[Senate Hearing 106-285] [From the U.S. Government Publishing Office] 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 U.S. GOVERNMENT PRINTING OFFICE 61-159 CC WASHINGTON : 1999 _______________________________________________________________________ For sale by the Superintendent of Documents, Congressional Sales Office U.S. Government Printing Office, Washington, DC 20402 COMMITTEE ON GOVERNMENTAL AFFAIRS FRED THOMPSON, Tennessee, Chairman WILLIAM V. ROTH, Jr., Delaware JOSEPH I. LIEBERMAN, Connecticut TED STEVENS, Alaska CARL LEVIN, Michigan SUSAN M. COLLINS, Maine DANIEL K. AKAKA, Hawaii GEORGE V. VOINOVICH, Ohio RICHARD J. DURBIN, Illinois PETE V. DOMENICI, New Mexico ROBERT G. TORRICELLI, New Jersey THAD COCHRAN, Mississippi MAX CLELAND, Georgia ARLEN SPECTER, Pennsylvania JOHN EDWARDS, North Carolina JUDD GREGG, New Hampshire Hannah S. Sistare, Staff Director and Counsel Joyce A. Rechtschaffen, Minority Staff Director and Counsel Darla D. Cassell, Administrative Clerk ------ PERMANENT SUBCOMMITTEE ON INVESTIGATIONS SUSAN M. COLLINS, Maine, Chairman WILLIAM V. ROTH, Jr., Delaware CARL LEVIN, Michigan TED STEVENS, Alaska DANIEL K. AKAKA, Hawaii GEORGE V. VOINOVICH, Ohio RICHARD J. DURBIN, Illinois PETE V. DOMENICI, New Mexico MAX CLELAND, Georgia THAD COCHRAN, Mississippi JOHN EDWARDS, North Carolina ARLEN SPECTER, Pennsylvania K. Lee Blalack, II, Chief Counsel and Staff Director Linda J. Gustitus, Minority Chief Counsel and Staff Director Mary D. Robertson, Chief Clerk C O N T E N T S ------ 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. GFall 1999 Adult Education Program, Gardiner, Maine, highlighting the course ``Day Trading For Beginners''.......... 213 2. GPicture 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. GTwo print outs from TCI Corporation's Web site.............. 216 4. GPrint out from All-Tech Investment Group, Inc.'s Web site... 218 5. GTwo print outs from On-Line Investment Services, Inc.'s Web site........................................................... 219 6. GSupplemental 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. GSecurities and Exchange News Release, dated September 16, 1999, SEC Investor Alert--Day Trading: Your Dollars At Risk.... 225 8. GNorth 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. GSupplemental questions and answers for the record of Saul Cohen, Consulting Counsel, Electronic Traders Association...... 228 10. GMemoranda 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 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 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- to-moment 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. --------------------------------------------------------------------------- \1\ See Exhibit No. 1 on page 213 in the Appendix. --------------------------------------------------------------------------- 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. 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 full-time 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 altogether. 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. --------------------------------------------------------------------------- \1\ See Exhibit No. 2 on page 215 in the Appendix. --------------------------------------------------------------------------- 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 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 3 on page 216 in the Appendix. --------------------------------------------------------------------------- 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 day-trading 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 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 day-trade 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 Commission. 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. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Levitt appears in the Appendix on page 55. --------------------------------------------------------------------------- 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 extend 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 sure-fire 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 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. 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 4 on page 218 in the Appendix. --------------------------------------------------------------------------- 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. 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. --------------------------------------------------------------------------- \1\ See Exhibit No. 3 on page 216 in the Appendix. --------------------------------------------------------------------------- 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 start-up 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 cease-and-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. 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 subject 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? 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 6 on page 221 in the Appendix. --------------------------------------------------------------------------- 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. 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. 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-rich-quick 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 4 on page 218 in the Appendix. --------------------------------------------------------------------------- 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-rich-quick 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 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 regulators. 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 follow-up responses to those questions.\1\ --------------------------------------------------------------------------- \1\ See Exhibit No. 6 on page 221 in the Appendix. --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 7 on page 225 in the Appendix. --------------------------------------------------------------------------- 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. --------------------------------------------------------------------------- \2\ The prepared statement of Ms. Schapiro appears in the Appendix on page 79. --------------------------------------------------------------------------- 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. 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. 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 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. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Hildreth appears in the Appendix on page 167. --------------------------------------------------------------------------- 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\ --------------------------------------------------------------------------- \2\ Exhibit No. 8 is retained in the files of the Subcommittee. --------------------------------------------------------------------------- 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: 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\ --------------------------------------------------------------------------- \1\ Exhibit No. 8 is retained in the files of the Subcommittee. --------------------------------------------------------------------------- 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 percent 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 day- trading 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 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 day-trading 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 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. 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 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. 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 3 on page 216 in the Appendix. --------------------------------------------------------------------------- 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. 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. --------------------------------------------------------------------------- \1\ Exhibit No. 8 is retained in the files of the Subcommittee. --------------------------------------------------------------------------- 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. 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 broker-dealers, 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. 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. 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. 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. 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. --------------------------------------------------------------------------- \1\ The prepared statement of Mr. Cohen appears in the Appendix on page 178. --------------------------------------------------------------------------- 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 invest 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 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 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 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. 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 5 on page 219 in the Appendix. --------------------------------------------------------------------------- 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 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? --------------------------------------------------------------------------- \1\ See Exhibit No. 5 on page 219 in the Appendix. --------------------------------------------------------------------------- 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 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 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 up-front 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. 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. 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? 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 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. 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 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 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. 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 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. 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 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\ --------------------------------------------------------------------------- \1\ See Exhibit No. 9 on page 228 in the Appendix. --------------------------------------------------------------------------- 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. 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