SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.
SECURITIES EXCHANGE ACT OF 1934
Rel. No. 37991 / November 26, 1996
Admin. Proc. File No. 3-8639
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:
In the Matter of the Application of :
:
HENRY JAMES FARAGALLI, JR. :
4008 Darby Road :
Bryn Mawr, Pennsylvania 19010 :
:
For Review of Disciplinary Action Taken by the :
:
NEW YORK STOCK EXCHANGE, INC. :
:
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OPINION OF THE COMMISSION
NATIONAL SECURITIES EXCHANGE -- REVIEW OF DISCIPLINARY
PROCEEDINGS
Violations of Exchange Rules
Conduct Inconsistent with Just and Equitable
Principles of Trade
Misrepresentations and Omissions to Customers
Unsuitable Recommendations
Unauthorized Transactions
Failure to Follow Customer's Instructions
Discretionary Trading Without Written
Authorization
Excessive Trading
Improper Outside Accounts
Where registered representative of member firm of
national securities exchange made misrepresentations
and omissions and unsuitable recommendations to
customers, exercised discretionary authority without
customers' prior written approval, engaged in excessive
trading in customer accounts, effected transactions
without the knowledge or authorization of customers,
failed to follow customer instructions, and opened
outside securities accounts without prior written
permission, held, exchange's findings of violations and
the sanctions it imposed sustained.
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APPEARANCES:
Thomas T. Loder, of Rubin & Associates, for Henry J.
Faragalli, Jr.
David P. Doherty, Regina C. Mysliwiec, Rex W. Mixon, Jr.,
Michael Krevor, and Kathleen M. Toner, for the New York Stock
Exchange, Inc.
Appeal filed: March 9, 1995
Last brief received: May 16, 1995
I.
Henry James Faragalli, Jr., who was a registered
representative with PaineWebber Incorporated ("PW" or the "Firm")
and Shearson Lehman Brothers Incorporated ("Shearson"), member
firms of the New York Stock Exchange, Inc. ("NYSE" or the
"Exchange"), appeals from disciplinary action. The NYSE found
that Faragalli made unsuitable recommendations, excessively
traded customer accounts, made untrue statements and omitted to
disclose to customers facts necessary to make his statements not
misleading, failed to follow a customer's instructions, engaged
in unauthorized trading, and broke down customer round-lot equity
positions into odd-lot sell orders to minimize the market impact
of those sales. The Exchange determined that Faragalli's conduct
was inconsistent with just and equitable principles of
trade. -[1]- The Exchange also found that Faragalli
violated NYSE Rule 408(a) by exercising discretionary power in
customer accounts without prior written authorization, and NYSE
Rule 407(b) by maintaining securities accounts at other firms
without obtaining his employer's prior written consent and
arranging for duplicate statements for such accounts to be sent
to his employer.
Faragalli was censured and suspended from membership,
allied membership, approved person status, and from employment or
association in any capacity with any NYSE member or member
organization for a period of nine years. Our findings are based
on an independent review of the record.
-[1]- NYSE Rule 476(a) provides that members and their
employees can be disciplined by the NYSE for
violating any rule of the Exchange or for conduct
that is "inconsistent with just and equitable
principles of trade."
As suggested by the number and variety of findings of
violations, the record in this case is massive, comprising
36 volumes and including roughly 12,000 pages of transcript
of extensive hearings held between 1992 and 1994. The case
against Faragalli was part of a larger investigation of, and
proceedings against, PW and certain of its personnel.
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II.
Faragalli was a salesman in the Philadelphia branch office
of PW between 1984 and 1987, and with Shearson between 1987 and
1994. In early December 1987, PW terminated Faragalli following
the Firm's receipt of numerous customer complaints. Faragalli
then became associated with Shearson. Faragalli left the
securities industry in November 1994.
The record establishes that Faragalli did not invest the
time required to become acquainted with his customers' financial
situations and needs. Significantly, the new account forms for
many of his customers were devoid of any information about the
customer's net worth, annual income, occupation, or dependents.
Although Faragalli claims to have discussed these matters with
his customers, the record indicates otherwise.
Moreover, once the client relationship was established,
Faragalli spent little time responding to his customers' concerns
or providing information concerning his handling of their
accounts. One customer, who had given Faragalli discretionary
authority over her account and whose account Faragalli actively
traded, recalled that Faragalli generally called her once or
twice a month, for about 30 seconds at a time. Faragalli
typically did most of the talking during these conversations, and
discouraged questions. 2/
Throughout the proceedings, Faragalli attempted to blame
others at PW, a downturn in the market, and even his own
customers for the conduct that the NYSE found violative. We
agree with the Exchange that this effort to "entirely offshift
responsibility" is "neither worthy nor credible." 3/
A. EECO Concentration in Customer Accounts
Much of the activity at issue relates to the common stock of
EECO Incorporated ("EECO"), a California-based electronics
manufacturer traded on the American Stock Exchange (the "AMEX").
Although the stock was never recommended by PW, Faragalli
2/ Another customer, for whom Faragalli also exercised
discretionary authority, dubbed Faragalli "the master of the
one-minute phone call." This customer added that whenever
he asked Faragalli "anything substantive about the account,
it was almost always, well, I'll get back to you on that.
And then more often than not, he'd call and had sort of
forgotten the question at that point . . . ."
3/ As we previously have held, "credibility determinations of
an initial fact finder are entitled to considerable weight
[and] can be overcome only where the record contains
`substantial evidence' for doing so." Anthony Tricarico, 51
S.E.C. 457, 460 (1993). See also Universal Camera v.
N.L.R.B., 340 U.S. 474 (1950).
