[Federal Register Volume 65, Number 137 (Monday, July 17, 2000)]
[Notices]
[Pages 44082-44088]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 00-17968]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-43021; File No. SR-NASD-99-41]
Self-Regulatory Organizations; National Association of Securities
Dealers, Inc.; Order Approving Proposed Rule Change and Amendment No. 1
and Notice of Filing and Order Granting Accelerated Approval of
Amendment No. 2 Relating to the Opening of Day-Trading Accounts
July 10, 2000.
I. Introduction
On August 20, 1999, the National Association of Securities Dealers,
Inc. (``NASD'' or ``Association''), through its wholly owned
subsidiary, NASD Regulation, Inc. (``NASD Regulation''), filed with the
Securities and Exchange Commission (``SEC'' or ``Commission''),
pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ a proposed rule change
relating to the opening of day-trading accounts.
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
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The proposed rule change was published for comment in the Federal
Register on September 21, 1999.\3\ The Commission received three
comment letters on the proposed rule change.\4\ On
[[Page 44083]]
February 18, 2000, NASD Regulation submitted Amendment No. 1 to the
proposed rule change.\5\ Amendment No. 1 was published for comment in
the Federal Register on March 2, 2000.\6\ The Commission received four
comment letters on the proposed rule change in Amemdment No. 1.\7\ On
June 21, 2000, NASD Regulation submitted Amendment No. 2 to the
proposed rule change.\8\ In this notice and order, the Commission is
seeking comment from interested persons on Amendment No. 2 and
approving the proposed rule change and Amendment No. 1, and is
approving Amendment No. 2 on an accelerated basis.
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\3\ Securities Exchange Act Release No. 41432 (September 14,
1999), 64 FR 51165.
\4\ See Letters from James H. Lee, President, Electronic Traders
Association (``ETA''), to Jonathan G. Katz, Secretary, SEC, dated
October 11, 1999; Bradley W. Skolnik, President, Indiana Securities
Commissioner, North American Securities Administrators Association
(``NASAA''), to Jonathan G. Katz, Secretary, SEC, dated October 12,
1999; and Lee B. Spencer, Jr., Chairman, Federal Regulation
Committee, Everett Lang, Co-Chairman, Discount Brokerage Committee,
Michael L. Michael, Chairman, Ad-Hoc Committee on Technology and
Regulation, and Michael Anderson, Co-Chairman, Discount Brokerage
Committee, Securities Industry Association (``SiA''), to Margaret H.
McFarland, Deputy Secretary, SEC, dated October 22, 1999.
\5\ In Amendment No. 1, NASD Regulation responded to issues
raised in the initial three comment letters by revising the proposed
rule change and the proposed rule text with respect to: modifying
the disclosure statement; revising the method for delivering the
disclosure statement; describing certain activities that will not
trigger application of the proposed day-trading rules; and
clarifying information-gathering requirements. See Letter from Alden
S. Adkins, Sr. Vice President and General Counsel, NASD Regulation,
to Katherine A. England, Assistant Director, Division of Market
Regulation (``Division''), SEC, dated February 10, 1999 (``Amendment
No. 1'').
\6\ Securities Exchange Act Release No. 42452 (February 23.
2000), 65 FR 11353.
\7\ See Letters from The Honorable Susan M. Collins, Chairman,
Permanent Subcommittee on Investigations, The Honorable Carl Levin,
Ranking Minority Member, Permanent Subcommittee on Investigations,
and The Honorable Richard J. Durbin, Committee on Governmental
Affairs, U.S. Senate, to Jonathan G. Katz, Secretary, SEC, dated
March 17, 2000 (``Senators''); Linda Lerner, General Counsel, All-
Tech Direct, Inc., to Jonathan G. Katz, Secretary, SEC, dated March
20, 2000 (``All-Tech''); Bradley W. Skolnik, President, Indiana
Securities Commissioner, NASAA, to Jonathan G. Katz, Secretary, SEC,
dated March 23, 2000; and Robert P. Mazzarella, Chairman, Discount
Brokerage Committee, and Michael L. Michael, Chairman, Ad Hoc
Committee on Technology and Regulation, SIA, to Jonathan G. Katz,
Secretary, SEC, dated March 23, 2000.
\8\ In Amendment No. 2, NASD Regulation responded to the comment
letters submitted on Amendment No. 1 and incorporated several
recommendations from the letters into the proposed disclosure
statement. See Letter from Joan Conley, Senior Vice President and
Corporate Secretary, NASD Regulations, to Nancy Sanow, Assistant
Director, Division, SEC, dated June 21, 2000 (``Amendment No. 2'').
