DYING WITH YOUR BOOTS ON:
STRATEGY AND TACTICS IN CONTESTING DISCIPLINARY PROCEEDINGS
Part II

In the first installment of this article, we considered the options available to one of twelve named individuals in an NASDR disciplinary proceeding.  In Part II we examine how our sole respondent defended himself against one customer's charges of unauthorized trading and related misconduct.

Burden of Proof

By way of preliminaries, when assessing your chances of prevailing in a contested self-regulatory proceeding, it's best to understand some fundamental issues of evidentiary proof.  The claimant (usually a department of enforcement or market regulation) has the obligation to prove its case. Technically, even if you default they'resupposed to introduce sufficient evidence to support their allegations. Simply put, you don't have to prove you're innocent; they have to prove you're guilty.  Realistically, however, that's a crock.  All too often disciplinary proceedings seem to operate on the assumption that those fine, upstanding young men and women in enforcement or regulation wouldn't have charged these low-life brokers without good reason.  Similarly, there's a corollary that customers would never ever lie about their broker's misconduct.  

Once the hearing begins, the SRO must prove its case against you according to the evidentiary standard applicable to civil cases.  This standard, commonly referred to as a burden of proof, is best explained by way of a comparison.  In a criminal case, the prosecution must prove its case beyond a reasonable doubt.  This extreme burden of proof exists because of the significant threat of imprisonment (or in murder cases, execution).  In civil proceedings, where incarceration is not an available remedy, the burden of proof is less stringent.  In civil proceedings a plaintiff/claimant must only show by a preponderance of the evidence that you are guilty.  In plain terms, this means that it's more likely than not.  If you hold up the proverbial scales they tip against you: even if ever so slightly. 

A troubling aspect of self-regulatory proceedings (and for that matter SEC proceedings) is that notwithstanding the fact that they are couched in the language of criminal prosecutions, the regulator must surmount only the lower, civil burden of proof.  As such, even though the various enforcement/market regulation staffs act like criminal prosecutors and even though the fines imposed upon respondents tend to mirror criminal sanctions (and suspensions/bars are frequently compared by registered persons to jail time), the bottom line is that it's still a civil proceeding.  So they only need to gently tip the scales against you to win; it's not beyond a reasonable doubt.   Similarly, if you assert your Fifth Amendment privilege against incrimination during a regulatory on-the-record interview (OTR) or hearing, you may be shocked to find that it is not applicable.  The Fifth Amendment protects you against incrimination and it is argued that since the SROs cannot put you in jail, they are not compelled to honor the privilege.  Consequently, they may construe your refusal to testify as an admission of guilt, whereas in a criminal proceeding no such inference could properly be drawn. Worse, your mere assertion of your Fifth Amendment rights and the resulting decision not to testify may serve as the basis for the SRO bringing charges against you for failure to give testimony, with the likely result of an industry bar. Now, here's an interesting dilemma.  You're charged by the United States Attorney with various securities law crimes.  A few months earlier you testified before the NASD during an OTR.  The transcript of that prior testimony may very well be provided to the U.S. Attorney.  Maybe it wasn't such a good idea to simply go down to the NASD without a lawyer? Here's another twist.  The U. S. Attorney was interested in pursuing you months before that NASD OTR.  Let's imagine a purely hypothetical conversation between the federal prosecutor and your NASD interrogator: Prosecutor:  Hey, you know we're looking into the activities of Reggie Repp and would love to ask him about Joe Smith, Fly-By-Night, Inc. and XYZ Broker-Dealer; but once we call him down here his lawyer may advise him against testifying and there's nothing we can do if he claims his Fifth. NASDR Staff: We can send him a Rule 8210 letter demanding his testimony and if he doesn't answer those questions I'll threaten him with a bar.    Prosecutor: That might help.  If he doesn't cooperate with you and he's thrown out of the business that might put a crimp in his ability to pay that high-priced criminal lawyer.  Also saves me the aggravation of issuing a subpoena. NASDR Staff: So, give me a list of those questions you want me to ask. Next time you visit your local NASD office, take a look and see if there's a back door.

Once our protagonist in Part I decided to go forward to trial, DOE was required to prove its case by a preponderance of the evidence.  Quite honestly, things should not have looked good for our unidentified respondent.  Of the original 12 named respondents, ten either plead guilty or were so found in default.  As you will recall, DOE decided to withdraw its charges against the eleventh respondent, leaving our surviving respondent with the prospect of a one-on-one hearing.  And the other side's "one" was the NASDR's Department of Enforcement --- not exactly equal odds. During the ensuing two days of hearings spread over six weeks, DOE called one customer by telephone and one customer testified in person, and presented four exhibits. Respondent personally testified on his own behalf and introduced one exhibit.  Let's examine that portion of DOE's case involving public Customer M.S.'s allegations.

Customer M.S.’s Allegations

DOE charged  Respondent with violating NASD Rules 2110 and 2120, in that he a) induced public customer M.S. to buy units and shares of Xechem International by making baseless price predictions and b) engaged in unauthorized purchases of Xechem.  DOE additionally charged Respondent with violations of NASD Rules 2110 and 2120 plus Securities and Exchange Act Section 10(b) and Rules 10b-5 and 10b-6 promulgated thereunder, in that hewrongfully preconditioned M.S.’s purchase of IPO units upon a requirement to purchase shares in the aftermarket. 

