NYSE Sanction Decision Remanded

James Gerard O'Callaghan, Exchange Act Rel. 57840 (May 20, 2008)

Time since appeal - 10 months, 25 days

Time since last brief - 7 months, 17 days

Pages - 18

Footnotes - 42 

Summary

O'Callaghan, an independent NYSE floor broker appealed a NYSE disciplinary action.  NYSE found that he violated Exchange Act Section 11(a) and Rule 11a-1 and NYSE rules by initiating and executing trades for an account of his father-in-law over which he had investment discretion.  That Exchange Act section specifically prohibits floor brokers from trading for an account over which the broker exercises investment discretion.  NYSE fined him $30,000 and suspended him for three months.  The Commission upheld the findings of violations, but remanded the sanctions to NYSE for further explanation.

O'Callaghan admitted that he had trading discretion over the account and that he was trying to save his father-in-law commissions by charging him floor broker rates.  He also loaned money to the account but did not receive interest  payments for the loans.  NYSE found that O'Callaghan's investigative and hearing testimony were contradictory.  

Under NYSE rules, a floor broker is prohibited from generating an order on the floor, determining the stock, size of the order, or whether it is a buy or sell.  Under NYSE rules, a floor broker with trading discretion would be required to place the order initially with an "upstairs" trading desk which would transmit it to an unaffiliated floor broker for execution, thereby precluding the "initiating" floor broker from exploiting his "time and place advantages" by executing the order himself.  O'Callaghan's own expert agreed that a floor broker could not create an order and execute it himself on the floor.

O'Callaghan testified in his own defense, but did not call any witnesses to corroborate his claims.  He did not call his father-in-law to testify, claiming he was ill.  The hearing panel specifically found that O'Callaghan was not credible as he gave contradictory explanations for his conduct.  

The main claims on appeal involved allegations that NYSE had denied O'Callaghan due process and failed to give him a fair hearing.  The Commission rejected these claims, finding the hearing process to be fair.  It noted that constitutional due process requirements to not apply to self-regulatory organizations.  O'Callaghan's primary claim was that NYSE had not obtained tapes of his telephone calls even though he had the ability to obtain them from the third-party vendor that kept them but did himself do so.

The fact that the violations occurred in 2000 and 2001, but the hearing did not begin until early 2005 did not constitute an unreasonable delay and O'Callaghan produced no evidence of prejudice resulting from this delay.

The Commission found that NYSE had not sufficiently articulated a remedial purpose for the three month suspension imposed on O'Callaghan.  It noted that the the purpose of an expulsion or suspension is to protect investors, not punishment.  NYSE in its decision noted that a three month suspension had the potential to be "catastrophic and terminal" on O'Callaghan's business.  Yet it also found mitigating factors.  The Commission found that NYSE had not explained how a three month suspension would protect the public.  It also noted that a detailed explanation of mitigating factors was required.  

Comment

The Commission itself has been reversed in recent years by various courts of appeals for failure to carefully articulate the basis for its sanctioning decisions.   

Petition For Review Of NASD Action Dismissed

Robert M. Ryerson, Exchange Act Rel. 57839 (May 20, 2008)

Summary

A NASD disciplinary panel suspended Ryerson from association with a member for two years and fifteen days, fined him $235,000, and ordered him to pay costs.  On appeal the NASD affirmed these sanctions, but modified the sanction by requiring him to pay all fines and costs after seven days written notice or face summary revocation (the initial sanction had conditioned payment of the monetary sanctions on his re-entry into the securities industry).

He was informed by NASD that he had thirty days to appeal this decision to the SEC.  After the appeal period NASD informed him that his registration would be revoked if he did not pay the monetary sanctions.  His lawyer took the position that the decision on appeal had not modified the initial decision conditioning payment on his re-entry.  Needless to say, NASD did not concur in this interpretation.  After receiving several letters from NASD demanding payment fourteen months after the NASD appellate decision, Ryerson filed an appeal with the SEC.  

The SEC dismissed the appeal on the ground that Ryerson had not complied with the requirement that he appeal within thirty days.  Although Commission rules permit it to extend the appeal period on a showing of extraordinary circumstances, none justify doing so in this instance.  The Commission noted that Ryerson had written notice from NASD that it considered the appellate decision dispositive and did not agree with his counsel's interpretation.  It also concluded that Ryerson had made a tactical decision not to timely appeal after learning of NASD's position.  Finally, the Commission denied Ryerson's request that it stay NASD's collection efforts noting that it has no jurisdiction to take such action.

Comment

It should not be surprising that the SEC does not think that the rule that allows thirty days for an appeal really means fourteen months instead.  Ryerson's appeal was filed with the Commission on October 17, 2008.  For some unexplained reason the Commission took 7 months and 3 days to issue this routine decision.

ALJ Ordered To Render Initial Decision

Nasdaq Stock Market, Exchange Act Release 57741 (April 30, 2008)

Nasdaq appealed to the Commission a decision by the Consolidated Tape Operating Committee to impose a new entrant fee of $833,000.  The Commission accepted jurisdiction as the dispute involved registered securities information processors, national market system plans, or transaction reporting plans pursuant to Exchange Act Section 11A.  In June 2007 the matter was assigned to an ALJ who held a hearing in November 2007.  The ALJ then transmitted the record of the hearing to the Commission's Secretary without preparing an initial decision.  The ALJ based this refusal on the fact that the original Commission order did not explicitly order him to do so.  The Commission seems to have remedied its initial defalcation by now ordering the ALJ to prepare an initial decision.  The order also gave the ALJ 120 days to file his decision.

