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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


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.     


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.


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."