Initial Decision of an SEC Administrative Law Judge
In the Matter of
|In the Matter of
RICHARDT-ALYN & CO.,
September 30, 1999
Appearances: David F. Newman and Merri Jo Gillette for the Division of Enforcement, Securities and Exchange Commission.
David M. Becker, Karen L. Barr, and Merritt A. Cole for Respondents
Before: Carol Fox Foelak, Administrative Law Judge
Richardt-Alyn & Co., Alan S. Feinberg, and Richard B. Feinberg were charged with violating the antifraud and recordkeeping provisions of the securities statutes. This initial decision finds that they accepted five limit orders from a customer for an OTC security and executed them with market makers at prices better than the limit price. They retained and did not disclose the trading profits and also charged the customer a fee for the executions. This practice violated their duty of best execution and thus the antifraud provisions. The Respondents' similar course of dealing with other broker-dealers did not violate the antifraud provisions because the Commission does not hold broker-dealers dealing with broker-dealers to the same level of duties owed to retail customers in executing trades. The books and records violations are unproven as Respondents' books and records accurately revealed their practice of obtaining and retaining trading profits in the trades at issue in this proceeding. The decision orders them to cease and desist from violations of the antifraud provisions, to disgorge $1375 in trading profits, censures them, and fines each individual respondent $5000.
The Securities and Exchange Commission (Commission) initiated this proceeding by an Order Instituting Proceedings (OIP) on September 26, 1996, 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).
I held a hearing in Philadelphia, Pennsylvania on February 10-13, 1997. The Division of Enforcement (Division) presented testimony from nine witnesses and introduced 209 exhibits. The Respondents presented five witnesses and two exhibits.1
My findings and conclusions are based on the record. I applied preponderance of the evidence as the applicable standard of proof. See Steadman v. SEC, 450 U.S. 91 (1981). Pursuant to the Administrative Procedure Act,2 I considered the following post hearing pleadings: the Division's Post-Hearing Brief, filed April 15, 1997; the Respondents' Post-Hearing Brief, filed June 2, 1997; and the Division's Reply, filed June 17, 1997. I considered and rejected all arguments and proposed findings and conclusions that are inconsistent with this decision.
The OIP alleges that, between January 1994 and March 1995, Respondents violated the antifraud provisions of the securities statutes by accepting orders for over-the-counter (OTC) purchases and sales from two broker-dealers, David Lerner Associates (DLA) and Flagship Securities (Flagship), and unspecified others, and misrepresenting to them the price at which their trades were executed. The OIP alleges that Respondents obtained approximately $18,000 in undisclosed trading profits by executions at more favorable prices than the prices they reported to these clients. The OIP also alleges that during this period the Respondents violated the books and records provisions of the securities statutes in connection with these trades.
The Respondents contend that each of the transactions in question consisted of two separate and distinct trades. The first trade occurred with their clients on a principal basis. The second trade was an offsetting trade with market makers. They contend that they were under no duty to disclose to their broker-dealer clients the prices at which they bought or sold the securities in the subsequent offsetting transactions. Additionally, the Respondents contend that they did not have the requisite scienter to support an antifraud violation.
Richardt-Alyn is primarily a specialist firm located on the trading floor of the Philadelphia Stock Exchange (PHLX). Tr. 301. It also serves as a floor broker. Tr. 301. The firm executes trades in both listed securities and OTC securities. Tr. 301, 426. OTC executions are less than five percent of the firm's business. Tr. 370. Richardt-Alyn executes trades of OTC securities for both broker-dealer clients and public clients. Tr. 301. Richardt-Alyn is not a market maker in any Nasdaq security. Tr. 307-08, 361. It has been registered as a broker-dealer since 1971. Tr. 289. The firm essentially consists of its active owners, brothers Richard B. Feinberg and Alan S. Feinberg, who have chosen to keep the firm small. Tr. 369-71, 475. During the time of the events in question, the firm had two additional employees. Tr. 37, 92-94, 370. There is absolute trust between the brothers in running the business. Tr. 371. They mutually agreed on, and both participated in, the activity at issue in this proceeding. Tr. 331-32, 379, 504.
Richardt-Alyn has been executing trades in OTC securities for DLA since 1991. Tr. 126-30, 148. It has been executing trades in listed and OTC securities for Flagship since 1991. Tr. 200. It has been executing trades in OTC securities for Douglas Jones at Birchwood Securities (Birchwood) and other broker-dealers since 1987. Tr. 262. It has been executing trades in OTC securities for Park Avenue Securities (Park Avenue) for at least ten years. Tr. 241. During the time period at issue, Richardt-Alyn obtained undisclosed trading profits in 177 OTC trades it executed for the four clients (mostly, DLA and Flagship). The record does not show the total number of OTC trades Richardt-Alyn executed for them.
The work area at Richardt-Alyn is a table approximately seven to twelve feet long. Tr. 34, 509. There are four seats at the table, with no dividers between them. Tr. 35. The positions are about three feet wide, and there is approximately five to six inches of distance between the seats. Tr. 35, 509. Richardt-Alyn has a National Association of Securities Dealers Automated Quotation System (Nasdaq) Levels 1 and 2 service, which includes the SelectNet system. Tr. 35, 42, 305-306, 378-79. Level 1 service displays the National Best Bid or Offer (NBBO) for OTC securities.3 Tr. 378-79.
SelectNet is an electronic communications network (ECN), or trading system, owned and operated by the Nasdaq Stock Market, Inc. This screen-based order communication and negotiation system is available only to National Association of Securities Dealers (NASD) members.4 See Report Pursuant to Section 21(a) of the Securities Exchange Act of 1934 Regarding the NASD and the Nasdaq Market, 62 SEC Docket 1375, 1400 n.52, 1443 n.16 (Aug. 8, 1996) (NASD 21(a) Report). SelectNet does not display prices; a broker-dealer enters a limit order that is broadcast to Nasdaq market makers (or directed to selected market makers); if accepted, the execution is displayed in a window on the screen that Richardt-Alyn had programmed to turn red. Tr. 306-07.
In 1992, the NASD examined Richardt-Alyn's practice of routing the orders of its broker-dealer clients through the Small Order Execution System (SOES). Tr. 321-28; Div. Exs. 110-15. SOES executions are at the NBBO.5 NASD 21(a) Report, 62 SEC Docket at 1504. The NASD concluded that Richardt-Alyn's use of SOES for broker-dealer client orders was improper. In 1993, the NASD and Richardt-Alyn entered into an Acceptance, Waiver, and Consent agreement (AWC) in which Richardt-Alyn accepted a fine of $2500. Div. Ex. 112. The firm's only other disciplinary history was an NASD fine of $500 in 1971 or 1972 for failing to have signatures on some new account cards. Tr. 372, 476. The firm has never been a respondent in an arbitration or the subject of a customer complaint. Tr. 372-73, 478.
B. Respondent Richard B. Feinberg
Respondent Richard B. Feinberg (R. Feinberg) has been a general partner of Richardt-Alyn since 1965, and has been registered in the securities industry since 1967. Tr. 288. R. Feinberg executes trades for the account of Richardt-Alyn and for the accounts of its clients, and also occasionally performs such clerical tasks as preparation of order and execution tickets, stock delivery tickets, blotters, and confirmations. Tr. 300. He is responsible for Richardt-Alyn's compliance with the securities laws. Tr. 300.
R. Feinberg has been active in the governance of PHLX for a number of years, spending approximately twenty hours a week on PHLX matters. Tr. 289-99, 371-72, 413. He was vice chairman for five and one-half years. Tr. 289. He also served in a number of other positions, including: Chairman of the Equity Rules Subcommittee; member of the Executive Committee; member of the Floor Procedure Committee; member of the Finance Committee; member of the Performance Committee; director of the Stock Clearing Corporation; Chairman of the Operations Committee of the Stock Clearing Corporation; member of the Internal Audit Committee; member of the Admissions Committee; and member of the Board of Governors. Tr. 289-291. R. Feinberg was Chairman of the Business Conduct Committee during nine of the previous twelve years. Tr. 291-92. One of the functions of the Business Conduct Committee is to enforce the rules and regulations of PHLX. Tr. 292-99.
1. R. Feinberg Did Not Announce a Scheme to Defraud
OTC executions are only five percent of Richardt-Alyn's business, and only some of its OTC trades are at issue. The Division urges that Respondents intentionally cheated on a small scale to avoid detection. There is testimony from several witnesses concerning whether or not R. Feinberg advised Richardt-Alyn employees that the way to succeed fraudulently in the securities business without getting caught is to steal only a little; a related issue is whether he used the term "cookie" to refer to trading profits on the trades at issue and thus displayed larcenous intent. Tr. 60-62, 104-07, 122-23, 330, 384-85, 459, 487-88, 505-08, 523. I find that R. Feinberg did not announce a scheme to defraud by stealing small amounts or otherwise instruct Richardt-Alyn employees to do so. Although stealing only a little might reduce the risk of detection, announcing such an intent would be self-defeating and would increase the risk of detection.