==========================================START OF PAGE 5======
actively solicited the purchase of EECO common stock. By July
1984, a PW Internal Audit Report disclosed that clients of the
Firm's Philadelphia branch office held 428,230 EECO shares, or
26% of the stock's float (roughly 16% of the total outstanding
EECO shares), and that "[s]ubstantially all such shares" were
held by Faragalli's customers. Much of this stock had been
purchased on margin. This report also stated that a "two week
test of daily transactions in EECO (July 2, 1984 through July 13,
1984) disclosed that PaineWebber executed from 44% to 100% of the
daily transactions for the test period." The Report recommended
that, "[i]n view of the illiquid nature of the EECO
concentration, [PW] management must expeditiously determine the
method of reducing or eliminating the EECO concentration on our
books."
As a result of PW's concern, Faragalli was instructed to
raise the equity in his customers' EECO positions initially to
40% and then to 50%. Between September 1984 and September 1985,
the total number of EECO shares held by Faragalli's customers
dropped from roughly 16% of the total number of shares
outstanding to slightly below 12% of the total.
In 1986, however, the number of EECO shares held by
Faragalli's customers began to rise again. Between February and
September 1986, the number of EECO shares held in his customers'
accounts rose from 307,877 to 391,340. By late summer 1986,
Faragalli's customers held over 15% of the total number of EECO
shares outstanding. 4/ During this period, EECO's average
daily trading volume, as averaged over each month, ranged between
4,274 and 16,438 shares.
4/ PW's compliance department had, by this time, become
increasingly alarmed about a number of trading problems in
Faragalli's customer accounts. These problems, which
included trade error corrections, margin violations, trades
through restrictions, and failures to allocate timely block
trades, typically involved EECO. PW's efforts to reduce
these problems had limited success. As a result, in
September 1986, senior PW personnel decided to fire
Faragalli. According to PW's regional compliance officer:
[I]t just did not seem that we were able to
properly contain or discipline or supervise
Henry . . . . That regardless of what we did,
and the directives that we put down, and how
much supervision we did, and the number of
people -- which we had added significant
staff in New York and with the Philadelphia
office to work with him, that it just didn't
seem to be working.
Faragalli appealed this decision to the Firm's president who
reversed it. At the time, Faragalli was the top producing
broker in PW's Philadelphia branch.
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Subsequently, the Philadelphia branch generated a weekly
internal document known as the "Henry Report" which, among other
things, tracked changes in EECO concentration in Faragalli's
customers' accounts. 5/ EECO concentration, however, remained
high and even grew toward the end of 1987. An August 1987
internal PW memo disclosed that, during the first six months of
1987, Faragalli's customers accounted for "48% to 73% of the
total monthly trading volume" in EECO. Moreover, during the last
half of 1987, Faragalli's customers held between 16% and 20% of
the total number of EECO shares outstanding. 6/ Throughout
this period, Faragalli recommended EECO stock to his customers,
without disclosing the extent of the aggregate concentration of
the security in his customers' accounts, or the adverse effect
such concentration had or could have on the stock's liquidity.
EECO's stock price fell dramatically following the general
market break that occurred in mid-October 1987 (the "Market
Break"). Between October 9 and October 29, 1987, the price of
EECO stock fell from $16-1/4 to $10-3/8. 7/ As a result,
several of Faragalli's customers who had purchased EECO on margin
received maintenance calls that were not met. Demand to purchase
EECO was so weak, however, that PW declined to liquidate certain
of its customers' holdings for fear of creating additional
maintenance calls.
Despite the collapse in the EECO market after the Market
Break, Faragalli continued to recommend the security, again
without disclosing its concentration or illiquidity or the
inability to liquidate the existing positions. In May 1990, EECO
filed for bankruptcy.
Omissions of Facts. It is undisputed that Faragalli, both
before and after the Market Break, failed to disclose to at least
10 of his customers the level of EECO concentration at PW or the
implications of that concentration for the stock's liquidity.
Moreover, although Faragalli strongly recommended EECO to his
customers, he failed to disclose that Standard & Poor's had rated
EECO "B" or "below average" with respect to the company's "past
5/ The Henry Report also summarized Faragalli's progress in
correcting the various account trading problems that had
been a continuing source of concern for PW's compliance
department. See n. 4, supra.
6/ These figures do not include the substantial number of
shares held by Faragalli's customers who took possession of
stock certificates and did not hold them in a PW account.
For example, as of December 1, 1987, a single customer of
Faragalli had taken possession of certificates representing
about 68,000 EECO shares, or roughly 1.7% of the total
outstanding. Earlier, in April 1987, another of Faragalli's
customers had taken possession of 37,000 EECO shares.
7/ EECO's closing price for 1987 was $6-1/2.
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performance of earnings and dividends and relative current
standing."
Faragalli contends that EECO was not illiquid, either before
or after the Market Break, and that the record contained "no
proper basis" for the Exchange's finding of illiquidity. We
conclude, however, that the market for EECO was heavily
concentrated in Faragalli's customers' accounts. Under the
circumstances, having recommended EECO stock to his customers,
Faragalli had a duty, which he breached, to disclose the fact of
this concentration, its market implications, and the subsequent
collapse of the EECO market following the Market Break. 8/
As Faragalli knew, PW was deeply concerned about EECO's
liquidity and the concentration of positions in Faragalli's
customers' accounts beginning in 1984. Although Faragalli now
claims EECO was liquid, he earlier had told one of his customers
that he could not sell the customer's holdings because doing so
"would wreck the whole market."
Faragalli claims that PW's failure to liquidate its
customers' EECO holdings following the Market Break was not
caused by a lack of liquidity in the market, but because PW was
confident of a rebound in the stock's price. John Bates, who
testified for the NYSE as an expert witness, stated, however,
that it would have been impossible to liquidate these holdings
except "at a distressed price." 9/ According to Bates, the
market could not "have absorbed all this [EECO] stock . . .
without creating perhaps more havoc for clients . . . ."
Similarly, Faragalli's branch manager, Lee Lovejoy, testified
that, following the Market Break, "we were unable to sell shares
of any size until probably along about January . . . . We were
trying to sell shares whenever possible. It just wasn't
possible." Apparently, one of the few significant sources of
demand for EECO immediately following the Market Break was
Faragalli's own customers. During November alone, his customers
increased their EECO holdings by 50,000 shares.
