Initial Decision of an SEC Administrative Law Judge
In the Matter of
In the Matter of
KENT T. BLACK,
December 31, 2001
|APPEARANCES:||Mitchell E. Herr for the Division of Enforcement, Securities and Exchange Commission
Bruce Sanders for Respondent Robert L. McCook
|BEFORE:||Lillian A. McEwen, Administrative Law Judge|
This Initial Decision concludes that Respondent McCook did not violate the federal securities laws as alleged in the instant case and dismisses the proceeding against him.
The Securities and Exchange Commission (Commission or SEC) instituted this proceeding pursuant to Section 8A of the Securities Act of 1933 (Securities Act) and Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 (Exchange Act). The Order Instituting Proceedings (OIP) was filed on September 26, 1997. On July 16, 1998, the Commission accepted an offer of settlement from Kent T. Black. See Kent T. Black, Order Making Findings and Imposing Sanctions and A Cease-and-Desist Order, 67 SEC Docket 1677 (July 16, 1998). On March 12, 1999, the Commission accepted offers of settlement from Larry E. Muller and Joel L. Hurst. See Order Making Findings and Imposing Sanctions and A Cease-and-Desist Order, 69 SEC Docket 1022 (Mar. 12, 1999) and Order Making Findings; Imposing Sanctions and A Cease-and-Desist Order, 69 SEC Docket 1018 (Mar. 12, 1999). I issued an Order Making Findings and Imposing Sanctions By Default against David E. Lynch on November 14, 2001. Thus, the hearing proceeded as to Robert L. McCook (McCook) only.
On April 28 through 30, 1998, a public hearing was held in Washington, D.C. McCook testified on his own behalf. He presented, with the Division of Enforcement (Division), four joint exhibits that I admitted. The Division called six witnesses and presented thirteen exhibits that I admitted.
I have construed the Division's Notice of Relevant Decision to be a motion to include the attached case as an update to the Division's posthearing filing. Pursuant to Rule 154 (a) and (b) and Rule 111(c) and (d), 17 C.F.R. § 201.111, .154, I have accepted the attached material. All other posthearing motions of the parties are DENIED, including Division's Motion To Strike McCook's Response to the Division's Posthearing Brief filed November 25, 1998, and McCook's request to sanction the Division for filing a Notice of Relevant Decision, pursuant to Rule 111(c) and (d).
The OIP alleges that McCook willfully aided and abetted violations of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5, and 17a-11 thereunder between October 1992 and March 1994. McCook is alleged to have committed these violations in connection with sales of government agency securities by another broker-dealer. If I conclude that the allegations in the OIP are true, I must then determine what, if any, remedial sanctions are appropriate pursuant to the federal securities laws.
FINDINGS OF FACT
I based the following findings of fact and conclusions on the entire record and the demeanor of the witnesses who testified at the hearing, applying preponderance of the evidence as the standard of proof.1 See Steadman v. SEC, 450 U.S. 91 (1981). All arguments and proposed findings and conclusions that were inconsistent with this decision are rejected. I find the following facts to be true.
Respondent Robert L. McCook
McCook has a bachelor degree in business administration with a major in finance from the University of Tennessee, and a master in business administration in finance from the University of Memphis (Tr. 697). After entering the securities industry in 1983, he earned several licenses, including a Series 3 for commodities, a Series 7, a Series 15 for interest rate options, and a Series 63 (Tr. 405). McCook worked for Thompson McKinnon Securities (Thomas McKinnon) as a stockbroker and then for the Exchange Bank of Chicago in Hallandale, Florida where he sold mortgage-backed pass through securities (Tr. 697). In 1988, he joined Crestar Bank investment division as a specialist in brokering odd lots of mortgage-backed pass through securities between broker-dealers (Tr. 698). At Crestar Bank, McCook often participated in transactions involving repurchase agreements because he had brokered bonds between dealers while at Thompson McKinnon (Tr. 331-32; Jnt. Ex. 11 at 20-21; Div. Ex. 10 at 88). "A repurchase agreement is the sale of a security with the commitment by the seller to buy the security back from the purchaser at a specified price at a designated future date. Basically, a repurchase agreement is a collateralized loan, where the collateral is a security" (Div. Ex. 17).
McCook always viewed the repurchase agreements, or "roll arrangements," as mere short-term financing for bonds because a broker-dealer might find it "less expensive to repo a security for thirty days than . . . to carry it for thirty days" (Jnt. Ex. 11 at 16). Crestar had no market-to-market or repo ledger for the transactions, and they were recorded as buys and sell-backs, with approved tickets. McCook never used or created a written repurchase agreement for the transactions, and neither did anyone else at Crestar (Tr. 401-11; Jnt. Ex. 11 at 17). Although McCook had been doing dealer-to-dealer oral repurchases since 1989, he was always required to get approval from Crestar traders or principals for them, which he did in conferences that usually lasted about two minutes. McCook regarded the repurchase arrangements as "common practice" for broker-dealers who had initially borrowed money to repurchase the securities into their inventory (Tr. 701-11; Jnt. Ex. 11 at 17-18, 20-21, 23-24).
On April 12, 1993, McCook was transferred when his department became the newly-created NASD member, Crestar Securities Corporation (Tr. 699-700). The transactions that gave rise to the OIP in the instant case occurred during McCook's tenure at Crestar Securities Corporation, where he remained until April 1994 (Tr. 700-01). At the time of the hearing, McCook lived in Midlothian, Virginia, and was employed at Southwick Investments (Tr. 406).
Robert L. McCook's Activities at Crestar
McCook participated in at least twelve complex transactions where bond prices were dictated by registered representatives Joel Hurst (Hurst), Larry Muller (Muller), or David Lynch (Lynch) at First Montauk Securities Corporation, Houston Branch (First Montauk Houston). The transactions occurring between April 1993 and February 1994 are described in more detail in the list below. McCook thought they were repurchase agreements that were not reduced to writing, like McCook had done at Thompson McKinnon in the early 1980s (Div. Ex. 10 at 86-88). The risk of a verbal repurchase transaction, from McCook's point of view, was that one end of the transaction may not be honored, making the holder subject to substantial market risk. McCook did not check the prices for the bonds because he assumed they would be sold by First Montauk and the broker whom he knew (Div. Ex. 10 at 94).
The twelve series of transactions involving blocks of bonds trading for large sums of money grew out of the business relationship between Hurst and McCook, which began well before April 1993, while McCook still worked for Crestar Bank, and before Hurst and Lynch opened First Montauk's Houston branch (Jnt. Ex. 11 at 23-25). McCook had met Hurst over the telephone, and traded with him about twice a week when Hurst was still president of Hurst-Murchison, a government securities corporation broker-dealer that Hurst formed in 1985 (Jnt. Ex. 16 at 18-20). Most of McCook's early trades with him involved customers on whose behalf Hurst purchased securities (Jnt. Ex. 16 at 256-58). McCook performed 99% of his work by telephone. Although McCook had to solicit business at the beginning of his career, by 1993 he had cultivated a national network of dealer banks and broker-dealers who called him half the time (Tr. 773-74). McCook earned $237,000 in 1993 on straight Crestar commission. From the unsolicited 15 transactions alleged in the instant case, McCook earned $30,000 (Tr. 774-75). Thus, the transactions usually began with a telephone call from Hurst to McCook.
On January 24, 1994, McCook received such a call in reference to 1483 SA bonds. Hurst stated he needed "to turn some bonds" but that he did not "want to write the ticket on the other side until we buy `em back next month." McCook refused to delay writing the ticket, stating "I kinda need to write the ticket" because "there are certain things I can and can't do," but "let's talk to Joy about it" (Div. Ex. 9 at 11). Joy Bailey (Bailey) was head of taxable trading at Crestar. Although McCook's direct supervisor was Charles Wright, the sales manager, the traders reported to Bailey (Jnt. Ex. 11 at 1-12). McCook meant to communicate to Hurst that he had to write the ticket at the time of the trade. Indeed, McCook thought that he would be reprimanded if he did not write the ticket promptly (Div. Ex. 10 at 19-22).
McCook told Hurst that he would "probably have to do it this week," rather than at a later time (Div. Ex. 9 at 12-13). Hurst wanted to buy the bonds back on the fourth of February (Div. Ex. 9 at 16-17). He explained that "we're just running tight. We've got a bunch of stuff on the books" (Div. Ex. 9 at 17). McCook thought Hurst meant that he had a temporary cash flow problem, typical of small dealers (Jnt. Ex. 11 at 79-80). He did not take the statement to be related to net capital issues presented by the 1492 security (Jnt. Ex. 11 at 80-82). McCook reminded Hurst that "the head of the trading has to okay this" and "I got to talk to [Bailey]" (Div. Ex. 9 at 16-18). Eight minutes later, McCook told Hurst that Hurst must sell the securities "to Doug Livingston at Simmons Bank for me this month, and then I'll buy `em back from him" (Div. Ex. 9 at 22).
Nobody at First Montauk asked McCook to conceal any transactions (Tr. 714-15). The insertion of a third party was accomplished without explanation or discussion in an offhand manner after McCook, Bailey, and John Tomlin (Tomlin), the head of trading, had discussed a First Montauk request for financing:
And the three of us got together and I think as I was walking away somebody said, you know, can you get somebody who you can run, want to let it go through, you know, or something. I can't remember exactly. It was something, can you use a third party or something?
The policy of insertion of the third party in First Montauk transactions was thus established after McCook's department morphed into Crestar Securities Corporation under NASD supervision in April 1993 (Tr. 717-18). Nobody from First Montauk ever suggested the use of a third party (Tr. 719-20). Crestar took the interest from the First Montauk securities during the span of the transaction. Indeed, for one month in 1993, Crestar earned over $100,000 profit on just one First Montauk transaction (Tr. 721-22). For only this one transaction, on January 24, 1994, McCook delayed writing a ticket for one week, at the request of First Montauk. Bailey or Tomlin approved this delay, but all other tickets were written on the same day or the next day, with management approval (Tr. 722-23). McCook knew of no actual delay by First Montauk in writing tickets, and he never asked a First Montauk employee to delay writing one, and he assumed that First Montauk tickets were accurately written on the trade date (Tr. 725-26). Furthermore, McCook never discussed any transactions with managers or personnel at First Montauk's headquarters or sent them any paperwork or confirmations (Tr. 724-27).
McCook did agree to delay writing the confirmation to a false date: "It's just that I'll have to write the ticket with you next week" "and [Livingston will] do it for 32nd, and I've got to have a point" (Div. Ex. 9 at 23). Thus, McCook communicated the fee for the transaction. Next, McCook clarified that "I am going to sell these back to you, on Friday of next week for the end of February settle, right?" and repeated, "I have to write the ticket next week" (Div. Ex. 9 at 25). He had already obtained Bailey's approval for the ticket delay (Div. Ex. 10 at 29; Jnt. Ex. 11 at 71-72). McCook did not ask Hurst why he wanted the date changed, and Hurst did not tell him (Jnt. Ex. 11 at 44-45).
