NASD Sanctions Upheld

Kevin M. Glodek, Exchange Act Rel. 60937, November 4, 2009

Time since appeal – 7 months 11 days
Time since last brief – 4 months 2 days

Glodek was found by the NASD to have committed fraud by making false statements to customers. He was fined $25,000 and suspended from association for six months. He did not dispute the finding of violations or the fine. He did appeal the suspension.

Glodek had a consulting agreement with a company by which he received stock in a company. He recommended the stock to customers making predictions that the company's stock would more than double within a few months. He also claimed the stock, then trading over-the counter would soon be listed on the Amex. Also, despite the company had significant unpaid payroll tax liabilities to the IRS, he claimed to customers the company was debt free.

Predictions of substantial and specific price increase of a stock are fraudulent unless there is a reasonable basis for them.

Glodek argued that it was improper for the NASD to increase the suspension above that imposed by the initial hearing panel. The Commission rejected this claim. It also disagreed with his claim that NASD should have justified its upward departure as the final sanction was within published NASD sanction guidelines. The Commission further noted that a lack of previously disciplinary history is not a mitigating factor.

The statute requires the SEC to uphold NASD sanctions if it finds they achieve the goal of being both remedial and suitable to deter future violations and not excessive or oppressive.

NASD Bar for Rep's Failure to Disclose Multiple Felony Charges And Misdemeanor Conviction Upheld

Jason A. Craig, Exchange Act Rel. 59137, December 22, 2008

Time since appeal filed - 10 months 16 days
Time since last brief - 6 months 3 days
Pages - 13
Footnotes - 48

Summary

Craig was a registered rep at a member firm. He failed to disclose four felony charges and a misdemeanor conviction on his U4 registration application. NASD barred him. The felonies involved drug and forged checks. The check charges in which Craig was charged with changing the payee on checks to himself were reduced to misdemeanors and he plead guilty. He also plead guilty to another misdemeanor charge based on forgery of a driver's license.

Discussion

Craig was told in an employment interview to disclose all criminal charges and convictions. He was fired after a mandatory finger print check showed charges and convictions that he failed to disclose on his U4.

Comment

Needless to say Craig was pro se. He obviously had time on his hands. Here, Craig's undisclosed misdemeanor conviction statutorily disqualified him from associating with a broker-dealer. One must wonder why the Commission dawdled for six months in issuing this opinion that involves no unusual factual or legal issues.

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

Summary

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.

Discussion

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."

Comment

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.

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.

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."

Morton Bruce Erenstein, Exchange Act Rel. 56768, November 8, 2007

NASD appeal, failure to cooperate

Time between appeal and decision - 9 months, 30 days.

Time between last brief and decision - 6 months, 21 days.

Pages - 17

Summary

Respondent, a registered representative appealed NASD sanctions.  The NASD found that he had failed to answer a question about his tax returns during testimony before the NASD staff and failed to timely respond to a written request for information from the NASD.  He was suspended from association for one year.

The NASD inquiry was based on a customer complaint that claimed Erenstein had, among other things, made unsuitable recommendations to a customer, and converted a customer's funds.  After his counsel responded to a request for a written response to the complaint, respondent then provided testimony to NASD staff.  He claimed that that the purportedly converted funds was compensation paid by the customer for assistance in liquidating certain securities.  He claimed he had orally informed his firm of this arrangement, but admitted he did not obtain written approval from his firm for this outside activity.  During his testimony he refused to answer a question from NASD staff about whether he reported the $10,000 he claimed was income on his tax returns. He claimed he had no documents that would verify that he had done specific work for the customer to earn the purported fee as opposed to converting the funds.  NASD staff then asked him to provide copies of his tax returns.  He refused to do so.  Respondent's counsel argued that the tax information was not relevant or that it was subject to a "heightened " standard of relevance.

About 7 months later, after receiving a Wells notice concerning possible disciplinary charges, respondent submitted the tax returns "under protest."  The $10,000 was not included in his initial tax return for the year in question, but was included in an amendment filed 5 years later. 

After proceedings were filed by the NASD, respondent filed for bankruptcy.  A discharge was entered by the bankruptcy court and the NASD staff determined not to seek monetary penalties against respondent.  

The NASD hearing panel imposed a bar.  On appeal the NASD reduced the sanction to a one year suspension, noting that respondent had eventually produced the tax return information sought by NASD staff.

The Commission found that there was no dispute concerning the facts that established the violations.  

The Commission also found that there is no obligation for the NASD to explain why it sought the information being sought as the rule speaks of "any matter involved in" an investigation.  The Commission cited various long standing precedent and noted that it is well established that an associated person may not "second guess" an NASD information request or "set conditions on their compliance."  A belief that the NASD does not need the information is no excuse for failure to provide it.  Thus, the NASD is not required to establish the relevancy of the request.  However, the Commission found the information requested here to be relevant, noting that omission of the money from his tax returns could support an inference that he had converted the funds and reporting the income would support an inference he did not.