Comment

Silliness (and apparent lethargy) reigns.  While not an earth shattering dispute, this matter shows at best benign neglect by the Commission.  First, the initial order apparently omitted standard language in all orders referring matters to an ALJ for hearing ordering the ALJ to prepare an initial decision.  Believe me when I say that there are numbers of Commission staff who fly-speck every order the Commission enters, especially for inclusion of the usual boiler-plate language.  Second, the Commission apparently took its sweet time in remedying its initial "clerical" blunder.  Once it became aware of the defect in the initial order, it could have cured that with a one sentence order. 

SEC Dismisses Appeal From FINRA Denial Of Relief

Matthew Brian Proman, Exchange Act Release 57740 (April 30, 2008)

Proman in 1998 settled NASD allegations that he had hired a stand-in to sit for his Series 7 exam.  He settled the matter by agreeing to a bar, a censure, and a $50,000 fine.  In 2007 he filed a request with FINRA seeking to vacate the bar.  When FINRA denied him relief, he appealed to the Commission.  The Commission dismissed the appeal finding that it has no jurisdiction.  Commission appellate jurisdiction over FINRA matters is governed by Exchange Act Section 19(d).  Relying on a 1998 decision, it ruled that requests such as Proman's are "collateral" to the original disciplinary action and is thus not an appealable disciplinary action 

Comment

To say that this is a routine matter, as it relies on clearly established precedent, is an understatement.  According to the opinion, Proman filed his appeal on August 20, 2007.  One has to wonder why it took the Commission eight months and ten days to produce this five page opinion.

Commission Sustains NASD Sanctions After Remand From Circuit

Paz Securities and Joseph Mizrachi, Exchange Act Rel. 57656 (April 11, 2008)

Time since remand - 8 months, 22 days

Time since last brief - 3 months, 23 days

Pages - 13

Footnotes - 33

Summary

In 2005 the Commission issued an opinion sustaining NASD sanctions against Paz Securities and Mizrachi, the president of the firm.  Paz was expelled and Mizrachi was barred.  In 2007 the D.C. Circuit remanded the case and ordered the Commission to consider whether lesser sanctions were appropriate.  The Court held that the Commission "did not adequately explain why the sanctions the NASD imposed were not punitive rather than remedial."  The sanctions were based on failure to timely cooperate with a NASD investigation.

The Commission on remand again sustained the sanctions.  

Discussion

The Commission noted that NASD sanction guidelines require a bar for complete failure to cooperate absent mitigating circumstances.  The Commission found this appropriate as a complete failure to cooperate renders the violator "presumptively unfit" because industry self-regulation cannot be effective without compliance with the rule that requires cooperation with NASD investigations.  This is because the NASD plays an important role, established by statute, and has no subpoena power.  Thus, its cooperation rule is the only way it can effectively conduct investigations of possible wrongdoing.  Therefore, the Commission found the cooperation rule and presumptive bar for violations to be wholly consistent with the purpose of the Exchange Act, namely the protection of public investors.

Paz and Mizrachi argued that they did not wholly fail to cooperate and that there were mitigating factors that rendered the sanctions punitive and excessive.  The Commission found that they were not merely slow to cooperate because the NASD had sent three requests for information that were not answered promptly.  Here, there was no response until after the NASD had charged Paz and Mizrachi in formal disciplinary proceedings that they failed to appear at.  In fact, they provided information only after a default had been entered revoking the firm and barring Mizrachi.  This was more than eight months after the original request for information.  The Commission found that the NASD should not have to bring disciplinary proceedings in order to compel cooperation.

The Court of Appeals remanded for the Commission to consider whether the conduct was mitigated because Paz and Mizrachi argued that they did not monetarily benefit, there was no injury to the investing public, and the information sought did not relate to injurious conduct.

The Commission noted that failure to cooperate with the NASD will never result directly in monetary benefit and rarely will it result in direct harm to a customer.  It noted that the fact that the NASD did not charge underlying violations is of no significance because Paz had already been revoked and Mizrachi barred thus rending any further investigation moot.

Further, the Commission noted that the argument that the failure to cooperate did not involve injurious conduct was mistaken because the underlying investigation involved violations of NASD rules that could have involved harm to customers.  The effect of the failure to cooperate was to shield transactions with customers from regulatory oversight.  Also, the transactions being investigated had implications for enforcement of the net capital rule which is designed to protect the public from failure of a firm.  Further, the importance of information requests must be measured at the time it is made, not with hindsight.  

It is not appropriate to revoke and bar only when the underlying NASD investigation involves known fraudulent activity.  

The Commission noted that lack of disciplinary history is not a mitigating factor because there should be no reward for complying with the duties imposed on a securities professional.  Finally, the Commission noted that there is risk Paz and Mizrachi will engage in future misconduct.  It based this finding on the fact that Mizrachi travels extensively, but did not arrange for someone to act in his absence to respond to NASD requests or notify NASD of his address changes.

Comment

The Commission too often in the past has not explained its sanctions or reasoning in its opinions and has of late been severely chastised by the D.C. Circuit in a number of cases. Here it does offer a detailed explanation.  We will have to see whether the appellate court finds this exposition persuasive. My own judgment is that it has improved substantially its explanation of sanctioning decisions recently.  

