SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 40335 / August 19, 1998 Admin. Proc. File No. 3-9346 __________________________________________________ : In the Matter of the Application of : : JUSTINE SUSAN FISCHER : 4400 Calle Del Conde : Tucson, AZ 85718 : : For Review of Disciplinary Action Taken by the : : NEW YORK STOCK EXCHANGE, INC. : __________________________________________________: OPINION OF THE COMMISSION NATIONAL SECURITIES EXCHANGE -- REVIEW OF DISCIPLINARY PROCEEDINGS Conduct Inconsistent with Just and Equitable Principles of Trade Making Material Misstatements Regarding Investment Strategy Unauthorized Transactions Excessive Trading Unsuitable Trading Exercise of Discretionary Power Without Written Authorization Registered representative of member firm of national securities exchange omitted to disclose material facts to customers, traded in customer's account without prior written approval and without authorization, and traded excessively and unsuitably in customers' accounts. Held, exchange's findings of violation and the sanctions it imposed are sustained. APPEARANCES: Michael Salcido, of Michael Salcido, P.C., for Justine Susan Fischer. Arthur S. Okun, Mary Brienza, and Sherrill Spatz, for the New York Stock Exchange, Inc. Appeal Filed: September 16, 1997 Last Brief Received: October 30, 1997 I. Justine Susan Fischer, who during the period at issue was a registered representative with PaineWebber, Inc., a member of the New York Stock Exchange, Inc. ("NYSE" or "Exchange"), appeals from NYSE disciplinary action. The Exchange found that Fischer: 1. Engaged in conduct inconsistent with just and equitable principles of trade by: a. making one or more misstatements and/or omitting to state material facts to one or more customers regarding an investment strategy; b. effecting transactions in the account of a customer without the prior approval of the customer; c. engaging in trading in the account of two customers that was excessive in view of the customers' investment objectives, investment experience, and the financial resources in the customers' accounts; and d. effecting margin transactions in the accounts of two customers that were unsuitable in view of the customers' investment objectives, investment experience, and the financial resources in the customers' accounts. [1]/ 2. Violated Exchange Rule 408(a) by exercising discretionary power in the account of a customer, without first obtaining the written authorization of the customer. The Exchange censured Fischer and imposed a bar for one year from employment or association in any capacity with any member or any member organization. We base our findings on an independent review of the record. II. Fischer joined PaineWebber in March 1982 as a registered representative and remained until she was discharged in November 1991. During the mid-to-late 1980s, PaineWebber recommended to its customers the purchase of discounted bonds issued by the Government National Mortgage Association ("GNMA"). The government guarantees the timely payment of both principal and interest on these bonds, which represent pools of underlying mortgages. Thus, investors are guaranteed the amounts due each month. Nevertheless, investors receive the total principal and interest payable on the instruments only if they hold the GNMAs until maturity. With the approval of PaineWebber, Fischer conducted several seminars for the public promoting the cash purchase of securities representing older GNMA pools that were trading at a discount. Subsequently, Fischer began to recommend and use margin to purchase such securities in several of her clients' accounts. Use of margin meant that, if there was a downturn in the bond market, these clients would have to either infuse cash or sell securities to meet margin calls. The Exchange's findings of violation relate to two customer accounts handled by Fischer at PaineWebber. The relevant facts are as follows. A. Lucille Van Campen In May 1983, Lucille Van Campen opened an account with Fischer at PaineWebber. At that time, Van Campen was 70 years old, had a high school education, had retired from a position as a secretary and bookkeeper for a physician, and was working part-time as a computer clerk earning $7 per hour. Van Campen also received $100 a week from a trust fund that had been established in 1978. In May 1984, Van Campen inherited an additional income interest in a trust fund worth $100 weekly. Van Campen owned a townhouse that was valued at about $85,000. At the time she opened her account, Van Campen's prior investment experience was limited to purchases of U.S. Treasury bills and certificates of deposit ("CDs"). The New Account Form for Van Campen, which she testified that she did not see until after she closed the account with Fischer, falsely indicated that Van Campen had a net worth of over $250,000, annual income of $75,000, and real estate valued at $150,000. Initially, Van Campen invested in municipal bonds. After attending PaineWebber seminars, at which Fischer promoted GNMAs as lucrative investments, Van Campen decided to