SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 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. : : --------------------------------------------------- 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. ==========================================START OF PAGE 2====== 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. ==========================================START OF PAGE 3====== ==========================================START OF PAGE 4====== 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. ==========================================START OF PAGE 6====== 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. ==========================================START OF PAGE 7====== 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. ==========================================START OF PAGE 8====== 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. ==========================================START OF PAGE 9====== 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). ==========================================START OF PAGE 10====== 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. ==========================================START OF PAGE 11====== 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. ==========================================START OF PAGE 12====== 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." ==========================================START OF PAGE 13====== 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