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II. Description of the Proposal
The NASD, through NASD Regulation, proposes to add two new rules to
its Rule 2300 series.\9\ New Rules 2360, approval Procedures for Day-
Trading Accounts, and 2361, Day-Trading Risk Disclosure Statement, only
apply to firms that are ``promoting a day-trading strategy.''
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\9\ NASD's 2300 series of rules covers Transactions With
Customers.
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The proposal focuses on disclosing the basis risks of engaging in a
day-trading strategy and assessing the appropriateness of day-trading
strategies for individuals. In particular, the proposal would require a
firm that is ``promoting a day-trading strategy,'' directly or
indirectly, to deliver a specified risk disclosure statement to a non-
institutional customer prior to opening an account for the customer. In
addition to delivering the risk disclosure statement, the proposal
would require a firm to either: (1) Approve the customer's account for
day trading; or (2) obtain a written agreement from the customer
stating that the customer does not intend to use the account for day-
trading activities. A firm would not be permitted to rely on the
written agreement from the customer if the firm knows that the customer
intends to use the account for day trading. In addition, if a firm
knows that a customer who provided such an agreement is engaging in a
day-trading strategy, the firm would be required to approve the account
for day trading.
As part of approving an account for day trading, a firm would be
required to have reasonable grounds for believing that the day-trading
strategy is appropriate for the customer. In making this determination,
the firm would be required to exercise reasonable diligence to
ascertain the essential facts about the customer, including his or her
financial situation, tax status, prior investment and trading
experience, and investment objectives. The firm also would be required
to prepare a record setting forth the basis on which the firm has
approved the customer's account for day trading. Any record or written
statement prepared or obtained by the firm pursuant to the proposed
rule change would have to be preserved in accordance with NASD Rule
3110(a).
A. Scope of Proposal
1. Firms ``Promoting a Day-Trading Strategy''
As discussed below, the proposed new rules only apply to firms that
are ``promoting a day-trading strategy'' and to new accounts opened by
all non-institutional customers at those firms.\10\ While the proposal
does not expressly define ``promoting a day-trading strategy,'' it does
state that none of the following actions alone would trigger the
proposed rule's requirements: (1) The promotion by a member of
efficient execution services or lower execution costs based on multiple
trades; (2) providing general investment research or advertising the
high quality or prompt availability of such general research; and (3)
having a web site that provides general financial information or news
or that allows the multiple entry of intra-day purchases and sales of
the same securities.\11\
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\10\ As proposed, ``day-trading strategy'' is defined as ``an
overall trading strategy characterized by the regular transmission
by a customer of intra-day orders to effect both purchase and sale
transactions in the same security or securities.'' The proposed
definition would include those instances where an individual
regularly transmits one or more purchase and sale (i.e., ``round-
trip'') transactions in a single day. The proposed definition of
``day-trading strategy'' also includes orders transmitted by non-
electronic means, such as by telephone.
\11\ In the original filing, activities that would not alone
trigger application of the rule were described in the proposed rule
change but were not part of the proposed rule text. In Amendment No.
1, NASD Regulation added these provisions to the proposed rule text.
See Amendment No., supra note 5.
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The proposal would apply to a member that affirmatively promotes
day-trading activities or strategies through advertising, training
seminars, or direct outreach programs. The proposal would only be
triggered by the firm's general promotional efforts or by firm-
sponsored promotional efforts.\12\ For instance, a firm generally would
be subject to the proposed rule if its advertisements address the
benefits of day trading, rapid-fire trading, or momentum trading, or
encourage persons to trade or profit like a professional trader. A firm
also would be subject to the proposed rule if it promotes its day-
trading services through a third party. Moreover, the fact that many of
a firm's customers are engaging in a day-trading strategy would be
relevant in determining whether a firm has promoted itself in this way.
Firms may not, however, promote day trading through individuals in an
effort to circumvent the proposed rule. In addition, if a principal or
officer of the firm is aware that brokers in the firm are soliciting
customers for day trading, then firm will be deemed to be promoting day
trading.\13\
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\12\ See amendment Nos. 1 and 2, supra notes 5 and 8.
\13\ Id. In Amendment No. 2, NASD Regulation noted that NASD
Rule 3010(a) requires that firms maintain a system to supervise the
activities of each registered representative that is reasonably
designed to achieve compliance with applicable securities laws and
regulations, and with NASD rules.
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While the proposal does not define the term ``promoting a day-
trading strategy,'' NASD Regulation represents that firms could submit
their advertisements to NASD Regulation's Advertising/Investment
Companies Regulation Department for review and guidance on whether the
content of the
[[Page 44084]]
advertisement constitutes such activity for purposes of the
proposal.\14\
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\14\ As a result, NASD Regulation believes that the proposal
should both limit concerns about any effect of the proposal on the
NASD's general suitability rule and allow firms to better determine
whether a particular advertisement would trigger the rule prior to
publication or distribution of the advertisement.