This proceeding has had a devastating effect on R. Feinberg professionally, financially, and personally; he cried when describing this. Tr. 392-93. He maintains he has never intentionally or unintentionally defrauded anyone. Tr. 391-92. R. Feinberg has not disavowed the trading practices at issue in this proceeding.
C. Respondent Alan S. Feinberg
Alan S. Feinberg (A. Feinberg) has been a general partner of Richardt-Alyn since 1965, and a registered broker-dealer since 1971. Tr. 424-25. A. Feinberg executes trades for Richardt-Alyn and for the accounts of its clients. Tr. 425. He is also primarily responsible for Richardt-Alyn's recordkeeping and books. Tr. 37, 413, 425. PHLX fined A. Feinberg $3000 in 1989 for front-running. Tr. 477. At the time of the hearing, A. Feinberg had been a member of the Business Conduct Committee for four or five months. Tr. 425. Outside of PHLX, A. Feinberg does a great deal of charitable work, and has devoted about twenty hours a week to charitable work for many years. Tr. 475-76, 531-38. The proceeding has had a devastating effect on A. Feinberg professionally and personally. Tr. 499-500.
D. Richardt-Alyn's Broker-Dealer Clients
The four clients for whom Richardt-Alyn executed the trades at issue are in the securities business. Two of them, DLA and Flagship, are broker-dealers specializing in tax-free municipal bonds. Tr. 126, 199. As such, they are compensated in their bond transactions with their retail customers by markups and markdowns that are not disclosed to the customers on confirmations or in any other way. See Division of Market Regulation, U.S. Securities and Exchange Commission, Staff Report on the Municipal Securities Market, 15-16 (Sept. 1993) (Municipal Securities Staff Report). The other two clients, Park Avenue (John Wallace) and Douglas Jones are traders, specialists, and market makers operating on the floor of PHLX. From the time that DLA and Flagship commenced executing OTC transactions for their retail customers through Richardt-Alyn (1991), through the time of the trades at issue in this proceeding (January 1994 to March 1995), broker-dealers commonly believed that they satisfied their duty of best execution to customers by transactions at the NBBO. However, the existence of a two-tier market, that includes electronic networks such as SelectNet and Instinet that enable transactions between the spread publicized on the widely disseminated NBBO, was well known in the securities industry. See, e.g., Tr. 266; see Order Execution Obligations (Final Rules), 62 SEC Docket at 2211-12, 2227-29.6 In recent years the Commission has commenced several initiatives aiming to increase price transparency in the market for municipal bonds and OTC securities. See Chairman Arthur Levitt, Remarks at Columbia Law School (Sept. 23, 1999); NASD 21(a) Report, 62 SEC Docket 1375; Order Execution Obligations (NPRM and Final Rules), 60 SEC Docket 1128 & 62 SEC Docket 2210; Municipal Securities Staff Report; Confirmation of Transactions, 57 SEC Docket 3014 (Nov. 17, 1994). R. Feinberg knew that DLA and Flagship did not have access to SelectNet or otherwise to the entire range of bids and asks from all market makers that might be between the spread. Tr. 366.
DLA is a broker-dealer specializing in tax-free municipal bonds. Tr. 126. It is based in Syosset, New York, and has been registered in the securities industry since 1975. Tr. 126. David Lerner is the principal of DLA. Tr. 126. Lerner wanted another broker-dealer to execute stock trades, an incidental part of DLA's business, to better accommodate DLA's bond customers. Tr. 129-30, 313.
During DLA's application for PHLX membership, Lerner met R. Feinberg, who solicited his business. Tr. 127-28, 309-10. Based upon their conversations, Lerner believed that Richardt-Alyn could execute his firm's trades more rapidly, efficiently, and cheaply than executions through the New York Stock Exchange. Tr. 128-30, 136-42, 309-310. Lerner's memory of the date and content of the conversations is not precise, due to the passage of time. Tr. 127, 129.
After their discussions, R. Feinberg and Lerner signed a written agreement and Richardt-Alyn began executing trades for DLA. Tr. 130-31; Div. Ex. 281. The agreement, entitled Omnibus Agreement,7 dated November 5, 1990, provides, with respect to OTC securities, that Richardt-Alyn, "will use due diligence to interrogate the [Nasdaq] system to determine the best inter-dealer market to executions."8 Div. Ex. 281.
The price at which DLA's trades were executed was important to Lerner because he wanted his retail customers to get a fair deal. Tr. 131-132. He believed that DLA would be getting the best possible prices, although he was unsure of the meaning of "best inter-dealer market" that described their agreement as to OTC securities. Tr. 131-32, 136-42.
Richardt-Alyn charged DLA a commission of two and one-half cents a share for any shares executed. Tr. 152-53, 157-58. DLA received a separate monthly bill of commissions charged for listed trades, while the commissions charged for OTC trades were included in the total trade price. Tr. 153-154, 157-58, 433; Div. Ex. 282.
During the time period at issue, the actual mechanics of DLA's execution of orders through Richardt-Alyn were handled by DLA's operations department. Tr. 147-48. The operations department did not have a way of determining the price at which a trade was executed in the Nasdaq market. Tr. 154, 165.
Lerner was not aware that Richardt-Alyn reported less favorable prices to DLA than the actual Nasdaq execution prices that Richardt-Alyn obtained for eighty-two trades, thus garnering trading profits in connection with these trades in the amount of $7958 in addition to the agreed upon commissions that DLA was charged. Tr. 135, 331, 504; Div. Exs. 1, 200-80.
During the time period at issue, Richardt-Alyn was the only broker-dealer through which DLA executed stock trades. Tr. 133, 160. Subsequently, DLA asked Richardt-Alyn to pay for order flow, and Richardt-Alyn declined. Tr. 404-05, 499. DLA, however, continues to do business with Richardt-Alyn; although DLA now usually executes its trades through three other broker-dealers, it calls on Richardt-Alyn when the others are not capable of executing a particular trade. Tr. 169-70, 404-05, 499.
Flagship is a broker-dealer based in Syracuse, New York. Tr. 198. It began operations in 1971, and deals primarily in municipal bonds. Tr. 198-99. Dennis Milewitz had been the vice president of Flagship since its inception. Tr. 198.
When Milewitz learned of this proceeding, he telephoned R. Feinberg and offered sympathy, saying that the proceeding was unfair. Tr. 235-36. However, his testimony in the proceeding was in support of the Division's case. Tr. 198-237. Official notice is taken of Milewitz's extensive criminal and disciplinary history of securities-related violations. See Dennis Milewitz, 67 SEC Docket 1827 (July 23, 1998). At the time of the hearing he was under a six month suspension pursuant to a settlement. Tr. 199-200; see also Flagship Securities, Inc., et al. 63 SEC Docket 31 (Oct. 15, 1996). Shortly after the hearing, on March 23, 1997, Flagship filed a membership continuance application, seeking the NASD's consent to his continued association with the firm, and this matter was eventually reviewed by the Commission. See Dennis Milewitz, supra. In view of the nature of his past securities-related violations and the possibility of bias deriving from the expectation of future Commission review of the membership continuance application, his testimony is considered unreliable. Thus, I have not relied on his testimony insofar as it was controverted on any material issue of fact.
In 1990, Milewitz asked Rick Garber, a Flagship sales representative, to locate a broker-dealer at PHLX that could execute equity trades for Flagship, as an accommodation to its regular customers. Tr. 201-02. Flagship wanted a broker-dealer operating at PHLX because Flagship already had a clearing account designated as "#836" at the Stock Clearing Corporation of Philadelphia (SCCP) for its municipal securities. Tr. 203. Garber, and later Milewitz, spoke with R. Feinberg and negotiated an agreement for Richardt-Alyn to execute Flagship's listed and OTC equity trades. Tr. 202-04, 373-76, 434. Pursuant to the agreement, Richardt-Alyn was to provide clearance and execution services for Flagship at the rate of two and one-half cents a share for OTC securities. Tr. 202.9
As with DLA, Flagship received a separate monthly bill of commissions charged for listed trades, while the commissions charged for OTC trades were included in the total trade price. Tr. 309, 435; Div. Ex. 389.
Flagship had a Level 1 Nasdaq workstation, which shows the NBBO for OTC securities. Tr. 221-22. Flagship did not have SelectNet. Tr. 214. Milewitz understood that Flagship would be trading securities through Richardt-Alyn at the NBBO. Tr. 221-23. To the extent that his testimony on this point conflicts with his testimony, at Tr. 207-08, that Richardt-Alyn would be acting on Flagship's behalf in order to get executions at the best price possible, there is no additional evidence in the record to support a finding that Milewitz understood that Richardt-Alyn would execute trades for him at prices that were better than the NBBO.
