 
``day-trading strategy'' also includes orders transmitted by non-
electronic means, such as by telephone.
    \11\ In the original filing, activities that would not alone 
trigger application of the rule were described in the proposed rule 
change but were not part of the proposed rule text. In Amendment No. 
1, NASD Regulation added these provisions to the proposed rule text. 
See Amendment No., supra note 5.
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    The proposal would apply to a member that affirmatively promotes 
day-trading activities or strategies through advertising, training 
seminars, or direct outreach programs. The proposal would only be 
triggered by the firm's general promotional efforts or by firm-
sponsored promotional efforts.\12\ For instance, a firm generally would 
be subject to the proposed rule if its advertisements address the 
benefits of day trading, rapid-fire trading, or momentum trading, or 
encourage persons to trade or profit like a professional trader. A firm 
also would be subject to the proposed rule if it promotes its day-
trading services through a third party. Moreover, the fact that many of 
a firm's customers are engaging in a day-trading strategy would be 
relevant in determining whether a firm has promoted itself in this way. 
Firms may not, however, promote day trading through individuals in an 
effort to circumvent the proposed rule. In addition, if a principal or 
officer of the firm is aware that brokers in the firm are soliciting 
customers for day trading, then firm will be deemed to be promoting day 
trading.\13\
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    \12\ See amendment Nos. 1 and 2, supra notes 5 and 8.
    \13\ Id. In Amendment No. 2, NASD Regulation noted that NASD 
Rule 3010(a) requires that firms maintain a system to supervise the 
activities of each registered representative that is reasonably 
designed to achieve compliance with applicable securities laws and 
regulations, and with NASD rules.
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    While the proposal does not define the term ``promoting a day-
trading strategy,'' NASD Regulation represents that firms could submit 
their advertisements to NASD Regulation's Advertising/Investment 
Companies Regulation Department for review and guidance on whether the 
content of the

[[Page 44084]]

advertisement constitutes such activity for purposes of the 
proposal.\14\
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    \14\ As a result, NASD Regulation believes that the proposal 
should both limit concerns about any effect of the proposal on the 
NASD's general suitability rule and allow firms to better determine 
whether a particular advertisement would trigger the rule prior to 
publication or distribution of the advertisement.
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2. Accounts Covered by the Proposed Rule
    The term ``non-institutional customer'' would mean a customer that 
does not qualify as an ``institutional account'' to mean the account 
of: (1) A bank, savings and loan association, insurance company, or 
registered investment company; (2) an investment adviser registered 
either with the SEC under Section 203 of the Investment Advisers Act of 
1940 or with a state securities commission (or agency or office 
performing similar functions); or (3) any other entity (whether a 
natural person, corporation, partnership, trust, or otherwise) with 
total assets of at least $50 million.\15\ The proposal would not apply 
to an existing customer unless the customer opens a new account at a 
firm that is promoting a day-trading strategy.
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    \15\ NASD Regulation believes that applying the proposed rule 
change to non-institutional customers would ensure that most 
individuals would be covered by the proposal, regardless of whether 
they engage in day-trading activities in their own name or in the 
name of a corporation or partnership.
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B. Requirements for New Customer Accounts of Firms Promoting a Day-
Trading Strategy