Respondent's argued that because he acted on the advice of counsel, a sanction based on that advice denied him his right to counsel.  He also argued that tax returns are confidential and that "discovery" is permitted only with a heightened showing of relevancy.  The Commission distinguished the cases cited by respondent concerning limits on NASD inquiry.  It noted that the Quattrone case involved only the issue of whether there was a genuine issue of material fact concerning whether the NASD complied with its own rules, and therefore summary disposition was inappropriate.  The Ochanpaugh case is not relevant because it dealt with the issue of whether the information sought by the NASD constituted  books of an associated person.  Here there was no question but that the tax returns were respondent's and in his possession.  

Also, the Commission rejected the argument about confidentiality of tax returns, noting that the courts permit such discovery where the taxpayer has made an issue of his income or where they are relevant and the information is not easily obtainable from another source. The Commission found that the cases cited by respondent do not support his claim that tax returns are subject to a heightened relevancy standard.  Here, respondent made his income an issue by claiming the money he had received was income he earned due to services he provided his customer.

Finally, the Commission dismissed the reliance on counsel argument by noting that reliance on counsel is immaterial to a person's obligation to supply information to the NASD.  Further, the NASD in imposing a sanction, took into account that respondent had relied on counsel's advice.

Respondent raised a number of procedural objections, including to the length of time the NASD took to consider the matter.  These were all rejected by the Commission.  It noted that the decision it reviews is that of the NASD on appeal, not the hearing panel decision.

Last, the Commission rejected respondent's claim a that the sanction was excessive.  It noted the crucial nature of the NASD cooperation rule because the NASD lacks subpoena authority to conduct investigations. The NASD guidelines provide for a two year suspension where there is mitigation.  Here, the one year suspension struck the appropriate balance according to the Commission.  The Commission also found that general deterrence is an appropriate goal in sanctioning, but that it is not sufficient by itself, as a justification for a suspension.  

 

Comment

In dealing with the tax returns, the Commission did not distinguish a NASD investigation from discovery in a civil matter and arguendo assumed the relevancy of the concept, finding on the facts that respondent had made an issue of his income.  It could have quashed this line of argument permanently by simply noting that the ability of NASD (or its own staff) to investigate a matter is simply not governed by the standards that may apply to discovery in a civil matter.  See, for example, SEC v. Isbrandtsen, 245 F.Supp 518 (S.D.N.Y., 1965) ( SEC entitled to make persistent and thororough inquiry).

The Commission has again provided an extensive discussion of why it believed the sanction appropriate in this case. 

Again, my long standing query --- why did it take 9 months to issue this decision?  The matter was routine and raised no difficult legal or factual issues.

Richard F. Kresge, Exchange Act Rel. 55988 (June 29, 2007)

NASD Appeal, control person liability.

Time between appeal and decision - 10 months, 0 days.

Time between last brief and decision - 7 months, 0 days.

Pages - 26

Comment

NASD found that respondent (the president of a broker-dealer) failed to supervise a branch office and failed to establish and enforce an adequate supervisory system. He was also found liable for violations of NASD rules concerning failing to register a registered representative and principal, failure to report customer complaints to the NASD and other rule violations. Respondent was barred in all capacities, ordered to pay restitution to customers of $3.8 million plus interest, and assessed costs of $9,500. Because the Commission dismissed findings of control person liability, the matter was remanded for a redetermination of sanctions.

This case presents a classic failure to supervise situation, unfortunately very typical of some small firms. It is of interest for its laundry list of fairly obvious supervisory failures.

Almost as an afterthought, at the conclusion of the opinion, the Commission makes a startling pronouncement about the scope of control person liability under Exchange Act Sectcion 20(a). The Commission found that Respondent did not have control person liability for violation of NASD Rules of Conduct because he did not personally participate in the underlying violative conduct. The opinion supports this strange conclusion by distinguishing the two cases relied on by the NASD, finding that in each, the presidents of the firms had actual personal involvement in the underlying conduct. Thus, 20(a) liability is being limited to actual participants in the underlying conduct. This is a remarkable pronouncement because, without extensive analysis, it seems to narrowly limit the scope of Section 20(a) liability beyond the specific language and clear intent of the statue simply because cases cited by the NASD involved personal involvement. Further, such a reading would render Section 20(a) unnecessary as persons with knowledge will usually be liable as direct participants or as aiders and abetters. The Commission's analysis obviously begs the question of why the statute itself should be so interpreted. Query whether the Commission believes that this qualification should apply in all potential Section 20(a) contexts? One has to wonder why such a significant matter is dealt with summarily and with so little discussion. Also, the Commission simply announced that it found the record did not support control person liability under Exchange Act Section 20(a) for respondent based on violations of Exchange Act Section 10(b) by salesmen. It unfortunately offered no explanation for this pronouncement.

