U.S. GOVERNMENT PRINTING OFFICE

WASHINGTON : 

1

79–010

" ! SENATE 106TH CONGRESS

2d Session

REPORT

2000

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

(II)

COMMITTEE ON GOVERNMENTAL AFFAIRS

FRED THOMPSON, Tennessee, Chairman

WILLIAM V. ROTH, JR., Delaware

TED STEVENS, Alaska

SUSAN M. COLLINS, Maine

GEORGE V. VOINOVICH, Ohio

PETE V. DOMENICI, New Mexico

THAD COCHRAN, Mississippi

ARLEN SPECTER, Pennsylvania

JUDD GREGG, New Hampshire

JOSEPH I. LIEBERMAN, Connecticut

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

ROBERT G. TORRICELLI, New Jersey

MAX CLELAND, Georgia

JOHN EDWARDS, North Carolina

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

TED STEVENS, Alaska

GEORGE V. VOINOVICH, Ohio

PETE V. DOMENICI, New Mexico

THAD COCHRAN, Mississippi

ARLEN SPECTER, Pennsylvania

CARL LEVIN, Michigan

DANIEL K. AKAKA, Hawaii

RICHARD J. DURBIN, Illinois

MAX CLELAND, Georgia

JOHN EDWARDS, North Carolina

K. LEE BLALACK, II, Chief Counsel and Staff Director

LINDA J. GUSTITUS, Minority Chief Counsel and Staff Director

MARY D. ROBERTSON, Chief Clerk

(III)

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

1Day 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’’). 2The 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. 3Opening Statement of Senator Susan M. Collins, Chairman of the Subcommittee, Overview

Hearing, at 3–4 (‘‘Collins Statement’’).

106TH CONGRESS REPORT

2d Session " ! SENATE 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

REPORT

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 indepth investigation of the day trading industry and announced that

subsequent hearings would highlight case studies developed by the

Subcommittee.3

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

2

4Day 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).

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 email 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

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

3

5There 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.

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.

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.

4

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

5

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).

9 ‘‘Proposed Rules Change by National Association of Securities Dealers, Inc.,’’ File No. SR–

NASD–0–03, Jan. 13, 2000.

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:

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

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

6

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.’’). 12Deposition of Henry D. Fahman, Dec. 15, 1999, at 119 (‘‘Fahman Dep.’’). 13 Ianthe Jeanne Dugan, ‘‘For These Day Traders, Stock Market Is One Big Casino,’’ Washington Post, Feb. 25, 1999, at A1. 14Training 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. 15Deposition of James H. Lee, Dec. 22, 1999, at 70 (‘‘Lee Dep.’’). 16 Id. 17SROs 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

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

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

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:

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

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

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

7

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 ¶6.02 (1998). 19 Id. 20 ‘‘About the Division of Enforcement,’’ www.sec.gov/enforce/abenf.htm, Jan. 30, 2000, at 1. 21The SEC has five presidentially-appointed commissioners, each serving a five-year term. Investor’s Advocate at 3. 22 Id. at 7–8. 23 Id. at 2. 24Prepared 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.

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

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:

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 selfregulatory organizations and other securities industry

sources, press reports, and investor complaints.22

The SEC files about 400 to 500 civil enforcement actions each

year.23

(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

(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

8

28 Id. at 77. 29 Id. 30Morgenson, Gretchen, ‘‘U.S. Accuses 3 Companies Of Violations,’’ New York Times, Feb. 23,

2000, at C1. 31 Id. 32 Investor’s Advocate at 6. 33Pursuant 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. § 78q(d)(1)(B). 34Prepared Statement of Mary Schapiro, President of NASDR, Overview Hearing, at 81

(‘‘Schapiro Statement’’). 35 ‘‘NASD Regulation—Who We Are,’’ www.nasdr.com/2200.htm. 36Schapiro Statement at 81. 37 Id. 38 ‘‘NASD Regulation—Who We Are,’’ www.nasdr.com/2200.html.

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

(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.

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:

NASDR Enforcement brings cases against members and

their associated persons based on information developed

internally by periodic examination of member firms,

9

39Schapiro Statement at 81a (errata sheet). 40 Id. at 81a (errata sheet)–82. 41 ‘‘NYSE, Member Firm Regulation,’’ www.nyse.com/regulation/memberfirmreg.html. 42 Id. 43 Id. 44 Id. 45Levitt 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 § 240.15b9–1. 48Levitt 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).

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

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

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

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

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,

10

51Schapiro Statement at 92. 52 Id. 53 Id. 54 Id. 55 Id. 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.

day traders at Phlx firms are now required to take and pass the

Series 7 examination.

(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

(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

(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

11

61 ‘‘NASAA: Who We Are,’’ www.nasaa.org/whoweare, at 1–2. 62 Id. at 1. 63 Id. at 2. 64 Id. 65 Id. 66The 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. §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, §12.205; Cal. Corp. Code §25202. 72Telephone 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.’’).

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

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

(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

12

73First 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. 74Second Bortner Int. at 2. 75First Bortner Int. at 1; Second Bortner Int. at 2. 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). 77Tennessee 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. 82 NASAA Report, ‘‘Preface.’’ 83 Id. at ‘‘Members of Project Group.’’ 84 Id. at 4.

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

(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.

(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

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;

13

85 Id. at ‘‘Summary.’’ 86 Id. at 5. 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. 90Sander and Sander, Day Trading Like a Pro, at 69. 91 Id. at 19. 92 Id. at 69. 93 Harvey I. Houtkin and David Waldman, Secrets of the SOES Bandit 1–2 (1999). 94 Cornerstone Training Manual, Introduction, at 3. 95 Id.

• 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

The NASAA Report also contended that day trading is analogous

to gambling and is unprofitable for most customers.86

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

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

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

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

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96Sander and Sander, Day Trading Like a Pro, at 70. 97 Id. 98 Id. 99 Id. at 71. 100 Id. at 157. 101 Id. at 159. 102Table 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. 103 NASAA Report at 3. 104Dugan, ‘‘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.

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.

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.

(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.

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

15

105 Cornerstone Training Manual, Introduction, at 3. 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.

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

(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 online 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.

16

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. 111Telephone Interview of James H. Lee, President of ETA, Aug. 11, 1999. 112 Id. 113 Harvey I. Houtkin, Remarks at an All-Tech Informational Seminar, July 21, 1999

(‘‘Houtkin Remarks’’). 114David Barboza, ‘‘Why Big Firms Are Courting Day Traders,’’ N.Y. Times, Aug. 13, 1999,

at C1. 115 Advertisement of On-Site Trading, Inc. (Feb. Hr’g Ex. 1). 116 Id. 117 Id.

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

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

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.

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 routVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00020 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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118 Barboza, ‘‘Why Big Firms Are Courting Day Traders,’’ at C1. 119Subcommittee 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. 120Levitt Statement at 64. 121 Id. 122www.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.

ing systems that could someday give all investors instant access to

the financial markets.118

(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.

