STATE OF FLORIDA
DIVISION OF ADMINISTRATIVE HEARINGS
DEPARTMENT OF BANKING AND ) FINANCE, DIVISION OF )
SECURITIES AND INVESTOR )
PROTECTION, )
)
Petitioner, )
)
vs. ) Case No. 00-3024PL
)
LARRY STEVEN KASE, )
)
Respondent. )
)
RECOMMENDED ORDER
Robert E. Meale, Administrative Law Judge of the Division of Administrative Hearings, conducted the final hearing in Orlando, Florida, on October 26 and 27, 2000.
APPEARANCES
For Petitioner: Chris Lindamood
Assistant General Counsel Department of Banking and Finance
400 West Robinson Street, Suite S-225 Orlando, Florida 32801
For Respondent: David S. Wood
Sarah A. Long
Baker & Hostetler, LLP Post Office Box 112
Orlando, Florida 32802-0112 STATEMENT OF THE ISSUE
The issue is whether Respondent is guilty of a failure to discharge adequately his compliance and supervisory
responsibilities, in connection with the churning of a securities account by an account representative, and, if so, what penalty should be imposed.
PRELIMINARY STATEMENT
By Administrative Complaint and Notice of Intent to Issue Cease and Desist Order, Impose Penalties and Revoke, Suspend, or Deny Application for Registration and Notice of Rights dated June 14, 2000, Petitioner alleged that Respondent was general securities principal for Allen Douglas, a corporate broker- dealer located at 1180 Spring Center Boulevard, Altamonte Springs, Florida, and, as a general securities principal, Respondent supervised the activities of James Singer, a registered securities representative employed by Allen Douglas. The administrative complaint alleges that, from May to November 1998, Allen Douglas failed to maintain or enforce adequate supervision to prevent Mr. Singer’s fraudulent mishandling of the account of Joseph Nellis. The administrative complaint alleges that Mr. Singer engaged in trading that was excessive, unsuitable, and unauthorized.
The administrative complaint alleges that Respondent’s failure to supervise adequately the activity of Mr. Singer violates Rules 3E-600.002(2) and 3E-600.12(5), Florida Administrative Code, as well as other provisions of law.
Respondent timely requested a formal hearing.
At the hearing, Petitioner called eight witnesses and offered into evidence 25 exhibits. Respondent called no witnesses and offered into evidence 10 exhibits. All exhibits were admitted except Petitioner Exhibits 20 and 23.
The court reporter filed the Transcript on November 30, 2000.
FINDINGS OF FACT
In February 1999, Petitioner conducted a three-day onsite examination of the activities of Allen Douglas Securities, Inc. (Allen Douglas Securities), which is a full- service brokerage firm, following the receipt of a complaint from a customer, Joseph Nellis. The examination covered, among other things, trading in Mr. Nellis’s account from May to November 1998, which is the relevant period in this case.
Based on the findings of the examination, Petitioner filed an administrative complaint dated September 17, 1999, against Allen Douglas Securities; the registered representative responsible for Mr. Nellis’s account, James Singer; the president of Allen Douglas Securities, Stephen Pizzuti
(Mr. Pizzuti); the vice-president of Allen Douglas Securities and brother of Mr. Pizzuti, Richard Pizzuti; and Respondent.
The administrative complaint alleged that Mr. Singer churned the Nellis account and assigned responsibility for Mr. Singer’s
wrongful acts to the Pizzutis and Respondent, as General Securities Principals and Mr. Singer’s supervisors, and to Respondent, as the compliance officer of Allen Douglas Securities.
Mr. Singer did not defend the allegations. By Stipulation and Consent Agreement between Petitioner, on the one hand, and Allen Douglas Securities and the Pizzutis, on the other hand, the company and the Pizzutis agreed to comply with the applicable securities laws, Allen Douglas Securities paid Petitioner $10,000 in administrative costs, the three respondents agreed to develop written supervisory procedures, the three respondents agreed to pay Petitioner for the cost of the examination, the three respondents agreed not to register Respondent in any capacity with Allen Douglas Securities, Allen Douglas Securities agreed to employ an onsite compliance officer at the Altamonte Springs office, Allen Douglas Securities agreed to copy Petitioner for one year with customer complaints, Allen Douglas Securities agreed to maintain its customer files in separate folders, and Petitioner agreed to register new Allen Douglas Securities branch offices in Tampa and Sarasota. The three respondents signed the Stipulation and Consent Agreement on November 24, 1999, and Petitioner signed it on November 29, 1999.