In an ambiguous footnote 31, the Commission implies that a person who cannot hire and fire, reward and punish, cannot be a supervisor. Surely the Commission does not mean that this footnote be taken literally and instead it should be interpreted to mean that ability to hire and fire is simply a factor in determining on a case by case basis whether a person is in fact a supervisor. This is because there are in fact supervisors who do not have the ability to hire and fire.

Key Points

• "Assuring proper supervision is a critical component of broker-dealer operations."
• Whether a particular supervisory system or written procedures is "in fact reasonably designed to achieve compliance" is a fact specific inquiry.
• "The president of a brokerage firm is responsible for the firm's compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties."
• Compliance systems must be tailored specifically to the firm's business and must address the activities of all of its reps and associated persons.
• Firm's president, CEO, financial and operations principal, and compliance officer had ultimate responsibility for the firm's operations.
• Even if there is a chain of qualified supervisors in the chain of command, "it is not sufficient for the person with overarching supervisory responsibilities to delegate supervisory responsibility to a subordinate, even a capable one, and then simply wash his hands of the matter until a problem is brought to his attention. . . . Implicit is the additional duty to follow up and review that delegated authority to ensure that it is being properly exercised." Here Kresge failed in that duty because he made no inquiry of his subordinate supervisors about anything happening at the branch office except it's financial performance.
• Respondent's argument that he delegate supervisory responsibility to others was rejected because, among other things, there is "an obvious need to keep [a] new office with . . . untried personnel under close supervision."
• Supervisory procedures were not specifically changed and tailored to reflect the fact that this very small firm acquired a new branch office.
• Supervisory procedures must set forth a specific chain of command and describe the division of supervisory duties in each office.
• Respondent cannot escape his supervisory failures by the fact that the NASD staff approved the firm's written procedures.
• Registered reps who change firms frequently in a short period are a red flag for compliance and supervision issues.
• A registered rep with a criminal conviction, or a pending customer arbitration, or less than two years of industry experience present supervisory red flags.
• Firms are required to make reasonable efforts "to determine that all supervisory personnel are qualified by virtue of experience or training to carry out their assigned responsibilities." Respondent failed in this duty concerning a branch manager who had only 6 months previously passed the principal's exam, had repeatedly changed firms in the last 5 years, and because he did not contact any of the manager's previous employers.
• Respondent had a duty to supervise the supervisor of the branch office, and failed to do so. He never reviewed any of the office's records and made no attempt to review the branch manager's performance. Although there was another individual designated as the immediate supervisor of the branch manger, that individual had been with the firm for only 6 months, had a wide variety of other duties, including personal customer accounts which Respondent knew were "overwhelming." Further, that individual almost never actually visited the branch office. Respondent also knew that individual did not review suitability of transactions in the branch office.
• The fact that someone has passed the supervisory exam does not automatically qualify them to be a supervisor. The firm must still determine that the individual can "effectively conduct their . . . responsibilities."
• An individual who negotiated the sale of a branch office, which he financed and owned, to the firm, was often present at the office was an associated person who should have been registered with the NASD. This is because he financed the office, was actively involved in hiring and firing, participated in meetings, and purported to act as the leader of registered reps in the office.
• Respondent's recantation at the hearing of previous sworn testimony was rejected by the hearing panel which credited his earlier inculpatory testimony. The Commission noted that "credibility determinations of an initial fact finder are entitled to considerable weight" and declined to overturn that determination.

Addition Discussion

Respondent has been in the industry since 1978 and founded the broker dealer in 1986. He was president, CEO, financial and operations principal, and owned 95 percent of the firm. He was the firm's compliance officer except during the period January 2002 through June 2002. The firm employed 10 persons and until January 2001 specialized in bonds, mutual funds, and listed securities.

In January 2001 the firm acquired a branch office that had 50 registered reps. In August 2001 the firm entered into an arrangement where it "acquired" another branch office in Brooklyn, purportedly controlled by one Ferragamo. There was no written agreement for this arrangement. In September 2001 on Ferragamo's recommendation, Respondent hired a branch manager for the Brooklyn office. The branch manager had worked for 6 firms in 5 years and Kresge did not contact any of them before hiring the manager. The new branch manager received no training. The office manager had passed the principal's examination only 6 months previously. Kresge also hired a number of registered reps for the Brooklyn office on Ferrigamo's recommendation, despite knowing that each had worked for a number of brokerage firms over a short period. Kresge knew none of these reps received a compliance manual and didn't know if they received any training concerning sales practices or suitability.

The Brooklyn branch primarily sold penny stocks, contrary to Ferragamo's representation to Kresge before the acquisition that it mainly sold listed securities. Other than casual conversations about the financial status of the branch office, Kresge did nothing to monitor the supervision of that office. Kresge never reviewed any records of the office, including records of customer complaints and customer account activity. He admitted that information in those records raised serious questions about the propriety of certain penny stock sales activity by the branch. Kresge knew that the person he had designated to supervise the branch manager was overwhelmed with other duties, but never monitored his supervision of the branch.