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

18

124Letter 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. 126 Id. 127 Id. 128 Id. 129 Id. 130 ‘‘Home page,’’ www.takingprofits.com, July 29, 1999, at 1. 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.

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

• 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

• 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

• You don’t have to be able to understand Economics, the

[sic] Stockmarket or International Finance.128

• I am not a rocket scientist, [sic] brainsurgeon or computer

whiz.129

(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

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

19

135The 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. 136Letter from Louis Russo, Taking Profits, to Subcommittee staff, Sept. 20, 1999, at 1 (Feb.

Hr’g Ex. 3). 137 ‘‘Home page’’ www.coastaldaytrader.com, July 30, 1999. 138Letter 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. 141 Id. 142 Id. 143 Id.

website at the end of a paragraph detailing the subscription costs

of his newsletters.135

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.

(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:

• Wealth Wizard monitors your portfolio in real time, executing trades automatically.141

• Wealth Wizard performs the kind of careful, tireless monitoring required, giving you a potential daily return on your investments, while minimizing your risks.142

• You make money on the way up and more on the way

down.143

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 modificaVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00023 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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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). 145Kane 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. 146 ‘‘Weekly Calendar of Advanced Support Services,’’ www.precisiondaytrader.com, July 29,

1999, at 1. 147The 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. 150 ‘‘Explanation of Events,’’ www.precisiondaytrader.com, July 29, 1999, at 1. 151 Id.

tion.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.

(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 ‘‘TradeTutor 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

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

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

In its response to the Subcommittee’s interrogatories, Precision had

no support for its statement ‘‘trading your way to a better life,’’ or

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152Letter 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. 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. 158Letter from Brian Zavodnik, WinningDayTraders, to K. Lee Blalack, II, undated, at 2 (Feb.

Hr’g Ex. 7). 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. 161 ‘‘Frequently Asked Questions,’’ www.thestockcam.com, Aug. 3, 1999, at 1. 162 Id.

ing 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.

(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.

(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:

• 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

• 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

RML Trading stated in its cover letter to the Subcommittee that

the above statement reflects ‘‘the opinions of successful day tradVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00025 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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163Letter 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. 167 Collins Statement at 3. 168Webster’s Third New International Dictionary at 932.

ers.’’ 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

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.

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.

(1) Regulators Liken Day Trading to Gambling. Securities regulators have been comparing day trading to gambling for some time.

23

169 NASAA Press Release, Nov. 25, 1998 (Feb. Hr’g Ex. 9). 170Prepared 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). 172 Houtkin Dep. at 227. 173 Brian Kunath ‘‘Day Trading: The ‘Dealerization’ of the Markets,’’ Global Investment Magazine, Dec. 1999, at 51. 174Lee Dep. at 82–86. 175 Id. 176Prepared Statement of Saul S. Cohen, Consulting Counsel for ETA, Overview Hearing, at

179 (‘‘Cohen Statement’’). 177 Id.

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

(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

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:

24

178 Cornerstone Training Manual, Introduction, at 4. 179 Id. 180 Id. 181 Id. (emphasis added). 182Syllabus, ‘‘Professional Traders Group, Training Seminar,’’ Jan. 4, 1999—Jan. 29, 1999, at

2 (Feb. Hr’g Ex. 11). 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).

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

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

[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

(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:

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

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 comVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00028 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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184Marcia Vickers, ‘‘A School for Day Traders,’’ Business Week, Nov. 8, 1999, at 148. 185 Id. 186 Houtkin Dep. at 231, 236. 187 Id. at 237. 188 Id. at 237–38. 189Dugan, ‘‘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. 191Dugan, ‘‘For These Day Traders, Stock Market Is One Big Casino,’’ at A1. 192 Interview of Chris Anderson, Aug. 25, 1999, at 1 (‘‘Anderson Int.’’). 193 Id. 194 Id.

monly 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

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:

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

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

(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

26

195 Interviews of Dr. Frederick Woolverton, Dec. 14, 1999 and Dec. 17, 1999, at 1 (‘‘Woolverton

Int.’’). 196 Id. 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. 200On-Site Trading, Inc., Training Manual, at 6 (Feb. Hr’g Ex. 13). 201 Raymond Fazzi, ‘‘Day Trading: Boom or Bust?’’ Asbury Park Press, Sept. 26, 1999, at A11. 202Training Manual, ‘‘Trading Psychology,’’ The Stockcam Institute, Inc., at G–2 (emphasis

added) (Feb. Hr’g Ex. 14). 203Fazzi, ‘‘Day Trading: Boom or Bust?,’’ at A11.

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

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

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:

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

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

27

204 Vanessa Richardson, ‘‘Addictions: Trading the Day Away,’’ Money, Sept. 1999, at 34. 205Woolverton Int. at 2. 206 Id. 207 Id. 208 Id. 209Deposition 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.

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.

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

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

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 manVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00031 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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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.’’). 215Fahman Dep. at 253. 216Letter 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.’’). 218Fahman Dep. at 256. 219 Id. 220 Edwards, ‘‘Minute by Minute Man,’’ at K1. 221 Id. 222Letter 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. 224 NASAA Report at 7.

ager 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

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

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

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

29

225 Id. at 4. 226 Id. 227 Cohen Statement at 186. 228 Id. 229 Id. 230 Id. 231 Id. at 188. 232Telephone call with Robert Bennett, Counsel for Momentum Securities, Inc., Jan. 24, 1999. 233Day 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).

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

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

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 tradVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00033 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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234 Cohen Statement at 188. 235Momentum 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. 236Tradescape’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).

ing profitability] to rest,’’ 234 and then ETA’s failure to pursue the

study, undermine the level of confidence ETA really has in its survey.

(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.

The Momentum data, which the firm has not made public, indicates that 64 percent of Momentum’s experienced traders were

31

238Momentum Survey at ‘‘Preliminary Results,’’ Feb. 1999. 239Feb. Hr’g Ex. 20. 240Feb. 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. 242Feb. Hr’g Ex. 21. 243Telephone Interview of Mark Peckman and Andrew Actman, Broadway Trading, Inc., Jan.

17, 2000. 244 Broadway Trading, Inc., Profitability Data for 1998 (Feb. Hr’g Ex. 22). 245 Id. 246Securities 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.

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

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.

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.

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

(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 WashVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00035 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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247Those 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. 251 Id. 252 Id. 253Day 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.

ington.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

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.

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

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 marVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00036 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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255 Collins Statement at 2. 256 Id. 257 Id. 258Levitt Statement at 18. 259 Id. 260GAO SOES Report at 14. 261 Id. 262 Id.

kets.’’ 255 She noted that ‘‘[n]ew technology now allows investors to

access the markets directly without the aid or advice of a brokerdealer, 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.

(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.