Hurst agreed to sell the bonds to the third party, David Livingston (Livingston) at Simmons National Bank (Simmons), for 35.4. McCook would purchase the bonds from the third party Simmons for 35.5 and Hurst would buy them back from McCook at 35.6 or 35.7. McCook agreed to "sell these back to you next Friday for the end of February settle" (Div. Ex. 9 at 26-27). McCook immediately called Livingston at Simmons and told him to call First Montauk and buy the bonds at 35.4 from them and sell them to McCook at 35.5, "For Jan[uary] settle" (Div. Ex. 9 at 40-41). McCook purchased the 1483 SA bond from Simmons on the same date as the telephone call, January 24, 1994. Simmons had already bought them from First Montauk. McCook in turn sold the same bonds back to First Montauk to settle later (Div. Ex. 10 at 28-29). McCook knew that the insertion of the third party Simmons was "a way to conceal the transaction" but he had done it to effect the transaction as directed by Crestar management (Div. Ex. 10 at 29-32, 65). Tomlin might have said, "Can you run it through somebody just so it won't look like we're buying and selling back to the same body" as the reason for the third party (Jnt. Ex. 11 at 54-55). McCook did not know who the customers were in the transactions, he did not evaluate the securities or read a prospectus, and he was not sure whether Crestar held any of the First Montauk securities in the Crestar inventory for net capital purposes or accounting (Div. Ex. 10 at 67-69). McCook thought that he was short-term financing inventory positions while the brokers attempted to market securities to their customers (Div. Ex. 10 at 70-71, 78-79, 82-83). A fee of 1/32 for $2 million in bonds would equal $625 as a repurchase finance charge for these bonds (Div. Ex. 10 at 72).
Nobody at First Montauk ever told McCook to conceal anything from Crestar (Div. Ex. 10 at 73-74). While Crestar had a position in the bonds until settlement, it earned interest on them, which was greater than the mark-up that McCook charged First Montauk (Div. Ex. 10 at 75-76). For the 1483 SA bonds, Crestar would have received a fee consisting of the mark-up at 3/32, or $700 (Div. Ex. 10 at 78-79). McCook did not think he was doing anything wrong by following instructions by his supervisors to insert a third party (Div. Ex. 10 at 79-80). Livingston at Simmons made 1/32 off the trade in exchange for his assistance to Crestar and McCook, and First Montauk did not initiate the Simmons relationship (Div. Ex. 10 at 85-86). In a typical repurchase transaction, Crestar simultaneously bought from and sold to another broker-dealer a security where Crestar held the security with a one-month extended settlement date. In exchange, Crestar charged a fee of 1/32 to 2/32 of the price plus interest payments generated from the securities during the holding period (Jnt. Ex. 11 at 11). McCook did not check the price or suitability of the bonds or evaluate them in any way pursuant to the First Montauk trades, and he "did not think there was any risk" (Div. Ex. 10 at 41). For the transactions in the instant case, either Bailey or Tomlin instructed McCook as to what trade date should be placed on the order ticket, and McCook did not know why their suggested dates were later (Jnt. Ex. 11 at 28). McCook never asked them why they had him change the dates and they did not explain the reason for the instruction (Jnt. Ex. 11 at 29-30). Because of net capital requirements, Crestar had to know its monthly securities position, and obtaining permission to do repurchases was the way that McCook kept the firm apprised of those positions (Jnt. Ex. 11 at 31-33). It was not until after Crestar became an NASD member, that McCook was instructed by Tomlin to use a third-party intermediary, something he had not done with repurchases in the past (Jnt. Ex. 11 at 33).
McCook did not discuss these transactions with his supervisors because he regularly performed them as trading rather than sales to customers, and both Tomlin and Bailey were much more experienced and knowledgeable than McCook in those matters. Charlie Wright conducted McCook's performance reviews, and McCook had been promoted several times by Crestar (Jnt. Ex. 11 at 35-36). As for the third party, McCook knew what the terms used by the managers meant and, thereafter, routinely inserted another broker-dealer into the First Montauk transactions. He did not question the managers because they were experienced principals (Tr. 770-72). Except for a February 4 delay in writing the sell-back ticket and the delays until the next day for other sell-back tickets, the paperwork for the 15 transactions proceeded like other routine Crestar paperwork (Tr. 771-73). McCook was not personally responsible for mailing confirmations to First Montauk or to any other party (Tr. 728-41). Part of the confirmation process is a telephone call from the back office to the contra party, during which the trade or deal may be disavowed. The transaction may also then be renegotiated or agreed upon (Tr. 743-44). In the normal course of business, McCook's Crestar ticket would have the same date as the First Montauk ticket for a given securities transaction (Tr. 748-51). The confirmation from Crestar, based on McCook's order ticket, would also be mailed to First Montauk in the ordinary course of business (Tr. 753-55). First Montauk charged higher prices for the same collateralized mortgage obligations (CMOs) at later dates, but McCook did not realize that anything was unusual. In 1993, he executed about 2,000 buys and sells and thus did not notice a pattern in any of the First Montauk securities. McCook traded short-term, high quality, low-market risk bank investment paper, which was increasing steadily in value. McCook assumed that the increase in the price of the CMOs was a function of the same rally (Tr. 766-67).
The postponement of the ticket writing resulted from the direction of Tomlin and Bailey to "write the sell-back in the morning." McCook assumed that because the First Montauk transactions were the only ones he was told to postpone, the direction was the correct manner in which to handle them (Tr. 768-69). Crestar took interest from the CMO coupons plus 65% of the total commission (Tr. 769-70). For all 15 transactions, Crestar received the same compensation of 2/32 plus an interest rate on the bonds. McCook disclosed to Bailey and Tomlin the full terms of each transaction (Tr. 541-43, 552-54). McCook did not evaluate the CMOs for fair market value because he was familiar with the main First Montauk broker, trusted him to act ethically, and "had no reason to suspect them of wrongdoing, foul play, so forth" (Tr. 764). He viewed the transactions as a favor to the broker and did not view his actions as putting Crestar at risk because he was sure that the brokers would redeem the securities, which they did (Tr. 408, 765). As for the delays in ticket writing, Bailey and Tomlin sometimes asked McCook to delay the buy tickets. Because he had known Bailey since 1986, and because Tomlin had more securities experience then he did, McCook did not question these experienced, licensed principals (Tr. 766). McCook did not check to see whether the bonds were bought or sold at the market price, and McCook never suggested a price for First Montauk or insisted that the bonds be traded at the market price either (Tr. 408; Jnt. Ex. 11 at 75-76). Because the coupon interest on the bonds was kept by Crestar during its holding period, McCook insisted on a fee of 1/32 to 3/32 added to the sale price so that he could generate a commission of one-third of the mark-up from the transactions (Jnt. Ex. 11 at 76-78). Crestar kept the rest of the mark-up plus the coupon interest (Tr. 409-11).
McCook engaged in short-term financing arrangements with First Montauk of Houston, Simmons Bank, and Trading Desk of Memphis Incorporated (TDI) (Tr. 406; Div. Ex. 10 at 5). Prices were set by the firm that sold the securities to McCook (Div. Ex. 10 at 6). McCook was unaware of mark-ups to customers on the bonds that were the subject of the transactions (Div. Ex. 10 at 8). Although McCook turned his ticket in on the day of the transaction for the buy and the sell back, McCook had no way of knowing whether the parties on the other side did the same thing (Div. Ex. 10 at 12). McCook never saw confirmations from the contra party in any transactions at Crestar including First Montauk and its clearing firm and nobody mentioned any First Montauk confirmation discrepancies to McCook (Jnt. Ex. 11 at 51-53).
McCook knew that the practice in the industry is to write the ticket and turn it in the same day for processing on the same day that a transaction is agreed upon. When McCook first began the prearranged transactions with First Montauk, McCook did write the sell-back on the same date. However, some time in 1993, McCook's superiors at Crestar asked him to delay the tickets until the next day (Tr. 462). McCook did not know whether the insertion of a third party into the transaction and the delay in writing the tickets were for the purpose of concealing the trades, when he was told to effect the transaction in that manner (Tr. 472-73). He did know that the order tickets should have been entered simultaneously, even though he had never seen the correct repurchase form (Tr. 319-50, 536). After approval, McCook agreed to Hurst's January 24, 1994, request to delay writing the ticket for the sale for more than a week (Tr. 474). McCook knew that Hurst needed short-term financing to carry the security, and that Hurst wanted to get the security from First Montauk's books onto Crestar's books (Tr. 485). McCook also knew that Crestar would keep track of the security for Crestar's net capital purpose (Tr. 486). When Bailey told McCook to insert a third party into the transaction, McCook suggested Livingston at Simmons as the third party, but McCook did not know why a third party was necessary, and he did not ask (Tr. 490-91). McCook viewed the trade as simply an accommodation for Hurst, whom he had done business with for six to eight years without a problem (Tr. 495).
On March 28, 1994, a similar series of transactions occurred. Hurst called McCook with a request to sell bonds at 56.8 to McCook and to buy them back at 56.11 "from this month till next month" on the last day of April (Div. Ex. 9 at 46, 49). McCook replied that he would have to talk to Bailey and that a third party would have to be inserted (Div. Ex. 9 at 49-50). A few minutes later, Muller at First Montauk called McCook, who told him they would use Livingston at Simmons Bank to buy the bonds from First Montauk. McCook informed Muller that he had already discussed the matter with Hurst, and had obtained Crestar approval. The terms were 56.8 from Muller and back to Muller at 56.9 (Div. Ex. 9 at 54-55). McCook immediately called Livingston at Simmons and told him to call Muller and "buy some bonds and then call me and sell 'em to me" (Div. Ex. 9 at 59). Livingston called McCook several minutes later to clarify the terms, and observed that as to the bond, "I think we've traded this one before" (Div. Ex. 9 at 63). McCook stated, "yeah, probably." Livingston asked, "You know, they aren't going to come back and put us in jail for this five years down the road, are they?" McCook replied, "No promises here" (Div. Ex. 9 at 63-64). Several minutes later, McCook telephoned Muller at First Montauk to tell him that he was selling First Montauk $2.4 million 1492 SAs at 56.11, because McCook had bought the securities from First Montauk at 56.8. McCook also stated that he had told Hurst and Livingston that the price was 56.11 and that he was writing a ticket to that effect (Div. Ex. 9 at 67-68).
Thus, on March 28, 1994, McCook agreed that Crestar would buy from First Montauk a group of securities that had already changed hands among the same parties in the past, without knowing that the market price of the bonds was falling while the prices between First Montauk and Crestar were rising, and without checking whether First Montauk was selling the bonds to customers at above market prices either (Tr. 513-15). The 1492 SA bonds that Crestar bought in October and November 1993 at 56 were clearing at Bear Stearns for mid to high twenties, but McCook did not know that (Tr. 514-17; Div. Ex. 5). When Livingston asked McCook whether they were going to jail, McCook thought he was joking. When McCook stated "no promises here," he was also joking (Tr. 518). On February 27, 1998, McCook testified for the prosecution against Kent Black, Hurst, Lynch, and Muller in criminal case 96-4261 lodged against them by the state of Florida (Div. Ex. 10).
Robert I. Rabinowitz (Rabinowitz), the general counsel at First Montauk had worked for the corporation since 1986 (Tr. 24). The possessor of a Series 7 general securities representative license and a Series 63 state agent license, Rabinowitz was also responsible for compliance matters during 1993-1994, in the First Montauk Red Bank New Jersey home office (Tr. 25). Although the firm had about eighty branch offices in 1993, the branch offices were actually independent contractors, and the Houston office alone at that time produced about 40% of the firm's total revenue (Tr. 26-27). The First Montauk Houston branch specialized in bonds (Tr. 28-30). Initially the Houston office brokers called their trades in to the First Montauk, New Jersey, home office, but at some point they were allowed to execute trades directly with dealers on the street and report the executed transaction to the home office after the trade had been finalized with another dealer (Tr. 31-32). By 1994, the Houston office, run administratively by Hurst, and with Lynch supervising the trading desk, had eight to ten registered representatives (Tr. 32).
