Securities and Exchange Commission
In the Matter of the Application of
KO SECURITIES, INC.
TERRANCE Y. YOSHIKAWA
For Review of Disciplinary Action Taken by
OPINION OF THE COMMISSION
REGISTERED SECURITIES ASSOCIATION - REVIEW OF DISCIPLINARY PROCEEDING
Prompt Receipt and Delivery of Securities
Books and Records
Failure to Obtain and Annotate Affirmative Determination for Short Sales
Failure to Maintain Books and Records
Registered firm and associated person violated NASD conduct rules by executing short sales without making and annotating the affirmative determinations required for each short sale, and violated Exchange Act and NASD rules by failing to maintain adequate records for such short sales. Held, association's findings of affirmative determination and recordkeeping violations, and sanctions it imposed for recordkeeping violations, sustained, but proceedings remanded for reconsideration of sanctions imposed with respect to affirmative determination violation.
Terrance Y. Yoshikawa, pro se.
Marc Menchel, Alan B. Lawhead, and Nancy C. Libin, for NASD.
Appeal filed: December 19, 2002
Last brief received: March 28, 2003
Ko Securities, Inc. ("Ko"), a former registered broker-dealer and former member of NASD, and Terrance Y. Yoshikawa, a former associated person, founder, president, and sole shareholder of Ko, appeal from NASD disciplinary action. 1 NASD found that Ko and Yoshikawa violated NASD Conduct Rules 3370 and 2110 by executing short sales without making and annotating the affirmative determinations required for each short sale. 2 NASD further foundthat Ko and Yoshikawa violated Exchange Act Rule 17a-3 3 and NASD Conduct Rule 2110 by failing to maintain records of the terms and conditions and time of entry and execution of the customer orders for the transactions in question. NASD fined Ko and Yoshikawa $147,450.81 jointly and severally for the affirmative determination violation, and fined Ko an additional $15,000 for the recordkeeping violations. 4 We base our findings on an independent review of the record.
Yoshikawa entered the securities industry in 1969 and founded Ko in 1980. During Ko's existence, Yoshikawa was a general securities principal, financial and operations principal, and options principal. Ko's business was evenly divided between retail and proprietary trading.
Ko's Short Selling of Entremed Stock. The relevant facts are undisputed. On Sunday, May 3, 1998, Yoshikawa read an article in the New York Times heralding two new drugs that appeared to cure cancerous tumors in mice and that were in the human clinical trial stage of research. The article identified Entremed as the company that had been formed to research, manufacture, and market these new drugs. Yoshikawa deduced that the New York Times article would cause the price of Entremed stock to jump the next day. On the evening of May 3, 1998, and early the following morning, Yoshikawa contacted several of Ko's clients (consisting of the firm's employees and their relatives) to recommend that they purchase Entremed stock. These clients subsequently authorized Yoshikawa to purchase Entremed stock for their accounts at his discretion. Before the market opened that Monday morning, however, Yoshikawa determined that Entremed stock was overpriced and decided that,instead of buying Entremed stock for his clients, he would sell Entremed stock short. 5
On Monday, May 4, 1998, Ko sold short several thousand shares of Entremed stock in pre-market trading. Around the time he started short selling Entremed stock, Yoshikawa directed a Ko employee to contact Ko's clearing broker, Correspondent Services Corporation, a Paine Webber subsidiary ("Paine Webber"), to determine whether Paine Webber had any Entremed stock to loan Ko to cover the short sales. While awaiting Paine Webber's response, Ko continued to short Entremed stock after the market opened. Some time between 11:00 a.m. and noon that morning, Paine Webber informed Ko that Paine Webber "had no [Entremed] stock to loan." Ko made no attempt to locate another dealer from which it could borrow Entremed stock. Nonetheless, Ko continued to trade Entremed stock throughout the day, selling short several thousand more shares of Entremed stock after the market had opened. 6 Throughout the day, Ko also purchased Entremed stock to cover its short positions. Ko's last transaction of the day completed its coverage of all of its short positions in Entremed. Trading in Entremed netted Yoshikawa a profit of $9,806.66, and Ko a profit of $135,644.15. Ko apportioned the remainder of the profits, totaling $394,012.58, among 14 customer accounts.
