UNITED STATES OF AMERICA
|In the Matter of
|ORDER MAKING FINDINGS,
ORDERING RESPONDENT TO
CEASE AND DESIST, AND
On August 5, 1999, the Securities and Exchange Commission ("Commission") instituted public administrative and cease-and-desist proceedings, pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b) and 21C of the Securities Exchange Act of 1934 ("Exchange Act") against Richard Harriton ("Harriton" or "Respondent").
Harriton has submitted an Offer of Settlement ("Offer") that the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings set forth herein, Harriton, by his Offer, consents to the entry of this Order Making Findings, Ordering Respondent to Cease and Desist, and Imposing Remedial Sanctions ("Order").
On the basis of this Order and the Offer submitted by Harriton, the Commission finds:
1. Richard Harriton, a resident of New York, New York, was at all relevant times president of Bear, Stearns Securities Corp. ("BSSC"). Harriton was at all relevant times a senior managing director of Bear, Stearns & Co., Inc., and a member of its management and compensation committee. Harriton was at all relevant times in charge of BSSC's clearing business.
B. Other Relevant Persons and Entity
1. Bear, Stearns Securities Corp. ("BSSC") is a Delaware corporation with its headquarters in New York, New York. BSSC is a broker-dealer registered with the Commission pursuant to Section 15(b) of the Exchange Act. It is a wholly-owned subsidiary of Bear, Stearns & Co., Inc., which is a wholly-owned subsidiary of The Bear Stearns Companies, Inc.
On August 5, 1999, BSSC consented to the entry of an Order by the Commission, without admitting or denying the Order's findings, instituting proceedings, making findings and imposing sanctions and a cease-and-desist order. The Commission found that BSSC caused violations of the antifraud provisions of the federal securities laws in connection with its clearing relationship with A.R. Baron & Co., Inc. The Commission also found that BSSC aided and abetted and caused Baron's violations of the Commission's net capital and contingency offering rules, and violated the Commission's credit-extension and recordkeeping rules.
2. A. R. Baron & Co., Inc. ("Baron") was a Delaware corporation with its principal place of business in New York, New York. Baron was registered with the Commission as a broker-dealer and was a member of the National Association of Securities Dealers ("NASD").
On May 29, 1996, the Commission issued a Temporary Cease-and-Desist Order against Baron to halt fraudulent practices.1 On June 27, 1996, Baron reported to the NASD that it had insufficient net capital and had ceased doing business. Baron was placed in liquidation pursuant to the Securities Investor Protection Act of 1970 on July 11, 1996. On October 17, 1996, Baron consented to the entry of an Order that, among other relief, revoked Baron's registration as a broker-dealer. The Order also made findings that Baron willfully violated Section 17(a) of the Securities Act and Sections 7(c), 9(a)(2), 9(a)(4), 10(b) and 15(c)(1) of the Exchange Act, Rules 10b-5 and 15c1-2 thereunder, and Regulation T promulgated by the Federal Reserve Board.2
3. Andrew Bressman ("Bressman"), a resident of Norwood, New Jersey, was, at all relevant times, president of Baron. In July 1995, Bressman was fined and suspended by the NASD for markup violations. In October 1996, he was subject to a proceeding brought by the Division of Enforcement for market manipulation. Bressman was indicted by a New York County Grand Jury in May 1997, and in December 1997, pled guilty to enterprise corruption and grand larceny in connection with his operation of Baron.
The violations that form the basis for this action occurred from September 1995 through July 1996, when BSSC was clearing for Baron. Throughout its existence, Baron, a typical boiler- room operation, engaged in widespread sales practice and related violations that defrauded customers of millions of dollars. During BSSC's clearing relationship with Baron, Harriton was a cause of certain of Baron's violations of the antifraud provisions of the federal securities laws and aided and abetted and caused Baron's violations of the Commission's rules governing broker-dealer net capital and the treatment of subscribers' funds in contingency offerings.
In July 1995, when BSSC began clearing for Baron, Baron was in a precarious financial situation, which deteriorated rapidly. Despite tight credit restrictions and other risk management efforts by BSSC, BSSC quickly became a substantial creditor of Baron. To protect BSSC from having to absorb large losses, BSSC, at Harriton's direction, charged unauthorized trades to Baron customers, liquidated property in customer accounts to pay for unauthorized trades, refused to return customer property that had been liquidated to pay for unauthorized trades and disregarded customer instructions. These actions forestalled Baron's collapse and enabled Baron to continue operations while Baron was in continual violation of the Commission's net capital requirements.
Harriton's conduct was a cause of Baron's violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5. Harriton also aided and abetted and caused Baron's violations of Section 15(c) of the Exchange Act and Exchange Act Rules 15c2-4 and 15c3-1.3
D. The Baron Fraud
1. Sales Practice Violations
Bressman and others established Baron in 1992 to underwrite the issuance of securities of small issuers trading in the over-the-counter markets, and to carry on market-making and retail sales of such securities. Baron operated in classic boiler-room fashion. Baron officers and employees placed cheap securities into the hands of family members, favored customers and nominees primarily through public offerings and private placements of the securities that it controlled, its so-called house stocks. Baron's retail sales force then ran up the prices of these securities by aggressively marketing them through the use of fraudulent, high-pressure sales tactics. Baron was able to control the overall market for each security through its market making activities.
There was never an independent market for Baron house stocks. Generally, any customer who bought shares of Baron stocks bought them out of Baron's inventory, and any customer who was permitted to sell shares of the house stocks sold them back into Baron's inventory. Any profits made by a customer selling Baron house stock were at the expense of another customer who later bought the stock out of Baron's inventory at a manipulated price. Few Baron customers ever purchased securities through Baron other than the house stocks.
The principals of Baron enforced a number of formal and informal policies to support the prices of Baron house stocks. The principals maintained a "no net selling rule," pursuant to which Baron brokers usually were not permitted to sell a house stock unless it was accompanied by a "crossing order," i.e., an order from another customer to purchase the same position. Baron brokers discouraged their customers from seeking to sell shares in the house stocks, often by misrepresenting anticipated market forces and company announcements, and were frequently penalized if they permitted their customers to sell.
