SEC Tea Party™

Finra Sanctions For Unregistered Distribution Upheld

2012-01-28T07:22:00.000-07:00

Midas Securities, Jay S. Lee, Exchange Act Rel. 66200, January 20, 2012

This case is significant for two reasons. It restates clearly the duty that brokerage firms have to investigate sales of large amounts of stock of little known issuers. Most important, from a supervisory standpoint, it finds supervisory procedures inadequate that require reasonable inquiry, but do not specify the type of inquiry that must be undertaken. Vague boilerplate written supervisory procedures will are not adequate.

Finra sanctioned Midas Securities and its president, Lee. The Commission upheld the sanctions. The sanctions here resulted from Midas' unregistered sale of securities on behalf of a Bulgarian customer who it knew to be involved in stock promotions. The customer had been sued by the SEC in a still pending case for his role in Spam promotions of another stock. Further, Lee and Midas had previously been sanctioned by Finra for the sale of unregistered securities.

The Commission rejected the defense that the firm could rely on the fact that the certificates had no restrictive legend. When a customer seeks to sell a large block of a little known stock the broker is required to undertake a searching inquiry to determine whether the customer is engaged in a distribution. Reliance on lack of a restrictive legend on the certificates is insufficient. Also, the issuer here had been the subject of a reverse merger only weeks before, often a red flag that a distribution may be taking place. Further exacerbating the situation was the fact that Midas reps knew the customer was a stock promoter who received stock directly from issuers in payment for his activities.

The Commission also rejected the defense claim that the broker could escape liability as the trades were unsolicited. The Commission has never recognized this as a defense as "a broker [relying on the Section 4(4) defense cannot merely act as an order taker." The Commission also rejected the defense claim that Finra had not established the existence of an unregistered distribution. It reiterated long standing precedent that any person relying on an exemption from the registration requirements must establish that exemption as an affirmative defense when the stock has not been registered as was the case here.

The Commission also found the firms supervisory procedures inadequate. Midas' procedures required it to conduct a "reasonable inquiry"into unregistered sales of large amounts of little known securities. However, the Commission characterized those procedures as "minimal" and found them to be deficient because they did not specify the type of inquiry that was required.

PCAOB Revocation and Fine For Failure To Produce Records Upheld on Appeal

2012-01-11T09:32:00.004-07:00

R.E. Bassie & Co., R. Everett Bassie, CPA, AAER 3354, January 10, 2012

PCAOB revoked Bassie & Co's registration and barred Bassie from associating with a registered public accounting firm and fined him $75,000. It found that the firm and Bassie failed to cooperate with a PCAOB investigation.

In late 2006 PCAOB staff required the firm to produce work papers relating to work done for a client in connection with an investigation. The documents were never produced and disciplinary proceedings were finally instituted in early 2009. In the intervening period the firm and counsel repeatedly asked for extensions of time to produce the documents, but never did so.

The PCAOB investigation involved Bassie's independence in connection with the audit of Calypso Wireless. The documents related to work Bassie did for entities that were involved in a law suit with Calypso.

Since PCAOB may demand any documents its staff deems relevant to an investigation its jurisdiction is not limited to work done only in connection with the audit of a public company. Because the issue in the investigation was Bassie's independence, any facts reasonably related to that issue were relevant to the PCAOB investigation.

The Commission also rejected respondents' claim that it was improper for the PCAOB hearing officer to proceed through summary disposition without trial. It found Bassie had not produced sufficient evidence of an actual advice of counsel defense to justify a hearing. Finally, the Commission upheld the sanctions, noting that PCAOB's ability to investigate is critical to its function and the fact that respondents had over an extended period never produced the documents.

Finra Supervision and Unregistered Sale Sanctions Upheld

2012-01-07T12:15:00.002-07:00

World Trade Financial Corp., et. al., Exchange Act Rel. 66114, January 6, 2012

World Trade, its president Rodney Michel, its supervisor of trading Jason Adams and Frank Brickell a rep appealed Finra sanctions. Finra found World Trade and Brickell sold unregistered stock and that Michel and Adams failed to supervise Brickell. It also found that World Trade had inadequate supervisory procedures.

World Trade was fined $45,000, Brickell $15,000, Michael $30,000 and Adams $20,000. Brickell was suspended for 30 days, Michel for 45 days, and Adams for 30 days.

The Commission upheld the sanctions.

Over a three month period World Trade sold 2.3 million shares of a thinly traded penny stock on behalf of three customers for proceeds totaling $295,000. Brickell received about $9,200 in commissions. This distribution was not registered with the Commission.

In assessing whether or not stock sold by customers was "free trading" the firm relied heavily on whether or not certificates had restrictive legends. The stock in question was subject to a spam based email campaign.

This was a classic penny stock pump and dump scheme. Brickell admitted that he knew "or should have known" that the company had recently undergone a reverse merger and that it had only begun to publicly trade just before his customers initiated their sales.

World Trade, Brickell, Michel, and Adams all claimed that they relied on the transfer agent to make sure that the shares were not part of an unregistered distribution.