Recordkeeping. Respondents initially executed their Entremed trades in Ko's proprietary Trade Allocation and Processing Omnibus Account ("TAPS Account") and allocated those trades to individual customer accounts later in the day. Respondents generally used the TAPS Account when purchasing large blocks of stock for multiple customers throughout the trading day so that the trades could be price-averaged before being allocated to customers. 7 Once the allocations were determined based on the available credit balance in each customer's account, Respondents filled out order forms on behalf of the customer to buy the securities from the TAPS Account. Respondents did not include the terms and conditions, time of entry, and time of execution on the customer orders.
NASD Decisions. The Hearing Panel found that Respondents violated NASD Conduct Rules 3370 and 2110 by short selling without making and annotating the affirmative determinations required for each short sale. The Hearing Panel also found that Ko violated Exchange Act Rule 17a-3 and NASD Conduct Rule 2110 by failing to maintain a record of the terms and conditions, time of entry, and time of execution of each customer retail order. 8 Based on these findings, the Hearing Panel fined Respondents $147,450.81 (consisting of $135,644.15 proceeds in Ko's account and $9,806.66 proceeds in Yoshikawa's account), jointly and severally, for the affirmative determination violation, and fined Ko an additional $15,000 for the recordkeeping violations. On appeal, NASD's National Adjudicatory Counsel ("NAC") affirmed the Hearing Panel's findings and sanctions.
Respondents do not dispute that they failed to determine that they would be able to borrow Entremed stock to cover their short sales, as specified in NASD Conduct Rule 3370(b)(2)(B). Respondents argue, without citation to authority, that they nonetheless complied with their obligations under the rule because they "otherwise provide[d] for delivery of the securities by the settlement date" when they purchased a sufficient number of shares of Entremed stock by the end of the day to cover their short sales. Respondents are incorrect. 9
NASD Conduct Rule 3370(b)(2)(B) provides that "[n]o member shall effect a 'short' sale for its own account in any security unless the member or person associated with a member makes an affirmative determination that the member can borrow the securities or otherwise provide for delivery of the securities by the settlement date." The plain language of this rule requiresthat the affirmative determination be made prior to executing a short sale because the rule proscribes a member from effecting a short sale without the affirmative determination. This reading, in addition to being the most sensible reading of the language, is consistent with the purpose of Rule 3370.
NASD Conduct Rule 3370, as amended, was designed "to address unnecessary speculation in connection with the short selling of broker-dealers' proprietary positions caused by the members' ability to [sell] short without securities to cover the short position." 10 The rule is meant to prevent abusive short selling and ensure that short sellers satisfy their settlement obligations. 11 In its Regulatory & Compliance Alert issued to all NASD members in March 1998, two months before Respondents' short sales of Entremed stock, NASD advised its members that compliance with Rule 3370 necessitated making an affirmative determination prior to executing a short sale and maintaining a written record of that determination. 12
Respondents defend their actions by citing to the alleged practices of certain third market firms, which Respondents claim also meet their affirmative determination requirements by covering short sales by the end of the trading day. 13 However, we have repeatedly held that the fact that a practice is common or widespread in an industry does not make such conduct proper orlegal. 14 As discussed above, the rule requires a determination before short sales begin that securities are available to cover. The expectation that securities will be available in the market is not enough. Accordingly, we find that Respondents violated NASD Conduct Rules 3370 and 2110 15 by executing short sales without making and annotating the affirmative determinations required for each short sale.
