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.