Securities and Exchange Commission
In the Matter of the Application of
NICHOLAS T. AVELLO
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
OPINION OF THE COMMISSION
REGISTERED SECURITIES ASSOCIATION - REVIEW OF DISCIPLINARY PROCEEDINGS
Operating Securities Firm Without Adequate Net Capital
Failure to Maintain Accurate Records
Filing Inaccurate Financial Reports
Filing Inaccurate FOCUS Reports
Former financial and operations principal of former member firm of registered securities association held responsible for firm operating a securities business without adequate minimum net capital, failing to maintain accurate financial records, making inaccurate financial reports to association, and filing inaccurate FOCUS II reports. Held, association's findings and sanctions sustained.
Nicholas T. Avello, pro se.
Jeffrey S. Holik, Norman Sue, Jr., Susan L. Beesley, and Shirley H. Weiss, for NASD Regulation, Inc.
Appeal filed: December 6, 2000
Last brief received: March 23, 2001
Nicholas T. Avello, formerly the financial and operations principal ("FINOP") of Hudson Knight Securities, Inc. ("HKS" or "the Firm"), a former member of the National Association ofSecurities Dealers, Inc. ("NASD"), appeals from NASD disciplinary action against him in a case that also included the Firm and Jonathan Webb, the Firm's chairman of the board and majority stockholder, as respondents. While the NASD found Webb and the Firm responsible for all of the net capital, recordkeeping, and reporting violations charged,1 it specifically absolved Avello from liability for most of the charges. The NASD found Avello liable for HKS operating a securities business on June 28, 1996, when HKS had insufficient net capital;2 failing to maintain accurate financial records and making inaccurate financial reports to the NASD;3 and filing six inaccurate quarterly FOCUS II reports on behalf of HKS between 1995 and 1997.4
In considering the appropriate sanction for Avello's violations, the NASD considered favorably Avello's diligence in reporting numerous recordkeeping and accounting errors to NASD staff and his efforts to improve the Firm's regulatory compliance. The NASD fined Avello $5,000 and assessed $665.80 in costs. We base our findings on an independent review of the record.
HKS, founded by Jonathan Webb, began operations in September 1995. Webb was the Chairman of the Board and a 50% shareholder. Courtney Knight was the President of HKS (until Webb discharged him in September 1996) and a 49% shareholder.5 Webb's mother, Myrna Webb, was the Firm's chief operations and administrative employee.
Avello has been a qualified FINOP since 1986 and has no prior disciplinary record. During the period in question, Avello worked for several broker-dealers as a part-time, off-site FINOP. He worked for HKS in this capacity from August 1995 until October 1997.6 Because he did not work out of the HKS office, Avello depended entirely on HKS for the accounting information he needed to submit the monthly reports required by the NASD of all broker-dealers in their first year of operation.
Under the Exchange Act and its rules, HKS was required to maintain $5,000 in net capital. A restrictive agreement between HKS and the NASD, however, required HKS to maintain $100,000 in net capital. From the beginning, HKS had difficulty maintaining this level, and on several occasions violated its restrictive agreement and the Commission's net capital requirements.7 Despite the NASD staff's advice to increase its capital to $145,000, HKS had only $125,000 in net capital when it opened for business. Throughout its existence, HKS remained thinly capitalized and constantly struggled to increase revenue and continue its operations.
When the monthly NASD new-member reports revealed that HKS had chronic difficulty maintaining the net capital required by its restrictive agreement, the NASD required HKS to continue submitting monthly reports even after completing its first year of operation. HKS's financial difficulties prompted NASD staff in 1996 to meet with Webb and Avello several times to address reporting issues and, between August and November, to make information requests.
According to the NASD staff, HKS did not respond adequately to the staff's information requests. Consequently, NASD staff directed Webb and Avello to attend a meeting at the NASD regional offices on November 15, 1996, and to bring with them all the financial records necessary to compute the Firm's net capital position as of November 14, 1996. At this meeting, Avello learned that Webb had regularly and systematically deceived him regarding the Firm's finances. The Firm's books, for whose accuracy Avello was responsible, reflected these deceptions, omitting or mischaracterizing several significant liabilities including many of those that provide the basis for the NASD proceedings. Upon learning of the errors and omissions, Avello began to correct them immediately.8
After the November 15 meeting, Avello obtained a commitment from Webb that HKS staff would give Avello complete financial information so that he could perform his FINOP duties. At Avello's insistence, Webb also agreed to replace the Firm's auditors. Avello thought that by reaching these agreements with Webb he had solved the most serious problems discovered at the November 15 meeting, and he continued correcting the errors and omissions and filing amended reports. When the new auditors performed the audit for 1996, however, they discovered a $50,000 loan from American National Bank & Trust Co. ("ANB") to HKS that Webb had not revealed to Avello nor to the NASD at the November 15 meeting.9 Avello made appropriate corrections in the Firm's books and records and directed the auditors to inform the NASD of this discovery, and they did.