    Before opening a new account for a customer, a firm that is 
promoting a day-trading strategy must deliver a risk disclosure 
document and either approve the account for day trading or obtain a 
written agreement from the customer stating that the customer does not 
intend to use the account for day-trading activities. Each of these 
requirements is described below.
1. Requirement to Provide a Day-Trading Risk Disclosure Statement
    As discussed above, the proposal would require a firm that is 
promoting a day-trading strategy to deliver a risk disclosure 
statement, discussing the unique risks posed by day trading, to all 
non-institutional customers prior to opening an account for such 
customers.\16\ The disclosure statement would include several factors 
that a customer should consider before engaging in day trading, 
including that: The customer should be prepared to lose all of the 
funds that he or she uses for day trading; day trading generally 
requires significant resource; \17\ and day trading on margin or short 
selling may result in losses beyond the initial investment.
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    \16\ NASD Regulation did not recommend that all firms, whether 
or not they promote day trading, be required to disseminate the 
disclosure statement to all new customers because the benefits of 
such a requirement are unclear. However, NASD Regulation advised 
that it will continue to monitor the growth of day-trading 
activities to determine whether, in the future, such a requirement 
might be justified. See Amendment No. 1, supra note 5.
    \17\ In Amendment No. 2, NASD Regulation adopted the Senators' 
suggestion to include in the risk disclosure statement a warning 
that investors with less than $50,000 in risk capital are not likely 
to succeed as day traders. See Amendment No. 2, supra note 8.
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    The disclosure statement also would include a provision stating 
that day trading generally is not appropriate for persons of limited 
resources and limited investment or trading experience and low risk 
tolerance. Another provision would explain that a day trader should 
know its firm's business practices \18\ because under certain market 
conditions, a day trader may find it difficult or impossible to 
liquidate a position quickly at a reasonable price, such as when the 
market for a stock suddenly drops, or if trading is halted due to 
recent news events or unusual trading activity. The provision would 
further state that the more volatile a stock is, the greater the 
likelihood that problems may be encountered in executing a 
transaction.\19\
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    \18\ See Amendment No. 2, supra note 8.
    \19\ See Amendment No. 1, supra note 5.
    \20\ See Amendment No. 2, supra note 8.
    \21\ Id.
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    The disclosure statement would further explain that, because a day-
trading strategy requires frequent trades, payment of commissions will 
add to losses or significantly decrease earnings. The disclosure 
document also would provide an example of how much annual profit a day 
trader would need to generate just to cover commission costs.\20\ The 
disclosure statement would conclude with a provision that informs 
investors of the potential need to register as an investment adviser or 
as a broker or dealer under federal and state registration 
requirements.\21\
    The firm would be permitted to develop an alternative risk 
disclosure statement, provided that the alternative statement was 
substantially similar to the mandated statement and was filed with, and 
approved, by NASD Regulation's Advertising/Investment Companies 
Regulation Department. In addition, NASD Regulation encourages all 
firms, particularly firms that provide on-line trading capability, to 
provide the mandated risk disclosure statement or a substantially 
similar disclosure statement to their customers. The proposed risk 
disclosure statement, as amended, follows. Proposed additions from 
Amendment No. 2 are in italics and proposed deletions are in 
brackets.\22\
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    \22\ Proposed NASD Rule 2360, pertaining to approval procedures 
for day trading accounts, remains unchanged from Amendment No. 1 and 
therefore its text is not set forth in this release.
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Rule 2361. Day-Trading Risk Disclosure Statement

    (a) Except as provided in paragraph (b), no member that is 
promoting a day-trading strategy, directly or indirectly, shall open 
an account for or on behalf of a non-institutional customer unless, 
prior to opening the account, the member has furnished to each 
customer, individually, in writing or electronically, the following 
disclosure statement:
    You should consider the following points before engaging in a 
day-trading strategy. For purposes of this notice, a ``day-trading 
strategy'' means 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.
    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. Further, 
certain evidence indicates that an investment of less than $50,000 
will significantly impair the ability of a day trader to make a 
profit. Of course, an investment of $50,000 or more will in no way 
guarantee success.
    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. You 
should be familiar with a securities firm's business practices, 
including the operation of the firm's order execution systems and 
procedures. 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