Although First Montauk's president did allow the Houston office to pay for a security and then locate a customer "in a couple of instances," the Houston office "generally" was not allowed to hold a position in a security without a committed buyer for it (Tr. 33). First Montauk did not want the firm's capital placed at market risk for any length of time, because it was a small firm with limited capital and resources, even though the firm did not have "regulatory concerns" (Tr. 33-34). Because First Montauk is a market-maker in equity securities, the firm did not want its inventory to be used for "fixed income securities" like the ones in the instant case (Tr. 35). As for net capital computations, the firm calculated its position "on a daily basis" and filed a FOCUS report with NASD after its net capital calculation "at month end" (Tr. 36). Hurst, Lynch, and Muller in Houston were supposed to engage only in riskless principal transactions, where the purchase and sale occurred simultaneously (Tr. 37-38). As for mark-ups, even for CMOs in riskless principal transactions, First Montauk's policy was that the difference between the purchase price and the sale price for the customer should not be more than 5%. This 5% guideline does not apply to inter-dealer transactions, however, because dealers are not part of the investing public that must be protected (Tr. 40).
A repurchase transaction, according to First Montauk's policy, is the sale of a security with the simultaneous obligation to buy the security back at a later date for a specific price. The Houston branch office was not allowed to engage in them, although they may serve a legitimate function in the securities business (Tr. 43-44). First Montauk did not approve repurchase agreements in 1993 and 1994 with Crestar, the TDI, or Simmons Bank, and Rabinowitz had never seen or communicated with McCook before the hearing in the instant case (Tr. 44-45, 60-61). First Montauk settled cases with the SEC, the county of Escambia, Florida, and National Guardian Life (NGL) and individual customers related to the activities of the Houston branch office (Tr. 55-60).
In 1990 the Houston affiliate office for First Montauk began operation so that Hurst and Lynch could sell fixed-income securities, with 80% of the total commission to remain in Houston for compensation and most expenses, and with 20% to go to First Montauk's main office in New Jersey (Jnt. Ex. 16 at 42-44). Lynch signed the agreement with the main office, but Hurst considered himself to be the branch manager with Series 7 and Series 63 licenses (Jnt. Ex. 16 at 48-50, 58, 103-05). The First Montauk Houston office did not have a principal, a branch manager, or a supervisor (Jnt. Ex. 16 at 56-60, 62-64). Hurst did not review outgoing correspondence to customers or the daily blotters (Jnt. Ex. 16 at 74-77). Trades made in Houston were called in to New Jersey to Brian Cohen (Cohen), senior vice-president of First Montauk (Tr. 170-71; Jnt. Ex. 16 at 85-86). Hurst set up Fiscam Group Corporation (Fiscam) to pay the expenses for First Montauk Houston, with himself as the only officer (Jnt. Ex. 16 at 91-93). Hurst had failed the Series 24 examination twice in 1988 (Jnt. Ex. 16 at 93).
There was no compliance or supervisor's manual at First Montauk Houston (Jnt. Ex. 16 at113-16). Cohen did review the back office and examined the trading blotter for Houston once a quarter, but copies of confirmations were not received in Houston from New Jersey First Montauk or a clearing firm (Jnt. Ex. 16 at 125-27, 149-51, 181-82). Houston customers were confirmed only after Cohen in New Jersey was notified of the trade, but Hurst never saw an order ticket that Cohen filled out in New Jersey (Jnt. Ex. 16 at 159-60). Neither Hurst nor anyone else reviewed the daily blotter at the end of each month (Jnt. Ex. 16 at 166-67).
First Montauk established prices based on the cost of the securities to First Montauk, but the trader usually set the price to the customer somewhere within the 5% mark-up price (Jnt. Ex. 16 at 210-11). Hurst paid office expenses through Fiscam, taking half of the commissions from the sales force for that purpose (Jnt. Ex. 16 at 239-40). Although Hurst did not draw a salary from Fiscam, the corporation did pay a salary to Hurst's brother as well as "the secretaries" (Jnt. Ex. 16 at 240-41). Hurst's income for 1993 before office expenses were deducted was over $2 million (Jnt. Ex. 16 at 244-46).
Cohen explained to Hurst that First Montauk Houston could not hold positions because it would "put them in net capital violation," but Hurst never discussed the issue with anyone else at First Montauk (Jnt. Ex. 16 at 261-63). The position limit set by Cohen for the Houston branch was $1 million, the figure given to Hurst, Muller, and Lynch (Jnt. Ex. 16 at 266-67). Hurst did not know, however, whether First Montauk was on a trade date or settlement date on a capital basis (Jnt. Ex. 16 at 268-70). Hurst did not know whether the firm filed monthly or quarterly, but Cohen was asked for permission before a position over $1 million was taken (Jnt. Ex. 16 at 269-73). Although Cohen approved the early transactions with Simmons Bank and Crestar, there came a time when Cohen told the traders that they could not engage in them any longer (Jnt. Ex. 16 at 294-96, 304-06). McCook never informed Hurst that he was writing a ticket for a later trade date than the actual one for the repurchases with Simmons Bank or TDI, although McCook always told Hurst that he needed permission from his supervisors to perform the transactions, and Hurst never told McCook why Hurst wanted to perform the transactions (Jnt. Ex. 16 at 317-22). Hurst needed the transactions so that he could extend the settlement date to avoid the net capital restrictions for First Montauk (Jnt. Ex. 16 at 321-22).
On October 6, 1993, the first step in a typical transaction was taken. First Montauk Houston bought bonds from Bear Sterns at 9.50 and sold the same bonds on November 16 to a First Montauk customer for 11 16/32 (Jnt. Ex. 16 at 347-51). Between those dates, the bonds had been traded to TDI and Crestar Securities by First Montauk Houston (Jnt. Ex. 16 at 347-51). On or about October 29, First Montauk Houston purchased the remainder of the tranche from Bear Stearns and then repurchased them before selling them on November 16, 1993 to a different customer at 11 16/32 (Jnt. Ex. 16 at 351-54). Thus, on November 15, First Montauk Houston had $40 million in inventory in bonds (Jnt. Ex. 16 at 354-57). The original purchase price for First Montauk was 9 16/32 but the bonds were sold to a First Montauk customer at 11 16/32, an over 20% mark-up (Jnt. Ex. 16 at 355-58). Hurst agreed that the mark-up was excessive and that it should not have been higher than 5% (Jnt. Ex. 16 at 358-60). On November 15, 1993, at 10:44 a.m., the same $40 million bonds from Bear Stearns were offered by First Montauk Houston to their customer NGL at 11 16/32. First Montauk Houston then sold the same $40 million bonds to TDI on November 15 at 2:50 p.m. (Jnt. Ex. 16 at 359-67).
The back office at Houston called all trades in to Cohen in New Jersey and confirmations generated by First Montauk New Jersey were sent to the clearing firm (Jnt. Ex. 16 at 368-70). The dates on several order tickets from Houston were changed in New Jersey to reflect later dates for several bond trades, including the tickets for the $40 million trades with Crestar and NGL (Jnt. Ex. 16 at 371-75, 379-38). The Houston branch had in fact repurchased the bonds on November 16 and sold them immediately on November 16 to its customer, but Hurst was not aware of the changes in dates by First Montauk New Jersey, nor was he aware at the time that the Houston branch had taken a position in the bonds from October 6 to November 15, 1993 (Jnt. Ex. 16 at 376-77). He did not know why New Jersey changed the trade dates for the orders (Jnt. Ex. 16 at 381-82).
On August 16, 1993, Houston took a position of over $1 million on Fannie Mae 44PS from ARBOR. On August 19, 1993, immediately after simultaneous repurchase transactions involving Crestar and the TDI, First Montauk Houston sold the bonds to its customer, NGL (Jnt. Ex. 16 at 384-87). Hurst obtained permission from Cohen in New Jersey to carry the bonds in inventory and to engage in the repurchase transactions (Jnt. Ex. 16 at 387-92). On August 19, 1993, NGL paid 13 8/32 for the same bonds that First Montauk Houston had bought at 11 26/32 on August 16, 1993 (Jnt. Ex. 16 at 400-02). The ticket generated by New Jersey First Montauk shows an altered trade date of August 16, 1993, for the NGL buy, which had actually occurred on August 19. Likewise the ticket generated by New Jersey First Montauk shows an altered trade date of August 16 for the TDI and Crestar trades, which had actually occurred on August 19 (Jnt. Ex. 16 at 403-08). The net capital restrictions were avoided by having tickets written on a date different from the actual date of the order, and Hurst knew that (Jnt. Ex. 16 at 407-09).
Before the January 24, 1994, conversation and transaction with McCook, Hurst had talked to Cohen at First Montauk New Jersey and ascertained from Cohen that because "our net capital was close" the date for purchasing the securities had to be February 4, 1994. Thus, when Hurst told McCook that "We're just running tight. We got a bunch of stuff on the books" Hurst was referring to the net capital problem raised by Cohen (Jnt. Ex. 16 at 424-26). Hurst's practice was to ask Cohen whether he could purchase bonds during the next month, and Cohen would tell First Montauk Houston how much it could spend on securities and when they could bring the bonds back into the firm (Jnt. Ex. 16 at 427-30).
Although Hurst never specifically told Cohen that First Montauk Houston would avoid net capital violations by engaging in complex repurchase agreements, Cohen did confirm each segment of the related transactions (Jnt. Ex. 16 at 433-34). On or about April 20, 1994, two trades for the same bond 1492 SA, face value $1.24 million, settled. First Montauk bought the bonds from Crestar for 56 11/32, but First Montauk bought the same bonds from the client Escambia County for 50 (Jnt. Ex. 16 at 453). On April 20, 1994, Comprehensive Capital bought the very same bonds from First Montauk Houston for 54. Thus, the same bonds were repurchased from Crestar at 56, purchased from the customer Escambia County at 50, and sold to Comprehensive Capital at 54 (Jnt. Ex. 16 at 452-54).
Lynch, during his tenure at First Montauk, used a Bloomberg screen and Hurst was a supervisor "on the trade desk" although Hurst did not have a Series 7 license (Jnt. Ex. 14 at 57-59, 73-75). None of the files of the sales staff were reviewed by Lynch or by anyone else (Jnt. Ex. 14 at 66-68). None of the employees or salesmen at the Houston branch office had a principal's license and Lynch never saw or read First Montauk's compliance manual (Jnt. Ex. 14 at 77-81). Lynch learned about CMOs from one training course and from other dealers, who sent analytics that Lynch and other traders checked on Bloomberg screens (Jnt. Ex. 14 at 97-100). The back office at the branch confirmed the trade date and settlement date with the client before generating the final ticket (Jnt. Ex. 14 at 108-09). The main office in New Jersey would not allow the Houston branch to hold bonds overnight, so a registered representative had to have a purchaser on hand before a bond was bought on the street (Jnt. Ex. 14 at 151-52).
First Montauk Houston registered representatives usually asked that a bond be held for thirty minutes to allow the client to commit to the purchase before finalizing the purchase of a bond (Jnt. Ex. 14 at 153-55). All trades were called in to New Jersey First Montauk headquarters (Jnt. Ex. 14 at 155-56). Even on "future settlements," New Jersey knew about the transaction, because it also would be called in as a "when - issued transaction" (Jnt. Ex. 14 at 156-60). First Montauk Houston sold almost exclusively to institutional clients, and the salesman sold parts of CMO tranches to them at the time of the issue of the security, and attempted to complete the sale by the future settlement date set by the offeror of the tranche, or primary dealers (Jnt. Ex. 14 at 161-64). The branch office also occasionally profited greatly on inverse floaters that the primary dealer set prices on but where settlement was three months forward for the new issue (Jnt. Ex. 14 at 164-66). Hurst got in trouble because he bought CMO principal-only bonds that became worthless before he could locate a regional dealer or institutional client (Jnt. Ex. 14 at 169-72). For dealer-to-dealer trades, the sales were based on the market price after the CMO was held for settlement, but for customer sales, the sales were usually made at only 5% over cost for the CMO (Jnt. Ex. 14 at 173-76).