invest in them. She sold her municipal bonds in July 1985 and invested the proceeds, approximately $18,000, in securities representing GNMAs. Van Campen explained to Fischer that she was trying to amass $100,000 for custodial care because she did not have immediate family to care for her. Fischer told Van Campen that the GNMAs would yield a higher rate of return than the municipal bonds. Van Campen also signed a Client Agreement that authorized Fischer to trade on margin in her account. Van Campen did not read the document and did not understand that it allowed for margin trading. Moreover, at the time, Van Campen did not understand that "margin" meant that she was borrowing money from PaineWebber to purchase the GNMAs. Fischer did not explain that, if the bond market fell, Van Campen could either have to infuse cash or sell GNMAs at a loss. Although Van Campen agreed, in general, to let Fischer roll over proceeds in her account, Fischer never asked for nor received written authorization to trade in the account without Van Campen's prior approval. Nevertheless, between November 1986 and August 1987, Fischer bought and sold numerous GNMAs in Van Campen's account. Fischer obtained Van Campen's prior approval for only two transactions in which Fischer needed additional funds for the purchases. For the remainder of the transactions, Fischer acted on a discretionary basis, without seeking Van Campen's authorization. As of December 1986, the Van Campen account had a margin debit balance of approximately $787,300. The margin interest charged to her account in 1986 totaled approximately $40,870. After reviewing her December statement, Van Campen set up a meeting with Fischer because she was concerned about the debit balance. Van Campen testified before the Hearing Exchange Panel that she asked when Fischer was going to sell some of the GNMAs, but Fischer insisted that the account was doing well. Van Campen testified that she came away from their conversation frustrated because "her mission was not accomplished." In April 1987, the value of the GNMAs declined due to a fall in the bond market. At that time, Van Campen contacted Fischer to check on her account. Fischer stated that she was leaving the country, but she advised Van Campen to keep the GNMAs. Shortly thereafter, Rudy Ferlan, Fischer's supervisor at PaineWebber, summoned Van Campen to a meeting at which he asked her for money to meet margin calls. Van Campen, who testified that at this point she lost all confidence in Fischer, requested that her account be transferred from Fischer to another registered representative. B. Patricia and Rudolph Malusa In the spring of 1986, after attending a seminar on GNMAs given by Fischer, Patricia and Rudolph Malusa opened an account with Fischer at PaineWebber. At that time, Rudolph Malusa was 57 years old, had a high school education, and was planning to retire from his position as a technician for a telephone company. Patricia Malusa was 56 years old, had a high school education, and worked part-time as a real estate broker. Their combined net worth, including their residence and three rental properties, was about $300,000. The Malusas informed Fischer that they were interested in conservative, income-producing investments because, after Rudolph Malusa retired, they would have limited income. The New Account Form for the Malusa account confirmed that their highest priorities were income and investment-grade investments. [2]/ In March 1986, the Malusas, relying on Fischer's assurances that GNMAs were safe, secure, and government- backed, purchased $10,390 of discounted GNMAs on a cash basis. A few months later, Fischer suggested that the Malusas "maximize" their account. P. Malusa testified that Fischer did not discuss what "maximizing" meant and did not use the word "margin." Rather, Fischer told P. Malusa that this was a safe strategy that Fischer used in both her own personal account and the accounts of family members and that "nobody had ever lost a cent." According to P. Malusa, Fischer did not explain that, if the bond market fell, the Malusas might have to infuse cash or sell GNMAs at a loss to meet margin calls. Nor did Fischer explain that the government guarantee that the entire amount of principal would be returned applied only if the GNMAs were held to maturity. During the period August 1986 through December 1986, Fischer bought more GNMAs for the Malusas' account. All but one of these purchases were on margin. As of December 31, 1986, the Malusa account had a margin debit balance of approximately $454,112. Margin interest charged to the Malusa account totaled approximately $5,479, which exceeded the GNMA interest earned during the same period by approximately $1,000. In early 1987, the bond market declined. The Malusas received numerous margin calls from PaineWebber. P. Malusa testified that she was not concerned by mailgrams that she received notifying the Malusas of margin calls, because Fischer had told them that mailgrams did not mean anything and were a "joke." Nonetheless, between February and April 1987, Fischer sold