Milewitz was not aware that from January 1994 through March 1995, Richardt-Alyn reported less favorable prices to Flagship than the Nasdaq execution prices that Richardt-Alyn obtained for eighty-seven trades, thus receiving trading profits amounting to $7819 in addition to the agreed upon commissions that Flagship was charged. Tr. 217, 331, 504; Div. Exs. 2, 300-86. Milewitz, however, did not care, as long as he was getting the NBBO. Tr. 221-23, 225-27.
Richardt-Alyn was the only broker that Flagship used to execute its equity trades. Tr. 218. Flagship has been satisfied with Richardt-Alyn's services, and is doing more business with Richardt-Alyn than before. Tr. 237, 498.
3. Park Avenue Securities
John Wallace owns Park Avenue, a specialist, market maker, and stock trading firm. Tr. 240. Park Avenue has been using Richardt-Alyn to execute its OTC trades, about ten per month, for at least ten years. Tr. 241. Park Avenue does not use Richardt-Alyn to execute trades in listed securities. Tr. 241.
During the time period at issue, Park Avenue paid one and three-quarters cents a share in commissions; in prior years it paid higher amounts. Tr. 250, 436. Park Avenue is billed for these commissions on a monthly basis. Tr. 249-50; see, e.g., Div. Ex. 420 at 5. Three Park Avenue trades, for the firm's account, in 1994, are at issue in this proceeding. Tr. 247-48; Div. Exs. 420-22.
When Wallace asked R. Feinberg to handle orders for him, R. Feinberg agreed and stated his charges. Tr. 250-51. Wallace placed limit orders, which were executed at his price; when he stated a price to Richardt-Alyn, he wanted the trade executed at that price. Tr. 244, 256-57. Wallace was not aware that Richardt-Alyn reported prices less favorable to him than the Nasdaq execution prices for the three trades at issue, thus receiving trading profits in addition to the stated charges. Tr. 251, 331, 504. Richardt-Alyn obtained $325 in trading profits in connection with Park Avenue's trades, in addition to the agreed upon commissions that Park Avenue was charged. Div. Exs. 4, 420-22.
4. Douglas Jones
Douglas Jones was an off-floor trader and assistant specialist with Birchwood. Tr. 261. Jones was affiliated with Birchwood from November 1993 through December 1994. Previously, he had similar positions with other firms. Tr. 262. In 1987, Jones began using Richardt-Alyn to execute equity trades for his own account. Tr. 262. Jones only rarely placed trades with Richardt-Alyn, roughly once every two years. Tr. 263.
On June 21, 1994, Jones placed thirteen trades (eleven purchases and two sales) in Lotus Development (Lotus) through Richardt-Alyn. Tr. 263-268; Div. Ex. 400 at 6. Five of the trades are at issue in this proceeding. Div. Exs. 400-04. Jones was trading for his own account, in the hopes of profiting from volatile prices associated with news of poor earnings. Tr. 263-64. He placed limit orders, handing the order tickets to R. Feinberg. Tr. 264-65. The orders were filled at his limit price after one to three minutes. Tr. 266. He assumed Richardt-Alyn would be using SelectNet, or Instinet, to fill his orders. Tr. 266. He was following the stock's price on a Shark machine. Tr. 266. Jones was aware of the "inside market," referring to trading by brokers at prices better than the more widely disseminated NBBO. Tr. 267. When Jones handed the orders to R. Feinberg, he assumed he would be charged a commission, as always. Tr. 265, 272-73, 278.
Jones viewed generic bid and offer prices on a Shark machine. Tr. 264-67. When he thought it was a good time to buy, he would write a limit order on a preprinted order ticket. Tr. 264. He would time stamp the ticket at his own post, and then walk twenty to twenty-five feet over to Richardt-Alyn's post. Tr. 264-65. He would hand his order ticket to R. Feinberg and say, "Would you buy this stock for me and bill me?" Tr. 50, 264-65. After a couple of minutes, one of the Respondents would yell out "you bought your stock at (the limit price)." Tr. 52, 265-66. For the five trades at issue, the Respondents entered an order on SelectNet and obtained an execution at a better price than the limit order. Tr. 332. The Respondents then altered the order ticket, changing the quoted execution price (limit price) to the actual execution price. Tr. 270; see Div. Ex. 400-403. They filled out a delivery ticket with the price quoted to the client, and time stamped it. Tr. 331-32.
It was Jones' understanding that Richardt-Alyn was acting on his behalf and being paid through commissions. Tr. 265, 269, 272-73, 284. Richardt-Alyn sent Birchwood a separate bill for commissions incurred by Jones. Tr. 273; see Div. Ex. 400 at 6. Price was very important to Jones because he was trading for his own account. Tr. 269, 276.
Jones was not aware that Richardt-Alyn reported prices less favorable to him than the Nasdaq execution price on the five trades, thus receiving trading profits in addition to commissions. Tr. 276, 331, 504. The trading profits amounted to $1375. Div. Exs. 3, 400-04.
E. How Richardt-Alyn Executed OTC Trades With Its Broker-Dealer Clients
1. DLA and Flagship
The OTC trades executed by Richardt-Alyn on behalf of DLA and Flagship from January 1994 through March 1995 followed a similar pattern. At DLA, one of the regional offices would receive a retail customer order to buy or sell a particular OTC security and would fax the order to the main office. Tr. 149. An employee at the main office would time stamp the order form when it was removed from the fax machine and then place a telephone call to Richardt-Alyn. Tr. 149-52.
At Flagship, when a sales representative received a customer order to trade an OTC security, he filled out an order ticket and gave it to Milewitz. Tr. 209. Milewitz time-stamped the order ticket at time of receipt and called Richardt-Alyn. Tr. 210.
Richardt-Alyn would almost always give a price confirmation for a market order while DLA or Flagship was still on the phone. Tr. 150-51, 158, 212-13, 334. For limit orders, Richardt-Alyn would call back within a few minutes with a price confirmation. Tr. 212-13, 256-57. The DLA or Flagship employee would then write the execution price on the order form, and time stamp it again. Tr. 152, 211.
After receiving the order, either A. Feinberg or R. Feinberg would check the Nasdaq Level 2 workstation screen and ascertain the NBBO price while the client was still on the phone. Tr. 495-96. He would then give the NBBO price to the client, with a statement such as "you got it at `x' price." Tr. 162, 496. The Respondent would fill out an order slip and time stamp it. Tr. 41, 334. In filling out the order slip, the Respondent would write down the price confirmation that was quoted to the client. See Div. Ex. 121. The Respondent would then immediately enter an order on the SelectNet system between the spread for the security ordered. Tr. 43-44, 332. If he was able to get an execution at a more favorable price than the price quoted, he would alter the order slip by writing over the old figure with the actual execution price. See Div. Ex. 121. If the Respondent was unable to execute at a more favorable price, he would execute at the NBBO. Either A. Feinberg or R. Feinberg would then fill out a delivery slip with the price quoted to its clients, and time stamp it. Tr. 331-32.
Richardt-Alyn secured an execution on SelectNet before giving a price confirmation on limit orders to DLA and Flagship. Richardt-Alyn delayed the price confirmation because it was waiting to see the price at which it could secure an execution on SelectNet. If Richardt-Alyn had input the order into SelectNet after the price confirmation, it could have given the price confirmation immediately and there would have been no reason for delay. By contrast, Respondents gave immediate price confirmations for market orders at the NBBO, because they were confident that they could obtain an execution at the NBBO or a better price.
The Division argues that time stamp evidence shows that the Respondents invariably obtained executions on SelectNet prior to giving their clients a price confirmation. I have carefully examined the time stamped exhibits entered into evidence.
A sequence of events over seconds or minutes cannot be established by time stamp evidence from different time pieces. Two exhibits from the same source may be reliably compared, but a comparison of time stamps from different sources which were never calibrated does not show which stamp was applied first. Also, the time stamps in this proceeding were applied manually and the human element can introduce additional variations. Due to the lack of calibration between the different sources, I have assigned no weight to such time stamp evidence for purposes of determining the sequence of events.
Richardt-Alyn executed its clients' orders on the Nasdaq market because it did not have an inventory of the OTC securities that they ordered. Tr. 72-73, 307-08, 361. Richardt-Alyn never disclosed to its clients that it had received a better execution price than the price given in the original price quote, nor that it was obtaining trading profits in addition to the commission. Tr. 135, 217, 331.
2. Park Avenue
When Wallace wanted to buy or sell a particular OTC security, he would first check the NBBO for the security using the Quotron system. Tr. 241-43. Wallace would then call or visit Richardt-Alyn and place a limit order for the security. Tr. 244. When placing an order, Wallace would say something like "buy me 1000" shares at a specified price. Tr. 244. Richardt-Alyn would call back a short time later confirming that Wallace's order had been filled at that price. Tr. 247, 256-57.