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encountered in executing a transaction. In addition to normal market 
risks, you may experience losses due to system failures.
    Day trading will generate substantial commissions, even if the 
per trade cost is low. [Day trading may result in your paying large 
commissions.] Day trading involves [may require you to trade your 
account] aggressive[ly] trading, and generally you will [may] pay 
commissions on each trade. The total daily commissions that you pay 
on your trades will [may] add to your losses or significantly reduce 
your earnings. For instance, assuming that a trade cost $16 and an 
average of 29 transactions are conducted per day, an investor would 
need to generate an annual profit of $111,360 just to cover 
commission expenses.
    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 a stock at a very high price in order to cover 
a short position.
    Potential Registration Requirements. Persons providing 
investment advice for others or managing the securities accounts for 
others may need to register as either an ``Investment Advisor'' 
under the Investment Advisors Act of 1940 or as a ``Broker'' or 
``Dealer'' under the Securities Exchange Act of 1934. Such 
activities may also trigger state registration requirements.
    (b) In lieu of providing the disclosure statement specified in 
paragraph (a), a member that is promoting a day-trading strategy may 
provide to the customer, individually, in writing or electronically, 
prior to opening the account, an alternative disclosure statement, 
provided that:
    (1) The alternative disclosure statement shall be substantially 
similar to the disclosure statement specified in paragraph (a); and
    (2) The alternative disclosure statement shall be filed with the 
Association's Advertising Department (Department) for review at 
least 10 days prior to use (or such shorter period as the Department 
may allow in particular circumstances) for approval and, if changes 
are recommended by the Association, shall be withheld from use until 
any changes specified by the Association have been made or, if 
expressly disapproved, until the alternative disclosure statement 
has been refiled for, and has received, Association approval. The 
member must provide with each filing the anticipated date of first 
use.
    (c) For purposes of this rule, the term ``day-trading strategy'' 
shall have the meaning provided in Rule 2360(e).
    (d) For purposes of this R[r]ule, the term ``non-institutional 
customer'' means a customer that does not qualify as an 
``institutional account'' under Rule 3110(c)(4).
* * * * *
2. Customer Acknowledgment
    The proposal would require firms to deliver the disclosure 
statement to each customer individually, by mail or electronic means, 
prior to opening the account. A firm would not satisfy the proposal's 
requirements by posting the disclosure statement in a remote location 
on its web site, and claiming that it was delivered to all customers in 
such manner. The proposal would not require customers to sign the 
disclosure statements.\23\
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    \23\ NASD Regulation added the ``individual'' delivery 
requirement in Amendment No. 1. NASD Regulation believes that any 
abuses of the delivery requirement could be detected during routine 
examinations. See Amendment No. 1, supra note 5.
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3. Approving Customer Accounts for Day Trading
    In addition to delivering a risk disclosure document. A firm must 
approve a customer's account for a day-trading strategy in accordance 
with certain procedures. Specifically, to approve a customer's account 
for a day-trading strategy, a firm must have reasonable grounds for 
believing that the strategy is appropriate for the customer and to 
exercise reasonable diligence to ascertain the essential facts relative 
to the customer. The proposal would expressly require a firm to review 
a customer's investment objectives, investment and trading experience 
and knowledge, financial situation (including estimated annual income 
from all sources, estimated net worth exclusive of family residence, 
and estimated liquid net worth), tax status, employment status (name of 
employer, self-employed or retired, marital status, number of 
dependents, and age.\24\ The proposal would not required firms to 
determine the source of funds, primarily because of concerns with 
defining the scope of any such obligation and the risks of imposing 
disproportionate burdens on firms.\25\
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    \24\ The proposed rule change originally included only an 
evaluation of the investment objectives, investment and trading 
experience and knowledge, financial situation and tax status. The 
additional factors were added in Amendment No. 1. See Amendment No. 
1, supra note 5.
    \25\ See Amendment No. 2, supra note 8.
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4. Accounts Used for Purposes Other Than Day-Trading Activities
    As an alternative to approving an account for a day-trading 
strategy, the proposal would permit a firm that is promoting a day-
trading strategy to obtain from the customer a written agreement that 
the customer does not intend to use the account for the purposes of day 
trading (``other-use agreement''). \26\ A firm would not be permitted 
to rely on an other-use agreement if it knows that the customer intends 
to use the account for day trading. Moreover, if a firm opens an 
account for a customer in reliance on an other-use agreement, but later 
knows that the customer is using the account for day-trading 
activities, then the firm would be required to approve the customer's 
account for day trading in accordance with the rule as soon as 
practicable, but in no event later than ten days from the date of 
discovery. The standard of knowledge is one of actual knowledge.\27\
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    \26\ The firm would be required to provide a risk disclosure 
statement to the customer even if the firm obtains an other-use 
agreement
    \27\ See Amendment No. 1, supra note 5. NASD Regulation believes 
that it is proper to hold a firm accountable for facts known to the 
firm. See Amendment No. 2, supra note 8.
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III. Summary of Comments