Reportedly, due to subsequent miscommunications, the administrative law judge dismissed the case then pending before the Division of Administrative Hearings, even though the issues involving Respondent had not been resolved. Petitioner later filed the Administrative Complaint commencing this case.
In this case, Petitioner again seeks to discipline Respondent for his alleged failure to discharge adequately his compliance and supervision duties at Allen Douglas Securities, of which Respondent was never an officer, director, shareholder, or employee.
Respondent has held a National Association of Securities Dealers (NASD) series 7 license (General Securities Representative) since 1976, a series 24 license (General Securities Principal) since 1980, a series 4 license (Registered Options Principal) since 1983, and a series 8 license (General Securities Sales Supervisor) since 1989. Except for two two- year periods, Respondent has been continuously employed in the securities industry since January 1980.
From October 1995 through October 1997, Respondent was registered with an NASD brokerage firm based in Sarasota, Florida, known as Executive Securities, Inc. (later known as Executive Wealth Management; all references to Executive Securities are to Executive Securities, Inc. and Executive Wealth Management). In 1995, while providing compliance
services to Executive Securities branch offices, Respondent met Mr. Pizzuti, who was the manager of the Executive Securities branch located in Altamonte Springs, Florida.
Although not as experienced as Respondent in the retail securities industry, Mr. Pizzuti has had substantial experience in this business. After acquiring his series 24 license in 1987, Mr. Pizzuti has managed eight separate offices and hundreds of brokers.
Respondent and Mr. Pizzuti dispute whether Respondent ever provided compliance services to Mr. Pizzuti’s branch of Executive Securities. Respondent testified that he did not, and Mr. Pizzuti testified that he did. They also dispute whether Mr. Pizzuti operated a branch office or a franchise of Executive Securities. Respondent testified that it was a branch office, and Mr. Pizzuti testified that it was a franchise.
Most importantly, Respondent and Mr. Pizzuti dispute the extent to which Respondent was responsible for compliance and supervision at Allen Douglas Securities. Respondent testified that, during the relevant period, he was responsible for compliance and supervision in options trading only. Respondent testified that he sporadically provided other compliance services, on a very limited basis, when he answered questions asked of him by Mr. Pizzuti or his brother or sometimes questions asked of him by brokers who had received a
customer complaint. Explaining that he happened to have been visiting the office at the time, Respondent testified that his compliance involvement intensified when Mr. Pizzuti received a letter from Mr. Nellis dated November 6, 1998, in which
Mr. Nellis expressed dissatisfaction in the handling of his account and directed that all trading terminate, except to the extent necessary to cover margin calls. Respondent acknowledged that he assumed greater compliance responsibilities at the very end of the relevant period, largely to deal with Petitioner and Mr. Nellis, but that he did so as an accommodation to
Mr. Pizzuti.
Mr. Pizzuti testified that his brother reported to him and Respondent on all compliance matters during the relevant period. Mr. Pizzuti testified that Respondent had served as the compliance officer in all matters for Allen Douglas Securities from prior to 1998 through the relevant period. As to non- options matters, Mr. Pizzuti testified that he relied on Respondent for “macro compliance,” but not “day to day compliance.” As to supervision during the relevant period,
Mr. Pizzuti testified that Respondent had input into the implementation of supervision practices and procedures to a greater extent than he had input into the design of these practices and procedures.
The relationship between Respondent and Mr. Pizzuti has become strained over time. Initially closing ranks when confronted with Mr. Nellis’s complaint and Petitioner’s investigation, Respondent and Mr. Pizzuti contended that
Mr. Nellis was a day trader and responsible for the losses that followed from his excessive trading. The Pizzuti brothers escaped personal discipline for an obvious failure in supervision, if not also compliance, presumably by blaming Respondent, as one of the conditions of their stipulation with Petitioner is that they not register Respondent in any capacity. Respondent now blames the Pizzutis for the failure in supervision, if not also compliance. This deterioration in relations is important in assessing certain of the evidence at various stages of the relationship between Respondent and the Pizzutis.