8/ Faragalli contends that the NYSE's hearing panel's
unsupported finding of illiquidity "tainted" its entire
decision against Faragalli and its characterization of the
evidence. As discussed herein, we believe that the findings
of the Exchange are supported by the record. Hence, we find
no prejudice.
9/ Faragalli notes that a sale of 191,000 shares of EECO stock
was effected on February 6, 1988 without, he claims, adverse
effect on the EECO market. Bates testified, however, that
this sale was hardly typical of the EECO market but
constituted "the culmination of an extraordinary effort on
the part of PaineWebber to locate buyers to take on a fair
share of [EECO] stock." Bates also pointed out that this
and certain other significant trades in EECO during 1988
occurred well after the period at issue.
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Faragalli notes that one expert called by the Division of
Enforcement, William Iommi, the AMEX's executive director of
trading analysis and inquiries, testified that, in 1987, EECO
stock was "pretty liquid, since it seemed that any time anybody
wanted to buy or sell they had no problem doing so." As Iommi
further testified, however, this apparent liquidity was dependent
on PW's support of the market, stating that "[o]bviously
PaineWebber had a lot to do with people being able to sell stock,
since it seemed as if they were a constant buyer during this
period." Iommi also observed that, during 1987, "on most
occasions if [EECO] ticked down you would see PaineWebber come in
with an order to buy to tick it back up . . . ." The impetus
behind PW's purchase of EECO stock was Faragalli. Thus, for
example, during the fall of 1987, purchases by Faragalli's
customers often accounted for well over 60% of all EECO purchases
on a given day.
It is clear, moreover, that Faragalli had to have known of
the risks of concentration. Repeatedly, between 1984 and 1987,
he was warned by PW's compliance department and others at PW
about the extent of his customers' EECO holdings. Additionally,
Firm compliance bulletins posted in PW's branch offices and
discussed at sales meetings emphasized the dangers posed by
concentration. These bulletins, entitled "Concentration -- The
Silent Threat," warned salespersons:
If a large position is accumulated in a
security with a small float, any adverse news
could create selling pressure and make it
difficult to liquidate the concentrated
position without contributing to severe
market erosion. This situation could be
exacerbated if forced selling occurs due to
margin calls.
These bulletins were directed at exactly the kind of situation
presented by EECO, yet Faragalli admittedly failed to alert his
customers to the danger. Faragalli's actions in recommending
EECO without disclosing this and the other facts discussed above
and infra were inconsistent with the NYSE's requirement of just
and equitable principles of trade. 10/
B. Additional Sales Practice Violations
Discretionary Trading
In 1984, Peter Ellison, a widower, opened an account with
Faragalli for himself and a custodial account for each of his two
minor children. The majority of the funds for the custodial
accounts came from an insurance settlement resulting from a car
accident. With Ellison's verbal consent, Faragalli exercised
discretionary authority over these accounts, but failed to obtain
from Ellison the written authorization required by NYSE rules.
10/ See text accompanying n. 18, and following n. 22.
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Faragalli also exercised discretionary authority over the account
of Marilyn Merolli, the widow of a deceased colleague of
Faragalli, without the requisite written authorization.
In exercising such control over these accounts, Faragalli
violated NYSE Rule 408(a) which prohibits the exercise of "any
discretionary power in any customer's account . . . without first
obtaining written authorization of the customer" as well as PW's
own requirements. 11/ Moreover, by failing to obtain the
requisite written authorization, Faragalli kept PW from
discovering his control over these accounts, and prevented the
Firm from subjecting the accounts to the extra degree of scrutiny
normally accorded such accounts pursuant to Firm procedures.
Excessive Trading. Faragalli used his discretionary
authority over the Ellison and Merolli accounts to pursue a
short-term trading strategy that was inconsistent with either
customer's investment objectives. 12/ Faragalli's trading in
Ellison's account produced an annualized turnover rate of 15.4
between April 1, 1984 and December 31, 1987. 13/ The Exchange
further calculated that the annualized "cost/equity maintenance
factor" for Ellison's account for the period at issue was 42.9.
Thus, the account had to increase in value 42.9 percent to break
even. Ellison testified, with respect to his personal account,
that he was seeking growth, capital gains, and a 10 to 15 percent
return, and that he was "willing to accept a reasonable degree of
risk." We believe that, under either measure of account
activity, Faragalli's trading in Ellison's account was excessive,
and violated just and equitable principles of trade.
Merolli had not worked outside the home since marrying in
the late 1960's and wanted to remain at home following her
husband's death to care for their son. She told Faragalli that
she sought "income, but I wanted . . . very, very safe
11/ Prior to exercising discretionary authority, PW required
salespersons to present to the branch manager for approval a
trading authorization executed by the client, together with
a letter from the customer outlining the customer's reasons
for requesting the use of discretion as well as his or her
investment objectives. Faragalli did not comply with these
requirements.
12/ It appears that this strategy was pursued in Ellison's
personal account alone, and not in his children's custodial
accounts.
13/ As we have previously noted, "[t]he turnover rate is `the
ratio of total cost of purchases made for the account during
a given period of time to the amount invested.'" Frederick
C. Heller, 51 S.E.C. 275, 279 (1993). See also Michael H.
Hume, Securities Exchange Act Rel. No. 35608 (April 17,
1995), 59 SEC Docket 347, 349 n. 4; Looper & Co., 38 S.E.C.
294 (1958).
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investments; because I couldn't afford to risk or lose any of the
money that I had." Faragalli's trading in Merolli's account
produced an annualized turnover rate of 7.5, between June 30,
1984 and December 31, 1987, and an annualized cost/equity
maintenance factor of 26.4 for the same period. Under the
circumstances, Faragalli's trading of Merolli's account was
excessive and in violation of Exchange requirements.