    After the original publication of the proposed rule change in the 
Federal Register,\28\ the Commission received comment letters form the 
ETA, NASAA, and the SIA, \29\ generally supporting aspects of the 
proposed rule change but recommending numerous significant changes to 
the proposal itself. NASD Regulation responded to these letters in 
Amendment No. 1.\30\ The Commission then published Amendment No. 1 for 
comment,\31\ and, in response, the commission received comments letters 
form All-Tech, the SIA, NASAA, and the Senators, again generally 
supporting features of the proposal but recommending various 
modifications.\32\
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    \28\ See supra note 3.
    \29\ See supra note 4.
    \30\ See Amendment No. 1 supra note 5. A summary of comments 
received on the original filing is included in Securities Exchange 
Act Release No. 42452 (February 23, 2000), 65 FR 11353 (March 2, 
2000).
    \31\ See supra note 6.
    \32\ See supra note 7.
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A. Issues Raised in Comment Letters to Amendment No. 1

1. Application of the Rule
    In its comment letter to Amendment No. 1, the SIA restated its 
concern that individual solicitations by a broker or brokers of a day-
trading strategy could cause an entire firm to be deemed to be 
promoting a day-trading strategy. In Amendment No. 1, NASD Regulation 
stated that if a broker targeted, for example, five customers for day 
trading without the firm's knowledge, the firm would not be deemed to 
be promoting day trading. However, if a principal or officer of the 
firm knew that the firm's brokers were promoting a day-trading 
strategy, the firm would be deemed to

[[Page 44086]]