In January 2002, because the Brooklyn office was overwhelming, Kresge hired a consultant on compliance, who he made compliance officer in February 2002. The compliance director was supposed to revise the firm's written supervisory procedures as Kresge knew at the time that the current procedures did not establish a supervisory chain of command. A draft of revised procedures was distributed throughout the firm in March and April 2002. This draft did not deal with penny stocks or bonds. It did not provide for methods to detect violations or ensure compliance. Further, there was no chain of command specified. The duties of the new compliance director were unclear. He did not have hiring and firing authority. Before he left the firm in June 2002 he recommended that the firm begin tape recording of Brooklyn reps. He also recommended that sales scripts be banned. Kresge ignored these recommendations. In April 2002 Kresge learned that two Brooklyn reps were operating from an unregistered location. That office was closed and the reps were placed under heightened supervision based on customer complaints about their sales practices.

From October 2001 when it opened, until April 2002, three reps in the Brooklyn office engaged in egregious sales practice fraud in selling three penny stocks. Each was tiny, and had assets of less than $100,000, minimal revenues, and operating losses. Each had "going concern" opinions issued by their auditors. The three reps solicited firm customers to buy $8.3 million of the three penny stocks. They enthusiastically recommended the stocks to customers, predicted rising prices for the stocks, but failed to disclose the poor financial condition of the companies. Many of the customers were retirees who were not interested in, and had no history of investing in speculative stocks.

From October 2001 until January 2002, when Kresge was the firm's compliance director, the Brooklyn office sold $3 million of one of the penny stocks. Kresge admitted the firm never attempted to determine whether it was in compliance with rules pertaining to penny stocks.

NASD rules require firms to report customer complaints. While compliance director Respondent was responsible for doing so, yet he never reviewed customer complaint files and never discussed customer complaints with the manager of the Brooklyn office. Respondent claims he did not report complaints because he was unaware of them. This in itself demonstrates the failure of the firm's supervisory procedures.

The Commission dismissed findings by the NASD that Respondent was liable under Exchange Act Section 20(a) for various activities of registered reps as a control person. Without explanation the Commission simply found that the record did not support this conclusion.

Sky Capital LLC (Exchange Act Rel. 55828 (May 30, 2007)

NASD Appeal - Jurisdiction - Alleged NASD staff misconduct

Time between appeal and decision - 6 months, 3 days.
Time between last brief and decision - 5 months, 4 days.
Pages - 9

Comment

Sky Capital, a broker dealer, applied for NASD membership. The application was denied. Later, the NASD reconsidered and permitted the application with various restrictions. Over a period of years the firm expanded and alleged that the NASD staff obstructed those efforts, although its expansions were ultimately permitted. Sky Capital also complained that the NASD staff conducted eight examinations of its operations. The firm claimed that the examinations were designed to destroy it by draining its financial resources. Two of those examinations were in progress at the time of the appeal. The other six had resulted in two minor disciplinary actions, which Sky consented to. Sky Capital filed a complaint with the NASD's Office of Ombudsman alleging staff harassment. To date the NASD has not acted upon that complaint.

The Commission found that it had no jurisdiction because the NASD had not issued any formal and final disciplinary orders. "We have stated that SRO action 'is not reviewable merely because it adversely affects the applicant.'"(footnote omitted)

This is a routine matter in which the Commission applied very clear statutory jurisdictional requirements and clear precedent. One must wonder why nine pages of ink were spilled deciding this and why it took five months to issue an opinion.

Without any explanation of why, the Commission simply stated that "the decisional process would not be significantly aided by oral argument." One has to wonder what determines whether or not oral argument will take place. The explanation in this decision provides no clue as to what factors the Commission uses to make this determination.

Key Points

• Without explanation the Commission denied Sky Capital's request for oral argument stating that "[w]e have determined that the presentation in the briefs and the decisional process would not be significantly aided by oral argument."
• The SEC's authority to review NASD actions is governed by Exchange Act Section 19(d). Review of a SRO action is limited in that section to actions that: 1) impose final disciplinary action; 2) deny membership; 3) prohibit or limit access to services of the SRO; or 4) bar a person from associating with a member. Since the complaint does not allege any such jurisdictional action, the Commission found it had no jurisdiction.
• Exchange Act Section 19(f) does not provide for Commission jurisdiction in the absence of jurisdiction under Section 19(d).
• The Commission has no jurisdiction to award damages or reassign NASD staff as requested by the firm. Under Exchange Act Section 19(e), the Commission's remedies when reviewing a NASD action are limited to affirming, modifying, or setting aside NASD sanctions.
• The NASD's Office of Ombudsman is does not provide a "fundamentally important service" that is central to the function of the NASD and therefore alleged failure of that office to act does not invoke Commission jurisdiction.

Hans N. Beerbaum, et. al, Exchange Act Rel. 55731 (May 9, 2007)

NASD Appeal - definition of associated principal.