To generate additional demand for house stocks and to present the appearance of liquidity, Baron brokers frequently purchased shares of house stocks for customer accounts without prior authorization. While many customers complained of unauthorized trading, Baron sometimes persuaded customers to accept unauthorized trades either by applying high pressure sales tactics or by manipulating the price of the stock up by the time payment was due.
2. Baron's Fraudulent Conduct Masked Its True Net Capital Position
During the time that BSSC cleared for Baron, Baron had a precarious net capital position. Baron employed several fraudulent tactics to improve the appearance of its net capital position by reducing the amount of inventory in its trading account and increasing its cash balance.4 The unauthorized trading described above was one means by which Baron sought to mask its true net capital position. If it could trick the customer into ratifying an unauthorized trade, Baron improved its net capital position by replacing a discounted security with cash. If the customer refused to accept the trades, Baron often canceled the trades after several days and then placed an unauthorized transaction in another customer's account so that when net capital was reported, it could at least temporarily claim to have replaced volatile securities with cash.
Another tactic Baron used to conceal inventory and improve its apparent net capital position was to enter into agreements with customers and other broker-dealers to "park" securities in their accounts.5 Baron principals, traders and registered representatives had parking arrangements with Baron customers as well as with other broker-dealers. Toward the end of Baron's existence, BSSC prohibited Baron from maintaining high unpaid customer balances and pressured Baron to sell its inventory to "the street" -- that is, to other broker-dealers, rather than to its retail customers. This directive forced Baron to reduce its unauthorized trading and parking in customer accounts, but led it to increase its parking in accounts at other broker-dealers.
Baron often moved stock out of its inventory through parking arrangements and unauthorized trades close to the end of the business day so that it could end each day appearing to be in compliance with BSSC's requirement that it maintain a specified level of cash on deposit at BSSC, and with the Commission's net capital rule. Baron would then take stock back into its inventory the next morning and, to the extent necessary, repeat the exercise the next afternoon. During the period BSSC cleared for Baron, customers failed to pay for over 80 percent of all purchases after 3:45 p.m.
E. The Relationship Between Clearing Broker and Introducing Broker
Clearing firms such as BSSC provide trade processing, clearance and other "back office" services to smaller, less capitalized brokers and dealers, called introducing firms. The services provided by clearing firms often include maintaining books and records; receipt, custody and delivery of customer securities and funds; extending credit to finance customer transaction in margin accounts; and in many cases, executing transactions on exchanges or on over-the-counter markets.
Pursuant to the applicable self-regulatory organization rules, every agreement between a clearing firm and an introducing firm must identify the division of responsibilities between the two firms.6 While these rules permit an allocation of responsibility for various functions between the introducing firm and the clearing firm, the Commission has emphasized in the release adopting the 1982 amendments to New York Stock Exchange Rule 382, that "no contractual arrangement for the allocation of functions between an introducing and carrying organization can operate to relieve either organization from their respective responsibilities under the federal securities laws and applicable SRO rules." Exchange Act Release No. 18497 (February 19, 1982).
When a clearing firm clears a purchase transaction, the clearing firm commits to pay for the securities purchased and delivers the securities to be sold into the accounts introduced to them by the introducing firm.7 With respect to some cash transactions, there is a period of time before the customer actually pays for the trade when the clearing broker has already committed to pay for the trade. If the customer has not paid for the trade at settlement,8 the clearing firm advances the funds for the trade. If the customer delays payment or ultimately fails to pay, the introducing firm may be responsible for payment if it has agreed to do so under the clearing agreement. Under those circumstances, the introducing firm becomes a debtor of the clearing firm.
When a customer has failed to pay for securities, the clearing firm, who has sought the extension of credit, must sell those securities from the customer's account.9 This transaction is frequently referred to as "selling out" the securities. If the securities are sold for a price that is equal to or greater than the original purchase price, the clearing firm is paid in full for the initial transaction, and there is no loss on the trade. If, however, the securities are sold out at a price less than the initial purchase price, there is a loss on the trade for which the customer, and, possibly, the introducing firm, may be responsible. When such a loss is created from selling out a purchase, the customer agreements typically provide the clearing firm a secured interest in cash and fully paid-for securities in the customer's account. Therefore, the clearing firm, or the introducing firm on its own initiative or at the direction of the clearing firm, can sell (or "liquidate") other securities in the account to cover the loss. If there is no cash or securities available in the customer's account to cover the loss, the loss is unsecured, and the introducing firm or clearing firm must pursue other remedies against the customer.
In the typical fully disclosed relationship between a customer, an introducing firm and a clearing firm, the clearing firm's contact with the customer is limited to transmitting confirmations, account statements and other correspondence such as proxy statements or Regulation T notifications. The introducing firm is responsible for accepting customer orders and other trading instructions. Under these circumstances, the clearing firm's primary (and frequently only) source of information about the customer is the introducing firm. Typically, the customer agreement between the clearing firm and the customer will authorize the clearing firm to accept instructions and orders from the introducing firm for the customer's account without inquiry or investigation, unless the clearing firm receives prior written notice from the customer to the contrary.
F. Harriton on Behalf of BSSC Agrees to Begin Clearing For Financially-Troubled Baron
In late February 1995, Baron's clearing firm, Adler Coleman, went bankrupt and was placed into liquidation under the Securities Investor Protection Act of 1970 ("SIPA"), leaving Baron without a clearing firm and unable to conduct its business. Baron then entered into a clearing relationship with Hanifen Imhoff Clearing Corp. ("Hanifen"). However, after eight weeks, Hanifen notified Baron that it was terminating the relationship due to Baron's numerous unpaid customer trades and indications that Baron was parking stock. With no other firm willing to clear for Baron, Bressman approached BSSC. 10
Harriton was aware of Baron's pending regulatory problems and the status of the Baron house stocks held by the Adler Coleman trustee. Although he was advised by other BSSC managers not to clear for Baron, Harriton decided that BSSC would begin clearing for Baron in June 1995. To limit its credit exposure, BSSC, at Harriton's direction, implemented stringent conditions on Baron's trading activities. BSSC required that Baron have no more than $12 million in customer debits (that is, customer transactions entered into but not yet paid) at any one time, and that Baron maintain at least $5 million on deposit with BSSC at all times as security for such transactions. These conditions placed significant financial pressure on Baron, which already had a history of operating losses and a minimal cushion of excess net capital.