After receiving Wallace's order, either A. Feinberg or R. Feinberg would fill out an order ticket and time stamp it. Tr. 246, 334. After executing the order, he would fill out a delivery slip with the price quoted to the client and time stamp it. Tr. 331-332. As to the three Park Avenue trades at issue in this proceeding, Respondents did not disclose to Wallace that they had executed his order at a price better than what they had quoted to him. Tr. 331, 504.
3. Douglas Jones
Jones' five June 21, 1994, Lotus trades were discussed above. The Respondents claim that during one of the trades Jones said, "take an eighth," thus inviting them to mark up his execution by one-eighth in return for a rapid execution. Tr. 332-33, 439-41. Jones denies having made this statement.10 Tr. 276-77. Viewing the evidence in the light most favorable to Respondents, in view of the Division's burden of proof, and allowing for the possibility of misunderstanding, Respondents claimed to have heard this statement in connection with only one trade. Tr. 332-33, 439-41. This would not explain why they retained trading profits on all five trades. Additionally, Respondents executed Jones' limit orders in the same manner as Park Avenue's limit orders and obtained extra trading profits for themselves in the same way on all 177 trades at issue in this proceeding. Respondents have not even suggested, and the evidence does not show, that any of the other three clients at issue authorized Respondents to retain a mark up or mark down on their trades. Respondents' claim that Jones authorized them to mark up his limit order price and keep the difference for themselves is rejected.
F. Richardt-Alyn Recordkeeping
The Richardt-Alyn order ticket has four copies. The market maker keeps one copy, Richardt-Alyn keeps two copies, and one copy is usually discarded. The Richardt-Alyn delivery ticket has three copies. One copy goes to PHLX. Richardt-Alyn generally attaches one copy of the delivery ticket to the corresponding order ticket and places the package in the broker-dealer client's coop.11 Richardt-Alyn separately files the third copy of the delivery ticket in its records. Tr. 70.
There are a number of items of information on Richardt-Alyn order tickets. See Div. Exs. 121, 400 at 1, 420 at 1. The account number of the client making the order is written in the bottom right corner. Tr. 64. DLA is account number 740, Flagship is 836, Park Avenue is 690, and Doug Jones at Birchwood is 90-6. Tr. 57, 69, 249, 272. The top right corner is time stamped, indicating when Richardt-Alyn received an order from its client. Tr. 245, 271, 334. Because Richardt-Alyn generally gave immediate confirmations on market orders, this time stamp also indicates the time when a price confirmation was given. Tr. 342. Underneath the time stamp are four lines of handwritten information. The first line contains either "B," indicating a buy order, or the "S," indicating a sell order. Tr. 246; Div. Exs. 121, 420. The second line indicates the number of shares bought or sold. Tr. 64-65, 246. The third line contains the four-letter symbol for the security in question. Tr. 246. The fourth line contains the price at which the trade was executed on SelectNet. Tr. 65. In some instances, the denominator of the price has been altered, and the underlying figure is less favorable than the price as altered. See, e.g. Div. Exs. 121, 400 at 1.
Richardt-Alyn's delivery tickets also have a number of items of handwritten information. See Div. Exs. 121, 400 at 1, 420 at 1. There is a time stamp across the top of the delivery ticket. There are two boxes underneath the time stamp entitled "RECEIVED" and "DELIVERED." Id. In a buy order, the account number of the broker-dealer client is found in the RECEIVED box and the account number of Richardt-Alyn is found in the DELIVERED box. Tr. 249. The account numbers are reversed for sell orders. Underneath these boxes are four lines of handwritten information. The first line contains the number of shares in the trade. The second line contains the symbol of the security traded. The third line is entitled "AMOUNT" and contains the contract price. Tr. 249. For DLA and Flagship, the contract price includes Richardt-Alyn's commission, added to the total price for the trade as quoted to them. Tr. 351-52. Commissions are not included in the contract price for Park Avenue and Birchwood, who receive separate monthly bills. Tr. 250, 272. At the bottom of the delivery ticket, the settlement date of the transaction is listed.
A comparison of Richardt-Alyn's order tickets and delivery tickets shows that the price listed in the order tickets does not correspond with the price component in the contract price listed on the delivery tickets. See Div. Ex. 121. For example, in a transaction with DLA12 on April 19, 1994, the order ticket lists a buy order for 100 shares of SYGN executed on SelectNet. See Div. Ex. 121 at 1. The execution price is nine and three-sixteenths. The denominator of this price has been written over; the original figure was nine and one-fourth. In the corresponding delivery ticket, the contract price is listed as $927.50. This represents Richardt-Alyn's commission of two and one-half cents a share, plus a price quoted of nine and one-quarter, multiplied by 100 shares purchased. In another instance, in a transaction with Doug Jones of Birchwood on June 21, 1994, the order ticket lists a buy order for 2000 shares of LOTS executed on SelectNet. See Div. Ex. 400 at 1. The execution price is thirty-eight and one-eighth. The denominator of this price appears has been written over; the original figure was thirty-eight and one-fourth.13 In the corresponding delivery ticket, the contract price is $76,500. This represents a quoted price of thirty-eight and one-quarter multiplied by 2000 shares purchased.
Richardt-Alyn also fills out trade tickets. See Div. Ex. 302 at 2. The trade tickets contain a description of the security traded and the quantity traded. The tickets contain the price at which Richardt-Alyn executed the trade with a market maker. Tr. 347. In a box entitled "ACCOUNT OF" is the account number of the transacting broker-dealer client. Tr. 347-48. In a box entitled "BROKER" is the name of the market maker with whom Richardt-Alyn executed the trade. Tr. 347. Beneath these figures are smaller boxes entitled "AMT," "COM," and "TOTAL." In the "AMT" box is a figure representing the Nasdaq execution price multiplied by the number of shares bought or sold. In the "COM" box is a figure representing Richardt-Alyn's agreed upon commission charge plus Richardt-Alyn's undisclosed trading profit. Tr. 348-49. These figures are added together in the "TOTAL" box and represent the total contract price.
Richardt-Alyn also has a Purchase and Sales blotter. See Div. Ex. 302 at 5. The Purchase and Sales blotter reflects the general ledger postings to be made to show the profits, losses, liabilities, and assets of the firm. Tr. 352, 430. The document is divided into a top half and bottom half, with columns of information printed in each half. The top half is entitled "PURCHASES" and the bottom half is entitled "SALES." In the "PURCHASES" section, under a column entitled "FROM WHOM BOT," is the symbol for the market maker with whom Richardt-Alyn executed the trade. Tr. 353-54. Under the corresponding column entitled "FOR WHOM PURCHASED," is the account number of the broker-dealer client who placed the order. Tr. 353-54. In the "SALES" section, under a column entitled "TO WHOM SOLD," is the symbol for the market maker with whom Richardt-Alyn executed the trade. Tr. 353-54. Under the corresponding column entitled "FOR WHOM SOLD," is the account number of the broker-dealer client who placed the order. Tr. 353-54. Both sections also contain columns entitled "PRICE" which reflect the price at which Richardt-Alyn executed each particular trade with a market maker. Both sections contain columns entitled "OTC-CLRN," which represent the commission charged for a trade and the undisclosed trading profit. See Div. Ex. 302 at 5.
G. One Trade or Two?
In support of their argument that they traded with the four clients on a principal basis, Respondents claim that each trade was actually two transactions -- one between Richardt-Alyn and the client, and the other, on SelectNet, between Richardt-Alyn and a market maker. The evidence, however, shows that one trade, not two, occurred. Richardt-Alyn's internal records only reflect a trade executed between Richardt-Alyn and a market maker. There is no record of a trade between Richardt-Alyn and its clients.
When Richardt-Alyn executes buy or sell orders for its own account, it writes its own account number, eighty-four, on the order slip. Tr. 346. By contrast, when Richardt-Alyn filled out order slips for its broker-dealer clients, it placed the client account number on the order slip. Div. Ex. 121.
For the trades in question, Richardt-Alyn's trade tickets list the account numbers of its broker-dealer clients under the heading entitled "ACCOUNT OF" and the name of the executing market maker under the heading "BROKER." See Div. Ex. 302 at 2. The trading tickets also combine Richardt-Alyn's stated commission and undisclosed trading profits into a section entitled "COM." Tr. 348-49.
In Richardt-Alyn's Purchase and Sales blotter, the account number of Richardt-Alyn's broker-dealer clients is found in the columns entitled "FOR WHOM BOT" and "FOR WHOM SOLD." Tr. 353-54; see Div. Ex. 302 at 5. The market makers executing each particular trade are listed in the corresponding columns entitled "FROM WHOM PURCHASED" and "TO WHOM SOLD." Tr. 353-54.