This is a significant case. It reiterates the long standing requirement that broker-dealers have an independent duty to investigate and ascertain that in connection with customer sales of little known thinly traded stocks an unregistered distribution is not taking place. The "broker" registration exemption in Exchange Act Section 4(4) is not available "if the broker knows or has reasonable grounds to believe that the selling customer's part of the transaction is not exempt [from registration].... when a dealer is offered a substantial block of a little-known security ... where the surrounding circumstances raise a question as to whether or not the ostensible sellers may be mere intermediaries for controlling persons or statutory underwriters, then searching inquiry [by the broker-dealer] is called for."

Finra Sanctions Against Rep For Misappropriating Customer Information Upheld

2012-01-07T11:51:00.001-07:00

Dante J. DiFrancesco, Exchange Act Rel. 66113, January 6, 2012

DiFrancesco was suspended for ten days and fined $10,000 by Finra. It found that he violated Finra's Rule 2110 ("high standards of commercial honor and just and equitable principles of trade").

DiFrancesco was planning to leave his firm and moving to another. He attempted to download data regarding his 200 personal clients. In fact, he downloaded and removed from the firm confidential personal information for 36,000 additional clients of his firm. He then provided that data file to his new firm. He did this after a manager at his firm told him to leave the firm immediately after blocking an email that contained the client list.

At the hearing DiFrancesco acknowledged his understanding that his firm considered all client information proprietary to the firm and that he intentionally violated firm policy.

The Commission upheld Finra's finding that DiFrancesco had violated Rule 2110. It noted that there is a duty to maintain the confidentiality of client information that "is grounded in fundamental fiduciary principles…." As to DiFrancesco's claim that he only intended to take information relating to his own clients, the Commission noted that intent is not required to establish a violation of Rule 2110.

NASDAQ Delisting Stay Pending Appeal Denied

2011-12-29T09:21:00.000-07:00

Cleantech Innovations, Inc., Exchange Act Rel. 66064, December 28, 2011

Cleantech's securities were delisted by Nasdaq after the exchange concluded the company had intentionally withheld documents from its staff. Cleantech sought a stay of the delisting pending resolution of its appeal on the merits.

In ruling on these matters the Commission considers: 1) whether there is a strong likelihood the company will prevail on appeal; 2) whether absent a stay there will be irreparable injury; 3) whether there will be substantial harm to the public; and 4) whether a stay is in the public interest.

Under Exchange Act Section 19(f) the Commission must dismiss an application to review a delisting if it finds "the specific grounds on which [the delisting] … is based exist in fact, that [delisting] … is in accordance with the rules [of the exchange] and such rules are, and were applied in a manner, consistent with the purposes of [the Exchange Act]."

The Commission opinion notes that stay applicants have the burden of establishing each of the four factors noted above. It found that Cleantech had not established a strong likelihood of succeeding on appeal as the company admitted that it had not furnished all the information sought by the exchange. Because the stock was still quoted in the pink sheets if found no irreparable injury or substantial harm to the public. The Commission found that when considering the public interest disadvantages to shareholders must be weighed against the ability of Nasdaq to regulate its markets and obtain accurate information from issuers. Thus "[the detriment to shareholders] is outweighed by the public interest in the exchange's obtaining full responses from the company to the exchange's requests for information."

Cleantech also moved for discovery concerning its claim on appeal that Nasdaq had failed to follow its own procedures in delisting the stock. The Commission denied this request noting that under its Rules of Practice no discovery is permitted in appellate proceedings under Section 19(f).

Finra Sanctions Inconsistent with Sanction Guidelines Remanded by Commission

2011-12-02T12:51:00.000-07:00

Kent M. Houston, Exchange Act Rel 34-66014, December 20, 2011

Finra barred Houston for his purported failure to "respond in any manner" to a Finra investigation.

Although Houston failed to appear for testimony before the investigators the record showed that he had apparently responded appropriately to Finra requests to produce documents. The Commission found that Finra had not sufficiently articulated why a bar was appropriate since Finra sanction guidelines establish a bar as the presumptive sanction only when there has been a total failure to cooperate. The opinion noted that while Finra may deviate from its sanction guidelines it must fully articulate why it is doing so.

While Finra found that Houston had also failed to notify his broker-dealer employer of outside employment, the sanctions were based solely on his failure to cooperate with the investigation.

The Commission remanded the matter to Finra due to the fact that it appeared he had in fact not been totally uncooperative during the investigation and because it found Finra's explanation for the bar was insufficient. It also noted that Finra might wish to reconsider its determination not to include Houston's failure to notify his employer of outside employment on reconsideration of the matter.

Commission Denies Interlocutory Appeal Based on Dodd-Frank Deadlines

2011-11-09T19:16:00.002-07:00

Montford & Co., Inc., IA Act Rel. 3311, November 9, 2011

Montford Co. and its Ernest Montford were charged administratively with IA act violations. They allege that the charges were not brought within the 180 day time limit following their receipt of a Wells notice as required by Dodd-Frank.

Section 4E of the Exchange Act requires that proceedings be brought within 180 days of a Wells notice unless the Division of Enforcement's Director extends the deadline and notifies the Chairman of his decision. The Division argued that it had complied with this requirement and provided emails and a declaration by its staff to demonstrate this. The ALJ denied respondent's motion to dismiss that was based on their claimed violation of Section 4E.