be promoting day trading. The SIA argued that knowing the strategies 
employed by its brokers is a good supervisory practice and should not 
trigger application of the day-trading rules to the entire firm. 
Alternatively, the SIA argued that the commentary accompanying the 
proposal should state that a number of the firm's brokers would need to 
be individually soliciting customers to day trade for these 
solicitations to cause the firm itself to be considered to be promoting 
a day-trading strategy. In response, NASD Regulation stated that, while 
solicitations by individual brokers would not alone cause a firm to be 
considered to be promoting a day-trading strategy, when an officer or a 
principal has knowledge of brokers soliciting accounts for day trading, 
the firm would be deemed to be promoting day trading and thus subject 
to the day-trading rules.\33\
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    \33\ See Amendment Nos. 1 and 2, supra notes 5 and 8.
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    The SIA also suggested that the proposal unfairly assigns the firm 
the responsibility for customers changing their minds with respect to 
the ``other use'' agreement. The SIA stated that because firms maintain 
records of customers' trades, it can be argued that firms always have 
actual knowledge. The NASD responded that, on balance, it believes the 
provision is appropriate and not overly burdensome, and that it is 
proper to hold a firm accountable for facts known to the firm.\34\
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    \34\ See Amendment No. 1, supra note 5.
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    On the other hand, NASAA expressed concern that the proposal could 
be read narrowly so as to not cover certain firms promoting day-trading 
activities. Accordingly, NASAA recommended that the NASD clarify that 
although the enumerated activities would not by themselves be deemed to 
be promoting a day-trading strategy, they could nevertheless still be 
considered part of a plan to promote day trading when combined with 
other acts. NASD Regulation stated that it believes that the proposed 
rule, as amended, addresses NASAA's concerns and pointed out that the 
proposed rule language specifies that firms would not be deemed to be 
promoting day trading activities solely by engaging in one of the 
listed activities, and that therefore such activities may be considered 
part of a plan to promote day-trading activities when combined with 
other acts.\35\
    Finally, All-Tech argued that the risk disclosure requirements were 
``hypocritical'' because they would impose additional regulatory 
requirements on day-trading firms and not on other firms that 
facilitate online trading. Citing findings by the Permanent 
Subcommittee on Investigations of the Senate Committee on Governmental 
Affairs, the NASD responded that it believes day-trading strategies 
present unique investor protection concerns that do not necessarily 
translate to other forms of trading. Thus, the NASD determined that 
there is no reason to change its position on this issue.\36\
Risk Disclosure Statement
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    \36\ Id.
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    The Senators recommended that the risk disclosure statement warn 
customers that investors with less than $50,000 in risk capital are not 
likely to succeed as day traders. NASD Regulation adopted this 
recommendation in Amendment No. 2, and qualified the warning by stating 
that risking capital of $50,000 or more does not, however, guarantee 
successful day trading. The Senators also recommended a provision 
explaining that there is substantial evidence that most day traders 
would need to generate at least $100,000 per year just to cover 
commission costs and trading fees. NASD Regulation incorporated this 
suggestion into the risk disclosure statement by supplementing the 
statement with a mathematical example highlighting the need to generate 
substantial earnings to cover day-trading costs.
    In addition, NASAA recommended changing the provision, captioned 
``Day trading requires knowledge of a firm's operations,'' to include 
the language removed by NASD Regulation in Amendment No. 1. NASD 
Regulation, in Amendment No. 1, replaced language in the original 
proposal with language suggested in a comment letter. NASAA stated that 
it believes that the deleted language better explained the need for 
customers to understand their own firm's execution systems and evaluate 
potential problems for themselves. Agreeing with the suggestion, NASD 
Regulation reinserted the removed text into the risk disclosure 
document.\37\
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    \37\ Id.
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Appropriateness Determination
    As mentioned above, the Senators suggested establishing a 
``rebuttable presumption'' that if an investor has less than $50,000 of 
risk capital, day trading is not appropriate for the customer. This 
presumption could be rebutted by other factors that the firm concludes 
outweigh the inadequate risk capital. The Senators further suggested 
that where a firm determines that day trading is an appropriate 
strategy for customers who do not possess $50,000 for investment 
purposes, the firm would be required to prepare and maintain a record 
setting forth the reasons that it deemed day trading to be appropriate 
for the customers. NASD Regulation chose not to incorporate this 
presumption into Amendment No. 2 for several reasons. First, NASD 
Regulation stated its belief that the $50,000 threshold may make sense 
for many investors, but it arguably is too low for very active day 
traders and too high for less active day traders. Second, imposing such 
a presumption could encourage individuals to misrepresent the value of 
their assets. Finally, NASD Regulation noted that the current proposal 
already requires a firm to document the basis on which it approves an 
account for a day-trading strategy.\38\
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    \38\ Id.
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    NASAA again recommended that the proposal incorporate some 
additional recordkeeping requirements included in the NASD options 
rules. Noting that it had considered this issue in preparing Amendment 
No. 1, NASD Regulation disagreed with this suggestion because it 
believes that many of these requirements are duplicative of obligations 
currently imposed on firms.\39\
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    \39\ See Amendment Nos. 1 and 2, supra notes 5 and 8.
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4. Sources of Customer funds
    The Senators suggested modifying the proposal to require broker-
dealers that are promoting day-trading strategies to inquire whether 
parties opening accounts plan to trade for others, and if so, to 
require firms to determine if parties need to be registered as 
investment advisors. In Amendment No. 2, NASD Regulation responded to 
this comment by stating that it believes that it would ``be difficult, 
if not impossible'' for firms to make this determination. However, NASD 
Regulation stated that customers should be informed of potential 
registration requirements and therefore amended the risk disclosure 
statement to include such a warning.

[[Page 44087]]

    NASAA recommended that the proposal require firms to obtain 
information on the sources of customer funds invested because of the 
prevalence of day traders using borrowed money to fund their accounts. 
NASD Regulation represented in Amendment No. 2 that is it considering a 
separate response to address this concern.\40\
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    \40\ See Amendment No. 2, supra note 8.
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B. Issues Raised in Comment Letters to Amendment No. 2

    Although Amendment No. 2 was not yet published, the Commission 
received one comment letter regarding the amendment.\41\ The SIA 
reiterated its concern that the proposed rule language may undermine 
what the SIA refers to as the safe harbor provision of the proposed 
rule. The SIA is concerned that, under the proposed rule, a firm could 
engage in the activities listed in proposed Rule 2360(g) and have the 
fact that they engage in those activities--activities that are 
specifically enumerated in the Rule as not deemed to be promoting a 
day-trading strategy--used in the determination that the firm is 
promoting a day-trading strategy.
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    \41\ See Letter from Michael L. Michael, Chairman, Technology 
and Regulation Committee, and Michael Hogan, Chairman, Ad-hoc Online 
Brokerage Legal Committee, SIA, to Nancy Sanow, Assistant Director, 
SEC, dated June 30, 2000 (``June 30 SIA Letter'').
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IV. Discussion

