Discovery Misconduct by FINRA Enforcement Prompts Tepid Response from Regulator

The Department of Enforcement charged Steven E. Larson, a former brokerage firm owner, chief executive officer, and chief compliance officer, with engaging in various types of deceptive conduct toward his customers and FINRA. Specifically, Enforcement alleged that Larson (1) omitted material information from a regulatory filing seeking a change in the firm's ownership; (2) gave incomplete and untimely responses to FINRA's document and information requests about a former registered representative of Larson's firm; (3) falsified firm records by backdating supervisory documents and then submitting some of them to FINRA; and (4) made fraudulent misstatements and omissions to customers about their church bond holdings and in connection with church bond cross trades he arranged. Enforcement claims that this alleged wrongdoing was connected by a common thread: Larson engaged in deceptions when he considered it useful in achieving his goals, whether it was encouraging customers not to sell their church bonds, shielding supervisory lapses from regulatory oversight, or ensuring that FINRA would approve a change in ownership for his firm. 

Larson denied any wrongdoing, and a nine-day hearing was held before a FINRA Extended Hearing Panel in April and August 2017.¹ After reviewing the evidence and the parties' post-hearing submissions, the Panel finds that Larson intentionally gave incomplete and untimely responses to FINRA's requests for documents and information and intentionally omitted material information from a regulatory filing. Further, a majority of the Panel finds that he falsified firm records by backdating supervisory documents and then submitted some of them to FINRA. ² As explained below, we impose sanctions for those violations. However, a majority of the Panel finds that Enforcement failed to prove the fraud charges.³ Therefore, those charges are dismissed.

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Footnote 1: Near the end of the hearing in April, Enforcement revealed that it had just become aware it had failed to produce to Larson all of the documents he was entitled to receive in discovery under FINRA rules. As a result, the Hearing Officer required Enforcement to review its document production, directed it to immediately produce to Larson any additional documents that he was entitled to receive, and adjourned the proceedings. As it turned out, Enforcement determined that it had failed to produce a substantial number of documents. Remedying this failure delayed the completion of the hearing by four months. After Enforcement produced the remaining documents, and Larson reviewed them, he moved for sanctions and to dismiss the proceeding based on Enforcement's non-compliance with its discovery obligations. The Hearing Officer denied the motions, and the hearing reconvened and was completed in August 2017. Due to the size of the record, Enforcement's  scheduling conflicts, and Larson's health issues, post-hearing briefing was not completed until January 3, 2018. 

Footnote 2: One Hearing Panelist dissents from the Panel majority's finding. See Hearing Panelist Dissent at Section V., p. 76. 

Footnote 3: The Hearing Officer dissents from the Panel majority's finding. See Hearing Officer Dissent at Section VI., p. 77.

Respondent Steven E. Larson is: 

1) Suspended for 18 months in all capacities from association with any FINRA member firm for violating FINRA Rules 1122 and 2010 by submitting materially misleading Continuing Membership Applications to FINRA;

2) Fined $37,000 and suspended for two years in all capacities from association with any FINRA member firm for violating FINRA Rules 8210 and 2010 by failing to provide complete and timely responses to FINRA's document and information requests; 

3) Suspended for 18 months in all capacities from association with any FINRA member firm for violating FINRA Rules 2010 and 4511 by falsifying firm records by backdating supervisory documents and then submitting some of them to FINRA; and 

4) Ordered to pay costs in the amount of $16,895.68, which includes a $750 administrative fee and the cost of the hearing transcript, $16,145.68. 

The suspensions imposed herein shall be served concurrently. 

If this decision becomes FINRA's final disciplinary action, the suspensions shall become effective with the opening of business on August 6, 2018. The fines and assessed costs shall be due on a date set by FINRA, but not sooner than 30 days after this decision becomes FINRA's final disciplinary action in this proceeding. 

Enforcement failed to prove by a preponderance of the evidence that Larson violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, or FINRA Rules 2020 and 2010 by making material misrepresentations and omissions in communications with customers (First Cause of Action) and in connection with recommendations of church bond cross trades (Second Cause of Action). Those charges are therefore dismissed. . . .

In sum, while the evidence did not establish that Larson timely signed the documents at issue, I would not have found that Enforcement established by a preponderance of the evidence that he backdated them. Enforcement fails to meet its burden of proof "where the totality of the evidence suggests an equally or more compelling inference than [Enforcement's] allegation." Accordingly, I dissent from the Panel majority's conclusion that Larson violated FINRA Rules 2010 and 4511 by backdating documents and producing some of them to FINRA.

In short, I conclude that Larson's misrepresentations and omissions constituted such an extreme departure from the standard of care required of securities professionals that he knew or must have been aware of the danger of misleading investors. Therefore, I would have found that he violated the federal and FINRA provisions alleged in the first and second causes of action, and would have imposed appropriately remedial sanctions.