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2. Accounts Covered by the Proposed Rule
The term ``non-institutional customer'' would mean a customer that
does not qualify as an ``institutional account'' to mean the account
of: (1) A bank, savings and loan association, insurance company, or
registered investment company; (2) an investment adviser registered
either with the SEC under Section 203 of the Investment Advisers Act of
1940 or with a state securities commission (or agency or office
performing similar functions); or (3) any other entity (whether a
natural person, corporation, partnership, trust, or otherwise) with
total assets of at least $50 million.\15\ The proposal would not apply
to an existing customer unless the customer opens a new account at a
firm that is promoting a day-trading strategy.
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\15\ NASD Regulation believes that applying the proposed rule
change to non-institutional customers would ensure that most
individuals would be covered by the proposal, regardless of whether
they engage in day-trading activities in their own name or in the
name of a corporation or partnership.
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B. Requirements for New Customer Accounts of Firms Promoting a Day-
Trading Strategy
Before opening a new account for a customer, a firm that is
promoting a day-trading strategy must deliver a risk disclosure
document and either approve the account for day trading or obtain a
written agreement from the customer stating that the customer does not
intend to use the account for day-trading activities. Each of these
requirements is described below.
1. Requirement to Provide a Day-Trading Risk Disclosure Statement
As discussed above, the proposal would require a firm that is
promoting a day-trading strategy to deliver a risk disclosure
statement, discussing the unique risks posed by day trading, to all
non-institutional customers prior to opening an account for such
customers.\16\ The disclosure statement would include several factors
that a customer should consider before engaging in day trading,
including that: The customer should be prepared to lose all of the
funds that he or she uses for day trading; day trading generally
requires significant resource; \17\ and day trading on margin or short
selling may result in losses beyond the initial investment.
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\16\ NASD Regulation did not recommend that all firms, whether
or not they promote day trading, be required to disseminate the
disclosure statement to all new customers because the benefits of
such a requirement are unclear. However, NASD Regulation advised
that it will continue to monitor the growth of day-trading
activities to determine whether, in the future, such a requirement
might be justified. See Amendment No. 1, supra note 5.
\17\ In Amendment No. 2, NASD Regulation adopted the Senators'
suggestion to include in the risk disclosure statement a warning
that investors with less than $50,000 in risk capital are not likely
to succeed as day traders. See Amendment No. 2, supra note 8.
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The disclosure statement also would include a provision stating
that day trading generally is not appropriate for persons of limited
resources and limited investment or trading experience and low risk
tolerance. Another provision would explain that a day trader should
know its firm's business practices \18\ because under certain market
conditions, a day trader may find it difficult or impossible to
liquidate a position quickly at a reasonable price, such as when the
market for a stock suddenly drops, or if trading is halted due to
recent news events or unusual trading activity. The provision would
further state that the more volatile a stock is, the greater the
likelihood that problems may be encountered in executing a
transaction.\19\
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\18\ See Amendment No. 2, supra note 8.
\19\ See Amendment No. 1, supra note 5.
\20\ See Amendment No. 2, supra note 8.
\21\ Id.
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The disclosure statement would further explain that, because a day-
trading strategy requires frequent trades, payment of commissions will
add to losses or significantly decrease earnings. The disclosure
document also would provide an example of how much annual profit a day
trader would need to generate just to cover commission costs.\20\ The
disclosure statement would conclude with a provision that informs
investors of the potential need to register as an investment adviser or
as a broker or dealer under federal and state registration
requirements.\21\
The firm would be permitted to develop an alternative risk
disclosure statement, provided that the alternative statement was
substantially similar to the mandated statement and was filed with, and
approved, by NASD Regulation's Advertising/Investment Companies
Regulation Department. In addition, NASD Regulation encourages all
firms, particularly firms that provide on-line trading capability, to
provide the mandated risk disclosure statement or a substantially
similar disclosure statement to their customers. The proposed risk
disclosure statement, as amended, follows. Proposed additions from
Amendment No. 2 are in italics and proposed deletions are in
brackets.\22\
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\22\ Proposed NASD Rule 2360, pertaining to approval procedures
for day trading accounts, remains unchanged from Amendment No. 1 and
therefore its text is not set forth in this release.