Days between appeal and decision – 11 months, 10 days.
Days between last brief and decision – 8 months, 4 days.
Pages – 10.

Comment

The Commission sustained the NASD finding that respondent acted as a general securities principal while his registration was suspended between 2002 and 2004. The NASD barred respondent and fined his firm $15,000 and assessed costs of $4,141. Respondent was pro se.

Respondent claimed that the firm had another principal who was properly licensed. The Commission held that "[t]he fact that a member firm properly registers one principal who exercises managerial authority does not mean that other associated persons who act as principals need not be registered as principals."

This was a routine matter that involved application of long standing precedent. Under the circumstances eight months to issue an opinion seems excessive.

Key points

• The following conduct constituted association with a firm: supervision of a registered representative's 180 transactions; receipt of an override commission based on sales by a registered representative; attestation to the accuracy of the firm's annual audit reports; filing of a withdrawal form for the firm's registration in a state; filing an amendment to the firm's Form BD reflecting a previous NASD disciplinary action; amendment of the firm's CRD information listing himself as CEO of the firm; and signed and approved anti-money laundering procedures for the firm listing himself as program compliance officer.
• The NASD defines a principal as a person who is "actively engaged in the management of the [member firm's] investment banking or securities business, including supervision, solicitation, conduct of business, or the training of persons associated" with a member firm.
• Approving, signing, and filing required periodic financial reports, disclosure forms, and required compliance and supervisory procedures on behalf of a firm are management responsibilities that are to be performed by a principal.
• Every associated person who holds an enumerated position and who has managerial responsibilities must be registered as a principal.
• The firm was liable because a firm can only act through its agents and is accountable for the actions of its responsible officers.

Summary

In 2002 NASD suspended respondent from associating with his firm when he was not registered as a principal of the firm. During that time, he did the firm's bookkeeping, wrote checks on its bank account, and was solely responsible for supervision of the firm's salesman, prepared and filed the firm's FOCUS reports, filed an amendment to the firm's Form BD, and received compensation from the firm. Respondent and the firm were each fined $2,500 and respondent was required to requalify as a principal. If unable to requalify in 90 days, he was suspended as a principal until he did so.

Respondent took the above mentioned actions that rendered him a principal.

There is no reason to find that the NASD sanctions are excessive, oppressive or impose an unnecessary or inappropriate burden on competition. Absent a such a finding, the Commission must sustain the NASD sanctions. Here the sanctions are consistent with NASD Sanction Guidelines. The violations here were serious as they extended for almost two years. Further, the violations mirror those that resulted in his original suspension from association as a principal. During the two year period, respondent failed the principals examination three times. Finally, during the hearing, respondent demonstrated a cavalier attitude toward the principal registration requirements. It was respondent's obligation to make sure that only a properly registered individual acted as a principal of the firm.

Howard Brett Berger, Exchange Act Rel. 55706 (May 4, 2007)

NASD disciplinary decision – challenges to NASD jurisdiction

Days between appeal and decision – 8 months, 20 days
Days between last brief and decision – 5 months, 21 days
Pages – 17

Comment

Respondent was barred by the NASD for failure to cooperate with a NASD investigation. He failed to appear at two scheduled interviews with NASD staff. The Commission affirmed the NASD action.

Respondent claimed that he was not subject to NASD jurisdiction. The NASD found that by filing an application for registration, respondent had subjected himself to NASD jurisdiction.

The Commission relied on two previous cases to the effect that persons may not challenge NASD jurisdiction before they are required to provide information to the NASD.

This was a very simple, straightforward matter. It raised no new issues of law and applied clear precedent. The only issue of note was whether NASD has jurisdiction over persons who have applied for registration. In this case, the issue was decided based on the particular facts of the case. NASD by-laws clearly provide for such jurisdiction. Under these circumstances, one must wonder why the Commission took 17 pages and more than 5 months after the briefs were filed to render a decision.

Key points

• Failure to appear before the NASD staff demonstrates a prima facie violation of NASD Rule 8210.
• NASD bylaws provide for jurisdiction over both registered persons and persons who have applied for registration.
• The standard for review of evidence in an administrative proceeding is preponderance of the evidence.
• Circumstantial evidence is appropriate in administrative proceedings.
• An initial fact finder's credibility findings are entitled to substantial weight and will not be ightly overturned.
• Where witnesses do not have specific recall, standard business practice may be relied upon as persuasive evidence.
• The Federal Rules of Civil Procedure and the Commission's Rules Relating to Investigations do not provide respondent any substantive rights.
• It is not fundamentally unfair that the NASD has no procedure for challenging its jurisdiction before a person is required to provide information to its staff.
• The only way for a person to challenge NASD jurisdiction is to fail to provide information to the NASD and then challenge any resulting NASD disciplinary action.
• The Commission declined to find that the sanction was excessive or oppressive.
• To establish advice of counsel as a mitigating defense a respondent must provide evidence that that he made complete disclosure to counsel, sought advice on the legality of the intended conduct, received advice that the intended conduct was legal, and relied in good faith on counsel’s advice.