Respondent probably provided compliance services to Mr. Pizzuti’s branch of Executive Securities. Mr. Pizzuti kept a copy of a memorandum dated March 6, 1996, and issued by Respondent, as “Compliance Officer” of “Executive Securities, Inc.” Although the recipients are merely “All Registered Representatives,” the retention of a copy of this memorandum by Mr. Pizzuti at his branch office suggests that the account representatives at this branch were the recipients of the memorandum.
Announcing a “Mandatory Compliance Meeting,” the memorandum explicitly illustrates the nature of Respondent’s compliance responsibilities, in describing the topics to be discussed, and implicitly illustrates the nature of Respondent’s supervisory authority, in warning of specific consequences-- implicitly to be imposed by Respondent--for tardiness or absence. The memorandum states in its entirety:
Please arrange your schedules to accommodate a mandatory compliance meeting on Friday, March 8, 1996, at 8:30 AM. No exceptions will be permitted. Please be prompt.
Anyone arriving later than 5 minutes following the starting time will be considered absent. Absent representatives will risk censure or imposition of fines. The session should be approximately 30 minutes long.
Subjects covered include suitability, discretion, basis for recommendation, asset turnover, margin, quality control, customer service. Call me . . . with comments or questions.
The memorandum reveals the nature of Respondent’s compliance responsibilities and supervisory authority at Executive Securities, and thus Respondent’s relevant experience and capabilities. The memorandum also illustrates the relationship between compliance responsibilities and supervisory authority that Respondent enjoyed with Executive Securities. Lacking hiring and firing authority at Allen Douglas Securities, Respondent testified that he was unwilling to assume wider
ranging compliance responsibilities. Aside from these matters, though, the memorandum is of little direct value in the present case because Mr. Singer was never employed by Executive Securities.
Mr. Singer was one of about 14 registered representatives employed by Allen Douglas Securities. His employment with Allen Douglas Securities ran from March 11, 1998, through November 18, 1998. Mr. Singer’s preceding employment was with Empire Financial Group, Inc., from
November 20, 1996, through February 13, 1998, and Charles Schwab
& Co., Inc., from November 4, 1991, through October 15, 1996. Mr. Singer was also registered with three other brokerage firms between July 22, 1988, through December 2, 1991.
Choosing to end his association with Executive Securities, Mr. Pizzuti formed or acquired American Trading and Brokerage, which, through a name change, became Douglas Allen Financial Group, Inc. (DAFG). Mr. Pizzuti was the sole shareholder of DAFG. On March 28, 1996, probably shortly after the formation of the company, the board of directors unanimously consented to its reformulation to comprise Respondent,
Mr. Pizzuti, and Richard Pizzuti, all of whom had series 24 licenses.
At the same time, the board of directors caused DAFG to form a subsidiary corporation to be licensed as a brokerage
firm. The new company, Allen Douglas Securities, was incorporated on September 26, 1996. DAFG was never registered with the NASD or Petitioner, presumably due to its status as a mere holding company that did not serve as a broker or dealer of securities.
Also at the same time, the board of directors required DAFG to set aside 9750 shares of DAFG stock for Respondent. A written agreement, incorporated into the minutes, provides that Respondent earned these shares, pursuant to a five-year vesting schedule, by serving as the “Chief Operating Officer and Compliance Officer” of Allen Douglas Securities and supplying Allen Douglas Securities with “the exclusive right to his research and financial reports.”
The vesting schedule was to “commence upon Mr. Kase’s assumption of duties” with “vested ownership [to] be recognized as follows: Completion of Year 1 Service--20 [percent;] Completion of Year 2 Service--40 [percent;] Completion of Year 3 Service--60 [percent;] Completion of Year 4 Service--80 [percent; and] Completion of Year 5 Service--100 [percent.] Despite the apparent “vesting” of ownership of varying percentages of the shares designated for transfer to Respondent, the schedule cautions:
The award is not transferable without the Board of Director’s consent. Mr. Kase is entitled to enjoy the benefits associated
with the beneficial ownership of the Corporation but is not permitted to transfer ownership or any rights to permanent ownership without the Board of Director’s consent. The Corporation holds the right to demand repudiation of all ownership rights in the event of failure to complete the service requirements.
Prominent among the items not in dispute between Respondent and Mr. Pizzuti is that Respondent did not earn any DAFG shares and never owned any shares of DAFG at anytime. By letter dated June 15, 1999, Respondent “acknowledge[d] my inability to meet the service requirements for sustaining an ownership interest in the company . . ..” As a result, Respondent acknowledged that he was “not entitled to any further claim of ownership interest in the company and am obliged to forfeit any current and future claims based upon service rendered to the company.”