M.S. testified that he had authorized Respondent to purchase 20,000 shares of Xechem.  A dispute arose concerning the subsequent purchase of an additional 20,000 shares. M.S. claimed that he never authorized the second 20,000 share purchase.  Apparently, when the firm demanded payment for the second purchase and threatened a sell-out, M.S. declined to tender additional funds and authorized the sale of the entire 40,000 share position for a loss of $23,000 (including $7,500 in commissions). 

Take My Wife . . . Please!

Respondent testified that M.S. initially authorized the second purchase,  but soon thereafter found himself unable to pay for the shares because his wife would not permit him to transfer sufficient funds from their joint account to cover the trade.  Respondent related further details indicating that M.S. was in the midst ofmarital difficulties at the time of the questioned transaction.  M.S. denied that he had effectively reneged on the second purchasebecause of a dispute with his wife, but admitted to receiving "surprise" divorce papers several months thereafter.  

The Sounds of Silence

The NASDR Hearing Panel placed considerable weight upon the fact that notwithstanding M.S.'s sizable loss, he never complained to anyone at Respondent’s firm nor consulted with anyone at Prudential or Kidder Peabody (where he maintained other securities accounts) as to his rights or legal options.  More troubling  was the fact that even after the NASD contacted M.S. pursuant to its investigation, the customer never inquired of the SRO as to how to recover his losses. When asked as to why he similarly failed to contact the Securities and Exchange Commission, the public customer claimed that the organization was “not in the phone book.” 

The Panel noted that M.S. was a successful businessman who owned a small manufacturing company.  Further, he had at least $500,000 in the stock market and  a history of engaging in “fairly aggressive” trading at a prominent, nationally-known BD.  Accordingly, the Panel could not fathom how M.S. would be upset at a five-figure loss arising from an unauthorized trade but never complain about it.

A Few More Straws on the Camel's Back

Additionally, the Panel determined that M.S.'s actual residence was Ohio but he had provided the Respondent with an address of record in Florida.  When questioned, M.S. admitted that he provided his grandfather’s Florida address because his actual  residence in Ohio would have created Blue Sky problems restricting his ability to purchase certain securities. Apparently the Panel concluded that the Respondent was not involved in any subterfuge in this regard and characterized M.S.'s use of a bogus residence as reflecting a “casual attitude toward legal requirements.”

The decision describes several examples of M.S. being uncertain or confused about significant details underlying his allegations.  Notably, he claimed that he had not traded on margin before the contested Xechem trade, but was then befuddled by proof that he had entered a $165,000 margin trade four days earlier. 

Ummm, How Do We Put This Nicely?

The Panel observed that a “witness whose testimony is not credible as to an important subject may be regarded as equally  unreliable on others. “ The decision specifically cited  a United States Circuit Court case that reiterated the maxim that “false in one thing, false in everything.” In commenting upon the staff's presentation, the decision ruefully notes that the DOE staff attorney “never asked [Respondent] about the matters alleged in the Complaint." As a consequence,  DOE's case against the Respondent solely rested upon M.S.'s testimony.  In fairly frank language, the Panel concluded that M.S. was “not a credible witness.”

Not only did the Panel rule in Respondent's favor on the issue of the unauthorized purchase, but having determined that the public customer was not believable, they also dismissed the allegations of improper price predictions and IPO/aftermarket tie-ins.  Under the attendant circumstances, the Panel concluded that the other two allegations by M.S., namely the  price predictions and the IPO/aftermarket tie-in, were tarred by the same brush that raised questions as to his credibility concerning the authorized trade issue. Accordingly, the Panel found that DOE failed to carry its burden of proof against the Respondent as to M.S.’s allegations.

Some Observations

In this case the Panel considered the sophistication and accomplishments of the public customer and concluded that against such a canvass his failures to complain, his failures to inquire, and his assorted glib explanations went to the heart of his credibility.  Further, DOE was apparently caught flat-footed . . . if not downright unprepared . . . and did not present a strong case.  Could this have been a by-product of the staff's overconfidence as to the inevitability of Respondent settling?  Could the built-in pro-prosecution biases within the self-regulatory system have blinded the staff as to the weakness of its case?  One can only speculate, but the decision is refreshing if only because the analysis undertaken by the Panel is comprehensive,  welcome and rare.  

Finally, disciplinary proceedings should serve a markedly different function from arbitrations. I believe that regulators have an ethical obligation to prosecute only those cases where the evidence is compelling that wrongdoing has occurred.  A disciplinary hearing must be something more than an opportunity to throw a batch of facts against a wall and see if something sticks.  Thankfully, not all SRO investigations conclude that violations have occurred.  At times the examiners will have many unanswered questions --- and likely some troubling issues --- but that does not amount to a case.  In the event that it comes down to a given customer's word against a given RR's word, it is not the proper place of a regulator to bring such a dispute before a regulatory panel.  Given the damage that regulatory proceedings can wreak on a RR's career, when all is said and done, pissing contests belong in arbitration.  

In the third installment of this article learn how the Respondent defended himself against allegations of improper price predictions.