The Commission denied this interlocutory appeal. It noted that such appeals are disfavored and that the ALJ had refused to certify the issue for such an appeal. Under Commission rules such certification is required. It ruled that respondents' disagreement with the ALJ's ruling that Section 4E had not been violated was not a proper basis for an interlocutory appeal.

It noted "once the Commission exercises its prosecutorial discretion to institute a proceeding, 'the appropriate remedy for any challenge to that exercise of discretion is to litigate the proceeding to a final decision.'"

Finra Bar of Rep Who Failed To Disclose Disbarment As Attorney Upheld

2011-10-24T19:23:00.003-06:00

Richard A. Neaton, Exchange Act Rel. 65598, October 20, 2011

Finra barred Neaton for failing to disclose disciplinary actions on his Form U4 application. The commission upheld the sanction on appeal.

Finra sanctioned Neaton for failing to amend his U4 to disclose two suspensions and the later revocation of his license to practice law. The revocation was based on findings that Neaton had misappropriated client funds held in his trust account. Form U4 specifically requires disclosure of the suspension or revocation of the authority to act as an attorney.

The Commission found Neaton acted willfully. This conclusion was based on the fact that he also falsely answered annual written inquiries from his firm asking about any sanctions entered against him by any regulatory body. The Commission noted that "willfully" under the securities laws requires only that the actor intentionally committed the act that constitutes the violation. There is no requirement that the person be subjectively aware that he is violating the law.

Neaton claimed he relied on the advice of his supervisors in filling out the U4. The Commission rejected this argument noting that individuals "must take responsibility for compliance . . . ."
This is another case of the Commission employing the "grandmother rule." This is a "test" frequently employed by the Commission in these situations – would you want this person handling your grandmother's money?

Exchange Bar Lifted For Failure To Prove Service

2011-10-15T07:32:00.001-06:00

Michael Picozzi III, Exchange Act Rel. 65569, October 14, 2011

Picozzi was barred by PCX for failing to provide information during an exchange investigation. PCX's successor, NYSE did not oppose the appeal due to the existence of an incomplete evidentiary record. Apparently it had no evidence that Picozzi was served with process in connection with the disciplinary proceeding. Accordingly the Commission set aside the findings of violations and sanctions.

Picozzi had sold his firm by the time PCX sent notice of the complaint to him at his former firm's address. He claimed that it was not forwarded to him. A bar was entered by default against him in 2004. Picozzi claims he never learned of the bar until he attempted to re-enter the industry following the expiration of a non-compete agreement in 2010.

There record included Picozzi's claims about not receiving notice. NYSE admitted there is virtually nothing in the record concerning service of process on Picozzi. It also admitted that due to passage of time it cannot determine whether Picozzi engaged in any improper conduct in connection with the PCX investigation. As a result it did not oppose Picozzi's petition.

In granting the petition the Commission noted that by doing so it was relying on NYSE's unique stance and the lack of information in the record about service of process on Picozzi. It stated that its ruling "in no way diminishes established precedent that a respondent's lack of awareness of official regulatory correspondence is not a defense where evidence shows that the regulatory entity properly sent correspondence to the address that the respondent provided to the regulatory agency."

Such cases include Dennis A. Pearson, Jr., Securities Exchange Act Rel. No. 54913 (Dec. 11, 2006), 89 SEC Docket 1627, 1638 (noting that "[i]t is the responsibility of NASD members and their associated persons to keep NASD apprised of any changes in their addresses, and a failure to respond to NASD in connection with an investigation . . . is not excused by that person's having temporarily moved from the address listed in the CRD"); Warren B. Minton, Jr., 55 S.E.C. 1170, 1177 n.15 (noting that associated persons have "a continuing duty to notify the [NASD] ... of [their] current address, and to receive and read mail sent to [them] at that address" (quotation omitted)).

Finra Findings and Costs Not Sanctions Subject to SEC Appellate Jurisdiction

2011-10-15T07:06:00.001-06:00

Sharemaster, Exchange Act Rel. 65570, October 14, 2011

This case is of interest to those who need to understand the SEC's interpretation of its jurisdiction over Finra disciplinary actions.

Finra sanctioned Sharemaster for failing to file an annual audit by a firm registered with PCAOB. At issue was whether or not an exemption from that requirement applied to Sharemaster. Finra's hearing panel found that Sharemaster was not subject to the exemption, ordered it suspended until it filed a compliant report and imposed costs of $1,785. Sharemaster appealed the Finra sanction to the SEC. It did not request a stay of the decision under Commission Rule 401(d).

While the appeal was pending Sharemaster filed a compliant annual report and the suspension was lifted.

Under Exchange Act Section 19(d) the Commission has jurisdiction over Finra action that: 1) imposes a final disciplinary sanction; 2) denies membership or participation of an applicant; 3) prohibits or limits any person's access to Finra services; or 4) bars any person from associating with a Finra member.

The Commission dismissed Sharemaster's appeal. It ruled that the Finra imposed suspension was not a final sanction as the suspension was contingent and had been lifted by Finra. It dismissed Sharemaster's argument that the finding of a violation and assessment of costs were final rulings.

The Commission opinion concluded that the only sanction potentially subject to appeal was the suspension. Because it had been lifted there was no jurisdiction. It found the costs not an appealable sanction as under Finra rules costs are not deemed sanctions. In ruling that the finding of violation was not an appealable sanction the Commission analogized to civil contempt actions in federal court. Once the civil contempt is purged by compliance with the order appellate jurisdiction is moot.

