U.S. GOVERNMENT PRINTING OFFICE

61–159 cc WASHINGTON : 2000

S. Hrg. 106–285

DAY TRADING: AN OVERVIEW

HEARING

BEFORE THE

PERMANENT

SUBCOMMITTEE ON INVESTIGATIONS

OF THE

COMMITTEE ON

GOVERNMENTAL AFFAIRS

UNITED STATES SENATE

ONE HUNDRED SIXTH CONGRESS

FIRST SESSION

SEPTEMBER 16, 1999

Printed for the use of the Committee on Governmental Affairs

(

For sale by the Superintendent of Documents, Congressional Sales Office

U.S. Government Printing Office, Washington, DC 20402

(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, Administrative 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

Opening statements: Page

Senator Collins ................................................................................................. 1

Senator Levin .................................................................................................... 4

Senator Cleland ................................................................................................ 5

WITNESSES

THURSDAY, SEPTEMBER 16, 1999

Hon. Arthur Levitt, Jr., Chairman, U.S. Securities and Exchange Commission, accompanied by Robert L.D. Colby, Deputy Director, Market Regulation, Securities and Exchange Commission ....................................................... 7

Mary L. Schapiro, President, NASD Regulation, Inc., Washington, DC ............. 19

Peter C. Hildreth, President, North American Securities Administrators Association, Washington, DC, accompanied by David Shellenberger, Chief of

Licensing, Commonwealth of Massachusetts Securities Division, Boston,

Massachusetts ...................................................................................................... 22

Saul S. Cohen, Consulting Counsel, Electronic Traders Association, New

York, New York .................................................................................................... 35

ALPHABETICAL LIST OF WITNESSES

Cohen, Saul S.:

Testimony .......................................................................................................... 35

Prepared statement, with attachments .......................................................... 178

Hildreth, Peter C.:

Testimony .......................................................................................................... 22

Prepared statement, with attachments .......................................................... 167

Levitt, Hon. Arthur, Jr.:

Testimony .......................................................................................................... 7

Prepared statement .......................................................................................... 55

Schapiro, Mary L.:

Testimony .......................................................................................................... 19

Prepared statement with attachments ........................................................... 79

Shellenberger, David:

Testimony .......................................................................................................... 22

EXHIBITS

* May Be Found In The Files of the Subcommittee

1. Fall 1999 Adult Education Program, Gardiner, Maine, highlighting the

course ‘‘Day Trading For Beginners’’ .............................................................. 213

2. Picture of road sign seen by Senator Carl Levin on freeway exit in

Detroit, Michigan, ‘‘Day Traders—Learn To Trade Futures & Options

On-Line—1–800–704–7071’’ ............................................................................. 215

3. Two print outs from TCI Corporation’s Web site ........................................... 216

4. Print out from All-Tech Investment Group, Inc.’s Web site .......................... 218

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

6. Supplemental answer provided for the record by Robert L.D. Colby, Deputy Director, Division of Market Regulation, Securities and Exchange

Commission, regarding Day Trading Margin Requirements ........................ 221

7. Securities and Exchange News Release, dated September 16, 1999, SEC

Investor Alert—Day Trading: Your Dollars At Risk ...................................... 225

Page

IV

8. North American Securities Administrators Association, Inc. (‘‘NASAA’’),

Day Trading Program Report, dated August 9, 1999 (Three parts: (1)

Findings and Recommendations, (2) Appendix, and (3) Analysis prepared

by Ronald L. Johnson, Investment Consultant, entitled ‘‘Day Trading—

An Analysis of Public Day Trading at a Retail Day Trading Firm’’) ........... *

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

10. Memoranda prepared by K. Lee Blalack, Chief Counsel and Staff Director, Brian C. Jones, Investigator, and Wesley M. Phillips, Investigator,

Permanent Subcommittee on Investigations, dated September 14, 1999,

to Permanent Subcommittee on Investigations’ Membership Liaisons,

regarding September 16 Hearing: Day Trading: An Overview ................... 246

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DAY TRADING: AN OVERVIEW

THURSDAY, SEPTEMBER 16, 1999

U.S. SENATE, PERMANENT SUBCOMMITTEE ON INVESTIGATIONS, OF THE COMMITTEE ON GOVERNMENTAL AFFAIRS, Washington, DC.

The Subcommittee met, pursuant to notice, at 9:37 a.m., in room

SD–628, Senate Dirksen Office Building, Hon. Susan M. Collins,

Chairman of the Subcommittee, presiding.

Present: Senators Collins, Levin, and Cleland.

Staff Present: K. Lee Blalack, Chief Counsel and Staff Director;

Mary D. Robertson, Chief Clerk; Glynna Christian Parde, Chief Investigator and Senior Counsel; Kirk E. Walder, Investigator; Brian

C. Jones, Investigator; Wesley Phillips, Detailee/GAO; Eileen M.

Fisher, Investigative Assistant; Elizabeth Hays, Staff Assistant;

Linda Gustitus, Minority Chief Counsel; Leslie Bell, Congressional

Fellow; Anne Bradford (Senator Thompson); Brian Benczkowski

(Senator Domenici); Michael Loesch (Senator Cochran); Felicia

Knight and Steve Abbott (Senator Collins); Seema Singh and Gregory Thomas (Senator Specter); Nanci Langley (Senator Akaka);

Lynn Kimmerly, John Brownlee, Michael Andel, and Andrew

Vanlandingham (Senator Cleland); Darla Silva (Senator Durbin);

and Peter Ludgin and Diedre Foley (Senator Lieberman).

OPENING STATEMENT OF SENATOR COLLINS

Senator COLLINS. The Subcommittee will come to order.

I would like to thank our witnesses for braving the hurricane to

be with us here this morning. I know that for some of you, who are

coming some distance, that was indeed a challenge, and I appreciate the efforts that you have made to be with us today.

We convene the first congressional hearing on day trading. This

hearing is the first in a series that the Permanent Subcommittee

on Investigations will hold on this subject.

Today’s hearing will provide an overview of the day-trading industry, while subsequent hearings will highlight case studies developed during our on-going investigation. These hearings continue

the tradition of the Subcommittee of investigating issues affecting

small investors.

Unlike traditional investing, day trading involves taking positions in stocks for very short periods of time, usually minutes or

hours, but rarely longer than a day. One day trader was recently

quoted as saying, ‘‘Wall Street’s not about investing anymore, it’s

about numbers. Who cares whether [the stock] is a car company or

2

1See Exhibit No. 1 on page 213 in the Appendix.

a chemical company? Who cares what they’re going to be doing in

[the year] 2000?’’

Day traders seek to profit in small increments from moment-tomoment fluctuations in the stock’s price. The firms that cater to

day traders provide high-speed computer access and real-time market quotes, which are necessary to rapidly take advantage of small

changes in stock prices.

The technology revolution that is affecting so many aspects of

American life is also changing, in a very fundamental way, the relationship between the ordinary investor and the markets. New

technology now allows investors to access the markets directly

without the aid, or the advice, of a broker-dealer, something that

was previously limited to a relatively small number of professional

traders. This dramatic change in access raises a host of questions

for Federal and State regulators, for the security industry, and for

investors.

Ironically, the three developments that have made day trading

possible are otherwise very positive for investors. The first is the

ability to execute transactions at the investor’s convenience using

the Internet. The second is dramatically lower commissions, and

the third is greatly expanded access to financial information, including documents such as a company’s Form 10–K contained in

the SEC’s EDGAR system.

I should emphasize that day-trading firms differ significantly

from traditional brokerage houses, and even from the discount brokerage industry. Online discount brokerage firms, such as Charles

Schwab, do not provide their customers with direct access to the

trading floor.

Moreover, the Subcommittee recognizes that the use of the Internet to obtain information about investing or to place, buy, and sell

orders has given consumers substantially greater access to financial information and investment opportunities previously available

only to industry professionals. Day trading, however, raises serious

concerns unrelated to the use of the Internet for trading or as a

source of financial information.

I would like to show something that illustrates why it is so imperative for the investing public to better understand day trading

and its risks.1 This course, and you can see the cover of the Adult

Education leaflet that was circulated, is from an adult education

program in Gardiner, Maine. It was recently sent to me by one of

my constituents. As you can see from the course offerings, folks in

Gardiner, Maine, can learn from their adult education course dried

floral arranging, perennial gardening, and Christmas wreath design, and for a fee of only $5, they can go to the local high school

and attend Day Trading for Beginners.

The very fact that adult education programs in small communities like Gardiner, Maine, might be teaching day-trading strategies reflects the increasing pervasiveness and popularity of the

day-trading phenomenon and the degree to which it is being presented to ordinary investors as just another bona fide investing

strategy. As an interesting side note, this particular course was

canceled after the tragic shooting by the Atlanta day trader.

3

Our hearing today will attempt to answer three questions. First,

is day trading really nothing more than gambling? To answer this

question, the Subcommittee is examining the profitability of day

trading, the risks involved, and the responses to this development

from the industry and the regulators.

Policymakers need to know whether day-trading firms teach investing or simply another form of card counting. Many day-trading

firms provide seminars for customers who wish to learn day-trading strategies. These seminars generally run for only several days

and cost anywhere from $1,500 to $5,000. One such course is called

‘‘1–800 RetireNow!’’ Enticed by such exaggerated promises, some

individuals who complete these courses actually give up their careers to day trade full time.

Now, very few Americans would think it prudent to quit their

jobs or to cash in their retirement savings to become professional

gamblers who support their families at a Las Vegas casino. Yet, the

day-trading industry estimates that nearly 5,000 citizens are fulltime day traders. The SEC’s estimate is even higher.

For example, a 28-year-old bank employee in California left his

job and borrowed $40,000 from credit cards to become a day trader,

only to lose all of his money day trading within 2 months. This

young man is now deeply in debt and living with his parents.

In Chicago, a waiter with no investment experience became a

day trader and lost an inheritance of more than $200,000. The

waiter told the Subcommittee staff that many of the people with

whom he day-traded knew as little about investing as he did.

In Boston, an elderly man with severe health problems lost about

$250,000 of his wife’s savings in just a few hours at a day-trading

firm.

The second important question is whether some day-trading industry firms are engaged in deceptive and fraudulent practices,

and if so, how pervasive is this misconduct? State regulators have

charged the day-trading industry has engaged in widespread

abuses, including deceptive advertising, trading by unregistered

broker-dealers, and violations of rules relating to suitability and

margin requirements. Although several day-trading firms settled

cases brought by State regulators, the industry as a whole strongly

contests these findings. We will hear testimony on these general

issues today, while the Subcommittee continues to investigate the

practices of specific day-trading firms.

The third question that is central to our inquiry is what is the

impact of day trading on individual companies and the markets?

The industry’s own estimates indicate that between 10 and 15 percent of the daily volume on the NASDAQ exchange is attributable

to day trading. Now, some critics argue that day trading increases

and creates excessive market volatility. Other observers, however,

contend that day trading increases market efficiency and liquidity,

while still others believe that day trading simply has had very little impact on the markets. By the conclusion of our investigation,

the Subcommittee hopes to have a much better understanding of

the economic impact of day trading on the markets and capital formation.

Finally, let me add that I convene this hearing highly skeptical

of day trading, but not as an advocate for banning the practice altoVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
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1See Exhibit No. 2 on page 215 in the Appendix.

gether. State securities regulators have estimated that more than

70 percent of day traders lose money and only about 12 percent

demonstrate the capacity to be successful. I find those statistics to

be very troubling.

These figures also raise critical questions about whether investors are truly informed of the risks involved or whether they are

simply being fleeced by some unscrupulous day-trading company.

If an investor is fully aware of the risks and decides to engage

in day trading anyway, that is his choice. If, however, a day-trading company fails to disclose the risks and entices the unsophisticated investor with deceptive advertisements and exaggerated

claims, that is quite another matter.

While we are confronted with many complex issues today, we are

very fortunate to have an outstanding group of witnesses to assist

us as we attempt to sort through the conflicting claims about day

trading. I particularly look forward to hearing testimony from the

Securities and Exchange Commission Chairman and the National

Association of Securities Dealers Regulation President about their

recent examination of more than 60 day-trading firms. The preliminary results of these examinations will be released for the first

time at our hearing today.

It is now my pleasure to recognize my distinguished colleague

and the Ranking Minority Member of this Subcommittee, Senator

Levin, for his opening statement.

Thank you.

OPENING STATEMENT OF SENATOR LEVIN

Senator LEVIN. Thank you, Madam Chairman, and thank you for

your leadership in trying to protect American consumers.

Earlier this year, this Subcommittee held hearings on sweepstakes, and today, we are talking about day trading. To me, they

fall under the same category of business practice, which involves

enticing consumers with the promise of quick money.

Many of us would love to get rich quickly and retire young, and

when you are told that there is a ready-made investment system

that holds out quick and large returns, the instinct to jump aboard

and try it out is there for many people. What can be overlooked,

however, is the fact that the system being promoted does not involve investment in the sense that we know it and understand it,

and that it does involve significant risk.

Once in the system, when you realize that you are starting to

lose money and think perhaps that this is not the right business

to be in, you can be enticed to recover your losses by borrowing

money and making more trades. That is a sketch of day trading,

and its visibility and allure to the public is growing.

Just the other day, I was exiting a freeway near my home in Detroit, and I came across a sign on a fence at the exit ramp.1 In big

bold letters, it announces ‘‘Day Trading’’ and gives an 800 number

to call.

Now, that particular notice does not use any promotional language other than getting people to notice the name and the number, but it shows just how pervasive this allure to day trading is

5

1See Exhibit No. 3 on page 216 in the Appendix.

that they put signs on fences for people to see if they can get them

to call 800 numbers to get into the system.

Too many firms, once people make that original contact, entice

consumers with deceptive and misleading advertisements, such as

‘‘earn 12 percent per day before a commission’’ and ‘‘6 to 7 figure

income per year.’’ One company claims to have a ‘‘trading system

with a profit-to-loss ratio of 12 to 1 and an average return better

than 18 percent per trade before slippages.’’ 1

Moreover, it claims that no experience is needed, and when

asked by State regulators to prove those claims, the company, TCI,

could not do it. Apparently, most day traders lose money.

Regulators have said that day traders must make a 56-percent

profit just to cover commissions and fees. A recent report by the

North American Securities Administrators Association revealed

that at one branch office, over 70 percent of the traders lost money.

In analyzing the trading strategy used through the types of

trades made, the report concluded that the majority of traders appeared to use strategies which engendered 100-percent risk of loss.

Day trading is not investing, and most people, even in the daytrading industry, acknowledge that. The SEC says it is gambling.

Given the estimate referred to in the testimony of the North

American Securities Administrators Association that 70 percent of

day traders lose money, you would have a better chance of playing

the slot machine.

Now, if day trading is gambling, and it sure looks like it to this

outsider, and more importantly, if it is gambling as is stated by the

SEC, a key insider, then on-site firms are gambling casinos and

should be regulated as such.

We have rules in the securities industry with respect to suitability and margin requirements in order to protect consumers. If

these rules are not sufficiently protective of persons solicited for

and engaged in day trading, I hope that we can develop legislation

and enact legislation which will protect those consumers.

Again, I want to thank you and commend you, Madam Chairman, for your leadership in another area where there is just too

much consumer abuse going on in this country.

Senator COLLINS. Thank you very much, Senator Levin.

I am now pleased to call on Senator Cleland. Senator Cleland

and I both in previous life were involved in securities regulations

of State officials, and he has been an active participant in all of our

investigations on securities issues.

OPENING STATEMENT OF SENATOR CLELAND

Senator CLELAND. Thank you, Madam Chairman.

Ladies and gentlemen, welcome to this hearing.

I am intrigued by the comments by the distinguished Senator

from Michigan, Senator Levin, and marvel at the insight of our

wonderful Chairman here who has decided to focus on a very fascinating issue of the world of securities and investments in America. I am delighted to be here at this hearing.

Let me just say that tragically enough, I have a personal interest

in the whole issue of day trading. Maybe the good news first. The

6

good news is I was securities administrator in Georgia for 12 years,

and my Administrative Assistant today in the Senate is Wayne

Howell who was the Assistant Commissioner of Securities in Georgia for 12 years—but we had a tragic incident in Atlanta.

We had a situation in which an individual killed his family members and then came in with guns ablazing into two different office

complexes killing and maiming a number of other people that he

day-traded with, and then after being apprehended off of an interstate north of Atlanta, killed himself after losing almost half-a-million dollars as a day trader.

That is an incredible situation. It has been discovered that in one

3-day binge, this day trader lost $153,000, according to a trading

report from Momentum Securities in Atlanta. Ultimately, his losses

totalled a half-a-million dollars.

In the wake of the shootings, the news reports and other studies

have led me to the conclusion, the risks associated with day trading are extremely serious. While many day traders are aware of the

possibilities of large losses, some are not.

The interesting thing about going to Las Vegas is it is sometimes

called ‘‘Lost Wages,’’ and that people understand they can go in, in

a $20,000 car and come out in a $200,000 bus, but people who daytrade are not necessarily aware of those kind of risks.