Commission Reverses NASD Fraudulent Markups Ruling Despite Finding "A Profound Disregard" For The Duty To Treat Customers Fairly

Dennis Todd Lloyd Gordon and Sterling Scott Lee, Exchange Act Release 57-57655 (April 11, 2008)

Time since appeal filed - 1 year, 1 month, 19 days

Time since last brief filed - 10 months, 12 days

Pages - 31

Footnotes - 102

Summary

This opinion is a travesty.  Despite finding that the the firm charged excessive markups and the individuals involved were aware of the pricing of the trades and "evince[d]" a profound disregard for the essential duty to treat one's customers fairly" without explanation it simply concluded that the record did not support a finding of fraud.   It is not out of line here to quote Woody Allen ("mockery of a sham").  The Commission has found fraud violations in literally dozens of similar markup cases.  The total failure to explain its conclusion that there was no fraud shown in the record is unacceptable for a public agency that purports to act in a judicial role. Under what circumstances will the Commission find sufficient evidence of fraud in the markup context?  We should expect more from the SEC.

The NASD sanctioned Gordon, the CEO of a broker-dealer and Lee, the president and chief compliance officer.  It found that they permitted an unregistered individual to function as a principal, and thereby failed to maintain an accurate membership application, caused the firm to charge excessive markups to customers in thirty-one transactions and failed to disclose the markups on confirmations.  The NASD barred Gordon and Lee and ordered them to pay joint and several restitution of $20,000 plus interest.

The Commission upheld the findings of violations relating to the unregistered principal.  As to the markups, it found them excessive under long standing precedent, but did not find them fraudulent.  As discussed below, this portion of the opinion is a stunning default by the Commission as it literally offered no explanation for its conclusion that there was no fraud.  It found Lee responsible for failure to disclose the markups to customers, but exonerated Gordon on this charge.

The bars imposed by the NASD for the unlicensed principal were sustained.  The bars based on the markups were reduced to a two year suspension because of the unexplained conclusion that there was no fraud.  Lee was given an additional thirty day suspension based on failure to disclose the markups.  The NASD order requiring restitution to customers for the excessive markups was upheld.

Unlicensed Principal

Lee and Gordon hired an individual at the broker who had a disqualifying criminal conviction that they claimed no knowledge of.  That individual exercised authority over a broad range of firm operations, including recruiting, hiring, firing, setting sales quotas, resolving a customer complaint, dealing with the clearing firm for the broker, and setting policy on use of firm equipment.  In particular the unregistered principal recruited registered representatives and helped the firm set up a branch office.  In short, the unregistered individual had an active management role at the firm.  These facts were established through emails.  

NASD rules define a principal as an associated person "actively engaged in the management of the member's investment banking or securities business, including supervision, solicitation, conduct of business, or training . . . "  Further, the requirement to register does not hinge on the individual's title, but rather "on the functions that he or she performs."  

Needless to say, the Commission found that the unregistered individual while "not holding an official managerial title nonetheless filled a management role . . . ."  It found that he "devoted a substantial amount of time and attention" to the broker "giving instructions and orders to Gordon and Lee about a wide variety of matters relating to the conduct [of the business]." Such persons who devote "significant time to firm affairs and participate in management decisions" are principals.

The Commission rejected the defense argument that each individual act of the unregistered individual was required to meet the legal definition of association as a principal. For example, it argued that firms hire recruiters to assist in the hiring of staff without those recruiters being required to register. In rejecting this argument, the Commission noted that "[i]n determining whether an individual is required to register as a principal we consider all of the relevant facts and circumstances, including the cumulation of individual acts that might not, on their own, show management."

The Commission also sustained the related finding that as a result of the unregistered principal, the firm's filings with the NASD were inaccurate in violation of NASD rules.  

The Commission also upheld the introduction into evidence of the investigative testimony of the unregistered individual and emails he authored despite the fact that Gordon and Lee were not permitted to attend and cross examine his testimony and he did not testify at the hearing.  It noted that hearsay may be used by the NASD, depending on the probative value of the evidence and the fairness of its use.  In evaluating the NASD's use of hearsay evidence, the Commission considers whether the statement is sworn, contradicted by direct testimony, whether the declarant was available to testify and whether the hearsay is corroborated.  The Commission found the evidence highly reliable as the testimony implicated the unregistered individual in the violations and was corroborated by other evidence.  It found his emails consistent with emails authored by Gordon and Lee.  

Finally, the Commission noted that it will not overturn credibility determinations unless there is substantial evidence for doing so.     

Markups

The thirty-one transactions at issue were in a thinly traded bulletin board OTC stock.  The trades were riskless principal trades in which the firm sold stock from its inventory to customers while contemporaneously acquiring the stock only after the sale to the customer had been made.  The firm was not a market maker in the stock.  Lee personally executed the trades and Gordon reviewed documentation for the trades at month-end.

The firm bought the stock from the seller at the inside bid plus five percent.  It sold the stock to the buyer at the inside offer.  Total firm profits on the trades were $32,000 (but it paid registered reps seventy-five percent of the total profits).  Markups ranged from twelve to fifty-five percent.

Of note is the fact that Gordon wrote to the Commission a request for a "no-action" letter that disclosed these facts. 

