==========================================START OF PAGE 1====== SECURITIES AND EXCHANGE COMMISSION Washington, D.C. SECURITIES EXCHANGE ACT OF 1934 Rel. No. 34-37559 \ August 13, 1996 Admin. Proc. File No. 3-8702 _________________________________________________ : In the Matter of the Application of : : DOMESTIC SECURITIES, INC. : 160 Summit Avenue : Montvale, NJ 07645 : : For Review of Denial of Access by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : _________________________________________________: OPINION OF THE COMMISSION REGISTERED SECURITIES ASSOCIATION -- REVIEW OF DENIAL OF ACCESS TO SERVICES Request to Amend Restrictive Agreement Where registered securities association denied request by member to have restrictive agreement modified to permit market making by the member in unlimited number of securities without articulating basis for decision, held, action set aside. APPEARANCES: Bill T. Singer, of Singer, Bienenstock, Zamansky, Ogele & Selengut, LLP. Norman Sue, Jr., for the National Association of Securities Dealers, Inc. Appeal filed: May 19, 1995 Briefing completed: August 14, 1995 I. Domestic Securities, Inc. ("Domestic" or "the firm"), a member of the National Association of Securities Dealers, Inc. ("NASD" or "Association"), has applied for review of a decision by the Association's National Business Conduct Committee ("the NBCC") dated May 4, 1995, in which the NBCC denied Domestic's request for modification of the terms of its restrictive agreement to permit the firm to expand the number of securities in which it was authorized to make a market from 50 to an unlimited number. Our findings are based on an independent review of the record. II. Domestic is a broker-dealer that has been in existence since 1984, first as a member of the New York Stock Exchange, Inc., then as an associate member of the American Stock Exchange, Inc. In June 1993, after its decision to concentrate its trading activities in market making for over-the-counter securities, Domestic applied for membership in the NASD. After the requisite pre-membership interview with the staff for District No. 10 provided for by the NASD's By-Laws, Domestic's membership application was granted effective May 5, 1994. -[1]- Although initially Domestic sought approval to make markets in an unlimited number of securities, the NASD conditioned its approval of Domestic's application on the firm entering into a restrictive agreement limiting to 50 the number of securities in which Domestic may make markets. The NASD sought this limitation out of a concern that Domestic's two principals, Harvey Houtkin and Mark Shefts, would not be able adequately to supervise Domestic in the making of additional markets simultaneously with ---------FOOTNOTES---------- -[1]- Schedule C, Part 1, Section (1)(c) to the By-Laws provides that the pre-membership interview shall review, among other things, (1) the nature, adequacy, source and permanence of applicant's capital and its arrangements for additional capital should a business need arise; (2) the applicant's proposed recordkeeping system; (3) the applicant's proposed internal procedures, including compliance procedures; (4) the applicant's familiarity with applicable NASD rules and federal securities laws; (5) the applicant's capability to properly conduct the type of business intended in view of the: A. number, experience and qualifications of the persons to be associated with it at the time of its admission to membership; B. its planned facilities; C. arrangements, if any, with banks, clearing corporations and others, to assist it in the conduct of its securities business; D. supervisory personnel, methods and procedures; and (6) other factors relevant to the scope and operation of its business. ==========================================START OF PAGE 3====== fulfilling their supervisory responsibilities for another NASD member firm, All-Tech Investment Group, Inc. ("All-Tech"). -[2]- Another provision of the restrictive agreement prohibited Domestic from seeking any amendment to the agreement for one year. In July 1994, Domestic sought to have the 50-security limitation lifted because of what it characterized as a dramatic and unforeseen change in circumstances. After changes in NASD rules affecting All-Tech's business, All-Tech had suffered a serious decline in its operations, from approximately 1,000 to 1,500 trades a day with approximately 60 customers, to approximately 200 trades a day with six customers. -[3]- Thus, Domestic reasoned to the NASD that the concern expressed by the NASD with Houtkin's and Shefts's ability to supervise two firms no longer had an adequate basis. At the same time, the reversal of fortunes for All-Tech increased the financial importance for Houtkin and Shefts of Domestic's making markets in more securities than the 50 allowed by the restrictive agreement. The District denied Domestic's request by letter dated July 20, 1994, on the basis of its staff recommendation that no modification to the restrictive agreement should be permitted within a year of May 5, 1994. Domestic contested the decision and sought a hearing. Hearings were held before a District Business Conduct Committee ("DBCC") on September 18, 1994, November 21, 1994, and January 12, 1995, before the DBCC issued an opinion denying Domestic's request on February 17, 1995. At the September hearing, the staff expressed