Registered in Florida as a broker-dealer on December 6, 1996, Allen Douglas Securities initially operated out of the location formerly used by the Executive Securities branch office managed by Mr. Pizzuti. As president and secretary of Allen Douglas Securities, Mr. Pizzuti was in charge of the new company. Serving as the branch manager (of the sole office) and vice-president of Allen Douglas Securities from early 1997, Richard Pizzuti conferred with his brother, when necessary, for
guidance as to, among other things, compliance matters with which Richard Pizzuti was unfamiliar.
Respondent memorialized his research responsibilities, as he entered into one-year contracts for 1997 and 1998 to provide securities research. Through these contracts, Respondent, as an independent contractor, agreed to provide investment research in return for which he was to earn, subject to a cap, the greater of $4500 monthly or three percent of the gross sales of DAFG for the month.
The first contract between Respondent and DAFG is dated January 1, 1997, and provides that DAFG shall transfer to Respondent 5000 shares of its stock, if Respondent grants DAFG an exclusive right to his research. However, the contract prohibits Respondent from transfering the stock, and the parties lined out a provision that would have eliminated this prohibition after one full year of exclusive service. The first contract provides for notices to Respondent to be sent to an address in Winter Park, Florida.
A second contract, substantially similar to the first contract, is dated January 1, 1998, and provides for notices to Respondent to be sent to two addresses: the same one in Winter Park, Florida, and a new one in Park City, Utah. The most significant difference between the two contracts is the omission
from the latter contract of the stock-ownership provisions described in the preceding paragraph.
The two contracts are primarily useful for four purposes. First, the contracts show that, between January 1997 and January 1998, Respondent had at least begun the process of relocating his residence from Winter Park, Florida to Utah.
Respondent testified credibly that he moved to Utah in January 1998, after which he only visited Florida from time to time. For 1998, Respondent visited Florida three or four times, usually for a combination of business and personal purposes.
The business usually involved Allen Douglas Securities.
The account applications signed by Respondent and introduced into evidence generally corroborate Respondent’s claim that he was not often in Florida between May and November 1998. For instance, Petitioner Exhibit 22 is an application for an options account that is signed by Respondent on July 18, 1998; however, the client, registered representative, and manager signed the application one month earlier. This delay most likely was due to the time it took to transmit the form to Respondent in Utah or the next visit that he made to Florida from Utah.
Second, the contracts show that, from January 1997 and January 1998, Respondent was an independent contractor, not an employee, of Allen Douglas Securities. The recitations of the
contracts concerning Respondent’s level of control regarding his work are entirely consistent with the record regarding how and even where Respondent performed his work.
Third, the contracts show that, between January 1997 and January 1998, Respondent’s role with Allen Douglas Securities had diminished, at least with respect to the likelihood that he would obtain an equity interest in the company in return for research.
Fourth, the contracts are inaccurate in one revealing respect. The contracts misidentify the company as DAFG, rather than Allen Douglas Securities. Allen Douglas Securities, as a broker-dealer, required Respondent’s services; DAFG, as a holding company, did not. This awkwardness of this transparent effort to distance Respondent from Allen Douglas Securities, and thus from securities liability, was betrayed by basing Respondent’s payments on the sales of DAFG. As a holding company, DAFG had no sales; Respondent was paid based on the sales of Allen Douglas Securities. For at least one of these years, Allen Douglas Securities actually issued Respondent the Form 1099 reporting the payments to the Internal Revenue Service. Respondent’s effort to characterize his relationship with DAFG, rather than Allen Douglas Securities, underscores his sophistication, at the expense of his candor, as he structured
the relationship to serve his liability needs rather than to reflect business reality.
The two contracts are incomplete in one important respect: they omit any discussion of Respondent’s compliance responsibilities. In 1998, most of Respondent’s income was derived from the services that he provided Allen Douglas Securities, in return for which he earned $52,500. This sum approximates the $54,000 that Respondent was due under the 1998 contract for his research. There were no separate payments for the compliance services, which assumed greater importance by the end of 1998.
This omission from the contracts may not be another attempt by Respondent to shield himself from liability. Based on the record, it is more likely than not that Respondent’s compliance responsibilities were negligible, at least through early 1998, when the second contract was signed.