(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.

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 tradVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00037 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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263 Robert H. Battalio, Brian Hatch, and Robert Jennings, SOES Trading and Market Volatility Vol. 32, No. 2 (June 1997). 264GAO SOES Report at 14. 265Gretchen 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. 270 Id. 271 Id at A1. 272 Id. 273 Id. 274 ‘‘Qualcomm Back Draft: Day Traders Bet on Look-Alikes,’’ Wall Street Journal, Jan. 10,

2000, at C1. 275 Id.

ing 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

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:

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

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

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:

Through it all has been a role reversal taking shape at

times between big investors and day traders. Not long ago,

35

276 Id. 277Susan Pulliam, ‘‘Day Traders Power Fuel—Cell Stock Rise,’’ Wall Street Journal, Feb. 16,

2000, at C2. 278Letter 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).

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

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.

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

36

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.

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.

37

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. 282Mark Shefts Int. at 1. 283 Houtkin Dep. at 29. 284 Id. 285 Id. at 29–30, 40–41. 286Shefts Int. at 2. 287 Houtkin Dep. at 30, 42. 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. 290Shefts Int. at 2. 291 Id. 292 Id.

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

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 AllState, 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

38

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. 297Generic letter from Harvey Houtkin, undated, bates number 4071 (Feb. Hr’g Ex. 25). 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’’). 300See. e.g., Portland Branch Agreement; Seattle Branch Agreement; Watertown Branch

Agreement; and, San Diego Branch Agreement.

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 Socalled 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

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

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 AllTech 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

39

301Portland 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. 302Shefts Int. at 5. 303Letter 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). 304Letter 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. 308 All Tech Investment Group Corporate Organization Chart, Aug. 16, 1999 (Feb. Hr’g Ex.

28). 309 Houtkin Dep. at 79. 310Shefts Int. at 6; Houtkin Dep. at 79; Ex. 28. 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). 312Mr. Lefkowitz is the firm’s Senior Vice President of Operations. Feb. Hr’g Ex. 28. 313Feb. Hr’g Ex. 29; Feb. Hr’g Ex. 30. This enforcement action will be discussed in detail in

section E, 2. 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

Continued

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

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

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

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 AllTech settled the matter in May 1999.

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

40

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. 317Feb. Hr’g Ex. 29. 318Feb. Hr’g Ex. 30. 319Feb. Hr’g Ex. 29. 320 Id. 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. 323 Houtkin Dep. at 127–45.

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 brokerdealer.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

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

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

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 AllTech 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 conVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00044 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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324 Id. at 150. 325Day 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). 326 Houtkin, Secrets of the SOES Bandit, at 42. 327Day 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).

tact. 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

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 AllTech 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.

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

(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

42

328Feb. Hr’g Ex. 26. 329 Id. 330 Id. 331 Interview of Harry Lefkowitz, Dec. 6, 1999, at 2 (‘‘Lefkowitz Int.’’). 332 Id. Until Mr. Ogele joined the firm in March 1999, Mr. Lefkowitz was responsible for opening new accounts at All-Tech. Id. 333Deposition 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. 334 All-Tech Branch Office Manual (‘‘Branch Office Manual’’) ‘‘Branch Procedures’’ at 2 (Feb.

Hr’g Ex. 35). 335Parish 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. 338Day 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).

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

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

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

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

43

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. 340Telephone 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. 341Deposition of Fred A. Zayas, Dec. 16, 1999, at 98 (‘‘Zayas Dep.’’). 342Mr. 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). 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). 344Telephone 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.’’). 345Shefts Int. at 9. 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.

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

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

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 wantVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00047 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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349Parish Dep. at 79–80. 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. 351Parish Dep. at 44. 352 Id. 353Shefts Int. at 5. 354Margala 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. 355Margala Int. at 2. 356Day 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). 357Feb. Hr’g Ex. 37. 358Margala Int. at 1. 359 Id. at 2; All-Tech ‘‘Experience Trader Qualification,’’ undated (Feb. Hr’g Ex. 41).

ed 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.’’

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

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 AllTech’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

45

360Margala Int. at 2. 361Day 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). 362Feb. Hr’g Ex. 39; Margala Int. at 3. 363Margala Int. at 3. 364Parish Dep. at 70. 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). 371 Bovee Int. at 1-2.

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

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

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

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

46

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. 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. 379Gogenko Int. at 2. 380 Id. 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.

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

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 AllTech’s policy required a minimum deposit of $50,000 of risk capital.378 Ms. Gogenko stated that she is a cosmetologist with an in- come 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

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 AllTech’’ employees in Atlanta.383

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

47

384Zayas Dep. at 103. 385 Id. 386Day 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). 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. 393 Id. at 53-55, 68-69. 394 Id. at 51-52. 395 Id. at 51.

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

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

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:

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

48

396 Id. at 51–52. 397 Id. at 58. 398 Id. at 58–60. 399 Id. 400 Houtkin Dep. at 187-88; Shefts Int. at 8; Lefkowitz Int. at 2. 401Feb. Hr’g Ex. 26. 402Lefkowitz Int. at 2.

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

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

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 AllTech’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

49

403 Houtkin, Secrets of the SOES Bandit, at 42 (emphasis added). 404 Houtkin Dep. at 182. 405Day 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). 406Lefkowitz Int. at 2; Shefts Int. at 8. 407Lefkowitz Int. at 2 . 408Shefts Int. at 8. 409Feb. Hr’g Ex. 35, Section 4, ‘‘Re: Day Trading Account Guidelines,’’ May 13, 1997. 410 Id.

minimum standard to $25,000, Mr. Houtkin published his second

book on day trading which stated as follows:

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

At his Subcommittee deposition, Mr. Houtkin was asked whether

the recommended deposit for opening a day trading account at AllTech 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

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.

50

411 Houtkin, Secrets of the SOES Bandit, at 44. 412 Id. at 45 (emphasis in original).

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.

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]

51

413Zayas Dep. at 144–46. 414 Id. at 146. 415Day 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). 416Parish Dep. at 156–57. 417 Id. at 157. 418 Id. at 158. 419There 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. 420Feb. Hr’g Ex. 26.

A: Yes.

Q: And did you do that for customers?

A: Sure. Yes.413

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

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

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. AllTech 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.

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 perVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00055 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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421Feb. 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. 423 Cook Int. at 5. 424 Id. 425 Id. 426 Id. 427Margala 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. 436 Interview of Marilyn Sherman, Oct. 6, 1999, at 4 (‘‘Sherman Int.’’). 437 Id.

mitted 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.

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

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

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

53

438 Id. 439 Id. 440Parish Dep. at 95–96. 441 Id. 442Sherman Journal Authorizations, June 1999 to Aug. 1999 (Feb. Hr’g Ex. 44). 443Sherman Int. at 4–A. 444Parish Dep. at 97. 445 Id. at 97–100. 446 Id. at 99–101. 447 Bovee Int. at 3. 448 Id. 449 Id. 450 Id. 451 Benson Int. at 7. 452 Id. 453 Id. 454 Esposito Dep. at 113–14, 116.