Now for a brief discussion of the arcane rules relating to markups (sales to customers) and markdowns (purchases from customers).  Both the Commission and the NASD prohibit excessive undisclosed markups or markdowns in securities transactions.  The analysis of these situations is complex and involves issues of whether or not the firm is a market maker, whether it dominates and controls the market, and other factors.  The NASD prohibits markups in excess of five percent unless the firm can show unique circumstances justify a higher markup. However, it also takes the position that markups of less than five percent may not necessarily be fair.  The Commission does not use a percentage analysis, but instead under the umbrella of the anti-fraud provisions of Rule 10b-5 prohibits transactions with customers where a broker charges prices that are not "reasonably related to the prevailing market price of the security."  

When a firm is not a market-maker the bests evidence of current market price (absent other evidence) is the dealer's contemporaneous cost.  When a dealer engages in riskless principal trades (as was the case here), contemporaneous cost must be used as the basis for calculating markups. This is because a riskless principal trades is the economic equivalent of an agency trade because the dealer is only buying in order to fill a customer order that is already in hand.  The firm is acting as an intermediary without exposing itself to any significant market risk.

Here, the firm was not maintaining an inventory in the stock, but was buying only to match retail purchase orders from customers.  The Commission found that the firm did not meet its burden of justifying markups exceeding five percent.  It noted that inter-dealer quotations may not be used as the basis for determining contemporaneous cost when calculating markups.  Gordon and Lee argued that there were special circumstances, namely the efforts they took to locate sellers of the stock and to locate buyers.  They did not produce an documents to support their claims to have endured extraordinary expenses.  Here, the prices charged were mechanically computed based on the bid/ask spread, and did not hinge on any extraordinary expenses involved in the transactions.  When prices are calculated independent of any special expenses and based on a mechanical formula, the Commission will not find support a defense claim of special circumstances that justify failure to calculate markups based on contemporaneous cost.

Comment

There is nothing remarkable about this decision as it relates to the unregistered principal violations.  The legal standard is a clear and longstanding one.  The most interesting issues relate to the evidence the Commission found persuasive.  First, it relied on voluminous emails. Second, it found highly persuasive the fact that persons dealing with the unlicensed principal understood that he was speaking and acting on behalf of the firm.

However, the markup discussion in this decision is another matter. In a stunning display of ipse dixit, with literally no explanation, the Commission found that the markups were not fraudulent on this record. It provided not a shred of explanation for this conclusion.  None.  It did find that in violation of SEC rule 10b-10, Lee was responsible for the fact that the firm did not disclose the markups.

This truly is a sorry result.  The Commission and the NASD have found markups of the magnitude here to be fraudulent and in violation of Rule 10b-5 in literally dozens of cases.  It is not a new legal concept that requires markups by non-market makers to be calculated based on contemporaneous cost when the firm is filling orders with in riskless principal transactions. At the very least, the Commission owes the industry and practitioners an explanation of why it did not find that the very high markups here were fraudulent.  For it to fail to do so is simply inexcusable.  This is particularly important here, where the Commission found not justification for the markups charged.

Most remarkable is the fact that the ipse dixit pronouncement that there was no fraud is contradicted later in the opinion when the Commission, in justifying its reduction of the sanction for the excessive markups finds that the conduct of Gordon and Lee "evinces a profound disregard for the essential duty to treat one's customers fairly."

9th Circuit Upholds Coordinated SEC/DOJ Investigations

U.S. v. Stringer

Although I rarely discuss non-SEC opinions the Ninth Circuit has just issued an important decision for all practitioners that deal with joint SEC/Department of Justice investigations.  Contrary to the claims of some, this is a major win for the SEC.  It ends the time wasting claims by some defense counsel that have tied up SEC resources in subpoena enforcement cases where persons receiving subpoenas argued that coordinated investigations are per se improper. Further, the decision will not restrict SEC investigations by hindering witness cooperation as all experienced defense counsel already know that the SEC and DOJ always share information and counsel never advise clients who may have potential criminal liability to cooperate with the SEC without an immunity grant.  Experienced defense counsel know that the only way to deal with an SEC investigation is to assume that the DOJ may be involved and to (in the words of Jack Nicholson)  "act accordingly," that is, either fully cooperate or take the Fifth.  Last, one commentator has argued that this, like the Martha Stewart case, will discourage cooperation with the SEC.  Again, I beg to differ.  The lesson from the Martha Stewart case is simple, if you are going to testify before the SEC, tell the truth.

In recent years various defense counsel have attempted to argue that it is inherently improper for the SEC and DOJ to conduct joint investigations and to share information they develop. Some have attempted to argue that any such investigations be completely independent and that any sharing of information or coordination between the SEC and DOJ is verboten.  This case should put and end to these defense claims.

Here, the court of appeals overturned a district court decision dismissing an indictment after finding that the SEC's practice of not disclosing details of its contacts with the DOJ was improper and tainted a subsequent criminal prosecution.  

Specifically, the circuit ruled:

"We vacate the dismissal of the indictments because in a standard form it sent to the defendants, the government fully disclosed the possibility that information received in the course of the civil investigation could be used for criminal proceedings. There was no deceit; rather, at most, there was a government decision not to conduct the criminal investigation openly, a decision we hold the government was free to make. There is nothing improper about the government undertaking simultaneous criminal and civil investigations, and nothing in the government’s actual conduct of those investigations amounted to deceit or an affirmative misrepresentation justifying the rare sanction of dismissal of criminal charges or suppression of evidence received in the course of the investigations."

