And unfortunately, for those who don’t.
The NASD has announced that as of October 16, 2000, any NASD member firm that is promoting a day-trading strategy will be required to furnish a risk disclosure statement to a non-institutional customer prior to opening a brokerage account. In addition, the firm will have to:
(1) approve the customer’s account for a day-trading strategy, or
(2) obtain from the customer a written agreement that the customer does not intend to use the account for day-trading purposes.
As part of the account approval process, the firm will be required to make a threshold determination that day trading is appropriate for the customer. A firm makes this determination by exercising reasonable diligence to ascertain the essential facts relative to the customer, including his or her: investment objectives; investment and trading experience and knowledge; financial situation; tax status; employment status; marital status and number of dependents; and age. The firm also is required to prepare and maintain a record noting the rationale for approving the customer’s account for day trading.
While these rule changes will place additional burdens on firms, the process should become part of the new account opening process. Increasingly firms are including additional documents and disclosures with their new account packages, including a request for a customer to verify their financial information and investment experience. The inclusion of day trading related questions should not prove to be a hardship.
However, compliance departments are now going to have to monitor trading to insure that anyone who is day-trading has been approved for day trading, and that the proper documentation is in place for each account that daytrades.
The rule changes apply only to firms which “promote a day trading strategy.” In NTM 00-62, the NASD has attempted to give some guidance to the term “promoting” but has intentionally not defined the term. According to the NASD a member will be subject to the day-trading rules if it affirmatively promotes day-trading activities or strategies through advertising, training seminars, or direct outreach programs. In the Notice the NASD provides an example, stating that a firm generally will be subject to the new rules if its advertisements address the benefits of day trading, rapid-fire trading, or momentum trading, or encourages persons to trade or profit like a professional trader. A firm also will be subject to the new rules if it promotes its day-trading services through a third party.
According to the NASD the day-trading rules only will be triggered by firms’ general promotional efforts or by firm-sponsored promotional efforts. The day-trading rules clarify that a member will not be deemed to be promoting a day-trading strategy for purposes of the rule solely by engaging in the following actions:
(1) promoting efficient execution services or lower execution costs based on multiple trades;
(2) providing general investment research or advertising the high quality or prompt availability of such general research; or
(3) having a Web site that provides general financial information or news or that allows the multiple entry of intra-day purchases and sales of the same securities.
The rule will therefore not apply to the vast majority of firms, since very few actually promote a day trading or momentum trading in advertising. However, there is an ominous sentence in the NASD release, which leaves the door open for the NASD to apply the rules to firms which do not advertise day-trading, or otherwise promote it in the general definition of the term.
NTM 00-62 states, in determining whether a firm promotes day-trading, that “the fact that many of a firm’s customers are engaging in a day-trading strategy will be relevant in determining whether a firm has promoted itself in this way.” The NTM also states that despite the exceptions noted above, “firms may not promote day trading through individuals in an effort to circumvent the rules. In addition, if a principal or officer of the firm is aware that brokers in the firm are soliciting customers for day trading, then the firm will be deemed to be promoting day trading.”
Without a definition of day-trading, or promoting, we are in a murky area here, and firms which have day-traders, even though the firm does not “promote” the activity, should be watching this rule and compliance with it very carefully. It is not hard to imagine the NASD bringing a proceeding against a firm which does not “promote” day-trading, for violation of the rule, arguing that since 10% of the firm’s active customers day-trade, that the firm, through its registered representatives, rather than advertising, is promoting day trading.
The rules also provide that a firm is not required to approve a customer’s account for a day-trading strategy if the customer provides a written agreement stating that the customer does not intend to use the account for day-trading purposes. Firms will undoubtedly seek to use this exemption as a way out of the requirement, but that is a short sighted decision. The NASD has stated that a firm cannot rely on such an agreement f the firm knows that the customer intends to use the account for day trading or if the customer actually does day trade. If the firm discovers that the customer is using the account to day trade, then it needs to review and approve the account, as if the agreement did not exist, no later than 10 days from the date of discovery of the day trading.
These requirements are contained in new NASD Rules 2360 and 2361. For the complete text of these rules, as well as regulatory guidance regarding their implementation, please see NASD Notice to Members 00-62, September 2000. NASD Rule 2360
NASD Rule 2360, Day-Trading Risk Disclosure Statement, requires firms that promote a day-trading strategy to deliver a disclosure statement to the customer discussing the unique risks posed by day trading. The day-trading rules require firms to deliver the disclosure statement to each customer individually, by mail or electronic means, prior to the opening of the account. Although the rules do not require a customer to sign the disclosure statement, firms are strongly urged to have these statements signed. Perhaps it is the author’s litigation mentality, but customers will not remember receiving the statement when they are testifying in an arbitration. Simply have them acknowledge receipt of the document.
The disclosure statement must contain several factors that a customer should consider before engaging in day trading. (See NASD Notice to Members 00-62 for the complete Disclosure Statement.) These factors include:
- Day trading can be extremely risky. Be cautious of claims of large profits from day trading.
- Day trading requires knowledge of securities markets.
- Day trading requires knowledge of a firm’s operations.
- Day trading will generate substantial commissions, even if the per trade cost is low.
In addition, the Disclosure Document must contain a notice that persons providing investment advice for others or managing securities accounts for others may need to be registered as either an “Investment Advisor” under the Investment Advisors Act of 1940 or as a “Broker” or “Dealer” under the Securities Exchange Act of 1934. Such activities may also trigger state registration.
Firms will have the choice of using the Disclosure Statement contained in Rule 2361, or may choose to develop an alternative risk disclosure statement. The alternative statements must be substantially similar to the mandated statement and filed with, and approved by, NASD Regulation’s Advertising Department.
In short, there is another regulatory landmine waiting for the weary compliance department, and it is Rules 2360 and 2361. Firms should insure that they are in compliance with the new rules, and should review their active accounts to identify the day traders at the firm. You already have a mechanism to identify your active accounts, review those for day trading. This is an excellent opportunity to do a suitability review on those accounts for your general compliance needs, and to insure that they have the proper disclosure statements, and firm approval, to continue trading.
Going forward is going to be a bit trickier, since you only have 10 days to approve a day trader after he starts day trading, and compliance officers need to beef up their active account reviews, and to examine accounts which are triggered on active account reports, not only for suitability, but for compliance with 2360 and 2361.
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Nothing herein is intended as legal or financial advice. The law is different in different jurisdictions, and the facts of a particular matter can change the application of the law. Please consult an attorney or your financial advisor before acting upon the information contained in this article.