Because the Houston branch sold only to insurance companies and banks, suitability was based merely on the portfolio of the insurance company or bank that was looking for a particular kind of CMO (Jnt. Ex. 14 at 178-82). When that bond was found by the First Montauk registered representative, the buy decision was made in thirty minutes and the ticket was written up simultaneously with the primary dealer; the back office at First Montauk in New Jersey had confirmation within minutes (Jnt. Ex. 14 at 183-87). Cohen was kept informed by telephone of every trade before headquarters confirmed it. The order tickets stayed in Houston, but the written client confirmations were sent from headquarters in New Jersey. The Houston branch office staff assumed that First Montauk in New Jersey merely generated an identical order ticket for the written confirmations (Jnt. Ex. 14 at 185-88). Because settlement during the month was left up to the customer, First Montauk in New Jersey had to be capable of delivering the bonds to the customer for payment within five days (Jnt. Ex. 14 at 187-88).
First Montauk's main office paid commissions to the branch office by taking information from the daily handwritten blotters generated by the salesmen, which recorded all relevant trade information such as security, customer name, trade date, and settlement date (Jnt. Ex. 14 at 192-95). The salesman would never allow the primary dealer to sell directly to a First Montauk customer without having First Montauk take a position in the security because the primary dealer would then be able to identify the customer and call them directly in the future (Jnt. Ex. 14 at 195). Likewise, the branch office mailed the CMO prospectus to each purchasing customer, from its back office (Jnt. Ex. 14 at 203-04).
Cohen at the head office of First Montauk told Lynch that the branch office could not take positions overnight, even on settlement date, because "they didn't have the net capital," but Lynch did not know what the net capital requirement was or when it was computed, and Lynch assumed that the three senior salesmen at the Houston branch had to absorb the loss in the event that bonds could not be sold by settlement date where they had taken a position (Jnt. Ex. 14 at 212-14). Lynch made $700,000 to $800,000 in 1993 and 1994 (Jnt. Ex. 14 at 217-18, 222). He was not aware of the practice of the branch office selling a security with an arrangement to buy the security back to avoid putting it on First Montauk's blotter (Jnt. Ex. 14 at 217-20). Thus, Lynch did not know when he sold the FNMA 1993, 44PS to NGL on September 1, 1993, that First Montauk had already traded it earlier with Crestar Securities and TDI (Jnt. Ex. 14 at 257-60) because he had not written the earlier tickets (Jnt. Ex. 14 at 263-64). Cohen knew that the Houston Branch office interpreted their instructions from the head office to mean that as long as they did not take delivery of bonds, the salesmen could take positions in them before the arrival of the settlement date (Jnt. Ex. 14 at 265-67). The sale price of the bonds to the customer NGL was based on the cost that First Montauk paid for the bonds at the end of the Crestar transactions (Jnt. Ex. 14 at 273-75). The sale to NGL of Security 28 SA, Fannie Mae 1993 28 SA also followed transactions between First Montauk, Simmons Bank, and Crestar (Jnt. Ex. 14 at 274-76). Lynch was not aware of these trades either (Jnt. Ex. 14 at 276-77). The same procedure was followed with Freddie Mac 24SQ, which had been traded between First Montauk and Comprehensive Capital before being sold to NGL by Lynch with no knowledge of or explanation for the earlier transactions, which had not been performed by Lynch (Jnt. Ex. 14 at 277-80).
Lynch had bought bonds from McCook for several years, and knew him through Hurst (Jnt. Ex. 14 at 287-90). He thought that the transactions with Crestar could have served a legitimate business purpose, and the increased price to the customer could have been simply the price paid for an extraordinarily good deal for the customer that would not have been possible or available to them otherwise (Jnt. Ex. 14 at 293-96). Because dealers in the primary market do not see each other's inventory, the offering prices often varied considerably for the same block of CMO's, and a tranche could be bought at a substantial bargain from dealer to dealer. The prices and bonds that NGL got were sometimes outstanding in spite of the increased cost basis (Jnt. Ex. 14 at 297-98). The intermediate transactions are a way to maintain control over the bonds until a buyer can be located, rather then running the risk of losing a sale of a good deal (Jnt. Ex. 14 at 309-10). First Montauk in Lynch's view had a right to whatever profit it could derive from their wise purchase of a bond below market price (Jnt. Ex. 14 at 310). Finally, the customer might often not have been able for some reason to buy the bonds that month but could pay for them a month in the future, and First Montauk did not want to lose the sale (Jnt. Ex. 14 at 313).
Muller, the holder of Series 7, Series 63, and Series 65 licenses, entered the securities business in 1987 after his construction company failed (Jnt. Ex. 15 at 42-43). At Hurst- Merchason, Muller had sold bonds to banks and other institutional clients, and in about two years, he sold CMOs (Jnt. Ex. 15 at 48-49). Later at First Montauk Houston, as a result of studying Bloomberg screens, Muller began to sell inverse floaters and interest-only bonds (Jnt. Ex. 15 at 55-56).
Muller admitted that he might have bought a bond from a dealer without having the cash or the ability to own it in inventory. If he knew that a customer needed a few days or weeks to purchase the same bonds, Muller would sell the bonds to Crestar with the simultaneous agreement to buy them back at a later date at a stated price, in order to enable the customer to acquire the bonds. He would also pay a sales commission in the form of 2/32 of mark-up to the purchasing dealer and allow the purchasing dealer to earn interest or income from the bonds during the holding period. The purpose of the transaction also might be to maintain control of the bonds by First Montauk until a customer could be located, without actually owning them. The cost of the control over the bonds was the several thirty-seconds that the other broker charged to hold them (Jnt. Ex. 15 at 160-64, 239-42). Cohen decided that for these kinds of transactions the trade dates would be changed so that the First Montauk purchase from the broker would not show as a simultaneous trade, but rather as occurring later in time, with no explanation as to why the dates had to be changed (Jnt. Ex. 15 at 292-95). Muller took Cohen's statement to mean that Cohen would change the date in New Jersey's documents as he saw fit (Jnt. Ex. 15 at 298-300).
On November 15, 1993, Muller sold bonds to an insurance company for two points higher than First Montauk's purchase price from Bear Sterns, after selling them to and buying them back from Crestar because the bonds were to be moved "out of our inventory," not to get a price "two points higher on a $9 bond" (Jnt. Ex. 15 at 309-12, 314). It also might have been done to accommodate the customer's settlement timing for the purchase (Jnt. Ex. 15 at 313). The participation by Simmons was at the suggestion of McCook, who told Muller that he did not want to write the ticket on the same day he bought it (Jnt. Ex. 15 at 328-32, 337-40). On October 28, 1993, Muller bought Fannie Mae 1993 220SB bonds from Bear Sterns for 9 1/2 and sold them to Simmons on the same date. First Montauk Houston purchased the same bonds from Crestar on November 2 and sold them to their customer Escambia County the same day for 10 1/2 (Jnt. Ex. 15 at 337-40). First Montauk Houston also sold bonds to Comprehensive Capital that it had bought in the same tranche from Bear Sterns. Some of those bonds the branch was able to buy back, and some were bonds that they ultimately lost control over and had to buy back from Comprehensive customers (Jnt. Ex. 15 at 341-44). First Montauk Houston often tried to buy an entire tranche of a CMO from a primary dealer so that they could "negotiate a better price" (Jnt. Ex. 15 at 347-48).
Muller never saw a First Montauk compliance or supervisory manual during his tenure, and he did not recognize a copy of First Montauk Securities Corporation Compliance and Procedure Manual for June 1990 or First Montauk Legal and Compliance Manual for January 1992 (Jnt. Ex. 15 at 107-08, 112-14). Muller left First Montauk in January 1995, due to loss of business, after making $950 thousand in 1994 (Jnt. Ex. 15 at 8-10, 24-25). At First Montauk, Muller earned commissions based on the trades recorded on office blotters by the branch back office, but the checks were mailed out of New Jersey headquarters to the brokers' personal accounts. Cohen called parties to confirm every trade (Jnt. Ex. 15 at 13-16).
Cohen, senior vice president of First Montauk, considered Hurst to be branch manager of the Houston office during 1993 and 1994. Muller sat on the trading desk there, "to find and analyze securities that they were looking to fill orders for" (Tr. 170-71). Although the Houston branch did not have direct contact with the clearing firm, they were authorized to execute transactions as a principal (Tr. 171). First Montauk in New Jersey did the processing via the clearing firm, generating confirmations and settlement notices (Tr. 172-73). For approval of inventory positions, the Houston branch asked Cohen because First Montauk "held small retail positions" only for its municipal bond activity (Tr. 173). The largest inventory was in over-the-counter securities (Tr. 174). The main office at First Montauk was responsible for the firm's books and records and net capital computations, not the Houston branch (Tr. 194-95). Cohen had never discussed books and records or net capital issues with McCook, and nobody ever told McCook that First Montauk did not allow the Houston branch to carry inventory (Tr. 194-97).
William J. Kurinsky (Kurinsky), vice president, chief financial officer and financial principal at First Montauk Securities, possessing a Series 27 license and a license as a financial and operations principal, and was responsible for the monthly FOCUS reporting and books and records of the firm (Tr. 65-66, 151-52). First Montauk computed FOCUS report inventory positions for net capital on a settlement date basis, the last day of each month (Tr. 67-69). Kurinsky's examination of the Houston branch trading revealed that First Montauk bought stocks back from Crestar that it had sold to TDI (Tr. 70-71). In the ordinary course of business, the clearing firm handled settlements after the Houston branch phoned orders into First Montauk New Jersey (Tr. 158-59). Repurchase agreements are hedging techniques for the purpose of locking in interest rates. "Banks do them a lot" (Tr. 166-67). However, Lynch and Muller were not supposed to do repurchase transactions (Tr. 166-67).
Because Kurinsky did not know that there was a commitment to purchase securities that had been sold, the FOCUS reports to NASD and the SEC did not include that information. And thus, were inaccurate as to net worth and liabilities for fifteen transactions (Tr. 90, 93-95). Adjusted net capital for First Montauk was negative $77,735 for April 1993, but First Montauk did not cease operations because Kurinsky was not aware of the nature of the Houston branch office transactions (Tr. 96-97). For August 1993, the true net capital position would have been negative $49,000; for October 1993, it would have been negative $65,000; for November 1993 negative $1,249,511 (Tr. 99-100, 104-06, 111-12). The same is true for several more months for First Montauk (Tr. 113-24; Div. Ex. 6). Kurinsky did not learn of net capital valuation problems until 1995, and he never discussed any of those matters with McCook and never saw McCook until the hearing (Tr. 128-29). The First Montauk main office had expressly permitted the Houston branch office to perform inventory transactions and to hold inventory on more than ten occasions before May 1994 (Tr. 129-31). Thus, $1 million of inventory was allowed from time to time (Tr. 132). Kurinsky adopted the calculations of net capital adjustments that Division counsel presented to him without generating calculations of his own from First Montauk's data (Tr. 147-48). Bona fide repurchasing agreements are generated "all the time, with firms that do that business" of buying and selling (Tr. 149-50).