On June 14, 2018, an Extended Hearing Panel ("Hearing Panel") issued a decision that found Steven E. Larson violated FINRA rules when he did not comply fully and promptly with a series of FINRA requests for information, backdated and provided to FINRA falsified records, and filed a misleading FINRA continuing membership application ("CMA"). For this misconduct, the Hearing Panel imposed concurrent suspensions on Larson of two years, 18 months, and 18 months, respectively. The Hearing Panel also ordered that Larson pay a $37,000 fine for his failure to respond fully and promptly to FINRA's information requests. 

Although the Hearing Panel found that Larson misled customers by misrepresenting and omitting material facts when he communicated with them about church bonds they owned, and when he arranged several cross trades of church bonds between his customers, a Hearing Panel majority nevertheless concluded that he did not do so with scienter. Consequently, the Hearing Panel dismissed Enforcement's two causes of action that alleged Larson engaged in fraud, in violation of the federal securities laws and FINRA rules. 

Enforcement appeals the Hearing Panel's findings that Larson did not commit fraud, and it requests that we impose a sanction on him for what it alleged were his reckless misrepresentations and omissions of material facts. Enforcement also seeks to increase to a bar the two-year suspension and $37,000 fine that the Hearing Panel imposed after it found Larson failed to respond fully and promptly to multiple FINRA requests for information. 

In addition to Enforcement's appeal, a Review Subcommittee of the National Adjudicatory Council ("NAC") called other elements of the Hearing Panel's decision for discretionary review. First, the Review Subcommittee called for review the Hearing Officer's decision to deny a motion Larson filed seeking to dismiss Enforcement's disciplinary claims as a sanction for its failure to comply with prehearing discovery obligations imposed under FINRA rules. Second, the Review Subcommittee called for review the Hearing Panel's findings that Larson violated FINRA rules when he allegedly did not comply fully and promptly with several requests for information issued by FINRA staff. 

After a thorough review of the entire record, we find: (1) the Hearing Officer did not commit clear error when he denied Larson's motion to dismiss Enforcement's claims; (2) the Hearing Panel majority erred in finding that Larson lacked the scienter required to commit fraud; and (3) the Hearing Panel properly found that Larson violated FINRA rules by failing to provide promptly full responses to three FINRA requests for information. For the remaining liability findings related to Larson's backdating and provision of falsified records to FINRA, and his filing of a misleading CMA, we affirm these findings, which the parties did not appeal and the Review Subcommittee did not call for review. 

For sanctions, we impose a single bar for Larson's acts of fraud. We affirm, but do not impose in light of the foregoing bar, the two-year suspension and $37,000 fine the Hearing Panel assessed for his failure to respond fully and promptly to multiple FINRA information requests. Finally, we affirm the 18-month suspensions the Hearing Panel assessed for Larson's remaining violations of FINRA rules, although these sanctions are also not imposed because of the bar. 

[A]lthough the Hearing Officer found Enforcement's failure to comply with its discovery obligations "disconcerting," based on both the period of Enforcement's noncompliance and the breadth of its discovery error, he found other factors weighed against dismissing Enforcement's claims. These factors included that the record did not show that Enforcement engaged in willful or contemptuous conduct or acted in bad faith; Enforcement promptly disclosed and admitted its error after learning of it; and Enforcement undertook substantial remediation efforts and completed its production of the newly discovered documents. 

a. Enforcement Discloses a Discovery Lapse

On April 7, 2017, before cross-examining Larson on the hearing's fifth day, Enforcement informed the Hearing Officer it had located in FINRA's files an email that FINRA obtained from Oakbridge during the investigations that led to Enforcement instituting disciplinary proceedings against Larson. Enforcement disclosed it had not identified a copy of the email as an exhibit in its prehearing submissions and failed to make a copy of the email available to Larson for his inspection and copying under FINRA Rule 9251, which imposes on Enforcement a duty to provide a respondent specified, prehearing discovery. After the Hearing Officer sought to determine the scope of Enforcement's discovery lapse, Enforcement informed the Hearing Officer that FINRA's files contained additional documents prepared or obtained in connection with its investigations that Enforcement failed to make available to Larson under FINRA Rule 9251, although it did not know the full extent of its discovery omission. 

b. The Hearing Officer Adjourns the Hearing and Orders Enforcement to File a Declaration Reporting Its Completion of Discovery 

Enforcement's disclosure of a discovery lapse caused the Hearing Officer to adjourn the hearing immediately. The Hearing Officer further ordered Enforcement to file a declaration detailing the steps it had taken to comply fully with FINRA Rule 9251. 

Enforcement filed the requested declaration on April 18, 2017. The declaration detailed Enforcement's failure to produce in prehearing discovery a large volume of emails and other documents that FINRA staff obtained in connection with the investigations that led to Enforcement's claims of Larson's alleged misconduct, a failure Enforcement described as "inadvertent[]."

. . .

Enforcement's declaration stated, however, the physical files for the latter two investigations also included a disc that contained more than 30,000 emails, including attachments, FINRA staff obtained from Oakbridge. The litigation support group never copied the disc's contents to Enforcement's discovery platform Enforcement stated this omission was due to an "apparent miscommunication," but it provided no further details. Because of this oversight, Enforcement did not produce for Larson's inspection and copying the emails contained on the disc, a failure that Enforcement accepted was inconsistent with its duties under FINRA Rule 9251(a).