Failure To Supervise Sanctions Upheld

2011-09-17T07:33:00.000-06:00

Dennis S. Kaminski, Exchange Act Rel. 65347, September 16, 2011

NASD sanctioned Kaminski for failure to supervise sales of variable annuities. He was suspended for eighteen months, fined $50,000 and ordered to requalify before acting in any capacity requiring qualification. The Commission rejected Kaminski's appeal.

Kaminsky supervised his firm's compliance department. He was also responsible oversight of operations and the firm's legal department.

In 2001 the firm consented to NASD sanctions related to supervisory procedures for variable annuity sales. That settlement required the firm to overhaul its compliance procedures as to annuity sales. As a result the firm established a formal review procedure for any "flagged" variable annuity transactions. In 2004 Kaminski received numerous memos and emails from a subordinate complaining that the compliance department was understaffed and that immediate action was required to remedy this. Kaminski also learned that the flagged annuity transactions were not in fact being reviewed promptly. In fact, for some period the firm simply stopped reviewing the flagged transactions. Kaminski admitted that he knew of staffing problems in the compliance department and the failure to promptly review flagged annuity transactions. There was conflicting testimony about whether Kaminski ordered that the flagged transactions not be reviewed.

The opinion focused on red flags indicating Kaminski's knowledge of the breakdown of supervisory procedures. Oddly enough, it did not stress, nor did it cite cases holding firm executives liable for supervisory failures unless they can establish an affirmative defense of both effective delegation and verification that the delegate is effective.

Commission Continues 35 Year Old Administrative Bar

2011-09-17T06:57:00.001-06:00

Mark S. Parnass, Exchange Act Rel. 65261, September 2, 2011

Parnass moved to vacate a Commission order issued in 1975 that barred him from association with any broker, dealer, investment company or investment adviser. He was allowed to associate with a broker-dealer in a non-supervisory non-proprietary capacity after eighteen months and in a supervisory or proprietary capacity after three and one-half years. The Commission vacated that part of the order barring him from investment adviser or investment company association but kept the remainder of the bar order in place. Since 1980 Parnass has been associated with broker-dealers in a supervised capacity.

Parnass consented to the 1975 order which followed an injunction based on his firm's violation of the net capital rule. He was also suspended from association with a broker-dealer for sixty days in a 1986 action charging him with sales of unregistered securities.

In 2004 Parnass sought relief from the 1975 bar order arguing that it subjected him to onerous application procedures and fees. The Commission denied that petition.

The Commission uses an extremely high bar (couldn't resist the pun) in determining whether to vacate previous disciplinary orders. In fact, administrative sanctions will "remain in place in the usual case and be removed only in compelling circumstances." The bar is even higher in Commission orders entered by consent as in the Commission's view violators receive significant benefits from settlement.

The Commission rejected Parnass' argument that the passage of thirty five years since the entry of the order alone constituted a compelling reason to vacate the order. His cause certainly was not helped by the 1986 registration violations. However the language used by the Commission made it clear that the passage of time argument standing alone would have failed under any circumstances.

The Commission did lift the investment company/investment adviser bars as it no longer imposes such collateral sanctions when the individual was not at the time of the violation associated with an adviser or investment company.

Commission Continues to Waste Resources Issuing Opinions Barring Convicted Felons

2011-08-30T18:23:00.000-06:00

Eric S. Butler, Exchange Act Rel. 65204, August 26, 2011

Butler was convicted of conspiracy to commit wire and securities fraud. His convictions for were overturned on appeal. The Commission barred him from association with any broker, dealer, or investment adviser.

Butler was charged with unauthorized purchases in accounts of his customers at Credit Suisse of auction rate securities. He touted government guaranteed student loan backed securities to his customers. However, some customers were placed into uninsured mortgage backed securities. Emails were sent to customers that falsified the names of the products actually purchased to make it appear that the customers had in fact bought guaranteed student loan backed instruments.

Jury instructions required that the jury find that Butler voluntarily, deliberately, and purposefully joined the conspiracy.

On appeal the appellate court dismissed the substantive wire and securities fraud counts on venue grounds but upheld the conspiracy convictions.

As one would expect the administrative law judge barred Butler based on his conviction without holding an evidentiary hearing.

The statute allows sanctions if the conviction involves the purchase or sale of a security or arises out of the conduct of a broker or dealer. Since he was associated with a firm that was both a broker-dealer and an investment adviser when the conduct occurred there is administrative jurisdiction under both the Exchange Act and Advisers Act.

Unsurprisingly the Commission concluded that the bars imposed by the ALJ were "amply warranted."

The Commission's treatment of these kind of cases is an enduring mystery. It approved of the ALJ's summary disposition without trial of the matter. Yet it does not summarily affirm the ALJ's imposition of clearly warranted sanctions. It wasted the time of its staff and its scarce monetary resources by issuing a thirteen page opinion replete with 39 footnotes. There was nothing in this case of particular interest or difficulty. When will the Commission begin to make wiser and more appropriate use of its limited human and monetary resources?