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Rule 2361. Day-Trading Risk Disclosure Statement
(a) Except as provided in paragraph (b), no member that is
promoting a day-trading strategy, directly or indirectly, shall open
an account for or on behalf of a non-institutional customer unless,
prior to opening the account, the member has furnished to each
customer, individually, in writing or electronically, the following
disclosure statement:
You should consider the following points before engaging in a
day-trading strategy. For purposes of this notice, a ``day-trading
strategy'' means an overall trading strategy characterized by the
regular transmission by a customer of intra-day orders to effect
both purchase and sale transactions in the same security or
securities.
Day trading can be extremely risky. Day trading generally is not
appropriate for someone of limited resources and limited investment
or trading experience and low risk tolerance. You should be prepared
to lose all of the funds that you use for day trading. In
particular, you should not fund day-trading activities with
retirement savings, student loans, second mortgages, emergency
funds, funds set aside for purposes such as education or home
ownership, or funds required to meet your living expenses. Further,
certain evidence indicates that an investment of less than $50,000
will significantly impair the ability of a day trader to make a
profit. Of course, an investment of $50,000 or more will in no way
guarantee success.
Be cautious of claims of large profits from day trading. You
should be wary of advertisements or other statements that emphasize
the potential for large profits in day trading. Day trading can also
lead to large and immediate financial losses.
Day trading requires knowledge of securities markets. Day
trading requires in-depth knowledge of the securities markets and
trading techniques and strategies. In attempting to profit through
day trading, you must compete with professional, licensed traders
employed by securities firms. You should have appropriate experience
before engaging in day trading.
Day trading requires knowledge of a firm's operations. You
should be familiar with a securities firm's business practices,
including the operation of the firm's order execution systems and
procedures. Under certain market conditions, you may find it
difficult or impossible to liquidate a position quickly at a
reasonable price. This can occur, for example, when the market for a
stock suddenly drops, or if trading is halted due to recent news
events or unusual trading activity. The more volatile a stock is,
the greater the likelihood that problems may be
[[Page 44085]]
encountered in executing a transaction. In addition to normal market
risks, you may experience losses due to system failures.
Day trading will generate substantial commissions, even if the
per trade cost is low. [Day trading may result in your paying large
commissions.] Day trading involves [may require you to trade your
account] aggressive[ly] trading, and generally you will [may] pay
commissions on each trade. The total daily commissions that you pay
on your trades will [may] add to your losses or significantly reduce
your earnings. For instance, assuming that a trade cost $16 and an
average of 29 transactions are conducted per day, an investor would
need to generate an annual profit of $111,360 just to cover
commission expenses.
Day trading on margin or short selling may result in losses
beyond your initial investment. When you day trade with funds
borrowed from a firm or someone else, you can lose more than the
funds you originally placed at risk. A decline in the value of the
securities that are purchased may require you to provide additional
funds to the firm to avoid the forced sale of those securities or
other securities in your account. Short selling as part of your day-
trading strategy also may lead to extraordinary losses, because you
may have to purchase a stock at a very high price in order to cover
a short position.
Potential Registration Requirements. Persons providing
investment advice for others or managing the securities accounts for
others may need to register as either an ``Investment Advisor''
under the Investment Advisors Act of 1940 or as a ``Broker'' or
``Dealer'' under the Securities Exchange Act of 1934. Such
activities may also trigger state registration requirements.
(b) In lieu of providing the disclosure statement specified in
paragraph (a), a member that is promoting a day-trading strategy may
provide to the customer, individually, in writing or electronically,
prior to opening the account, an alternative disclosure statement,
provided that:
(1) The alternative disclosure statement shall be substantially
similar to the disclosure statement specified in paragraph (a); and
(2) The alternative disclosure statement shall be filed with the
Association's Advertising Department (Department) for review at
least 10 days prior to use (or such shorter period as the Department
may allow in particular circumstances) for approval and, if changes
are recommended by the Association, shall be withheld from use until
any changes specified by the Association have been made or, if
expressly disapproved, until the alternative disclosure statement
has been refiled for, and has received, Association approval. The
member must provide with each filing the anticipated date of first
use.
(c) For purposes of this rule, the term ``day-trading strategy''
shall have the meaning provided in Rule 2360(e).
(d) For purposes of this R[r]ule, the term ``non-institutional
customer'' means a customer that does not qualify as an
``institutional account'' under Rule 3110(c)(4).
* * * * *
2. Customer Acknowledgment
The proposal would require firms to deliver the disclosure
statement to each customer individually, by mail or electronic means,
prior to opening the account. A firm would not satisfy the proposal's
requirements by posting the disclosure statement in a remote location
on its web site, and claiming that it was delivered to all customers in
such manner. The proposal would not require customers to sign the
disclosure statements.\23\
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\23\ NASD Regulation added the ``individual'' delivery
requirement in Amendment No. 1. NASD Regulation believes that any
abuses of the delivery requirement could be detected during routine
examinations. See Amendment No. 1, supra note 5.