Enforcement claimed it immediately informed the Hearing Officer of the discovery deficiency when it first learned of it on April 7, 2017. To remediate this error, on April 17, 2017, Enforcement provided Larson all the emails that it failed to produce to him prior to the hearing. To "lessen any prejudice resulting from the late production," Enforcement also provided Larson with a subset of these emails, which consisted of approximately 200 emails that Enforcement determined could arguably be related to the amended complaint's third cause of action or had been identified conducting a keyword search. Finally, Enforcement further reviewed its prehearing discovery production for other possible deficiencies, and it identified and produced to Larson an additional 160 documents and 17 emails that it determined had been "inadvertently omitted." Enforcement's declaration attested that Enforcement did not withhold from this late-produced discovery any material exculpatory evidence and that it had complied fully with FINRA Rule 9251 . . .

Enforcement estimated that the volume of discoverable documents it failed to produce prior to the hearing was greater than double the total number of documents Enforcement provided Larson in prehearing discovery.

(g) Failure to Make Documents Available - Harmless Error

In the event that a Document required to be made available to a Respondent pursuant to this Rule is not made available by the Department of Enforcement, no rehearing or amended decision of a proceeding already heard or decided shall be required unless the Respondent establishes that the failure to make the Document available was not harmless error. The Hearing Officer, or, upon appeal or review, a Subcommittee, an Extended Proceeding Committee, or the National Adjudicatory Council, shall determine whether the failure to make the document available was not harmless error, applying applicable FINRA, SEC, and federal judicial precedent.

The story begins in 2018, with the Government's indictment of Mr. Sadr. After a two-week trial in March 2020, a jury found him guilty on five counts. But in part because of its disclosure failures, the Government later agreed that the Court should grant Mr. Sadr's motion for a new trial, vacate his guilty verdict, and dismiss the indictment against him with prejudice. The Court did just that, thus ending this criminal proceeding with respect to Mr. Sadr-but it is not the end of the matter. As this Court stated to the Government lawyers at trial and in several later orders, the serious and pervasive issues related to disclosure failures and misleading statements to the Court by at least one or more of the Government lawyers must be addressed separate and apart from the resolution of this case against Mr. Sadr. . . .

Almost a century ago, the Supreme Court defined the singular role federal prosecutors

play in our system of justice:

The United States Attorney is the representative not of an ordinary party to a

controversy, but of a sovereignty whose obligation to govern impartially is as

compelling as its obligation to govern at all; and whose interest, therefore, in a

criminal prosecution is not that it shall win a case, but that justice shall be

done . . . . He may prosecute with earnestness and vigor-indeed, he should do

so. But, while he may strike hard blows, he is not at liberty to strike foul ones. It

is as much his duty to refrain from improper methods calculated to produce a

wrongful conviction as it is to use every legitimate means to bring about a just

one.

Berger v. United States, 295 U.S. 78, 88 (1935).

The Government in this case has failed to live up to these ideals. The Court has recounted these breaches of trust, proposed some systemic solutions, urged referral to the Office of Professional Responsibility for admitted prosecutorial failures apparent in the existing record, and ordered further fact-finding. The cost of such Government misconduct is high. With each misstep, the public faith in the criminal-justice system further erodes. With each document wrongfully withheld, an innocent person faces the chance of wrongful conviction. And with each unforced Government error, the likelihood grows that a reviewing court will be forced to reverse a conviction or even dismiss an indictment, resulting in wasted resources, delayed justice, and individuals guilty of crimes potentially going unpunished.

The Court thus issues this Opinion with hopes that in future prosecutions, the United

States Attorney for the Southern District of New York will use only "legitimate means to bring about a just" result. Id. Nothing less is expected of the revered Office of the United States Attorney for the Southern District of New York. That Office has a well- and hard-earned reputation for outstanding lawyers, fierce independence, and the highest of ethical standards. The daily work of the prosecutors in that Office is critically important to the safety of our community and the rule of law. Those who stand up in court every day on behalf of that Office get the benefit of that reputation-but they also have the responsibility to maintain it.

The Court hereby ORDERS that the Acting United States Attorney ensure that all current AUSAs and SAUSAs read this Opinion. Within one week of the date of this Opinion, the Acting United States Attorney shall file a declaration affirming that this has occurred.

The Court FURTHER ORDERS that each of the trial team AUSAs, supervising Unit

Chiefs, and the SAUSA submit the declarations described in Section III no later than October 16, 2020. By October 30, 2020, the executive leadership for the USAO may submit a brief as to why no further proceeding for additional fact-finding or credibility determinations is necessary. Counsel for Mr. Sadr may, if they wish, submit a  responsive filing by November 13, 2020, and the Government a reply by November 20, 2020.

• FINRA
• Enforcement
• Discovery
• Larson
• OHO
• NAC
• CMA
• backdating
• church bonds
• email
• Rule 1122
• Rule 4511
• Rule 9280
• BrokeAndBroker
• Bill Singer