Summary

On April 15, 2003, four days before his licenses expired, respondent filed a registration form with the NASD and later filed two amendments. His registration was never successfully completed and the firm he was seeking to associate with later filed a form with the NASD terminating his association. The interviews that respondent failed to appear for were scheduled in January and February 2004.

Respondent argued that he was not subject to NASD jurisdiction because his previous registration had lapsed and his 2003 application had not been successfully completed.

The Commission found that because respondent had signed the initial application and two amendments he was an associated person because he had applied for registration and was therefore subject to NASD jurisdiction.

The Commission rejected respondent's claim that because the registration form and amendments were electronically filed and "signed" with his purported signature without proof that he actually mechanically signed the form, the NASD had no jurisdiction. It noted that he testified that he wanted to register to enable himself to receive commissions. It found unpersuasive respondent's claim that the firm had failed to comply with NASD regulations that it maintain a hard copy of the mechanically signed application. Here the Commission found substantial circumstantial evidence that respondent had signed and submitted the application. Particularly persuasive were first person answers to amendments to the form explaining disciplinary matters. Also, a compliance employee of the firm testified that it was his normal practice not to fill in details in amended forms.

The Commission rejected respondent's claim that he should be entitled to challenge NASD jurisdiction without first appearing before the NASD staff. He claimed it was unfair to punish him for failure to appear when that failure was based on his challenge to NASD jurisdiction. The Commission reiterated earlier cases holding that the only way to challenge NASD jurisdiction is to fail to cooperate and then defend any action seeking sanctions (this despite the fact that NYSE disciplinary proceedings permit such challenges).

Respondent argued that the he relied on advice of counsel in not appearing before the NASD staff and that this should mitigate the sanction. The Commission rejected this argument because respondent submitted not evidence that he had fully complied with the requirement for invoking such a defense, namely that he had made full disclosure to counsel, sought advice from counsel, and relied in good faith on counsel's advice.

Donner Corporation International et. al., Exchange Act Rel. 55313 (February 20, 2007)

Broker dealer research reports, Appeal of NASD action

Days between appeal and decision – 10 months, 8 days.
Days between last brief and decision – 8 months.
Pages – 32

Comment

This is a significant opinion that reiterates several critical points concerning the duties of broker-dealers as to research reports. The conduct here was egregious and involved canned issuer paid for glowing research reports on speculative stocks where there was no disclosure of the payments. The reports omitted various negatives concerning the companies including going concern qualifications, financial distress and other significant facts. Research reports must contain an "accurate picture of the risks associated with the issuers" and may not only contain positive information, particularly when the issuers are struggling or are startups. Negative information contained in public filings by issuers must not be omitted.

The defense argument that an auditor's going concern qualification need not be disclosed because it is merely an opinion wins points for creativity. Unfortunately audits themselves result only in opinions so obviously the argument fails.

Key points

• Inculpatory investigative testimony by a respondent given closer in time to the events at issue should be given greater weight that contradictory trial testimony.
• The "in connection" requirement of Section 10(b) is met by a false research report. "Where the fraud alleged involves public dissemination in a document such as a press release, annual report, investment prospectus or other such document on which an investor would presumably rely, the 'in connection with' requirement is generally met by proof of the means of dissemination and the materiality of the misrepresentation or omission." SEC v. Rana Research, Inc., 8 F.3d 1358, 1362 (9th Cir. 1993). The requirement is also satisfied when a statement is made "in a manner reasonably calculated to influence the investing public." Orlando Joseph Jett, Securities Act Rel. No. 8395 (Mar. 5, 2004), 82 SEC Docket 1211, 1250-51 n. 37 (citing SEC v. Texas Gulf Sulphur Co., 401 F.3d 833, 862 (2d Cir. 1968)).
• "[T]he materiality of information relating to financial condition, solvency and profitability is not subject to serious challenge." "Material facts include . . . those facts which affect the probable future of a company and which may affect the desires of investors to buy, sell, or hold the company's securities.
• "While there was not necessarily a duty to disclose the issuer's complete financial information in research reports, where the research reports disclosed selected "positive" financial information, there was a duty to disclose all material information.
• Recommending stock as a "speculative buy" did not relieve the publisher of research reports of the duty to make full and accurate disclosures of all material information.The incomplete nature of research reports was not ameliorated by any duty of investors to read public filings by issuers because the research reports themselves were required to "convey a complete and accurate picture and could not depend on other information available to investors."
• When a securities recommendation is made to a customer, full disclosure must be made of all material facts. A broker may not satisfy that obligation by pointing to bits and pieces of information that appeared in the media or elsewhere and were never brought to the customer's attention.
• "Disclosure of a "going concern" qualification of financial statements may not be omitted on the ground that such qualification is merely "opinion."
• Failure of the NASD to take action following an examination of the firm does not exonerate the respondents.
• Reduction in sanctions is not warranted because there was no evidence in the record that investors purchased any stock in reliance on the research reports.