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

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

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

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-auVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00057 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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455Mr. 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. 461 Id. at 118–19. 462 Id. at 119. 463 Id. at 118–19. 464Lefkowitz Int. at 3. 465 Id.

thor 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

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.

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

55

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. 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. 469Parish Dep. at 115. 470 Id. at 120–21.

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

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:

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

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:

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 recVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00059 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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471 Id. 472 Id. at 121. 473 Id. 474 Bovee Int. at 2. Mr. Beal was a registered representative who was ultimately fired by AllTech 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. 480Strawbridge Int. at 6. 481Telephone Interview of Dr. Leslie Levine, Nov. 1, 1999, at 1 (‘‘Levine Int.’’). 482 Id. 483 Houtkin Dep. at 325.

ommend a stock to you, you assume I know something

about the company, right? I know nothing about almost

any of these companies.471

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 fourletter symbol. So I don’t look at them as recommendations. They’re

strictly trades.’’ 473

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

Stock picks were not limited to the Beaverton and San Diego offices of All-Tech. Dr. Leslie Levine, who was a customer at AllTech’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

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.

57

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). 485Day 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). 486 ‘‘Reasons to Initiate a Trade’’ (Feb. Hr’g Ex. 47). 487Parish Dep. at 145. 488 Id. at 145–46. 489Zayas Dep. at 86.

(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

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:

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

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:

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

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 ofVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00061 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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490 Harlacher Int. at 3. 491Day 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). 492Levine 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. 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.

fice, 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

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

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

59

497Parish 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. AllTech Investment Group, Inc., Case No. 90–00515, filed Dec. 28, 1999. 499Day 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. 501Margala Int. at 2. 502 Id. Ms. Margala stated that, when she first went to All-Tech, she wanted to open her ac- count 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. 503 Ex. 35, ‘‘Branch Procedures,’’ Sections 3(A) at 3, and 3(B) at 3; Houtkin Dep. at 288. 504Parish 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.

point, however, Mr. Cook had not yet started live trading with AllTech.497 Ironically, Mr. Cook eventually lost $175,000 day trading

at the firm and has filed an NASD arbitration claim against AllTech.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

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

60

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. 511 Houtkin Dep. at 293. 512 Cook Int. at 4. The problem apparently started in the fall of 1998. Margala Int. at 4; Sherman Int. at 3. 513Day 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).

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

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

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

61

514 Cook Int. at 4; Margala Int. at 4; Sherman at 3–4. 515 Cook Int. at 4; Margala Int. at 4. 516Margala Int. at 4; Haseltine Int. at 2; Sherman Int. at 4. 517 Harlacher Int. at 2. 518Margala Int. at 2. 519 Id. 520 Harlacher Int. at 2. 521 Bovee Int. at 1. 522 Id. 523Parish Dep. at 45. 524 Id. 525 Id. at 46.

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

(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

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

(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 reVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00065 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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526Day 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). 527Feb. Hr’g Ex. 15, at 4. 528Feb. Hr’g Ex. 16, at 4. 529 Id. 530 Benson Int. at 8. 531 Id. 532Feb. Hr’g Ex. 17, at 4. 533Zayas 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. 535Shefts Int. at 8. 536 Houtkin Dep. at 199.

sponded. ‘‘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.

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

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.

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

63

537Shefts 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. 538Parish Dep. at 173. At one point, boot camps lasted one weekend each. Ex. 35, 9A. ‘‘AllTech Training Camp, Inc. Training Program and Weekend Boot Camp.’’ 539Shefts Int. at 5. Paper trading is simulated trading without the use of real money. 540 Ex. 40, at 2. 541 All-Tech Training Group, Inc. Manual, ‘‘Welcome to All-Tech Training Group,’’ at 5 (Feb.

Hr’g Ex. 52). 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.

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

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

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

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

64

547 Id. at 1, 3. 548 Id. at 1. 549 Id. at 6. 550 Id. 551Day 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. 554San Diego ‘‘Branch Office Survey,’’ Aug. 4, 1997, at 6 (Feb. Hr’g Ex. 53). 555Parish 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. 556Parish Dep. at 143. 557Sherman Int. at 3; Margala Int. at 2–3; Haseltine Int. at 2. 558Parish Dep. at 143. 559 Id. at 144.

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

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

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

Given the testimony of these former customers—and even former

branch managers—it appears that All-Tech may have overstated

65

560Day 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). 561Shefts Int. at 6; Houtkin Dep. at 79; Feb. Hr’g Ex. 28. 562Schedule 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. 563Shefts Int. at 6. 564 Houtkin Dep. at 313. 565 Id. at 313–15. 566 Id. at 315. 567Shefts 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.

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.

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

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

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

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 eviVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00069 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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569The 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. 570Zayas 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. 571Parish Dep. at 160. 572 Id. at 160–61. 573 Houtkin Dep. at 317. 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). 576Feb. Hr’g Ex. 55a at ¶ 162; Feb. Hr’g Ex. 55b at ¶ 3. 577Feb. Hr’g Ex. 55a at 2. 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).

dence, however, of actual audits until Mr. Ogele was hired last

year.569

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

(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

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

The Securities Division settled the matter with each of the respondents on May 3, 1999.578 During his Subcommittee deposition,

67

579 Houtkin Dep. at 145. 580 Id. at 145–46. 581Zayas Dep. at 55. 582 Id. at 73. 583 Id. at 74. 584 Id. at 146. 585Feb. Hr’g Ex. 57, at 1. Like Mr. Houtkin, Mr. Lefkowitz described Mr. Zayas as a ‘‘rogue

broker.’’ Lefkowitz Int. at 3

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

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

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: • 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;

68

586 In re All Tech, Docket No. R–98–77, ‘‘Offer of Settlement,’’ May 3, 1999, at 1–3; In re AllTech, 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. 587 In re All-Tech Investment Group, Inc., Offer of Settlement, Docket No. R–98–77, May 3,

1999, at 2. 588Ogele Int. at 1. 589 Id. 590 Houtkin Dep. at 329–30. 591Ogele 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).

• 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

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

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

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 AllTech employees in the Watertown office. Though Mr. Lefkowitz atVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00072 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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595 Houtkin Dep. at 302. 596Zayas 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. 599Zayas 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. 602Mr. 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.

tributed 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

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.

70

604 Id. at approximately 3:45. 605Olson Int. at 1. 606Zayas Dep. at 45. Jody Krajack is the trader who Mr. Houtkin allegedly found to trade

Mr. Zayas’ account. Id. at 34–35. 607 Houtkin Dep. at 307–309. 608Zayas Dep. at 36, 51. 609 Id. at 37. 610Sherman Int. at 2–3. 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.