GNMAs in the Malusa account to meet valid margin calls without discussing the sales with the Malusas. After receiving their April account statement indicating the sale of several GNMAs, the Malusas became concerned and contacted Fischer to set up a meeting. Fischer, along with Ferlan and a PaineWebber associate who was introduced as a "hedge expert," met with the Malusas. P. Malusa testified before the Panel that they informed the Malusas that: this thing that happened [the bond market fall] would probably never happen again, but just to be sure, that they were going to put this hedge in place. And it was like a seesaw, he said. If this went down, that would go up, and that never would we ever have a problem again, if we could just get our hands on some more money and rescue the account, stabilize the account where it was. Because the Malusas did not have cash on hand, Ferlan suggested that they borrow against one of their life insurance policies to pay down the margin debit in their account, which totaled $232,540. The Malusas also sold their shares of a mutual fund for approximately $9,400 and deposited the proceeds along with the funds from the life insurance policy, which they had been forced to sell, into their account to reduce their margin debt and open a "hedge" account investing in commodity futures. [3]/ Despite the Malusas' desire to reduce their debit balance, between June and August 1987, Fischer purchased more GNMAs on margin for the Malusa account. At the end of August, the margin debit balance had increased to approximately $248,740. Year-to-date margin interest charged to the Malusa account totaled approximately $11,020. III. A. Fischer challenges the Exchange's finding that she made material misstatements or omitted to disclose material facts to PaineWebber's customers about her strategy of trading GNMAs on margin. She asserts that the investments were safe and endorsed by PaineWebber. Fischer claims that trading GNMAs permitted clients to "enjoy the 'spread,'" which appears to be a reference to the discount between the then-current market value of the GNMAs and their face principal value. She further asserts that the leverage afforded by trading on margin permitted clients to multiply the spread "ten times over" since initial margin for these transactions was ten percent. Fischer concedes, however, that her clients could only "enjoy the spread" if they held the GNMAs to maturity. If the market moved against her clients, and they did not have the ability to meet margin calls, the GNMAs would have to be liquidated. The customers would suffer substantial losses if the liquidation occurred below the original discount at which the GNMAs had been purchased. Fischer failed to explain the risks of margin trading to Van Campen and the Malusas and did not explain that additional cash infusions, which neither Van Campen nor the Malusas had the resources to provide, might be necessary in the event of a market downturn. Moreover, when the Malusas received margin calls, Fischer told them to ignore the mailgrams, despite the fact that Fischer sold several of their GNMAs to meet valid margin calls. Fischer further asserts that, if Van Campen and the Malusas had held on to their GNMAs, as she did and as she recommended that they do, they would not have lost any money. At the time, however, Fischer's income was over $100,000, and she had a net worth of approximately $1 million. She, unlike Van Campen and the Malusas, apparently had available funds to cover margin calls. Fischer further represented to Van Campen and the Malusas that the margin interest payments would be covered by the GNMA interest, the "spread" from the account, and the periodic return of the GNMA principal. She argues that the "remaining principal" (which we understand to mean the total amount of principal payments the holder would receive if the GNMA were held to maturity) on the GNMAs always exceeded the margin debt. This assertion was misleading. The return of principal was, in fact, the partial return of the customer's original investment in the GNMA. Using the return of principal to pay interest and commissions meant that these customers would receive the return of their original investment only if the amount of the discount from the face value of the GNMA offset the use of their principal to pay margin interest. Fischer also argues that PaineWebber, through her supervisor, Ferlan, authorized and approved her strategy and all information that she gave to clients. Fischer argues that PaineWebber authorized and encouraged the sale of GNMAs on margin as evidenced by a representative from the New York office who attended and spoke at seminars with her. Fischer, however, cannot use PaineWebber or its employees as a shield. [4]/ PaineWebber promoted selling discounted GNMAs on a cash basis, an investment that the NYSE found was relatively safe. It was Fischer's responsibility to determine which of her customers could suitably engage in margin trading. PaineWebber did not authorize the sale of GNMAs on margin to investors, such as Van Campen and the