From the inception of Allen Douglas Securities,
Mr. Pizzuti consulted with Respondent over compliance issues with which Mr. Pizzuti was unfamiliar. However, nothing in the record suggests that Mr. Pizzuti needed to, or did, consult with Respondent over every compliance issue. Relying on his substantial experience in the retail securities industry,
Mr. Pizzuti handled the many common compliance issues without soliciting the advice of Respondent.
Analysis of Respondent’s precise responsibilities at Allen Douglas Securities requires careful consideration of two facts.
First, compliance and supervision are largely distinct tasks. Compliance requires the development of policy, and supervision requires the execution of policy by ensuring that subordinates behave within certain acceptable parameters. Compliance and supervision overlap when a superior must determine if certain behavior of a subordinate constitutes a violation of policy. Thus, a superior’s determination of whether a registered representative’s trading activity is excessive for a particular account requires the collection of data concerning the trading activity and account holder, analysis of this data in light of prevailing standards for assessing excessive activity, and communicating to and enforcing upon the registered representative any determinations arising out of this analysis. This potentially complex process necessarily involves both compliance and supervision tasks.
Second, Respondent’s compliance and supervision responsibilities were evolved over time. This case requires a determination of Respondent’s compliance and supervision responsibilities from May to November 1998. Evidence of Respondent’s responsibilities before and after the relevant
period is useful in inferring the exact extent of these responsibilities during the relevant period.
Contemporaneous documentation is helpful in identifying the allocation of compliance and supervision responsibilities at Allen Douglas Securities at various times. One valuable source of information is the Form BD, which is a Uniform Application for Broker-Dealer Registration. This is a form used by a broker-dealer for initial registration and amendments to registration.
The first Form BD, which is dated December 4, 1996, represents the initial application of Allen Douglas Securities. Prepared by Mr. Pizzuti, as are all the Forms BD, the December 4, 1996, Form BD seeks registration with the Securities Exchange Commission and NASD. In response to a question asking for the names of each chief executive officer, chief financial officer, chief operations officer, chief legal officer, chief compliance officer, direction, any other person with similar functions, or shareholder, the December 4, 1996, Form BD identifies
Mr. Pizzuti as president, Mark Thomes as chief financial officer, and DAFG as the sole shareholder.
The record contains several Forms BD for 1997. Nearly all of these amendments sought to add different states to the registration of Allen Douglas Securities.
However, two of the Forms BD in 1997 mention Respondent. By Form BD dated May 5, 1997, Allen Douglas Securities named Respondent, as of May 1997, as its senior registered options principal and compliance registered options principal, as well as municipal bond principal. This Form BD names Mr. Pizzuti as the person in charge of compliance. A Form BD dated November 5, 1997, assigns these responsibilities exactly as did the May 5, 1997, Form BD.
A Form BD dated March 3, 1998, only changes a state registration. A Form BD dated May 11, 1998, changes a state registration, names a new clearing house, and names two new municipal bond principals, Mr. Thomes and another person whose name is illegible.
A Form BD dated May 26, 1998, restates the previously supplied information concerning DAFG as the shareholder,
Mr. Pizzuti as the president, Mr. Thomes as the chief financial officer and municipal bond principal, and Respondent as the registered options principal. A Form BD dated June 16, 1998, changes a state registration. The last available Form BD is dated September 25, 1998, and again restates the previously supplied information set forth in the first sentence of this paragraph.
During this period, Respondent issued some documents reflecting his activities with Allen Douglas Securities. On
December 29, 1997, on letterhead entitled, “Allen Douglas Compliance Memo,” Respondent provided advice to all registered representatives, with a copy to Mr. Pizzuti, concerning “Options Trading--Basis for Recommendations and Suitability.” This memorandum, which is limited to options trading, warns the registered representatives to be careful with options trading, which Respondent described generically as “drifting toward increased speculation bordering on gambling.” Noting that options trading generates a disproportionate share of customer complaints and is not especially profitable for a broker-dealer, the memorandum states: “We tend to maintain higher standards and stricter discipline regarding options trading than most firms in our industry. We intend to continue maintaining higher standards than the industry requires.” At the bottom of the memorandum is Respondent’s typewritten name and “Compliance Registered Options Principal,” below which is “Fax.”
On February 6, 1998, Respondent sent a short e-mail to an employee of Allen Douglas Securities asking for help in assembling a research file on a particular bulletin-board stock.