    The Commission finds that the proposed rule change is consistent 
with the requirements of the Act \42\ and the rules and regulations 
thereunder applicable to a national securities association. In 
particular, the Commission finds the proposal is consistent with the 
requirements of Section15A(b)(6) of the Act,\43\ because the proposed 
rule change is designed to prevent fraudulent and manipulative acts and 
practices, to promote just and equitable principles of trade, and, in 
general, to protect investors and the public interest.
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    \42\ In approving the proposed rule change, the Commission has 
considered the proposed rule's impact on efficiency, competition, 
and capital formation. 15 U.S.C. 78c(f).
    \43\ 15 U.S.C. 78o-3(b)(6).
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    During the past few years, the problems and risks associated with 
day trading have received widespread attention by regulators, 
legislators, the media, and the public. For example, on February 25 of 
this year, the Commission's staff issued a report providing the results 
of its examination of 47 registered broker-dealers providing day-
trading facilities to the general public.\44\ In addition, earlier this 
year, the Permanent Subcommittee on Investigations of the Senate 
Committee on Governmental Affairs held a series of hearings detailing 
day trading practices.\45\ The NASD Regulation proposal, as amended, is 
intended to provide a measured regulatory response to assure that firms 
promoting a day-trading strategy check to make certain that day trading 
is an appropriate investment strategy for a customer opening a day-
trading account and that the customer is aware of its risks.
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    \44\ This study, Report of Examinations of Day-Trading Broker-
Dealers, is available on the internet at http://www.sec.gov/news/studies/daytrep.htm.
    \45\ Staff of the Permanent Subcommittee on Investigations, 
Senate Comm. On Governmental Affairs. 106th Cong., 2d Sess., 
Memorandum on Day Trading (February 24, 2000).
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    Certain brokerage firms focus primarily, or even exclusively, on 
promoting day-trading strategies to individuals. These firms generally 
advertise on the Internet and elsewhere as ``day-trading'' firms or 
otherwise highlight their execution and other services as desirable for 
``serious'' or ``professional'' traders. In addition, many of these 
firms offer training on day-trading techniques, as well as provide 
computer facilities and software packages specifically designed to 
support and accommodate day trading.
    Day trading, however, raises unique investor protection concerns. 
In general, day traders seek to profit from very small movements in the 
price of a security. Such a strategy often requires aggressive trading 
of a brokerage account and the use of strategies including margin 
trading and short selling. As a result, day trading generally requires 
a significant amount of capital, a sophisticated understanding of 
securities markets and trading techniques, and a high tolerance for 
risk. Even experienced day traders with in-depth knowledge of the 
securities markets may suffer severe and unexpected financial losses.
    The Commission finds that requiring a member firm to disclose the 
risks of day trading to non-institutional customers when the firm 
promotes a day-trading strategy should help alert individuals who are 
new to day trading to the risks associated with that strategy. In 
addition, requiring a member firm to determine whether a day-trading 
strategy is appropriate for a customer should help to assure that 
individuals who are unable to bear the risks of day trading, or who 
have investment objectives incompatible with day trading, are not 
approved for day trading. In summary, the Commission finds that the 
risk disclosure statement and appropriateness review mandated by the 
proposed NASD rules are thoughtfully designed and tailored to address 
investor protection concerns raised by the increasingly popular trading 
strategy referred to as day trading.
    The Commission notes that the proposed rule change focuses on the 
promotion of trading strategies that can present high risks to 
individuals that do not have the investing experience or financial 
means to sustain those risks and, as revised, the proposed NASD rules 
should not be unduly burdensome for firms to apply. Firms that are 
actively promoting a day-trading strategy should be responsible for 
assessing whether the strategy is appropriate for an individual who 
opens a day-trading account at that firm. These firms also should be 
required to disclose the risks of engaging in a day-trading strategy to 
an individual prior to opening an account for that individual.
    While the commenters generally favored the concept of providing 
greater disclosure of day-trading risks, they also suggested various 
modifications to the proposal. The Commission believes that NASD 
Regulation has responded adequately to commenters' concerns and 
suggestions by incorporating some recommendations into the proposal and 
explaining why it was not incorporating others. In particular, in 
response to comments submitted on the original proposed rule change, 
NASD Regulation: (1) Refined the definition of ``day-trading 
strategy,'' (2) added more detail regarding the information that a firm 
must obtain at a minimum from a customer before approving the account 
for a day-trading strategy; (3) incorporated into the rule those 
activities that would not be deemed to be ``promoting a day-trading 
strategy,'' and (4) revised the disclosure statement to discuss the 
risks associated with trade executions during volatile market 
conditions and systems failures, among other revisions.
    Amendment No. 2 further refines the risk disclosure document to 
take into account various comments and suggestions submitted regarding 
Amendment No.1. Amendment No.2 amends the risk disclosure document to: 
(1) Indicate that an investment of less than $50,000 will impair the 
ability of a day trader to profit, while an investment of $50,000 or 
more does not guarantee success; (2) provide an example of the annual 
profits needed to cover commission costs; (3) encourage investors to 
become familiar with the firm's business practices, including its order 
execution systems and procedures; and (4) inform investors