Faragalli challenges the Exchange's trading analysis for
failing to take account of securities and other assets held by
Ellison and Merolli away from the Firm. The Exchange's analysis,
which focused solely on securities held at PW, was fully
consistent with precedent, and appropriate under the
circumstances. 14/ By its very nature, excessive trading is
measured by looking at the assets under the salesman's control.
As we previously have observed, a "customer's wealth certainly
`does not provide a basis for engaging in excessive trading in
his account.'" 15/
Unsuitable Recommendations. Ellison sought "growth" for his
children's custodial accounts through "conservative" investments
so that the children would have enough money to pay for college
in 10 years. Faragalli used his discretionary authority over the
accounts to amass large blocks of EECO stock. By spring 1987,
each account was heavily concentrated in EECO, with well over
$100,000 in the security. 16/ In April 1987, his branch
manager, Lovejoy, told Faragalli that the custodial accounts
should be diversified. Faragalli ignored this advice, and kept
the accounts almost entirely in EECO through the Market Break.
Moreover, over time, Faragalli substantially increased
Ellison's personal holding of EECO stock. In February 1987, for
example, the account held roughly 6,500 EECO shares, worth
approximately $111,000 at that time. The account's total equity
14/ Cf. Peter C. Bucchieri, Securities Exchange Act Rel. No.
37218 (May 14, 1996), 61 SEC Docket 2771, 2778 (observing
that "the assets by which the rate of activity is to be
measured are those in the account, not other assets that the
customer may possess," in finding a violation of the NASD's
rule against excessive trading); Frederick Heller, 51 S.E.C.
at 279-80 (rejecting claim that excessive trading analysis
under NASD rules had to consider assets other than those in
the account at issue). Additionally, Bates testified that,
in not including "off-statement assets in the calculation of
turnover," the Division's analysis was consistent with
industry practice.
15/ Frederick Heller, 51 S.E.C. at 280 (citation omitted).
16/ Ellison's son held 6,825 EECO shares, worth $109,200, out of
a total net equity in the account of $122,547, and Ellison's
daughter held 9,575 shares, worth $153,200, out of a total
net equity of $153,951.
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was only $45,000. Thus, Ellison's EECO holdings represented
approximately 250% of the equity in his account, a concentration
level described as "absurd" by Bates. 17/
Faragalli also concentrated Merolli's account in EECO.
Initially, upon assuming responsibility for the account following
the death of Merolli's husband in 1980, Faragalli recommended
conservative, income-producing investments which were consistent
with Merolli's needs and objectives. Over the years, however, as
Faragalli assumed increasing control over the account, his
recommendations became far more aggressive and speculative,
although Merolli's objectives remained the same. Although
Merolli expressed deep reservations about EECO stock at various
times from 1984 through 1987, Faragalli repeatedly persuaded her
not to sell, telling her that if she would "hang in there a
little longer, it's really going to double." 18/ By the end
of 1987, Faragalli had acquired 10,100 EECO shares for Merolli's
account, which constituted 96% of the account's long market
value.
Faragalli also recommended that Merolli engage in a
significant amount of margin trading without explaining the
associated risks. Merolli had not had a margin account prior to
her husband's death and demonstrated a general aversion to debt
in her financial dealings. 19/ On Faragalli's recommendation,
however, she maintained a margin debt throughout most of the
period Faragalli controlled her account. In 1986, well before
the Market Break, Merolli's account had accumulated a margin debt
of $106,000 on equity of just $64,000. 20/ After the collapse
in EECO prices following the Market Break, Merolli called
Faragalli, who told her not to open her account statements "for
the next few months" because "its all gonna come back." 21/
17/ Ellison ultimately settled claims against PW and Faragalli
for close to $100,000.
18/ Faragalli further assured Merolli by asking her "with your
[husband] up there looking down on me, would I do anything
wrong to you or your son?"
19/ For example, Merolli did not carry a balance on her credit
cards or a mortgage on her home.
20/ According to Bates, margin is "a sophisticated tool" which
was wholly inappropriate for this account. See Timoleon
Nicholaou, 51 S.E.C. 1215, 1217 (1994) (salesperson's
improper use of margin in customer's account violated just
and equitable principles of trade), aff'd, No. 94-3990 (6th
Cir.), 1996 WL 140339 (unpublished opinion).
21/ Ultimately, Merolli settled with PW and received a payment
of $85,000 plus the elimination of her account's margin debt
of roughly $39,000.
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Thomas Thompson, a musical agent in his 70s, opened an
account with Faragalli in the summer of 1987. The funds for this
account came from a lump-sum retirement payout Thompson received
in 1986 upon turning 70. Thompson's accountant described
Thompson as "not a very sophisticated individual [or] financially
astute . . . a neophyte as far as his investment knowledge [who]
relied on the advice of other people." The accountant added that
Thompson was a "very, very, very conservative investor." 22/
Thompson told Faragalli that he wanted "taxfree investments
that would pay a regular income mainly," and that he did not want
to speculate. Among other securities, Faragalli recommended
EECO, telling Thompson that it was "growing very fast . . . a
sure thing." Faragalli also recommended that Thompson open a
margin account.
Based on Faragalli's recommendation, Thompson authorized the
purchase of a "reasonable amount" of EECO stock. 23/
Faragalli, however, purchased over 5,000 shares of EECO for the
account during the first month the account was opened. By the
end of October 1987, Thompson's account held 12,000 EECO shares
and a margin debit balance of $155,509. As of the end of 1987,
Thompson's losses on his account with Faragalli were over
$100,000.
Donald Henry and his wife opened a joint margin account with
Faragalli in about 1969. Neither of the Henrys had any prior
experience or education related to investing. Henry owned, with
his brother, a small machine shop where Henry worked. Henry's
wife was a teacher's aide. They reported total adjusted gross
income for each of 1986 and 1987 of under $50,000.
Henry described himself to Faragalli as a "very
conservative" investor. He told Faragalli that he and his wife
"didn't have a lot of money, and . . . wanted to make a good
return . . . better than the banks; . . . and a little bit of
growth." He also told Faragalli that he wanted "stable
securities." Although they discussed the Henrys' investment
objectives, Faragalli never asked the Henrys about their
financial situation.