This was more than merely parallel SEC/DOJ investigations.  As the court explained:

"The SEC facilitated the criminal investigation in a number of ways. The SEC offered to conduct the interviews of defendants so as to create “the best record possible” in support of “false statement cases” against them, and the AUSA instructed the SEC Staff Attorney on how best to do that. The AUSA asked the relevant SEC office, located in Los Angeles, to take the depositions in Oregon so that the Portland Office of the USAO would have venue over any false statements case that might arise from the depositions, and the SEC did so. Both the SEC and USAO wanted the existence of the criminal investigation kept confidential. The SEC Staff Attorney, at one of the Portland depositions, made a note that she wanted to “make sure [the] court reporters won’t tell [[defense counsel]]” that there was an AUSA assigned to the case."

The court ruled that the SEC had no affirmative duty to disclose its cooperation with the DOJ and that it was sufficient for Fifth Amendment purposes for it to disclose the possibility that it might share information obtained in its investigation with the criminal prosecutors.

Protective Order Granted For Financial Information In Connection With Appeal

Gregory O. Trautman, Exchange Act Release 57545

As is its practice, the Commission granted a protective order sealing certain personal and confidential financial information Trautman filed in connection with his pending appeal of an ALJ's initial decision that can be viewed here  (also see the ALJ's  denial of a motion to correct here).  Respondents typically file such information in an effort to establish an "inability to pay" defense to disgorgement or penalties.

NASD Sanction Against Chief Compliance Officer Upheld

Robert E. Strong, Exchange Act Release 57426

Time from appeal to decision - 11 months, 12 days.

Time from final brief to decision - 7 months, 3 days.

Pages - 33

Footnotes - 51

Summary

Strong was formerly the Chief Compliance Officer of a small firm with about 40 registered representatives.  The NASD found that he failed to: supervise the personal trading of an analyst at the firm; enforce NASD disclosure requirements for research reports; and failed to file reports with the NASD.  He was fined $10,000 and charged with costs of $3,723.  

NASD Rule 2711 imposes restrictions on personal trading by research analysts and requires that research reports contain various disclosures.  Strong was specifically hired by the firm to be responsible for compliance with the rule.   Among other things, the rule prohibits analysts from trading in a security they follow for 30 days before and five days after the publication of a report.  Strong was required to pre-approve any analyst trades and to retain evidence of the review.  He admitted that he did not do so.   In addition he did not request that the trading desk monitor activity in analyst's accounts.  In addition, there was evidence that Strong had disciplinary authority, but it was not clear that he had the ability to fire anyone.

The analyst in question here prepared ten research reports that were sent to four to five clients.  The analyst made 112 trades in stocks he followed during a 13 month period, including 41 buys of stocks that he had made buy recommendations.  Four of those buys were within 30 days of a research report on the stock.  He earned $116,000 in profits.

Strong claimed he was not responsible for supervising the trader because he did not have the authority to cancel improper trades and he was not the line supervisor of the analyst.  Here, Strong had clear supervisory responsibility over the analyst.  He in fact did have authority to cancel trades.  Further, after consultation with the president of the firm, he had authority to discipline persons for violations of compliance procedures.  The fact that the president of the firm shared supervisory duties with Strong does not exonerate him according the the Commission.  See, Steven P. Sanders, 53 SEC 889, 904 (1998) ("[E]ven where supervisory responsibility is shared between firm executives, each can be held liable for supervisory failures.").  

Strong also ignored at least one red flag of irregularity.  After the analyst liquidated his entire position in a stock he was publicly recommending, Strong did not heighten his supervision of the analyst's trading activities.  Further, for many months, Strong did not follow the requirement that the analyst's trades be pre-approved.

Rule 2711 requires research reports to disclose whether or not: the analyst owns a financial interest in the stock that is subject to the recommendation; and whether the firm makes a market in the stock.  Eight of the research reports failed to include these or three other mandatory disclosures required by the rule.  Strong claimed he was not responsible for these violations because he relied on the firm's president to monitor the reports for compliance with the rule.  The Commission rejected this argument, noting that the firm's procedures required Strong to review all research reports for the purpose of ensuring compliance with Rule 2711.

Strong also failed to file a required attestation with the NASD that the firm had in place written procedures to ensure compliance with Rule 2711.

Exchange Act Section 19(e) requires that the SEC sustain the NASD sanctions unless it finds the sanctions to be excessive, oppressive, or impose an unnecessary burden on competition.  

The Commission upheld the sanctions, noting that NASD sanction guidelines call for a fine of between $5,000 and $50,000 and a suspension.  

Comment

This case is of some note because it reiterates the obligation of supervisors even when that supervisor shares responsibility with others.  

The Commission found supervisory liability where the supervisor had the ability to, in consultation with others, impose disciplinary sanctions and where it was not explicit that the supervisor had the ability to fire.

However, the Commission continues to move at a glacial pace.  One has to wonder why it permitted four months for briefing and took seven months to issue a decision.  This was a routine matter that involved no difficult factual or legal issues. 

 

Hearing Ordered On Reg A Exemption

Euro Capital Inc., Investment Advisers Act Release 33-8898

The Commission ordered a hearing on whether to suspend the Regulation A exemption sought by Euro Capital Inc.  The ALJ was ordered to render an opinion within 120 days.