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

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

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

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

(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:

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.

71

612Zayas Dep. at 50. 613Parish Dep. at 40–41. 614 Id. at 42. 615Strawbridge Int. at 8. 616 Id. 617 Id. 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. 620The 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. 622Frederick M. Benson, CRD # 2876856, at ‘‘Employment History’’ (‘‘Benson CRD’’) (Feb. Hr’g

Ex. 64). 623Portland Branch Agreement, at Rider. 624 Houtkin Dep. at 226. 625Feb. 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. 626 Benson Int. at 2.

Q: And that was the sum total of your training?

A: That was it.612

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

(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

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

11⁄2 years, without being licensed, and acted as a branch manager

for six months without a license.

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

72

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. 631Typed notes, Sept. 22, 1998, produced by Georgia Bovee (Feb. Hr’g Ex. 65). 632 Id. 633Strawbridge Int. at 3. 634 Id. 635 Benson Int. at 5. 636Feb. Hr’g Ex. 16, at 1. 637 Benson Int. at 5. 638 Id. 639 Bovee Int. at 4. 640 Id. 641Zayas Dep. at 46. 642Zayas 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.

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 brokerdealer 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

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:

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 127⁄16. THAT CAUSED ME TO LOSE

$143.00 WITH COMMISSION.632

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

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

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

73

643Zayas Dep. at 46–47, 130. 644Watertown Agreement at 1. 645Zayas 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. 649Zayas Dep. at 172. 650 Id. at 173. 651 Id. 652 Id. at 174. 653 Investment Advisers Act of 1940, Section 202(a)(11), Codified at 15 U.S.C. § 80b–2(a)(11).

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

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

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, AllTech’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 govVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00077 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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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, § 12.205; Cal. Corp. Code § 25202. 657Feb. 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.’’ 658Zayas Dep. at 171. 659 Id. at 34. 660 Id. at 35. 661 Id. at 36. 662 Id. at 77–78. 663Feb. Hr’g Ex. 35, Section 4(B), Sample Forms: Instructions for Investment Advisor Representation Letter and Letter.

ernment.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

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

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:

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 deVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00078 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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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). 665Fahman Dep. at 72, 188–89. 666 Id. at 32, 34. 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. 672 Id. at 70, 106. 673 Id. at 67.

tailed 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

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

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

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 NoVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00079 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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674Moon Int. at 2. 675Fahman Dep. at 68. 676 Id. 677 Id. at 189. 678Letter from Providential Securities, Inc. to Wesley Phillips, Investigator for the Subcommittee, undated (Feb. Hr’g Ex. 68 ). 679Fahman Dep. at 189–190. 680Feb. Hr’g Ex. 68. 681Fahman Dep. at 189, 191. 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. 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.

vember 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

Mr. Fahman said that about 5,000 customers currently maintain

accounts with Providential.677 In 1998, Providential’s gross reve- nues 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

(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

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

77

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. 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. 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. 703Fahman 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.

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

(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

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

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 servVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00081 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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704 Id. at 80. 705 Id. 706 Id. at 80, 82. 707 Id. at 83, 92. 708 Id. at 92; Moon Int. at 2. 709Fahman Dep. at 84. 710 Id. at 82–83. 711 Id. 712 Id. at 84. 713Subcommittee Interview with SEC senior officials, Dec. 17, 1999. 714Fahman Dep. at 19, 84.

ices.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

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 brokerdealer.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

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.

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

79

715 Interview of Tony Nguyen, Dec. 9, 1999, at 2 (‘‘Nguyen Int.’’). 716Fahman Dep. at 64. 717 Id. at 84–85. 718 Id. at 86–87. 719 Nguyen Int. at 2. 720 Id. 721 Id. 722 Id. 723Fahman Dep. at 79. 724 Id. at 95. 725Letter 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.

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

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

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

(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

80

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). 728Telephone Interview of William Shepherd, Jan. 14, 2000, at 1 (‘‘Shepherd Int.’’). 729Second Amended Statement of Claim, Case No: 98–02900, at 4–5 (‘‘Richardson Complaint’’). 730Shepherd Int. at 1. 731Moon Int. at 2. 732 Ex. 71, at 3. 733 Id. 734Shepherd Int. at 1. 735 NASDR CRD for Kwang Ho Kim (Feb. Hr’g Ex. 72). Kwang Ho Kim is also known as Keith

Kim.

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

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

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

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736 ‘‘Customer Acknowledgment of Risk,’’ Providential Securities, Inc. (Feb. Hr’g Ex. 73). 737 Id. at 1. 738 Id. at 1–2. 739 ‘‘Acknowledgment of Liability,’’ Hahna Global Securities, June 6, 1998 (Feb. Hr’g Ex. 74). 740 Id.

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

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

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 reVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00085 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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741Fahman Dep. at 243. 742 Id. at 242. 743 Id. 744Two 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. 745Providential advertisement (Feb. Hr’g Ex. 75). 746 Id. 747 Id. 748 Id. 749Fahman Dep. at 247. 750 Id. 751Day 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). 752Fahman Dep. at 246. 753 Id. 754Day 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).

viewing 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

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

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

(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

83

755 ‘‘Welcome to Providential Securities,’’ www.providential.net/english/main.html, Dec. 14,

1999, at 1. 756 Id. 757Moon Int. at 4. 758 Id. 759 Id. 760Telephone Interview of Holly Clark, Nov. 22, 1999, at 3 (‘‘First Clark Int.’’); Telephone

Interview of Matt Lehr, Nov. 29, 1999, at 4 (‘‘Lehr Int.’’). 761 ‘‘Who We Are,’’ www.sipc.org, Feb. 10. 2000. 762 ‘‘Welcome to Providential Securities, ‘‘www.providential.net/english/main.html, Dec. 14,

1999, at 1. 763Letter 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).

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

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

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:

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

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

84

764 Id. 765 Id. 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. 771Deposition of Huan Van Cao, Dec. 28, 1999, at 158, 161–68 (‘‘Cao Dep.’’). 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.

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

(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

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

85

776Fahman Dep. at 136–37. 777 Id. at 137. 778Providential Securities, Inc., General Supervisory Procedures and Compliance Manual,

(Oct. 1998) (Feb. Hr’g Ex. 78). 779 Ex. 78, ‘‘Branch Office Supervisory Procedures,’’ at 7. 780 Id. (emphasis in original). 781Fahman 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. 783Feb Hr’g Ex. 78, ‘‘Branch Office Supervisory Procedures,’’ at 7.