22/ Thompson previously had invested his retirement payout with
another brokerage firm and had suffered a substantial loss.
Although Faragalli points to Thompson's prior account to
suggest that Thompson was an experienced investor, Thompson
was largely uninvolved in the management of that earlier
account. As with Faragalli, Thompson relied on the
salesperson involved to advise him about investments that
suited his needs and objectives.
23/ Although Thompson expressed some doubts about the stock, he
accepted Faragalli's recommendation because he "figured that
Mr. Faragalli knew what he was doing, and what he was doing
was in my best interests."
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Henry and his brother also opened a cash account for their
business. Henry's objectives for the business account were even
more conservative. That account was intended to invest, for
short periods, excess cash generated by the business. Henry
testified that he had to "make sure that [he was] not going to
lose it or anything's going to happen to it."
During 1986-1987, Faragalli encouraged the Henrys to acquire
a large block of EECO stock. By the end of October 1987, the
Henrys held close to $100,000 in EECO stock, out of a total long
market value of $158,168 in their account. In addition, their
margin account had a debit balance of close to $109,000. The
Henrys were concerned about their level of margin exposure. They
repeatedly asked Faragalli to reduce their EECO stake, but
Faragalli assured them that everything was fine and told them to
trust him. Shortly after the Market Break, Faragalli recommended
that Henry buy at least 2,000 shares of EECO stock for the
business account. At some point in November 1987, the Henrys,
who had placed their life savings in the PW account, received a
margin call for over $100,000, which they met by obtaining a bank
loan.
* * * *
Faragalli's recommendations to these customers were
unsuitable and violated just and equitable principles of trade.
Faragalli defends his recommendations by pointing to the
purported affluence of his customers. 24/ We previously have
observed, however, that, for a broker to recommend risky or
speculative investments such as EECO, "[h]e must be satisfied
that the customer fully understands the risks involved and is not
only able but willing to take those risks." 25/ A customer's
wealth, in other words, does not give a salesperson a license to
disregard the customer's investment objectives. Faragalli's
customers were seeking conservative, income-producing
investments, and did not wish to speculate. In recommending that
they use margin to acquire large, relatively illiquid
concentrations of EECO, Faragalli clearly disregarded his
customers' investment objectives.
24/ Faragalli does not argue that Ellison's alleged wealth made
Faragalli's trades in the children's account suitable.
Indeed, Faragalli does not appear to challenge the finding
of unsuitability made with respect to either of the
custodial accounts.
25/ Cf. Arthur Joseph Lewis, 50 S.E.C. 747, 749 (1991) (applying
the NASD's suitability rule) (emphasis in the original).
See also Eugene J. Erdos, 47 S.E.C. 985, 989 (1983) (finding
a violation of the NASD's suitability rule because
salesperson's recommendations were inconsistent with the
customer's "financial situation and needs.").
==========================================START OF PAGE 14======
In addition, Faragalli's estimates of these customers'
wealth are of questionable reliability. For example, the
"$350,000 in real estate holdings" that Faragalli attributes to
Merolli was based on an estimate Faragalli solicited from a real
estate salesperson of the value of houses in Merolli's
neighborhood. Merolli testified that the home was worth less
than $200,000. 26/ Faragalli claimed that Thompson's assets
included two homes: "one on New York City's exclusive Upper West
Side and one in exclusive Westchester County." Thompson
testified, however, that he did not own the New York apartment,
and the home he did own was not in Westchester County. Faragalli
also apparently substantially overvalued the Henrys' machine
shop. Moreover, although certain of these customers could
arguably be considered affluent, the bulk of their assets were
illiquid, consisting, for the most part, of real estate or
ownership interests in closely-held businesses.
Unauthorized Trading and Failure to Follow Instructions.
During 1987, Faragalli made unauthorized purchases of EECO stock
for the accounts of three different customers: David Singer,
William McMahon, and David Christensen. On October 16, 1987,
Faragalli recommended the purchase of 1,000 shares of EECO stock
to Singer, and told Singer that he would be able to sell the
stock in a short time for a profit. Singer declined to buy the
stock. Faragalli called Singer later in the day to repeat the
recommendation, and Singer declined again. Faragalli called
Singer a third time that day and told Singer that he had
purchased the stock for Singer's account. Singer repeated that
he did not want to purchase the shares. Upon receiving
confirmation for the trade, Singer complained to Faragalli, who
said that he was "taking care" of it. Singer complained to
Faragalli's branch manager, Lovejoy, in November, when the stock
remained in his account. 27/
26/ Moreover, Faragalli obtained this estimate six years after
the period at issue in this case, and thus could not have
considered it at the time.
27/ Faragalli cites Lovejoy's testimony that, in October 1987,
Faragalli's sales assistant told Lovejoy that Singer had
verbally agreed to send PW $7,500 to meet the margin call
triggered by this purchase. Faragalli argues that this two-
level hearsay evidence constitutes a "confess[ion]" by
Singer that he authorized the purchase.
Singer unequivocally denied authorizing the purchase or
offering to make partial payment to satisfy margin
requirements: "I never mentioned that I would send seventy-
five hundred dollars. It never even dawned on me to send
any money whatsoever." As indicated, we consider Singer's
credited testimony to be more reliable than Lovejoy's
hearsay testimony.
==========================================START OF PAGE 15======
William McMahon authorized the purchase of a total of 1,000
shares of EECO during September and October 1987. Faragalli,
however, purchased a total of 2,300 shares for McMahon's account,
the purchase of 1,300 shares having never been authorized. 28/
Christensen authorized Faragalli to purchase for
Christensen's personal account 5,200 shares of EECO stock between
March and October 1987. Faragalli, however, purchased a total of
twice that number of shares during this period.
In August 1987, Christensen directed Faragalli to open a
corporate account for Christensen's business, and to invest
$200,000 of the business' funds in a government bond mutual fund.