The recent tragedy in Atlanta showed us just how stressful day

trading can really become. Traders without the proper experience

or training are at the greatest risk of losing their entire portfolios.

I do not think most people who day-trade are aware of that.

I believe I do echo the sentiments of my colleagues on this Subcommittee when I state that there is an obvious need, as stated by

our Chairman and our Ranking Minority Member, and I state that

there is a great need to take a closer look at this issue.

Specifically, I am concerned with an apparent abuse of existing

regulations by many day-trading firms, as highlighted in the North

American Securities Administrators Association Day Trading Report.

My Administrative Assistant now, who was the assistant administrator for securities in Georgia, is a former head of the North

American Securities Administrators Association.

So I am optimistic that in addition to shedding light on the problems associated with this segment of the securities industry, this

hearing will act as a catalyst for increased cooperation between

representatives of the trading firms, regulators, and investors.

Such cooperation, I think, is essential to ensuring the continued viability of this practice, while also protecting the interest of the

American people.

We used to say in our office in Atlanta, and in Georgia, to our

investing public, if it sounds too good to be true, it probably is too

good to be true, and that caution should certainly be applied to day

trading.

Madam Chairman, I am glad to be with you today and look forward to our panelists.

Senator COLLINS. Thank you very much, Senator.

I am pleased to welcome our first witness this morning, the Hon.

Arthur Levitt, the Chairman of the Securities and Exchange ComVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
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1The prepared statement of Mr. Levitt appears in the Appendix on page 55.

mission. Chairman Levitt is now in his second term at the SEC,

and he is the longest-serving SEC Chairman in history.

I also want to add as a comment that I think of all the SEC

Chairmen in history that there is no one who has been more dedicated to educating the small investor than Chairman Levitt, and

I commend him for the emphasis that he has placed on that important duty.

We were here previously in this Subcommittee and heard testimony from Chairman Levitt on the persistent problem of fraud in

the micro-cap markets. We benefited tremendously from his testimony then, and we look forward to hearing his views on day trading as well.

I would note that the SEC has just announced today that they

will be posting an investor alert on day trading on their Web page.

I think that is an excellent example of the Chairman’s commitment

to investor protection, and I look forward to hearing his testimony.

Pursuant to Rule 6 of the Subcommittee, all witnesses who testify are required to be sworn in. So, at this time, I would ask

Chairman Levitt to stand and raise his right hand.

Do you swear that the testimony you are about to give to the

Subcommittee will be the truth, the whole truth, and nothing but

the truth, so help you, God?

Mr. LEVITT. I do.

Senator COLLINS. Thank you.

Please proceed. We would ask that you attempt to limit your formal testimony to 10 minutes to allow time for questions.

TESTIMONY OF HON. ARTHUR LEVITT, JR.,1 CHAIRMAN, U.S.

SECURITIES AND EXCHANGE COMMISSION; ACCOMPANIED

BY ROBERT L.D. COLBY, DEPUTY DIRECTOR, MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION

Mr. LEVITT. Chairman Collins, Senator Levin, Senator Cleland,

and Members of the Subcommittee, thank you for the opportunity

to be here this morning to discuss day trading and its impact on

our Nation’s securities markets.

This hearing could not be more timely. It seems almost every day

we hear one story or another about day trading. As we speak, the

Commission is conducting examinations of day-trading firms. I will

have more to say about this in a moment, but let me begin by stating the obvious.

Technological developments are revolutionizing our capital markets from how people invest to how brokers do business to how our

markets function. Today’s individual investor, for example, has

ready, instant access to market data, and in some cases markets,

that up until a few years ago was available only to securities professionals.

One of the byproducts of this revolution has been the emergence

of the day trader. Through the use of sophisticated computer software, day traders sit in front of computer screens and look for

nothing more than real-time price movements.

What it is that they are buying or selling is of absolutely no concern to them. The coin of the realm for the day trader does not exVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00011 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
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tend beyond volatility. If you sense a stock will rise, buy. And if

you sense that it might fall, sell. That is the strategy of day trading. It is not illegal, it probably is not unethical, but it is highly

risky.

In recent months, I have been asked more than once why the

SEC cares whether a day trader loses his or her money. It is their

life, and it is their choice, but I do not think that is the issue.

I am concerned that many day traders do not fully understand

the level of risk that they are assuming. I am concerned that many

people may be lured into the false belief that day trading is a surefire strategy to make them rich, and, when individuals are swayed

by misleading advertising, the Commission has a duty to act.

That is why I believe we should be focusing on the advertising

and marketing practices of a number of day-trading firms. It is in

this area that I believe that the Commission’s partnership with the

States and State regulators is absolutely crucial. A number of

States have been leaders in addressing this issue not just as a matter of securities law, but more importantly, as a matter of consumer protection.

The NASD also has proposed rules that are designed to address

the sales practices of day-trading firms. This proposal will require

these firms to disclose up-front risks associated with this activity

and to screen potential day traders to determine suitability. Eliminating deceptive marketing and advertising practices is a large

part of the solution. Another is how day-trading firms comply with

the law.

The Commission is in the process of completing an examination

sweep of day-trading firms. Our preliminary findings indicate that

many of these firms have extremely lax compliance practices. The

inability of some firms to monitor their adherence to the capital,

margin, and short-sale rules or to maintain adequate books and

records, raises very serious concerns. These rules, in many ways,

go right to the heart of the integrity of our markets and market

participants.

The Commission intends to vigorously pursue any violations of

law and has a number of enforcement investigations underway.

The use of margin in particular raises a number of issues.

We found that many day traders do not fully appreciate that, by

borrowing to buy securities, they can actually lose substantially

more than their initial investments. So when day-trading firms aggressively promote the lending of equity between day traders to

cover margin deficiencies, I find it very troubling. We are reviewing

the practice to ensure that firms are following the law and are fully

disclosing to customers the risks of day trading on margin.

The SEC can regulate, and the Congress can probably legislate

if they wish, but if an individual does not take the personal responsibility to be informed of the risks involved in day trading, I believe

that no rule or law will ever fully protect him or her.

I do not minimize, in any way, the responsibility of the firm to

fully disclose the risks involved, but day traders really need to take

the time to consider what they are getting themselves into.

I commit to you that the SEC will do everything it can to ensure

that day-trading firms are operating within the boundaries of the

law, but I sincerely hope that individuals considering this type of

9

strategy do their homework before risking their hard-earned

money. Thank you.

Senator COLLINS. Thank you very much, Chairman Levitt.

Day trading has really arisen out of a booming stock market and

an unprecedented access to technology. On some days, it is the

dark side of the booming stock market.

However, the boom is not going to go on forever. What is going

to happen if stock prices plunge to people who have given up their

careers and are day-trading full time when we know already, on

the basis of some preliminary studies, that the profitability is very

questionable in a booming stock market?

Mr. LEVITT. Just from my own experience and in our markets,

having lived through more cycles than most present investors have

ever experienced, I would say that my expectation would be that

many day traders will be completely wiped out, and most, the vast

majority of day traders, will endure punishing losses. But the discipline of the marketplace will do more to dis-abuse investors of the

notion of easy profits by day trading than almost anything else we

can do.

Senator COLLINS. The day-trading industry has been very critical

of a report that was issued by the State regulators association,

NASAA, and has criticized it as focusing on one branch office that

was badly run of one day-trading firm. However, we now have considerably more data to look at as a result of the examinations that

NASDR and the SEC have conducted, which I understand you have

some preliminary results from.

It is my understanding that together you have examined around

67 day-trading firms. Could you share with us what the preliminary results of your examinations have been and whether the findings from those examinations have supported the conclusions of the

NASAA report or not?

Mr. LEVITT. I think that the NASAA effort is absolutely critical

to anything that we hope to accomplish in terms of eliminating

some of the really bad practices of day trading.

Our joint investigation and examination done with the NASDR

resulted in approximately 10 referrals to the Enforcement Division

for scrutiny. I find that worrisome. That is a very high percentage

of referrals, and clearly, there is a problem.

Senator COLLINS. Can you give us some further idea of the types

of problems that your investigators found?

Mr. LEVITT. Some of the problems involved the use of margin.

Some involve lending deficiencies, short sale violations. There were

some net capital violations, including both incorrect computations

and net capital deficiencies. We observed a number of advertising

violations, including failures to obtain NASD approval of advertising and potentially the kind of misleading advertising that you

have cited before.

We noted supervision deficiencies, including instances where

there were no written procedures and deficient supervision with respect to lending, review of branch offices and short sale activity.

We also found books and records violations where firms were simply sloppy in basic procedures. These were the areas that came to

light during these recent examinations.

10

1See Exhibit No. 4 on page 218 in the Appendix.

Senator COLLINS. Would it be fair to say, then, that many of the

problems uncovered by your examiners were similar to those that

were found by the State regulators?

Mr. LEVITT. I think there clearly was some overlap, yes.

Senator COLLINS. I would like to turn to the issue of appropriateness or suitability. When a broker in a traditional brokerage house

recommends a stock, the broker has to determine its suitability for

the investor and does a review of the investor’s investment objectives, financial status. Those kinds of issues are carefully reviewed.

By contrast, it is my understanding that day-trading firms currently do not do any sort of suitability review. Is that correct?

Mr. LEVITT. I am not aware of any suitability reviews that are

being engaged in by day-trading firms. I can recall, again, in my

days as a stockbroker, when a client came in who was overly aggressive, we were very concerned about the appropriateness of

their embarking on that kind of activity.

We have asked the NASD to take a look at this issue because

I think—I certainly feel that there is a responsibility on the part

of any firm to see to it that individuals who clearly are not in a

position to engage in that kind of activity, to take that kind of

risk—an individual, for instance, a retired person, who depended

for his or her very survival on a return from their investments—

are not allowed to day trade. That, I would regard as absolutely irresponsible. The NASD is examining this, and I believe they will

have some very specific recommendations in that regard.

Senator COLLINS. I would like to follow up on that point by showing you an exhibit that suggests to me that some day-trading firms

may actually be targeting people who are not suitable for day trading, who are unsophisticated investors, or who simply would be

taking risks that they cannot afford to take.

This particular exhibit is a marketing pitch by All-Tech, and I

think it illustrates my concern. This was on All-Tech’s Web site as

of July 26 of this year, and in case it is difficult to read, I am just

going to read through it. It says, ‘‘Electronic day trading attracts

people dead-ended or unhappy in their current field of endeavor

and people with a desire to make trading their life’s work.’’ 1

This is the part that concerns me: ‘‘Electronic day trading appeals to executives, victims of downsizing or layoffs, retirees, graduating students, and anyone who recognizes the unlimited earning

potential and quality of life which day trading may achieve.’’

Is day trading generally appropriate for someone who has been

laid off from his job or has just graduated from college?

Mr. LEVITT. Absolutely not.

Senator COLLINS. So would this be the kind of advertising pitch

that would concern the SEC or—I realize the NASDR has been delegated the authority to review such matters.

Mr. LEVITT. Without regard to the Nation’s securities laws, just

as a private citizen, I find that kind of advertising absolutely appalling. It is a plea to the worst instincts of people who might otherwise be spending their time in casinos rather than in engaging

in that practice. I think it is very, very bad.

11

1See Exhibit No. 3 on page 216 in the Appendix.

What the NASD is considering is requiring day-trading firms to

determine whether day trading is appropriate for particular customers.

Senator COLLINS. And it is my understanding those proposed

rules are now before the SEC or have just been submitted to the

SEC for review. Is that correct?

Mr. LEVITT. We have published them for comment.

Senator COLLINS. So they are now in the public comment phase?

Mr. LEVITT. Yes.

Senator COLLINS. Unfortunately, we have a vote that has just

begun. I am going to yield to Senator Levin for questions and go

vote, and we will hope to keep the hearing going between us.

Thank you.

Senator LEVIN [presiding]. Thank you.

While Senator Collins’ chart is up there, the unlimited earnings

potential, do you have any comment about unlimited earnings potential?

Mr. LEVITT. Unlimited loss potential would be more appropriate.

[Laughter.]

Senator LEVIN. I would like to put up another picture from a

Web site of a company called TCI.1 You have a provision in the Securities Act and a rule which prohibits deceptive practices, including material misstatements and omissions.

This firm, I do not think actually is a broker. This firm is a

trainer of day traders. It allures people with these promises here

of what day trading can do for them.

It says their potential earnings, 6 to 7 figure income per year,

and then later down on the screen, it says no experience, no selling, no boss, no employees, no inventory, no traveling, no invoice

collection. All you need is a computer and a small amount of startup capital. That is all that you need.

Now, would you agree that is a misleading advertisement?

Mr. LEVITT. Yes.

Senator LEVIN. The Massachusetts Attorney General got a ceaseand-desist order against TCI for that statement. We then went to

the TCI’s Web site in preparation for this hearing to see what they

are saying now, and here is what we found. This is as of yesterday.

This is after a cease-and-desist order against them. ‘‘The absolute

best and most mechanical trading system that we know of in the

financial market with a profit-to-loss ratio of 12 to 1 and an average return better than 18 percent per trade before slippages.’’

Do you believe that day trading will produce a profit-to-loss ratio

of 12 to 1?

Mr. LEVITT. I think that claim is ridiculous.

Senator LEVIN. Now, this firm trains people, allegedly. I do not

know if that is the word I would pick, but, nonetheless, shows people how to day-trade, and, yet, I do not know that it is subject to

SEC enforcement. It is, I think, to State enforcement, but because

they do not do the actual trading for the person, but train the person, I think we have to find a way in our law nationally, federally,

to get at that kind of misrepresentation.

12

I am wondering whether or not there is anything you are considering which would get to this situation where TCI is not engaged

in the actual brokerage operation, but is misleading and using deceptive advertising in order to try to lure people into buying their

course. Is there anything you are considering which would get at

this?

Mr. LEVITT. As you have noted, because TCI is not a broker, not

registered with the SEC, we would have to prove that the ad is

fraudulent in connection with a securities transaction. We would

certainly examine that connection with this or any other advertising that really goes beyond the pale as this one does.

Senator LEVIN. You have to show that there is fraud in relation

to a specific transaction.

Mr. LEVITT. Yes.

Senator LEVIN. But if there is fraud in relation to a process of

trading, then the current law at least would not seem to cover that.

Is that correct?

Mr. LEVITT. I believe so.

Senator LEVIN. And that is one of the issues that we need to face

because these are not specific transactions that are being promoted.

Mr. LEVITT. It is a process.

Senator LEVIN. It is a process which is being promoted, and that,

it seems to me, is one of the big issues we should address, to get

at that problem that we are now dealing with a process which is

being held out too often as a process of big returns, and where

there are deceptive representations about that process. We have

got to find a way to get at the representation, even though it does

not relate to a specific stock transaction. Would you agree that

would be a——

Mr. LEVITT. Yes.

Senator LEVIN. OK. Now, on the issue of margin—well, no. Let

me go back to the suitability requirement because this relates to

this same process question that we were just talking about.

Is the current suitability requirement that a broker determine

whether an investment is suitable for a customer—is that what the

suitability requirement is in general?

Mr. LEVITT. Yes.

Senator LEVIN. All right. Would that requirement then apply to

whether a process is suitable for a customer or only whether a specific transaction is suitable for a customer?

Mr. LEVITT. I believe that the process would be covered by suitability requirements. In other words, again, a broker or a firm that

took an elderly widow with limited resources and allowed that person to engage in a strategy such as this would run afoul of——

Senator LEVIN. Of the current suitability rule.

Mr. LEVITT. Yes.

Senator LEVIN. All right. Now, who makes the determination on

suitability? Is it the broker, or is it the customer?

Mr. LEVITT. I think it is the broker that has the responsibility.

Senator LEVIN. That responsibility falls on the broker to make.

Mr. LEVITT. Yes.

Senator LEVIN. OK. Now, on the margin issue, I do not know

that there has been a survey of this, but do you believe that the

average new day trader understands that he or she would be subVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
13

ject to a margin call if that day trader buys too much stock on margin during a day even if at the end of the day the day trader no

longer holds that stock and even if the day trader did not lose

money on that stock transaction, indeed maybe made a profit?

Would the average new day trader realize that the margin rules

apply to a position at a moment in time during the day?

Mr. LEVITT. My guess, again, based on my own experience handling retail customers, is that the typical customer does not understand and is often surprised by that.

I have also been corrected, Senator, in response to an earlier

question which I would like to call to your attention. That is, that

today’s rule requires a broker to make sure the recommendation of

a security is suitable for the investor, but the NASD is expanding

that requirement now to include the recommendations of a strategy. So the rule today deals with the security. The rule, as will be

expanded if this proposal is approved by the Commission, would include strategies.

Senator LEVIN. All right. I think that is a very important change.

I was not sure, but that was my understanding, too. So I am glad

that you have clarified that point because that is a critical issue.

That is now under consideration?