Notwithstanding Avello's efforts to keep accurate books and records in the face of active deception by Webb, the NASD's investigation uncovered many errors for which it ultimately held Avello liable.10 We discuss these below.
In November 1995, Courtney Knight opened an American Express Small Business Corporate Card Account for HKS. Under the agreement, Jonathan Webb, Myrna Webb, and Knight received American Express cards for their business expenses. The account agreement provided that HKS would be liable for all charges on the account, even though HKS expected that the individuals using the cards would pay their own balances.
All three of the cardholders used the cards but failed to pay the balances due. Avello knew that the individuals were not paying their American Express bills. Although the account agreement clearly provided that HKS was responsible for all charges on the cards, Avello claims that he was under the mistaken impression (allegedly gained from HKS managers and American Express customer service personnel) that the person using the card was primarily liable for the balance and that HKS was only secondarily liable; therefore he did not book the account balances as an HKS liability. In November 1996, the NASD directed Avello to book the account balances as an HKS liability, and he did so.
In late 1995, HKS agreed to direct trades to two other broker-dealers in return for payment. Avello counted the receivables generated by these "payment-for-order-flow" agreements as allowable assets when calculating HKS's net capital. On June 3, 1996, the NASD informed Avello that he should not characterize payment-for-order-flow receivables as allowable assets for net capital purposes. Soon thereafter, HKS canceled its agreement with one broker-dealer and renegotiated its agreement with the other, Herzog, Heine, Geduld ("Herzog"). Under the renegotiated Herzog agreement, the payments were no longer denominated as "payment for order flow" but as "rebates receivables" instead. Avello booked the receivables under the new Herzog agreement as allowable assets. NASD staff reviewed the renegotiated agreement, determined that the receivables were, in effect, payment-for-order-flow receivables under a different name, and informed Avello that the receivables were not allowable assets. Avello disagreed with the NASD's interpretation andcontinued to book the Herzog receivables as an allowable asset through August 1996.
In early 1996, Webb, on behalf of HKS, took out a sole-recourse, $60,000 loan from ANB, secured by earned but unpaid underwriting fees.11 Despite his timely receipt of complete and accurate information from HKS concerning the terms of the loan, Avello did not book this liability in January 1996, the first month it was incurred. In February and March 1996, he failed to book two payments made by HKS, thereby overstating the loan liability in HKS's reports to the NASD. He booked the loan liability accurately in April and May.
In June 1996, the lead underwriter sent HKS the final payment of the underwriting fee HKS had earned. HKS did not apply the final payment to the outstanding loan balance.12 However, when Avello asked Webb whether the loan balance had been paid off, Webb responded untruthfully that it had. Without any evidence of repayment beyond Webb's representation, Avello removed the liability from the books. Had Avello checked with the lender he would have discovered that the loan had not been repaid.
In early 1996, HKS entered a lease agreement with the National Bank of Detroit ("NBD") for office furniture and equipment. Webb gave Avello the bank debit memoranda which characterized the monthly withdrawal as "rent" pursuant to a rental agreement, and Avello accordingly treated the monthly payments as monthly rental expenses. He did not ask to see, and no one provided him with, the underlying agreement with NBD which clearly memorialized a capital lease transaction. When NASD examiners showed Avello the lease agreement in November 1996, Avello agreed that the terms of the lease required that the full lease be capitalized and treated as a liability on HKS's books.
In HKS's monthly financial reports for February 1996, Avello entered as an asset an amount characterized as a "deposit in transit," (a check or other payment on its way to the bank, but not yet credited). The Firm's bank never received or credited the check in question. Because the bank never received the check, Avello should have backed the check out of HKS's net capital calculations and should have corrected already filed reports. He did not do so. Also, in HKS's March 1996 reports, Avello treated as an allowable asset a receivable forunderwriting fees that NASD examiners determined was "stale" and therefore could not be allowed as an asset for net capital purposes.13
During 1997, the NASD received information from Courtney Knight and HKS creditors regarding delinquent debts of HKS that had never been indicated on the financial reports submitted to the NASD.14 The liabilities included unpaid balances owed to Bloomberg, L.P., a financial information services provider; Vedder Price, a law firm that turned the delinquent HKS account over to Transworld Systems, a collection agency; MidCom, a telecommunications service provider; and United Parcel Service, the package delivery company.15 Avello testified that he had had significant difficulty getting accounts payable information from the newly hired HKS staff accountant. Nonetheless, Avello claimed that he did his best to submit reports for HKS on a timely basis despite his doubts regarding their completeness and accuracy. On his final report submitted to the NASD, Avello made a handwritten notation that the report was likely not accurate.