[[Page 44088]]

about the potential need to register as an investment advisor or 
broker-dealer under certain conditions.
    As noted above, the SIA expressed concern about a statement in 
Amendment No. 2 advising firms that the activities specified in Rule 
2360(g) may be considered part of a plan to promote day trading when 
combined with other acts. \46\ Rule 2360(g) provides that firms will 
not be deemed to be promoting a day-trading strategy solely by engaging 
in one of the listed activities. The Commission believes that NASD 
Regulation addressed this concern in its Amendment No. 2 by correctly 
noting that Rule 2360(g) would not subject a firm to the new rules 
solely by engaging in the activities listed in that rule. The 
Commission finds that, in making the determination of whether a firm is 
promoting a day-trading strategy, it is reasonable for NASD Regulation 
to consider all of the firm's activities, including those listed in 
Rule 2360(g).
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    \46\ See June 30 SIA Letter, supra note 29.
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    Finally, the Commission notes that the NASD will announce the 
operational date of the proposed rule change in a Notice of Members to 
be published no later than 60 days following the date of approval by 
the Commission. The operational date will be 30 days following the date 
of publication of the Notice to Members announcing Commission approval.
    The Commission finds good cause for approving Amendment No. 2 prior 
to the thirtieth day after the date of publication of notice in the 
Federal Register. The Commission finds that the additional disclosures 
noted in Amendment No. 2 will provide greater information to investors 
about the risk of day trading and thus should strengthen the proposal. 
Moreover, the amendment raises no significant regulatory issues. 
Accordingly, the Commission finds good cause, consistent with Sections 
15A(b)(6) \47\ and 19(b)(2) \48\ of the Act, to approve Amendment No. 2 
to the proposed rule change on an accelerated basis.
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    \47\ 15 U.S.C. 78o-3(b)(6).
    \48\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning Amendment No. 2, including whether Amendment No. 2 
is consistent with the Act. Persons making written submissions should 
file six copies thereof with the Secretary, Securities and Exchange 
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Copies 
of the submission, all subsequent amendments, all written statements 
with respect to the proposed rule change that are filed with the 
Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for inspection and copying in the 
Commission's Public Reference Room. Copies of such filing will also be 
available for inspection and copying at the principal office of the 
NASD. All submissions should refeer to File No. SR-NASD-99-41 and 
should be submitted by August 7, 2001.

VI. Conclusion

    It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act 
\49\ that the proposed rule change (SR-NASD-99-4), as amended, is 
approved and Amendment No. 2 to the proposed rule change is approved on 
an accelerated basis.

    \49\ 15 U.S.C. 78s(b)(2).
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    For the Commission, by the Division of Market Regulation, 
pursuant to delegated authority.\50\
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    \50\ 17 CFR 200.30-3(a)(12).

Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-17968 Filed 7-14-00; 8:45 am]
BILLING CODE 8010-01-M