In February 2010, BrokeAndBroker reported on the Securities and Exchange Commission (SEC) case involving Axiom Capital Management, Inc., its former registered representative Gary J.Gross, and its former compliance officer David Siegel. See, "Gross Abuse: Broken PIPEs" at http://www.brokeandbroker.com/index.php?a=blog&id=317 As a result of the SEC's August 31, 2010, settlement with Gross's supervisor David Siegel, we have reprinted and updated that article.
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Gross Abuse: Broken PIPEs
by Bill Singer, http://BrokeAndBroker.com
On September 22, 2008, the United States Securities and Exchange Commission (the "SEC") filed a civil complaint in the United States District Court for the Southern District of Florida against former Axiom Capital Management, Inc. ("Axiom") registered representative Gary J. Gross ("Gross"). Securities and Exchange Commission v. Gary J. Gross, (Case No. 08-CIV-81039-MARRA).http://www.sec.gov/litigation/complaints/2008/comp20732.pdf The Complaint alleged that from at least early 2004 through approximately September 2006, (the "relevant time") Gross defrauded several of his customers by
- making material misrepresentations and omissions about the risks and suitability of securities he bought for them,
- churning customer accounts, and
- fabricating customer account values.
While Gross reaped more than $700,000 in ill-gotten gains, his customers lost more than $2.7 million. Many of Gross' customers often were elderly, unsophisticated investors, who wanted only to preserve their principal and grow their portfolio while investing with minimal risk.
A PIPES Hosing
Among the various trade practices allegations, the SEC particularly focused on Gross's s touting the purported profit potential of various private placements and investments known as PIPEs (private investments in public equities) to his customers. Gross told his customers the private placements and PIPEs were riskless and the issuers were high-quality companies. Gross promised some customers they would be able to sell these investments within months and reap large profits. However, Gross failed to disclose the risks accompanying these investments.
Contrary to Gross's representations, the PIPEs transactions he was pushing involved start-up ventures in search of funding, with little or no track record. Gross also did not tell customers they would receive restricted stock they could not trade until the issuers' registration statements were declared effective. Additionally, Gross did not tell his customers that the issuers' registration statements could be delayed, and that customers would consequently be unable to convert their restricted shares into free-trading common stock within the time Gross promised.
BILL SINGER'S COMMENT: PIPE transactions continue to be a troubled and troubling vehicle for financing. Shortly after the Tech Wreck of 2000 and the tragedy of 9/11, smaller issuers found themselves unable to raise capital as easy as in prior years. Such issuers began offering discounts (often up to 15% off the current market price of their stock) to institutions or high-net-worth investors, coupled with a promise to promptly register the shares with the SEC (typically within 90 to 120 days). The market discount was deemed necessary to compensate the investor for the risk of holding unregistered shares in the interim. The discount was rationalized as a fair bargain because it avoided the time delay and costs of a more traditional public offering. In theory, not a bad bargain for a cash starved business ready to launch a product.
However, in practice, PIPEs offerings are often predatory transactions that excessively dilute pre-existing shareholders. The worst of these deals use a convertible security whose conversion price is linked via discount to the common stock's market price, thus creating a perverse incentive to bash and dump the subject shares. Faced with this sell-off, the common’s price drops further and the issuer must increase the number of shares under the terms of the PIPE. Those additional shares are also dumped, resulting in the so-called Death Spiral PIPE.
While recent changes to securities laws and rules have sought to ameliorate some of the dangers posed to shareholders by PIPEs, there are still widespread reports of abuse. Some PIPEs investors use the inside information about the pending transaction to trade ahead of the public-- often engaging in naked short selling (selling shares short without borrowing publicly-traded shares to cover) and then covering that short with the acquired PIPE shares.
Upon hiring Gross, Axiom established its first branch office in Boca Raton, Florida for him. The office was staffed primarily by Gross, his branch manager David A. Siegel ("Siegel"), and a sales assistant. However, Gross arrived at Axiom in December 2002 as damaged goods, due to customer complaints about Gross at previous firms. In fact, the State of Florida required, among other things, that Axiom place Gross on strict supervision (under which he remained until terminated in January 2007).
Producing Manager: Recipe for Disaster?
In May 2003, Axiom hired Siegel as branch manager for its Boca Raton branch office and to supervise Gross. See, Order Instituting Public Administrative Proceedings Pursuant To Section 15(b) Of The Securities Exchange Act Of 1934 And Section 203(F) Of The Investment Advisers Act Of 1940 (In the Matter of David A. Siegel, Securities Exchange Act Of 1934 Release No. 61564 / Investment Advisers Act Of 1940 Release No. 2985/ Administrative Proceeding File No. 3-13787; February 22, 2010) http://sec.gov/litigation/admin/2010/34-61564.pdf. Siegel’s compensation was based on commissions he generated from his own customers and a two percent override he received of the branch office’s net commissions.