Motions for Reconsideration Rejected

2011-08-14T07:32:00.000-06:00

Kent D. Sweat and Intermountain Financial Securities, Inc., Exchange Act Rel. 34-65117 (August 11, 2011)

Cobalis Corp., Exchange Act Rel. 34-65118 (August 12, 2011)

Sweat's appeal of Finra sanctions was dismissed for failure to timely file his brief. He sought reconsideration on the grounds that he had been ill. The Commission rejected his motion for reconsideration noting that the motion did not specify the nature of the illness or explain why this made it impossible for him to file his brief.

Cobalis' Exchange Act registration was revoked despite repeated claims that it would soon file its delinquent periodic reports. Its motion to reconsider was based on claims that it had hired a CPA and would soon be able to file its delinquent reports. The Commission rejected the motion viewing it as simply a rehash of previous arguments about its attempts to become current with its filings.

The lessons here are obvious folks. Motions for reconsideration are granted only under exceptional circumstances. They must be supported by argument and explanation. Rehashing arguments rejected the first time around won't do.

Adviser Employee Sanctioned For Taking Gifts From Brokers - Indigent, Homeless and Without Wheels Test Revived

2011-08-10T12:19:00.000-06:00

Robert L. Burns, IA Act Rel. 3260, August 5, 2011

Burns was a trader at Fidelity who received gifts from brokers that sought and obtained orders from Fidelity in violation of Section 17(e) of the Exchange Act. The Commission imposed a censure, $141,000 of disgorgement plus interest and a $40,000 civil penalty. It based the amount of disgorgement on the amount paid by the donor of the gift. Because his total assets were enough (just barely) to pay such amounts it refused to reduce the monetary penalties and rejected Burns' inability to pay argument.

Burns sent orders to ten firms from which he accepted gifts such as rare wine, travel, and tickets to entertainment and sporting events. The value of those gifts was $141,000.

Exchange Act Section 17(e) prohibits persons affiliated with investment companies from receiving compensation or any economic benefit "for the purchase or sale of any property to or for" an investment company.

Burns did not contest receiving the gifts. The Commission rejected his claim that he could not be found to violate the statute unless it could be established that he traded to the detriment of Fidelity clients. The harm involved is the conflict of interest, and potential, rather than actual harm to clients.

The Commission also rejected Burns' argument that the value of the gifts for purposes of calculating disgorgement should be based on the recipient's subjective belief as to the actual value of the item. Here, the Commission based the disgorgement amount on the actual price paid by the broker who provided the gifts.

Burns claimed his total net worth was $277,000. The Commission rejected his inability to pay argument noting that his net worth was in excess of the amount of disgorgement, interest, and penalty sought. This demonstrates a very hard line by the Commission in determining when to limit such monetary sanctions. This Commission will apparently diminish such amounts only when there are literally no assets available to satisfy the judgment. This recalls the rhetoric of a long ago chairman of the SEC who famously announced that monetary sanctions would be reduced only if a respondent could prove he was "indigent, homeless, and without wheels."

Commission Upholds Issuer Revocation

2011-07-25T10:49:00.000-06:00

American Stellar Energy, Inc., Exchange Act Rel. 64897, July 18, 2011

The Commission upheld a summary revocation of the company's registration that was revoked by an ALJ after the company failed to file periodic reports. American Stellar's last filing was in 2008 for its 2007 fiscal year.

The ALJ did not hold a hearing and ruled on the pleadings. The Commission in its opinion argued that revocation was appropriate to prevent delinquent filers from making half hearted serial efforts to become compliant. It reasoned that this was contrary to the public interest in company's being current in their filings so that investors can have adequate information.

Yet by not summarily affirming its ALJs in situations like this the Commission actually encourages appeals which due to its insistence on issuing opinions puts the public at risk while it dawdles. The Commission always has the option of remanding cases such as this to the ALJ if it believes that a hearing should have been held. Under Commission rules an appeal nullifies the ALJ's decision. But in the routine delinquent filing case where the ALJ has acted summarily, it should and simply affirm the revocation. Appeals in such routine cases harm the public by encouraging appeals that postpone the inevitable revocation.

Finra Sanctions Upheld - No Action Letter Not A Defense

2011-07-14T13:12:00.003-06:00

FCS Securities and Dale Edward Kleinser, Exchange Act Rel. 64852, July 11, 2011

Kleinser was the sole proprietor of FCS. Finra sanctioned them based on FCS' failure to file annual audited reports in 2006 and 2007. They argued that FCS was exempt from the requirement to file audited reports as it was a BD that limited its business to buying and selling mortgage backed debt instruments (such firms being exempt from the audit requirement). Finra argued that the exemption applied only to firms that were actively engaged in business and that FCS was in fact dormant and did no business. It therefore was not eligible for the exemption.

Finra fined FCS and Kleinser $5,000 and suspended the firm for four months. The Commission upheld the sanctions. It found that FCS had the burden of establishing eligibility for the exemption. It reasoned that FCS had never proved any actual transactions and that as a dormant firm it could not claim the exemption.

The opinion is of interest primarily because it discusses the importance (or lack thereof) of Commission no-action letters. These letters are staff pronouncements whereby the staff will indicate that no enforcement action will be recommended to the Commission if the party adheres to the conduct described in the letter.

