Occasionally, the Securities and Exchange Commission (SEC) issues a decision that is not only well written, but also succinctly clarifies and defines what constitutes a violation. In recently deciding that Registered Representative James J. Barbato (Barbato) of the Stuart-James Co., Inc. (Stuart-James), a former registered broker-dealer, engaged in

• fraudulent price predictions,
• material misrepresentations and omissions,
• unsuitable recommendations,and
• churning,

the SEC issued an Opinion that acts as a primer for sales practice violations. Barbato explains in easily understandable terms what you shouldn't do, why it's wrong, and how the SEC will amass its proof.

• barred Barbato from association with any broker or dealer or from participating in any penny stock offering;
• ordered him to cease and desist from committing or causing any violation or future violation of Section 17(a) of the Securities Act of 1933, Section 10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder; and
• ordered him to disgorge $45,142.20, plus $45,690.05in prejudgment interest

Barbato joined Stuart-James as a registered representative in its Altamonte Springs, Florida branch office in May 1985. By 1989, Barbato had been promoted to branch manager of Stuart-James's Orlando, Florida branch. Barbato handled more than three hundred Stuart-James customer accounts. The SEC determined that Barbato engaged in violations with respect to the offer and sale of a number of unseasoned speculative securities (three of which were deemed "penny stocks") to at least seven Stuart-James customers.

In cases such as Barbato, RRs often claim that the defrauded customers were sophisticated and knew that the higher rates of return expected from speculative investments entailed greater risk. The SEC traditionally rejects arguments that customers were not defrauded because they were "sophisticated or wished to speculate" In essence, there's no open season on the wealthy.

In Barbato, the SEC reminded RRs that sales of speculative securities require a heightened sensitivity to the specific circumstances of the customer. Where, as here, customers appeared to be inappropriate candidates for penny stock purchases, the RR's burden of justifying particular recommendations is all that much greater.

In Barbato, the SEC determined that churning occurred in a customer account of a retiree based upon purchases totaling $214,899 and generating $33,884 in commissions on an average account equity of $42,359. From March 1988 through July 1990, the account had a turnover ratio of 2.1 and a break-even cost factor of 38 percent, and for the sub-period between July 1989 and July 1990, the turnover ratio was to 4.1 and the break-even cost ratio was 57.9 percent.

Although the SEC normally uses turnover ratio as its key measure in scrutinizing excessive trading, the break-even cost factor may also be considered. With penny stock trading, where the costs of trading are higher relative to the price of the securities traded, the break-even cost factor may be a more effective measure of excessive trading, especially for customers who are on fixed incomes, disabled, or retirees.