BILL SINGER'S COMMENT:As a veteran regulatory lawyer, I know that regulators particularly dislike so-called “producing managers,” i.e., managers who engage in a supervisory role and also produce commissions. The problem such a dual role presents for regulators is that they want supervisors to be supervising full-time and not otherwise distracted by having to generate their own commissions. Moreover, when a producing manager's compensation includes the common branch override, that injects yet another potential conflict in the form of the more that supervisor says "no," the lower the branch's revenue may be and the lower the resulting override payment.
In the best of all possible worlds, there is little to quibble about with the concern about producing managers. However, in reality, smaller brokerage firms often have branches staffed by a manager and two or three other registered folks. Economically, it is often impossible to pay that manager only a salary -- and, just as often, many potential managers of such small shops want to work their own book of business and get an override ( the you-can't-pay-me-enough to give up my production and supervise problem).
Still, given that Gross was supposed to be subject to strict supervision, Axiom should have realized that using a producing manager to supervise him was not calculated to curry favor with regulators. Further, given Gross's prior troubles and the dicey nature of his business, this would clearly be an individual who, if he strayed, had the potential to put his firm's and his supervisor's heads on the regulator's chopping block.
Not surprisingly, the SEC alleges In the Matter of David A. Siegel that Branch Manger Siegel failed reasonably to supervise Gross by failing to follow both Axiom’s written supervisory procedures manual and an internal Axiom memorandum entitled “Heightened Supervision of Gary Gross.” As a consequence, the SEC alleges that Siegel failed to notice on numerous occasions when several of Gross’ customers entered unsolicited orders to purchase or sell the same obscure securities, often on the same day. Further alleged, is that Siegel also failed to regularly use the firm’s monthly Active Account Report, review monthly customer account statements, or take other reasonable action to monitor for churning by Gross. The SEC’s parting shot is the allegation that Siegel profited from Gross’ violations of the federal securities laws in the form of commissions he received based on Gross’ commissions -- like I said, you serve as a producing manager with supervisory duties at your peril.
On November 25, 2008, the United States District Court for the Southern District of Florida entered a judgment by consent against former Axiom Capital Management, Inc. ("Axiom") registered representative Gary J. Gross ("Gross") in the civil action entitled Securities and Exchange Commission v. Gary J. Gross, (Case No. 08-CIV-81039-MARRA) http://www.sec.gov/litigation/complaints/2008/comp20732.pdf,
- permanently enjoining him from violations of Section 17(a) of the Securities Act of 1933 and Section 10(b) and Rule 10b-5 of the Exchange Act,
- ordering him to pay disgorgement and a civil penalty pursuant to Section 20(d) of the Securities Act and Section 21(d) of the Exchange Act, and
- barring him from participating in an offering of penny stock as defined by Exchange Act Rule 3a51-1.
Thereafter, pursuant to an offer of settlement from Gross in which he was barred from association with any broker, dealer, or investment adviser, the Securities and Exchange Commission (“SEC”) entered an Order Instituting Public Administrative Proceedings Pursuant To Section 15(b) Of The Securities Exchange Act Of 1934 And Section 203(F) Of The Investment Advisers Act Of 1940, Making Findings, And Imposing Remedial Sanctions. (In the Matter of Gary J. Gross, Securities Exchange Act Of 1934 Release No. 59090 / Investment Advisers Act Of 1940 Release No. 2820/ Administrative Proceeding File No. 3-13308; December 12, 2008). http://www.sec.gov/litigation/admin/2008/34-59090.pdf
Spanking the Firm Too
In addition to going after Branch Manager Siegel, the SEC proposed to proceed against Axiom, citing the firm's failure reasonably to supervise Gross in connection with his sale of private placement offerings and private issuances of public entities (PIPEs) (collectively "private placements"), from approximately January 2005 through at least September 2006. The SEC alleged that Axiom failed reasonably to supervise Gross because it failed to devise a reasonable system to implement the firm’s policies and procedures regarding review for suitability of private placement investments and review of subsequent transactions to determine suitability of the transaction in light of the customer’s current holdings.
Two years after Gross settled with the SEC, Axiom walked down that same path. In anticipation of an SEC proceeding against it, Axiom submitted an Offer of Settlement: Order Instituting Public Administrative Proceedings Pursuant To Section 15(b) Of The Securities Exchange Act Of 1934 Making Findings, And Imposing Remedial Sanctions. (In the Matter of Axiom Capital Management, Inc., Securities Exchange Act Of 1934 Release No. 61563/ Administrative Proceeding File No. 3-13786; February 22, 2010) http://www.sec.gov/litigation/admin/2010/34-61563.pdf
The SEC determined that Axiom’s written supervisory procedures manual (“WSP”) required the registered representative to determine whether a private placement was a suitable investment to recommend to a customer; however, it failed to provide a clear mechanism for supervisory oversight of these determinations. Elsewhere, the WSP provided that the supervisor was responsible for reviewing transactions for suitability “where appropriate,” but failed to define appropriate circumstances for this suitability review.