Malusas, who did not have either the resources or the sophistication necessary to make such investments. B. Fischer also challenges the Exchange's findings both that she violated Exchange Rule 408(a) and engaged in conduct inconsistent with just and equitable principles of trade by exercising discretionary power and effecting transactions in Van Campen's account without first obtaining Van Campen's authorization. Exchange Rule 408(a) prohibits employees of member firms from exercising discretionary power in a customer's account without first obtaining written authorization from the customer. Fischer neither asked for, nor received, written discretionary authority from Van Campen to effect any purchases without Van Campen's prior approval. Fischer does not claim to have received any such written authorization. Fischer argues, however, that Van Campen knew that Fischer was using the funds Van Campen gave her and reinvesting the proceeds from the GNMAs to purchase additional GNMAs. She argues that Van Campen orally authorized the trades and authorized her to reinvest the returns of principal and interest. Van Campen agrees that she orally authorized two sets of purchases of GNMAs and brought money to Fischer to make such transactions. Fischer, however, effected other reinvestments without either Van Campen's prior approval for each transaction or a written authorization for discretionary trading. Fischer also claims that Van Campen never complained about or repudiated any trades. That Van Campen did not complain about the transactions is not a defense. Even assuming that a failure to complain amounted to ratification, we have repeatedly held that ratification of a transaction after the fact does not mean trades were properly authorized. [5]/ C. The Exchange found that Fischer engaged in excessive and unsuitable trading in both the Van Campen and Malusas' accounts. The Division of Enforcement's expert found that the turnover rate in the Van Campen account was 12.7 and in the Malusas' account was 5.2. [6]/ The "break- even return" in the Van Campen account was 111.2%, which means that, in order to pay for the cost of commissions and margin interest, the average annual return in the account would have had to be 111.2% The Van Campen account had one of the highest break-even returns the expert's firm had ever calculated. The Malusas would have needed to earn 48.9% on their investments in order to break even. [7]/ Fischer contends that she did not engage in trading that was excessive in view of Van Campen's and the Malusas' investment objectives, experience, and financial resources. She argues that the Exchange's expert used faulty methods to calculate the "break-even returns" because the expert did not take into account the fact that the GNMAs were sold before maturity. We disagree. The turnover rates and break-even points for these accounts were extremely high. [8]/ Moreover, the Division's expert correctly calculated the break-even returns; Van Campen and the Malusas were forced to sell the GNMAs before maturity in order to meet margin calls. Fischer admits that her strategy was not suitable for these customers. She suggests, however, that this failure involved a "judgment call." We disagree. During the period Fischer was purchasing GNMAs on margin in the Van Campen account, Van Campen paid approximately $57,800 in margin interest and $49,500 in commissions. As of December 1986, Van Campen faced a margin debit balance of $787,300, when her income consisted of only part-time work at $7 an hour and two small trust funds. The Malusas were forced to sell their life insurance policy and a tax-free mutual fund in order to "rescue" the account from margin calls and to avoid liquidating their investments at a market price much lower than that at which the GNMAs had been purchased. Moreover, the Malusas were paying margin interest plus commissions in excess of their annual income, and had margin debt well in excess of their net worth. Over the life of the account, the Malusas incurred margin interest charges of approximately $30,800 and paid approximately $22,600 in commissions. Additionally, the strategy was inappropriate in light of the customers' goals and objectives. While Van Campen wanted to turn her initial investment of $18,000 into $100,000, for custodial care, Fischer's strategy was not appropriate considering Van Campen's net worth, income, and level of sophistication. The Malusas indicated a preference for conservative, income-producing investments. Neither client was interested in nor had the financial resources or experience to engage in highly leveraged trading. [9]/ * * * * * We therefore sustain the NYSE's findings that Fischer made material misstatements regarding investment strategy, engaged in unauthorized transactions and excessive and unsuitable trades, and exercised discretionary power without written authorization. IV. Fischer argues that the sanctions are excessive and that other associated persons who engaged in worse misconduct in unrelated matters have received lighter penalties. Fischer claims that she was