The default setting on SelectNet indicates trading as principal. Tr. 356-57. With each transaction in question, one of the Respondents affirmatively acted to input that Richardt-Alyn was acting as agent. Tr. 354-57, 458; see Div. Ex. 302 at 6; but see Tr. 390-91.
When Richardt-Alyn trades securities for its own account, it completes an order slip. Tr. 431, 446-48. However, in the transactions at issue there is no separate order slip documenting a trade between Richardt-Alyn and its broker-dealer clients. Tr. 441-44. In each of Richardt-Alyn's transactions with its broker-dealer clients, there is only one order slip documenting a trade. Tr. 441-44. This order slip contained the account number of the broker-dealer client and the price with which Richardt-Alyn was able to execute with a market maker. See Div. Ex. 121. Only the trade on SelectNet was reported to Nasdaq. Tr. 357-58.
Respondents claim that when they gave a price confirmation to the customer, they considered themselves bound to honor that price, and therefore a transaction had occurred. Tr. 381, 456, 496. After this commitment, Richardt-Alyn was ostensibly at risk, and whether it chose to immediately execute at the NBBO, or gamble on getting a better execution at SelectNet was no longer its clients' concern. After they gave a price confirmation, they never returned to the client with a different price.14 Tr. 498. When the clients were given a price confirmation, they considered the transaction to be completed and did not expect Richardt-Alyn to return with a worse price. Tr. 162-63, 222-23, 257-58, 280. R. Feinberg testified that Richardt-Alyn got a worse execution on SelectNet than the price quoted to the broker-dealer client on two occasions. Tr. 401-02, 497-98. By contrast, Richardt-Alyn was able to execute on SelectNet at better than the prices quoted to its broker-dealer clients on 177 occasions. Tr. 436-37. Respondents had no economic incentive to return to their broker-dealer clients before the settlement date, and change the prices given. Accepting a loss on an occasional transaction in which they got an inferior SelectNet price would maintain their business relationship with the client, in a context of mostly profitable SelectNet executions. Overall they could expect to execute at a price at least as good as the NBBO. See Order Execution Obligations (Final Rules), 62 SEC Docket at 2228.
H. The 1992 NASD Exam and 1993 AWC
The Respondents contend that the NASD examination and AWC in 1992 and 1993, respectively, changed their perception of their relationship with their broker-dealer clients. Richardt-Alyn asserted it was routing their orders through SOES on an agency basis. See Div. Ex. 111-e. The NASD concluded that it was inappropriate for Richardt-Alyn to use SOES for its broker-dealer clients. Richardt-Alyn agreed to discontinue this practice and pay a $2500 fine. Div. Ex. 112. R. Feinberg testified that an NASD representative, whose name he could not recall, told him, in connection with the SOES matter, that Richardt-Alyn's trades with DLA and Flagship were on a principal basis. Tr. 393-94.
The Respondents contend that the NASD's adverse ruling and the statement of the NASD representative led them to conclude that they had been trading with their clients on a principal basis all along. Tr. 379-80. In effect, they claim that they began retaining trading profits obtained through SelectNet executions because of this new perception. They mutually decided to do this after discussing it three or four times between themselves; they did not consult counsel. Tr. 379-80. They note that because the transactions through SOES were at the NBBO, the cost to their clients was unchanged since they continued to charge the clients the NBBO, while executing through SelectNet and obtaining better prices for themselves at times. Tr. 383. They did not, however, discontinue charging commissions or change their commission structure. Tr. 155-56, 383. The Respondents never told their broker-dealer clients that the basis of their relationship had changed or that they were obtaining trading profits through SelectNet executions. Tr. 155-56, 365.
I. Credibility - Marotta's Testimony
Linda Marotta, a long time employee of Richardt-Alyn, testified at the hearing. Tr. 32-125. Much of her testimony corroborated other evidence. However, I have not relied on her testimony as to facts that are disputed or not corroborated by other credible evidence. The credibility of some of her testimony is diminished by inconsistency with more credible evidence and by bias.
Marotta started working for Richardt-Alyn in 1981 as a clerk, and subsequently became a registered representative. Tr. 33, 38-39, 328. During 1994, Marotta accumulated a number of grievances with Richardt-Alyn which culminated in her resignation on December 8, 1994. Tr. 73-74, 91-100, 110-20, 491-92, 494-95. Marotta took maternity leave in the spring of 1994, but was given only four weeks of paid leave, rather than the eight weeks which she felt was appropriate. Tr. 91-92. She was also upset that Richardt-Alyn had changed her compensation structure. Tr. 93, 484-85. After she became a registered representative, Richardt-Alyn discontinued the salary she had drawn as a clerk, forcing her to rely solely on sales commissions. Also, according to Marotta, Richardt-Alyn had cheated her out of $10,000 in commissions. Tr. 100, 113-15. Marotta was angry and upset with the Respondents when she resigned from the firm. Tr. 98, 118, 120, 494-95. Shortly thereafter, she contacted her attorney, who arranged a meeting with Commission staff. Tr. 99. She told Commission staff that Respondents were cheating their clients, selling short on the down tick, front running, and had cheated her out of $10,000 in commissions.15 Tr. 99-100.
In addition, Marotta's testimony on some points is inconsistent with more credible evidence. For example, Marotta testified that she observed the Respondents engaging in the activity of obtaining undisclosed trading profits immediately prior to her maternity leave. Tr. 47. However, there is no record of the alleged activity for the two week period prior to Marotta's maternity leave. See Tr. 102-03; Div. Exs. 1-4, 200-80, 300-86, 400-04, 420-22. Additionally, her testimony that she had a good view of the SelectNet screen from her position at the post is inconsistent with the seating arrangements and layout of the post. Tr. 35, 43-44, 93-95, 509-10, 512; Resp. Ex. 2.
I conclude that the Respondents willfully violated the antifraud provisions in connection with their execution of customer trades with Jones by retaining undisclosed trading profits. This practice violated their duty of best execution and thus the antifraud provisions. Their similar course of dealing with broker-dealers, however, did not violate the antifraud provisions because the Commission does not hold broker-dealers dealing with other broker-dealers to the same level of duties owed to retail customers in executing trades. I further conclude that the allegation of books and records violations is unproven because Respondents' books and records accurately revealed their practice of obtaining and retaining trading profits in the trades at issue in this proceeding.
The OIP charged the Respondents with violating Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder (antifraud provisions).16 Section 17(a) of the Securities Act makes it unlawful "in the offer or sale of" securities, by jurisdictional means, to:
1) employ any device, scheme, or artifice to defraud,
2) obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary to make the statement made not misleading, or
3) engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Section 10(b) of the Exchange Act and Rule 10b-5 thereunder proscribe similar practices "in connection with" the purchase or sale of securities. Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder proscribe similar practices by brokers and dealers in connection with transactions in OTC securities.
Scienter is required to establish violations of Section 17(a)(1) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; it is "a mental state embracing intent to deceive, manipulate, or defraud." Aaron v. SEC, 446 U.S. 680, 686 & n.5, 695-97 (1980); see also Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n. 12 (1976).
Recklessness can satisfy the scienter requirement. David Disner, 52 S.E.C. 1217, 1222 & n. 20 (1997); see also SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992); Hollinger v. Titan Capital Corp., 914 F.2d 1564, 1568-69 (9th Cir. 1990). Reckless conduct is conduct which is "`highly unreasonable' and which represents `an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.'" Rolf v. Blyth, Eastman Dillon & Co. , 570 F.2d 38, 47 (2d Cir. 1978) (quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977)).
Material misrepresentations and omissions violate Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 10b-5 thereunder, and Exchange Act Section 15(c) and Rule 15c1-2 thereunder. The standard of materiality is whether or not a reasonable investor or prospective investor would have considered the information important in deciding whether or not to invest. See SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. 224, 231-32, 240 (1988); TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
The Antifraud provisions are incorporated in the duty of best execution insofar as they apply to the obligations of broker-dealers to their customers in respect to prices and other aspects of executing trades. The Commission has variously articulated this duty in terms of the "shingle" theory, a relationship of trust and confidence, and agency. See Order Execution Obligations, 62 SEC Docket at 2242-44; Randall W. Quinn, Deja Vu All Over Again: The SEC's Return to Agency Theory in Regulating Broker-Dealers, 1990 Colum. Bus. L. Rev. 61 (1990); Newton v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266, 270 (3rd Cir. 1998); E.F. Hutton & Co., 49 S.E.C. 829, 831-32 (1988). The Commission has stated that the duty of best execution must evolve as changes occur in the market that give rise to improved executions for customer orders, including opportunities to trade at more advantageous prices. Order Execution Obligations, 62 SEC Docket at 2242-43. Indeed, in 1998, in Newton v. Merrill Lynch, the court held that a broker-dealer's execution of a customer trade at the NBBO when a better price was readily available breaches the duty of best execution and constitutes a material misrepresentation in violation of the Antifraud provisions. 135 F.3d at 273-274.