concern with the recent date of Domestic's NASD membership, and uncertainty as to whether Domestic had adequate numbers of experienced traders, ---------FOOTNOTES---------- -[2]- Early in the hearing process, the District 10 staff suggested that the reason for the 50- security limitation was because Domestic had requested it in the business plan submitted to the staff on January 5, 1994. This suggestion is contradicted by the existence in the record of a business plan submitted October 28, 1993, in which no such restriction is included. Later statements by staff in the testimony also support the findings in the text above. -[3]- All-Tech is engaged primarily in retail trading for customers using the NASD's Small Order Execution System ("SOES"). NASD Rule changes for SOES which came into effect in January 1994 affected the profitability of All-Tech's customers' trading strategy on SOES, precipitating the decline in its business. ==========================================START OF PAGE 4====== supervisory procedures, and capital for the requested business expansion. Domestic argued that, while its membership in the NASD was new, the firm itself dated from 1984; that it was run by and staffed with adequate trading personnel; that it had made, and would continue to make, every adjustment in its supervisory procedures requested by the NASD staff; and that its capital was adequate. At the panel's suggestion, the hearing was adjourned for the purpose of giving the staff and Domestic an opportunity to negotiate a compromise between the 50-security limit and Domestic's request for authority to make a market in an unlimited number of securities. A new hearing was scheduled for November 21, in the event that the parties could not reach a negotiated agreement. -[4]- On November 18, though an agreement had not been reached, the NASD staff requested a postponement of the November 21 hearing date, arguing that a partial analysis of Domestic's trading activity gave cause for concern, and more time was needed to conclude the analysis. The request was denied and, at the hearing, the staff described the trading information on which its analysis had focussed. In the period covered by the analysis, a substantial majority of Domestic's trading was with a firm called HMS Securities, Inc. ("HMS"). HMS was formerly owned by Wanshef, Inc. ("Wanshef"), a corporation owned by Houtkin and Shefts that also owns Domestic. HMS is currently owned by an employee of All-Tech. The NASD staff's analysis showed that Domestic would sell short certain securities positions to HMS, which would then allocate the purchased securities to customers who predominantly were related to Houtkin and Shefts. Those customers' securities would be sold through SOES, usually on the same day as the purchase, and Domestic's short position would be covered later in the day by sales to it by Houtkin and Shefts family members, although not always the same members who had made the original purchases. The staff suggested that this activity might involve violations of SOES rules, which at that time prohibited short- selling and required that multiple SOES transactions made as the result of a "single investment decision" be aggregated for the purpose of determining compliance with the SOES order size ---------FOOTNOTES---------- -[4]- Domestic made clear that its request for unlimited market-making authorization was unchanged, but that it was willing to compromise on some lesser number for the sake of resolving the situation by settlement. ==========================================START OF PAGE 5====== limitation rule. -[5]- The staff conceded, however, that its analysis was inconclusive. The hearing was adjourned again after the staff agreed to increase to 500 the number of securities in which Domestic could make a market, contingent on Domestic providing adequate documentation of the qualifications of its traders, of its supervisory procedures, and of the sufficiency of its capital. Protracted negotiations between the NASD staff and Domestic ensued, but no agreement resulted. Consequently, yet another hearing was scheduled before the panel on January 12, 1995. At this hearing, the sole ground for the staff's opposition was a "heightened concern" over the trading activity discussed above, based on further, although still not complete, analysis and development of the facts. -[6]- The DBCC decision denied Domestic any relief from the provisions of its restrictive agreement. Because the staff had raised no objections to Domestic's qualifications under Part 1, Section (1)(c)(1)-(5) of Schedule C, the DBCC limited the scope of its inquiry to the requirement in Section (1)(c)(6) that consideration be given to ". . . other factors relevant to the scope and operation of [the firm's] business." The DBCC noted the concerns raised by the staff at the hearings concerning the pattern of trading activity involving Domestic and HMS and their customers. In addition to the matters discussed above, the DBCC identified as problematic the facts that: many of the HMS customer accounts under review were joint accounts between Houtkin or Shefts and a family member or business entity; Domestic and HMS were located in adjoining suites; Wanshef, owned by Houtkin and Shefts, maintained two accounts at HMS, one of which was used to finance other HMS customers' day trading; Domestic had a customer