Summary

Appeal by former member firm (Donner Corp.), firm's president (Baclet) and two registered representatives (Uberti and Runyon). The NASD found that Donner, Baclet, and Uberti violated Section 10(b) and NASD rules by preparing and disseminating twenty-five research reports. It found that Uberti and Runyon violated those same provisions in connection with an additional two research reports. In addition the NASD found that Danner, Baclet, and Uberti violated Securities Act Section 17(b) because they received undisclosed compensation for preparing the research reports. Finally, Donner and Baclet were found to have failed to have adequate supervisory procedures and failed to document Donner's approval of research reports by a principal of the firm. Donner was expelled, Baclet and Uberti were barred and Runyon was suspended for six months. Runyon was fined $20,000 and ordered to requalify as a principal.

Donner distributed research reports on low priced stocks for compensation. Such reports were 70 percent of Donner's revenue. Sometimes, Donner received additional compensation in the form of stock of the issuer if the stock reached a target price after the research was issued. Many of the reports recommended the stocks as a speculative or strong buy. None of the research reports disclosed the compensation. The sole relevant disclosure was that Donner may provide investment banking services to the issuer. Sometimes the research reports disclosed that Donner may receive "a fee" for those services. The research reports were drafted by an "independent contractor" hired by Donner. The contractor had no previous experience as a securities analyst and worked full time at an orthodontics manufacturer. He was paid $100 per report. He was given no training by Donner. Donner told him to follow a "template" drafted by Donner that Baclet knew was "generally positive" and opined that the company was highly undervalued and was poised to become a "major player." The contractor obtained information for his drafts from public sources available on the internet, but made no attempt to verify the information he obtained.

Uberti was the contractor's primary contact at Donner. Although he reviewed the drafts, he claimed he had no "compliance" responsibility for the reports despite the fact that he admitted it was his obligation to determine if the drafts had inaccurate information. Baclet admitted that he reviewed a substantial number of the reports. Virtually all the company's public filings contained "going concern" qualifications to the financial statements that were not reported in Donner's optimistic research reports. Other highly important negative information was also included in the public filings that was omitted from the research, including inadequate working capital, cash flow deficiencies, and loan defaults. Baclet was responsible, according to Donner's written supervisory procedures, for review of research reports. He admitted that in reviewing the research reports, he did not compare them to the public filings of the issuers. Indeed, he admitted that at the time of the evidentiary hearing that he had only read a small number of the reports.

Compliance officers at the firm were not licensed with the NASD and did not review the reports. In 2001 Uberti and Runyon left Donner and formed an unregistered firm that also prepared research reports. They jointly prepared research reports on behalf of this firm. They too hired the same contractor to prepare research reports. These reports were similar to those distributed by Donner and ignored negative information contained in public filings by the issuers.

The misrepresentations in the research reports were clearly material. The fact that the company continued in business after the date of the going concern qualification does not render the qualification immaterial. The fact that Form 8-K disclosure is not triggered by a going concern qualification does not render such qualification immaterial. Form 8-K does not purport to define the universe of material facts that require disclosure.

Baclet's scienter is established by his contracting with an unqualified contractor, his responsibility as principal of Donner to review the research, staffing of the compliance and legal departments with unqualified or inexperienced staff, failure to compare the research reports with public filings by the issuers and knowledge that Donner was paid by the issuers to publish positive research reports. Because he did not review the final reports, he had no basis to believe that the research presented an "accurate picture of the risks associated with the issuers."

Uberti's scienter is established by his knowledge that public filings he reviewed contained negative information about the issuers that was not included in the research. He reviewed the research reports and knew of the omissions. Uberti could not rely on Baclet or the compliance and legal staff because he had actual knowledge of the falsity of the research reports. He had no knowledge of the type of review that Baclet, legal and compliance conducted. The record established that Uberti had substantial responsibility for writing the final reports.

Runyon together with Uberti reviewed and authorized all the research reports issued by the firm they formed after they left Donner. Each had actual knowledge of the negative information in public filings by the issuers that was not included in the research reports.

Securities Act Section 17(b) was violated where there was no disclosure of the full amount of actual compensation paid by the issuers for the research. Disclosure that the broker-dealer "may" contract for investment banking services with the issuer and sporadic disclosure that such services might be in the form of a "fee" did not comply with Section 17(b). The reports were prepared for compensation from the issuer and the specific amount of compensation was never disclosed. Uberti knew that Donner received compensation from the issuers and wrote the disclaimer contained in the research. Baclet negotiated the compensation with the issuers.

Donner's compliance procedures were inadequate because they did not specify the procedures to be used for preparation, review and approval of research reports. There was no written record of who reviewed and approved each research report. The sanctions against Donner and Baclet were upheld. The Commission remanded for reconsideration of the sanction against Uberti. It noted that the hearing panel initially suspended him for two years, but that the NASD on appeal had imposed a bar against him. The hearing panel also found that Uberti was remorseful.