While the antifraud provisions are most often applied in cases of fraud against the investing public, they can also apply to fraud against broker-dealers. U.S. v. Naftalin, 441 U.S. 768, 774-77 (1979) (Section 17(a)); A. T. Brod & Co. v. Perlow, 375 F.2d 393, 396-97 (2d Cir. 1967) (Section 10(b) and Rule 10b-5). In those cases, customers defrauded broker-dealers with "heads I win, tails you lose" schemes.17 However, the Commission has never imposed the same duties broker-dealers owe to investors on a broker-dealer dealing with another broker-dealer. For example, Rule 10b-10 of the Exchange Act lists items that must be disclosed to "customers," including, in principal transactions, the amount of profit in connection with each transaction. Rule 10b-10(d)(1) of the Exchange Act, however, explicitly excludes broker-dealers from the definition of "customer." See also Exchange Act Rule 15c1-1(a). The Division cites numerous cases in which broker-dealers were held to have violated the antifraud provisions by obtaining secret profits; in all such cases, the secret profits were obtained at the expense of retail customers. There is no case holding that a duty of best execution applies between two broker-dealers.
The record contains evidence and arguments as to whether the relationship of Richardt-Alyn to the clients was that of principal or agent. The Division, for example, points to the fees Richardt-Alyn charged for the transactions, and argues that the clients understood that they would get the best prices.18 The status of principal or agent is not dispositive of the duties a broker-dealer owes to a customer. Opper v. Hancock Securities Corporation, 250 F. Supp. 668, 675 (S.D.N.Y.), aff'd, 367 F.2d 157 (2d Cir. 1966). However, all precedent pertaining to an agency relationship in the context of the antifraud provisions of the securities laws involves a broker-dealer's relationship to a retail customer. There are no cases holding that a broker-dealer violated the antifraud provisions arising out of an agency relationship with another broker-dealer.
Accordingly, the record does not show any violation of the antifraud provisions arising out of Respondents' course of dealing with Flagship or DLA. Furthermore, the record does not show any violation of the antifraud provisions in connection with the transactions involving Park Avenue, a broker-dealer, which were for the firm's account.
2. Transactions with Jones Violated the Antifraud Provisions
The record shows Jones dealt with Respondents as a customer and placed limit orders, not market orders. Respondents filled five orders for OTC securities at better prices than his limit and retained and did not disclose the trading profits. No matter how sophisticated the customer and how experienced in the securities industry, the broker-dealer owes the customer the duty of best execution. E.F. Hutton & Co., 49 S.E.C. at 831-32, 838. Accordingly, Respondents violated the antifraud provisions in connection with the five Jones trades. The record shows that Respondent Richardt-Alyn is effectively wholly owned and operated by Respondents R. Feinberg and A. Feinberg, both of whom agreed on the course of action at issue and both of whom participated in the Jones trades. Accordingly, the conclusion of violation applies to all three Respondents.
The record shows that Respondents did not disclose to Jones the price at which five of his limit order trades were executed. Instead, they executed the trades with market makers at prices that were better than the prices they disclosed to him, and retained the undisclosed trading profits for themselves. The facts underlying this conclusion were established by Respondents' own admissions and by their own books and records.
The standard of materiality is whether or not a reasonable investor would have considered the information important. SEC v. Steadman, 967 F.2d at 643; see also Basic Inc. v. Levinson, 485 U.S. at 231-32, 240; TSC Industries, Inc. v. Northway, Inc., 426 U.S. at 449. In this case, the omitted or misrepresented information was clearly material. The record clearly shows that Jones considered the misrepresented and omitted information important. Additionally, for each of the five trades, the retained trading profits greatly exceeded the commission per share that Jones expected to pay and was charged. See Newton v. Merrill Lynch, 135 F.3d at 273-274 (a broker that accepts a customer order while intending to breach the duty of best execution has made a material misrepresentation).
The record shows the Respondents' scienter: their intent was to deceive and defraud. Respondents intentionally gave Jones a less favorable price on his limit orders than the price at which they had already executed the trade on SelectNet. In the alternative, the Respondents were reckless in a belief that this met their duty of best execution of customer trades.
The Division requests sanctions pursuant to Sections 8A of the Securities Act and 15(b)(6), 21B, and 21C of the Exchange Act. The Commission must find willful violations to impose sanctions under Sections 15(b) and 21B of the Exchange Act. It is well settled that a finding of willfulness does not require an intent to violate, but merely an intent to do the act which constitutes a violation. Jacob Wonsover, 69 SEC Docket 694, 709-13 (Mar. 1, 1999), appeal filed, No. 99-1167 (D.C. Cir.); see also Steadman v. SEC, 603 F.2d 1126, 1135 (5th Cir. 1979), aff'd on other grounds, 450 U.S. 91 (1981); Arthur Lipper Corp. v. SEC, 547 F.2d 171, 180 (2d Cir. 1976); Tager v. SEC, 344 F.2d 5, 8 (2d Cir. 1965). The acts which constituted the Respondents' violations were, as described above, clearly intentional. Their violations of the antifraud provisions were thus willful.
The OIP charged Respondents with violating Section 17(a) of the Exchange Act and Rule 17a-3 thereunder. Section 17(a)(1) provides that brokers and dealers "shall make and keep for prescribed periods such records, furnish such copies thereof, and make and disseminate such reports as the Commission, by rule, prescribes as necessary or appropriate in the public interest." The requirement that records be kept embodies the requirement that they be accurate. James F. Novak, 47 S.E.C. 892, 897 (1983).
The Commission has emphasized the importance of the records required by the recordkeeping rules as "the basic source documents and transaction records of a broker-dealer." Statement Regarding the Maintenance of Current Books and Records by Brokers and Dealers, Exchange Act Release No. 10756, 1974 SEC LEXIS 3290 (Apr. 26, 1974). The recordkeeping rules are "a keystone of the surveillance of brokers and dealers by our staff and by the security industry's self-regulatory bodies." Edward J. Mawod & Co., 46 S.E.C. 865, 873 n.39 (1977) (citations omitted), aff'd, 591 F.2d 588 (10th Cir. 1979). Scienter is not required to prove a violation of Section 17(a)(1) of the Exchange Act and the rules thereunder. Stead v. SEC, 444 F.2d 713, 716-17 (10th Cir. 1971); SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. 587, 610 (S.D.N.Y. 1993), aff'd sub nom. SEC v. Posner, 16 F.3d 520 (2d Cir. 1994), cert. denied, 513 U.S. 1077 (1995).
Rule 17a-3 requires brokers and dealers to make and keep current certain books and records, including:
1) blotters containing an itemized daily record of all purchases and sales of securities, all receipts and deliveries, all receipts and disbursements of cash and all other debits and credits (Rule 17a-3(a)(1));
2) ledgers reflecting all assets and liabilities, income and expense and capital accounts (Rule 17a-3(a)(2));
3) memoranda of each brokerage order and of each purchase and sale of securities for the account of the member, broker, or dealer showing the price and, to the extent feasible, the time of execution (Rules 17a-3(a)(6) and (7)); and
4) copies of confirmations of all purchases and sales of securities (Rule 17a-3(a)(8)).19
There was no violation of Exchange Act Section 17(a) and Rule 17a-3. Respondents' books and records, such as blotters and order tickets, accurately reflected the Respondents' transactions, and memorialized the difference between prices charged or paid to the clients and prices paid or charged to market makers.20These records that Respondents created are, in fact, the chief evidence in the Division's case against them, which is based on the price difference.
The Division requests a cease and desist order; a one year suspension of R. Feinberg and A. Feinberg from association with a broker-dealer; disgorgement; and a second tier civil monetary penalty of $50,000 each against R. Feinberg and A. Feinberg. The Respondents urge that this proceeding be dismissed.
For the reasons discussed below, these sanctions will be ordered: a cease and desist order against all three Respondents; censure of R. Feinberg and A. Feinberg; disgorgement by Richardt-Alyn of $1375 plus prejudgment interest; and civil money penalties of $5000 each against R. Feinberg and A. Feinberg.
When the Commission determines administrative sanctions, it considers:
the egregiousness of the defendant's actions, the isolated or recurrent nature of the infraction, the degree of scienter involved, the sincerity of the defendant's assurances against future violations, the defendant's recognition of the wrongful nature of his conduct, and the likelihood that the defendant's occupation will present opportunities for future violations.
Steadman v. SEC, 603 F.2d at 1140 (quoting SEC v. Blatt, 583 F.2d 1325, 1334 n.29 (5th Cir. 1978), aff'd on other grounds, 450 U.S. 91 (1981)).