"No action letters express the views of the Commission staff. they do not constitute Commission precedent, nor do they limit subsequent Commission action. We are not bound by statements of Commission staff ...." (footnotes omitted)

In other words, only the individual sending the letter can rely on the staff response according to the Commission. This of course begs the question of whether or not a due process argument could succeed by someone whose conduct mirrored that of the no action requestor.

Kleinser argued that his conduct was covered by a previous no-action letters. The opinion notes that the no action letters simply did not address the issue of what constituted transactions and exactly what kind of instruments were covered by the exemption and were too vague to be relied on.

Commission Upholds 12j Registration Revocation

2011-07-14T13:04:00.000-06:00

Cobalis Corp., Exchange Act Rel. 64813, July 6, 2011

The Commission took more than a year to decide this appeal. Cobalis' Exchange Act registration was revoked by the ALJ because the company had failed to file periodic reports since 2008. During much of this period it was in bankruptcy proceedings. Despite claims to be able to become compliant it was unable to pay its auditor as late as March 2011.

The ALJ revoked the company's Exchange Act registration by summary disposition without an evidentiary hearing.

The Commission needless to say could have, and should have, summarily affirmed the ALJ's decision. The company failed to become current in its filings despite repeated assurances that it would soon do so. The Commission has previously ruled that when there is a recurrent failure to file periodic reports only compelling evidence will justify a lesser sanction than a revocation.

Commission Dismisses NASD Proceeding

2011-07-03T13:34:00.001-06:00

American Funds Distributors, Inc., Exchange Act Rel. 64747, June 24, 2011

In an appeal that had been languishing for two years the Commission in a 2-1 vote dismissed NASD proceedings based on allegations that American Funds violated its anti-reciprocal rule. NASD had censured AFD and fined it $5 million.

Two Commissioners (Schapiro and Walter were recused), two (Paredes and Casey) voted to dismiss the proceeding and one (Aguilar) dissented.

AFD had agreed to direct securities transactions and commissions commissions to retail firms selling affiliated mutual funds if certain sales targets were met.

The conduct in question occurred before the rule at issue was substantially amended in 2004.

AFD argued and the Commission agreed that language in the former rule prohibiting directed trading if "conditioned upon" sales was ambiguous. The opinion concludes that given the ambiguity of the rule and lack of previous enforcement action it was unfair for NASD to sanction AFD.

In an effort to rescue some coherence for the order here, footnote 23 claims "we do not intend to suggest that regulatory requirements are enforceable only to the extent the language used precisely delineates each course of conduct that is covered."

Commissioner Aguilar dissented. He noted that AFD's position was that its conduct violated the rule only if there was a binding contractual arrangement to pay directed commissions as opposed to the somewhat vague quid pro quo that the NASD found. He noted that the rule was intended to prohibit such quid pro quo arrangements under any guise.

Bar of Enjoined Investment Adviser Upheld

2011-06-18T07:34:00.001-06:00

Sherwin Brown and JAmerica Financial, Inc., IA Act Rel. 3217, June 17, 2011

Brown was a half owner and president of JAmerica, a registered investment adviser. In 2008 the district court issued a summary judgment order enjoining Brown and JAmerica. The court found that they had 250 clients and that Brown had misappropriated at used almost $900,000 of investor funds for non-investment purposes over and above his normal fees. In other words, he misappropriated investor funds. In the civil action the court prohibited Brown from submitting responses to the Commission's summary judgment motion as a sanction for his asserting the Fifth Amendment at a deposition.

The court found that Brown and JAmerica had violated the anti-fraud provisions of the Securities and Exchange Acts and the Advisers Act. In addition to the injunction, the court ordered Brown and JAmerica to disgorge $869,000, plus prejudgment interest of $226,000 and imposed a total of $480,000 of penalties against the two defendants.

The ALJ revoked JAmerica's adviser registration and barred Brown and JAmerica from associating with any adviser after finding that the conduct was egregious and recurrent.

Brown made various arguments contesting the district court proceedings upon which this case was based. The Commission takes the position that challenges to the findings of the district court in an earlier civil action are collaterally estopped and refuses to entertain them.

The Commission also rejected Brown's challenge to the summary disposition of the matter without an evidentiary hearing by the ALJ. It upheld the ALJ's decision based on Rule 250(b) that permits this if "there is no genuine issue with regard to any material fact and the party making the motion is entitled to a summary disposition as a matter of law." It noted that Brown's response to the motion did not create any genuine issues of fact necessitating an evidentiary hearing.

In upholding the sanctions the Commission noted:

We have held that antifraud injunctions merit the most stringent sanctions and that our "foremost consideration must . . . be whether [the] sanction protects the trading public from further harm." Thus, "an antifraud injunction can . . . indicate the appropriateness in the public interest" of a bar from participation in the securities industry and that "ordinarily, and in the absence of evidence to the contrary, it will be in the public interest to revoke the registration of, or suspend or bar from participation in the securities industry . . . a respondent who is enjoined from violating the antifraud provisions." (footnotes omitted)

In an interesting aside, the opinion noted that the Commission is not obligated to make its sanctions uniform on a case-by-case basis.