From July 1995 through June 1996, BSSC provided clearing services for Baron on a fully disclosed basis. Similar to most fully-disclosed clearing relationships, BSSC provided back office services to Baron, such as maintaining books and records relating to the accounts of Baron's customers, clearing securities transactions, safekeeping Baron customers' securities and cash balances, and providing credit to Baron customers who traded on margin. BSSC also sent confirmations, monthly statements and dividends directly to Baron customers. BSSC's conduct with respect to Baron, however, extended well beyond these routine clearing functions, and included approving and disapproving trades, providing working capital and, at times, preventing Baron from rescinding certain unauthorized trades.
Further financial pressures on Baron appeared soon after BSSC began clearing for Baron. On July 24, 1995, the NASD imposed sanctions against Baron, including a fine and restitution of over $1.3 million. In addition, the Adler Coleman SIPA trustee had begun selling to the street Adler Coleman's significant inventory of Baron house stocks. These sales exerted downward pressure on the price of these thinly traded stocks and decreased the value of Baron's inventory of these stocks that Baron held in its proprietary account at BSSC. Throughout late July and August 1995, Baron bought from the street large positions of its house stocks to alleviate the downward pressure on the price of its house stocks caused by the SIPA trustee sales.
In certain instances, Baron made unauthorized purchases of these house stocks for its customers' accounts. In other instances, Baron initially purchased the house stocks in its proprietary accounts; in those instances, however, Baron was immediately forced to move the stock out of its proprietary account in order to comply with BSSC's deposit requirements (which prohibited too much concentration of the illiquid house stocks in Baron's inventory), and with the Commission's net capital rule. To remove the illiquid house stocks from Baron's proprietary accounts, and to increase the cash in those accounts, Baron routinely engaged in unauthorized transactions and parking of stock. When, despite the high pressure tactics of Baron salespeople, certain customers refused to pay for the unauthorized trades, the securities had to be sold out. Since the prices of the Baron house stocks were declining throughout this period, the sell-out transaction was usually resulted in a loss, which created a debit in the customer account. Unless there was cash or fully paid-for securities in the account, the debit was unsecured and BSSC was the creditor. As unsecured debits increased, so did the risk that BSSC would not be repaid for the trades it had cleared.
G. Early Signs of Unauthorized Trading
Within the first two months of the clearing relationship, BSSC employees observed signs that Baron was engaging in fraudulent practices. BSSC employees became aware of classic indications of unauthorized trading and parking -- a high incidence of failures to pay for trades, excessive trade cancellations, corrections and credit extensions, numerous customer complaints against Baron and a pattern of stock being sold to customers from Baron's inventory and then purchased back into the inventory by Baron close to settlement at a loss. Baron's trading and nonpayment patterns raised serious concerns at BSSC, to the point that Harriton assured BSSC's Margin Department on August 30, 1995, that he would terminate BSSC's clearing arrangement with Baron in the near future.
Despite Harriton's assurances to BSSC's margin department, BSSC continued to clear for Baron. On August 30, 1995, the NASD informed Bressman that Baron was not in compliance with its net capital requirement and would not be allowed to stay in business unless it raised additional money. Bressman quickly raised $3.5 million in subordinated loans from investors over the Labor Day weekend. When the NASD refused to recognize the new capital until original, signed loan documents were submitted to it, Harriton intervened with the NASD and insisted that Baron be permitted to make markets immediately.
Baron resumed trading on September 7. After seeing significant credit exposure from Baron's trading activity, Harriton assigned a co-manager of BSSC's Relationship Management Group to monitor unpaid purchases and Baron's compliance with BSSC's equity requirements on a daily basis. The manager also performed detailed analyses of Baron's trading patterns which suggested it was making unauthorized trades or parking securities and reported his analyses to his supervisor, who in turn reported them to Harriton.
Additional BSSC staff were required to assist the manager in handling the numerous complaints from Baron customers. Peter Murphy, Harriton's deputy, regularly complained to Harriton about the extensive amount of BSSC staff time consumed by dealing with Baron problems. During the first three months of the clearing relationship, BSSC received over 50 complaints of sales practice abuses by Baron's sales force, which consisted of only a dozen brokers during most of the year BSSC cleared for Baron, and never exceeded 40 brokers.
H. Large Unauthorized Trades
Beyond the information gathered by his staff, Harriton was aware of unauthorized trades at Baron because of his own involvement in these transactions in September 1995. Those transactions involved two Baron house stocks that the Adler Coleman trustee was selling in open market transactions -- Advanced Mammography Systems, Inc. and Cypros Pharmaceuticals Inc. The trustee's sales depressed the price of these stocks, and, in an attempt to reverse the decline, Baron purchased the stock into customer accounts without the customers' authorizations. The transactions occurred in the accounts of at least three customers: Diversified Investment Fund, Inc., Diaward Steel Works, Ltd. and Fiduciary Management Services, Ltd. Had Baron not moved large amounts of its inventory through unauthorized trades into its customer accounts, it would have been apparent from Baron's own books and records that the firm was under its net capital requirement and was required to cease operations.