Bar For Enjoined IA - No Investor Losses

Jeffrey L. Gibson, Exchange Act Release 57266

Time between appeal and decision - 1 year, 3 months, 22 days.

Time between last brief and decision - 1 year 17 days.

Time since oral argument - 5 days.

Pages - 11

Footnotes - 33

Summary

Gibson was barred from investment adviser or broker-dealer association by the ALJ based on a previous injunction for violations of the anti-fraud provisions of the securities laws.  He sold 43 limited partnership interests to 38 investors for about $875,000 in a business that intended to buy and operate coin operated car washes.

Instead of investing the funds as specified, Gibson misappropriated about $450,000 of the money he had raised from investors by investing the funds in other commercial real estate. Gibson had also told investors that investor funds would be invested in money market funds until car washes could be acquired.  Gibson also sent post-investment lulling letters to investors the purported to describe rates of returns from various properties, without telling investors that the funds had not been used as claimed in the offering materials.

He consented to a district court injunction and he was ordered to pay a penalty of $25,000 and to disgorge $427,000 to investors.  He liquidated the commercial real estate to pay the penalty and disgorgement amounts.

At the trial before the ALJ the Division of Enforcement moved for summary disposition.  Thirty-one investors filed substantially identical declarations claiming to "ratify" Gibson's actions and stating they wished him to remain their investment adviser.  The ALJ granted the Division's motion.

Using the standard factors set out in Steadman v. SEC, 603 F.2d 1126, 1140 (5th Cir. 1979) in determining what sanctions are in the public interest, the Commission upheld the ALJ's bar.  Here, the Commission found that Gibson's misappropriation occurred over a three year period, involved several types of misconduct, and involved a large number of his clients.  It also concluded that Gibson's conduct exhibited a high degree of scienter.

Comment

Again the lesson is simple.  Enjoined investment advisers who have court orders prohibiting anti-fraud violations will be barred even when there are no investor losses.

Further, the Commission will ignore the wishes of investors.  Indeed, it found that Gibson's ability to retain the confidence of his investors was testament to his persuasiveness and hence his potential ability to engage in similar misconduct in the future.

One must wonder why the Commission exercised its discretion to hear oral argument in this matter as no novel or significant issues are presented for decision.  Indeed, the Commission rejected Gibson's objection to the ALJ's granting of summary disposition finding summary disposition to be appropriate because "there is no genuine issue with regard to any material fact. . . ."  The lack of novel factual or legal issues is further underscored by the fact that the opinion was rendered only five days after the argument.  Under these circumstances, the Commission's decision to wait one year and 12 days to hear oral argument is puzzling.  If there were no issues of material fact confronting the trial judge, and the opinion itself relies on extensive Commission precedent, it is puzzling that: 1) the Commission even decided to hear oral argument; and 2) it took more than a year to schedule the oral argument.

Adelphia Audit Partner Sanctioned - No Reliance On Prior Audits

Gregory M. Dearlove, AAER 2779

Time since appeal filed - 2 years, 4 months, 1 day.

Time since final brief filed - 2 years, 27 days.

Time since oral argument - 1 year, five months, 7 days.

Pages - 60

Footnotes - 168

Summary

This is a disciplinary proceeding against a CPA and arises from the Adelphia fraud. Respondent was formerly a partner at Deloitte & Touche and was the engagement partner for the audit of Adelphia for the 2000 audit of that firm. He was denied the privilege of appearing or practicing before the Commission with a right to reapply after four years.  He was also ordered to cease and desist violations of Exchange Act Section 13(a).  The ALJ had barred him from appearing before the SEC.

Adelphi filed for bankruptcy in June 2002 after disclosing related party transactions with the Rigas family that controlled the company.  As part of a settlement with the Department of Justice, Adelphia agreed to pay $715 million to a victims' restitution fund and the DOJ declined to file criminal charges.  In 2005 the Rigas settled civil charges brought by the Commission and consented to injunctive relief.  The Commission also brought an administrative action against Deloitte which the firm settled, among other things it agreed to a $25 million penalty and consented to findings it had "engaged in repeated instances of unreasonable conduct" concerning the 2000 audit of Adelphia.

This opinion contains a comprehensive discussion of the Generally Accepted Auditing Standards (GAAS) that apply to audits of public companies.  Among other things, "[u]nless and until an auditor obtains an understanding of the business purpose of material related party transactions, the audit is not complete."

Respondent argued that he should have been able to rely on the fact that the related party transactions had been subject to prior year audits.  The Commission rejected Dearlove's argument, stating "[W]e reject any suggestion that the conduct of prior auditors should be a substitute for the standards established by GAAS."  Further, it noted that rotation of auditors has long been required by the AICPA and federal law as a means of insuring impartiality. The Commission also rejected this defense on factual grounds, finding that the 2000 audit did not document how the prior audits were performed or what evidential matter supported those conclusions.  

Much of the opinion discusses highly technical accounting issues.  Those are summarized very briefly below.

The Commission noted that it was improper for Adelphia to net its related party receivables and payables.  Also, the company reflected a dramatic drop in the net figure, which the Commission found should have alerted the auditors to more carefully scrutinize this matter. Dearlove could not explain how the audit had tested this practice by the company.  The work papers do not reflect that the auditors gave any consideration to the propriety of this netting by the company.  The Commission found that Dearlove accepted the practice "primarily, if not solely" because the prior auditors had as well.