The Commission determines sanctions pursuant to a public interest standard.21 Thus, in addition to issues related to the violator, it "weigh[s] the effect of [its] action or inaction on the welfare of investors as a class and on standards of conduct in the securities business generally." Arthur Lipper Corp., 46 S.E.C. at 100; Richard C. Spangler, Inc., 46 S.E.C. 238, 254 n.67 (1976). The amount of a sanction depends on the facts of each case and the value of the sanction in preventing a recurrence. Berko v. SEC, 316 F.2d 137, 141 (2d Cir. 1963); Leo Glassman, 46 S.E.C. 209, 211-12 (1975).
1. Cease and Desist
Sections 8A of the Securities Act and 21C of the Exchange Act authorize the Commission to issue a cease and desist order against a person who "is violating, has violated, or is about to violate" any provision of the Acts or rules thereunder. As concluded above, all Respondents willfully violated Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 10b-5 thereunder, and Exchange Act Section 15(c) and Rule 15c1-2 thereunder. Further, the record shows a reasonable likelihood of such violations in the future.22 The relevant factors to consider when assessing the likelihood of recurrent violation include "`whether a defendant's violation was isolated or part of a pattern, whether the violation was flagrant and deliberate or merely technical in nature, and whether the defendant's business will present opportunities to violate the law in the future.'" SEC v. Steadman, 967 F. 2d at 648 (quoting SEC v. First City Fin. Corp., 890 F.2d 1215, 1228 (D.C. Cir. 1989)).
Respondents' violative actions involved five trades with one customer on one day. To the extent that more than one trade was involved, their violations were not isolated. The violations were closer to "flagrant and deliberate" than "merely technical." The Respondents' business is in the securities industry, so their business will present opportunities to violate the law in the future. While R. Feinberg and A. Feinberg articulated the heavy personal, professional, and financial cost resulting from this proceeding, they did not disavow like conduct in the future. R. Feinberg and A. Feinberg decided to retain trading profits without disclosing this to the customer or without obtaining the advice of anyone else as to the propriety of this plan. This adds to the likelihood of future violation. Since Richardt-Alyn is effectively wholly owned and operated by the two individual Respondents, and since they mutually agreed on the practice at issue and participated in the violative trades with Jones, a cease and desist order against all three is appropriate. Accordingly, it is appropriate to order all Respondents to cease and desist from committing or causing and violations or future violations of Securities Act Section 17(a), Exchange Act Section 10(b) and Rule 10b-5 thereunder, and Exchange Act Section 15(c) and Rule 15c1-2 thereunder.
Exchange Act Section 21C(e) authorizes disgorgement in this proceeding. Disgorgement is an equitable remedy that requires a violator to give up wrongfully obtained profits causally related to the proven wrongdoing. First City Fin. Corp., 890 F.2d at 1230-31; see also Hateley v. SEC, 8 F.3d 653, 655-56 (9th Cir. 1993). It returns him to where he would have been absent the violative activity. Richardt-Alyn's wrongfully obtained profits from the violative trades with Jones amount to $1375. Accordingly, disgorgement of $1375 is appropriate in this case.
3. Civil Money Penalty
Section 21B(a) of the Exchange Act authorizes the Commission to impose civil money penalties for willful violations of the Securities or Exchange Acts or rules thereunder. In considering whether a penalty is in the public interest, the Commission may consider six factors: (1) fraud; (2) harm to others; (3) unjust enrichment; (4) previous violations; (5) deterrence; and (6) such other matters as justice may require. Section 21B(c); New Allied Dev. Corp., 52 S.E.C. 1119, 1130 n.33 (1996); First Sec. Transfer Sys., Inc., 52 S.E.C. 392, 395-96 (1995). See also Jay Houston Meadows, 61 SEC Docket 2444, 2456-58 (May 1, 1996), aff'd, 119 F.3d 1219 (5th Cir. 1997); Consolidated Inv. Servs., 52 S.E.C. 582, 590-91 (1996).
Respondents violated the antifraud provisions, so their violative actions "involved fraud [and] reckless disregard of a regulatory requirement" within the meaning of Exchange Act Section 21B(c)(1). Previous violations consist of a $500 NASD fine for a technical infraction around 1971, the 1993 NASD settlement pertaining to alleged improper use of SOES, and a 1989 PHLX fine of A. Feinberg of $3000 for front-running. The record evidence of unjust enrichment and harm to others is limited to the $1375 in undisclosed trading profits that Richardt-Alyn retained.
A penalty is in the public interest in this case. A penalty in addition to a cease and desist order, censure, and disgorgement is necessary for the purpose of deterrence. See Exchange Act Section 21B(c)(5); H. Rep. 101-616 (1990). A second tier penalty, as the Division argues, is appropriate because the violative acts involved reckless disregard of a regulatory requirement. See Section 21B(b)(2).
The maximum second tier penalty for a natural person for "each act or omission" is $50,000 for the violations in this proceeding.23 Exchange Act Section 21B, like most civil penalty statutes, leaves the precise unit of violation undefined. See Colin S. Diver, The Assessment and Mitigation of Civil Money Penalties by Federal Administrative Agencies, 79 Colum. L. Rev. 1435, 1440-41 (1979). Respondents' entire course of action was in connection with trading with one customer on one day and will be considered as one violation. In view of the limited profits and harm to others, quantified as $1375, a penalty of $5000 each is appropriate for R. Feinberg and A. Feinberg.
The Division requests, pursuant to Section 15(b) of the Exchange Act, that R. Feinberg and A. Feinberg each be suspended from association with any broker or dealer for twelve months.
Based on the factors enunciated in Steadman v. SEC, 603 F.2d at 1140, it is in the public interest to censure R. Feinberg and A. Feinberg. Combined with other sanctions ordered, this is an appropriate remedy and deterrent. Their violations involved scienter. Their business presents them with the opportunity to commit violations of the securities laws in the future. They displayed remorse by indicating the heavy professional, personal, and financial cost that they have incurred. However, consistent with their defense of the charges against them, neither has recognized the wrongful nature of his conduct. Nonetheless, their proven violations involved only five out of 177 trades which were alleged to be violative, which reduces the egregiousness of the violations. Thus, censure, in combination with the other sanctions ordered, is the appropriate remedy under Section 15(b) of the Exchange Act.
Pursuant to Rule 351(b) of the Commission's Rules of Practice, 17 C.F.R. § 201.351(b), I hereby certify that the record includes the items set forth as of the record index issued by the Secretary of the Commission on July 16, 1997.
Based on the findings and conclusions set forth above:
It is ordered that, pursuant to Sections 8A of the Securities Act and 21C of the Exchange Act, Richardt-Alyn & Co., Richard B. Feinberg, and Alan S. Feinberg, 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 Section 15(c) of the Exchange Act and Rule 15c1-2, thereunder.
It is further ordered that, pursuant to Sections 15(b) and 19(h) of the Exchange Act, Richard B. Feinberg and Alan S. Feinberg ARE CENSURED for violations of Section 17(a) of the Securities Act; Section 10(b) of the Exchange Act and Rule 10b-5 thereunder; and Section 15(c) of the Exchange Act and Rule 15c1-2, thereunder.
It is further ordered that, pursuant to 21B of the Exchange Act, Richard B. Feinberg and Alan S. Feinberg each PAY A CIVIL MONETARY PENALTY of $5000.
It is further ordered that, pursuant to Section 21C of the Exchange Act, Richardt-Alyn & Co. DISGORGE $1375 plus prejudgment interest at the rate established under Section 6621(a)(2) of the Internal Revenue Code, 26 U.S.C. § 6621(a)(2), compounded quarterly, pursuant to Rule 600 of the Commission's Rules of Practice, 17 C.F.R. § 201.600. Pursuant to Rule 600(a), prejudgment interest is due from July 1, 1994, through the last day of the month preceding which payment is made.
Payment shall be made on the first day following the day this initial decision becomes final by certified check, U.S. Postal money order, bank cashier's check or bank money order payable to the Securities and Exchange Commission. The check[s] and a cover letter identifying the Respondent[s] and Administrative Proceeding No. 3-9099, should be delivered by hand or courier to the Comptroller, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, Virginia 22312. A copy of the cover letter should be sent to the Commission's Division of Enforcement at the same address.
This order shall become effective in accordance with and subject to the provisions of Rule 360 of the Commission's Rules of Practice, 17 C.F.R. § 201.360. Pursuant to that rule, a petition for review of this initial decision may be filed within 21 days after service of the decision. It shall become the final decision of the Commission as to each party who has not filed a petition for review pursuant to Rule 360(d)(1) within 21 days after service of the initial decision upon him, unless the Commission, pursuant to Rule 360(b)(1), determines on its own initiative to review this initial decision as to any party. If a party timely files a petition for review, or the Commission acts to review as to a party, the initial decision shall not become final as to that party.