Throughout August and September 1995, the price of Advanced Mammography, a Baron house stock, was steadily declining. Baron was unable to make bona fide sales of a large amount of Advanced Mammography out of its inventory, but also could not keep the stock in its inventory due to BSSC's restrictions on concentration and its net capital concerns. Baron responded to these pressures by placing large blocks of Advanced Mammography in customer accounts, and either canceling or selling out the trades when customers refused to pay for them. By September 1, Baron had canceled or sold out 72 Advanced Mammography purchases made in customer accounts, and was left holding a large block of stock for which there was little market interest.
On September 1, 1995, Baron "sold" 80,000 shares of its accumulated Advanced Mammography stock for $720,000 to Diversified Investment Fund, Inc. Baron made the sale without authorization, even though Diversified's account was non-discretionary and Diversified had provided written instructions to Baron that all purchases had to be authorized in writing. Diversified complained to BSSC about the unauthorized trade in Advanced Mammography on September 5 (when it first learned of the trade), and refused to pay for the purchase. Harriton was aware of Diversified's complaint.
On September 7, BSSC's chief compliance officer replied to Diversified's complaint, and told Diversified that Baron was responsible for all matters pertaining to execution of transactions. The same day, Harriton instructed Baron to sell out the unpaid trade. Baron sold the securities back to Baron's inventory at a $270,000 loss to Diversified, and entered a $270,000 debit in Diversified's account. As a result, Diversified's account was placed on a 90-day restriction pursuant to the requirements of Regulation T. 11 On September 8, BSSC liquidated approximately $40,000 worth of Diversified's fully paid-for securities (representing all that remained in the account) to cover part of the $270,000 debit that resulted from the sell-out.
On September 13, Baron's chief financial officer stated in writing that the trade was "erroneously entered" into Diversified's account and was "not authorized" by Diversified. On September 22, Baron asked BSSC to reverse it. Reversing the trade would have freed Diversified from the 90-day credit restriction, and would have forced Baron to bear the entire decline in the value of the stock. BSSC refused to reverse the trade in Diversified's account and return the $40,000.
Under continued pressure by BSSC to reduce Baron's inventory of Advanced Mammography stock, Bressman and his leading broker, Roman Okin, decided on September 11, 1995, to move $2.3 million worth of Advanced Mammography through an unauthorized purchase from Baron's proprietary account to the account of Diaward Steel Works, Ltd., an Okin customer. Bressman believed that such a large trade could not be made without Harriton's approval. Consequently, on or about September 11, 1995, Bressman informed Harriton that Baron wished to sell 250,000 shares of Advanced Mammography to Diaward, and asked if BSSC would process the trade. Harriton agreed only after receiving Bressman's assurances that Diaward had significant equity in its account, and that Diaward had signed the BSSC customer agreement, which permitted BSSC to liquidate any customer assets that it held to pay for trades.
The trade could not be processed immediately because, one month earlier, BSSC had imposed a 90-day restriction on Diaward's account as a result of the cancellation of other transactions that Diaward had refused as unauthorized. Indeed, in late August, BSSC had made an inquiry into those purchases after receiving inquiries by Diaward and two other customers. On September 12, upon receiving Baron's explanation that the previous cancellations were Baron's fault, BSSC lifted the restriction on Diaward's account so the $2.3 million Advanced Mammography trade could be made. Okin then made the Advanced Mammography purchase for Diaward's account at a cost of $2.3 million without Diaward's authorization.
Upon receiving the confirmation slip for the trade on September 12, Diaward immediately complained to Baron. Okin then attempted to persuade Diaward to ratify the unauthorized trade by falsely representing that Baron had already sold the securities for Diaward at a $240,000 profit. Okin sent Diaward forged BSSC confirmation slips purporting to show that the profitable sale had occurred on September 12. In fact, the price of Advanced Mammography had declined after the unauthorized trade.
BSSC continued to demand that Baron obtain payment for the transaction. Okin then traveled to Hong Kong the following week to pressure Diaward into paying for the unauthorized trade. While Okin met with Diaward, Bressman telefaxed him a letter falsely corroborating the information in the forged confirmation slips showing the non-existent profitable sale on September 12. Okin told Diaward that it could not receive the profits from the purported sale unless it first paid for the Advanced Mammography stock. Okin failed to persuade Diaward to pay for the unauthorized trade.
Okin's representations made Diaward suspicious. On September 16, Diaward (a long-standing customer of Bear Stearns Asia Limited) wrote a letter to Baron, with a copy to BSSC, directing that Diaward securities be transferred out of the Baron account and into its Bear Stearns account in Hong Kong. In addition, on or about September 19, Diaward submitted the forged confirmation slips to its retail broker at Bear Stearns Asia. The broker told Diaward that the confirmation slips differed from those of Bear Stearns and pulled price data from the computer showing that Advanced Mammography had not traded on September 12 at the price shown on the confirmation slips.
Meanwhile, Harriton and his staff were tracking the Diaward trade on a daily basis and questioning Bressman about it in an effort to obtain payment. Bressman informed them that Okin was traveling to Hong Kong to persuade the customer to pay for the trade. In a September 20 Regulation T notice, BSSC told Diaward that unless BSSC received payment for the purchase by September 25, it would sell out the Advanced Mammography stock to cover the purchase price and hold Diaward responsible for any shortfall. BSSC, in fact, did not wait until September 25. Rather, Harriton directed Baron to sell out the position on September 22, when the value of Diaward's fully paid-for securities, worth approximately $1 million, almost exactly equaled the loss that would result from the sell-out of the Advanced Mammography stock. Baron responded by writing out sell tickets and telefaxing them to BSSC for processing. BSSC then notified Diaward that, unless BSSC received $1 million from Diaward by September 26, BSSC would liquidate fully-paid-for stock in Diaward's account to offset the $1 million loss.
Diaward received the September 20 Regulation T notice from BSSC on September 25. Diaward immediately telefaxed and sent by courier to BSSC a letter expressing shock at BSSC's actions, detailing the conversations with Bear Stearns Asia, and attaching the forged confirmations. Harriton's deputy received the letter no later than September 28 and immediately showed it to Harriton. Harriton called Bressman to his office, showed him the letter and forged confirmation slips, and demanded that Bressman settle the dispute. He did not ask if the forgery allegations were true or otherwise demand an explanation from Bressman or Okin.