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

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:

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

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

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

86

784 Id. at 8. 785Fahman Dep. at 161, 163. 786 Id. at 216. 787Feb. 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.

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

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

PROVIDENTIAL DAY TRADING CUSTOMER ACCOUNT FORMS THAT FAILED TO INCLUDE REQUIRED

FINANCIAL INFORMATION ON INCOME AND/OR NET WORTH

Branch

Number of

forms reviewed

Number of

forms without

required infor- mation

Percentage of

forms without

required infor- mation

California branches1 ............................................................................................... 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 ProviVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00090 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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788Feb. Hr’g Ex. 69, at 2. 789 Id. 790Feb. Hr’g Ex. 18, at 13. 791Fahman Dep. at 195. 792 Id. at 134. 793 Id. 794 Id.

dential 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

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

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:

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

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 requireVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00091 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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795 Id. at 142–44. 796 Id. at 143. 797 Id. 798 Id. at 143–44. 799This 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). 801Fahman 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.

ments.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

(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

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

During his Subcommittee deposition, Subcommittee staff asked

Mr. Fahman about the opening of a day trading account for a bus

89

805 New Account Approval-B for Clara B. and Daryl Larry Grabowski, Apr. 13, 1999 (Feb. Hr’g

Ex. 82). 806 Id. 807Fahman Dep. at 224. 808 New Account Approval-B for Shao-Shin Liu, undated (Feb. Hr’g Ex. 83). 809Fahman Dep. at 215–16. 810 Id. at 253. 811 Id. 812Feb. Hr’g Ex. 18, at 4. 813Moon Int. at 5. 814Fahman Dep. at 256. 815 Id.

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.

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.

(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:

90

816 Id. at 256–57. 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. 823Moon Int. at 5.

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

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

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 PresiVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00094 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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824 Id. 825 Id. at 3. 826 Id. 827 Id. at 5. 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. 833Moon 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.

dent 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

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

(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

92

836Feb. Hr’g Ex. 84. 837 Id. 838 Id. 839Fahman Dep. at 50–56. 840 Id. at 50–52. 841 Id. at 55–56. 842Mr. 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. 843Moon Int. at 6. 844Letter 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. 846Feb. 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.

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

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

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

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 listVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00096 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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847Letter from Huan Van Cao, Senior Vice President of Hahna Global Capital Management,

to Brenda Richardson, Mar. 20, 1998 (Feb. H’g Ex. 86). 848Le Int. at 3. 849Moon 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. 850Trading records provided to the Subcommittee by Brenda Richardson. 851 Cao Dep. at 216, 220. 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 illprepared to day trade. Id. 856 Id. at 4.

ed 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

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

(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 GroCorporation.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

94

857 Id. at 5. 858 Id. 859 Id. at 4. 860 If. at 6. 861 Id. at 5. 862 Id. at 6. 863 Cao Dep. at 78–79. 864 Id. at 83. 865 Ex. 86. 866 Cao Dep. at 85. 867First Richardson Int. at 6–7. 868 Id. at 6. 869 Id. at 6. 870 Id. 871 Id. 872 Cao Dep. at 112. 873 Id. at 110, 112

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

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

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

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

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

95

874First 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. 878First Richardson Int. at. 7. 879 Id. 880 Cao Dep. at 114. 881 Id. at 113. 882 Id. at 132. 883Shepherd Int. at 1. 884 Id. 885 Id. 886 Cao Dep. at 216. 887 ILe Int. at 1. 888 Id. at 2.

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

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

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

(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

96

889 Cao Dep. at 145–46. 890 Id. at 136. 891 Id. at 136–37 (emphasis added). 892Le Int. at 2. 893 Id. 894The 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. 895Le Int. at 2. 896Day 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). 897Le Int. at 3. 898 Id.

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:

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

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

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 meetVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00100 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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899 Id. 900 Id. 901 Cao Dep. at 167. 902 Id. at 168–70. 903 Id. at 168. 904 Id. at 169–70. 905Le Int. at 4. 906 Id. 907 Id. 908 Id. 909 Id. 910 Id. 911 New Account Approval-B for Amy Le, undated (Feb. Hr’g Ex. 87).

ing, 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

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:

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

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

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

98

912 Id. 913Moon Int. at 5. 914Fahman Dep. at 239. 915Le Int. at 4. 916 Id. 917 Id. at 4–5. 918 Id. at 5. 919 Id. 920 Id. 921 Id. 922 Id. at 6. 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. 926Le Int. at 5. 927 Cao Dep. at 149, 167. 928Telephone 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.’’).

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

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

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

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,

99

929 NASD Regulation, Inc., Statement of Claim (No Case #), at 1 (‘‘Tran Complaint’’). 930 Cao Dep. at 162. 931 Id. at 158. 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. 934 Ex. 71. 935 Id. 936Fahman 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). 938Fahman Dep. at 183. 939Le Int. at 6.

Dung Tran, has since filed an NASD arbitration claim against Mr.

Cao and Providential, which is discussed in more detail below.929

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:

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

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.

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

(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 SepVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00103 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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940 Cao Dep. at 189. 941Moon Int. at 6. 942 Cao Dep. at 181, 192. 943Letter 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. 946Day 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). 947Feb. Hr’g Ex. 89. 948 Id. at Schedule F.

tember 1998.940 Mr. Moon told Subcommittee staff that he terminated Mr. Cao in August 1998, after Ms. Le complained about his

trading activities.941

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

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.

(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

101

949 Id. at Schedule C. 950 Cao Dep. at 209–10. 951 Id. at 209. 952 Cao Dep. at 189. 953 Id. at 190. 954 Id. at 190–91. 955 Id. at 191–92. 956 Id. at 214. 957 Id. at 216.

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

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

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:

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

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.

102

958 Cao Dep. at 114, 116. 959 Id. at 116. 960 Id. at 125. 961 Id.

(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:

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

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 anVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00106 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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962 Id. at 217. 963Moon Int. at 7. 964Feb. Hr’g Ex. 72. 965Tran 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.’’). 967Tran Complaint at 5–6. 968 Id. at 5, 6, 8. 969 Id. at 13. 970 Id. at 6. 971 Id. at 9. 972Moon Int. at 6. 973 Cao Dep. at 217, 219.

other 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

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

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.

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 disVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00107 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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974See NASD Rule 2310. 975Telephone Interview with Holly Clark, Dec. 28, 1999, at 1 (‘‘Second Clark Int.’’). 976 Id. 977 Id. 978 Id. 979 Id. at 2. 980 Id. 981 Id. 982 Id. at 1. 983 Id.

cussed 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.

(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

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

Ms. Clark told Subcommittee staff that, in January and February 1999, she started day trading at a firm called Wein SecuriVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00108 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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984 Id. at 2. 985 Id. 986 Id. at 3. 987 Id. at 2–3. 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. 992Fahman Dep. at 232–34. 993Providential Securities, Inc.’s Customer Acknowledgment of Risk for Holly C. Clark, Apr.

13, 1999, at 4 (attached hereto at Ex. 92). 994Second 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.

ties 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

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

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

(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

106

999Second Clark Int. at 4. 1000 Id. at 4–5. 1001 Id. at 4. 1002First 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. 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. 1009Second Clark Int. at 6. 1010 Id. at 3. 1011 Bogardis Int. at 2; Lehr Int. at 2; Scherner Int. at 2. 1012Lehr Int. at 2. 1013 Id.