Mr. LEVITT. Yes. That has been put out for public comment.

Senator LEVIN. Now, going back to margin, assume a situation

where someone who has a $50,000 equity capital investment is allowed to buy $100,000 with that $50,000, so there is a margin of

$50,000 using somebody else’s money. They are in and out in a day.

Assume that there is no loss on the transaction, but at some moment in time during that day, the person had a purchase of

$120,000, more than was allowed, even for an hour. What does the

margin rule provide in that situation? $50,000 in the account in

cash. At a moment in time, they were—$120,000 purchase, more

than is allowed by the rules, no loss at the end of the day because

it was sold, let’s say, for as much as it was purchased for, plus commissions or whatever. What, then, is supposed to be the result?

Mr. LEVITT. That is a violation of the margin rules.

This is Bob Colby who is the head of our division of Market Regulation. I would like him to respond to that, if I may.

Mr. COLBY. The New York Stock Exchange margin rules, which

apply to this trading for day traders, require them to take margin

on the largest position, short or long, outstanding at any point during the day, even if the trading is flat at the end of the day.

Senator LEVIN. What is the effect of that violation that I just outlined, if it was clear? Was I talking your language?

Mr. COLBY. Yes, but I did not get the numbers perfectly.

Senator LEVIN. Well, they had $120,000 position, I think you call

it.

Mr. COLBY. Yes.

Senator LEVIN. So they only had $50,000, let’s say, in the bank.

They are only allowed $100,000 under my hypothetical, but they

were $120,000.

Mr. LEVITT. They are in violation.

Senator LEVIN. Right, there is a violation, but what is the practical effect? Are they then required to increase their account to

$60,000? What happens?

14

1See Exhibit No. 6 on page 221 in the Appendix.

Mr. COLBY. They are required to put into the account enough

margin to cover their largest position.

Senator LEVIN. But it is done.

Mr. LEVITT. During the day, they should be asked for additional

funds.

Senator LEVIN. As a practical matter, does that happen where

broker firms dealing with day traders will ask people for funds for

an hour or 20 minutes?

Mr. LEVITT. It happens in our markets. It happens in the commodity markets all the time.

Senator LEVIN. Where people are actually asked right then, write

out a check, give me cash?

Mr. COLBY. They are asked at the end of the day.

Senator LEVIN. Not at the end of the day. The end of the day,

there——

Mr. COLBY. They are asked at the end of the day, which means

that they have to have the capability to come up with the funds

at the end of the day to cover that large position.

Senator LEVIN. And if they do not?

Mr. COLBY. If they do not, then the firm is in violation, and they

have to close the customer account down.

Senator LEVIN. So the customer must at the end of the day come

up with the $60,000, the extra $10,000?

Mr. COLBY. Margin to cover its largest position open during the

day.

Senator LEVIN. And if that customer does not have that $10,000,

under my hypothetical, at the end of the day, put in that account,

the account must be closed?

Mr. COLBY. That is right.

Senator LEVIN. OK. I am going to have to put us in recess just

for a few minutes to go vote.

I note that Senator Cleland wanted to ask you some questions,

and I know that the Chairman is going to be back for some additional questions. So if we could just ask you to stay there.

Mr. COLBY. Senator, I spoke too concisely on that. They are required to come up with it at the end of the day. They are required

to have that amount, but they do not have to get it in for 7 days.

Senator LEVIN. And if they do not get it in for 7 days——

Mr. COLBY. If they do not get it in 7 days, that is when the account is closed.

Senator LEVIN. The account must be closed. The word ‘‘closed’’ is

the word I am emphasizing.

Mr. COLBY. I believe it actually has to be frozen.

Senator LEVIN. At what level? Frozen so you cannot act on it?

Mr. COLBY. Yes, but I—could we supplement this?

Senator LEVIN. I have got to run. Can you figure out what the

right answer is? 1

Mr. COLBY. Yes. [Laughter.]

Senator LEVIN. Because I think there may not be any effective

penalty, and if there is no effective penalty, because there was no

loss, then it seems to me we have got a problem we also ought to

address as well, but let me run and come back.

15

We will stand in recess.

[Recess.]

Senator CLELAND [presiding]. The Subcommittee will come to

order.

May I just say that this is a scary moment in American history

with me in charge. [Laughter.]

I am on the Armed Services Committee also, and at one moment

of distress, everyone was gone and I was the last person sitting. I

had decided that instead of declaring war, we would just adjourn

for lunch. So that might be our best course today.

Chairman Levitt, you have decided to have a wonderful staff person join you at the table. I do not know whether I should swear

in the gentleman there. We will assume—I will make a command

decision. I will assume that you both will be truthful, as a good

staff person always is.

Chairman Levitt, would you just give us a little bit of insight

here on day trading? I thought I knew a little bit about securities,

again having been a securities regulator at the State level for a

dozen years, up until about 1996. I thought I knew the business

fairly well, though not the technicalities of it. As I mentioned to

Wayne Howell, my current administrative assistant, who was my

assistant administrator, Assistant Secretary of State for Securities

Regulation in Georgia, day trading seems to me a relatively new

phenomenon.

Is it a part of this whole world of e-commerce that we have

learned is revolutionizing our society, and that enables, shall we

say, a consumer, in this case an investor, to directly access a commodity, cars, books, in this case, stocks, and, therefore, bring to the

table in effect their own needs or whatever without going through

a whole series of professional standards, laws, regulatory environments that have been set up since 1934, say since the SEC was

created? Do you see this day trading as risky business, in effect

part of e-commerce, bypassing the normal regulatory environment

that was set up for people accessing the securities industry?

Mr. LEVITT. I think we have always had day traders in the securities industry. We have always had people who were prepared to

take extraordinary and, in some cases, foolish risks to make a

quick dollar. Clearly, a market such as we have experienced tends

to bring the more aggressive, less careful practices on the part of

individuals. We see more bad thinking and bad decisions than you

do during other kinds of markets.

We have also seen the technology changes that you have referred

to making it possible for traders to do what they never could have

done in the past because, with a few strokes of a key, they can buy

or sell hundreds of thousands of dollars worth of securities.

I think what that implies is kind of an emotional linkage there.

Our literature and our television and movies have stressed the

machismo of the trader, and individuals sitting behind their computer terminal begin to think that, well, they are as strong and

smart and willing to take risks as that revered professional trader.

What they do not know is that they lack the resources; they lack

the experience, and, perhaps most importantly, they lack the emotions of a professional.

16

1See Exhibit No. 4 on page 218 in the Appendix.

I think I mentioned before, that of the 30 examinations we have

completed of day-trading firms, a third of them have resulted in enforcement recommendations. That is a significant number, and

that, I think, substantiates your observations.

Senator CLELAND. I do not want to beat that point too much to

death, but I guess I am hypersensitive to the question of, shall we

say, the psychological mood of those who are attracted to get-richquick schemes just in general.

Senator COLLINS [presiding]. I am glad you did.

Senator CLELAND. I am in the middle of a question. Would you

like for me to continue my question?

Senator COLLINS. I would like you to continue. Thank you.

Senator CLELAND. It has to do with one of your charts.

Senator COLLINS. OK.

Senator CLELAND. If we could put that first chart back up.1

Chairman Levitt, again, I do not want to beat this to death, but

having lived through the Atlanta tragedy where a guy named Mark

Barton took a number of lives and went down with his ship and

ultimately took his own life, all in the space of a few days, I guess

I came onto several words here. It just jumped out at me. It attracts people who are dead end, unhappy in their current field, victim, layoffs, then, on the other side, the flip side, the real get-richquick part of it, the unlimited earnings potential. In other words,

on the one side, you have that kind of psychological profile—but on

the other side is gold.

Now, quickly—and that, as it has come to be discovered, was basically Mark Barton’s psychological profile, dead end, unhappy in

the current field, a victim, and all of a sudden day trading became

his way out, but it was his way down, and he took his family and

his associates—he went right back to the scene of his day trading

and started pulling the trigger. And as I recall—maybe I am incorrect, but as I recall, before he pulled the trigger with one of his fellow associates, he said, ‘‘I hope this does not spoil your day.’’

I mean, it seems to me that in this world of securities, there always has been that side of the securities industry that attracted

those who wanted to get rich quick and those things at the margin,

the boiler rooms that prey on the elderly with the nonexistent gas

stocks and oil stocks and so forth and gold mines, on the phone,

the penny stock ripoffs, that maybe this is in that genre.

I wonder, from your point of view, do you think it is the role of

Congress to require day-trading firms to live under the same auspices and under the same laws and regulations as, say, Merrill

Lynch?

Mr. LEVITT. I do not think so, Senator.

I think that the proposal now out there from the NASD to address the issue of suitability really goes a long way toward doing

that job.

I think hearings of this kind are terribly important in terms of

alerting the public to the fact that day trading is not the kind of

business that this ad would suggest.

The tragedy in Atlanta was one involving an aberrational personality that could have occurred with someone who had been to the

17

racetrack or casinos too often and taken out his frustrations in a

similar way in a different venue.

So I think that the important job that all of us have is to call

public attention to the fact that investors simply have to be careful;

that as far as I am concerned, it is a casino mentality that brings

people to day trading, and that the overwhelming numbers of people practicing day trading will lose their money, and it is not easy

money. It has always led investors to a very sorry ending. I do not

think legislation could be sufficiently pointed to go to the emotional

depths of individuals who have a predilection toward making the

easy dollar.

Senator CLELAND. I agree that Congress cannot be everyone’s

personal psychologist, but the attitude that it is their life and their

choice—I guess in my State the total laissez-faire attitude resulted

in a loss of life and a loss of choices for a number of people, and

somewhere in between, I think we have to find a reasonable solution.

Mr. LEVITT. I agree, Senator. I do not have a laissez-faire attitude about this, and I think the process that is being played out

today is critically important.

Senator CLELAND. You are so kind to comment and state with

such a strong and firm conviction your warning to American investors as you have done so beautifully.

Madam Chairman, I turn the hearing back to you.

Senator COLLINS. Thank you very much, Senator Cleland.

Chairman Levitt, I just have two final questions for you before

we move on to our next panel of witnesses.

First, I want to give you the opportunity to respond to criticisms

of the SEC’s efforts to crack down on some troubling marketing

and other practices of day-trading firms by giving you an opportunity to respond to Saul Cohen’s previous comments about the

SEC’s efforts. We will be hearing from Mr. Cohen later today.

In his written testimony today, he was very critical of the

NASAA study, but in previous writings, Mr. Cohen wrote an article

called ‘‘The Empires Strike Back, Part Two,’’ in which he also

sharply attacks the SEC for its efforts to oversee the day-trading

industry and to correct abuses.

Specifically, he labels the SEC’s policy regarding day trading as

‘‘a war’’ and accuses the SEC of resorting to intimidating examination tactics and of ‘‘coming down with hobnailed boots on day-trading firms.’’

I want to give you the opportunity to address those very pointed

criticisms.

Mr. LEVITT. The SEC historically has dealt with a number of constituencies that make up our great American capital markets, and

it has been the position of this Commission and I expect our predecessor Commissions, that no constituency is more important than

the individual investor.

At this point in time in the history of our country’s markets, with

more investors involved in equities today than ever before, it is essential that the SEC serve to protect investors and place their interests above those of firms, brokers, or anyone else in the system.

Part of the process is the collaboration of the commission with

the NASD and other self-regulatory organizations and State reguVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00021 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
18

1See Exhibit No. 6 on page 221 in the Appendix.

lators. I believe that the combined efforts of the SRO’s, the States,

and the SEC with a commitment to protecting investors in the

midst of a rapidly proliferating interest in gambling practices such

as day trading, has been a balanced effort and an important effort.

This effort, as part of our process, is exposed to public comment,

protects the interests of investors, is fair, and, I believe, is reasonable and balanced.

Senator COLLINS. Well, I want to go on record as commending

the SEC for its examination and consumer protecting efforts, as

well as the other regulatory bodies involved.

The comments of a prominent representative of the Electronic

Traders Association being so harsh towards the regulators raises

real questions in my mind about their willingness to correct the

problems that you have identified, and it is something that we are

going to continue to watch closely.

I have just one final question for you, and that is the question

that I raised at the very beginning of this hearing, and that is,

based on your observations to date, do you believe that day trading

is having an impact on the market in terms of increasing volatility

or perhaps in a positive sense increasing liquidity, or do you think

the volume is too small to have an impact?

Mr. LEVITT. As best I can tell, the volume of day trading probably amounts to not more than 5 percent of total volume in our

markets. I think an argument can be made that it does represent

some modest increase in liquidity. I do not think it has had a significant impact on volatility in our markets, and I do not intend to

sound a note of doom with respect to electronics. I think electronics

and technological changes in our markets have been exciting and

important, critically important developments as our markets move

ahead. I am very supportive of technology as being the best, and

perhaps only, way that this Nation’s markets can compete in increasingly globalized markets. It is where we target individuals

who are inappropriate for certain techniques such as day trading

that I take exception. The appropriate response to that, I believe,

is hearings such as this, as well as the kinds of alerts and warnings that all of us can convey to see to it that we eliminate bad

practices and clamp down hard on fraud.

Senator COLLINS. Thank you very much, Chairman Levitt. I

want to thank the SEC for its efforts and——

Senator CLELAND. Madam Chairman.

Senator COLLINS. Yes.

Senator CLELAND. I would just like to associate myself with your

remarks particularly commending the Chairman with his strong

consumer protection and investor protection role that he plays in

our government.

Thank you very much, Chairman Levitt.

Mr. LEVITT. Thank you.

Madam Chairman, Senator Levin, before he left, asked a number

of questions about margins which I would like to supplement our

testimony with. Within the next several days, we will send followup responses to those questions.1

19

1See Exhibit No. 7 on page 225 in the Appendix.

2The prepared statement of Ms. Schapiro appears in the Appendix on page 79.

Senator COLLINS. That would be very helpful. I, too, am very interested in the whole issue of the margin issues and the borrowing

and the increased lending among customers. So I look forward to

getting your replies.

In addition, your full testimony and any additional information

will be included in the hearing record.1

Again, thank you very much for your assistance.

Mr. LEVITT. Thank you.

Senator COLLINS. I would now like to welcome our next panel of

witnesses this morning.

Mary L. Schapiro is the President of NASD Regulation, and

Peter Hildreth is the President of the North American Securities

Administrators Association, known as NASAA.

As the President of the NASDR, Ms. Schapiro is responsible for

regulating member brokerage firms, individual registered representatives, and overseeing the NASDAQ Stock Market.

We look forward to hearing about her organization’s recent examinations of day-trading firms, as well as NASDR’s recent proposed rules to strengthen disclosure and suitability or appropriateness determinations for day trading.

Mr. Hildreth testified before the Subcommittee earlier this year

on securities fraud on the Internet and was extremely helpful to us

in that investigation as well.

In addition to serving as President of NASAA, he is Chief of the

New Hampshire State Securities Commission. He is accompanied

by David E. Shellenberger, who is the Chief of Licensing of the

Massachusetts Securities Division. Mr. Shellenberger took a lead

role in preparing NASAA’s report on day trading.

As I have explained earlier, all witnesses are required to be

sworn. So I would ask that you stand and raise your right hand.

Do you swear the testimony you are about to give to the Subcommittee will be the truth, the whole truth, and nothing but the

truth, so help you, God?

Senator COLLINS. Ms. Schapiro, I am going to ask you to begin,

please.

TESTIMONY OF MARY L. SCHAPIRO,2 PRESIDENT, NASD

REGULATION, INC., WASHINGTON, DC.

Ms. SCHAPIRO. Thank you very much, Madam Chairman. Good

morning, Senator Cleland.

I appreciate very much the opportunity to testify on behalf of

NASD Regulation, Inc., and I also want to commend the Subcommittee for conducting these hearings which can only serve to

further the education of investors about these important issues.

NASD Regulation is the world’s largest securities self-regulatory

organization. It has responsibility for the oversight and surveillance of the NASDAQ Stock Market but, more importantly for

these hearings today, we are also responsible for regulation, licensing, testing and examination for and enforcing compliance with our

rules and the securities laws for our 5,600 broker-dealer members.

20

I would like to preface my comments today by emphasizing that

day trading is a legal trading strategy and to the extent it is conducted in accord with regulatory requirements, by individuals who

are capable of understanding and assuming the risks involved, we

neither encourage nor discourage it. However, with that said, we

see day trading as a highly risky form of trading that deserves the

closest scrutiny of regulators.

Thus far, NASDR has taken a three-pronged approach to addressing the investor protection concerns that arise from day trading. First, we have been disseminating information and advisories

to our members, reminding them of their many obligations under

existing rules, and these advisories are fully outlined in my written

statement. We have also been emphasizing to investors the risks

involved with day trading.

Second, we have enhanced our examination and enforcement programs and, third, we have proposed new rules in this area and are

exploring additional rulemaking initiatives.

