LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

Bon mots

"You can observe a lot just by watching." Yogi Berra

"We do not distain to borrow wit or wisdom from any man who is capable of lending us either." Henry Fielding, Tom Jones

"In our complex society the accountant's certificate and the lawyer's opinion can be instruments for inflicting pecuniary loss more potent than the chisel or the crowbar." United States v. Benjamin, 328 F.2d 854, 862 (2d Cir. 1964)

NASD Bar For Failure To Supervise Upheld

Ronald Pellegrino, Exchange Act Rel. 59125, December 19, 2008

Time since appeal - 10 months 20 days
Time since last brief - 6 months 28 days
Pages - 29
Footnotes - 74


Pellegrino was a general securities principal at a NASD member firm starting in 2001. NASD found he failed to establish and maintain appropriate supervisory procedures and barred him from associating with a member firm in a principal capacity. Subsidiaries of the firm issued securities that were sold by the firm's 200 sales agents. NASD found there were systematic abusive sales practices that lead to substantial customer losses and that the firm did not adequately supervise the sales. The Commission upheld the NASD's supervisory bar. The opinion should be noted for four significant points. First, unlike the Exchange Act, NASD rules allow a finding of failure to supervise without an underlying violation. Second, full disclosure in a prospectus does not cure a suitability violation. Third, suitability requires a detailed analysis rather than reliance on simplistic mathematical concentration formulas. Fourth, supervision requires appropriate implementation - written procedures that are not followed are no defense.


A majority of the firm's revenues came from the sale of the securities of its affiliates and the sale of the proprietary products was the main focus of the firm. Much of the proceeding was based on facts stipulated to by Pellegrino. He claimed on appeal he had been manipulated into agreeing to the stipulations. The Commission noted that stipulations will be honored "'in the absence of compelling circumstances' justifying setting [them] aside."

The firm's supervisory principal had no prior securities experience and he had no formal supervisory training. Most of the reps were offsite in remote offices. There was no supervisory staff at the firm and the supervisory principal understood that "generating sales" was the firm's first priority.

The subsidiaries whose securities were sold purported to be in the business of acquiring business receivables, including annuities, structured settlements, equipment leases, and lottery prizes. They purchased receivables where the collateral did not qualify for conventional financing. The securities they issued were debentures and investment certificates that were unsecured general obligations. The securities were highly risky because they were subordinated to all other debt and liabilities of the issuers. Starting in 1999 one subsidiary began having financial difficulties and in 2004 it filed for bankruptcy. Just before Pellegrino joined the firm it issued a prospectus showing that it had insufficient earnings to pay preferred stock dividends and had a high debt to equity ratio. Most investors were unsophisticated and had a low risk tolerance. Sales agents routinely recommended the affiliates' debt as "very safe" and "low risk." They compared the investments to collecting interest from bank deposits and claimed the investments were as safe as bank accounts.

The firm deemed the proprietary products suitable for investors so long as they were limited to forty percent of an investor's net worth and preferred stock of the firm or subsidiaries did not exceed 20 percent of their net worth. Internal compliance guidelines purported to prohibit low risk tolerance investors from buying preferred stock of the firm or subsidiaries.

Pellegrino knew when he was hired that the firm and subsidiaries were in dire financial straits when he started work there. He knew the firm was disorganized and in his own words "dysfunctional." Soon after starting he concluded that the firm's supervisory system was deficient. Pellegrino did take some action. He hired two additional compliance staff and eliminated some sales agents who were in geographically remote regions. He terminated a group of sales agents whose sales practices raised concerns. He instituted a procedure for sending questionnaires to customers.

However, Pellegrino failed to replace the inexperienced part time compliance officer because the firm's president insisted that he stay in place. The compliance officer was replaced only at the insistence of state regulators and Pellegrino resisted their demands to remove him.

NASD advised Pellegrino that sales agents were minimizing risks of the investments including the deteriorating financial condition of the issuers that was disclosed in prospectuses. Among other things he learned that sales agents were telling customers to ignore the prospectus. He also learned from a survey of customers that they did not understand the risk of the investments. His response was to assist sales agents in identifying customers who still had "buying power." Pellegrino also led compliance training sessions that emphasized that suitability could be determined solely based on the concentration formula the firm had in place.

After he learned of an scheduled NASD exam Pellegrino distributed a memorandum to sales agents that discussed the need to make sure the products were suitable for investors. After he testified before the NASD he removed the unqualified part-time supervisor of sales agents and replaced him with an experienced compliance officer.

The firm failed in December 2003. Testimony indicated preferred stockholders would lose their entire investments and debenture holders might receive 30 percent of their investment. During Pellegrino's tenure the firm sold $4.1 million of proprietary investments to 165 clients.

Pellegrino was found liable because he had overall responsibility for oversight of the firm's supervisory procedures and because he knew sales agents were selling risky securities to investors who wanted low risk and told them to ignore prospectus risk disclosures.

The opinion notes that delivery of a prospectus with full risk disclosure does not cure a suitability violation. The Commission also rejected Pellegrino's defense that NASD should have notified the firm of supervisory failures. He could not reasonably rely on NASD's silence.

The primary factor the Commission cited in upholding the bar was its finding that Pellegrino failed to act in the face of clear evidence of "patent irregularities."


No new or unique issues were raised by this case yet it took the Commission more than six months to render an opinion. This case provides a good summary of the supervisory requirements that broker-dealers are required to obey. Practitioners should note that unlike the Exchange Act, that requires an underlying violation for supervisory liability, NASD rule 3010 requiring adequate supervision can be violated without an underlying infraction.

This is another sad example of remote offices staffed by "independent contractors" in a firm whose main priority was sales. Here, despite compelling evidence that customers were being told to ignore obvious risks sales were paramount. Also, this case demonstrates that disclosure in a prospectus does not insulate supervisors or sales agents from fraudulent oral sales claims that contradict the written disclosure. This problem of firms with numerous remote locations is a systematic and continuing problem which the Commission should consider addressing through aggressive examination of such firms as well as enforcement actions of its own.