Commission Affirms Finra Sanctions For Unsuitable Recommendations

2011-05-28T08:23:00.001-06:00

Richard G. Cody, Exchange Act Rel. 64565, May 27, 2011

Finra suspended Cody for one year and levied fines and costs totaling $34,000. It found he made unsuitable recommendations to retail customers, churned customer accounts, sent misleading information to customers, and failed to update his U4 to disclose settlements. The Commission upheld the sanctions on appeal.

The customers involved were largely unsophisticated in investment matters, had modest means, and were retired or nearing retirement. They were seeking low risk income producing investments.

Cody recommended Credit Suisse bonds collateralized by manufactured housing installment purchase contracts to two customers. The tranche recommended by Cody was eighth out of eleven tranches in priority. He described them to one customer as "asset backed securities supported by mortgages on homes." Cody did no independent investigation of the bonds and recommended them to customers after a brief conversation about them with another member of his firm.

He recommended highly speculative junk rated bonds to another customer. Those bonds yielded a gain of $2,000 on a $108,000 investment over a six month period when sold.

Cody also sent a customers spread sheets he prepared analyzing her account that used par value rather than market value for bonds, understating actual market value by 9% to 36%.

Cody settled complaints with two of his customers paying a total of $76,000. He did not amend his U4 disclosure form for two years to reflect these payments.

This case offers a good summary of the due diligence responsibilities of a sales agent who recommends a security to a customer. Agents must have "reasonable grounds for believing the recommendation is suitable upon the basis of the facts . . . disclosed by such customer as to his other security holdings and as to his financial situation and needs."

Recommendations violate this rule if:

the agent's understanding of the investment is insufficient to establish a reasonable basis for making a recommendation;
the agent inadequately assesses whether the recommendation is suitable for the specific investor; or
the level of trading is excessive in light of the customer's investment needs and objectives.

The Commission noted that Cody's recommendation of the Credit Suisse bonds was unreasonable as he made no investigation to determine their specific characteristics. He failed to learn what tranche they represented and how this would affect their risks and liquidity. It was imperative that he understand the "essential features" of those bonds including their credit rating history.

The test requires actual objective investigation and knowledge, rather than the rep's personal subjective belief in the suitability of the investment. See, F.J. Kaufman & Co. of Va., 50 SEC 164, (1989) ("a broker-dealer in his dealings with customers impliedly represents that his opinions and predictions respecting a [security] which he has undertaken to recommend are responsibly made on the basis of actual knowledge and careful consideration. . . . [I]t is not a sufficient excuse that a dealer personally believes the representation for which he has no adequate basis."); Distribution by Broker-Dealers of Unregistered Securities, Exchange Act Rel. 6721 (February 2, 1962) ("[T]he making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations which, in turn, requires that, as a prerequisite, he shall have made a reasonable investigation.").

Cody claimed that because the Credit Suisse customers had previous experience in buying asset backed securities his recommendations were reasonable. The Commission dismissed this argument noting that the customers' experience was irrelevant to the suitability of these particular bonds. See, Larry Ira Klein, 52 SEC 1030, 1037, n. 28 (1996); Hanley v. SEC, 415 F.2d, 589, 596 (2d Cir. 1969)("The fact that [the broker's] customers may be sophisticated and knowledgeable does not warrant a less stringent [investigation] standard.").

Cody also claimed that because his firm approved the transactions he has no liability. It noted that regardless of whether a firm monitors or approves transactions agents "are responsible for the suitability of the recommendations they make to their customers."

As to the non-investment grade bonds Cody recommendation the Commission noted they were per se unsuitable for the customer who was retired, had modest means, and wanted low-risk investments that preserved his principle. It noted that suitability is determined at the time a recommendation is made and therefore it is irrelevant whether or not the investment makes a profit.

Further, the Commission found that Cody engaged in excessive trading in a customer's account. Commissions during a sixteen month period were $41,000 while the account earned $32,000. The account would have needed to earn almost 9% just to pay the commissions.

Sanctions For Misleading Marketing Materials Upheld - Margin Risks Require Specific Disclosures

2011-05-14T13:19:00.001-06:00

Phillip L. Spartis and Amy J. Elias, Exchange Act Rel. 34-64489, May 13, 2011

Spartis and Elias were reps at Salomon Smith Barney. NYSE found that they violated exchange rules by sending misleading communications to customers that omitted material facts or were misleading.NYSE Rule 472.30 prohibits the making of misleading communications to customers. Both were censured. The Commission upheld the sanctions. The violations alleged occurred as long as 12 years ago.

Between 1998 and 2001 Spartis and Elias advised Worldcom employees who were granted stock options. When customers did not immediately sell the stock obtained by exercising Worldcom options Spartis and Elias used various marketing materials describing an exercise and hold strategy. Due to the need to pay for the stock, taxes, and fees, this could strategy could require a significant amount of cash. Many customers opted to borrow on margin from Smith Barney to finance this strategy. These customers were betting that Worldcom stock would appreciate faster than the interest costs of margin loans. This market risk was not present for those customers who chose an exercise and sell strategy.

The marketing materials featured a graph that compared gains under the two strategies. NYSE alleged this was materially misleading because it failed to depict any risk that Worldcom stock would not appreciate or decline in price. The graph only assumed a constant market price rise for Worldcom stock. The materials showed precise possible gains for each customer but "left it to the customers to guess as to their possible losses and the risks involved if the stock remained flat or declined."