With respect to examination and enforcement activities, we have

been engaged in a cooperative day trading examination initiative

with the SEC, as you have heard from Chairman Levitt. As part

of that effort, NASDR examined 22 day-trading firms that varied

significantly in size and makeup. Fifty-five NASDR examiners received special training in the intricacies of day trading.

During these specialized exams several potential problem areas

surfaced. In the area of advertising, for example, we found sales

materials and advertisements that range from assertions of immediate execution to statements of profits that can be generated from

day trading.

One practice under review is the dissemination through public

statements or Web sites, training materials and public statements

of what may be materially misleading information regarding the

success rate of customers. Our staff is investigating whether the

firms’ claims of customer success rates can be substantiated as our

rules require.

In addition to our ongoing investigations, we have already filed

one formal disciplinary action against Lakeside Trading. That complaint alleges, in the advertising area, misleading statements that

imply direct access to the markets by their day-trading customers

and the failure to disclose material risks associated with the trading.

Our examinations also surfaced Regulation T and margin lending

and disclosure practices that are of great concern to us, particularly

when we find firms facilitating and even encouraging loans from

one customer to another customer, loans from a principal of a firm

to a customer, and loans arranged by the firm from third parties

to customers. Absent these infusions of capital, many of the recipients of the loans would be unable to continue to trade.

Another area of concern relates to registration issues. Our exams

identified individuals engaged in day trading for firms’ proprietary

account who are not qualified and registered. One disciplinary action has been filed and concluded in that area in which we fined

a day-trading firm $25,000 for failure to properly qualify and register 14 people.

21

Problematic short-selling practices at some day-trading firms

have also been identified, including short-sales that are not properly marked, and where no affirmative determination has been

made that the shares can, in fact, be delivered to the buyer. We

have seen potential violations of our rules prohibiting customer

short-sales on what is commonly known as a ‘‘down-tick.’’

Supervision deficiencies were also identified during our examinations. Our rules require that a firm establish and maintain a supervisory system that allows them to carefully supervise the activities of each associated person. We found that at some day-trading

firms, written supervisory procedures did not adequately address

many aspects of their core business including lending practices, advertising and marketing, and short-selling.

We are currently reviewing the results of our examinations and

completing investigations growing out of them. To the extent that

these investigations indicate that violations of our rules or the Federal securities laws have taken place, further enforcement actions

will be instituted.

In addition to our examination and enforcement activities, we

have been working on several rulemaking initiatives to address the

investor protection concerns associated with day trading that we

believe are not adequately addressed under existing rules.

As you heard earlier, in April of this year we solicited comment

on and in August filed with the SEC, proposed rules that would require firms that promote day-trading strategies to first determine

the appropriateness of day trading for each customer. And, second,

to disclose to customers the risk that are associated with day trading.

In order for a firm to approve an account for day trading, the

firm would be required to have reasonable grounds for believing

that a day-trading strategy is appropriate. To do so, they must obtain and keep information about the customer such as their financial situation, their tax status, their prior investment and trading

experience and their investment objectives.

The proposed rules also require that a firm that promotes day

trading deliver a specialized risk disclosure statement to a customer prior to opening an account, informing investors that day

trading can be extremely risky, that investors should be prepared

to lose all of their funds used for day trading and that they may

lose funds beyond their initial investment.

In addition to this proposed rule, we are looking very closely at

whether changes to existing rules regarding margin and lending

practices are necessary. We have solicited comment on some of

these issues.

Concerns that we have identified include what levels of margin

are appropriate for these types of activities, whether the timing of

the margin deposit requirements should be changed, and whether

minimum initial and maintenance cash deposits should be required.

We are also addressing the role of firms that arrange loans between customers. We are particularly concerned about what, if any,

risk disclosures are being made both to the customer obtaining the

loan and the customer who is providing the loan. We believe facilitation of these lending activities by firms may pose a fundamental

22

1The prepared statement of Mr. Hildreth appears in the Appendix on page 167.

2 Exhibit No. 8 is retained in the files of the Subcommittee.

conflict of interest between the firm and the customer, given that

these are the loans that often allow customers to continue to trade

when they would not otherwise be in a financial position to do so

and, thereby, continue generating commission income to the firm.

We pledge to continue to be very vigilant with respect to day

trading through examinations, regulatory initiatives, and the

prompt completion of ongoing enforcement actions. We intend to

continue to work together with the SEC and the States to address

the many issues raised by day trading.

At this time, we do not see a need for any new legislative initiatives, but believe that by continuing our current approach of dissemination of information to our members and investors, examination and enforcement efforts, and the development of new NASD

rules and other policy initiatives, we can effectively address investor protection concerns associated with day trading.

Thank you.

Senator COLLINS. Thank you, Ms. Schapiro.

Mr. Hildreth, welcome.

TESTIMONY OF PETER C. HILDRETH,1 PRESIDENT, NORTH

AMERICAN SECURITIES ADMINISTRATORS ASSOCIATION,

WASHINGTON, DC; AND DAVID SHELLENBERGER, CHIEF OF

LICENSING, COMMONWEALTH OF MASSACHUSETTS SECURITIES DIVISION, BOSTON, MASSACHUSETTS

Mr. HILDRETH. Thank you.

Chairman Collins, Senator Levin and Senator Cleland, I am

Peter Hildreth, Director of Securities Regulation for the State of

New Hampshire and President of the North American Securities

Administrators Association.

Thank you for the opportunity to appear before you once again

and to present the views of NASAA as you look into issues and

problems surrounding day trading. We recognize and appreciate

your leadership in focusing attention on the problems in this area.

Last December, in part because of the enforcement actions taken

by Texas and Massachusetts, the NASAA board of directors formed

a project group to research the industry, prepare a report of its

findings and make recommendations. The project group, chaired by

David Shellenberger, gathered information, analyzed issues and

studied trading records. The NASAA day-trading project group report, released in August, was the result of that effort.2

We believe there are problems associated with the day-trading

industry, not the least of which is the hype about how average people can get rich quickly with no experience necessary. We hope our

report, the first of its kind, will help Congress and the public as

well as our fellow regulators better understand the issues and

problems. We believe it will also help in framing appropriate responses from Congress and regulators.

Electronic day trading has become part of our culture. It has captured the national imagination, in part, because it combines two

major developments that characterize America in the late 1990’s:

23

1 Exhibit No. 8 is retained in the files of the Subcommittee.

The bull market on Wall Street and the technology revolution

brought about by the personal computer and the Internet.

Unfortunately, much of the early media coverage tended to glamorize day trading. The fact is day trading is anything but glamorous. As our report makes clear, day trading is very risky and

most people who day trade will lose all of the funds they put into

it.

We have not examined all day-trading firms and their hundreds

of offices we believe exist. However, at the firms and branch offices

we have examined, we found problems with marketing, suitability,

loan arrangements, supervision, and customers trading other people’s money without regard to licensing requirements.

There were several issues you asked us to address in our testimony. The first was a general discussion of day trading. I think

that Chairman Levitt has already discussed how day trading is distinguished from other investment strategies. My written testimony

provides NASAA’s perspective on this issue. So, in the interest of

time, I will move on to other issues you asked us to address, such

as the risk of day trading.

Trading is, by definition, a form of speculating as distinguished

from investing. Day trading is trading on an extremely short-term

basis and is highly speculative. When firms promote their services

with claims as to the potential for success and profitability, they

have an obligation to tell their customers the truth about the risks.

We also believe they have an obligation to determine whether

day trading is suitable or appropriate for that particular customer.

That means not accepting just anyone who comes through the door

with a check and wants to sit down at the computer and trade.

We commissioned an outside expert, Ronald L. Johnson, to analyze customer account records from a day-trading firm in Massachusetts that was the subject of an enforcement action. His analysis suggests the majority of day traders, more than 70 percent,

lose money. Only about 12 percent showed the potential to be profitable.1

Mr. Johnson also found that day traders would have to generate

annual returns of 56 percent just to cover commissions and margin

interest, never mind taxes. These are long odds, indeed, just to

break even.

This was the first such analysis of retail day-trading account

data. It was a limited sample but the results are consistent with

what we found in other investigations, such as evidence from a

Block Trading branch office where 67 of 68 accounts lost money.

We urge others, especially academics, to conduct further research

on the profitability of day trading by retail customers. However,

the burden of proof remains on the day-trading firms. They must

justify their claims of customer profitability in their marketing that

suggests that average people can make a career of day trading.

As to the findings of State regulators’ exams, some of the abuses

and problems that the project group has observed include: Deceptive marketing, including inadequate risk disclosure. As you noted

in your presentation, Chairman Collins, one firm On-Line Investment Services, Inc., maintained a Web site claiming that 85 perVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
24

cent of its customers were profitable. They deleted that claim when

Massachusetts asked for proof.

We also found violation of suitability requirements. In a case

against Landmark Securities, Inc., the complaint alleged that the

manager falsified information on new account forms to create the

impression day trading might be appropriate for that customer.

The customer, a recent college graduate, was a part-time bartender

with an annual income of $15,000, a net worth of less than

$15,000, and no prior investing experience.

Other abuses we noted are questionable loan arrangements, including promotion of loans from one firm’s customers and loans to

customers by brokers, and also failure to supervise.

The next issue is our position on the NASD proposed rule. In a

comment letter to the NASD, the NASAA project group endorsed

the draft rules on appropriateness and risk disclosure and made

suggestions for enhancing the rules. We recommend that the SEC

approve the rules.

As to other legislative or regulatory initiatives, we believe the

NASD should also adopt a rule prohibiting the abuse of loans I

have discussed. We also recommend enhanced regulatory attention

to day-trading firms.

First, the proposed NASD rules on appropriateness and disclosure. The project group believes that the existing rules on suitability apply to day trading. The failure by some day-trading firms

to adhere to the existing suitability rules, however, suggest that

specific day-trading rules are warranted.

Day trading is a particularly risky program of trading that warrants heightened suitability and disclosure requirements. The

NASD already has special suitability requirements for opening option accounts and the like.

Second, the matter of a ban on loan programs. Day-trading firms’

promotion and arrangement of lending among customers to meet

margin calls is problematic. Firms have promoted the loans in

order to keep accounts open that would otherwise be closed or restricted for failure to meet margin calls. These loans serve to undermine margin requirements and encourage customers to trade

beyond their means. Some of these loans come with interest rates

that in some States may exceed legal limits. A typical rate is a

tenth of a percent for an overnight loan or 36.5 percent on an

annualized basis. In addition, the loan programs have invited severe compliance problems including forgeries and the unauthorized

transfer of customers’ funds.

We believe the loan programs are highly questionable under existing law. Nonetheless, we believe the NASD should adopt and explicit rule prohibiting the programs.

Finally, enhanced focus on day-trading firms. Too many daytrading firms continue to engage in highly questionable conduct as

you heard from Chairman Levitt’s report. More enforcement actions should be brought.

But let me be clear. State regulators do not have a problem with

day trading per se. It has been around a long time, long before the

personal computer. We believe investors should have available to

them all the latest technologies. Technology and information have

25

revolutionized investing. They have leveled the playing field between Wall Street and Main Street.

Our concerns are with day-trading firms that aren’t being honest

with their customers about the risks. Firms that essentially say,

‘‘hey, come on down, we will sell you a training course, you can sit

in front of the computers and you will get rich.’’ This is

hucksterism. The odds are that you will not get rich. The odds are

you will lose all the money with which you trade.

The fact is day trading is not investing, it is gambling. There are

no other words for it. Day traders can lose a lot of money in a

hurry. People should not be gambling with money they cannot afford to lose.

As Chairman Collins mentioned, All-Tech’s recent Web site illustrates that some firms have held out day trading as an option for

retirees, people laid off from their jobs, even college graduates just

starting out. This sort of marketing is irresponsible, reckless and

predatory.

Day-trading firms need to play by the same rules that the rest

of the brokerage industry has to follow. Frankly, in the examinations we have conducted of day-trading firms, we have found a cavalier attitude toward regulatory compliance. Too many firms either

don’t know the rules or are flouting them because they think the

rules don’t apply to them.

Well, the rules do apply. We expect that more enforcement actions will be brought and that these will send a message to the

firms that appear to believe they are above the law.

Chairman Collins, I greatly appreciate the opportunity to chair

the NASAA project group’s findings with the Subcommittee today.

NASAA and its members stand ready to assist you as you continue

your investigation into the practices and operations of the day-trading industry.

Senator COLLINS. Thank you very much, Mr. Hildreth.

Mr. Shellenberger, do you have any formal comments you would

like to make?

Mr. SHELLENBERGER. No, Chairman Collins. I am prepared to

answer any questions that may be asked, though.

Senator COLLINS. Thank you very much.

Ms. Schapiro, you stated in your written testimony that NASDR

examiners had identified questionable practices, questionable marketing and advertising practices at nearly 80 percent of the daytrading firms that you have reviewed to date. Is that correct?

Ms. SCHAPIRO. Yes.

Senator COLLINS. That is of great concern to me because that

suggests that we are not dealing with isolated examples of misleading advertisements or exaggerated claims but rather an industry pattern of deceiving unsophisticated investors.

Could you give us some examples of the kinds of deceptive marketing practices that your examiners uncovered?

Ms. SCHAPIRO. Sure.

I think as a general matter we have seen extremely aggressive

marketing and promotional campaigns engaged in by a number of

day-trading firms. Some of the advertisements and sales literature

which have been of particular concern to us includes promises of

enormous profit potential, very high levels of customer success

26

rates without there being any counter balancing information about

either the risks or the fact that you can lose all of your money and

more than your initial investment.

We have seen ads that suggest that you are guaranteed immediate execution in the market place. When we all know that as

good as the technology is, you are not guaranteed an immediate

execution.

And, we have seen advertisements that suggest that anybody can

do this with just a little bit of a training or studying a manual

when, in fact, sophisticated understanding of market operations

and how stocks react in different markets and areas is very important to be successful.

So, generally, I would say exaggeration, potentially misleading

information and wild claims would characterize many of the ads

that we have looked at and are investigating.

Senator COLLINS. And I would note that the SEC examiners and

the State regulators have also found a similar pattern of widespread abuse with advertising in this area.

Ms. SCHAPIRO. I think that is right. It is interesting to me that

the examinations done by all three of us are very similar and largely parallel in their findings.

Senator COLLINS. That does seem to be a consistent and very

troubling theme or finding of all three regulatory organizations.

Your examinations also indicated, Ms. Schapiro, that nearly half

of the day-trading firms had established lending programs whereby

day-trading customers who cannot meet the margin calls can borrow from other day-trading customers. This raises real concerns in

my mind about suitability and appropriateness.

If a day trader can’t meet the margin call and is encouraged by

the firm to borrow from a fellow day trader, what does that say

about whether the individual should be day trading in the first

place?

Ms. SCHAPIRO. That is a wonderful question and I think that my

greatest concern in this area is that it is fundamentally a very severe conflict of interest for a firm to suggest to a customer who has

run out of capital that that customer borrow money from other customers or from principals of the firm in order to continue to generate commissions for the firm. We are looking very closely at this

issue and I would hope that in the next several months we will

have taken some action with respect to the facilitation of lending

arrangements by the broker-dealer.

Senator COLLINS. Mr. Hildreth, I know this has been of particular concern to the State regulators. Would you like to comment

on this and should NASDR simply ban this practice?

Mr. HILDRETH. Well, I think that certainly the NASD should

look—what they are seeing in these exams is what we talked about

in the report. And I know that Dave Shellenberger has some things

to say about those also. But it would seem to me that with that

widespread, as it appears in the industry, practice, is something

that we have some real grave concerns about for the same reasons

that Ms. Schapiro stated. Keeping people trading when there are

some real concerns if they don’t have the money, perhaps just to

generate commissions.

So, I think certainly it should be looked at.

27

Senator COLLINS. Mr. Shellenberger.

Mr. SHELLENBERGER. Yes, thank you, Chairman Collins.

One of the problems with the loan programs, and by the loan

programs, of course, what we are referring to is day-trading firms

promoting and arranging loans between customers so that customers can meet margin calls that they otherwise could not meet.

The purpose of these loan programs is simply to keep accounts

alive that would otherwise be closed and allow the brokerage firms

to obtain a continuing stream of commissions.

These programs encourage people to lose even more money. They

certainly, as Madam Chairman has recognized, raise suitability

concerns. If people are trading beyond their own means, don’t have

enough funds to meet margin calls, should they be day trading in

the first place? To indicate the magnitude of this issue, we alleged

in Massachusetts in the case against Landmark Securities that

with respect to the tiny retail account held by the part-time bartender and recent college graduate in that office, $2.7 million in

loans flowed through this person’s account in only 9 months.

Senator COLLINS. I think this is an area where we really do need

to see regulatory action. It just raises all sorts of concerns.

We also need to do a better job upfront screening out people for

whom day trading is not appropriate. And I think that is why the

NASD’s appropriateness regulations are very important in that regard because we would have fewer people who would be tempted

to borrow from fellow day traders if we were screening, if the industry was screening potential clients upfront.