Christensen told Faragalli that, unlike the funds in his personal
account, he "wanted to be pretty careful with" his business'
funds. Faragalli never opened the corporate account, but instead
purchased $200,000 of the bond fund for Christensen's personal
account. 29/
Faragalli claims that the trades at issue were
authorized, and that Christensen never directed him to open a
corporate account. 30/ The Exchange, which heard Faragalli's
testimony as well as the customers' contrary testimony, declined
to credit Faragalli. We see no reason to disturb that
28/ Faragalli does not appear to challenge the Exchange's
findings of violation with respect to McMahon's account in
his brief to us.
29/ Faragalli denies that Christensen directed him to open a
corporate account. He notes that, in a letter from
Christensen, dated November 3, 1987, Christensen stated
that, at the time of the bond fund purchase, he "neglected
to tell [Faragalli] to issue them in the company name."
Christensen testified, however, that he wrote this letter
"as a favor" to Faragalli, who "dictated" the language, and
that, in fact, the statement was false. In addition, a
letter from Christensen in early October 1987, demanded that
the bond fund be moved "immediately" out of his personal
account, and makes no reference to any error on
Christensen's part as being the cause of the funds'
misplacement. Moreover, in his brief to us, Faragalli
himself inexplicably questioned the authenticity of
Christensen's November 3 letter.
30/ Faragalli contends that he would have had no reason for not
opening the corporate account had Christensen so directed.
By placing the bond fund in Christensen's personal margin
account, rather than in a separate corporate account as
directed, however, Faragalli could use the fund to finance
additional margin purchases of EECO.
==========================================START OF PAGE 16======
determination. 31/ We find that Faragalli violated just and
equitable principles of trade by engaging in unauthorized trading
in these three accounts and by failing to follow Christensen's
instructions.
C. Outside Accounts
Between 1985 and 1990, Faragalli and members of his family
opened at least nine accounts at brokerage firms other than PW or
Shearson, without the permission of his employer. Most of these
accounts were held in the name of Faragalli's wife, Katherine
Marietta Faragalli ("KMF"), who maintained several accounts at
Merrill Lynch (including custodial accounts for the Faragallis'
children and a joint account with Faragalli), and at Thomson
McKinnon Securities, Inc. ("Thomson McKinnon") and A.F.
Investments, Inc. ("AF"). Faragalli's brother, Michael
Faragalli, was, at different times, a salesman at Thomson
McKinnon and AF. Faragalli, who controlled each of these
accounts, used some of them to trade in EECO. For example, KMF's
Thomson McKinnon account bought EECO stock in 25 separate
transactions between August and September 1988.
In October 1988, Thomson McKinnon first notified Shearson
that KMF had accounts with Thomson McKinnon. Shearson told
Faragalli that such outside accounts were prohibited. Although
Faragalli closed these accounts, he retained the accounts at
Merrill Lynch that had not yet been discovered by Shearson, and
continued trading in EECO. When, in the fall of 1989, Merrill
Lynch discovered that Faragalli had not obtained Shearson's
authorization for these accounts, it asked him to do so. Merrill
Lynch closed the accounts when Faragalli was unable to obtain
Shearson's authorization.
At roughly the same time that Faragalli's Merrill Lynch
accounts were discovered, Faragalli "lent" his brother between
$5,000 and $10,000 to trade EECO in an account in his brother's
name at Prudential Bache, his brother's employer at that
time. 32/ Although Faragalli and his brother deny it,
Faragalli apparently directed his brother's trading of EECO in
this account. 33/
31/ See n. 3, supra.
32/ During the last two months of 1989, for example, Michael
Faragalli bought EECO stock on over 30 separate occasions in
this account.
33/ Michael Faragalli earlier had told a Prudential Bache
official that he traded EECO at Faragalli's direction. In
addition, Faragalli's brother admitted that he had over
$370,000 in another securities account. We question his
need to "borrow" funds from Faragalli.
==========================================START OF PAGE 17======
Faragalli's conduct violated NYSE Rule 407(b), which
prohibits a registered representative from having securities
accounts "with respect to which he has the power, directly or
indirectly, to make investment decisions," at another firm or
bank "without the prior written consent" of his employing firm.
Faragalli also failed to have duplicate reports and monthly
statements of these outside accounts sent to his employer, as
required by NYSE Rule 407(b). 34/
III.
Faragalli raises various procedural arguments.
A. Faragalli argues that, because all but one of the
allegations relate to actions that occurred more than four years
before the NYSE filed its charges, these proceedings are barred
by the three-year statute of limitations announced by the Supreme
Court in Lampf v. Gilbertson, 501 U.S. 350 (1991).
We have previously held, however, that Lampf is inapplicable
to proceedings of this kind. 35/ To the contrary, it is well
34/ The practice also violated PW's and Shearson's own internal
rules. Indeed, Faragalli's branch manager at Shearson
testified that he did not allow any of his salespersons to
have outside accounts, regardless of the circumstances,
because of the resulting supervisory difficulties.
At the NYSE hearing (but not in his brief to us), Faragalli
did not deny that he violated the express terms of this
rule, but claimed that he lacked any intent to do so or to
use these accounts for any improper purpose. There is,
however, no scienter requirement with respect to NYSE Rule
407(b).
Moreover, we do not believe Faragalli's current claim that
he was oblivious to the rule's requirements, about which he
had been informed as early as 1969 and which were well known
at PW. It also appears that Faragalli took steps to conceal
these accounts from his employers, including stating that he
was "unemployed" or "self-employed" on new account forms at
one of the outside firms.
35/ See Steven B. Theys, 51 S.E.C. 473, 480 (1993).
We note that, prior to the commencement of hearings in this
matter, Faragalli sought a declaratory judgement to the
effect that the proceedings were time barred. This motion
was denied based on a lack of subject matter jurisdiction.
Faragalli v. New York Stock Exchange, Civ. No. 92-3791 (Aug.
31, 1992 E.D. Penn.).
(continued...)