Bear Stearns sells to First Montauk @ 9.5 on 10/29/93 to settle 11/30/93
First Montauk sells to Simmons @ 9.953125 on 10/29/93 to settle 11/30/93
Simmons sells to Crestar @ 9.96875 on 11/01/93 to settle 11/30/93
Crestar sells to First Montauk @ 10.00 on 11/02/93 to settle 12/30/93
First Montauk sells to Escambia @ 10.5 on 11/02/93 to settle 12/30/93
Bear Sterns sells to First Montauk @ 9.5 on 10/6 & 10/22/93 to settle 11/30/93
First Montauk offers to NGL @ 11.5 on 11/15/93
First Montauk sells to TDI @ 11.2344 on 11/15/93 to settle 11/30/93
TDI sells to Crestar @ 11.25 on 11/15/93 to settle 11/30/93
Crestar sells to First Montauk @ 11.28125 on 11/16/93 to settle 12/03/93
First Montauk sells to NGL @ 11.5 on 11/16/93 to settle 12/03/93
Arbor sells to First Montauk @ 11.8125 on 8/16/93 to settle 8/30/93
First Montauk sells to TDI @ 12.8125 on 8/19/93 to settle 8/30/93
TDI sells to Crestar @ 12.87 on 8/19/93 to settle 9/30/93
Crestar sells to First Montauk @12.9375 on 8/19/93 to settle 9/30/93
First Montauk sells to NGL @ 13.25 on 9/01/93 to settle 9/30/93
Bear Stearns sells to First Montauk @ 85 on 9/28/93 to settle 9/30/93
First Montauk sells to Simmons @ 88.875 on 9/28/93 to settle 9/30/93
Simmons sells to Crestar @ 88.90625 on 9/28/93 to settle 9/30/93
Crestar sells to First Montauk @ 89 on 9/29/93 to settle 10/18/93
First Montauk sells to NGL @ 92 on 10/06/93 to settle 10/18/93
Bear Stearns sells to First Montauk @ 49.375 on 4/21/93 to settle 4/30/93
First Montauk sells to TDI @ 52 on 4/21/93 to settle 4/30/93
TDI sells to Crestar @ 52.03125 on 4/27/93 to settle 4/30/93
Crestar sells to First Montauk @ 52.09375 on 4/27/93 to settle 5/28/93
First Montauk sells $750K to American @ 54.6875 on 5/05/93 to settle 5/28/93
First Montauk sells $1MM to American @ 54.6875 on 5/17/93 to settle 5/28/93
First Montauk sells $2MM to NGL @ 54.6875 on 5/25/93 to settle 5/28/93
First Montauk sells $5.6MM to TDI @ 54.6875 on 5/25/93 to settle 5/28/93
First Montauk sells to TDI @ 54.6875 on 5/25/93 to settle 5/28/93
TDI sells to Crestar @ 54.75 on 5/25/93 to settle 5/28/93
Crestar sells to First Montauk @ 54.8125 on 5/26/93 to settle 6/30/93
First Montauk sells $200K to Towler @ 57.5 on 6/17/93 to settle 6/30/93
First Montauk sells $2MM to VASA @ 56.375 on 5/27/93 to settle 6/30/93
First Montauk sells $3.4MM to TDI @ 54.8125 on 6/22/93 to settle 6/30/93
First Montauk sells to TDI @ 54.8125 on 6/22/93 to settle 6/30/93
TDI sells to Crestar @ 54.875 on 6/22/93 to settle 6/30/93
Crestar sells to First Montauk @ 54.9375 on 6/23/93 to settle 7/30/93
First Montauk sells $2.4MM to Escambia @ 57.65625 on 7/23/93 to settle 7/30/93
First Montauk sells $1MM to OL of L @ 57.65625 on 7/09/93 to settle 7/30/93
Escambia sells to First Montauk @ 56.0625 on 9/08/93 to settle 9/30/93
First Montauk sells to Simmons @56.5 on 10/12/93 to settle 10/15/93
Simmons sells to Crestar @ 56.53125 on 10/12/93 to settle 10/15/93
Crestar sells to First Montauk @ 56.59375 on 10/13/93 to settle 11/02/93
Crestar sells to First Montauk @ 56.59375 on 10/13/93 to settle 11/02/93
First Montauk sells to Simmons @ 56.59375 on 11/02/93 to settle 11/04/93
Simmons sells to Crestar @ 56.65625 on 11/02/93 to settle 11/04/93
Crestar sells to First Montauk @ 56.71875 on 11/03/93 to settle 12/30/93
Comp. Capital sells to First Montauk @ 56.25 on 12/21/93 to settle 12/30/93
First Montauk sells to Simmons @ 56.25 on 3/28/94 to settle 3/30/94
Simmons sells to Crestar @ 56.28125 on 3/28/94 to settle 3/30/94
Crestar sells to First Montauk @ 56.34375 on 3/28/94 to settle 4/29/94
Crestar sells to First Montauk @ 14.25 on 6/23/93 to settle 7/30/93
First Montauk sells $3.25MM to Comp. Capital @ 15 on 7/07/93 to settle 7/30/93
First Montauk sells $19.890866MM to TDI @ 14.96875 on 7/27/93 to settle 7/30/93
TDI sells $19.890866MM to Crestar @ 15.03125 on 7/27/93 to settle 7/30/93
Crestar sells $19.890866MM to First Montauk @ 15.09 on 7/28/93 to settle 8/27/93
First Montauk sells $11.890866MM to NGL @ 16.625 on 8/16/93 to settle 8/31/93
First Montauk sells $8MM to American @ 15.8438 on 8/19/93 to settle 8/31/93
American sells to First Montauk @ 35.125 on 1/24/94 to settle 1/26/94
First Montauk sells to Simmons @ 35.125 on 1/24/94 to settle 1/26/94
Simmons sells to Crestar @ 35.15625 on 1/24/94 to settle 1/26/94
Crestar sells to First Montauk @ 35.2188 on 2/04/94 to settle 2/28/94
(Div. Ex. 5, Div. Ex. 13). Although the Division contends that McCook participated in fifteen groups of transactions, I find that the number should be limited to the twelve sets of transactions that are the subject of the stipulation between the Division and McCook, since many underlying documents are not clearly generated by McCook. (Div. Ex. 13.)
I adopt the opinions of the two expert witnesses as described below. What is not included has been rejected after consideration.
Roger Cox was qualified as an expert in the area of trading in CMOs, the nature of the bonds in the instant case. In his expert opinion, the market value of CMOs depends on the characteristics of the particular obligation and complex economic factors, such as prepayment speeds, which may be very sensitive to interest rates (Tr. 230-39). Inverse interest only CMOs are the highest risk in the category (Tr. 240). The pattern of trading in the instant case reveals prearranged trades, excessive price mark-ups, and price manipulation (Tr. 244).
Mark-ups by Crestar and other entities caused the aggregate mark-ups on the CMOs to range from 8 to 20.6% (Tr. 250-51). The trading prices for the CMOs bear no relationship to the market because the CMOs were sold to several entities and bought back from them at fixed predetermined prices and ultimately sold to the customer at the last inflated price (Tr. 261). The difference in the transaction dates made discovery of the simultaneous nature of the transactions more difficult (Tr. 264). Likewise, delays in writing trading tickets increased the likelihood of default but made detection of the simultaneous agreements less likely (Tr. 263-64).
A repurchasing agreement is a short-term investment arrangement between two parties where the very same security is transferred from the buyer to the seller after interest is paid and the security is purchased back by the seller. It is a short-term investment, with the security being held as collateral for the repayment of a loan in effect (Tr. 266-67). In the instant case, because three parties are involved, it cannot be a repurchasing agreement, because the confirmation does not describe the nature of that transaction (Tr. 268). In a dollar-roll transaction, which is common in the CMO market, the transaction also involves only two parties, and the ownership position of the securities remains on the books, even though a buy ticket and sell ticket are generated on the same day and the agreement is to buy it back in thirty days, for purposes of financing (Tr. 268-70). Thus, any legitimate securities transaction is routinely supported by written documentation of the oral agreement (Tr. 270-71). Employees who postpone paperwork associated with a verbal agreement are usually terminated (Tr. 272).
A repo or repurchase agreement is a short-term financing transaction that involves the exchange of collateral for cash at a stated financing rate (Tr. 353). A reverse repo involves the cash and securities in the other direction. From one party's perspective, it is a security sold under agreement to repurchase. From the other party's perspective it is a security purchased under agreement to resell (Tr. 354). Between 1974 and 1983, in his "banking days," Cox had fairly extensive experience with repurchases and how confirmations describing the financing rate and period were filled out for them (Tr. 354-55). A master repurchase agreement might also be generated by an institutional client such as a securities broker-dealer (Tr. 355-57). Cox also engaged in dollar roll transactions, a paired transaction that would generate two order tickets and two confirmations. Instead of a stated financing percentage rate, the financing charge "is embodied in the price difference and the earnings coupon interest . . . on the underlying collateral" for the period of financing (Tr. 358-60). A pre-arranged trade, on the other hand, would involve a verbal commitment to execute a transaction without generating supporting documentation for it (Tr. 359-360).
Because McCook did not determine whether the securities were bought or sold at market prices as opposed to manipulated prices by consulting Bloomberg to evaluate the securities used as collateral, there is no possibility that the fifteen transactions are repurchase transactions or cross-bond transactions (Tr. 383-87). Since the agreements run the securities through a complex loop of buys and sells, they cannot be dollar rolls either (Tr. 386). The transactions are not reofferings of securities because the "mark-up levels . . . imbedded in the transaction prices" are too small and the entire loop is the subject of a simultaneous agreement (Tr. 385-86). The imbedded mark-ups were earned by TDI, Simmons, and Crestar. The excessive mark-ups were earned by First Montauk (Tr. 386-87).
In Cox's opinion, a repurchase agreement does not involve the simultaneous agreement to buy and sell a security (Tr. 388). A repurchase agreement is a collateralized loan, a financing transaction. Instead of a sell, there is maturity of the repurchase agreement, or a close-out if there is no initial stated date. If there is no stated maturity date in an open-ended repurchase agreement, "you will have another ticket that's generated, but simply associated with that ticket; it is a revised or corrected ticket, if you will, that then places a maturity date on the transaction that has occurred" (Tr. 389). The open-ended repurchase is closed out by delivery of "the collateral back to wherever you got it from to begin with, versus the cash payment, with no tickets written for the transaction" (Tr. 389-90).
For a fixed-maturity repurchase, the ticket confirmation would describe the terms of the agreement, and the cash and securities would cross twice as they would in a crossed bond transaction where tickets are also written. Tickets are not written for a reoffering, however, if there is no agreement reached at the reoffered price (Tr. 391-92). In Transaction 13, an agreement to the entire transaction process was reached on January 24 (Div. Ex. 9, Transaction 13). However, the order ticket was not written until February 4 (Div. Ex. 5 at 242). Therefore McCook falsified the order ticket in the opinion of Cox (Tr. 399-400).
Andrew Seth Davidson, the president of Andrew Davidson and Co., a consultant firm that specializes in investment management and risk management, (Tr. 580-81) was qualified as an expert in the area of CMOs in the securities industry (Tr. 602). The five transactions for security 1492 SA, in the instant case, showed steady price increases from the Bear Stearns purchase ranging from 1/32 to 5% regardless of rising or falling prices in the market in 1993 (Tr. 601-08). During October through November 1993, the market value of 1492 SA was about half the price at which the parties in the instant case exchanged the security (Tr. 609-10). Thus the trading practice was an extreme departure from industry norms (Tr. 610). Security 1932 SA, which is the Fannie Mae 9328 SA, was traded by the parties in a more reasonable manner, since it ultimately sold at a "reasonable price" (Tr. 613). The securities are "complex" and "as the markets change, what is reasonable in one environment might be unreasonable in another" (Tr. 612). Market values for the securities at issue could have been obtained by "comparison of them to similar security prices or by calling several dealers, who could furnish prices in a day or two" (Tr. 613-14). For the fifth transaction in the instant case, First Montauk sold to TDI and TDI sells to Crestar, and Crestar sells to First Montauk, and First Montauk "sells that bond to a variety of other parties at a higher price again," so that First Montauk "ends up making a bid ask spread or a profit on this bond twice and with the chain of their ownership broken by some intermediaries who earn about 1/32 or 2/32 profit through their temporary ownership of those particular securities" (Tr. 616-17). It is highly unusual for a broker to use two parties as intermediaries and then get the bond back (Tr. 617).