account at HMS; and the firms used the same clearing broker. The DBCC concluded: ---------FOOTNOTES---------- -[5]- The short-selling rule ceased to be effective in January 1995. The rule concerning aggregation of transactions is still in effect. -[6]- The staff stated that it was not opposing Domestic's request on the basis of: (1) the firm's traders or their qualifications, (2) the adequacy of the firm's supervisory procedures, (3) the adequacy of the firm's capital, or any of the first five of the six factors enumerated in Part 1, Section (1)(c) of Schedule C. ==========================================START OF PAGE 6====== Whether or not there was an actual violation of the SOES rules . . . we leave to the [NASD]'s disciplinary process. However, we find that the trading activity set forth in the record . . . gives at least the appearance of an attempt to circumvent [SOES rules]. . . . It is our opinion that serious questions have been raised . . . not only about what seems to be [Domestic's] role in giving the appearance of participating in a pattern of trading which may have been inconsistent with the SOES rules . . . but also as to the overall transactions and interrelationships between Domestic, HMS, Wanshef, Inc., Houtkin, Shefts and the other related accounts at HMS. . . . [W]e are concerned that in actuality Houtkin and Shefts may have more control over the activities of HMS than its shareholders may have. (Footnote omitted; emphasis in original.) Based on these concerns, -[7]- the DBCC denied Domestic's request to have its restrictive agreement amended. -[8]- On appeal, the NBCC reviewed the history of the case and concluded: ---------FOOTNOTES---------- -[7]- The DBCC added: "[t]his could very well be the type of activity the staff was apprehensive about and which gave rise to the one year period in the Agreement during which the staff wanted to review the Firm's operations." This supposition, however, is contradicted by the record. The staff was emphatic in its assertion that it was unaware of the trading activity between the two firms until shortly before the November 21, 1994 hearing, arguing that the recent nature of the discovery justified its request for a postponement of the hearing. -[8]- Domestic appealed the DBCC's decision to the Commission during the pendency of the appeal to the NBCC. Domestic argued that the basis for Commission jurisdiction would be the futility of exhaustion of administrative remedies before the NASD. The NBCC issued its opinion prior to our acting on Domestic's earlier appeal, which was subsequently withdrawn. ==========================================START OF PAGE 7====== The controversy herein . . . centers on whether the trading activity and relationships described by NASD staff between Domestic and HMS, which facts were never disputed by Domestic and which we accept for purpose of this proceeding, constitute sufficient grounds for denial of Domestic's request to expand its market making activities. We are not prepared to state without qualification that staff concerns as to possible regulatory violations, or the fact of an open investigation by regulatory authorities, without more, cannot in any circumstances justify the denial of requests for amendment of restriction agreements. Moreover, we recognize the genuine concern of the DBCC that the facts identified raised serious concern that NASD rules may have been violated. Nevertheless, based on our independent review of the record, we believe that the current restrictions should be modified. The NBCC modified the restrictive agreement to permit Domestic to increase the number of securities in which it makes a market from 50 to 500, subject to a requirement that the applicant maintain 135% of minimum required net capital. The sole reason the NASD gave for not granting Domestic's request to make markets in an unlimited number of securities was that "an unlimited number cannot be justified on the basis of this record." The reason to grant an expansion from 50 to 500 was based on the NASD's conclusion that "applicants have made a sufficient showing to justify an expansion of the number of its markets" and its observation that "as of November 21, 1994, both the staff and the applicant were favorably inclined to compromise their differences in order to . . . permit the applicant to increase the number of stocks in which it makes a market from 50 to 500" subject to the requirements enumerated above. This appeal followed. III. The NBCC was correct in rejecting the reasoning and decision of the DBCC. For the reasons discussed below, however, we cannot sustain the decision to grant Domestic only a partial modification of the 50-security limitation. Information concerning regulatory violations by a firm may under some circumstances be the basis for denying requests to ==========================================START OF PAGE 8====== amend restrictive agreements. -[9]- However, the basis for the restriction at issue here is not clear. Without a connection to a regulatory purpose, such a broad-based limitation on Domestic's ability to function as a market maker in the wholesale dealer market appears to impose a burden on competition "not necessary or appropriate in furtherance of the purposes" of the Securities Exchange Act of 1934 ("the Act"). The NBCC's decision to grant Domestic authority to expand its number of markets to 500, rather than the unlimited authority sought by Domestic, also is not sustainable for a different reason. Section 19(f) of the Act requires us, in reviewing a limitation on access to services, to find that the specific grounds on which such limitation is based exist in fact, and that the limitation "is in accordance with [NASD rules], and that such rules . . . were applied in a manner consistent with the purposes of" the Act. The NBCC's decision does not state the specific grounds on which its limitation is based, and therefore we are unable to determine whether the NASD's rules were applied appropriately. 