Spartis and Elias claimed that the customers were sophisticated and knew that Worldcom's stock might decrease in value. They also claimed that management had approved the marketing materials.

The Commission agreed with NYSE that the analysis did not present a balanced assessment of the risks and rewards of the two strategies but instead focused exclusively on possible benefits of the buy and hold strategy. Sales materials that only highlight benefits without providing specific risk disclosures are materially misleading. The Commission was particularly troubled by the fact that there was no disclosure of the particular and heightened risks resulting from financing the buy and hold strategy with borrowed money. Margin transactions are inherently more risky than cash based strategies for two reasons. First, if the value of the security drops the customer may be required to meet a margin call and deposit substantial amounts of additional cash. Second, margin interest adds to the costs of the transaction and increase the amount of appreciation required for the customer to realize a gain.

The Commission rejected respondents' defense that their supervisors approved the marketing materials. "... even if there was supervisory approval, it is well established that the duties owed by a securities professional to his or her customer are not 'abridged by a failure on the part of his [or her] supervisors."

Respondents also claimed that the possibility of a decline in the price of Worldcom was an obvious risk that did not require specific disclosure. The Commission rejected this argument noting that the materials "presented a one-sided picture of the customer's earnings potential under the exercise and hold strategy and by omitting important risk disclosures." Further, generic risk disclosures of general market risk were insufficient. A "vague disclaimer which merely warns the reader that the investment has risks will ordinarily be inadequate."

Lastly, the Commission ruled that NYSE Rule 472.30 under which respondents were charged does not require scienter.

As is its practice the Commission in part justified the sanctions as in the public interest by noting that it was "troubled" by the respondents' failure to accept responsibility for their actions. The Commission needs to stop this practice of justifying its sanctions when respondents vigorously defend themselves. Sanctions should be based only on the conduct and violations involved. Any time a respondent defends herself she is opening herself up for a claim by the Commission that enhanced sanctions are justified for failure to "accept responsibility." The punishment should fit the crime and it is no crime to defend oneself.

Sanctions Upheld For Firm That Filed Audited Report By Non-PCAOB Member Accountant

2011-05-14T12:55:00.000-06:00

Gremo Investments, Inc., Exchange Act Rel. 64481, May 12, 2011

Finra sanctioned Gremo for filing an annual report that was audited by an accounting firm that was not registered with the Public Company Accounting Oversight Board. Finra suspended the firm until it filed a compliant annual report and imposed a $1,000 fine. The Commission affirmed the Finra sanctions.

From 2003 until December 2008 the Commission exempted non-public broker-dealers such as Gremo from the requirement that their audits be performed by a PCAOB member accounting firm. Finra in 2009 issued two notices to members notifying them that the exemption had expired and that they were required to use PCAOB member firms for audits of their 2009 fiscal year. Gremo filed for an extension of the deadline for filing its annual audit claiming that the PCAOB application of its accounting firm was pending. Ultimately Gremo filed an audited annual report despite the fact that its accounting firm was not in fact a PCAOB member.

Finra Sanctions For Selling Away Sustained - Ignorance Defense Rejected

2011-05-14T12:29:00.000-06:00

Harry Friedman, Exchange Act Rel. 64486, May 13, 2011

Finra fined Friedman $77,500 and suspended him from all types of association for engaging in private securities transactions without providing written notice to his broker-dealer employer.

Friedman was a branch office manager and assisted in a reverse merger. He and a rep at the firm each purchased $12,500 of stock in the resulting public company for a penny a share prior to the stock's opening for trading. He later sold almost half his stock for $1.25 and $1.40 per share in violation of a lock-up agreement that prohibited resale of the stock until a later date reaping a profit of $550,000. Friedman did not report either the initial purchase or the resale of the stock to his employer.

Friedman's partner claimed he had given oral notice of the transactions to their employer, but no evidence of written notice was produced. Finra Rule 3040 requires prior written notice of any private securities transaction. Oral notice does not satisfy the rule. The hearing panel also found the claim to have given oral notice not credible. As is its practice, the Commission upheld that credibility finding. Further, the Commission noted that each person who engages in a private transaction must individually give written notice of such transactions and Friedman could not rely on any notice given by his partner.

The Commission rejected Friedman's claim that Finra Rule 3030 exempted him from the requirements of Rule 3040. Rule 3030 exempts passive investments in instruments other than securities from the notice requirements of Rule 3040. Since these transactions involved securities the Rule 3030 exemption did not apply.

Last, the the Commission rejected Friedman's defense of ignorance of the rule's requirements. It noted he had nine years of securities industry experience and was a registered principal and branch manager. He failed to consult the his firm's compliance manual, which had he done so would have alerted him to the need to report the transactions. Further, associated persons are "assumed as a matter of law to have . . . knowledge of [SRO] rules and requirements."

Stop order proceedings dismissed

2011-02-12T06:52:00.000-07:00

Sahas Technologies LLC, Securities Act Rel. 9189, February 17, 2011

One day after the SEC instituted stop order proceedings against Sahas for filing a deficient registration statement the company filed to withdraw its registration. Such withdrawals are automatically effective unless the Commission denies the application within fifteen days. The Division's motion to dismiss the proceedings was granted.

One can only wonder why any time, effort, and money was spent on something so utterly trivial.