By Bill Singer
Former A.G. Edwards and Sons, Inc. (AGE) registered representative Luis Miguel Cespedes was found by the New York Stock Exchange (NYSE) to have recommended and effectedunsuitable transactions that resulted in
All fourteen customers at issue filed arbitration complaints against AGE, which reached settlement agreements with twelve of the customers for a total amount of approximately $1,100,000. Cespedes personally contributed $20,000 to the Firm's settlement with one of the customers, but did not contribute to any of the other settlements.
The NYSE censured Cespedes and imposed a ten-year bar from membership, allied membership, approved person status, and from employment or association in any capacity with any NYSE member or member organization. Cespedes appealed to the Securities and Exchange Commission (SEC) In the Matter of the Application of Luis Miguel Cespedes, Securities Exchange Act of 1934 Rel. No. 59404, Admin. Proc. File No. 3-12988 (February 13, 2009).In affirming the NYSE decision, the SEC found that
failed to explain adequately to these inexperienced customers the significant risk of loss that his recommendations of highly concentrated technology sector portfolios entailed.
Cespedes recommended that all of the customers at issue invest the majority, and in many cases all, of their account values in the technology sector. Many of the customers were of an advanced age and already retired or about to retire. At least one customer was forced to return to work at a low-paying job to pay for her living expenses. Many of the customers had relatively modest incomes and net worth and relied significantly on Cespedes to provide investment recommendations suitable to their life situations and needs. Cespedes
The customers in whose accounts Cespedes used margin did not understand what margin was. Several of the customers testified that they had the impression that Cespedes sold securities in their accounts to cover checks they wrote to make purchases, including at least two automobile purchases. These customers later learned that no securities had been sold and that they had, instead, incurred significant margin debt in connection with these checks. The numerous violations of suitability provisions and the significant harm suffered by vulnerable and unsophisticated customers warrant the imposition of serious sanctions against Cespedes.
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Suitability: Not a Matter of "Understanding"
Over the years I have heard so many brokers explain to me that the NASD or NYSE or SEC has it all wrong when it comes to accusing them of suitability violations. The broker insists that everything was explained to the client, who agreed to buy the suggested stock. The broker also adds that the client said that he or she understood the risk but didn't want to miss out on this opportunity. Which brings us to an interesting point. If a broker lays it all out there--even to the point where the client is nodding approval and says to buy or sell per your advice, is that the end of the suitability issue? Well, folks, let me cite the SEC's viewpoint on this point:
A registered representative is obligated to make "a customer-specific determination of suitability and to tailor his recommendations to the customer's financial profile and investment objectives." 12/ Even if a customer understands a broker's recommendation and decides to follow it, this does not relieve the broker of the obligation to make reasonable recommendations. 13/ By recommending unsuitable transactions, a registered representative acts inconsistently with just and equitable principles of trade. 14/
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Every few years some sexy, everyone-is-pushing-it, the next-big-thing sector lights up trading screens all over Wall Street. These stocks are the black letter definition of risky. At first, just a few clients own some shares, then a few own a lot of shares, then everyone owns some shares, and, finally, just before the bubble bursts, everyone owns a lot of shares. And when the bubble bursts, the Plaintiff/Claimants lawyers come out of the woodwork and point the accusing finger at every broker. The time-honored defense that quickly surfaces is that it was only a little bit of risk or it was only a modest portion of the portfolio. Again, wonderful sounding defense but it doesn't often defend you. Consider the SEC's opinion:
We have previously held that risky investments are unsuitable recommendations for investors with relatively modest wealth and limited investment experience. 18/ We have also found that recommendations leading to high concentration of customer accounts in particular securities is "beyond what is consistent with the objective of safe, non-speculative investing." 19/ Highly speculative investment strategies are "suitable only for an individual who could withstand the loss of the entire principal amount." 20/
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Testing, Testing, One...Two...Three
In 2002, a complaining customer in New Jersey tape-recorded five telephone conversations with Cespedes in California. In those tapes, Cespedes acknowledged that a heavy concentration of securities in the technology sector was unsuitable for someone of the customer's age and that the customer "never truly understood" the use of margin in his account. Cespedes further encouraged the customer to file an arbitration claim against the Firm as a way to recoup some of the money lost as a result of Cespedes's unsuitable recommendations. Cespedes objected to the admission of the tape and transcripts, claiming that the use of the tapes in his NYSE disciplinary proceeding was illegal under California law because he was not aware that he was being recorded and did not consent to the taping. Cespedes argues that, as a California resident, he is entitled to the protection of its laws.
Cal. Penal Code § 632 prohibits the taping of telephone conversations without the consent of all parties to the conversation.