Also on September 28, BSSC directed Baron to liquidate Diaward's fully paid-for securities. Bressman complied by writing out the necessary sell tickets and telefaxing them to BSSC for processing. Baron bought Diaward's securities into its own inventory and sold them to other customers later that same day. Harriton allowed the trades to settle on October 3, 1995. Had the Advanced Mammography trade been booked to Baron as it should have been, and not to Diaward, it would have been immediately apparent from Baron's books and records that Baron was in violation of its net capital requirement as a result of the decline in the stock's value. Baron then would have been required to cease operations, exposing BSSC to substantial losses.
On October 6, BSSC sent Diaward a letter, approved by Harriton, which stated that Diaward's request to transfer its securities (an apparent reference to Diaward's letter of September 16 or to a second transfer request made on September 26) was received when the debit balance in Diaward's account was over $1 million, and, therefore, BSSC was unable to follow Diaward's instructions. Although BSSC had sent confirmation slips to Diaward, the letter did not disclose that the debit was the result of the September 22 sell-out of the transaction Diaward previously had complained was unauthorized and that the securities that were the subject of the transfer request were no longer in the account because they had been liquidated on September 28 to cover the debit. In fact, when the letter was sent, all that was left in Diaward's account was a balance of $118.41 from the liquidation. The letter closed by suggesting that Diaward contact Baron to resolve differences concerning the account.
Following the Adler Coleman bankruptcy, the trustee held over 5 percent of the outstanding shares of Cypros. In August 1995, the trustee began selling shares of Cypros, placing downward pressure on the price of that security. The price of Cypros went from $9 per share on August 1, 1995 to $6.50 per share on August 29, 1995.
On August 31, 1995, the NASD notified Baron that it was under its net capital requirement. In addition, a Baron customer wanted to sell 163,000 shares of Cypros that was in his account. Faced with a net capital deficiency, an inventory of declining value, and a customer order to sell 163,000 shares of Cypros, that same day, Baron made an unauthorized purchase of 150,000 shares of Cypros for the account of its customer Fiduciary at a cost of $1,115,000.12
On September 18, after several fruitless complaints to Baron about the unauthorized trade, Fiduciary contacted BSSC. On September 20, Fiduciary received confirmations of a second unauthorized purchase of 104,000 shares of Cypros and again complained to BSSC. When an officer of Fiduciary, Ian Barry, complained directly to officers of BSSC, including Harriton, he was told that Baron was responsible for the conduct, and that he should direct Fiduciary's grievances to Baron. After meeting with Fiduciary, Bressman agreed on behalf of Baron to repay Fiduciary in daily installments through October 6, 1995. However, after making one payment, Baron stopped, largely because Harriton would not permit Baron to sell the Cypros shares that had been placed in Fiduciary's accounts back to Baron's proprietary account (because it would increase Baron's concentration in its house stock and thereby increase BSSC's credit exposure), and there was no other market for a large block of Cypros stock.
I. Harriton Facilitates Baron's Misdirection of Funds from the PaperClip IPO
Also during September 1995, Baron underwrote a best-efforts initial public offering ("IPO") of securities of PaperClip Imaging Software Inc., which it purposely allowed to be oversubscribed by approximately 100%. BSSC did not perform clearing services for the IPO, and had no security interest in the excess funds, which were required to be returned directly to customers.
After obtaining Harriton's agreement to receive the money, but without customer authorization, Baron instructed the escrow agent for the offering to wire the excess subscription money directly to a BSSC account, from which BSSC credited the funds to various Baron customer accounts. Approximately $1.7 million was used to satisfy existing and future customer debits. Despite BSSC's participation in and direct benefit from this arrangement, BSSC never sought customer authorization before accepting the money, and did not return the funds even after some customers complained about the unauthorized use of their funds.
J. BSSC's Actions With Respect to Baron's Trading
By mid-September, BSSC began taking steps to protect itself from Baron's activities. When BSSC first cleared for Baron in July 1995, Baron's traders entered trades into the BSSC system for processing. Due to the large volume of cancellations, corrections and customer complaints; trading patterns suggesting parking or unauthorized trading; and BSSC's credit exposure arising from late day trades that increased concentration of house stocks in Baron's proprietary account, starting September 22, Harriton required that each trade ticket reflecting a trade other than to the street be telefaxed to BSSC. BSSC then determined whether the trade would be allowed based on whether the trade increased BSSC's credit exposure by making Baron a net buyer of its house stocks on that day. If the trade was allowed, the trade ticket was sent to BSSC's order desk for processing.
In addition, from October 3-10, Harriton sent two BSSC employees to Baron's premises to stop trades that increased BSSC's credit exposure -- generally, customer sales to Baron's proprietary account. BSSC held such customer sell orders until the end of the trading day and only permitted them to be executed if they did not adversely affect BSSC's credit exposure. BSSC rejected at least 30 trades that Baron already had accepted from its retail customers. Neither Baron nor BSSC told customers that BSSC had placed conditions on the execution of trades in their accounts, or that BSSC had blocked execution of sales of their securities to their broker.
Harriton also required that Baron's Chief Financial Officer call customers for whom large purchases were being made and verify that the customers had approved the trades, using a script supplied by BSSC, with BSSC employees listening in on the calls. In fact, on October 11, three customers denied any knowledge of the previous day's trades in their accounts.
K. Harriton Temporarily Terminates the Clearing Agreement
On October 11, Harriton called Bressman to his office and told him that he was taking Baron "off the box," i.e., ceasing to clear for Baron's market making activities, because the relationship had become too expensive and risky for BSSC. Without a firm to clear its trades, Baron could no longer make markets in the house stocks that comprised the bulk of its inventory, and the value of that inventory declined immediately and precipitously. Baron could no longer hide its net capital violation from regulators, and the firm was required to cease operations. BSSC was left with an approximately $1 million loss from unpaid trades that Baron lacked the funds to cover.