Would you agree with that, Ms. Schapiro?

Ms. SCHAPIRO. Yes, absolutely.

Senator COLLINS. Mr. Shellenberger, as you are very well aware

the day-trading industry has been extremely critical of NASAA’s

report on profitability of day trading in which it was found that

more than, I believe it is, 70 percent of day traders are going to

lose their money, perhaps even more, and only 12 percent were

found to have the capacity to perhaps make a profit.

The industry has countered with a study on day-trading profitability that was conducted by Momentum Securities. Have you reviewed that study and could you give us your thoughts on it?

It is my understanding that the Momentum study acknowledges

that 56 percent of day traders lose money in the first 3 months but

it claims that after that point 64 percent of day traders actually

make money.

What are your views on the Momentum profitability study?

Mr. SHELLENBERGER. Chairman Collins, on behalf of the NASAA

project group I requested copies from the Electronic Traders Association of any studies, including Momentum’s purported study. I

have yet to receive any documentation, anything related to that

study. So, I am only familiar with the press clippings concerning

it.

Senator COLLINS. Well, that is problematic in and of itself, I

would say. If you, as a regulator, are making a request for information that is that vital and are not receiving the cooperation of the

day-trading industry that is of great concern to me.

Mr. SHELLENBERGER. Yes. I should clarify, Chairman Collins,

that Momentum Securities is not registered in Massachusetts so

28

we cannot legally force them to produce these records. Nonetheless,

we did request them through the ETA. Claims of profitability or

losses are meaningless unless the data are subject to scrutiny.

So, I have been unable to scrutinize these claims. However, on

the face of the claims there is a problem. And that is Momentum

has acknowledged that the majority of its customers did lose money

at least for a period of months. They claim that after that apparently the surviving customers were profitable. I don’t know whether that is true or not.

The question would be, how many people are going to burn

through their capital and still have some money left once they supposedly learn how to day trade? I suggest that it may be too late.

For instance, Ron Johnson, in reviewing our sample, found that

the average account was only open 4 months.

Senator COLLINS. So, in other words, given the high turnover of

day traders, many of them aren’t going to still be able to day trade

because they will be broke by the time they may finally have figured out how to do this profitably?

Mr. SHELLENBERGER. Absolutely. Assuming that it is even possible for them to learn.

Senator COLLINS. Have you seen anything, based on your further

examinations, that leads you to question your initial findings that

more than 70 percent of day traders will lose their money?

Mr. SHELLENBERGER. No, Chairman Collins.

In fact, I believe that the 70 percent figure probably understates

the problem. Ron Johnson concluded that if many of these people

beyond the 70 percent continued to trade, those that had shown

profits would end up losing money because, for instance, in many

instances the profits had been gleaned from only one trade. Well,

if you can make 50 percent of your profits in one trade, you can

lose 100 percent of your capital in the next trade.

Senator COLLINS. Ms. Schapiro, has the NASD done any work on

the profitability of day trading?

Ms. SCHAPIRO. We haven’t done a broad look at the profitability.

In the context of the specific investigations of day-trading firms

that are ongoing where they have made claims of customer success

rates, we are requiring them to substantiate that those success

rates are, in fact, true.

Through that mechanism we will have a better sense, at least

anecdotally, of what the success rates are and what the profitability is of day trading at particular firms.

Senator COLLINS. I hope you will share that information with the

Subcommittee.

Ms. SCHAPIRO. We will be happy to do that.

Senator COLLINS. The appropriateness regulations that the

NASD has proposed, and which are now pending before the SEC,

apply, it is my understanding, to only new accounts. Is that correct?

Ms. SCHAPIRO. As the rule was proposed, yes, we applied it on

a ‘‘going forward’’ basis to new accounts.

Senator COLLINS. Would it not be useful to apply it also to current accounts, so that there at least is a disclosure of the risks?

Ms. SCHAPIRO. We will certainly revisit that issue.

29

1See Exhibit No. 3 on page 216 in the Appendix.

We targeted it to an account opening because that’s a very definitive event that can trigger the need to do the appropriateness determination.

To the extent that there are accounts already out there at firms

that aren’t even traditional day-trading firms but where people are,

in fact, day trading, we thought it would be very difficult, as an

operational matter, to go back and try to apply the rules to all of

those accounts. But it is something we will look at very carefully.

In submitting these rules to the SEC, we have said that this is

a first step. And, if we determine there are additional regulatory

initiatives that are needed in this area, we won’t hesitate to recommend those.

Senator COLLINS. Thank you very much. My time has clearly expired, and I will now turn to Senator Levin for his questions.

Senator LEVIN. Mr. Shellenberger first, I believe you were the

folks who got the restraining order against TCI; is that correct?

Mr. SHELLENBERGER. Yes, Senator Levin. Specifically, the cease

and desist order applied to what we had alleged in the licensing

section as a Ponzi scheme, beyond what we allege were false claims

as reflected by the advertisement. Then the hearing officer referred

the matter of the deceptive advertising to the Attorney General’s

office because he had concerns regarding our jurisdiction.

Senator LEVIN. That is the original one, I believe, and I want to

show you the new one that is currently on their Web site and ask

you whether or not those concerns are still real, when they say that

this system is the absolute best that they know of, and it says a

profit to loss ratio of 12 to 1 and an average return of better than

18 percent per trade before slippages.1

It seems to me it’s worse than their first site.

Mr. SHELLENBERGER. Yes. Senator Levin, I would share your

concerns. The response, once regulators have raised questions regarding specifically Web sites, has been that these Web sites

change. I believe this site has been modified. But I share your concerns that this remains unacceptable.

You had asked a prior witness, Chairman Levitt, regarding the

SEC’s jurisdiction in this matter, and this is a very technical area.

But I would note, if I may, that there are State consumer protection acts that prohibit deceptive advertising and, in addition, such

matters may be under the purview of the Federal Trade Commission.

Senator LEVIN. This is a current Web site, by the way. This is

after the change. So at least as of yesterday, it was their Web site.

Is this under Massachusetts’ jurisdiction if that is false advertising? Is that what your Attorney General is looking into now?

Mr. SHELLENBERGER. Senator Levin, the referral was made to

the Attorney General’s office from the Massachusetts Division of

Securities, because Massachusetts, I believe, like most States, has

a Consumer Protection Act Chapter 93(a) which, among other

things, prohibits unfair or deceptive acts or practices, including advertising. So this, in my view, would be subject to scrutiny under

that law.

30

1 Exhibit No. 8 is retained in the files of the Subcommittee.

Senator LEVIN. If the Attorney General concluded that was false

and deceptive advertising, and if TCI is located—and I don’t know

where they’re located——

Mr. SHELLENBERGER. In California, Senator.

Senator LEVIN [continuing]. In California, would you be able to

get at them because the advertising is on a Web site which obviously comes into Massachusetts? Would you be able to get a subpoena, for instance, under existing legal theory?

Mr. SHELLENBERGER. Senator Levin, I know that this area of

States being able to obtain jurisdiction in response to Web site advertisements has been the subject of some brilliant Law Review articles that I have only skimmed.

I can tell you that TCI has at least closed down its branch office

in Massachusetts, and I don’t expect them in my back yard again.

Whether we would be able to enforce a subpoena on a California

corporation that, to our knowledge, did not do business with any

of our citizens, would be questionable.

Senator LEVIN. Madam Chairman, I think this is an area that we

also want to add to our list of things that we’re looking into, because, given the amount of electronic trading, given the fact that

this kind of a course and strategy is available electronically, or the

touting of it is done electronically, it would be good to have not just

the watchdogs in Washington, the Federal Trade Commission or

others looking into these kind of phony representations, it would be

good to have 50 States being able to go after them as well. That

may require some kind of change in Federal law to authorize subpoenas. I’m not sure exactly what the legal complexity is, but I

think we ought to add this, given the amount of electronic trading

and the way in which these courses are advertised, to our list of

things that we’re looking into for possible legislation.

I think this question will go to you, Mr. Hildreth. You indicated

in your testimony that the odds are you won’t get rich, and the

odds are you’ll lose all the money with which you trade. We will

hear testimony later on this morning from Mr. Cohen that day

trading is not gambling. But then he says the majority of those

who do day trade after training do not lose money.

You’re telling us that the odds are you will lose all the money

with which you trade?

Mr. HILDRETH. That’s right.

Senator LEVIN. That’s about as sharp a conflict as we can possibly have. I’m just wondering what your reaction is to his comment?

Mr. HILDRETH. My statement is based on the report 1 that was

produced by Dave Shellenberger’s project group, and hiring an outside consultant. It is based on the data that we have.

We also had the testimony of the manager of one of these sites,

who said 67 out of 68 lost money.

Senator LEVIN. They also will be testifying later on this afternoon that much of NASAA’s report, that this mumble jumble would

be unnecessary if NASAA had accepted ETA’s March, 1999 offer to

provide current trading information.

31

Now, we’re going to be getting testimony under oath later on this

morning that ETA offered NASAA, in March of this year, to provide current trading information. I’m wondering, did they, and if

so, what was it?

Mr. HILDRETH. Dave Shellenberger is the appropriate person to

respond, since he’s the Chairman who would have dealt with them

on that issue.

Mr. SHELLENBERGER. Thank you, Senator Levin.

The answer is that that’s a false assertion. What had happened

is that the ETA, through its counsel, asked me to comment on a

possible study that might be done by the ETA. The project group

determined not to make any suggestions or comment but, rather,

to reserve comment. The reason is that we did not want to endorse

a study or survey of which we did not know the particulars.

I would stress, Senator, if I may, that the burden of proof is on

the industry. Before they make these claims of 85 percent success

rates, before they make the claims that retirees should make careers of day trading, they should have the facts. It disturbs me that

apparently studies have not been done to date, other than the alleged Momentum study.

Senator LEVIN. Can any of you comment on the adequacy of current laws and regulations to address the problems which we have

identified, and if you would prioritize the new regulations or laws

that are needed in terms of their importance? Maybe we can start

with you, Ms. Schapiro.

Ms. SCHAPIRO. OK. Well, we have identified a lot of problems, as

you’ve heard. I think, with respect to advertising, for example,

there are adequate regulations in place, assuming sufficient enforcement resources, to pursue all of those advertisements and

marketing materials in an aggressive way.

I think we have said, with respect to margin, and particularly

margin lending practices, that we need to do some more work, as

SRO’s and the SEC, to look at whether there ought to be a prohibition and, at a minimum, enhanced disclosure of the risks of margin

lending or some other modification to address the practices that we

have seen with respect to margin lending.

I think we also ought to look at whether, under the margin

rules—and you asked these questions earlier, Senator Levin—we

should be shortening the time frames by which Regulation T margin deposits must be made. It’s currently 7 days and perhaps it

ought to be shorter, given the kind of mismatch we have of these

trading strategies that are intraday, with margin payments being

required only within 7 days.

I think with respect to short sales or short selling, the current

regulatory and legal structure is adequate.

With respect to supervision, there is a very detailed and comprehensive supervisory structure in place in the largest brokerdealers, and the best run small- and medium-size firms. Day-trading firms need to adopt those kinds of supervisory structures and

hire compliance people who can ensure that they are following the

rules and regulations that apply equally across the board to all

broker-dealers.

32

Senator LEVIN. Just very quickly, if I may, does your organization support the proposed rule on suitability, that it apply to strategy as well as——

Ms. SCHAPIRO. We wrote it. It is our rule and we are 100 percent

behind it.

Senator LEVIN. Mr. Hildreth.

Mr. HILDRETH. We support it, as I said, and filed a comment letter in support of that.

We wouldn’t be here today if the current rules were met by the

industry. What we found is the rules are being broken. I think that

there is a need to look at the loan issues, and perhaps just ban

them outright.

If the current rules were being complied with, I don’t think we

would be here. I think the day-trading industry just has to comply

with those.

Senator LEVIN. But in terms of new regulations and rules, the

first thing would have to be with the loan, and second, would be

suitability or not?

Mr. HILDRETH. Well, we have supported the suitability proposal,

and we hope that that’s going to be approved quickly. We would

like the NASD and the SEC to look at a ban on the lending programs.

Senator LEVIN. Is there anything else from our third witness?

Mr. SHELLENBERGER. Senator, I concur with Mr. Hildreth’s comments, and I emphasize that the industry seems to be doing a good

job of violating existing law.

Senator LEVIN. Thank you. Thank you, Madam Chairman.

Senator COLLINS. Senator Cleland.

Senator CLELAND. Thank you very much, Madam Chairman.

Ms. Schapiro, we’re glad to have you with us today. I have spoken to your organization, mostly as Secretary of State in Georgia,

and as a State regulator. Mr. Hildreth, it’s nice to see you. I have

great respect for your organization as well.

I mentioned earlier today that Wayne Howell, my AA, has been

very instrumental in my understanding of the regulatory process,

in terms of the world of securities, and he was the former head of

your organization. Mr. Shellenberger, as a former State regulator,

we respect your role immensely.

I think it is fascinating, Madam Chairman, a couple of things I

have gotten out of this today. First, Mr. Hildreth, you’re the second

person to sit in that chair today to refer to day trading as gambling, the first being Arthur Levitt, head of the SEC, and then you,

heading the North American Securities Administrators Association,

referring to it as gambling.

That is certainly far beyond any understanding of investment or

even just speculative investment. It seems to me that our testimony today has reflected that it is, indeed, gambling.

As a matter of fact, I started off somewhat quizzically about the

relationship with Las Vegas, that it is now clear you have better

odds in Vegas than in day trading, and that it’s not roulette but

it’s Russian roulette, where there’s a bullet in the chamber. If you

keep playing this roulette game long enough, you’re going to be

dead.

33

To hear the fact that, as a minimum, some 82 percent that go

into day trading don’t make anything, and 70 percent lose money,

12 percent have a potential of maybe making some money, that’s

astounding odds against you. So I think something is broken here.

I’m not sure what’s broken, but I think some things need fixing.

What I would like to suggest here, before I leave the panel, is

to ask Ms. Schapiro, Mr. Hildreth, and Mr. Shellenberger, what is

your best shot here and what can this Subcommittee or Congress

do to help get this thing back on track, to help main street get back

in line with Wall Street, not abandoning the technology and certainly not wiping out the opportunity for the individual investor to

get involved in the process, but how do we make this work?

Ms. Schapiro.

Ms. SCHAPIRO. I believe, from the perspective of the U.S. Congress, the most important thing—because we don’t have any recommendations at this point for specific legislative initiatives—

would be to continue to support the regulators through hearings

like this, that help us have an audience to air some of these issues

and concerns, and continue to support the regulators in their initiatives to enact some new rules governing this kind of trading, have

adequate resources, particularly for the Securities and Exchange

Commission, to do the kinds of examinations and enforcement

cases that will help protect investors.

Senator CLELAND. Mr. Hildreth.

Mr. HILDRETH. I would also say that this type of hearing goes a

long way, toward publicizing this issue. When we released the report, there was a great deal of coverage, and that’s good, because

people need to know the real risks. They are not being told that

when they see an ad that says you can come in here, be trained

for a few days, and you can retire—or you’ve already retired and

you can make extra money.

It is important to get the message out, that day trading is risky.

This kind of hearing, what you’re doing here today, I think goes a

long way in that regard. Again, I do think that the SEC and the

NASD need the support of Congress, the SEC more directly, certainly, with the funds to do it.

I would note once again, as I think Chairman Levitt mentioned

earlier, that the three groups—the SRO’s, the SEC and the

States—really do work well together on these kinds of issues, and

we look forward to doing that. We hope you give the SEC the resources to do it.

Senator CLELAND. Mr. Shellenberger.

Mr. SHELLENBERGER. Senator, I concur with the statements of

Ms. Schapiro and Mr. Hildreth. I’m not sure additional legislation

is needed. However, we find hearings of this nature very helpful in

alerting the public, not only to the risks and problems, but reminding them that, as one of the Senators noted earlier today, if something sounds too good to be true, it probably is.

Senator CLELAND. That was me. [Laughter.]

Mr. SHELLENBERGER. It was a brilliant remark, with which I concur. [Laughter.]

Thank you.

34

Senator CLELAND. Help me understand day trading just a little

bit. First of all, I’m an individual citizen. Can I buy stocks through

the Internet?

Ms. SCHAPIRO. Absolutely.

Mr. HILDRETH. Yes.

Ms. SCHAPIRO. Without day trading, you may open an on-line account at any one of hundreds of brokerage firms——

Senator CLELAND. But you’ve got to go through a brokerage firm

to do that?

Ms. SCHAPIRO. Yes. Well, you do, if you’re not going to engage

in day trading. If you’re going to engage in day trading, you have

a couple of options. You can go on site, at a brokerage firm that

is an NASD member and sit at what is the equivalent of a work

station that one might see on a trading desk in a NASDAQ trading

room at a big firm, and you may access the market through that

terminal at the brokerage firm.

