SEC ALJ Parses Through Evidentiary Objections

July 18, 2014

It's not always about the fireworks at trial.  Sometimes, the pyrotechnics of the motion practice leading up to the first day of testimony determine who ultimately wins the war. The battles over what evidence is admissible and who does or doesn't get to testify may seem like minor skirmishes but, in fact, such firefights often prove devastating to one side or the other.

In the Matter of Thomas C. Gonnella, Respondent (Order Instituting Administrative and Cease-and-Desist Proceedings, 33 Act Release No. 9544; 34 Act No. 71472; 40 Act IA Release No. 3771; 40 Act IC Release No. 30904; Administrative Proceeding File No. 3-15737 / February 4, 2014), we are presented with the following Summary:

1. Between May and November 2011, Gonnella, at the time a trader at Firm A, agreed with Ryan King, another trader who worked at Firm B, to defraud Gonnella's firm by temporarily placing securities from Gonnella's trading book at Firm A in King's trading book at Firm B and later repurchasing them. The purpose of this arrangement was to allow Gonnella to avoid charges by Firm A to his trading profits, and ultimately his year-end bonus, that would result from holding the securities for too long. Instead of incurring those charges or selling the securities in bona fide market transactions, and in violation of Firm A's policies, Gonnella placed the securities with King, who purchased them on behalf of Firm B, with the understanding that he would repurchase them thereafter and that Firm B would not be exposed to market risk because Gonnella would repurchase them at a profit to Firm B at the expense of Gonnella's employer, Firm A.

2. Gonnella placed ten securities with King. With respect to nine securities, Gonnella, on behalf of Firm A, repurchased them before the securities had even settled in Firm B's account. With respect to the tenth security, Gonnella did not immediately repurchase it. He later did so at a loss to Firm B, but made Firm B whole by selling it two other bonds from Gonnella's trading book at Firm A at prices favorable to Firm B and unfavorable to Firm A. King then used the resulting profit on the two bonds to offset the loss incurred on the tenth security. With respect to each of the foregoing transactions, Gonnella did not disclose to Firm A that he sold the securities to King on the understanding that he would thereafter repurchase them from King at a profit to Firm B.

3. In total, Gonnella and King's trades caused Firm A to lose approximately $174,000. Gonnella and King never told their firms the truth about their trades, which was that they were not bona fide market transactions but were done solely to reset the holding period on securities in Gonnella's trading book and allowed Firm B to earn improper profits at Firm A's expense.

4. After Gonnella's supervisor began inquiring about the trades, Gonnella and King interposed interdealer brokers in subsequent transactions and spoke on their cell phones to evade detection. They continued to conduct round-trip trades until Firm A detected Gonnella's conduct and summarily fired him. Firm B later fired King for the same misconduct.

One Down

In the Matter of Ryan King, Respondent (Order Instituting Administrative and Cease-and-Desist Proceedings And Imposing Remedial Sanctions And A Cease-And-Desist Order, 33 Act Release No. 9543; 34 Act No. 71471; 40 Act IC Release No. 30903; Administrative Proceeding File No. 3-15736 / February 4, 2014), King settled the SEC's charges, and, in accordance with the terms of that settlement, he became subject to a Cease-And-Desist against future violations of securities laws and ordered to pay disgorgement of $22,606.80 and prejudgment interest of $1,503.66 to the United States Treasury. Additionally, King was
  • Barred (with the right to apply for reentry after three years to the appropriate self-regulatory organization or, if there is none, to the SEC) from 
    • association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization; and 
    • from participating in any offering of a penny stock, including: acting as a promoter, finder, consultant, agent or other person who engages in activities with a broker, dealer or issuer for purposes of the issuance or trading in any penny stock, or inducing or attempting to induce the purchase or sale of any penny stock; and
  • Prohibited from serving or acting as an employee, officer, director, member of an advisory board, investment adviser or depositor of, or principal underwriter for, a registered investment company or affiliated person of such investment adviser, depositor, or principal underwriter.
DOE Says Don't

Prior the the commencement of the hearing, the SEC's Division of Enforcement ("DOE") and Gonnella filed five motions with SEC Administrative Law Judge ("ALJ") James E. Grimes.  In The Matter of Thomas C. Gonnella, Respondent (Order On Motions In Limine, Admin. Proc. Ruling Release No 1579, Admin. Proc. File No. 3-15737 / July 2, 2014). 