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3. Approving Customer Accounts for Day Trading
In addition to delivering a risk disclosure document. A firm must
approve a customer's account for a day-trading strategy in accordance
with certain procedures. Specifically, to approve a customer's account
for a day-trading strategy, a firm must have reasonable grounds for
believing that the strategy is appropriate for the customer and to
exercise reasonable diligence to ascertain the essential facts relative
to the customer. The proposal would expressly require a firm to review
a customer's investment objectives, investment and trading experience
and knowledge, financial situation (including estimated annual income
from all sources, estimated net worth exclusive of family residence,
and estimated liquid net worth), tax status, employment status (name of
employer, self-employed or retired, marital status, number of
dependents, and age.\24\ The proposal would not required firms to
determine the source of funds, primarily because of concerns with
defining the scope of any such obligation and the risks of imposing
disproportionate burdens on firms.\25\
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\24\ The proposed rule change originally included only an
evaluation of the investment objectives, investment and trading
experience and knowledge, financial situation and tax status. The
additional factors were added in Amendment No. 1. See Amendment No.
1, supra note 5.
\25\ See Amendment No. 2, supra note 8.
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4. Accounts Used for Purposes Other Than Day-Trading Activities
As an alternative to approving an account for a day-trading
strategy, the proposal would permit a firm that is promoting a day-
trading strategy to obtain from the customer a written agreement that
the customer does not intend to use the account for the purposes of day
trading (``other-use agreement''). \26\ A firm would not be permitted
to rely on an other-use agreement if it knows that the customer intends
to use the account for day trading. Moreover, if a firm opens an
account for a customer in reliance on an other-use agreement, but later
knows that the customer is using the account for day-trading
activities, then the firm would be required to approve the customer's
account for day trading in accordance with the rule as soon as
practicable, but in no event later than ten days from the date of
discovery. The standard of knowledge is one of actual knowledge.\27\
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\26\ The firm would be required to provide a risk disclosure
statement to the customer even if the firm obtains an other-use
agreement
\27\ See Amendment No. 1, supra note 5. NASD Regulation believes
that it is proper to hold a firm accountable for facts known to the
firm. See Amendment No. 2, supra note 8.
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III. Summary of Comments
After the original publication of the proposed rule change in the
Federal Register,\28\ the Commission received comment letters form the
ETA, NASAA, and the SIA, \29\ generally supporting aspects of the
proposed rule change but recommending numerous significant changes to
the proposal itself. NASD Regulation responded to these letters in
Amendment No. 1.\30\ The Commission then published Amendment No. 1 for
comment,\31\ and, in response, the commission received comments letters
form All-Tech, the SIA, NASAA, and the Senators, again generally
supporting features of the proposal but recommending various
modifications.\32\
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\28\ See supra note 3.
\29\ See supra note 4.
\30\ See Amendment No. 1 supra note 5. A summary of comments
received on the original filing is included in Securities Exchange
Act Release No. 42452 (February 23, 2000), 65 FR 11353 (March 2,
2000).
\31\ See supra note 6.
\32\ See supra note 7.
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A. Issues Raised in Comment Letters to Amendment No. 1
1. Application of the Rule
In its comment letter to Amendment No. 1, the SIA restated its
concern that individual solicitations by a broker or brokers of a day-
trading strategy could cause an entire firm to be deemed to be
promoting a day-trading strategy. In Amendment No. 1, NASD Regulation
stated that if a broker targeted, for example, five customers for day
trading without the firm's knowledge, the firm would not be deemed to
be promoting day trading. However, if a principal or officer of the
firm knew that the firm's brokers were promoting a day-trading
strategy, the firm would be deemed to
[[Page 44086]]
be promoting day trading. The SIA argued that knowing the strategies
employed by its brokers is a good supervisory practice and should not
trigger application of the day-trading rules to the entire firm.
Alternatively, the SIA argued that the commentary accompanying the
proposal should state that a number of the firm's brokers would need to
be individually soliciting customers to day trade for these
solicitations to cause the firm itself to be considered to be promoting
a day-trading strategy. In response, NASD Regulation stated that, while
solicitations by individual brokers would not alone cause a firm to be
considered to be promoting a day-trading strategy, when an officer or a
principal has knowledge of brokers soliciting accounts for day trading,
the firm would be deemed to be promoting day trading and thus subject
to the day-trading rules.\33\
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\33\ See Amendment Nos. 1 and 2, supra notes 5 and 8.