Our review of the record confirms the violations found by the NASD. Specifically, the net capital report filed by Avello for HKS on June 28, 1996, asserting that HKS had $670 in excess of the $100,000 in net capital required by its restrictive agreement, contained several errors. It did not include a $7,774 balance owed to American Express, erroneously characterized the $5,963 receivable from Herzog for order flow as an allowable asset, failed to record the $49,473 balance attributable to the ANB sole-recourse loan, and misreported the $59,126 liability attributable to the NBD lease. Adjusting the net capital calculation for these errors alone (excluding additional errors attributable to Webb) yields a $21,666 negative position for netcapital for June 28, 1996, $26,666 less than the $5,000 in net capital Rule 15c3-1 required HKS to maintain.
The financial reports submitted to the NASD for which Avello was held liable were inaccurate. They were based on inaccuracies in the Firm's books and records. The books and records and the reports based on them included the erroneous information that produced the June 1996 net capital calculation errors as well as mistakes regarding a deposit in transit that was never credited and a stale receivable asset. Various financial reports also omitted the miscellaneous debts owed by HKS to vendors for January through August 1997. Finally, because the FOCUS reports Avello filed for the quarters ending December 29, 1995, March 29, 1996, June 28, 1996, September 30, 1996, March 31, 1997, and June 30, 1997, incorporated all of the errors just described, they also were inaccurate.
These net capital, recordkeeping, and reporting violations were attributable to Avello's errors. Avello decided to rely on representations by HKS management regarding the American Express account agreement in the face of language in the agreement itself that contradicted those representations. Avello decided to treat receivables generated by the Herzog agreement as allowable assets even though NASD staff had told him not to do so. He also decided to remove the balance of the sole-recourse loan from HKS's liabilities even though he had no evidence that the loan had been repaid other than Webb's oral representation. Webb's statement could not have withstood a demand for evidence of repayment or even further questions, but Avello never inquired further.
Avello determined to accept, on the basis of a bank debit memorandum without examination of the underlying agreements, Webb's representation that the agreement with NBD by which HKS had the use of office furniture and equipment was only a rental agreement and not a capital lease that should have been added to the Firm's liabilities. When Avello was shown the NBD agreement by NASD staff, Avello agreed that he should have added it to the Firm's liabilities. The failure to review that agreement, or even ask to see it, is not commensurate with a FINOP's responsibilities.
Avello should not have continued to file financial reports that he knew were based on inadequate financial information. In making these filings Avello failed to include numerous HKS liabilities, such as charges for UPS delivery services, telephone service, legal services, information services, and other services. By continuing to serve as FINOP even though he knew the information on which he was basing reports was inadequate and possibly inaccurate, Avello helped to conceal the extent of theFirm's financial difficulties from the NASD. These failures constitute an abdication of Avello's duties as a FINOP.16
Although Avello does not dispute the errors discovered by the NASD or the facts describing his role in making and reporting those errors, he argues that it is nonetheless somehow unfair to hold him liable. We disagree.
Avello argues that the NASD's decision is inconsistent with its precedent of not holding a FINOP responsible for violations that the FINOP discloses to the NASD. Avello cites no authority establishing that such precedent exists. Moreover, even if it did exist, it would not be applicable to Avello. Avello did not disclose to the NASD any of the violations for which the NASD found him liable; the only violations he disclosed were the net capital deficiency caused by the $65,000 bounced check in May 1996 and the $60,000 ANB loan discovered by auditors in the course of their 1996 annual audit. The NASD did not hold Avello liable for these violations.
We also reject Avello's argument that the hearing he received from the NASD was procedurally and substantively defective because the NASD did not join the former president of HKS, Courtney Knight, as an "indispensable party" to the proceedings.17 The record contains voluminous evidence regarding each of the errors with which the NASD charged Avello, and Avello has made no showing either that he attempted to secure Knight's testimony on his own or that any testimony Knight might have offered would have contradicted that evidence.
