Phillip L. Spartis and Amy J. Elias, Exchange Act Rel. 34-64489, May 13, 2011
Spartis and Elias were reps at Salomon Smith Barney. NYSE found that they violated exchange rules by sending misleading communications to customers that omitted material facts or were misleading.NYSE Rule 472.30 prohibits the making of misleading communications to customers. Both were censured. The Commission upheld the sanctions. The violations alleged occurred as long as 12 years ago.
Between 1998 and 2001 Spartis and Elias advised Worldcom employees who were granted stock options. When customers did not immediately sell the stock obtained by exercising Worldcom options Spartis and Elias used various marketing materials describing an exercise and hold strategy. Due to the need to pay for the stock, taxes, and fees, this could strategy could require a significant amount of cash. Many customers opted to borrow on margin from Smith Barney to finance this strategy. These customers were betting that Worldcom stock would appreciate faster than the interest costs of margin loans. This market risk was not present for those customers who chose an exercise and sell strategy.
The marketing materials featured a graph that compared gains under the two strategies. NYSE alleged this was materially misleading because it failed to depict any risk that Worldcom stock would not appreciate or decline in price. The graph only assumed a constant market price rise for Worldcom stock. The materials showed precise possible gains for each customer but "left it to the customers to guess as to their possible losses and the risks involved if the stock remained flat or declined."
Spartis and Elias claimed that the customers were sophisticated and knew that Worldcom's stock might decrease in value. They also claimed that management had approved the marketing materials.
The Commission agreed with NYSE that the analysis did not present a balanced assessment of the risks and rewards of the two strategies but instead focused exclusively on possible benefits of the buy and hold strategy. Sales materials that only highlight benefits without providing specific risk disclosures are materially misleading. The Commission was particularly troubled by the fact that there was no disclosure of the particular and heightened risks resulting from financing the buy and hold strategy with borrowed money. Margin transactions are inherently more risky than cash based strategies for two reasons. First, if the value of the security drops the customer may be required to meet a margin call and deposit substantial amounts of additional cash. Second, margin interest adds to the costs of the transaction and increase the amount of appreciation required for the customer to realize a gain.
The Commission rejected respondents' defense that their supervisors approved the marketing materials. "... even if there was supervisory approval, it is well established that the duties owed by a securities professional to his or her customer are not 'abridged by a failure on the part of his [or her] supervisors."
Respondents also claimed that the possibility of a decline in the price of Worldcom was an obvious risk that did not require specific disclosure. The Commission rejected this argument noting that the materials "presented a one-sided picture of the customer's earnings potential under the exercise and hold strategy and by omitting important risk disclosures." Further, generic risk disclosures of general market risk were insufficient. A "vague disclaimer which merely warns the reader that the investment has risks will ordinarily be inadequate."
Lastly, the Commission ruled that NYSE Rule 472.30 under which respondents were charged does not require scienter.
As is its practice the Commission in part justified the sanctions as in the public interest by noting that it was "troubled" by the respondents' failure to accept responsibility for their actions. The Commission needs to stop this practice of justifying its sanctions when respondents vigorously defend themselves. Sanctions should be based only on the conduct and violations involved. Any time a respondent defends herself she is opening herself up for a claim by the Commission that enhanced sanctions are justified for failure to "accept responsibility." The punishment should fit the crime and it is no crime to defend oneself.