At the bottom of the memorandum is “Compliance.” Two more e-mails dated June 29, 1998, to Mr. Pizzuti concern options accounts and compliance.
In one of these e-mails, dealing with options accounts, Respondent responded to an options account application
that Mr. Singer sought to open for a customer otherwise unrelated to this case. Respondent stated: “This is a weak qualifier. I am willing to approve it but it requires close supervision. . . . Place a special emphasis on monitoring activity in this account.”
In the other e-mail, dealing with options compliance, Respondent restricted a particular broker, identified only by number, to closing already-open options positions. Respondent conditioned reinstatement of full options trading privileges upon a review of account activity and demonstration of suitability.
By e-mail dated July 7, 1998, Mr. Singer responded to Respondent’s e-mail and noted that the customer had followed Mr. Singer from firm to firm and had directed the trading in his account. By e-mail dated July 8, 1998, Respondent did not yield, instead warning Mr. Singer:
. . . When a firm qualifies and accepts an account as suitable for options trading, we must monitor the activity and assess the suitability of transactions. We are not permitted to accept a trade simply because it was the client’s idea. If it is remotely reasonable to assume that the firm should have considered a particular trade or series of trades to be unsuitable, whether solicited or unsolicited, then the firm must assume it can and will likely be held accountable for adverse results and financial loss.
The only documents that assign Respondent a broader role in compliance and supervision are the Written Supervisory Procedures of Allen Douglas Securities and a Designated Responsibility matrix, both of which appear to have been prepared by Mr. Pizzuti. The date of origin of the Written Supervisory Procedures is undeterminable. The matrix is dated September 11, 1998, although Mr. Pizzuti insists that earlier, unproduced matrices exist and characterize Respondent identically. The September 11, 1998, matrix assigns a broad range of compliance and supervision responsibilities to Respondent, reserving for Mr. Pizzuti only the tasks of hiring and reviewing correspondence.
The Written Supervisory Procedure and Designated Responsibility matrix are self-serving documents obviously prepared by Mr. Pizzuti. Through these entirely internal documents, Mr. Pizzuti appears to have attempted to have assigned broad compliance and supervision responsibilities to Respondent.
Mr. Pizzuti’s effort to make a broad, internal assignment of responsibilities contradicts his earlier, public acceptance of compliance responsibilities by the Form BD dated May 5, 1997. The credibility of the Written Supervisory Procedure and Designated Responsibility matrix is further undermined by the failure of Mr. Pizzuti to prepare new Forms BD
at the times of these changes in compliance responsibility, despite his obvious incentive to do so, as Respondent was purportedly relieving Mr. Pizzuti of potential liability in this area. Also, given Respondent’s knowledge of compliance issues and previously noted sophistication in the preparation of the two contracts, he unlikely would have bothered to try to shield himself from liability in the two contracts, and then waste this effort by allowing Mr. Pizzuti to name him as the compliance officer in internal documents.
Filed documents and documents prepared by Respondent reveal that he had comprehensive compliance and supervision responsibilities in the area of options only during the relevant period. Respondent provided compliance assistance, but not supervisory assistance, on an as-needed basis throughout his tenure with Allen Douglas Securities. Undoubtedly, Respondent’s contributions in compliance matters not involving options became more substantial at the end of 1998 and start of 1999, but Respondent never replaced Mr. Pizzuti in this area. Eventually, well after the conclusion of the relevant period, Respondent assumed substantial compliance responsibilities. For instance, by letter on Allen Douglas Securities letterhead to Petitioner’s auditor dated April 13, 1999, Respondent designated himself as “Senior Compliance Officer.”
Focusing on Respondent’s compliance and supervision responsibilities during the relevant period, he appears to have discharged commendably his acknowledged responsibilities in options trading. From May to November 1998, only five options trades took place in the Nellis account. Consistent with his original claim assigning substantial responsibility to
Mr. Nellis, Respondent testified that the system worked as to options trading: Mr. Nellis tried trading options, found that he was not comfortable trading options, and chose not to trade options after a few minor trades.
However, Mr. Nellis denied any knowledge of the options trading. More likely, given Mr. Nellis’s past trading experience, his education, and his receipt of monthly statements from Allen Douglas Securities, Mr. Nellis more or less condoned months of very, very heavy trading by Mr. Singer in Mr. Nellis’s account, as discussed below, in the expectation of big profits. When the heavy trading produced significant losses, Mr. Nellis complained. Under this more likely scenario, Mr. Nellis did not intervene at all until early November 1998, and, prior to that, he would no more likely have stopped Mr. Singer from trading options than he not have stopped Mr. Singer from trading excessively in non-options.