Section 17(a)(1) of the Exchange Act requires registered brokers and dealers to create and maintain books and records reflecting their operations and dealings as required by rules promulgated by the Commission. 16 Exchange Act Rules 17a-3(a)(6) and (7) require members to make and keep records of each order, purchase and sale, and confirmation thereof. 17 These records must reflect the terms and conditions of each order, time of entry, the price at which each order was executed, the time of execution (if feasible), and, if applicable, whether the order was entered pursuant to discretionary authority. Implicit in the recordkeeping rules is the precondition that information contained in these records be accurate. 18
Respondents do not dispute that their records do not adequately include this information regarding the Entremed trading on May 4, 1998. Rather, they assert that "[m]arking the times of execution on the client tickets did not seem to be relevant" and "marking the terms and conditions on each ticket was not of the highest priority on this particular day." The import of Exchange Act Rules 17a-3(a)(6) and (7) is that broker-dealers are required to make recordkeeping a priority. These records are "'the basic source documents and transaction records of a broker-dealer,'" and "'the keystone of the surveillance of brokers and dealers by our staff and by the securities industry's self-regulatory bodies.'" 19 Accordingly, we find that Respondents violated Exchange Act Rule 17a-3 and NASD Conduct Rule 2110 by failing to maintain records of the terms and conditions, time of entry, and time of execution of each customer order.
Respondents allege that NASD's disciplinary action against them is "part of an on-going pattern of harassment by the NASD of Ko Securities and myself." Respondents claim that NASD is prejudiced and biased against them. As evidence, they refer to unidentified"other dealers" who interpret affirmative determination in the same manner as they do, yet have not been prosecuted for "this supposed violation."
Respondents' claims are wholly unsubstantiated. An NASD Division of Market Regulation employee testified that her review of Ko's trading resulted from an objective, computerized, market-wide review of trading in Entremed stock on May 4, 1998 that identified unusual trading activity by Ko. That employee elaborated that her investigation revealed four firms that had executed a large number of short sales in Entremed stock in pre-market trading on May 4, 1998. 20 Of the four, Ko was the only firm that sold Entremed stock short without determining in advance that there were Entremed shares available to borrow.
To the extent that Respondents are attempting to argue that they are the victims of "selective prosecution," they must establish that the action against them was motivated by an unjust motive. 21 A party seeking to assert such a claim must demonstrate that he or she was singled out for enforcement, while others who were similarly situated were not, and that the prosecution was motivated by arbitrary or unjust considerations such as race, religion, or the desire to prevent the exercise of aconstitutionally protected right. 22 Respondents have not so supported their claim.
Pursuant to Exchange Act Section 19(e), 23 we must sustain NASD's sanctions unless we find, having due regard for the public interest and the protection of investors, that the sanctions are excessive or oppressive or impose an unnecessary or inappropriate burden on competition. 24
The NASD Sanction Guidelines for short sale violations recommend a base fine of $1,000 to $2,000 for a first action. The Guidelines also advise:
. . . in egregious cases or those with evidence of willful misconduct, consider adding the amount of the short-selling customer's "transaction profit" to the fine for the executing member and/or associated person. 25
NASD calculated the fine of $147,450.81 as a $2,000 base fine plus $145,450.81, the amount of Respondents' profits from the short sales. 26 However, NAC did not make a finding that the misconduct was willful, and specifically determined that this was not an egregious case with respect to the affirmative determination violation. 27 Thus, NASD's basis for adding Respondents' profits to the fine is unclear. Accordingly, we remand this proceeding to NASD to address the issue of sanctions for the affirmativedetermination violation. 28 In remanding, we do not intend to suggest any view as to a particular outcome.
For recordkeeping violations, the NASD Sanction Guidelines recommend a fine of $1,000 to $10,000, and a 30-day suspension of both the firm and the responsible individual; and in egregious cases, a fine of $10,000 to $100,000, and up to a two-year suspension or expulsion for both the firm and the responsible individual. 29 NAC determined that under the circumstances, the $15,000 fine was warranted because Respondents' recordkeeping violations were egregious. The sanctions for the recordkeeping violations here are thus well within the range that the Guidelines suggest. Respondents' cavalier attitude toward recordkeeping requirements, as evidenced by their haphazard completion of customer orders after the close of trading on May 4, 1998, demonstrates a fundamental disrespect for the procedures necessary to the functioning of an orderly market. Accordingly, we find that the sanctions imposed on Respondents for the recordkeeping violations were not excessive, oppressive, or an undue burden on competition.