L. Harriton Resumes BSSC's Clearing Agreement with Baron
Unable to find any other firm willing to clear for Baron, in late October 1995, Bressman asked Harriton to resume the clearing relationship. Bressman promised to raise additional capital and pay BSSC for its losses. Harriton decided on behalf of BSSC to take Baron back, imposing even stricter conditions on Baron's trading activity, including a much lower ceiling on customer debits and a larger deposit (as a percentage of customer debits) as collateral. This decision was made despite substantial evidence of misconduct at Baron.
Before Baron could resume trading, however, it had to satisfy the NASD that its net capital position was stable. Because of Baron's history of net capital violations, the NASD set various limitations on Baron on November 8, 1995, including a requirement that it maintain $720,000 in excess of its net capital requirement of approximately $250,000. When Baron subsequently experienced difficulty in assuring the NASD that it was in compliance with this requirement, Harriton again intervened with the NASD by arguing that Baron should be allowed to resume business. After being told by the NASD that Baron needed additional capital to resume business, Harriton agreed on behalf of BSSC to convert $176,000 that Baron owed BSSC into a subordinated loan of $176,000. Harriton did so knowing that Baron still had not disclosed at least $1 million in liabilities stemming from unauthorized trades, which should have been reflected in Baron's net capital calculations.
Baron resumed trading on November 22, 1995. Harriton placed personnel at Baron offices for six weeks, and required all order tickets to be telefaxed to BSSC for processing. Baron customers continued to complain of unauthorized trading to BSSC, which continued to refer them back to Baron.
M. Harriton Extends BSSC's Clearing Agreement with Baron
At Harriton's direction, BSSC issued a notice to Baron in December 1995 that the clearing relationship would be terminated in 90 days. During this time customer complaints of unauthorized trading continued unabated, and Baron continued to experience net capital problems, notifying the NASD of net capital deficiencies on several occasions. Around the time the 90 days was due to expire, Murphy urged Harriton to allow the termination to occur, noting that BSSC had recouped its million dollar loss from Baron and that there was no economic reason to continue to clear for it. But despite Murphy's urging to follow through with Baron's termination, Harriton did just the opposite, and on March 15, 1996, revoked the termination letter and indefinitely extended Baron's clearing relationship with BSSC.
N. Baron Finally Collapses
Baron's unauthorized trading continued in 1996, and BSSC continued to receive numerous customer complaints. BSSC's relationship manager for Baron received at least two telephone calls a day from Baron customers during the first six months of 1996. Toward May and June, the BSSC relationship manager for Baron was fielding ten such calls a day. BSSC continued to refer complaining customers back to Baron, and continued to clear for it.
On May 29, 1996, the Commission issued an emergency temporary cease-and-desist order against Baron, Bressman and Okin to halt Baron's fraudulent trading practices. Among other things, the order required Baron to employ a special compliance agent, install a telephone taping system, and submit a sworn accounting. On June 5, 1996, Baron notified the NASD and the Commission that it might have been out of net capital compliance as of May 24. Harriton then arranged for BSSC to provide what BSSC termed a "non-purpose" loan of $1.5 million to Baron, which would be collateralized by securities in a wealthy Baron customer's account.13 BSSC wired the money to Baron on June 14. It was quickly consumed, and on June 24, Baron issued another notice that it had fallen out of net capital compliance, and ceased making markets.
Up until the last minute, however, Baron continued engaging in fraudulent practices. On July 1, 1996, the Commission's Division of Enforcement applied for a supplemental temporary cease-and-desist order to enforce the provisions of the prior order, which Baron was violating, obtain asset freezes against it, Bressman and Okin, and for other relief. After filing for bankruptcy on July 3, in an unsuccessful attempt to halt the Commission proceedings, Baron, Bressman and Okin consented to supplemental orders. On July 11, 1996, on the application of the Securities Investor Protection Corporation, Baron was placed into liquidation under the control of an independent trustee.
A. Harriton Was a Cause of Baron's Violations of the Antifraud Provisions
Section 21C of the Exchange Act authorizes the Commission to issue a cease-and-desist order on a showing that respondent was a cause of a securities law violation. Section 21C(a) provides in relevant part:
If the Commission finds after notice and opportunity for a hearing, that any person is violating, has violated, or is about to violate any provision of this title, or any rule or regulation thereunder, the Commission may publish its findings and enter an order requiring such person, and any other person that is, was, or would be a cause of the violation, due to an act or omission the person knew or should have known would contribute to such violation, to cease or desist from committing or causing such violation and any future violation of the same provision, rule, or regulation.14
The guilty pleas of Baron and its principals, as well as the Commission's findings in its actions against Baron, attest to Baron's systematic violations of the antifraud provisions of the federal securities laws.15 As demonstrated by the facts discussed above, Harriton's actions were a cause of Baron's fraud, as defined in Section 21C of the Exchange Act, and enabled Baron to defraud customers during its clearing relationship with BSSC.
B. Harriton Aided and Abetted Baron's Violations of the Net Capital Provisions
Liability for aiding and abetting is established when (1) there is a primary violation; (2) the aider and abettor knew, or was reckless in not knowing of the primary violation, and (3) the aider and abettor provided substantial assistance in the violation. See In the Matter of Russo Secs., Inc. and Ferdinand Russo, Exchange Act Release No. 39181 (Oct. 1, 1997).
Baron violated Section 15(c)(3) of the Exchange Act and Rule 15c3-1 thereunder by conducting a securities business with insufficient net capital. From August 1995 through June 1996, Baron regularly operated in violation of the net capital rule. To hide this fact from regulators, Baron placed proprietary securities into customer and other broker-dealer accounts through unauthorized sales and parking arrangements, and failed to include certain liabilities in its net capital calculations.