Avello's other procedural objections to the hearing also lack merit. Contrary to Avello's claims, the Hearing Panel allowed Avello to testify fully regarding the violations with which he was charged, and Avello presented a persuasive case that he should not be held responsible for a number of the offenses with which the NASD charged him. The NASD recognized that, as to many of the grievous inaccuracies contained in the filings Avellosubmitted to the NASD, Webb and HKS were the only parties who should be held responsible.18
We reject as wholly unsubstantiated Avello's contention that the NASD's decision to proceed against him, and not Knight, is the result of racial discrimination. The NASD has wide discretion in deciding against whom to proceed and Avello has not presented a scintilla of evidence suggesting that race influenced the NASD's enforcement decision.19 Moreover, any purported violation by Knight is irrelevant to Avello's culpability.20
In defending against the substance of the NASD's charges, Avello emphasizes that he was a victim of Webb's deceit. However, the NASD took this into account by refusing to find Avello liable for the violations that it found arose from Webb's deceit. Avello complained that his other errors were the fault of the Firm's accounting staff, arguing that his responsibility as FINOP did not extend to ensuring that their information was accurate. We view Avello's responsibilities regarding the HKS accounting staff differently. The NASD defines a FINOP as a person associated with a member firm whose duties include:
Commission precedent makes clear that
[o]nce [a person] agree[s] to serve as the firm's FINOP, and for so long as he retain[s] that position, he [is] responsible for carrying out its attendant duties and obligations. The facts that he maintain[s] his own practice and work[s] for the firm only on a part-time basis [does] not lessen his obligations or provide any excuse for his failure to meet them.22
Avello was responsible as the HKS FINOP for ensuring the accuracy of the financial reports submitted over his signature.
Avello complains that, when FINOPs ask the NASD to protect them in disputes with their employing broker-dealers, the NASD refuses to become involved. On the other hand, according to Avello, if a FINOP violates his or her professional duties, the NASD holds the FINOP to the highest standards. The significance of Avello's argument is unclear. The NASD is required to establish standards for FINOPs and to discipline them when they fail.23 The NASD's purported handling of corporate employment disputes is not before us here.
Avello attempted to support his claim regarding the NASD's purportedly unfair treatment of FINOPs, in part, by attaching to his reply brief extra-record materials, which the NASD has moved to strike. Avello has not explained why the documents could not have been produced at the hearing. Moreover, our limited examination of the documents for the purpose of evaluating the NASD's motion makes clear that the documents are not material to any issue before the Commission.24 In light of those determinations, we decline to admit the proffered extra-record material.
The NASD fined Avello $5,000 and assessed $665.80 in costs against him. The NASD took account of Avello's cooperation with the NASD staff's examinations and review of HKS, his willingness to acknowledge and remedy errors brought to his attention, and his determination to ensure that if HKS operated it did so within the bounds of the NASD and Commission financial responsibility rules. Nonetheless, Avello made serious errors of judgment of a kind that a FINOP cannot be allowed to make without significant sanctions. The sanctions imposed on Avello by the NASD are at the low end of the ranges established by the NASD Sanction Guidelines for his violations.25 Avello's errors could easily justify more serious sanctions. We find that the sanctions imposed on Avello are neither excessive, oppressive nor an unnecessary or inappropriate burden on competition.26 The sanctions also reflect fully the NASD's favorable view of Avello's cooperative attitude, as well as his willingness to correct mistakes brought to his attention.
An appropriate order will issue.27
By the Commission (Chairman PITT and Commissioner GLASSMAN and CAMPOS); Commissioners GOLDSCHMID and ATKINS not participating.
Jonathan G. Katz
In the Matter of the Application of
NICHOLAS T. AVELLO
For Review of Disciplinary Action Taken by the
NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC.
ORDER SUSTAINING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION
On the basis of the Commission's opinion issued this day, it is
ORDERED that the disciplinary action taken by the National Association of Securities Dealers, Inc., ("NASD") against Nicholas T. Avello, and the NASD's assessment of costs, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
1 Neither Webb nor HKS applied to the Commission for review of the NASD decision.
2 The NASD found that this violated Securities Exchange Act Rule 15c3-1, 17 C.F.R. § 240.15c3-1 as well as NASD Conduct Rule 2110, which requires NASD members and associated persons to observe in their business conduct "high standards of commercial honor and just and equitable principles of trade."
3 The NASD found that Avello submitted inaccurate reports to the NASD for the following periods: November and December 1995; January through March, and May through September 1996; and January through August 1997. The NASD found that this violated Exchange Act Rule 17a-3, 17 C.F.R. § 240.17a-3, and NASD Conduct Rule 3110 which requires members to "make and preserve books, accounts, records, memoranda, and correspondence in conformity with all applicable laws, rules, regulations and statements of policy promulgated thereunder and with the Rules of [the NASD] and as prescribed by SEC Rule 17a-3." The NASD also found that Avello's conduct violated NASD Conduct Rule 2110.