DOE objected to five proposed exhibits: four as irrelevant and immaterial, and the fifth as hearsay. DOE also sought to bar a prospective character witness on the basis that the testimony would be irrelevant and unduly repetitive. Finally, DOE sought to exclude an expert's report prepared by Professor Richard W. Painter.  

Respondent Gonnella sought to bar the testimony of Ryan King.

The Here And Now of Hearsay

Although the SEC's Rules of Practice exclude "immaterial, irrelevant, or unduly repetitious" evidence, ALJ Grimes noted there is no per se bar to the admission of hearsay in SEC hearings, and that such evidence is typically weighed rather than deemed outright inadmissible. In discerning the probative value and reliability of any proffered hearsay, the ALJ referenced the following factors:
  • Fairness of use
  • Possible bias of declarant
  • Type of hearsay
  • Whether statements are anonymous or signed/sworn
  • Contradictions in direct testimony
  • Availability of declarant to testify
  • The corroborated nature (if any) of the hearsay 
Ya Win Some, Ya Lose Some

Taking the factors cited above into account, the ALJ ruled as follows on DOE's motions to exclude:
  • DENIED without prejudice subject to renewal at hearing, the first four of five exhibits referenced above. Deeming DOE's motion as premature, the ALJ erred on the side of inclusiveness and noted that the exhibits' relevance cannot be ascertained prior to the hearing (assuming that Gonnella even offers such proof);
  • DENIED the fifth exhibit. The ALJ asserted that he will give the exhibit whatever weight he deems is appropriate with the bounds of precedent for whatever "hearsay" issues are presented; 
  • DENIED in part the presentation character witnesses by Gonnella. The ALJ noted that Gonnella advised that he intended to call only one or two such witnesses, which would render as moot the objection based upon an unduly repetitious nature of the testimony. Having opened the door for the proposed character witnesses, the ALJ acknowledged DOE's assertion that the testimony may, at best, be "minimally relevant" since it has been alleged that Gonnella lied to his superiors and engaged in a scheme to defraud his employer; however, the ALJ similarly allowed that such character testimony may be relevant in determining sanctions following a finding of liability. Notwithstanding, the ALJ protected his prerogatives by reminding the parties that if he ultimately deems the proffered testimony as irrelevant, he will not afford any weight to that portion.
The Good Professor

The ALJ denied in part the proposed report and testimony of an expert witness, Professor Painter. The report was admitted to the extent that it does not address legal conclusions, such as whether a given act or admission is a violation, which, after all, is the job for the ALJ --- and the ALJ further warned that he will give whatever weight is appropriate to the contemplated testimony but is not inclined to entertain the professor's conclusions and opinions about legal precedent, which would be more appropriately discharged through a post-hearing brief. If DOE wants to challenge the professor's qualification, the ALJ suggested as robust a cross-examination as was warranted. 

A King's Prerogative?

Finally, the ALJ denied Respondent Gonnella's motion to exclude Ryan King's testimony, which seemed premised upon some odd objections that King should be required to first plead guilty before testifying, and that King's role as having entered into a cooperation agreement somehow should preclude DOE from calling him.  

Bill Singer's Comment

For those respondents who are convinced that the deck is stacked against them at the SEC. this ALJ's rulings may come as a surprise. After all, DOE didn't fare all that well with its objections -- of course, on the other hand, neither did Respondent Gonnella.  Ultimately, it's refreshing and important for the integrity of the process to see such independence by those charged with adjudicating the SEC's cases.  

The other important lesson from this matter is the reminder to those who find themselves dragged into an SEC hearing that the rules of evidence in courts (state or federal) are NOT necessarily the same as those in administrative hearings.  Typically, things are a bit looser in hearings versus courtroom trials, and ALJs often have more latitude in taking documents into evidence and letting testimony stand for "what it's worth."