Now this issue comes up with surprising frequency, and I'm rarely amazed these days when one of my stockbroker clients will send me a print-out of the laws of a particular state, most notably California or Florida, in which two-party consent is the rule for taping phone calls; i.e., both the caller and the called must agree to the taping, in contradistinction to one-party-consent states that require only one party's approval. In his SEC appeal, Cespedes cited Kearney v. Salomon Smith Barney, Inc., 39 Cal.4th 95 (2006), in which the California Supreme Court found that California residents whose telephone conversations with businesses located in Georgia were being recorded without the California residents' knowledge maintained the right to pursue an injunctive action against the Georgia businesses because the recordings were illegal under California law, although they were legal under Georgia law. Case closed in Cespedes' favor? You'd think so -- clearly, Cespedes has raised a valid objection against the NYSE having received the apparently illegally taped calls into evidence and using them against him. Well, not so fast. Consider the SEC's analysis:
However, SRO proceedings are informal and are not bound by the same rules of procedure and evidence that apply in court proceedings. 34/ Unlike a federal or state court, the NYSE lacks subpoena power, and the record indicates that James J was unwilling to testify at the hearing. The Hearing Board made a reasonable determination that the tapes provided a source of useful information about Cespedes's conduct with respect to James J's accounts. For these reasons, we find that the NYSE's determination to admit the audiotape and written transcripts was appropriate, and we agree with the NYSE's finding that Cespedes's statements on the tapes exhibits bad faith and is an aggravating factor in our sanctions analysis.
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In case you missed that logic, let me rephrase it in more understandable English. The SEC found that self-regulatory proceedings are "informal." As such, the SEC seems to think that the laws of the land somehow end at the NYSE's or FINRA's doors (which, frankly, many courts seem to similarly rule). This logic escapes me. Because some organization conducts informal proceedings, that organization gets to disregard state and federal laws? If that same organization lacks subpoena power, and the individual who apparently illegally taped a conversation will not voluntarily appear to testify (remember, that individual in Cespedes was a complaining customer, not the broker), then it's okay to just let in what is an uncontroverted illegal tape?
While I have no doubt that evidentiary rules, fairplay, and due process are not always convenient for self-regulatory organizations, I'm not sure that mere inconvenience warrants allowing the fruits of illegal activity. That's one hell of a dangerous, slippery slope. There is not and cannot be any legitimate question that the taping of a California resident under the circumstances in Cespedes is illegal. Cal. Penal Code § 632 specifically states that fact.
The SEC seems to suggest that a NYSE Hearing Board may make a "reasonable determination" that an illegally recorded phone conversation provides a legitimate source of evidence in SRO proceedings. Let's just call it what it was: an expedient determination--there was nothing reasonable about it.
Okay, look, the SEC's ruling is absurd. You don't like laws that require all parties consent to a taping? Fine, change the law. For the record, I support only one-party consent. Betcha didn't see that one coming, did you? Nonetheless, it demeans the NYSE and the SEC to permit illegal evidence to be introduced into any proceeding. Further, in Cespedes there seems little doubt that the findings and sanctions would have been the same without such illegal evidence. Why debase the process?
In response to requests from a number of readers, I have posted the current, verbatim California penal section. Moreover, to those of you who say that it's one thing to prohibit tape recordings but it's quite another to not allow their use in evidence, please note Section 632(d) below. For the record, I didn't make that up and it is not my "opinion" or "musing" as to how this law should be applied to such evidence. As such, once again I ask you: Why should the SEC and/or FINRA permit what the penal codes expressly prohibits?
California Penal Code Section 632
(a) Every person who, intentionally and without the consent of all parties to a confidential communication, by means of any electronic amplifying or recording device, eavesdrops upon or records the confidential communication, whether the communication is carried on among the parties in the presence of one another or by means of a telegraph, telephone, or other device, except a radio, shall be punished by a fine not exceeding two thousand five hundred dollars ($2,500), or imprisonment in the county jail not exceeding one year, or in the state prison, or by both that fine and imprisonment. If the person has previously been convicted of a violation of this section or Section 631, 632.5, 632.6, 632.7, or 636, the person shall be punished by a fine not exceeding ten thousand dollars ($10,000), by imprisonment in the county jail not exceeding one year, or in the state prison, or by both that fine and imprisonment.
(b) The term "person" includes an individual, business association, partnership, corporation, limited liability company, or other legal entity, and an individual acting or purporting to act for or on behalf of any government or subdivision thereof, whether federal, state, or local, but excludes an individual known by all parties to a confidential communication to be overhearing or recording the communication.
(c) The term "confidential communication" includes any communication carried on in circumstances as may reasonably indicate that any party to the communication desires it to be confined to the parties thereto, but excludes a communication made in a public gathering or in any legislative, judicial, executive or administrative proceeding open to the public, or in any other circumstance in which the parties to the communication may reasonably expect that the communication may be overheard or recorded.
(d) Except as proof in an action or prosecution for violation of this section, no evidence obtained as a result of eavesdropping upon or recording a confidential communication in violation of this section shall be admissible in any judicial, administrative, legislative, or other proceeding.
(e) This section does not apply (1) to any public utility engaged in the business of providing communications services and facilities, or to the officers, employees or agents thereof, where the acts otherwise prohibited by this section are for the purpose of construction, maintenance, conduct or operation of the services and facilities of the public utility, or (2) to the use of any instrument, equipment, facility, or service furnished and used pursuant to the tariffs of a public utility, or (3) to any telephonic communication system used for communication exclusively within a state, county, city and county, or city correctional facility.
(f) This section does not apply to the use of hearing aids and similar devices, by persons afflicted with impaired hearing, for the purpose of overcoming the impairment to permit the hearing of sounds ordinarily audible to the human ear.