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."

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.