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The SIA also suggested that the proposal unfairly assigns the firm
the responsibility for customers changing their minds with respect to
the ``other use'' agreement. The SIA stated that because firms maintain
records of customers' trades, it can be argued that firms always have
actual knowledge. The NASD responded that, on balance, it believes the
provision is appropriate and not overly burdensome, and that it is
proper to hold a firm accountable for facts known to the firm.\34\
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\34\ See Amendment No. 1, supra note 5.
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On the other hand, NASAA expressed concern that the proposal could
be read narrowly so as to not cover certain firms promoting day-trading
activities. Accordingly, NASAA recommended that the NASD clarify that
although the enumerated activities would not by themselves be deemed to
be promoting a day-trading strategy, they could nevertheless still be
considered part of a plan to promote day trading when combined with
other acts. NASD Regulation stated that it believes that the proposed
rule, as amended, addresses NASAA's concerns and pointed out that the
proposed rule language specifies that firms would not be deemed to be
promoting day trading activities solely by engaging in one of the
listed activities, and that therefore such activities may be considered
part of a plan to promote day-trading activities when combined with
other acts.\35\
Finally, All-Tech argued that the risk disclosure requirements were
``hypocritical'' because they would impose additional regulatory
requirements on day-trading firms and not on other firms that
facilitate online trading. Citing findings by the Permanent
Subcommittee on Investigations of the Senate Committee on Governmental
Affairs, the NASD responded that it believes day-trading strategies
present unique investor protection concerns that do not necessarily
translate to other forms of trading. Thus, the NASD determined that
there is no reason to change its position on this issue.\36\
Risk Disclosure Statement
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\36\ Id.
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The Senators recommended that the risk disclosure statement warn
customers that investors with less than $50,000 in risk capital are not
likely to succeed as day traders. NASD Regulation adopted this
recommendation in Amendment No. 2, and qualified the warning by stating
that risking capital of $50,000 or more does not, however, guarantee
successful day trading. The Senators also recommended a provision
explaining that there is substantial evidence that most day traders
would need to generate at least $100,000 per year just to cover
commission costs and trading fees. NASD Regulation incorporated this
suggestion into the risk disclosure statement by supplementing the
statement with a mathematical example highlighting the need to generate
substantial earnings to cover day-trading costs.
In addition, NASAA recommended changing the provision, captioned
``Day trading requires knowledge of a firm's operations,'' to include
the language removed by NASD Regulation in Amendment No. 1. NASD
Regulation, in Amendment No. 1, replaced language in the original
proposal with language suggested in a comment letter. NASAA stated that
it believes that the deleted language better explained the need for
customers to understand their own firm's execution systems and evaluate
potential problems for themselves. Agreeing with the suggestion, NASD
Regulation reinserted the removed text into the risk disclosure
document.\37\
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\37\ Id.
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Appropriateness Determination
As mentioned above, the Senators suggested establishing a
``rebuttable presumption'' that if an investor has less than $50,000 of
risk capital, day trading is not appropriate for the customer. This
presumption could be rebutted by other factors that the firm concludes
outweigh the inadequate risk capital. The Senators further suggested
that where a firm determines that day trading is an appropriate
strategy for customers who do not possess $50,000 for investment
purposes, the firm would be required to prepare and maintain a record
setting forth the reasons that it deemed day trading to be appropriate
for the customers. NASD Regulation chose not to incorporate this
presumption into Amendment No. 2 for several reasons. First, NASD
Regulation stated its belief that the $50,000 threshold may make sense
for many investors, but it arguably is too low for very active day
traders and too high for less active day traders. Second, imposing such
a presumption could encourage individuals to misrepresent the value of
their assets. Finally, NASD Regulation noted that the current proposal
already requires a firm to document the basis on which it approves an
account for a day-trading strategy.\38\
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\38\ Id.
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NASAA again recommended that the proposal incorporate some
additional recordkeeping requirements included in the NASD options
rules. Noting that it had considered this issue in preparing Amendment
No. 1, NASD Regulation disagreed with this suggestion because it
believes that many of these requirements are duplicative of obligations
currently imposed on firms.\39\
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\39\ See Amendment Nos. 1 and 2, supra notes 5 and 8.
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4. Sources of Customer funds
The Senators suggested modifying the proposal to require broker-
dealers that are promoting day-trading strategies to inquire whether
parties opening accounts plan to trade for others, and if so, to
require firms to determine if parties need to be registered as
investment advisors. In Amendment No. 2, NASD Regulation responded to
this comment by stating that it believes that it would ``be difficult,
if not impossible'' for firms to make this determination. However, NASD
Regulation stated that customers should be informed of potential
registration requirements and therefore amended the risk disclosure
statement to include such a warning.