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

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

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.

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

107

1014 Id. 1015 Id. 1016Scherner Int.at 2. 1017 Id. 1018 Nguyen Int. at 2–3. 1019 Id. 1020 Id. at 3. 1021 Id. 1022 Id. 1023 Id. 1024 Id. 1025Fahman Dep. at 267.

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

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.

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

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.

108

1026Feb. Hr’g Ex. 18, at 12. 1027 Cao Dep. at 156–57. 1028Fahman 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. 1030Fahman Dep. at 172. 1031Feb. Hr’g Ex. 69, at 1–2; Feb. Hr’g Ex. 18, at 6–7. 1032Moon Int. at 3.

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

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.

109

1033Fahman 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. 1036One form was completed in July 1998 and Subcommittee staff could not determine the

dates for four other forms. 1037Fahman Dep. at 146–47. 1038Feb. Hr’g Ex. 71, at 3. 1039Fahman Dep. at 57. 1040 Id. at 181. 1041 Id. at 107. 1042 ‘‘Momentum Securities, Inc.,’’ www.soes.com, Jan. 14, 2000 (‘‘www.soes.com’’).

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

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

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

110

1043Lee Dep. at 18–20. Mr. Lee also holds these securities licenses with a registered brokerdealer 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. 1047www.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. 1050Letter 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). 1051www.soes.com 1052Lee Dep. at 23. 1053 Id.at 58–59. 1054Momentum’s Organization Chart and Structure, undated (Feb. Hr’g Ex. 94). 1055Letter 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).

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

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

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

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

111

1056Lee Dep. at 104. 1057Feb. Hr’g Ex. 95, at 1. 1058Lee Dep. at 37. 1059 Id. at 34–48. 1060 Id. at 40–48. 1061 Interview of David Dial, Dec. 21, 1999, at 1 (‘‘Dial Int.’’). 1062 Id. 1063 Id. 1064 Id. 1065 Id. 1066Lee 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. 1067Dial Int. at 1.

but the firm continued to operate under the Momentum name.1056

In fact, in a letter to NASD Regulation, Mr. Lee confirmed that

[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

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

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

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 manageVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00115 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1068Lee Dep. at 40–42. 1069 Id. 1070 Id. at 48. 1071 Id. at 54. 1072 Id. at 50. 1073 Id. 1074 Id. at 86–89. 1075 Id. at 87–88. 1076 Id.

ment companies, but he could not identify them all by name.1068

Mr. Lee stated as follows:

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

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

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

113

1077 Id. at 88–89. 1078 Id. at 88. 1079 Id. at 90. 1080 Cohen statement at 204. 1081Lee Dep. at 91. 1082 Adam Cohen, ‘‘A Portrait of a Killer,’’ Time, Aug. 9, 1999, at 22. 1083 Id. 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.

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.

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

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.

(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

114

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.’’). 1093 Hoehn Int. at 2. 1094 Id. 1095 Id. 1096 Id. 1097 Id. 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. 1099Dial Int. at 1. 1100 Id. 1101 Id. 1102 Hoehn Int. at 2. 1103 Id.

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

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

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

115

1104Dial Int. at 1. 1105 Hoehn Int. at 2. 1106Dial Int. at 1. 1107 Id. 1108 Id. 1109 Id. 1110 Id. 1111 Id. 1112 Cheetham-Webb Int. at 1. 1113 Id. 1114 Id. 1115 Id. 1116Letter from Scott Webb to Alyce Wenzel, Apr. 1998, at 1 (Feb. Hr’g Ex. 97). 1117Dial 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.

and, in the summer of that year, Mr. Hoehn traveled to Tyler for

two weeks of training at Momentum’s branch office.1104

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

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

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

(2) Scott Webb’s Unsuitability for Day Trading and His Resulting

Losses. Upon arriving in Atlanta, Messrs. Hoehn and Webb moved

116

1120 Hoehn Int. at 3. 1121Wenzel 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’’). 1123Momentum 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. 1124Feb. Hr’g Ex. 136. 1125 Id. 1126Feb. Hr’g Ex. 98; Feb. Hr’g Ex. 99. 1127 Id. 1128 Id. 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. 1131Telephone Interview of Roy A. Webb, Dec. 9, 1999, at 1 (‘‘Webb Int.’’). 1132 Id.

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.

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

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

117

1133Promissory Note between Gerald Simpson and Scott Webb, July 29, 1998 (Feb. Hr’g Ex.

101). 1134 Hoehn Int. at 2. 1135Wenzel Int. at 1. 1136Day 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). 1137Telephone Interview of Ronda McPherson, Dec. 12, 1999, at 1 (‘‘McPherson Int.’’). 1138 Id. 1139 Hoehn Int. at 2. 1140 Id. at 3. 1141 Cheetham-Webb Int. at 1. 1142 Id. 1143Wenzel Int. at 1. 1144Day 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).

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

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.

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

(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

118

1145Dial 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. 1147Dial Int. at 2. 1148 Id. 1149Syllabus 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. 1155Wenzel Int. at 1. 1156Webb Int. at 1.

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

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

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

(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

119

1157 Hoehn Int. at 2. 1158 Id. 1159 Id. at 3. 1160Dial Int. at 2. 1161 Hoehn Int. at 3. 1162Wenzel Int. at 1; Webb Int. at 1. 1163Day 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).

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

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

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

120

1164Dial Int. at 2. 1165 Id. 1166 Id. 1167Momentum Securities, Inc. Branch Examination, Atlanta, Georgia, Sept. 14, 1998 to Sept.

17, 1998 (Feb. Hr’g Ex. 103). 1168 Id. at 3. 1169 Id. 1170Day 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).

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

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:

[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

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

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,

121

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. 1173 Id. at 6. 1174 Id. 1175 Id. at 7.

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

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

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:

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

122

1176 Id. 1177Momentum Securities, Inc. Branch Examination, Atlanta, Georgia, Mar. 5, 1999, at 1

(Feb. Hr’g Ex. 104). 1178 Id. at 2. 1179 Hoehn Int. at 2. 1180Dial Int. at 1–2.

would come in considering the shape of the Atlanta office.1176

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

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.