Harriton knew, or was reckless in not knowing, that Baron was operating in violation of its net capital requirement. BSSC required Baron to supply BSSC with copies of all financial information and reports filed with its designated examining authority (the NASD) or with the Commission. In addition, Harriton, who required introducing firm principals to sign personal guarantees when their firm's net capital fell below $150,000, made Bressman sign personal guarantees in August, September and November 1995.
By September 28, 1995, when Harriton knew, or was reckless in not knowing, that the Diaward trade was unauthorized, he knew, or was reckless in not knowing, that liquidating $1 million in Diaward's account to satisfy the sell-out deficit would create an additional $1 million liability that was required to be deducted from Baron's net capital. At this time, at a minimum, Harriton had a general awareness of Baron's net capital, which was below $1 million at that time, based on his knowledge of Baron's assets at BSSC and that Baron had little or no assets outside of BSSC. Harriton's knowledge that Baron had all its liquid assets in its proprietary accounts at BSSC is evidenced by his awareness of the numerous times that Baron ran out of money to meet its obligations, of Baron's numerous acknowledged net capital violations, which occurred while BSSC was clearing for Baron, and other indications that Baron had no additional collateral to provide BSSC.
Harriton provided substantial assistance to Baron's violations of the net capital rule by directing BSSC to continue clearing trades for Baron at a time when he knew or was reckless in not knowing that the firm had insufficient net capital. Harriton thus aided and abetted some of Baron's net capital violations.
C. Harriton Aided and Abetted Baron's Violation of Section 15(c)(2) and Rule 15c2-4 of the Exchange Act
Exchange Act Rule 15c2-4 states that when securities are being offered for distribution on an "all or nothing" basis,
it shall constitute a "fraudulent, deceptive, or manipulative act or practice" as used in section 15(c)(2) of the [Exchange] Act, for any broker, dealer or municipal securities dealer participating in any distribution . . . to accept any part of the sale price of any security being distributed unless: . . . all such funds are promptly transmitted to a bank which has agreed in writing to hold all such funds in escrow for the persons who have the beneficial interests therein and to transmit or return such funds directly to the persons entitled thereto when the appropriate event or contingency has occurred.
17 C.F.R. § 240.15c2-4 (emphasis added). As the Commission noted in a 1995 release concerning the requirements of Exchange Act Rule 10b-9 and Exchange Act Rule 15c2-4 as they relate to issuers, underwriters, and broker-dealers engaged in "all or nothing" offerings, "[t]he purpose of the requirements is to insulate the proceeds of the offering from possible unlawful activities by, or financial reversals of, the broker-dealer participating in the offering." Exchange Act Release No. 11532 (July 11, 1995).
Baron's treatment of funds received from certain subscribers who were owed a return of funds from the PaperClip offering violated Rule 15c2-4, because, after placing the subscribers' money in an escrow account at Citibank, Baron did not return their excess money directly to them. Instead, without authorization, Baron instructed Citibank to wire the money to the subscribers' Baron brokerage accounts at BSSC. Baron did so, knowing that BSSC would obtain a secured interest it otherwise would not have had in millions of dollars of customer funds, some of which it would use to offset customer debits. At least $1 million in excess subscription money never was returned to the subscribers because it was used to fund unpaid for purchases and future purchases. Baron engaged in this conduct to pay for customer debits, which otherwise would have been charged to Baron, and to benefit BSSC's position as a Baron creditor.
Harriton knew or was reckless in not knowing that the PaperClip subscribers had not authorized the transmittals of their excess funds to customer accounts at BSSC. By agreeing to and accepting these transmittals on behalf of BSSC, and then asserting BSSC's security interest against the funds, Harriton substantially assisted Baron's violation of Rule 15c2-4.
Based on the above, the Commission finds:
A. That Harriton was a cause of Baron's violations of Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Exchange Act Rule 10b-5.
B. That Harriton willfully aided and abetted and caused Baron's violation of Section 15(c)(2) of the Exchange Act and Exchange Act Rule 15c2-4.
C. That Harriton willfully aided and abetted and caused Baron's violation of Section 15(c)(3) of the Exchange Act and Exchange Act Rule 15c3-1.
Accordingly, pursuant to Section 8A of the Securities Act and Sections 15(b) and 21C of the Exchange Act:
A. IT IS ORDERED that Respondent cease and desist from committing or causing any present or future violation of Section 17(a) of the Securities Act of 1933 [15 U.S.C. § 77q(a)];
B. IT IS ORDERED that Respondent cease and desist from committing or causing any present or future violation of Section 10(b) of the Exchange Act [15 U.S.C. § 78j(b)], and Exchange Act Rule 10b-5 [17 C.F.R. § 240.10b-5] promulgated thereunder;
C. IT IS ORDERED that Respondent cease and desist from causing any present or future violation of Section 15(c)(2) of the Exchange Act [15 U.S.C. § 78o(c)(2)], and Exchange Act Rule 15c2-4 [17 C.F.R. § 240.15c2-4] promulgated thereunder;
D. IT IS ORDERED that Respondent cease and desist from causing any present or future violation of Section 15(c)(3) of the Exchange Act [15 U.S.C. § 78o(3)] and Exchange Act Rule 15c3-1 [17 C.F.R. § 240.15c3-1] promulgated thereunder.
E. IT IS ORDERED that Respondent pay a civil penalty in the amount of $1,000,000 pursuant to Section 21B of the Exchange Act. Payment shall be made within ten (10) days of entry of this Order by U.S. postal money order, certified check, bank cashier's check, or bank money order, made payable to the Securities and Exchange Commission and shall be transmitted by certified mail to the Comptroller, U.S. Securities and Exchange Commission, Mail Stop 0-3, 6432 General Green Way, Alexandria, VA, 22312, under cover of a letter that identifies Harriton and the name and file number of this proceeding. A copy of the cover letter and of the form of payment shall be simultaneously transmitted to counsel for the Commission; Gerald W. Hodgkins, Division of Enforcement, Securities and Exchange Commission; Washington, DC 20549; and
F. IT IS ORDERED that Respondent be, and hereby is, barred from association with any broker or dealer, with the right to reapply for association after two years to the appropriate self-regulatory organization, or if there is none, to the Commission.