The ALJ rejected the Division of Enforcement's claim that Adelphia's treatment of various debt as a contingent, rather than a primary liability was wrong.  The Division did not appeal this finding.  Nevertheless, the Commission found that Dearlove's auditing of this was not in compliance with GAAS.  This is an important finding, accountants will be held liable for a GAAS violation even if the underlying accounting was appropriate.  Thus, getting to the right result is not a defense in a Rule 102(e) proceeding.  In support of this conclusion, the Commission noted that disclosures relating to the debt were not adequate.

Adelphia transferred debt from its subsidiaries to various Rigas controlled entities after the close of quarters, but nevertheless retroactively reflected the lesser debt amounts on the company's books. The Commission found this debt reclassification a violation of GAAP, even though there was no expert testimony that supported this conclusion.  The absence of expert opinion does not prevent the Commission from making findings as to the "principles of accounting."

The Rigas acquired Adelphia stock with funds borrowed jointly by themselves and Adelphia.  This debt was not recorded on Adelphia's books.  The Commission also found the auditors violated professional standards in their audit of these transactions.

The opinion contains a comprehensive discussion of the factors the Commission will consider when disciplining auditors.  It noted that auditors play a crucial rule in the system of public reporting as "[i]nvestors have come to rely on the accuracy of the financial statements of public companies when making investment decisions.  Because the Commission has limited resources, it cannot closely scrutinize every financial statement.  Consequently, the Commission must rely on the competence and independence of the auditors who certify, and the accountants who prepare, financial statements.  In short, both the Commission and the investing public rely heavily on accountants to assure corporate compliance with federal securities law and disclosure of accurate and reliable financial information."

It also noted that a negligent audit can inflict as much harm on investors as one that is conducted with an improper motive.  

The Commission found that it was appropriate to impose a cease and desist order against Dearlove for causing Adelphia's Exchange Act reporting violations.  In doing so it reiterated a three part test for "causing" liability namely: 1) a primary violation; 2) respondent contributed to the violation; and 3) respondent knew or should have known his conduct would contribute to the violations.  It further noted that negligence was sufficient to satisfy the knowledge requirement of the test.

The Commission rejected Dearlove's claim that the Commission's rule that set a deadline for trial judge to issue an opinion violates due process because here, a motion for a sixty day postponement of the trial was denied by the judge.   In rejecting this argument the Commission cited to the test set forth in Unger v. Sarafite, 376 U.S. 575 (1964) which noted that there is no mechanical test for deciding when denial of a continuance is so arbitrary as to violate due process.  The Commission noted that it has long articulated the test in terms of whether the denial "constituted 'an unreasoning and arbitrary insistence upon expeditiousness in the face of a justifiable request for delay.'"  In the past the Commission has rarely found a denial of due process when there were extraordinary circumstances for a postponement of trial, such as the respondent being left without counsel shortly before the hearing.  Here the judge's schedule allowed for 121 days between service of the order and completion of the hearing.  Further,  counsel was familiar with the matter as he had been involved in the matter for the two prior years when respondent's investigative testimony was taken.

Comment

The Commission's finding that Dearlove violated GAAS even though the accounting treatment of a debt item was appropriate is highly significant for auditors of public companies.  They can thus be held responsible for bad auditing practices even if the underlying accounting was valid.

Also noteworthy is the Commission's conclusion that it may make findings that accounting principles were not properly applied even absent expert testimony to support such a finding.  The Commission will make its own judgments about what constitutes proper accounting treatment of a transaction.

The Commission noted that under some circumstances "unreasonable conduct is not necessarily a less egregious disciplinary matter than either intentional or reckless conduct, or highly unreasonable conduct in circumstances warranting heightened scrutiny."

The Commission allowed respondent to reapply for reinstatement after four years. It stated, with little explanation, that it believed this sanction would encourage rigorous compliance with auditing standards, without being punitive.  This reversion to ipse dixit reasoning may cause the Commission issues before the court of appeals should an appeal be taken.

The Commission's finding that an auditor who signs an audit report after conducting an audit that does not comply with GAAS contributes to a violation of the reporting provisions is significant.

The Commission's ruling that there was no due process violation because the trial judge denied Dearlove's motion for a 60 day continuance after scheduling 121 days between the start of the proceedings and conclusion of the trial is one that practitioners should note.  This is another case where the Commission is clearly signaling that it will not interfere with scheduling or trial management decisions by its ALJs.  It pointed out that Commission rules specify such deadlines are not rigid and that the trial judge can petition the Commission to extend the deadline for rendering an initial decision.  Someone prone to sarcasm might note that the Commission took significantly longer than 121 days after oral argument to render its opinion, let alone the 300 days it allocated for the ALJ to conclude the trial and render an opinion.

Corporate Officers, Registered Reps And Supervisor Sanctioned

John A. Carley, Eugene C. Geiger, Thomas A. Kaufmann, Edward H. Price, Christopher H. Zacharias, Exchange Act Rel. 8888

Time between appeal and opinion - 2 years, 5 months, 26 days.

Time between final brief and opinion - 2 years, 1 month, 3 days.

Time between oral argument and opinion - 11 months, 24 days.

Pages - 51.

I supervised this matter when I was still at the Commission so I will not provide editorial comment or extensive discussion.  However, please note that the dates listed above are not typographical errors.  A brief summary of the case follows.

This matter involved a complex unregistered public distribution of stock by officers of a public company assisted by two registered representatives at a broker-dealer.  It involves very complex issues under the registration provisions of Section 5 of the Securities Act and also the supervisory duties of a broker-dealer.  

