SEC’S ORDER REQUIRING RESTITUTION REJECTED AS “NONSENSE”

The D.C. Circuit reversed a Commission ruling upholding an order requiring a broker to pay restitution in a “trading away” case. The court concluded that “the SEC decision borders on whimsical or rests on notions of strict liability.” The case was sent back to the SEC for reconsideration. Siegel v. SEC, Case No. 08-1379 (D.C. Cir. Decided Jan. 12, 2010).

The case is based on a disciplinary action brought by the NASD against Michael Siegel. From 1997 through June 1999, Mr. Siegel was employed as a registered representative with Rauscher Pierce Refsnes, Inc., an NASD firm member. The NASD’s Department of Enforcement filed a complaint against Mr. Siegel in 2002 alleging that while employed with Rauscher he violated the Code of Conduct rules with respect to four clients. Those clients invested in World Environmental Technologies, Inc., a speculative start-up company which eventually failed, wiping out their investment.

The NASD complaint claimed that Mr. Siegel violated NASD Conduct Rules 3040 and 2110 when he “sold away,” that is engaged in private securities transactions on behalf of his clients without notifying the firm. It also alleged violations of Rules 2310 and 2110 when he recommended World ET without having reasonable grounds to do so. The record demonstrated that the clients were sophisticated and wanted to speculate. Mr. Siegel, who knew the company and had served on its board, did not read the prospectus he furnished the clients about the company. He did not make anything on the transactions.

The hearing panel concluded that Mr. Siegel violated the rules as alleged in the complaint. It imposed a six month suspension and a $20,000 fine for the violation of Rules 3040/2120 and a six month suspension and a $10,000 for violations of Rules 2310/2110. It did not require restitution. The suspensions were to be served concurrently. On appeal to the NASD’s National Adjudicatory Council, the decision of the panel was affirmed. However, Mr. Siegel was ordered to pay restitution and his suspensions were to be served concurrently. The SEC affirmed this decision.

The DC Circuit reversed and remanded the case to the SEC for further consideration by the on the question of restitution. That question focuses on the cause of the loss suffered by the clients, the court noted. Restitution is payable under Principle 5 in NASD’s Sanction Guidelines to remediate misconduct in certain circumstances. Specifically, it can be order when “when an identifiable person . . . has suffered a quantifiable loss as a result of a respondent’s misconduct, particularly where a respondent has benefited from the misconduct.”

Under this principle, there must be a demonstration of a causal connection between the broker’s misconduct and any loss at issue. In assessing the question of causation the Circuit Court noted that there are various theories of causation which range from “but for” to “proximate” to “substantial factor” to “loss causation.” Each theory approaches the question of causation from a different vantage point. “But for” causation, the Court noted, may be almost limitless. “Proximate causation,” on the other hand, would require a direct relation between the conduct and the alleged injury. The “substantial factor” test is used when there have been two or more concurrent causes. In contrast, “loss causation” focuses on the reason why the investment was lost and would preclude an award where the investment would have been lost regardless of the fraud.

After reviewing these tests, the Court noted that the use of these tests may not always be clear or mutually exclusive. Nor is the list exhaustive. At the same time, the Court stated it did not know which test should be used under Principle 5. Making this determination is the responsibility of the SEC. The Commission, however, failed to offer any explanation of the applicable test of causation. Rather, the SEC offered only a footnote commenting on causation which the court described as “nonsense.” Accordingly, the matter was remanded to the SEC to reconsider the question of causation and restitution.

TRIALS ARE ABOUT THE BASICS

When litigating in court it is always critical to focus on the basics, taking the time and making the effort to proceed step-by-step. This is true whether the case is very simple or extremely complex. The SEC was recently reminded of this point in SEC v. Fraser, Case No. 2:09-cv-00442 (D. Ariz. Filed March 6, 2009), discussed here, a financial fraud case against three former executives of now bankrupt CSK Auto Corporation, where there is a parallel criminal case. It took the SEC three tries to plead a complaint before it could move forward into discovery. Whether the SEC has valid claims remains to be seen. Is clear however that without a properly framed complaint the Commission would not have the opportunity to establish its claims.

The CFTC recently learned the same lesson. Unfortunately for the CFTC, the lesson came on appeal when the omission could not be corrected. In CFTC v. Dizona, Case No. 08-20418 (5th Cir. Decided Jan. 14, 2010), the Commission brought an action seeking injunctive and other relief against six individuals. Five of the defendants, including Anthony Dizona, were natural gas traders on the West Trading Desk of Coral Energy Resources, L.P. The sixth defendant was an analyst on the West Trading Desk.

The CFTC’s complaint claimed that from October 2001 through June 2002 the defendants submitted price and volume data to two industry reporting services that was not based on actual trades. Rather, the information submitted was knowingly false and inaccurate in violation of Section 13(a)(2) of the Commodity Exchange Act. The purpose was to try and manipulate the price indices for natural gas. Five defendants settled.

Mr. Dizona proceeded to trial. During a jury trial, the Commission’s key exhibit was a data compilation prepared by a member of the staff. The compilation was prepared from documents obtained pursuant to subpoena from the company. It listed all the price and volume information reported. Prior to trial, the district court concluded, based on a local rule, that the defendant had waived all objections to the authenticity of Commission exhibits. At trial, a Commission staff member testified that virtually all of the prices reported that were recorded on the data compilation were biased upward. Expert testimony offered by the Commission generally supported the notion that the prices submitted were biased, but was not keyed to the specific data in the data compilation schedule. A defense expert disputed the CFTC’s expert.

The jury concluded that Mr. Dizona had not knowingly delivered false reports, but had attempted in eight instances to manipulate the price. Both sides filed post trial motions. The district court granted the defense motion and overturned the jury’s verdict against Mr. Dizona. The court denied the CFTC’s motion.

The Fifth Circuit, in a 2-1 decision, affirmed the entry of a verdict in favor of the defense. The Circuit Court’s decision turned on the admissibility of the document compilation schedule prepared by the CFTC staff. It was undisputed that the evidence in question on the data compilation was produced pursuant to subpoena. It is also undisputed that prior to trial the district court concluded that Mr. Dizona had waived his objections to the authenticity of the Commission’s exhibits under the local rules. But authenticity is a different question from admissibility under Federal Rule of Evidence 803(6). That rule is concerned with whether the documents can be admitted as an exception to the hearsay rule as records kept in the ordinary course of business. Under Rule 803(6), either the custodian of the records or an “other qualified witness” must testify to lay the proper foundation. While the witness need not be the author of the records, the person must be someone who can explain the record keeping system of the organization and vouch that the requirements of the rule have been met – that is, they were kept in the ordinary course and it was a regular practice of the business to keep such records.

In this case, the CFTC offered testimony about obtaining the documents pursuant to subpoena, the manner in which the data compilation was prepared and obtained the pretrial ruling on authenticity. None of this addresses the requirements of Rule 803(6) the Court concluded. Testimony on the key Rule 803(6) requirements was missing. Accordingly the key schedule on which the Commission based its case was not admissible. Under these circumstances the Circuit Court concluded, there was insufficient evidence to support a verdict in favor of the CFTC.

In dissent, Judge Reavley noted that if the data compilation schedule was sufficient to support the CFTC’s position. Since the explanations offered by Commission’s investigator about the practices of the company were not contested – although they were hearsay – this should have been sufficient, according to the dissent. The majority, however, did not accept this interpretation of the Rule. The CFTC lost, not for lack of evidence, but for failing to carefully comply with the rules of evidence, the basics.