not a "rogue broker" and reiterates that her conduct was approved by PaineWebber and Ferlan. Fischer does not challenge the Exchange's finding that she engaged in unsuitable margin transactions in clients' accounts. We have sustained the Exchange's other findings of violations. The totality of Fischer's misconduct reflects a serious misunderstanding of her responsibility to her clients and the nature of what she urged them to do. She recommended a highly risky investment strategy of trading GNMAs on margin to clients who did not understand and could not afford the risks involved, while failing to reveal those risks. Fischer still does not appreciate the significance of her actions. In light of Fischer's serious misconduct, we conclude that the sanctions assessed by the Exchange are neither excessive nor oppressive. An appropriate order will issue. [10]/ By the Commission (Chairman LEVITT and Commissioners JOHNSON, HUNT, and CAREY); Commissioner UNGER not participating. Jonathan G. Katz Secretary **FOOTNOTES** [1]:/ Fischer does not appeal the finding of violation with regard to this part of this charge. [2]:/ The then-current PaineWebber New Account Form listed four categories of risk: income, investment grade, capital gains, and speculative. The form required the customers to rank all four degrees of risk. [3]:/ The NYSE found that, because another registered representative handled the hedge account, Fischer bore no responsibility for that account. [4]:/ A broker has responsibility for his or her own actions and cannot blame others for her own failings. Dan A. Druz, Securities Exchange Act Rel. No. 35203 (Jan. 9, 1995), 58 SEC Docket 1621, 1628 n.18 (branch manager is not excused for his own failure to supervise by the supervisory failing of others in the firm). Moreover, Ferlan settled an action by the Exchange for his failure to supervise Fischer. Rudolph Louis Ferlan, NYSE Case No. 96-3 (Jan. 23, 1996). Fischer complains that her sanctions are more severe than those imposed on Ferlan, but, as we have repeatedly held, sanctions in settled cases may well differ from those in litigated cases. James Alan Schneider, Securities Exchange Act Rel. No. 37463 (July 22, 1996), 62 SEC Docket 1089, 1094. [5]:/ Neil C. Sullivan, 51 S.E.C. 974, 976 (1994); Frank J. Custable, 51 S.E.C. 643, 650 (1993). [6]:/ The turnover rate is computed by dividing the aggregate amount of purchases in an account by either equity in the account (the equity formula) or by the average monthly investment (the Looper formula). The Looper formula represents the cumulative total of the net investment at the end of each month, exclusive of loans, divided by the number of months under consideration. See, Looper & Co., 38 S.E.C. 294, 297 n.6 (1958). The Division's expert testified that the Looper formula is more accurate in the case of GNMAs because determining their price is quite complex. Under the equity formula, which the expert calculated but did not rely on because of pricing difficulties, the turnover rate in the Van Campen account was 23.2 and in the Malusa account was 12.3. [7]:/ Under the equity formula, the break-even return for Van Campen's account was 202.4% and for the Malusas' account was 115.4% [8]:/ See Mihara v. Dean Witter & Co., Inc., 619 F.2d 814, 819 (9th Cir. 1980) (where account turned over approximately 14 times in about two years, turnover reflected churning); Frederick C. Heller, 51 S.E.C. 275, 277 (1993) (where break-even return was 36%, annualized turnover ratio was 6.4, and investments were held for short periods, broker found to have engaged in excessive activity); Shearson Lehman Hutton Inc., 49 S.E.C. 1119, 1122 (1989) (where break-even return was 50% and turnover rate was 7.4, broker's trading was excessive); Samuel B. Franklin & Company, 42 S.E.C. 325, 330 (1964) (turnover rates of 3.5 and 4.4 are excessive). [9]:/ "As we have held, the broker has a duty to satisfy himself that speculative investments are suitable for the customer and that the customer understands and is willing to take the risks." Donald T. Sheldon, 51 S.E.C. 59, 74 n. 59 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995). See also, Henry James Faragalli, Securities Exchange Act Rel. No. 37991 (Nov. 26, 1996), 63 SEC Docket 847. [10]:/ All of the arguments advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed in this opinion. UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. 40335 / August 19, 1998 Admin. Proc. File No. 3-9346 __________________________________________________ : In the Matter of the Application of : : JUSTINE SUSAN FISCHER : 4400 Calle Del Conde : Tucson, AZ 85718 : : For Review of Disciplinary Action Taken by the : : NEW YORK STOCK EXCHANGE, INC. : __________________________________________________: ORDER SUSTAINING DISCIPLINARY ACTION TAKEN BY NATIONAL SECURITIES EXCHANGE On the basis of the Commission's opinion issued this day, it is ORDERED that the disciplinary action taken by the New York Stock Exchange, Inc. against Justine Susan Fischer be, and it hereby is, sustained. By the Commission. Jonathan G. Katz Secretary