Under the more likely scenario, in which Mr. Nellis did not stop the options trading, Respondent’s close supervision
of Mr. Singer’s options trading was probably why Mr. Singer was unable to damage the Nellis account through options trading, as he did through non-options trading. Reading Respondent’s unyielding e-mail of July 8, 1998, Mr. Singer necessarily must have realized that, if he were to assume the role of rogue broker, he would have to do it in an area unsupervised by the watchful Respondent.
It is difficult to harmonize the evident level of supervision that Respondent provided over Mr. Singer’s options trading with the non-supervision that Mr. Singer received over his non-options trading, if Respondent in fact was responsible for the latter during the relevant period. The trading activity in the Nellis account from May to November 1998 was, under all relevant circumstances, wildly excessive, or, as Respondent described it, “breathtaking.”
Churning arises when a broker in control of an account trades too often, so as to support the inference (in the absence of direct evidence of intent) that the broker’s intent was primarily to generate commissions for the broker rather than to generate profits for the client. Relevant factors include the client’s sophistication, the client’s objectives, the extent to which the client actually relied on the broker, the party initiating the trades, the extent to which the client approved
of broker-initiated trades, and the effect of the commissions on the potential for profitability.
Mr. Nellis is a 1985 graduate of the University of Tennessee. At the time in question, he was working in real estate sales. His annual earnings, largely in the form of commissions, were $35,000 to $63,000, and his net worth was
$75,000 to $100,000. Before transferring his account to Allen Douglas Securities in May 1998, Mr. Nellis had traded at Dean Witter and Empire Financial. At Empire Financial, Mr. Singer had been Mr. Nellis’s registered representative for the first four months of 1998.
During Mr. Singer’s assignment to the Nellis account for the seven months from May to November 1998, the average account equity was $41,620; the total purchases were $4,987,559, the total commissions were $17,289, and the total margin interest was $20,286. Over seven months, commissions and interest equaled half of the account balance.
Conventional turnover analysis requires the calculation, over a single year, of the total purchases divided by the account equity. This ratio expresses the annual frequency of annual turnover of an account. Although current trading volumes and reduced commission costs have necessitated reconsideration of acceptable ranges for these turnover ratios, historically a ratio of 6:1 was excessive, even for an
especially active account. The annual turnover ratio in Mr. Nellis’s account was over 200:1. In August 1998, the turnover ratio for one month was 75:1, as the $20,000 account, in that month alone, purchased $1.5 million in securities.
A better measure of activity is the commission to equity ratio, which measures the rate of return that an account would have to generate to cover the commissions. In other words, an account paying 20 percent of its average balance in commissions must earn 20 percent of its average balance to break even. A good measure of a reasonable expected return is that, over the long run, the securities market has produced an annual rate of return of 10-12 percent. Again annualized, the commission to equity ratio of Mr. Nellis’s account was 71.2 percent, meaning that he would have had to earn 71.2 percent over the year just to pay the commissions.
An even better measure of activity is the total cost to equity ratio, which measures the rate of return that an account would have to generate to cover the commissions and margin interest. Adding Mr. Nellis’s margin interest results in an annualized ratio of 83.6 percent, meaning that he would have had to earn 83.6 percent over the year just to pay the commissions and interest.
Over seven months, Mr. Singer executed about 240 trades in the Nellis account, or about 34 per month. Mr. Nellis
claims to have approved less than five percent of these trades. During the preceding 13 months at Empire Financial, Mr. Nellis executed only six trades and held his securities an average of
127 days. During the relevant period, about one-third of the trades in the Nellis account were day trades.
The financial impact of the excessive trading was exacerbated by the leveraging of Mr. Nellis’s account. Thus, when the market declined during the summer of 1998, his account, which averaged 50 percent leverage and reached 90 percent leverage, responded dramatically.
There is no question that Mr. Singer churned this account. Mr. Singer was in control of the Nellis account,
Mr. Singer excessively traded the Nellis account, and Mr. Singer excessively traded the account to advance his own interests, rather than the interests of Mr. Nellis.