Anyone interested in a comprehensive discussion of Securities Act registration would be advised to consider the Commission's discussion of these sometimes difficult issues.  The opinion reiterates that broker-dealers must be vigilant to red flags that may alert them that they are participating in an unregistered distribution of stock by corporate insiders.

Cease and desist orders were entered against all respondents charged with violations (failure to supervise is not a violation).  One registered representative was barred, another was barred with a right to reapply after five years and the supervisor was barred from acting in a supervisory capacity.

The two corporate officers were ordered to disgorge a total of $4 million between them and ordered to pay prejudgment interest totaling $2 million.  Each of the registered representatives was ordered to disgorge $873,000 and pay prejudgment interest of $454,000. Each representative was also ordered to pay a civil penalty of $110,000 and the supervisor was ordered to pay a $55,000 penalty.  

ALJ's Motion To Extend Time For Decision Denied As Moot

Trautman Wasserman & Co., et. al., Exchange Act Rel. 57243

Now for some real trivia folks.  The ALJ moved for an extension of time in which to file her initial decision, but rendered that motion moot by filing her decision before the deadline.  The Commission therefore denied the pending motion by the judge.

Comment

If the Commission can publish this why can't it publish the briefs of the parties in its cases?

Investment Adviser Barred For Inflating Performance Data And Assets Under Management

Warwick Capital Management, Inc., Advisers Act Rel. 2694

Time between appeal and decision - 10 months, 21 days.

Time between last brief and decision - 7 months, 26 days.

Pages - 21.

Summary

The control person of an investment adviser who claimed inflated assets under management and performance results will be barred.  A bar and cease and desist orders are appropriate despite the fact that there was no misappropriation of investor funds.

Warwick, an investment adviser and its president Lawrence appeal an initial decision by an ALJ.  The law judge found respondents: 1) violated Section 203A of the Advisers Act by maintaining its registration with the Commission despite having less than $25 million under management; 2) respondents violated Advisers Act Sections 206(1) and (2) and Warwick violated and Lawrence aided and abetted violations of IA Section 206(4) by falsely representing total assets under management and publishing false performance data.  The ALJ barred Lawrence and entered cease and desist orders against both respondents.

After 1997 when advisers needed $25 million under management to qualify for Commission registration, Warwick reported between $26 and $37 million under management.  This was a sharp increase over the $5 million it had reported 8 months earlier.  Warwick's registration was cancelled by the Commission in January 2002 and it never filed to withdraw its registration.  Warwick continued to hold itself out as registered with the Commission after that date.  Further, Warwick continued to publicly claim it had assets under management of between $26 and $94 million through early 2004.

Lawrence admitted in sworn testimony to the Commission staff that between 1998 and 2003 he had only between $2 million and $10.5 million under management.  Although Lawrence claimed to have managed substantial other assets, the ALJ found those claims to be not credible and unsupported by credible evidence.

Warwick also published inflated performance return data, claiming annual returns as high as 77 percent.  Lawrence admitted in testimony the actual return was about 25 percent.  He claims to have sent a correcting letter to a data service changing the returns he first claimed, but the service never received his purported letter.

At the hearing, Lawrence claimed various records were destroyed in a fire.  Unfortunately for him, he had previously testified the records were destroyed in a flood.  Apparently he never got around to claiming the destruction was by a horde of locusts.

In upholding the finding that Lawrence aided and abetted violations by Warwick, the Commission noted that recklessness satisfies the knowledge requirement for aiding and abetting, citing the formulation in Sundstrand Corp v. Sun Chem. Corp., 553 F.2d 1033, 1044-1045 (7th Cir. 1977).  Lawrence's aiding and abetting was established because he signed documents with the false performance data.  Because he was solely responsible for managing Warwick, the Commission found Lawrence must have known that the claimed amount of assets under management was inflated.

Inflated performance data and size of assets under management are material because they gave an erroneous impression of the firms size and abilities.  Investors routinely consider an adviser's past performance and attractiveness to other investors when making investment decisions.  Respondents are liable for misrepresentations made to a data service because they knew that those statements would be repeated or otherwise conveyed to investors.

Conduct occurring more than five years before the proceedings were instituted maybe the basis for imposing sanctions or civil penalties (see 28 U.S.C. 2462).  However, such evidence may be considered to establish motive, intent, or knowledge in committing violations within the limitations period.  And, no statute of limitations applies to consideration of the cease and desist remedy. 

Comment

The Commission will require advisers to prove with credible evidence claims that they meet the asset test in order to maintain registration.  

Over the years, some of the Commission ALJ's have been unwilling to admit prior sworn testimony by respondents as substantive evidence, despite authority for doing so.  Here, the Commission considered prior inconsistent sworn testimony by a respondent.  Note, Commission case law also admits as substantive evidence for all purposes prior sworn testimony of non-respondents, a practice that is contrary to the federal rules of evidence.  See, Allesandrini & Co., 45 S.E.C. 399 (1977).

The Commission rejected the Division of Enforcement's request for second tier penalties, with very limited explanation.  It concluded that the bar and cease and desist orders were sufficient remedies primarily because Warwick only had two clients at the time of the hearing and because Warwick would have to cease operations due to the bar imposed on Lawrence.

Appeal From NASD Action Dismissed For Lack Of Jurisdiction