Carol Fox Foelak
Administrative Law Judge
--Citations are to the hearing transcript "(Tr.__)" and to the exhibits admitted into evidence at the hearing. The Division exhibits are "(Div. Ex.__)," and the Respondent exhibits are "(Resp. Ex.__)."
--See 5 U.S.C. §557(c).
--The clients whose trades are at issue in this proceeding had Level 1 service, or similar, that displayed the NBBO. Tr. 208-09, 264-66, 241-43, 580.
--Instinet is another ECN. It is a proprietary screen-based automated trading system consisting of a network of computer terminals, accessible only to some broker-dealers and participating institutional investors; participants enter orders to buy and sell anonymously and execute against those orders through a computerized system. NASD 21(a) Report, 62 SEC Docket at 1399 & nn. 48-50, 1443 n.15. During the time at issue in this proceeding, Instinet quotes were not displayed on Nasdaq or otherwise broadcast to the public and did not modify the quotes on Nasdaq. During the time at issue, Instinet and SelectNet were the two most significant ECNs in the Nasdaq market. Order Execution Obligations (Final Rules), 62 SEC Docket 2210, 2228 (Sept. 12, 1996).
--In the Order Execution Obligations (Notice of Proposed Rule Making (NPRM)), 60 SEC Docket 1128 (Oct. 10, 1995), the Commission indicated, obliquely, that using SOES satisfied a broker-dealer's duty of best execution for a customer's transaction. See 60 SEC Docket at 1130.
--The NPRM in that proceeding also discussed the two-tiered market. Order Execution Obligations (NPRM), 60 SEC Docket 1128.
--"Omnibus" describes a type of relationship between a clearing broker and an introducing broker. The clearing broker (Richardt-Alyn) executes all trades to and from a single account belonging to the introducing broker (DLA). A clearing broker is the introducing broker's agent, and acts on the introducing broker's behalf, performing those duties delegated in order to fulfill the introducing broker's obligations to its retail customers. See William J. Fitzpatrick & Ronald T. Carman, An Analysis of the Business and Legal Relationship Between Introducing and Carrying Brokers, 40 Bus. Law. 47, 48 (1984). In an omnibus arrangement, the clearing broker has no knowledge of the identities of the final retail customer for the trades executed.
--With respect to non-Nasdaq OTC securities, the agreement provided that Richardt-Alyn "will obtain the quotes of at least three market-makers before execution." Div. Ex. 281.
--Flagship also leased an exchange seat from Richardt-Alyn. Tr. 202, 374-75. A letter dated July 31, 1990, from R. Feinberg to Garber (Div. Ex. 388) does not represent the terms of the agreement that was finally reached between Richardt-Alyn and Flagship some weeks later. Tr. 202-03, 373-76.
--Marotta testified that she did not hear Jones make the statement. Tr. 52. However, as discussed below, I have not relied on her testimony as to controverted facts.
--A coop is a pigeonhole in which Richardt-Alyn kept order tickets and delivery tickets for a particular broker-dealer client. Each client had a different coop. Tr. 45.
--DLA's account number is found on both the order ticket and the RECEIVED box on the delivery ticket.
--Jones filled out the order ticket himself, but the eight in the denominator of thirty-eight and one-eighth is not in his handwriting. Tr. 270.
-- Milewitz testified that on rare occasions the Respondents would call back and change the price, for better or worse. Tr. 223. This testimony is inconsistent not only with Respondents' testimony, but also that of Pansy Rayson of DLA, who testified that Richardt-Alyn never called back to change the price after having given a confirmation. Tr. 163. I reject the testimony of Milewitz on this disputed point for the reasons discussed above and credit the testimony of Rayson and the Respondents.
-- Shortly after Marotta left she called A. Feinberg and told him she was owed $70 in commissions, and he forwarded that amount to her. Tr. 115, 495. Marotta never filed an arbitration or lawsuit concerning $10,000 in commissions, nor did she ask the Respondents for $10,000 or for an explanation of their calculations of her commissions. Tr. 114-15.
--The term "antifraud provisions," as used in the Conclusions of Law, encompasses Section 17(a) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and Section 15(c) of the Exchange Act and Rule 15c1-2 thereunder.
--In Naftalin, the customer's fraudulent short sale scheme was to place sell orders with broker-dealers and not deliver the securities when the price moved against him. In Perlow, the customers placed buy orders with broker-dealers with the fraudulent intent of paying only if the price moved in their favor by the settlement date.
-- Only DLA had a written agreement with Richardt-Alyn. That agreement provided for executions at the NBBO, by referring to a quote based system of pricing ("interrogate the [Nasdaq] system"). By contrast, using SelectNet, a broker-dealer does not obtain a price quote; he enters an order and waits to see if it is executed.
--This rule is not violated by inaccurate confirmations. Hattier, Sanford & Reynoir, 66 SEC Docket 922, 926-27 n.11 (Jan. 13, 1998), aff'd, No. 98-60134 (5th Cir. 1998) (unpublished opinion). Exchange Act Rule 10b-10, which is not applicable in this proceeding, is violated by inaccurate confirmations. Bison Sec., Inc., 51 S.E.C. 327, 333 (1993).
--The only recent reported Commission cases that specifically rule on blotter and order ticket violations are settlements. (There are no such rulings on ledger violations that bear on the facts in this case.) Even these rulings would not support a conclusion that Rules 17a-3(a)(1) and 17a-(3)(a)(7) were violated. In contrast to the instant case, in which blotters and order tickets revealed the Respondents' activities accurately, the blotter and order ticket irregularities in these cases were for the purpose of concealing wrongdoing. Howard A. Rubin, 45 SEC Docket 1530, 1531 (Mar. 20, 1990) (absence of entry for transaction); PaineWebber Inc., 61 SEC Docket 179, 205-06 (Jan. 17, 1996); Goldman, Sachs & Co., 55 SEC Docket 3208, 3214-16 (Feb. 3, 1994) (failure to record side agreements, such as parking agreements); Cantor Fitzgerald & Co., 56 SEC Docket 812, 816-17 (Mar. 17, 1994); Howe Barnes Inv., Inc., 62 SEC Docket 2627, 2633 (Sept. 23, 1996) (inaccurate or no time stamp and unclear customer, security, and buy/sell information); Lehman Brothers Inc., 59 SEC Docket 3135, 3140 (Aug. 15, 1995) (failure to record customer names accurately); James W. Adams, 63 SEC Docket 964, 965 (Dec. 2, 1996); Carroll McEntee & McGinley Sec., Inc., 54 SEC Docket 2407, 2410-11 (Sept. 2, 1993); First Fidelity Sec. Group, 61 SEC Docket 68, 79 (Jan. 9, 1996) (inaccurate prices - failing to reveal kick-backs or hidden fees); Refco Sec., Inc., 62 SEC Docket 1330, 1332-33 (Aug. 6, 1996); Gruntal & Co., 61 SEC Docket 1994, 2005-06 (Apr. 9, 1996) (blotters that did not reflect theft of customer securities and funds); M. Rimson & Co., Inc., 63 SEC Docket 2707, 2716-17 (Feb. 21, 1997) (tickets naming registered representatives who were not involved in the transactions).
-- See, e.g., Exchange Act Sections 15(b)(6)(A) and 21B(a), (c), and (d).
--Neither the Commission nor any court of appeals has ruled on whether the Commission must find a likelihood of future violation to issue a cease and desist order. See Warren G. Trepp, Order Dismissing Proceedings, Exch. Act. Rel. No. 41913 (Sept. 24, 1999). The courts have, however, ruled that a likelihood of future violation is required when considering the cease and desist authority of other administrative agencies. See Precious Metal Associates, Inc. v. CFTC, 620 F.2d 900, 912 (1st Cir. 1980); Borg-Warner Corp. v. FTC, 746 F.2d 108, 110-11 (2d Cir. 1984); NLRB v. Savin Business Machines Corp., 649 F.2d 89, 93 (1st Cir. 1981); Citizens State Bank v. FDIC, 751 F.2d 209, 214-15 & n.9 (8th Cir. 1984). Cease and desist authority was added to the sanctions available to the Commission in administrative proceedings by the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. As noted in the House Report on the legislation, other federal agencies, for example, the Commodity Futures Trading Commission (CFTC), Federal Trade Commission (FTC), National Labor Relations Board (NLRB), and each of the federal bank regulatory agencies, are empowered to issue cease and desist orders; a cease and desist order was described as an administrative remedy comparable to an injunction. H. Rep. 101-16, at 23-24 (1990). A likelihood of future violation is required for an injunction. SEC v. Steadman, 967 F.2d at 647-48; United States v. W.T. Grant Co., 345 U.S. 629, 633 (1953).
--The Commission increased the amounts for violations occurring after December 9, 1996. Adjustment to Civil Monetary Penalty Amounts, 61 Fed. Reg. 57773 (Nov. 8, 1996).
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