[[Page 44087]]
NASAA recommended that the proposal require firms to obtain
information on the sources of customer funds invested because of the
prevalence of day traders using borrowed money to fund their accounts.
NASD Regulation represented in Amendment No. 2 that is it considering a
separate response to address this concern.\40\
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\40\ See Amendment No. 2, supra note 8.
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B. Issues Raised in Comment Letters to Amendment No. 2
Although Amendment No. 2 was not yet published, the Commission
received one comment letter regarding the amendment.\41\ The SIA
reiterated its concern that the proposed rule language may undermine
what the SIA refers to as the safe harbor provision of the proposed
rule. The SIA is concerned that, under the proposed rule, a firm could
engage in the activities listed in proposed Rule 2360(g) and have the
fact that they engage in those activities--activities that are
specifically enumerated in the Rule as not deemed to be promoting a
day-trading strategy--used in the determination that the firm is
promoting a day-trading strategy.
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\41\ See Letter from Michael L. Michael, Chairman, Technology
and Regulation Committee, and Michael Hogan, Chairman, Ad-hoc Online
Brokerage Legal Committee, SIA, to Nancy Sanow, Assistant Director,
SEC, dated June 30, 2000 (``June 30 SIA Letter'').
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IV. Discussion
The Commission finds that the proposed rule change is consistent
with the requirements of the Act \42\ and the rules and regulations
thereunder applicable to a national securities association. In
particular, the Commission finds the proposal is consistent with the
requirements of Section15A(b)(6) of the Act,\43\ because the proposed
rule change is designed to prevent fraudulent and manipulative acts and
practices, to promote just and equitable principles of trade, and, in
general, to protect investors and the public interest.
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\42\ In approving the proposed rule change, the Commission has
considered the proposed rule's impact on efficiency, competition,
and capital formation. 15 U.S.C. 78c(f).
\43\ 15 U.S.C. 78o-3(b)(6).
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During the past few years, the problems and risks associated with
day trading have received widespread attention by regulators,
legislators, the media, and the public. For example, on February 25 of
this year, the Commission's staff issued a report providing the results
of its examination of 47 registered broker-dealers providing day-
trading facilities to the general public.\44\ In addition, earlier this
year, the Permanent Subcommittee on Investigations of the Senate
Committee on Governmental Affairs held a series of hearings detailing
day trading practices.\45\ The NASD Regulation proposal, as amended, is
intended to provide a measured regulatory response to assure that firms
promoting a day-trading strategy check to make certain that day trading
is an appropriate investment strategy for a customer opening a day-
trading account and that the customer is aware of its risks.
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\44\ This study, Report of Examinations of Day-Trading Broker-
Dealers, is available on the internet at http://www.sec.gov/news/studies/daytrep.htm.
\45\ Staff of the Permanent Subcommittee on Investigations,
Senate Comm. On Governmental Affairs. 106th Cong., 2d Sess.,
Memorandum on Day Trading (February 24, 2000).
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Certain brokerage firms focus primarily, or even exclusively, on
promoting day-trading strategies to individuals. These firms generally
advertise on the Internet and elsewhere as ``day-trading'' firms or
otherwise highlight their execution and other services as desirable for
``serious'' or ``professional'' traders. In addition, many of these
firms offer training on day-trading techniques, as well as provide
computer facilities and software packages specifically designed to
support and accommodate day trading.
Day trading, however, raises unique investor protection concerns.
In general, day traders seek to profit from very small movements in the
price of a security. Such a strategy often requires aggressive trading
of a brokerage account and the use of strategies including margin
trading and short selling. As a result, day trading generally requires
a significant amount of capital, a sophisticated understanding of
securities markets and trading techniques, and a high tolerance for
risk. Even experienced day traders with in-depth knowledge of the
securities markets may suffer severe and unexpected financial losses.
The Commission finds that requiring a member firm to disclose the
risks of day trading to non-institutional customers when the firm
promotes a day-trading strategy should help alert individuals who are
new to day trading to the risks associated with that strategy. In
addition, requiring a member firm to determine whether a day-trading
strategy is appropriate for a customer should help to assure that
individuals who are unable to bear the risks of day trading, or who
have investment objectives incompatible with day trading, are not
approved for day trading. In summary, the Commission finds that the
risk disclosure statement and appropriateness review mandated by the
proposed NASD rules are thoughtfully designed and tailored to address
investor protection concerns raised by the increasingly popular trading
strategy referred to as day trading.
The Commission notes that the proposed rule change focuses on the
promotion of trading strategies that can present high risks to
individuals that do not have the investing experience or financial
means to sustain those risks and, as revised, the proposed NASD rules
should not be unduly burdensome for firms to apply. Firms that are
actively promoting a day-trading strategy should be responsible for
assessing whether the strategy is appropriate for an individual who
opens a day-trading account at that firm. These firms also should be
required to disclose the risks of engaging in a day-trading strategy to
an individual prior to opening an account for that individual.