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 satVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00126 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1181Letter 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). 1185 Hoehn Int. at 3. 1186 Id. 1187 Id. 1188 Id. 1189Dial Int. at 2. 1190 Id.

isfy 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

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

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

124

1191 Hoehn Int. at 3. 1192Dial 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. 1193Dial Int. at 2. 1194 Id. 1195 Id. 1196Momentum Journal Authorizations into the Claypool Account (Feb. Hr’g Ex. 106). 1197 Id.

ever communicated directly with the lending customers, who were

usually located in other branch offices and particularly Tyler.1191

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

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

125

1198 Id. 1199 Id. 1200Dial Int. at 2. 1201Feb. Hr’g Ex. 106. 1202 Id. 1203 Id. 1204 Id. 1205 Id.

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

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

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 discloVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00129 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1206Letter 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. 1212Letter from William Cathriner, Momentum Chief Compliance Officer, to Scott H. Maestri,

NASDR Compliance Examiner, Aug. 23, 1999, at 1 (Feb. Hr’g Ex. 108).

sures 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

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.

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

127

1213Feb. Hr’g Ex. 103, at 6–7. 1214 Id. 1215 Id. at 7. 1216Momentum Securities, Inc. ‘‘Brokerage Operations Manual’’ (July 1999) (Feb. Hr’g Ex.

109). 1217Lee 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. 1221 Id. at 122.

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.

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

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.

(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,

128

1222Ms. 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. 1225 Id. (emphasis added). 1226 Id. 1227 New Account Approval-B for Benchmark Trading Fund, Ltd., Apr. 14, 1998 (Feb. Hr’g Ex.

111). 1228 Id. 1229 Id. 1230 Id.

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:

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

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.

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:

129

1231Lee Dep. at 244. 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. 1234Lee Dep. at 245–46. 1235 New Account Approval–B for Lunker Investments Corporation, Dec. 2, 1998 (Feb. Hr’g Ex.

114). 1236Feb. Hr’g Ex. 110, at III–5. 1237Feb.

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

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:

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

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:

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?

130

1238Lee Dep. at 248. 1239 New Account Aprpoval–B for Flora Siman, July 7, 1998 (Feb. Hr’g. Ex. 115). 1240 Id. 1241Lee Dep. at 254. 1242Feb. Hr’g Ex.110, at III–5. 1243 Id. 1244Letter 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.

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

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

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.

(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

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

131

1246 Id. at 2. 1247Lee Dep. at 121–25. 1248 Id. at 136. 1249 Id. at 139–40 (emphasis added). 1250Dial Int. at 2. When asked what amount of risk capital he considered necessary for a po- tential 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.

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:

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

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

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

The Subcommittee will assume that the testimony of Mr. Lee

and Mr. Dial accurately describes the firm’s policy prior to April

132

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). 1255Lee Dep. at 269, 274, 281, 282. 1256 Id. at 121. 1257Feb. Hr’g Ex. 109, Risk Management, at 2 (emphasis added).

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

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:

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

133

1258Lee Dep. at 161. 1259 Id. at 161–62. 1260 Id. at 153. 1261 Id. at 128–29. 1262 Id. at 153. 1263 Id. at 128–29. 1264Momentum Securities, Inc., New Account Paperwork Check List for Manfred Pojar, July

1, 1999 (Feb. Hr’g Ex. 121). 1265 Id. at 298. 1266 Id.

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

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

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

One new account form suggests that most customers that lack

the requisite capital can easily open the account by claiming past

134

1267Momentum 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. 1269Feb. Hr’g Ex. 109, Risk Management, at 4. 1270Lee Dep. at 265–66.

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.

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:

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

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

135

1271 Id. at 258–60. 1272Feb. Hr’g Ex. 109, New Account Approval at 20, 29–30, 33–34. 1273 Id. at 20. 1274 Id. 1275 Id. 1276 Id. at 29–30. 1277 Id. at 29. 1278 Id. at 30.

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.

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

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

136

1279 Id. at 33–34. 1280 Id. at 33. 1281 Id. at 34. 1282Mr. 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. 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. 1289 Id. at 117–18. 1290 Id. at 118. Mr. Lee said that Ms. Ewton still works with Momentum today. Id.

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

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

(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

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

137

1291 Id. 1292 Id. 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.

exams.’’ 1291 During his deposition, however, Mr. Lee indicated that

he had very little knowledge about the audits performed by Ms.

Ewton:

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

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

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?

138

1297 Id. at 122. 1298 Id. at 116 (emphasis added). 1299Feb. Hr’g Ex. 105. 1300Lee Dep. at 319; Momentum Securities, Inc., ‘‘Preliminary Results,’’ Feb. 1999 (‘‘Texas

Facts’’) (Feb. Hr’g Ex. 123).

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

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.

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 pubVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00142 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1301Feb. Hr’g Ex. 123, at 2. 1302 Id. 1303Lee 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. 1304Feb. Hr’g Ex. 123, at 2. 1305Lee Dep. at 339. 1306Feb. Hr’g Ex. 123, at 5 (emphasis in original). 1307 Id. at 4–7 (emphasis omitted).

lic 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

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

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

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 exVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00143 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1308Lee Dep. at 339. 1309 Id. at 342. 1310Momentum 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. 1311Feb. Hr’g Ex. 123, at 4. 1312Lee Dep. at 346. 1313 Id.

pected 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

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:

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

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.

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

141

1314 Id. at 206–207. 1315Momentum 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). 1316Lee Dep. at 207–21. 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. 1322 Id. at 208. 1323 Id. 1324 Id. at 220. 1325 Id. 220–21.

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

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

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.

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

142

1326Letter 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.

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

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.

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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.’’

(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.

(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

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ing. 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 speVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00148 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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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). 1331The NYSE rule change uses slightly different language but is substantively the same. 1332Meeting with NASDR officials, Dec. 28, 1999.

cial 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.

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 daytrading [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

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

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1333Meeting with SEC officials, Dec. 17, 1999. 1334Telephone Conversation with NASDR official, Feb. 4, 2000. 1335The 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.’’

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.

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.

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

147

1336Lefkowitz Int. at 2; Shefts Int. at 8. 1337Lefkowitz Int. at 2 . 1338Shefts 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. 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. 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.

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:

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

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:

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. ThereVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00151 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1343Letter 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).

fore, Cornerstone places more emphasis in sufficient opening account equity than on income or general net

worth.1343

(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,

149

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 twentynine 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 leVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00153 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1344Deposition of Barry Parish, Nov. 30, 1999, at 94 (‘‘Parish Dep.’’). 1345Parish Dep. at 95–96. 1346 Interview of Justin Hoehn, Dec. 21, 1999, at 2 (‘‘Hoehn Int.’’).

veraged 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.

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

151

1347 Interview of Tae Goo Moon, Dec. 9, 1999, at 7 (‘‘Moon Int.’’).

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

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 discreVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00155 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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1348Mr. Cao claimed to have day traded for twenty-one or twenty-two customers. Cao Dep.

at 136. 1349Le Int. at 2, 6. 1350 Id. 1351For 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.

tionary 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

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 proVerDate 11-MAY-2000 02:39 Aug 03, 2000 Jkt 079010 PO 00000 Frm 00156 Fmt 6659 Sfmt 6602 E:\HR\OC\SR364.XXX pfrm01 PsN: SR364
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motion 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.

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