An appropriate order will issue. 30
By the Commission (Chairman DONALDSON and Commissioners GLASSMAN, GOLDSCHMID and ATKINS); Commissioner CAMPOS, not participating.
Jonathan G. Katz
In the Matter of the Application of
KO SECURITIES, INC.
TERRANCE Y. YOSHIKAWA
For Review of Disciplinary Action Taken by
ORDER SUSTAINING FINDINGS OF REGISTERED SECURITIES ASSOCIATION, REMANDING FOR RECONSIDERATION OF CERTAIN SANCTIONS, AND SUSTAINING DISCIPLINARY ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION
On the basis of the Commission's opinion issued this day, it is
ORDERED that the findings of violation made by NASD against Ko Securities, Inc. and Terrance Y. Yoshikawa with respect to the affirmative determination violation, be, and they hereby are, sustained; and it is further
ORDERED that the sanctions imposed on Ko Securities, Inc. and Terrance Y. Yoshikawa by NASD with respect to the affirmative determination violation, be, and they hereby are, remanded to NASD for reconsideration; and it is further
ORDERED that the disciplinary action taken by NASD against Ko Securities, Inc. and Terrance Y. Yoshikawa for recordkeeping violations, and NASD's assessment of costs, be, and they hereby are, sustained.
By the Commission.
Jonathan G. Katz
1 Yoshikawa indicates that, on August 28, 2002, Ko withdrew its NASD broker-dealer registration and Yoshikawa submitted his Form U-5 and left the securities industry.
2 Rule 3b-3 under the Securities Exchange Act of 1934 defines a "short sale" as "any sale which is consummated by the delivery of a security borrowed by, or for the account of, the seller." 17 C.F.R. § 240.3b-3.
NASD Conduct Rule 3370(b)(2)(B) generally prohibits a member from effecting a short sale for its own account unless the member "makes an affirmative determination that the member can borrow the securities or otherwise provide for delivery of the securities by the settlement date."
NASD Conduct Rule 3370(b)(4)(B)(ii) provides that, in order to satisfy the affirmative determination requirement for customer or proprietary short sales, the "member must keep a written record which includes . . . if the member or person associated with a member locates the stock, the identity of the individual and firm contacted who offered assurance that the shares would be delivered or that were available for borrowing by settlement date and the number of shares needed to cover the short sale."
NASD Conduct Rule 2110 requires a member to observe "highstandards of commercial honor and just and equitable principles of trade."
3 17 C.F.R. § 240.17a-3. Exchange Act Rule 17a-3 requires every member of a national securities exchange and every broker and dealer to maintain and keep current books and records relating to their business.
4 NASD also assessed costs.
5 In pre-market trading on Monday, May 4, 1998, Entremed stock rose to a high of $85 per share, up from its closing price of $12 per share the previous Friday, May 1, 1998. Ko was not a market maker in Entremed stock and, until May 4, 1998, did not own any Entremed stock.
6 Respondents sold short a total of over 56,000 shares of Entremed stock on May 4, 1998, including the pre-market trading.
7 Respondents claim that they did this to ensure that their customers would receive best execution.
8 The Hearing Panel dismissed allegations that Ko violated Regulation T by executing short sales in customer cash accounts and that Ko's individual customer order tickets should have reflected the Entremed short sales.
9 Respondents do not dispute that they failed to make an appropriate written annotation of how they would cover the short sales as required by NASD Conduct Rule 3370(b)(4)(B)(ii). They offer no argument to rebut this charge.
10 See Notice of Proposed Rule Change by NASD Relating to the Prompt Receipt and Delivery of Securities, Exchange Act Rel. No. 34-26746 (Apr. 20, 1989), 43 SEC Docket 1194; Public Disclosure of Material Short Security Positions, Securities Exchange Act Rel. No. 34-29278 (June 7, 1991), 49 SEC Docket 3.
11 See Notice of Filing of Proposed Rule Change by the NASD Relating to the Use of Hard to Borrow Lists, Exchange Act Rel. No. 34-42306 (Jan. 3, 2000), 71 SEC Docket 1144.