You may also go into a limited liability company that might not

be a member of the NASD and, therefore, not subject to all the

rules and regulations of the NASD, but perhaps a member, for example, of the Philadelphia Stock Exchange, and trade as a limited

partner of that LLC. You would deposit your own capital, which becomes part of the firm’s capital, and trade as a partner, not as a

customer and, therefore, not benefit from suitability and a number

of other rules that protect customers.

You would also have the benefit of even greater leverage, because

you wouldn’t be subject to the Regulation T margin requirement of

50 percent initial margin and 25 percent maintenance margin but,

rather, whatever margin level is arranged between that limited liability company and their clearing firm. It could be as low as 15

percent margin. So you have several alternatives on how you want

to approach day trading.

Senator CLELAND. Thank you. The panel has been most gracious

with their time.

Madam Chairman, thank you for holding this hearing. It is obviously a very fascinating part of the world in which we live, and certainly day trading is very risky business and these people are trying to help. Thank you very much.

Senator COLLINS. Thank you very much, Senator.

I want to thank our panel for their very helpful testimony. We

look forward to continuing to work with you as we continue our investigation as well.

Our final witness this morning is Saul Cohen, the consulting

counsel to the Electronic Traders Association, which is known as

ETA. Mr. Cohen has extensive experience in securities regulation

and is currently a partner in the law firm of Proskauer, Rose in

New York City.

ETA is a nationwide association of firms and individuals which

promote the interests of the day-trading industry.

Mr. Cohen, before you get too comfortable, I do need to swear you

in.

Do you swear the testimony you are about to give will be the

truth, the whole truth, and nothing but the truth, so help you,

God?

Mr. COHEN. I do.

35

1The prepared statement of Mr. Cohen appears in the Appendix on page 178.

Senator COLLINS. Thank you very much. You may proceed.

TESTIMONY OF SAUL S. COHEN,1 CONSULTING COUNSEL,

ELECTRONIC TRADERS ASSOCIATION, NEW YORK, NEW YORK

Mr. COHEN. Thank you, Senator. I’m the notorious Mr. Cohen referred to before.

For those who are interested, the quote is from a much larger

and broader article on philosophical concepts of regulation. It appears in two parts, in the Wall Street Lawyer.com, and it really

deals with the threats of the Internet.

But, in any event, I thought I would start with two quick quotes

from Chairman Levitt’s written testimony, because they are so

much at odds at what anything else anybody has said here.

‘‘To date, however—’’ page 7 ‘‘—we have not found marked and

widespread fraud by these firms.’’ Page 13, ‘‘The staff has found

isolated instances where day-trading firms appear to have failed to

comply with margin requirements or properly disclose terms and

conditions of loans in contravention of SEC rules.’’ Mr. Levitt was

also kind enough to say that day traders don’t add to volatility.

Senator Levin had asked a very perceptive question before, he

never got an answer, and that had to do with margin. It was perceptive in two ways. One was what would happen if you didn’t

come up with money, and the answer is, if you didn’t come up with

money, then after 7 days your account would be frozen and you will

not be able to do anything but liquidating transactions. That’s a

universal rule.

The part that I thought was interesting was that it indicated

that it was possible to make a profit on a margin trade. All we’ve

heard today so far is people going to margin because otherwise

they’re going to go broke sooner. But the point is that you can go

into margin, and lots of people go into margin transactions because

they want to keep profitable trades.

On-site traders will emphatically tell you that they’re not gamblers and day trading is not gambling. ETA traders have an extremely high percentage of college and professionally educated people. The New York Times pointed out just in August that ‘‘many

former professional traders, brokers and financial service professionals are becoming full-time day traders.’’

Successful day trading requires skill, hard work, and access to

state-of-the-art technology.

And while I’m at it in regards to this, in terms of risk disclosure,

ETA has supported risk disclosure much broader and deeper than

the NASD risk disclosure. It has been in place for months. And it

requires that the particular individual involved sign the risk disclosure statement.

Senator Levin, because I know margin is of interest to you, there

is language in here that says you may sustain a total loss of the

initial margin funds and any additional funds you deposit with

your broker, and you may incur losses beyond your initial investment. There is lots and lots of disclosure in that form.

You may well be, to go back to the subject of gambling, aware

of people who are called ‘‘quant’’ traders. These are people who inVerDate 11-SEP-98 12:33 Jan 27, 2000 Jkt 000000 PO 00000 Frm 00039 Fmt 6633 Sfmt 6633 61159.TXT SAFFAIRS PsN: SAFFAIRS
36

vest millions of dollars in computers, special phone lines and software, so that they can day trade successfully. They’re not gamblers. They are market professionals.

Day trading is not a cult, although sitting here today, I wondered

about that, from a regulatory view, and there is nothing new about

day traders. They have always existed on exchange floors. They’re

still there today. At least since the advent of Thomas Edison’s stock

ticker, there have been day traders in what are called upstairs offices.

Now, I have repeated on-site day traders several times to differentiate these 4,000 or so individuals who Mr. Levitt also mentioned in his written statement have a very limited reach, so it’s

important to understand what we’re looking at. From the estimated

250,000 people encouraged to trade on line through such household

names, including the one the Chairman mentioned, Charles

Schwab and Discover. You may have seen the Discover ad which

shows a pig farmer who trades on line. The copy for the ad runs,

‘‘Gorden Gekko, Eat Your Heart Out. Wall Street used to be about

greed. Now it’s about brains, about taking control of your money.

So go ahead. Yup.’’ That’s a New York advertiser trying to be a

farmer. ‘‘Just a mouse click away.’’

Now, contrast the pig farmer with the on-site trader. ETA members get almost instantaneous executions, very often instantaneous

executions. The farmer doesn’t. ETA traders get price improvement. And if we’re talking about consumer issues—and that’s the

most important consumer issue this Subcommittee ought to be concerned with—the pig farmer does not get price improvement. His

order goes to a market maker in a preferencing arrangement. ETA

traders take advantage of the firm’s intellectual capital. That is,

the people around them, the experience of the other traders—well,

I guess the pig farmer has his pigs.

It’s very important, when we talk about on-site trading and risk,

to understand that you would have to be totally oblivious to the

world to not understand the risk because you are sitting in that office, cheek by jowl, with other traders.

Now, there are, of course, lots of complaints by day traders, but

they’re from the on-line day traders. ‘‘Why is the system down?

Why did it take so long for my order to get executed?’’ There are

virtually no complaints from on-site day traders, so we’ve got a

mystery on our hands. If there are no complaints, why is NASAA,

not the SEC or NASD, seeking to isolate on-site day-trading

brokerages from every other part of the securities industry?

According to NASAA, on-site firms are a public danger in three

respects. On-site firms routinely violate securities regulations. To

quote Mr. Hildreth, ‘‘day-trading firms need to play by the same

rules the rest of Wall Street follows. If they don’t get their act together, they’ll be under increasing regulatory pressure.’’

The NASAA report charges on-site firms with order entry

failings, short sale, margin and books and record violations, even

omissions to disclose the risk of loss, and false marketing. But

NASAA, in its survey of regulatory cases, apparently hasn’t noticed

that just over the past 18 months, and just looking at the top 100

well-capitalized firms by the SIA, not the hundreds of others—that

Merrill Lynch and half a dozen other firms were disciplined for

37

order entry matters. Piper Jaffray fined for short sale violations.

Schroder, Cowen, and Fahnestock cited for margin. Salomon Smith

Barney and three other firms, books and records. Merrill Lynch

fined $2 million for sales materials which ‘‘omitted material facts

in the risks of investment losses.’’ And Prudential Securities was

fined $500,000 for false marketing information regarding CMO’s.

The Subcommittee also, I think, is aware that institutional investors have been buying interests in on-site firms. I think you’re

aware then that these investments are made after considerable due

diligence and simply would not be made if day-trading firms were

securities industry rogues. That’s one of the reasons why I think

Mr. Levitt felt comfortable in writing that there’s no widespread

fraud.

The second charge against day-trading firms by the NASAA was

that on-site firms engage in deceptive advertising. But it should be

noted that no advertising, even as compelling as the Discover ad

about the pig farmer that I just went through, can withstand reality. And, by the way, ETA has a statement of principles that decries in any sense deceptive advertising. It talks about giving a full

picture to people and so forth.

Day traders, as I have said before, are intelligent and well educated. They are on site. They can quickly observe from the traders

around them what the range of risks and rewards are. To go back

to Senator Levin for a minute, his comment about ‘‘well, isn’t this

a surprise when you get the margin notice?’’ Well, if it’s a surprise,

it’s a surprise once. It’s not going to be a surprise the second time.

It is important to understand, by the way, with regard to risk

and the risk of loss, that if this market collapses, you’re much better off being a day trader holding securities for 4 minutes than people who are holding securities for months and years, as I am in

some of my accounts.

ETA members need not advertise for customers. Most prospects

are references from customers.

A third charge, on-site day traders lose money in wholesale lots.

We have heard over the last year all kinds of numbers. We have

heard 7 out of 10, 8 out of 10, 9 out of 10 lost money. Massachusetts—and they were here before, Mr. Shellenberger—67 out of 68

lost money at one firm. Well, if that happened, you would think the

Boston press would pick it up and they would notice 67 people running out of the office yelling ‘‘plague.’’ No one is that dumb.

Now the report is out, and I’ve got to tell you, as somebody who

is a professional in this business, this is an amateurish report.

NASAA’s expert, Mr. Johnson, turns out to be a former commodity

trader who earns his living as a plaintiff’s witness, and whose resume, which we have put in our materials, lists with pride that,

for 2 years, he ‘‘published daily hot line trading recommendations,’’

a fancy way, Senator, of saying that he gave option tips, and that

he ‘‘developed a low-price stock strategy that returned over 30 percent.’’ You would think NASAA would be going after him for that

kind of advertising.

This expert, who operates out of his apartment, studied a grand

total of 17 day-trading accounts. These, on average, traded for 4

months, 2 years ago, one office, on non-ETA firms. His conclusion?

Sixty-five percent of the accounts had a risk of ruin; that is, if they

38

kept going, never learned anything but just kept making the same

mistake they made before, they were going to lose money. They

would never stop and would never quit before they lost all their

money. They would lose all their money.

We tried to avoid the numbers game. We tried, no matter what

Mr. Shellenberger is telling you—and there is correspondence on

this and I will supply it to this Subcommittee afterwards, supply

the Blue Sky people with current information for use in an independent survey. We provided them with a methodology of four

pages. NASAA demurred. He told you why they demurred. They

didn’t want to endorse an independent study.

We estimate, without any claim of scientific accuracy—but I can

tell you that I spoke to a half-a-dozen on-site firms—that most customers will lose money or break even in the first 3 to 5 months.

They’re not going to wipe themselves out in the first 3 to 5 months.

They’ll lose some money. And that thereafter nearly two out of

three are going to net $28,000 a month, with the odd man out losing $6,000 to $8,000.

But, hopefully, to put this particular matter to rest, because it

is so important, ETA is in the process of retaining KPMG to conduct a day-trading profitability study.

Let me go back to another point that was made before, Senator—

and you’ve really made a number of perceptive points. One of them

had to do with—I think this was asked of Mary Schapiro—would

you allow somebody right out of college to day trade? A good question. How about right out of Wharton? I interviewed somebody

right out of Wharton in January, who was out day trading for a

year, and he made $750,000 in January. I felt very foolish being

a lawyer.

Given these facts, why has NASAA sought to demonize on-site

day traders? The reason, quite frankly—and they said it here—is

that they want the publicity. This is what Mr. Hildreth said last

January. ‘‘We need to reposition ourselves to cultivate media contacts. The news media is hungry for good crime stories, and with

a little imagination, we can find them stories to write about.’’

Now let me move finally to something that is more positive. ETA

members seek to meet all regulatory requirements and to foster

high standards of ethics. We have statements of principles and we

have risk disclosure that goes well beyond the NASD. ETA members tell prospects that day trading is not for everyone. In fact,

ETA’s own risk disclosure statement is broader and deeper than

NASD requires, and acknowledging signature by the customer. We

frankly urge that in the NASD’s risk disclosure that they get it

signed by customers. ETA’s statement of principles reads, ‘‘We will

not make misleading or exaggerated claims, and will provide a balanced perspective in our presentation.’’ We think you ought to consider asking the entire securities industry to adopt the statement

of principles along these lines.

The hardest issue to deal with is the appropriateness issue. It is

very, very difficult. It’s difficult because it undercuts what has been

years and years of suitability theory. The security industries association has taken the position opposed to the NASD proposal because, in the past, all suitability decisions—and this was spoken to

39

before by Mr. Colby—dealt with particular trading recommendations, not overall strategy. So this is a strategy.

We have been working very hard to get to the point where we

can agree with the kind of appropriateness standard. We think

that, in doing that, one of the ways to do it is there are existing—

and you might ask Ms. Schapiro about this—the NASD has existing rules on option trading. Option trading is a lot like day trading.

It’s a collection of different strategies. It’s an approach to the market, not a particular recommendation thing. It starts off with somebody being approved, getting a risk disclosure statement and then

being approved to trade options, or in this case, to day trade. We

think that’s a much better approach to appropriateness. It’s much

more focused than the generalized language they’ve been using.

Senator COLLINS. Mr. Cohen, I’m going to ask you to wrap up

your comments.

Mr. COHEN. I will wrap up. OK.

Let me wrap up with what I know is a particular concern of this

Subcommittee, and that is consumers. Day traders help consumers.

Day-traders’ activities drive electronic communication networks,

the ECN’s. These ECN’s provide market transparency. They are

real competitors to market makers. The market makers are the

group disciplined by the SEC and the Justice Department for collusive pricing, so the result for the small investor, the consumer, is

better quote information and better handling of retail size orders.

Day traders add importantly to liquidity and depth in the market

without adding to volatility, so the small investor will find another

side when he’s ready to buy or sell.

Last, day traders limit orders—and day traders put in a large

amount of limit orders—compete directly with market makers. The

result of that is that dealer spreads are narrowed and the small

investor, the proverbial ‘‘Aunt Janet in Portland,’’ who is selling

stock to pay for her daughter’s or her niece’s first year in college,

is going to get a better price on her trade because there’s a day

trader in between the market maker’s spread.

This is the way the SEC intended it, and this is how it’s working.

Thank you very much.

Senator COLLINS. Thank you, Mr. Cohen.

We are going to take a 10-minute recess because, unfortunately,

we have another vote on.

[Recess.]

Senator COLLINS. The Subcommittee will come back to order.

Mr. Cohen, I think it’s important for the record that I clarify that

the SEC has confirmed to us that the reference in Chairman

Levitt’s testimony to the absence of widespread fraud in the industry was referring to such things as forgeries and other kinds of outright fraud, as opposed to the widespread pattern of deceptive advertising.

Mr. COHEN. Did you also ask him about the isolated instances of

margin problems?

Senator COLLINS. I think, Mr. Cohen, that I’m the Chairman and

you’re not.

Mr. COHEN. OK. I’m sorry. I had the belief we were going to have

a discussion of these issues.

40

1See Exhibit No. 5 on page 219 in the Appendix.

Senator COLLINS. I did want to set the record straight in that regard.

Mr. Cohen, in your testimony this morning you cited ETA’s statement of ethical principles to support your contention that day-trading firms do not make exaggerated or misleading statements regarding trading results. Indeed, the statement of ethical principles

indicates that ETA members ‘‘will not make misleading or exaggerated claims about our services or the benefits of day trading, and

will provide a balanced perspective in our advertisements and presentations.’’ It goes on to say, ‘‘We will not obscure the reality that

most people lose money in their initial training period and that

many will not ultimately become successful day traders.’’

I would like to show you two statements that were taken off the

Web site of On-Line Investment Services, Inc. It is my understanding that this company is a member of your board of governors. Is my information correct on that?

Mr. COHEN. They’re an ETA member. I don’t know whether

they’re a member of the board.

Senator COLLINS. On-Line Investment Services was one of the

five members of ETA, it is my understanding, who adopted the

statement about the principles from which you quoted in your testimony. Is that correct, to your knowledge?

Mr. COHEN. Yes.

Senator COLLINS. I want to show you this first statement, which

says, ‘‘We have a successful rate of about 85 percent with customer

traders, meaning people who come here and actually make money

at this over time.’’ 1

Is that consistent with the ethical principles?

Mr. COHEN. It would be consistent if it’s accurate. I don’t know

whether it’s accurate. But the point I would make, because I have

no information on it, is that the language on the bottom—and I can

just about read it without my glasses—‘‘Cited information is no

longer found on Web site.’’

The statement of principles is a learning curve for all industries.

The statement of principles was adopted a couple of months ago.

I don’t know when this statement was made or when it came off,

but it’s conceivable that it’s as long ago as a year or more.

But the two parts to it, that somebody ought to ask again, is

whether or not this is accurate as a statement, and second, when

it was on and when it came off and what the circumstances were.

But I don’t know.

It’s important to understand——

Senator COLLINS. Let me understand. Are you saying that this

statement is OK if it was before the statement of principles?