==========================================START OF PAGE 18======
established that no statute of limitations applies to the
disciplinary actions of the Exchange or other self-regulatory
organizations ("SROs"). 36/ Apart from the applicability of
this limitation, Faragalli failed to establish that he was
35/(...continued)
Faragalli's suggestion that these proceedings are governed
by Pennsylvania law is incorrect. They are governed by the
NYSE's rules
36/ Frederick C. Heller, 51 S.E.C. 275, 280 (1993). As we there
observed, "a limitations period . . . would impair [a self
regulatory organization's] statutory obligation and duty to
protect the public and discipline its members." Id.
We note that the United States Court of Appeals for the
District of Columbia Circuit recently ruled that the statute
of limitations contained in 28 U.S.C. Section 2462
prohibited this Commission from imposing a censure and a
supervisory suspension in an administrative proceeding
because the proceeding had been initiated more than five
years after the conduct at issue. Johnson v. SEC, No. 95-
1340 (D.C. Cir. June 21, 1996), rehearing denied (Aug. 28,
1996). Johnson is distinguishable from this case because
there the action was brought by this Commission, not, as
here, by an SRO.
SROs are private organizations that operate subject to a
scheme of government regulation. Many courts and this
Commission have determined that SROs are not subject to the
requirements applicable to a government agency. See, e.g.,
Shultz v. SEC, 614 F.2d 561, 569 (7th Cir. 1980) (Chicago
Board Options Exchange not "authority of the government" and
thus not governed by the Administrative Procedure Act);
United States v. Solomon, 509 F.2d 863, 868-71 (2d Cir.
1975) (self-incrimination privilege does not apply to
questioning in New York Stock Exchange proceeding); Daniel
Turov, 51 S.E.C. 235, 238 (1992) (Fifth, Sixth, and Seventh
Amendments to United States Constitution do not apply to New
York Stock Exchange, which is not a government agency);
Sumner B. Cotzin, 45 S.E.C. 575, 578 (1974) (NASD not a
federal agency subject to strictures of the Administrative
Procedure Act). We believe that Johnson is inapplicable to
SRO proceedings. In any event, much of the conduct at issue
in this case occurred within five years of the institution
of proceedings, and all of the violations culminated within
that period. Thus, these proceedings would not be barred by
Section 2462 even if that section were deemed to apply. See
also Larry Ira Klein, Securities Exchange Act Rel. No. 37835
(October 17, 1996), __ SEC Docket ____.
==========================================START OF PAGE 19======
prejudiced because of the delay, although invited to do so at the
hearing. 37/
B. Faragalli complains about the admission of complaint
letters from 45 of his customers who did not testify in these
proceedings. Faragalli contends that the customers' complaints
were outside the scope of the Division's allegations in that
"[n]one of these witnesses were named or described in the
charges, and none appeared as witnesses." 38/
Although these customers did not testify at the hearing,
they were listed in an appendix to the Division's complaint as
being among those to whom Faragalli failed to disclose EECO's
concentration and who complained to the Firm concerning EECO
transactions in their accounts. 39/ Consequently, Faragalli
was on notice that the allegations of the Division encompassed
the complaints of these customers.
The NYSE's Hearing Officer stated that these letters were
admitted for the purpose of establishing the dates on which the
complaints were made to counter Faragalli's contentions that PW
fomented discontent among his otherwise satisfied customers after
Faragalli left the Firm. The Exchange's findings of violation
were made with specific reference to one or more of the customers
37/ See, e.g., Howard Alweil, 51 S.E.C. 14, 16 (1992).
While most of the allegations in this case relate to conduct
that occurred in the fall of 1987 prior to the Market Break,
some relate to actions occurring as late as January 1990.
Under the circumstances, we do not believe that Faragalli
was prejudiced.
Faragalli's request to have the question of whether a
particular statute of limitation applies to these
proceedings certified to the United States Court of Appeals
for the Third Circuit is denied. His further request for a
stay pending an appeal of that issue is now moot.
38/ Faragalli cites, as evidence of the prejudicial impact of
the admission of these letters, the fact that the Exchange's
decision noted that PW paid a total of $3 million to these
and other of Faragalli's customers in settlement of their
claims. The fact that PW decided to settle with Faragalli's
customers is not unduly prejudicial to Faragalli. Faragalli
had the opportunity to, and did, explain why such
settlements did not reflect his own liability.
39/ The Division twice offered, during an evidentiary hearing,
to call "many" of these customers as witnesses, but this
offer apparently was declined by Faragalli's attorney.
==========================================START OF PAGE 20======
who testified at the hearing, and were not based upon the
allegations made in these letters. 40/
We note that the Exchange found Faragalli not guilty on one
of the nine charges against him, and declined to find him guilty
on the remaining charges with respect to certain of the customers
who testified. We conclude that the NYSE carefully considered
each of the charges, as well as the supporting testimony,
separately. There is no indication that the Exchange's findings
of violation were based, as Faragalli alleges, upon some vague
notion that, in light of these complaint letters, Faragalli was
"a bad man" who "must have done something."
C. Faragalli complains about the admission of NYSE exhibits
that summarize trading in EECO by all of Faragalli's customers.
Faragalli claims that these exhibits were somehow designed to
establish that Faragalli was manipulating the EECO market.
The NYSE's complaint does not allege that Faragalli engaged
in a manipulation, and neither the Exchange nor we have made such
a finding against Faragalli. 41/ The evidence of which
Faragalli complains was, however, directly relevant to certain
central issues in the case: Faragalli's knowledge of the EECO
market, the degree to which it was concentrated, and his possible
efforts to mask that concentration. We therefore find no error
in the Exchange's decision to admit this evidence. 42/
40/ It is well established that "hearsay statements may be
admitted as evidence and, in an appropriate case, may even
form the sole basis for findings of fact." Mark James
Hankoff, 50 S.E.C. 1009, 1012 (1992), and the cases there
cited. The cases cited by Faragalli to support his
contention that he was improperly denied the right to
confront the authors of the complaint letters involved
criminal proceedings, and are inapplicable to disciplinary
proceedings.
