UNITED STATES OF AMERICA
In the Matter of
KENT T. BLACK,
| ORDER MAKING FINDINGS AND
IMPOSING SANCTIONS BY DEFAULT
AGAINST DAVID E. LYNCH
This proceeding was initiated by the Securities and Exchange Commission ("Commission") with an Order Instituting Administrative Proceedings ("OIP") Pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Sections 15(b), 19(h), and 21C of the Securities Exchange Act of 1934 ("Exchange Act") on September 26, 1997. A prehearing conference was held on April 23, 1998, five days before the scheduled hearing date for Respondents Lynch and McCook. At the prehearing conference, counsel for Lynch disclosed Lynch's intention to not attend the hearing or defend the proceeding against him. Counsel for the Division of Enforcement ("Division") stated that the Division would put on a prima facie case against Lynch and move for a default. (Transcript of Prehearing Conference of April 23, 1998 at 98-99.)
The hearing as to Respondents Lynch and McCook took place on April 28 through 30, 1998. Neither Lynch nor his counsel appeared at the hearing. The Division filed its Motion for an Order Making Findings, Imposing Remedial Sanctions and a Cease and Desist Order Against David E. Lynch by Default ("Default Motion") on May 14, 1998.
Pursuant to Rule 155(a) of the Commission's Rules of Practice, 17 C.F.R. § 201.155(a), a respondent who fails to appear at a hearing, respond to a dispositive motion, or otherwise defend the proceeding may be deemed to be in default. The administrative law judge may determine the proceeding against a defaulting party upon consideration of the record, including the OIP.
Respondent Lynch is in default. Accordingly, for the purpose of determining this proceeding as to Lynch only, I find that the following allegations in the OIP are deemed to be true:
David E. Lynch ("Lynch") at all relevant times was a registered representative and trader associated with the Broker-Dealer in its Houston office. Lynch is a resident of Spring, Texas.
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The Broker-Dealer's Houston office was opened by [Respondent Lynch and another respondent] in October 1990. The Houston office was established to sell fixed-income products, primarily mortgage-backed securities, to institutional clients.
At all relevant times, the Houston office had the authority to execute riskless principal transactions. The procedure required [Respondent Lynch and others] to arrange and confirm both sides of each transaction, and then call the details directly in to a principal in the Broker-Dealer's main office. The principal then would write an order ticket for each transaction, and provide that information to the Broker-Dealer's clearing firm.
The Broker-Dealer did not allow the Houston office to hold positions in securities unless they received approval from the main office. In order to circumvent the Broker-Dealer's restriction on holding positions, [Respondent Lynch and others] engaged in a parking scheme which enabled them to purchase bonds and secretly hold them "off the books," while still maintaining control of the securities. From October 1992 through March 1994, the Houston traders parked government agency securities on at least seventeen occasions, including every month from March 1993 through March 1994.
The parking scheme began in approximately October 1992. On at least two occasions, [Respondent Lynch and others] parked securities directly with [a Registered Representative] with another broker-dealer. Following those transactions, the scheme changed slightly. From that point forward, whenever [Respondent Lynch and others] wanted to park securities, they entered into an arrangement with [the Registered Representative] whereby the Broker-Dealer would sell the bonds to another dealer for settlement that month. That dealer would then sell the bonds to [the Registered Representative's] firm for a fraction higher than it had purchased them from the Broker-Dealer. The Broker-Dealer would then repurchase the bonds from [the Registered Representative's] firm for settlement the next month, with [the Registered Representative's] firm earning a small profit on the transaction. [Respondent Lynch and others] used the time between settlement dates to find a customer for the bonds. The parking scheme essentially allowed [Respondent Lynch and others] an extra month to find a customer for securities over which they maintained control.
Each time [Respondent Lynch and others] executed a parking transaction, they filled out tickets for the sale and the repurchase from the other dealers. These trades were then called in to the Broker-Dealer's principal in the main office, who wrote his own tickets. For each of the parking transactions, however, one or more of the order tickets written by the principal contained trade dates different than the trade dates on the Houston tickets.
The inaccurate order tickets written in the main office depicted each of the parking transactions as two separate riskless principal trades, thereby enabling the scheme to go undetected.
On at least seven occasions [Respondent Lynch and others] used the parking scheme to manipulate the price of certain government agency securities and conceal undisclosed excessive markups charged to the Broker-Dealer customers. The excessive markups on the seven transactions alone amounted to approximately $1.85 million.
In those instances, [Respondent Lynch and others] purchased bonds and marked them up considerably on the sale to the other dealers. These dealers then marked up the securities another 1/32 or 2/32 when selling them to [the Registered Representative's] firm. [The Registered Representative's] firm then marked up the securities another 2/32 when selling them back to the Broker-Dealer. The Broker-Dealer, through [Respondent Lynch and others], would then mark up the securities another 4% - 5% when selling them to innocent, bona fide customers.
[Respondent Lynch and others] dictated the prices on the parking transactions. The other firms acquiesced in these price setting transactions. Therefore, the trades involving the other dealers were fictitious, non-bona fide transactions, and did not indicate or reflect the actual market value of those securities.
As a result of the parking scheme described above, the Broker-Dealer maintained inaccurate books and records, insofar as, among other things, the firm's books and records did not reflect the liabilities arising from [Respondent Lynch's and others'] commitments to repurchase the securities involved, and contained incorrect valuations of the firm's positions. The firm also computed its net capital inaccurately. During the scheme, [Respondent Lynch and others] knew that the parking of these securities caused the Broker-Dealer's books and records and net capital computations to be inaccurate.