Mr. COHEN. I’m saying it’s OK if it’s correct. I’m saying it

shouldn’t have been there if it’s incorrect, but in any case, it’s before the statement of principles.

What I would say is—and this is important to understand—ETA

represents something like 54 percent of all day traders who enter

a majority of orders. It does not represent all day-trading firms, nor

does it have the power of government to say do this or do that. The

fact that someone may or may not subscribe to ethical principles

41

1See Exhibit No. 5 on page 219 in the Appendix.

doesn’t mean they’re going to do it. On the other hand, the ethical

principles were formulated and the discussion was formulated over

the past few months, as this industry continues to learn and to

grow, because it’s very important to this industry—and I will now

go back to what the Blue Sky people said, that this industry gain

community acceptance. So the purpose of us being here is to dispel

a number of misconceptions with the hope that we will get a fair

hearing, so that a number of these misconceptions, in fact, can be

dispelled.

Senator COLLINS. Well, one reason you’re being asked to testify

today, and were given the opportunity to make your opening statement, was to make sure that the industry’s viewpoint was represented.

Mr. COHEN. I’m sorry, Senator. I’m not making it clear, and it’s

my fault, not yours.

We represent 54 percent of the day traders. I cannot tell you we

represent the entire day-trading industry.

Senator COLLINS. I understand that, Mr. Cohen, and that is why

we selected examples of deceptive advertising to show you that are

from members of your association. We’re not asking you about nonmembers.

Mr. COHEN. Well, I appreciate that. I have seen just one, and

what I’ve said with regard to it first is that I don’t know whether

it’s deceptive because I don’t know what the number is, from an accuracy standpoint, and I don’t know what the date is and whether

it reflects the statement of principles that was adopted 2 to 3

months ago.

Senator COLLINS. My point is that a company should not be making deceptive statements——

Mr. COHEN. If it’s deceptive. I agree with you. There is no dispute——

Senator COLLINS [continuing]. Regardless of whether it’s before

or after the statement of principles.

Mr. COHEN. If it is deceptive, it shouldn’t be on there. If it’s

not——

Senator COLLINS. Let me show you a similar statement, again by

On-Line Investment Services, which is a member of your board of

directors. I have confirmed that——

Mr. COHEN. Again, can you tell me when these were? Are you

talking about 1998?

Senator COLLINS. I believe that these were within the last year.

I am uncertain when they were removed.

But that is not my point. My point is that it is troubling if it is

misleading consumers at any point.

Can I ask you about this statement: ‘‘On-Line’s trading and mentoring programs boast an 85 percent success rate for new traders.’’ 1 Do you think that is accurate? Could it possibly be accurate?

Mr. COHEN. Could it possibly be accurate? I don’t know whether

it is accurate or not accurate. I just wouldn’t hazard a guess as to

whether it’s——

If it is not accurate, it should not be used. I don’t think there’s

any doubt. And I agree with you. Whether you have a statement

42

of principles or not, you should not use statements that are inaccurate. I just can’t tell you whether it’s accurate or inaccurate.

Senator COLLINS. You noted in your testimony—you said in a

very straightforward way that disclosure of risk is simply not an

issue. That’s on page 6 of your testimony.

Mr. COHEN. That’s right.

Senator COLLINS. The problem with that is the preliminary results of the joint examinations, the results announced by the SEC

and NASD today, suggest otherwise. We have written testimony

from Chairman Levitt saying that the SEC staff examined the Web

sites of 40 day-trading firms and discovered that half of those Web

sites today—I’m not talking about last year—had little or no risk

disclosure, and many of them downplayed the risk associated with

day trading.

Do the SEC’s preliminary findings that you’ve heard today

change in any way your view that the disclosure of risk is not a

problem with this industry?

Mr. COHEN. I don’t believe disclosure of risk is a problem, and

I’ll tell you why.

First, ETA members, although we’re 54 percent of the industry,

six firms, I don’t know what the other 34 firms are doing. But beyond that—and this is the important point, and I don’t seem to be

able to get it across—no matter what the risk disclosure was, you

could put it in neon lights, when you show up at a day-trading

firm, if you’re there a day, 2 days, 3 days, you will know every risk.

You don’t have to have it spelled out.

I’m not suggesting there shouldn’t be risk disclosure, or that people shouldn’t sign off on it. What I’m saying is that common sense

will tell you that if you spend 24 hours in day-trading firms, you’re

going to know what’s going on. This is very different from where

people are in the rest of the brokerage business. Because in the

rest of the brokerage business, you’re isolated. You are one customer with one broker, or one customer with an on-line firm, and

you don’t know what’s going on. You don’t know what the risks are.

But here you’re present and viscerally you know what the risks

are. You cannot miss the risks if the guy next to you is losing a

lot of money. You will know what’s happening, or someone else

will.

Senator COLLINS. Do you support the NASD’s appropriateness

rule?

Mr. COHEN. I have gone through that before. I think the difficulty with it is that the Securities Industry Association has pointed out—and it’s important to understand, that day trading, as a

group, is just a small part of the securities industry, that there has

never been a test like that in general, that all tests have dealt with

specific securities. That was the testimony, the recommendation as

to specific securities.

ETA would like to have some form of appropriateness test. It

doesn’t think the model that’s been given is a good one. The model

we’re suggesting that people look at is the option rule, 2860, the

NASD option rule, which says that first you give people risk disclosure, they sign off on the risk disclosure, and then they sign up for

particular strategies. Because what day trading is, just like option

43

trading, it is a series of strategies. All risky, some riskier than others.

Senator COLLINS. I don’t see what you could object to in the appropriateness rule. All it is doing is requiring a day-trading firm

to sit down with the customer, to get basic financial information,

to look at whether or not day trading might be an appropriate

strategy for this individual, to look at their investment goals.

What’s wrong with that? Wouldn’t that screen out some of the

people——

Mr. COHEN. Senator, I——

Senator COLLINS [continuing]. Who should not be engaging in

this practice?

Mr. COHEN. Senator, what I heard——

Senator COLLINS. Mr. Cohen, I would appreciate you letting me

finish my question.

Mr. COHEN. I’m sorry. I thought you had. I apologize.

Senator COLLINS. My point is, what is wrong with having an upfront screen that would screen out some people for whom day trading is clearly inappropriate because of their financial status?

Mr. COHEN. May I answer now?

Senator COLLINS. I would appreciate your answer.

Mr. COHEN. I was one of those who watched Chairman Greenspan’s testimony on the long-term capital management disaster. He

made a number of points, one of which was regulation for the sake

of regulation really doesn’t do much good.

An appropriateness test, in general, is not going to do much good

if it’s blurry and is completely generalized, which is why we have

suggested focusing on an options test. What I will tell you is that

these things can have an unfortunate effect, what is known as regulatory ‘‘creep,’’ which is that when you start off with regulations

that are blurry to begin with—if you look at the NASDR’s regulation, for example, they say we don’t define the word ‘‘promote.’’

We’re not saying who promotes day trading. That’s very important.

They don’t define it. They say we’re not going to define it. Leave

it open.

Well, I think it’s a lot less of concern to on-site day-trading firms

than it is to on-line firms, who I think are in an impossible position, because one of the tests the NASDR has in its suitability proposal is that you are promoting day trading, even if you do not advertise. I think I indicated before from the Discover ad, where the

advertising is, that even if you don’t advertise, if you have any day

traders. Well, there are on-line firms with a million and a half customers. If one percent of them, one percent, are day trading, doing

two or three trades a day, that’s triple the amount of day traders

in the day-trading industry.

So this is a much broader and wider question, which is why the

Securities Industry Association is opposed to this. What we have

tried to do is look at it constructively and say let’s get something

that can work. We think the options model is the one that works.

It’s a little hard, frankly, to be criticized—I’m not suggesting

you’re criticizing—but to ask pointed questions when we’re saying

look at something more focused than more general with regard to

this.

44

Senator COLLINS. Let me turn to another practice that troubles

me. Many day-trading firms have customer lending programs and

they, in fact, promote and arrange loans from 1 day trader and customer to another.

Isn’t the result of that practice to encourage people who are losing money to keep on trading?

Mr. COHEN. Senator, you may have been out for a vote when I

answered that before, with regard to Senator Levin. He had used

a very good example of somebody who made money, and I pointed

out to him that yes, in fact, there are perfectly good reasons why

one would lend money to someone else.

First of all, this loan was no risk. These are closed transactions.

They’re not open transactions. So the risks are known.

The practice of lending money from account to account has gone

on as long as the securities industry has gone on. It is noted.

There’s a New York Stock Exchange rule, 431(f)(4) that deals with

it. There are letters of authorization forms that have existed since

I’ve been in practice. So there is nothing special about it.

One of the problems that this Subcommittee seems to be having

is building on an edifice that I don’t think is there, on a base that’s

there. You’re focusing and trying to turn this part of the securities

industry into something separate from the rest of the industry. But

every regulation you write has an impact on the rest of the industry, and that’s why you get opposition from the Securities Industry

Association.

Senator COLLINS. I think the problem the Subcommittee is having is that we’re very concerned when we hear from State regulators, from the SRO, from the SEC, that day trading is a real

problem and that we do need effective new regulations in order to

ensure that small, unsophisticated investors realize what they’re

getting into, realize how highly risky this practice is, and realize,

in fact, that they are likely to lose their money.

Mr. COHEN. I’m sorry. If I may just finish——

Senator COLLINS. You may respond.

Mr. COHEN. I’m in agreement with you up to the last five words,

and that is, yes, it’s risky, they should have these disclosures

made, there are disclosures. I don’t think there’s a certainty that

people will lose money in on-site day trading.

But hopefully, when the study, the real study is done and it’s

over, there will be a much better feel of statistics to argue about

than we have now.

Senator COLLINS. Senator Levin.

Senator LEVIN. One of the day traders that we’re familiar with

says the following in their literature, the material that they hand

out. ‘‘Prior experience in trading is not essential to be successful in

this business, although it is important to understand that all forms

of investing involve risk in the loss of capital. An investors lack of

familiarity with securities trading can even be a strong asset, not

a liability.’’

Do you agree with that?

Mr. COHEN. Yes.

Do you want an explanation?

Senator LEVIN. If you want, sure.

45

Mr. COHEN. Mr. Levitt and I, I guess, share one thing, which is

age. We were around in the Sixties when there were ‘‘gunslingers,’’

people who traded the market successfully because they hadn’t

learned any of the lessons of the past, because each market is different and each thing changes. So not having previous experience

can be an advantage because you’re starting fresh.

I have gone to day-trading firms. I have sat down with the people. They are more or less uniform, the ones I have seen. They are

young, they are computer types, people who have grown up with

video games, and they sit there in half-darkened rooms, like a

movie theater, looking at screens—it’s not something I could do for

10 minutes, and they can do it endlessly, looking at it. And up

until the end of the day, they count it as counting points.

Now, whether or not that is a comfortable style of investing for

people of my age, I can’t tell you. But that’s where the world is.

It’s taking advantage of the information edge that is provided by

this technology in the same way that people took advantage of the

information edge of Mr. Edison’s stock ticker 110 years ago.

Senator COLLINS. Senator Levin, would you allow me to intervene on just one point on that, because I think you’ve raised a very

interesting point, and Mr. Cohen’s response is interesting to me.

The NASD has proposed as part of the risk disclosure statement

that potential clients of day-trading firms receive a statement saying that day trading requires knowledge of securities markets. So

would you oppose that statement being included?

Mr. COHEN. By the time you start day trading, you will have

knowledge of the securities markets. I don’t think we’re talking

about——

Let’s see what we’re talking about. I don’t think Ms. Schapiro is

going to say we expect you to have taken courses in finance or have

an MBA, and no one is going to start day trading in an on-site

firm, day one, without any knowledge of how the business works.

So I don’t think that’s a problem for anyone in terms of how the

markets work.

Does it mean you could get a job at Goldman Sachs as an analyst

or a technical analyst somewhere? No. But I don’t think that’s anybody’s test.

Senator COLLINS. Senator Levin.

Senator LEVIN. Do you think these day traders are investors?

Mr. COHEN. No.

Senator LEVIN. Pardon?

Mr. COHEN. No. It’s an approach to the market to make money.

Some are going to be successful and some won’t.

Senator LEVIN. Then you don’t agree with the part of the statement I read, which says an ‘‘investor’s’’ lack of familiarity——

Mr. COHEN. Senator, the trouble is, when somebody writes articles, you can only use so many words for the same thing. An investor is one of these——

Senator LEVIN. This isn’t an article. This is the day trader’s literature.

Mr. COHEN. ‘‘Investor’’ is a word that is used commonly for anybody who trades in the market. It’s an old——

Senator LEVIN. You would agree they’re not investors?

46

Mr. COHEN. They’re not investors. These are people who are

traders.

Senator LEVIN. Are you telling your members not to describe

themselves as investors?

Mr. COHEN. I’m sorry?

Senator LEVIN. Are you telling your members not to describe

these folks as investors?

Mr. COHEN. If I’m asked, I’ll tell them to try to find better phrasing. Traders would be better.

Senator LEVIN. You’re telling your members a number of things,

though, aren’t you?

Mr. COHEN. When I’m asked. I should point out——

Senator LEVIN. Aren’t you asking them to get risk disclosure

statements signed?

Mr. COHEN. Let me answer it in two ways, OK?

First, I have been counsel to ETA only since August, although

my views and theirs are the same broad identification. Second, I

don’t see a reason why you wouldn’t have them sign risk disclosure

statements.

Senator LEVIN. You are asking them to do that?

Mr. COHEN. The ETA is asking them.

Senator LEVIN. Your client.

Mr. COHEN. ETA, as my client, is asking its members to have

day traders sign risk disclosure forms.

Senator LEVIN. So when I say ‘‘you,’’ I mean you or your client.

Mr. COHEN. The client. I don’t see anything wrong with it, so if

you want me to identify with it, I will.

Senator LEVIN. Good. Your client then is asking its members to

sign this risk disclosure statement, which is Appendix C in your

materials. Is that correct?

Mr. COHEN. Yes.

Senator LEVIN. But your client is not asking people to avoid the

use of the word ‘‘investor’’?

Mr. COHEN. Senator, what we will do is, when the NASDR approves its appropriateness rule, which I assume is going to happen,

we will send this to NASDR advertising for review and ask them

to sign off on it. I don’t think they’re going to have a problem with

the word ‘‘investor,’’ but if that’s a problem for anyone, it will be

changed to ‘‘trader.’’

Senator LEVIN. Relative to that disclosure statement, Appendix

C, is this something which is required for signature by your members of their customers, or is this just something which is recommended to——

Mr. COHEN. It’s a trade association recommendation. We don’t

have the power to enforce it.

Senator LEVIN. You have the power to do anything you want and

say ‘‘you’re not going to be a member of this association unless you

follow our rules.’’ You can do that, can’t you?

Mr. COHEN. Pardon?

Senator LEVIN. Any association can say its members have got to

live up to the rules.

Mr. COHEN. Trade associations—and I was at various times associated with membership of the Securities Industry Association—basically provide recommendations to their members, and beyond

47

that, as long as the member is in good standing, the member stays

in good standing. So that is a wonderful example, and perhaps you

ought to apply it to a group that represents hundreds of brokers

rather than six.

Senator LEVIN. My question, though, is this, that you can make

the adoption of this risk disclosure statement a condition of membership of the association.

Mr. COHEN. I assume we could if somebody thought that was

crucial to life, yes.

Senator LEVIN. All right. Do you know how many of your members in fact require their customers to——

Mr. COHEN. I don’t.

Senator LEVIN. Do you care?

Mr. COHEN. Do I care? Yes. I would certainly like to know later

on.

Senator LEVIN. Could you find out for us?

Mr. COHEN. Oh, absolutely.

Senator LEVIN. How many members do you have again?

Mr. COHEN. We have 6—we have 40-something members, but 6

are——

Senator LEVIN. I’m sorry. Forty?

Mr. COHEN. Forty-something firms. Six are on-site trading firms.

Those on-site trading firms represent 54 percent of all traders, day

traders, so far as we know.

Senator LEVIN. So——

Mr. COHEN. It is, again, our estimates.

Senator LEVIN. I understand. Your estimate is that you represent

a majority of the day traders.

Mr. COHEN. Right, and a majority of the day-trading orders being

placed.

Senator LEVIN. I would like to ask you about the informal survey

that you referred to on page 11 of your testimony.

Mr. COHEN. Right.

Senator LEVIN. You have surveyed certain of its members to obtain a rough estimate of customer profitability.

Mr. COHEN. Right.

Senator LEVIN. Then you said these estimates were that after an

initial period of 3 to 5 months of losses, 60 to 65 percent netted in

the range of $28,000 per month, but the balance of customers losing $6,000 to $8,000 per month.

What was the capital investment that that represents?

Mr. COHEN. I’m sorry. I don’t understand the question.

Senator LEVIN. Well, how much of $28,000 is what percentage of

their investment that they have put down in the firm of their capital?