10/ The NBCC's decision does not state how, or in what degree, the NASD concluded that Domestic failed to meet the criteria in Part 1 of Schedule C. 11/ Moreover, our own review of the record does not reveal the basis for the NASD's decision. The NASD staff specifically conceded that none of the first five factors of Part 1, Section (1)(c) of Schedule C were an issue in opposing Domestic's request. The staff's views, while not binding on the NASD, evidence lengthy analysis and on-site examinations by the staff that are uncontradicted by anything in the record. ---------FOOTNOTES---------- -[9]- We take no position with respect to the NASD staff's characterization of these facts. 10/ The NBCC's decision does not discuss the standards for determining to place restrictions on the number of securities in which a new member may make markets. Therefore, among other things, we have no basis for determining the relative fairness of the NASD's action with respect to Domestic. 11/ The NASD argues on appeal that Domestic is not "aggrieved" by the NBCC's decision, because Domestic can reapply at a later time for additional modification of the restrictions on its market-making authorization. However, Domestic claims that it is aggrieved by the present limitation on its business, and that the NASD's invitation to Domestic to return is meaningless unless the NASD articulates what Domestic must do to achieve success on any future request for modification. ==========================================START OF PAGE 9====== Further evidence in the record supports the staff's con- clusions concerning the first five factors. Domestic, although new to the NASD, has been in existence since 1984. It has 12 traders with a wide variety and depth of experience. 12/ It has undertaken to employ as many traders as are necessary to accommodate its increase in business. 13/ The firm has given adequate assurances that it is able to maintain sufficient net capital. 14/ Its supervisory and compliance procedures have been substantially revised in consultation with the NASD staff. In testimony undisputed by the staff (who conducted on-site examinations), Domestic has asserted that its equipment is "state-of-the-art," and that the spreads it has been quoting in the securities which it has authority to trade have been among the narrowest in the industry. The disciplinary history of Domestic's control affiliates (reported in the firm's application for membership), although evidencing various SOES rules violations, does not indicate any propensity not to comply with the duties incumbent on a market maker. Given these facts, together with the abbreviated nature of the NASD's analysis, we are unable to discern the path by which the NASD arrived at its conclusion to limit to 500 the number of securities in which Domestic can make markets. We cannot make the findings that the Act requires. Accordingly, we set aside the NASD's action limiting the number of securities in which Domestic can make markets. An appropriate order will issue. 15/ By the Commission (Chairman LEVITT and Commissioners WALLMAN, JOHNSON, and HUNT). 12/ For example, Houtkin and Shefts, in managing an earlier incarnation of Domestic, Domestic Arbitrage Group, made markets in over 400 securities. Between them, they have over 40 years of experience as traders. Another of their traders has over 20 years of experience. 13/ As of September 1994, no trader was responsible for more than seven securities. Domestic has represented that it would apportion securities to traders based on trading activity levels in each security. 14/ The record indicates that the firm maintains approximately $800,000 in capital. 15/ All of the contentions advanced by the parties have been considered. They are rejected or sustained to the extent that they are inconsistent or in accord with the views expressed herein. ==========================================START OF PAGE 10====== Jonathan G. Katz Secretary UNITED STATES OF AMERICA before the SECURITIES AND EXCHANGE COMMISSION SECURITIES EXCHANGE ACT OF 1934 Rel. No. Admin. Proc. File No. 3-8702 _________________________________________________ : In the Matter of the Application of : : DOMESTIC SECURITIES, INC. : 160 Summit Avenue : Montvale, NJ 07645 : : For Review of Denial of Access by the : : NATIONAL ASSOCIATION OF SECURITIES DEALERS, INC. : _________________________________________________: ORDER SETTING ASIDE ACTION TAKEN BY REGISTERED SECURITIES ASSOCIATION On the basis of the Commission's opinion issued this day, it is ORDERED that the action of the National Association of Securities Dealers, Inc. in restricting the number of securities in which Domestic Securities, Inc. can make a market, be, and it hereby is, set aside. By the Commission. Jonathan G. Katz Secretary