By the Commission.
Jonathan G. Katz
|1||On July 3, 1996, Baron filed for Chapter 11 bankruptcy. On July 10, 1996, the Securities Investor Protection Corporation ("SIPC") filed an action for the appointment of a trustee and liquidation of Baron's assets. James W. Giddens of the law firm of Hughes Hubbard & Reed was appointed as trustee the next day. On the Commission's motion, trustees were appointed in the bankruptcies of Baron's president, Andrew Bressman, and a principal registered representative, Roman Okin. The trustees in the Bressman and Okin bankruptcies, in turn, have filed actions against various relatives to recover fraudulently conveyed assets. Both Bressman and Okin have consented to court orders that the Commission's claims against them are nondischargeable.|
|2||On May 13, 1997, the Office of the District Attorney for the County of New York obtained indictments of Baron and 13 of its officers and employees, charging them with criminal securities fraud. The 174 count indictment charged violations of the New York State Enterprise Corruption laws and the Martin Act (New York State's securities law), and charged a scheme to defraud in the first degree and grand larceny. With the exception of Baron's former Chief Financial Officer ("CFO"), John McAndris, all of the parties pled guilty to enterprise corruption and grand larceny, and some are awaiting sentencing. McAndris was tried and on February 26, 1998, was found guilty on 25 charges.|
|3||Section 21C of the Exchange Act authorizes the Commission to issue a cease-and-desist order on a showing that the respondent was a cause of a securities violation. See, infra, III.A., Legal Discussion.|
|4||Baron calculated its net capital based on the securities positions in the firm's trading and other proprietary accounts, and the cash on the firm's books. The formulas used for calculating net capital require that, in addition to discounting all proprietary securities positions, substantial securities positions concentrated in a small number of stocks, as were typically found in Baron's trading accounts, be discounted further.|
|5||"Parking " refers to the practice of concealing stock ownership by placing the stock in the account of a third party, while secretly retaining the obligation to repurchase that stock at a future date. While persons may park stock for a variety of reasons, Baron parked stock to maintain the appearance of compliance with the Commission's net capital rules. As the court explained in SIPC v. Vigman, 908 F.2d 1461, 1464 n. 4 (9th Cir. 1990), rev'd on other grounds sub. nom. Holmes v. SIPC, 503 U.S. 258 (1992), "[p]arking is a mechanism used to evade the net capital requirements. . ." in order to avoid taking a haircut on "stock it holds for its own account" and
[t]o reach technical compliance with its net capital requirements, a brokerage firm "sells" stock from the brokerage's own account to a customer . . . . This avoids the discount for reporting purposes. Once the brokerage firm has filed its report . . . and met its net capital requirement, the firm `buys' the shares back from the customer, usually at the same price at which it sold the stock plus interest.
Because the securities in its proprietary accounts were exclusively house stocks, for which, in calculating net capital, a substantial haircut was required, Baron had a strong incentive to park those stocks before calculating net capital.
|6||See New York Stock Exchange Rule 382; National Association of Securities Dealers Rule 3230; and American Stock Exchange Rule 400.|
|7||When the purchaser and seller in a transaction both are accounts maintained by a clearing firm, the clearing firm does not commit to pay for the trade. Instead, it simply makes the appropriate entries on its books and records to reflect the transactions.|
|8||One reason that a customer might not have paid for the trade by the settlement date is (as frequently happened at Baron) that the trade was not authorized. Other reasons include: (1) the trade may have been on margin; (2) there may be a delay in transmitting funds; or (3) the customer may have changed his or her mind and be refusing the trade.|
|9||Regulation T [12 C.F.R. § 220.8(d) (1995)], promulgated by the Federal Reserve Board, requires that payment for a securities purchase be obtained from a customer within one payment period -- which in 1995-96 was five business days. If payment is not received, the transaction must be canceled or liquidated. A creditor may apply to its designated examining authority (for BSSC, the New York Stock Exchange) for an extension of the payment period if it has a good faith basis to do so; for example, where the check is delayed in the mail. Customer agreements generally provide both the introducing firm and the clearing firm with the right to sell the securities when the customer has not paid.|
|10||BSSC had briefly cleared for Baron in 1992, but terminated the clearing relationship because Baron's concentration in a few house stocks created too much financial exposure for BSSC.|
|11||Pursuant to Regulation T, a cash account must be restricted (or frozen) for 90 days after a trade has been sold out or canceled for nonpayment. During the period of restriction, purchases in cash accounts can be made only if funds are on deposit in the account on the trade date. See In the Matter of Sutro Bros. & Co., Exchange Act Release No. 7052 (April 10, 1963).|
|12||Fiduciary's account had been transferred from another brokerage firm when its account executive moved to Baron. At the time the account was transferred, it contained only investment grade securities. When those securities were sold at Fiduciary's direction, instead of remitting the cash directly to Fiduciary, as instructed, Baron used the cash for the unauthorized transactions described above.|
|13||Harriton previously had required Bressman to get a notarized statement from the wealthy client that all trades in his account at Baron were authorized.|
|14||See In the Matter of Incomnet, Inc., Joel W. Greenberg and Stephen A. Caswell, Exchange Act Release No. 40281 (July 30, 1998).|
|15||See New York v. A.R. Baron & Co., Inc., Litigation Release No. 15363 (May 13, 1997); In the Matter of A.R. Baron & Co., Inc., et al, Exchange Act Release Nos. 37240 (May 23, 1996) (Order to show cause why a Temporary Cease-and Desist Order should not issue); 38236 (May 29, 1996) (imposing a Temporary Cease-and-Desist Order); 37514 and (August 2, 1996) (supplementing the Temporary Cease-and-Desist Order); In the Matter of A.R. Baron & Co., Inc., Exchange Act Release No. 37831 (October 17, 1996) (Order making findings of antifraud violations and revoking registration).|
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