Mr. COHEN. Anywhere between, I would say, 28 and 56 percent.

Senator LEVIN. Of their what?

Mr. COHEN. Twenty-eight and 56 percent.

Senator LEVIN. Of their capital?

Mr. COHEN. Of their capital. I am talking $28,000 a month, 300

percent a year, current, if you make that kind of money, on

$100,000.

48

Senator LEVIN. Let me say that the—let’s talk about that initial

period of 3 to 5 months of losses. Let’s just focus on that. What was

the average loss in that 3 to 5——

Mr. COHEN. I didn’t—and I apologize for this. I didn’t take it

down to a number, but the understanding I had when I was finished was that it was not a significant number. It was a loss number, but it wasn’t a wipe-out loss number. It was a loss number.

Senator LEVIN. Can you provide that to the Subcommittee?

Mr. COHEN. From our six firms? Yes.

Senator LEVIN. Well, whoever you did this informal survey of.

Mr. COHEN. Yes, absolutely.

Senator LEVIN. I mean, you have told us——

Mr. COHEN. Senator, yes.

Senator LEVIN. Were you asked for this information by Massachusetts or by the NASAA?

Mr. COHEN. I don’t—I really have nothing to do with Massachusetts. I’m not sure. You are talking about ETA being asked by Massachusetts?

Senator LEVIN. Yes.

Mr. COHEN. The Massachusetts thing is fascinating in itself.

Senator LEVIN. Without getting into that, we had testimony this

morning that you were specifically asked for the backup information here.

Mr. COHEN. And we were willing—not with regard to—we are

talking apples and oranges.

Senator LEVIN. Relative to this survey of yours.

Mr. COHEN. Let me see if we can define it, OK? Massachusetts

is talking about some comments that the Los Angeles Times ran in

an article in January in which—and then there was correspondence

back and forth, and I was not the counsel involved in it, between

Massachusetts acting, I guess, for ETA, acting for the Blue Sky

people from NASAA and ETA.

That correspondence is apparently subject to two interpretations.

I think the Subcommittee ought to look at the correspondence. My

understanding of it is that the—and that is what is reflected in the

written submission—is that ETA offered to submit current information to NASAA with the methodology, which I have actually seen

the methodology, we can supply it, and NASAA said no. And I

think Mr. Shellenberger told you why he said no, because they did

not want to endorse, as he put it, what the results would be.

So the second survey that we are talking about is one that is at

a later point, that I participated in, in this past summer—and I

don’t recall. I think it was in August—in which I spoke to a number of the firms and got those responses.

Senator LEVIN. I am referring to the informal survey. Were you

asked by them for any information relative to that informal survey

that you refer to page 11?

Mr. COHEN. ETA—I should look at the statement because I think

we are talking about different things.

Senator LEVIN. That is what I want to find out. Are you saying

to us that that informal survey that you have taken, that you refer

to on page 11, is not the subject of any request by the——

Mr. COHEN. It says there are—it is actually clearly written as I

look at it: Earlier this year ETA informally surveyed certain of its

49

members to obtain a rough estimate of customer profitability. Its

members considered these numbers still to be representative in August. My understanding was that earlier this year, membership—

one or two of the members had been asked about it—these were

their numbers. For the purpose of dealing with this as an issue,

there was a—as part of a phone conference, the subject came up,

what are the numbers, can I get a feel for the numbers. I raised

the question. These are the responses I got from the particular people. So I am comfortable that is what I was told, and these are estimates. And the only way anybody is ever going to get comfortable

with this is to do what ETA now proposes to do, and that is to get

KPMG or someone else to do a study.

Senator LEVIN. But I want to go back to my question.

Mr. COHEN. OK. Senator, I am told the information has been

supplied both to the Subcommittee and to the Texas regulator that

asked the questions. That’s what counsel for——

Senator LEVIN. All right. That answers it. My time is up for this

round.

Mr. COHEN. All right. Sorry.

Senator LEVIN. Thank you.

Mr. COHEN. Is that what these lights mean?

Senator COLLINS. I apologize for not giving you an explanation,

and I assumed the staff had done so.

Mr. COHEN. I thought I was almost boiled.

Senator COLLINS. I have another commitment that I have to

keep. I have asked Senator Levin to proceed with the hearing because there are a number of additional areas that we are both

eager to pursue with you, Mr. Cohen. So I am going to turn over

the Chairman’s gavel to Senator Levin with my thanks.

I do want to take this opportunity to thank our staffs for their

very hard work on this hearing and to let people know that the

Subcommittee’s interest, if anything, has only been strengthened

by the overview hearing today. We will be continuing in an ongoing

investigation to look at the specific practices of selected day-trading

firms to gain a better understanding of this day-trading phenomenon.

So, with that, I would thank Senator Levin for his willingness to

continue the hearing in my absence.

Senator LEVIN [presiding]. Thank you, Madam Chairman.

I want to go back to page 11 to understand what it is you are

telling the Subcommittee. What is the average amount of capital

that was put up at risk that this net of $26,000 is based on? Is that

the capital investment of $100,000, 60 to 65 percent, in the range

of $28,000 a month? Give us an update.

Mr. COHEN. The $28,000 is a P&L number. Capital is a balance

sheet number. I mean, they are different things.

Senator LEVIN. Right.

Mr. COHEN. My understanding of capital is that—and this is

based simply on my understanding, having worked with day traders over a period of months, is that capital runs from $50,000 to

$100,000.

Senator LEVIN. So you are saying that this informal survey demonstrated that after an initial period of 3 to 5 months of losses that

50

65 percent profited, in the range of $28,000 per month based on an

average capital investment of perhaps $50,000 or $100,000.

Mr. COHEN. Yes.

Senator LEVIN. You are going to supply us the data to support

that estimate?

Mr. COHEN. I understand data regarding those estimates have

been supplied to the Subcommittee, but if they have not, I will find

out from counsel who is doing it.

Senator LEVIN. Now——

Mr. COHEN. I would also think it would be useful to wait for the

KPMG study.

Senator LEVIN. That may or may not be useful, but the basis of

this representation would be very useful to me.

Mr. COHEN. The representation——

Senator LEVIN. People who have $50,000 or $100,000 at risk and

are making $300,000 a year profit, that is an absolutely incredible

representation that you are making.

Mr. COHEN. Here is what we wrote. In August, ETA’s executive

committee members considered these numbers still to be representative. Please note that these are only estimates. Unlike the NASAA

report, they do not purport to be scientific. No one is purporting or

representing these are scientific. This was the feel of the people

who are running these firms that these were the numbers.

Senator LEVIN. You are representing to this——

Mr. COHEN. Absolutely. I am representing that I was informed

by the——

Senator LEVIN. Well, let me finish my statement now.

You are representing to this Subcommittee that the estimates,

the estimates of certain of your members to get an estimate of customer profitability demonstrates that after an initial period of 3 to

5 months of losses, 60 to 65 percent of those day traders netted in

the range of 28,000 per month which is over $300,000 a year, based

on a capital investment of $50,000 to $100,000. Now, that is what

you are representing.

Mr. COHEN. Absolutely. And let me say further that the capital

issue really is not important because it——

Senator LEVIN. It may not be to you.

Mr. COHEN. If the average trade is 700 shares and the average

NASDAQ stock is $27.15, according to the SIA statistics, you are

talking about an average trade of $20,000 that somebody holds for

4 minutes.

Senator LEVIN. I understand.

Mr. COHEN. OK.

Senator LEVIN. I am only talking about a return on how much

money you are putting at risk. That is what I am talking about.

Mr. COHEN. Well, we have not done it as a return on capital, but

we have put it as P&L numbers, the way it was written here.

Senator LEVIN. I understand.

I will tell you again, I find that estimate incredible, and I would

like to see the data that supports it, and I think it is the kind of

touting——

Mr. COHEN. Well, it will either be or it will not be.

Senator LEVIN. I think it is.

Mr. COHEN. Well, let’s wait for the numbers.

51

Senator LEVIN. Yes. But I think it is the kind of touting—I am

stating my opinion. I am giving you my estimate now. You are telling the world——

Mr. COHEN. Well, as a lawyer, when I speak to clients——

Senator LEVIN. Well, now, let me finish. Keep $50,000 here or

$100,000 at risk. Play with it for a year. You will make $300,000—

no. Two-thirds of you will make $300,000.

Mr. COHEN. I don’t——

Senator LEVIN. That is what you are saying the estimate of your

members are.

Mr. COHEN. I think that is what you are saying it says.

Senator LEVIN. No, that is what you said.

Mr. COHEN. Can I use my own words?

Senator LEVIN. Now it is your turn.

Mr. COHEN. Thank you very much.

What this says is that there is a period of time in which people

will lose money. It is part of the normal learning curve, and that

after that period, people will make money, and two out of three will

average something like $28,000 net a month. That is based on discussions I have had with people running on-site firms, and I have

no reason to believe that since they are there every day and more

or less have a feel for it that those are not correct estimates, but

we do not represent they are scientific and it says here they are

not scientific, which is why we are going out to get KPMG to get

these numbers.

Senator LEVIN. You are also representing that they consider

these numbers to be representative?

Mr. COHEN. Yes.

Senator LEVIN. That is a tout.

Mr. COHEN. It is a tout—if it is inaccurate, I am saying what it

says here.

Senator LEVIN. OK.

Mr. COHEN. We consider them to be representative. We spoke to

our people. They believe they are representative.

This is a document produced for this Subcommittee.

Senator LEVIN. It still ought to be accurate.

Mr. COHEN. It is accurate, so far as I know, and I would think

you would want us to give you the broadest possible read we can,

which is what we tried to do.

Senator LEVIN. Yes.

Mr. COHEN. Apparently, Senator, you have less problems with

the NASAA report written by this guy out of his apartment.

Senator LEVIN. Yes. I have a lot of problems with this report

here because I do not believe you can put $50,000 to $100,000 at

risk and then over a period of a year, two-thirds of the people who

do that get back a return of over $300,000. I do not believe it.

Mr. COHEN. Senator——

Senator LEVIN. OK? I just do not believe it.

Mr. COHEN. Well, that is fair. You——

Senator LEVIN. You apparently do believe it.

Mr. COHEN. You certainly——

Senator LEVIN. Do you believe it?

Mr. COHEN. I believe it. I certainly feel you are free not to believe

it, but you also might ask yourself the question why haven’t there

52

been any complaints. Why if in fact something like 70 percent of

people lose money in 6-month periods which mean 20,000 over 3

years, NASAA, this Subcommittee, the SEC, and the NASD have

not been inundated with complaints by losing day traders?

Senator LEVIN. I think maybe people want to gamble.

Mr. COHEN. Well——

Senator LEVIN. If people want to gamble, you say they ought to

be free to do so.

Mr. COHEN. The American—I haven’t said that at all. What we

have said is this is not gambling, that the people who trade in this

market—Senator, I do not know what your previous profession

was. You are good at it. I assume you were a lawyer. But this is

not gambling.

Senator LEVIN. See, you made another assumption here. That I

was good at it. [Laughter.]

Mr. COHEN. I have often been criticized for criticizing people, but

to be criticized for praising somebody is a little different, but it is

Washington and I am not used to it.

I do not know if you were here when we talked about it, but the

opening of my statement, I said that day traders do not regard this

as gambling. That is a quote that is in the newspapers. That is

something you can find. The people who do it do not think they are

gambling. They think they are using informational edges in order

to trade successfully.

Senator LEVIN. I would like to go to another statement of yours

on page 17 of your testimony, where you say day trading is not

gambling.

Mr. COHEN. Yes.

Senator LEVIN. You say the majority of those who day-trade after

training do not lose money.

Mr. COHEN. Yes.

Senator LEVIN. What is that based on?

Mr. COHEN. That is based on the same survey.

Senator LEVIN. This same unscientific survey?

Mr. COHEN. This same unscientific survey.

Senator LEVIN. I do not see all of those qualifiers next to your

statement here.

Mr. COHEN. Senator, I kind of feel that when people read the

document, they read it as a whole, but that may well be a failing,

and I will footnote things in the future.

Senator LEVIN. No, I think——

Mr. COHEN. When I write Law Review articles, I put footnotes

after every sentence, so——

Senator LEVIN. That is the kind of unqualified statement which

people believe.

Mr. COHEN. Well, if they don’t read the whole thing.

Senator LEVIN. Most people do not read 25 pages of testimony.

They will look at one flat-out statement. The majority of those who

day-trade after training do not lose money. That is what they hear.

Mr. COHEN. I was here this morning sitting in the audience

when somebody quoted something out of context that I said in an

article that I wrote. So I know people on this Subcommittee certainly don’t read entire articles.

53

Senator LEVIN. Well, are you saying that that is out of context,

what I just read?

Mr. COHEN. What I am saying is that my article was out of context as it was quoted, and what this says, if you refer back to part

of the summary—it is part of the summary, which I think fairly

said means if it is part of a summary, you go back to the full text

where it is referred to.

Senator LEVIN. OK. You are going to let the Subcommittee know

what percentage of your members require your Exhibit C to be

signed by their members. Is that something you are going to give

us?

Mr. COHEN. Yes, sir.

Senator LEVIN. If you have not already given us the material

that supports this unscientific survey of yours, you are going to let

us have the background material for your conclusion about netting

$28,000, two-thirds of the people per month.

You also indicated that you would supply to the Subcommittee

what were the losses during the 3-to-5-month period.

Mr. COHEN. I don’t recall you asking that, but if it is part of the

same stuff, it is all the same material. So it should be——

Senator LEVIN. Would you do that——

Mr. COHEN. Yes.

Senator LEVIN [continuing]. If I did not ask for it? I will ask for

it now.

One other question. You said that after training, you indicate

that the majority of those who day-trade based on that informal

survey are now saying that they do not lose money. Does that

training include the 3 to 5 months of losses?

Mr. COHEN. Yes.

Senator LEVIN. You consider that part of training?

Mr. COHEN. Yes. That is part of the learning process. I could

have used a different phrase. I apologize for the phrasing. It could

have been after the learning process, but everybody is always

learning.

Senator LEVIN. You also have training before the 3 to 5 months

begins, don’t you?

Mr. COHEN. Senator, let me answer it this way. A lot of people

who come into day trading have traded previously. There was a

New York Times article that said professionals are coming to the

business. So they presumably start trading day one with a vast

amount of skill and experience. If we are talking about people who

have not traded before, what we are talking about in their case is

this 3-to-5-month period, which includes training and actual trading.

Senator LEVIN. I guess my question is: You do training prior to

the actual trading? Does some of the training that you are referring

to take place before the actual——

Mr. COHEN. I believe firms train people who have not been in the

market before, that they have training programs. They certainly

have training programs. I cannot tell you whether every on-site

firm has got one.

Senator LEVIN. If in fact your survey is accurate that most people

lose money in the first 3 to 5 months, assuming you are accurate

54

1See Exhibit No. 9 on page 228 in the Appendix.

on that, would you be willing to have your risk disclosure statement notify people that most people lose money for 3 to 5 months?

Mr. COHEN. I think it says it now, but I haven’t gone back over

it.

Senator LEVIN. No. I do not think it says quite that. It says you

can lose money. I am asking——

Mr. COHEN. I thought it says—well, I apologize. I am not able

to find it, but I do not have a problem if that is your question that

people lose money in the first 3 to 5 months.

Senator LEVIN. That most people.

Mr. COHEN. That most people.

Senator LEVIN. You do not have any problem in modifying your

statement?

Mr. COHEN. I don’t see a reason not to.

Senator LEVIN. Good.

Mr. COHEN. By the way, that, of course, goes well beyond the

risk disclosure of the NASDR, but we are well beyond where the

NASDR is.

Senator LEVIN. I think that would support that claim if you did

that.

We want to thank you and the other witnesses for appearing

today. The hearing will be recessed. We will now adjourn this hearing because it is the first of a series of hearings.

Again, I want to thank our Chairman for her leadership here. We

are getting into an area which I think all of us would acknowledge

as an extremely important area to consumers, and I think you also

would acknowledge that, Mr. Cohen, even though there is obviously

a difference here that this is a very important area to consumers.

I think that on that, you would not disagree.

Mr. COHEN. What I would say—thank you for the opportunity at

least to comment on it. The consumers I would be concerned about

are the online as opposed to the on-site people, and what I would

say is it depends where you look in the telescope. What I am looking at the telescope is the on-site day traders are providing enormous benefits to consumers, the average guy throughout the market.

Senator LEVIN. I thank all of our witnesses for coming forward.

One other question, just for you and the other witnesses, if we

still have them here. If we have additional questions for the record,

whether you would be willing to answer those questions?

Mr. COHEN. Of course. 1

Senator LEVIN. I do not know if our other witnesses are all here.

Mr. HILDRETH. Yes.

Senator LEVIN. Thank you all.

Mr. COHEN. Thank you.

Senator LEVIN. We will stand adjourned.

[Whereupon, at 1:10 p.m., the Subcommittee was adjourned.]

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