A repurchase transaction of a CMO in the mortgage market is called "a roll." The transaction usually consists of a buy and sell occurring simultaneously, a short-term interest rate, and a settlement date a month in the future, with the risk of the security remaining with the original holder (Tr. 619). On the trade date balance sheet, the original holder still owns the security, due to the simultaneous sale and repurchase agreement. Thus, in the instant case, for purpose of net capital calculation, the security stays with First Montauk even during the roll or repurchase transaction with Crestar (Tr. 620). Ownership interests and financing interests are clearly very different issues in mortgage trading (Tr. 620). Order tickets are not usually held back for entry on the books several days after a transaction because the delay and dishonesty would result in problems related to accounting, capital, debt inventure, and risk position. The ticket also establishes that the agreement has been accurately recorded (Tr. 621). The transactions in the instant case are not repurchase transactions, because the expert could not "identify a business practice or customary practice that would make sense with inserting a third party in this fashion" (Tr. 624-25).
First Montauk earned the greatest profit as to all the parties to the transactions in 1492 SA in the instant case (Tr. 626). Each party to the sale could have obtained a fair market value price for the security by telephone calls to dealers (Tr. 627-28). Many of First Montauk's customers for these securities earned profits lower than Treasury bond rates and some lost a great deal, because the mark-ups increased the customer's price (Tr. 638-47). The 1492 SA was an inverse floater CMO with a 22% coupon that has a later 7 1/2% yield (Tr. 650). "The roll transaction is extremely common in the mortgage portion of the trading business." In other markets the transaction would be called "repurchase agreements and they'll be slightly restructured" (Tr. 657). For a roll transaction, the trade date books should also reflect that "the risk is still on the books of the original party that held that bond" (Tr. 658). The series of Transactions 14 and 15 as described in Division Exhibit 5, "looks slightly unlike a roll transaction" because the transaction is not computed at a financing rate but instead by the addition of a price increase at the later date (Tr. 658). The series "looks like a roll in terms of the dates of the settle date, the trade dates and settle date. It doesn't look like a roll in the extent of the pricing." The transaction "would be a mispriced roll" (Tr. 658-59). The roll would be mispriced because the 2/32 difference in the price of the security may have been higher than the usual financing rate. The total return on the transaction as a roll should have been about equal to "repo rates during that time period" (Tr. 659). Bloomberg calculates roll transaction market rates in this manner (Tr. 660).
Davidson was asked about general industry practice in recording and accounting for ownership of a CMO that was the subject of a roll. He answered:
These rolls here, there's issues of whether or not these are secured type financing transactions and whether or not you're recording that as an asset or as a contingent liability and I'm not an expert at how every individual institution records those transactions. But generally, you're dealing with either that you record ownership of an asset with a liability or you record a financing transaction with some sort of contingent liability.
Some transactions in the instant case do look like purchase agreements (Tr. 667-73; Div. Ex. 5). The use of repo markets as the primary means to finance inventory by dealers is "very common" (Tr. 674-75). Dealers function in this manner in the ordinary course of business because the firm operates on a "relatively narrow capital margin" (Tr. 675). By financing their highest quality asset, the firm gets "the maximum leverage on their holding" (Tr. 675). Liquid, high-quality securities result in "the maximum amount of borrowing at the lowest possible rate." Because the party on the other side of the transaction can also sell the securities "they are confident of the value of those loans" (Tr. 675).
A dealer cannot always instantly buy and then sell a security to a customer; therefore, "to minimize their inventory and capital requirements while maximizing their profit on that capital," the dealer buys securities often hoping to sell them later at a profit. The dealer then searches for a way "to borrow the financed ownership of that security during that time period" between the acquisition of the security and the final sale to a customer (Tr. 676). That search is "really just driven by efficient use of your capital. So, if you had a million dollars worth of capital and you didn't use any financing, then you could only own a million dollars of securities at any one time period. So through financing, you can have a much larger balance sheet" (Tr. 677).
A third party might be used in a financing transaction in the ordinary course of business. Corporate credit policy may preclude direct financing transactions with a party. Every firm "has a limit how much transaction they can have outstanding with a certain counterparty. So, sometimes a firm can be at that limit." If "firm A would like to sell to firm B, but firm A is already at its limit with a number of outstanding transactions with firm B. So, firm A will sell to firm C, who will then sell to firm B." Such an arrangement is not common because it is usually associated with a money loss (Tr. 678). The fifteen transactions in the instant case could not be repos, rolls, cross-trades, or any transaction in the usual course of the securities business (Tr. 692-93).
CONCLUSIONS OF LAW
The OIP alleges that McCook willfully aided and abetted violations by First Montauk of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5, and 17a-11, thereunder.
The Division argues that net capital limitations restricted First Montauk Houston from holding CMOs in inventory without the permission of First Montauk's president. Thus, the sales staff was required to engage in riskless principal transactions, where a purchaser must be located and committed to the transaction before the firm purchased a CMO (Div. Br. at 1-3). It contends that McCook helped the Houston branch to evade net capital limitations by assisting Hurst, Lynch, and Muller in parking securities at Crestar over month's end in fifteen transactions. If the extra steps had been eliminated, First Montauk would have been required "to reduce its calculated net capital" (Div. Br. at 4). The bonds were thus routed through Simmons and Crestar for the purpose of circumventing First Montauk's net capital requirements (Div. Br. at 5).
According to the Division, the parking transactions caused First Montauk's net capital and books and records to be inaccurate, as described by Kurinsky (Div. Br. at 5). If the Houston branch had not engaged in parking, First Montauk "would have reported net capital deficiencies for April, August, October, and November 1993" (Div. Br. at 6). McCook therefore knew that the third party was inserted mainly to conceal the nature of the transactions (Div. Br. at 7) and he changed trade dates for the same reasons (Div. Br. at 9).
Pursuant to section 15(c) of the Exchange Act and Rule 15c3-1, "A broker or dealer shall maintain net capital of not less than $250,000 if it carries customer or broker or dealer accounts and receives or holds funds or securities for those persons." Section 17(a)(1) of the Exchange Act and Rule 17a-3 demand that "every broker or dealer registered pursuant to section 15 of the [Exchange Act] of 1934, as amended, shall make and keep current the following books and records relating to his business." Implicit in these provisions is the requirement that information contained in a required book or record is accurate. See, e.g., James F. Novak, 47 S.E.C. 892, 897 (1983).
The Commission describes the importance of the records required by the record keeping rules as "the basic source documents and transaction records of a broker-dealer." Statement Regarding the Maintenance of Current Books and Records by Brokers and Dealers, 4 S.E.C. Docket 195, 196 (1974). The record keeping rules are "a keystone of the surveillance of brokers and dealers by our staff and by the security industry's self-regulatory bodies." Edward J. Mawod & Co., 46 S.E.C. 865, 873 n.39 (1977) (citations omitted), aff'd, 591 F.2d 588 (10th Cir. 1979). "Scienter is not required to prove a violation of Section 17(a)(1) of the Exchange Act and the rules thereunder." SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. 587, 610 (S.D.N.Y. 1993), aff'd sub nom. SEC v. Posner, 16 F.3d 520 (2d Cir. 1994) (citing Stead v. SEC, 444 F.2d 713, 716-17 (10th Cir. 1971)).
Rule 17a-3(a) of the Exchange Act, in relevant part, requires the preparation of memoranda by brokers and dealers and maintenance of certain books and records, including:
blotters containing an itemized daily record of all purchases and sales of securities, all receipts and deliveries of securities, all receipts and disbursements of cash and all other debits and credits. Such records shall show the account for which each such transaction was effected, the name and amount of securities, the unit and aggregate purchase or sale price, the trade date, and the name or other designation of the person from whom purchased or received or to whom sold or delivered;
* * *
ledgers (or other records) reflecting . . . repurchase and reverse repurchase agreements;
* * *
memoranda of each brokerage order . . . given or received for the purchase or sale of securities, whether executed or unexecuted, showing the terms and conditions of the order or instructions and of any modification or cancellation thereof, the account, the time of entry, the price at which executed and, to the extent feasible, the time of execution or cancellation; and
* * *
memoranda of each purchase and sale of securities for the account of such member, broker, or dealer showing the price and, to the extent feasible, the time of execution; and, in addition, where such purchase or sale is with a customer other than a broker or dealer, a memorandum of each order received, showing the time of receipt, the terms and conditions of the order, and the account in which it was entered.
Rules 17a-3(a)(1), (4), (6) and (7), 17 C.F.R. § 240.17a-3.
Rule 17a-5(a) of the Exchange Act requires brokers and dealers who clear transactions or carry customer accounts to file accurate quarterly FOCUS Reports, which contain statements of financial condition and income. "FOCUS is an acronym for the Financial and Operational Combined Uniform Single report, which broker-dealers are required to file monthly and quarterly with self-regulatory organizations. The report contains figures on capital, earnings, trade flow, and other required details." Dictionary of Financial and Investment Terms 202 (4th ed. 1995).
Section 15(c)(3) of the Exchange Act and Rule 15c3-1 require that "every broker or dealer shall at all times have and maintain net capital...." In accordance with Rule 17a-11(b), "every broker or dealer whose net capital declines below the minimum amount required . . .shall give notice of such deficiency that same day" to the Commission. This rule is designed to ensure that broker-dealers have sufficient liquid capital to protect the assets of customers and to meet their responsibilities to other broker-dealers. See Lowell H. Listrom, 50 S.E.C. 883, 886 (1992), aff'd, 975 F.2d 866 (8th Cir. 1992) (unpublished table decision); see also Joseph S. Barbera, 2000 WL 1671434, *1 (November 7, 2000). Furthermore, Rule 17a-11(d) also provides that "every broker or dealer who fails to make and keep current the books and records required by Rule 17a-3, shall give notice of this fact that same day . . . specifying the books and records which have not been made or which are not current."
For aiding and abetting liability under the federal securities laws, three elements must be established: (1) a primary or independent securities law violation committed by another party; (2) awareness or knowledge by the aider and abettor that his or her role was part of an overall activity that was improper; and (3) knowing and substantial assistance by the aider and abettor in the conduct that constitutes the violation. See Graham v. SEC, 222 F.3d 994, 1000 (D.C. Cir. 2000); Woods v. Barnett Bank, 765 F.2d 1004, 1009 (11th Cir. 1985); Investors Research Corp. v. SEC, 628 F.2d 168, 178 (D.C. Cir. 1980); IIT v. Cornfield, 619 F.2d 909, 922 (2d Cir. 1980); Woodward v. Metro Bank, 522 F.2d 84, 94-97 (5th Cir. 1975); SEC v. Coffey, 493 F.2d 1304, 1316-17 (6th Cir. 1974); Russo Sec. Inc., 65 SEC Docket 1990, 1998 & n.16 (Oct. 1, 1997); Donald T. Sheldon, 51 S.E.C. 59, 66 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995); William R. Carter, 47 S.E.C. 471, 502-03 (1981). A person cannot escape aiding and abetting liability by claiming ignorance of the securities laws. See Sharon M. Graham, 53 S.E.C. 1072, 1084 n.33 (1998), aff'd, 222 F.3d 994 (D.C. Cir. 2000).