4 The NASD found that this violated Exchange Act Rule 17a-5, 17 C.F.R. § 240.17a-5, as well as NASD Conduct Rule 2110.
5 Another individual not involved in this proceeding held one percent of HKS stock. The record does not indicate whether Knight remained a shareholder after Webb discharged him.
6 Avello continued to perform some non-FINOP services for HKS for a short time thereafter.
7 The net-capital-related charges against HKS, Webb, and Avello included violations of both Commission Rule 15c3-1, 17 C.F.R. § 240.15c3-1, and the restrictive agreement between HKS and the NASD, which required HKS to maintain $100,000 in net capital. The only net capital-related charge before us is the finding against Avello of one violation of Rule 15c3-1.
8 The underlying calculations establishing the net capital violations involved in this matter are not in dispute. It is also undisputed that HKS operated a securities business on all relevant dates.
9 The auditors who audited the Firm's books for 1995 also had not discovered the loan.
10 The NASD did not hold Avello liable for the omission of the $50,000 ANB loan. Similarly, the NASD did not hold Avello responsible for reporting errors caused by a dishonored $65,000 personal check from Webb deposited in HKS's account on May 31, 1996. When Avello prepared the monthly reports for May 31, 1996, he did not know, and could not have known, that Webb's deposit would be returned. As soon as Avello learned Webb's check had been dishonored he reported thematter to the NASD and revised all the reports impacted by the bad check. Finally, the NASD did not hold Avello responsible for erroneously reporting that $125,000 HKS held in a securities account was good capital. The NASD found that Avello performed an adequate investigation that was frustrated by misinformation from Webb and lack of cooperation by the broker-dealer who held the HKS account.
11 This is not the same loan that was discovered by the 1996 audit.
12 It appears that HKS used the proceeds to cover the May 31, 1996, check bounced by Webb. See note 10 supra.
13 The record does not reflect how old the receivable was. Avello has not disputed the determination that he misclassified the asset at issue.
14 Jonathan Webb had terminated Knight's employment with HKS in September 1996, as a result of a dispute regarding Knight's use of corporate funds for his personal use. Knight's contact with the NASD occurred after his termination.
15 At the hearing NASD staff presented bills for Bloomberg for the period January through August 1997, but only summary amounts owing as of August or September 1997 for the other creditors. Avello does not dispute that each of the reports for the period from January through August 1997 was accurate.
16 Gilad J. Gevaryahu, 51 S.E.C. 710, 713 (1993) ("[The FINOP] made no effort to investigate the matter further or obtain supporting documentation. Instead, he simply accepted [his employer's] word. . .. In our view, [the FINOP's] action amounted to a total abdication of his responsibilities as FINOP.");
17 Nothing in the NASD Rules expressly provides for joining someone as an "indispensable party," and the NASD lacks the power to subpoena witnesses. The NASD may require an associated person to give information or testify under oath in an NASD proceeding. NASD Procedural Rule 8210(a)(1).
18 See note 10 supra.
19 To the extent that Avello is attempting to argue that he is the victim of "selective prosecution," he must establish, not merely assert, that the action against him was motivated by an unjust motive such as his race. See United States v. Huff, 959 F.2d 731, 735 (8th Cir.); Barry C. Wilson, 52 S.E.C. 1070, 1074 (1996). Avello has failed to bring to light any evidence of much less establish any improper motive on the part of the NASD.
20 See Randolph K. Pace, 51 S.E.C. 361, 373 (1993).
21 NASD Membership and Registration Rule 1022(b)(2).
22 Gevaryahu, 51 S.E.C. at 712-13.
23 Exchange Act Sections 15A(b)(6), (7), 15 U.S.C. §§ 78o-3(b)(6), (7).
24 See Sidney C. Eng, 53 S.E.C. 709, 720-21 (1998) (citing SEC Rule of Practice 452, 17 C.F.R. § 201.452).
25 NASD Sanctions Guidelines (1996 ed.), at 23, 35, 40 (reporting, recordkeeping, and net capital rules violations subject to fines between $1,000 and $20,000, requalification requirements and suspension in appropriate cases).
26 Exchange Act Section 19(e), 15 U.S.C. § 78s(e).
27 We have considered all of the arguments advanced by the parties. We have rejected or sustained them to the extent that they are inconsistent or in accord with the views expressed in this opinion.
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