41/ We note, however, that at least one of the Division's
charges specifically incorporated an allegation of
manipulative activity, by stating that Faragalli's odd lot
trading was done "with the purpose and/or effect of
minimizing the market impact of these sales on the price of
the stock . . . ." Although the Exchange found Faragalli
guilty of this charge, we have not. See n. 46, infra.
42/ Faragalli further complains that the Division delayed its
introduction of these documents until "just three hearing[]
[sessions] before the . . . record was closed." The
documents, which consisted primarily of PW business records,
and summaries and compilations of previously admitted
evidence, were introduced on March 2 and March 3, 1994,
during the Division's cross examination of Faragalli.
Following March 3, the hearing was adjourned until March 23,
(continued...)
==========================================START OF PAGE 21======
D. Faragalli complains that NYSE procedures do not permit a
respondent to require production of documents by witnesses who
appear for the Division, which he claims "cripples a Respondent's
ability to defend." 43/ The NYSE stated that Faragalli was
granted access to virtually all of its investigatory files. The
rules governing the proceedings of the Exchange have been
approved by this Commission pursuant to the requirements of the
Securities Exchange Act of 1934.
Although Faragalli argues that additional discovery would
have materially assisted his defense, his only specific claim is
made with respect to Singer. Faragalli suggests that Singer's
trading records from accounts at unrelated broker-dealers might
have demonstrated that Singer was buying stock at the time that
the alleged unauthorized trade occurred in Singer's account. If
Singer made such trades, Faragalli claims, it would undermine his
assertion that he could not have authorized the purchase because
he lacked sufficient funds. Singer's supposed trading in other
accounts would not demonstrate whether he authorized the trade at
issue. The NYSE, which heard both Faragalli and Singer testify,
credited Singer's assertion that he had not authorized the trade.
We see no reason to reject that determination. 44/
IV.
Faragalli contends that the sanctions are excessive. He
notes that, aside from these and related proceedings, he has
never been subject to disciplinary or customer-initiated
42/(...continued)
1994, when Faragalli was subject to redirect testimony by
his lawyer. Thus, Faragalli had nearly three weeks to
review this evidence. It appears that, at least with
respect to certain of these documents, Faragalli's lawyer
waived objection to their admission.
43/ Faragalli claims that he was able to refute charges made
with respect to two of the ten customers who testified
against him because he was able to introduce documents (such
as trading records at firms other than PW) obtained through
another proceeding or voluntary cooperation. Faragalli
suggests that he would have been able successfully to defend
against allegations relating to other customers had he had
similar access to potentially exculpatory documents in the
possession of customers. Although it is true that the
Exchange declined to find, as alleged, that Faragalli had
made unauthorized trades in the accounts of both customers,
and had made unsuitable recommendations to one and engaged
in improper odd-lot trading in the second account, the basis
for the Exchange's decision to dismiss certain violations is
unclear. Given the evidence, we might have reached
different conclusions.
44/ See n. 3, supra.
==========================================START OF PAGE 22======
arbitration proceedings. He contends that, for the most part,
his "career was complaint free and exemplary." 45/
We believe that, in imposing these sanctions, the NYSE
properly considered the wide-ranging scope and serious nature of
Faragalli's misconduct. The record in this case provides ample
evidence of serious misconduct over several years at two
different firms and involving numerous customers. Faragalli
betrayed the trust that these customers placed in him.
Additionally, we are troubled by Faragalli's complete
unwillingness to recognize anything amiss in his actions, as well
as by his continuing efforts to blame the Market Break, PW, and
even his own customers for his predicament. Under the
circumstances, we do not find the sanctions imposed by the
Exchange to be oppressive or excessive. 46/
45/ Faragalli also contends that the sanctions imposed on him
are disproportionately severe when compared to those imposed
on his supervisors at PW. It is well settled that the
appropriate remedial action depends on the facts and
circumstances of each particular case and cannot be
determined precisely by comparison with the action taken in
other cases. See Butz v. Glover Livestock Commission Co.,
Inc., 411 U.S. 182, 187 (1973); Hinkle Northwest, Inc., 47
S.E.C. 12, 18-19 (1978), aff'd, 641 F.2d 1304 (9th Cir.
1981). Moreover, the supervisors settled the cases against
them, and "in settled cases we take into account pragmatic
considerations such as the avoidance of time-consuming and
manpower-consuming adversary proceedings." Blinder,
Robinson & Co., Inc., 48 S.E.C. 624, 636 n. 36 (1986). See
also David A. Gingras, 50 S.E.C. 1286, 1294 (1992).
46/ The Exchange also found Faragalli liable for violating just
and equitable principles of trade in connection with his
breaking up round-lot EECO positions in the accounts of two
of his customers and selling them as odd lots to minimize
the market impact. Although the record indicates that
Faragalli engaged in this practice on hundreds of occasions
in the accounts of numerous customers, the Exchange
inexplicably made findings that this particular violation
occurred with respect to only a small number of trades in
just two accounts. We believe that the Exchange failed to
establish that these trades had, or that Faragalli intended
that they have, an impact on the EECO market. As indicated,
our determination not to sustain this finding of violation
does not justify a reduction in the sanctions imposed by the
Exchange.
==========================================START OF PAGE 23======
An appropriate order will issue. 47/
By the Commission (Chairman LEVITT and Commissioners JOHNSON
and HUNT); Commissioner WALLMAN not participating.
Jonathan G. Katz
Secretary
47/ 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. 37991 / November 26, 1996
Admin. Proc. File No. 3-8639
---------------------------------------------------
:
In the Matter of the Application of :
:
HENRY JAMES FARAGALLI, JR. :
4008 Darby Road :
Bryn Mawr, Pennsylvania 19010 :
:
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 Henry James Faragalli, Jr. be, and
it hereby is, sustained.
By the Commission.
Jonathan G. Katz
Secretary