Primary or Independent Violations Committed by First Montauk Sales Staff
The process of determining whether First Montauk violated securities laws must begin with an examination of parking, which is the means by which the books and records violations are alleged to have occurred. Securities parking is, at a minimum, comprised of the following elements:
(1) a pre-arrangement to sell and then buy back securities (to conceal true ownership);
(2) on the same, or substantially the same, terms (thus keeping the market risk entirely on the seller);
(3) for a bad-faith purpose, accomplished through a sham transaction in which nominal title is transferred to the purported buyer while the economic incidents of ownership are left with the purported seller.
Yoshikawa v. SEC, 192 F.3d 1209, 1214 (9th Cir. 1999). Stock parking is a mechanism used to avoid the discount or "haircut" applied by NASD to the securities in the brokerage inventory. To disguise the true ownership of the securities, the brokerage firm engages in a sham transaction whereby the securities change hands long enough to allow the inventory to reflect a sale that avoids the net capital discount. "Once the brokerage firm has filed its NASD report and met its net capital requirement, the firm gets the securities back in a sham buy, usually at the same price for which it sold the securities, plus interest." Id. at 1212. "Haircut is a securities industry term referring to the formulas used in the valuation of securities for the purpose of calculating a broker-dealer's net capital." Dictionary of Financial and Investment Terms 235 (4th ed. 1995).
On the other hand, the mere consideration of required net capital deductions when deciding whether to sell a security from inventory does not create parking upon the sale.
[T]his type of rational economic calculation is to be expected from any NASD firm that is leanly capitalized and must keep careful tabs on its net capital position. Making such strategic economic decisions about the net capital consequences of buying securities into, or selling securities out of, inventory simply does not evince a design to circumvent the net capital rules; if anything, it tends to demonstrate that care is being taken to follow those rules.
Id. at 1219.
In the instant case, Hurst testified that he engaged in the pattern of transactions with McCook and others in order to avoid net capital haircut requirements that Cohen had described to him. I conclude therefore that the sales to McCook and the purchases from McCook described in Division Exhibits 5 and 13 were a pre-arrangement to sell and then buy back securities in order to conceal true ownership on the FOCUS reports for First Montauk.
This conclusion is consistent with the opinions of the experts in the instant case. Cox ascertained that the trading prices for the CMOs bore no relationship to the market because the CMOs changed hands at fixed prices that were set by First Montauk Houston. The bonds were ultimately sold to various First Montauk customers at the last inflated price. Cox also determined that the participation of three parties is not described in the confirmation for the transactions. The concealment of true ownership is accomplished by the participation of three parties and the lack of a written agreement or accurate record. The verbal commitments to execute transactions that did not generate supporting documentation convinced Cox that these were prearranged trades. Davidson also calculated the price increases as higher than the usual interest rates for financing of bond purchases, and he concluded that First Montauk customers often sustained losses as a result of the mark-ups that resulted from the transactions at issue.
As for sales and buy-backs on the same or substantially the same terms, thus keeping the market risk on the seller, I conclude that the actions of First Montauk employees, Hurst, Lynch, and Muller, satisfy this element. An examination of the trades in the instant case reveals asymmetrical settlement dates. See Whiteside, 49 S.E.C. 963, 964-65 (1988). That is, settlement usually occurs close to the sell date of the First Montauk sale, whereas settlement for the repurchase by First Montauk usually occurred several weeks after the First Montauk buy (Div. Ex. 5). These terms were for the primary benefit of First Montauk. Of course, the same is true of the prices, which varied only as a result of the fees charged by Crestar and the inserted third parties. The combination of these terms kept the market risk entirely on First Montauk. First Montauk set all prices on the first day of the agreement, and First Montauk bought the securities back at the price agreed upon, regardless of the market price for the bonds. Thus, the second element of parking has been established.
The third element of parking securities requires that the prearranged sells and buys must be accomplished through a sham transaction in which nominal title is transferred to the purported buyer while the economic incidents of ownership are left with the purported seller. I conclude that the Division has not proved this element by a preponderance of the evidence. This conclusion is based on the prompt sales of the securities by First Montauk to its own customers, the use of coupon benefits by the purchaser, the fees charged to First Montauk by the purchasers, and the refusal of First Montauk to allow its brokers to hold any securities overnight in the Houston branch office.
First Montauk Houston had an agreement with Crestar that left First Montauk obligated to purchase the bonds at the price set by First Montauk regardless of the market price of the bonds at the time of the repurchase. Thus, First Montauk assumed the risk that the market price might fall drastically between the date of the agreement and the date of settlement for the repurchase. However, the Division has proved that each initial agreement was between Crestar and First Montauk, and not between the inserted third party and First Montauk. Thus, when Crestar or First Montauk relinquished the bonds to the third party, ownership passed to the third party. First Montauk was then protected in its repurchase plans by the mere hope that the agreement between the third party and Crestar would proceed as planned.
There is nothing in the record to suggest that between the date of the sale to the third party and the date of the settlement for the third party that the third party had mere nominal title. Likewise, nothing in the record suggests that Crestar was able to collect and earn interest from the coupons with mere nominal title. Indeed, the descriptions of the confirmation process for Crestar and First Montauk established that the back offices of the two firms processed the transactions as isolated buys and sells minus the verbal agreements among the sales staff. Thus, to the back offices the transactions were not shams, because they were not processed as shams. Davidson, the Division's expert, conceded that the transactions could be a means of financing that might be described as a contingent liability (Tr. 660-67). Unlike the respondent president in Charles V. Mercer, 8 SEC Docket 264 (October 24, 1975), who sold securities to accounts that he controlled, and then repurchased them a few days later, in an effort to conceal the true financial condition of his firm, the parties to the agreement here had no economic stake in their firms. In addition, the First Montauk sales were to firms that First Montauk Houston did not control. The parties in the instant case must also be distinguished from respondents in Sumner B. Cotzin, 45 S.E.C. 575 (1974), who transferred securities from the firm accounts to the personal account of the proprietor of the firm to circumvent net capital requirements. In the instant case, the parties had no personal stake in the firms' or in the buyers' accounts.
Finally, in Yoshikawa v. SEC, 192 F.3d 1209 (9th Cir. 1999), the court reversed and remanded where the respondent admitted that he had executed trades among the firm's accounts and several proprietary accounts in order to prevent or reduce the risk of falling below net capital requirements. The trades were executed in order to shift losses out of the inventory account and avoid the required haircuts that would have resulted from the losses. The court described the three-way sales that constituted the alleged parking. It found no parking because the trades had been reported, they were paid with real funds, they were executed mid-month, and they were at market prices.
Likewise, in the instant case, the record does not establish that there was an effort to conceal the trades: I infer that real funds were used for the transactions; only four of the twelve transaction series involved a sale initiated by First Montauk within a week of when the general counsel, Rabinowitz, testified that net capital was computed (at month-end); and expert testimony established that (with the exception of bond tranche 1492 SA) the majority of the transactions among the firms might have been at market prices. Indeed, even the customers of First Montauk probably bought at market price eventually although many earned profits lower than treasury bond notes (Tr. 638-47).
The Division's proof as to fraud established undisclosed mark-ups to customers, not significant departures from market price. Moreover, the experts agreed that establishing a true market price for these CMO tranches was no easy task (Tr. 613-14). I reject the opinion of Cox that the agreements constituted parking transactions because his definition of parking as "an undisclosed ownership in securities" is not consistent with the definition that I have used in the instant case (Tr. 379).
Net Capital Violations
Although I have concluded that the Division has not established parking by First Montauk, there remains the issue of the alleged net capital violations. The Division has proved by a preponderance of the evidence that the FOCUS reports did not include the oral agreement of First Montauk to purchase the CMOs back in the future from Crestar at the point in time when First Montauk sold CMOs to the inserted third party (consisting of Simmons or TDI). I conclude that the oral agreement with Crestar should have been included in the First Montauk FOCUS report as an obligation and thus should have been reflected in its net capital computations. Furthermore, Kurinsky, First Montauk's chief financial officer, conceded that First Montauk should have reported negative net capital for at least four months between April 1993 and November 1993, months that are included in the twelve transactions series that I have already described (Div. Ex. 5, Div. Ex. 6, Div. Ex. 13). Kurinsky's testimony is consistent with the opinion of Davidson, that for purposes of net capital calculations the original holder still owns the security, due to the nature of the agreement (Tr. 619-20).
Books and Records Violations
The net capital violations that I have described above were caused in turn by violations of the securities laws requiring that broker-dealers maintain accurate books and records. The daily blotter at First Montauk Houston was not reviewed for accuracy at the end of each month (Jnt. Ex 16 at 166-67). This failure violated Rule 17a-3(a), which mandates maintenance of accurate "blotters containing an itemized daily record of all purchases and sales of securities, all receipts and deliveries of securities, all receipts and disbursements of cash and all other debits and credits."
First Montauk New Jersey changed several order tickets from Houston to reflect later dates for bond trades, including the $40 million trade with Crestar and NGL that I have described (Jnt. Ex. 16 at 371-75, 379-80; Div. Ex. 5, Div. Ex. 13, Transactions 1 and 2). Cohen at First Montauk New Jersey approved transactions for Hurst that involved back-dating the trading date by three days, from August 19 to August 16, 1993 (Jnt. Ex. 16 at 387-409). Cohen regularly changed dates to conceal simultaneous trades that First Montauk Houston had performed (Jnt. Ex. 15 at 292-300). No repurchase agreements were reduced to writing at First Montauk (Tr. 353-59). These failures constituted violations by First Montauk of sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5, and 17a-11, thereunder. Brokers and dealers must file accurate quarterly FOCUS Reports, which contain statements of financial condition and income; maintain net capital; and give notice when net capital declines below the minimum amount.
Aiding and Abetting Liability
I have concluded that the Division has proved a primary or independent securities law violation by First Montauk, pursuant to their net capital and books and records irregularities. The next element to establish aiding and abetting liability is an awareness or knowledge by the aider and abettor that their role was part of an overall activity that was improper. See Graham v. SEC, 222 F.3d 994, 1000 (D.C. Cir. 2000). I conclude that this element has not been proved.
The Division's expert, Davidson, testified consistently with McCook's version of events although he refused to characterize the transactions as rolls or repurchases, due to the insertion of a third party (Tr. 624-25). Repurchases (or rolls as they are called in the mortgage market) usually do consist of a buy and sell occurring simultaneously, a short-term interest rate, and a settlement date a month in the future, with the risk of the security remaining with the original holder (First Montauk in the instant case) (Tr. 619). The subject of at least five of the twelve transactions that I have found McCook a party to is the bond tranche 1492 SA. It is an inverse floater CMO with a 22% coupon that has a later 7.5% yield.
Davidson acknowledged that some transactions did look like purchase agreements and that financing inventory via repurchases was very common. A firm may operate on such a narrow capital margin that in the ordinary course of business the firm may finance its highest quality asset to get the maximum leverage on the holding. Liquid, high-quality securities allow the firm to borrow the maximum amount of money at the lowest possible rate, because the lender, or the other side, can also sell the securities. Therefore, the lender is confident of the value of the loans (Tr. 667-75). Although McCook never researched the market value of the bonds, I credit his testimony that his experience in the industry plus his history of business with Hurst led him to view these loans as good business for Crestar.
Davidson's explanation of related financial motives for seeking a loan against recently purchased securities also contradicts the Division's theory. Davidson explained that because a dealer cannot always instantly buy and then sell a security to a customer, the dealer buys securities often hoping to sell them later at a profit. The goal is to minimize inventory and capital requirements while maximizing profit on the capital. This rule of efficient use of capital will thus drive the search for a way to borrow the financed ownership of the security during the time period between the acquisition of the security and the final sale to a customer. Thus, if the dealer had a million dollars worth of capital and he did not use financing, he could only own a million dollars in securities during a specific period of time. However, through financing "you can have a much larger balance sheet" (Tr. 677). This strategy for the use of capital was exactly what McCook attributed to First Montauk Houston.