While the commenters generally favored the concept of providing
greater disclosure of day-trading risks, they also suggested various
modifications to the proposal. The Commission believes that NASD
Regulation has responded adequately to commenters' concerns and
suggestions by incorporating some recommendations into the proposal and
explaining why it was not incorporating others. In particular, in
response to comments submitted on the original proposed rule change,
NASD Regulation: (1) Refined the definition of ``day-trading
strategy,'' (2) added more detail regarding the information that a firm
must obtain at a minimum from a customer before approving the account
for a day-trading strategy; (3) incorporated into the rule those
activities that would not be deemed to be ``promoting a day-trading
strategy,'' and (4) revised the disclosure statement to discuss the
risks associated with trade executions during volatile market
conditions and systems failures, among other revisions.
Amendment No. 2 further refines the risk disclosure document to
take into account various comments and suggestions submitted regarding
Amendment No.1. Amendment No.2 amends the risk disclosure document to:
(1) Indicate that an investment of less than $50,000 will impair the
ability of a day trader to profit, while an investment of $50,000 or
more does not guarantee success; (2) provide an example of the annual
profits needed to cover commission costs; (3) encourage investors to
become familiar with the firm's business practices, including its order
execution systems and procedures; and (4) inform investors
[[Page 44088]]
about the potential need to register as an investment advisor or
broker-dealer under certain conditions.
As noted above, the SIA expressed concern about a statement in
Amendment No. 2 advising firms that the activities specified in Rule
2360(g) may be considered part of a plan to promote day trading when
combined with other acts. \46\ Rule 2360(g) provides that firms will
not be deemed to be promoting a day-trading strategy solely by engaging
in one of the listed activities. The Commission believes that NASD
Regulation addressed this concern in its Amendment No. 2 by correctly
noting that Rule 2360(g) would not subject a firm to the new rules
solely by engaging in the activities listed in that rule. The
Commission finds that, in making the determination of whether a firm is
promoting a day-trading strategy, it is reasonable for NASD Regulation
to consider all of the firm's activities, including those listed in
Rule 2360(g).
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\46\ See June 30 SIA Letter, supra note 29.
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Finally, the Commission notes that the NASD will announce the
operational date of the proposed rule change in a Notice of Members to
be published no later than 60 days following the date of approval by
the Commission. The operational date will be 30 days following the date
of publication of the Notice to Members announcing Commission approval.
The Commission finds good cause for approving Amendment No. 2 prior
to the thirtieth day after the date of publication of notice in the
Federal Register. The Commission finds that the additional disclosures
noted in Amendment No. 2 will provide greater information to investors
about the risk of day trading and thus should strengthen the proposal.
Moreover, the amendment raises no significant regulatory issues.
Accordingly, the Commission finds good cause, consistent with Sections
15A(b)(6) \47\ and 19(b)(2) \48\ of the Act, to approve Amendment No. 2
to the proposed rule change on an accelerated basis.
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\47\ 15 U.S.C. 78o-3(b)(6).
\48\ 15 U.S.C. 78s(b)(2).
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V. Solicitation of Comments
Interested persons are invited to submit written data, views, and
arguments concerning Amendment No. 2, including whether Amendment No. 2
is consistent with the Act. Persons making written submissions should
file six copies thereof with the Secretary, Securities and Exchange
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549-0609. Copies
of the submission, all subsequent amendments, all written statements
with respect to the proposed rule change that are filed with the
Commission, and all written communications relating to the proposed
rule change between the Commission and any person, other than those
that may be withheld from the public in accordance with the provisions
of 5 U.S.C. 552, will be available for inspection and copying in the
Commission's Public Reference Room. Copies of such filing will also be
available for inspection and copying at the principal office of the
NASD. All submissions should refeer to File No. SR-NASD-99-41 and
should be submitted by August 7, 2001.
VI. Conclusion
It Is Therefore Ordered, pursuant to Section 19(b)(2) of the Act
\49\ that the proposed rule change (SR-NASD-99-4), as amended, is
approved and Amendment No. 2 to the proposed rule change is approved on
an accelerated basis.
\49\ 15 U.S.C. 78s(b)(2).
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For the Commission, by the Division of Market Regulation,
pursuant to delegated authority.\50\
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\50\ 17 CFR 200.30-3(a)(12).
Margaret H. McFarland,
Deputy Secretary.
[FR Doc. 00-17968 Filed 7-14-00; 8:45 am]
BILLING CODE 8010-01-M