BILL SINGER'S COMMENT: One of the problems with settled regulatory cases is that the respondents typically throw in the towel and that leaves the regulator to write the history of the case. Unfortunately, such unbridled freedom often results in "findings" that tend to go a bit overboard. For example, traditionally, the SEC and self-regulatory organizations impose the determination of whether a given investment is suitable for a given client squarely on the shoulders of the registered representative and regulatory cases frequently underscore this by admonishing that the buck stops with the individual broker. Consequently, to complain about an unclear mechanism for supervisory oversight of the registered person's determination of suitability strikes me as a bit of a stretch. If the issue is that in this specific case, given Gross's background, given the ages of his clients, given the propensity for risky PIPEs, and so on that Axiom was on notice that Siegel and other supervisors had a heightened supervisory obligation to specifically review Gross's suitability determinations, then that's one thing -- and I concur. However, to suggest that every suitability determination by every registered person imposes some oversight issue on a member firm is not in keeping with regulatory precedent.
Similarly, if one thing makes me livid, it's the perfunctory critiques of WSPs that always creep into these cases. For those of you unfamiliar with the issue, you cannot get approved to become a member of FINRA without having your WSPs rigorously reviewed by the Staff -- and that review has long been a bone of contention by many applicants, who often complain about being asked to write and rewrite various provisions as a precondition to becoming FINRA members. Further, virtually every FINRA/State/SEC examination or investigation of a member firm starts off with a request to see the current WSPs, which are then combed through in detail for whatever gotchas rear their ugly heads. Consequently, I will almost guarantee that the "where appropriate" language now scorned by the SEC was viewed by other regulators since 1990 (when Axiom first became a registered broker-dealer) without so much as a negative word. It is probably only in hindsight that the SEC now voices its distress over what was never hidden and likely previously reviewed by regulators without nary a word. I'm sure that if some regulator expressed prior disapproval about the lack of specificity with what constitutes "where appropriate" that Axiom would have promptly amended the language -- on the other hand, if no regulator did express concern, isn't Axiom within its rights to infer from the lack of complaint that the provision was deemed compliant?
In settling with the SEC, Axiom agreed to several undertakings. The firm will retain an Independent Consultant to (i) review Axiom’s written supervisory policies and procedures concerning suitability review of private placements; and (ii) review Axiom’s systems to implement its written supervisory policies and procedures concerning suitability review of private placements and suitability reviews subsequent to the purchase of a private placement.The Independent Consultant is required upon concluding the review (or within 120 days at the most) to submit a report to Axiom and the SEC in which the supervisory issues noted are addressed through recommended changes or improvements to policies, procedures, and practices. It is anticipated that Axiom will adopt, implement, and maintain such recommendations or reach a mutual resolution of any disputes with the Independent Consultant. Finally, pursuant to Axiom’s Offer of Settlement, the SEC imposed a Censure and a $60,000 civil penalty.
Last But Not Least
On August 31, 2010, without admitting or denying the SEC's findings, Siegel settled his case. Order Making Findings and Imposing Sanctions Pursuant To Section 15(b) Of The Securities Exchange Act Of 1934 And Section 203(F) Of The Investment Advisers Act Of 1940 (In the Matter of David A. Siegel, Securities Exchange Act Of 1934 Release No. 62803 / Investment Advisers Act Of 1940 Release No. 3077/ Administrative Proceeding File No. 3-13787; August 31, 2010) http://sec.gov/litigation/admin/2010/34-62803.pdf
The SEC found that Siegel failed reasonably to supervise Gross with a view to preventing and detecting Gross’s violations of the federal securities laws from approximately January 2004 through at least September 2006 while Siegel and Gross were associated with Axiom . During this time period, Gross violated Section 17(a) of the Securities Act and Section 10(b) of the Exchange Act and Rule 10b-5 thereunder by, among other things, making unsuitable investment recommendations, engaging in unauthorized transactions and churning customer accounts.
Specifically, the SEC found that during the relevant period, Siegel
- was Gross’ direct supervisor, but failed reasonably to supervise Gross with a view to preventing and detecting his violations of the federal securities laws;
- failed to follow both Axiom’s written supervisory procedures manual and an internal Axiom memorandum entitled "Heightened Supervision of Gary Gross" in relation to his supervision of Gross;
- did not reasonably monitor Gross’ orders for unauthorized transactions;
- failed to ensure that Gross’ customers’ margin use was suitable;
- failed to review Gross’ customers’ private placement transactions and subsequent investments for suitability;
- failed to notice on numerous occasions when several of Gross’ customers entered unsolicited orders to purchase or sell the same obscure securities, often on the same day;
- failed to regularly use the firm’s monthly Active Account Report, review monthly customer account statements, or take other reasonable action to monitor for churning by Gross; and
- profited from Gross’ violations of the federal securities laws in the form of commissions he received based on Gross’ commissions.
Accordingly, the SEC barred Siegel from association in a supervisory capacity only with any broker, dealer, or investment adviser. The SEC further ordered Siegel to disgorge $10,600 plus $35.33 in prejudgment interest.