Davidson even supplied a business motive for the use of a third party in a financing transaction in the ordinary course of business. Crestar might have a credit policy inconsistent with direct financing transactions with a party like First Montauk. Every firm limits the transactions that can remain outstanding with one certain counter party. The selling to a third party firm who in turn will sell to the firm seeking the loan would solve the problem of the limit. Davidson observes that such an arrangement would not be common, however, because it is usually associated with a money loss (Tr. 678).
Additional testimony from First Montauk employees supplied reasonable motives for the series of transactions. Kurinsky observed that the prearranged sales could effectively lock in interest rates for the bonds (Tr. 166-67). Muller explained that the repurchase arrangements were sometimes necessary to gain time to locate a customer or to allow the customer to gather funds for the purchase. Thus, the transactions were often the only way to avoid losing a sale (Jnt. Ex. 15 at 239-42). Muller and Lynch both agreed that First Montauk's efforts to buy an entire tranche of a CMO from a primary dealer at bargain rates often led to problems in locating willing and able customers (Jnt Ex. 14 at 297-310, Jnt. Ex. 15 at 347-48).
Accordingly, the evidence presented does not prove the Division's case by a preponderance of the evidence. The Division has not shown that McCook was aware or should have been aware that his role was part of an overall activity that resulted in net capital or books and records violations. Furthermore, the evidence presented bolsters McCook's characterization of usual business conduct and usual business motives and a complete lack of awareness of aiding or abetting improper conduct of First Montauk. I, therefore, am unable to conclude that he knew or should have known that there was something different or improper about First Montauk's conduct.
Finally, Hurst never told McCook that Hurst needed the transactions so that settlement dates could be extended to avoid net capital restrictions for First Montauk (Jnt. Ex. 16 at 321-22). Hurst knew that First Montauk New Jersey changed the trade dates on the orders to avoid net capital restrictions (Jnt. Ex. 16 at 407-09). I am unable to conclude that McCook knew that his role in the transactions was part of an overall activity that was improper. The acts that constituted the improper conduct were performed at First Montauk New Jersey, not at First Montauk Houston. Thus, First Montauk New Jersey computed net capital positions monthly; second, their headquarters were responsible for changing dates on the order tickets; and third, the failure to supervise the sales staff at First Montauk Houston resulted in agreements to trade that were never reduced to writing, inconsistencies in blotter entries, and substantial mark-ups that were not revealed to customers. These improper acts are not alleged to have been committed by any Crestar employees, and they involve no Crestar customer accounts.
There is nothing in the record to suggest that McCook worked near the First Montauk New Jersey employees who engaged in improper conduct. Because no Crestar customers were involved in the transactions, McCook had no duty to investigate or to inquire about the motives or concealed activity of the wrongdoers. Like the respondent in Warren G. Trepp, 65 SEC Docket 614, 640 (Aug. 18, 1997), who was held not to have aided and abetted his customers' misrepresentations and creation of inaccurate financial statements, McCook was too far removed from the perpetrators in the "chain of causation" to be aware of the violations in the instant case. Id. at 640. Thus it is not likely that McCook had actual knowledge of the improper acts.
The Division makes much of the failure of McCook to ascertain the fair market value of the bonds, in spite of McCook's trust in a colleague with whom he had traded for several years and in spite of the complex structure of the bond tranches. It is not likely that McCook would have noticed a pattern in the transactions, which stretched over at least twelve months, at the rate of about one set per month, especially in light of the great volume of other business that he generated at Crestar. McCook attended no meetings held by First Montauk and he was privy to no discussions among First Montauk employees about net capital issues or books and records. Thus, the facts in SEC v. National Student Marketing Corp., 457 F. Supp. 682 (D.C. 1978), are easily distinguishable from the facts in the instant case. In that case, the attorneys were aiders and abettors to material financial misrepresentations that grew out of the decision to proceed with a planned merger in spite of several negative material adjustments to company financial reports. The attorneys were present during the discussions as to whether to proceed with the merger in light of the new information that the shareholders were unaware of. Id. at 700-01. The court held that the attorneys therefore knew of the improper decision to keep the shareholders ignorant of the retroactive adjustments. Unlike McCook, who informed Crestar supervisors about every segment of the transactions via conversations and written records, the attorneys remained silent and "lent the appearance of legitimacy to the closing." Id. at 713. Thus, the attorneys aided and abetted the improper merger transaction. Id. at 714.
McCook's ignorance of any improper acts by First Montauk is demonstrated by his habit of getting approval for each buy and sell series that involved First Montauk and by his creation of tickets for each phase of the transaction approved by Crestar management (Tr. 701-11; Jnt. Ex. 11 at 16-18). There is no evidence that contradicts his testimony that each trade was approved by Crestar management; indeed, that approval process is corroborated by First Montauk sales staff and by the recorded telephone conversations that were admitted into evidence at the hearing. Likewise, McCook's testimony that he had recorded accurate dates for trades except when he was instructed otherwise by Crestar management, is not contradicted by any trial evidence. The taped conversations also demonstrate that McCook resisted requests by First Montauk Houston to alter dates on tickets.
Because I have determined that McCook was unaware that his role was part of an overall activity that was improper, the conclusion should properly be reached at this point that McCook was not an aider and abettor. However, in the alternative, I will proceed to the third element of aiding and abetting. I assume only for these purposes that the Division has proved that McCook knew that his role was part of an overall scheme. The scheme was perpetrated by the broker-dealer First Montauk to frustrate net capital requirements by engaging in security transactions that were not properly described in blotters and order tickers pursuant to the relevant books and records rules. I must now determine whether McCook knowingly and substantially assisted the conduct that constitutes the violation. I conclude that he did not.
In the context of the twelve transaction sets described above, the Division makes much of two acts by McCook. The first act is the insertion of the third parties, Simmons and TDI. The Division contends that the insertion was the result of McCook's suggestion. However, the transcript of the telephone conversation and the unrebutted testimony of McCook established that the suggestion of insertion of the third party into the transactions came from Bailey and Tomlin, the two Crestar managers (Jnt. Ex. 11 at 54-55; Div. Ex. 10 at 30-65). McCook's testimony that he was ignorant as to net capital issues was credible and unrebutted. The Division's own expert witness, Davidson, placed the phenomenon of the third-party insertion in a business context.
It is equally likely that as of April 1993 Crestar Securities no longer wished to risk financing First Montauk Houston's CMO acquisitions. After all, they did present the possibility of volatile market price fluctuations, and a small operation like First Montauk might disavow the repurchase on the next transaction. Thus, for Crestar, the insertion of a third-party spread the risk of disavowal around, and eliminated large direct financing transactions with First Montauk. Thus, Davidson reasoned, in the ordinary course of business it might be in Crestar's best interest to share the risk of disavowal with another bank or broker-dealer (Tr. 678). I conclude that mere corporate credit policy was the basis for Crestar's insistence on a third party. It is also possible that Crestar had sustained a loss in a similar circumstance and did not want to repeat it.
Through the insertion of the third party Crestar was able to enjoy the proceeds of the coupon interest and also assess fees in the form of mark-ups on the bonds, while simultaneously reducing their risk. On the other hand, First Montauk derived no benefit from the third entity. The agreement between First Montauk and Crestar lost the simultaneous exchanges that are characteristic of repurchase agreements, and the acquisition of the bonds by a third party reduced the amount of control that First Montauk could exert over the bonds. Probably most importantly, the fees that First Montauk paid as interest for the financing was increased by 50%, from 2/32 to Crestar to 3/32 to Crestar plus the third-party. To recoup this business cost, First Montauk raised the price of the bonds to its customers, but because it did so without revealing to the customers the extent of the mark-ups, First Montauk found itself in violation of excessive mark-up rules in addition to net capital and books and records rules. Understandably, McCook carried out the instructions of the Crestar managers, not only to please his superiors but also to salvage the First Montauk business, which generated commissions for him. His conjecture that the purpose of the insertion of the third party might be concealment of the transaction demonstrates his awareness of the fact that the Crestar managers might not have fully appreciated compliance issues.
The second act of McCook that the Division characterizes as an act done for the purpose of distorting net capital is the inaccurate dating of the Crestar order tickets. McCook conceded that he did delay writing a ticket for one week pursuant to Hurst's request (Div. Ex. 9 at 26-27, 40-41) and approved by Crestar management (Div. Ex. 9 at 23-25). McCook never asked Hurst or the Crestar managers why the dates should be changed. The Division established a pattern of altered dates for Crestar tickets, which McCook denied doing, and which he attributed to the Crestar back office or Crestar management (Tr. 722-23).
Because the system of supervision for McCook at Crestar did not require him to reduce repurchase agreements to writing or to sign off on matched confirmations or to double check dates and records, it is more likely that Crestar management found it to be in its best interest to change transaction dates than that McCook risked losing his job to accommodate First Montauk and protect the small commission he earned on the transactions. The Division's expert Cox opined that delaying a ticket is a serious transgression (Div. Br. at 9). I find McCook's denials of altering trade tickets to be credible and with the exception of one alteration, any changes in Crestar order tickets were generated by their back office or by management. McCook's accusation of Crestar ticket alteration was not rebutted at trial or by any credible evidence.
McCook had no access to First Montauk's books and records or to First Montauk's data that generated net capital reports. Thus, First Montauk was free to record any date on its order tickets without fear of discovery by McCook. Certainly, there would be no need for the two sets of order tickets to match, given the absence of effective supervision over McCook or over the sales staff at First Montauk. Indeed, McCook assumed that First Montauk tickets accurately recorded the trade dates (Tr. 725-26). The post-hearing stipulation by Smith establishes that Crestar was familiar with repurchase agreements, and the testimony of Kurinsky at First Montauk established that the broker-dealer acted unilaterally in its manipulation of dates and transactions in net capital matters (Tr. 331-32; McCook Br. at 9, 16).
McCook may be in a situation similar to the one that the respondent encountered in Warren G. Trepp, 65 SEC Docket 614 (Aug. 18, 1997). Mr. Trepp kept bonds in his firm's inventory for a fee and at the request of the customer. The administrative law judge held that Trepp had not aided and abetted the customer's violations because Trepp was too remote from the customer's activities to be aware of them or to assist them actively. Id. at 640. However, the decision concluded that Trepp had aided and abetted his own firm's net capital and books and records violations, because Trepp's firm had not disclosed the parking agreement on its own trading tickets. Id. at 637-38. Crestar Securities is not a party in the instant case, but McCook's activities are similarly more likely to have occurred pursuant to Crestar's instructions than pursuant to First Montauk's improper machinations. The Division has not proved that McCook aided and abetted violations of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11, thereunder as alleged in the OIP. Accordingly, this case must be dismissed.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), it is certified that the record includes the items set forth in the Record Index issued by the Secretary of the Commission on November 23, 1999, plus the Judge's Amended Exhibit List issued on October 10, 2001.
IT IS ORDERED that the proceeding against Respondent Robert L. McCook be, and it hereby is, dismissed.
This Order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this Initial Decision may be filed within twenty-one days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within twenty-one days after service of the Initial Decision upon such party, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this Initial Decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the Initial Decision shall not become final as to that party.
Lillian A. McEwen
Administrative Law Judge
|1||Citations to exhibits offered by the Division, Joint Exhibits and the transcript of the hearing will be noted as "Div. Ex. __," "Jnt. Ex. __," and "Tr. __," respectively. McCook's Posthearing Brief and the Division's Posthearing Brief will be noted as "McCook Br. at ___," and "Div. Br. at ___," respectively.|
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