Properly recording these transactions on the Broker-Dealer's books and records would have adversely affected the Broker-Dealer's computation of net capital and, in some instances, resulted in undisclosed net capital deficiencies . . . .
The parking scheme also caused the Broker-Dealer to file inaccurate FOCUS reports with the NASD, thereby presenting to regulators a misleading picture of the firm's net worth. Furthermore, the scheme caused the Broker-Dealer to fail to disclose to the Commission that the firm was in net capital violation on numerous occasions.
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As a result of the conduct described above, [Respondent Lynch] willfully violated Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.
As a result of the conduct described above, [Respondent Lynch] willfully aided and abetted violations of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5 and 17a-11, thereunder.
The OIP seeks the entry of a cease and desist order pursuant to Section 8A of the Securities Act and Section 21C of the Exchange Act, remedial sanctions, and a civil money penalty. In its Default Motion, the Division identifies those remedial sanctions it feels are appropriate, arguing for an industry bar and disgorgement of $485,558 plus prejudgment interest. Additionally, the Division argues that the civil money penalty sought in the OIP should be a third-tier civil money penalty of $100,000.
Cease and Desist Order
The Division requests that Lynch be ordered to cease and desist from committing or causing any violations or future violations of Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and to cease and desist from aiding or abetting any violations or future violations of Sections 15(c) and 17(a) of the Exchange Act and Rules 15c3-1, 17a-3, 17a-5, and 17a-11 thereunder. Based on the findings detailed above, I find the entry of such a cease and desist order to be in the public interest.
Civil Money Penalty
Section 21B of the Exchange Act establishes three tiers of civil money penalties. To impose a second-tier civil money penalty, the respondent must have committed an act or omission involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement. There is an additional requirement to impose a third-tier civil money penalty: the act or omission must directly or indirectly result in substantial losses, create a significant risk of substantial losses, or result in substantial pecuniary gain to the respondent.
In its Default Motion, the Division requests that Lynch be ordered to pay a third-tier civil money penalty in the maximum amount of $100,000. I do not find such a sanction to be warranted in this case and instead find it in the public interest that Lynch be ordered to pay the maximum second-tier civil money penalty of $50,000.
As is stated above, the OIP seeks an award of unspecified remedial sanctions. In its Default Motion, the Division describes the remedial sanctions it feels appropriate in this case: an industry bar and disgorgement.
The Division requests that Lynch be "collaterally barred" from the securities industry. Specifically, the Division requests that Lynch be "barred from association with any broker, dealer, municipal securities dealer, investment company or investment advisor." The Division's Default Motion was made prior to the U.S. Court of Appeals for the District of Columbia Circuit decision in Teicher v. SEC, 177 F.3d 1016 (D.C. Cir. 1999), which prohibits the imposition of a collateral bar.
The OIP alleges that Lynch was at all times a registered representative and trader associated with a certain broker-dealer. Section 15(b)(6) of the Exchange Act authorizes sanctions against persons associated with a broker-dealer if they have willfully violated the securities laws and a sanction is in the public interest. Lynch's willful violations of the securities laws are detailed above. I find it in the public interest that Respondent Lynch be barred from association with any broker or dealer.
In its Default Motion, the Division cites to Exhibit 5 introduced at the hearing in this matter as evidence of $485,558 in excessive commissions received by Lynch in eight transactions. The Division requests that Lynch be ordered to disgorge this amount, as well as prejudgment interest.
Section 21C of the Exchange Act, which authorizes cease and desist proceedings, also authorizes disgorgement of ill-gotten gains causally related to proven wrongdoing. See SEC v. First City Fin. Corp., 890 F.2d 1215, 1230-32 (D.C. Cir. 1999). Although the OIP was brought pursuant to Section 21C of the Exchange Act and seeks remedial sanctions in addition to a cease and desist order, it does not indicate that disgorgement is one of the remedial sanctions being sought. The OIP does not specifically allege that Lynch personally received $485,558 in ill-gotten gains causally related to his wrongdoing. Such an allegation would possibly indicate that disgorgement of that amount was being sought. The OIP did not provide Lynch adequate notice that disgorgement of any amount, much less $485,558, would be sought in this administrative proceeding, and I cannot conclude that Lynch would have defaulted had he known the full extent of his exposure.
I find it fundamentally unfair to impose a disgorgement sanction upon a defaulting respondent without notice of the threat of such a sanction. Similarly, Rule 54(c) of the Federal Rules of Civil Procedure states that a judgment by default is limited to the relief requested in the demand for judgment. See also Fong v. United States, 300 F.2d 400, 413 (9th Cir. 1962); Lambert D. Vander Tuig, Order Entering Default, Making Findings and Imposing Remedial Sanctions, 73 SEC Docket 47, 49 n.1 (Aug. 16, 2000) (citing Fed. R. Civ. Pro. 54(c), Fong, and 10 Charles A. Wright et al., Federal Practice and Procedure § 2663, at 172 (1983)). Therefore, I decline the Division's request to order Lynch to pay disgorgement of $485,558 plus prejudgment interest.
Accordingly, IT IS HEREBY ORDERED that David E. Lynch cease and desist from committing or causing any violations or future violations of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5; and cease and desist from aiding and abetting any violations or future violations of Sections 15(c) and 17(a) of the Securities Exchange Act of 1934 and Rules 15c3-1, 17a-3, 17a-5, and 17a-11 thereunder.
IT IS FURTHER ORDERED that David E. Lynch be and he hereby is barred from association with any broker or dealer.
IT IS FURTHER ORDERED that David E. Lynch pay a second-tier civil money penalty in the amount of $50,000.
Lillian A. McEwen
Administrative Law Judge
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