12 Hence, Yoshikawa's explanation to the Hearing Panel that he was reluctant to ask NASD staff for a definitive interpretation of the affirmative determination requirement out of fear that such a request would trigger an NASD investigation of Ko is irrelevant; NASD's Alert had already given him a definitive interpretation.
13 Respondents do not identify these other firms.
14 See, e.g., Charles E. Kautz, 52 S.E.C. 730, 733 (1996); Donald T. Sheldon, 51 S.E.C. 59, 66 n.32 (1992), aff'd, 45 F.3d 1515 (11th Cir. 1995); C.A. Benson & Co., Inc., 42 S.E.C. 107, 111 (1964) (noting that it is "immaterial that others may also have violated the NASD's rules and have not yet been reached by the enforcement machinery"); cf. Hilliard v. Walker's Party Store, Inc., 903 F. Supp. 1162, 1175 (E.D. Mich. 1995) (observing "that a practice is common does not make it proper or legal").
15 Conduct that violates an NASD regulatory requirement is also inconsistent with just and equitable principles of trade. See, e.g., Stephen J. Gluckman, Securities Exchange Act Rel. No. 41628 (July 20, 1999), 70 SEC Docket 418, 428 (noting it is a "long-standing and judicially-recognized policy that a violation of another Commission or NASD rule or regulation constitutes a violation of Conduct Rule 2110").
16 15 U.S.C. § 78q(a)(1).
17 17 C.F.R. §§ 240.17a-3(a)(6) and (7).
18 See Merrill Lynch, Pierce, Fenner & Smith Inc., Exchange Act Rel. No. 33367 (Dec. 22, 1993), 55 SEC Docket 2281.
19 Pryor, McClendon, Counts & Co., Inc., Securities Act Rel. No. 8245 (June 26, 2003), ___ SEC Docket ___ (quoting Edward J. Mawod & Co., 46 S.E.C. 865, 873 n.39 (1977)).
20 Of the four firms, Ko was one, another was involved in an ongoing inquiry at the time of the hearing, one did not have any affirmative determination violations, and one failed to properly annotate the affirmative determination it had obtained, against which NASD took informal action.
21 See, e.g., Barry C. Wilson, 52 S.E.C. 1070, 1074 (1996); United States v. Huff, 959 F.2d 731, 735 (8th Cir. 1992).
22 Ralph W. LeBlanc, Exchange Act Rel. No. 48254 (July 30, 2003), __ SEC Docket ___; Russo Sec., Inc., Exchange Act Rel. No. 44186 (Apr. 17, 2001), 75 SEC Docket 1124A, 1124P; Michael Markowski, 51 S.E.C. 553, 559 n.23 (1993), aff'd, 34 F.3d 99 (2d Cir. 1994). Respondents do not specifically allege racial bias on appeal; however there was some discussion of race before the Hearing Officer. During that discussion, Respondents did not present a scintilla of evidence suggesting that race influenced NASD's investigations of Respondents. An employee of NASD's Division of Market Regulation specifically denied, under oath, any personal motivation for NASD's investigations of Respondents.
23 15 U.S.C. § 78s(e).
24 Id. Respondents do not claim, nor does the record show, that NASD's sanctions impose an unnecessary or inappropriate burden on competition.
25NASD Sanction Guidelines (2001 ed.) at 70. The NASD Sanction Guidelines define "transaction profit" as "the profit that the short-selling customer realized." Id. at 70 n.3.
26 NASD did not include the amount of the Respondents' customers' profits. The Guidelines also suggest, in egregious cases, either a suspension or expulsion (for a firm) or bar (for an individual).
27 NAC rejected the argument made by NASD's Division of Market Regulation that the amount of the fine imposed on Respondents should be increased to reflect customer profits generated from the short sales.
28 See John P. Goldsworthy, 53 S.E.C. 576, 580 (1998); Robert A Grunburg, 52 S.E.C. 398, 404 (1995); Stephen R. Flaks, 46 S.E.C. 891, 895 n.8 (1977).
29 NASD Sanction Guidelines at 34.
30 We have considered all of the parties' contentions. 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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