Many Day-Trading Firms Violating Law, Study Says

In the most negative portrait yet of the controversial day-trading industry, a U.S. Senate staff study has turned up a variety of securities law violations at day-trading brokerages and concludes that many firms entice investors with misleading claims of profitability.

The eight-month Senate investigation--which in part focuses on a Southland day-trading firm that caters to the Vietnamese community--found that the industry is rife with “disturbing business practices” in which some firms forge customer documents, engage in unauthorized trading and routinely skirt rules governing “margin” loans to customers.

At the same time, the firms themselves are racking up large profits, mainly via commissions paid by client traders, the study said. Cumulative profits at the top 15 day-trading firms tripled in the last two years to more than $66 million, according to the Senate staff document. However, “only a tiny fraction” of novice day traders make money, and the “majority” of experienced traders lose money, the document concludes.

The results of the study will be discussed at a two-day hearing by the Senate Governmental Affairs Committee’s permanent subcommittee on investigations, beginning today in Washington.

“The results of our investigation present a serious indictment of the day-trading industry,” said Sen. Susan Collins (R-Maine), chairwoman of the subcommittee. “While the firms differ, the overall pattern is one of day-trading firms very aggressively enticing unsophisticated investors to trade with money that they can’t afford to lose.”

Senate investigators culled their analysis from 50,000 pages of documents supplied by 18 firms, interviews with 107 people and depositions of seven others.

Day-trading brokerages have multiplied in recent years, offering individual investors access to souped-up computers that enable rapid-fire trading.

Most day traders attempt to make outsize profits from very small movements in stock prices over the course of a trading session, buying and selling repeatedly. The brokerages charge $15 to $25 per trade.

At those rates, the typical day trader must earn at least $111,360 annually from trading just to break even after paying commissions, according to the Senate staff analysis.

The study also found there to be more day traders than the 5,000 previously assumed. Between January 1998 and October 1999, 12,666 day-trading accounts were opened nationwide, the study said.

The Senate probe comes at a sensitive moment for day-trading firms, many of which are attempting to clean up their image and offer services that appeal to the growing legion of amateur investors trading stocks over the Internet.

Indeed, a number of large Wall Street firms, such as Charles Schwab and Morgan Stanley Dean Witter, have taken stakes in day-trading firms that have developed advanced trading systems with potentially mainstream applications.

Nevertheless, the Senate document indicates that day trading remains plagued by abuses. The biggest issue, experts say, is that many day-trading firms overstate the profit potential to investors and downplay the risks. Even when firms supply customers with extensive risk-disclosure forms, employees sometimes promise newcomers that they can make money.

The results of the Senate staff investigation come one day after the Securities and Exchange Commission sued a pair of day-trading firms on charges that they made improper “margin” loans to customers. The loans enabled people to continue day trading and generating commissions for the brokerages, the SEC said.

The Senate document echoes charges leveled by state securities regulators last August, who found problems with deceptive advertising, illegal loan schemes and improper bookkeeping.

Saul Cohen, an attorney for the Electronic Traders Assn., a day-trading trade group, said he hadn’t seen the Senate document and would not comment.

The Senate analysis includes a case study of Providential Securities Inc., a Fountain Valley-based brokerage serving the Vietnamese community, at which one trader is alleged in 1998 to have guaranteed a part-time clerk at a Little Saigon record store a 20% annual return if she invested money with which he would day trade.

The woman, Amy Le, told investigators that she eventually turned over a total of $48,000, part of it borrowed from her elderly mother, that she hoped would be invested conservatively and earn enough for her to replace her aging car.

But after initially telling her that he had a “moneymaking machine,” the day trader, Huan Van Cao, lost $35,000 of her money, she told the investigators.

Providential has 10 offices in Southern California, Oregon and New York, including five that offer day trading, the firm said.

The report says that Cao was a “de facto representative” of Providential who tried to drum up day-trading business in the Vietnamese community for Providential’s now-shuttered Los Angeles office--a point that both he and the firm deny.

In an interview, Cao said Le claimed to be poor, but said he decided to day-trade her account anyway because he thought he could help her. Cao claimed that he handled her money for only two weeks and turned a $2,000 profit.

Le’s losses came from another trader who later took over her account, Cao said. Cao acknowledged that he did not warn Le of the risks of day trading, but only because she claimed to be knowledgeable about the stock market, he said.

“I’m not the kind of person who would mislead anybody,” Cao said.

Nevertheless, a National Assn. of Securities Dealers arbitration panel awarded Le nearly $38,000 in a claim against Cao, Providential and others.

Senate investigators found that when opening new accounts, Providential frequently did not ask customers for basic financial information to determine whether day trading was suitable for them. Of 234 Providential day-trading accounts studied, 61 contained no information on either annual income, net worth or both.

At the Los Angeles branch, three of four accounts lacked that information. That office’s branch manager told Senate investigators that none of his day-trading customers were profitable.

“How in God’s name are you going to do a suitability analysis of a prospective day trader if you don’t know what they make in income, you don’t know what their net worth is and you don’t even know how much money they’re going to deposit in the account?” said one source familiar with the document.

Henry Fahman, Providential’s president and chief executive, denied the charges in the Senate staff study.

The firm made sure that customers were suited to day trading, he said. If there were any accounts with insufficient documentation, they may have been opened by a rival firm and later transferred to Providential, he said.

“We have one of the most comprehensive risk-disclosure documents on the Street,” Fahman said.