The gaps in the record concerning the finer points in the extent to which Respondent assisted the Pizzutis with compliance issues during the seven months in question ultimately prove irrelevant. In identifying the compliance and supervision issues presented by Mr. Singer’s egregious behavior in this case, Mr. Pizzuti and his brother had absolutely no need for the compliance expertise (or any supervisory authority, of which Respondent none outside of options trading) of Respondent. The compliance issue was that Mr. Singer was churning Mr. Nellis’s
account, and the supervisory issue was that the Pizzutis needed to fire Mr. Singer. As the Pizzuti brothers presumably do not need a weatherman to know which way the wind blows, neither do they need Respondent to know that supervisors need to examine daily trading tickets, that Mr. Singer was churning Mr. Nellis’s account, that churning is bad, and that Mr. Singer had to be stopped immediately.
Petitioner has failed to prove by clear and convincing evidence that Respondent had any role whatsoever in the compliance and supervision issues present in Mr. Singer’s churning of the Nellis account. The customer abuse in this case happened on the watch of the Pizzutis, not Respondent.
CONCLUSIONS OF LAW
The Division of Administrative Hearings has jurisdiction over the subject matter. Section 120.57(1), Florida Statutes. (All references to Sections are to Florida Statutes. All references to Rules are to the Florida Administrative Code.)
Petitioner must prove the material allegations by clear and convincing evidence. Department of Banking and Finance v. Osborne Stern and Company, Inc., 670 So. 2d 932 (Fla. 1996).
Section 517.161(1) authorizes Petitioner to revoke or suspend any registration for a violation of any provision of
Chapter 517, Florida Statutes, or any rule promulgated under Chapter 517, or for a demonstration of unworthiness to transact business.
Section 517.221 authorizes Petitioner to issue a cease and desist order or impose an administrative fine for a violation of any provision of Chapter 517, Florida Statutes, or any rule promulgated under Chapter 517.
Section 517.301(1)(a) prohibits, in connection with the offer, sale, or purchase of a security, the employing of any device, scheme, or artifice to defraud; the making of any untrue statement or failure to state material information; or the engaging in any fraudulent or deceitful transaction.
Rule 3E-600.013(1)(b) provides that a person demonstrates his or unworthiness by “[i]nducing trading in a customer’s account which is excessive in size or frequency in view of the financial resources and character of the account.”
It is unnecessary to consider in any detail the various provisions that predicate discipline upon a failure to discharge adequately compliance and supervision responsibilities. Petitioner has failed to prove that Respondent failed to discharge adequately such responsibilities in connection with Mr. Singer’s abusive trading in the Nellis account during the relevant period.
It is
RECOMMENDED that the Department of Banking and Finance enter a final order dismissing the Administrative Complaint against Respondent.
DONE AND ENTERED this 26th day of December, 2000, in Tallahassee, Leon County, Florida.
ROBERT E. MEALE
Administrative Law Judge
Division of Administrative Hearings The DeSoto Building
1230 Apalachee Parkway
Tallahassee, Florida 32399-3060
(850) 488-9675 SUNCOM 278-9675
Fax Filing (850) 921-6847 www.doah.state.fl.us
Filed with the Clerk of the Division of Administrative Hearings this 26th day of December, 2000.
COPIES FURNISHED:
Honorable Robert F. Milligan Office of the Comptroller Department of Banking and Finance The Capitol, Plaza Level 09 Tallahassee, Florida 32399-0350
Robert Beitler, Acting General Counsel Office of the Comptroller
Department of Banking and Finance Fletcher Building, Suite 526
101 East Gaines Street Tallahassee, Florida 32399-0350
Chris Lindamood
Assistant General Counsel Department of Banking and Finance
400 West Robinson Street, Suite S-225 Orlando, Florida 32801
David S. Wood Sarah A. Long
Baker & Hostetler, LLP Post Office Box 112
Orlando, Florida 32802-0112
NOTICE OF RIGHT TO SUBMIT EXCEPTIONS
All parties have the right to submit written exceptions within
15 days from the date of this recommended order. Any exceptions to this recommended order must be filed with the agency that will issue the final order in this case.
| Issue Date | Document | Summary |
|---|---|---|
| Jan. 17, 2001 | Agency Final Order | |
| Oct. 26, 2000 | Recommended Order | Petitioner failed to prove that Respondent, who was not a shareholder, officer, director, or employee of brokerage firm, had any compliance or supervision responsibilities over registered representative who was churning an account. |