Rooney A. Sahai, Exchange Act Rel. 55046 (January 5, 2007)

Review of NASD disciplinary action
Days between appeal and decision – 9 months, 29 days
Days between last brief and decision – 6 months, 2 days
Pages – 8

Comment

This is a routine appeal construing NASD Sanction Guidelines. The Commission had earlier heard an appeal of this matter and remanded it to NASD for reconsideration of the sanction. NASD Sanction Guidelines distinguish between failure to respond "in any manner" and other failure to respond timely or completely. The Commission reduced Respondents' bar to a two year suspension, finding he had partially complied with the NASD request and imposed a $5,000 fine. While it explained the reasoning for imposing the suspension, the explanation for imposing the fine was somewhat conclusory. The Commission has faced difficulty in recent years in connection with its explanations for its sanctioning decisions. See, for example a case I handled at the trial level, e.g., The Rockies Fund, Inc. v. SEC, 428 F.3d 1088 (D.C. Cir. 2005) ("Accordingly, because the SEC did not explain its reasoning, we hold that the SEC arbitrarily and capriciously imposed third-tier sanctions on the petitioners.")

This case illustrates two recurring issues with SEC opinions. First, this was a routine matter involving basic interpretation of the NASD's Sanctions Guidelines. Yet the decision took almost 10 months. Second, despite criticism noted above, there is only limited explanation of why the Commission chose the amount of the fine.

Key points

• "[NASD] Rule 8210 is an essential tool for NASD's enforcement responsibilities . . . . "
• "[R]ecipients of requests under Rule 8210 must respond to the requests or explain why they cannot and may not set conditions for their compliance." (fn omitted)
• The NASD is not required to justify its information request.
• When a Respondent fails to produce information he has a duty to explain that inability. Stating that a complete search has been made is an insufficient explanation and the details of the search should be explained.
• The NASD is not a state actor and is not subject to the Eighth and Fourteenth Amendment prohibitions against discriminatory prosecution.
• Respondent alleging discriminatory prosecution has the burden of producing evidence to support such claims.

Summary

Respondent was barred from all NASD association (on remand from the Commission) for violation of NASD Rule 8210 which requires associated persons to provide information to NASD in NASD investigations.

Respondent was associated worked out of his home and was associated with a NASD member in 1999 and 2000. The NASD investigation began in 2001 and concerned customer complaints about forged transactions, unauthorized transactions, and undisclosed outside business activities.

Respondent testified before the NASD staff who then sent respondent a written request to provide certain information and documents. Although he eventually provided some of the requested information after some delay and several NASD follow-up requests, ultimately, Respondent was unable to provide information to the NASD about the whereabouts of two of his former staff who he claimed might have been responsible for the allegedly forged documents. He claimed that due to computer malfunction, his computer based address book records were no longer available. Respondent's lawyer testified that Respondent had no other current records of the whereabouts of those employees.

NASD Sanction Guidelines provide different sanctions depending on whether the respondent has failed "in any manner " to respond or whether there is mitigation or the person did not respond in a timely manner. In the first instance the guidelines provide for up to a bar and $50,000 fine. In the second the maximum guideline penalty is a two year suspension and a $25,000 fine.

Here the NASD contended that respondent failed to respond in any manner. The Commission agreed that Respondent had failed to respond to two NASD requests for information. It found that he partially responded to five NASD staff requests. Further, the Commission found Respondent's explanation for failing to produce, stating only that he had searched his files and not found the information was inadequate. It held that he should have identified which files he actually reviewed and should have contacted his accountant to attempt to find the missing information.

The Commission held that under these circumstances it was not appropriate to conclude that Respondent had not responded "in any manner." Therefore, a bar was excessive under the NASD's Sanction Guidelines. The Commission found that Respondent should be sanctioned at the high end of the Sanction Guidelines, and therefore suspended him for the maximum two years provided for persons who partially respond. Further, the Commission imposed a $5,000 fine.

The Commission's only explanation for the imposition of the $5,000 fine was as follows, "because [Respondent] is no longer subject to a bar, we find it appropriate to impose the $5,000 fine identified by NASD as appropriate for the unauthorized transactions but not imposed."

The Commission also found lacking Corespondents' argument that the bar was a violation of the Eighth and Fourteenth Amendments to the Constitution. It ruled that those Amendments do not apply to the NASD because it is a private actor. The fact that The Exchange Act authorizes it to discipline members does not convert it into a state actor. Perpetual Securities, Inc. v. Tang, 290 F.3d 132 (2d Cir. 2002); Desiderio v. NASD, 191 F.3d 198 (2d Cir. 1999).

The Commission rejected Respondent's claim he was subject to selective prosecution because of his race. The Commission found that he had not met his burden of producing evidence to support this claim.